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By Laura Kennedy & Mary-Lynn Desmeules
Illustration: Susanna Denti
WHILE AN INTERNATIONAL JOB POSTING MAY BE A DREAM COME TRUE, BEFORE YOU PACK, BRUSH UP ON THE TAX DIFFERENCES
As more and more businesses expand operations globally and transfer employees from one continent or country to another, it is increasingly important for chartered accountants to have an awareness of various expatriate tax issues. Some such tax matters have a broad impact and can make a difference in how much income tax an employee pays and to which country.
One of the most important questions a CA can ask a client is if he or she or a senior officer/shareholder in the organization is a US citizen. US citizens are required to file annual US income tax returns no matter where they reside. If your client is a US citizen, be cautious when applying traditional Canadian tax-planning techniques as they may cause unforeseen tax problems. Consider the following situation: Maria, a US citizen, sells shares of the family business to realize a capital gain of $350,000. For Canadian income tax purposes, Maria will claim the enhanced capital gains exemption (Section 110.6) so she does not pay any Canadian income tax on the transaction. However, for US tax purposes, the gain is fully taxable because the Canadian capital gains exemption does not apply on her US return. The new US bill reducing the capital gain tax rate will not apply to gain on shares of a foreign personal holding company. This may result in an unintended US tax liability. Other situations to watch out for include estate freezes and tax-deferred transfers under the Canadian income tax act, including Section 85 transfers to Canadian corporations and transfers to Canadian partnerships.
In April, the US Internal Revenue Service issued Notice 2003-25, in which it indicated it has become aware that many taxpayers with interests in Canadian RRSPs are unfamiliar with the requirements for filing US tax forms 3520 and 3520-A. This notice was followed by a subsequent notice, Notice 2003-57, in August. Previous instructions had indicated that RRSPs were exempt from filing Form 3520. The IRS has stated it will not require Forms 3520 and 3520-A to be filed for taxation years before 2002, but it will require them to be filed for 2002, and it has granted an extension for filing until August 15. Where a taxpayer has filed an election under the Canada-US Treaty to exempt RRSP earnings from current US taxation, following the procedure in Revenue Procedure 2002-23, the requirement to file Form 3520-A and Form 3520 is waived for the 2002 taxation year. However, Form 3520 has to be filed if there was a distribution from the plan during 2002. The latest notice also states where a Form 3520 or Form 3520-A has been filed for 2002 and is incomplete, the IRS will not assess penalties for failure to file unless it requests such information and the taxpayer fails to submit the requested information. If a tax-payer has failed to file an election under Revenue Procedure 2002-23 for 2002 to defer US tax on accrued income within the plan, he or she may make the election by filing an amended US return by August 15, 2003. The IRS has said that it is working to develop a more simplified reporting regime for Canadian retirement plans for future tax years.
US citizens and permanent residents may claim the foreign earned income exclusion, which effectively exempts up to US$80,000 of foreign employment or of self-employment income. As a result of this exclusion, most US citizens residing abroad have no US income tax liability. The Bush administration was proposing to eliminate the foreign earned income exclusion. The Tax Bill, signed May 28, does not repeal the exclusion. Given Canada's generally higher income tax rates, most Americans living in Canada and who have only Canadian-source income will not have a regular US tax liability because they may claim a foreign tax credit for Canadian taxes paid on Canadian-source income. However, with the removal of the exclusion, many US citizens would have found themselves subject to US alternative minimum tax (AMT) on their income. This is because under the Internal Revenue code, the AMT calculation only allows a foreign tax credit for AMT purposes to the maximum of 90% of the AMT liability before the foreign tax credit. Since AMT is generally not creditable for Canadian income tax purposes, the end result would have in effect resulted in double taxation.
Canadian businesses are expanding their operations internationally. Many issues need to be considered in this context, both corporate and personal. One often-overlooked consideration is the application of social security agreements.
