Navigating the United States-Canada Tax Treaty as an American Expat

Dec 29, 2023

The US-Canada Tax Treaty can be helpful for Americans living in Canada, although not as valuable as it would be to non-citizens (due to the savings clause).

This article will shed light on the treaty’s main provisions and how they affect U.S. citizens residing in Canada.

Do I have to pay U.S. income tax if I live in Canada?

Americans living in Canada must file a U.S. expatriate tax return with the Internal Revenue Service (IRS) each year as long as they meet certain income and filing requirements.
The United States taxes its citizens on their worldwide income, regardless of where they live or work.
In addition to filing a U.S. tax return, U.S. citizens residing in Canada must file appropriate forms such as FBAR (Foreign Bank Account Report) and form 8938 (per FATCA) with the United States government.

Taxes covered

The United States-Canada Tax Treaty specifically addresses Income Tax.

Regarding social security taxes (primarily an issue for self-employed U.S. citizens working in Canada), taxpayers will find relief in the Social Security Totalization Agreement between the U.S. and Canada.

The fact that it refers to income tax can be problematic regarding the Net Investment Income Tax (NIIT) as its classification is uncertain.

Article II:

  1. This Convention shall apply to taxes on income and on capital imposed on behalf of each Contracting State, irrespective of the manner in which they are levied,

  2. The existing taxes to which the Convention shall apply are:
    (a) In the case of Canada, the taxes imposed by the Government of Canada under Parts I, XIII and XIV of the Income Tax Act; and
    (b) In the case of the United States, the Federal income taxes imposed by the Internal Revenue Code.

  1. The Convention shall apply also to: (a) Any identical or substantially similar taxes on income; and (b) Taxes on capital, which are imposed after the date of signature of the Convention in addition to, or in place of, the existing taxes.

  2. Notwithstanding the provisions of paragraphs 2(b) and 3, the Convention shall apply to: (a) The United States accumulated earnings tax and personal holding company tax, to the extent, and only to the extent, necessary to implement the provisions of paragraphs 5 and 8 of Article X (Dividends); (b) The United States excise taxes imposed with respect to private foundations, to the extent; and only to the extent, necessary to implement the provisions of paragraph 4 of Article XXI (Exempt Organizations); and (c) The United States social security taxes, to the extent, and only to the extent, necessary to implement the provisions of paragraph 4 of Article XXIX (Miscellaneous Rules).

How can I avoid double taxation in Canada?

One option is to take advantage of the Foreign Earned Income Exemption (FEIE).
This allows United States expatriates to exclude up to a certain amount of foreign income from United States taxation.
As of 2022, the maximum exclusion is 120,000 USD per year.
This means that if your only income is earned income (wages or self-employment income) and that income in Canada is less than this amount, you may not have to pay U.S. income tax on that income.
Form 2555 excludes all foreign-earned income from your taxable income.

Another option is to claim a Foreign Tax Credit (FTC).
The FTC allows United States expatriates to offset their United States tax liability against the amount of taxes they have already paid to a foreign government on the same income.

This means that if you already pay Canadian taxes on your Canadian income, you can use those taxes to reduce your U.S. tax liability – the foreign tax credit will give you a dollar-for-dollar credit for taxes paid to Canada.

Canada’s taxes are higher than those paid in the United States, so most customers pay no taxes.

What is the tax treaty between the United States and Canada?

The Canada- United States Tax Treaty is a formal agreement between Canada and the United States. It aims to prevent the double taxation of income of residents of one or both of these contracting states, prevent tax evasion, and provide for fair tax treatment of individuals and businesses.

What is the savings clause?

The savings clause is part of the US-Canada tax Treaty. It states that U.S. citizens cannot use the tax treaty to reduce their U.S. tax liability.

The purpose of the Savings Clause is to allow the United States to continue collecting taxes from its citizens and residents even if they live in another country.

However, the savings clause does not affect specific provisions of the contract.

