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Recent changes to the Canada-U.S. Tax Treaty may affect business travelers and assignees on short-term assignments. Kovalchuk examines the possible effects stemming from the change to the Fifth Protocol.

Changes to the Fifth Protocol of the 1980 Canada-U.S. Tax Treaty will affect cross-border employers and their internationally mobile employees. The protocol provides changes to the taxation of pension contributions, equity awards, and capital gains. Communicating these significant changes to affected employees will be an important undertaking for HR departments of multinational organizations.

The provisions intend to reduce the potential negative tax effect of global mobility on individuals working between the United States and Canada in two ways.

First, the protocol attempts to ease concern about deductibility of contributions to cross-border pension plans. Next, it brings relief from potential double taxation of stock option benefits to internationally mobile employees.

The provisions on deductions for pension contributions and treatment of stock options took effect on January 1, 2009. The provision for capital gains on departure is effective on a retroactive basis for dispositions that occurred after September 17, 2000.

Pension Plans

Short-term assignees who remain in their home country pension plan and their employers will benefit from these pension plan changes. Cross-border commuters who participate in a pension plan from their country of employment and not their country of residence also will benefit.

In tax years ending prior to January 1, 2009, pension deductions were permitted only for country-specific qualified pension plans. The United States would not permit a U.S. taxpayer a deduction for contributions made to a Canadian pension plan.

Effect on Short-term, Cross-border Assignees

If a U.S. expatriate who is on assignment in Canada wants to deduct his or her U.S. qualified retirement plan contributions for Canadian tax purposes and let his or her Canadian employer deduct the employer’s contributions, the expatriate:

• must be a member of the U.S. qualifying retirement plan prior to starting to work in Canada;
• must have been a non-resident of Canada prior to starting the Canadian assignment;
• must be on Canadian assignment of less than five years;
• must be taxable in Canada while on assignment;
• may only deduct contributions that are attributable to services performed in Canada; and
• must not participate in any other pension plan except the home country plan.

The amount of deduction allowed in Canada will be limited to the lesser of the actual amount contributed and the amount allowed under the domestic law of the United States to a U.S. resident.

Effect on Commuters

Most commuters continue to reside in their home country and work in another jurisdiction (for example, a resident of the United States who works in Canada). The individual will remain in the host country (country of employment) qualified retirement plan.

Before changes to the Fifth Protocol, the commuter only could claim a deduction for pension contributions when calculating his or her host country taxable income. No deduction was allowed in the home country. Now, the commuter will be able to claim a pension deduction in the home country (in addition to the host country) if:

• the individual is taxable in the host country on the services rendered in the host country;
• the individual remuneration is borne by a resident of the host country or a permanent establishment of the employer in the host country;
• contributions to the qualifying retirement plan are attributable to services provided in the host country; and
• contributions for the qualifying retirement plan are deductible in the host country.

Take this example: John is a resident of the United States and commutes to Canada daily to work for a Canadian employer. John participates in the Canadian employer’s Registered Pension Plan (RPP). Under the previous rules, John was taxable in Canada on his earnings and was able to claim a deduction for his contributions to the RPP in computing his Canadian taxable income. As a resident of the United States, John also had to report his earnings in the United States; however, he could not deduct his RPP contribution for U.S. tax purposes. As a result, the RPP contribution only would reduce John’s Canadian tax liability and the amount of foreign tax credit that he would claim on his U.S. tax return. In addition, employer contributions to the RPP on John’s behalf were taxable to John in computing his taxable income for U.S. tax purposes.

However, under the new rules, John now will be able to deduct his RPP contribution in computing his U.S. taxable income. The amount of deduction is limited to the lesser of the actual amount contributed, the amount allowed under Canadian law and the 401(k) contribution limit for the year. In this situation, John will realize tax savings to the extent that his overall taxes are reduced by the Canadian pension contribution. Under the terms of the protocol, the employer contributions to the RPP no longer will be taxable to John for U.S. tax purposes in the year of contribution.

Effect on Employment Income

For many years, expatriates have expressed concerned about inconsistent treatment of the employment benefit resulting from a stock option exercise. In the past, although Canadian and U.S. domestic laws contained similar rules regarding the timing of recognition of income from stock options (i.e., on exercise of stock options), the countries applied different principles when determining the sourcing of stock option benefits for allocation of taxation rights between Canada and the United States.

The United States required employment income arising from the exercise of options to be apportioned on the basis of location of employment during the period from grant to vest (i.e., future services) while the Canada Revenue Agency (CRA) generally considered stock options to relate to services rendered in the year of the grant (i.e., past services). These differences sometimes resulted in double taxation when an employee who was granted stock options while working and living in one country then moved to work for the same or a related employer in the other country before exercising or disposing of the option.

Now, a stock option benefit will be considered to have been derived in one country to the extent that the individual’s main place of employment was in that country during the time between the granting of the option and its exercise. This common sourcing method is the key to avoiding double taxation.

Looking Ahead

It is important for transferees and their managers to stay aware of treaty changes. Business travelers may find it easier and more economical to commute country to country because changes to the treaty have eased double taxation issues. To discuss how the treaty changes will affect your pension plan and employment income, speak to your HR department, local representative, or tax advisor and discover the potential benefits and considerations when working overseas.

The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP.

Tatyana Kovalchuk is a senior manager in Ernst & Young LLP’s Human Capital practice, San Jose, CA. She can be reached at +1 408 947 6871 or tatyana.kovalchuk@ey.com.