3
The Treaty
The Canada-US Treaty is formally known as the “Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital” (hereafter referred to as the “Treaty”) and exists primarily to prevent the same income being taxed by more than one country (double taxation). This can occur whenever you are a resident of one country and earn income in another country (e.g., you are living in the US and have interest, dividend, employment or business income, or pension income from Canada). These situations create a potential for double taxation because your country of residence, the US, and Canada have the right to tax the same income.
The Treaty also aids in the enforcement of the countries’ tax laws by providing for exchanges of information between the different tax authorities and in some cases requires the other country to assist in the collection of tax due to the other country. For example, if you owe the IRS money and you move to Canada, in some cases Canada Revenue Agency (CRA) will be bound by the Treaty to assist in the collection efforts of the IRS, and vice versa.
Tax treaties include procedures for resolving differences of opinion between the countries on questions such as the taxation of a specific types of income, in which country the income was earned, or the tax residency of the taxpayer. In the Treaty, this is referred to as sending the issue to the “competent authority.” Basically this means that the issue gets sent to the legal departments of the CRA and the IRS, they then decide who has the right to tax the individual or company. The result could be more significant than simply knowing who to write the check to because it could result in higher tax if one country gets to tax the income verses the other country.
Tax treaties are increasingly important in this era of increased globalization. Treaties provide dependable answers as to which country has the right to tax businesses that operate or invest abroad, new ventures that seek foreign investment and individuals who want to live or work in another country.
Canada was America’s first treaty partner when, in 1936, The Reciprocal Tax Convention, came into force. The Reciprocal Tax Convention was in effect until 1941, and then it was replaced by the Canada-US Tax Convention. The current Treaty was signed on September 26, 1980. The Treaty has been amended by five protocols; the most recent became effective January 1, 2009.
Note: The time between when the Treaty is negotiated and signed, and when it is ratified by the respective governments can be significant. This difference in time can cause planning nightmares, as happened with the latest protocol when 15 months passed between the Treaty being signed and the governments ratifying them.
The Treaty is based on the model developed by the Organisation for Economic Co-operation and Development (OECD), but also includes some features that are unique to the Canada-US relationship. As cross-border situations evolve, the Treaty must also evolve to remain effective. The Treaty has been updated in 1983, 1984, 1995, 1997, and 2009. These changes to the Treaty, known as Protocols, ensure the Treaty has adopted the latest tax developments in each country, as well as the changing needs of Canadian and US individuals and businesses. The latest Protocol to the Treaty, the Fifth Protocol was signed on September 21, 2007, and came into force on January 1, 2009, after it was ratified by the Canadian and US governments.
The discussion in this chapter is not a technical interpretation of the Treaty, it is also not meant to be all encompassing, but rather to make readers aware of some Articles (Chapters) of the Treaty that relate to Canadians living in America.
The Treaty applies to residents of Canada and the US and applies to all taxes imposed under the Income Tax Act of Canada and to the income and estate taxes imposed by the US Internal Revenue Code. The Treaty also applies to the US accumulated earnings tax, personal holding company tax, US excise tax on private foundations, and social security taxes. Estate tax imposed by the US Internal Revenue Code was added to the third protocol to the Treaty and was previously not addressed.
Taxes imposed by the provinces in Canada and by the states of the US are not covered by the Treaty. In the US, each state has its own tax laws and some of the states will not directly accept the provisions of the Canada-US Tax Convention, but will indirectly accept them because their tax laws use as the starting point for tax computation, the federal adjusted gross income. Since the starting point is federal adjusted gross income, any income, deduction, or exclusion for US purposes will be allowed for state income tax purposes, unless otherwise specifically noted; one such state is Arizona. Some states do not accept the provisions of the Treaty because they have their own system of computing income; one such state is California. Some states, such as Michigan accept taxes paid to a Canadian province as a credit against the state tax.
Note: The point made above about some states indirectly allowing for the benefits of the Treaty and some not, is very important. One example that will be discussed in more detail in Chapter 6 is the taxation of RRSPs by Arizona and California. The Treaty allows the annual earnings of RRSPs to be deferred if the proper election and forms are filed. In a state like Arizona, if the deferral is properly made and thus is not part of the federal adjusted gross income, the income will not be included in Arizona and thus will also be deferred in Arizona. However, since the deferral has no effect in California, the annual earnings of your RRSP will be taxed if you live in California. The only ways around this issue are to not live in a state like California or to cash out your RRSPs.
