The international boundary that divides the United States and Canada is the longest international border on Earth, and many communities and businesses have interests lying on both sides. The shared border facilitates the largest trade relationship between any pair of countries in the world.
It is therefore unsurprising that Americans and Canadians frequently run into their neighboring country’s tax laws. Although dealing with international tax concerns is often complicated, a special relationship between the United States and Canada offers some protection for citizens who earn income or conduct business in both countries.
The U.S.-Canada Tax Treaty
Both Canada and the United States tax their residents on worldwide income. In this article, I will mainly refer to resident individuals (citizens and noncitizens), but it is important to note that U.S. residents also include partnerships, corporations, and estates and trusts based in the United States. In Canada, individuals who spend more than 183 days in the country over a 12-month period, Canadian corporations, corporations founded elsewhere if their “mind and management” is located in Canada, and estates and trusts for which the majority of trustees reside in Canada are all considered residents. The question of residency can be complicated in certain situations, an issue to which I will return later.
For most residents of either country, one of the largest tax concerns when working or earning income across the border is double taxation. The U.S.-Canada Tax Treaty, formally known as “The Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital,” was designed specifically to address this concern. The treaty was originally drawn up in 1980, though it has undergone several significant amendments (or “protocols”) in following years, the most recent of which occurred in 2007. Most of the treaty’s provisions are reciprocal, benefiting both U.S. and Canadian residents.
Under the treaty, U.S. residents who earn income in Canada are only subject to Canadian income tax on certain types of income, including income earned from employment in Canada, income earned from business conducted in Canada, and capital gains derived from taxable Canadian property. In turn, Canadian residents are only subject to U.S. income tax on income effectively connected with a trade or business in the United States and income from the United States that is fixed, determinable, annual or periodical.
Employment income, for both U.S. and Canadian residents, is fairly straightforward under the treaty. Nonresidents who earn income from working in the neighboring country are usually subject to that country’s income tax. The treaty provides exemptions for employment income below $10,000 a year (in the currency of the country in which the work is rendered). Individuals may also be exempt if they earn more than that amount, but are not physically present in the neighboring country for 183 or more days in the 12-month period, and if the income is not paid by or on behalf of a resident of the neighboring country. Canadian residents earning U.S.-source self-employment income may likewise be exempt, regardless of the magnitude of their earnings, if they do not have a fixed base of operations in the United States.
The treatment of passive income is a little more complicated under the treaty’s provisions. Earned interest, in most cases, is only taxable by the recipient’s country of residence. Dividends, however, may be taxed by both the recipient’s country of residence and the issuing company’s country of residence. The treaty caps foreign tax at 15 percent for recipients who are also the dividends’ beneficial owner, though the treaty does not define “beneficial owner,” which has left the provision open to some debate. Royalties are taxed by the income recipient’s country of residence; they may also be taxed by the payer’s country. However, if the foreign recipient is the beneficial owner, the payer’s country may not levy a tax greater than 10 percent.
The treaty stipulates that capital gains from the sale of personal property located in the nonresident country are generally exempt from that country’s income tax if the seller does not have a permanent establishment there. For example, if an American residing in the United States sells 20 shares of a Canadian company that does not principally derive its value from real property situated in Canada, she will owe only U.S. income tax on the capital gains resulting from the sale. The reverse would also be true. This exemption does not apply to real property or to personal property belonging to a company that has “permanent establishment” in the country (a concept discussed in more detail below).
Tax on retirement income is also governed by the treaty. Social Security benefits paid to a nonresident are taxable by the recipient’s current country of residence. For Canadian residents, 15 percent of the benefit amount is tax-exempt; for American residents, any benefit that would not be subject to Canadian tax if it were paid to a Canadian is equally exempt from U.S. income tax. Foreign-source pensions or annuities are taxable in the country of origin, but at no more than 15 percent of the gross amount for a periodic pension, or at 15 percent of the taxable amount for an annuity. The treaty further specifies how various retirement accounts from each country are to be treated for tax purposes.
Overall, the treaty is designed to minimize the instances in which residents of either country are taxed twice on the same income. While the exact provisions affecting an individual’s situation may vary, the tax treaty generally reduces the amount of tax most people will pay.
Cross-Border Taxation for Individuals
As with any tax regime, it is essential to understand what and when you are required to file. U.S. residents who are subject to Canadian income tax must file a return known as the “Income Tax and Benefit Return for Non-Residents and Deemed Residents of Canada.” Canadian residents subject to U.S. income tax must file Form 1040-NR, also known as the “U.S. Nonresident Alien Income Tax Return.” They may also need to file state tax returns, regardless of whether they are required to file federal tax returns, as individual states are not bound by the treaty.
U.S. persons living in Canada receive an automatic extension on their federal U.S. tax returns to June 15. However, any tax due must still be paid by April 15. American residents living or working in Canada who take the position that any U.S. income tax is overruled or reduced by treaty must state that position on Form 8833. Other forms U.S. taxpayers living in Canada may need to file include Form 8891, Form 3520, Form FinCEN 114 and Form 8938, depending on their particular situation.
Unlike the United States, Canada does not require individuals to file a return if no taxes are due, unless the Canada Revenue Agency (CRA) requests otherwise. Canadian nonresidents are also exempt from filing if their only Canadian income derives from certain types of passive income (such as dividends or pension payments), where the tax for nonresidents is withheld at the source.
