A Deep Dive into the United States-Canada Income Tax Treaty

The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify U.S. and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The U.S. currently has income tax treaties with approximately 58 countries. This article discusses the implications of the United States.-Canada Income Tax Treaty.

There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the U.S. is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- Canada income tax treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States-Canada income tax treaty and the implications to individuals attempting to make use of the treaty.

Definition of Resident

The determination of an individual’s country of residence is important because the treaty only applies to residents of the United States and Canada.

The term “resident of the United States” means: 1) a business entity formed in the United States, or 2) any other person (except a corporation or any entity treated under United States law as a corporation) resident in the United States for purposes of United States tax, but in the case of an estate or trust only to the extent that the income derived by such person is subject to United States tax as the income of a resident. Section 7701(b) of the Internal Revenue Code treats an alien individual as a U.S. resident where such an individual is 1) lawfully admitted for permanent residence, (26 C.F.R. Section 301.7701(b)-1(b)(1)) “Green card test:” An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.”) (2) meets the substantial presence test, (An individual meets the substantial presence test with respect to any calendar year if i) such individual was present in the United States at least thirty-one days during the calendar year, and ii) the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar year (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ⅙) equals or exceeds 183 days) or iii) makes a first year election.

In contrast, an individual is a deeded resident of Canada if an individual has a continuing relationship with Canada. An individual may also be considered a resident of Canada if he or she has stayed in Canada for 183 days or more.

Because the United States and Canada have their own unique definition of residency, a person may qualify as a resident of both countries. For example, an alien who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of Canada under its definition of resident. To resolve this issue, the United States has included tie-breaker provisions in many of its income tax treaties. Tie-breaker rules are hierarchical in nature, such that a subordinate rule is considered only if the superordinate rule fails to resolve the issue. Article IV(2) of the United States-Canada income tax treaty provides the following tie-breaker for individuals:

a) He shall be deemed to be a resident of the Contracting State in which he has a permanent home available to him; if he has a permanent home available to him in both States or in neither State, he shall be deemed to be a resident of the Contracting State with which his personal and economic relations are closer (centre of vital interests);

b) If the Contracting State in which he has his central of vital interests cannot be determined, he shall be deemed to be a resident of the Contracting State in which he has an habitual abode;

c) If he has an habitual abode in both States or in neither State, he shall be deemed to be a resident of the Contracting State of which he is a citizen; and

d) if he is a citizen of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

Below, please see Illustration 1 which provides an example how a treaty-tie breaker can be analyzed and resolved.

Illustration 1.

Justin Lieber is a citizen and resident of Canada. Lieber owns Zoomtube, a company incorporated in Canada that is in the process of expanding to the much more lucrative U.S. market by opening a branch office in the United States. Lieber is divorced and maintains an apartment in Canada, where he spends every other weekend visiting his children. Lieber’s first wife, who kept their house in their divorce, has never left Canada. Lieber becomes a U.S. resident alien under the substantial presence test as he operates Zoomtube’s U.S. branch. In the United States Lieber owns a luxury condominium in Malibu where he lives with his second wife.

Because Lieber is considered a resident of both the United States and Canada, the treaty tie-breaker procedures must be analyzed to determine which country has primary taxing jurisdiction. With an apartment in Canada and a condominium in the United States, Lieber has a permanent home available in both countries. With Lieber’s children and his home office in Canada as opposed to the lucrative portion of his business and his new wife in the United States, Justin Lieber does not have a center of vital interests in either country. Furthermore, because Lieber regularly spends time in both countries, he arguably has a habitual abode in both. As a result, under the treaty tie-breaker, Justin Leber may be considered a resident of Canada because he is a citizen of Canada.

Dual Resident Companies

Article 2 of the United States- Canada income tax treaty addresses companies that are otherwise considered resident in the United States and Canada. Article 2 Subparagraph 3(a) provides a rule to address a situation when a company is a resident of both countries but is created under the laws in force in only one country. In such a case, the rule provides that the company is a resident only of the country under which it is created. For example, if a company is incorporated in the United States but the company is also otherwise considered a resident of Canada because the company is managed in Canada, Article 2 Subparagraph 3(a) provides that the company shall be considered a resident only of the United States for purposes of the tax treaty.

