The United States has tax treaties (also referred to as "conventions") with over 60 countries. For U.S. income tax purposes, these treaties generally do not benefit U.S. persons, i.e., U.S. citizens and residents; rather, they reduce U.S. taxes on the U.S. source income of residents of foreign countries (nonresident aliens). Tax treaties contain tests for determining residency for purposes of the treaty. Treaty provisions generally are reciprocal (apply to both treaty countries), so they similarly benefit U.S. persons by reducing income taxes imposed by the other country.
Even though tax treaties generally preserve or save the right of the United States to tax its citizens and residents on worldwide income with a "saving clause," treaties may have exceptions to saving clauses that also benefit U.S. persons in terms of their U.S. income taxes.
This article will illustrate some of these exceptions, as they apply to individuals, using the tax treaty in which the "contracting states" are the United States and Canada. The reporting requirements for claiming tax treaty benefits on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b), are not discussed. In all cases, see the treaty for details and conditions.
This article uses the current United States–Canada income tax treaty text posted by Canada's Department of Finance.
This article also refers to the authoritative U.S. Department of the Treasury Technical Explanation of the most recent (2007) protocol amendments to the U.S.–Canada tax treaty.
The treaty's saving clause is found in Article XXIX ("Miscellaneous Rules"):
2.(a) Except to the extent provided in paragraph 3, this Convention shall not affect the taxation by a Contracting State of its residents (as determined under Article IV (Residence)) and, in the case of the United States, its citizens and companies electing to be treated as domestic corporations.
Notice that the saving clause specifically mentions U.S. citizens, since the United States taxes its citizens even if they live abroad. Canada also taxes worldwide income, but only of its residents. Also, notice that the saving clause explicitly mentions that Paragraph 3 contains exceptions.
Exception 1: Article IX ("Related Persons"), Paragraphs 3 and 4
Treaty Article IX addresses transactions between related persons in the contracting states and permits tax authorities to adjust the amount of the income, loss, or tax payable to reflect an arm's-length scenario. Paragraphs 3 and 4 provide that if such an adjustment is made, the other contracting state must make a corresponding adjustment.
This exception can affect a U.S. person because if Canadian authorities adjust the income from a transaction, the United States may make a corresponding adjustment of the related U.S. person's income for U.S. tax purposes.
Exception 2: Article XIII ("Gains"), Paragraph 6
Assume a non-U.S. citizen who was a resident of Canada moved to the United States and became a resident. When he moved to the United States, he sold his principal residence in Canada and realized a gain. To calculate U.S. taxes on this gain, the adjusted basis of the principal residence in Canada that was sold is its fair market value (FMV) when he ceased to be a Canadian resident. This could benefit the U.S. resident; for example, if damage to his principal residence reduced its adjusted basis, the basis will be stepped up to its FMV.
Note: See Article XIII (Gains), Paragraph 5, for when the gain from the sale of real estate in one contracting state is recognized for income tax purposes in the other state.
Exception 3: Article XIII ("Gains"), Paragraph 7
The purpose of Article XIII, Paragraph 7, is to coordinate U.S. and Canadian tax on gains in the case of a timing mismatch (Technical Explanation, p. 25); for example, if a Canadian resident is deemed, for Canadian tax purposes, to recognize capital gain upon emigrating from Canada to the United States. Paragraph 7 resolves the timing mismatch of taxable events by allowing the individual an election to be treated by the United States as having sold and repurchased the property for its FMV immediately before the Canadian taxable event.
The election is available 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. This saving clause exception helps U.S. persons who were residents of Canada immediately before emigrating to the United Sates because they can synchronize U.S. and Canada tax recognition of the gain. See the technical explanation for which types of property this election applies to.
Exception 4: Article XVIII ("Pensions and Annuities"), Paragraph 1
Article XVIII, Paragraph 1, provides that Canadian pensions and annuities that are paid to a U.S. resident can be taxed by the United States; however, the amount of the pension that would be exempt from Canadian taxes for Canadian residents getting the same pension or annuity is exempt from U.S. taxes. This would benefit a U.S. person receiving a Canadian pension if some of the pension is tax-exempt for Canadian tax purposes.
Exception 5: Article XVIII ("Pensions and Annuities"), Paragraph 3
Article XVIII, Paragraph 3, defines the word "pensions" to include retirement plans and amounts paid under a sickness, accident, or disability plan, but not including payments under an income-averaging annuity contract (which are subject to Article XXII ("Other Income")) or social security benefits (Technical Explanation, p. 29). Furthermore, the definition of "pensions" includes payments from individual retirement accounts (IRAs) in the United States and from registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs) in Canada.
Paragraph 3(b) includes Roth IRAs as pensions with a limitation: If a contribution is made to a U.S. Roth IRA by a Canadian source, then the accretions of that U.S. Roth IRA, starting from the time of the first Canadian contribution, will no longer be considered a "pension" for treaty purposes. Thus, the Roth IRA will in effect be bifurcated into a pension part, which continues to be subject to the rules of Article XVIII, and a savings account part, which is not subject to the rules of Article XVIII. This is not necessarily a benefit for U.S. persons but it may affect taxation of future accretions.
Exception 6: Article XVIII ("Pensions and Annuities"), Paragraph 4
Article XVIII, Paragraph 4(a), defines "annuity" for purposes of the treaty (Technical Explanation, p. 31). The term does not include a payment that is not periodic or any annuity the cost of which was deductible for tax purposes in the contracting state where the annuity was acquired. Items excluded from the definition of "annuity" and not dealt with under another article of the Convention are subject to the rules of Article XXII ("Other Income").
