Demystifying the Saving Clause and Re-Sourcing Rules in Treaties
Lori Hellkamp is a partner and Alden DiIanni-Morton is an associate in the Washington office of Jones Day.
In this article, the authors explore two lesser-known provisions in U.S. income tax treaties that can cause unexpected issues for taxpayers trying to claim treaty benefits.
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the views or opinions of Jones Day.
In a global economy, it is not uncommon for businesses to operate with an international footprint or for individuals to live and work in multiple countries over the course of their careers. The network of income tax treaties in place around the world can ease some of the tax frictions inevitable to this reality. The United States currently has income tax treaties with 68 countries.1 Significantly, these treaties seek to facilitate cross-border investment and movement by, among other things, reducing or eliminating the excess (double) taxation that can otherwise result. That said, U.S. taxpayers and even tax professionals sometimes fail to appreciate some of the impediments to this goal inherent in many U.S. treaties. While countless articles have discussed the “limitation on benefits” clause in U.S. treaties — perhaps the most well-known potential roadblock to treaty access — this article focuses on two other, less-known (or at least, less-understood) provisions: the presence of a saving clause and the absence of a re-sourcing provision. These two dry and technical provisions, which are usually buried within the dense text of other articles, can pose a trap for the unwary by producing unexpected, and generally unfavorable, tax results for U.S. taxpayers — including sometimes turning off treaty benefits entirely.
A primary goal of U.S. income tax treaties is to alleviate double taxation when each country views a taxpayer as its own resident or claims the right to tax the same income. The United States’ magnanimity has limits, however. U.S. treaties typically contain a saving clause, which can add significant complexity to the determination of a U.S. person’s tax liability by essentially turning off, in whole or in part, otherwise available treaty benefits. Similarly, the absence of a (sufficiently robust) re-sourcing provision can sometimes render ineffective the U.S. foreign tax credit by which double taxation is supposed to be relieved.
A. Saving Clause
All U.S. tax treaties have a saving clause2 permitting the United States to continue to tax its own citizens and residents3 — and in many cases, former citizens and noncitizen residents4 — as if the treaty were not in effect.5 Translated into plain English, this means that the United States, subject to some exceptions discussed below, can impose U.S. tax on U.S. persons (and some former U.S. persons) despite anything to the contrary in the relevant treaty. Fundamentally, treaties do not alter the U.S. system of worldwide taxation, and U.S. persons remain subject to U.S. income tax even if they are foreign residents under a treaty’s tiebreaker provision or have (only) foreign operations and income. Further, U.S. citizens residing abroad will not be entitled to all the treaty benefits allowed to other, similarly situated residents of the same foreign country because of the operation of the saving clause.
The saving clause is most often (but not always) found in the general scope, personal scope, or miscellaneous articles of U.S. tax treaties. For example, the current U.S. model treaty has a saving clause in the general scope provision,6 while the relevant language in the treaties with Canada and France is in the miscellaneous provision.7 Regardless of where it is located, a typical saving clause will generally contain language similar to this:
Notwithstanding any provision of the Convention, a Contracting State may tax its residents (as determined under [the Residence article]), and by reason of citizenship may tax its citizens, as if the Convention had not come into effect.8
The saving clause is, however, typically tempered by exempting specific provisions from its application — although which ones are carved out varies from treaty to treaty and can sometimes further vary depending on the relevant U.S. person’s citizenship or immigration status.9 U.S. treaties generally exempt three core articles from the saving clause: (1) relief from double taxation, (2) nondiscrimination, and (3) access to mutual agreement procedures. Perhaps the most important among these, and the most relevant for purposes of this article, is the relief from double taxation (or sometimes the elimination of double taxation) provision, without which the utility of a treaty would be significantly diminished.10
Many treaties exempt additional benefits beyond these three core articles from the saving clause.11 For example, the U.K.-U.S. treaty also exempts the articles on associated enterprises, pensions, social security, annuities, alimony and child support, pension schemes, government service, students, teachers, diplomatic agents, and consular officers.12 On the other hand, the Morocco-U.S. treaty offers additional exemptions for only visiting students, trainees, and government employees, while the Greece-U.S. treaty contains no exemptions.13
B. Re-Sourcing Income
Also relevant, and just as capable of potentially turning off treaty benefits, are the re-sourcing rules — or rather, some treaties’ lack thereof.
