Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Tax, July 2008
Amendments to Article XV of the Canada-United States Income Tax Convention (the Treaty) appear to expand the circumstances in which Canada and the U.S. may tax each other's residents who exercise employment in the other Contracting State.
Under current Article XV, subject to Article XV, a resident of one state may be taxed by the other state on salary, wages or "similar" remuneration from employment exercised in the other state. The Fifth Protocol to the Treaty (the Protocol) changes the wording to remove the word similar. The Technical Explanation (TE) states this change was only intended to clarify that Article XV applies to any form of compensation, including payments in kind, so as to be consistent with the commentary to the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention (OECD Commentary) and the technical explanation to the 2006 U.S. Model Tax Convention. The change results in language that is consistent with how both countries have interpreted Article XV to date.
Under current Article XV, remuneration derived by a resident of one Contracting State from employment exercised in the other Contracting State in a calendar year may only be taxed in the state of residency if:
(i) the remuneration does not exceed $10,000; or
(ii) the employee is present in the other Contracting State for a period or periods not exceeding 183 days in the calendar year and the remuneration is not borne by an employer who is a resident of the other Contracting State or by a permanent establishment or fixed base that the employer has in the other Contracting State.
"Borne by" is taken to mean deductible in computing taxable income.
The $10,000 exception remains in place and unchanged. However, the 183-day test is amended such that the 183 days is aggregated for a period or periods in any 12-month period which commences or ends in the relevant calendar year. The 183 days need not occur in the same calendar year. This is obviously broader than the current provision in the Treaty.
Under the Treaty, if the employee is present in the other Contracting State for less than 183 days, the employee may still be taxed in the other Contracting State if the remuneration is "borne by" an employer who is a resident of the other Contracting State or by a permanent establishment the employer has in the other state. Under the Treaty the language suggests the remuneration must be borne by an "employer". Thus if a resident of the U.S. is employed by a non-Canadian employer (perhaps the U.S. parent of a Canadian subsidiary) and performs services for the Canadian company in Canada, for a fee to be paid to the non-resident employer, the employee cannot be subject to tax if he or she is in Canada for less than 183 days unless the non-resident employer itself has a permanent establishment in Canada and the wages are borne by the permanent establishment. This would be the case even if the Canadian resident pays a tax deductible fee to the non-resident employer to pay for such services. The remuneration is not borne by an "employer" in Canada.
The Protocol amends the language such that the employee is taxable if the remuneration exceeds $10,000 and is "borne by" a "person" resident in the other Contracting State or by a permanent establishment in the other state. Consistent with other amendments, the concept of a fixed base is deleted from Article XV. On the face of the language a determination of employer status for the resident of the other Contracting State (or permanent establishment in the other state) is not necessary. This would appear to catch any situation where a parent corporation remains the employer but provides employees as a service to its subsidiary (resident in the other Contracting State) for a fee. It also could apply where the employee of an arm's-length service provider is providing services, for the arms-length service provider, who charges a fee to the person resident in Canada or to the permanent establishment. Arguably the embedded employment costs that are in the service fee are borne by the payer resident in the other Contracting State.
The TE suggests the language is perhaps not meant to be read this broadly but is intended only to clarify that the U.S. and Canada understand that in certain "abusive" cases substance over form principles may be applied to recharacterize an employment relationship, as described in the OCED Commentary to Article 15 of the OECD Model Tax Convention. Subparagraph 2(b) of Article XV is said to have the same meaning as the corresponding article in the OECD Model Tax Convention and the U.S. Model Tax Convention. In both these cases, the remuneration must be "borne by an employer resident in the other Contracting State (or a permanent establishment)".
The abuse referred to in the OECD Commentary is a situation where an international hiring company is used as the employer so as to provide the services of the employer to the resident of the other Contracting State so as to avoid the employment relationship being in the other Contracting State and thus avoiding the "borne by the employer" problem. In these situations, the OECD Commentary says the formal legal employment relationships should be ignored and an analysis should be done of the functions involved to determine who is the true employer. The true employer is understood to be the person having the rights to the work produced and the significant responsibilities and risks. The OECD Commentary only refers to abusive situations.
The pure language of amended Article XV does not lead one to this analysis. On the new language the employer question is simply not relevant. It will be interesting to see if the Canada Revenue Agency in Canada and the Internal Revenue Service in the U.S. actually interpret the new language in accordance with the TE. If so the amendments may only result in broader taxation where abusive international hiring corporations are used, or where a parent provides its employees to a subsidiary in the other Contracting State to assist the subsidiary in carrying out its work but does not change the formal legal employment relationship so as to avoid taxation of the employees in the other Contracting State.
The diplomatic notes to the Protocol contained a new rule that provides guidance as to taxation where stock options are granted to employees while employed in one of the countries but exercise or dispose of them while employed in the other country with the same or related employee. The new rule generally takes a "perdiem" approach to allocating sourcing based on the number of days the employee's principal place of employment is in Canada, or the U.S., as a fraction of total days employed. The rule is not intended to apply where there is an immediate transfer of ownership of underlying securities such as where the options are in the money at the date of grant. In that case, the competent authorities of the two countries may agree to apportion the benefit in a different manner. It is to be noted that the tests in paragraph 2 of Article XV for the purpose of determining ultimate taxability of the option benefit as remuneration are applied to the years the services are performed, not the year the option is exercised. The rule is discussed in detail in "Protocol Amending Canada – U.S. Tax Treaty signed September 21, 2007", Blakes Bulletin on Tax – September 2007. The TE provides no further significant guidance to the new rule.
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