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April 30, 2021 | Blog

Foreign Income Sourcing: Keys to Successful Foreign Tax Credit Calculation

With the advent of technology, an increasing number of taxpayers are diversifying their sources of income. It has never been easier to invest in foreign assets such as stocks or real estate. The income from those assets is, of course, taxable in Canada. In this article, we will see how to properly source this income, essential to the foreign tax credit (FTC) calculation, and how to calculate the FTC.

From tax expert Gerry Vittoratos

Key information elements required
Before starting the process of calculating the FTC, it is important to determine the source country of the foreign income. How you source will depend on the type of income received. It is essential to properly determine the type of foreign income received (non-business or business income) to confirm the source country. Below is a table that sums up how to determine the source country per type of foreign income [Folio S5-F2-C1]:

Type of income

How to source

Employment income

Location of employer’s office. If the employment requires duties to be performed in both Canada and outside of Canada, an apportionment of the individual’s regular salary or wages based on the number of working days spent in Canada, and in that other country, is usually considered appropriate in determining the foreign-source income from the employment.

Interest income

Residence of the debtor. Other factors of much less importance: where the contract giving rise to the interest income was formed, where payments are made, where any loaned funds are put to use or where any property securing a loan is located.

Dividend income

Residence of the corporation paying the dividend. Other factors to consider:

·       the provisions in an income tax treaty (if any) between Canada and the particular foreign country in question, that can determine the corporation’s residence for the purposes of the treaty; and

·      subsection 250(5), which (in conjunction with such a treaty) may deem the corporation not to be resident in Canada.

Rental income

Location of the property for a building. For other tangible or corporeal property, the country where the property is used.

Capital Gains

Location of property if it’s an immovable. For a stock or bond, the securities or stock exchange in which it is sold, regardless of the location of the security issuer’s transfer office.

Business income

Location where the operations in substance, or profit-generating activities, take place.

Once you have sourced the country, the next step is to determine whether there’s a tax treaty between Canada and that country. There are several reasons for this. For one, the treaty might indicate specific rules on how the type of income received is to be taxed. Because of this, the treaty might disqualify certain deductions, such as subsection 20(11) deduction (see below). The treaty might also indicate whether a portion of the income received is exempt from taxation [ITA 126(7)].  

Another consideration is the double-taxation prevention rules found within each treaty. What would otherwise be income from a source in Canada might be deemed to be income from a source in the foreign country [Folio S5-F2-C1, par 1.49].

The tax treaty between Canada and the foreign country is an essential document to the computation of FTC.

Foreign tax credit calculation

As mentioned above, there are two categories of foreign-sourced income: non-business and business. The non-business foreign tax credit formula is as follows:

Foreign Tax Credit [ITA 126(1)(d)] – Lesser of:

Tax paid to foreign government

XX

[B / C] X D

B: Net foreign non-business income (FNBI) less

·      income from that foreign country for which you claimed a capital gains deduction [ITA 110.6, ITA 126(9)(a)(ii)]

·      income that was, under a tax treaty between Canada and that country, deductible as exempt from tax in Canada or in that country

·      a deduction you claimed under subsections 20(11) or 20(12) and under subsection 4(3) relating to the foreign income,

C: Net income for tax purposes less:

·      net capital losses of other years you claimed [ITA 111(1)(d)]

·      capital gains deduction you claimed [ITA 110.6, ITA 126(9)(a)(ii)]

·      amount deductible as security options deductions [ITA 110(1)(d) & (d.1)]

·      amounts deductible as net employment income from a prescribed international organization, as foreign income exempt under a tax treaty, or as adult basic education tuition assistance [ITA 110(1)(f) &(g) & ITA 126(9)(iii)]

·      amount deductible as a Canadian Forces personnel and police deduction [ITA 110(1)(f) & ITA 126(9)(iii)]

·      amount deductible under the home relocation loan [ITA 110(1)(f) & ITA 126(9)(iii)]

D: Tax otherwise payable Federal Tax payable plus:

·      Dividend Tax Credit [ITA 82(1)(b)]

·      Political Contributions Tax Credit [ITA 127(3)]

·      Investment Tax Credit [ITA 127(5)]

·      Labour-sponsored funds tax credits [ITA 127.4]

XX

The FTC is limited to 15% of gross foreign income (other than real or immovable property) [“non-business income tax” ITA 126(7)] and must be calculated individually for each country [ITA 126(6)(b)]. Any tax credit amount not claimed cannot be carried forward to a future year.

Two deductions are also offered within the ITA for foreign non-business income (FNBI): Subsections 20(11) and 20(12). For subsection 20(11), taxpayers can claim a deduction for any foreign tax that exceeds 15% of foreign income. There are limitations; for one, you cannot claim this deduction for foreign property income from a real or immovable property; and a tax treaty might limit the amount to be withheld on the foreign income to less than 15% [TI 2009-0320581E5]. In the latter case, you cannot use the ITA 20(11) deduction for any amount in excess of 15% of foreign income; the excess amount can only be recouped in the foreign country.

For subsection 20(12), taxpayers can claim a deduction for foreign non-business-income tax paid during the year. However, this deduction is excluded from non-business-income tax for purposes of the foreign tax credit (FTC) [ITA 126(7)(c)]. A deduction under subsection 20(12) requires an equivalent reduction in respect of the relevant foreign country of the non-business-income tax eligible for a foreign tax credit, the foreign non-business-income amount which is used in calculating the amount of foreign tax credit which may be claimed, and the amount of net income used in that calculation.

For capital gains, where a taxpayer has a taxable capital gain allocated to one foreign country and an allowable capital loss allocated to another foreign country, the taxable capital gain is included in computing the foreign tax credit formula variable FNBI for the first country and the allowable capital loss is subtracted in computing FNBI for the second country against all income to the extent that such allowable capital loss is deductible in computing the taxpayer’s income for the year under ITA 3.

The calculation of the business foreign tax credit is as follows:

Foreign Business Tax Credit [ITA 126(2)] - Lesser of:

Tax paid to foreign government

XX

[B / C] X D

B: Net foreign business income (FBI)

Net amount by which the business income you earned in a foreign country is more than the business losses you incurred in that country.

C: Net income for tax purposes less:

·      net capital losses of other years you claimed [ITA 111(1)(d)]

·      capital gains deduction you claimed [ITA 110.6, ITA 126(9)(a)(ii)]

·      amount deductible as security options deductions [ITA 110(1)(d) & (d.1)]

·      amounts deductible as net employment income from a prescribed international organization, as foreign income exempt under a tax treaty, or as adult basic education tuition assistance [ITA 110(1)(f) &(g) & ITA 126(9)(iii)]

·      amount deductible as a Canadian Forces personnel and police deduction [ITA 110(1)(f) & ITA 126(9)(iii)]

·      amount deductible under the home relocation loan [ITA 110(1)(f) & ITA 126(9)(iii)]

D: Tax otherwise payable Federal Tax payable plus:

·      Dividend Tax Credit [ITA 82(1)(b)]

XX

Tax otherwise payable less non-business income tax credit

XX

Any excess amount of foreign business tax credit not used can be carried forward for 10 years and carried back for three years [ITA 126(7)]. To claim the carry back, a T1-ADJ form must be filled [Folio S5-F2-C1, par.1.103].

To summarize, sourcing foreign income is an essential exercise to properly claim the foreign tax credit. By sourcing properly, you can better assess any factors that can affect the calculation, the biggest being the provisions found in a tax treaty with that country. 

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