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By Edward Tanenbaum, Esq.
Alston & Bird LLP, New York, NY
It's not often that one comes across cases dealing with treaty tie-breakers, especially the provision dealing with "center of vital interests," so when I came across a recent Canadian court case,1 it prompted me to review the area.
The tie-breaker issue comes up in a situation where two countries deem a taxpayer to be a resident of the respective country. Absent a treaty, and unless certain statutory exceptions are available, such a taxpayer may be subject to multiple reporting obligations and tax burdens (net of potential foreign tax credits). However, if the person is a resident of a country that maintains a tax treaty with the United States that contains a treaty tie-breaker provision, then the person will be subject to the residency rules of just one of the countries, at least for calculating that person's tax obligations.
For example, let's say a foreign person comes to the United States either to visit or work. At least initially, he/she would typically be taxed as a nonresident alien and would be subject to limited U.S. tax on income effectively connected with the conduct of a U.S. trade or business (ECI) and on U.S.-source "fixed or determinable annual or periodical" income that is not ECI.
However, there are two ways in which that person may become a U.S. tax resident subject to worldwide taxation no different than U.S. citizens.
Under the first test, a foreign person becomes a U.S. tax resident if he/she is lawfully admitted for permanent residence in the United States. A lawful permanent resident is an individual granted the privilege to reside permanently in the United States, i.e., someone who holds a "green card" under U.S. immigration law.
Under the second test, if a person is present in the United States for a certain number of days over a testing period, he/she becomes a U.S. tax resident. Under this "substantial presence" test, if a person is physically present in the United States for at least 31 days in the current year being tested, and the number of days present in the current year, plus one-third of the days present in the preceding year, plus one-sixth of the days present in the next preceding year equals or exceeds 183, then the individual is a U.S. tax resident in the current year.
An exception to the "substantial presence" test exists if the individual can prove that he/she has a "closer connection" to a foreign country in which that person maintains his/her tax home and provided he/she is not present in the United States for 183 days or more in the current year being tested. (The "closer connection" exception is not available to a person holding a "green card" or to a person who has taken steps to obtain the "green card.") A closer connection can be demonstrated by reviewing various facts such as the location of the person's permanent home, location of family, location of personal belongings, location of social, political, cultural, or religious organizations, location of business activities, etc. A person claiming the exception must timely file Form 8840 ("Closer Connection Exemption Statement for Aliens") in order for the claimed exception to be valid.
A person who is a U.S. tax resident under either or both tests and who cannot claim the closer connection exception may be able to claim the tie-breaker exception under an applicable treaty, provided that the individual is also treated as a resident under the treaty country's tax laws. The treaty would establish a single residence for the individual, at least for purposes of calculating his/her income tax liability. (The individual, nonetheless, is still treated as a U.S. resident for FBAR purposes or for purposes of determining whether a foreign corporation is a controlled foreign corporation.) A person claiming a tie-breaker provision must file Form 8833 (Treaty Based Return Position Disclosure under Section 6114 or 7701(b)).
A typical tie-breaker provision of a treaty provides that a person will be deemed a resident of the country in which the individual has a permanent home available to the taxpayer. If the taxpayer has a permanent home available to him/her in both (or neither) countries, the taxpayer will be deemed a resident of the country in which the taxpayer has his/her center of vital interests. If that cannot be determined, the taxpayer will be deemed a resident of the country in which he/she has a habitual abode. If a habitual abode exists in both (or neither) countries, the taxpayer will be treated as a resident of the country of which he/she is a national and if the taxpayer is a national of both countries, the Competent Authorities are to settle the issue by mutual agreement.
Most U.S. treaties, as well as the 2006 U.S. Model Income Tax Treaty, do not expand upon the center-of-vital-interests test. However, the OECD Model Convention on Income and on Capital (OECD Model) provides a detailed explanation of "center of vital interests" and is often used as an aid in interpreting U.S. bilateral treaty provisions.
Thus, the OECD Model, and its Commentary, provide that an individual's center of vital interests is deemed to be in the country to which the individual's personal and economic relations are closer. (This test is similar, although not identical, to the statutory "closer connection" test.) Thus, the location of the individual's family and social relationships, the location of the individual's occupations, the location of the individual's political, cultural, or other activities, place of business, the place from which the individual administers his/her property, and similar factors, are all relevant and looked at as a whole.
