Dear Tax Talk,

We are a U.S. corporation doing business in Europe. We provide service and installation of proprietary software to banks. One Spanish company has withheld 10 percent of our invoices as income tax. What do we need to do to avoid paying double tax in the U.S.?

— Gonzalo

Dear Gonzalo,

When corporations do business in various countries, as well as in various states, there is a risk that they may be double-taxed on the same income. The federal government will allow a credit for foreign income taxes paid to another country on income earned in that country. States sometimes also provide a credit or they use a system known as apportionment to avoid double tax.

Corporations claim a foreign tax credit by completing Form 1118 and attaching it to their appropriate income tax return. In order to claim the credit, two key elements are foreign source income and that the tax at issue is based on income (as opposed to value, such as sales tax or the more common overseas tax: value added tax). In the case of services, income is sourced in the country where the services are performed. In your case, this would be Spain.

Income tax usually applies either on a gross basis when it is passive income such as interest, dividends or royalties, or on a net basis such as from the provision of services. Net means the total of your invoices less the direct cost of providing the services such as your payments to your employees as well as indirect costs such as overhead. In your case, the Spanish customer is withholding 10 percent of your invoices, which would be gross basis taxation more akin to royalty income.

There appears to be confusion as to the appropriate taxation in your situation. If you provided services that generated the billing in your invoices, then gross basis taxation is inappropriate. If your billing is strictly income for the licenses to use your software, then it is royalty income and gross basis taxation is appropriate.

The U.S. maintains various treaties with other countries. Article 12 of the U.S. and Spain Income Tax Treaty provides the following:

Notwithstanding other provisions of this paragraph, royalties received as a consideration for technical assistance shall be taxable at the rate applying to the royalties stipulated in respect of the rights or property to which the technical assistance is related. To this effect, the taxable base shall be computed net of labor and of material costs incurred in producing such royalties.

In other words, the treaty provides that your Spanish customer needs to consider your costs when withholding Spanish income tax. Even though you may receive a credit for the Spanish tax withheld, it may be excessive when you consider your costs. Since the matter deals with Spain’s tax system, you should consult an accountant or attorney in Spain for further guidance.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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