Apr 03, 2024
Introduction – The Canadian Foreign Tax Credit System
An individual who is a Canadian tax resident is liable to pay Canadian income tax on worldwide income. This could result in double taxation where that Canadian taxpayer is also subject to income tax in another jurisdiction on any part of that income. To ameliorate double taxation, if that foreign jurisdiction has the primary right to tax that income, then Canada’s system offers various mechanisms to reduce Canadian tax payable. The principal mechanism of relief from double taxation is the foreign tax credit system under section 126 of the Income Tax Act.
Whether and when a foreign tax credit can be claimed for foreign taxes paid is a complicated and fact-specific analysis. And while some cases may prove straightforward, other cases may seem like trying to fit a square peg in a round hole. The question of withholding taxes paid on foreign income, for example, can present difficulties. As will be explained in greater detail later, a withholding tax is a tax withheld and remitted by the payor at source, rather than the taxpayer remitting the income tax directly.
This article aims to provide a brief overview of the Canadian foreign tax credit system as it might interact with the withholding tax regimes of foreign jurisdictions. This article will begin by briefly describing the statutory and common law regime in Canada concerning foreign tax credits. It will then briefly overview the Canadian withholding tax regime, and the concept of withholding taxes employed by tax regimes worldwide. This article will then explore circumstances where withholding taxes paid in a foreign jurisdiction may or may not qualify for the foreign tax credit in Canada. This article will conclude with some observations on the requirements for properly claiming any foreign tax credit when filing a Canadian income tax return, and some pro tax tips on withholding taxes and foreign tax credits.
The Canadian Foreign Tax Credit System
If it applies, subsection 126(1) permits a taxpayer to deduct from the tax for that year otherwise payable “an amount equal to… any non-business income tax paid by the taxpayer for the year to the government of a country other than Canada… as the taxpayer may claim […] not exceeding, however… that portion of the tax for the year otherwise payable… if the taxpayer is resident in Canada with throughout the year.” Subsection 126(2) provides a similar rule for business income taxes paid in a given tax year. In either case, the foreign tax credit claimable for a given tax year is limited to the amount of Canadian tax “otherwise payable”. It cannot be used to subsidise Canadian tax (i.e. bring tax payable in Canada below $0 in a tax year).
A “business income tax” includes an income or profits tax that can reasonably be regarded as paid in respect of income from a business carried on in a foreign country. A non-business income tax is defined by exclusion: it includes everything that does not constitute a “business income tax” (or cannot be specifically deducted under certain other provisions of the Income Tax Act). Whether a particular source of income qualifies as a business or not is a fact-specific analysis for Canadian tax purposes. The Income Tax Act defines a business as including “a profession, calling, trade, manufacture or undertaking of any kind whatever”, and can even include a single transaction (otherwise referred to an “adventure or concern in the nature of trade”) but does not include an office or employment. Generally, a business will then constitute any activity undertaken in pursuit of profit but will not capture employment or certain passive income-earning activities (such as leasing property for rent, lending money to earn interest, or holding shares to earn dividends).
In order for a taxpayer to claim a foreign tax credit under subsection 126(1) or 126(2), there are essentially three conditions that must be met:
- The taxpayer must be a tax resident of Canada;
- The amount paid to a foreign government must be in the nature of an “income or profits” tax; and
- The income or profits tax must be a “non-business-income tax” (for purposes of subsection 126(1)), or a “business-income tax” (for purposes of subsection 126(2)).
The following sections will discuss these conditions in turn, and will explore (as appropriate) when a withholding tax paid in a foreign jurisdiction may or may not satisfy these conditions.
1. The Taxpayer Must be a Tax Resident of Canada
Under subsection 2(1) of the Canadian Income Tax Act, an individual who is a resident of Canada is subject to tax on worldwide income. In contrast, a non-resident individual is only subject to tax on Canadian-source income. The foreign tax credit is limited to Canadian tax residents (except in extremely limited circumstances).
A tax resident of Canada is not the same as a citizen or permanent resident of Canada. Rather, the concept of “residence” for the Canadian income tax system is linked to the extent and permanent of an individual’s connecting ties with Canada. A taxpayer can be a resident of Canada under two distinct domestic rules:
- a taxpayer may be “ordinarily resident” within the meaning of subsection 250(3); or
- where that taxpayer is not otherwise ordinarily resident in Canada at any point in a given taxation, that taxpayer may be a “deemed resident” under paragraph 250(1)(a).
