Countries often impose withholding taxes on payments to nonresidents for the performance of services. For instance, the U.S. imposes a 30% withholding tax on certain U.S. source payments, including payments for services, to nonresidents. Code §§871(a)(1)(A) and 881(a)(1). The U.S. withholding tax is only imposed on “U.S. source” income. In the context of services, this generally means services performed in the U.S. Code §861(a)(3) and Treas. Reg. §1.861-4.
A number of countries, however, impose withholding taxes on services payments to nonresidents, regardless of where the services are performed. See, for instance, Chile and Costa Rica. In these circumstances, double taxation can occur.
The U.S. normally avoids double taxation by allowing a tax credit (the “foreign tax credit”) for foreign income taxes paid (foreign gross withholding taxes are generally considered “income taxes” for purposes of Code §901 --- see, for instance, Rev. Rul. 69-446 and Rev. Rul. 74-82).
However, in general the foreign tax credit is limited to the amount of U.S. tax imposed on foreign source income. If services are performed in the U.S., the services would be U.S. source income and the foreign tax credit allowed with respect to that income would be zero. Thus, if another country were to tax services performed in the U.S., the income likely would be subject to both foreign and U.S. income taxes.
U.S. income tax treaties typically prevent this double taxation under “avoidance of double taxation” articles. However, in the absence of a treaty, double taxation can occur.