Ask clients about cross-border activities

The expert

Katri Ulmonen, CA, MS (US) Tax, International Tax Services Partner, MNP

Client profile

Robin is a Canadian citizen and resident who works in both the U.S. and Canada as a self-employed consultant. she specializes in short-term projects with high fees. she is neither a U.S. citizen nor legal permanent resident.

The problem

Robin earned $25,000 in Canada in 2011. She worked in the U.S. from March 1 to June 30, 2011 and earned $100,000. She just returned after finishing a $500,000 contract in California that ran from January 15 to February 15, 2012.

When she received the cheque for the 2012 contract, the American company withheld 30% and remitted it to the IRS. Robin wants to reverse that withholding tax and ensure she is not required to file U.S. income tax since she is a Canadian citizen and resident.

(This case study deals with federal tax only and does not address state, sales or self-employment tax issues.)

The issues

According to the 2007 Amendments to the Canada-U.S. Tax Convention (1980), as of 2010, a Canadian self-employed person who works in the U.S.; earns more than 50% of his or her income from U.S. sources; and is present in the U.S. for more than 183 days in a twelve-month period is subject to American taxation laws (see “Important U.S. tax information,” next page). Robin was in the U.S. 196 days in 2011 through a combination of work and vacation time.

Further complicating matters, Robin wasn’t providing the right paperwork to her client. When she signed her second contract in 2012, the company asked her to complete a W-9 form, which applies only to U.S. residents. Robin ignored the request, but not filling it out led to the 30% withholding tax.

Robin also purchased an inexpensive vacation property in Palm Springs in 2011. She vacationed there from January 15 to February 28 and from November 1 to November 30, 2011. She told her advisor about the U.S. vacations, but mentioned neither the home purchase nor the length of time spent. She didn’t think her advisor needed to know because she made the down payment out of her cash reserve, so it didn’t affect her portfolio.

Robin’s advisor did know she earned some income in the U.S. In previous years, the bulk of her income came from Canadian sources. The advisor assumed that pattern would continue and didn’t ask for an update. When Robin called her advisor about the U.S. tax withholding, she mentioned the 2011 U.S. contract. He asked how much of her income was U.S.-sourced in 2011—almost all of it was.

Robin didn’t think it mattered since she was a Canadian citizen and resident and would be filing Canadian taxes (which are based on residency). This was the first year the bulk of her income was U.S.-sourced, but there’s a high likelihood most of her 2012 income will also be primarily U.S.-sourced.

This situation could have been avoided had Robin’s advisor asked a few extra questions, which knowing about the U.S.- sourced income and vacations should have triggered. Ulmonen says, “The 2007 amendments treaty to the U.S.-Canada tax convention changed the circumstances when non-residents were subject to U.S. taxation, yet most people are unaware.”

The solution

• • 2011 income: Robin is out of luck for 2011. She meets both the 50% income and 183 day tests, and must file Form 1040NR, an income tax form for non-U.S. residents to claim U.S. income and expenses, by the April 15 U.S. tax deadline; claim income and allowable expenses from U.S. sources; and pay U.S. federal tax on net income. “She then files her normal Canadian income tax, and claims a foreign tax credit for the U.S. taxes she paid,” says Ulmonen. “Provincial credits may not apply, so she could be subject to partial double taxation.”
  • Residency: Robin will be considered a non-resident alien for U.S. taxation purposes in 2012 unless she provides Form 8833 and claims a residency tiebreaker under the Treaty. In other words, she must provide proof of her permanent ties to Canada, such as a permanent residence, finances, health insurance and provincial driver’s licence. This needs to be filed with her 2011 1040NR.
  • 2012 income: Because Robin meets the 50% income and over-183 day tests for the 12-month period ended February 29, 2012, she must withhold and remit 30% of the gross income to the IRS. She will have to wait until 2013 to recover any excess tax withheld by filing a 1040NR for 2012. For any future U.S.-based contracts, Robin needs to provide a Form 8233 (for less than 50% of gross income from U.S. sources and fewer than 183 U.S. days in a 12-month period) to exempt future U.S. tax withholding.

    In future, Robin will need to carefully monitor her time in the U.S. to keep it under 183 days. The rolling formula makes this difficult. “Even a day trip across the border to a casino counts,” says Ulmonen.

    Client Acceptance: 6/10

    Robin was unhappy that her advisor had not educated her better about U.S. taxation law. She has since hired a U.S. tax specialist who is working to rectify the situation. Robin is carefully monitoring her time in the U.S. to ensure it remains under 183 days.

    Advisor degree of difficulty 9/10.

    Because of Robin’s American-sourced income, an advisor will need to work with an expert who specializes in U.S. taxation issues. These experts are in demand and hard to locate. Since the tax deadline in the U.S. is April 15, time is not on the client’s side.

    Important U.S. tax information

    Anyone who’s not a legal permanent U.S. resident, yet is in the country more than 183 days, is considered a resident alien for taxation purposes and is required to file income tax with the IRS.

    There’s another rule that could catch the unwary who can be deemed residents if they meet the substantial-presence test. This test calculates residency based on:

    • 31 days during the current year; and
    • 183 days during the three-year period that includes the current year and the two years immediately before that, counting:
      • All the days someone was present in the current year, and
      • 1/3 of the days someone was present in the first year before the current year, and
      • 1/6 of the days someone was present in the second year before the current year.

    Common U.S. tax forms

    Canadian residents who consult for companies in the U.S. should expect their accounting departments to request these tax forms:

    • W-9: Form used by U.S. residents to exempt tax withholding. It does not apply to non-residents. Instead, non-residents should use Form 8233 to request exemption from withholding U.S. income due to Treaty tiebreaker provisions.
    • Form 8833: Form used to claim a Treaty tiebreak. When Canadian residents have residential ties to both the U.S. and Canada, they can claim a “treaty-return position” showing their personal and economic relations are closer to Canada. The form must be filed along with a 1040NR.
    • 1040NR: Tax form used by U.S. non-residents to report U.S.-sourced income and expenses. Equivalent to the Canadian T-1 General.
    • Form 8840: Form to exempt non-residents who meet substantial-presence test from the deemed residency rule. Can be filed separately from Form 1040NR.

Source: U.S. Internal Revenue Service