Do you have to modify your tax planning? Interest deductibility; Cross-border recognition of pension plans; Relief for some but not all?
Executive TaxBreaks, Winter 2008 (08-1)
Will executives and employers have to modify their tax planning?
Interest deductibility: CRA rethinks its position
Cross-border recognition of pension plans – finally!
All taxpayers are created equal but some are more equal than others
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While the protocol amending the Canada-U.S. tax treaty (signed September 21, 2007) contains a number of relieving measures that were expected, it also contains a large number of surprise changes, some of which may have adverse consequences for certain taxpayers. This article outlines the changes that could have an impact on tax planning matters for executives and their employers. (The rules regarding pension plans are discussed in another article of this newsletter.)
Employee stock options
Executives who render services in both Canada and the United States are currently at risk of double taxation in certain circumstances. The protocol provides long-awaited guidance with respect to the taxation of stock option income received by such individuals. The apportionment of taxing rights between Canada and the United States is to be determined based on the individual’s “principal place of employment” during the period from the date of grant to the date of exercise or disposal of the options. Such apportionment will eliminate the possibility of double taxation of option income; however, to date no guidance has been provided as to the determination of “principal place of employment.”
Changes have been made in determining when a resident of one country is subject to tax by the other country on employment income earned in that other country.
In the present treaty, a resident of one country (Canada) who exercises employment in the other country (United States) is taxed only in his or her country of residence on such employment income on the following conditions:
- the individual’s employment income earned in that other country (United States) does not exceed $10,000; or
- the individual employee is present in the other country (United States) for 183 days or less in a year and the employment income is not borne by an employer who is a resident of that other country or by a permanent establishment or a fixed base which the employer has in that country.
According to the protocol, the 183 days test must be met in “any twelve-month period commencing or ending in the fiscal year concerned.” A further requirement is added that the employment income must also not be paid by, or on behalf of, a person who is a resident of that other country (United States).
Both of these changes will result in an increased number of Canadians taxable in the United States and Americans taxable in Canada.
Emigration and double taxation
The present treaty provides a rule intended to coordinate the taxation of gains where an individual is treated as having disposed of a property for purposes of one jurisdiction, but not the other. This rule provides that such an individual may elect to be taxable also in the other jurisdiction as if he or she had disposed of and re-acquired the property at the same time. The result of such an election is a step-up in the cost basis of the property, thereby avoiding double taxation of the gain upon eventual sale. This rule is a key planning tool for individuals with significant net worth who have moved, or intend to move, to the United States.
The difficulty with the existing rule is that an individual must be subject to tax in the second jurisdiction at the time of the deemed disposition. The protocol therefore extends this election to individuals deemed to dispose of a property in one jurisdiction, regardless of their residency status in the second jurisdiction. Related changes have also been made to the taxation of taxable Canadian property sold by non-residents of Canada who were subject to the tax departure when they left Canada.
Stock options and death
Under the current treaty, Canadian residents who hold unexercised employee stock options of U.S. companies run the risk of double taxation at time of death: for U.S. purposes, such options are subject to U.S. estate tax, while for Canadian purposes, there is a deemed employment income inclusion. The treaty permits a foreign tax credit to be claimed for U.S. estate taxes paid on U.S. situs assets to offset Canadian taxes due on the related U.S. source income. However, where the deceased employee had no U.S. working days, the employment income is considered Canadian source income and the U.S. estate tax paid on such options is not creditable.
The protocol provides that where a share or option is property situated in the United States, any employment income in the year of death in respect of the share or option may be treated as U.S. source income. This will permit the U.S. estate tax payable on such share or option to be claimed as a tax credit against Canadian taxes payable, eliminating the double taxation.
According to the new definition of “permanent establishment,” a non-resident is deemed to have a permanent establishment in the other country if services are provided there for an extensive period.
This measure will have a very significant impact on consultants and other service providers. However, the change will not generally apply to taxpayers until their third taxation year ending after the protocol comes into force.
Interest paid to non-residents
The protocol provides for the elimination of withholding tax on interest paid to unrelated non-resident lenders. Canadian domestic law has already been thus amended, regardless of lenders’ country of residence, effective January 1, 2008.
