Foreign Tax Credits are almost always reviewed by the Canada Revenue Agency (CRA), at least for individual taxpayers. Interestingly, based on our experience, this is often the most easily mistaken area for the DIY tax return filings.
If you are reading this article the chances are that you have either received a review letter from the CRA or trying to calculate your foreign tax credits. In either case, this post may help you avoid at least some of the common mistakes you can make during the process.
As with our all other posts, the mandatory disclaimer, this post is not tax advice of any sort. You must consult your professional income tax accountant havign experience with International tax issues in Canada.
Foreign Tax Credit in Canada
Residents of Canada are taxed on their worldwide income, which may include foreign income from business, property, or employment.
To prevent double taxation, the foreign tax credit under section 126 of the Income Tax Act allows foreign taxes paid to offset Canadian taxes. The credit can apply with or without tax treaties, depending on the jurisdiction.
There are two types of credits; foreign business-income taxes and non-business income taxes, and they are calculated on a country-by-country basis, factoring in the income type and foreign taxes paid.
Without going into technical and lengthy discussions about these let’s dive straight into the most common mistakes while calculating foreign tax credits or responding to the CRA Review letters.
Unless your foreign tax credit is reported on T5, T3 or other slips, there is a more than likely chance that you will receive a review letter from the CRA.
Common Mistakes or Oversights
Some of the common mistakes or oversights, both in calculation and responses to those CRA Review letters are listed below.
Not responding to Review Letter
Lately, we had an influx of inquiries from the taxpayers looking our assistance with the reassessments issued by the CRA. One of the major reasons is that those taxpayers took those review letters casually and somehow decided not to respond. It’s a no-brainer that the CRA disallowed the whole foreign tax credit reported on those tax returns.
If this is the case with you, don’t worry, act immediately and call the phone number written on the original review letter. Agree with the agent on a timeline, either respond yourself or hire a professional income tax accountant to deal with them. If you do not respond, you can expect this reassessment going to collections.
For many commuters to the U.S. or someone temporarily working in the U.S. this could result in tens of thousands of dollars.
Sending Incomplete Documents to the CRA
Many taxpayers (wrongfully) claim that the CRA had denied their foreign tax credits or had reduced the credit significantly for no reason. When we take a look at those DIY submissions, the taxpayer did not send the documents listed in that review letter. If you are claiming a large foreign tax credit, it is important to exercise care while responding to those review letters.
One of the missed documents is the account transcript or the assessment from the foreign tax authority. Many taxpayers struggle to get this from foreign countries. In some countries, the tax authorities may not send automatic notices of assessments, transcripts or other equivalent notices.
For example, when you file a tax return with the Internal Revenue Service in the United States, you do not get an automatic transcript. The IRS issues such notices if there are any suggested changes to the tax return. In such cases, the CRA does allow sending them either proof of payment or a refund. This is an acceptable alternative as long as the amounts of refund or payment match with those mentioned on the U.S. individual tax returns. If they do not, you can request a transcript from the IRS.
In short, tax return alone will not help you, you must attach either a transcript or a matching proof of payment or refund, to claim the foreign tax credit.
Misunderstanding the Tax Residency
Canada taxes its tax residents on their worldwide income. Further, Canadian domestic tax law applies a very subjective approach to tax residency.
In practice, I have seen many taxpayers who consider themselves factual residents of Canada after conducting some research on the internet. The Internet is a very dangerous place to do such research and there are chances that ChatGPT is going to provide a very well-written incorrect response. It does not stop here. Many Canadian tax preparers with limited exposure to International tax often mislead their clients to believe that their clients were factual residents of Canada.
Canada has tax treaties with many countries. These tax treaties provide tie-breaker rules (generally Article IV) to decide the tax residency where a taxpayer is considered a resident of both countries per the domestic tax laws of each. Per Canadian domestic tax law, if a factual resident of Canada becomes a tax resident of a treaty country, that taxpayer becomes a deemed non-resident of Canada. A Deemed non-resident of Canada does not have to pay taxes to Canada on foreign-sourced income earned during the non-resdiency period.
A very common case could be of someone who moved to the U.S. on a TN Visa and had a home in Canada, misled to believe that she was a Factual resident of Canada. At times, taxpayers do not want to file as a non-resident of Canada due to departure tax implications.
Read more: Tax residency in Canada.
Confusing Taxes Withheld with Total Taxes Paid
Many times tax filers think that the taxes withheld on foreign information slips qualify as foreign taxes paid.
It depends!
If the taxes are withheld on the forms such as Canadian information slips such as T3, or T5, you do not need to file a tax return with foreign tax authorities. Certain times, foreign slips such as U.S. Form 1042-S, if issued for the FDAP income are also considered final tax liability.
