Canadian Foreign Tax Credit

Sep 13, 2021

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]

This credit is a provision of Canadian law, namely section 126 of the Income Tax Act (ITA)^[2] and similar provincial statutes.^[3] 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] 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]

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] Fortunately for Canadians employed in the US, the US-Canada tax treaty expressly includes FICA^[7] taxes (social security and medicare) in Canadian FTC,^[8] 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] 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]

On this point, Meyer v. The Queen^[11] 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] 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]

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] 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] 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] 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]

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]

“Income”, like “tax”, presents interpretive difficulties. In Dagenais v. The Queen,^[19] 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] and a foreign tax on capital gain counts as an income or profits tax for FTC purposes.^[21]

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] or to “the government of a state, province or other political subdivision of that country”.^[23] 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] (US law generally considers foreign taxes to “accrue” on the last day of the foreign tax year under the “all-events” test.^[25])

“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]

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] or the lifetime capital gains exemption (LCGE).^[28] Some address other kinds of obvious double-benefit scenarios, such as tax that could be refunded to the payor of the income^[29] or tax separately claimed as a deduction from income.^[30]

Two exclusions are more surprising:

• The “non-business-income tax” excludes amounts deductible (whether or not deducted in fact) under s. 20(11).^[31] 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]

  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]

  US citizens with US dividends will also claim the s. 20(11) deduction under the treaty credit procedure.^[34] 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] and the US tax beyond that amount will usually be recovered by US FTC with the income “re-sourcing” provisions.^[36]

• The “non-business-income tax” excludes foreign taxes on Canada-source income arising by reason of the taxpayer’s citizenship.^[37] 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] 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]

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] or “from businesses carried on… in that country”.^[41]

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]—and to Canadian jurisprudence finding various things exempt from tax as not being “income from a source”.^[43]

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]

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] 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] (Note that the residence of the employer is not a factor.)
• Interest and dividend income is sourced to the payor’s residence.^[47]
• Real estate rental income, and capital gain from the sale of real estate, are sourced to the location of the property.^[48]
• Capital gain from the sale of exchange-traded stock is sourced to the location of the exchange.^[49]
• Business income is sourced to “the place where the operations in substance, or profit generating activities, take place”.^[50]

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] but is includible in “foreign non-business income” for the purpose of calculating entitlement to s. 126 credit without regard to the treaty.^[52]
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] The gain from their Canadian deemed disposition^[54] would be Canada-source^[55] but for the treaty, which deems gain to arise in the US,^[56] making Canadian FTC available.^[57]

FTC and Canadian Residence

In general, the Canadian FTC is for Canadian tax residents^[58] with income from other countries. A non-resident would use a foreign tax credit offered by the country they reside in^[59] 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] and former residents who elected^[61] to postpone the departure tax.^[62]

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] without any proration of foreign tax paid “for the year”^[64] 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] 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]

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] on J-1 visa status. Alex only spent 100 days in the US.^[68] He made US$25000 from the internship,^[69] 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] His Form 1040-NR shows $2809 in federal income tax.^[71]

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]

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] and Ontario tax (before FTC) of $2072.99.^[74]

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] and is refunded $224 for the Climate Action Incentive.^[76]

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]

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]
• $1550 of US social security tax,^[79]
• $362.50 of US medicare tax,^[80] and
• $2755 of US federal income tax.^[81]

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]

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