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How Changes To 5th Protocol Affect Internationally Mobile Employees

By: Tatyana Kovalchuk & Kerry Gray
October 2009

The fifth protocol to the 1980 Canada-U.S. Tax Treaty contains three changes of particular interest to high net-worth individuals moving between these two countries. These provisions intend to minimize the potential negative tax impact of global mobility on these individuals.

The protocol addresses long-standing concerns regarding the deductibility of contributions to cross-border pension plans (Article XVIII – Pensions). In addition, the treaty contains measures to bring relief from the possibility of double taxation of stock option benefits to internationally mobile employees. Finally, the third change allows an individual subject to departure tax, particularly a high net-worth individual, to receive reciprocal treatment in the other country.

5th protocolThe first two provisions, deductions for pension contributions and treatment of stock options, took effect on January 1, 2009. The third provision, capital gains on departure, is effective on a retroactive basis for dispositions that occurred after September 17, 2000.

Pensions

Pension plan changes benefit short-term assignees who remain in their home country pension plan as well as their employers.

The changes also benefit cross-border commuters who participate in a pension plan based on their country of employment rather than their country of residence.

Under the previous rules effective for tax years ending before January 1, 2009, pension deductions were allowed only for country specific qualified pension plans. Canada would not allow a Canadian taxpayer to claim a deduction for a contribution to the U.S. pension plan when computing Canadian taxable income. Similarly, the U..S would not allow a U.S. taxpayer a deduction for contributions made to a Canadian pension plan.

The fifth protocol will now allow a Canadian taxpayer to claim a deduction for a contribution to a U.S. pension plan, in specifically defined circumstances, and vice versa. In addition, employer’s contributions to a Canadian pension plan will no longer need to be imputed in the employee’s U.S. taxable income. In order to obtain this relief, the pension plan must be a qualified retirement plan (QRP).

For Canadian plans, a QRP includes registered and tax-sheltered plans, such as registered pension plans (RPPs), group registered retirement savings plans (RRSPs), and deferred profits sharing plans (DPSPs). Retirement compensation arrangements (RCAs) do not qualify as QRP. For U.S. purposes, a QRP will include most common tax-sheltered retirement plans such as 401(k) plans, other qualified plans under Sec. 401(a), simplified employee pensions under Sec. 408(k), simple retirement accounts under Sec. 408(p), certain qualified annuity plans and trusts and the Thrift Savings Fund.

  • Short-term cross-border assignees

In order for a U.S. expatriate who is on assignment in Canada to deduct his U.S. qualified retirement plan contributions for Canadian tax purposes, and to allow his Canadian employer to deduct the employer’s contributions, the expatriate:

    • Must be a member of the U.S. qualifying retirement plan prior to starting to work in Canada
    • Must have been a non-resident of Canada prior to starting the Canadian assignment
    • Must be on Canadian assignment of less than five years
    • Must be taxable in Canada while on assignment
    • May only deduct contributions that are attributable to services performed in Canada
    • Must not participate in any other pension plan except the home country plan (for example, cannot also participate in a Canadian plan)

The amount of deduction allowed in Canada will be limited to the lesser of the actual amount contributed and the amount allowed under the domestic law of the U.S. to a U.S. resident.

The rules will apply in a similar manner to a Canadian expatriate who is on a short-term assignment, less than five years, in the U.S. However, there appears to be practical barriers to granting the proposed relief where the assignee is a non-resident of Canada. For example, a non-resident of Canada will not be able to make group RRSP deductions if they do not have RRSP contribution room. Provided that these technical matters can be resolved, the protocol changes will help expatriate individuals remain in home country pension plans while on assignment in a host country, a key concern of these individuals.

  • Commuters

In a typical commuter scenario, an individual remains resident in their home country and takes an employment position in the other jurisdiction (for example, a resident of Canada who works in the U.S., or a resident of the U.S. who works in Canada). In these scenarios, the individual will participate in the host country (the country of employment) qualified retirement plan.

Under the previous rules, the commuter would only be allowed to claim a deduction for pension contributions in computing their host country taxable income. No deduction would be allowed in their home country. Under the fifth protocol, the commuter will be able to claim a pension deduction in the home country (in addition to the host country) provided that:

  • The individual is taxable in the host country on the services rendered in the host country
  • The individual remuneration is borne by a resident of the host country or a permanent establishment of the employer in the host country
  • Contributions to the qualifying retirement plan are attributable to services provided in the host country
  • Contributions for the qualifying retirement plan are deductible in the host country

Let’s look at an example. John is a resident of Ontario, Canada, who commutes to the U.S. daily to work for a U.S. employer. John participates in the U.S. employer’s 401(k) plan. Under the previous rules, John was taxable in the U.S. on his earnings and was able to claim a deduction for his contributions to the 401(k) plan in computing his U.S. taxable income. As a resident of Canada, John also had to report his earnings in Canada. However, he couldn’t deduct his 401(k) contribution for Canadian tax purposes.

