Canada: Foreign Tax Credits: Section 126 Of The Income Tax Act — A Canadian Tax Lawyer's Analysis

Last Updated: July 16 2018
Article by David Rotfleisch

Introduction: Why Provide a Foreign Tax Credit?

Canada taxes its residents on their worldwide income; it taxes non-residents on their Canadian-sourced income. Many countries tax income in the same way. As a result, Canadian residents earning foreign-sourced income incur double tax if the source country also taxes that income. Most would agree that this results in inequitable treatment as between Canadian residents earning foreign income and those earning solely Canadian-sourced income. Moreover, the resulting double taxation might discourage taxpayers from pursuing productive investments abroad.

How does Canada provide relief from double tax? Enter section 126 of Canada's Income Tax Act. This section effectively reduces a Canadian resident's tax payable in Canada to the extent of the resident's foreign tax liability.

The rest of this article examines section 126's foreign tax credit ("FTC") in more detail.

Eligibility for the Foreign Tax Credit

Eligibility for the foreign tax credit requires a taxpayer to meet three conditions.

First, the person seeking the FTC must be a Canadian resident. Generally, only a Canadian resident may receive the FTC. But a non-resident of Canada may qualify for FTCs in very specific situations—e.g., subsection 126(1.1) provides a FTC for a foreign bank with a branch in Canada, and subsection 126(2.2) contemplates FTCs for a taxpayer who, upon ceasing to be a resident in Canada, realized a taxable gain from the deemed-disposition triggered by non-residence.

Second, the FTC applies only if the amount that the taxpayer paid to the foreign government was a "tax." According to Canadian courts, a tax must be (1) enforced by law; (2) imposed by a public body under legislative authority; (3) compelled from the payor—i.e., not a voluntary payment; and (4) collected for a public purpose (see: Shawinigan Water & Power Co. (1953), 53 DTC 1036 (Can. Ex. Ct.)). So, a user fee, for instance, is not a tax and thus wouldn't qualify for the FTC. Likewise, payments to a foreign government for employment or unemployment insurance, pension, and social security are not payments relating to tax.

Third, not only must the Canadian taxpayer have paid a foreign tax but also the taxpayer must have paid a tax on "income or profits." In other words, the foreign tax must relate to proceeds that, had you received them from within Canada, would be included when computing your taxable Canadian income. As a result, you don't qualify for FTCs if you paid a foreign tax on funds that wouldn't be taxable in Canada. So, gambling taxes paid in the United States, for instance, don't qualify for Canadian FTCs. This shouldn't be a surprise. Foreign tax credits are meant to provide relief from double tax; if the income is taxable in only one of two countries, double tax doesn't arise and relief isn't warranted.

Two Types of Foreign Tax Credits: Non-Business-Income Tax Credit & Business-Income Tax Credit

Section 126 provides two types of foreign tax credits: one for foreign taxes on business income; the other for foreign taxes on non-business income. Subsection 126(1) sets out the rule for computing FTCs for foreign taxes on non-business income—i.e., foreign tax levied on employment income, capital gains, dividends, interest, rent, and royalties. Subsection 126(2) sets out the rule for computing FTCs for foreign taxes on business income—i.e., foreign tax levied on income from business operations in the foreign country.

Computing the Foreign Tax Credits

Basically, under the FTC system, foreign tax reduces Canadian tax dollar-for-dollar. The FTC—whether for foreign tax on business or non-business income—cannot exceed the Canadian tax otherwise payable. In other words, in any given tax year, a taxpayer's FTC entitlement maxes out at that taxpayer's Canadian tax payable.

Moreover, FTCs are computed on a country-by-country basis. And the taxpayer must apply all FTCs relating to foreign tax on non-business income before applying any FTCs relating to foreign tax on business income. (Unused FTCs for non-business income cannot be carried over to other years. So, the Income Tax Act ensures that they are used first.)

Example: Computing FTCs

A Canadian corporation earned the following amounts during the year:

$500,000 in business income from the United States and paid $170,000 in US income tax;
$100,000 non-business income from the United Kingdom and paid $10,000 in UK income tax; and
$400,000 income from Canada and paid Canadian tax at a rate of 30%.

