Fourth Circuit Upholds IRS Collection of Canadian Income Taxes Payable

By Paul Bercovici  |  October 25, 2019

In the very recent unanimous decision of Retfalvi v. United States,¹ the United States Court of Appeals for the Fourth Circuit upheld a decision of the United States District Court for the Eastern District of North Carolina which found that the IRS was authorized by Article XXVI A of the US-Canada Income Tax Treaty to collect outstanding Canadian income taxes payable by a resident and citizen of the United States.

THE ASSISTANCE IN COLLECTION ARTICLE IN THE US-CANADA INCOME TAX TREATY

As a general rule, most countries (including the US) will not take steps to enforce a tax debt on behalf of another country. However, the US has in the past taken such steps where it is obligated to do so by the terms of an in-force income tax treaty. Of the 70 or so income tax treaties the US has entered into with other countries, five treaties obligate the US and its treaty partner to provide assistance and support to each other in the collection of income taxes due. The Convention Between the United States of America and Canada With Respect to Taxes on Income and On Capital (hereinafter referred to as the “Treaty”) is unique among all other US income tax treaties in that the Treaty has a specific “Assistance in Collection” article.

Article XXVI A (Assistance in Collection) of the Treaty was added by Article 15 of the Third Protocol to the Treaty. The Third Protocol to the Treaty entered into force in 1995. According to the Technical Explanation² to the Treaty, the Assistance in Collection article was added to the Treaty because of “the confluence of several unusual factors”, including: the close similarity of the legal and procedural protections afforded by the US and Canada to their citizens and residents and by the fact that these protections apply to the tax collection procedures used by each State; that the agreed procedures could be administered appropriately, effectively, and efficiently; and that the potential benefits to both countries of obtaining such assistance would be immediate and substantial and would far outweigh any cost involved.

Article XXVI A, paragraph 1 allows the tax administration of either Contracting State to assist and support the other State in the collection of “revenue claims”. For these purposes, the term “revenue claim” is defined to include all categories of taxes collected by or on behalf of the Government of a Contracting State³ as well as interest, costs, additions to taxes and civil penalties.⁴ Article XXVI A establishes certain procedural rules for applying for collection assistance and imposes certain limitations on claims for unpaid taxes made by a Contracting State. Pursuant to Article XXVI A of the Treaty, a “requested State”⁵ will not take steps to enforce a tax debt on behalf of an “applicant State”⁶ unless:

• The tax debt is “finally determined”;⁷
• The “applicant State” provides a certification that the taxes have been “finally determined”;⁸
• The “requested State” exercises its discretion to accept a particular application for collection assistance, and if accepted by the “requested State” is obligated to pursue such “revenue claim” as if it were the “requested State’s” own “revenue claim”.⁹

It is also important to note that Article XXVI A, paragraph 8 provides that a “requested State” is not to provide assistance to an “applicant State” for a claim in respect of an individual taxpayer, where the individual taxpayer can demonstrate that he or she was a citizen of the “requested State” during the taxable period to which the claim relates.

THE RETFALVI CASE

Background

Paul M. Retfalvi (the “Taxpayer”) was a medical doctor who was born in Hungary and moved to Canada in 1988. The Taxpayer became a Canadian citizen in 1993 and became a US citizen in 2010. Sometime in 1996, the Taxpayer sold two condominiums located in Vancouver, British Columbia. The Canada Revenue Agency (“CRA”) alleged that the Taxpayer’s reporting of the gains realized on the sale of the two Vancouver condominiums was improper and issued him a Notice of Assessment in 2009. In March 2010 the Taxpayer filed a timely administrative appeal challenging the CRA’s assertion that he had improperly reported the gains realized on the sale of the two condominiums. On July 4, 2011, the CRA sent the Taxpayer a Notice of Confirmation, denying his appeal and informing him that he had 90 days to file an appeal with the Canadian Tax Court challenging the CRA’s decision. The Taxpayer did not file an appeal with the Canadian Tax Court within the 90-day period for doing so (i.e., by October 3, 2011). As a result, the Canadian income tax liability became final on October 3, 2011.

On October 27, 2015, the CRA referred the assessment to the US pursuant to Article XXVI A of the Treaty. On November 16, 2015 the IRS issued a “Final Notice — Notice of Intent to Levy and of Your Right to a Hearing” (the “November 2015 IRS Notice”) and instructed the Taxpayer to pay $124,286.83 in US currency to satisfy the outstanding Canadian tax debt. In the November 2015 IRS Notice the IRS informed the Taxpayer that it intended to use its collection procedures if the Taxpayer did not pay the Canadian tax debt within the allotted period and that the Taxpayer had 30 days to seek a hearing before the IRS Office of Appeals to contest the November 2015 IRS Notice. After sorting out certain procedural issues, the IRS denied the Taxpayer’s appeal on March 24, 2016.