As previously stated, not many cases have dealt with the treaty tie-breaker provisions and, in particular, the center-of-vital-interests test. Needless to say, it is a highly factual analysis. In one case, Podd v. Comr.,2 the court initially determined that the Canadian citizen in question did not establish that he was a resident of Canada in order to invoke the tie-breaker provisions. Nonetheless, in analyzing the facts, the court observed that the taxpayer had a home available to him in Canada; he kept many belongings there, including two automobiles; and he maintained an office there. Thus, he had a permanent home in Canada. But the taxpayer also had his girlfriend's apartment in Florida available to him; he stayed there frequently; he conducted business from that apartment; he docked a boat at its marina; and he listed the apartment address as his own on the insurance policy for the boat.
The court determined that the taxpayer had a permanent home available to him in both countries and, therefore, turned to the center-of-vital-interests test. However, the Court in Podd did not find a clear result under this test. In Podd, the taxpayer was born and raised in Canada. His family lived there. He had business interests in Canada. He maintained a Canadian driver's license and two cars in Canada. He had Canadian health insurance and membership in a Canadian health club. Yet, his girlfriend lived in the United States. He owned stock in U.S. corporations and functioned as a vice president of one of them. He supervised the U.S. operations of the Canadian company in which he owned shares. He had shares in two partnerships with U.S. property holdings. He obtained a U.S. driver's license and maintained both a car and a boat in the United States. Given the nature and extent of his connections to both countries, the court could not conclude that a single country was the center of his vital interests. (It did find, however, that, in the end, the United States was his habitual abode.)
The recent Elliot v. the Queen case, although a Canadian case, illustrates once again the extent to which a detailed analysis of the facts will dictate the outcome under the center-of-vital-interests test. After having concluded that the individual U.S. citizens who were acting as consultants in Canada had residency in Canada under Canadian law, the court then proceeded to analyze the facts of the case under the treaty tie-breaker rule of the U.S.-Canada Income Tax Treaty.
The court concluded that the taxpayers were deemed to be residents of the United States, and not Canada, for treaty purposes as their personal and economic relations were closer to the United States under the center-of-vital-interests test. Factors taken into consideration included: living entirely in the United States before coming to Canada; leaving Canada at the conclusion of the two-year consultancy work; maintaining all pre-existing U.S. ties; creating a limited number of ties in Canada; having substantial homes in the United States; the taxpayer's entire adult family lived in the United States, including extended family; multiple cars, homes, pets, recreational equipment existed in the United States; investments and retirement funds existed in the United States; the taxpayers attended and had memberships at various U.S. organizations; cell phones were registered with U.S. carriers; the taxpayers continued their U.S. liability insurance, etc. While short-term leased apartments were available to the taxpayers in Canada, cars were rented in Canada, basic home furnishings were purchased in Canada, and checking accounts were established in Canada, these all paled in comparison to the U.S. connections. The court found that the depth and the nature of the taxpayers' personal and economic relations/ties favored the United States as the center of vital interests.
There is no question that the facts of this particular case weighed heavily in favor of the United States as the center of vital interests of the taxpayers. However, the facts are rarely that clear and that is where the test, and its outcome, can be quite inconclusive. This is especially true if the taxpayer has personal contacts predominantly in one country and economic interests predominantly in the other. Thus, it should be painfully obvious that a case must carefully be built to sustain the taxpayer's desired position. The factors to be developed include:
1. Housing arrangements (location of personal belongings, permanent and continuous use of home, use of address on official documents);
2. Transportation (location of registered vehicles, place of issuance of driver's license);
3. Insurance (place where health and car insurance policies are maintained);
4. Civic relations (place of membership in clubs and in non-profit, religious, and community organizations; political affiliation);
5. Family (frequency and duration of visits of or with family members);
6. Business (nature of occupation, location where business is conducted, location of personal investments);
7. Other personal matters (e.g., medical treatment);
8. Tax positions (positions claimed on official U.S. tax forms and documents).
In the end, it is all very subjective but proper planning can go a long way.
This commentary also will appear in the May 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Cole, Kawano, and Schlaman, 940 T.M., U.S. Income Tax Treaties - U.S. Competent Authority Functions and Procedures, and Williamson, 943 T.M., U.S. Income Tax Treaties - Provisions Relating Only to Individuals, and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation, and ¶7160, U.S. Income Tax Treaties.
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