Chat with us, powered by LiveChat U.S. Taxation of Residents and Non Residents – Tax Partners

U.S. Taxation of Residents and Non Residents

Due to the wide range of alternatives available to Canadian residents who conduct business in the U.S., this discussion has been restricted to the provision of personal services by Canadians in the U.S. only.

Non-residents who are taxable in the U.S. on their U.S. source income must file form 1040 NR by June 15 each year for the prior calendar year. Married residents of Canada may claim exemptions for a spouse and dependent children who lived with them. Although the maximum tax rate used on the form 1040 NR is the same as that for form 1040, fewer deductions and exemptions are generally available, resulting in a higher overall federal tax cost. Non-residents filing form 1040 NR cannot claim the standard deduction, but must itemize deductions.

(a) Canadians Employed in the U.S.

A resident of Canada who is employed by a Canadian company in the U.S falls under the Canada U.S. Income Tax Convention (Treaty) – Article XV – “Dependent Personal Services”, which states:

“Subject to the provisions of Articles XVIII (Pensions and Annuities) and XIX (Government Service), salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived there from may be taxed in that other State.”

This has been defined to mean that employment income is exempt from U.S. taxation and withholding unless it is over $10,000 per year. If it is over $10,000 per year, it is exempt only if:

The individual was in the U.S. less than 183 days in any calendar year, and

The cost is not borne by (deductible by) a U.S. resident employer or an employer with a fixed base in the U.S.

Therefore, to be exempt under the Treaty, an individual must be employed in the U.S. by a Canadian corporation without a fixed base in the U.S. Employment in the U.S. by U.S. employers, and Canadian employers with a permanent establishment or fixed base in the U.S. is fully taxable in the U.S.

A Canadian employer with a fixed base in the U.S. who hires or transfers Canadian residents to work in the U.S. should ensure that U.S. withholding taxes are deducted and remitted to the U.S., and that withholdings to Revenue Canada are eliminated, except for those required to fund Canada Pension Plan (under the Totalization Agreement). Failure to do so can create a cash flow problem for the employee, since they will be taxable in the U.S. and will have to pay U.S. taxes before the Canadian withholdings are recovered through the operation of the foreign tax credit.

Although persons employed by U.S. resident employers and foreign employers with a U.S. fixed base are subject to tax withholding at source on U.S. source income, and are liable to file form 1040 NR to disclose that income, the overall tax cost to the individual will not necessarily be increased as a result of the operation of the foreign tax credit available in Canada for the taxes paid to the U.S. or a state.

A person who is exempt from U.S. taxation under the Treaty must still file:

• U.S. 1040 NR Nonresident Alien Individual tax return – this return would not include any income, but would be filed to preserve the Treaty based exemption from taxation.

• Form 8833 – Disclosure of Treaty Based Position – disclosing the basis for exclusion of income. Law requires this, with severe penalties for failure to disclose a Treaty based position.

• Form 8840 – Closer Connection Exemption – to prevent taxation of world income in the United States by virtue of presence in the U.S. – through the establishment of a closer connection to Canada;

• U.S. Form 8233 Exemption from Withholding on Compensation for Independent Personal Services of a Nonresident Alien Individual – to prevent withholding of income tax at source on employment income from U.S. sources.

• Canadian T-1 Individual Income Tax Return – including world income and the employment income earned in the United States;

Failure to file may result in a fine, and potential denial of the Treaty exemption.

Persons who fail to file the Treaty based disclosure returns on the presumption that they are not taxable in the U.S. also risk having tax assessed in the U.S. at a later date when the Canadian return is barred from adjustment as a result of the time statute to include the additional tax under the foreign tax credit provisions in Canada – thus resulting in potential double taxation. It is therefore extremely important to comply with the letter of the law when it applies to the filing of tax returns, even if the is no apparent immediate tax liability.

(b) Canadian Residents Providing Self Employed Personal Services in the U.S.

A Canadian resident providing personal services in the U.S. as a self-employed individual formerly fell under the Canada U.S. Income Tax Convention (Treaty) — Article XIV – “Independent Personal Services”, which exempted self employment income from taxation in the U.S. regardless of amount or time spent in the U.S. as long as no permanent establishment was maintained in the U.S. Effective January 1, 2008, Treaty Article XIV has been eliminated, and instead replaced by the following in the Fifth Protocol:

Permanent Establishment Defined:

The definition of “permanent establishment” was subject to much interpretation in the former Treaty. Under the new rules, the application of benefits in many cases is tied to whether a person or company has a permanent establishment in a contracting state. A permanent establishment is now created where an individual spends more than 183 days in the other state and during that time more than 50% of the gross revenue generated by the business is derived from services rendered in the other state by that individual. A permanent establishment may also be created where services are provided in the other state for more than 183 days in any 12-month period with respect to a project for a resident of the other state.

Proportional Taxation:

Consistent with changes in the definition of “permanent establishment” mentioned above, the blanket exemption from taxation available to individuals or businesses providing business services in the other state (but not through a permanent establishment) has been repealed. Now, “business profits” are taxable in each state on a basis proportional to the activity carried out through a permanent establishment in each state.

Assuming that the individual is not deemed to have a permanent establishment in the U.S. under the new definition, the following filings may be required each year:

• U.S. 1040 NR Nonresident Alien Individual tax return – this return would not include any income, but would be filed to preserve the Treaty based exemption from taxation.

• Form 8833 – Disclosure of Treaty Based Position – disclosing the basis for exclusion of income. Law requires this, with severe penalties for failure to disclose a Treaty based position.

