7 March 2012 External T.I. 2011-0392071E5 - U.S. Social Security Disability Lump Sum Benefit

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: What is the correct treatment of a U.S. Social Security Disability lump sum benefit paid to a resident of Canada?

Position: The entire amount is included in the recipient's income pursuant to clause 56(1)(a)(i)(B) and a deduction is allowed under paragraph 110(1)(f) for the amount (15%) exempted by the Convention. The taxpayer may opt to have subsection 56(8) apply and a special tax calculation in section 120.3 may reduce the recipient's Canadian tax.

Reasons: Paragraph 5(a) of Article XVIII of the Canada-US Tax Convention provides that a benefit under the social security legislation in the United States paid to a resident of Canada shall be taxable in Canada as though it were a benefit under the Canada Pension Plan, except that 15 percent of the amount of the benefit will be exempt from Canadian tax. Therefore a resident of Canada in receipt of a retroactive lump-sum U.S. Social Security benefit is eligible to make the election pursuant to subsection 56(8).

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									2011-039207
									S. Fron

March 7, 2012

XXXXXXXXXX :

Re: Taxation of Social Security Disability Lump Sum Benefit

This is in response to your email in which you asked us to confirm the treatment of a United States (U.S.) Social Security Disability (SSD) lump sum benefit received prior to 2010 by a U.S. citizen who is a resident of Canada. The taxpayer was approximately 35 years old when she received the SSD lump sum. You confirmed that amount received was for a period of time which began after 1996 and that it was entirely related to SSD. Since then she has been receiving monthly SSD payments.

You noted that Interpretation Bulletin IT-122R2 (Archived) - United States social security taxes and benefits indicates that "disability insurance benefits paid under the Social Security Act up to the age of 65 are not considered to be income and therefore are not subject to tax in Canada."

You also noted that the guidance provided in IT-122R2 appears to contradict paragraph 5 of Article XVIII "Pensions and Annuities" of the Canada - United States Tax Convention (the Convention).

Our Comments

Article XVIII - "Pensions and Annuities" of the Canada - United States Tax Convention (the Convention) provides guidance to the tax treatment of pensions and annuities received by a resident of a Contracting State from a source in the Other Contracting State.

In particular, paragraph 5 of Article XVIII states:

5. Benefits under the social security legislation in a Contracting State (including tier 1 railroad retirement benefits but not including unemployment benefits) paid to a resident of the other Contracting State shall be taxable only in that other State, subject to the following conditions:

(a) a benefit under the social security legislation in the United States paid to a resident of Canada shall be taxable in Canada as though it were a benefit under the Canada Pension Plan, except that 15 per cent of the amount of the benefit shall be exempt from Canadian tax; ...

This wording was made effective for 1996 and later years by the Forth Protocol which amended the Convention.

Paragraph 5 of Article XVIII of the Canada-U.S. Convention on the Taxation of Income and Capital (the "Convention") grants Canada the exclusive right to tax benefits under the social security legislation in the U.S. received by a resident of Canada. Subject to the conditions expressed in paragraph 5(a) of Article XVIII of the Convention, a benefit under the social security legislation in the U.S. paid to a resident of Canada shall be taxable in Canada as though it were a benefit under the Canada Pension Plan ("CPP"), except that 15 percent of the amount of the benefit shall be exempt from Canadian tax.

Article 2 of the Technical Explanations of the Fourth Protocol of the Convention provides an explanation of paragraph 5(a) of Article XVIII of the Convention. It states:

The Protocol returns to a system of residence-based taxation in which social security benefits are exclusively taxable in the State where the recipient lives. Social security benefits will generally be taxed as if they were benefits paid under the social security legislation in the residence State. Therefore, social security benefits will be taxed on a net basis at graduated rates and low-income recipients will not pay any tax on these benefits. However, the Protocol modifies the residence State's taxation of cross-border benefits in order to take into account how the benefits would have been taxed in the source State if paid to a resident of that State.

In the case of Canadian recipients of U.S. social security benefits, the Protocol provides that only 85 percent of these benefits will be subject to tax in Canada. This reflects the fact that, although in Canada social security benefits are fully includible, a maximum of 85 percent of United States social security benefits are includible in income for U.S. tax purposes. See Code section 86. This is also consistent with the taxation of social security benefits under the Convention prior to the effective date of the 1995 Protocol, since at the time the pre-1996 rule was adopted the United States included a maximum of 50 percent of the social security benefits in income.

On July 29, 1997 the Department of Finance issued "Frequently Asked Questions" (FAQ) related to the taxation of social security benefits (see webpage http://www.fin.gc.ca/toc/1997/usssfaq-eng.asp ).

RESIDENTS OF CANADA WHO RECEIVE U.S. SOCIAL SECURITY BENEFITS

1. What U.S. social security benefits are affected by the proposed changes to the tax treaty?

The benefits that are affected are those provided under Title II of the U.S. Social Security Act. These include retirement, survivor, and disability benefits. Railroad retirement benefits provided under Tier 1 of the Railroad Retirement Act are also affected. In these questions and answers we use the term "U.S. social security benefits" to refer to all of these benefits.

