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Revenue Canada sets its sights on tax equalization payments for expatriates.

A recent Canadian Tax Court decision could make the cost of relocating to Canada more expensive. The decision will affect companies that make tax equalization payments to their foreign expatriate employees to compensate them for the higher tax liability they incur while working in Canada.

In the 1991 Splane case, the Canadian Federal Court of Appeal held that mortgage interest differential payments to transferred employees are not taxable, because the payments do not improve the employees' economic position. Splane called into question the taxability of certain other move-related items, such as employer reimbursements for additional housing costs, cost-of-living allowances and perhaps even tax equalization payments received by foreign expatriates working in Canada.

The recent Tax Court of Canada case of Gernhart is the first to address the taxability of tax equalization payments. The court held that tax equalization payments paid to an expatriate employee working and residing in Canada left her better off than other Canadian-resident employees receiving the same income but no such payments. As a result, the court decided that such payments are benefits of employment and thus taxable as employment income.

Revenue Canada has already been using Gernhart as ammunition against employees and employers who treated such payments as nontaxable reimbursements of out-of-pocket costs. With this decision, Revenue Canada is likely to carry out an aggressive campaign to identify and reassess others who adopted the same treatment. Such reassessments will be expensive for Canadian employers, because they may need to make additional payments to employees under existing tax equalization agreements and they may be required to remit additional tax withholdings (plus interest and penalties) for failure to make and remit the appropriate source deductions.

At this point, it is unclear whether this decision will affect foreign employees working temporarily in Canada and receiving tax equalization payments, but who are not resident in Canada for tax purposes.

Given the high stakes involved, it is likely that this decision will be appealed to a higher court. In the meantime, companies and their expatriate employees who may be affected by the Gernhart decision should assess their potential exposure and determine a course of action.

From Jim Yager, KPMG Toronto, Toronto, Canada
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Author:Yager, Jim
Publication:The Tax Adviser
Article Type:Brief Article
Date:Jun 1, 1997
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