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 of Canada for treaty purposes is determined by reference to the internal laws of each country.
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. As such, a gift of U.S. real estate is still subject to U.S. gift tax.
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.
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, 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. Tax treaties usually reduce these withholding taxes. Tax treaties usually reduce the withholding tax rate on dividends to 15 percent or less.
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. The treaty also provides that tax on dividends shall not exceed 5 percent of the gross amount of the dividends if the beneficial owner is a company or Real Estate Investment Trust (“REIT”) which owns at least 10 percent of the voting stock of the company paying the dividends. The term “dividends” means income from the shares or other right, not being debt-claims, participating in profits, as well as income that is subjected to the same taxation treatment as income from shares under the laws of the State of which the payor is a resident.
The United States-Canada Income Tax Treaty provides that interest and royalties generally may be subject to a withholding tax of 10 percent, although a complete exemption applies in certain circumstances. For example, interest paid to a contracting state, or political subdivision thereof, is exempt from withholding tax. In addition, a complete exemption generally applies to copyright royalties and payments for the use of, or to use, computer software, parents, and know-how.
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.
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 individual retirement accounts (“IRAs”) in the United States and from registered retirement savings plans (”RRSPs”) and registered income funds (“RRIFs”) in Canada.
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.
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 taxpayer 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.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.