By Anthony Diosdi
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 tax exemptions and reductions that treaties provide are available only to a resident of one of the treaty countries. Income derived by a partnership or other pass-through entity is treated as derived by a resident of a treaty country to the extent that, under the domestic laws of that country, the income is treated as taxable to a person that qualifies as a resident of that treaty country. Under Article IV of the U.S.-Canada Income Tax Treaty, a resident is any person who, under a country’s internal laws, is subject to taxation by reason of domicile, residence, citizenship, place of management, place of incorporation, or other criterion of a similar nature. Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country. Whether a person is a resident of the United States or Canada for treaty purposes is determined by reference to the internal laws of each country.
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 to U.S. law, generally, an individual is a resident in Canada for tax purposes if there is a continuing relationship between the individual and Canada. In making this determination, all of the relevant facts must be considered, such as the maintenance of a dwelling suitable for year-round occupancy, credit cards, bank accounts, social and business ties, and personal property. Ordinarily, individuals are considered to be a resident where they maintain a fixed abode for themselves and their families. If an individual who, as a matter of fact, is considered not to be a resident of Canada sojourns (i.e., is a temporary resident) in Canada for 183 days or more in a calendar year, the individual is deemed to be a resident in Canada for the entire tax year.
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 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.
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. Under the LOB provision, a Canadian corporation or trust generally can qualify for treaty benefits only if it satisfies a “publicly traded” test or an ownership and “base erosion” test. If neither of these tests is satisfied, a Canadian corporation can qualify for treaty benefits with respect to a given item of income if 1) the income is derived in connection with (or incidental to) an active Canadian business that satisfies certain requirements (the “active conduct of a trade or business” test) or 2) the corporation satisfies a “derivative benefits” test.
If none of these tests are satisfied, a Canadian entity may qualify for treaty benefits if the complement authorities in the United States determine that the entity’s creation and existence did not have a principal purpose of obtaining treaty benefits that would not otherwise be available and that denial of treaty benefits would be inappropriate. These LOB provisions are not reciprocal. However, the Canadian taxing authorities reserve the right to deny treaty benefits in abusive situations.
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 U.S.-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). It should be noted that the 1995 Canada Protocol makes no changes in the U.S. gift tax rules.
A Canadian resident who is not a U.S. citizen and not a permanent resident or domiciled in the United States is subject to U.S. estate tax only on U.S.-situs property, which includes shares of a U.S. corporation and direct interest in U.S. property, and may potentially include interests in partnerships that own U.S.- situs property or are engaged in business in the United States.
Business Profits and 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,
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. Generally, when an employee who is a resident of one treaty country derives income from services performed in the other treaty country, that income is usually taxable by the host country. However, the employee’s income is exempted from taxation by the host country if the employee is present in the host country for 183 days or less.
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.
Dividends, Interest, and Royalties
Like the United States, most foreign countries impose flat rate withholding taxes on dividends, interest, and royalty income derived by offshore investors from sources within the country’s borders. Below, please find the treaty rates for dividends, interest, and royalties.
Dividends
Subparagraph 2(a) of Article X of the United States-Canada Income Tax Treaty the U.S. withholding tax rate on dividends paid to a Canadian shareholder is 5 percent if the shareholder is a corporation that owns at least 10 percent of the voting stock of the U.S. corporation, and 15 percent if the shareholder is an individual. Under Article VII of the treaty, management fees generally are not subject to U.S. tax, assuming the Canadian shareholder receiving the fees does not maintain a permanent establishment in the United States. The term “dividends” as used in the treaty means income from shares or other rights, not being debt-claims, participating in profits, as well as income subject to the same taxation treatment as income from shares by the taxation of the State of which the company making the distribution is a resident.
