Canadians who relocate to the U.S. for work assignments may find different tax rules in both countries expose them to double taxation. Fortunately for many of them, recent amendments to the Canada-U.S. Tax Treaty (Fifth Protocol) relating to pensions, stock options and capital gains will provide relief.
For example, when individuals take on temporary assignments in the U.S., it isn’t uncommon for them to continue contributing to their Canadian employer pension plans. Although the current treaty deals with the taxation of pension benefits and the continued deferral of tax on income within the plans, it does not address the deductibility of pension contributions.
Under current U.S. law, a deduction for contribution to a Canadian plan is not permitted. However, under the new Protocol, cross-border commuters and people on short term cross-border assignments will be permitted to claim a deduction on their U.S. returns for contributions made to certain Canadian retirement plans, including RPPs, group RRSPs and DPSPs. Likewise, Americans on assignment to Canada will be permitted to deduct 401(k) contributions for Canadian tax purposes. The new rules may come into effect in 2009.
Employees who are granted stock options while in Canada, but exercise them while living in the U.S., could also be faced with double taxation with relation to the stock option benefit, because of the different sourcing rules in Canada and the United States. For Canadian tax purposes, the income may be sourced to the country of employment at the time the option was granted, but for U.S. purposes the income is apportioned on the basis of location of employment during the period from granting to vesting.
So, if an employee is awarded stock options while living and working in Canada and relocates to the U.S. to work (say halfway between the grant and vest dates), the option benefit is taxable in full by Canada. However, the U.S. would consider the proportion of the stock option benefit—represented by the time living and working in the U.S. during the granting to vesting period—to be U.S. source income (50% of the income). Therefore, in completing the U.S. return, a foreign tax credit would not be allowed with respect to the proportion of taxes that relate to the period (50% of the Canadian tax). As a result, 50% of the stock option benefit would be exposed to double taxation.
This double tax hadn’t previously been addressed in the treaty, but under the new protocol, the stock option benefit is considered to be derived in a country to the extent the individual’s principal place of employment was in that country between the granting and exercise of the option. This rule may also become effective in 2009.
The final rule relates to capital gains on assets owned at the time Canadian residency ceases. In the year of departure, an individual is taxed in Canada on any accrued gains on property owned (although there are a number of exceptions). Instead of paying the tax immediately, the individual may post security with the CRA and defer payment until the year of disposition. When the property is sold, the U.S. will generally tax the gain based on the asset’s original cost. This results in double taxation on the portion of the gain that accrued before departure from Canada. However, limited relief is available by amending the Canadian return for the year of departure to claim a foreign tax credit.
To avoid this, many clients have been told to sell most investments before ceasing Canadian residency and then repurchasing them as residents of the U.S. to strike a new cost base for U.S. tax purposes. But under the new protocol, an election is available for emigrating individuals to have a deemed disposition and reacquisition for U.S. purposes. This change was actually announced in 2000 and once the protocol is in force, will be applicable to deemed dispositions that occurred after September 17, 2000.