Canadian Foreign Tax Credit

In this foundational post, I’ll cover the basics—and some not-so-basic subtleties—of the Canadian foreign tax credit (FTC). I’ll focus mainly on its application to individuals (not corporations) with “non-business” income such as from foreign employment, pensions, and investments.

Overview

The Canadian foreign tax credit is a credit taken on Canadian federal and provincial tax returns for income tax paid to a foreign jurisdiction. In the source-and-residence paradigm, it operates as the primary relief mechanism for the double taxation of a Canadian resident’s income from sources outside Canada.^[1]For a thorough and compelling exploration of the foreign tax credit and its role in Canada’s outbound taxation regime, see Li, Jinyan; Cockfield, Arthur; and Wilkie, J. Scott, International … Continue reading

This credit is a provision of Canadian law, namely section 126 of the Income Tax Act (ITA)^[2]RSC 1985, c. 1 (5th Supp.), as amended. and similar provincial statutes.^[3]Each Canadian province and territory offers a foreign tax credit under its own tax law for the balance of foreign tax that remains after the federal credit. See e.g. Ontario’s Taxation Act, 2007, … Continue reading A popular misconception is that FTC requires a tax treaty; in fact it can be claimed even for tax paid to non-treaty countries. But treaties do sometimes expand or clarify the scope of the credit, as we’ll see below.

Because the FTC is a “dollar for dollar” credit against Canadian tax, it ensures export neutrality when the source country’s tax rate does not exceed Canada’s—that is, the taxpayer’s bottom line is the same whether income is foreign or domestic.

But Canada protects itself from refunding foreign tax beyond the Canadian rate, by limiting credit^[4]ITA s. 126(1)(b) for non-business income; s. 126(2.1) for business income. to the amount of Canadian tax otherwise payable on foreign income (the “FTC limitation”), using a formula for proportional allocation of tax to income.

The federal FTC is claimed on Form T2209 with the taxpayer’s return. The provincial FTC is claimed on Form T2036 for provinces and territories other than Quebec, or on Form TP-772-V for Quebec. The CRA also provides extensive interpretive guidance in Folio S5-F2-C1.

Foreign Tax

The calculation of Canadian FTC begins with the measure of foreign “income or profits tax” paid by the taxpayer for the year, subject to exclusions embedded in the s. 126(7) definitions of “non-business-income tax” and “business-income tax”. There’s a lot to unpack here!

The foreign tax must be a tax

Calling something a tax does not make it so. The standard adopted by the CRA and the Tax Court of Canada is that a tax is “a levy, enforceable by law imposed under the authority of a legislature, imposed by a public body and levied for a public purpose.”^[5]Yates v. The Queen, 2001 CanLII 772 (TCC), citing Lawson v. Interior Tree Fruit and Vegetable Committee of Direction, [1931] SCR 357, echoed in CRA Folio S5-F2-C1 para. 1.5.

In the CRA’s view, the requirement of “public purpose” generally prevents contributions to foreign social security programs from counting as a foreign tax.^[6]Income Tax Technical News No. 31R2 (2006). Fortunately for Canadians employed in the US, the US-Canada tax treaty expressly includes FICA^[7]Federal Insurance Contributions Act, codified as Chapter 21 of the US Internal Revenue Code (“IRC”). taxes (social security and medicare) in Canadian FTC,^[8]US-Canada tax treaty, Art. XXIV(2)(a)(ii). even though the CRA did not consider them to qualify under the Income Tax Act alone.

Lack of public purpose proved fatal to a claim of FTC for premiums paid to the Maine State Retirement System.^[9]Nadeau v. The Queen, 2004 TCC 433 (CanLII). Similar logic would likely apply to a variety of US state-level payroll deductions, such as California State Disability Insurance (SDI).

The tax must be compulsory

FTC disputes and litigation have often centered on the “voluntary” nature of an alleged payment of foreign tax. As implied by the concept of an “enforceable levy”, payments to a foreign country are not a “tax” to the extent that the taxpayer obtained, will obtain, or could obtain—including by a treaty-based claim—a refund from the foreign tax authority.^[10]CRA Folio S5-F2-C1 para. 1.25, 1.33–1.35.

On this point, Meyer v. The Queen^[11]2004 TCC 199 (CanLII). is at first glance illustrative, and on closer inspection curious. The CRA capped the appellant’s FTC for US tax on US pension income at the 15% rate specified by treaty,^[12]US-Canada tax treaty, Article XVIII(2)(a). and his protestations of having actually paid US tax above that rate were unavailing. “By not claiming the benefit of the Treaty,” wrote Hershfield, J., “the Appellant has gifted the United States Treasury a fiscal advantage that it agreed in the Treaty not to have.”^[13]Meyer, para. 24.