The October 2016 Decision of the U.S. District Court, E.D. North Carolina¹⁰

The Taxpayer filed suit for a declaratory judgment and injunctive relief to prevent the collection of the Canadian income tax debt by the IRS. The court dismissed the Taxpayer’s suit for lack of jurisdiction. The Taxpayer did not appeal the decision. The Taxpayer did, however, pay the Canadian tax amount due and file a refund claim with the IRS. The Taxpayer’s refund claim was subsequently denied by the IRS.

The August 2018 Decision of the U.S. District Court, E.D. North Carolina¹¹

In September 2017, the Taxpayer brought suit in the U.S. District Court, E.D. North Carolina for the refund of the amount he paid in connection with the IRS’s collection of the Canadian tax debt on behalf of the CRA. The Taxpayer’s suit for refund contained nine counts. All nine of the counts were based on constitutional arguments that particular provisions of the Treaty were invalid. Among the constitutional challenges raised by the Taxpayer to the collection of the Canadian tax debt by the IRS were the following:

• That the Treaty constituted a “bill for raising revenue” that did not originate in the House of Representatives, and was therefore in violation of the Origination Clause;
• That the Treaty violates the Taxing Clause (which in the view of the Taxpayer conferred on Congress the exclusive right to enact taxing legislation); and
• That the Treaty is not “self-executing” (and is therefore unenforceable because it had not been validated by the requisite implementing legislation)

All of the Taxpayer’s arguments challenging the collection of the Canadian tax debt by the IRS were rejected by the court. In addition, the court held that the IRS had the authority to collect the assessment on behalf of the CRA pursuant to Article XXVI A.

The July 2019 Decision of the United States Court of Appeals for the Fourth Circuit

In its unanimous decision of July 16, 2019, the United States Court of Appeals for the Fourth Circuit affirmed the decision of the U.S. District Court, E.D. North Carolina. The United States Court of Appeals for the Fourth Circuit rejected all of the Taxpayer’s constitutional challenges to Article XXVI A of the Treaty and concluded that,

. . . if the United States accepts a request from Canada to collect a revenue claim, the United States must collect the revenue claim as if it were its own revenue claim.

One interesting aspect of the case worth noting is that Dr. Retfalvi was unable to invoke Article XXVI A, paragraph 8 to take the position that the US was not permitted to assist Canada in the pursuit of its claim because he became a citizen of the US after the taxable period to which the Canadian “revenue claim” related.¹²

THE TAKEAWAY

The recent decision of the United States Court of Appeals for the Fourth Circuit in Retfalvi v. United States unequivocally confirms that Article XXVI A of the Treaty is constitutionally valid and that it can be used by the taxation authorities of the US and Canada to enforce a legitimate tax debt of the other country. Time will tell whether one or both countries will rely on the Retfalvi decision to invoke Article XXVI A to enforce more cross-border tax debts in the future. With more and more individuals maintaining significant connections to both the US and Canada it appears inevitable that the IRS and CRA will seek to increase their use of Article XXVI A in appropriate circumstances to collect on outstanding tax debt on behalf of the other country.

Paul Bercovici, LL.B., is the Principal of Marks Paneth LLP, New York, New York. Paul can be reached at PBercovici@markspaneth.com.

This article originally appeared in the October 2019 issue of the Taxes & Wealth Management publication by Thomson Reuters.

¹ 2019 U.S. App. LEXIS 21004, decided on July 16, 2019.

² Technical Explanations to income tax treaties and protocols are official guides to income tax treaties and protocols. Technical Explanations also explain the policies behind particular provisions and the understandings reached by the parties during the negotiations with respect to the interpretation and application of certain provisions.

³ Article XXVI A(9).

⁴ Article XXVI A(1).

⁵ The “requested State” is the Contracting State from which assistance is requested.

⁶ The “applicant State” is the Contracting State applying for collection assistance.

⁷ Article XXVI A(2). A “revenue claim” is “finally determined” when the “applicant State” has the right under its internal law to collect the “revenue claim” and all administrative and judicial rights of the taxpayer to restrain collection in the “applicant State” have lapsed or been exhausted.

⁸ Article XXVI A(2).

⁹ Article XXVI A(3).

¹⁰ 2016-2 U.S.T.C. Par. 50,499.

¹¹ 2018-2 U.S.T.C. Par. 50,378.

¹² As noted earlier, Article XXVI A, paragraph 8 provides that a “requested State” is not to provide assistance to an “applicant State” for a claim in respect of an individual taxpayer, where the individual taxpayer can demonstrate that he or she was a citizen of the “requested State” during the taxable period to which the claim relates.

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