Canadian Treaty Relief from Double Taxation

Covered expatriates risk being taxed twice: once by the United States on assets they own when when they expatriate, and a second time by their home country when they sell assets or take pension distributions.The double taxation problem has been largely solved for expatriates who live in Canada, but not (as far as I know) for other residents of countries.

What's a Double Taxation Problem?

Let's talk first about what a double-taxation problem is. It occurs because two countries want to tax you, and neither country cares that the other country taxed you.

Two Countries Claim You

If you are a taxpayer in two different countries, both countries will impose their domestic tax laws on you, and insist on the right to force you to pay tax on your income.

ExampleYou are a dual U.S./Canadian citizen. You live in Canada.The United States will tax your income because of your (U.S.) citizenship status. Canada will tax your income because of your (Canadian) resident status.

(Usually) Solved by the Foreign Tax Credit

The normal solution is a concept called the foreign tax credit. One of the two countries will allow you to reduce your tax bill by the amount of tax paid to the other country.

ExampleYou are a U.S. citizen. You live in Canada. In 2017 you earn income that is taxable in both countries.You pay US$100 in income tax to Canada on that income.You owe tax to the United States because of that income. But the United States allows you to reduce the tax payment you owe to the IRS by the US$100 you paid to Canada.

In U.S. tax law, this is called the foreign tax credit, and you claim it on Form 1116.To absolutely no one's surprise, the U.S. foreign tax credit rules are complex and idiosyncratic. You will not be shocked to learn that other countries, too, have equally complex and idiosyncratic foreign tax credit rules.

With Expatriation, the System Breaks

But what happens when the foreign tax credit system breaks down? Easy answer: both governments will extract tax from you on the same item of income.The system will break because of the peculiar features of the other country's domestic tax laws. For expatriation, there will be some feature of the other country's tax law that prevents that country from giving the expatriate a credit for the income tax paid to the United States when expatriation occurred:

• Nonevent. An event that triggers tax under U.S. tax law (e.g., expatriation) is not an event that triggers tax under the other country's tax law. If you owe no tax in the other country, why should the other country give you local tax relief for U.S. tax paid in the year you renounced?
• Timing. You pay tax to the United States in one year because of renunciation of citizenship, but you pay tax to the other country in a later year. Your home country's foreign tax credit rules might let you park the tax credit and roll it forward until you use it, but typically only if there was an actual taxable event that triggered the foreign tax. And renunciation of U.S. citizenship is not a taxable event for any other country's tax purposes.

ExampleYou are a dual U.S./Canadian citizen. You live in Canada.You own land in Canada that you bought for US$1,000,000 many years ago. Now it is worth US$2,000,000.You renounce your U.S. citizenship in 2017, and are a covered expatriate. For U.S. tax purposes, you have US$1,000,000 of long-term capital gain.¹ You pay tax to the United States.But, from the Canadian point of view, what happened to you and your land? Absolutely nothing. Something must happen to make you be taxable on your capital gain. Canadian tax law does not treat renunciation of U.S. citizenship as a taxable event.You owe no Canadian tax in 2017. You get no foreign tax credit on your Canadian income tax return for having paid tax on a "pretend" sale of your land. Why should the Canadian tax system reduce your tax payments in Canada for the U.S. tax paid in 2017 because you expatriated?The real estate market is flat. You decide to sell your land in 2019. You are no longer a U.S. taxpayer and you are selling a non-U.S. asset, so U.S. tax law is irrelevant.For Canadian income tax purposes you have a US$1,000,000 capital gain, and you must pay Canadian tax in 2019 on that gain.Will Canada give you a credit in 2017 for the U.S. tax you paid in 2017 when you expatriated? No, because of the way the foreign tax credit rules work.Result. You pay U.S. tax on US$1,000,000 of capital gain in 2017, and Canadian tax on that gain in 2019. Canadian tax laws do not care about the U.S. tax you paid in 2017. You must pay Canadian tax in full in 2019.

Double Taxation Solved (?) For Canada

The Canada/U.S. income tax treaty solves this problem. Arguably. But only for expatriation-triggered gains, not losses.

How the Problem is Solved

The treaty solution is simple: the "pretend" taxable event caused under U.S. tax law by expatriation is matched by an election under Canadian tax law to have a "pretend" sale for Canadian tax purposes.This puts the taxable event--under both tax systems--in the same tax year. Both countries tax you, and this allows you to use the foreign tax credit method to ensure there is no double-taxation.