The situation in Meyer is complicated by the fact that the appellant was a US citizen, for whom the “saving clause” preserves US taxing rights notwithstanding otherwise-available treaty benefits.^[14]US-Canada tax treaty, Art. XXIX(2)(a). With respect, Hershfield, J. plainly erred in stating that Art. XXIX(3), which lists exceptions to the saving clause, “provides that [the 15% rate] applies to citizens of the U.S.”^[15]Meyer, para. 22. In fact, the exception list (both currently and in the year at issue) omits the paragraph in question. The US is not bound by the 15% limit in taxing its citizens’ pensions.

Rate limits aside, the Meyer appellant’s excess US tax might have been recoverable under a different treaty provision,^[16]US-Canada treaty, Art. XXIV(4), providing a special foreign tax credit procedure for US citizens in Canada. but it appears no one undertook the analysis to ascertain that entitlement in his case. It remains possible, at least in theory, that a US citizen in Canada with US pension income might validly claim Canadian FTC above the 15% rate. But Meyer makes clear that the onus is on the taxpayer “to bring evidence that the foreign tax … was not gratuitously paid … under the laws of the foreign jurisdiction.”^[17]Meyer, para. 22.

The tax must be on income or profits

Section 126 demands an “income or profits tax”, and thus grants no credit for sales tax, property tax, gift tax, estate tax, wealth tax, etc.^[18]CRA Folio S5-F2-C1, para. 1.9.

“Income”, like “tax”, presents interpretive difficulties. In Dagenais v. The Queen,^[19]1999 CanLII 557 (TCC). which involved US lottery winnings, the Tax Court found that it does not suffice for foreign law to tax an item as “income”. Foreign tax must attach to something characterized as “income” by the Income Tax Act.

Income is sometimes contrasted with capital (and in that narrower sense it is understood as business income). But in the scheme of the ITA, “income for the year” includes capital gain,^[20]ITA s. 3(b). and a foreign tax on capital gain counts as an income or profits tax for FTC purposes.^[21]CRA Folio S5-F2-C1, para. 1.7.

The tax must be paid to a foreign country or political subdivision

Foreign tax includes payments “to the government of a country other than Canada”^[22]ITA s. 126(7) defns. “non-business-income tax” and “business-income tax”. or to “the government of a state, province or other political subdivision of that country”.^[23]ITA s. 126(6)(a). So Canada allows credit for state income taxes in the US, and even for municipal income taxes such as those of New York City, Philadelphia, or Detroit.

The asymmetry here is striking, as many states’ tax laws don’t offer any credit for foreign taxes. For example, a resident of California with income from Canada is double-taxed, but a resident of Canada with income from California is not.

Paid “for” the year, not “during” the year

The year in which credit is claimed is based on the tax year to which the foreign tax relates, not on when you happen to pay the bill. For example, if you paid an amount owing with your 2020 US tax return when you filed it in April 2021, this payment is included in the FTC calculation on your 2020 Canadian return.

Thus—despite using the word “paid”—the Canadian foreign tax credit operationally resembles the “accrued” option of the US foreign tax credit, which is for tax “paid or accrued during the taxable year”.^[24]IRC § 901(b) (emphasis added); see also § 905(a) (accrued option available to cash-basis taxpayer, subject to conditions). (US law generally considers foreign taxes to “accrue” on the last day of the foreign tax year under the “all-events” test.^[25]Pub. 514 p. 3 (“Accrual method of accounting”), Reg. § 1.461-1(a)(2).)

“For the year” also entails a proration of tax paid to a country like Australia or the UK, whose tax year is not aligned with the calendar year. The CRA has indicated that this proration may occur “on the basis of the portion of income earned during the calendar year”.^[26]T.I. 2002-0143605, quoting 1989 Round Table comments. (Folio S5-F2-C1 is more ambiguous, stating only that proration is “on a calendar year basis”, para. 1.32.)

Legislative exclusions

The Income Tax Act carves out a number of definitional exclusions which limit the amount treated as foreign tax. Some of these address income that is not truly double-taxed, such as because of a treaty exclusion^[27]ITA s. 126(7) defn. “non-business-income tax” para. (i) and defn. “business-income tax” para. (b), both referencing the s. 110(1)(f)(i) deduction for treaty-exempt amounts. or the lifetime capital gains exemption (LCGE).^[28]ITA s. 126(7) defn. “non-business-income tax” para. (g), referencing the capital gains deductions available under s. 110.6. Some address other kinds of obvious double-benefit scenarios, such as tax that could be refunded to the payor of the income^[29]ITA s. 126(7) defn. “non-business-income tax” para. (e) and defn. “business-income tax” para. (a). or tax separately claimed as a deduction from income.^[30]ITA s. 126(7) defn. “non-business-income tax” para. (c), referencing the s. 20(12) deduction for foreign tax on business and property income.

Two exclusions are more surprising:

• The “non-business-income tax” excludes amounts deductible (whether or not deducted in fact) under s. 20(11).^[31]ITA s. 126(7) defn. “non-business-income tax” para. (b). This effectively caps credit at 15% for foreign tax on income from “a property other than real or immovable property”—generally, interest and dividend income^[32]Note that capital gains are not “income from a property”, ITA s. 9(3)..
  
  Fortunately, thanks to the treaty network, Canadian residents rarely face foreign tax above 15% on dividends or interest. The s. 20(11) deduction is mainly needed for income from non-treaty countries, or from countries like India, whose treaty dividend rate is 25%.^[33]Canada-India tax treaty, Art. 10(2)(b).
  
  US citizens with US dividends will also claim the s. 20(11) deduction under the treaty credit procedure.^[34]US-Canada tax treaty, Art. XXIV(5)(a). But in this case the ITA’s 15% cap is largely redundant, as Canada’s treaty-based FTC obligation is similarly capped at 15%,^[35]US-Canada tax treaty, Art. XXIV(5)(b), granting credit up to the amount of US tax that a non-US-citizen would owe under Art. X(2)(b). and the US tax beyond that amount will usually be recovered by US FTC with the income “re-sourcing” provisions.^[36]US-Canada tax treaty, Art. XXIV(5)(c) and (6).
• The “non-business-income tax” excludes foreign taxes on Canada-source income arising by reason of the taxpayer’s citizenship.^[37]ITA s. 126(7) defn. “non-business-income tax” para. (d). With this provision, Canada casts a leery eye at the citizenship-based taxation regime of its neighbour to the south, and takes pains to protect its residual tax on US-source income from cross-crediting techniques.
  
  The citizenship exclusion aligns well with the treaty credit procedure for US citizens in Canada, which compels Canadian credit only for the hypothetical US tax that would arise without citizenship.^[38]US-Canada tax treaty, Art. XXIV(4)(a). But it is troublesome for planning in cases where the treaty may not fully recover the US tax, such as in the sale of a principal residence.^[39]In general, principal residence gain is fully exempt from Canadian tax, ITA s. 40(2)(b), but exempt from US tax only up to a dollar limit, IRC § 121(b), which can leave a substantial exposure for a … Continue reading

Foreign-Source Income

No matter the foreign tax paid, section 126 limits FTC based on the source of income. The fraction of Canadian tax erased by credit for the tax of a foreign country is at most the fraction of income which is “from sources in that country”^[40]ITA s. 126(1)(b)(i). or “from businesses carried on… in that country”.^[41]ITA s. 126(2.1)(a)(i).

The concept of income from a source hearkens to the legislative framework of section 3(a), which casts the net of Canadian tax around each “income… from a source inside or outside Canada, including… income… from each office, employment, business and property”—a legacy of British law which regarded these “basic sources” as “things which were inherently productive of income”^[42]Report of the Royal Commission on Taxation (Carter Report) (1996), vol. 3, p. 65.—and to Canadian jurisprudence finding various things exempt from tax as not being “income from a source”.^[43]E.g., Manrell v. The Queen, 2001 CanLII 838 (TCC) (payment under a non-compete agreement); Schwartz v. Canada, 1996 CanLII 217 (SCC) (damages for breach of contract).

In international tax, “source” also refers to the location of a source of income (e.g., inside or outside Canada). One leading treatise notes the term’s dual shades of meaning as both “a qualitative notion, referring to the intrinsic nature of income” and “a territorial notion referring to the location where income is earned”.^[44]Li, Cockfield, and Wilkie, supra. note 1, p. 61.