So that you have an idea of what is addressed in the Treaty as well as to have a quick reference, Table 4 is the Table of Articles (Contents) of the Treaty. We will not discuss all of the Treaty Articles, but many of these topics have additional details in other chapters of this book (e.g., dividends and interest will be discussed in Chapter 7 on investments).
Table 4: TREATY ARTICLES
| Article I: | Personal Scope |
| Article II: | Taxes Covered |
| Article III: | General Definitions |
| Article IV: | Residence |
| Article V: | Permanent Establishment |
| Article VI: | Income from Real Property |
| Article VII: | Business Profits |
| Article VIII: | Transportation |
| Article IX: | Related Persons |
| Article X: | Dividends |
| Article XI: | Interest |
| Article XII: | Royalties |
| Article XIII: | Gains |
| Article XIV: | Independent Personal Services |
| Article XV: | Dependent Personal Services |
| Article XVI: | Artistes and Athletes |
| Article XVII: | Withholding of Taxes in Respect to Independent Personal Services |
| Article XVIII: | Pensions and Annuities |
| Article XIX: | Government Service |
| Article XX: | Students |
| Article XXI: | Exempt Organizations |
| Article XXII: | Other Income |
Note: The nondiscrimination provision basically prevents a country from taxing its noncitizens more than its citizens.
Beware that these general rules may be overridden by the “savings clause.” The saving clause preserves the right of each country to tax its own residents as if no tax treaty were in effect. Thus, once you become a resident alien of the US, you generally lose any tax treaty benefits that relate to your US income. The saving clause may prohibit you from claiming certain Treaty benefits because you are a US citizen. One example is that capital gains are generally taxable, only in the country of residence. However, a US citizen living in Canada will still have to report all capital gains on his or her US tax return.
1. Residency
An individual or an entity such as a corporation or partnership is considered to be resident of a country if it is the individual’s or entity’s country of domicile, residence, place of management, place of incorporation, or other criteria of a similar nature. If you or an entity of yours is considered a resident, you and/or that entity will be subject to the taxes of that country; therefore, it is very important to know which country you are or your entity is a resident of.
US citizens are always taxed on their worldwide income, regardless of where they actually reside. US citizens that reside in Canada will also be taxed as Canadian residents, under the laws of Canada.
If you are a non-US citizen, you may spend time and have activities in both Canada and the US; in some of those circumstances, your tax residency may be in question. When an individual’s residency status is question, the Treaty has tie-breaker rules in which to settle the issue.
The tie-breaker rules provide four questions for you to answer. If the answer to the first question does not clarify which country you are a resident of, go on to the next question, and so on until you can determine which country you are a resident of. Once you get a clear answer, stop, that is where you are a resident.
• Where is your permanent home?
• Where are your closest economic and personal relations?
• Where is your habitual abode (the country where you spend most of your time)?
• What country are you a citizen of?
If after answering these four questions you cannot determine where you are considered resident, then you can request that the “competent authorities” of Canada and the US settle the issue by Mutual Agreement. What this means is that the CRA and the IRS will get together and decide.
Businesses that operate on both sides of the border need to understand in which jurisdiction they will be taxed on their profits. The concept of “Permanent Establishment” is defined in the Treaty to determine which country has the right to tax the profits of the business. A permanent establishment for businesses is analogous to residency for individuals. For example, the profits of a business resident in Canada would be taxable in the US only to the extent that some or all of the profits are attributable to a permanent establishment in the US. A permanent establishment would include the following:
• Place of management
• Branch
• Office
• Factory
• Workshop
• Mine, oil or gas well, quarry, or other place of resource extraction
• Building or construction site that lasts more than 12 months
• Person acting on behalf of the resident of the other country if he or she has the authority to conclude contracts (not including independent agents)
A permanent establishment would not include a facility used solely for storage or warehousing, distribution, research, or advertising. It would also not include a business that uses a broker or an independent agent. A permanent establishment can also occur when a business in one country sends an employee to work in the other country for more than 183 days in any 12-month period, and more than 50 percent of the revenues of the business are derived from the services provided in the other country.
