This article was originally published on August 19 2019 by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc
If you’re a Canadian resident working for a U.S. company in Canada, there are a multitude of crossborder implications regarding employment law, payroll reporting, income taxes and Social security taxes. The evolution of the professional employer organization (PEO) since the 1980s has become a popular solution for U.S. and Canadian employers when employing remote workers.
PEOs make up a billion-dollar industry. What began as a provider of payroll services evolved to a provider of virtually all HR management functions and it could affect tax responsibilities. Many people, lawyers included, are not familiar with PEOs.
PEOs involve leased employment agreements with a company in which the PEO acts as the legal employer through a co-employment relationship and the PEO is responsible for hiring, firing, payroll, benefits administration, etc. In the U.S., there are more than 900 PEOs employing about 3.7 million people and the number is growing. In Canada, the concept is relatively new, with only 177 PEOs operating as of 2017.
While there are benefits in choosing the PEO route, the arrangement can lead to confusion about tax liabilities and determination of joint employment regarding who is liable for certain taxes, such as for unemployment and workers’ compensation. There may also be confusion about whether income paid to employees is exempt under a tax treaty.
The U.S. Department of Labor recently proposed a new standard to test the relationship between a PEO and its “client” in terms of joint-employer status. It is deemed to be joint employment if the
PEO meets any of these conditions:
- Hires or fires the employee.
- Supervises and controls the employee’s work schedules or conditions of employment.
- Determines the employee’s rate and method of payment.
- Maintains the employee’s employment records.
Here is how the Canadian PEO works for a U.S. company. The company enters into an agreement with the PEO to “lease” an employee. The PEO is the legal employer, responsible for payroll,
benefits, employment standards and other HR management functions, while the U.S. company retains daily oversight of the employee (i.e., common law employer). This allows the company to
hire the talent it needs and to manage the employer’s regulatory requirements at a reasonable cost with little disruption to the business.
Let’s say a U.S.-based company — we’ll call it ABC Inc. — employs a Canadian resident remotely in Canada; we’ll call him John. How does ABC Inc. manage John’s payroll and HR matters? Should
ABC Inc. hire a Canadian payroll expert or an employment lawyer to keep it out of trouble? It might because Canada has a different framework than the U.S. for employment law.
So ABC Inc. enters into an agreement with the Canadian PEO to effectively lease John. But what happens, in terms of taxation, if he travels to the U.S. to meet clients or attend meetings? Who is
the employer when it comes to determining if his remuneration is eligible for a treaty exemption under Article XV of the United States – Canada Income Tax Convention (1980)?
In this case John lives and works in Canada, but his “functional employer” is ABC Inc. even though a Canadian-based PEO administers his payroll and benefits. So when he travels south of the
border on business he is advised that he is covered under the treaty because his “legal employer” is in Canada. Therefore, John doesn’t have to pay income tax in the U.S.
John assumes he is exempt from U.S. taxation because his compensation earned while working on U.S. soil is paid by the Canadian PEO. Here’s what the treaty says according to subparagraph
XV(2)(b): If the compensation is not paid/borne by a U.S. resident and the employee doesn’t spend more than 182 days in the U.S. during any 12-month period beginning or ending in the
year, the compensation earned while on U.S. soil will be exclusively taxed in Canada, the employer’s country of residence.
That sounds straightforward. John gets paid in Canada. He pays tax in Canada. He does not meet any of the U.S. residency tests and continues to be a tax resident of Canada. Also, the PEO is
based in Canada and is not a U.S. resident.
Unfortunately for John, the relationship between ABC Inc. and the Canadian PEO constitutes a joint-employer relationship and ABC Inc. is a U.S. resident. That means the “borne by” test of the
treaty is met. So, despite being a Canadian resident who lives and works in Canada, John is still working for a U.S. company and any compensation allocated to time spent working on U.S. soil is
subject to taxation by Uncle Sam, assuming his compensation during the year exceeds the treaty threshold of US$10,000.
What is the upshot of all this? If you are a company in a cross-border PEO arrangement or an employee under this arrangement, understand what joint-employer status means and the possible
cross-border implications for income taxes and Social Security taxes. Will the PEO administer the U.S. payroll obligations in addition to the Canadian? What if a U.S. state does not follow the
treaty?
This is where the advice of a cross-border tax expert is highly recommended.
So, you’re a Canadian who decides to move to the Sunshine State. At this point in the season – that season being “not winter, but also not spring” – it’s something I think about every day. However, if you’re a Canadian who: 1) Flew south for more than just the winter; 2) Is a resident of California; and 3) holds RRSPs, LIRAs, RRIFs or other Canadian tax-deferred accounts, you need to read this.
