The Canada-U.S. Tax Treaty and Americans With Canadian-Source Income

According to the Migration Policy Institute (MPI), about 800,000 Canadians are residing in the United States.¹ This number is trending downward for various reasons, according to MPI. Some of the reasons are changing U.S. policies and the improved economic and educational conditions in Canada. The MPI also estimates that about 57,000 Canadians are residing in the United States without authorization. Further, it is estimated that approximately 3.1 million individuals in the United States claim to be Canadians or to have Canadian roots.

On the flip side, according to MCA Cross Border Advisors, there are about 1 million Americans residing and working in Canada.² MCA attributes this migration to several reasons, including marriage, work, retirement, and other cultural or economic reasons. Even though there is no estimate for the number of individuals in Canada who claim to be American or to have U.S. roots, we can assume that number exceeds 1 million. Further, there does not seem to be any record kept of the number of individuals who have dual citizenship or dual residency with both the United States and Canada. But it is possible to have dual citizenship, and it is generally accepted that there are individuals who have dual residency. Regardless of the statistics, there are millions of individuals who have crossed the border from either direction and now are residing in the neighboring country.

Because the two countries are contiguous and have similar cultures as well as an excellent relationship, it’s natural and expected that individuals will cross the border to live and work. However, with this cross-migration, tax nexus questions arise such as:

• Which country has the primary income tax nexus over the migrant?

• Do both countries share equal nexus?

• Is there some agreement between the two countries in which a list of circumstances exists that determines nexus?

The major tax questions that arise include the taxation of income for personal services, such as:

• Will both countries tax the income from personal services (employment or self-employment) regardless of whether the individual being taxed is an American generating a Canadian salary or a Canadian generating a U.S. salary?

• How will income from investments be treated?

• How is the income from pensions and annuities handled?

• If a Canadian is generating U.S. employment income, does that individual pay the employment tax and, if so, is that person eligible for Social Security or Medicare benefits?

These are just some of the tax issues that arise. The total number that may arise from this cross-border migration is unlimited, and all cannot be addressed here. Instead, the focus here is the main issues covered by the Canada-U.S. income tax convention (treaty),³ which provides the answers to some of these key tax issues.

Applying the Canada-U.S. Tax Treaty

The first issue to discuss is determining the application of the Canada-U.S. tax treaty. In other words, the discussion of which individuals will be affected by the treaty. It covers those individuals who are a citizen of one country but reside in the other or have income from the other country. Article IV of the treaty provides definitions of a resident of Canada and a resident of the United States. Article IV also provides a list of tiebreakers if residency cannot clearly be determined.

Under Article IV of the treaty, a resident is referred to as a “resident of a Contracting State.” The term “Contracting State” means a party to the treaty. The term “resident of a Contracting State” means any person who, under the laws of that state, is liable to pay tax because of domicile, residence, place of management, place of incorporation, or any other criterion of similar nature.⁴ Under the treaty document posted by Canada,⁵ the treaty goes on to say in paragraph 1:

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.

Essentially, a resident, under Article IV, is any person who has established a nexus with a taxing authority by way of domicile, residency, or any other physical connection. Under U.S. tax law,⁶ a resident is any individual who is:

• lawfully admitted for permanent residence;

• has met the substantial presence test;⁷ or

• makes an election to be a resident.⁸

In Canada residency status for income tax purposes depends on whether the person has established significant residency ties.⁹ Significant residency ties are indicated if the person has a home, a spouse or common law partner, or dependents in Canada. Secondary residential ties may also be relevant.

Determining a person’s residency status under the treaty is important because both the United States and Canada tax residents on worldwide income, whereas they tax nonresidents only on income sourced domestically. For example, the United States will tax a resident on worldwide income but only tax a nonresident alien on U.S.-source income.

Defining a resident under a treaty clarifies who is a resident of one of the treaty countries and has income from the other. This person can then claim the benefits of the treaty on income from the nonresident treaty country. For example, a resident of the United States can claim the benefits of the treaty on Canadian-source income.

