What Is a Tax Treaty?

A tax treaty is a bilateral—two-party—agreement made by two countries to resolve issues involving double taxation of passive and active income. Tax treaties generally determine the amount of tax that a country can apply to a taxpayer's income, their capital, estate, or wealth.  Some countries are seen as being tax havens. These countries typically do not enter into tax treaties.

A tax treaty is also called a Double Tax Agreement (DTA).

Tax Treaty Explained

When an individual or business invests in a foreign country, the issue of which country should tax the investor’s earnings arises. Both countries – the source country and the residence country – may enter into a tax treaty to agree on which country should tax the investment income to prevent the same income from getting taxed twice.

The source country is the country that hosts the inward investment and is also known as the capital-importing country. The residence country, or capital-exporting country, is the investor’s country of residence. To avoid double taxation, tax treaties may follow one of two models: The OECD Model and the United Nations (UN) Model Convention.

OECD Tax Model

The Organization for Economic Co-operation and Development (OECD) is a group of 36 countries with a drive to promote world trade and economic progress. The OECD Tax Convention on Income and on Capital is more favorable to capital-exporting countries than capital-importing countries. It requires the source country to give up some or all of its tax on certain categories of income earned by residents of the other treaty country. The two involved countries will benefit from such an agreement if the flow of trade and investment between the two countries is reasonably equal and the residence country taxes any income exempted by the source country.

U.N. Tax Treaty Model

The second treaty model is formally referred to as the United Nations Model Double Taxation Convention between Developed and Developing Countries. A treaty that follows the UN—an international organization that seeks to increase political and economic cooperation among its member countries—gives favorable taxing rights to the foreign country of investment. Typically, this favorable taxing scheme benefits developing countries receiving inward investment. It gives the source country increased taxing rights over the business income of non-residents compared to the OECD Model Convention. The United Nations Model Convention draws heavily from the OECD Model Convention.

Withholding Taxes

One of the most important aspects of a tax treaty is the policy on withholding taxes, which determines how much tax is levied on income (interest and dividends) from securities owned by a non-resident. For example, if a tax treaty between country A and country B determines that their bilateral withholding tax on dividends is 10%, then country A will tax dividend payments that are going to country B at a rate of 10%, and vice versa.

The United States has tax treaties with multiple countries, which helps to reduce—or eliminate—the tax paid by residents of foreign countries. These reduced rates and exemptions vary among countries and specific items of income. Under these same treaties, residents or citizens of the United States are taxed at a reduced rate, or are exempt from foreign taxes, on certain items of income they receive from sources within foreign countries. Thus, tax treaties are said to be reciprocal as they apply in both treaty countries. Often, analysts are used to identify these options.