However, taxes withheld on W2 (employment income), Form 8805 from a U.S. partnership, or 8288 etc require a taxpayer to file a U.S. tax return. Often higher withholdings on such information slips result in a refund from the U.S. In such cases, the tax return shows the actual tax paid to the U.S.
Confusing Non-Business Taxes with Business Taxes
At least on three separate occasions, I have seen that CRA disallowed a taxpayer’s foreign tax credit because the then-accountant of the taxpayer reported non-business foreign taxes as business taxes. Sadly, one of those tax returns were prepared by a very well-known accounting firm. It is important to ask your accountant for any questions or clarifications to ensure that such mistakes don’t happen.
For the purpose of this post, skipping the discussion on foreign business income, and foreign non-business income, you must correctly determine the character of the income under Canadian tax law.
This can become quite challenging when the tax situation involves any hybrid entity. It is not uncommon for Canadian tax residents to set up a U.S. LLC relying on an online or a local tax accountant’s advice in the U.S. As a reminder, Canada treats the U.S. LLC as a foreign corporation, so if there is a Schedule K-1 from active business, the income is reported to the extent of the distribution from such an LLC, as an investment income in Canada. This hybrid entity mismatch is discussed in another post. The same applies to U.S. S-Corps. In short, if you have a Schedule K-1 issued by such entities, the taxes paid by you as an individual are not business taxes! Reporting such income as business income and claiming business taxes will cause a reassessment. Further, there will be a mix of non-business foreign tax credit limited to treaty rates and a possible foreign tax deduction.
Do not ignore the Foreign Accrual Property Income where a deduction is available due to the Foreign Accrual Tax instead of Foreign tax credit.
Paying Foreign Taxes while Ignoring Tax Treaties
Many tax treaties limit the income taxes imposed on certain income from a foreign country to a predefined rate in tax treaties.
This happens usually when a DIY taxpayer or an accountant with limited knowledge of international tax, misunderstands the sourcing rules. Some of the examples are paying taxes to the U.S. on Social Security payments made to a Canadian tax resident. Another example could be paying taxes on the treaty exempt Capital gains, or paying taxes on business profits in the absence of permanent establishment in a foreign country.
Where the income taxes are not required to be paid to a foreign country due to a tax treaty, there is no foreign tax credit available. Of course, such FTC claims result in reassessments.
Including Payroll Taxes or Excise Taxes
Payroll taxes are not creditable for the purpose of foreign tax credit. The only exception is the United States where social security taxes and medicare taxes are creditable towards Canadian foreign tax credit claims.
Similarly taxes such as property taxes, Value added taxes, or excise taxes are not creditable.
Interperiod Allocations
Our Canadian tax year for individual taxpayers ends on December 31st. There are countries that use tax year that does not align with ours, for example, Australia or United Kingdom.
In such cases, the income is allocated or apportioned to calendar year based on the Canadian tax rules. Foreign taxes paid are also allocated to this income. You will need two foreign tax returns and assessments to support the calculations in your working papers.
Ignoring CRA Mistakes
A few times, I have seen that the CRA makes mistakes in their own foreign tax calculations too!
In those cases, two different taxpayers were refunded much larger amounts than they should be due to typographic errors by the CRA agents. In another case, there was an amount owing due to a mistake which was resolved by filing a timely objection.
Bottom line is that you must carefully read any notice of reassessment. Try to understand the reason for reassessment and verify the calculations before paying any amount mentioned on the reassessment. If needed, ask for a professional help.
U.S. Canada Sourcing Rules and FTC Calculations
U.S. citizens living in Canada often experience the foreign tax credit review process every year. Many see reassessments as well.
For these taxpayers, it is important that both tax returns are prepared at the same time if the income is coming from both countries. It is less important if the income is coming from one country only.
For example, a U.S. citizen may have social security and pensions from the U.S., CPP and OAS from Canada, and other sources of income. For such cases, if both tax returns are not prepared by the same firm, it is best to let the two accountants talk to each other to ensure that foreign tax credit calculations are correct.
How do we help?
Maroof HS Cross Border Tax Professional Corporation is a full scale tax preparation and planning tax firm. Our area of expertise span advanced income tax issues for both Canada and the U.S. If you are a Canadian tax resident who has income from Canada, or any other country, you can rely on us to ensure that we prepare accurate income tax return for you.
We have a very structured methodology of preparing complex income tax returns. We provide the copies of worksheets and most of our clients respond to foreign tax credit reviews themselves without any issue. To-date, I must say that we have earned bragging rights that not-even-once the CRA has reassessed the tax returns prepared by us that involved foreign tax credits. We have also successfully helped many clients to correct the tax returns due to incorrect determination of tax residency by some very well-reputed firms.
If you need help, we are always available, get in touch!
