The Canadian income tax system can be complex by itself. The complexities expand significantly where the tax systems of other countries are also relevant. Most nations have a network of “Income Tax Conventions”, more often referred to as “Tax Treaties”, to govern the interaction of their tax systems with those of other nations.
But this is Law Now – relating law to life in Canada. Don’t tax treaties really only impact huge, publicly traded multinational corporations? What impact do they have on an average Canadian?
The short answer is “more than you might think”!
Income from Other Countries
Discussions of income earned in foreign jurisdictions commonly turns to tax evasion – illegally hiding income offshore. Canada is a nation of immigrants. People are more mobile in general in the 21st century than before. Financial planners advise that an investment portfolio needs exposure to foreign markets. Many Canadians have income from foreign countries and rely on one or more treaties in respect of their income tax exposure.
As a general rule, the country from which income is derived, the “source country” has the first right to tax it – most treaties start with this presumption. However, the treaties often cap the tax which can be charged by that source country, and sometimes modify the rules in other ways.
Virtually all tax treaties limit the tax which the source country can collect on investment income. While Canada, as the source country, typically permits the other country’s tax to reduce the Canadian tax otherwise payable on such income, the maximum credit is normally 15%. Treaties typically limit the other country’s tax at, or below, this 15% level.
Many treaties go further and exempt income on investments held by a tax-exempt retirement vehicle from tax in the other country. This allows Canadian pension funds and Registered Retirement Savings Plans to diversify their portfolios internationally without attracting taxation by the foreign jurisdiction (and vice versa).
Treaties also commonly limit foreign tax applied to pensions benefits, again often at a 15% rate.
Many treaties also address amounts which would not be taxable in the source country and require Canada, as the other country, to similarly exempt such receipts from tax. Typically, non-taxable benefits sourced from Canada also will not be taxable in the other country as well.
For Canadian tax purposes, treaties override domestic tax law..The treaties often address social security benefits. For example, under our treaty with the United States, 15% of U.S. social security benefits received by a Canadian resident are exempt from Canadian tax, reflecting the United States’ tax system, which taxes only a portion of these benefits. Under the treaty, the United States treats Canadian social security benefits, such as the Canada Pension Plan or Old Age Security, in the same manner as U.S. social security, and also exempts any benefits which would be tax-free in Canada from U.S. taxation.
Typically, the income of an individual employed outside Canada is taxable in the foreign jurisdiction. However, this is sometimes modified by a treaty, especially for employees whose services in the other country are limited.
An additional concern often arising for international employees is the potential exposure to the social security systems of both countries. This is not addressed in the treaties, but social security agreements are often negotiated to better co-ordinate the two nation’s systems for international workers. Canada has entered into social security agreements with over 50 other countries at this time.
Treaties also govern how business income is taxed. Often treaties require that the level of business presence in the other country is increased before the other country may impose taxation. This can simplify the tax situation of residents of one country carrying on limited business activities in the other.
Not Taxable in Canada?
For Canadian tax purposes, treaties override domestic tax law. It is not uncommon for something subject to Canadian taxation under the Income Tax Act to be exempt from tax under the treaty. This does not mean such items can be ignored for Canadian income tax purposes, however.
Rather, such amounts are required to be reported as income, and a deduction is then claimed in computing taxable income (at Line 256 of a personal income tax return). As a consequence, this tax-exempt income is still included in the computation of “Net Income” and can impact eligibility for various social programs, as well as some other calculations under the Canadian income tax system.
Foreign countries often require filings to assert treaty benefits, with penalties and/or loss of treaty benefits resulting where such filings are not undertaken.
Discussions of income earned in foreign jurisdictions commonly turns to tax evasion – illegally hiding income offshore. In addition to provisions governing cross-border taxation, treaties typically include provisions on exchange of information. These provisions typically permit the tax administration of the two countries to obtain information from each other’s records. Under some treaties, the countries can also undertake collections activities on each other’s behalf.
Don’t tax treaties really only impact huge, publicly traded multinational corporations? What impact do they have on an average Canadian? The short answer is “more than you might think”!
In recent years, Canada (like many other nations) has expanded its treaty network with a new form of international agreement called Tax Information Exchange Agreements (“TIEAs”). Unlike the treaties discussed above, these TIEAs do not typically modify either nation’s taxation powers, as they are normally negotiated with countries lacking income taxes. They allow each nation access to financial information from the other, intended to be used to detect and challenge tax avoidance and evasion.
At the time of writing, the Department of Finance listed 23 such agreements in force, two signed but awaiting implementation, and five more under negotiation. Two examples of existing TIEAs are Panama (effective December 6, 2013) and the Isle of Man (effective December 20, 2011). Both countries have received recent media coverage in respect of alleged tax abuses.
Canada, like many countries, has devoted significant resources in recent years to expand investigation of international transactions believed to avoid Canadian taxation. Access to other nations’ financial information facilitates such investigations.
Concerns have been raised, however, over the extent to which pursuit of tax enforcement should be allowed to compromise the right to privacy. The United States, in particular, has taken aggressive steps to access foreign information, resulting in an expanded TIEA between Canada and the United States implemented in 2014.
Negotiation of Treaties
While treaties are negotiated independently by the two countries participating, the Organization for Economic Cooperation and Development (“OECD”) suggests standard treaty provisions. Many countries prefer different approaches, so treaties tend to differ in phrasing and in substance, although generally following a common organizational structure.
The OECD has been working to update its standard treaty methodologies to better reflect the modern electronic economy. The present model of business taxation was developed to address mail order businesses a century ago. Its evolution into the internet age is far from complete, a source of concern to many nations.
Treaties are renegotiated at irregular intervals. Those relying on treaty provisions are wise to review the treaty’s status annually to ensure it is unchanged. Issues also arise when the tax system in the foreign country is amended, as some treaty provisions depend on the tax treatment of income items in the foreign jurisdiction.
For example, changes to the taxation of social security pensions in Germany significantly changed the income tax obligations of Canadian recipients, both in Germany and in Canada under the Treaty, a matter which has been evolving since 2005 and enjoys its own page on the Canada Revenue Agency (“CRA”) website.
Applying the Treaties
Tax matters can be complex at the best of times. An international border can increase complexity dramatically. While treaties are intended to simplify tax matters, “simple” is a relative term, especially in tax matters.
A review of the relevant treaty is important for any Canadian receiving income from a foreign nation. Often, accessing treaty benefits requires filings in the foreign country. For example, many investors have been surprised to receive documents required to assert residency in Canada, and access treaty benefits, commonly for investments in United States securities.
Most investment firms have systems for identifying and accessing treaty benefits on portfolio investments. Failure to complete these forms can result in excessive taxes being withheld by the foreign investee. Recovery of the excess typically requires filings in the foreign jurisdiction, often carrying costs (whether time and research, or professional fees) disproportionate to the taxes at stake, so double taxation often results.
The CRA commonly reviews claims for foreign taxes on Canadian tax returns, and denies tax relief (credits or deductions) for taxes in excess of the treaty limits.
It is prudent to obtain expert advice prior to committing to income-earning activity in the foreign country to obtain an understanding of the income tax requirements, identify all required filings and avoid unexpected tax costs. Often, this requires coordination of advice from Canadian and foreign advisors. As neither the complexities nor the costs scale down for seemingly minor activities, it is not uncommon for Canadians to decide against pursuing an opportunity or, worse, to later discover that the costs of tax compliance outstrip the benefits of the activity.
As with most tax matters, a proactive approach is strongly advised.