While U.S. tax treaties seek to prevent double taxation, the principal mechanism for actually relieving double tax generally remains subject to U.S. domestic law. Specifically, the relief from double taxation article typically provides that the United States will allow an FTC to a U.S. person against their U.S. federal income tax liability for taxes paid or accrued to a foreign treaty country to prevent double taxation. In general, the FTC granted by a treaty is not broader than the FTC permitted by U.S. domestic law and is made available only “in accordance with the provisions and subject to the limitations of” domestic U.S. law.14
Because the U.S. FTC permitted by a treaty remains subject to domestic law requirements and limitations, when a treaty allows the foreign country to tax income that is viewed, under U.S. law, as U.S.-source income, the U.S. taxpayer may be unable to claim a U.S. FTC unless that income is re-sourced to the foreign country. In other words, when the income in question is not viewed as foreign-source income by the United States, U.S. FTCs may not be available to offset all the foreign taxes borne, despite the existence of the treaty and the benefits purportedly conferred under its relief from double taxation article. This is because under U.S. domestic law, FTCs are generally available only for foreign taxes paid on foreign-source (not U.S.-source) income.15 Therefore, the re-sourcing provisions come into play when there is a discrepancy between the relevant sourcing rules of the code and the assignment of taxing rights under the treaty. The application of a re-sourcing provision can allow U.S.-source income subjected to foreign tax by the foreign country under the terms of the treaty to be considered foreign-source income for U.S. FTC purposes.
For example, the key re-sourcing language in the 2016 U.S. model treaty provides:
For the purposes of applying [the relief from double taxation paragraph granting a U.S. FTC], an item of gross income . . . derived by a resident of the United States that, under this Convention, may be taxed in [foreign treaty country] shall be deemed to be income from sources in [foreign treaty country].16
The specifics of the re-sourcing language can vary significantly from treaty to treaty, but the language is typically contained in the relief from double taxation article.17 Some treaties contain comprehensive re-sourcing rules, which generally ensure that any income the other country is permitted to tax in accordance with the treaty will be deemed foreign-source income for U.S. FTC purposes.18 These broad provisions are the most helpful for U.S. taxpayers. This approach also seems to be Treasury’s current preferred approach based on the 2006 and 2016 model treaties.19 Many older U.S. treaties, however, still contain more limited re-sourcing rules, which apply in only some of the circumstances in which a foreign treaty country is permitted to tax amounts potentially viewed as U.S.-source income under the code.20 Commonly, these provisions are limited to providing relief in situations in which the affected U.S. taxpayer is a U.S. citizen resident in the foreign treaty country and do not address situations in which the U.S. taxpayer is a U.S. citizen resident in the United States or a corporation.
There are also some treaties containing re-sourcing rules that are made expressly “subject to” domestic source rules.21 These treaties are the subject of much debate, as a re-sourcing provision that is literally subject to, and thus possibly trumped by, domestic source rules could be read to mean that any conflicting domestic sourcing rules (for example, sections 861-865) apply instead of the treaty. Under this reading, a treaty would defer to the code in the event of any sourcing conflict, effectively rendering the treaty re-sourcing rules moot. Presumably this is not the intent.22 Finally, there are also treaties with no re-sourcing language at all.23
This discussion would be incomplete without highlighting a couple of additional, practical points. First, even when treaty re-sourcing is available for the relevant income, it is still generally the section 901 FTC that is the mechanism by which double taxation relief is granted. Consequently, just as is so often the case outside of the treaty context, there will frequently be at least some leakage because of the various requirements and limitations of section 904 (for example, separate basket limitations, required expense allocations, and so forth). Also, any item of income re-sourced by a treaty is generally subject to its own special, separate basket limitation and cannot be cross-credited.24
Second, when re-sourcing is unavailable under the relevant treaty and double taxation results, a taxpayer can still seek recourse by pursuing competent authority relief. Practically, however, this can be costly and take significant time to resolve. Requesting competent authority assistance also does not provide any guarantee of a favorable outcome. Alternatively, if no U.S. FTC is available, the foreign taxes paid may be deductible under section 164 (although a deduction is generally less favorable than a credit).