Limited Liability Companies

Under the United States- Canada income tax treaty, U.S. limited liability companies (“LLCs”) may potentially not be treated as a resident of the United States. The Canadian tax authorities will “look through” a U.S. LLC to determine if it is entitled to treaty benefits for Canadian tax purposes.

Hybrid Entities

Articles IV(6) and (7) of the United States- Canada income tax treaty discusses hybrid entities. A hybrid entity is an entity that is classified as fiscally transparent in one country and fiscally opaque in another country. Article IV(6) is generally a relieving rule that ensures entitlement to treaty benefits when they might otherwise not be available because income is earned through an entity, such as a limited liability company, that the U.S. treats as fiscally transparent but Canada treats as fiscally opaque. Article IV(6) provides that an amount of income, profit, or gain is considered derived by a person resident in one contracting state if: (1) the amount is considered under the state’s tax laws to be derived by that person through an entity (other than an entity that is a resident of the other contracting state); and (2) by reason of that entity being considered fiscally transparent under the first state’s laws, the treatment of the amount under those laws is the same as it would by if the amount had been derived directly by that person.

Permanent Establishment

A central issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all the income from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory or workshop. A permanent establishment also exists if employees or other dependent agents habitually exercise in the host country an authority to conclude sales contracts in the taxpayer’s name.

The  United States-Canada income tax treaty defines a permanent establishment as a fixed place of business through which a resident of one of the Contracting States engages in industrial or commercial activity. This includes the following: 1) a place of management; 2) a branch; 3) an office; 4) a factory; 5) a workshop; and 6) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources. The treaty specifically excludes certain activities from the definition of permanent establishment. Some of these activities are: 1) the use of facilities for the purpose of storage, display, or delivery of goods or merchandise belonging to the resident; 2) the maintenance of a stock of goods or merchandise belonging to the resident for the purpose of storage, display, or delivery; 3) the maintenance of a stock of goods or merchandise belonging to the resident for the purpose of processing by another person; 4) the purchase of goods or merchandise, or the collection of information, for the resident; and 5) Advertising, the supply of information, scientific research or similar activities which have a preparatory or auxiliary character, for the resident.

A resident of a Contracting State shall not be deemed to have a permanent establishment in the other Contracting State merely because such resident carries on business in that other State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

Marketing products in either the United States or Canada solely through independent brokers or distributors does not create a permanent establishment, regardless of whether these independent agents conclude sales contracts in the exporter’s name. In addition, the mere presence within the importing country does not create a permanent establishment. Please see Illustration 2 and Illustration 3.

Illustration 2.

USAco, a domestic corporation, markets its products through the internet to Canadian customers. Under the United States-Canada Income Tax Treaty, the mere solicitation of orders through the internet does not constitute a permanent establishment. Therefore, USAco’s export profits are not subject to Canadian income tax.

Illustration 3.

USAco decided to expand its Canadian marketing activities by leasing retail store space in Vancouver, Canada in order to display its goods and keep an inventory from which to fill foreign orders. Under the United States-Canada income tax treaty, USAco’s business profits would still not be subject to Canadian income taxation as long as USAco does not conclude any sales through its foreign office. However, if USAco’s employees start concluding sales at the Vancouver office, USAco may have a permanent establishment in Canada,

The United States-Canada income tax treaty provides a special rule for an enterprise that provides services but does not have a permanent establishment. If an enterprise meets either of the two following tests, the enterprise will be deemed as providing services through a permanent establishment. First, the services must be performed in the other country by an individual who is present in that other country for a period or periods aggregating 183 days or more in any twelve-month period. Second, during the period or periods, more than 50 percent of the gross active business revenues of the enterprise (including revenue from active business activities unrelated to the provision of services) must consist of income derived from the services performed in that country by that individual. If the enterprise meets both of these tests, the enterprise will be deemed to provide services through a permanent establishment. This test is employed to determine whether an enterprise is deemed to have a permanent establishment by virtue of the presence of a single individual. For purposes of this test, the term “gross active business revenues” means the gross revenues attributable to active business activities that the enterprise has charged or should charge for its active business activities, regardless of when the actual billing will occur or of domestic law rules concerning when such revenues should be taken into account for tax purposes. Such activities are not restricted to the activities related to the provision of services. However, the term does not include income from passive investment activities.