2. How do the proposed changes affect the taxation of these benefits?

The U.S. currently withholds a non-refundable tax equal to 25.5% of the U.S. social security benefits that it pays to a Canadian resident who is not a U.S. citizen or resident alien. Canada does not tax these benefits and therefore does not allow the recipient to use the tax that was withheld as a credit on the recipient's Canadian tax return. Canada does require the recipient to include U.S. social security benefits in net income, but allows the recipient to deduct an equal amount in calculating taxable income.

Under the proposed changes, the U.S. will stop withholding tax. U.S. social security benefits received by a resident of Canada will be taxable in Canada. However, Canada will include in taxable income only 85% of the benefits you receive. The other 15% will be exempt from tax.

It is important to note that no distinction is made between retirement, survivor, and disability benefits in any of the above sources. We considered whether some distinction may exist in the U.S. with respect to the treatment of Social Security Benefits. The U.S. Internal Revenue Service's Publication 915 - Social Security and Equivalent Railroad Retirement Benefits makes no distinction between retirement, survivor, and disability benefits.

In terms of your comments with respect to Interpretation bulletin IT-122R2, it should be noted that this bulletin was cancelled in 2004 by Income Tax Technical News 31. The bulletin no longer reflects the CRA's views and should not be relied on. Accordingly, we will ensure that the cancelled status of bulletin is appropriately reflected on the CRA website.

Clause 56(1)(a)(i)(B) of the Income Tax Act (the "Act") includes in a taxpayer's income the amount of any benefit under the Canada Pension Plan or a provincial pension plan as defined in section 3 of that Act; therefore, the SSD benefits to which paragraph 5 of Article XVIII of the Convention applies are included in the taxpayer's Canadian income under clause 56(1)(a)(i)(B).

The entire amount of the benefit received in the year under the social security legislation in the U.S. must be included in income on line 115 - "Other pensions or superannuation". The portion of the benefit that is exempt from Canadian tax pursuant to paragraph 5(a) of Article XVIII of the Convention (i.e. 15 percent) is deducted under paragraph 110(1)(f) of the Act, and is taken as a deduction in the calculation of taxable income at line 256 - "Additional deductions". An additional deduction of 35 percent is available under paragraph 110(1)(h) of the Act only where the recipient has received SS benefits since before 1996.

As the SSD benefits are included in the taxpayer's Canadian income under clause 56(1)(a)(i)(B), an individual in receipt of a retroactive lump-sum benefit under the social security legislation of the U.S. may, pursuant to subsection 56(8) of the Act, opt to exclude from income in the year received, any CPP benefits that relate to one or more prior years (except where the prior year benefits are less than $300) and to pay tax on those benefits as if they had been received in the prior years to which they relate ("the Election"). Section 120.3 of the Act provides the calculation for the payment of tax on this basis.

In such a situation, an individual cannot make the Election pursuant to subsection 56(8) of the Act when filing an income tax return electronically. An individual can only make the Election by filing a paper income tax return, and the benefit statement received from the U.S. Social Security Administration must be included. The benefit statement must provide a breakdown of the lump-sum amounts in respect of the previous years.

There is no prescribed form or manner to file the Election pursuant to subsection 56(8). However, the Canada Revenue Agency ("CRA") recommends that a letter or note be included with the return indicating that the individual is applying paragraph 5(a) of Article XVIII of the Canada-US Convention on the Taxation of Income and Capital to have the benefit under the social security legislation in the U.S. taxed as though it was received under the CPP. The note should also indicate that the individual is choosing to apply subsection 56(8) of the Income Tax Act in respect of the retroactive portion of the benefit.

When processing the return, the CRA will determine the most beneficial tax calculation by comparing two separate tax calculations. The first calculation involves including the entire lump-sum payment amount in taxable income in the year received, and calculating the tax payable in the usual manner. The second calculation ("special tax calculation") adds to tax payable in the taxation year the benefit was received, the tax that would have been payable under Part I of the Act for each taxation year had the retroactive portion of the benefit not been included in computing income in the year received because of subsection 56(8), but instead had been included in computing income in the particular taxation year to which the portion relates. A comparison is made of the taxes payable resulting from the two calculations, and the calculation that is most beneficial to the taxpayer is the one that is used. If the special tax calculation is to the taxpayer's benefit, the portion of the lump-sum payment that relates to previous years is not included in the calculation of net income or taxable income for the year in which it is received.

CRA will not adjust any previous-year returns with regard to the special tax calculation for prior years. Taxpayers, therefore, cannot make changes to those tax years such as contributions to an RRSP and tax credits.

I trust that these comments will be of assistance.

Yours truly,

Steve Fron
Acting Manager
Trusts Section II
For Director
International Division/ Division des opérations internationales
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch