US Canada Income Tax Treaty Technical Explanation

The United States and Canada share a deeply integrated economic relationship, creating complex tax obligations for those with financial activities in both nations. The U.S.-Canada Income Tax Treaty governs these obligations to mitigate double taxation, where the same income is taxed by both countries. The treaty establishes a framework for allocating taxing rights, preventing discriminatory tax treatment, and creating a formal channel for exchanging information to prevent tax evasion.

Determining Tax Residency Under the Treaty

The benefits of the U.S.-Canada Income Tax Treaty are available to a “resident” of one or both countries. Article IV defines residency as being liable to tax by reason of domicile, residence, citizenship, or place of incorporation. For individuals considered residents by both countries, the treaty establishes four “tie-breaker” tests in sequence.

The first test is where the individual has a “permanent home.” If a home exists in both countries, the next test is the “center of vital interests,” where personal and economic relations are closer. If that is unclear, the “habitual abode” test considers where the person spends more time. The final test is citizenship.

If residency is still unresolved, the competent authorities of both countries will settle it by mutual agreement. For corporations, a company created in one of the countries is deemed a resident of that country.

Taxation of Business and Investment Income

Business Profits

Under Article VII, one country can tax the profits of a business from the other country only if the enterprise has a “permanent establishment” (PE) there. If a PE exists, the host country may tax only the profits attributable to that PE. A PE is a fixed place of business, such as a place of management, branch, office, or factory.

A construction project constitutes a PE if it lasts more than 12 months, and using a drilling rig for more than three months in a year can also create one. A PE also exists if an agent habitually concludes contracts in the enterprise’s name.

Dividends

Article X caps the withholding tax on dividends paid to a resident of the other country at 15%. A lower 5% rate applies to intercompany dividends if the beneficial owner is a company that owns at least 10% of the voting stock of the company paying the dividend.

Interest

Under Article XI, interest arising in one country and beneficially owned by a resident of the other is taxable only in the recipient’s country of residence, resulting in a 0% withholding rate. This exemption does not apply if the interest is treated as a dividend payment under the source country’s domestic laws.

Royalties

Article XII allows a 10% withholding tax on royalties. However, a 0% rate applies to payments for patents, computer software, and most copyrights. The 10% rate applies to royalties not covered by this exemption, such as for trademarks and motion pictures used for television broadcasting.

Capital Gains

Article XIII sets rules for taxing capital gains based on asset type. Gains from selling real property in the other country may be taxed by that country. This rule also covers shares in a company whose value is derived principally from such real property. The host country can also tax gains from selling personal property attributable to a permanent establishment. Gains from any other property sale are taxable only in the seller’s country of residence.

Taxation of Personal Service and Retirement Income

Dependent Personal Services / Employment Income

Article XV states that income from employment is taxed where the services are performed. However, the income is exempt from tax in the host country if all three of the following conditions are met:

• The employee is present in the host country for not more than 183 days in any twelve-month period.
• The remuneration is paid by an employer who is not a resident of the host country.
• The remuneration is not borne by a permanent establishment the employer has in the host country.

Independent Personal Services / Self-Employment Income

A 2007 protocol eliminated Article XIV, which governed independent personal services. This income now falls under the Business Profits rules in Article VII. A self-employed individual from one country is not taxable in the other unless they have a permanent establishment there. This change aligns the treatment of self-employment income with that of other business profits.

Pensions and Annuities

Under Article XVIII, periodic pension payments and annuities from one country paid to a resident of the other are taxable only in the recipient’s country of residence. Government-administered social security benefits are also taxable only in the recipient’s country of residence. For U.S. Social Security benefits paid to a Canadian resident, Canada may only include up to one-half of the benefit amount in taxable income.

Key Overriding Provisions and Treaty Benefit Claims

The Saving Clause

The “saving clause” in Article XXIX allows both countries to tax their residents and citizens as if the treaty did not exist. For example, the U.S. retains the right to tax its citizens living in Canada on their worldwide income. The clause has exceptions, preserving benefits like relief from double taxation under Article XXIV and the non-discrimination clause.

Limitation on Benefits (LOB)

Article XXIX-A, the Limitation on Benefits (LOB) provision, is an anti-treaty-shopping rule ensuring only bona fide residents of the U.S. and Canada receive treaty benefits. To qualify, an entity must be a “qualified person,” which includes individuals and publicly traded companies. An entity that is not a qualified person may still be eligible if it meets the “active trade or business” test.

Claiming Treaty Benefits

Treaty benefits must be claimed affirmatively on a tax return. In the United States, this is done by filing IRS Form 8833, Treaty-Based Return Position Disclosure, when a taxpayer’s position is that a treaty overrules U.S. tax law and reduces tax. On the form, the taxpayer must identify the treaty articles relied upon and summarize the facts. Failure to file when required can result in penalties.

Mechanisms for Relief and Dispute Resolution

Relief from Double Taxation

Article XXIV provides relief from double taxation by obligating each country to grant its residents a credit for income taxes paid to the other country. A U.S. resident who pays Canadian income tax can claim a foreign tax credit against their U.S. tax liability. The credit is limited to the amount of domestic tax attributable to the foreign source income, preventing it from offsetting tax on domestic income.

Mutual Agreement Procedure (MAP)

For disputes over the treaty’s application, Article XXVI provides the Mutual Agreement Procedure (MAP). A taxpayer who believes they are being taxed improperly can present their case to the “competent authority” of their residence country. The MAP is a government-to-government negotiation to resolve issues like residency status or profit allocation. If the authorities cannot agree, the treaty provides for an arbitration process.