Canada has a wide network of social security (or totalization) agreements, including agreements with such major trading partners as the US, Britain and Mexico. As a general rule of thumb, the country in which an individual is employed has the right to apply social taxes to that person's employment income earned in that country. An individual employed in the US would normally be subject to US social taxes (FICA/Medicare). FICA/Medicare taxes are significantly higher than Canadian CPP premiums. For example, a Canadian resident earning $70,000 a year would pay CPP premiums of $1,802. A US resident earning an annual salary of US$70,000 would pay FICA/Medicare premiums of US$5,355. Where an employee is transferred for a short-term period (defined as five years or less for transfers to the US) to a related employer in the US, the Canadian employer can apply for a certificate of coverage and pay CPP premiums for the employee rather than FICA/Medicare. This benefits the employee in a number of ways. First, when he or she retires, the employee will only have to be concerned about applying for CPP retirement benefits rather than retirement benefits from multiple countries. Second, many countries require that social security contributions be made for a minimum period of time before any benefits can be collected. In order to draw any payment from US Social Security, an individual must have at least six quarters (1½ years) of coverage in the plan. Thus if an individual accepted a short-term transfer of one year to the US and a certificate of coverage was not applied for, he or she would pay US FICA/Medicare of US$5,355 but would not be able to collect any retirement benefit. Finally, both the employee and employer benefit because the cost of CPP is less than the FICA/Medicare.
Typically, in a temporary transfer situation, the employer should apply for a certificate of coverage from Canada Customs & Revenue Agency prior to the transfer. The certificate allows the employee to be exempt from foreign country social security coverage and instead continue to pay CPP premiums on his or her employment earnings. All is not lost if the employer belatedly discovers it didn't apply for this certificate — CCRA will process retroactive certificates of coverage.
Another common situation is foreign companies (particularly US companies) extending their operations to Canada. Often Canadian startup operations are staffed with US employees who participate in US benefits programs. Participation in such programs can lead to unintended results. For example, one common retirement savings program in the US is known as the 401(k) plan — a type of pension plan in which the employee annually elects how much of his or her income he or she wants to contribute (within statutory limits, currently US$12,000 for 2003). For US tax purposes, these contributions reduce US taxable income and taxable wages are reported net of the contribution. However, for Canadian income tax purposes, the individual will be subject to Canadian tax on his or her gross income before deducting the 401(k) contribution. An employee's 401(k) contribution is easily identified on the W-2 slip (currently reported in Box 12b, with a notation D). Consequently, the Canadian income taxes are often higher than expected.
In addition, there can be other Canadian income tax implications beyond the scope of this article if the foreign plan is considered to be a retirement compensation arrangement, an employee benefit plan or a salary deferral arrangement.
Another issue coming up more frequently is the situation of US restricted stock programs being extended to Canadian-resident executives or directors of US corporations. Restricted stock plans are typically not utilized by Canadian corporations because they do not receive favourable Canadian tax treatment. The following describes a typical restricted stock plan: the corporation will award a certain number of restricted shares to the executive — under the terms of the award, the shares are held in a trust account and can't be accessed by the executive until the restrictions have lapsed (this is generally a time-based criteria, such as continued employment with the company for a specified number of years). If the executive does not meet the criteria, he or she will forfeit the right to the shares. Most restricted stock plans allow the executive to exercise the voting rights attached to the shares, as well as to receive any dividends paid on such shares. As a result, CCRA's view is that essentially all the rights and conditions of ownership have passed to the executive and therefore the individual is subject to Canadian income tax upon the grant of the restricted stock. However, for US tax purposes, such plans are usually not taxable until the restrictions lapse. This can lead to cash flow difficulties since the individual is taxed in Canada on an asset he or she can't liquidate in order to pay the tax liability.
Hopefully this gives one an appreciation for some expatriate tax issues affecting corporations and individuals. Many more have yet to be addressed.
Laura Kennedy, CA, is partner with Kennedy McLeman Chartered Accountants in Calgary. Mary-Lynn Desmeules, LLB, is partner in the human capital group of Ernst & Young LLP in Montreal
Technical Editor: Michel Lanteigne, FCA, managing partner tax for Canada, Ernst & Young LLP |
