Tax treaty net basis elections.

• Author: Lan, David

There are two basic methods of taxation for foreign taxpayers with income from U.S. sources: net income tax at graduated rates where the foreign person is engaged in a U.S. trade or business, or a 30% tax on gross payments of other fixed or determinable annual or periodic (FDAP) income. Tax treaties reduce the flat 30% rate on gross payments where the FDAP income recipient is a qualified resident of a treaty country. However, treaties may also offer special elections that recharacterize certain types of FDAP income that would otherwise be subject to withholding tax as effectively connected and thus taxable on a net basis at U.S. graduated rates.

Generally, the elections operate by recharacterizing the relevant income as business profits derived from a "deemed" permanent establishment. As business profits, the relevant income is no longer treated as income subject to withholding, but rather as effectively connected business income subject to taxation at U.S. graduated rates and eligible for related expense deductions.

The benefits of making such an election are typically dependent on the applicable withholding rate and the extent to which the taxpayer can offset the relevant income with deductible expenses. Where a high withholding tax rate applies or where significant deductions are available, an election to be taxed at a net basis may reduce or eliminate the taxpayer's effective U.S. tax liability.

The most common election is for income derived from real property (e.g., rental income), but some treaties contain more unusual elections, such as the net basis elections for interest under the U.S.-Israel treaty and royalties under the U.S.-Kazakhstan treaty.

Income from Real Property

An election for income derived from real property to be taxed on a net basis is available in most U.S. tax treaties. The term "real property" is broad and generally encompasses, but is not limited to, any real estate, options, rights, covenants, accessories, agricultural livestock, and forestry equipment situated in the relevant treaty country.

The 2006 U.S. Model Income Tax Convention provides in Article 6(5) that "a resident of a Contracting State who is liable to tax in the other Contracting State on income from real property situated in the other Contracting State" may "elect for any taxable year" to "compute the tax [for any tax year] on such income on a net basis as if such income were business profits attributable to a permanent establishment in such other...