For interest paid to related non-resident lenders, the maximum withholding rate will be reduced to 7% for the year in which the protocol is ratified by the United States, 4% for the second year, and 0% for the third and subsequent years.
Protocol effective date
When the United States has ratified the protocol (Canada did so on December 14, 2007), both countries will announce the completion of procedures. Most of the proposed changes will be effective as of the first January 1 of the year following U.S. ratification (this was not yet done at time writing).
Lorna Sinclair, TorontoBack to top
In our Fall 2006 edition, in “Using credit lines for investment and personal purposes,” we described a Canada Revenue Agency (CRA) technical interpretation on interest deductibility that was quite favourable to taxpayers. In that interpretation, the CRA expressed the view that, where a taxpayer had drawn on a personal credit line for both eligible and ineligible purposes, the taxpayer could designate repayments towards the credit line as first reducing the portion of the total borrowing that was used for an ineligible purpose.
In 2007, the CRA reconsidered this position and now indicates that it is not the correct approach to follow. According to the CRA, payments are to be applied proportionately against the eligible and ineligible portions of the borrowing, based on the relative balances outstanding at the time of repayment.
In the scenario described in the earlier technical interpretation, the credit line had an opening balance of $60,000 which related to borrowed money used for personal purposes. The taxpayer then drew $40,000 on the credit line and invested the money in securities that otherwise met the requirements for an interest deduction under the Income Tax Act (the Act). Subsequently, a series of repayments were made. Throughout the series of transactions, the $40,000 remained invested in the eligible securities. Under the new approach suggested by the CRA, the deductible portion of interest would be as follows:
|Jan 1||Opening balance||$60,000||$0||$60,000|
|Jan 31||Ending balance||$60,000||$40,000||$100,000||40%|
|Feb 28||Ending balance||$48,000||$32,000||$80,000||40%|
|Mar 31||Ending balance||$24,000||$16,000||$40,000||40%|
As there were no further borrowings after January 1, the proportion of the total borrowing that relates to eligible purposes does not change and therefore neither does the deductible amount of the interest charged.
The CRA suggests that taxpayers who wish to restore full deductibility of the interest relating to the borrowing for an eligible use may sell the investments, use the proceeds to repay that portion of the total borrowing, and then reacquire the investments by drawing on a new credit facility that is used solely for that purpose. However, in addition to dealing with the practical difficulties and transaction costs this approach presents, taxpayers must exercise caution when following this advice to avoid a tax pitfall. Where the disposition results in a loss and the investments are reacquired within 30 days of the disposition by the taxpayer or an affiliated person, the loss will be a “superficial loss” and will not be available to the taxpayer. (For further explanation of superficial losses, see “Income tax amendments create RRSP trap in our Fall 2007 edition.)
Given this latest interpretation, taxpayers should use dedicated credit facilities for investment purposes and consult their tax advisor beforehand to ensure that any interest incurred will be deductible.
Stewart Bullard, VancouverBack to top
Executives who contribute to pension plans and who are subject to both Canadian and U.S. tax laws will welcome a number of provisions that appear in the new protocol to the 1980 Canada-U.S. tax treaty, which was signed by both governments on September 21, 2007.
For example, effective January 1 of the year following the year in which the protocol is ratified by the United States (this was done in Canada on December 14, 2007), American employees working in Canada who contribute to a qualifying U.S. pension plan will qualify for a tax deduction in Canada; conversely, a U.S. deduction will be available both for Canadian employees working in the United States, and for American citizens resident and employed in Canada, who contribute to a qualifying Canadian plan.
Although the principle is simple, the supporting rules are detailed and complex, but can be summarized as follows:
- Only employee contributions to “qualifying retirement plans” will be deductible for the purpose of the new rules.
- Generally, to qualify, retirement plans must meet two conditions: first, the plan must be a qualifying plan in one of the countries, for example a registered pension plan in Canada and a 401k plan in the United States; second, the plan must be employer-sponsored, that is, there must be some level of employer contribution made to the plan in addition to the employee contribution. It should be noted that Roth Individual Retirement Accounts (IRAs) in the United States are specifically excluded from the definition of a qualifying retirement plan.
