Foreign tax credits are also mentioned in the context of employment income. For example, in a recent case, a taxpayer who was a Canadian resident working for the Spanish government at its embassy in Ottawa attempted to claim the foreign tax credit for mandatory contributions to a national pension plan in Spain. The Canada Revenue Agency (CRA) disallowed the taxpayer’s foreign tax credits, and the taxpayer ultimately took the matter to the Tax Court.
In court, the taxpayer argued that the amounts at issue had been withheld by the Spanish government and should therefore be treated as tax paid to a foreign jurisdiction. The CRA was of the view that these amounts did not constitute tax. The fundamental question was therefore whether the amounts withheld by Spain could amount to a tax.
To answer this question, the judge began by reviewing the four characteristics of a “tax”, as determined by a decision of the Supreme Court of Canada in 1930: enforceable by law, imposed under the authority of the legislator, imposed by a public body and carried out for a public purpose.
Despite the absence of evidence at trial, including “very little description” as to the mechanisms for collecting these funds, the authority under which this was done and whether the deductions were subtracted from the taxpayer’s gross income in As part of his Canadian tax returns, the judge concluded that the first three elements of the Supreme Court’s test were met. In other words, the amounts claimed by the taxpayer were likely withheld by the Spanish government due to Spanish law which makes such payments mandatory.
The problem, the judge explained, lies in the last component of the Supreme Court’s test. The taxpayer testified that the amounts at issue, for which foreign tax credits were denied, were deducted by Spain in order to contribute to the Spanish national pension scheme. Although the taxpayer was unsure of the benefits he would ultimately receive from the plan, he acknowledged that he would likely receive payments in the future.
The judge therefore concluded that the sums collected by the Spanish government “do not meet the definition of a tax, in that they were not collected for a public interest.… [T]The pension deductions were made by the Spanish government for the future benefit of the contributor.…These payments were not made for the purpose of generating revenue for the state. Therefore, these amounts were not eligible for foreign tax credits.
While this case may be very factual, it shows that a foreign tax credit is not always guaranteed. Take, for example, the foreign tax credit for withholding tax on investment income. This is only available when these investments are held in a non-registered account. What if a client holds foreign investments in a registered plan, such as an RRSP, RRIF, TFSA or RESP?
This is where things can get a little tricky. If, for example, a client holds foreign stocks in a registered account and dividends are paid on those stocks, they will likely be subject to a 15% non-resident withholding tax by the paying country before receiving the registered plan. This can be considered a sunk cost, as it is not possible to claim a foreign tax credit for withholding tax paid by a registered account.
The only exception to the above is for US stocks held in an RRSP or RRIF. Because of this unique provision of the Canada-US tax treaty, an exemption from withholding tax automatically applies when US dividends are paid into an RRSP or RRIF. Note that this same break does not apply to US dividends paid into a TFSA or RESP.
Jamie Golombek, CPA, CA, CFP, CLU, TEP, is Managing Director, Tax and Estate Planning at CIBC Private Wealth Management in Toronto.