Anti-Treaty Shopping Provision (Limitation on Benefits)

Because tax treaties provide lower withholding rates on dividend, interest, and royalty income, individuals who are not residents of either treaty country may attempt to take advantage of a treaty. This practice is known as “treaty shopping.” Anti-treaty shopping provisions also known as limitation on benefits (or “LOB”) provisions target such individuals or corporations. The principal target of a LOB provision is a corporation that is organized in a treaty country by a resident of a non-treaty country merely to obtain the benefits of that country’s income tax treaty. Therefore, even if a corporation qualifies as a resident of the treaty country, that corporation is not entitled to treaty benefits unless it also satisfies the requirements of the treaty’s LOB provision.

Like most tax treaties, the United States-Canada income tax treaty contains a LOB provision, designed to prevent “treaty shopping” by residents of third countries. The LOB Article provides that the tax benefits provided by the United States- Canada income tax treaty is restricted to residents of Canada or the U.S. that either: 1) are qualifying persons” or (2) satisfy one of three specific tests relating to their establishment, operation, or ownership.

For purposes of the treaty, a “qualifying person” means a resident of the United States or Canada that is: (1) natural person; (2) Canadian or U.S. political subdivision; (3) a company or trust whose “principal class of shares” or units is primarily and regularly traded on one or more “recognized stock exchanges;” (4) a company, if five or fewer companies or trusts own directly or indirectly, more than 50% of the aggregate votes and value of the shares of the company and more than 50% of the votes and value of each disproportionate class of shares (other than certain distressed preferred shares), provided that each company or trust in the chain of ownership is a “qualifying person;” (5) companies or trusts that are not primarily owned, directly or indirectly, by other than qualifying persons, provided the amount of the expenses deductible from the gross income of such entities, which are paid or payable, directly or indirectly, to persons other than “qualifying persons,” is less than 50% of the relevant entity’s gross income for the applicable period; (6) an estate; and (7) certain not for profit or tax-exempt entities.

Where a resident of the United States is not a “qualifying person” for purposes of the treaty, the resident may still be entitled to claim certain Canadian tax benefits provided the person is engaged in the active conduct of a U.S. trade or business. Although the U.S. Internal Revenue Code and its Regulations do not provide a precise definition of the term “active conduct of a U.S. trade or business,” the Internal Revenue Service (“IRS”) has defined “trade or business” as “an activity carried on for livelihood or for profit. For an activity to be considered a business, a profit motive must be present and some type of economic activity must be involved. It is disguised as an activity purely for personal satisfaction. A business usually has regular transactions that produce income. To carry out these transactions, it has to incur a number of expenses. The difference between the amount of money it takes in and the amount it pays out is its profit or loss. If in one year the business has a loss because there is little or no income to offset expenses, there may be a question as to whether a business carried on that year.” See IRC Pub. No. 334, Tax Guide for Small Business.

To the extent such an active trade or business is undertaken in the United States, treaty benefits may be available in respect of income derived by the U.S. resident in Canada “in connection with or incident to that trade or business” (including any such income derived directly or indirectly by that person through one or more other persons that are residents in Canada), but only if that trade or business is “substantial” in relation to the activity carried on in Canada giving rise to the income in respect to the treaty benefits claimed.

Finally, a company may claim a beneficial treaty position if it satisfies the derivative benefits test. Its purpose is actually to expand treaty benefits to a corporate resident in either contracting state with respect to an item of income. This test applies to closely held corporations that cannot otherwise qualify for treaty benefits to obtain treaty relief. Similar to the ownership-base erosion test, the derivative benefits test also consists of two parts, both of which must be satisfied. The first part requires at least 95 percent of the aggregate voting power and value of the corporation be owned, directly or indirectly, by seven or fewer shareholders who are equivalent beneficiaries. An “equivalent beneficiary” is a person who is the resident of another country that has entered into its own bilateral income tax treaty with the U.S. and who is entitled to the benefits of that other treaty as either an individual, a contracting state (or subdivision), a publicly traded company, or a qualified pension fund or tax-exempt organization within the meaning of the other treaty. However, the benefits afforded to the person by the other treaty (or by any domestic law or other international agreement) must be at least as favorable as the ones afforded by the current treaty under which the person is an equivalent beneficiary. For example, if the other treaty subjects the person to a rate of tax on dividends, interest, or royalties that is higher than the rate applicable under the current treaty, then the person would be disqualified from being an equivalent beneficiary under the current treaty.

