International Tax Corner: Edition 6

The International Tax Corner: Edition 6

Tax Residency under the Internal Revenue Code (“Code”) and Treaties

This edition focuses on individuals, not companies or other legal entities. In Edition 4, we discussed the concept of residency and its importance. The jurisdiction of residency may impose tax on worldwide income. If you’ve been reading with us, the US taxes its citizens on worldwide income, including lawful permanent residents (Green Card holders) and those meeting the Substantial Presence Test (i.e., 183-day / 122-day test).

What if both the Code and another jurisdiction treat someone as a resident? The first decision on your roadmap is seeing if there’s an active income tax treaty. If so, there may be hope. The second decision is whether the person qualifies for treaty benefits.[1]

Let’s assume Freddy is a Canada national spending time in Canada (175 days) and the US (190 days) and both countries treat him as a tax resident. Freddy is the CEO of a company with offices in both countries, and he spends so much time in each country that he’s purchased homes in each, and that’s where he stays when traveling back and forth. Each house has its own set of cars. No frequent hotel points or Uber/Lyft or public transportation for him. He has personal bank accounts in each country. He’s an avid sportsman so belongs to country clubs in each. And, like many athletes at mid-life, he still thinks he can perform like in his youth, so he’s often at the orthopedist’s and physical therapist’s office in each country. He’s super social, so he has groups of friends in both countries.

Where is Freddy a tax resident? We already mentioned both countries treat him as a resident, and if you’ve been paying attention, he meets the US’ Substantial Presence Test. Let’s also assume he qualifies for treaty benefits. Do both Canada and the US tax him on worldwide income? Article 4 in US treaties typically manages residency via a tiebreaker. But, before getting to the tiebreaker, it’s important to truly confirm residency under Paragraph 1. We’ve seen clients jump directly to the tiebreaker before confirming it’s even necessary.

[1] Almost every US tax treaty has a Limitation on Benefits article designed to limit treaty shopping (i.e., ensure only those meriting benefits may claim them). We’ll cover this item in another edition.

Tax Treaty

Paragraph 1 of the Canada-US treaty defines “resident” and generally ensures it means someone taxable on worldwide income. For the purposes of this Convention, the term “resident” of a Contracting State means any person that, under the laws of that State, is liable to tax therein by reason of that person’s domicile, residence, citizenship, place of management, place of incorporation or any other criterion of a similar nature. . ..[2]

To keep things in perspective, the Canada-United States: Technical Explanation (1997) of the Protocols (1983 and 1984) amending Income and Capital Tax Treaty (1980) states at Article IV Residence: Article IV provides a detailed definition of the term “resident of a Contracting State.” The definition begins with a person’s liability to tax as a resident under the respective taxation laws of the Contracting States. A person who, under those laws, is a resident of one Contracting State and not the other need look no further. However, the Convention definition is also designed to assign residence to one State or the other for purposes of the Convention in circumstances where each of the Contracting States believes a person to be its resident. The Convention definition is, of course, exclusively for purposes of the Convention.

[2] For extra credit, the sentence and paragraph continue in italics below. The underlined part is important but not discussed in this edition -, but in the case of an estate or trust, only to the extent that income derived by the estate or trust is liable to tax in that State, either in its hands or in the hands of its beneficiaries. For the purposes of this paragraph, an individual who is not a resident of Canada under this paragraph and who is a United States citizen or an alien admitted to the United States for permanent residence (a “green card” holder) is a resident of the United States only if the individual has a substantial presence, permanent home or habitual abode in the United States, and that individual’s personal and economic relations are closer to the United States than to any third State. The term “resident” of a Contracting State is understood to include:

(a) the Government of that State or a political subdivision or local authority thereof or any agency or instrumentality of any such government, subdivision or authority, and

(b)(i) a trust, organization or other arrangement that is operated exclusively to administer or provide pension, retirement or employee benefits; and

(b)(ii) a not-for-profit organization that was constituted in that State and that is, by reason of its nature as such, generally exempt from income taxation in that State.

There’s a lot of meat in the above paragraph. For starters, if someone is a resident of only one state, stop. Do not pass go. You are done. Note the above is from the Technical Explanation of various Protocols. US treaties have Treasury Department Technical Explanations (“TEs”), designed to provide context to treaty provisions. In a way they can be similar to Treasury Regulations that explain the Code. There’s typically a TE to every treaty and protocol, so it’s not always easy to keep up to date. Some research services provide consolidated treaties or consolidated TEs so you can find one version that has all guidance. Also, Canada is the only US treaty partner that explicitly states it follows the TE.

Paragraph 2 has the tiebreaker designed to determine a single residency jurisdiction. If an individual is resident of both Contracting States, then the treaty determines residency –

(a) he shall be deemed to be a resident of the Contracting State in which he has a permanent home available to him; if he has a permanent home available to him in both States or in neither State, he shall be deemed to be a resident of the Contracting State with which his personal and economic relations are closer (centre of vital interests);

What’s a permanent home and what’s a centre of vital interests? Some treaties have their own, direct guidance while others may be silent or point us to the OECD Model Treaty and its Commentary. (Organization for Economic Cooperation and Development). Each taxpayer has a unique set of facts that need to be applied step by step. Sometimes 2.a. provides a definitve answer and Freddy can feel comfortable he’s a Canada tax resident, for example. Under the assumed facts, Freddy may very well have a permanent home in both countries. It’s unclear where his centre of vital interests is. Even if there’s clarity, we typically recommend finishing the tie-breaker analysis just in case the IRS raises issues.

(b) if the Contracting State in which he has his centre of vital interests cannot be determined, he shall be deemed to be a resident of the Contracting State in which he has an habitual abode;

Habitual abode can be tricky as well. Don’t assume a “normal” everyday usage. Look to the US Model Treaty and/or the OECD Model if whatever treaty you’re reviewing is silent. It could be related to the amount of time in each state and/or the frequency, length of time in each country and regularity.

(c) if he has an habitual abode in both States or in neither State, he shall be deemed to be a resident of the Contracting State of which he is a citizen; and

(d) if he is a citizen of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement.

As the facts and circumstances drive tax answers, we tend to ask question upon question so we can provide accurate advice. In our experience, we can typically get reasonably comfortable on a jurisdiction of residency and, at a bare minimum, a supportable filing position.

Of note, this is just for income tax. Estate tax is a separate animal.

Green Card Cases

Green Card holders are US tax residents under the Code. However, they could potentially be a resident in a tax treaty partner jurisdiction and a non-resident for US income tax purposes based on the above treaty tiebreaker. So be careful of any knee-jerk conclusions with Green Card holders. Also remember the income tax rules are different from the immigration rules, so a Green Card holder might have US tax and information filing obligations even if unable legally to enter the country!

 

About Schwartz International

The International Tax Nerds at Schwartz International team with individuals, companies of all sizes and other accounting and law firms to provide practical international tax planning, structuring, implementation, and compliance advice.

We live and breathe international tax daily, and since we’ve lived in various countries, we understand the diverse cultural challenges you face. We work in four key areas: International Tax Advisory; International Tax Compliance; Cryptocurrency; and Law via our sister company, The Schwartz Law Firm.

Visit our website to learn more International Tax Nerds or contact us at info@internationaltaxnerds.com.

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