Is the Canadian income of a US consultant who is treated as an employee under Canadian tax law subject to US self-employment tax?
Taxpayer Says: US self-employment tax is not due because of a tax treaty with Canada that states the US may not tax self-employment income to the extent Canada has the right to tax the income.
Internal Revenue Service Says: The treaty offers no protection because Canada did not have the right to tax the income, so the income is subject to US self-employment tax.
From Internal Revenue Code Section 1401: A tax is imposed on the self-employment income of every individual, including the income earned by an American citizen working in a foreign country.
From Internal Revenue Code Section 911: Foreign earned income is excluded from gross income under certain circumstances.
From Internal Revenue Code Section 1402(a)(11): IRC Section 911 does not apply to self-employment income.
From Internal Revenue Code Section 1401(c): If there is an agreement in effect between the US and a foreign country pursuant to section 233 of the Social Security Act, then the self-employment income of an individual is exempt from American self-employment taxes to the extent the income is subject to tax under the Social Security system of the foreign country.
From the Agreement With Respect to Social Security, U.S.-Can., Mar. 11, 1981, 35 U.S.T. 3403: The US may not tax self-employment income to the extent that Canada has the right to tax such income under the agreement.
THE CAUSE OF THE DISPUTE
Under the US-Canada tax agreement, if you’re employed and work in either the US or Canada, you’re subject to the employment taxes of only the country in which you work.
If you’re self-employed and would have to pay self-employment taxes in both countries, you’re subject to the self-employment taxes of only the US unless you’re a resident of Canada.
If you would have to pay employment taxes in both countries because you are considered by the US to be self-employed and by Canada to be an employee, the tie-breaker rule is that you’re treated as self-employed.
In this case, the tie-breaker rule applies. Taxpayer, a US resident, was considered self-employed in the US and an employee in Canada. Under the tie-breaker rule, the IRS has the exclusive right to tax him as a self-employed person residing in the US. Without the tie-breaker rule, the Canada Revenue Agency would have the right to tax him as an employee working in Canada.
The dispute arose because the Canada Revenue Agency did not apply the tie-breaker rule. The taxpayer’s attempts to recover Canadian taxes withheld from Canadian wages were unsuccessful.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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