Temporary Assignment of an Employee From Canada to the United States

This article is the second in a series of four examining the Canadian and U.S. income tax implications of the temporary assignment of an employee from Canada to the United States. Specifically, these articles address the situation of an employee remaining employed by a Canadian entity, but temporarily assigned to work in the U.S.

Our previous article (Winter 2015 U.S. Tax Alert) examined the importance of the determination of “residency” for personal income tax purposes. In this article, we build on the residency issue and address the Canadian and U.S. personal tax liabilities based on different residency scenarios. In the remaining two parts, we will examine the concept of tax equalization, corporate payroll matters and corporate tax matters.

Taxation of a resident of Canada and a non-resident of the U.S. – no Treaty relief

Canadian taxation

Where an individual continues to be considered a factual resident of Canada, they continue to be taxable in Canada on their worldwide income regardless of where the income is earned. The individual is required to file a full-year Canadian tax return in the same manner as would have applied prior to their temporary assignment to the U.S. Assuming the individual does not qualify for relief from U.S. tax under the Canada-U.S. Income Tax Convention (the Treaty), the employment income earned by the individual as a result of work days in the U.S. is taxable in the U.S. and the state in which the work was performed. In order to alleviate double taxation on the U.S. source employment income, a foreign tax credit is granted in Canada for the taxes paid in the U.S., including the U.S. federal tax, U.S. Social Security, U.S. Medicare and state tax.

In many cases, the combined U.S. tax on the U.S. source employment income is less than the Canadian federal and provincial tax on the same income. Consequently, the foreign tax credit would reduce the Canadian federal and provincial tax on the U.S. source income by the full amount of all of the U.S. taxes paid. In this case, the individual would still be required to pay Canadian tax on the U.S. source income equal to the difference between the Canadian tax rate and the U.S. tax rate. However, if the combined U.S. federal and state taxes exceed the Canadian federal and provincial taxes on the U.S. source income, the foreign tax credit would be limited to the Canadian federal and provincial taxes on the U.S. source income.

U.S. taxation

A non-resident alien of the U.S. who does not qualify for relief from U.S. tax under the Treaty is still only taxable in the U.S. on their U.S. source income, including compensation for services performed in the U.S. The individual is required to file a non-resident U.S. tax return (Form 1040NR). Generally, a non-resident state tax return is also required to report only the state source income. However, an assessment of the individual's state residency status is required to determine whether the state would consider the individual a resident for tax purposes and thus subject to tax in the state on worldwide income for the state residency period. (It is also possible that the state may not impose a personal income tax at all). In this situation, some double taxation could result, with no relief available through the Treaty.

Taxation of a resident of Canada and a non-resident of the U.S. – with Treaty relief

Canadian taxation

As mentioned above, where an individual continues to be considered a resident of Canada, they continue to be taxable in Canada on their worldwide income regardless of where the income is earned. The individual is required to file a full-year Canadian tax return in the same manner as would have applied prior to their temporary assignment to the U.S. In this fact pattern, the Treaty does not modify the individual’s Canadian tax treatment.

Treaty overview

An exemption from U.S. tax under the Treaty impacts only an individual's liability for U.S. federal personal tax. It does not provide an outright exemption from the employee's U.S. federal or state personal tax return filing obligations, nor does it provide any relief from the employer's U.S. payroll reporting requirements. Some states do not follow the Treaty, and an exemption from U.S. federal tax may not exempt the individual from state tax.

Article 15 of the Treaty deals with employment income (applicable to 2009 and subsequent years). An exemption may be available under either paragraph 2(a) or paragraph 2(b). The paragraph 2(a) exception applies where U.S. source employment income earned in the year is less than US$10,000. Based on the U.S. Treasury Department's technical interpretation of the Treaty, we understand that this $10,000 limit applies on a calendar year basis. In many cases, the U.S. source income earned will be greater than $10,000. Therefore, in order to find a Treaty exemption from U.S. tax, it is necessary to meet the conditions of paragraph 2(b).

