The International Tax Corner: Edition 5
What are Treaties?
In the area of international taxation, countries enter into various treaties (agreements). While the most common one deals with income taxation, others deal, separately, with social security and estate, inheritance, and gift taxes.
A treaty is a contract, i.e., a legally binding agreement between sovereign states. While they may have long titles, perhaps boring ones, they’re still contracts. Take for instance the income tax treaty between Mexico and the US. I pick this one for a few reasons – CONVENTION BETWEEN THE GOVERNMENT OF THE UNTIES STATES OF AMERICA AND THE GOVERNMENT OF THE UNITED MEXICAN STATES FOR THE AVOIDANCE OF DOUBLE TAXATION AND THE PREVENTION OF FISCAL EVASION WITH RESPECT TO TAXES ON INCOME.
The original signature date was September 18, 1992. But remember, the US Senate needs to ratify treaties before they can come into force. Each country has its own mechanism. Other relevant dates,
- Treaty in force date: December 28, 1993
- Treaty effective date: In Mexico, from January 1, 1994. In the United States, from January 1, 1994.
- Protocol 1 signature date: September 8, 1994
- Protocol 1 in force date: October 26, 1995
- Protocol 1 effective date: In Mexico, from October 26, 1995. In the United States, from October 26, 1995.
- Protocol 2 signature date: November 26, 2002
- Protocol 2 in force date: July 3, 2003
- Protocol 2 effective date: In Mexico, from January 1, 2004. In the United States, from January 1, 2004. For Article II, from September 1, 2003.
I don’t believe most people ever look at all those dates, but they can be important. Take the instance a few years ago when I was assisting a client with a royalty withholding issue with Spain. At the time, several treaties and protocols were being held up by US Senator Rand Paul, even some that had been negotiated years prior. So, I’m on the phone explaining the US withholding rate under the treaty, and my counterpart keeps raising his voice insisting on a different rate and, essentially, don’t you know how to read?! It took me a minute, but I finally realized he was reading from the Protocol both nations signed; yet the US hadn’t yet ratified. It’s not always super easy, but it’s important you make sure you’re working with the correct version of any treaty. Once I explained the issue, and he explained his incredulity that one Senator could essentially kill (or severely delay a vote on) a treaty, we got along just fine. I’m just glad I grew up on Schoolhouse Rock.
As with any contract, it’s important those impacted know when it becomes effective. For the Mexico-US treaty, Article 29, Entry Into Force, is the key. Paragraph 1 states, The Contracting States shall notify each other when their respective constitutional and statutory requirements for the entry into force of this Convention have been satisfied. The Convention will enter into force on the date of receipt of the later of such notifications. Clearly in my Spain-US treaty example, my colleague hadn’t done all his homework.
Determining when it’s effective may take an abacus, some caffeine and some patience, with the latter two items at times being mutually exclusive. The point is the treaty states when it’s effective. This date can differ depending on the issue involved. Paragraph 2: The provisions of the Convention shall have effect:
a) in respect of taxes imposed in accordance with Articles 10 (Dividends), 11 (Interest), and 12 (Royalties), for amounts paid or credited on or after the first day of the second month next following the date on which the Convention enters into force if the Convention enters into force prior to July 1 of that year; otherwise, on the first day of January of the year following the year in which the Convention enters into force;
b) in respect of other taxes, for taxable periods beginning on or after the first day of January of the year following the year in which the Convention enters into force.
Paragraph 3. touches on a different issue. The existing agreement between the United Mexican States and the United States of America for the avoidance of double taxation of income derived from the operation of ships or aircraft in international traffic concluded by exchange of notes of August 7, 1989, shall terminate upon the entry into force of the Convention. However, the provisions of the said agreement shall continue in effect until the provisions of the Convention, in accordance with the provisions of paragraph 2b), shall have effect.
Those impacted need to understand the complexity of simply determining when a treaty has effect. Other issues are also important, and we’ll get to those in another edition – perhaps the most important is whether a taxpayer (individual/company/etc. may claim treaty benefits). That’s handled by the Limitation on Benefits article the US has in almost every single income tax treaty.
Well-drafted contracts also say when they’re no longer in force. Article 30 of the Mexico-US treaty provides time periods; yet disallows termination prior to 5 years from the date the treaty enters into force, as long as there’s 6 months’ notice. Here’s some more bedtime reading:
Article 30 Termination
1. This Convention shall remain in force until terminated by a Contracting State. Either Contracting State may terminate the Convention at any time after five years from the date on which the Convention enters into force, provided that at least six months prior notice of termination has been given through diplomatic channels. In such event, the Convention shall cease to have effect:
a) in respect of taxes imposed in accordance with Articles 10 (Dividends), 11 (Interest), and 12 (Royalties), for amounts paid or credited on or after the first day of the second month next following the expiration of the six months period;
b) in respect of other taxes, for taxable periods beginning on or after the first day of January next following the expiration of the six months period.
Confusing? Not really. Once you understand that they are agreements, effective dates are not confusing. To use a simple day-to-day example, you always encounter: you “buy” house insurance; does that contract not have an effective date and a termination date? In fact, it even tells you the exact times it becomes effective and terminates.
We’ll do more treaties soon. The key is they’re contracts.
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