Tiebreakers to Decide Residency

Article IV of the Canada-U.S. tax treaty provides further steps to determine the residency of an individual when the status is not easily resolved.¹⁰ Because U.S. and Canadian residency rules are different, it is possible for a person to satisfy residency conditions in both countries. These additional tiebreaking steps clarify residency status under the treaty in this situation.

If residency status is uncertain, under Article IV, paragraph 1, the treaty provides the following deciding factors:

• The person will be a resident of the country with an available permanent residence. If the person has an available permanent residence in both or neither country, residency will be in the country in which the person has established a closer personal or economic relationship.

• If the country cannot be determined for which the person has a closer personal and economic relationship, then residency is in the treaty country in which the person stays more frequently (has a habitual abode).

• If the person has a habitual abode in both or neither country, then residency is based on citizenship.

• If the person is a citizen of both countries (dual citizenship) or of neither, then residency will be satisfied by mutual agreement between the two treaty countries.

To illustrate, John Smith was born and raised in Ogden, Utah. He is a self-employed fishing guide operating around northern Utah. He is divorced from his first wife, who resides in Provo, Utah, with their two children. John has remarried a Canadian woman and has expanded his business to include Calgary, Alberta, in which his second wife resides. John’s self-employed fishing guide business now operates out of both Ogden and Calgary. John maintains an apartment near Ogden where he can be closer to his children during the off-season when the demand for fishing guides in Calgary decreases.

Under the first tiebreaker, John has a permanent residence in both the United States and Canada as well as a close personal and economic relationship in both countries. He has children in the United States and a wife in Canada. He also earns income from his fishing guide service in both the United States and Canada. Under the second tiebreaker, John does not have a habitual abode in either country because he spends an equal amount of time in both places. Because John is not a dual citizen, the third tiebreaker determines that John is a resident of the United States under Article IV. If John had dual citizenship, then the countries would have to make a mutual agreement on John’s residency.

Under Article IV of the Canada-U.S. tax treaty, the United States has further guidance for dual residents determined to be Canadian under the tiebreaking rules. If a person is determined to be Canadian but has a U.S. green card, the person can claim the benefits of the treaty and be treated by the United States as a nonresident for U.S. income tax purposes. This means the person will only be taxed on the U.S.-source income and not the person’s worldwide income. However, the person must file a timely nonresident U.S. income tax return (Form 1040NR or 1040NR-EZ) and must disclose the treaty position by filing Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).”¹¹

The United States has also provided guidance for a taxpayer considered a dual resident of the country and a third country and derives Canadian income. This person can only claim treaty benefits from Canada if the person has a substantial presence, permanent home or habitual abode in the United States, and a personal or economic relationship closer to the United States than to the third country.¹² Further, a U.S. citizen or green card holder living in Canada is required to file U.S. Form 1040 and report worldwide income under the savings clause of the Canada-U.S. tax treaty.¹³

Income From Personal Services

Income from personal services under the treaty is compensation received by a person through employment or self-employment. Under the Canada-U.S. tax treaty, employment compensation (wages and salaries) derived by a resident of the United States or Canada is taxable only in the country of residency, unless the employment takes place in the other country.¹⁴ If the employment is exercised in the other country, then the compensation may be taxed by the other country.

Essentially, this means that if a person receives compensation from employment in the country of residency, then the country of residency will tax that compensation. If, however, that employment extends into the country of nonresidency, then the country of nonresidency can tax the compensation earned from employment in the nonresident country.

For example, John Smith is an independent construction contractor out of Spokane, Washington. Most of John’s jobs are in eastern Washington and northern Idaho. However, periodically John wins a bid on a contract in Canada. If John works on a Canadian project, John will have income from a Canadian source, which is subject to Canadian tax. Therefore, the United States may tax the Canadian income (worldwide income) and Canada may tax the Canadian-source income from the Canadian construction jobs.

