Saving Clause: Pitfalls when Reading a Tax Treaty

Saving Clause & Tax Treaty Limitations

Saving Clause & Tax Treaty Limitations

Saving Clause & Tax Treaty Limitations: When it comes to reading tax treaties, one of the biggest and most important aspects of a treaty is whether or not there is a saving clause. A saving clause is inserted into each tax treaty in order to limit the applicability of the treaty to certain residents and citizens. For US Citizens and other US Persons, this generally means that the taxpayer will be unable to claim certain benefits that may otherwise be allowable to other residents under the tax treaty, such as avoiding tax on pension.

Let’s take a common example: Taxation of a Foreign Pension for US Citizens living abroad.

Tax Treaty Application

In the common situation, a US citizen resides overseas permanently and is considered an Expat of the United states. They have not formally expatriated, and are therefore  still considered a US person — and  subject to U.S. tax on their worldwide income.

The Taxpayer now reaches the age of retirement (congratulations!) and are ready to begin receiving distributions from a pension plan overseas.

They take a brief look at the treaty which provides the following:

Article 23

Private Pensions and Annuities

• Except as provided in Article 22 (Governmental Functions), pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that Contracting State.

At First Glance the Treaty Shows Signs of Tax Exempt Pension 

This seems like a win for the taxpayer, right?

She resides full-time in career and any pension she receives as a resident of Korea for her past employment is only taxable in that contracting state — which is Korea.

The Saving Clause

This is where the Saving Clause kicks in and limits the benefits of the treaty to a U.S. Citizen living abroad.

What does the Saving Clause Provide?

The IRS frames the Saving Clause as follows:

Saving Clause

• Most tax treaties have a saving clause that preserves the right of each country to tax its own citizens and treaty residents as if no tax treaty were in “effect.”

• However, the saving clause generally excepts specified income types from its application, which may allow you to claim certain treaty benefits even if you are a U.S. citizen or resident.”

With the saving clause, the United States reserves the right to tax US citizens on their worldwide income.

Thus, just because the taxpayer resides full time in Korea does not mean she gets the opportunity to use the treaty in order to minimize otherwise taxable pension.  If the Taxpayer was being taxed in Korea on this pension it would be no big deal, since she can still apply the foreign tax credits — but this is not taxable income in Korea, and so only the US would have the opportunity to tax the pension distribution — absent another provision or tax provision.

Article 4/Paragraph 4 of the US & Korea Tax Treaty

• • (4) Notwithstanding any provisions of this Convention except paragraph (5) of this Article, a Contracting State may tax a citizen or resident of that Contracting State as if this Convention had not come into effect.

What does this Mean

It means that despite what’s provided in the tax treaty, a contracting state such as the United states may still tax a Citizen of that contract state (US) as if there was no tax treaty in effect.

Saving Clause Does Not Apply to All Sections of the Treaty

It is important to note that while the savings clause limits the applicability of the US tax treaty on certain matters, it is not all encompassing and so looking below these sections provide the portions of the treaty which are not impacted by the saving clause.

(5) The Provisions of Paragraph (4) Shall Not Affect

(a) The benefits conferred by a Contracting State under

• • Articles 5 (Relief from Double Taxation)
    •  7 (Nondiscrimination)
    •  24 (Social Security Payments), and
    • 27 (Mutual Agreement Procedure); and

(b) The benefits conferred by a Contracting State under

• • • Articles 20 (Teachers), 21 (Students and Trainees), and 22 (Government Functions), upon individuals who are neither citizens of, nor have immigrant status in, that Contracting State

Savings Clause May Limit Tax Benefits

In conclusion, while a bilateral tax treaty between the United States and foreign country make sure to limit the applicability of certain tax rules — there are limitations, especially when it involves a U.S. citizens. Even if the citizen resides overseas, the saving clause may reduce or eliminate certain tax reduction strategies.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.

Contact our firm today for assistance.