Capital gains taxation can be straightforward in a purely domestic context, but for individuals with financial ties to both Canada and the United States, such as dual citizens, cross border investors, or expatriates, the analysis becomes significantly more complex. Both countries assert taxing authority over capital gains realized by their residents and, in some cases, non-residents. However, the Canada-US Tax Treaty, specifically Article XIII, plays a pivotal role in allocating taxing rights and mitigating double taxation.
This blog provides a concise overview of how capital gains are taxed in both the United States and Canada, with a focus on how Article XIII of the Treaty governs cross border capital gains and helps harmonize the tax obligations of affected taxpayers.
US Taxation of Capital Gains
Under the US Internal Revenue Code, US citizens and residents are subject to tax on their worldwide income, including capital gains realized on the sale of securities, real property, and other capital assets.
Capital Gains Tax Rates
Capital gains are categorized based on the holding period:
- Short-term capital gains (assets held for one year or less) are taxed at ordinary income tax rates (up to 37%)
- Long-term capital gains (assets held for more than one year) are taxed at preferential rates of 0%, 15%, or 20%, depending on income level
An additional 3.8% Net Investment Income Tax (NIIT) may apply to higher-income individuals.
Capital Gains for Non-Residents
Non-resident aliens are generally not subject to US capital gains tax on US securities unless:
- The gains are effectively connected with a US trade or business, or
- The gain arises from the disposition of US real property interests (USRPI), which are subject to tax under FIRPTA (Foreign Investment in Real Property Tax Act)
Canadian Taxation of Capital Gains
Under the Income Tax Act, Canadian residents are also taxed on their worldwide capita gains, with distinct mechanics compared to the US.
Inclusion Rate and Taxation
Capital gains are subject to tax on 50% of the realized gain (the ‘inclusion rate’). The included portion is taxed at the individuals’ marginal tax rate, which varies by province.
Non-Residents of Canada
Non-residents are generally not taxed on gains from Canadian securities, except in cases involving ‘Taxable Canadian Property’ (TCP), which includes:
- Real property situated in Canada
- Resource property
- Shares in private corporations (or in public corporations if certain asset thresholds are met)
- Certain partnerships or trust interests
Unless one of the exceptions applies (e.g. Treaty protection), these dispositions may be subject to Part XIII.2 tax and Section 116 clearance certificate requirements.
Article XIII of the Canada-US Tax Treaty: Capital Gains
The primary purpose of Article XIII of the Treaty is to allocate taxing rights between Canada and the US on capital gains and to eliminate or reduce the risk of double taxation.
General Rule (Paragraph 4)
As a baseline, Article XIII(4) states: ‘Gains derived by a resident of a Contracting State from the alienation of property shall be taxable only in that State…”
Exception: This rule does not apply to real property or certain business assets located in the other state.
Implication:
- A US resident selling shares of a Canadian company is taxable only in the US
- A Canadian resident selling US securities is taxable only in Canada
This treatment does not apply to real property, which is governed separately.
Real Property (Paragraph 1)
Article XIII(1) confirms that each country retains the right to tax gains from the disposition of real property located in its jurisdiction.
For example:
- A US resident selling Canadian real estate is taxable in Canada under domestic law and under the Treaty
- The same US resident must also report the gain on their US tax return, but may claim a foreign tax credit for Canadian taxes paid
Business Property and Permanent Establishments (Paragraph 2)
Where the property sold is attributable to a permanent establishment or fixed base in the other country (e.g. a branch office or rental business), that country may retain taxing rights over the gain.
Shares of Real Property Holding Companies (Paragraph 3)
To prevent avoidance of real estate taxation through holding companies, Article XIII(3) permits taxation in the source country where shares derive more than 50% of their value from real property situated there.
This aligns with Canadian ‘Taxable Canadian Property’ (TCP) rules and US FIRPTA provisions.
Emigration and Deemed Dispositions (Paragraph 6 and Article XIII(7)
When an individual ceases to be a resident of Canada, Canadian law triggers a deemed disposition (exit tax) on most property. Under Article XIII(7), a US resident who was formerly Canadian may elect to have this deemed disposition also recognized in the US, aligning the timing of gain recognition for foreign tax credit purposes.
Coordination Taxation Through Foreign Tax Credits
To mitigate double taxation, both countries offer a foreign tax credit (FTC) mechanism:
- A Canadian resident who sells US real property and pays US tax may claim a Canadian FTC for the US tax paid
- A US citizen on a Canadian real estate sale can similarly apply an FTC for Canadian taxes against US tax owed
Proper coordination of tax timing, currency conversion, and reporting compliance (e.g. IRS Form 1116, Canadian T2209) is essential to ensure credits are not lost or misapplied. Further complicating matters is the fact that some states, such as California, do not adhere to the Canada-US Tax Treaty.
Practical Considerations
Currency Gains: Canada taxes capital gains in CAD, while the US uses USD. Currency fluctuations can result in gains or losses that are taxable in one country but not in the other, complicating planning and compliance.
Treaty Override via Savings Clause: The US may override Treaty protections for its citizens and residents via the ‘savings clause’ in Article XXIX but allows exceptions for capital gains rules under Article XIII(7).
Reporting Obligations: US citizens residing in Canada may have to report the same gain under two tax systems, each with different forms, thresholds, and consequences (e.g. FBAR, Form 8938, T1135).
Conclusion: Understand the Rules Before you Sell
Cross border capital gains taxation is not simply a matter of calculating the proceeds from a sale. A thorough understanding of domestic tax law, the Canada-US Tax Treaty, and foreign tax credit coordination is essential to achieving an efficient, compliant result. Article XIII provides vital protections against double taxation, but its effectiveness depends on careful planning and documentation.
Whether disposing of real estate, business assets, or marketable securities, individuals with ties to both countries should review their situation with a cross border financial planner before completing a transaction. The right strategy could reduce your overall tax burden while helping you avoid penalties and missed credit opportunities.