Recently, an X [formerly Twitter] user shared a post about his client, who was a UK citizen living in Spain. The X user complained that his client's $2.5M inheritance was harshly taxed by both the UK and Spain, at the rates of 40% and 60% consecutively, leaving the heir with only $665,000 (equivalent of 25% of the inherited amount). Although the X post might be entirely fictitious, this opens the door to discussing how Canadians with U.S. ties can avoid similar situations.
In this article, we will first explain the meaning of double taxation; we will provide background of why Canada enters into treaties with numerous countries to prevent double taxation. We will x-ray the Canada–United States Tax Treaty and its provisions on inheritance. Next, we will offer solutions on how Canadian citizens can seek benefits under the tax treaty and avoid being victims of harsh double taxation, as the heir in our X scenario. Last, pro-tax Tips and Frequently Asked Questions will follow, as always.
Preamble: Why focus on the Canada-U.S. Treaty?
Our focus on Canada's treaty with the United States is because the U.S. is the most important country to Canadians from geographical, political, economic and other perspectives. Canadians have the most dealings and interactions with the United States.
As a result, this article will be more meaningful to Canadians when it is focused on the U.S. Moreover, most Canadian and American tax treaties are mirrors of each other, with just a few nuances, as requested by various states. Therefore, understanding the Canada-U.S. Tax Treaty and the concepts that guide it will enable Canadian taxpayers to replicate this understanding in other treaty jurisdictions that they may be dealing with.
Canada's Tax Treaties and Avoiding Double Taxation
From a cross-border perspective, double taxation occurs when the same or comparable taxes are levied against the same taxpayer in different jurisdictions for the same time period, in respect of the same income, assets or transaction. Countries usually enter into treaties to remove double taxation, while at the same time preventing tax evasion.
Canada has entered into various treaties with numerous countries to mitigate or eliminate double taxation of Canadian residents with ties to those countries. These treaties are usually bilateral agreements between Canada and those particular countries. The treaties reconcile the right of each state to tax; reduce taxes or rates among states; facilitate exchange of tax information between states; recognize the taxes levied in one state as a credit in the other state; and where both states have a right to tax, a tiebreaker clause is usually included to avoid double taxation.
These treaties also have provisions that eligible taxpayers in the treaty states could follow in order to seek benefits under the tax treaty. As mentioned, one of the most important countries that Canada has a tax treaty with is the United States of America.
Canada is also a party to multilateral treaties, trade agreements, information exchange agreements, and conventions. These agreements impact aspects of cross-border taxation, or even help to administer it. They also help to prevent double taxation and tax evasion.
The Canada-U.S. Tax Treaty and Its Benefits
Canada has a bilateral tax treaty with the United States, which has been amended severally, consolidated and concisely referred to as the "Canada-U.S. Tax Treaty."
For Canadian residents to maximize their tax exemptions in the U.S. under the treaty, they have to promptly and accurately file the U.S. Form 1040 Federal Tax Return Form for income earned in the U.S. This helps to prevent double taxation when the income is reported in Canada. It ensures that the taxpayer's expenses, interest payments and other deductions in the U.S. are recognized in Canada while at the same time obviating penalties and late-filing interests.
However, the U.S. tax return form may not be needed where the income to be reported relates to a transaction in which the taxes were withheld and remitted by the U.S. payor. Nevertheless, taxpayers are advised to still file their returns unless advised otherwise by a tax lawyer or tax accountant.
Whereas Canadian taxes are levied based on residence, U.S. taxes are levied based on both citizenship and residence. Canada taxes its residents on their worldwide income, while the U.S. does the same for both its citizens, regardless of country of residence, and residents, regardless of citizenship. Non-residents of each country are taxed only on incomes earned from the source country. As a result, Canadians resident in the U.S. will seek tax treaty benefits for their incomes from a U.S. source, and vice versa.