Finally, a few code-based re-sourcing elections may be available in narrow circumstances under section 865(h) (certain gains from the sale of stock and certain intangibles), section 904(h)(10) (certain dividends and interest),25 and section 245(a)(10) (certain dividends), if the relevant income is taxed by a foreign country under an applicable treaty but would be considered U.S.-source income in the absence of re-sourcing relief.
Broadly speaking, U.S. income tax treaties can, and do, successfully operate to ensure that U.S. taxpayers qualifying for treaty benefits are taxed only once on most (if not all) of their income. There are, however, situations in which the interaction of treaty provisions and U.S. domestic law can undermine the availability of treaty benefits that would otherwise theoretically be available — and that many assume are available. That is why when these issues arise, both the taxpayers trying to claim treaty benefits and their advisers can be caught by surprise. In practice, problems most commonly occur when the U.S. income tax rate exceeds the applicable foreign rate or the absence of re-sourcing relief means income taxed by the foreign country is characterized as U.S.-source income under domestic law. The following examples are intended to illustrate these potential issues in some common fact patterns.
Example 1: Assume the U.S. income tax treaty with Country A generally permits the imposition of tax on capital gains by only the country of residence and contains a traditional saving clause and a tiebreaker clause to determine residency for purposes of the treaty. John, a U.S. citizen living in Country A and a Country A resident under the treaty, owns stock in a U.S. company (US Co.). John is exempt from Country A taxes on certain capital gains under a Country A tax holiday regime. While the holiday is still in effect, John sells all his US Co. stock and assumes that, as a resident of Country A, he is not subject to U.S. tax on the resulting gain because the treaty exempts Country A residents from U.S. capital gains tax. However, John is incorrect: The saving clause overrides the treaty’s capital gains article. Accordingly, all of John’s gain is subject to U.S. income tax, and no U.S. FTC is available because no Country A taxes were paid on the gain. Further, even if Country A had imposed some amount of tax on John’s gain, to the extent that tax was less than the applicable U.S. tax rate, John would still generally be required to pay the difference to the United States because the available FTC would be less than the applicable U.S. tax.26
Example 2: Assume the U.S. income tax treaty with Country B permits the imposition of tax by Country B on certain shareholders for the gain attributable to the sale of stock in a company if that company is itself resident in Country B or holds material Country B real estate.27 Further assume that the treaty with Country B contains a traditional saving clause and has either no re-sourcing provision or a very limited re-sourcing provision. Holdco, a Delaware corporation and U.S. resident for purposes of the Country B-U.S. treaty, owns stock in Country B Corp. (B Co.). B Co. holds significant rental real estate, most of which is in Country B. When Holdco sells its B Co. stock, Holdco is subject to Country B income tax on the gain in accordance with the treaty. Under U.S. domestic law, all that gain is generally U.S.-source income under section 865(a) and would be subject to U.S. corporate income tax. Accordingly, if this gain is not able to be re-sourced under the Country B-U.S. treaty, double taxation could result — although Holdco may be able to make an affirmative section 865(h) election.