If there is a permanent establishment in the other country, the Treaty will tax the business profits as if the permanent establishment were a distinct and separate entity. That means that only the revenues generated and expenses incurred in that permanent establishment would determine the profits that would be subject to tax in the other country. In other words, if you have a Canadian business with a permanent establishment in the US, the profits of the US operations attributed to the permanent establishment in the US would be taxed in the US. Additionally the Treaty allows for the allocation of certain head office expenses, such as general administrative expenses, that would be allocable to the permanent establishment even though the expense was incurred in the other country.
The domestic tax rules of each country include the application of foreign tax credits (see Chapter 5 for more information), which is a mechanism to eliminate double tax. To take this example one step further, if you have a business in Canada that had a permanent establishment in the US, the US would tax the profits on the US operation only and Canada would tax the profits on the worldwide profits. The company would be allowed a foreign tax credit for the taxes paid to the US so that in the end, the tax paid in Canada, after credits, is only the tax on the Canadian profits.
2. Real Property
The Treaty directs that income derived from real property (real estate) situated in the other country may be taxed in the other country. Any rental income from the use of real property is taxed in the country where the property is located. Any sale of real property is also taxed in the country where the real property is located. As an example, when you moved to the US you did not sell your Canadian home and you decided to rent your home in Canada while you are living in the US. The profit on the rental income will be taxable in Canada. In addition, as a US resident, you must include the rental income in your world income. Any income tax you pay in Canada can be taken as a foreign tax credit on your US tax return. When you decide to sell your home, the same idea applies, you will be taxed in Canada and the US on the profit and a foreign tax credit is taken in the US to prevent double taxation.
The Income Tax Act (ITA) allows you an unlimited exemption for gain on your principal residence; however, any gain that occurs after the home is no longer your principal residence is taxable upon sale. The problem is that when it comes time to sell your home in the future, how do you determine that amount of gain since the time it was your principal residence? The answer is to get at least one (three would be better) “broker’s opinion” as to the value of your home, as close as possible to your date of exit from Canada. The amount up to this value will be tax free as your principal residence; any price received above that amount will be taxable as a capital gain in Canada.
The taxation of a home that was, at some point, used as your principal residence in Canada, can be significantly different in the US and Canada. The main reason is that while Canada allows for an unlimited exemption of gain, the US allows for $250,000 per person ($500,000 per couple), if the home was your principal residence at least two out of the previous five years. So one way the taxation could be different is if the gain is greater than the $250,000 or $500,000, or the other way it could be different is if you have rented the Canadian home for four years or more after moving to the US. In this later case, you would lose the exemption all together.
The other way the tax could be different is when there is a change in the value of the currency. You could have a no gain or even a loss in the value of the home, but the currency could improve by the time you sell and you would have a gain that would have to be reported. This issue applies to everything, but is most pronounced in real estate because of the time span between purchase and sale.
For example, since we are trying to illustrate the effect of changes in the currency, let’s assume there are no other factors to consider and let’s say that you bought a cottage (not your principal residence) in Canada for C$200,000 in 2000. In 2011, you sold the cottage for the same C$200,000. Obviously, in Canada you would have no gain. However, assuming you were living in the US when you sold the cottage, your gain from a US perspective would be US$65,340. The reason for this is that when you bought the cottage in 2000, the annual average exchange rate was 1.48520240 Canadian dollars for each US dollar or .6733 US dollars for each Canadian dollar. This means that you bought the cottage for the equivalent of US$134,660. When you sold the cottage in 2011, the annual average exchange rate was .98906920 Canadian dollars for each US dollar or 1.011 US dollars for each Canadian dollar. This means that you sold the cottage for the equivalent of US$202,200, a gain of US$65,340.
3. Dividends, Interest, and Royalties
Dividends paid by a company in one country to a resident of the other country may be taxed in the other country. In addition, the country from which the payer of the dividend is resident can tax the dividend as well. What this means is that if you are living in the US and you receive a dividend from a Canadian company, there will be withholding in Canada (Canadian tax) and that dividend will have to be included in your US income and taxed accordingly (US tax). In every case where income is reported and subject to tax in both countries, a foreign tax credit is available to avoid double tax.