The paragraph 2(b) exception is more complex and applies when all of the following criteria are met:

1. The employee is not present in the U.S. for more than 183 days in any 12-month period beginning or ending in the year.
2. The remuneration is not paid by, or on behalf of, a person (employer) who is a resident of the U.S.
3. The remuneration is not borne by a permanent establishment in the U.S.

All three tests must be met for the Treaty exemption to apply. Careful evaluation of each criterion is necessary to make the proper determination of eligibility for Treaty relief.

When counting the number of days of presence in the U.S., partial days in the U.S. are counted as full days (with the exception of time spent in the U.S. in transit to another country). Furthermore, all days of presence in the U.S. must be included in the calculation, including work days and non-work days, regardless of whether the reason for the presence in the U.S. relates to the foreign assignment.

U.S. taxation

Assuming the individual qualifies for relief from U.S. tax under the Treaty, the employment income earned as a result of workdays in the U.S. remains reportable on a U.S. tax return. However, it is not taxable in the U.S., as a treaty-based deduction is granted for the same amount, resulting in no taxable income. A non-resident alien of the U.S. who qualifies for relief from U.S. tax under the Treaty is still required to file a non-resident U.S. tax return (Form 1040NR) as well as a form to disclose a treaty-based return position (Form 8833). Generally, a non-resident state tax return is also required to report only the state source income and any Treaty relief. Not all states follow the Treaty, so an assessment of the individual's liability for state tax – including their state residency status – is necessary on a case-by-case basis.

Taxation of a part-year resident of Canada and a part-year resident of the U.S.

Canadian taxation

When an individual ceases to be a resident of Canada part way through a year (and begins U.S. residency for tax purposes), only a part-year Canadian tax turn is required. Generally, relief from U.S. taxation is not available under Article 15 of the Treaty where an individual ceases Canadian residency and takes up U.S. residency. Some of the more significant rules applicable to a part-year Canadian tax return are as follows:

• The individual is taxed on their aggregate worldwide income during the period of Canadian residence.
• Certain income from Canadian sources during the non-resident period (i.e. income earned for days of employment in Canada, or business income from Canada during the period of non-residence, including business income from an interest in an active partnership in Canada, but not including income from investments such as interest or dividends received during the non-resident period).
• Contributions to RRSPs are subject to normal limitations and may be made within 60 days of the end of the calendar year of the move.
• Personal tax credits are prorated on a daily basis for the period of residence unless more than 90 per cent of the individual's worldwide income for the entire year is reported on the Canadian part-year return.
• Actual charitable donations and medical expenses paid while a resident are eligible for tax credits, subject to normal limitations. Personal tax credits for charitable donations are also available to non-residents reporting employment or business income, as well as taxable capital gains.
• Normal graduated tax rates apply.
• Income arising from the deemed disposition of assets on departure from Canada, including taxable capital gains and employment income from certain stock option benefits (as described below in the "deemed dispositions of assets" section) is included in taxable income on the Canadian part-year return.

Ceasing Canadian residency – deemed dispositions of assets ("departure tax")

When an individual ceases to be a resident of Canada, the Act deems the individual to have disposed of certain types of properties at fair market value. Any resulting net capital gain is taxable. These deemed disposition rules are commonly referred to as the "departure tax" provisions. The departure tax rules are beyond the scope of this article, but they are highly complex and should be reviewed carefully as part of any departure from Canada.

Canadian taxation during non-residency

Individuals who have ceased Canadian residency are generally subject to Canadian tax only on income that is sourced to Canada or that has a connection with Canada. Certain types of income, such as business and employment income, are taxed at graduated rates. Other types of income, such as dividends, are subject to a flat rate of withholding tax at source. In limited circumstances, it is possible to elect that income that would otherwise be taxed at a flat rate be taxed at graduated rates.

