(a) Canada – U.S. Income Tax Convention, 1980
Article XXIV of the Canada - U.S. Income Tax Convention, 1980 (Treaty) sets out the rules for foreign tax credits which are available in circumstances where each country claims a right to tax the same income. The Treaty also deals with the treatment to be applied to specific types of income, specific occupations or business endeavors, the determination of residence, and withholding taxes.
By invoking protection under the Treaty, an individual or company claims special exception from taxation under the specific tax laws in either Canada or the U.S. because of a potential for double taxation.
Essentially, the Treaty provides that taxpayers be taxed in their country of permanent residence, unless they have a "permanent establishment" or "fixed base" available to them in the other country. A "permanent establishment" or a "fixed base" has been defined to be an office, a permanent residence, or can be established through the use of an agent who has authority to bind the taxpayer. Under certain circumstances, such as where a part year resident of the U.S. elects to be taxed as a U.S. resident for the entire year, Treaty protection is not available.
It is also important not to claim Treaty protection from U.S. taxation on the basis of residence in situations where a Canadian has obtained permanent resident status in the U.S., since such a statement is inconsistent with and may invalidate the U.S. visa status.
Residents of both Canada and the U.S. may find that their overall income tax liability in any year is not affected by a requirement to file and pay U.S. income taxes, since the operation of the foreign tax credit allows a deduction from Canadian tax to the extent that the same income has been taxed in the U.S.
Canadians who work in the U.S. and are exempt by Treaty from U.S. taxation may apply for exemption from withholding of income and other taxes in the U.S., but must have taxes withheld if their income, time present in the U.S., residence of their employer, or other factors disqualify them from Treaty protection.
(b) Claiming Foreign Tax Credits
Where a resident of Canada is taxed on income earned in the U.S., a claim may be made on the Canadian T1 return for relief from Canadian taxation, but only to the extent that tax was paid on that specific income, and only to the extent of the tax actually paid or payable to the U.S., as limited to the Canadian tax which would be otherwise payable on the same income.
For example, a Canadian resident who files a U.S. 1040 NR return upon which U.S. source employment income was declared, would include the gross amount of the employment income, convert the income to Canadian dollars, and calculate tax on the result. The foreign tax available for credit against the Canadian tax calculated, would be the actual amount of the tax accrued for that employment income after taking into account deductions for all deductible items in the U.S. (Under new rules set out in the Fifth Protocol to the Treaty, ratified on December 15, 2008, deductions for contributions to U.S. pension plans would be also deductible in Canada if other conditions for pension deductibility are met in Canada.) Canadians who move to the U.S. may find that they have paid tax on Canadian source income including rental income in Canada, and must include the rental or other income in their U.S. form 1040 and file form 1116 (Foreign Tax Credit) to claim a foreign tax credit. Under these circumstances, the credit available is restricted to the actual amount of tax paid or accrued on each specific category of income. Foreign income taxes that cannot be used in any year can be used in respect of the same category of income in future periods for a limited time.
(c) Alternative Minimum Tax
The operation of the Alternative Minimum Tax (AMT) rules may sometimes limit the benefit of items otherwise deductible. Under AMT all income items and deductions are re-calculated using AMT rules, and a separate tax rate is applied, subject to the AMT deduction. The tax actually payable in any year is the higher of the tax calculated under the regular rules, and that calculated under the AMT rules. Although the rules for AMT calculation differ in the U.S. and Canada, they operate in a similar manner, and can give rise to a tax liability where no tax would otherwise be payable.
(d) Totalization Agreement - Social Security
An international agreement respecting social security between Canada and the U.S. sets out the rules for social security taxation for residents of one country working in the other. This agreement, also known as the Totalization Agreement, provides that a Canadian working in the U.S. on a temporary assignment (of up to 5 years) for a Canadian company is exempt from U.S. Social security taxes if he remains covered by the Canada Pension Plan (CPP).
In order to prove coverage under the CPP, form CPT 56 must be completed and certified by Revenue Canada. This certified form then acts as the authority not to withhold and remit U.S. social security taxes at source from employment income. A similar exemption is available to self-employed Canadian residents who work temporarily in the U.S. (Reciprocal rules are available for U.S. residents working for U.S. companies temporarily in Canada.)
However, Canadian residents employed by U.S. companies in the U.S. are not eligible for relief under the Totalization Agreement. Caution should therefore be used in the transfer of employees to the U.S. to ensure that the transferees remain residents of Canada, and continue to be engaged by the Canadian company (or its subsidiary), since a person would not be covered under the CPP where he/she was considered to be "an employee engaged locally outside Canada".
Even though all U.S. social security taxes are available as a foreign tax credit to Canadian residents working in the U.S. – resulting in no overall increase in tax to the employee, the benefits of the Totalization agreement are:
If the employee were engaged in the U.S. for 5 years in total, he/she would not be eligible for U.S. social security benefits (since 10 years service are required) – resulting in wasted contributions.
While the employee is working temporarily in the U.S., Canada Pension Plan premiums will continue to be made, and will count toward eventual CPP benefits.
The overall cost to the employer is less, since the 2012 employer portion of U.S. social security taxes is 6.2% of the first $US110,100 (plus medicare tax of 1.45% without limit), while the employer portion of CPP is 4.95% of $CDN 51,100, or $C 4,712.40 (for 2013).
A non U.S. citizen who moves into or out of the U.S. in a year, is considered a "dual status alien", and is taxed for that year as if the tax year consisted of two periods, one for the time of residence and the other for the nonresident period. Although the income tax liability for the period that the individual is a nonresident alien is determined under the rules relating to nonresident aliens, the taxable income for the year that is subject to the regular graduated tax is determined by combining all income for the period of U.S. residency with any income for the non-residency period that is effectively connected with the conduct of a U.S. trade or business.
A dual status individual is generally entitled to one personal exemption, except that a resident of Canada may claim exemptions for the nonresident period for a spouse and children. However, a dual status alien cannot claim the standard deduction, but must itemize deductions on his income tax return.
The above rules will not apply in cases where a Canadian moves to the U.S. in a tax year, is married to an individual who is a U .S. resident at the end of the year, (i.e.. a Canadian spouse moving with him will qualify) and both elect under IRC 6013(g) or (h) to be treated as U.S. residents for the entire year. An alien who moves to the United States too late in the year to meet the substantial presence test may also elect to be a resident for part of that year, if he/she meets certain conditions in IRC 7701(b) and is present in the U.S. for at least 31 days in the year.
Under certain circumstances, this election can be beneficial, and calculations contemplating the effect of the election should be made in the preparation of the dual status tax return to determine the optimal treatment. Persons making this election cannot claim any benefit under any foreign tax Treaty which the U.S. is party to.