Under the original treaty of 1984, personal services were separated into two categories: independent and dependent personal services. Independent personal services provide that:

any income derived by an individual who is a resident of a Contracting State in respect of personal independent services may be taxed in that State. Such income may also be taxed in the other Contracting State if the individual has or had a fixed base regularly available to him in that other State but only to the extent that the income is attributable to the fixed base.¹⁵

In the earlier example, if John Smith has set up a Canadian construction company that regularly operates in Canada, he has set up a fixed base of income in Canada. Therefore, Canada may tax the income generated by the Canadian construction company.¹⁶

Under the treaty, dependent personal services (now called income from employment) are “salaries, wages and other similar remuneration derived by a resident of a Contracting State” from employment.¹⁷ However, the meaning of these terms goes beyond the simplistic nexus of dependent personal services equals employment and independent personal services equals self-employment.

Dependent personal services are referred to as employment income of a nonresident alien, and independent personal services are referred to as self-employment income of a nonresident alien. Using the same basic earlier example, if John Smith lived only in the United States and had not remarried, his income in Canada would be considered independent personal services income because John is self-employed (independent contractor). If, however, John was an employee of a U.S.-based construction company, his income in Canada would be considered dependent personal services, now referred to as “income from employment.” Since John is a nonresident alien in Canada, he would meet the definition of providing dependent or independent personal services in Canada depending on his employment status.

For independent personal services (income from self-employment), Canada will levy tax if the person has a permanent establishment in Canada. Under the 1984 treaty:

the business profits of a resident of the Contracting State shall be taxable only in that State unless the resident carries on business in the other Contracting State through a permanent establishment situated therein.¹⁸

A PE is “a fixed place of business through which the business of a resident of a Contracting State is wholly or partially carried on,”¹⁹ and the term “permanent residence” includes “a place of management, a branch, an office, a factory, a workshop and a mine, oil or gas well, a quarry or any other place of extraction of natural resources.”²⁰ A building or construction site as well as an installation project all constitute a PE.²¹ Article V of the treaty provides other situations in which a PE would be created.

If a U.S. citizen or resident creates a PE in Canada and receives income from that PE, then Canada will tax that income. For example, John from the previous examples sets up a construction office in Canada to bid on Canadian construction jobs and then provides the construction services out of that Canadian office. The income from the Canadian construction services is taxable to John under the treaty since he created a PE with the Canadian office.

If a U.S. citizen or resident carries on a business in Canada, the income is treated as business profits, which would include deductions similar to those allowed in the United States. Further, if a U.S. citizen or resident does business in both the United States and Canada, business profits are attributable to each country based upon the profits that the PE might be expected to make if it were a distinct entity.²²

For dependent personal services, U.S. citizens or residents temporarily in Canada for employment are not subject to Canadian income taxes on the pay the U.S. citizen or resident has earned while in Canada as long as the U.S. citizen or resident qualifies under one of the treaty exemptions. Excluding entertainers, U.S. citizens or residents can exclude up to C $10,000 per year from employment in Canada. If, however, the income earned is greater than C $10,000, then the U.S. citizen or resident can only exclude that income from Canadian income tax if:

• the U.S. citizen or resident was in Canada for 183 days or less during the year; and

• the income was not paid by a Canadian resident and is not from a PE in Canada.²³

In other words, a U.S. citizen or resident can exclude more than C $10,000 if that person was in Canada for 183 days or less during the year and the remittance received was from a U.S. source.

Using the same basic set of facts from the earlier examples, John was assigned by his employer (a U.S. company) to work on the construction of a new water treatment plant in Calgary, Alberta. John worked on the water treatment plant for 90 days during the year and was paid C $25,000 (about $20,000 based upon current exchange rates). John receives this payment from his U.S. employer. John can exclude this income from Canadian income tax, assuming the U.S. company has not established a PE in Canada. However, if John was in Canada for more than 183 days or the remittance came directly from a Canadian source, or both, then John could not exclude the remittance from Canadian income tax because it was greater than C $10,000 and the other required conditions were not met.

Special Rules for Income From Personal Services

Under the treaty, there are exceptions to the general rules previously discussed. Entertainers, government employees, students, and apprentices have special provisions. Each of these groups has a different treatment that is unrelated to the other groups and to the other parties for which the treaty applies.