Yet it is remarkable that despite the central importance of “source” to the FTC limitation, the Income Tax Act provides no explicit rules to assign the territorial source of income.^[45]Contrast with the US’s detailed rules in IRC § 861–865. Instead this task is left in large part to administrative interpretation, and Folio S5-F2-C1 steps in to fill the gap. Generally:

• Employment income is sourced to “the physical place where [the employee] normally performs the related duties”.^[46]CRA Folio S5-F2-C1, para. 1.57. (Note that the residence of the employer is not a factor.)
• Interest and dividend income is sourced to the payor’s residence.^[47]CRA Folio S5-F2-C1, para. 1.58, 1.59.
• Real estate rental income, and capital gain from the sale of real estate, are sourced to the location of the property.^[48]CRA Folio S5-F2-C1, para. 1.60, 1.62.
• Capital gain from the sale of exchange-traded stock is sourced to the location of the exchange.^[49]CRA Folio S5-F2-C1, para. 1.65.
• Business income is sourced to “the place where the operations in substance, or profit generating activities, take place”.^[50]CRA Folio S5-F2-C1, para. 1.53.

Tax treaties provide their own sourcing rules, which don’t always match the rules that would apply above for credit under the ITA. For capital gain, the US-Canada treaty yields examples in both directions:

1. A Canadian resident sells US-traded stock. The gain is “deemed to arise” in Canada for purposes of the treaty’s double-tax elimination provisions,^[51]US-Canada tax treaty, Art. XIII(4), Art. XXIV(3)(b). but is includible in “foreign non-business income” for the purpose of calculating entitlement to s. 126 credit without regard to the treaty.^[52]See Folio S5-F2-C1 para. 1.52 (sourcing rules in a treaty “do not alter the determination of the location of a source of income for purposes beyond that treaty’s scope”); and US-Canada treaty … Continue reading
2. An owner of US real property moves from Canada to the US, and utilizes the treaty election to treat the property as sold and repurchased on the emigration date for US tax purposes.^[53]US-Canada tax treaty, Article XIII(7). The gain from their Canadian deemed disposition^[54]ITA s. 128.1(4). would be Canada-source^[55]CRA Folio S5-F2-C1, para. 1.63. but for the treaty, which deems gain to arise in the US,^[56]Art. XIII(1), Art. XXIV(3)(a). making Canadian FTC available.^[57]This example is presented in Folio S5-F2-C1 para. 1.64; see also para. 1.49.

FTC and Canadian Residence

In general, the Canadian FTC is for Canadian tax residents^[58]For a discussion of Canadian tax residency, see CRA Folio S5-F1-C1. with income from other countries. A non-resident would use a foreign tax credit offered by the country they reside in^[59]For example, IRC § 901 in the US. to relieve double taxation of Canada-source income.

In a few corner cases, Canadian FTC is available to some non-residents, such as foreign banks doing business in Canada,^[60]ITA s. 126(1.1). and former residents who elected^[61]Election under ITA s. 220(4.5) to postpone tax on gain from the s. 128.1(4) deemed disposition of property on the emigration date. to postpone the departure tax.^[62]FTC available in this case under ITA s. 126(2.21).

But a startling loophole exists for part-year residents. Section 126 extends credit generally to a taxpayer “resident in Canada at any time in a taxation year”^[63]ITA s. 126(1) and (2) (emphasis added). without any proration of foreign tax paid “for the year”^[64]ITA s. 126(1)(a) and (2)(a). to the period of Canadian residence. Of course, the limitation of FTC to Canadian tax otherwise payable on foreign income still applies to a part-year resident, and for this we look only at foreign income for the resident period.^[65]For non-business income, ITA s. 126(1)(b) clauses (i)(B) and (ii)(A)(II). For business income, ITA s. 126(2.1)(a) clauses (i)(B) and (ii)(A)(II). Still, where foreign rates are lower than Canada’s, the inclusion of foreign tax from the non-resident period is a boon to the part-year resident.^[66]The CRA confirmed this position in the Jun 2013 STEP Roundtable (2013-0480311C6) response to Question 5, by pointing to no reduction of foreign tax for a part-year resident except via the … Continue reading

Examples

Below are two fully-worked examples to illustrate the operation of Canadian FTC. (The income amounts and other situational facts are made up, but I have attempted an accurate calculation of the tax liability that would arise.)

Example 1: Alex

Alex is a single resident of Ontario who completed a summer internship in Seattle in 2019, working for a US employer^[67]If Alex had worked in the US for a Canadian employer, his income might be exempt from US tax under Art. XV(2)(b) of the US-Canada tax treaty. on J-1 visa status. Alex only spent 100 days in the US.^[68]If Alex had met the substantial presence test, had a “green card” (Permanent Resident), or been a US citizen, his situation would be more complicated. He made US$25000 from the internship,^[69]If Alex had made less than US$10000 from the US employer, his income might be exempt from US tax under Art. XV(2)(a) of the US-Canada tax treaty. and C$15000 in Canada from other jobs during the year.

