Technical Explanation to new Canada-U.S. Treaty Protocol – Impact on cross-border executives
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On July 10, 2008, the U.S. Treasury Department released a Technical Explanation (TE) of the pending protocol (the Protocol) to the Canada-U.S. income tax treaty (the Treaty) dated September 21, 2007. The TE is an official U.S. guide to the Protocol. Canada’s Department of Finance endorsed the U.S. Treasury Department’s TE in its news release issued on July 10, 2008.
This article focuses on the five income tax changes affecting cross-border executives discussed in the TE: exemption of employment income, stock option sourcing, stock options and death, Canadian departure tax, and pension contributions. The article also discusses the Single Individual Test which creates a permanent establishment (PE) through the cross-border provision of services.
Exemption of employment income
The Protocol has renamed Article XV of the treaty from “Dependent personal services” to “Income from employment.” This change is to conform to the current U.S. and Organisation for Economic Co-operation and Development (OECD) model conventions. Article XV of the treaty specifies limitations on the right of the country in which services are rendered to tax employment income.
The Protocol has also removed the reference to “similar” remuneration from Paragraph 1 1 of Article XV. The TE provides that this change is to clarify that the article applies to any form of proceeds from employment, including payments in kind.
Under the current treaty, a resident of one country (e.g., Canada) who exercised employment in the other country (e.g., the United States) would only be taxed in his or her country of residence on employment income if:
(a) the individual’s employment income earned in that other country did not exceed $10,000; or
(b) the individual employee was present in the other country for 183 days or less in a year and the employment income was not borne by an employer who was a resident of that other country or by a PE or a fixed base which the employer had in that country.
It has now been clarified that part (a) of the test will continue to apply on a calendar-year basis. However, the Protocol changes part (b) of the test in two respects. First, the 183-day test must now be met in “any 12-month period commencing or ending in the fiscal year concerned.” This change is consistent with the exemption provided in the OECD model convention and recently ratified international tax treaties. But, in practice, it will be challenging for individuals to track the 183-day test period.
The change in the 183-day test period will affect planning for short-term assignments and business travelers between Canada and the United States. For example, an employee present in Canada from November 1 until May 5 of the subsequent year would have spent less than 184 days in each of two calendar years and, consequently, under the existing treaty provision, his income would be exempt from Canadian tax, assuming all other conditions are met. Under the new Protocol, the employee will have a Canadian filing requirement, having spent more than 183 days in Canada in a 12-month period beginning November 1. Unfortunately, it may not be possible for the individual to reach this determination before the filing due date in Canada (April 30). However, the TE does not provide any guidance or clarification regarding such practical difficulties (including the possible levying of interest and penalties).
The second change in part (b) of the test is that the employment income must not be paid by or on behalf of a “person” who is a resident of that other country. Previously, the payment was required to be made by or on behalf of an “employer.” The definition of person does not envisage any form of employment relationship with the individual.
Previously, an employee of an employer resident in Country A could claim an exemption for services rendered in Country B if no employment relationship existed with the resident of Country B. However, this may no longer be possible, as existence of an ”employer-employee” relationship (under the common law or economic employer concept) is now not required. This change is intended to clarify that in certain tax evasion cases, substance over form principles may be applied to recharacterize the employment relationship.
Stock option sourcing
The Notes to the Protocol provide that 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.
The proportion attributable to a contracting state is computed by multiplying the income by a fraction. The numerator of the fraction is the number of days between grant and exercise during which the employee’s principal place of employment was situated in that country. The denominator is the total number of days between date of grant and exercise of the option that the employee was employed by the employer.
The TE also provides that if the terms of an option are such that grant of the option is appropriately treated as a transfer of ownership, then competent authorities may agree to attribute income based on the facts of the situation.
The OECD Commentary to the model convention and the recent domestic U.S. position adopt a sourcing period based on date of grant to date of vesting. Usually, by the date of vesting, the employee has performed the services required to earn the right in the options.
The TE does not provide any further guidance on the definition of “principal place of employment.” For cross-border executives with multijurisdictional roles, this concept may be difficult to apply. It may also pose challenges in situations where an employee is on short-term assignment or may continually work in both countries during the same period of time. Further, no guidance is provided on the time period over which this concept of “principal place of employment” has to be applied, i.e., on a year-to-year basis or over the period to which the stock options relate.
Stock options and death
Under the current treaty, employees who are residents of Canada and hold unexercised stock options in U.S. companies run the risk of double taxation upon death.
Under Canadian rules, death triggers a deemed disposition of the options and an employment income inclusion. Because such options would be treated as U.S. situs assets by the United States, their value could be also subject to U.S. estate tax upon death of the employee.
The TE has confirmed that the clarifications provided in the Notes to the Protocol ensure that tax credits will be available in cases where there are inconsistencies in the ways in which Canada and the United States view income and property.
The Notes provide that any employment income in respect of the shares or options constitutes income from property situated in the United States. This provision ensures that the estate tax paid on the shares or options in the United States will be allowable as a tax credit in Canada.
