“What if" series — Significant tax implications to Canadian residents working for a US employer in Canada

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Episode 59: “What if" series — Significant tax implications to Canadian residents working for a US employer in Canada

Release date: June 18, 2013
Guest: Linda Lee
Running time: 11:20 minutes

In this episode of Tax Tracks, PwC’s Linda Lee discusses the payroll obligations for US employers with Canadian employees working in Canada and the repercussions for the Canadian employees.

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“What if" series — Significant tax implications to Canadian residents working for a US employer in Canada

You’re listening to another episode of PwC’s Tax Tracks at www.pwc.com/ca/taxtracks. This series looks at the most pressing technical and management issues affecting today’s busiest tax directors.

Sharon: Hi, it’s Sharon Mitchell, welcome to our “What if” podcast series that discusses various tax situations and issues with the Canada Revenue Agency. Today we have Linda Lee, a Senior Manager with PwC Human Resource Services tax group. Linda has specialized in International Assignments and Expatriate Management at PwC for many years.

Welcome Linda.

Linda: Thank you Sharon.

Sharon: Linda, in an earlier episode of this “What If” podcast series, we discussed some of the issues that arise when a US company hires Canadian residents to work in the US, but I understand that we may see US companies hiring Canadian residents to work in Canada. When might we see this type of arrangement?

Linda: While this can happen with any US company, the most common scenario may be when a US company is looking to break into the Canadian market. This type of employer may have only one or two employees in Canada. The employees may work in Canada most of the time, while travelling to the company head office in the US occasionally. The advantages to the US Company are that the employees are already familiar with the Canadian market, and the company can be confident that the employees are legally entitled to work in Canada.

One topic we won’t discuss further today is that a company in this situation should consider whether the employee inadvertently creates a Permanent Establishment in Canada. I would encourage anyone who is interested in this further to listen to our Commuter Series podcast episodes 50 — 53 at www.pwc.com/ca/taxtracks.

Sharon: OK Linda, but in both cases, we have US employers and Canadian employees. Wouldn’t the issues be the same?

Linda: In some ways. For example, all employers with Canadian resident employees have an obligation to withhold and remit income tax to Canada Revenue Agency (CRA) and also to issue a T4 slip to report both the compensation earned and the taxes remitted to CRA. This obligation is the same for both Canadian and non-Canadian employers.

Given that the US Company is likely withholding and remitting income tax to the US Internal Revenue Service and perhaps a local state tax authority as well, the total tax withheld from the employee could be quite high. As discussed in an earlier episode, there is a waiver process by which the employee can request a reduction in the Canadian tax.

Now also in addition to remit tax to CRA, issue a T4, and allow the employee to apply for a waiver, the US Company would have to apply for a business number in Canada. US multinational companies that operate in Canada will have a business number, but many of the smaller companies in these scenarios may not.

Sharon: That’s good to know. What about social security? Is the US employer required to withhold CPP and EI as well?

Linda: Yes, that’s correct. In addition to the income tax withholding, the employer also has an obligation to withhold CPP and EI on the earnings. Remember that even though the employer is based in the US, the employee is a Canadian who works in Canada. He or she is subject to the same taxes as you or I.

Sharon: So it’s important that the US Company operate Canadian payroll for its Canadian employees. What if the US Company does not want to register the business in Canada?

Linda: Sharon, it is important for the US employer to have a Canadian payroll, and as you would expect, there is an administrative cost of operating Canadian payroll. However, a non-resident employer with only a few employees in Canada may see this cost as excessive. In some cases, the non-resident employer that has little presence in Canada may be apprehensive about registering for a business number in Canada partially for that reason.

When a US company is looking at its options, it should take potential penalties into consideration. CRA will assess penalties for failures to withhold tax, remit tax on a timely basis, or to issue T4 slips. Interest is also charged on any unpaid tax and on these penalties. The company could find that the penalties and interest outweigh any “cost savings” by not operating payroll.

In addition, there are implications for the employees.

Sharon: How so for the employees?

Linda: Let’s look at an example. Our employee, we’ll call him “John Smith” — John spends most of his time working in Canada, but between meetings and other duties, he spends approximately 10% of his workdays in the US. Now his employer operates US payroll only, he does not receive a T4 slip. All of his taxes withheld from him are remitted to the IRS and the state authority, and he receives a W2 slip (the US T4 equivalent), and that reports all of his compensation.

Mr. Smith will have to file a US tax return, but as he is neither a US resident nor a US citizen and he doesn’t usually work in the US, this tax return will only report 10% of his compensation. Because this is such a low amount, he can expect to receive a refund from the IRS, but it will take time. Furthermore, the IRS may question why he’s reporting less income on the return than what is reported on the W2, causing additional delays.