The second part of the derivative benefits limits a corporation’s payments that are deductible for tax purposes in the contracting state where the corporation is a resident to be less than 50 percent of its gross income for the taxable year. However, the second parts of both tests differ in who they define to be a restricted recipient of the deductible payment. In the case of the derivative benefits test, restricted recipients include 1) recipients who are not equivalent beneficiaries, 2) recipients who are equivalent beneficiaries only because they function as a headquarters company for a multinational corporate group consisting of the corporation and its subsidiaries, and 3) recipients who are equivalent beneficiaries that are connected to the corporation (by at least a 50 percent ownership interest) and benefit from a special tax regime with respect to the deductible payment. Like the ownership-base erosion test, the payments limited by this second part of the test do not include arm’s-length payments made in the ordinary course of business for services or tangible property.

The U.S. income tax treaty with Canada broadly allows residents of any jurisdiction that has an income tax treaty with the U.S. to be treated as equivalent beneficiaries. In contrast, the U.S. treaties with Belgium, Sweden, and Finland limit equivalent beneficiaries to residents of a country in the EU or EEA, residents of a NAFTA country, and residents of Switzerland. The U.S. treaty with Mexico is even narrower, limiting equivalent beneficiaries to residents of a NAFTA country.

Personal Services Income

United States-Canada income tax treaty provisions covering personal services compensation are similar to the permanent establishment clauses covering business profits in that they create a higher threshold of activity for host country taxation.
Income from personal services under the treaty is compensation received by a person through employment or self-employment. Under the treaty, employment compensation in the form of wages or salaries derived by a resident of the United States or Canada is taxable only in the country of residence, unless the employment takes place in the other country. In other words, if a person receives compensation from employment in the country of residency, then the country of residency will tax that compensation. However, if that employment takes place in the other country, the compensation may be taxed by the other country.

The United States- Canada income tax treaty provides exceptions to entertainers, government employees, students, and apprentices. For entertainers from the U.S., the treaty excludes C $15,000 in gross receipts from Canadian income tax. There is also an exclusion of C $10,000 under the treaty for U.S. athletes participating in team sports in Canada. Employee athletes on a team with regularly scheduled league games in both the United States and Canada receive an exemption. For employees of a government agency, their salaries or wages related to the discharge of their services are exempt from taxation.

Related Persons

Article IX of the United States-Canada income tax treaty addresses transactions between related persons in the contracting states and permits the tax authorities of each country to adjust the amount of the income, loss, or tax payable to reflect an arm’s-length scenario. In other words, if the Canadian tax authorities adjust the income from a transaction in which a U.S. person was involved, the IRS may make a corresponding adjustment to that individual’s U.S. income tax liability. Internal Revenue Code Section 267(b) has defined a related party to include: 1) brothers and sisters; 2) spouses; 3) ancestors and lineal descendants (father, son, grandfather); 3) entities that are more than 50 percent owned, directly or indirectly, by individuals, corporations, trusts, and partnerships; and 4) controlled groups (any two entities that are both owned more than 50 percent by the same party).

Income from Real Property

Tax treaties typically do not provide tax exemptions or reductions for income from real property. Consequently, both the home and host country maintain the right to tax real property. Article VI of the United States-Canada income tax treaty provides that income derived by a Canadian resident from U.S. real property may be taxed in the United States and vice versa.

Dividends

Article X of the United States-Canada income tax treaty governs dividends. Article X of the treaty limits the amount of tax on dividends to 15 percent of the gross amount of dividends. The definition of the term dividends is intended to cover all arrangements that yield a return on an equity investment in a corporation. The term dividends includes income from shares, or other corporate rights that are not treated as debt under the law of the source State.