ExampleYou are a U.S. citizen. You live in Canada.You own land in Canada that you bought for US$1,000,000 many years ago. Now it is worth US$2,000,000.You renounce your U.S. citizenship in 2017, and are a covered expatriate. For U.S. tax purposes, you have US$1,000,000 of long-term capital gain.You choose to use the income tax treaty to force a "pretend" sale of the land under Canadian tax law, so you have US$1,000,000 of capital gain in Canada for income tax purposes in 2017, too.Now you can use the foreign tax credit system to ensure that the US$1,000,000 of capital gain is only taxed once.

Yes, you pay tax as if you sold the land, while actually still owning the land. But now your acquisition cost for Canadian purposes is US$2,000,000.When you later sell the land only the appreciation in value above that amount will be taxable in Canada. You will not, of course, owe tax to the United States as you will no longer be a U.S. taxpayer.

The Treaty Language

Article XIII, Paragraph 7 of the income tax treaty between the United States and Canada (as modified by the 2007 protocol) says:

Where at any time an individual is treated for the purposes of taxation by a Contracting State as having alienated a property and is taxed in that State by reason thereof, the individual may elect to be treated for the purposes of taxation in the other Contracting State, in the year that includes that time and all subsequent years, as if the individual had, immediately before that time, sold and repurchased the property for an amount equal to its fair market value at that time.

Let me helpfully strip out the diplomatic gibberish for you:²

Let's say you expatriate and have to pay U.S. income tax because U.S. tax law says you sold all of your assets when you expatriated, even though you really didn't. In that case, you can choose to make Canada treat you as if you sold all of your assets for Canadian income tax purposes too, even though you really didn't sell them.

It is an elegant³ solution: the U.S. "pretend" sale is matched by a simultaneous "pretend" sale in Canada. Because you have two "pretend but real" sales in both countries, the foreign tax credit rules synchronize, and you can use tax paid in one country to reduce the tax liability to the other country.

The Technical Explanation

The Treasury Department routinely writes an explanation to help us understand what a treaty says. They helpfully wrote a technical explanation (PDF) to tell us what they did in the Fifth Protocol (PDF) to the Canada/U.S. income tax treaty--the source of the language quoted above.

The (Relevant) Text from the Technical Explanation

In this case, here is what the Technical Explanation says:

The purpose of paragraph 7, in both its former and revised form, is to provide a rule to coordinate U.S. and Canadian taxation of gains in the case of a timing mismatch. Such a mismatch may occur, for example, where a Canadian resident is deemed, for Canadian tax purposes, to recognize capital gain upon emigrating from Canada to the United States, or in the case of a gift that Canada deems to be an income producing event for its tax purposes but with respect to which the United States defers taxation while assigning the donor’s basis to the donee. The former paragraph 7 resolved the timing mismatch of taxable events by allowing the individual to elect to be liable to tax in the deferring Contracting State as if he had sold and repurchased the property for an amount equal to its fair market value at a time immediately prior to the deemed alienation.The election under former paragraph 7 was not available to certain non-U.S. citizens subject to tax in Canada by virtue of a deemed alienation because such individuals could not elect to be liable to tax in the United States. To address this problem, the Protocol replaces the election provided in former paragraph 7, with an election by the taxpayer to be treated by a Contracting State as having sold and repurchased the property for its fair market value immediately before the taxable event in the other Contracting State. The election in new paragraph 7 therefore will be available to any individual who emigrates from Canada to the United States, without regard to whether the person is a U.S. citizen immediately before ceasing to be a resident of Canada. If the individual is not subject to U.S. tax at that time, the effect of the election will be to give the individual an adjusted basis for U.S. tax purposes equal to the fair market value of the property as of the date of the deemed alienation in Canada, with the result that only post-emigration gain will be subject to U.S. tax when there is an actual alienation. If the Canadian resident is also a U.S. citizen at the time of his emigration from Canada, then the provisions of new paragraph 7 would allow the U.S. citizen to accelerate the tax under U.S. tax law and allow tax credits to be used to avoid double taxation. This would also be the case if the person, while not a U.S. citizen, would otherwise be subject to taxation in the United States on a disposition of the property.[Paragraph omitted].[Paragraph omitted].If in one Contracting State there are losses and gains from deemed alienations of different properties, then paragraph 7 must be applied consistently in the other Contracting State within the taxable period with respect to all such properties. Paragraph 7 only applies, however, if the deemed alienations of the properties result in a net gain.Taxpayers may make the election provided by new paragraph 7 only with respect to property that is subject to a Contracting State’s deemed disposition rules and with respect to which gain on a deemed alienation is recognized for that Contracting State’s tax purposes in the taxable year of the deemed alienation. At the time the Protocol was signed, the following were the main types of property that were excluded from the deemed disposition rules in the case of individuals (including trusts) who cease to be residents of Canada: real property situated in Canada; interests and rights in respect of pensions; life insurance policies (other than segregated fund (investment) policies); rights in respect of annuities; interests in testamentary trusts, unless acquired for consideration; employee stock options; property used in a business carried on through a permanent establishment in Canada (including intangibles and inventory); interests in most Canadian personal trusts; Canadian resource property; and timber resource property.