Notable benefit provisions of the Canada-U.S. treaty are:
- withholding tax rates for dividends emanating from a contracting state are capped at a reduced rate of 5-15%, depending on ownership;
- there are no withholding taxes for Interest income, unless the interest is connected to a Permanent Establishment (PE), in which case it is capped at 15%;
- withholding taxes on royalties are capped at 10%;
- pensions and annuities are generally capped at 15%;
- Social Security payments are solely taxed by the contracting state where the recipient resides;
- business income is exempt from taxation in the other contracting state, except if attributable to a PE;
- income from non-resident employers are tax-free if they are below US$10,000 and the employee is a non-resident;
- entertainers are allowed an exemption of US$ 15,000 from taxation of their gross receipts;
- there are also credits and corresponding credits for taxes paid in contracting jurisdictions;
- tiebreaker rules are available, for situations where a taxpayer qualifies as a resident of both contracting jurisdictions; mutual agreement procedures are also available to resolve disputes, as with all tax treaties.
Taxation of Inheritance under the Canada-U.S. Tax Treaty
Canada does not have an inheritance tax. In Canada, upon the death of a citizen, there is a deemed disposition of all the deceased's properties at fair market value. The capital gains incurred on the deceased's properties are then taxed at the usual rate on one-half portion of the realized gains.
The deceased's non-capital income is also calculated and included in income, taxed at the prevailing income tax rate, as though the deceased were alive. After all applicable taxes are levied, the beneficiaries can then inherit the remainder of the estate on a tax-free basis, as a general rule.
However, in the United States, upon the death of a citizen, applicable resident or a person with U.S property, estate taxes are levied based on the value of their worldwide assets. The U.S. exempts estates whose value does not exceed US$13,990,000 from taxation. Canadian residents with worldwide assets exceeding the US$13,990,000 threshold will be taxed on the value of their U.S. properties.
The rate of the tax graduates from 18% to 40% when the value of the U.S. properties exceed $1M. Canadians who have property in the U.S., with their worldwide assets exceeding this threshold, will be subject to U.S. estate taxes on the value of their U.S. property. Canadians seeking to inherit from the U.S. will have their inheritance subject to these estate taxes. Such properties could include real estate, shares, cryptocurrency, etc.
Under the Canada-U.S. Tax Treaty, there is certain relief that can reduce these taxes. They are in the form of credits found in Article XXIX B of the Canada-U.S. Tax Treaty. There is the usual foreign tax credit, which is contained in most tax treaties; there are also the unified and marital tax credits. These credits will be explained below:
- The foreign tax credit imputes credits to Canadians, which is equivalent to the value of estate taxes they paid in the U.S. As a result, Canadians would not have to pay the same or comparable tax in Canada again. They will only pay the difference between the Canadian and U.S. marginal rate, if the Canadian tax has a higher rate. Unified tax credits allow deceased Canadian residents with U.S. properties to claim an equivalent amount of credit as their U.S. counterparts against U.S. estate taxes due. These credits allow Canadians to gift a portion of their estate on a tax-free basis. Where the unified credit available to a U.S. non-resident is greater than the unified credit due to a U.S. citizen in similar circumstances, Canadians are allowed to claim the greater of the credits.
- There is also the marital tax credit, which is available to the surviving spouse of the deceased in addition to the unified tax credit; the value of this marital tax credit is the equivalent of the lesser of the unified credit and taxes due on the transfer of the qualifying U.S. property.
Canadian residents who are not citizens of the U.S. are required to file the Form 706 Estate Tax Return, where their U.S. assets exceeded US$60,000 upon their death. Compliance with this filing requirement is necessary to enable Canadians to assess applicable treaty credits. It is important to comply with these filings even if there are no taxes owing under the treaty.
It is important to note that Canadian provinces may still insist on charging provincial taxes because the provinces and Canadian territories do not have an equivalent credit system for U.S. estate taxes. Our expert Canadian tax lawyers are available to help you navigate this complex network of taxes across varying external and internal jurisdictions.
Application to X [formerly Twitter] scenario of a Canadian Resident with U.S. ties
If the scenario complained about in the X post were to apply to a Canadian inheriting from the U.S., the first step the Canadian should take would be to ensure that the deceased's estate files the U.S. Form 1040 federal tax returns, and Form 706 Estate Tax Return if the U.S assets exceed US$60,000.