Subparagraph 2(a) of Article X of the United States-Canada income tax treaty limits the amount of tax that may be imposed on dividends by the Contracting State in which the company paying the dividends is a resident if the beneficial owner of the dividends is a resident of the other Contracting State. The treaty limits the rate to 5 percent of the gross amount of the dividends if the beneficial owner is a company that owns 10 percent or more of the voting stock of the company paying the dividends.

For example, assume USCa, a U.S. corporation, directly owns 2 percent of the voting stock of CanCo, a Canadian company that is considered a corporation in the United States and Canada. Further, assume that USCo owns 18 percent of the interests in the LLC, an entity that in turn owns 50 percent of the voting stock of CanCo. CanCo pays a dividend to each of its shareholders. Provided that LLC is fiscally transparent in the United States and not considered a resident of Canada, USC’s 9 percent ownership in CanCo through LLC (50 percent x 18 percent) is taken into account in determining whether USCo meets the 10 percent ownership threshold. In this example, USCo may aggregate its voting stock interests in CanCo that it owns directly and through LLC to determine if it satisfies the ownership requirement for purposes of satisfying the 10 percent threshold.

The treaty expands the treatment of dividends to Real Estate Investment Trusts (“REIT”). REITS are not eligible for the 5 percent maximum rate on tax and provide that the 15 percent maximum rate on withholding tax applies to dividends paid by REITs only if one of three conditions is met. First, the dividend will qualify for the 15 percent maximum rate if the beneficial owner of the dividend is an individual holding an interest of not more than 10 percent in the REIT. Second, the dividend will qualify for the 15 percent maximum rate if it is paid with respect to a class of stock that is publicly traded and the beneficial owner of the dividend is a person holding an interest of not more than 5 percent of any class of the REIT’s stock. Third, the dividend will qualify for the 15 percent maximum rate if the beneficial owner of the dividend holds an interest in the REIT of 10 percent or less and the REIT is “diversified.” A REIT is diversified if the gross value of no single interest in real property held by the REIT exceeds 10 percent of the gross value of the REIT’s total interest in real property.

Interest

Article XI of the United States- Canada income tax treaty provides that interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other state. Under the treaty, “interest” is income from any debt claims whether or not secured by a mortgage and whether or not the person claiming the interest possesses a right to share in the debtor’s profits. Interest also includes income from government bonds and securities. Article XI of the treaty provides that interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. Under these rules, if a U.S. resident receives interest income from a Canadian source, the U.S. may tax that interest income. At one time the United States- Canada income tax treaty provided that Canada could also tax this interest income at 15 percent. However, this provision of the treaty was repealed and now interest income of a U.S. resident is exempt from Canadian tax. However, this exemption does not apply if the owner of the interest income carries on a trade or business or has carried on a trade or business through a permanent establishment in Canada for which interest income is effectively connected.

Royalties

Article XII of the United States- Canada income tax treaty provides that tax on royalties shall not exceed 10 percent of the gross amount of the royalties. The term “royalties” means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work (including motion picture films and works on film or videotape for the use in connection with television), any patent, trademark, design or model, plan, secret formula or process, or for the use of, or the right to use, tangible personal property or for information concerning industrial, commercial or scientific experience, and gains from the alienation of any intangible property or rights contingent on the productivity, use or subsequent disposition of such property or rights.

Private Pensions and Annuities

Under Article XVIII of the United States-Canada income tax treaty, pensions and
annuities arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State, but the amount of any pension included in income for the purpose of taxation in that other State shall not exceed the amount that would be included in the first-mentioned State if the recipient were a resident thereof.

However, pensions may also be taxed in the Contracting State in which they arise and according to the laws of that State; but if a residency of the other Contracting State is the beneficial owner of a periodic pension payment, the tax so charged shall not exceed 15 percent of the gross amount of each payment. Annuities may also be taxed in the Contracting State in which they arise and according to the laws of that State; but if the resident of the other Contracting State is also a beneficial owner of such an annuity payment, the tax so charged shall not exceed 15 percent of the portion of such payment that is liable to tax in the first-mentioned State.