The treaty also provides for benefit tax treatment of real estate investment trusts or “REIT.” In the United States, a REIT is a common vehicle for earning income from rental property. In general, REITs have fully transferable interests and have a minimum of 100 investors. REITs make current distributions out of income derived from U.S. real estate investments. The distributions are taxed in the United States as corporate distributions but there are no corporate level taxes. Under Article X, paragraph 7(c) of the treaty, however, the REIT must withhold U.S. tax at 15 percent on dividends paid by U.S. REIT: 1) to a Canadian resident individual owning 10 percent or less of the REIT; 2) if the dividends are paid regarding a class of stock that is publicly traded and the beneficial owner is a person owning not more than 5 percent of any class of stock; or 3) if the REIT is diversified, the owner owns 10 percent or less of the interest in the REIT. In other cases, the withholding tax rate is 30 percent.
Interest
According to the treaty, interest arising in a Contracting state and beneficially owned by a resident of the other Contracting State may be taxed only in the other state. The term “interest” as used in the treaty means income from debt-claims of every kind, whether or not secured by mortgage, and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from government securities and income from bonds or debentures, including premiums or prizes to such securities, bounds or debentures, as well as income assimilated to income from money lent by the taxation laws of the Contracting State in which the income arises.
Royalties
The treaty provides that royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. However, such royalties may also be taxed in the Contracting State in which they arise, and according to the laws of that State; but if a resident of the other Contracting State is the beneficial owner of such royalties, the tax so charged shall not exceed 10 percent of the gross amount of the royalties. The term “royalties” as used in the treaty 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 pictures and works on film, videotape or other means of reproduction for use in connection with television), any patent, trade mark, design or model. Plan, secret formula, or for the use of, or for the use of, or the right to use, tangible personal property or for information concerning industrial, commercial or scientific experience, and notwithstanding provisions of Article XIII (Gains), includes gains from the alienation of any intangible property.
Private Pensions and Annuities
The United States- Canada Income Tax Treaty discusses retirement accounts. The treaty refers to retirement accounts as “pensions.” Article XVIII or Article 13 paragraph 1 of the treaty includes pensions paid by private U.S. employers (including pre-tax 401K and Roth 401k arrangements), Section 403(b) plans, as well as any pensions paid in respect of government services. The definition of “pensions” also includes payments from IRAs in the United States and from registered retirement savings plans (“RRSPs”) and registered retirement income funds (“RRIFs”) in Canada. In addition, Article 13 subparagraph 3(b) provides that the term “pensions” generally includes a Roth IRA, within the meaning of Internal Revenue Code Section 408A. Consequently, under paragraph 1 of Article 13, distributions from a Roth IRA to a resident of Canada generally continues 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 paragraph 7 of Article 13 to defer any taxation in Canada with respect to income accrued in a Roth IRA, until such time as and to the extent that a distribution is made from the Roth IRA or any plan substituted therefore. 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, subparaph 3(b) of Article 13 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 persian at that time with respect to contributions and accretions from such time and accretions from such time will be subject to tax in Canada in the year of accrual. Furthermore, following a rollover contribution from a Roth 401(k) arrangement to a Roth IRA, the Roth IRA will continue to be treated as a pension subject to the rules of Article 13.
Assume, for example, that Mr. X moves to Canada on July 1, 2008. Mr. X has a Roth IRA with a balance of 1,100 on july 1, 2008. Mr. X elects under paragraph 7 of Article 13 to defer any taxation in Canada with respect to income accrued in his Roth IRA while he is a resident of Canada. Mr. X makes no additional contributions to his Roth IRA until July 1, 2010, when he makes an after-tax contribution of 100. There are accretions of 20 during the period of July 1, 2008 through June 30, 2010, which are not taxed in Canada by reason of the election under paragraph 7 of Article 13. There are additional accretions of 50 during the period July 1, 2010 through June 30, 2015, which are subject to tax in Canada in the year of accrual. On July 1, 2015, while Mr. X was still a resident of Canada, Mr. X received a lump-sum distribution of 1,270 from his Roth IRA. The 1,120 that was in the Roth IRA on June 30, 2010 is treated as a distribution from a pension plan that, pursuant to paragraph 1 of Article 13, is exempt from tax in Canada provided it would be exempt from tax in the United States under the Internal Revenue Code if paid to a resident of the United States. The remaining 150 comprises the aftertax contribution of 100 in 2010 and accretions of 50 that were subject to Canadian tax in the year of accrual.