While the treaty does relieve some instances of double taxation, individuals can take further steps to minimize income tax overlap. Qualified U.S. citizens and resident aliens can exclude a certain level of foreign earnings from income with the foreign earned income exclusion - up to $99,200 in the 2014 tax year. Alternatively, U.S. residents can claim a foreign tax credit on income taxes paid in Canada, or take an itemized deduction for eligible foreign taxes. Taxpayers should note that if they take the foreign earned income exclusion, any foreign tax credit or deduction will generally be reduced since these benefits cannot be applied to excluded income. Similarly, Canadian residents can usually claim a foreign tax credit for taxes paid in the United States. They can also submit an application to the CRA requesting a reduction in their Canadian tax withholding relating to their U.S.-source employment income if that income is already subject to withholding in the United States.
Some individuals working or living across the border may also face estate tax concerns. Canada has no estate or inheritance taxes. However, a deceased Canadian resident is deemed to have realized all accrued income items as of the year of his or her death; these items, with some exceptions, must be reported on a terminal personal income tax return. Noncitizens who die in the United States are only subject to U.S. estate tax on assets deemed to be located in the United States. An individual exemption of up to $60,000 is generally available, but, as a provision of the tax treaty, Canadians can claim a prorated amount of the $5.34 million exemption that Americans receive. A Canadian or U.S. citizen who dies in the other country may ultimately face three levels of taxation: capital gains tax due to Canadian rules; U.S. and Canadian income tax on deferred compensation, retirement plans, annuities and similar contractual rights; and U.S. estate tax on worldwide property (for U.S. persons) or U.S. estate tax on U.S.-based assets (for Canadians). As you can imagine, these situations call for relatively sophisticated estate planning.
All these concerns become more complicated when it is unclear whether an individual is a resident of the United States, Canada or both. Dual residency is possible, mainly because of the relatively loose definition of who qualifies as a resident in Canada. The treaty does, however, include tiebreaking provisions when determining an individual’s residency status for tax purposes. The provisions proceed in a set hierarchy:
- The individual has a permanent home in the country;
- The individual has his or her center of vital interests (personal and economic relationships) in the country;
- The individual has a habitual abode in the country;
- The individual is a citizen of the country.
If none of these provisions can break the tie, competent government authorities from both countries must determine the individual’s residency by mutual agreement. Very few people want to face such a situation, so you should be sure to establish residency (or avoid establishing it) with care.
If an American becomes a Canadian resident, the CRA deems that he or she has effectively disposed of and immediately reacquired all Canadian property at proceeds equal to its fair market value on the date he or she takes up residence. This value becomes his or her new cost basis for determining future gains and losses. Conversely, if a taxpayer gives up Canadian residency, his or her cost basis resets again at the date resident status no longer applies. Any tax incurred by way of capital gain or loss can be paid with the tax return for the year of emigration. If the taxpayer plans to return to Canada, he or she can instead post security, which remains in place until the property is actually disposed of or the individual returns to Canada and “unwinds” the deemed disposition. Either way, if a person emigrates with “reportable property” exceeding CA$25,000, he or she must report all holdings to the CRA upon departure.
Cross-Border Taxation for Businesses
Conducting business across the U.S.-Canadian border can introduce a host of tax issues, the full extent of which are beyond the scope of this article. However, there are some basic frameworks to keep in mind.
Doing business in a given country does not automatically subject you to that country’s tax. Business activities become taxable abroad only if they rise to the level of “permanent establishment.” The U.S.-Canada Tax Treaty defines permanent establishment as having a fixed place of business or a dependent agent in the country. Additionally, a service provider that spends 183 or more days in a 12-month period in Canada may be considered to have permanent establishment automatically, as long as it also earns more than 50 percent of its gross active business revenues from services performed in Canada. A service provider working on the same or connected projects for resident customers is also considered to have permanent establishment.
Once a business has permanent establishment, it must carefully consider its tax structure in order to secure treaty benefits. Historically, there have been two main ways American companies have structured their business when operating in Canada. The first is to employ a Canadian subsidiary to carry out Canadian business activities. The second is to use an unlimited liability company (ULC), a structure offered by certain Canadian provinces that is transparent for U.S. tax purposes. However, given recent amendments to the treaty and falling Canadian corporate tax rates, ULCs are becoming a less attractive option for cross-border enterprises.
You may notice that U.S. limited liability companies (LLCs) did not make this list. This is because LLCs are viewed as taxable corporations for Canadian tax purposes, but as disregarded entities for U.S. tax purposes, a discrepancy that precludes LLCs from treaty benefits. (U.S. residents must pay taxes to meet treaty definitions.) Fortunately, recent treaty provisions have alleviated some of the historical problems U.S. LLCs have faced with regard to Canadian taxation, at least for American LLC members. Unfortunately, Canadian LLC members could still face double taxation due to the differing ways the countries tax the entity. Using LLCs will continue to require careful planning on both sides of the border.
LLCs are not only subject to Canadian income tax. Profits earned by LLCs with permanent establishment in Canada are also subject to a 25 percent branch tax; however, for LLCs owned by U.S.-based corporations, the rate is reduced to 5 percent, and the first $50,000 of profits are excluded.
Cross-border enterprises doing business in Canada should also be aware of the federal goods and services tax (GST), a value-added tax of 5 percent imposed at point-of-sale for certain goods and services. Some provinces replace the GST with a combined harmonized sales tax (HST), which folds the GST with a provincial tax component; with some exceptions, the HST applies to most of the same goods and services. However, a business is only required to remit the amount by which the GST or HST it has collected exceeds the amount of GST or HST it has paid over the same period. The treaty does not govern this tax.
The high level of trade between the United States and Canada serves the interests of both countries, as well as those of individuals and enterprises that do business across the international boundary. When engaging in business across the border, be sure to fully assess the tax consequences of your situation. There are many rules, exemptions and exceptions to keep in mind but, with careful planning, you can keep your tax concerns to a minimum and take full advantage of the neighborly relationship.