How is a Foreign Tax Treaty Made?

Tax treaties can control whether or not certain types of foreign source income need to be reported for federal income tax purposes. Tax treaties don’t directly control whether or not an FBAR (Foreign Bank Account Report, FinCEN Form 114)must be filed. However, if under an international tax treaty income is not reported that can have an impact on whether or not penalties will be asserted by the IRS for failure to file an FBAR. Sometimes clients ask our tax lawyers how tax treaties are made. Here is an explanation adapted from IRS training materials that we obtained pursuant to a Freedom of Information Act (FOIA) Request.

The responsibility to negotiate tax treaties (from the Office of the International Tax Counsel, Department of Treasury).

After a tax treaty is drafted, it is signed by diplomatic agents for each country. The tax treaty is then sent to the President of the United States for his signature. After that a letter of transmittal is sent to the Senate requesting approval of the President’s ratification of the treaty.

The tax treaty is referred by the Senate to the Committee on Foreign Relations, which then conducts tax treaty hearings. After the Committee’s deliberations, it may report on the Senate floor with the recommendation that the tax treaty be approved as negotiated, or that the Senate approve the tax treaty with certain amendments, reservations, or understandings. The Committee may also decline to report the tax treaty favorably.

Following Committee action, the tax treaty is reported to the full Senate, which must advise and consent to the tax treaty’s ratification by a vote of two-thirds of the members of the Senate that are present. As of the end of 2014 several tax treaties have been held up by Senator Rand Paul under the Senate’s rules which permit one Senator from bringing a motion for a vote to the floor. This is referred to placing a “hold” on the treaty. No new tax treaties or treaty updates have been approved by the Senate since 2010, when Paul was first elected.

If the tax treaty is approved without reservation or amendment, the President may then exchange instruments of ratification with the foreign government (assuming the foreign government has also completed its internal procedures to ratify the tax treaty). If the Senate has approved the tax treaty with a reservation or amendment, it may be necessary to renegotiate portions of the tax treaty before the foreign country will ratify it. If the renegotiation is limited in scope, it will ordinarily be done in the form of a protocol by a two-thirds vote as if it were a separate tax treaty.