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By Thomas St.G. Bissell, Esq.
A recent commentary by this author discussed the potential double-tax issues that can arise where a nonresident alien who is resident in a tax treaty country and employed by a foreign "disregarded entity" (DE) of a U.S. company makes business trips into the United States.1 Similar double-tax issues may also arise where a U.S. citizen who is resident in a tax treaty country makes business trips into the United States, and where the individual's employer is a DE owned directly by a U.S. parent company.
In the case of a U.S. citizen 2 who is resident outside the United States and working in a non-tax-treaty country, double tax problems can arise with respect to the citizen's salary allocable to U.S. business trips (U.S.-source salary). The reason is that the United States is the only developed country that taxes its citizens on their worldwide income even if they are resident outside the country of their citizenship, and thus a U.S. citizen who is resident in a foreign country must file an annual tax return on Form 1040 to report his worldwide earned income (subject only to possible exclusion of foreign-source salary under §911). Thus, a highly paid U.S. citizen who visits the United States on business is likely to be subject to a relatively high average U.S. personal income tax rate. Although he may reduce his U.S. tax under §901 by claiming a foreign tax credit for some or all of his foreign income taxes, the credit may not be claimed against the portion of his U.S. tax that is allocable to his U.S.-source earned income. If the foreign country where he is resident taxes the same U.S.-source earned income – a common situation where the U.S. citizen is paid from a non-U.S. payroll – and does not allow a full tax credit for U.S. tax on that income (and does not otherwise exclude the U.S.-source earned income in calculating his taxable income), unrelieved double taxation may result.
Because of this potential problem for U.S. citizens based in non-treaty countries, most recent U.S. income tax treaties contain a complex set of rules to ensure that double taxation is relieved in this situation. If a U.S. citizen is resident in a tax treaty country that taxes his worldwide income,3 Article 23.4 of the U.S. Treasury's 2006 Model Income Tax Treaty contains rules that are intended to relieve potential double taxation and in effect to tax the individual on a "net basis" at the higher of the two countries' average tax rates. This is accomplished in the following way:
1. If the United States has the right under the treaty to tax an item of U.S.-source income that would be realized by a nonresident alien who is resident in the treaty country, a "theoretical" U.S. tax is calculated on the particular item of U.S.-source income. This theoretical U.S. tax is equal to the U.S. tax that would have been imposed on the hypothetical nonresident alien. In most cases, this theoretical tax will be lower than the effective rate of U.S. tax that is imposed (before calculation of the U.S. foreign tax credit) on the particular U.S. citizen's U.S.-source income.4
2. The theoretical U.S. tax is then credited against the treaty country's income tax that is imposed on the item of U.S.-source income that is realized by the U.S. citizen.
3. If the theoretical U.S. tax is lower than the actual U.S. tax that is imposed by the United States on that income (as will usually be the case), the United States will "re-source" a portion of the income and treat it as foreign-source income, so that a sufficient amount of the incremental tax imposed by the treaty country on the U.S.-source income may be credited against the U.S. citizen's U.S. tax under §901 (contrary to the general §901 rule that does not permit the U.S. tax on U.S.-source income to be reduced by a credit for foreign income taxes, even if imposed on the same U.S.-source income) in order to relieve double taxation. Although this step in the calculation can be complex, it is clearly illustrated in the Technical Explanation to Article 23 of the U.S. Treasury's 2006 Model Treaty.5
The effect of these calculations is to impose effective tax on the item of U.S.-source income at the higher of the "average" tax rate on the income in either the United States or in the treaty country, but not at a still higher effective rate. Thus, the calculations are intended to prevent economic double taxation from occurring, while dividing up the total tax revenue on the item in an equitable manner between the two governments.
However, if the U.S. citizen is employed by a foreign DE that is directly owned by a U.S. company, unrelieved double taxation can potentially occur if: (1) the treaty country tax authorities assert that the United States would have no right to impose the "theoretical" tax on a hypothetical nonresident alien employee of the DE who was resident in the treaty country on the grounds that a hypothetical alien resident in the treaty country should be exempt from U.S. tax under the treaty's "Dependent Personal Services" article (because his employer, the DE, should be considered to be resident in the treaty country and not in the United States); and (2) if the IRS disagrees with the treaty country authorities (as presumably it would). Thus, the treaty country might not allow the U.S. citizen to claim a foreign tax credit for any theoretical U.S. tax under step 2, above. If the IRS disagreed, it is unclear whether the IRS would permit all of the U.S.-source salary to be re-sourced to the foreign country (so as to allow a full foreign tax credit against U.S. tax for the treaty country's income tax) or only an allocable portion of the U.S.-source salary. If only a portion of the salary could be re-sourced, then the U.S. citizen could be subject to worldwide tax at an average rate that is higher than the average rate in either country.