Paragraph 7 of Article 13 provides a rule with respect to the taxation of a natural person on income accrued in a pension or employee benefit plan in the other Contracting State. Thus, paragraph 7 of Article 13 applies where an individual is a citizen or resident of a Contracting State and is a beneficiary of a trust, company, organization, or other arrangement that is a resident of the other Contracting State, where such trust, company, organization, or other arrangement is generally exempt from income taxation in that other State, and is operated exclusively to provide pension, or employee benefits. In such cases, the beneficiary may elect to defer taxation in his State of residence on income accrued in the plan until it is distributed from the plan (or from another plan in that other Contracting State to which the income is transferred pursuant to the domestic law of that other Contracting State).
For example, let’s assume that Tom is a Canadian citizen that comes to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Tom contributed money into a 401K plan. Tom has returned to Canada and would like to withdraw money from his U.S. based 401K. However, Tom is concerned about the U.S. federal 30 percent withholding tax and the 10 percent early withdrawal penalty.
Since Tom is a citizen of Canada, a country that the U.S. has a bilateral income tax treaty, Tom may utilize the U.S.- Canada Income Tax Treaty to potentially avoid the 30 percent withholding tax and the early withdrawal penalty. Paragraph 3(a) of Article 13 defines the term pension to include a 401K plan. Paragraph 7 of Article 13 of the U.S.- Canadian Income Tax Treaty defers taxation in Tom’s State of residence until it is distributed from the plan. Residency for tax treaty purposes is determined under domestic law of each country. Since Tom has returned to Canada and is presumably taxed in that country, Tom is a resident of Canada. If Tom makes a timely election under paragraph 7 of Article 13 of the United States- Canada Income Tax Treaty to defer taxation of the 401K plan distribution until he re-establishes residency in Canada, Tom can potentially avoid U.S. withholding tax and early withdrawal penalties on the distributions he receives from the U.S. based 401K plan.
The U.S.- Canada Income Tax Treaty can also be utilized by a U.S. citizen or resident that is a beneficiary of a Canadian tax-free pension or employee benefit plan. The IRS promulgated Rev. Proc. 2014-55 which discusses how a U.S. person can elect to defer U.S. taxes on any accrued but undistributed income until the income is distributed. Rev. Proc. 20-14-55 applies to a U.S. person who is a beneficiary of an RRSP, RRIF, a Canadian registered pension plan, or a Canadian deferred profit sharing plan.
Workers on Short-Term Assignments in the Other Contracting State
Paragraphs 8 and 9 of Article 13 address the case of a short-term assignment where an individual who is participating in a “qualifying retirement plan” on one Contracting State (the “home State”) performs services as an employee for a limited period of time in the other Contracting State (the “host State”). If certain requirements are satisfied, contributions made to, or benefits accrued under, the plan by or on behalf of the individual will be deductible or excludable in computing the individual’s income in the host State. In addition, contributions made to the plan by the individual’s employer will be allowed as a deduction in computing the employer’s profits in the host State.
Paragraph 8 of Article 13 promotes uniform deductibility of United States and Canadian based pension contributions. For example, this provision of the U.S. -Canada Tax Treaty provides that citizens and residents of the United States who become Canadian residents may benefit from the treaty if 1) they move back to the United States to work as an employee and 2) they were Canadian residents immediately before they began performing those services in the United States. These individuals could deduct, for U.S. income tax purposes, contributions to preexisting Canadian retirement plans or plan from their U.S. taxable income.