Under the treaty, entertainers include actors, radio personalities, musicians, and athletes from the United States. For these individuals, the rules discussed earlier for income from employment or from self-employment do not apply. For entertainers, the exclusion amount is C $15,000 in gross receipts, including expense reimbursements, regardless of whether the services are dependent or independent.²⁴ For athletes, the exemption amount is C $10,000,²⁵ except for those athletes participating in a team sport.²⁶ Employee athletes on a team with regularly scheduled league games in both the United States and Canada receive an exemption.

For example, John Smith is a singer performing one night in Toronto. His income from that appearance is C $1 million. Therefore, he cannot exclude this income from Canadian tax since his gross receipts exceed C $15,000. Further, if John Smith were a professional golfer and played in the Canadian Open and finished in 10th place with prize money totaling C $82,000, he would not be able to exclude that money from Canadian income tax, because it would exceed C $10,000. But if he finished in 47th place with prize money totaling C $8,000, he could exclude it because it would be less than C $10,000. If John were a center fielder for the Los Angeles Angels (employee playing on a team), he could exclude his income from Canadian income tax for those games played against the Blue Jays in Toronto.²⁷

For employees of a government agency, their salaries or wages related to the discharge of their services are exempt from taxation. Under the treaty:

remuneration, other than a pension, paid by a Contracting State or political subdivision or local authority thereof to a citizen of that State in respect of services rendered in the discharge of functions of a governmental nature shall be taxable only in that State.²⁸

Therefore, if an employee of a government agency performs services in the nonresident country, the nonresident country will not tax that compensation. However, this exemption does not apply if the employee is providing service in connection with a trade or business (for-profit enterprise).

For example, John Smith works for the Federal Bureau of Investigation out of the Spokane office. He is investigating a U.S. kidnapping case in which the kidnappers are believed to have originated in Canada and are believed to be in Canada. Working with the Royal Canadian Mounted Police, John spends several months in Canada investigating the case. The salary John earns while in Canada is exempt from Canadian income tax.

Payments received by a student, apprentice, or business trainee for full-time education or training in a contracting state are exempt from taxation of that contracting state as long as the student, employee, or business trainee was a resident in the other contracting state immediately before the person’s education or training.²⁹ For example, John Smith’s employer, a U.S. company, sends John to Vancouver, British Columbia, for a three-month training session. John’s salary is paid by his U.S. employer. The salary John earns while he is in the three-month training session is exempt from Canadian income tax.

Income From Pensions and Annuities

In the context of this treaty, the term “pensions” includes payment under a retirement plan or fund, retirement benefits, superannuation, armed forces retirement pay, war veteran’s pensions, allowances and amounts paid under a sickness, and an accident or disability plan but does not include payments under an income-average annuity contract.³⁰ Pensions do not include social security benefits,³¹ which are kept separate. Pensions also include payments from IRAs. The term “annuities” describes a fixed sum paid at predetermined intervals during the recipient’s life or over another stated period in consideration for an upfront investment or payment. Annuities do not include nonperiodic payments or any annuity in which the cost was tax deductible.³²

Under the treaty, the general rule is:

pensions and annuities arising from a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State, but the amount of any pension included in income for the purposes of taxation in that other State shall not exceed the amount that would be included in the first-mentioned State if the recipient were a resident thereof.³³

In other words, if a person was a resident of the first country and earned pension income from a source within the second country, then both countries could tax the pension income but only to an extent. Pension income from a Canadian source and paid to a resident of the United States is subject to both Canadian tax and U.S. tax. However, the Canadian tax is limited to 15 percent of the gross amount (periodic pension) or of the taxable amount (annuity).³⁴ Canadian pensions and annuities paid to a U.S. citizen or resident can be taxed by the United States, but the amount included in U.S. taxable income cannot be greater than the amount that would be included in Canadian income if the recipient were a Canadian citizen or resident.³⁵

Canadian or U.S. social security benefits paid to a resident of the other are taxable only in the state in which the recipient is a resident. For example, a resident of the United States will only pay U.S. tax on Canadian social security benefits, not Canadian tax. Likewise, a Canadian resident will only pay Canadian income tax on social security benefits received from the United States.³⁶

