Residents of Canada are generally taxed on their worldwide income. For many, this includes income earned from business, property, or employment in another country. In most cases, income earned abroad will be subject to taxes in the jurisdiction where it is earned. To ensure that foreign income is not subject to double taxation, the foreign tax credit provisions found in section 126 of the Act provide for a method whereby the income taxes paid to a foreign jurisdiction offset Canadian income tax otherwise payable.
Before determining the amount of foreign tax credit available to a taxpayer, consideration must be given to the type of income earned. This is because there are two types of foreign tax credit available under section 126: a foreign tax credit for foreign business-income taxes and a foreign tax credit for foreign non-business income taxes. Additionally, the foreign tax credit is calculated on a country-by-country basis which requires taxpayers to categorize their income based on where the income was earned as well as how it was earned. Another consideration that must be taken into account before calculating the amount of the foreign tax credit available is the nature of the foreign taxes paid. Once a taxpayer’s income for a year has been properly categorized, calculated, attributed to the relevant countries where it was earned, and the foreign taxes examined for eligibility, this information may be used to apply for a foreign tax credit when filing a tax return for the year.
Foreign Business Income (FBI)
The total amount of a taxpayer’s income from businesses carried on by the taxpayer in a particular foreign country is included in the calculation of FBI, in the foreign tax credit formula with respect to that country. Amounts that could otherwise be regarded as income from property are included in FBI as business income if such income amounts pertain to or are incident to the foreign business activities of the taxpayer.
Foreign Non-Business Income (FNBI)
The calculation for the foreign non-business tax credit uses the total foreign non-business income, such as pension income, employment income, director’s fees, commissions, interest, dividends, and some taxable capital gains in excess of allowable capital losses. Capital gains and losses on publicly traded securities are generally considered foreign income if the securities were traded on a foreign stock exchange. However, if any of the foreign income is exempt from income or profits tax in the foreign country due to a tax treaty with that country, then it is not included in the calculation of the foreign tax credit. Foreign non-business income is not reduced by net capital losses carried forward from a previous year.
When Canadians trade securities on US stock exchanges, the capital gains are exempt from tax in the US due to the tax treaty, so there should be no withholding tax deducted from proceeds of sale, and the gains from these sales should not be included in the foreign tax credit calculation. If the account is actually held with a brokerage in the US, an IRS W-8Ben form must be filed with them to ensure there are no withholding taxes on sales proceeds. If your trade confirmation for US securities shows a small amount titled “US tax”, usually for a fraction of 1%, this amount is actual a securities exchange fee, not withholding tax.
When foreign property income (other than from real property, or from a trust) has had withholding tax in excess of 15% deducted, the excess can be deducted from income on line 232 of the personal tax return, “Other deductions”, as a s. 20(11) deduction. The excess foreign tax over 15% deducted under s. 20(11) reduces the amount of foreign non-business income which is used in the foreign tax credit calculation. If your foreign income is reported on a T3, then it is from a trust (such as a mutual fund or ETF), so this deduction does not apply. Personal income tax software will automatically provide the s. 20(11) deduction for income and foreign taxes reported on a T5, and will ignore any excess tax paid on a T3, as it should.
Calculation of Foreign Tax Credit
The calculation of the foreign tax credit may not be automatically done by your tax software, if you have foreign income which is not reported on a T-slip. These amounts may have to be manually typed into a worksheet in the software.
It becomes more complex when the individual wants to deduct a portion of the foreign tax from income as well as using the foreign tax credit, because the portion deducted from income must be excluded from the foreign taxes in the tax credit calculation. A detailed description of the foreign tax credit calculation was found in the Canada Revenue Agency (CRA) income tax folio S5-F2-C1: Foreign Tax Credit.
In most cases, the foreign tax credit you can claim for each foreign country is whichever of the following two amounts is lower:
- the foreign income tax you actually paid; or
- the tax due in Canada on your net income from that country
If the federal foreign tax credit is less than the foreign tax you paid, you may also be able to claim a provincial or territorial tax credit. For territories, and provinces other than Quebec, form T2036 Provincial Foreign Tax Credit is used.
The foreign taxes are sometimes not completely recovered by the federal and provincial foreign tax credits, but in some circumstances the foreign tax credit can be higher than the foreign taxes paid. Non-business foreign taxes which are not recovered as a tax credit may be deducted from income on line 232 of the personal tax return, “Other deductions”, as a s. 20(12) deduction (foreign taxes reported on a T3 are not eligible). This deduction is not usually done automatically by income tax software.
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