As an expat, understanding how tax treaties and totalization agreements will impact your tax situation is essential. A tax treaty is an agreement between the US and a foreign country that provides relief for those who would otherwise be subject to taxation in both countries. As a US citizen or Green Card holder, you are subject to taxation on worldwide income. If you happen to be a resident of a foreign country for tax purposes, then the tax treaties and totalization agreements could provide significant financial benefits to you. Before diving deep into technical details, let’s first take a look at the difference between these two as they pertain to US persons, which includes US citizens and resident aliens only.
Tax Treaties and Totalization Agreements: What’s the Difference?
Each treaty defines which taxes are covered. All agreements include the federal income imposed by the Internal Revenue Service on form 1040 and the income tax imposed by the foreign country, which varies from country to country. Tax treaties don’t include social insurance known in the US as the social security tax. Social security taxes have various names across the globe. Totalization agreements deal with social security taxes only. A totalization agreement defines which country the tax is paid to and how to deal with credits earned, so it ensures that a person will be eligible for benefits under a system somewhere.
Totalization agreements will only affect self-employed persons and people sent by their employer to work in another country. So, if you are a US citizen working for a US employer in a foreign country, then this applies to you. If you work for a foreign affiliate of the US company, you pay social security tax in the foreign country, but the credits earned there would count toward benefits in both countries. The totalization agreement spells out what happens in a case like this. For self-employed persons, the totalization agreement would tell them what country should be paid the tax. Tax treaties cover income tax, while the totalization agreement covers social insurance.
A Closer Look at Tax Treaties and Totalization Agreements
When dealing with tax treaties, the first thing you need to determine is if you are subject to tax in the US and the country in which you reside. (As a US person, you are subject to tax on worldwide income regardless of where it is earned.) Next, determine if you are subject to tax in your resident country based on their rules.
Now that you know you whether you are subject to double taxation, the next step is to use the tax treaty to avoid double taxation – if only it were that simple. Every tax treaty has a provision in it known as the savings clauses, which allows each country to tax you as if the treaty didn’t exist. This clause means the US can tax citizens as if there was no tax treaty, and the foreign country can tax its residents as if there was no treaty. So does this mean US citizens can’t benefit from tax treaties? Unfortunately, the answer is maybe. Certain benefits provided by the tax treaty override the savings clause so US citizens can make use of them. Each treaty will spell out which parts apply. So, US citizens must look at the treaty to determine what benefits they can use. For US citizens that are residents of the UK, social security benefits would only be taxable in the United Kingdom. However, interest earned on their bank account would be subject to tax in both countries. Specific treaties allow Green Card holders to be taxed in the other country if they elect, but rules are complex. Basically, you should consult a highly trained tax expert before doing this.
Forms to File
If the benefits of a treaty are claimed, you might need to file Form 8833 to alert the IRS of the benefits you claimed. Not submitting the form could cost you $1,000, and if you claim benefits that you aren’t entitled to, then you could be subject to other penalties for underpaying your taxes.
For totalization agreements, let’s look at an example of an independent contractor that works remotely in the United Kingdom. Without the benefits of the totalization agreement, the contractor would pay US self-employment tax on their Form 1040 and national insurance (aka, the UK social security equivalent) in the UK. The totalization agreement states that social security tax should only be paid in the UK so the US person wouldn’t pay US self-employment. Self-employment is often the most significant percentage of tax spent, so this is a considerable savings.
To use the benefits, you must request a certificate of coverage from your host country stating that you are covered by their social charges. Attach this statement to your US income tax. No unique forms are required in order to claim benefits. Each country has different rules for applying to get the certificate. We recommend that you request the letter as soon as possible since it can take a while to receive. Claiming the benefit without a statement is a bad idea; you could be subject to penalties for not paying enough tax.
The benefits provided by these agreements can save you some tax liability, but there are drawbacks, and you must scrutinize them to see if they can benefit you.
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