Both Countries Auditing the Same Income: What Happens, Who Goes First, and How the Treaty Keeps It From Being Taxed Twice

A cross-border taxpayer's income is on two returns, and each agency can examine its own. When both do, the danger is not the examinations themselves but their mismatch: the IRS increases US tax on income Canada already taxed, and Canada does not correspondingly reduce its tax; or the CRA reassesses a foreign tax credit downward because it disagrees with how the US tax was computed. The mechanisms that prevent double taxation are the foreign tax credit (each country credits the other's tax on the same income), the redetermination rules that require a taxpayer to adjust one side's credit when the other side's tax changes, and, when the agencies disagree, the treaty's mutual agreement procedure under Article XXVI. The taxpayer's job is to keep both agencies informed of the other's actions and to maintain one consistent set of facts.

Key takeaways

• Each agency examines its own return on its own timeline; neither defers to the other. The IRS's statute is three years from filing (six for a substantial foreign-income omission); the CRA's normal reassessment period is three years from assessment (six with an unfiled T1135 and omitted foreign income).
• An adjustment on one side changes the credit on the other: a US increase in tax on US-source income increases the Canadian foreign tax credit (claim it by adjustment request); a CRA increase in Canadian tax increases the US foreign tax credit (under section 905(c) the taxpayer must notify the IRS and redetermine, and may claim the additional credit by amended return).
• A reduction on one side reduces the other's credit, and the taxpayer must report it: a CRA reassessment reducing Canadian tax means the US credit was overclaimed; section 905(c) requires notification and the US tax is due with interest.
• The characterization can differ: the IRS may treat an amount as US-source and Canada as Canadian-source (a bonus for work in both countries; a pension from cross-border employment); each then taxes it fully and neither credits the other. That is the case for competent authority.
• The mutual agreement procedure (Article XXVI): the taxpayer presents the case to the competent authority of their residence country within the treaty's time limit; the two authorities negotiate a resolution that eliminates the double tax; the process takes years; the taxpayer generally must protect the domestic appeal rights (a notice of objection; an IRS protest) in parallel.
• Sequencing: respond to each examination on its own terms, tell each examiner about the other's examination, provide consistent documents to both, and compute the credit consequences of any proposed adjustment on the other side before agreeing to it.

How the examinations interact

The agencies do not coordinate examinations. Under the treaty's Article XXVII they can request information from each other about a taxpayer, and each may learn that the other has opened a case, but each proceeds independently. A taxpayer under examination by both answers each on its own schedule with its own document requests.

What connects them is the foreign tax credit. A Canadian resident with US-source income claims a credit on the T1 for US tax; a US citizen in Canada claims a credit on the 1040 for Canadian tax. An adjustment to the tax on one side changes the correct credit on the other. The taxpayer, not the agencies, is responsible for making the corresponding change.

Adjustments that increase the other side's credit

An IRS examination that increases US tax on US-source income (disallowing a deduction on a rental; recharacterizing a payment) means the Canadian resident paid more US tax on the same income. The Canadian foreign tax credit rises; the taxpayer files an adjustment request (within ten years) with the IRS's final determination; the CRA allows the additional credit if the US tax is on income Canada also taxes.

A CRA reassessment that increases Canadian tax on income a US citizen also reported on the 1040 means the US credit rises. Under section 905(c), the taxpayer notifies the IRS of the change in foreign tax and redetermines the credit, filing an amended return to claim it (within the refund period; the redetermination itself is not time-limited).

Adjustments that reduce the other side's credit

A CRA reassessment that reduces Canadian tax (a deduction the taxpayer had not claimed; a loss carryback) means the US credit already claimed was too high. Section 905(c) requires the taxpayer to notify the IRS and redetermine; the additional US tax is due with interest from the original due date. Failing to notify is a separate penalty.

An IRS adjustment that reduces US tax (a refund; a treaty position accepted) means the Canadian credit was too high; the taxpayer files an adjustment request reducing it, and the CRA assesses the difference with interest.

The mismatch that neither credit fixes

The credits work when both countries agree on what the income is and where it comes from. When they disagree on source or character, the credit fails: Canada treats a signing bonus as Canadian-source (services in Canada) and taxes it fully; the IRS treats it as US-source (paid by a US employer for a US job) and taxes it fully; neither credits the other because each says the income is its own. The same with an employer pension where the employment straddled the border, a severance, a partnership allocation, or a transfer pricing adjustment between related companies. The taxpayer is taxed twice.