A distribution from a U.S. Roth IRA to a Canadian resident is exempt from Canadian tax to the extent it would have been exempt from U.S. tax if paid to a U.S. resident. Further, a Canadian resident may elect to defer Canadian tax on accrued income within the U.S. Roth IRA but not on its distribution. Finally, a Canadian resident cannot defer the Canadian tax on any U.S. Roth IRA income accrued from contributions made after the person becomes a Canadian resident. In other words, a person can defer Canadian tax on accrual income from contributions made as a U.S. resident but cannot defer Canadian tax on income accruals from any contributions made as a Canadian resident.³⁷

For tax-deferred plans, the general rule is that income accruals within some Canadian retirement plans, such as the registered retirement savings plan and the registered retirement income fund, are subject to U.S. tax even if that income is undistributed. However, a U.S. citizen or resident can elect to defer the U.S. tax on the accrued income until the time the income is distributed. Under Rev. Proc. 2014-55, 2014-44 IRB 1, the U.S. citizen or resident can make this election by using one of the two allowed methods, depending on which the person is eligible for.

An eligible individual is a beneficiary of a Canadian retirement plan who:

• was a U.S. citizen or resident at any time while a beneficiary of the plan;

• has satisfied requirements for filing a U.S. federal income tax return for each tax year during which the individual was a U.S. citizen or resident;

• has not reported as gross income on a U.S. federal income tax return the earnings that accrued in, but were not distributed by, the plan during any tax year in which the individual was a U.S. citizen or resident; and

• has reported all distributions received from the plan if the individual made an election under Article XVIII(7) of the convention for all years during which the individual was a U.S. citizen or resident.³⁸

If an individual is eligible, that person can make the deferral election by simply reporting the income when it is first distributed. In other words, an eligible individual can make this election, not by filing a statement of election, but by simply reporting the income on a U.S. federal income tax return for the year distributions first occur.³⁹ If an individual is ineligible, consent of the IRS commissioner must be obtained.⁴⁰

Alimony, separate maintenance payments, or child support payments from Canadian sources that are paid to U.S. citizens or residents are not subject to Canadian tax.⁴¹ However, the treaty states that:

the amount included in income for the purposes of taxation in that Other State shall not exceed the amount that would be included in income in the first-mentioned State if the recipient were a resident thereof.⁴²

Basically, a U.S. citizen or resident who is a recipient of Canadian-source alimony, separate maintenance payments, or child support can also exclude these payments from U.S. taxable income but only to the extent that Canada would have exempted these payments if the person was a Canadian citizen or resident. To illustrate, John Smith, a U.S. citizen and resident, receives alimony payments from his ex-spouse, a Canadian citizen or resident. John can exclude these payments from both Canadian and U.S. income tax but in the latter only to the extent Canada would have excluded these payments had John Smith been a Canadian citizen or resident.

Under U.S. income tax law, alimony and separate maintenance payments are no longer deductible for the payer, and the recipient no longer includes these payments in their gross income for divorces effective after December 31, 2018.⁴³ For divorces effective before January 1, 2019, the payer can still use these payments as a negative adjustment to gross income, and the recipient includes the amount in gross income.⁴⁴

Income From Investments

The Canada-U.S. tax treaty has several provisions addressing income from investments. A resident or citizen of one country may have income from investments in the other country. The treaty provides specific articles that address interest, dividends, gains, royalties, and so forth. Each receives special mention and discussion in the treaty.

Income From Interest

Under the treaty, “interest” is income from any debt claims whether or not secured by a mortgage and whether or not the person claiming the interest possesses a right to share in the debtor’s profits. Interest also includes income from government bonds or other securities.⁴⁵

The general rule provided by the treaty is “interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State.”⁴⁶ Therefore, if a U.S. citizen or resident receives interest income from a Canadian source, the United States may tax that interest.

