Sometimes it helps to take incredibly complicated things and draw a parallel to something familiar. So, when you have a topic as complex as tax treaties, we better make the comparison really familiar.
Let's start off with the basics – what is a tax treaty and why is it so complicated? The IRS has a nice little definition laid out on their page for tax treaties – "residents (not necessarily citizens) of foreign countries are taxed at a reduced rate, or are exempt from U.S. income taxes…"
So, in its simplest form, a tax treaty is an agreement between two countries that their residents abroad are entitled to reduced, or exempt taxation. Simple, right? Well, not exactly. That's a simple definition for what tax treaties are supposed to be, but it doesn't address the fact that the real world is a lot messier. Throw in the exceptionally complicated tax code, and things are bound to take a turn for the worst.
Where's the analogy?
Now I want you to think back. Scratch that, I want you to think way back. Go all the way back to the first birthday you can remember and give yourself a minute to run over the events of the day. You probably woke up early and laid in bed giddy with anticipation. And then — when you just couldn't take it anymore — you burst out of your room and started off the day's festivities. Before you knew it, your friends and family had made their way over and were congratulating you on being born. And then, the pinnacle of the entire day arrived – cake.
It was chocolate or it was vanilla. No matter which, it was delicious and you couldn't wait to eat it all. But the second you blew out the candles, it was whisked away. And despite your outstretched fingers trying to hold it one last time, you knew you would never see it in its entirety again.
Here's our analogy – that first birthday cake, the one you long for the most, is not so different from a tax treaty. The tax treaties that you can read about on the IRS's website, the ones that were ratified by the Senate, are presented in their entirety. They're whole and they are incredibly attractive. Each one of them provides an opportunity for taxpayers to benefit substantially, and that's something we always like to see.
But then they're taken away, and we're left knowing that what we get isn't going to be the same. Instead, we quickly learn that what we're going to end up with is just a piece of what we once had.
The saving clause
With the IRS, there is always a tripwire. There's always something that completely flips everything you've learned on its head. With tax treaties, this game-changer is known as a saving clause. According to the IRS, "Most tax treaties have a saving clause that preserves the right of each country to tax its own residents as if no tax treaty were in effect."
If you're feeling like this single sentence renders the entire point of tax treaties moot, you're not alone. One has to wonder why the U.S. government would enter into treaties if it had no intention of following them. But it has done this exact thing time and time again, and it continues to do so on a regular basis.
The clawback
There is a counter to a saving clause – a clawback. If this feels like a tennis match, each side giving and taking something during the course of a volley, then you're understanding how frustrating it can be. A clawback is a set of circumstances that overwhelm the saving clause. While the majority of the tax treaty provisions are swept aside by the saving clause, the clawback makes sure that a few of them can't be ignored (i.e., pensions are usually dragged back under the protection of the treaty). If we were to go back to our birthday cake analogy, think of the clawback as the slice of cake that you do get. While it might not be the equivalent of the entire cake that you had minutes before, in certain circumstances, the piece that you get can be the piece that you needed.
Is it a perfect solution? Far from it. But, at the same time, if it's the provisions that you need, a clawback can be your saving grace. In the game of back and forth, it turns out tennis is far more interesting than tax treaties.
Protocols and exchange of notes
The core treaty is in place, significant parts of it are unavailable thanks to the saving clause, and some of it has been resurrected through clawbacks. We're coming to the end, so hopefully, we haven't lost anyone along the way.
Next to come into play are protocols. Protocols are supplements to the treaties themselves; they have to be entered into with the same set of rules, regulations, and procedures. The purpose of a protocol is to give more clarification on aspects of the treaty that are murky or leave too much room for interpretation. For example, if a U.S. person is looking to renounce their citizenship, but the IRS deems that they're doing it solely for tax-avoidance purposes, the IRS holds the right to tell them, "Go ahead, but we're going to continue to tax you like a U.S. person for the next ten years." However, as laid out in the protocols, if it's not for tax-avoidance purposes, then there is no issue.
The question is now begging to be asked – how does the IRS decide who is trying to avoid taxes and who just wants to get the hell outta Dodge? This is where the explanatory notes come into effect. Exchange of notes refers to the notes that each country gives the other in order to explain how they understand the language of the treaty. So, in the notes coming from the U.S., the IRS can elaborate on the treaty and protocols and clarify the things that might be too vague. They can say something like, "This is what we look for when we think someone is renouncing their citizenship for tax-avoidance purposes." Notes are there to lay out the details that aren't necessarily provided in the treaty or protocols.
Global treaties, worldwide taxation
The U.S. is unique in that it taxes its citizens on worldwide income, regardless of where they might live. Please be aware – the U.S. government and the IRS are not joking around. Thanks to FATCA (the Foreign Account Tax Compliance Act) becoming a federal law in March of 2010, U.S. taxpayers are required to disclose all foreign financial accounts exceeding $10,000 in value. This fixation on worldwide taxation also requires foreign institutions to search their records for suspected U.S. persons and disclose their assets and identities to the U.S. Department of the Treasury (if a country doesn’t comply, it could be frozen out of U.S. markets) .
It's important to be aware of your tax obligations, no matter where in the world you might reside. Hopefully you're covered under provisions reclaimed by a tax treaty clawback. However, for many people, this isn't the case. For those people, it's imperative that they understand their obligations in order to avoid hefty fines and criminal allegations. Tax treaties sound nice and incredibly helpful, but as we've seen, they're misleading in what is provided. Having the knowledge and understanding of your worldwide taxation obligations is necessary for all U.S. taxpayers with foreign accounts or residency.
You are not a corporation
Of course you're not a corporation! You're a person, but that also means that you're going to be taxed like a person. Corporations have found a hundred-and-one different ways to avoid U.S. worldwide taxation (or more often, ways to significantly reduce their tax bills). But just because they're able to take advantage of establishing their residency in a non-U.S. country (often by having a smaller, foreign company overtake the larger, U.S.-based corporation), doesn't mean that the same options are available for individual taxpayers. As much as we all might like to get a piece of the "Dutch sandwich" (an international tax-avoidance scheme), it's just not in the cards.
So, despite the fact that corporations are constantly getting away with absurd — and oftentimes perfectly legal (although ethically ambiguous) — schemes, that doesn't mean that you should try and outsmart the IRS. Because when they come knocking, and they always do, they're not going to go easy on someone who tried to make them look foolish.
In conclusion
Tax treaties aren't as simple as the name implies. They're not even close to being as simple as they should be. Instead of just detailing what the taxpayer is privileged to, these treaties are undermined by saving clauses that strip them of their substance. By now you should understand that these treaties are a constant back-and-forth between your rights and what the IRS wants to keep from you. Having a knowledge of what is promised but not delivered on is not something to take lightly. Instead of reading a tax treaty and planning your future around what is provided, you now know that it's necessary to consider the saving clause, clawbacks, protocols, and exchange of notes before making any decisions.
If you find yourself in a situation where a tax treaty might be advantageous to you, vet it thoroughly and make sure that there's nothing hidden in the saving clause that might cause you to stumble. If you're feeling overwhelmed, stop for a minute and take a few deep breaths. There is a lot of information here, and so much of it can have a massive impact on your future – both for saving money and avoiding IRS penalties, fines, and even criminal prosecution. And, if you find yourself feeling completely lost, don't be afraid to reach out and ask for help.
