How international athletes are taxed in Canada: Toronto Maple Leafs' captain John Tavares embroiled in tax litigation with CRA

Editor's note: To see how Mr. Tavares' contract is structured yearly, visit Spotrac.

JOHN Tavares, NHL all-star and captain of the Toronto Maple Leafs, is used to making headlines. Since signing with the Leafs in 2018, Tavares led the Leafs to their first second-round playoff appearance in nearly two decades, as well as the only recorded loss in the NHL to former Zamboni driver David Ayres in 2020. But Tavares' headline-breaking appeal to the Tax Court of Canada in January 2024 piqued not only the interest of Canadian news media, but tax practitioners throughout North America as well. In dispute is nearly $7 million in taxes the CRA alleges that Tavares owes in connection with his decision to sign with the Leafs in 2018.

Compensation packages paid to North American superstar athletes have been increasingly scrutinized in popular media in recent years. In 2023, MLB player Shohei Ohtani's controversially signed a 10-year, $700 million contract with the Los Angeles Dodgers, the largest contract in professional sports history, which defers nearly $680 million in salary to pay out starting in 2034. There are unquestionably strategic reasons a team would favour paying higher bonuses or deferring salary to later years. Recharacterizing and restructuring salary payments might offer professional teams greater flexibility to finance operations in current operating years and to plan around league luxury taxes and salary caps. And as with any sensible business decision, income tax is always a consideration as well.

Tavares' appeal represents a high-profile opportunity for the CRA to test the limits to structuring the salaries of professional athletes in Canada in court. The results of Tavares' appeal could have lasting implications for any Canadian professional sports team and any professional athlete looking to play in Canada, and any U.S. league, player or team looking to break into the Canadian market.

This article aims to break down the circumstances giving rise to Tavares' appeal and the law underlying both the CRA's claim and Tavares' defence. This article will begin by briefly setting out the rules concerning taxation of athletes in Canada, and the relevant provisions of the Canada-U.S.A Tax Treaty. This will be followed with a brief review of the facts set out in Tavares' appeal and the legal arguments set out by his Canadian tax litigation lawyer. We will conclude with some observations on Tavares' case as a whole, and some pro tax tips on settlement at the Tax Court of Canada, and how those rules may inevitably force Tavares' appeal to a public hearing.

Canadian taxation of U.S.A.-resident athletes

To begin, a review of the law concerning taxation of athletes in Canada is required. This begins with the concept of tax residence. A tax resident of Canada is taxable on worldwide income pursuant to Part I of the Income Tax Act. On the other hand, a person who is a non-resident of Canada is typically only subject to tax on specific kinds of Canadian-source income. Tax residence can be distinguished from citizenship or nationality, as the applicable tests consider personal and economic connections to Canada. This can be contrasted with the U.S.A., where all citizens are subject to tax.

A person who is "employed in Canada" is subject to tax on that employment income either as a tax resident, or as a non-resident pursuant to subsection 2(3) of the Income Tax Act. Generally speaking, a person is "employed in Canada" when performing employment duties within the territory of Canada. Section 115 of the Income Tax Act supplements this rule by deeming a non-resident to be employed in Canada where employment services are rendered outside of Canada's territory, but there is a significant economic link between Canada and that employment. Paragraph 115(2)(c.1) of the Income Tax Act explicitly deems a non-resident person receiving a "signing bonus" to be employed in Canada, and the amount forms fully-taxable employment income.

Without this rule, a Canadian sports team would be able to deduct the cost of paying a non-resident athlete a bonus, and the non-resident athlete would pay no Canadian tax. Given the frequent movement of athletes between Canadian-based and U.S.A.-based teams throughout North American leagues, this rule plays an essential role in protecting the Canadian tax base from erosion.

The bonus that a U.S.A.-resident athlete receives from a Canadian sports team would likely be taxable in the U.S.A. under its domestic laws as well. To prevent double taxation in both countries, there are two principal tax regimes. First, Canada and the U.S.A. have entered into a bilateral treaty, the Canada-U.S.A. Tax Treaty, setting out rules to determine which country has the primary right to tax employment income and in what circumstances. Second, both Canada and the U.S.A. offer a foreign tax credit, so an athlete can claim a deduction for taxes paid in one jurisdiction to offset taxes in the other.