• Form 8840 – Closer Connection Exemption – to prevent taxation of world income in the United States by virtue of presence in the U.S. – through the establishment of a closer connection to Canada;

• U.S. Form 8233 Exemption from Withholding on Compensation for Independent Personal Services of a Nonresident Alien Individual – to prevent withholding of income tax at source on self employment income from U.S. sources.

• Canadian T-1 Individual Income Tax Return – including world income and the self employment income earned in the United States;

• Canadian form CPT56 – Application for Certification of Coverage of Employment under the Canada Pension Plan Pursuant to Article V of the Agreement on Social Security between Canada and the United States. – to prevent the requirement to deduct and pay social security taxes in the United States.

If, however, the individual does have a permanent establishment in the U.S. under the new definition, the following forms will be required each year:

• U.S. 1040 NR Nonresident Alien Individual tax return – this return would include income and expenses associated with the U.S. permanent establishment.

• Canadian T-1 Individual Income Tax Return – including world income and the self employment income earned in the United States;

• Canadian form CPT56 – Application for Certification of Coverage of Employment under the Canada Pension Plan Pursuant to Article V of the Agreement on Social Security between Canada and the United States. – to prevent the requirement to deduct and pay social security taxes in the United States.

(c) Canadians Providing Personal Services in the U.S. as Independent Contractors Through Their Own Canadian Corporation

Canadian residents may use a Canadian corporation to derive income from personal services in the U.S. In such a case the individual would fall under Treaty Article XV (Dependent Personal Services) for the time spent providing services in the U.S. The Canadian corporation would be proportionally taxable in the U.S. if it has a permanent establishment as defined in the Fifth Protocol to the Treaty.

If the individual has no other dealings in the U.S., the individual employed by his own corporation may fall under Treaty Article XV (Dependent Personal Services) if the time and income threshold amounts are met. Assuming the individual is not exempt under Treaty the following filings may be required each year:

Personal Filings:

• U.S. 1040 Individual tax return (Including world income if factual or elected residence is established in the U.S; A separate state return is also required;

• Canadian T-1 Individual Income Tax Return – including world income and a foreign tax credit for taxes on the 1040;

• Form 5471 Information Return of US Persons with Respect to Certain Foreign Corporations: Any person who is or becomes a U.S. person by virtue of residence, who operates a foreign corporation, must disclose and include in income all passive and personal services income not derived from the country of incorporation – Subpart F. Income.

Any US person (including someone who becomes a US person during the year) must include in current taxable personal income on his 1040, his distributive share of Subpart F income earned by a foreign controlled corporation during the year on form 5471 whether distributed or not (subject to some deductions for qualifying deficits) pursuant to IRC Sec 951. Subpart F income includes income of the foreign corporation which relates to passive activities like rents, interest and dividends (unless part of active business), services rendered outside the foreign country, foreign personal holding company income, sales commissions earned for sales outside of the foreign country.

This law includes personal service income of US persons, which has been channeled through a foreign country in their personal corporation. Therefore, a Canadian who goes to the US to work providing personal services in the US through a Canadian corporation he/she controls, and becomes a US person by virtue of residence, would be liable to include all net service income in his/her US return which is earned by the Canadian corporation, whether distributed or not. To further complicate matters under US rules (IRC267), Canadian style accruals of management bonuses are not permitted to cash basis related parties, and all “bonus” amounts must be paid within the tax year increasing the complexity of tax planning for corporations operating in the U.S.

Corporate Filings:

• U.S. Form 1120-F U.S. Income Tax Return of a Foreign Corporation – The corporation would file details of income and expenses related to the U.S. component of operations on a “proportional” basis.

• U.S. Form W-2 & W-3 – Wage & Tax Statement and Summary Remittances of tax should be made if the expected stay in the U.S. is over 183 days in the year or if more than $10,000 is paid (otherwise forms 1042 &1042S are filed).

• U.S. Form 5472 – Information Return for 25% Foreign Owned Corporation and Related Party Transactions – to disclose dealings with the Canadian shareholder.

• Canadian T-2 Corporation Income Tax Return – Foreign tax credits may need to be applied at the corporate level if all U.S. source income is not disbursed as salary.

• Canadian form CPT56 – Application for Certification of Coverage of Employment under the Canada Pension Plan Pursuant to Article V of the Agreement on Social Security between Canada and the United States. – to prevent the requirement to deduct and pay social security taxes in the United States.

Canadians who operate a small business corporation that would otherwise be eligible for the “Small Business Deduction” under Para. 125 of the Income Tax Act (Canada) should be cautioned that in order to be eligible for the low corporate rate of tax on Canadian Controlled Private Corporations, the corporation must be engaged in an active business carried on in Canada. Income from personal services rendered by the majority shareholder in the U.S. and paid to the corporation will not be eligible for the lower Canadian corporate rate of tax.

(d) Per Diem Expenses While Temporarily Working Away From Home

Canadians who work temporarily in the U.S., and are away from home for business purposes may be eligible to claim a deduction from U.S. taxes for the costs of lodging, food and travel incident to their engagement. For U.S. purposes, per diem and expense reimbursement plans fall into two categories:

• Accountable Plans – in which the employee accounts for each specific expense and returns the balance. These are not taxable, not includable in a W-2, and not subject to FICA, FUTA, etc.; and

• Non-Accountable Plans – which are included on the W-2, but for which the employee can claim itemized deductions subject to the 2% of AGI deduction on Schedule A.

If an expense reimbursement is less than the rate prescribed by the IRS (in tables provided for that purpose) for the area in which the individual works, it will automatically be classified as an accountable plan reimbursement, and will not be taxable.