FOREIGN TAX CREDIT — MAKE SURE THE FOREIGN TAX IS MANDATORY
As you may know, Canada provides a “foreign tax credit” (FTC) to Canadian residents, to reduce double taxation on foreign-source income.
The FTC rules are complex. In general terms, Canada allows a credit to a Canadian resident for foreign income tax paid on foreign-source income, up to a limit of the Canadian tax payable on the same income.
The effect is that you pay total tax equal to the higher of the two rates of tax (Canadian and foreign) on the foreign-source income.
Thus, for example, suppose you earn $1,000 in dividends on a U.S. stock, and the U.S. company withholds $150 as withholding tax. (We'll ignore exchange rate issues for this example; assume all amounts are in Canadian dollars.) Assume you are in a 40% tax bracket, so you pay $400 of Canadian tax on the same $1,000 of dividend income.
In this example, Canada will grant you a foreign tax credit of $150 on your Canadian tax return, so that you only pay $250 of Canadian tax on the dividends. The total tax burden ($150 to the U.S. and $250 to Canada) will thus equal the $400 of Canadian tax you would have paid if there had not been any foreign tax. (Most developed countries have similar rules.)
The FTC has many complexities and traps. One trap you should be aware of is that the foreign tax must be mandatory. If you could have avoided paying the foreign tax, or recovered it from the foreign government, then you cannot claim it as a foreign tax credit.
Thus, for example, suppose your U.S.-source income is interest rather than dividends, and the interest is exempt from U.S. tax under the Canada-US. tax treaty. If the U.S. payor withheld U.S. tax, and you can recover that tax from the U.S. government by claiming relief under the treaty, then the U.S. tax you paid is not eligible for the foreign tax credit, because Canada will consider it to be a “voluntary” payment to the U.S. rather than a foreign tax. So instead of claiming a foreign tax credit, your only option may be to claim back the wrongly-charged tax from the U.S. Internal Revenue Service.
This interpretation was confirmed in the Meyer (2004) and Marchan (2008) decisions of the Tax Court of Canada.
Note also that the foreign tax credit applies only to an “income or profits tax”. It is not available for social security taxes other than paid to the U.S. Most U.S. “FICA” (Federal Insurance Contributions Act) payments do qualify, due to a specific provision in the Canada-U.S. tax treaty.
Finally, note that the foreign tax credit for “non-business-income tax” is based on the amount of foreign tax you actually paid, but net of any refunds such as a U.S. child tax credit. This was confirmed by the Federal Court of Appeal in the Zhang case (2008).