Both mechanisms are very relevant to Tavares' appeal. To begin, Article XV of the Canada-U.S.A. Tax Treaty states that Canada maintains the right to tax U.S.A. residents on employment income where the employee is paid by or on behalf of a Canadian resident (i.e., Maple Leafs Sports and Entertainment).

So, an American sports star signing with a Canadian team would be subject to full Canadian taxation on employment income and signing bonuses. In isolation, these rules would penalize Canadian sports teams seeking to attract international talent. Broadly speaking, Canada's marginal tax rates exceed the marginal tax rates applicable throughout the U.S.A. An American sports player could escape double taxation by claiming a foreign tax credit in the U.S.A. for higher income taxes paid in Canada. But, when taking into account the extraordinary salaries earned by many top-paid sports players in North America, the high rates of tax in Canada may disincentivize choosing to play for a Canadian sports team.

To provide relief, Canada and the U.S.A. have mutually bargained for favourable tax treatment of signing bonuses under the Canada-U.S.A. Tax Treaty. Very generally, under Article XV of the Canada-U.S.A. Tax Treaty, Canada maintains the right to tax American residents on employment income where the employee is paid by or on behalf of a Canadian resident (i.e., Maple Leafs Sports and Entertainment). But Article XVI(4) limits Canada's right to tax any "inducement" (i.e., a signing bonus) paid by a Canadian resident to a American-resident athlete at 15% of the gross amount of that inducement. For that athlete, a foreign tax credit is likely available in the U.S.A. for that withholding tax, to reduce U.S. taxes otherwise payable.

This treaty-reduced rate ensures favourable tax treatment to American-resident athletes who receive a signing bonus for agreeing to play for a Canadian sports team. It also heavily incentivizes athletes to receive a higher proportion of salary payable as a bonus, to reduce Canada's claim to tax that salary. This rule sits at the core of Tavares' recently launched appeal at the Tax Court of Canada.

Facts of the Appeal

The Notice of Appeal filed by Tavares' lawyer provides a helpful summary of facts central to Tavares' ongoing tax litigation. In 2009, Mississauga, Ontario born Tavares moved from Canada to New York City to begin his NHL playing career for the New York Islanders. Tavares subsequently became a non-resident of Canada on January 1, 2010. In 2018, after entering free agency, Tavares chose to sign a seven-year contract with the Toronto Maple Leafs and to return to Canada. Under the terms of his contract, Tavares was entitled to an annual salary of USD $650,000 for the 2018-2019 NHL season, and an annual salary of USD $910,000 for his remaining six seasons. In addition, Tavares was entitled to a total signing bonus of USD $70,890,000, with USD $15,250,000 payable on July 1, 2018, prior to moving to Canada to play for the Leafs.

On July 1, 2018, Tavares received a total of USD $11,395,792 from MLSE, owner of the Toronto Maple Leafs. That amount represented Tavares' total signing bonus, less a 15% withholding tax of USD $2,024,438 remitted by MSLE to the Canada Revenue Agency, and USD $1,753,750 held in escrow as required by the NHL Collective Bargaining Agreement. Tavares reported his full signing bonus on his 2018 U.S.A. tax return, and claimed a foreign tax credit for the 15% withholding tax paid in Canada on that bonus. Tavares subsequently declared that he departed the U.S. on his 2018 U.S. tax return, and filed tax returns in Canada as a resident from 2019 onward. (His employment income, including his signing bonus, received from 2019 onward were fully reported and taxed in Canada.)

The CRA later initiated an audit of Tavares' 2018 taxation year. The CRA found that Article XVI(4) of the Canada-U.S.A. Tax Treaty did not apply to Tavares' 2018 signing bonus, and that he was not eligible for the reduced treaty rate of 15%. As a result, in November 2022, the CRA reassessed Tavares' 2018 taxation year and increased his taxable income in Canada by $17,771,862, resulting in total taxes payable of $6,847,428.

Tavares' lawyer then objected to the CRA's assessment of his 2018 taxation year. Before that objection concluded, in January 2024, Tavares appealed the dispute to the Tax Court of Canada, instead of waiting for a decision from the CRA.

