This article is the first in a series of four parts that will examine the Canadian and U.S. income tax implications when an employee employed by a Canadian entity is assigned temporarily to work in the U.S. This first article focuses on the importance of the determination of "residency" for personal income tax purposes. Future articles will address personal tax liabilities based on different residency determinations, the concept of tax equalization, corporate payroll matters, and corporate tax matters.
Determination of Canadian residency status
The major determinant of an individual's liability for Canadian tax is the individual's residency status. Individuals are subject to Canadian tax on worldwide income if they are residents of Canada or are deemed to be residents of Canada. Non-residents of Canada generally are taxed only on Canadian source income.
Because the term "resident" is not defined in the Canadian Income Tax Act, residency is a question of fact based on one's particular situation. However, Canadian case law and the CRA's assessment practice have evolved to provide some guidelines. Courts generally have held that residence is determined on the basis of the degree to which a person settles into or maintains their ordinary mode of living at the place in question. In addition, an individual will be regarded as establishing Canadian residency if the person is "ordinarily resident" in Canada, which depends on whether Canada is the place where the individual, in the settled routine of their life, regularly, normally or customarily lives.
The primary factor the CRA considers when determining an individual's residency status is whether the individual maintains residential ties to Canada. The most important of such ties, referred to as "primary residential ties" are:
a) a dwelling place (whether leased or owned) that the individual may have available for their occupation; and
b) a spouse or dependents who may remain in Canada during the individual's absence from Canada.
In addition to primary residential ties, certain secondary residential ties are also evaluated collectively in making a determination of residency status. These secondary ties include personal property in Canada, social and economic ties with Canada, medical insurance coverage in a Canadian province or territory, a driver's license in Canada, a seasonal dwelling in Canada, a Canadian passport or landed immigrant status and memberships in Canadian professional organizations. No single secondary residential tie is sufficient, in and of itself, to determine residency status.
Where it is determined that the individual has not severed all residential ties with Canada, the CRA will also consider the following factors to evaluate the significance of those ties:
a) Evidence of intention to permanently sever residential ties – The CRA has indicated that there must be a degree of permanence to an individual's stay abroad. Though the length of stay abroad is one factor, there is no particular length that necessarily results in an individual becoming a non-resident. Generally, if there is evidence that an individual's return to Canada was foreseen at the time of departure, the CRA will attach more significance to the remaining residential ties with Canada in determining whether the individual continues to be a factual resident of Canada.
b) Regularity and length of visits to Canada – Where an individual permanently severs all ties to Canada, occasional return visits to Canada will not affect the individual's residency status. However, where the visits are more than occasional, and are even regular in nature, and the individual has maintained secondary residential ties with Canada, these regular/lengthy visits will be used to evaluate the significance of the remaining ties.
c) Residential ties outside Canada – In addition to severing Canadian residency ties, it is important that an individual establish residency ties in the new country of domicile. Acquisition of a residence in another country reduces the significance of any remaining residential ties with Canada and reinforces the presumption that Canadian residency has ceased. However, establishing residential ties abroad does not, in and of itself, imply that an individual is not a resident of Canada.
On the basis of the above criteria, Canadian residency generally will be considered to have ceased where the individual and their family have moved out of the country, sold their Canadian permanent residence (depending on the circumstances, renting to an arm's-length party may be enough), closed Canadian bank accounts, changed club memberships to non-resident status and severed other residency ties to Canada. Again, no single factor is determinative; all factors are assessed collectively.
Although it is a question of fact as to what date an individual becomes a non-resident of Canada, the CRA will consider it to be the date on which the individual severs all residential ties to Canada. As such, this date generally will be the latest of:
a) the date the individual leaves Canada;
b) the date the individual's spouse and/or dependents leave Canada; and
c) the date the individual becomes a resident of the other country.
Where an individual retains residential ties to Canada to the extent that the individual cannot be considered a non-resident, they will remain a factual resident of Canada and be subject to Canadian tax on worldwide income. However, this residency determination under Canadian domestic law can be modified by a tax treaty, as described later below.
