What happens when the foreign tax credit is denied

The purpose of the Canada-U.S. tax treaty is to avoid double taxation of the same amount—and not to allow taxpayers to benefit by claiming a foreign tax credit where no foreign tax has been paid. This was the conclusion reached in the recent tax case (Arsove v The Queen, 2016 TCC 283) involving Sally Arsove, a U.S. citizen resident in Canada, whose foreign tax credit was denied by the CRA.

U.S. return

In 2013, Arsove received a distribution from her U.S. Individual Retirement Account (IRA) equal to US$5,617.78, less taxes withheld of 10%, or US$561.78. When she filed her 2013 U.S. tax return, she reported the distribution along with her Canadian source income, for a total of US$79,487.

She reported US$561.78 of taxes withheld on the IRA distribution and claimed a foreign tax credit on her U.S. return of US$13,298 in respect of her Canadian-sourced income. As a result, she reported zero tax payable in the U.S. and thus claimed—and ultimately received—a full refund of the US$561.78 of taxes withheld on her IRA distribution.

Canadian return

When Arsove filed her 2013 Canadian return, she reported $5,785 (being US$5,617.78 multiplied by the 1.03 average Canadian/U.S. exchange rate for 2013) of foreign non-business income in respect of the IRA distribution. She also claimed a $868 foreign tax credit (i.e., 15% of $5,785) in respect of the IRA distribution.

CRA denied Arsove’s foreign tax credit since “the appellant did not pay any non-business income tax to the Internal Revenue Service (IRS) in 2013 […] and so she is not entitled to a foreign tax credit pursuant to […] the Income Tax Act (ITA).”

Arsove argued she was entitled to a foreign tax credit equal to 15% of her U.S.-sourced income since it was “a periodic pension payment received from an individual retirement account (IRA) distribution” in accordance with the Canada/U.S. tax treaty.

CRA disagreed. While tax of US$13,298 was indeed calculated on the U.S. return, the total tax payable was actually zero after deducting a foreign tax credit of the same amount, leading to the above-mentioned refund of US$561.78.

Nonetheless, Arsove felt it appropriate to claim a foreign tax credit in the amount of $868 against her Canadian tax “as if the United States had collected the 15% tax that it was entitled to levy pursuant to […] the treaty.”

The law

Under the Canada-U.S. tax treaty, when a U.S. citizen who is also a resident in Canada earns U.S.-source pension income, the U.S. is allowed to tax the first 15% of that income while the excess is taxable in Canada. To avoid double taxation, a taxpayer is allowed to claim a foreign tax credit for the 15% tax paid to the U.S. when computing the Canadian tax, and is entitled to a foreign tax credit against her U.S. tax for the tax paid in Canada over and above 15%.

Judgment

The judge said it appeared that Arsove incorrectly filed her U.S. return because she treated the total amount received from the IRA distribution as being sourced and taxable in Canada and she accordingly claimed a foreign tax credit against her U.S. tax payable. In other words, she acted as though she had paid tax in Canada on the total amount and not just on the portion on which tax over 15% was levied. As a consequence, she paid no tax in the U.S. The IRS, “for some reason, did not make any corrections in this regard and therefore accepted the return as filed. In the end, no U.S. tax was paid on that pension income.”

The judge explained that if Arsove had “properly interpreted […] the treaty, the portion of the IRA distribution income that should have been deemed to be sourced in Canada would only have been that portion on which U.S. tax exceeding 15% would have been levied.”

Arsove argued that the amount of tax paid is the amount of tax calculated prior to deducting the foreign tax credit (i.e., US$13,298). The judge disagreed, citing a prior case that said the appropriate tax paid to a foreign jurisdiction was “to be the amount of the levy ultimately imposed upon the appellant by the authority of the United States government by the operation of its tax legislation.”

The ITA only permits a Canadian resident to claim a foreign tax credit against Canadian tax owing when tax has been paid to the government of another country. Since Arsove paid no tax to the U.S., she was not entitled to claim a foreign tax credit. Quoting the prior case, the judge reminded Arsove that “the purpose of the foreign tax credit is to prevent double taxation.”

In short: No double taxation? No foreign tax credit.

Jamie Golombek

Tax & Estate

Managing Director, Tax and Estate Planning, CIBC Private Wealth Team Jamie Golombek is Managing Director, Tax and Estate Planning with CIBC in Toronto. As a member of the CIBC Private Wealth team, Jamie works closely with advisors from across CIBC to support their clients and deliver integrated financial planning and strong advisory solutions. He joined the firm in 2008 after 12 years with a global investment company, where he was involved in both internal and external consulting on all areas of taxation and estate planning. Jamie has also worked for Deloitte as a tax specialist in the Toronto office, where he specialized in both personal and corporate tax planning. Jamie is quoted frequently in the national media as an expert on taxation. He writes a weekly column called “Tax Expert,” in the National Post, has appeared as a guest on BNN, CTV News, and The National, and for several years was a regular personal finance guest on The Marilyn Denis Show. He received his B.Com. from McGill University, earned his CPA designation in Ontario and qualified as a US CPA in Illinois. He has also obtained his Certified Financial Planning (CFP) and Chartered Life Underwriting (CLU) designations. In 2023, Jamie was named a CPA Ontario Fellow. The FCPA is the highest distinction that can be bestowed upon a CPA who brings distinction to themselves and to their profession through leadership and achievement in their professional, community or personal lives. Jamie is a past chair of the Investment Funds Institute of Canada’s Tax Working Group. He is also a member of CPA Ontario, the Illinois CPA Society, the Estate Planning Council of Toronto, the Canadian Tax Foundation and the Society of Trust and Estate Practitioners. For nearly two decades, Jamie taught an MBA course in Personal Finance at the Schulich School of Business at York University in Toronto.