Canadian and US tax systems: a comparison

  • Author : Michael Cadesky
  • Date : June 2012
ABOUT THE AUTHOR: Michael Cadesky TEP has practised in Canadian and international tax for more than 30 years. He was formerly Chair of STEP Canada and Chair of STEP. He is a Vice President of STEP

The top personal tax rates in Canada are roughly comparable to those in the US. In both countries, the rates depend on where the individual lives. Canada and the US both levy a federal income tax and a provincial or state income tax. The US allows income tax to be levied locally (for example, by a city), while Canada does not. The US allows for joint filings (spouses may combine their income on a joint return) while Canada does not.

Both countries grant a reduced tax rate on capital gains and certain dividends. For an individual, the US allows a 15 per cent federal tax rate for long-term capital gains (generally property that has been held for at least a year) and for most corporate dividends. Canada allows capital gains to be taxed at half of the normal tax rate, and grants a reduced tax rate on dividends paid by Canadian, but not foreign, corporations.

The tax rates in the US are more graduated than those in Canada, with the top tax bracket reached at a higher income threshold (USD379,150 in the US versus CAD128,801 for Canada (2011)).

Both countries allow deductions for expenses incurred in earning income (employment expenses, business expenses, interest expense on investment loans, etc). However, the US allows additional deductions (called itemised deductions) for mortgage interest on a residence, property taxes, state and local income tax, casualty losses, etc), which Canada does not. The US has a system of curtailing losses from tax shelters and passive activities in general (activities where the individual does not materially participate) by restricting such losses to passive income. A passive loss not otherwise deductible may be claimed when the investment is ultimately disposed of. Canada has no such system.

‘Canada taxes citizens based on residency; the us taxes regardless of where in the world a person resides’
Basis for taxing individuals

Canada taxes individuals based on residency; citizenship is irrelevant. The test of residency follows common-law principles, with a deeming rule that a person physically present in Canada for at least 183 days in a calendar year is deemed resident for that entire year.

The US taxes its citizens regardless of where in the world a person resides. If an individual is not a US citizen, a statutory residency test applies based on substantial presence in the US (generally 183 days in the calendar year, but a three-year weighted average test may also apply), or if an individual has a green card (US permanent residence status for immigration purposes).

When an individual becomes resident in Canada, a step-up is given to fair market value in the cost of most property owned by the individual at that time. This can be of considerable benefit. In addition, an individual never previously resident may establish a non-resident trust, which will not be taxed by Canada for the first 60 months of the individual’s residency. Capital distributions may be received tax-free even if their origin is income of previous years that has become capital of the trust.

The US generally allows no step-up when a person becomes resident, unless a step-up is granted under an international tax treaty, and also does not generally grant exemptions to foreign trusts. (A foreign non-grantor trust is not itself taxed but, if a US resident beneficiary withdraws funds from the trust, this may be treated as income even if the payment is characterised as capital from past earnings.)

If a Canadian resident becomes a non-resident, a departure tax system applies whereby most assets owned at that time are considered sold at fair market value, producing capital gains or losses. As the US does not grant a step-up on arrival, generally no tax is triggered on departure. However, if the individual is a US citizen or a long-term green-card holder (having held a green card for eight years), capital gains tax may arise if the individual gives up US citizenship or surrenders the green card.

The US has an estate and gift tax system with a current maximum rate of 35 per cent. Canada has no estate and gift tax system. Instead, property that is gifted or held at the time of death is deemed to be disposed of at fair market value, producing capital gains.

Both the Canadian and US tax systems accommodate various estate-planning techniques, but these differ greatly because of the underlying tax systems.

Corporate tax rates

In the past, the corporate tax rates in Canada were significantly higher than those in the US. However, over the past ten years this situation has reversed so Canadian corporate tax rates are now significantly lower. The maximum corporate tax rate in Canada is now around 26 per cent. In addition, for Canadian corporations that carry on an active business and are controlled by Canadian resident persons, a reduced tax rate of around 15 per cent applies on the first USD500,000 of income annually.

The general US corporate tax rate is 35 per cent federally, with state and local taxes adding as much as 10 per cent more (state and local tax is deductible for federal purposes, reducing the effective tax rate). The US allows reduced corporate tax rates on the first USD75,000 of income annually, and this limit, designed to benefit small business, has not increased in decades.

‘Canadian dividends do not result in any material double taxation; this is not the case in the us’

Under the Canadian system, profits of a Canadian corporation distributed to Canadian resident shareholders by way of dividends do not result in any material double taxation (tax overall at more than the top personal tax rate). This is not the case in the US. Because of this, there is a strong incentive to earn income personally rather than through a corporation, where the income would be taxed twice (at the corporate level and at the personal level). The US tax system allows double tax to be avoided for private business through two alternative types of flow-through entities (the subchapter selection for a corporation and the flow-through entity rules for US limited liability companies and certain foreign companies). Under these rules, the income of the company is taxed to the shareholder as if it were earned directly. With limited exceptions (mutual fund corporations, for example), the Canadian tax system has no equivalent.

International corporate groups

Canada uses an exemption system for taxing international corporate group profits repatriated by dividends to a Canadian parent company. While complex, the rules are reasonably benign, provided the income earned in foreign subsidiaries is active business income, not passive income. The US has a foreign tax credit system rather than an exemption system. This subjects foreign dividends to tax in the hands of the US parent corporation with relief for foreign tax paid, and brings the corporate tax paid on that income to the US rate.

Both countries require extensive reporting for foreign subsidiaries, and have complex rules for determining whether income is active business income or passive income (foreign accrual property income in the case of Canada and subpart F income for the US).

The US allows for filing extensions (six months is typical). Canada does not allow extensions. The delay in getting US tax information is a major problem in timely completion of Canadian tax returns for Canadians with US income.

Working with the two systems

Because of the complexities of the Canadian and US tax systems, and the fundamental differences between them, working on Canada-US tax matters is a challenge. Canadians frequently have business dealings in the US, and vice versa. Canadians commonly own holiday properties and real estate investments in the US, establish US businesses or hold US investments. US persons have a similar interest in Canada. In addition, there are estimated to be about 1 million US citizens living in Canada, many of whom may be delinquent in their US tax filings.

Practising in this area requires knowledge of the tax systems in both countries. Normally this means working collaboratively with a tax advisor in the other country.


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