The mutual agreement procedure

Article XXVI allows a taxpayer who considers that the actions of one or both countries result in taxation not in accordance with the treaty to present the case to the competent authority of their residence country (the CRA's competent authority services division; the IRS's Advance Pricing and Mutual Agreement program or the Office of the Deputy Commissioner (International)), within the treaty's time limit (Article XXVI(2) requires the other competent authority to receive notification that the case exists within six years of the end of the taxable year to which the case relates). The competent authorities then negotiate; if they agree, one country adjusts to eliminate the double tax, and the agreement is implemented regardless of domestic time limits. The process takes two to four years on average. The taxpayer should file a domestic objection or protest in parallel to protect the right to appeal if the competent authorities do not agree (the CRA and IRS ask that domestic appeals be held in abeyance during the MAP).

Sequencing and consistency

1. Tell each examiner about the other examination; provide the other agency's document requests and proposed adjustments.
2. Give both agencies the same documents: the same contracts, the same working-day schedules, the same valuations.
3. Before agreeing to a proposed adjustment on one side, compute its effect on the other side's credit and, if the other side will not follow, its double-tax cost; negotiate with that in view.
4. File the redetermination or adjustment request on the other side promptly after a final determination.
5. Where the adjustment produces double tax the credits cannot fix, request competent authority within the time limit and protect domestic appeals.

Worked example

A Toronto executive received a $300,000 retention bonus in 2023 while splitting time between Toronto and the employer's New York office (40% of workdays in New York). She reported 40% as US-source on a 1040-NR and 100% on her T1 with a credit for the US tax on the 40%.

• IRS examination. The examiner asserts the bonus is 100% US-source (paid by the US parent for services to the US business); proposes tax on the full $300,000.
• CRA examination. Separately, the CRA reviews the credit and accepts the 40% as filed.
• The mismatch. If she agrees with the IRS, the US taxes 100%; Canada taxes 100% and credits only the US tax on 40% (Canada considers 60% Canadian-source). Double tax on 60%.
• Response. She contests the IRS's sourcing with the working-day schedule; she informs the CRA of the IRS's position; if the IRS finalizes at 100%, she requests competent authority under Article XXVI within the treaty's time limit and files a notice of objection in Canada in parallel; the competent authorities agree on a working-day allocation, and one country adjusts.

Official sources

"Where a person considers that the actions of one or both of the Contracting States result or will result for him in taxation not in accordance with the provisions of this Convention, he may... present his case in writing to the competent authority of the Contracting State of which he is a resident." Article XXVI(2) requires the other competent authority to have "received notification that such a case exists within six years from the end of the taxable year to which the case relates." — Canada-United States Tax Convention, Article XXVI, https://www.canada.ca/en/department-finance/programs/tax-policy/tax-treaties/country/united-states-america-convention-consolidated-1980-1983-1984-1995-1997.html

Article XXVII of the Canada-United States Tax Convention provides for the exchange of information between the competent authorities of the two countries for the purposes of carrying out the Convention and the domestic tax laws of each country. — Canada-United States Tax Convention, Article XXVII, https://www.canada.ca/en/department-finance/programs/tax-policy/tax-treaties/country/united-states-america-convention-consolidated-1980-1983-1984-1995-1997.html

The IRS explains that the foreign tax credit is limited to the U.S. tax attributable to foreign-source income and is computed separately for each category (basket) of income on Form 1116. — Internal Revenue Service, Foreign Tax Credit, https://www.irs.gov/individuals/international-taxpayers/foreign-tax-credit

Practitioner note

Two examinations are two conversations about one set of facts, and the taxpayer is the only party in both. We give each agency the same documents, tell each about the other, and compute the credit effect of every proposed adjustment on the far side before we agree to it. When the two agencies characterize the income differently, the credits cannot fix it and competent authority can; under Article XXVI(2) the other competent authority must receive notification of the case within six years of the end of the taxable year to which it relates.

See also: For the full picture of what each agency charges, see late-filing penalties on both sides of the border, and browse every cross-border tax topic guide, organized by situation.

Next step

Fairlight prepares the coordinated response to examinations on both sides, the foreign tax credit redeterminations that follow any adjustment, and the competent authority request where the credits fail. See cross-border pricing or book a call.