Will a U.S. Tax Treaty Apply to a U.S. State’s-Imposed Tax?

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Two countries form a treaty under the general principles of contract law. A fundamental aspect of contract law requires a meeting of the minds – a shared understanding of the agreed terms. Accordingly, unless expressly stated, a treaty ought to apply only to the two contracting sovereigns. But this is about tax law, tax treaties, and, more importantly, an exploitation point for statutory interpretation. States may, under certain theories of interpretation, be bound to the provisions of a tax treaty between the United States and a foreign country.

A state that defers to the definition of gross income provided in the Internal Revenue Code (“The Code”) opens the door to a persuasive interpretation of law requiring a state to follow a U.S. tax treaty. The Code defines gross income as all income from whatever source derived except as otherwise provided in this subtitle.[1] While one may stop at section 61, the definition forces one to look at other sections of the Code that limit or modify the definition. Section 894 modifies the definition of income and links it to the application of tax treaties. Section 894(a)(1) provides that the provisions of the Code shall be applied to any taxpayer with due regard to any treaty obligation of the United States which applies to such taxpayer. Without an express limitation under a state’s tax laws on the definition of income, these provisions may apply.

When a state makes the choice to depend on the federal government for its laws, it receives the whole bag of tricks of freedoms, limits, and restrictions – the good, the bad and the ugly – and ought to be bound by such. A different conclusion would allow states or state officials to selectively choose an interpretation that best suits a particular set of facts. The citizens would be unable to find or rely on interpretations outside of state-mandated tax guidance and would lose confidence in the elected officials. A state legislature may restrict application of a U.S. tax treaty to its laws. However, a state may also universally accept/adopt the Code’s Section 61 definition.

Alternatively, the U.S. model tax treaty provides express language that the U.S. tax treaty applies only to federal taxes imposed on a taxpayer by the Internal Revenue Service.[2] While such language suggests limiting the taxpayer from availing itself to the tax treaty, a state’s tax form generally requires a declaration of the amount of federal gross income.[3] The states that elect this method of income reporting understand that what constitutes gross income will be limited by other sections of the Code. Logically, a taxpayer that follows its income reporting with a good faith belief that income, taxed by a foreign country, is exempt or excluded under a particular treaty ought to be able to appeal to the treaty to prevent double taxation. However, the application of a U.S. tax treaty to a state that utilizes its own definition of income or gross income may not be appropriate.

A second part will follow this part one in a series on the applicability of a U.S.-based tax-treaty to taxes imposed at the state level. Please stay tuned to learn about how another Contracting country would handle a tax imposed by U.S. State.


[1] I.R.C. §61

[2] U.S. Model Tax Treaty, Art. 2(3)(b).

[3] I.R.C. §61

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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