Change to Canada-US Tax Treaty Affecting Cross-Border Employees

19 décembre 2011

( Disponible en anglais seulement )

Article XV(2) of the Canada-US Tax Treaty (the “Tax Treaty”) provides for an exemption from taxation of remuneration derived by an employee resident in a country (referred to herein as “residence state”) in respect of temporary employment exercised in the other country (referred to herein as the “source state”). Where certain conditions are met, such remuneration is exempt from taxation in the source state. Article XV(2) of the Tax Treaty was amended by the Fifth Protocol to provide for a change which appeared at first blush to be minor but is now causing unintended frustration for some employees temporarily working on the other side of the border.

Article XV(2) as amended by the Fifth Protocol provides that remuneration will be exempt from taxation in the source state if (i) the employee’s remuneration attributable to employment exercised in the source state does not exceed $10,000 in the currency of the source state; or (ii) the employee is present in the source state for a period or period not exceeding an aggregate of 183 days in any twelve-month period commencing or ending in the fiscal year concerned, and the remuneration is not paid by, or on behalf of a “person” who is a resident of the source state and is not borne by a permanent establishment in the source state. The minor change to Article XV(2) was to replace the word “employer” with the word “person”.

As the Technical Explanation to the Fifth Protocol explains, the minor change from “employer” to “person” was intended “only to clarify that both the United States and Canada understand that in certain abusive cases, substance over form principles may be applied to recharacterize an employment relationship.” According to CRA, this change is aimed at determining who is in fact exercising the functions of employer.

There has been recent indication that some Internal Revenue Service (“IRS”) auditors are taking a broad view of the implications of the change that goes beyond what was intended when the Fifth Protocol was negotiated. The result is that a change intended to clarify matters is now becoming a source of uncertainty. This is particularly relevant to intra-group services arrangements where Canadian employees are sent on a temporary basis to work in the United States.

This broad interpretation could catch arrangements where a Canadian parent sends a Canadian resident employee across the border on a temporary basis to assist a US subsidiary with its business operations. The Canadian resident employee maintains his or her employment with the Canadian parent and does not enter into a new or separate employment relationship with the US subsidiary with the result that the employee effectively engages in a contract of service while in the United States. The arrangement provides that the US subsidiary reimburses the Canadian parent in respect of the Canadian resident employee’s remuneration for services performed in the United States.  Assuming the employee earns in excess of US$10,000, his or her presence in the US falls below the 183-day threshold and the Canadian parent does not have a permanent establishment in the US, Article XV(2) should apply straightforwardly and dispense with any US tax liability for the Canadian resident employee. However, the change in terminology leaves open the interpretation that the subsidiary was the “person” that bore the cost of the Canadian employee’s services exercised in the United States, thereby undermining the relief available to the employee under Article XV(2).

In practice, what this means is that Canadian employees working temporarily in the United States are being challenged on the availability of treaty relief, despite the fact that such challenge is inconsistent with the intention behind the change, the Technical Explanation and the expressed views of CRA. In order to assist their cross-border Canadian resident employees, Canadian employers should consider implementing cross-border arrangements with their US subsidiaries to properly document the purpose of the arrangement, where instructions are coming from and absence of any functions, benefits or risks being borne by the US subsidiary should the IRS come knocking on their employee’s door.

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