As we discuss in Chapter 4 the Canadian Taxation of Nonresidents, without the benefit of the Treaty, the withholding would be 25 percent, but because of the Treaty, the withholding is only 15 percent when paid to individuals. However, an intercorporate dividend paid between a parent corporation and its subsidiary that is resident in the other country will have only a 5 percent withholding tax.
Interest paid by a resident of one country to a resident of the other country after January 1, 2009, will only be taxed in the country of residence. The Fifth Protocol eliminated the nonresident withholding tax on interest, when the interest is paid as part of an arm’s length transaction.
Most royalties are exempt from any withholding taxes, such as copyright royalties in respect of the production or reproduction of any literary, dramatic, musical, or artistic work. Royalties from motion pictures and works on film, videotape, or other means of reproduction for use in connection with television are subject to 10 percent withholding. Royalties for industrial equipment are subject to a 30 percent withholding.
4. Gains
The treaty provides different rules for capital gains from real property and for gains from other capital property. Generally, gains are taxable only in the country of residence, except that gains arising from real property are taxed in the country where the real property is located, and in the country of residence, as we have already discussed. Generally, all other gains, such as the gains you incur in your investment portfolio are not taxable in the country they occurred; they are taxable only in the country you are resident of.
The Treaty allows you to step up the basis in your assets when you move to the US because you are subject to a “deemed disposition” of your capital assets when leaving Canada. This deemed disposition assumes that you sell all of your assets except for your Canadian real estate and your retirement assets such as RRSPs. The gain that results in this deemed disposition is reported on your final Canadian tax return. If this provision did not exist in the Treaty, when you eventually sold those properties as resident of the US, you would have to pay tax again in the US, on the same assets. The Treaty states that if you are not subject to US tax at the time of emigration from Canada to the US, you can elect to adjust the cost basis in those assets to fair market value at the date of the deemed disposition. Therefore, this “step up” in basis for US tax purposes ensures that only the post-emigration gain will be subject to US tax.
Warning: The ability to step up your cost basis is granted by the Treaty. You must make an election on your first US tax return, using Form 8833 (Treaty Election). The step up is not automatic; failure to make the election will cause double tax. You may not want to make the election to step up your basis if you have a net loss on your assets when you exited Canada. You cannot pick and choose which assets to step up, it is a decision that is made across the board for all assets that are subject to the deemed disposition tax.
US citizens that were residents of Canada that immigrate to the US also have a problem since the deemed disposition of their assets upon emigrating from Canada is not a US tax issue so you end up with a timing mismatch. The Treaty alleviates this problem as well by allowing a step in basis on the property to the value equal to the fair market value at the date of emigration. The US citizens are allowed to report the difference between their cost and fair market value at emigration and report the gain, which would then be allowed the foreign tax paid to Canada to offset the US tax on the gain.
Further, the US citizen is deemed to have repurchased the property at an amount equal to its fair market value at the time so, in essence, only the post-emigration gain will be taxed in the US. The problem with this option is where does the cash to pay the tax come from? Most times the best solution is to actually sell the assets, since you have to pay Canadian tax anyway. By selling the assets this will trigger a US tax on the gain, but you now have the cash to pay the tax and if you really like the asset, you can always buy it back.
5. Personal Services
If you are living in the US and receive employment income (or self-employment income) for services performed in Canada, the income is exempt from tax in Canada if the income does not exceed $10,000 in the source country currency. Alternatively, the income is also exempt in the source country (Canada, in this case) if you were not present in Canada for more than 183 days in any 12-month period and that the income is not “borne by” a person or business (or permanent establishment) that is resident in the source country. The term “borne by” means allowable as a deduction in computing taxable income. The simple reason for this is that if someone or some business is deducting the employment expense, someone has to report the offsetting amount of income. Likewise, if the expense is not being claimed in Canada, there is no need to report the income.