The Appellant's Arguments Before the Tax Court of Canada

The Notice of Appeal filed by Tavares' lawyer does not set out full details on the CRA's legal position. Nor has tax counsel for the Department of Justice filed a Reply setting out the legal position of the Department of Justice. But the Notice of Appeal is still revealing. (All of these documents are or will be a matter of public record and will be made available by the Tax Court of Canada.)

Chiefly, Tavares has argued that Article XVI(4) of the Canada-U.S.A. Tax Treaty should apply to the signing bonus he received in 2018. His Notice of Appeal argues the signing bonus was correctly characterized as an "inducement to sign an agreement relating to the performance of the services of an athlete" which would qualify for the treaty-reduced tax rate. Curiously, the Notice of Appeal rejects the characterization of Tavares' signing bonus as "salary, wages or other remuneration in respect of an employment", which Canada could fully tax pursuant to Article XV(1) of the Canada-U.S.A. Tax Treaty. In support, the Notice of Appeal argues the bonus was an inducement because it was payable to Tavares regardless of whether he actually actively played for the Leafs, or if he was injured or relegated. This is contrasted from Tavares' yearly salary, which could be restricted or reduced based on his performance for the Leafs.

The CRA's legal position is implicitly that the 2018 signing bonus was not an "inducement and was actually part of Tavares' salary and "other remuneration". The disproportionate nature of Tavares' signing bonus — a total of USD $70,890,000 payable over six years, relative to his total salary of USD $5,230,000 — was assuredly a factor for CRA when making this decision.

Tax commentators have speculated for decades on how to properly differentiate between an "inducement" and an athlete's regular salary. To date, there are no reported cases on the question at the Tax Court of Canada. And the CRA's long-standing administrative positions provide little further guidance on the matter, and whether the quantum of an athlete's bonus is a relevant factor to be considered. But clearly, there must be a distinction beyond how parties characterize those payments under contract. Whether the ratio between Tavares' signing bonus and his annual salary is relevant to answering this question will be up to the courts to decide.

In any case, whether Tavares is victorious or not, he should not face double taxation on his income. If Tavares is successful at court, then his reassessment will be overturned. If the CRA succeeds in upholding its reassessment at court, then Tavares' may be able to re-file in the U.S.A. to claim additional foreign tax credits. If the U.S.A. is unwilling to receive the puck, Tavares might invoke Article XXVI of the Canada-U.S.A. Tax Treaty, and force both the CRA and Internal Revenue Service ("IRS") in the U.S.A. to find a mutually agreeable solution to avoid double taxation.

Pro Tax Tip: Principled settlement rules at the Tax Court of Canada almost guarantee a hearing for Tavares' appeal

At the Tax Court of Canada, all settlement offers need to be principled. In other words, a settlement must be based on a result that could actually be reached by the CRA, owing to the facts and law in play. The CRA is not entitled to compromise on the law for the purposes of settlement. As a result, the CRA and an appellant at the Tax Court of Canada cannot decide on a fair quantum of tax to pay for settlement of an appeal.

As a result, there can be very little wiggle room to settle in some tax litigation cases. For example, where the legal issue in question is binary, such as an income/capital characterization on a single transaction, there is no middle ground to find a clear compromise. If the number of legal issues is limited, and the issues are binary, then settlement can become nearly possible.

In Tavares' case, the issue is very binary. The CRA has asserted that his signing bonus was fully taxable in Canada; Tavares has asserted the signing bonus was an "inducement" that qualified for a favourable rate of tax under the Canada-U.S.A. Tax Treaty. Further, Tavares' contract clearly spells out what part of his remuneration was intended as a signing bonus versus an annual salary. These factors work together to constrain opportunities for Tavares' Canadian tax litigation lawyer and the Department of Justice Canadian tax counsel to settle the matter pre-emptively.

David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm and is a Certified Specialist in Taxation Law who has completed the CICA in-depth tax planning course. He appears regularly in print, radio and TV and blogs extensively.  

With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, cryptocurrency traders, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax audit representation and tax litigation. Visit www.Taxpage.com and email David at david@taxpage.com. Read the original article on Taxpage. Photo David Rotfleisch courtesy Rotfleisch & Samulovitch P.C. Title image: Scott Gummerson, Unsplash.