What is a Tax Treaty?
A tax treaty is an agreement between two countries regarding how they tax each other's citizens.
How Does a Tax Treaty Work?
In the U.S., residents of foreign countries that have tax treaties with the U.S. are taxed at a reduced rate or are exempt from paying U.S. taxes altogether. The reduced rates and exemptions vary widely among the countries that have tax treaties with the U.S.
For example, let's assume that John is a Canadian citizen who owns his own company. John's company earned $10,000 last year, and some of the revenue was from business conducted in the U.S. Because of the tax treaty between the U.S. and Canada, John's business profits are not subject to taxation by the U.S. government.
Generally speaking, tax treaty benefits are reciprocal, meaning that they apply in both treaty countries.
Why Does a Tax Treaty Matter?
Tax treaties do not lower the U.S. taxes owed by U.S. residents. American residents must pay U.S. income tax on their "worldwide" income. Interestingly, some states in the U.S. do not honor provisions of U.S. tax treaties; others do.