Similarly, an individual who immediately before her death was resident in Canada or a resident/citizen of the Unites States and held at that time an RRSP in Canada, will be eligible for a tax credit on U.S. estate tax from Canadian income tax and vice versa.
Canadian departure tax and capital gains
The Protocol amends the treaty to provide double taxation relief on departure tax imposed in Canada when an individual ceases Canadian residency. Departure tax is the amount of tax an individual has to pay on the unrealised but accrued gain on certain assets owned by the individual when he ceases Canadian residency.
The treaty allowed a taxpayer, who emigrated from Canada, to adjust a property’s basis for U.S. tax purposes to fair market value as of the date of deemed alienation in Canada, so that only the post-emigration gain was subject to U.S. tax. This election was not available to certain non-U.S. citizens. The Protocol will allow any individual who is subject to departure tax to make the election in the year the property is deemed to be disposed of, or in any subsequent year. Presumably, such election can be made on the tax return for the year the property is actually sold.
The TE has clarified that the change brought about by the Protocol extends the benefit of the election to any individual who emigrates 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 TE also clarifies that the election has to be made in respect of all properties and can only be made when the deemed alienation of such properties results in a net gain.
The Protocol clarifies a number of issues and significantly enhances the deductions available for cross-border commuters and assignees.
Roth Individual Retirement Accounts (IRAs)
The Protocol provides that the Roth IRA will be a pension for purposes of the treaty. As a result, distributions from a Roth IRA to a resident of Canada will be exempt from Canadian taxation to the extent that the fund would have been exempt from U.S. taxation if paid to a U.S. resident. Further, the holder can elect to defer taxation on income accumulating in the IRA until distributed.
However, if the holder contributes to a Roth IRA while a resident of Canada, 2 those contributions and income earned on those contributions will be treated as a normal savings account. As a result, the contributions will be subject to taxation on an accrual basis.
Sourcing of insurance funded retirement plans
For U.S. tax purposes, payments under life insurance and annuity contracts issued by foreign branch of a U.S. life insurance company (such as annuity payments or cash withdrawals) are generally subject to a 30% withholding tax when paid to a non-resident alien. The Protocol clarifies that if the payer has a PE in Canada, the payments will be deemed to arise in Canada and thus not be subject to U.S. taxation provided:
(a) the obligation giving rise to the annuity or life insurance contract must have been incurred in connection with the PE and
(b) the cost of the annuity or other payment must be borne by the PE.
Cross-border pension contributions
The Protocol has significantly expanded the situations where cross-border assignees can deduct contributions to home or service country retirement plans. However, there are also significant restrictions that are intended to prevent the doubling up of deductible benefits and limit the types of programs to which deductible contributions can be made.
For the purposes of these rules the concept of a “qualifying retirement plan” is crucial. The Protocol sets out general requirements and lists certain programs that will qualify. The general requirements are that the plan must be a trust, company organization or other arrangement that:
- is resident in the contracting state, generally exempt from taxation in that state and operated primarily to provide pension or retirement benefits;
- is not an individual arrangement in which the employer has no involvement; and
- per the competent authority of the other state, generally corresponds to pension or retirement plans established in that state.
Taxpayers can apply to the competent authority of the other contracting state to determine whether a domestic plan generally corresponds to a pension or retirement plan that is established and recognized for tax purposes in that state and satisfies the general requirements.
The Canadian and U.S. tax authorities have already agreed that certain plans will be recognized as qualifying retirement plans. At this time, Canadian registered pension plans, group RRSPs, deferred profit sharing plans and RRSPs or registered retirement income funds that are funded solely by rollovers from the preceding plans will be characterized as qualified retirement plans. U.S. qualified 401(a) plans, 401(k) plans, IRAs that are part of a simplified employee 408(k) pension plan, 408(p) simplified retirement accounts, 403(a) qualified annuity plans, 403(b) plans, 457(g) trusts, the Thrift Saving Fund and any IRA funded solely by rollovers for the preceding plans will also be characterized as qualified retirement plans.
Short term assignees
Cross-border assignees who participate in a “qualifying retirement plan” of the home country who provide services in the host country can claim a deduction or exclude the contribution from income in the host country 3 provided the following requirements are satisfied:
- the employee’s remuneration is generally taxable in the host country;
- the individual participated in the home country plan immediately before beginning to render services in the host country;
- the individual was not a resident of the host country immediately before he or she began performing services in the host country.
Also, the deduction cannot be claimed once the individual has performed services in the host country for the employer or a related employer for more than 60 out of the last 120 months preceding the employee’s current taxation year.
The contributions and benefits must be attributable to services performed by the individual in the host country and must be made or have accrued during the period in which the individual performs those services.
There are a number of provisions intended to prevent double dipping and restrict the deductions.
If the individual is accumulating benefits in the home country pension plan with respect to contributions to that plan that relate to services in the host country, the employment income used to determine those benefits or contributions must be excluded in determining the individual’s ability to participate in host country tax-preferred retirement programs.
Also, deductions can only be claimed to the extent that tax relief could have been claimed in the home country had the taxpayer resided there at the time of the contribution. Further, where a U.S. citizen is rendering services in the United States and contributing to a Canadian plan, the permitted deductions will not exceed the amounts permitted in the United States if the individual had been a resident contributing to a generally corresponding pension or retirement plan in the United States.