In the original treaty, Canada could also tax this interest income, but a 15 percent ceiling on the rate was in place. However, that part of the treaty was repealed. Under the new rules, interest income a U.S. citizen or resident receives is exempt from Canadian tax.⁴⁷ The exemption does not apply if the owner of the interest income carries on a trade or business or had carried on a trade or business through a PE in Canada for which the interest income is effectively connected.⁴⁸

Income From Dividends

“Dividends” are income from participating in a company’s profits as well as income taxed to an individual using the same tax treatment as that used in the country in which the company making the distribution is a resident.⁴⁹ The general rule is that dividends paid by a company that is a resident of one country and paid to a citizen or resident of the other country may be taxed by the other country.⁵⁰ However, those dividends may also be taxed by the country that is the host country of the company paying the dividend. However, the tax may not exceed:

• 10 percent of the gross amount of the dividends if the beneficial owner is a company that owns at least 10 percent of the voting stock of the company paying the dividends; or

• 15 percent of the gross amount of the dividends.⁵¹

Further, a 5 percent rate applies to intercorporate dividends paid from a subsidiary to a parent corporation owning at least 10 percent of the subsidiary’s voting stock.⁵²

For example, John Smith owns stock in a Canadian corporation and receives a dividend from it. Under the rules of the treaty, both the United States and Canada may tax this dividend income. However, under these circumstances, Canada (the country of residency for the payer) cannot exceed a maximum of 15 percent. If the beneficial owner of the dividends (payee) was a corporation owning at least 10 percent of the voting shares of the payer, then the tax rate cannot exceed 10 percent.

Income From Gains on the Sale of Property

Gains from the sale of personal property in one country by a resident of the other country are exempt under the treaty from taxation by the first country.⁵³ For example, John Smith, a U.S. citizen and resident, disposes of personal Canadian property and realizes a gain from this disposition. The personal property gain is generally exempt from Canadian tax but not from U.S. tax. However, this exemption is contingent on the condition that John has not created a PE in Canada.⁵⁴ If a PE was created, personal property gains may be taxed by both countries.

“Real property” is defined as:

shares of a company the value of which is derived principally from real property or an interest in a partnership, trust, or estate referred to in subparagraph (b), but does not include property (other than mines, oil or gas wells, rental property or property used for agricultural of forestry) in which the business of the company, partnership, trust or estate is carried on.⁵⁵

Regarding real property, any gains may be taxed by both countries under the treaty.⁵⁶

If an individual owned a capital asset on September 26, 1980, that was not part of the business property of a PE, then the tax levied is subject to only the appreciation after 1984 (year of original treaty signing).⁵⁷ For example, John Smith, a U.S. citizen and resident, disposes of a Canadian capital asset not part of a Canadian PE at a gain. John held this capital asset since January 1980 (thus held it on September 26, 1980). Any appreciation occurring from January 1980 to December 31, 1984, is exempt from taxation by Canada under the treaty.

Income From Royalties

“Royalties” under the treaty are:

payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work (including motion picture films and works on film or videotape for use in connection with television), any patent, trademark, design or model, plan, secret formula or process, or for the use of, or the right to use, tangible personal property or for information concerning industrial, commercial or scientific experience.⁵⁸

Under the original treaty, “royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed by the other State.”⁵⁹ However, some royalties may be exempt in the contracting state. For example, generally speaking, royalties from specific copyrights, from the right to use computer software, payments for the use of, or the right to use, patents, or payments for broadcasting may be exempt from taxation in the contracting state.⁶⁰ Exemptions granted do not apply if the beneficiary of the royalty carries on or has carried on a business in the contracting state through a PE and the royalty income is connected to the PE.⁶¹

Other Issues Under the Treaty

Charitable Contributions

Under the treaty, a U.S. citizen or resident may deduct charitable contributions made to qualified Canadian charitable organizations. However, contributions made to a qualified Canadian charitable organization are still subject to the limits under IRC section 170.⁶² Further, any contributions made to Canadian charitable organizations are limited by Canadian-source income. If the U.S. citizen or resident does not have any Canadian-source income, then a deduction will not be allowed on a U.S. income tax return.⁶³

For example, John Smith, a U.S. citizen and resident, makes a charitable contribution to a qualified Canadian charitable organization. If John Smith also has Canadian-source income, he would multiply his adjusted gross Canadian-source income by the applicable percentages under IRC section 170 to determine the amount of his Canadian charitable contribution deduction on the U.S. tax return. If John had no Canadian-source income, he would multiply the applicable percentage by zero, his Canadian adjusted gross income, and would receive no deduction.