As an example (adapted from "Example 2" in the Treasury's Technical Explanation to Article 23.4 of its 2006 Model Treaty), assume that the U.S. citizen realizes $100x of U.S.-source income allocable to U.S. business trips and that the relevant tax rates on that income are as follows: (1) the U.S. tax rate on a hypothetical nonresident alien earning this $100x is 15%; (2) the average rate of U.S. tax on the U.S. citizen's worldwide income (including his U.S.-source salary income) is 35%; and (3) the average rate of income tax in the treaty country on the U.S. citizen's worldwide income (including his U.S.-source salary income) is 40%. If the two countries agree that the United States has the right to tax the U.S.-source salary paid by the DE to the U.S. citizen, the U.S. citizen's net U.S. tax on the U.S.-source income will be $15x and the net treaty country tax on the same income will be $25x, resulting in total worldwide tax on the income of $40x. No onerous double taxation will occur, because the total tax of $40x is equal to the average rate of tax in the treaty country.
However, if the treaty country tax authorities argue that the United States has no right to tax the $100x of U.S.-source salary, the treaty country will impose $40x of tax on the income with no credit for the theoretical $15x of U.S. tax. Assuming that the IRS disagrees and considers that the United States has the right to tax a hypothetical alien who earns the same $100x U.S.-source salary, the United States will still impose $15x of U.S. tax. As a result, total tax on the U.S.-source salary will equal $55x (i.e., $40x of treaty country tax plus $15x of U.S. tax).
As discussed in the previous article with respect to nonresident aliens, the special DE employment tax regulations cannot avoid this problem, because for U.S. tax purposes it is believed that the DE must still be disregarded in doing the reciprocal credit calculations under Article 23 of the model treaty. To the extent that double taxation does occur in practice, however, potential relief should be available under the Competent Authority provisions of the relevant treaty.
In certain treaty countries it may be possible to avoid (or minimize) this problem by arranging for the U.S. citizen to have a "dual contract" with the U.S. multinational group. For example, the U.S. parent company might arrange to pay salary for U.S. business trips directly under a separate employment contract, and separately from the salary that is otherwise paid by its DE subsidiary with respect to business days worked within the treaty country. If the income tax laws in the treaty country permit the U.S. citizen to avoid paying tax to the treaty country on salary received from a non-treaty-country employer for days worked outside the treaty country, the double tax problem could be avoided.6 In order to strengthen the argument that the employee was exempt from tax in the treaty country on his U.S.-source salary, however, it may be advisable to ensure that the "benefit" of his services within the United States inures to the U.S. employer, and that no chargeover of his U.S.-source salary is made to the DE for corporate income tax purposes.
This commentary also will appear in the July 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, and Williamson, 943 T.M., U.S. Income Tax Treaties — Provisions Relating Only to Individuals, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation, and ¶7160, U.S. Income Tax Treaties.
3 The United States will tax this income because a U.S. citizen or resident alien is subject to U.S. personal income tax on worldwide income. It is assumed for purposes of this discussion that the individual is subject to the treaty country's income tax on his worldwide income, and that no special exclusions or deductions are available under that country's tax law with respect to salary for work done outside that country (whether in the United States or in a third country) where the individual's employer is a company that is resident in the treaty country for purposes of the treaty country's tax laws. See, however, the clarification of this concept in footnote 6, below.
4 In the case of salary allocable to U.S. workdays, the applicability of the lower tax brackets to the hypothetical nonresident alien would almost always result in a theoretical U.S. tax lower than the actual tax imposed at the average U.S. tax rate that applies to the actual U.S. citizen or resident alien, because only the alien's U.S.-source income would be taken into account. In addition, if the hypothetical alien realizes U.S.-source income that is taxed at a flat U.S. withholding rate under the treaty – such as U.S.-source dividends, which are usually subject to a flat treaty rate of 15% – the theoretical U.S. tax on that income will almost always be lower than the average rate of U.S. tax on the U.S. citizen's income.
6 The tax laws of the United Kingdom and of several other European countries generally permit this kind of tax planning for certain employees who are working for a limited period of time within the country. It has been assumed throughout this commentary that if the treaty country's tax laws do permit salary allocable to foreign business trips to be excluded from gross income in the treaty country, that exclusion is only available if the salary is paid by an employer that is not resident in the treaty country. Because most treaty countries will consider a DE that is incorporated in the treaty country to be resident in the treaty country, any exclusion for salary allocable to foreign business trips would usually not be available with respect to salary paid by the DE.
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