Overtly One-Sided, But Expect Mirror-Image Treatment

The first thing that strikes you is the one-sided nature of the discussion:

Such a mismatch may occur, for example, where a Canadian resident is deemed, for Canadian tax purposes, to recognize capital gain upon emigrating from Canada to the United States[.]

The treaty is tailored to solve problems for Canadians becoming nonresidents of Canada (for income tax purposes) and moving to the United States. It says nothing about the reverse: U.S. taxpayers bailing out in favor of Canada.This is not surprising. The Fifth Protocol was signed in 2007. When this treaty language was written, the current incarnation of the U.S. exit tax (enacted in 2008) did not exist.Working hypothesis: We should expect the treaty language to be applied in a mirror-image fashion, so that an American expatriate can claim a "pretend" sale in Canada in order to match up the taxable events and eliminate double taxation.

Only for Gains, Not Losses

The treaty solution extends to gains but not losses:

If in one Contracting State there are losses and gains from deemed alienations of different properties, then paragraph 7 must be applied consistently in the other Contracting State within the taxable period with respect to all such properties. Paragraph 7 only applies, however, if the deemed alienations of the properties result in a net gain.

This is potentially contradictory:

• The first sentence just tells both countries to treat gains or losses from "pretend sales" (deemed alienations, in diplomatspeak) consistently.
• But the second sentence says that you cannot use the treaty if the pretend sale would result in a taxable loss.

The following paragraph of the Technical Explanation solves the contradiction (emphasis added):

Taxpayers may make the election provided by new paragraph 7 only with respect to property that is subject to a Contracting State’s deemed disposition rules and with respect to which gain on a deemed alienation is recognized for that Contracting State’s tax purposes in the taxable year of the deemed alienation.

In other words, you can only use the treaty to solve double taxation problems if both countries would treat the pretend sale as generating a taxable gain.

ExampleYou are a dual U.S./Canadian citizen, living in Canada.You have land in Canada that you bought for US$2,000,000. Now it is worth US$1,500,000.You renounce your U.S. citizenship, and you are a covered expatriate.You are treated as having a pretend sale for U.S. exit tax purposes, and recognize a US$500,000 capital loss on your U.S. income tax return.You cannot make a treaty election to have a pretend sale for Canadian tax purposes for this land.

This makes sense. The Canadian system does not want to give you an arbitrary tax break (take a capital loss right now). And you will not be double-taxed in the future: you received the U.S. tax benefit from the capital loss in the U.S., and are now out of the U.S. tax system permanently.From a Canadian tax point of view, the capital loss will still be available to you when you actually sell the land.

What About Retirement Accounts?

I do not think this treaty language solves the problem of pensions. Article XIII, Paragraph 7 provides a solution for gain caused because a taxpayer is treated as having "alienated" property. In legal jargon, that means sale.The U.S. exit tax laws applicable to covered expatriates tell us that retirement accounts are taxed:

• Some accounts, like IRAs, are treated as if there is a full distribution on the day before expatriation.⁴
• Other accounts, like foreign pensions, are treated as if there is a lump sum distribution of the present value of the future expected pension benefits, on the day before expatriation.⁵

In both of those cases, there is no deemed "alienation" of property. There is, rather, a deemed distribution of benefits from a special type of tax-deferred account. Therefore, Article XIII, Paragraph 7 will not protect a U.S. expatriate from potential double taxation on these types of accounts.

If a Treaty Solution Fails

For covered expatriates with assets in other countries, take a look at your income tax treaty for similar language.For covered expatriates who live in a country without a treaty, then there is no solution for you in the tax laws.You will need to find a DIY solution if either of these situations apply to you.The only DIY solution I know is to make an actual sale of an asset prior to expatriation. If there is an actual sale of an asset (and not a pretend sale), then the tax authorities in both countries must recognize the event and impose the tax laws accordingly.The two countries will apply their foreign tax credit rules to eliminate double taxation. This may be better for you.