Income of a non-resident that is subject to tax at graduated rates (and for which a Canadian tax return must be filed) includes:

• income from employment or business carried on in Canada during the year (i.e., employment income attributable to work days spent in Canada after the move unless exempt from tax under the Treaty);
• certain payments by residents of Canada to persons formerly resident in Canada in respect of an office or employment (i.e., a bonus received from the individual's Canadian employer after ceasing residency, but relating to services performed while a resident of Canada);
• the employment benefit arising when an individual exercises an employee stock option granted while the individual was a resident of Canada (i.e. the difference between the exercise price for the shares and the fair market value of the shares at the date of exercise);
• one-half of capital gains arising on the disposition of taxable Canadian property (see the discussion on non-resident withholding tax below); and
• certain amounts that would normally be subject to a flat withholding tax rate but that the individual has elected to be taxed at graduated rates (i.e. rents, RRSP and DPSP payments).

Generally, on a tax return reporting these types of income, the non-resident is not permitted to claim the personal tax credits to which they would be entitled as a resident of Canada. An exception is made for individuals who report more than 90 per cent of their annual worldwide income on the Canadian non-resident return.

Some of the more common types of Canadian-source income that a non-resident may receive and that are subject to a flat rate of withholding tax include:

• Investment income – Dividends from Canadian corporations (other than special tax-deferred dividends) and some forms of interest paid from Canada to non-residents of Canada are generally subject to a withholding tax rate of 25 per cent. Under the Treaty, the withholding tax rate is reduced to 15 per cent and zero percent for dividend and interest income paid or credited to residents of the United States, respectively. However, interest on federal, provincial or municipal government bonds (including Canadian Treasury Bills and Canada Savings Bonds), as well as many long-term corporate bonds, is currently exempt from withholding tax.
• Other income – Lump-sum superannuation or pension payments, including those from RRSPs, are subject to a withholding tax of 25 per cent. The Treaty does not provide for a reduced rate on these lump-sum payments. However, it does provide a reduced rate of 15 per cent on periodic pension and annuity payments. As an alternative to the 25 per cent rate on lump-sum superannuation and pension payments, a non-resident may elect to file an income tax return as though they were a resident of Canada, and be taxed at graduated rates on these amounts.
• Retiring allowance – A retiring allowance paid to a non-resident of Canada would not be subject to tax at the graduated rates. Instead, a person paying a retiring allowance to a non-resident person is normally required to withhold 25 per cent on behalf of the non-resident. The determination of whether a lump-sum amount, or a portion thereof, paid to an employee on termination of employment constitutes "pay in lieu of notice" or a "retiring allowance" is a question of fact.
• Rental income – As a general rule, a non-resident of Canada is subject to a 25 per cent withholding tax rate on gross rental income. However, the non-resident may elect to be taxed on their net rental income as though they were resident in Canada. The advantage here is that the rental income is taxed on a net basis at graduated tax rates, allowing certain expenses to be claimed. The election must be filed within a prescribed time period on a yearly basis. As well, an income tax return must be filed by the non-resident to include all real property rental income and expenses for the year. Where this election is made, the non-resident individual is no longer required to remit the 25 per cent withholding tax on the gross rent, but instead must withhold and remit 25 per cent on any amount available to be paid to the non-resident. The term "any amount available" means the estimated excess of gross rents collected over disbursements deductible in computing income. Capital outlays and non-cash items, such as depreciation for income tax purposes, are not deductible in computing the withheld amount, but these deductions may be claimed on the tax return. The 25 per cent non-resident withholding tax remitted for a particular year, if any, on account of the non-resident individual would be applied against the tax liability on the tax return.

U.S. taxation

A part-year resident of the U.S. is taxable in the U.S. on worldwide income from the date U.S. residency begins. Generally, the individual is required to file a dual-status tax return (Form 1040 and 1040NR), though elections are available to permit filing a full-year U.S. tax return, which could result in a lower overall rate of tax. A part-year resident state tax return might also be required to report worldwide income from the date state residency begins. Again, an assessment of the individual's state residency status is necessary, independent of the federal residency analysis.

This article highlights the differing Canadian and U.S. personal income tax filing obligations, depending on the residency status of the employee involved. Our Summer 2015 U.S. Tax Alert will include an article discussing the concept of tax equalization as a useful tool to assist companies and their employees with the tax complexities we have identified. Our Fall 2015 U.S. Tax Alert will include an article drawing attention to a selection of corporate income tax matters associated with a temporary assignment. As always, contact your Collins Barrow advisor for more information on any of these topics.