Example 3: Assume the U.S. income tax treaty with Country C generally permits the imposition of tax on a resident’s wages and other services income by only the country of residence and contains (1) a tiebreaker clause to determine residency for purposes of the treaty, (2) a traditional saving clause, and (3) limited or no re-sourcing provisions. Alice, a U.S. citizen and resident of Country C under the terms of the Country C-U.S. treaty, lives in Country C and is employed by a Country C employer. Occasionally, Alice travels to the United States to perform work for her employer. While the income from employment article of the Country C-U.S. treaty generally exempts her wage income from U.S. income tax (which is taxed by Country C) because she is a Country C resident, the saving clause overrides this article.28 Accordingly, Alice is still (also) subject to U.S. income tax on all her wage income29 and must rely on the U.S. FTC to avoid double taxation — and will still generally be subject to U.S. taxation to the extent of any difference between the Country C rate and applicable U.S. income tax rate (if the U.S. rate is higher). Further, if there is no re-sourcing provision or the treaty’s re-sourcing provision does not apply to the portion of her wages attributable to her work performed in the United States, she has double taxation exposure because those amounts are generally U.S.-source income under section 861(a)(3).30
Example 4: Assume the U.S. income tax treaty with Country D permits withholding on royalties that, under the treaty, are generally deemed to arise in the country of the payer’s residence.31 The Country D-U.S. treaty also contains a traditional saving clause but limited or no re-sourcing rules. IP Co., a U.S. corporation, licenses U.S. intellectual property rights to a resident of Country D, for which a royalty is paid to IP Co. Under the royalties article in the Country D-U.S. treaty, Country D withholding (at the prescribed reduced rate) is permitted. IP Co. may, however, have difficulty taking a U.S. FTC for the Country D tax withheld unless re-sourcing relief is available, as the tax would generally be viewed for U.S. tax purposes as having been imposed on U.S.-source income under section 861(a)(4).
U.S. income tax treaties are an important tool for helping taxpayers manage cross-border taxation in a global economy. In most cases, the U.S. treaty network provides an adequate framework for ensuring that taxpayers avoid double taxation and enjoy nondiscriminatory tax treatment and access to administrative procedures for resolving issues that arise. However, it is always important to take into consideration the potential effect of the saving clause and whether re-sourcing relief is or may be available, because failure to do so can lead to unpleasant surprises when taxpayers try to take advantage of treaty benefits they thought were available.
1 While negotiations are ongoing and several new treaties have been signed in recent years, few protocols and no new treaties have been ratified since 2010 because of political impediments in the Senate.
2 While the treaty with Pakistan, signed in 1957, does not contain a traditional saving clause, U.S. citizens and corporations are excluded from the definition of “resident of Pakistan,” thus essentially producing a similar effect as a saving clause. See Pakistan-U.S. treaty, article 2(1)(i).
3 Generally, a noncitizen is treated as a U.S. resident under domestic law if the person (1) is a lawful permanent resident (i.e., a green card holder), (2) meets the substantial presence test, or (3) otherwise elects to be so treated under section 7701(b). See section 7701(b)(1)(A). Most U.S. tax treaties have tiebreaker rules to prevent an individual from being treated as a resident of both the United States and the other country under the treaty. See, e.g., Australia-U.S. treaty, article 4(2), and 2016 U.S. model treaty, article 4(3). This determination can have a limited effect in some situations, however, because these rules are trumped by the saving clause.
4 Certain former citizens and former long-term residents are often brought within the scope of the saving clause to allow the United States to impose tax under section 877. See, e.g., 2016 U.S. model treaty, article 1(4) (“Notwithstanding the other provisions of this Convention, a former citizen or former long-term resident of a Contracting State may be taxed in accordance with the laws of that Contracting State.”).
5 See, e.g., Netherlands-U.S. treaty, article 24(1); U.K.-U.S. treaty, article 1(4); and 2016 U.S. model treaty, article 1(4).
6 2016 U.S. model treaty, article 1(4).
7 Canada-U.S. treaty, article 29(2), and France-U.S. treaty, article 29(2).
8 Ireland-U.S. treaty, article 1(4) (emphasis added).
9 See, e.g., Mexico-U.S. treaty, article 1(5); see also 2016 U.S. model treaty, article 1(5).
10 As discussed in more detail in the next section, even though the saving clause does not apply to (and thus does not override) the relief from double taxation article, U.S. taxpayers will still need to navigate the gauntlet of domestic law requirements and limitations to claim a U.S. FTC.