The Canada-US Income Tax Convention or “tax treaty”, provides a tax deferral for RRSP and similar retirement accounts until the time of withdrawal. Essentially, giving Canadian retirement plans the same tax treatment as US Individual Retirement Accounts (IRAs). But not every state follows federal tax treaties. California is a state that does not abide by federal tax treaties. According to the California State Franchise Tax Board (FTB), your RRSP is…well…more like a savings account. Translation – the income and capital gains are taxable in the year earned!
The IRS has issued Revenue Procedure 89-45 which provides guidance with respect to why, under US domestic tax law, RRSPs, LIRAs and RRIFs are not considered to be the same as US IRAs. This particular procedure goes on to explain that, in fact, the earnings from this type of plan should be reported as part of your gross income on your US tax return. Of course, this is before considering Income Tax Treaties.
In summary, a California resident must include any earnings from their RRSP in their taxable income and pay taxes in the year it is earned. There is an upside. (Finally!) But one would need to have good bookkeeping skills to take an advantage of it. After tax is paid on these earnings, the earnings will also be treated as capital invested in the RRSP, for California tax purposes. When a taxpayer receives a distribution from their RRSP, the amount of the contributions and the previously taxed earnings is considered a nontaxable return of capital for the California purposes. However, the withdrawal will be taxable federally, meaning an adjustment will be required state-side to avoid double-taxation
Pursuant to Barry v Commissioner, the courts concluded that dividends paid out of a CFC (following a 962 election) in a country in which has no treaty with a US, is a dividend but taxed at ordinary rates. It has always been my understanding that if a CFC that is otherwise not a PFIC and is situated in country who is party to US treaty, such as Canada, distributes a dividend following a 962 election, would be eligible for qualified dividend rates. In Barry V Commissioner, the courts concluded that the dividend was not considered as paid out of a notional domestic corporation (as the petitioner contends) and neither is considered as paid out of qualified foreign corporation (i.e. non-PFIC in a country that has a treaty with the US) and is therefore subject to ordinary rates.
GILTI will have its own basket with or without a 962 election. However, the proposed regulations do not contain rules on the foreign tax credit as it relates to GILTI, much less the appropriate basket when a distribution is paid out of the notional corporation (under 962). Such guidance is still pending. Neither is it clear that assuming the 962 election is not made and a dividend is distributed concurrently (assuming all income is active business income) in the same year as the GILTI inclusion, that the Canadian tax would also fall into the GILTI basket (or in the general basket if there is no income inclusion (under pre-TCJA Sec. 904) in the US due to PTI or under the CFC look-through rules), or whether or not the Canadian tax would be subject to a grind. Therefore, I would reserve any conclusions with respect to foreign tax credits.
Under the 962 election, we are still waiting for guidance if the 50% deduction under Sec. 250(a)(1)(B) is available to an individual shareholder who makes the 962 election. There is speculation that it would be however, without the 50% deduction, my tentative calculation (again absent any further guidance) demonstrates that a 26.3% tax rate is required in Canada in order to eliminate the GILTI tax on a 962 election. If the 50% deduction is available to individuals on a 962 election, then a 13.125% tax in Canada would eliminate GILTI (again based my tentative calculations). There is also a possibility that Congress may consider extending the 50% deduction to individual shareholders but would require a legislative fix.
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US Tax and Reporting Obligations – How They Stand Today
Every year, Americans abroad pay thousands of dollars to file taxes in two or more countries which apply tax treaties that will often (but not always!) offset any balance of US taxes due. While accountants make money from obliging expats and IRS agents review returns that generally add little to the coffers that pay them, US citizens living outside of the states must contend with an overwhelming amount of compliance, as well as detailed and punitive foreign reporting. Sadly, we now know that any relevant relief for American emigrants has been overlooked by both of the tax reforms bills recently passed in Congress.
Residency-Based Taxation Recommendation – Simpler or More Complex?
Groups representing US citizens living and working abroad have reached out to both the House and the Senate and received resounding support with promises that work is underway. However, to the contrary, the recently passed House and Senate tax bills only offer US corporations a territorial tax policy exempting them from taxation on their foreign-sourced income. Relief for American individuals who live and work abroad does not appear forthcoming.
