Claiming a 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 since it depends on what is actually considered to be a foreign tax.
This came up most recently in a case involving a Canadian resident working for the Spanish government at the Embassy of Spain in Ottawa. But before delving into the case details, let’s review the purpose of the foreign tax credit.
As Canadian residents, we’re taxable on our worldwide income. That means even income earned abroad, whether it be foreign employment income or foreign investment income, is subject to Canadian tax at marginal tax rates. But this foreign income, in most cases, is also subject to foreign tax in that foreign jurisdiction. To avoid paying double tax on the same income, you may be entitled to claim a foreign tax credit on your Canadian return for foreign taxes paid on that foreign income.
For most of us, our only experience with claiming a foreign tax credit likely occurs if we earn foreign interest or dividends in a non-registered investment account. For example, if I own Pfizer Inc. shares in my non-registered trading account, the dividend income would be subject to a 15-per-cent non-resident withholding tax in the United States. I would then pay Canadian tax on that U.S. dividend income at my normal marginal rates when I file my Canadian return, but be entitled to claim a foreign tax credit for the non-resident tax withheld, thus avoiding double tax.
The taxpayer in the recent case claimed a foreign tax credit of $842 in 2016, $2,527 in 2017 and $2,545 in 2018, consisting of mandatory contributions to a nationally run pension plan in Spain. The Canada Revenue Agency 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 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” of 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 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 were deducted by Spain in order to contribute to the Spanish national pension plan. The taxpayer was uncertain as to what benefits he will ultimately receive from the plan, but acknowledged he would likely receive some payments in the future.
The judge, therefore, concluded that the amounts collected by the Spanish government did “not meet the definition of a tax, in that they were not collected for a public interest … The 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 did not qualify for foreign tax credits.
This result is consistent with prior case law. For example, in a 2001 tax case, contributions a Canadian taxpayer paid to a national insurance plan in the United Kingdom were also found not to be eligible for the foreign tax credit. A similar conclusion was reached again by the Tax Court in a 2019 decision, which held that contributions to a foreign insurance plan are not a tax for public purposes, partly because the contributor receives “a direct personal and financial benefit in the future for their contributions.”
One final caution when it comes to claiming foreign tax credits. As noted above, a foreign tax credit for withholding tax on investment income is only available when those investments are held in a non-registered account. But what if you hold your foreign investments inside of a registered plan, such as a registered retirement savings plan (RRSP), registered retirement income fund (RRIF), tax-free savings account (TFSA) or registered education savings plan (RESP)?
That’s where things can get a bit tricky. If, for example, you hold foreign stocks in your registered account and dividends are paid on those stocks, they will likely be subject to a 15-per-cent non-resident withholding tax by the payor country before hitting your registered plan. You should consider this a sunk cost, because 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 a 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. That’s because these accounts are not “operated exclusively to administer or provide pension, retirement or employee benefits,” which is the requirement under the Canada-U.S. treaty to be exempt from withholding tax.