Mr. Smith, as a Canadian resident is also going to file a Canadian tax return reporting all of his compensation. Canada will recognize a foreign tax credit for the US tax due, but the amount allowed is based on the final amount on his US tax return rather than what is reported on the W2 slip. Remember, that Taxpayer spends most of his time working in Canada, so almost all of his income is taxable in Canada without the benefit of a foreign tax credit. I would expect him to have a large balance due to the CRA when he files his Canadian return. While he should receive a US tax refund that will at least partially offset this balance, I would almost guarantee that he will not receive that refund by April 30 when the Canadian tax is due.

In future years, the CRA may require Mr. Smith to make quarterly instalment payments meaning that in addition to the US tax withheld from him, he would also need to find the funds to pay Canadian tax throughout the year.

Sharon: Well, it certainly sounds like US companies need to ensure they are aware of all the risks associated with Canadian resident employees to avoid non-compliance, both for their own and their employees’ benefit. I imagine there are other issues on top of the payroll and administrative matters. Can you give me an example of another issue you’ve seen?

Linda: Sharon, employees in this situation could also face unforeseen tax implications for their pensions or retirement income. This is regardless of whether the payroll obligations are met.

To give some context, you and I are Canadians who work in Canada for a Canadian employer. When we make contributions to either our pension plans or our Registered Retirement Savings Plans, we can claim a deduction for those contributions on our tax returns. The investment income earned within the pension or RRSP is not taxed annually, but when we make withdrawals from these plans, most likely after retirement, we’ll pay tax on the full distribution. As a result, we have the benefit of deferring when we pay the tax to a later year.

Sharon: I’m familiar with this, and I suspect that many of our listeners are as well — so where does it get complicated?

Linda: A US resident who works in the US for a US employer would have a similar experience. The listeners may be familiar with the term “401(k)”, a common US retirement plan. I will refer to a 401(k), but there are other US retirement plans out there. The employee is not taxed on the portion of his or her income that is contributed to a 401(k) plan, the investment income earned within the 401(k) is not taxed annually, but when the US resident makes withdrawals from this plan, tax will be due on the distribution — this is the same arrangement as with our Canadian RRSPs.

Then we go back to Mr. John Smith from our previous example. Now remember, Mr. Smith spends 10% of his workdays in the US and 90% of his workdays in Canada. His US employer has established a 401(k) plan and he makes contributions to this plan.

Mr. Smith’s US tax return only reports 10% of his total compensation, and therefore, he can only deduct 10% of his 401(k) contribution in the US.

Sharon: Well that sounds reasonable Linda, besides he can claim a deduction in Canada, right?

Linda: He can, but there are restrictions. Even though Mr. Smith has to report 100% of his compensation in Canada, he can only claim a deduction for his 401(k) contributions to the extent that he can claim them in the US. In his case, he can only deduct 10% of the total contributions in the US, so he can only deduct 10% of his total contributions in Canada. There is no deduction available for the remaining 90%. Furthermore, just like contributions to a Canadian pension plan can impact the amount we can contribute to an RRSP, contributions to a US pension plan can also impact the eligible RRSP room. Mr. Smith may find himself in a position where he is not receiving a full deduction for his US pension contributions and yet still have limitations place on his RRSPs.

It could get worse. So, many years from now, Mr. Smith will retire and will start to withdraw the funds from his 401(k) plan. Even though Mr. Smith did not receive a full deduction for his total contributions, he could still be subject to tax on his total distribution. Even though it would happen many years apart, in his case, 90% of his 401(k) contribution is subject to “double tax”.

Sharon: Nobody wants to hear that term “double tax”. Is there a way to avoid this Linda?

Linda: Sharon, there is no “one size fits all” approach, but we could look at ways to either reduce or eliminate the impact of this.

Sharon: it sounds like both the employers and employees will need to review the tax implications and reporting requirements more carefully and take any preventative actions.

Linda: Sharon, you’re right, and the key word is preventative. We can look at a situation after it has happened, but the best approach is up front planning to avoid these types of situations.

Sharon: Great, thanks for joining us today, Linda. If people listening to this podcast have any questions pertaining to these types of employment arrangements, Linda’s contact details will be listed on our PwC podcast website at www.pwc.com/ca/taxtracks.

The information in this podcast is provided with the understanding that the authors and publishers are not herein engaged in rendering legal, accounting, tax or other professional advice or services. The audience should discuss with professional advisors how the information may apply to their specific situation.

Copyright 2013 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP, an Ontario limited liability partnership, or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity. For full copyright details, please visit our website at pwc.com/ca.

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Through interviews with prominent PwC tax subject matter professionals, Tax Tracks is an audio podcast series that is designed to bring succinct commentary on tax technical, policy and administrative issues that provides busy tax directors information they require.