Paragraph 4(b) gives rules to establish which contracting state is considered the source of annuity payments. Generally, the resident state of the annuity payer is the source of the payments; an exception to this rule is a payer having a permanent establishment (e.g., a branch of a life insurance company) in a different state than where the payer is a resident. Under the exception, the payment will be deemed to arise in the Contracting State in which the permanent establishment is situated if both of the following requirements are satisfied: (1) The obligation giving rise to the annuity or other amount must have been incurred in connection with the permanent establishment, and (2) the annuity or other amount must be borne by the permanent establishment. When these requirements are satisfied, for example, in the case of a Canadian branch of a U.S. insurance company in Canada, the payments will be deemed to arise in Canada. This would potentially enable a U.S. person to take the foreign tax credit for Canadian taxes paid on that income.
Exception 7: Article XVIII ("Pensions and Annuities"), Paragraph 5
Article XVIII, Paragraph 5, addresses social security payments. U.S. and Canadian social security payments are only taxed by the country where the payee resides. Also, there are limits on how much of the payments are taxable. This effectively makes Social Security payments tax-free for U.S. income tax purposes for U.S. persons who are residents of Canada.
Exception 8: Article XVIII ("Pensions and Annuities"), Paragraph 6(b)
Under Article XVIII, Paragraph 6(a), alimony and child support are only taxable in the recipient's state. Paragraph 6(b) exempts from tax in the payee's state any amount that would be tax-exempt if the payer and payee were in the same state. Therefore, any amount of a Canadian alimony payment that would be tax-exempt if the alimony was paid to a Canadian resident in Canada, is also tax-exempt for U.S. taxation purposes.
Exception 9: Article XVIII ("Pensions and Annuities"), Paragraph 7
Assume a U.S. natural person resident or citizen is a beneficiary of a Canadian tax-free pension or employee benefit plan. The U.S. person can elect to defer U.S. taxes on any accrued but undistributed income until the income is distributed (Technical Explanation, p. 32). As mentioned in Exception 5, Roth IRAs are not always treated 100% as pensions for purposes of Article XVIII. The technical explanation mentions that U.S. rules for making this election are in Rev. Proc. 2002-23. However, the IRS has issued the more recent Rev. Proc. 2014-55 explaining how to take advantage of this tax treaty benefit. The revenue procedure applies to an individual who is a citizen or resident of the United States and a beneficiary of one of the following Canadian plans: a RRSP, a RRIF, a registered pension plan, or a deferred profit sharing plan.
Exception 10: Article XVIII ("Pensions and Annuities"), Paragraph 8
Article XVIII, Paragraph 8, promotes uniform deductibility of cross-border pension contributions (Technical Explanation, p. 32). For example, citizens of the United States who became Canadian residents may benefit from Paragraph 8 if (1) they move back to the United States to work as an employee and (2) they were Canadian residents immediately before they began performing those services in the United States. They could deduct, for U.S. tax purposes, contributions to the pre-existing Canadian retirement plan from their U.S. income. See the treaty for qualifying conditions and contribution limitations.
Note: in this scenario, benefits are available under Paragraph 8 only for so long as the individual has not performed services in the United States for the same employer (or a related employer) for more than 60 of the 120 months preceding the individual's current tax year; if the individual continues to perform services in the United States beyond this time limit, he or she is expected to become a participant in a U.S. plan.
Exception 11: Article XVIII ("Pensions and Annuities"), Paragraph 10
Article XVIII, Paragraph 10, addresses the case of a commuter who is a resident of one contracting state (the "residence state") and performs services as an employee in the other contracting state (the "services state") and also is a member of a retirement plan in the state where the employee provides services (Technical Explanation, p. 35). If certain requirements are satisfied, contributions made to, or benefits accrued under, the qualifying retirement plan by or on behalf of the individual will be deductible or excludible in computing the individual's income in the residence state. Paragraphs 11 and 12 set limitations on the amount of Paragraph 10's U.S. tax benefits.
For example, a U.S. resident works in Canada for a Canadian employer or for a non-Canadian employer who has a permanent establishment in Canada. Contributions made to a Canadian qualifying retirement plan by or for that U.S. resident are deductible by that individual for U.S. tax purposes.
Exception 12: Article XVIII ("Pensions and Annuities"), Paragraph 13
Paragraphs 13 (and 14) of Article XVIII address the case of a U.S. citizen who is a resident of Canada and performs services as an employee in Canada and participates in a qualifying retirement plan in Canada (Technical Explanation, p. 36). If the requirements are satisfied, contributions made to a qualifying retirement plan in Canada by or on behalf of the U.S. citizen will be deductible or excludable in computing his or her taxable income in the United States.
Conclusion
Tax practitioners whose clients are U.S. citizens or U.S. residents with income that flows to or from a country that has a tax treaty with the United States should investigate the relevant tax treaty. Special care should be given to the article that contains both the savings clause and any exceptions that may affect their clients' U.S. tax liabilities. IRS reporting requirements for benefiting from a tax treaty can be found in the instructions to Form 8833 and Regs. Sec. 301.6114-1(b).
Allen Schulman (schulman.allen@gmail.com) is an Enrolled Agent in Lakewood, N.J.
