Bilateral Tax Agreement

A bilateral tax agreement, also called a tax treaty, is an arrangement between two 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 jurisdiction. A bilateral tax agreement can improve the relations between two countries, encourage foreign investment and trade, and reduce tax evasion.

Bilateral tax agreements are often based on conventions and guidelines established by the Organization for Economic Cooperation and Development (OECD), an intergovernmental agency representing 35 countries. The agreements can deal with many issues such as taxation of different categories of income (business profits, royalties, capital gains, employment income, etc.), methods for eliminating double taxation (exemption method, credit method, etc.), 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.

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.

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 in 2018 allowed Americans living abroad to deduct the first $104,100 in earnings, but not passive income, from their tax return. 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 around 15 percent of $100,000 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.