Readers will be aware that the September 21, 2007 protocol (the "Protocol") to the Canada-U.S. Income Tax Convention (the "Treaty") results in numerous changes to the Treaty. The July 10, 2008 Technical Explanation to the Treaty provides welcome clarification of many of the Protocol’s provisions.
The Protocol makes significant changes to the existing provisions in the Treaty regarding pensions. Currently, Article XVIII (Pensions and Annuities) of the Treaty provides several rules governing the treatment of cross-border pension distributions and the ability to defer tax on income accrued in a foreign pension plan until distribution. However, the current Treaty does not provide any rules in respect of contributions and accrued benefits. While the changes that will be effected by the Protocol will not generally affect the taxation of distributions of pensions and annuities, the Protocol contains new provisions that govern the treatment of crossborder pension contributions and benefits accruals and also adds provisions regarding U.S. Roth IRAs. The new rules are designed to facilitate movement of employees between Canada and the United States by eliminating a possible deterrent for cross-border commuters and those on temporary work assignment. These changes are discussed in more detail below.
A new rule provides that Roth IRAs (as defined in section 408A of the U.S. Internal Revenue Code) and similar plans are considered to be pensions. Accordingly, distributions from a Roth IRA (as well as other similar plans) to a resident of Canada will generally be exempt from Canadian tax to the extent that they would have been exempt from U.S. tax if paid to a resident of the U.S. Additionally, a resident of Canada may elect to defer any taxation in Canada with respect to income accrued in a Roth IRA but not distributed by the Roth IRA, until and to the extent that a distribution is made from the Roth IRA or any plan substituted therefor. The effect of these rules is that, in most cases, no portion of the Roth IRA will be subject to taxation in Canada.
However, where an individual makes a contribution to a Roth IRA while they are a resident of Canada (other than rollover contributions from another Roth IRA), the Roth IRA will lose its status as a "pension" for purposes of the Treaty with respect to the accretions from the time such contribution is made. Income accretions from such time will be subject to tax in Canada in the year of accrual. In effect, the Roth IRA will be bifurcated into a "frozen" pension that will continue to enjoy the benefit of the exemption for pensions and a non-pension (essentially a savings account) that will not.
Cross-border Pension Contributions and Benefit Accruals
The following three scenarios are addressed by the Protocol: (1) short-term cross-border work assignments, (2) cross-border commuters, and (3) U.S. citizens resident in Canada. For all three scenarios, the individual must be participating in a "qualifying retirement plan" as defined in the Protocol.
Qualifying Retirement Plan
A qualifying retirement plan is a plan that, among other things, is generally exempt from income taxation in its country of residence and is operated primarily to provide pension or retirement benefits. New Annex B, which will form part of the amended Treaty, defines those plans or arrangements that will be considered qualifying retirement plans. The types of Canadian plans that will qualify will include: registered pension plans; Group RRSPs; DPSPs; and RRSPs and RRIFs funded exclusively by rollover contributions from one of the foregoing.
(1) Short-term Cross-border work assignments
New rules apply for an individual who continues to participate in a qualifying retirement plan in one treaty country (the "home country") while on short-term work assignment (up to five years) in the other treaty country (the "host country"). Provided certain conditions are met, the contributions made to the home country plan and the benefits accrued under the plan by or on behalf of the individual will be deductible or excludable in computing the individual’s income in the host country. Similarly, contributions made to the plan by the individual’s employer will be allowed as a deduction in computing the employer’s profits in the host country.
The Technical Explanation outlines in detail the numerous conditions required to be met in order for individuals to avail themselves of the above treatment. In addition, tax relief applies only to the extent that the contributions or benefits would qualify for tax relief in the individual’s home country if the individual was a resident of, and performed the services in, that country. In other words, benefits will be limited as if the individual continued to be a resident of the home country. Where Canada is the home country, the amount of contributions that may be excluded from the employee’s income for U.S. tax purposes is limited to the amounts specified in the Income Tax Act (Canada) for RRSPs, DPSPs and registered pension plans. However, there is a special rule in the Protocol applicable to citizens of the United States which is intended to ensure that U.S. citizens working temporarily in the United States and participating in a Canadian plan will not get more favourable tax treatment in the United States than U.S. citizens participating in a U.S. plan.
As noted above, contributions made to the home country plan by an individual’s employer will be allowed as a deduction in computing the employer’s profits in the host country. This is the case even if such a deduction might not be allowable under the host country’s domestic laws. This rule is applicable whether the employer is a resident of the host country or a permanent establishment that the employer has in the host country. The maximum amount of the allowable deduction for an employer is to be determined under the laws of the home country.
(2) Cross-border Commuters
The Protocol addresses the case where a commuter is a resident of one treaty country (the "residence country") and performs services as an employee in the other treaty country (the "services country") and is a member of a qualifying retirement plan in the services country. Contributions made to, or benefits accrued under, the qualifying retirement plan by or on behalf of the individual will be deductible or excludable in computing the individual’s income in the residence country, so long as certain requirements are satisfied.
Benefits that are granted in the residence country under the Protocol are available only to the extent that the contributions or benefits accrued qualify for tax relief in the services country. Accordingly, where the United States is the services country, the amount of contributions that may be excluded under this rule is the U.S. dollar amount specified in the U.S. Internal Revenue Code. Where Canada is the services country, the amount of contributions that may be excluded from the employee’s income is subject to the limitations in the Income Tax Act (Canada) for RRSPs, DPSPs and registered pension plans.
Additionally, benefits granted by the residence country under the Protocol are limited to the amount of certain benefits that would be allowable under the domestic law of the residence country. For example, a U.S. resident working in Canada and participating in a Canadian qualifying retirement plan may not be treated any better for U.S. tax purposes than they would be treated if they were working in the U.S. and participating in a U.S. plan. On the other hand, where Canada is the residence country, the amount of contributions otherwise allowable as a deduction may not exceed the individual’s deduction limit for contributions to RRSPs (after taking into account any actual RRSP contributions deducted for the year).
Any amount deducted by the individual will be taken into account in computing the individual’s deduction limit for subsequent taxation years for contributions to RRSPs.
(3) Special Rules for U.S. Citizens Resident in Canada
The Protocol also provides new rules that address the special case of a U.S. citizen who is resident in Canada and performs services as an employee and participates in a qualifying retirement plan in Canada. Under these rules, a U.S. citizen resident in Canada may deduct or exclude for U.S. tax purposes contributions to, or benefits accrued under, a qualifying retirement plan in Canada, provided certain conditions are met.
The rules described above are applicable for taxation years that begin after the calendar year in which the Protocol enters into force.