This will ensure that the estate and the beneficiary can claim all available benefits and credits due to them under the Canada-U.S. treaty. It will also ensure that deductions, taxes, expenses and other payments made in the U.S. will be recognized in Canada. This effectively prevents double taxation and harsh tax rates.
Pro tax tips: Canada also has similar tax treaties with the UK, Spain and other European Countries.
For Canadians with ties to Europe, Canada has treaties with most European countries, including the UK and Spain, which were the alleged taxing jurisdictions in our X [Twitter] scenario. All these treaties with Canada address both double taxation and tax evasion.
Canada has treaties with the following European countries: France, Luxembourg, Slovak Republic, Slovenia, Armenia, Germany, Greece, Malta, Spain, Austria, Azerbaijan, Sweden, Hungary, Switzerland, Iceland, Belgium, Netherlands, Bulgaria, Ireland, Norway, Italy, Türkiye, Ukraine, Croatia, United Kingdom, Cyprus, Czech Republic, Poland, Denmark, Portugal, Republic of Romania, Russia, Estonia, Latvia, Serbia, Finland, Lithuania and more.
Canada's treaty with each of these countries might look the same, but there are always nuances. Our experienced Canadian tax lawyers can help you review applicable treaties so that the taxpayer can take advantage of the benefits offered by the applicable tax treaty. This will save you from being a victim of harsh double taxation, as in our X scenario.
While reviewing tax treaties, attention should be paid to residence, citizenship or similar requirements to determine persons to whom the treaty apply.
Frequently Asked Questions (FAQs):
What is tax evasion? Do tax treaties prevent tax evasion?
Tax evasion is criminal behaviour. It manifests in various ways, i.e. falsification of records, hiding or intentionally underreporting incomes, and similar behaviour aimed at evading taxes due. Tax evasion should not be confused with tax avoidance – which is a lawful arrangement of taxpayer's affairs in a manner that reduces tax liabilities.
Tax treaties help to prevent tax evasion. The primary way this is achieved is through information sharing among state parties. Almost every Canadian tax treaty has provisions on information sharing and administrative assistance with the other contracting state(s).
Tax treaties can also checkmate abusive or aggressive forms of tax avoidance.
How is Residence determined under the Canada-U.S. Treaty?
A resident under the treaty is clarified as: "any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management, or any other criterion of a similar nature."
A resident under the laws of Canada is generally determined based on residential ties to Canada. Factors such as having a home, spouse and family in Canada may point towards significant residential ties. However, even if they don't, you could still be deemed a resident of Canada if you lived for up to 183 days or more in Canada within the tax year (unless you are deemed a resident of another country via a treaty).
Under the laws of the United States, you are a resident when you are a green card holder or when you meet the substantial presence test, i.e. lived for 183 days or more in the U.S. within the tax year or meet the weighted-day count over a 3-year period. You can also elect to be treated as a U.S. resident if certain conditions apply to you, or when you are deemed a U.S. resident under a treaty.
What happens if a person is a resident of both the U.S. and Canada? Will the person have to pay taxes in both jurisdictions?
There are tiebreaker rules under the Canada-U.S. treaty which provide relief in this situation. The person will have to pay taxes only in the jurisdiction to which he has stronger ties, and then claim credit for the paid taxes in the other jurisdiction.
There are tiebreaker rules to determine which jurisdiction the taxpayer is more connected with. First, where does the taxpayer have his permanent home? If the taxpayer has a permanent home in both jurisdictions, then the taxpayer will be deemed to be a resident of the state where his personal and economic relations are closer. This latter rule is called the "center of vital interests" test.
Second, factors such as family, business, employment, social ties, and more, are considered in making this determination. If the Center of Vital Interests test is not determinative of residence, the habitual abode of the taxpayer will be the deciding factor, i.e. where the taxpayer spends most of his time. If the habitual abode test is still not decisive, the determination will fall on the nationality of the taxpayer. Where all fails, the Mutual Agreement Procedure is available to make a final determination.
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.