Article XVIII of the United States- Canada income tax treaty defines the term “pensions” to include any payment under a superannuation, pension, or other retirement arrangement, Armed-Forces retirement plan, war veterans pensions and allowances, and amounts paid under a sickness, accident, or disability plan, but does not include payments under an income-averaging annuity contract or social security.

The term “pensions” includes pensions paid by private employers (including pre-tax and Roth 401(k) arrangements) as well as any pension plan in respect of government services. Further, the definition of “pensions” includes payments from individual retirement accounts (“IRAs”), registered retirement savings plans (“RRSPs) and registered retirement income funds (“RRIFs).

Subparagraph of Article XVII of the treaty provides that the term “pensions” generally includes a Roth IRA, within the meaning of Section 408A of the Internal Revenue Code. Thus, under Article XVII of the treaty, distributions from a Roth IRA to a resident of Canada generally continue to be exempt from Canadian tax to the extent they would have been exempt from U.S. tax if paid to a resident of the United States. In addition, residents of Canada generally may make an election under the treaty to defer any taxation in Canada with respect to income accrued in Roth IRA, until such time as and to the extent that a distribution is made from the Roth IRA or any plan substituted thereof. Because distributions will be exempt from Canadian tax to the extent they would have been exempt from U.S. tax if paid to a resident of the United States, the effect of these rules is that, in most cases, no portion of the Roth IRA will be subject to taxation in Canada. However, Article XVII of the treaty also provides that if an individual who is a resident of Canada makes contributions to his or her Roth IRA while a resident of Canada, other than rollover contributions from another Roth IRA, the Roth IRA will cease to be considered a pension at that time with respect to contributions and accretions from such time will be subject to tax in Canada in the year of accrual.

Article XVII, Paragraph 1 of the United States-Canada income tax treaty provides that Canadian pensions and annuities that are paid to a U.S. resident can be taxed by the United States or vice versa; however, the amount of the pension that would be exempt from Canadian taxes for Canadian residents getting the same pension or annuity is exempt from U.S. taxes or vice versa. Article XVII, Paragraph 3, defines the word “pensions” to include retirement plans and amounts paid under a sickness, accident, or disability plan, but does not include payments under an income-averaging annuity contract. Furthermore, the definition of “pensions” includes payments from IRAs in the United States and from registered RRSPs and RRIFs in Canada.

The United States-Canada income tax treaty has recognized the mobility of employees between Canada and the United States and provided for a special provision for cross-border workers. Under the treaty, individuals who reside in one country and work in the other country on a short-term work assignment (fewer than five years) may make contributions to pension plans or retirement plans and continue to contribute to their home country pension plans.

Social Security Payments

Article XVII, Paragraph 5 of United States- Canada income tax treaty addresses social security payments. According to the treaty, U.S. and Canadian social security payments are only taxed by the country where the payee resides.

Gains from the Disposition of Property

Under Article XIII of the United States Canada income tax treaty, gains realized from the sale of property may be taxed by both Contracting States. Under Article XIII of the treaty, residents of both countries may receive a step-up basis on certain property sold in one country for tax purposes in the other country. Paragraph 7 of Article XII allows favorable tax treatment in cases of a timing mismatch. For example, if a Canadian resident is deemed, for Canadian tax purposes, to recognize capital gain upon emigrating from Canada to the United States. Paragraph 7 of Article XIII of the treaty resolves taxable events by allowing the individual an election to be treated by the United States as having sold and repurchased the property for its fair market value immediately before the Canadian taxable event. The election is available to any individual who immigrates from Canada to the United States, without regard to whether the person is a U.S. citizen immediately before ceasing to be a resident of Canada. The exception contained in the savings clause of the treaty assists U.S. persons who were residents of Canada immediately before immigrating to the United States because they can synchronize U.S. and Canada tax recognition of the gain. See Tax Insider, Tax Treaty Benefits for U.S. Citizens and Residents, (February 8, 2018) by Allen Schulman.

Branch Profits Tax

The United States has enacted a branch profits tax. The branch profits tax treats a U.S. branch of a foreign corporation as if it were a U.S. subsidiary of the foreign corporation for purposes of taxing repatriations of profit. As such, the branch profits tax puts earnings and profits of a branch of a foreign corporation deemed remitted to its home office on equal footing with the earnings and profits of a U.S. corporation paid out as a dividend to its foreign parent.