In addition, his participation in the 401(k) plan restricted his ability to contribute to a Canadian RRSP plan as it would give rise to a pension adjustment. The net result, the 401(k) contribution would only reduce John’s U.S. tax liability and the amount of foreign tax credit that he would claim on his Canadian tax return. In the future, when John would receive his 401(k) distributions, John would have to pay U.S. tax on the distribution. Since the amount was already taxable in Canada in the years when contribution was made to the plan, John wouldn’t be able to claim a foreign tax credit on his Canadian tax return. In this instance, John would find himself in a double taxation situation.

However, under the new rules, John will now be able to deduct his 401(k) contribution in computing his Canadian taxable income. The amount of deduction is limited to the lesser of the actual amount contributed, the amount allowed under the U.S. law and the RRSP contribution limit for the year, after taking into account other RRSP contributions. In this situation, John will realize tax savings to the extent that his overall taxes are reduced by the U.S. pension contribution. At current Ontario top tax rates, the savings will be approximately 46 per cent of the allowable contribution.

Employment Income

An important employment income provision of the protocol addresses a long-standing concern over inconsistent treatment of the employment benefit resulting from a stock option exercise.

Previously, while Canadian and U.S. domestic laws contained similar rules regarding the timing of recognition of income from stock options upon exercise of stock options, the two countries applied different principles when determining the sourcing of stock option benefits for allocation of taxation rights between Canada and the U.S. The Canada Revenue Agency (CRA) generally considered stock options to relate to services rendered in the year of the grant (past services) whereas the U.S. required employment income arising from the exercise of options to be apportioned on the basis of location of employment during the period from grant to vest (future services). These differing principles could give rise to double taxation when an employee who has been granted stock options while working and living in one country then moved to work for the same or a related employer in the other country before exercising or disposing of the option.

Under the new rules, a stock option benefit will be considered to have been derived in one country to the extent that the individual’s principal place of employment was in that country during the time between the granting of the option and its exercise, thereby avoiding double taxation.

Individual’s Gains at Emigration

Canada imposes a tax on a deemed disposition (accrued, but unrealized gains) of certain assets owned by an individual when ceasing Canadian residency. The gain is calculated as a difference between a fair market value of the asset at the time of departure and the asset’s cost basis. This may result in double taxation if there is no corresponding increase in the U.S. tax basis of the asset. The U.S. recognizes capital gains at the time of actual disposition of the asset using original cost basis.

The departure tax does not apply to individuals who were residents of Canada for less than 60 months in the last 120 months prior to departure and if they owned the asset at the time of entry to Canada or acquired it through gift or inheritance during their Canadian residency. In addition, certain assets – pension assets, unexercised stock options, Canadian real or business property – are exempt from Canadian departure tax. The protocol allows an election to create a deemed disposition for U.S. tax purposes, where the individual leaves Canada to take up residence in the U.S. This election is available to any departing individual, regardless of whether the individual is subject to U.S. tax immediately before ceasing Canadian residency.

In the event the individual is not subject to U.S. tax at the time of departure, the election will adjust the cost basis of the property equal to the fair market value at the date of deemed disposition in Canada. Only post-emigration gains will be taxable in the U.S., thus avoiding double taxation.

For individuals who are considered U.S. tax residents at the time of deemed disposition, the election will create a disposition that will be reported for U.S. tax purposes with the ability to claim a foreign tax credit to avoid double taxation.
The election must be made for all assets subject to departure tax in Canada. In addition, the U.S. basis bump is only available if there is a net gain resulting from assets subject to a deemed disposition in Canada.

Please note that no U.S. states follow the treaty, so there could be additional state tax liability at the time of actual disposition.
These changes are effective for dispositions or deemed dispositions that occurred after September 17, 2000.

Moving Forward

It is imperative one stay aware of such treaty changes, especially if you are currently a cross-border employee or considering such a position. As double taxation issues are eased with changes to the treaty, business travelers may find it easier and more economical to commute country-to-country. However, if you have questions on how the treaty changes will affect your pension plan and employment income, speak to your human resources department, local representative, or tax advisor to discuss the potential benefits and items to consider while working abroad.

Tatyana Kovalchuk is senior manager in Ernst & Young LLP’s human capital practice in San Jose, CA, and Kerry Gray is a tax services partner in the human capital practice in Toronto, ON.

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