An “ordinary resident”, often called a “factual resident”, is a person who has established significant social and economic ties to Canada such that Canada has become “the place where in the settled routine of his life he [or she] regularly, normally or customarily lives.” Relevant factors for determining whether an individual is a factual resident of Canada include that person’s:
- past and present habits of life;
- regularity and length of visits in Canada;
- ties within Canada;
- ties elsewhere (i.e. outside of Canada); and
- permanent or otherwise of purposes of any stay abroad.
The CRA has published its own views in Income Tax Folio S5-F1-C1 (“Determining an Individual’s Residence Status”) as to what factors will militate in favour of an individual being a Canadian factual resident. While the CRA’s published views on Canadian tax law do not have force of law in Canada, they have been recognized by Canadian courts as fundamental tools for the interpretation and application of Canada’s tax laws to other taxpayers, provided they are consistent with Canadian tax case law (which is not always the case). Primary factors to consider whether that individual has (i) a “dwelling place” (i.e. a home or apartment) available for his or her long-term use in Canada, (ii) a spouse or common-law partner in Canada, or (iii) any dependants in Canada. Secondary ties will include personal property (i.e. furniture and vehicles), economic ties (i.e. bank accounts, investments, registered plans, credit cards and other debt), immigration status (i.e. citizenship or permanent resident status), government documents (i.e. health insurance, driver’s licence, passport), and social ties (i.e. memberships to professional organizations or unions, or recreational clubs or religious organizations) in Canada. Whether any combination of these ties is sufficient to find an individual is an ordinary resident of Canada is a fact-specific determination, and each case will require individual consideration.
Alternatively, an individual might be a “deemed resident” of Canada throughout a tax year if that person “sojourned” in Canada for 183 days or more in that year. The term “sojourned” generally means the individual was “temporarily resident” in Canada, and the person remained in Canada, casually or intermittently, with a sense of permanence. Like factual residence, this can also involve a fact-specific analysis to determine whether the rule has been triggered.
Neither of these rules preclude a person from both being a tax resident of another country simultaneously as a Canadian tax resident. To deal with the complications of dual residence, Canada has formed a number of bilateral treaties with other countries which include a series of tie-breaker tests for determining in which jurisdiction a dual resident person should be viewed as a resident. If an individual is viewed as a resident of the other jurisdiction under those tie-breaker rules, and not Canada, then subsection 250(5) of the Income Tax Act will oust any domestic tax status (either factual or deemed residence) as of the date of conflict. If an individual is viewed as a resident of Canada under those tie-breaker rules instead, then whatever domestic tax status in Canada will stand, and typically the other jurisdiction will deem the individual a non-resident instead of fully taxable under its own tax laws.
2. The Tax Must be an “Income or Profits” Tax
To qualify as an “income or profits” tax, an amount paid must meet two conditions: (i) the amount must be a “tax”, and (ii) the amount must be in the nature of an “income or profits” tax.
To constitute a “tax”, a payment must be (i) extracted under compulsion of law, and (ii) must be collected as revenue to be used for general public or government purposes. Canadian courts have recognized that the compulsory nature of the amount paid as a “tax” is an essential and unavoidable feature of finding that amount to be a “tax” for purposes of section 126.
Generally speaking, a foreign tax will be regarded as an income or profits tax if the basis of taxation in the foreign jurisdiction is substantially similar to that of the Income Tax Act. Courts have found that the income or profits in question giving rise to the tax must have an identifiable “source”, similar to the Canadian tax system, such as employment, business, or property as defined by the Income Tax Act. Further, a foreign tax is generally considered “substantially similar” to that of the Canadian tax under the Income Tax Act where that foreign tax is subject to the terms of a bilateral treaty between Canada and that other jurisdiction.
3. The Tax Must be Either a “Non-Business-Income Tax” or a “Business Income Tax
As described above, a non-business-income tax is defined by exclusion with reference to a business-income tax. Whether a source of income is that of a business or a non-business source is a fact-specific analysis.