The branch profits tax is calculated and paid by the foreign corporation (shareholder or owner) on a Form 1120-F (U.S. Income Tax Return of a Foreign Corporation). The branch profits tax applies regardless of whether the U.S. trade or business of the foreign corporation is substantial compared to its worldwide activities. Thus, a foreign corporation owner of any U.S. entity such as an LLC may need to pay a branch profits tax equal to 30 percent of the “dividend equivalent amount” when such amount is distributed to its non-U.S. owners. The branch profits tax generally applies to foreign corporate entities doing business in the U.S. through a branch and thereby generating effectively connected income, including a corporation that conducts a U.S. trade or business through an LLC.

The United States-Canada income tax treaty expressly authorizes the imposition of the U.S. branch profits tax. However, under the treaty, the branch profits tax may not, however, be imposed at a rate in excess of 5 percent. For the purpose of this rule, branch profits are determined after allowance for certain loss carryovers and a $500,000 exemption.

Estate Tax Provision

Unlike most tax treaties, the U.S.-Canada income tax treaty provides relief from the U.S. estate tax. Individuals residing in Canada should be concerned about the application of the U.S. estate and gift tax if they directly own U.S. situs property. This is because non-U.S. resident individuals are subject to U.S. estate and gift tax on U.S. situs property above a unified credit amount.The current unified credit is $60,000.  Article XXIX(B) of the United States- Canada income tax treaty attempts to eliminate the imposition of double tax on an asset, subject to both Canadian death taxes and U.S. estate taxes. Article XXIX(B) of the treaty is intended to provide some relief against double taxation on death, but it does not provide any relief from U.S. gift tax. Those who are not U.S. citizens or residents are subject to U.S. estate tax only on the value of their U.S. situs assets. See IRC Section 2103. The unified credit available to Canadians is based on the value that their U.S. situs assets bear to the value of their worldwide estate. See Article XXIX(B)(2).

The U.S. Estate Tax Calculation and the Impact of the Treaty

The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $13,999 or $27,998 for a married couple (for the 2025 calendar year).

Article XXIX(B) of the U.S.-Canada income tax treaty provides relief from the U.S. estate tax. Under the treaty, a Canadian real estate investor is entitled to relief from the U.S. estate tax, but the treaty does not provide any relief from the U.S. gift tax. A Canadian investor can claim a pro rata portion of the U.S. unified credit and marital credit for estate tax purposes. The pro rata portion is based on the percentage of the individual’s gross U.S. estate and gross worldwide estate.

Claiming a Treaty Position to Reduce or Eliminate the U.S. Estate Tax

The taxation of non-U.S. domiciliaries can be harsher than that of U.S. domiciliaries. Non-U.S. domiciliaries are subject to estate tax on their U.S. situs assets and are not allowed an exemption of only $60,000. Article XXIX(B) of the U.S.- Canada income tax treaty provides a pro rata unified credit to the estate of an individual domiciled in Canada (who is not a U.S. citizen) for purposes of computing the U.S. estate tax. The pro rata portion is based upon the ratio that the Canadian resident’s gross estate situated in the United States at the time of his death bears to his or her worldwide gross estate. Below, please see Illustration 4, Illustration 5, and Illustration 6 which discusses how pro rata unified credit is computed. For purposes of these illustrations, Canadian residents are not subject to U.S. estate tax unless their gross worldwide estate exceeds $10 million (for 2018 calendar year). All amounts contained in the illustrations discussed below are in U.S. dollars.

Illustration 4.

Justin Lieber owns a vacation home in Florida with a value of $5,000,000, unencumbered by a mortgage. His other worldwide assets amount to $5,000,000. There will be no U.S. estate tax whether or not Justin Lieber is survived by his spouse.

A Canadian citizen who passes away owning U.S. assets is entitled to a credit against his U.S. estate tax liability in an amount equal to that proportion of the U.S. unified credit as his U.S. situated estate bears to his worldwide estate.

Illustration 5.