Income Tax Credits

Under the treaty, both the United States and Canada allow a foreign income tax credit for any income tax paid to the other country.⁶⁴ The United States offers an FTC for essentially any foreign income tax paid by a taxpayer required to file a U.S. income tax return.⁶⁵ In lieu of an FTC, the United States allows a deduction for foreign taxes paid.⁶⁶ A U.S. taxpayer is not allowed to use both the credit and the deduction in the same tax year. It is an either-or circumstance.

Foreign Income Exclusion

In addition to the Canada-U.S. tax treaty, the United States allows a foreign income exclusion from U.S. tax. This exclusion applies to U.S. citizens and residents living abroad. Because the United States taxes its citizens and residents on a worldwide basis (all U.S. and foreign income), any foreign income earned by a U.S. citizen or resident is subject to U.S. income tax. The United States recognizes that any foreign income received by a U.S. citizen or resident can likely face double taxation. To fix this, the United States provides that foreign income, up to specific limits, can be excluded from U.S. income tax. The United States also allows the exclusion of housing costs for a U.S. citizen or resident living abroad.⁶⁷ However, specific conditions must exist for a U.S. citizen or resident to exclude this foreign income and housing costs from U.S. taxation.

First, this exclusion is only available to an individual who has a tax home in a foreign country and who is:

• a citizen of the United States and establishes proof to the satisfaction of the secretary of bona fide residency of a foreign country or countries for an uninterrupted period that includes an entire tax year, or

• a citizen or resident of the United States who, during any period of 12 consecutive months, was present in a foreign country or countries during at least 330 full days in such period.⁶⁸

Second, the income excluded must be foreign earned income.⁶⁹ Foreign earned income is an amount received by the individual from sources within a foreign country or countries that constitutes earned income attributable to services performed by the individual during a period of 12 consecutive months in which the individual is present for 330 consecutive days.⁷⁰ Earned income includes:

wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered but does not include that part of the compensation derived by the taxpayer for personal services rendered to a corporation that represents a distribution of earnings and profits rather than a reasonable allowance as compensation for the personal services actually rendered.⁷¹

In the case of a U.S. citizen engaged in:

a trade or business in which both personal services and capital are material income-producing factors, under regulations prescribed by the Secretary, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income.⁷²

If these two conditions are met, the U.S. citizen can exclude the foreign earned income from U.S. taxation but only up to a limit. For 2023 the foreign income exclusion limit is $120,000,⁷³ and it is claimed on IRS Form 2555.

Further, U.S. citizens are allowed to exclude housing costs from U.S. taxation.⁷⁴ The term “housing costs” means an amount equal to the excess of the housing expenses of an individual for the tax year to the extent such expenses do not exceed the product of 30 percent of the daily housing expenses multiplied by the number of days the individual was a bona fide resident of the foreign country over an amount equal to the product of:

• 16 percent of the daily amount for the calendar year in which such tax year begins, multiplied by

• the number of days of the tax year within the applicable period.⁷⁵

“Housing expenses” are the reasonable expenses paid or incurred during a tax year by an individual for housing in a foreign country.⁷⁶ The amount for the annual housing costs exclusion is contingent on the tax year and on the foreign country and city. The IRS provides an updated number for the housings cost exclusion, based on city and country for each year in the “Instructions to Form 2555.” The 2022 exclusion amount for Canada ranged from $36,000 (Quebec) to $63,200 (Toronto).⁷⁷

Closing Remarks

Because the United States and Canada are contiguous and share an excellent relationship, it is understandable that individuals will cross the Canada-U.S. border to live and work. Therefore, it makes sense that the two countries have a tax treaty to work out the tax issues that arise when citizens and residents of the two countries cross the border.

Even though the number of individuals crossing the border from either direction is somewhere less than a few million, the number of individuals affected by this treaty is enough that both the U.S. and Canadian governments felt the need to address the tax issues through mutual agreement. Tax practitioners, especially those who serve a resident alien or nonresident alien clientele, should be aware of the tax issues covered by this treaty to serve clients better.