The distinction is not meaningless for foreign tax credit purposes. Paragraph 126(2)(c) of the Income Tax Act provides an ordering rule; a taxpayer must use non-business foreign tax credits first before business foreign tax credits can be deducted. This is because the Canadian tax system permits unused foreign business tax credits to be carried forward by 10 years, and carried back by 3 years, in a rough parity to how business losses are treated for tax purposes. In contrast, excess foreign non-business-income taxes cannot be carried over to other years (but may still be deductible under subsection 20(12) in very limited cases).
With this background in mind, it is now worth exploring the concept of a withholding tax, using Canada’s withholding tax regime as an example.
Withholding Taxes in Canada and Abroad
Part XIII of the Income Tax Act governs the Canadian withholding tax regime that applies to non-residents of Canada receiving passive income (e.g. rents, royalties, interest, dividends, crypto staking income) from Canadian sources. The withholding tax regime is Canada’s mechanism for protecting its tax base while ensuring effective collection of taxes paid to non-residents. Because of its simplicity, withholding taxes form a part of most internationally conscious tax systems around the globe.
A withholding tax is unlike the typical Canadian income tax in several ways. First, the tax is withheld at source. In other words, a Canadian resident payor is liable to collect the tax at the time the non-resident is paid. This is similar to how an employer under Canadian tax law is required to withhold and remit income tax from employee remuneration directly to the CRA. This is further unlike a self-employed individual, who is obligated to remit income taxes directly to the CRA. Second, to simplify collection, the withholding tax is extracted from income on a gross basis, rather than being taxed at a graduated rate like the Canadian income tax. For example, rental income received by a non-resident of Canada is subject to a withholding tax of 25% on the gross amount of income, regardless of how much rental income is earned, while that same income earned by a Canadian tax resident would be taxed according to applicable federal and provincial marginal rates. Third, the non-resident has no obligation to file a return to report withholding taxes paid in Canada. The collection and remittance of the withholding tax is the end of the matter in most cases.
Under Canada’s bilateral tax treaties, the typical withholding tax rates levied under Part XIII will be modified, reduced or eliminated all-together. For example, Article X of the Canada-U.S.A. Tax Treaty reduces Canada’s withholding tax on dividends paid by a Canadian resident corporation to a tax resident of the U.S.A. in certain cases. Similarly, any withholding taxes imposed by the U.S.A. on dividends paid by a U.S.A. resident corporation to a Canadian tax resident are restricted.
When Might a Withholding Tax Qualify or Not Qualify for a Foreign Tax Credit?
As addressed above, the Canadian withholding tax regime is imposed by Part XIII of the Income Tax Act. In order to qualify as an “income or profits” tax for the Canadian foreign tax credit, the basis for that tax must be substantially similar to that of the Income Tax Act. Given that Canada’s tax system levies withholding taxes on passive income sources paid to non-residents, it is not controversial to say that withholding taxes levied in foreign jurisdictions could generally qualify as “income or profits” taxes for the foreign tax credit, whether the tax is remitted to that country’s taxing authority in the year it is levied or not.
One potential issue, however, could lie in whether an amount paid as a withholding tax meets the definition of a “tax”, because it must be paid compulsory to a law. As discussed above, certain withholding tax rates may be reduced or eliminated under the terms of Canada’s bilateral treaties. Canadian courts have recognized that an excessive payment made by mistake lacks this necessary characteristic of compulsion to qualify as a tax.
For example, in the informal-procedure case of Meyer v. The Queen, 2004 TCC 199 at the Tax Court of Canada, the appellant was a Canadian tax resident who filed as a tax resident in both Canada and the U.S.A., and reported his U.S.A. pension income in both jurisdictions. The appellant claimed foreign tax credits in Canada for the full amount of taxes that he paid in the U.S.A. on his pension. The Tax Court of Canada concluded that the appellant was a Canadian tax resident, and thus the U.S.A. was only validly entitled to levy withholding taxes on his U.S.A.-source pension income. Under the Canada-U.S.A. Tax Treaty, the appellant’s pension payments were subject to a maximum withholding tax in the U.S.A. of 15% on the gross amount of those payments. The Tax Court of Canada concluded the taxes paid in the U.S.A. as a resident, which exceeded this 15% withholding tax rate, were the result of a calculation error, not a law, and could not substantiate a claim for foreign tax credits in Canada. The appellant was thus subject to double taxation on part of his pension income without relief through the Canadian foreign tax credit regime. The Tax Court of Canada also arrived at a similar result in the informal-procedure case of Shindle v. The Queen, 2009 TCC 133.