These would be:
Paragraphs 3 and 4 of Article IX (Related Persons),
Paragraphs 6 and 7 of Article XIII (Gains),
Paragraph 5 of Article XXIX (Miscellaneous Rules),
Paragraphs 3 and 5 of Article XXX (Entry into Force),
Articles XVIII (Pensions and Annuities), XIX (Government Service), XXI (Exempt Organizations), XXIV (Elimination of Double Taxation), XXV (Non-Discrimination) and XXVI (Mutual Agreement Procedure)

When the taxpayer cannot use a treaty provision since it didn’t survive the saving clause, we can typically use Article XXIV (Elimination of Double Taxation). The result is that instead of tax-free income, such income is then re-sourced by treaty, and we could claim a foreign tax credit for taxes paid to Canada.

The tax treaty between the U.S. and Canada provides relief from Double Taxation.

As mentioned above, when income would be tax-free to a foreigner (by using a treaty position that didn’t survive the savings clause), a U.S. citizen can re-sourced it by the treaty, and we could claim a foreign tax credit for taxes paid to Canada.

This can apply to any income. For instance, what would otherwise be a nasty situation is when a U.S. citizen earns income on international waters (for example, while working on a cargo or cruise ship).

The taxpayer could not exclude that income using the Foreign Earned Income Exclusion since it was not earned in a foreign country.

Furthermore, per the Internal Revenue Code, such income would be U.S. Sourced (when earned by a U.S. citizen), thereby preventing the taxpayer from claiming a foreign tax credit.

Even in this instance, the income will be re-sourced by treaty to Canada, allowing the taxpayer to claim a foreign tax credit for taxes paid to Canada, restoring a certain sense of fairness.

Article XXIV, paragraph 1:

In the case of the United States, subject to the provisions of paragraphs 4, 5, and 6, double taxation shall be avoided as follows: In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a citizen or resident of the United States, or to a company electing to be treated as a domestic corporation, as a credit against the United States tax on income the appropriate amount of income tax paid or accrued to Canada; and, in the case of a company which is a resident of the United States owning at least 10 percent of the voting stock of a company which is a resident of Canada from which it receives dividends in any taxable year, the United States shall allow as a credit against the United States tax on income the appropriate amount of income tax paid or accrued to Canada by that company with respect to the profits out of which such dividends are paid. Such right amount shall be based upon the income tax paid or accrued to Canada. Still, it shall not exceed that proportion of the United States tax that taxable income arising in Canada bears to the entire taxable income.

 Sourcing of dividends and interest income

While generally consistent with the Internal Revenue Code, the U.S.-Canada tax treaty clarifies income sourcing. It ensures that the sourcing is the same in both the United States and Canada. This will allow United States and Canadian taxation to overlap and the foreign tax credit to work as intended.

Sourcing is essential: The taxpayer will pay tax to the country where income is sourced and claim a foreign tax credit in the other country.

Article X – Dividends addresses the sourcing of dividend income. Typically, dividends are sourced in the country where the payor corporation is incorporated.

Main paragraphs of Article X:

  1. Dividends paid by a company that is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other state.

  2. However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State; but if a resident of the other Contracting State is the beneficial owner of such dividends, the tax so charged shall not exceed: (a) 10 percent of the gross amount of the dividends if the beneficial owner is a company which owns at least 10 percent of the voting stock of the company paying the dividends; (b) 15 percent of the gross amount of the dividends in all other cases. This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.

  3. The term “dividends,” as used in this Article, means income from shares or other rights, not being debt-claims, participating in profits, as well as income subject to the same taxation treatment as income from shares by the taxation laws of the State of which the company making the distribution is a resident.

  4. The provisions of paragraph 2 shall not apply if the beneficial owner of the dividends, being a resident of a Contracting State, carries on business in the other Contracting State of which the company paying the dividends is a resident through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein. The holding regarding which the dividends are paid is effectively connected with such permanent establishment of a fixed base. In such case, the provisions of Article VII (Business Profits) or Article XIV (Independent Personal Services), as the case may be, shall apply.

