Congratulations to South African Charl Schwartzel for rising above the rest of the competitive field and capturing the Green Jacket in the 2011 Masters Tournament. Of the $8 million total prize purse, Charl takes home $1.44 million for his first place finish. Before taxes, of course.
A fundamental principle of international taxation is that the country in which income is earned—also known as the “source” country—has the primary right to tax the income. If the taxpayer is a resident of the source country, then the source country and resident country are the same. When the source country is not the taxpayer’s country of residence, however, the resident country only has residual taxing rights on the income. Sometimes, the source country relaxes its primary taxing rights on the income by law or treaty.
As noted, Mr. Schwartzel is a resident of South Africa. Can he also be considered a U.S. resident? Under the Internal Revenue Code, a non-U.S. citizen is considered a U.S. resident for tax purposes under the “substantial presence” doctrine if the taxpayer (i) spends at least 31 days in the U.S. during the tax year in question and (ii) has a weighted average of 183 days spent in the U.S. over the present year and prior two years. But, if the non-U.S. citizen spends fewer than 122 days in the U.S. during the tax year, the taxpayer is exempt from substantial presence.
We don’t know how many days Mr. Schwartzel will spend in the U.S. in 2011. Now that he’s recently joined the PGA Tour and plans to play in about 18 U.S. events, it’s very possible he will satisfy the substantial presence test. In that case, the analysis is simple: Uncle Sam has no limitations on taxing the $1.44 million in winnings. If Mr. Schwartzel is not a U.S. resident in 2011, however, the analysis is different.
In general, income of foreign persons that is effectively connected to a U.S. trade or business is taxed on a net income basis. In other words, like a U.S. resident, the foreign person may deduct operating costs from gross income and pay tax on the resulting net income. Certainly, if Mr. Schwartzel participates in 18 U.S. golf events in 2011, he will have effectively connected income to a trade or business. Accordingly, Uncle Sam taxes the Masters Tournament income as if Charl was a U.S. resident, unless a tax treaty applies to change the result.
The purpose of tax treaties is to reduce source country taxation that would otherwise be imposed on residents of a treaty partner under the source country’s tax law. Treaties may only reduce tax imposed on nonresidents; they never increase it.
Under most tax treaties, the business profits in the source country of a foreign taxpayer are subject to tax in the source country only if the profits arise through a permanent establishment in the source country. Many treaties, however, have specific provisions that address the business profits of athletes and entertainers. The United States-South Africa Tax Treaty is no exception.
Specifically, Article 17, “Entertainers and Sportsmen,” governs the tax treatment of Mr. Schwartzel’s winnings from the 2011 Masters Tournament. The first paragraph states if the income is not taxable in the source country under other articles in the treaty, then the source country may tax the income unless the gross profits are less than $7,500. For Mr. Schwartzel, this means Uncle Sam gets paid in full.
If you’ve made it this far, you can easily see that the issues regarding the taxation of income earned by foreign athletes are not straightforward. As fellow tax blogger Kay Bell recently discussed, professional and non-U.S. resident golfers Retief Goosen and Sergio Garcia are currently in dispute with the IRS regarding the U.S. income tax treatment of endorsement earnings.