Bryan Bosling, a Canadian resident, owns two vacation homes in California and Hawaii, each of which is unencumbered by a mortgage and has a value of $5,450,000. Bryan also owns Canadian property with a total value of $10,900,000. When Bryan dies in 2018, his estate, for U.S. estate tax purposes, would be entitled to a prorated unified credit of $2,208,900 (i.e., $4,417,800 × ($10,900,000 / $21,800,000)). When applied against his computed gross U.S. estate tax of $4,305,800, this prorated unified credit results in a net U.S. estate tax liability of $2,096,900 (i.e., $4,305,800 – $2,208,900). If Bryan Bosling has a Canadian spouse and leaves property to her outside of a qualified domestic trust (“QDOT”), the U.S. will allow an election to be made for an additional nonrefundable marital credit up to the amount of the proportionate credit.

The estates of individuals not domiciled in the United States are generally not entitled to a marital deduction for U.S. estate tax purposes. Marital deductions refers to exceptions to gift and estate taxes for transfers made to spouses. Almost all property qualifies for this deduction and there is no limit. The deduction does not avoid transfer taxes completely, but rather, the spouse receiving the property must pay the eventual estate taxes. The marital deduction for non-U.S. citizens is limited to an annual exclusion of $175,000 for the 2023 calendar year.

Below, please find Illustration 6, which demonstrates how the marital deduction is applied under Article XXIX(B) of the United States-Canada income tax treaty.

Illustration 6.

The facts are the same as in Illustration 2, except that Bryan Bosling leaves one of his two vacation homes in the U.S. to his Canadian spouse. The additional marital deduction “credit” allowed under the U.S.-Canada treaty equals the excess of the computed gross U.S. estate tax over the estate tax computed without including the U.S. property passing to the Canadian spouse. The marital deduction credit is capped at the estate’s prorated unified credit. Here, the U.S. estate tax on the vacation home not passing to Bryan’s spouse is $2,125,800. Thus, the marital deduction credit equals $2,180,000 (i.e., $4,305,800 – $2,125,800). After taking into account both the prorated unified credit and the marital deduction credit, the net U.S. estate tax liability owed by Bryan’s estate is reduced to zero (i.e., $4,305,800 – $2,208,900 – $2,180,000). Any excess marital deduction credit does not result in a refund.

Treaty Charitable Deduction

United States- Canada income tax treaty Article XXIX(B)(1) states that a Contracting State shall accord the same death tax treatment to a bequest by an individual resident in one of the Contracting States to a qualifying exempt organization resident in the other Contracting State as it would have accorded if the organization had been a resident of the first Contracting State. The exempt organizations that qualify for this provision are referred to in paragraph 1 of Article XXI (Exempt Organizations). A gift or bequest by a U.S. domiciliary to a U.S. exempt organization is typically deductible for U.S. estate tax purposes. See IRC Section 2055. This deduction is typically only available to bequests made to U.S. based exempt organizations. Although a deduction for estate tax purposes is typically limited to domestic charities, the United States- Canada income tax treaty broadens this deduction to Canadian residents subject to the U.S. estate tax. Under Article XXIX(B)(1) of the treaty, in certain cases, a Canadian resident subject to U.S. estate tax will be permitted a U.S. estate tax deduction for a charitable bequest made to a Canadian-registered charity.

Disclosure of Treaty-Based Return Positions

Any individual or entity that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.

The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:

1. The name and employer identification number of both the recipient and payor of the income at issue;

2. The type of treaty benefited item and its amount;

3. The facts and an explanation supporting the return position taken;

4. The specific treaty provisions on which the taxpayer bases its claims;

5. The Internal Revenue Code provision exempted or reduced; and

6. An explanation of any applicable limitations on benefits provisions.

Conclusion

This article was designed to provide the reader with an introduction to the United States- Canada income tax treaty. Sometimes individuals, entities, and investors may utilize the treaty to reduce or even eliminate withholding and income taxes. The United States- Canada income tax treaty has greatly assisted in removing tax warriors between the United States and Canada. Hopefully the current disputes between the United States and Canada will not establish barriers between the two countries.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals.

Anthony has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or [email protected].

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.