Bilateral Tax Agreement

What Is a Bilateral Tax Agreement?

A bilateral tax agreement, a type of tax treaty signed by two nations, is an arrangement between jurisdictions that mitigates the problem of double taxation that can occur when tax laws consider an individual or company to be a resident of more than one country.

A bilateral tax agreement can improve the relations between two countries, encourage foreign investment and trade, and reduce tax evasion.

Key Takeaways

  • A bilateral tax agreement is a treaty established between nations for the purpose of avoiding double taxation on their citizens for income earned in either country.
  • When an individual or business earns income or invests in a foreign country, the issue of which country should tax the investor’s earnings may arise.
  • Both countries may enter into a bilateral tax agreement to determine which country should tax the income to prevent the same income from getting taxed twice.
  • Tax treaties such as these can also foster stronger economic, diplomatic, and political ties over the long run.

Understanding Bilateral Tax Agreements

Bilateral tax agreements are often based on conventions and guidelines established by the Organization for Economic Cooperation and Development (OECD), an intergovernmental agency representing 38 countries.

The agreements can deal with many issues such as taxation of different categories of income (i.e., business profits, royalties, capital gains, employment income), methods for eliminating double taxation (e.g., via the exemption method and credit method), and provisions such as mutual exchange of information and assistance in tax collection.

As such, they are complex and typically require expert navigation from tax professionals, even in the case of basic income tax obligations. Most income tax treaties include a “saving clause” that prevents citizens or residents of one country from using the tax treaty to avoid paying income tax in any country.

Bilateral Tax Agreements and Residency

A primary consideration is the establishment of residency for tax purposes. For individuals, residency is generally defined as the place of primary domicile. While it is possible to be a resident of more than one country, for tax purposes only one country can be considered the domicile.

Many countries base domicile on the number of days spent in a country, requiring careful record-keeping of physical stays.

For example, most European nations consider anyone who spends more than 183 days per year in-country to be domiciled and thus liable for income tax.

The United States Is Different...

Unique among developed nations, the United States requires all citizens and green card holders to pay U.S. federal income tax, regardless of domicile.

To prevent onerous double taxation, the U.S. provides the Foreign Earned Income Exclusion (FEIE), which for 2022 allows Americans living abroad to deduct the first $112,000 in earnings, but not passive income, from their tax return. For 2023, the amount is $120,000. The earnings can come from either a U.S.- or foreign-based source.

However, if the income is from a U.S. company, the IRS expects the taxpayer and the employer to pay payroll taxes, currently 15.3% in earnings. Income from a foreign source is usually exempt from payroll taxes. Foreign taxes paid on earned income beyond the exclusion amount can often be deducted as a Foreign Tax Credit.

Does the U.S. Have Double Taxation Treaties?

Yes, the U.S. does have double taxation treaties with many countries. Under these treaties, the residents of these foreign countries are eligible for a reduced tax rate or tax exemption from U.S. income taxes on income they earned from U.S. sources.

What Is Bilateral Relief?

Bilateral relief is when two countries come together to determine a way to provide relief from double taxation (being taxed in both countries) on the same income for their residents. Bilateral relief is the agreement designed by the two countries to accomplish this relief.

What Do Bilateral Tax Agreements Cover?

Bilateral tax agreements cover a variety of sources of income, such as wages, salaries, royalties, commissions, and capital gains. Eliminating double taxation can be done in a variety of ways, such as through exemption or credits.

What Is the Benefit of a Double Tax Treaty?

The benefit of a double tax treaty is to prevent an individual from having to pay income tax twice in two or more different countries. The benefit is that it reduces the tax burden on the individual, allowing them more take-home pay.

Article Sources
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  1. Organization for Economic Cooperation and Development (OECD). "Coordination of Bilateral Tax Treaties / the OECD Model Tax Convention."

  2. Organization for Economic Cooperation and Development (OECD). "Our Global Reach."

  3. Internal Revenue Service. "United States Income Tax Treaties - A to Z."

  4. Cornell University, Legal Information Institute. "26 CFR § 301.6362-6 - Requirements Relating to Residence."

  5. European Union. "Income Taxes Abroad."

  6. Internal Revenue Service. "Frequently Asked Questions (FAQs) About International Individual Tax Matters."

  7. Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2023."

  8. Internal Revenue Service. "Foreign Earned Income Exclusion."

  9. Internal Revenue Service. "Topic No. 751 Social Security and Medicare Withholding Rates."

  10. Internal Revenue Service. "Foreign Tax Credit."

  11. Internal Revenue Service. "Tax Treaties."

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