Cross-Border Tax Issues: Tax Treaties
by George Gonzalez
Do you engage in international business or investing activities? If so, it is highly recommended that your tax planning take into consideration tax treaties.
Tax Treaties are bi-lateral agreements between two countries*. Canada has income tax treaties with about 94 countries. The U.S. has income tax treaties with approximately 70 countries, and also has estate and gift tax treaties with about 15 countries.
* (There is a current movement led by the Organisation for Economic Co-operation and Development (OECD) for countries to enter multi-lateral tax treaties. However, as of this writing, this has not taken root.)
The key importance of tax treaties is that they override the general tax laws of the countries who are parties to the treaty when there is a contradiction between the treaty’s provisions and the countries’ general tax laws. This means that while a specific income or other tax item may get certain treatment under a treaty country’s general tax laws, that tax item may get a different treatment under the treaty, often to a taxpayer’s advantage. Thus, it behooves you, and your tax planner, to understand the provisions of any applicable tax treaty in cross-border activities.
In this article I discuss, in separate sections, tax treaties for Canadians and tax treaties for Americans.
Tax Treaties: Canadians
A discussion of Canadian tax treaties should really start with the topic of residency. Canada’s income tax system, like that of many other countries, is based on residency. This means that a tax resident of Canada is subject to taxation on their worldwide income (both Canadian-source income and foreign-source income), whereas a non-resident is subject to Canadian income tax on Canadian-source income only.
Virtually all of Canada’s income tax treaties have a section dedicated to tax residency. This section serves to “break a tie” when, under the two countries’ general tax laws, you are considered a resident of both countries. This is particularly important for Canadians because under Canadian tax law there are multiple tests for residency any of which could result in someone being deemed a resident. (Refer to my article “Canadian Taxation: Tax Residency” in these web pages.)
One of Canada’s tax residency tests is the “six-month” or “183-day” rule that many people are familiar with (spend 183 days or more during the year in Canada and you are considered a Canadian tax resident). However, this is only one of the many Canadian tax residency tests. Some of the tests fall under the “significant residential ties” category, some tests fall under the “secondary residential ties” category, and yet other tests fall under the “deemed residents” category (including the 183-day rule). Under Canada’s tax laws, it is entirely possible to be considered a tax resident even if you spend most or all of the year outside of Canada.
Thus, the importance of referring to an applicable tax treaty, if there is one, for determining of which country you should be considered a tax resident. Let us suppose, for example, that you have moved from Canada to Portugal. After the move you continue to have “significant residential ties” as defined under Canadian tax law and would, therefore, continue to be a resident of Canada under general Canadian tax law. Assume that under Portugal’s general tax laws you are also considered a tax resident of Portugal. We would thus have to look to the Canada-Portugal tax treaty to break the tie. Assuming further that the tie is in Portugal’s favour, you would be considered a tax resident of Portugal, not Canada.
The result in the example would be despite Canada’s general tax laws that hold that you are still a tax resident of Canada. Depending on circumstances this could be a very beneficial outcome, i.e., you may pay lower overall taxes as a resident of Portugal than you would as a resident of Canada.
In the above example, if, instead of Portugal, you had moved to a country with which Canada did not have a tax treaty, you would continue to be considered a tax resident of Canada and therefore continue to be subject to Canadian taxation on your worldwide income.
Tax residency is one of many aspects of a tax treaty that are important to consider in tax planning. Another one is the withholding tax paid by non-residents on Canadian-source income. Many, but not all, types of Canadian-source income are subject to the withholding tax, e.g., dividend income, pension income and rental property income. The default withholding tax rate under Canadian general tax law is 25%. Most treaties reduce this rate. Many treaties, for example, provide for a 15% withholding rate on dividend income.
Tax treaties in international tax planning are important whether you are a tax resident of Canada or not. You and your tax planner should understand the provisions of any applicable tax treaty in your cross-border activities, and plan accordingly.
Tax Treaties: Americans
First let us say that a discussion of U.S. tax treaties is unique because of the uniqueness of the U.S. income tax system. The U.S. is one of only three countries in the world that imposes income tax based on citizenship, rather than residency or some other factor, and arguably is the only one that does to the fullest extent possible. Because of the U.S. system, we need to divide U.S. taxpayers into three groups: U.S. citizens, U.S. permanent residents, and U.S. non-residents.
- A U.S. citizen is subject to income taxation on worldwide income (both U.S.-source income and foreign-source income) regardless of where they reside.
- A U.S. permanent resident, often referred to as a green card holder, is taxed as if they were a U.S. citizen, i.e., subject to taxation on their worldwide income.
- A U.S. non-resident is taxed on U.S.-source income only.
Tax Treaties and U.S. Citizens: With a few exceptions, an income tax treaty will not usually reduce the U.S. income tax liability of a U.S. citizen. For a U.S. citizen residing in a foreign country, there are provisions within general U.S. tax law that help eliminate double taxation, and may even result in a lower tax on worldwide income than what would otherwise be paid if the U.S. citizen was a resident**, but these are not treaty-based. On the other hand, if you are a U.S. citizen who resides in a foreign country, it is possible that a tax treaty between the U.S. and your country of residence may reduce your tax payable to that country.
** (Refer to my other articles on the Foreign Earned Income Exclusion, the Housing Exclusion, and the Foreign Tax Credit.)
As mentioned, there are a few exceptions to the general rule that a tax treaty will reduce the U.S. income tax liability of a U.S. citizen. To name a couple: one such exception is the Canada-U.S. tax treaty which has special provisions regarding how Canada and the U.S. each get to tax governmental pension income (U.S. Social Security benefits and Canada Pension Plan benefits). Another example relates to U.S. IRAs owned by Canadian residents (see my article “Cross-Border Tax Issues: Canadian Residents with U.S. IRAs” in these web pages).
The U.S. also has also estate and gift tax treaties (as opposed to income tax treaties) that should be taken into account in tax planning. The estate and gift tax treaty with Germany, for example, offers special relief to U.S. estate taxation when one of the spouses is a German citizen.
Hence, a U.S. citizen should always check on whether there may be an applicable U.S. tax treaty that could provide tax benefits.
Tax Treaties and U.S. Permanent Residents: A green card holder is generally taxed like a U.S. citizen even when they reside outside of the U.S. However, a treaty could reduce the U.S. income tax liability of the non-citizen/U.S. resident residing outside of the U.S. foreign country. Under some situations a green card holder may have the option of electing non-resident status and thus be taxed as a non-resident of the U.S., rather than as a U.S. permanent resident, under the U.S. tax treaty. In such case, the green card holder would pay U.S. tax on U.S. source income only, not on worldwide income.
Tax Treaties and U.S. Non-Residents: A non-resident of the U.S. is subject to U.S. taxation on U.S.-source income only. Some types of income (business income, etc.) must be declared and tax paid thereon by the filing of a non-resident income tax return (Form 1040NR). Other types of income (dividend income, etc.) are subject to the U.S. withholding tax. The default withholding tax rate under U.S. general tax law is 30%. Many U.S. treaties reduce this rate, however. For example, the withholding tax rate on dividend income under many U.S. tax treaties is 15%.
Thus, as for U.S. citizens and U.S. permanent residents, if you are a U.S. non-resident who has U.S. source income, it is important to incorporate the provisions of any applicable U.S. tax treaty into your tax planning.