What is a “Saving Clause”?
As far as I’m aware, all US tax treaties contain a saving clause. Generally in Article 1 of the treaty, the saving clause is what allows the US to tax based on citizenship when almost every other country on the planet taxes based on residence. In the Australia/US treaty, the saving clause is found in paragraph 3 of Article 1. As explained in the US Treasury Technical Explanation of the Treaty:
“Paragraph 3 contains the traditional “saving clause” under which each Contracting State reserved the right to tax its residents … as if the [Treaty] had not come into effect. The two States also reserve the right so to tax their citizens, individuals electing under their respective domestic laws to be taxed as residents…”
So the “saving clause” saves each country from having to allow treaty benefits to their residents (or citizens).
Article 1, paragraph 4 then carves up the rest of the treaty, specifying specific treaty provisions that the saving clause does NOT apply to.
So, when you’re reading the treaty, you need to check paragraph 4 to see whether a specific treaty provision applies to you as a resident of Australia or as a citizen of the US.
As John Richardson explains, the saving clause GUARANTEES the right of the US to tax US citizens wherever they live.
“Savings clause” in US Tax Treaties guarantees US right of taxation on residents and citizens of other nations
Fixing the Saving Clause
In an ideal world, each country has sovereignty over its own territory. This means that each country should be able to tax the economic activity within its borders without interference. In semi-technical tax jargon, this can be stated as:
The Australian Source income of Australian Residents should be taxable only by Australia.
If a tax treaty exists, its purpose is to specify what each country can tax when residents of one country have income or assets from the other country. The treaty works in conjunction with the tax law for non-resident taxpayers in each country. For example, if you’re not an Australian resident for tax purposes, then Australia will tax you only on Australian Source income under the tax rules for foreign-resident (non-resident) taxpayers. Where there is a treaty, it can override Australian tax law to determine how a particular foreign person is taxed on their Australian income.
The Saving Clause allows the US to reach into the Australian tax base and tax the Australian source income of those Australian resident taxpayers the US claims as citizens. This erodes the ability of the affected US Persons to take advantage of Australian public policy and tax breaks encouraging retirement savings and local investment. The Saving Clause, and the US practice of citizenship based taxation more generally, frustrates Australian domestic policy by allowing a foreign government to apply its own idiosyncratic tax rules to income earned on Australian soil by Australian residents. In the long run, this will disadvantage the affected US Persons and make them more likely to require Australian government assistance in the form of the Age Pension and other social safety net programs in Australia.
Clearly, the main problem is the US practice of taxing non-resident citizens on their worldwide income (Citizenship Based Taxation, CBT) – under CBT US citizens living outside the US are treated as tax-resident in TWO countries simultaneously: wherever they actually live and the US. Without CBT, the Saving Clause wouldn’t matter. The US would still have the right to tax Australian source income, but US tax law wouldn’t actually impose any tax on non-US source income of Australian residents. While Australia cannot change US law, Australia can stand up for its own interests when negotiating treaties and other international agreements with the US.
How can Australia protect its tax base from this exceptional US practice of Citizenship Based Taxation? Until the US changes to the international norm of residence based taxation, there will always be a possibility of some Australian source income being taxed by the US and paid by tax-compliant US citizens resident in Australia. In Explaining the Saving Clause III we propose three possible solutions. The most comprehensive of these is to incorporate into the treaty a “Tax Base Preservation Clause”.
A Tax Base Preservation Clause would provide that income arising in the country of residence can only be taxed by that country of residence. This clause should, at a minimum, apply to all citizens and permanent residents of the country of residence, regardless of what other citizenships (or right of permanent residence) that they may hold. For countries using residence based taxation, this principle is implicit in both their national tax laws and in the way they interpret their international tax treaties. In treaties with the US, however, this principle needs to be explicitly stated. The US can tax its citizens however it wants, as long as it is not taxing the Australian source income of Australian-resident US citizens. In order to have the intended effect, if a Saving Clause remains, the Tax Base Preservation clause must be among those excepted from the Saving Clause.
With a Tax Base Preservation Clause in the treaty, US citizens might still have to file US returns, but the return would include only non-Australian source income plus a Form 8833 stating the treaty position that Australian-source income is not taxable in the US. Since FBAR is required not by the tax code, but by the Bank Secrecy Act, any exemption for FBAR filing on Australian accounts would need to be explicitly mentioned in the treaty.
7 thoughts on “Saving Clause”
Correct, the Saving Clause reserves the right of the U.S. to disregard a treaty claim by U.S. citizens for most treaty benefits. However, Article 18, Paragraph 2, is specifically exempt from the Saving Clause, which is the provision that exempts Australian Superannuation Funds from U.S. taxation.
Mr. Castro where are you licensed to practice law or accounting?
Florida and D.C. have no record of you.
John GREAT to see you on here. The more experts the better
I thought Article 18, Paragraph 1 is the reference the IRS would use for Australian Superannuation funds. My super fund refers to benefits as a “Pension” and it relates to my past employment. I would love for Paragraph 1 to not be in the treaty……but it is. It concerns me as the IRS can have many interpretations of this Article. Have you been successful in defending US citizens / residents in respect of your understanding of the treaty? I would love to see actual testimonies on your web site.
Unfortunately, Article 18 Paragraph 1 is not available to US citizens (or residents) as it is not one of the provisions excepted from the Saving Clause. Furthermore, just because an Australian super fund calls a product a “pension” doesn’t mean that it is necessarily a pension under US tax law or the treaty. The position taken by Mr Castro (and others) is that Superannuation is a government mandated program, similar to a privatised social security scheme, and therefore falls under Article 18 Paragraph 2 rather than Paragraph 1.
The position of the IRS on this is far from settled. Documents released under FOI indicate that their thinking (at least a couple of years ago) was that Super was like an unqualified retirement plan (e.g. 402(b)), but this has not been challenged in court or formalised with a Revenue Ruling. In my opinion, the uncertainty is the big problem. If the IRS would formally rule on how they think they can tax superannuation, then a) it would relieve the uncertainty faced by US taxpayers with superannuation and b) it would give us something to discuss with Australian policy makers when they get around to negotiating a revised treaty.
John- what is meant by the use of “may” in the saving clause?
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