Anyone who travels internationally for business has heard something about the 183-day test. But recent changes to the Canada-United States income tax treaty mean it’s now crucial for employers and frequent travellers to understand what the rule means.
These changes will come into effect in less than one year — on Jan. 1, 2010. When they do, corporations and employees will feel the squeeze of some significant and unexpected tax issues. Documenting the number of days people spend working outside of Canada is about to become much more important, both to employees and the businesses they represent.
It all comes down to the way “permanent establishment” is defined — a new test is about to change how this works. When a Canadian company carries on business in the U.S., those activities will only be taxable in the U.S. if they are “sufficiently substantial.” Once business activities cross that threshold, they’ve created a permanent establishment (PE) in the U.S. And that means the Canadian business is subject to U.S. tax, or vice versa.
What sets this new test apart from the longstanding tests of a PE? It doesn’t require the Canadian business to have any physical assets, an office or management presence in the U.S.
Under this new test, a PE can be created by providing services in the other country. Here’s one scenario: A Canadian consulting company sends employees to work in the U.S. to provide services to a U.S. customer at the U.S. customer site. If that project requires Canadian employees to be present in the U.S. for 183 days or more in any 12-month period commencing or ending in the year, it will create a PE there. A project will include projects that are geographically and commercially related.
When counting days, don’t forget — if a group of people are in the country working on the same project on the same day, this is counted as one day. But if different people are in the country working on the same project on different days, each of these days must be counted in measuring the length of the project against the 183-day rule.
Once this threshold is exceeded, the profits of the project will be taxed in the U.S., and the employment income of the employees working on the project will also be subject to U.S. income tax (unless their employment income associated with U.S. workdays on the project is less than $10,000 US).
A second PE test has been introduced that will mainly be important to sole proprietors and small businesses. Two requirements must be met under this test. The first is that an individual must be present in the other country for more than 183 days in any 12-month period. The second is that more than 50 per cent of the gross revenue of the business must be derived from the services of that individual in the other country.
What needs to be documented?
Tracking employees’ time is vital. Companies need to know how many days each of the employees spends in the U.S. They need to be able to compare those numbers against the 183-day threshold at any time. Don’t forget — one day means any part of the calendar day. Even if an employee is only in the U.S. for a few hours, her presence still counts as one full day. It’s also important to look into any state or provincial rules employees and employers need to be following. In addition to tracking time, it’s key to note the type of work activity taking place because certain activities that are preparatory or auxiliary to the main activity do not count in the days test.
What about employees?
Although companies should track this information for employees, individuals also need to pay attention to another 183-day test. This comes into play when determining if an employee is subject to U.S. personal tax. In general, when employees are in the U.S. for fewer than 183 days in any 12-month period, they will not be taxable in the U.S. For this test, the total number of days spent in the U.S. includes personal or vacation time and not just work days.
However, being in the U.S. fewer than 183 days in a 12-month period does not automatically exclude Canadian employees from U.S. taxation. If their remuneration is borne by a permanent establishment of the Canadian company in the U.S., or by a U.S. employer, Canadian employees will be taxable in the U.S., even if they are in the U.S. for fewer than 183 days (subject to the $10,000 US minimum rule.)
Canadian residents who spend a lot of time in the U.S. also need to consider a third 183-day test — the test of residency under the Internal Revenue Code. For this rolling test, business and personal days spent in the U.S. over a three-year period are taken into account.
U.S. tax authorities add the number of days spent this year in the U.S., one-third of those days from the preceding year, and one-sixth of those days from the year before that. If the total exceeds 183, then the individual is considered a U.S. resident and subject to tax. However, if a person has a closer connection to Canada, and is in the U.S. fewer than 183 days a year, the U.S. residency can be broken by the U.S. closer-connection test. American workers also face a similar Canadian residency test. However, it is based on days in the current year, not the three-year period.
Luckily, the treaty also considers where a person’s home is located, and what kinds of social or economic ties the person has to each country. This treaty determination of residency can override the U.S. 183-day rule. But Canadians are still required to file a U.S. tax return and claim a treaty exemption by making a statement of fact about why they are not residents of the U.S.
It’s important to plan now. Companies need all departments around the table when they develop a day-tracking model. Operations, HR, taxation and legal departments need to understand why this is so important, and how they are going to approach it. Then it’s time to develop a system for tracking these days, and monitoring how close the company is to crossing the 183-day threshold.
Jennifer Horner is an executive director in Ernst & Young’s human capital practice. Kerry Gray is a partner in Ernst & Young’s human capital practice.