6. Artists and Athletes
Income of an artist or athlete may be taxed in the source country where the gross revenue exceeds $15,000 in the currency of the source country. For example, if a musician that is a resident of the US performs in a concert in Canada and receives more than C$15,000 (gross, before expenses), the musician must report and pay tax in Canada on all of the income (less expenses). The musician does not simply report the amount above the C$15,000 threshold; $15,000 or less is exempt, $15,001 and greater is taxable. The gross receipts would include all expense reimbursements. The US resident musician would also include her US receipts and expenses in her Canadian tax return and she would receive a credit against her Canadian tax for taxes paid in the US.
An entertainer would include a theater, motion picture, radio, or television artist. In order to qualify as an artist or entertainer, the taxpayer must generally “provide the performance that the audience seeks to experience.” There was a case in Canada of a play-by-play personality who claimed that he was an entertainer and the court ruled that he was not an artist for purposes of this article of the Treaty, but rather a radio journalist.
The Treaty also treats the income of artists and athletes as being earned by the artist and athlete regardless of whether the income is earned directly or indirectly through some type of entity, such as a corporation. Therefore, in the example above, if the US resident musician earned the income from a concert in Canada through a corporation, the corporation would pay tax in Canada on the income earned in Canada.
These rules do not apply to an athlete who is employed by a team that participates in a league, such as the National Hockey League or Major League Baseball. Therefore, a US resident hockey player who earns a salary from a US hockey team would be exempt from Canadian taxation if he was not present in Canada for more than 183 days in any 12-month period and his remuneration was not borne by a team in Canada and the team did not have a permanent establishment in Canada (or the income earned was less than C$10,000).
Chapter 4 provides additional information regarding actors providing film or video services.
7. Pensions and Annuities
An important article of the Treaty that seniors should be interested in is the article that pertains to pensions and annuities. The tax treatment of pensions and annuities in one country is respected by the other country. This means that if you receive a pension or an annuity in the US that is partially taxable and partially tax free, Canada will treat it the same way. Company or government pensions and annuities are subject to a 15 percent nonresident withholding tax. The term pension, as it is used in the Treaty means a company or government retirement benefit for employment services performed. The Treaty defines an annuity as “a stated sum paid periodically at stated times during the life or during a specified number of years, under an obligation to make payments.”
Though the Treaty treats IRAs (including Roth IRAs) and RRSPs as pensions, Registered Savings plans are taxed differently than company and government pensions and annuities. Withdrawals from an RRSP are always considered a lump-sum distribution and subject to 25 percent withholding. Withdrawals from an RRIF can be either a lump-sum or periodic. Lump-sum distributions are subject to 25 percent withholding and periodic payments are subject to 15 percent withholding. (A periodic distribution has a specific definition, see Chapter 6 for the definition.) The last thing we will note here is that Registered Savings plans have special reporting requirements in the US, whereas a pension generally does not.
US retirement accounts can generally be broken down into employer-sponsored plans such as 401(k), 403(b), profit-sharing plans, defined benefit retirement plans, and Individual Retirement Accounts (IRAs), such as a traditional IRA and Roth IRA. There are other types of accounts, but these are the most common. A traditional IRA is analogous to an RRSP; you contribute money to an account you control, up to a certain limit. Contributions up to the limit are tax deductible and continue to be deferred until withdrawn. Minimum distributions are required beginning in the year you turn age 70.5.
The big difference between an RRSP and IRA is the contribution limits. For 2012, the contribution limit for an RRSP is C$22,970, while the contribution limit for an IRA is $5,000 if you are younger than 50 and $6,000 if you are 50 or older. Another big difference is that while you can carry over any unused RRSP contributions you did not make, in the US there is a “use it or lose it rule”— you are not able to carry over your unused contributions.
A Roth IRA is similar to a Tax-Free Savings Account (TFSA), where you receive no deduction for contributions, but the money comes out tax free. A TFSA creates a number of additional reporting issues in the US. It may not be worth keeping the TFSA because of the additional tax preparation costs. Additionally, because the income earned in the TFSA is not tax free in the US, we recommend liquidating the TFSA before coming to the US, or if you are already in the US, as soon as possible.
The Fifth Protocol tried to create parity in the treatment of retirement plans between the US and Canada. A qualified contribution and deduction in one country qualifies as a deduction in the other country, subject to the limits of that country. For example, if a Canadian resident, US citizen contributes more than $5,000 or $6,000 to his or her RRSP, only the $5,000 or $6,000, if older than 50, will be deductible. Per the Treaty, the plans also retain the tax characteristics in the other country. For example, a Roth IRA continues to be tax deferred and withdrawals continue to be tax free for Canadian residents. One exception to this is the TFSA; it is not identified in the Treaty as a “pension” and it is therefore not covered by the Treaty and by default is taxable in the US.
