Proposed changes to the Canada-United States tax treaty are likely to affect every employer with a cross-border workforce or that transfers employees between the two countries.
The fifth protocol to the treaty, signed in September, outlines changes to the permanent establishment rules and to the rules that determine when an employee is subject to tax in the other country.
Combined, these changes are likely to increase the number of cross-border employees subject to tax in the other country. The protocol contains a number of other measures, such as changes to pension contributions, stock-option benefit allocation and the taxation of U.S. business trainees in Canada.
Tracking the days when an employee works in another country is critical to determining when an employee resident in Canada is taxable in the U.S. and vice versa. If such an employee is taxable, the amount of income subject to tax will generally be determined by a pro-ration of compensation based on workdays spent in the host county.
As the employer is responsible for employer income tax and social security withholdings in the host country, tracking time spent in the U.S. by a Canadian employer and in Canada by an American employer is important to both the employee and the employer. Three changes will make tracking days even more important:
changes to the “183-day test;”
clarification of the method of taxing cross-border stock options; and
changes to the definition of permanent establishment.
The ‘183-day’ rule
There is a general rule in the tax treaty that a Canadian resident employee working in the U.S. will be taxable in the U.S. if he is present for more than 183 days in a given year. (The same is true for a U.S. resident employee working in Canada).
The adoption of the protocol will mean this test is now changed to a test of whether the Canadian resident is present in the U.S. for more than 183 days in any 12-month period.
Therefore, when determining whether a Canadian employee’s income is taxable in the U.S., it will be necessary to look at time spent in the U.S. in any 12-month period. Then, at the end of the subsequent year, it will be necessary to also look at days in that year and the previous year when tracking days.
Taxing stock options
The treaty protocol contains long-awaited guidance regarding the apportionment of taxing rights on the exercise of stock options. Under the new rule, the stock-option benefit is considered to have been derived in a country to the extent that the employee’s principal place of employment was in that country during the time between the granting of the option and its exercise.
Therefore, if the country of employment of an individual changes during the period from grant to exercise of the option, this information will need to be tracked so the stock-option benefit will be properly taxed when it is exercised.
The treaty ensures there is some kind of sustained physical presence before a non-resident business is taxable on business profits earned in the other country. This sustained physical presence is known as a permanent establishment (PE).
This protocol will deem a Canadian company to have a PE in the U.S. if it provides services there for an aggregate of 183 days or more in any 12-month period with respect to the same (or connected) project for a customer, where the customer is resident in the U.S.
This PE test concerns the business providing services — not the individual. There could be more than one person working consecutively in the U.S. on a project, where each individual is present in the U.S. for fewer than 183 days in a given 12-month period, and the enterprise could be deemed to have a PE because in aggregate the services are being provided over a period of more than 183 days.
In this situation, employees directly associated with this project who work in the U.S. will be taxable in the U.S. on the associated earnings, even if each one was in the U.S. for fewer than 183 days in any 12-month period.
The effective date for these changes will be no earlier than Jan. 1, 2008. The changes to employee taxation will take effect on Jan. 1 of the calendar year following the calendar year that the treaty is ratified in both countries.
As of press time, the treaty had not yet been ratified in either country. The changes to permanent establishments will not be effective until 2010 at the earliest.
Jennifer Horner is a tax specialist and executive director with accounting and tax firm Ernst & Young in Kitchener, Ont.