Clients who invest in foreign stocks or own mutual funds or segregated funds that earn foreign income are likely familiar with the concept of claiming a foreign tax credit. After all, the foreign tax credit is the primary way Canadian residents can avoid paying double tax on foreign income. But the ability to claim a foreign tax credit is not always straightforward, as we will see.
For many clients, their sole experience with claiming the foreign tax credit likely occurs if they earn foreign interest or dividends in Canadian non-registered investment accounts. For example, if a client owns, say, Pfizer shares in their non-registered trading account, the U.S. dividend income would be subject to a 15% non-resident withholding tax. When they file their Canadian tax return, they will pay Canadian tax on that U.S. dividend income at their normal marginal rates but be entitled to claim a foreign tax credit for the 15% non-resident tax withheld, thus avoiding double tax.
Foreign tax credits also come up in the context of employment income. For example, in a recent case, a taxpayer who was a Canadian resident working for the Spanish government in its embassy in Ottawa attempted to claim the foreign tax credit for mandatory contributions to a nationally run pension plan in Spain. The Canada Revenue Agency (CRA) denied the taxpayer’s foreign tax credits, and the taxpayer ultimately took the matter to Tax Court.
In court, the taxpayer argued that the amounts at issue were withheld by the government in Spain, and therefore should be treated as tax paid to a foreign jurisdiction. The CRA’s view was that these amounts were not a tax. The seminal issue, therefore, was whether the amounts withheld by Spain could be akin to a tax.
To answer this question, the judge began with a review of the four characteristics of a “tax,” as determined by a 1930 decision of the Supreme Court of Canada: enforceable by law, imposed under the authority of the legislature, imposed by a public body and made for a public purpose.
Despite a lack of evidence at trial, including “very little description” as to the mechanics of collecting these funds, the authority under which it was done and whether the deductions were subtracted from the gross income of the taxpayer as part of his tax filings in Canada, the judge concluded that the first three components of the Supreme Court test were met. In other words, the amounts being claimed by the taxpayer were likely withheld by the Spanish government because of Spanish legislation that makes such payments compulsory.
The problem, the judge went on to explain, lies with the final component of the Supreme Court’s test. The taxpayer testified that the amounts at issue, for which the foreign tax credits were denied, were deducted by Spain in order to contribute to the Spanish national pension plan. While the taxpayer was uncertain as to what benefits he will ultimately receive from the plan, he did acknowledge he will likely receive some payments in the future.
The judge therefore concluded that the amounts collected by the Spanish government “do not meet the definition of a tax, in that they were not collected for a public interest.… [T]he pension deductions were made by the Spanish government for the future benefit of the contributor.… These payments were not made in order to generate income for the state.” As a result, these amounts didn’t qualify for foreign tax credits.
While this case may be quite fact specific, it shows that a foreign tax credit is not always guaranteed. Take, for example, the foreign tax credit for withholding tax on investment income. This is only available when those investments are held in a non-registered account. What if a client holds foreign investments inside a registered plan, like an RRSP, RRIF, TFSA or RESP?
That’s where things can get a bit tricky. If, for example, a client holds foreign stocks in a registered account and dividends are paid on those stocks, they will likely be subject to a 15% non-resident withholding tax by the payor country before hitting the registered plan. This can be considered a sunk cost, as there is no ability to claim a foreign tax credit for withholding tax paid by a registered account.
The one exception to the above is for U.S. stocks held in an RRSP or RRIF. Because of this unique provision in the Canada-U.S. tax treaty, there is an exemption from withholding tax that is automatically applied when U.S. dividends are paid to an RRSP or RRIF. Note that this same break does not apply to U.S. dividends paid to a TFSA or RESP.
Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the Managing Director, Tax & Estate Planning with CIBC Private Wealth in Toronto.