As both cases were informal-procedure cases, those decisions are non-binding. And to date, the Tax Court of Canada has not ruled on a general-procedure appeal involving this exact question to create any precedent. Nevertheless, these cases should be treated as persuasive, and predictive of how the court might rule in the future. Further, this position aligns with CRA’s general policy, which views excessive tax payments as “voluntary contributions” that aren’t the valid subject matter of Canada’s foreign tax credit.
So, in a cross-border context, taxpayers should be very careful to obtain professional advice from an expert Canadian tax lawyer on tax residence in Canada, and the implications of that residence status. Paying withholding taxes above a treaty-reduced rate, or income taxes as a resident when withholding taxes should have been imposed instead, may create future tax compliance challenges that are far from easy to fix.
Pro Tax Tip: When Claiming any Foreign Tax Credit, Prepare Yourself Thoroughly for an Audit by the CRA
The CRA regularly audits even minimal foreign tax credit claims. Similar to business losses in Canada, they provide substantial tax advantages, and are scrutinized aggressively to avoid misuse or abuse by taxpayers.
When claiming any foreign tax credit, that claim should be well-documented. Typically, the CRA will accept a copy of a tax return filed with a foreign government, together with copies of any receipts or documents to establish payment. With respect to withholding taxes, where a tax return may not need to be filed and where a tax assessment may not be issued in a foreign jurisdiction, any receipts or documents that establish payment take on a much more important evidentiary role.
Further, to claim the Canadian foreign tax, the amount of foreign tax must be converted into Canadian dollars. The applicable rate of exchange is typically the prevailing rate when the foreign tax is actually paid, but any acceptable rate to use can depend on the circumstances. The conversion rate used to calculate the Canadian foreign tax credit should also be well-documented. Failure to support a foreign tax credit claim with thorough documentation could result in the entire credit being denied by the CRA. When in doubt, an expert Canadian tax lawyer should be engaged to explore how best to record and calculate a foreign tax credit claim to avoid the worst outcomes of a CRA tax audit. Further, if the CRA incorrectly denies a foreign tax credit claim, an experienced Canadian tax lawyer should be engaged immediately to file a Notice of Objection to that assessment so that decision can be overturned, and the correct foreign tax credit can be claimed.
FAQs:
What is a Foreign Tax Credit?
A foreign tax credit is one of Canada’s principal methods of relieving double taxation. When income earned by a Canadian tax resident is taxed in a foreign jurisdiction, the Canadian Income Tax Act typically allows a taxpayer to claim a credit against Canadian tax liability for those foreign taxes. Section 126 of the Income Tax Act governs the regime. However, the foreign tax credit is limited to the amount of Canadian tax “otherwise payable”; it cannot be used to subsidise Canadian tax (i.e. bring tax payable in Canada below $0 in a tax year).
What are the Conditions to Qualify for a Canadian Foreign Tax Credit?
In order for a taxpayer to claim a foreign tax credit under subsection 126(1) or 126(2), there are essentially three conditions that must be met. First, the taxpayer must be a tax resident of Canada. Second, the amount paid to a foreign government must be in the nature of an “income or profits” tax, which is a legal question. Third, the income or profits tax must be a “non-business-income tax” (for purposes of subsection 126(1)), or a “business-income tax” (for purposes of subsection 126(2)).
When Might Foreign Withholding Taxes Paid Not Give Rise to a Foreign Tax Credit for a Canadian Tax Resident?
To constitute a “tax” for Canada’s foreign tax credit, a foreign tax must be paid under compulsion of law. An amount paid by a Canadian tax resident that exceeds the applicable tax rate in a foreign jurisdiction risks being viewed as a “voluntary payment”. This might include payments that exceed reduced withholding tax rates under a bilateral tax treaty with Canada. If a tax payment made to a foreign taxing authority exceeded the applicable withholding tax rate under a bilateral treaty, that excess amount paid may not give rise to a foreign tax credit claim in Canada.
Disclaimer: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