8. Social Security
Social Security benefits paid by Canada in the form of Canada or Quebec pension (CPP or QPP) and Old Age Security (OAS) and Social Security benefits paid by the US are taxable only in the country of residence. Because the benefits are taxable only in the country of residence, there is no withholding by the country paying the benefits. In the US, your Canadian benefits are taxed the same as US social security is taxed in the US. For Americans living in Canada receiving US social security, the benefits are only 85 percent taxable in Canada.
Canadians who attain the age of 65 years of age are entitled to receive OAS which is based on the number of years after age 18 that the applicants have resided in Canada. In order to receive the full entitlement, the applicants have to have resided in Canada for 20 years after age 18. If the applicants have resided in Canada after age 18 for at least ten years, they can receive an OAS pension if they reside outside Canada.
The US-Canada Agreement on Social Security allows you to count the years you contributed to the US Social Security system, to count as years of residency in Canada for purposes of qualifying for OAS.
As a resident of Canada receiving OAS, you will have $0.15 of every dollar of your benefit clawed back, if your income is greater than $69,562 (in 2012). As a resident of the US, you are not subject to the clawback and receive the maximum monthly benefit of C$540.12 (2012), if you qualify under the rules above.
9. Government Service
Employees of foreign governments are taxable in their home country. As an example, an employee of a Canadian consulate office in the US would only be taxable as a resident of Canada and would not be taxable in the US provided the employee was also not a US citizen. If the employee was a US citizen, he or she would be taxed in Canada on his or her earnings in Canada as a nonresident of Canada and would also be taxed in the US on that income and would receive a credit against US taxes for the tax paid to Canada.
10. Students
Under the Treaty an individual who normally resides in one country and becomes a full-time student, apprentice, or business trainee in the other country would be exempt from tax on payments received from his or her country of residence. A Canadian resident who attends school in the US would be exempt from tax on any amounts received for the student’s maintenance, education, or training from Canada. Any income earned by the student in the US through employment would naturally be taxable in the US.
11. Taxes Imposed by Reason of Death
The Treaty includes rules to coordinate the death tax regimes of each country. The US imposes an estate tax at death, which is a tax on the fair market value of assets owned by the decedent (the person who died) at death. Canada imposes an income tax on the accrued gain of assets to the date of death. (We have devoted an entire chapter to US Estate and Gift Tax; please read Chapter 10 for more details.)
One thing that confuses many people including professionals is the estate tax exemption allowed to US residents. Residents of the US have the same exemption as US citizens. In 2012, that amount is $5,120,000. The US citizen gets an unlimited marital deduction, but a noncitizen resident does not. This means that if your estate exceeds the exemption, a US citizen can receive an unlimited amount for a deceased spouse, whereas a non-US citizen can only receive the exemption amount tax free. Nonresidents are generally allowed a $60,000 exemption. The Treaty allows for a pro-rata exemption based on your US assets to your worldwide assets. Note: Your worldwide assets include the death benefit of your life insurance.
The other important feature of this section of the Treaty is to provide a tax credit for death taxes paid to the other country. While there are some important exceptions to this credit (see Chapter 10), generally speaking, if you have assets in both countries and death taxes are paid in both countries, there will be a credit allowed for the other country’s tax.
Table 5 includes a summary of the various types of income and the withholding rates.
Table 5: TYPES OF INCOME AND WITHOLDING RATES
| Types of Income | Withholding Rates |
| Wages | Withholding is done through the paycheck in the typical way |
| Interest | 0 percent if an arm’s length transaction |
| Dividends | 15 percent (5 percent for payments of subsidiary to parent corporation) |
| Royalties | 0 percent (TV or film 10 percent and Industrial Equipment 30 percent) |
| Rents | 30 percent on gross rents |
| Gains (non-real property) | Gains (non-real property); generally taxable only in the country of residence |
| Pensions and Annuities | 15 percent |
| Social Security | 0 percent |