This is part 2 of a three part series explaining how the Saving Clause works in international tax treaties. In part 1, we saw how international transactions are taxed for almost 90% of the world’s population under Residence Based Taxation (RBT). We looked at the example of Maria, an Australian resident with rental income in Santiago Chile. Maria pays tax to Chile on the rental income, but is not required to report or pay tax in Chile on any of her Australian income. On her Australian tax return, Maria reports the Chilean rental income and is able to deduct the tax paid in Chile from her Australian tax. Essentially, Chile has the first right to tax Chilean source income.
Part 2 – Adding a Saving Clause
At this point we’re going to make one small change to our example. Instead of being a Chilean citizen with property in Santiago, what if Maria is an American citizen with property in San Diego? While this seems like a minor change, there are actually TWO major differences. First, Maria is now a US citizen. The US is the only country in the world to tax its citizens on their worldwide income, wherever they live in the world, using the same rules that apply to US residents. This practice of citizenship based taxation (CBT) is what causes most of the problems that Maria will face. But, the tax problem of CBT is amplified by the second difference: the tax treaty between Australia and the US contains a saving clause.
As a US citizen living in Australia, Maria now has TWO countries that claim the right to tax her on all of her worldwide income. In fact, both countries will be taxing her under resident tax rules – for tax purposes she lives in TWO countries! This causes a problem. Which country gets the first claim on taxing Maria’s income? The general rule here (which can be modified by the treaty) is that the country where the income arises has the first claim on Maria’s income and the other country must allow a tax credit for tax paid to the source country.
So, back to Maria’s taxes: with regard to the income on the rental property, there’s actually no difference from the initial scenario. Maria will pay US tax on the US-source rental income and will get a credit for that US tax against the Australian tax on the same rental income. The difference is the treatment of Maria’s Australian Source income. Because the US applies CBT, the US claims the right to tax Maria’s Australian Source income – her salary, superannuation, Australian investments – using the same rules as those that apply to US resident taxpayers. Since this income is Australian Source, Maria is able to reduce her US tax liability with a credit for taxes paid to Australia on the same income. If the US and Australia had the same tax rules, then this wouldn’t be much of a problem (a hassle, yes, but the credit for Australian tax would generally offset all of the US tax). The problem comes when the US taxes income that’s not taxed in Australia, or applies different rules for computing taxable income.
Wait a minute, why doesn’t the tax treaty with the US stop this? After all, Australia is already taxing Maria on her worldwide income. Allowing the US to tax the San Diego rental property makes sense, but not her Australian source income. For example, Article 15 of the tax treaty says:
(1) Subject to the provisions of Article 18 (Pensions, Annuities, Alimony and Child Support) and 19 (Governmental Remuneration), salaries, wages and other similar remuneration derived by an individual who is a resident of one of the Contracting States in respect of an employment or in respect of services performed as a director of a company shall be taxable only in that State unless the employment is exercised or the services performed in the other Contracting State. …
Yes, treaties are difficult to read! For the moment, we’ll assume that Maria is employed by an Australian company and performs all the duties of her job in Australia. Maria is a resident of Australia (“one of the Contracting States”), so this clause says her income can only be taxed in Australia unless she actually works in the US (“the other Contracting State”). Why, then, does the US get to tax Maria’s salary? Because Maria cannot use Article 15 of the treaty!
Yes, that’s right. Because Maria is a US citizen, she is only allowed to use a small part of the Australia/US Tax Treaty. This is due to the “Saving Clause”. Remember what Article 1 of the Australia/Chile Tax Treaty looked like? It was just one sentence. Here’s the equivalent article of the Australia/US Tax Treaty:
(1) Except as otherwise provided in this Convention, this Convention shall apply to persons who are residents of one or both of the Contracting States.
(2) This Convention shall not restrict in any manner any exclusion, exemption, deduction, rebate, credit or other allowance accorded from time to time:
(a) by the laws of either Contracting State; or
(b) by any other agreement between the Contracting States.
(3) Notwithstanding any provision of this Convention, except paragraph (4) of this Article, a Contracting State may tax its residents (as determined under Article 4 (Residence)) and individuals electing under its domestic law to be taxed as residents of that state, and by reason of citizenship may tax its citizens, as if this Convention had not entered into force. For this purpose, the term “citizen” shall, with respect to United States source income according to United States law relating to United States tax, include a former citizen or long-term resident whose loss of such status had as one of its principal purposes the avoidance of tax, but only for a period of 10 years following such loss.
(4) The provisions of paragraph (3) shall not affect:
(a) the benefits conferred by a Contracting State under paragraph (2) of Article 9 (Associated Enterprises), paragraph (2) or (6) of Article 18 (Pensions, Annuities, Alimony and Child Support), Article 22 (Relief from Double Taxation), 23 (Non-Discrimination), 24 (Mutual Agreement Procedure) or paragraph (1) of Article 27 (Miscellaneous); or
(b) the benefits conferred by a Contracting State under Article 19 (Governmental Remuneration), 20 (Students) or 26 (Diplomatic and Consular Privileges) upon individuals who are neither citizens of, nor have immigrant status in, that State (in the case of benefits conferred by the United States), or who are not ordinarily resident in that State (in the case of benefits conferred by Australia).
Paragraph (3) contains the Saving Clause – it “saves” (or reserves) the ability of the US to tax its citizens on Australian source income! It does this by saying that the US can tax its citizens as if the treaty didn’t exist! Paragraph (4) gives US citizens resident in Australia the ability to use a very limited subset of the treaty provisions. There’s no mention of Article 15 in paragraph (4), so Maria can’t use it to exclude her Australian salary from US tax.
So, what parts of the treaty can US citizens living in Australia use to exclude Australian source income from their US tax return? Only the parts listed in Article 1 paragraph (4):
- Paragraph (2) of Article 9 relates to business enterprises, and is not likely to be applicable to individuals.
- Paragraph (2) of Article 18 relates to Social Security or other public pensions – these are taxable only by the country paying the pension. US Social Security benefits are taxable only by the US and Australian public pensions (and arguably superannuation) are taxable only by Australia.
- Paragraph (6) of Article 18 relates to alimony child support payments – these are taxable only in the country where they arise. A US citizen receiving child support under an Australian court order is not taxed on that child support on their US tax return.
- Article 22 provides for foreign tax credits to avoid double taxation.
- Article 23 says that neither country can have tax rules that discriminate against citizens of the other country. That is, the US cannot have tax laws that treat Australian citizens living in the US any worse than US citizens living in the US, and vice versa.
- Article 24 provides procedures for the “competent authority” in the two countries to agree between themselves on the meaning or application of the treaty.
- Paragraph (1) of Article 27 specifies the “source” of income for the purpose of determining which country has to provide a foreign tax credit. Generally, the source country has the first right of taxation and where the income is also taxed in the non-source country, that country must provide a credit (under Article 22) for taxes paid to the source country.
That’s it! Because of the Saving Clause, Maria must prepare her US tax return as if the rest of the treaty didn’t exist!
In summary, the purpose of the saving clause is to allow the US to tax the Australian source income of Australian resident US taxpayers. This is directly contrary to the principle that we started with in Part 1:
The Australian Source income of Australian Residents should be taxable only by Australia.
In Part 3 of this series we will explore the effect of removing the saving clause (without changing the US practice of CBT) plus other changes Australia might ask for in the treaty to stop the US from taxing the Australian source income of Australian residents.