Two recent client situations remind us that certain provisions in the Canada US Income Tax Convention (“Treaty”) can lower a client’s overall tax liability even where the answer isn’t so obvious when entering information in tax software. The first example is the subject of today’s blog. The second example will be posted later this month.
A Canadian resident, nonresident alien of the US worked in the US in 2012 as an employee. The individual was married and his spouse did not earn much income in the year. The individual also had certain Canadian tax items such as RRSP contributions, child care expenses and nonrefundable tax credits that reduced his Canadian taxes but not his US taxes.
The individual was subject to US federal income tax, state income tax, US Social Security and Medicare taxes. Under Canadian tax law and the Treaty, all of these taxes are eligible for a foreign tax credit in Canada. In this client’s situation, his total US tax liability was higher than his Canadian tax liability as a result of allowable deductions listed above. As a result, reducing his US tax liability would not change the amount of the foreign tax credit allowed on the Canadian return and would actually result in a decrease in their overall tax liability.
Ordinarily, most married US resident taxpayers will file a joint income tax return to take advantage of more generous tax brackets . However, married nonresident aliens of the US are prohibited from filing a joint tax return and are required under US domestic law to file US tax returns as married filing separate which often results in a higher overall US tax burden. However, under Article XXV, paragraph 3 of the Treaty, a taxpayer can elect to calculate his/her US federal tax liability based on the married filing joint tax rates.
In our client’s situation, the taxpayer earned approximately $100,000 from working in the US. As his spouse did not work in the year, the calculation of his US federal tax liability under the Treaty on a joint basis reduced his US taxes by $4,000 compared to calculating it on a married filing separate basis. The taxpayer still was able to claim enough of a foreign tax credit on his Canadian tax return to eliminate all the Canadian tax liability. As a result, using the Treaty here reduced his overall tax liability by approximately $4,000.
The determination of whether to use the Treaty in this situation depends on the amount of US income earned, the amount of income the spouse earned, the amount of state income tax and US Social Security and Medicare taxes paid and the amount of the Canadian tax liability on the income. Article XXV may not work to reduce US federal tax in all situations. Further reductions in US federal and state tax can be achieved where family members can be claimed as exemptions on the US tax return.
Where reliance on this Treaty provision is used, we will often warn our clients that the US Internal Revenue Service will, in most cases, incorrectly assess the return. However, after a little assistance, the IRS manages to correct the assessment yielding the expected income tax savings.
Written by Steven Flynn, CA/CPA