Determination of U.S. residency status
The major determinants of an individual's liability for U.S. tax are residence status and citizenship. U.S. citizens, as well as lawful permanent residents (as defined below), are taxed on their worldwide income regardless of where they live. Non-residents of the U.S. are taxed on their U.S. source income only. In the year that an individual who is not a U.S. citizen (an "alien") becomes a U.S. resident, that individual is considered to be a "dual-status alien" (i.e. an individual having both a resident and non-resident period for U.S. tax purposes).
During the non-resident period (i.e. prior to moving to the U.S.), an individual normally is considered to be a non-resident alien of the U.S. As noted above, non-resident aliens are required to pay U.S. tax on income derived from U.S. sources only. Income from U.S. sources falls into two categories: it may be either "effectively connected" or "not effectively connected" to the U.S. Effectively connected income (which includes compensation for services performed in the U.S.) is subject to tax at graduated tax rates. Income that is not effectively connected (e.g. interest, dividends, rents, royalties) is subject to a flat withholding tax. Once an individual becomes a U.S. resident, that individual is subject to U.S. tax on worldwide income at graduated rates.
An alien is considered a resident of the U.S. if the individual is a lawful permanent resident at any time during the calendar year, or meets the "substantial presence" test. A lawful permanent resident of the U.S. is an individual holding a green card for immigration purposes. An alien will meet the substantial presence test if the individual:
a) is present in the U.S. for 31 consecutive days in the calendar year; and
b) is present in the U.S. for at least 183 days in the calendar year and the immediately preceding two years based on the following formula:
days in the current year x 100%
days in the immediately preceding year x 1/3
days in the second preceding year x 1/6
For these calculations, part days in the U.S. are treated as full days, except for daily commuters (special exceptions exist that allow commuting days not to be counted for this test). Generally, an alien's residency period begins on the first day of presence in the U.S. in the calendar year. However, in certain situations the U.S. residency start date will ignore the first ten days of U.S. presence if it can be shown that the individual had closer connections to Canada. The U.S. tax rules surrounding residency for the first and last years of residence are complex; the facts of each case must be reviewed to make a proper determination.
Residency under the Canada-U.S. Income Tax Convention
Where an individual is considered a tax resident of the U.S. under U.S. domestic residence rules, and is also considered a Canadian resident under Canadian domestic residence rules, the individual's tax residence in both countries is determined according to the residency clause contained in the Canada-U.S. Income Tax Convention (the Treaty). Article 4 of the Treaty contains a list of ordered tie-breaker rules to determine tax residency. If an Individual's residency status cannot be settled by the first tie-breaker test, the next test is considered, and so on until the tie is broken and the country of residency is settled. The tie-breaker rules are ordered as follows:
- An individual is a resident of the country in which they have a permanent home available to them.
- If a permanent home is available to the individual in both countries, or in neither country, they are considered to be a resident of the country in which they have their centre of vital interests (i.e. the country with which personal and economic relations are closer).
- If a centre of vital interests cannot be determined, the individual will be deemed to be a resident of the country in which they have a habitual abode.
- If the individual has a habitual abode in both countries, or in neither country, they shall be deemed a resident in the country in which they are a citizen.
- If the individual is a citizen of both countries, or of neither country, the competent authorities of the two countries shall settle the question by mutual agreement.
If, after consideration of the Treaty tie-breaker rules, the individual is considered a resident of the U.S., then, for purposes of applying the Treaty and for Canadian and U.S. income tax rules, the individual is deemed to be a non-resident of Canada. Where, on the other hand, an individual remains a Canadian resident under the Treaty but lives or works in the U.S., the individual is deemed to be a non-resident of the U.S. With some exceptions, the provisions of the Treaty, or domestic law, may prevent the same income from being taxed in both countries. As a general rule, the country in which the income was earned has the primary taxing rights.
This article discusses some of the concepts associated with residency for Canadian and U.S. personal income tax purposes. See our next issue of U.S. Tax Alert for further discussion on the impact of the residency determination on the income tax reporting and filing obligations for Canadian employees assigned to work temporarily in the U.S. Contact your Collins Barrow advisor for more information.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.