A recommendation put forth by the American Citizens Abroad (ACA) on behalf of American expatriates recommended a residency-based taxation (RBT) policy. This would contrast with the existing citizen-based taxation (CBT) rules which affects world-wide income for all US citizens, irrespective of residency. The suggested policy would exempt the foreign income for Americans who truly qualify as residents of a foreign country. The test for an American to be a “qualified individual” is set forth in section 911 of the Internal Revenue Code (IRC). It considers whether the person is a bona fide resident of a foreign country for at least one full uninterrupted tax year regardless of employment status. The bona fide residence (BFR) test as set out in the IRC is determined on a case-by-case basis. Factors to consider include, intention of the trip, nature and length of stay abroad, whether you are maintaining a home in the US, where your family is residing, among other factors.
A detailed side-by-side comparison of the proposed RBT versus the current law, first published in December of 2016, can be read at https://www.americansabroad.org/media/files/e547e516/Residency-Based_Taxation_ACA_Side-By-Side_Comparison_Vanilla_Approach_171101_v2_.pdf. It highlights the basic tax-neutrality for US tax revenues from foreign-sourced income, which is essential for Congressional consideration. The RBT policy does not recommend any changes to US source income or gains from sales of US real property, which would continue to be taxable for federal income tax purposes. It would also not apply to US armed services or diplomatic corps stationed abroad.
Special rules and definitions set out in existing bilateral tax treaties would still apply to those living in certain countries. In addition, lucky residents of nations deemed tax havens would still be eligible for the RBT. Individuals would have the ability to “opt out” of the RBT prior to relocating should the net tax result work against them. This might be an option for someone who would be frequently traveling back to the US and have no interest in “day counting”. Or perhaps a person who has an estate in the US that would be better served under the current CBT would consider the opt out.
Simplification of Tax Regime through Additional New Taxes
The ACA’s proposal goes further to suggest any real losses to tax revenue could be mitigated by imposing a departure tax on Americans newly relocating but whose plan is to be abroad short term. The minimum threshold for triggering the departure tax could be set relatively high so as not to be punitive. Those Americans making a permanent or long-term move would meet the criteria for the RBT program while those who are currently abroad and show they are “qualified” would have the new policy automatically apply. This suggestion would ultimately shift the tax burden to the ultra-rich who leave stateside to avoid US taxation rather than impede average Americans from pursuing opportunities.
When a Citizen Taxpayer is Not a Priority
As it stands, the bulk of the tax reform is aimed at simplifying an incredibly chaotic tax system and aiding American multinational corporations in hopes of stimulating domestic job creation. This clearly leaves most of the bills’ advantages for US citizens stateside. For those of us living and working abroad, it looks like our relief is still just a hope in the future.
Canadian businesses and individuals who make sales or provide services to U.S.-based clients or customers are considered to have income that is “effectively connected with the conduct of a trade or business in the United States”. Under U.S. domestic tax law non-residents who carry on a U.S. trade or business are subject to U.S. taxation at the federal and possibly state levels.
Articles V and VII of the Canada-U.S. Income Tax Convention (the “Treaty”) provide an exception from U.S. federal income tax as long as the income of a Canadian sales or service provider is not attributable to a U.S. permanent establishment (“PE”). A PE is defined as a fixed place of business through which a non-resident carries on business and may include a place of management, a branch, an office, a factory or workshop, a place of extraction of natural resources (such as a mine), a building, construction or installation project lasting more than 12 months, use of an installation or drilling rig or ship for the exploration or exploitation of natural resources for more than 3 months in any 12 month period, or an independent contractor or employee acting regularly in the U.S. and possessing the authority to conclude contracts. In addition, a PE may be considered to exist if a service provider or an employee is present in the U.S. for over 182 days in any 12-month period, and during such period more than 50% of the gross active business income is derived from the said services, or if a service provider spends in the U.S. over 182 days in any 12-month period with respect to the same or connected project for customers who are either residents of the U.S. or maintain a PE in the U.S. (and the services are performed in respect of that PE.)
To claim relief under the Treaty from U.S. federal taxation on U.S. income by reason of an absence of a U.S. PE, the service provider must timely file a Treaty-Based Position Disclose Under Section 6114 or 7701(b) with the Internal Revenue Service (“IRS”) using Form 8833 along with either personal or corporate U.S. income tax return for non-resident/foreign corporation on Forms 1040NR or 1120-F. Failure to file a treaty-based position disclosure could result in the loss of a benefit of tax deductions to the filer, i.e. the filer becomes subject to taxation on U.S. gross revenue.
The deadline for a U.S. income tax return with a treaty-based position disclosure is the 15th day of the 6th month following the end of the fiscal or calendar year of the filer. An additional 6-month extension of time to file is available for foreign corporate filers and a 4-month extension for foreign individual filers by filing of an extension request on or before the original due date.
Penalties for failure to file and disclose a treaty-based position vary from $1,000 to $10,000 per type of filer – individual or corporation – and are imposed on each non-disclosed type of income.