11 See 2016 U.S. model treaty, article 1(5).
12 U.K.-U.S. treaty, article 1(5).
13 Morocco-U.S. treaty, article 20(4), and Greece-U.S. treaty, article 14(1). An interesting variation on this is the China-U.S. treaty, which appears to contain no exemptions from the saving clause for U.S. citizens. See 1984 Protocol to China-U.S. treaty, section 2. The technical explanation (TE) clarifies, however, that it is understood that the benefits of the core provisions (relief from double taxation, nondiscrimination, and MAP) are not subject to the saving clause. See China-U.S. treaty TE, article 1.
14 See, e.g., Netherlands-U.S. treaty, article 25(4); Switzerland-U.S. treaty, article 23(2); and 2016 U.S. model treaty, article 23(2). Because of the U.S. system of worldwide taxation, it generally falls on the United States (rather than the treaty partner) to provide a credit against U.S. tax to relieve double taxation resulting from a person’s U.S. citizenship. But see 1992 Protocol to Russia-U.S. treaty, section 8(a) (credit required to be granted by Russia against the Russian tax on income generally includes a credit for U.S. income taxes paid by U.S. citizens imposed solely by reason of their U.S. citizenship).
16 2016 U.S. model treaty, article 23(3).
17 See, e.g., 2016 U.S. model treaty, article 23. There is also sometimes sourcing language in operative provisions specific to the type of income being addressed (see, e.g., Spain-U.S. treaty, article 11(5)) or in dedicated sourcing provisions in older treaties (see, e.g., Israel-U.S. treaty, article 4, and South Korea-U.S. treaty, article 6). Most of these provisions are subject to the saving clause, however, which is why the re-sourcing language contained in (or incorporated by cross-reference into) the relief from double taxation article can be important, as then it is insulated from the effects of the saving clause and clearly intended to be available for U.S. FTC purposes. See, e.g., TE to 2006 Protocol to Germany-U.S. treaty, article 12.
18 See, e.g., Mexico-U.S. treaty, article 24(3) and (4)(c); Germany-U.S. treaty, article 23(2) and (5)(c); and Japan-U.S. treaty, article 23(2) and (3)(c).
19 2016 U.S. model treaty, article 23(3) and (4)(c); and 2006 U.S. model treaty, article 23(3) and (4)(c).
20 See, e.g., Denmark-U.S. treaty, article 23(2)(c); France-U.S. treaty, article 24(2)(b); Switzerland-U.S. treaty, article 23(3)(c); South Africa-U.S. treaty, article 23(2)(c); Pakistan-U.S. treaty, article 15(3); and Netherlands-U.S. treaty, article 25(6)(c) and (7).
21 See, e.g., India-U.S. treaty, article 25(3); Luxembourg-U.S. treaty, article 25(4); Sweden-U.S. treaty, article 23(4); Austria-U.S. treaty, article 22(4); and Thailand-U.S. treaty, article 25(3).
22 It seems far more likely Treasury negotiated the “subject to domestic source laws” language to accommodate only the special and limited sourcing rules in section 904, specifically section 904(h) (previously codified at section 904(g)). Indeed, the better answer, and the one that more closely aligns with Treasury’s stated treaty policy of preventing double taxation, is that the “subject to” language should not cause domestic sourcing rules to override a treaty’s re-sourcing concessions in every instance of conflict but rather in only the narrow and specific instances clearly contemplated by Congress under the source maintenance rules of section 904(h). See, e.g., New York State Bar Association, “Report on Treaty Re-Sourcing Rules,” at 28-30 (Nov. 24, 2014); Warren Crowdus, “The Interaction of Treaty and Code Source Rules,” J. Int’l Tax’n (Apr. 2002). Guidance from Treasury confirming this interpretation would certainly be well received by the tax bar, however.
23 See, e.g., Hungary-U.S. treaty; U.S.-Venezuela treaty; Morocco-U.S. treaty; Poland-U.S. treaty; and Greece-U.S. treaty.
