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Sending Employees Overseas - the Tax Credit Minefield

That 80% of the Canadian income tax on the first $100,000 of wages earned can be eliminated is good news for internationally-assigned employees. It almost seems too good to be true … and in some cases it is. The Overseas Employment Tax Credit (“OETC”) is an appealing but ambiguous tax credit which should be fully understood by those planning to apply for it, in order to avoid unfortunate surprises. If Assignment Managers do not properly plan for it, the OETC can give rise to significant problems:

  • Disgruntled employees
  • Time and expense of defending against litigation
  • Time and expense of defending against tax audits
  • Assignment costs that have been driven up as a result

For Assignment Managers, OETC claims can amount to navigating through uncharted territory, and our advice is to plan, plan, plan!

Background

The Government of Canada originally introduced the OETC in 1980 to facilitate competitive bidding by Canadian companies in the international business market. The Canadian parliament wished to provide an incentive for Canadian companies to help them find new international business. The objective was to reduce the upfront payroll costs of Canadian companies, to assist them in finding and retaining international contracts, and in doing so, earn foreign-based profits – which would then be taxed corporately by Canada. The 1979 Budget Supplementary Information to the Department of Finance’s Technical Notes, 4 th ed., Consolidated to 1992 proposed the OETC when it stated:

“To maintain Canadian competitiveness in overseas contracts, the budget proposes that employees of taxable Canadian corporations, working overseas in prescribed countries for more than six months, be partially exempt from Canadian tax.”

The effect of the introduction of the OETC was that employers welcomed the opportunity to capitalize on emerging Eastern European and Pacific Rim economies. The OETC allowed employers to entice employees to accept assignments because of the additional after-tax income that the tax credit provided.

Of course, in helping Canadian companies to earn foreign profits in the international marketplace, Canada also benefits through corporate taxation on these profits. The assumption at the time was that this new corporate tax revenue would more than offset the cost of providing the OETC to individuals.

What is the OETC?

The OETC is a credit which allows employees working abroad to shelter up to $80,000 from Canadian taxation. Employees who meet the eligibility guidelines must apply for the tax credit and have the application certified by their employer. Savvy employers will often share the benefit of this tax credit with employees.

Employer Conditions

For the OETC to be granted, the employer must comply with the definition of “specified employer”, which means that the company must be a resident of Canada, and the terms of its contract with the employee must clearly define the working arrangement. The company must also be involved in one of a broad number of qualifying activities, including exploration for petroleum, natural gas, minerals and similar resources; engineering, or construction and installation.

Employee Conditions

Employees must also satisfy certain conditions in order to qualify for the OETC. Applicants must be residents of Canada, and “all or substantially all” – in other words 90% - of the employee’s work must be performed outside Canada for at least six consecutive months during the qualifying period.

Reduction of Withholdings

If an employee is certain to be eligible for the OETC, an application should be made to reduce monthly income tax withholdings at source. A letter must be submitted, along with supporting documentation, indicating that the employee and the specified employer will be able to meet all qualifying criteria. 

In our experience, applications for reductions of withholdings must be carefully crafted, as the CRA will usually attempt to bring forth all manner of subtle reasons why the reduction should not be allowed. If your company’s corporate organization chart is even slightly complex, you may run into a brick wall. We, however, favour this review process, as any potential problems are brought to the table early in the project and not years later when the employee’s OETC claim is eventually denied.

It is essential that employers apply for reductions of tax withholdings annually, and certainly each time a new contract is obtained. This approach will ensure that the CRA examine the facts in advance, thus reducing the risk of subsequent adverse CRA rulings.

Employers Beware

Approval of the OETC Form T626 should not be taken lightly by employers, as litigation is always a threat. OETC forms require that the employer “certify” that eligibility conditions have been met by the employee, allowing him to qualify for the OETC. This is a serious statement, and employers should be very certain of what they are agreeing to when they certify on Form T626 that the employee is eligible for the credit. There are many traps for the unwary or uninformed, and employers can end up with very disgruntled employees. Audits of OETC can occur up to three years after the claim has been submitted, and with a typical claim of $20,000 per year, an unsuccessful claimant might have to repay $60,000!

At CompassTAX we assist our clients with eligibility issues, in determining whether applying for an OETC would be appropriate and whether certifying the application would be unwise.

Rotational Assignment Tax Policy

Due to the substantial risks for employers inherent in this process, it is essential that multi-national employers have a Rotational Assignment Tax Policy. Such assignment policy clearly spells out in full the tax aspects of the assignment, and should include:

  • Usually a statement that all host country filings will be handled by a local tax service provider. Many Canadian employers have no understanding of the host country tax filing requirements for their assignees, or for their corporation, for that matter. Increasingly, foreign countries are climbing on the tax bandwagon and introducing new tax systems, often with little fanfare;
  • A statement that all foreign taxes will (or will not) be paid by the employer with (or without) withholding from the employee’s wages;
  • A statement that the preparation of the employee’s Canadian income tax returns will be arranged and paid for by the employer. The proper integration of a foreign tax return into the employee’s Canadian return is usually complex;
  • An indication of whether some (or all) of the tax benefits realized by the employee should be returned to the employer (after all, in many cases the employer will be paying the employee’s host country tax without withholding);
  • A statement as to whether the employee will bear tax arising from the assignment at some pre-determined fixed percentage.

In summary, very often the important issue of tax is not mentioned in contracts, and parties are left to fight over the meaning of vague statements involving tax. Employers should ensure that all tax clauses in contracts are crystal-clear and can be easily applied in the real world.

Rotational Assignment Tax Policies have the added advantage of attracting and retaining employees in the midst of a global talent war. In today’s business market it is increasingly difficult for corporations to fill positions with talented employees, and any positive measures that companies can take toward retention are worthwhile in deterring employees from jumping ship. A Rotational Assignment Tax Policy results in increased productivity and motivation among employees, as their personal tax burdens are relieved and they feel that they are being care of.

Tax Audits

Applications for OETC are increasingly being scrutinized by the CRA in tax audits. Given the uncertainty surrounding acceptance of OETC claims, it is prudent for employers to include qualifications upfront in their Rotational Assignment Tax Policy. These riders should indicate that the employer will do its best to arrange for OETC conditions to be met, and highlight that acceptance of the claims is at the discretion of the CRA and any interpretations they might choose to make.

In anticipation of an employee’s OETC claim being audited, a number of defensive strategies can be adopted. It is important that information and paper trails be available as evidence, should a claim go to appeal. Assignment Letters and contracts should clearly define the working relationship between the corporation and the employee, as this is often a point of debate.

Problems often arise where employees are seconded to a group company outside Canada which holds the ultimate contract with the customer. Such inter-corporate arrangements must be clearly documented.

Conclusions

Employers must pay strict attention to all aspects of the assignment tax process and plan, plan, plan. Ignoring the key elements of withholding, remitting, annual reporting, foreign tax and the above applications, can result in expensive and time-consuming disruptions to the flow of international business.

At CompassTAX ™ , we conduct our Assignment Tax Reviews to ensure that the assignment tax policies of our clients minimize risk. Our Assignment Tax Reviews include:

  • Use of an OETC Organizer to help determine employee eligibility;
  • Preparation of all necessary tax forms;
  • Development of tax audit counter-strategies;
  • Customization of inter-entity agreements from our template library;
  • Review of compensation strategies;
  • Preparation of employee income tax returns.

Well-designed assignment tax policies are a corporate responsibility, and merit experienced input to ensure successful negotiation of the tax credit minefield. Contact us at (403) 531-2200 or www.compasstax.ca for more information about how CompassTAX ™ can help you with your assignment tax planning.