- Further, contributions to a qualifying retirement plan will only be deductible where the employee comes into one of the following three categories and certain other conditions are met:
- Assignees: These are conventional inter-company expatriates; relief is restricted to the first 60 months of any assignment. As in practice most assignments run for less than five years, this condition is unlikely to have significant practical implications.
- Commuters: These employees live in one country, but are employed and work in the other. There is no time limit on the deduction for this category.
- U.S. citizens in Canada: U.S. citizens who reside and work in Canada can now claim a U.S. tax deduction for their contributions to qualifying Canadian retirement plans. Again, there is no time limit on the deduction for these employees.
- There will be a general limitation on the employee deduction in Canada and the United States. With respect to Canada, the protocol indicates the deductible limit will be linked to the domestic rules pertaining to RRSP contributions, while in the United States, the protocol is more ambiguous and states the deduction will be determined by the U.S. limits of a generally corresponding pension plan.
In summary, most employer sponsored plans will be eligible for relief, but only for those employees who fall into one of the above categories. In this regard. it is likely that the new rules will be advantageous to most expatriate employees — those on formal company assignment — and those employees who live in Canada or the United States, but work in the other country. There will also be U.S. tax relief available for U.S. citizens resident and working in Canada.
The new rules confirm that if an employee contribution is deductible, then any associated employer contributions should not be considered taxable income.
Issues to be resolved
One of the key issues not addressed to date is how the U.S. and Canadian authorities will identify qualifying plans; that is, whether the claim is made on the individual’s tax return or whether the plan administrator will be required to register the plan with the relevant tax authorities before any tax relief can be claimed by the participants.
Where the changes will affect tax-equalized employees, the tax equalization policy should be reviewed to ensure it is clear who (the employer or the employee) is entitled to the benefit of this new deduction.
Note to employers
Employers should be aware of any related implications that may arise as a result of changes to the eligible participant criteria, and check their Canadian and U.S. pension plans to ensure that the criteria are flexible enough to allow employees to take advantage of these new rules. It goes without saying that they should also communicate these changes to any affected employees.
Alex Legg, VancouverBack to top
In the Winter 2007 edition of this newsletter, in “CRA backs off from taxing income that never was,” we described relief being offered to former employees of a now-defunct B.C. company in respect of tax and interest paid or payable on employment benefits arising from participation in an employer stock purchase plan. At that time, we were unclear as to how this relief would be provided as there was no ability within the Income Tax Act (the Act) to make such a concession, nor were we aware of any proposed legislative changes to the Act that would make it possible. The details of the concession have now emerged.
The relief was granted by a Remission Order that was published in the November 14, 2007 edition of the Canada Gazette, the official newspaper of the Government of Canada. Remission Orders are made under the Financial Administration Act and are a mechanism by which the government (and not the Canada Revenue Agency) can authorize the remission of monies to a person or class of persons in respect of, amongst other things, any tax that is paid or payable to the government where it is considered to be in the public interest to do so and, amongst other things, great injustice or great hardship to a person has occurred.
While there is little doubt that some of the employees may have suffered great hardship, this was clearly not the case for all employees, some of whom were granted tax and interest relief for amounts of less than $1,000. If not due to great hardship, then the remission order must have been granted due to great injustice. It is unclear how these particular individuals can be seen to have suffered a great injustice while thousands of other taxpayers across Canada who have deferred stock option benefits several multiples greater than the value of the underlying stock or who have paid tax on phantom gains have not suffered such an injustice.
It is somewhat ironic that this relief was provided in the same year that the Canada Revenue Agency (CRA) introduced the Taxpayer Bill of Rights. Under this bill, taxpayers “have the right to have the law applied consistently.” Although the Remission Order does not technically alter the application of the stock option benefit rules in the Act to these individuals, the practical effect is that those rules have been overridden, thus giving the appearance that the law has not been applied consistently. According to a recent article in the Ottawa Citizen, “Tories forgive huge JDS tax bills,” the commissioner of the CRA wrote to the National Revenue Minister expressing his concerns over the provision of this relief.
These employees obtained this relief due to the lobbying efforts of their Member of Parliament (MP). Affected taxpayers should consider writing to their MP to express their concerns on this issue and to request equal treatment.
Stewart Bullard, Vancouver
A quarterly newsletter on tax issues of particular interest to high-income corporate executives and professionals.