In order for paragraph 8 to apply, the remuneration that the individual receives with respect to the services performed in the host state must be taxable in the host State. This means, for example, that where the United States is the State, paragraph 8 would not apply if the remuneration that the individual receives with respect to the services performed in the United States is exempt from taxation in the United States under Internal Revenue Code Section 893.
The individual also must have been participating in the plan, or in another similar plan for which the plan was substituted, immediately before he began performing services in the host State. The rule regarding a successor plan would apply if, for example, the employer has been acquired by another corporation that replaces the existing plan with its own plan, transferring membership in the old plan over to the new plan. In addition, the individual must not have been a resident of the host State immediately before he began performing services in the host State.
Benefits are available under paragraph 8 of Article 13 only so long as the individual has not performed services in the host State for the same employer (or a related employer) for more than 60 of the 120 months preceding the individual’s current taxable year. If the individual continues to perform services in the host State beyond this time limit, he is expected to become a participant in a plan in the host State. Canada’s domestic law provides preferential tax treatment for employer contributions to foreign pension plans in respect of services rendered in Canada by short-term residents, but such treatment ceases once the individual has been a resident in Canada for at least 60 of the preceding 72 months.
The contributions and benefits must be attributable to services performed by the individual in the host State, and must be made or accrued during the period in which the individual performs these services. This rule prevents individuals who render services in the host State for a very short period of time from making disportionately large contributions to home State plans in order to offset the tax liability associated with the income earned in the host State. In the case where the United States is the host State, contributions will be deemed to have been made on the last day of the preceding taxable year if the payment is on account of such taxable year and is treated under U.S. law as a contribution made on the last day of the preceding taxable year.
If an individual receives benefits in the host State with respect to contributions to a plan in the home State, the services to which the contributions relate may not be taken into account for purposes of determining the individual’s entitlement to benefits under any retirement plan of the host State. The purpose of this rule is to prevent double benefits for contributions to both a home State plan and a host State plan with respect to the same services. Thus, for example, an individual who is working temporarily in the United States and making contributions to a qualified retirement plan in Canada with respect to services performed in the United States may not make contributions to an individual retirement account (within the meaning of Internal Revenue Code Section 408(a)) in the United States with respect to the same services. Paragraph 8 of Article 13 states that it applies only to the extent that the contributions or benefits would qualify for tax relief in the home State if the individual were a resident of and performed services in that State. Thus, benefits would be limited in the same fashion as if the individual continued to be a resident of the home State.
Where the United States is the home State, the amount of contributions that may be excluded from the employee’s income under paragraph 8 of Article 13 for Canadian purposes is limited to the U.S. dollar amount specified in Internal Revenue Code Section 415 or the U.S. dollar amount specified in Section 402(g)(1) to the extent contributions are made from the employee’s compensation. For this purpose, the dollar limit specified in Section 402(g)(1) means the amount applicable under Internal Revenue Code Section 402(g)(1)(C)) or, if applicable, the parallel dollar limit applicable under Internal Revenue Code Section 457(e)(15) plus the age 50 catch-up amount under Section 414(v)(2)(B)(i).
Where Canada is the home State, the amount of contributions that may be excluded from the employee’s income under paragraph 8 of Article 13 for U.S. purposes is subject to the limitations specified in subsections 146(5), 147(8), 147.1(8) and (9) and 147.2(1) and (4) of the Income Tax Act paragraph 8503(4) of the Income Tax Regulations, as applicable. If the employee is a citizen of the United States, then the amount of contributions that may be excluded is the lesser of the amounts determined under the limitations specified in the previous sentence and the amounts specified in the previous paragraph. The amount of the allowable deduction is to be determined under the laws of the home State. Thus, where the United States is the home State, the amount of the deduction that is allowable in Canada will be subject to the limitations of Internal Revenue Code Section 404 (including Section 401(a)(17) and 415 limitations). Where Canada is the home State, the amount of the deduction that is allowable in the United States is subject to the limitations specified in subsections 147(8), 147.1(8) and (9) and 147.2(1) of the Income Tax Act, as applicable.