Likewise, the sourcing of interest income is found in Article XI – Interests. Typically, interest income is sourced in the country where the payor is a resident.

Main paragraphs of Article XI:

1. Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.
2. However, such interest may also be taxed in the Contracting State in which it arises and according to the laws of that State, but if a resident of the other Contracting State is the beneficial owner of such interest, the tax so charged shall not exceed 15 percent of the gross amount of the interest.

Sourcing of rental income from a real estate property

The rental income from a real estate property is sourced in the country in which that real estate is located. This is addressed by Article VI – Income from Real Property.

Article VI:

  1. Income derived by a resident of a Contracting State from real property (including from agriculture or forestry) situated in the other Contracting State may be taxed in that other State.

  2. For this Convention, the term “real property” shall have the meaning it has under the taxation laws of the Contracting State where the property in question is situated and shall include any option or similar right in respect thereof. The term shall, in any case, have the usufruct of real property and rights to explore for or to exploit mineral deposits, sources, and other natural resources; ships and aircraft shall not be regarded as real property.

  3. The provisions of paragraph 1 shall apply to income derived from the direct use, letting, or use in any other form of real property and to income from the alienation of such property.

 Sourcing of Capital Gains

Intangibles and securities

Article XII provides that capital gains arising from the sale of intangible securities are sourced in the country where the taxpayer is a resident.

Real Estate

As an exception, Article XII, Paragraph 1 provides that the capital gains arising from the same real estate (real property) are sourced in the country where the real property is located.

Article XII, Paragraph 1:

  1. Gains derived by a resident of a Contracting State from the alienation of real property situated in the other Contracting State may be taxed in that other State.

 Corporations – and how they can be taxed in only one country and not the other

 Article VII – Business profits address this. It provides that a corporation can conduct business in another country without being subject to taxation so long as it doesn’t have a “permanent establishment” in the other country.

This applies to the corporation itself; it wouldn’t have any bearing on subpart F and GILTI income consideration.

Article VII, Paragraph 1:

  1. The business profits of a resident of a Contracting State shall be taxable only in that State unless the resident carries on business in the other Contracting State through a permanent establishment situated therein. If the resident carries on or has carried on, business as aforesaid, the business profits of the resident may be taxed in the other State but only so much of them as is attributable to that permanent establishment.

 The term’ permanent establishment’ is widely used in tax treaties using the OECD template.

It is further defined in Article V:

  1. For this Convention, the term “permanent establishment” means a fixed place of business through which the business of a resident of a Contracting State is wholly or partly carried on.

  2. The term “permanent establishment” shall include especially: (a) A place of management, (b) A branch, (c) An office, (d) A factory, (e) A workshop, and (f) A mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

  3. A building site or construction or installation project constitutes a permanent establishment if, but only if, it lasts more than 12 months.

  4. Using a drilling rig or ship in a Contracting State to explore for or exploit natural resources constitutes a permanent establishment if, but only if, such use is for more than three months in any twelve months.

  5. A person acting in a Contracting State on behalf of a resident of the other Contracting State other than an agent of an independent status to whom paragraph 7 applies shall be deemed to be a permanent establishment in the first-mentioned State if such person has, and habitually exercises in that State, an authority to conclude contracts in the name of the resident.

  6. Notwithstanding the provisions of paragraphs 1, 2, and 5, the term “permanent establishment” shall be deemed not to include a fixed place of business used solely for, or a person referred to in paragraph 5 engaged solely in, one or more of the following activities:(a) The use of facilities for storage, display, or delivery of goods or merchandise belonging to the resident;(b) The maintenance of a stock of goods or merchandise belonging to the resident for storage, display, or delivery;(c) The maintenance of a stock of goods or merchandise belonging to the resident for processing by another person;(d) The purchase of goods or merchandise, or the collection of information, for the resident; and(e) Advertising, the supply of information, scientific research, or similar activities with a preparatory or auxiliary character for the resident.