Alex’s US wages are taxable to the US under IRC § 871(b)(1) as nonresident alien’s income “effectively connected” with US trade or business.^[70]See also § 861(a)(3) (income is US-source where services are performed in the US) and § 864(b) (deeming employment to be “trade or business” for the purpose of classifying income as … Continue reading His Form 1040-NR shows $2809 in federal income tax.^[71]Form 1040-NR instructions (2019), Tax Table (p. 68). (Alex’s marginal US tax rate is 12%.)

For his Canadian return, Alex translates to Canadian dollars his foreign income (US$25000 = C$33172.50) and foreign tax (US$2809 = C$3727.26) using the annual average exchange rate of USD/CAD = 1.3269.^[72]Bank of Canada, Annual Exchange Rates, 2019.

As a resident of Canada, Alex’s worldwide income of C$15000 + C$33172.50 = C$48172.50 is taxable in Canada. He computes Canadian federal tax (before FTC) of $5262.56^[73]Form T1 (2019) federal tax calculation: ($48172.50 – 47630) × 20.5% + 7145 = $7256.21. This is then reduced by 15% × ($12069 (Basic Personal Amount) + $1222 (Canada Employment Amount)) = $1993.65. and Ontario tax (before FTC) of $2072.99.^[74]Form ON428 (2019) Ontario tax calculation: ($48172.50 – 43906) × 9.15% + 2217 = $2607.38. This is then reduced by 5.05% × $10582 (Ontario Basic Personal Amount) = $534.39.

Because only $33172.50 ∕ $48172.50 = 68.862% of Alex’s income is from foreign sources, his FTC is limited to that fraction of his Canadian tax otherwise payable:

• Federal FTC limitation = $5262.56 × 68.862% = $3623.90
• Provincial FTC limitation = $2072.99 × 68.862% = $1427.50

Alex recovers his entire US tax of C$3727.26, by claiming C$3623.90 in federal FTC on Form T2209 and the remainder of C$103.36 in provincial FTC on Form T2036.

Finally, Alex observes that some adjustments which affect his tax refund or balance owing are applied after (and thus outside of) the FTC calculation. In particular, he pays an additional $493.13 as Ontario Health Premium,^[75]Form ON428 (2019) Line 81: ($48172.50 (taxable income) – 48000) × 25% + 450. and is refunded $224 for the Climate Action Incentive.^[76]Form T1 Schedule 14 (2019), base amount.

Example 2: Brenda

Brenda has the same facts as Alex, except that instead of working in Seattle on a J-1 visa, she worked in San Francisco on a TN visa.

This introduces two new wrinkles. First: besides her US federal return, Brenda needs to file a tax return with the state of California. Second: unlike Alex, Brenda isn’t exempt from FICA.^[77]IRC § 3121(b)(19) lists the nonimmigrant visa types for which a nonresident alien’s services are not “employment” for purposes of Chapter 21.

Brenda’s foreign tax for Canadian FTC purposes is US$5110.50 = C$6781.12, produced by summing the following amounts:

• $443 of California state income tax^[78]Form 540NR (2019) and 540NR Tax Booklet 2019. California begins with Brenda’s worldwide income of C$48172.50 = US$36305, determines that a taxable income of $36305 – 4537 (Calif. standard … Continue reading,
• $1550 of US social security tax^[79]$25000 × 6.2%, per Pub. 15 (2019).,
• $362.50 of US medicare tax^[80]$25000 × 1.45%, ibid., and
• $2755 of US federal income tax^[81]Form 1040-NR instructions (2019), Tax Table (p. 68), based on taxable income of $25000 – 443 (California tax) = $24557. Brenda pays slightly less federal tax than Alex thanks to the deduction for … Continue reading.

Her Canadian return looks similar to Alex’s, except that Brenda’s FTC fills both the federal and provincial limitations. She claims the maximum credit for C$3623.90 (federal FTC) + C$1427.50 (provincial FTC) = C$5051.40, but the remainder of C$1729.72 in foreign tax cannot be recovered from Canada.

Brenda might be surprised by hitting the FTC limitation, since she’s heard that tax rates are generally higher in Canada than in the US. In principle, the FTC allows credit for foreign tax up to the Canadian tax rate. How did Brenda end up above the limit?

Two distorting factors affect the tax rate comparison in Brenda’s FTC calculation. One is the treaty-based inclusion of FICA. The other is Canada’s “basic personal amount”, which lowers her effective rate of Canadian tax. The US analog to the basic personal amount is the standard deduction, but the standard deduction isn’t available to nonresident aliens.^[82]IRC § 63(c)(6)(B).

The devil, as they say, is in the details.