Employers contributing to the home country pension plan will be allowed a deduction in computing the employer’s profit in the host country. It should be noted that Canada already generally permits these deductions. Further, the deduction will be extended to contributions made by a person related to the employer, such as the parent company, where such contributions are treated in the host country as contributions by the employer. However, the amount deductible will be determined under the law of the home country. Intercompany communications on this point will be critical.
If an individual is resident in one country (the resident state), renders services in another country (the services state), and participates in a qualifying retirement plan in the services state, a deduction for employee contributions to the plan can be claimed provided:
- the individual is performing services as an employee in the services state;
- the remuneration received by the employee is taxable in the services state;
- the remuneration is borne by either an employer resident in the services state or a PE of that employer that is located in the services state;
- the contributions are attributable to those services and are made or accrued during the period in which the individual performed those services;
- the amount is deductible in the services state (for U.S. tax purposes, the dollar amounts specified under §415 and 402(1)(g) of the Internal Revenue Code are relevant. For Canadian tax purposes, the limitations specified in subsections 146(5), 147(8), 147.1(8), 147.1(9), 147.2(1) and 147.2(4) of the Income Tax Act are relevant); and
- the amount deductible does not exceed the amount that would have been deductible in the resident state. In Canada, the deduction that is capped is the individual’s deduction limit for a registered retirement savings plan (RRSP), taking into account actual contributions made by the employee to RRSPs. For U.S. purposes, the deduction cannot exceed the amount that a U.S. resident could have deducted under a generally corresponding pension or retirement arrangement established in and recognized for tax purposes in the United States.
Contributions to a qualifying retirement plan in Canada will be treated as contributions to an acceptable corresponding U.S. retirement or pension plan. This will affect the taxpayer’s ability to contribute to an IRA.
U.S. citizens resident in Canada
The Protocol specifies that U.S. citizens resident in Canada who perform services as employees in Canada and participate in a Canadian qualifying retirement plan will be able to claim a deduction for plan contributions or exclude plan benefits from immediate taxation in the U.S. provided:
- the U.S. citizen is performing services as an employee in Canada;
- the remuneration is taxable in Canada;
- the remuneration is borne by an employer who is a resident of Canada or has a PE in Canada; and
- the contributions and benefits are attributable to those services and are made or accrued during the period in which the U.S. citizen rendered those services. For U.S. purposes, contributions will be deemed to be made on the last day of the preceding taxable year if the payment is on account of such taxation year and is treated under U.S. law as a contribution made on that date.
The amount deductible is the lesser of the amount that would be deductible for Canadian tax purposes and the amount deductible in the U.S. by residents on contributions to generally corresponding pension or retirement plans. Contributions made to a qualifying retirement plan by or on behalf of an individual to a generally corresponding pension or retirement plan, thus restricting the individual’s ability to contribute to an IRA.
Permanent establishment – Provision of services
New paragraph 9 of Treaty Article V (Permanent Establishment) adds a special rule for an enterprise of a contracting state that provides services in the other contracting state, and sets out circumstances under which such services may result in the creation of a PE in the other contracting state. When an enterprise does not have a PE under the existing provisions of Article V, it will be deemed to provide those services through a PE if one of two tests is met. New paragraph 9 is generally effective as of the third taxable year that ends after the Protocol enters into force (e.g., for a calendar year taxpayer, 2010, if the Protocol enters into force in 2008). However, services rendered and days of presence that occur prior to January 1, 2010, are not considered in applying the two tests.
The Single Individual Test, set out in paragraph 9(a), is relevant only to enterprises that earn most of their income through the services of one or a small number of individuals. The Enterprise Test, set out in paragraph 9(b), is relevant to every services business. Please refer to our July 24, 2008 alert, “Technical Explanation provides guidance on proposed Canada–U.S. Treaty Protocol” for details on the Enterprise Test.
Single Individual Test
Under the Single Individual Test, an enterprise of one contracting state will be deemed to provide services through a PE in the other contracting state if the services are performed by an individual who is present in the other country for 183 days in aggregate in a 12-month period, and more than 50% of the gross active business revenues of the enterprise are derived from those services. This provision is applicable to independent contractors or enterprises providing services through a small number of key employees.
The TE clarifies the method of counting days for purposes of the 183-day rule. For the purposes of applying the Single Individual Test, all days the relevant individual is physically present in the host country are counted, regardless of whether services are actually provided on those days. This is in contrast to the method used for the Enterprise Test, which only counts those days during which services are actually provided.
The TE also clarifies that “gross active business revenue” means gross revenue that an enterprise has charged or should charge for its active business activities.This is regardless of when the services are billed or when they are taken into account for tax purposes. Active business activities are not restricted to the activities related to provision of services and excludes income from any passive investment activities.
1 In Article XV, Paragraph 1, “salaries, wages and other similar remuneration…” has been replaced with “salaries, wages and other remuneration…”
2 Excluding certain rollover contributions.
3 The employer can also claim a deduction in determining the employer’s taxable profits in the host country.
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