  7. A resident of a Contracting State shall not be deemed to have a permanent establishment in the other Contracting State merely because such resident carries on business in that other State through a broker, general commission agent, or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

  8. The fact that a company that is a resident of a Contracting State controls or is controlled by a company that is a resident of the other Contracting State or which carries on business in that other State (whether through a permanent establishment or otherwise) shall not constitute either company a permanent establishment of the other.

  9. For the Convention, the provisions of this Article shall be applied in determining whether any person has a permanent establishment in any State.

Taxes Imposed Because of Death

This does not apply to U.S. citizens, as they (or rather the executor of the estate) would have to file an estate tax return and they would not be taxed on the first $13.61 million (2024 number), of inheritance (after deducting gifts made while alive).

But for foreigners, the threshold is only $60,000 of U.S. situs assets.
Article XXIX B, Taxes Imposed because of Death, fixes that situation by putting a Canadian resident on the same footing as a U.S. citizen, raising the exemption to $13.61 million (2024).

Article XXIX B, Paragraphs 1 & 2:

  1. Where the property of an individual who is a resident of a Contracting State passes because of the individual’s death to an organization referred to in paragraph 1 of Article XXI (Exempt Organizations), the tax consequences in a Contracting State arising out of the passing of the property shall apply as if the organization were a resident of that State.

  2. In determining the estate tax imposed by the United States, the estate of an individual (other than a citizen of the United States) who was a resident of Canada at the time of the individual’s death shall be allowed a unified credit equal to the greater of(a) The amount that bears the same ratio to the credit allowed under the law of the United States to the estate of a citizen of the United States as the value of the part of the individual’s gross estate that at the time of the individual’s death is situated in the United States bears to the value of the individual’s entire gross estate wherever situated; and(b) The unified credit allowed to the estate of a nonresident not a citizen of the United States under the law of the United States. Any suitable credit otherwise allowable under this paragraph shall be reduced by the amount of any credit previously allowed concerning any gift made by the individual. A credit otherwise allowable under subparagraph (a) shall be allowed only if all information necessary for the verification and computation of the credit is provided.

 Definitions found in Article III

 Definitions found in Article III:
1. For this Convention, unless the context otherwise requires:

(a) When used in a geographical sense, the term “Canada” means the territory of Canada, including any area beyond the territorial seas of Canada, which, by international law and the laws of Canada, is an area within which Canada may exercise rights concerning the seabed and subsoil and their natural resources;

(b) The term “United States” means: (i) The United States of America, but does not include Puerto Rico, the Virgin Islands, Guam or any other United States possession or territory; and (ii) When used in a geographical sense, such term also includes any area beyond the territorial seas of the United States which, by international law and the laws of the United States, is an area within which the United States may exercise rights concerning the seabed and subsoil and their natural resources;

(c) The term “Canadian tax” means the Canadian taxes referred to in paragraphs 2(a) and 3(a) of Article II (Taxes Covered);

(d) The term “United States tax” means the United States taxes referred to in paragraphs 2(b) and 3(a) of Article II (Taxes Covered);

(e) The term “person” includes an individual, an estate, a trust, a company and any other body of persons;

(f) The term “company” means any body corporate or any entity which is treated as a body corporate for tax purposes;

(g) The term “competent authority” means: (i) In the case of Canada, the Minister of National Revenue or his authorized representative; and (ii) In the case of the United States, the Secretary of the Treasury or his delegate;

(h) The term “international traffic” means any voyage of a ship or aircraft to transport passengers or property except where the principal purpose of the voyage is to transport passengers or property between places within a Contracting State; (i) The term “State” means any national State, whether or not a Contracting State; and (j) The term “the 1942 Convention” means the Convention and Protocol between the United States and Canada for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion in the case of Income Taxes signed at Washington on March 4, 1942, as amended by the Convention signed at Ottawa on June 12, 1950, by the Convention signed at Ottawa on August 8, 1956 and by the Supplementary Convention signed at Washington on October 25, 1966.

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