NHL player John Tavares’ well-publicized litigation pending before the Tax Court of Canada demonstrates the principle that resolving cross-border tax disputes in a purely domestic fashion can be problematic. The facts of the case are straightforward and worth discussing briefly. Before getting into the substance, our intent here is to not to evaluate the substance of Tavares’ case. That will be done elsewhere. Rather, we are more focused on the cross-border tax aspects of the dispute and the process.
From 2009-2018 Tavares played for the New York Islanders. During this time, it is safe to assume that he was a US federal tax resident and a New York State tax resident. New York has very aggressive rules regarding residency. For the purposes of our analysis we do not assume he was a New York City resident.
On July 1, 2018, he signed with the Toronto Maple Leafs. Tavares became a Canadian tax resident in September 2018 and stopped being a US tax resident after that tax year. On signing the contract, he was paid a signing bonus of USD $15,250,000 less an escrow payment of $1,753,750. On this signing bonus, he paid tax to Canada of 15% or USD $2,024,438 under Article XVI(4) of the Canada-US Tax Treaty (the “Treaty”). He reported and paid US federal tax on the full signing bonus and presumably the state of New York. In 2022, the Canada Revenue Agency (CRA) re-assessed Tavares for CAD $6,847,428 representing tax on the full amount of the signing bonus as a Canadian tax resident along with CAD $1,203,256 of arrears interest. Tavares filed a notice of objection, which the CRA never responded to and then filed a Notice of Appeal in the Tax Court of Canada.
The dispute raises a number of interesting observations about cross-border tax and dispute resolution.
First, though a great deal of media commentary has focused on how Canada’s high tax rates and CRA’s challenge of the treaty-based signing bonus tax reduction will dissuade athletes like Tavares from playing in Canada, in Tavares’ case his original filing position likely had a relatively small tax benefit. In 2018, the highest applicable combined tax rate for a resident of Ontario was 53.53%. The highest effective rate for a New York tax resident that year was 45.82% (comprising 37% federal tax and 8.82% New York State tax that was effectively not deductible against the federal). The differential between the top Canadian and US rates was therefore just 7.71%. As applied to the signing bonus, this means Tavares saved approximately CAD $1.3 million of overall tax. This is about equal to the arrears interest that CRA is now imposing (CAD $1.2 million).
Second, aggressively front-loading the bonus significantly increased the risk of double taxation should CRA ultimately be successful in litigation. From the Notice of Appeal, we can intuit that the plan was to have a large signing bonus to take advantage in the reduction of Canadian tax under Article XVI(4). This exposed the signing bonus to full US and New York state tax. Had Tavares simply been paid a salary, he would have presumably paid only Canadian tax since he would no longer have been a US federal or NYS tax resident.
There is a risk of double taxation at between the US federal system and Canada. Assume for the sake of argument that Tavares loses his Tax Court case and any subsequent appeal including a potential appeal to the Supreme Court of Canada. It is entirely possible that the litigation drags out over a 5-year period. By then Tavares will owe the CRA the $6.8 million in reassessed tax and several million in interest payments. He would have to go and try and get a refund from the United States. The interest represents a net economic cost to Tavares since that cannot be used as a credit against US federal tax. While a US refund may also come with overpayment interest, the interest paid by the IRS may be at a lower rate than the interest paid to the CRA and the refund interest is subject to tax at ordinary income rates in Canada. Thankfully for Tavares, there is a 10-year statute of limitations under the Internal Revenue Code for refund claims related to foreign tax credit adjustments. In theory, that gives Tavares plenty of time to file his claim for refund, but the Canadian litigation could drag it out beyond the statutory period. Additionally, the determination by a Canadian court does not bind the United States in the application of its domestic law or its interpretation of the Treaty, so any change in characterization or sourcing for Canadian tax purposes could create a mismatch with the US treatment that could interfere with the ability to claim foreign tax credits in one or the other country.
The State of New York also presents a double tax risk. Frontloading the compensation likely exposed it to New York State tax where it would not have been otherwise. New York only offers a foreign tax credit for income sourced to and tax paid to a Canadian province. This presents the same potential sourcing problem as in the federal system and at best a credit is only available for the portion of the tax that is paid to Ontario. Worse for Tavares, in New York, a claim for credit or refund of an overpayment of income tax must be filed by the taxpayer within three years from the time the return was filed or two years from the time the tax was paid, whichever is later. That means that he is currently out of time for a New York adjustment and New York will not refund the tax (even if it is creditable).
In short, Tavares’ downside risk related to his CRA challenge is not just the Canadian tax. It is the arrears interest (not creditable in the US), potential US federal tax (due to expiry of the refund claims period or a sourcing conflict) and the New York state tax (where a refund claim is closed). All of this needs to be weighed against the potential upside of CAD $1.3 million of total US/Canada tax savings. Readers can form their own opinion as to the wisdom of taking an aggressive position on the signing bonus for a total Canada/US tax savings of $1.3 million, in relation to a total contract of over USD $70 million weighed against these downside risks.
Third, the Notice of Appeal suggests a purely domestic approach to what is fundamentally a cross-border dispute. Under Article XXVI of the Treaty, there is a process called the mutual agreement procedure or MAP. That process obliges the CRA and the IRS to try and negotiate a resolution to the application of the Treaty to a specific taxpayer’s case. For Tavares, seeking assistance under MAP would have been very wise for a number of reasons.
First, it is possible that a negotiation between the CRA and IRS would have moved the CRA off its audit and assessment position since the Canadian competent authority would have the sole determination to reach an agreement with the IRS and could have overruled the audit report.
Second, even if Canada’s position prevailed in the negotiations, but the IRS agreed with it, an automatic US refund would flow from that process without worry about the source or credit questions raised above. Finally, even if CRA and IRS could not agree on the taxation of the signing bonus, the litigation position in Canada would be significantly enhanced compared to the current position. As the Canadian Supreme Court put it in Crown Forest Industries Ltd. v. Canada, unlike a domestic statute, the Treaty is to be interpreted to give effect to the parties to the Treaty. At the conclusion of the MAP process, the IRS’ position would be reported to Tavares. Presumably, this would be that the United States believes the signing bonus was governed by Article XVI(4). Having the written opinion of one of the parties to the Treaty is a powerful argument to deploy against the CRA in litigation. Indeed, one struggles to think of a Canadian or US tax treaty case where a court in either country has reached a conclusion that is opposite of the position of the other party to the treaty. Without MAP, Tavares doesn’t have this.
All in, by aggressively frontloading his compensation towards a signing bonus, Tavares saved himself a lot of Canadian tax, but much less overall tax than you might think. And in taking a position that was highly likely to invite CRA scrutiny he exposed himself to considerable risk of double taxation if he is not successful. The failure to seek relief under MAP to involve the IRS only worsens his double tax exposure. The Tavares case provides a stark reminder that cross-border issues deserve a cross-border perspective.