So, the corporation's total income is $1 million, and its Canadian tax otherwise payable is $300,000 ($1 million x 30%).

The corporation's FTC for UK tax is $10,000, which is the lesser of:

  1. $10,000 in UK tax; and
  2. $30,000 in Canadian tax otherwise payable on the UK income ($100,000 x 30%).

The corporation's FTC for US tax is $150,000, which is the lesser of:

  1. $170,000 in US tax; and
  2. $150,000 in Canadian tax otherwise payable on the US income ($500,000 x 30%).

The corporation's final Canadian tax liability is therefore $140,000 ($300,000 - $10,000 - $150,000).

Excess Foreign Tax Credits: What Happens When the Foreign Tax Rate Exceeds the Canadian Tax Rate?

A Canadian-resident taxpayer may pay foreign tax at a rate exceeding the Canadian tax rate. Under Canada's foreign-tax-credit system, a taxpayer pays combined foreign and Canadian tax at the higher of the two rates. If the foreign tax rate exceeds the Canadian rate, the result is an excess FTC.

Excess FTCs for foreign taxes on business income can be carried forward for ten years and carried back for three years. But unused FTCs for foreign tax on non-business income cannot be carried forward or back. They can, however, be deducted from a taxpayer's income under subsection 20(12).

In addition, section 110.5 allows corporations to convert unused FTCs into non- capital losses, which the corporation can deduct against its income. The corporation elects under section 110.5 to increase its taxable income by an amount sufficient to absorb the excess FTC, and the corporation's non-capital loss is increased accordingly.

For example, a Canadian corporation has an excess FTC in the amount of $6,000. The FTC relates to foreign tax on business income. So, the corporation can carry the amount forward. But the corporation still never has the opportunity to use the excess FTC because the Canadian tax rate—say, 30%—equals the tax rate in the country where the corporation conducts business. The corporation elects under section 110.5 to increase its taxable income by $20,000, which is the amount required to use the $6,000 excess FTC ($6,000 ÷ 30% tax rate = $20,000). As a result, the corporation also receives a non-capital loss in the amount of $20,000. The corporation can carry over the $20,000 non-capital loss in the same way that it could carry over the excess FTC. The non-capital loss, however, proves more advantageous because it isn't subject to the restrictions that precluded the corporation from using the excess FTC.

The Role of Canada's Tax Treaties & Foreign Tax Credits

A tax treaty is a bilateral agreement between Canada and another country. Canada's tax treaties support Canada's domestic foreign-tax-credit system in section 126 of the Income Tax Act. In particular, the tax treaties try to minimize the potential for excess FTCs by either limiting the source country's tax rate, providing for common income-computation rules, or imparting one country with exclusive tax jurisdiction.

Some of Canada's tax treaties also include a tax-sparing credit, which is a foreign tax credit that a country gives to a resident even though the source country waived income tax. Suppose, for instance, that a Canadian resident received rental income from another country, and that country's domestic law exempts the Canadian resident from tax. Section 126 of Canada's Income Tax Act doesn't permit the Canadian resident to receive a FTC: no foreign income taxes were paid. Yet Canada's treaty with the source country might still entitle the Canadian resident to receive a Canadian tax credit at a treaty-prescribed rate. Two examples of Canadian treaties that include a tax-sparing credit are:

  • Paragraph 4 of Article 23 of the Canada-India Tax Treaty (a.k.a., Agreement Between the Government of Canada and the Government of the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital);
  • Paragraph 5 of Article 22 of the Canada-Brazil Tax Treaty (a.k.a., Convention Between the Government of Canada and the Government of the Federative Republic of Brazil for the Avoidance of Double Taxation with Respect to Taxes on Income)

Tax-sparing-credit clauses typically appear in tax treaties where one party is a developed country and the other is an emerging country. Supporters of the credit believe that it provides a worthwhile incentive for taxpayers in developed nations to invest in developing countries.

Tax Tips - Foreign Tax Credits

A Canadian-resident corporation with excess FTC may wish to consider electing under section 110.5 of the Income Tax Act. This election allows the corporation to convert its unusable excess FTCs into non-capital losses, which aren't subject to the same restrictions that may have rendered the FTCs effectively unusable.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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