24 See section 904(d)(6). Although a discussion of the domestic FTC rules is beyond the scope of this article, there may be situations in which a taxpayer chooses not to use an available treaty re-sourcing benefit because of the effect of section 904(d)(6) on the taxpayer’s FTC calculations.
25 Although the better answer is that this election is also available when a treaty’s relief from double taxation provision is made expressly subject to domestic source rules, the TE to the Luxembourg-U.S. treaty casts some doubt on this interpretation (albeit rather unpersuasively) by asserting that a section 904(h)(10) election is unavailable. See TE to Luxembourg-U.S. treaty, article 25; but see TEs to each of the other treaties with this “subject to” language, supra note 22 (containing no language precluding the election). Further, many authorities explicitly contemplate permitting the election in the treaty context. See, e.g., reg. section 1.904-5(m)(7)(i); TE to 2006 U.S. model treaty, article 23(3); TE to 2006 Protocol to Germany-U.S. treaty, article 12(2); TE to Belgium-U.S. treaty, article 22(3); and TE to Japan-U.S. treaty, article 23(2).
26 For similar facts, see, e.g., Cole v. Commissioner, T.C. Summ. Op. 2016-22 (Israel-U.S. treaty’s capital gain exemption does “not stand alone, and its effect is completely eliminated here under the saving clause . . . since petitioner is a United States citizen” (citing Filler v. Commissioner, 74 T.C. 406, 410 (1980))).
27 Most U.S. treaties in effect generally allow the foreign treaty country to impose tax on gains from the sale of shares in a company if the assets of that company consist of significant real (“immovable”) property located in that country. (This is essentially a reverse-FIRTPA right.) See, e.g., France-U.S. treaty, article 13(2)(b); Australia-U.S. treaty, article 13(2)(b); and Netherlands-U.S. treaty, article 14(1)(b). Some treaties also permit taxation of a U.S. person by the other country on gain attributable to the sale of stock in a company resident in that foreign country if the U.S. seller meets (or met) a prescribed ownership threshold (see, e.g., China-U.S. treaty, article 12(5); Israel-U.S. treaty, article 15(1)(e); and Kazakhstan-U.S. treaty, article 13(3)) or if the other country’s domestic law would otherwise permit taxation of that gain (see, e.g., India-U.S. treaty, article 13).
28 See also 2020 Competent Authority Agreement, Italy-U.S. treaty, article 19 (“Pursuant to the saving clause . . . the United States retains its right to tax the income of its citizens and lawful permanent residents as if there were no convention. . . . As such, a U.S. citizen or lawful permanent resident would not be entitled to claim the benefit of [the relevant treaty provision] to exempt remuneration from U.S. federal income tax. Rather the individual would be subject to tax in both the United States and Italy.” (Internal quotations omitted.)); Abrahamsen v. Commissioner, 142 T.C. 405, 410-411 (2014) (saving clause overrides relevant treaty article for U.S. person); Savary v. Commissioner, T.C. Summ. Op. 2010-150, at 4-5 (same); Filler, 74 T.C. 406 (same); LTR 9628024 (same); FSA 1999-792 (May 20, 1993) (same).
30 See also Savary, T.C. Summ. Op. 2010-150, at 9-10 (no U.S. FTC available for U.S.-source income earned by U.S. citizen resident in France). Similar re-sourcing complications can arise if a U.S. citizen or resident performs services in the United States as a director of a foreign company because some U.S. treaties do not limit the foreign country’s right to tax directors’ fees to only compensation for services performed in that foreign country. See, e.g., Denmark-U.S. treaty, article 16, and Switzerland-U.S. treaty, article 16. In these situations, the foreign country and the United States may both seek to tax the U.S. person on those fees. To the extent they are attributable to services performed in the United States, such fees would generally be U.S.-source income for FTC purposes under section 861 unless re-sourcing relief is available.
31 See, e.g., Italy-U.S. treaty, article 12(6).