A week rarely passes without a call from someone who demonstrates a misunderstanding of U.S. tax rules and regulations due to bad tax advice they received. The advice may have come from a friend or a family member, but sadly, it usually comes from a tax advisor who is not familiar with the intricacies of international tax.
Well, this week was no different than most in that respect. A U.S. citizen, let’s call him Hans, who has worked in Austria his entire adult life, called our office with questions about how the U.S.- Austria tax treaty applies to him. He had previously been advised, like many others, that a tax treaty with the U.S. overrides domestic U.S. law. (Technically this is true and it is what the treaty states, but keep reading). It is this domestic U.S. law that requires U.S. citizens to report and pay tax on their worldwide income based on their U.S. citizenship; rather than their residence, like most countries.
So let’s look a little more closely at Hans’ particular case. As it turns out, Hans is a former UN employee and, as such, he gets his UN pension tax free in Austria. He has no interest or ambition to move to the U.S., and according to the U.S.- Austria tax treaty, you pay tax on your pension in your country of residence. This sounds great for Hans because he is an Austrian resident, and, as previously stated, former UN employees in Austria receive their pensions tax-free in Austria! Here is the catch. If the U.S. chooses to invoke what is known as the “savings clause”, Hans will have to pay U.S. tax on his UN pension income even though his pension is income he earned exclusively outside of the U.S., and the fact that it won’t be taxed in his country of residence, Austria.
The savings clause is in almost every U.S. tax treaty. What the savings clause does is preserve or “save” the right of each country to tax its own residents and citizens as if the tax treaty didn’t exist. The clause totally negates the language of the treaty so that, in this particular case, the U.S. can do whatever it wants with regards to taxing its citizens and residents. Our friend Hans a, U.S. citizen, would be required to pay tax on his UN pension income in the U.S., even though it is tax-free in Austria, if the U.S. chooses to invoke the savings clause.
This doesn’t mean that Hans can’t claim that his pension income is not subject to U.S. tax based on the tax treaty, but is it worth the risk, since if the U.S. invoked the savings clause he would owe a bunch of tax? It is a tough question to answer, and if the U.S. invokes the savings clause Hans could be subject not only to U.S. tax, but also penalties and interest!
If you need help evaluating how a tax treaty, including the savings clause, applies to your situation, give us a call. Our international tax advisors are well versed in tax treaties and how they apply to U.S. citizens and residents.