Cross-Border Commuters
Paragraphs 10, 11, and 12 of Article 13 address the case of a computer who is a resident of one Contracting State (the “residence State”) and performs services as an employee in the other Contracting State (the “services State”) and is a member of a “qualifying retirement plan” in the services State.
In order for paragraph 10 of Article 13 to apply, the individual must perform services as an employee in the services State the remuneration from which is taxable in the services State and is borne by either an employer who is a resident of the services State or by a permanent establishment that the employer has in the services State. The contributions and benefits must be attributed to those services and must be made or accrued during the period in which the individual performs those services. Paragraph 10 of Article 13 states that it applies only to the extent that the contribution or benefits qualify for tax relief in the services State. Where the United States is the services State, the amount of contributions that may be excluded under paragraph 10 is the U.S. dollar amount specified in Internal Revenue Code Section 415 or the U.S. dollar amount specified in Internal Revenue Code Section 402(g)(1) to the extent contributions are made from the employee’s compensation. Where Canada is the services State, the amount of contributions that may be excluded from the employee’s income under paragraph 10 is subject to the limitations specified in subsections 146(5), 147(8), 147.1(8) and (9) and 147.2(1) and (4) of the Income Tax Act and paragraph 8503(4) of the Income Tax Regulations, as applicable.
Paragraph 11 of Article 13 provides that where Canada is the residence State, the amount of contributions otherwise allowable as a deduction under paragraph 10 may not exceed the individual’s deduction limit for contributions to RRSPs remaining after taking into account the amount of contributions to RRSPs deducted by the individual under the law of Canada for the year. The amount deducted by the individual under paragraph 10 will be taken into account in computing the individual’s deduction limit for subsequent taxation years contributions to RRSPs. The rule prevents double benefits for contributions to both RRSP and a qualifying retirement plan in the United States with respect to the same services.
Paragraph 12 of Article 13 provides that if the United States is the residence State, the benefits granted to an individual under paragraph 10 may not exceed the benefits that would be allowed by the United States to its residents for contributions to, or benefits otherwise accrued under, a generally corresponding pension or retirement plan established in and recognized for tax purposes by the United States. For purposes of determining an individual’s eligibility to participate in and receive tax benefits with respect to a pension or retirement plan or other retirement arrangement in the United States, contributions made to, or benefits accrued under, a qualifying retirement plan in Canada by or on behalf of the individual are treated as contributions or benefits under a generally corresponding pension or retirement plan established in and recognized for tax purposes by the United States.
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. However, since the U.S. has a right to tax U.S. citizens on their worldwide income, if a U.S. citizen receives a distribution from Canadian social security while residing in Canada, the U.S. will have the right to tax the social security payments regardless of the verbiage of the treaty.
Gains from the Disposition of Property
Article XIII of the U.S.- Canada Income Tax Treaty authorizes the United States to tax gains from the alienation of personal property associated with a permanent establishment in the United States and real property situated in the United States. Real property situated in the United States includes real property as defined under the domestic laws of the country in which the real estate is located. Article XIII of the U.S.- Canada Income Tax Treaty was amended in 1983 to conform to the U.S. Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”).
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. The second-level 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.
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. 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. An individual or entity reports treaty-based positions either by attaching a statement to its return or by using Form 8833.
Conclusion
Often the terms of a U.S. tax treaty modify the tax results that one would otherwise obtain under the Internal Revenue Code. Correctly taking a treaty position can in certain result in substantial tax savings. On the other hand, taking an incorrect treaty position can result in the assessment of significant penalties and interest. If you are considering taking a treaty position involving a U.S. bilateral income tax treaty, you should consult with an experienced international tax attorney to assist you. We have substantial experience advising clients regarding the U.S.- Canada Income Tax Treaty.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & 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 other tax professionals.
He 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 adiosdi@sftaxcounsel.com.
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.