As a general rule, a Canadian resident can claim of credit against his/her/its Canadian income tax liability for foreign income taxes paid (“foreign tax credit”-“FTC”). The rules relating to claiming FTCs are generally found in section 126 of the Income Tax Act (“the Act”).
Unless the foreign tax is related to a business carried on in a foreign country, it is classified as a “non-business income tax” (“NBIT”) and the FTC is provided in subsection 126(1).
In the ideal situation, a FTC will be provided for the full amount of the NBIT, and all double tax is avoided. In effect, the foreign tax is a “wash” because it is fully recovered by a credit against Canadian tax.
However, in order to claim a FTC, there has to be some foreign source income recognized for Canadian tax purposes. Under the general limitation, the FTC allowed is the lesser of the foreign tax paid, or the foreign source income multiplied by the average Canadian tax rate. Without any foreign source income, there can be no FTC. In addition, the rules apply on a country by country basis.
But what happens if a Canadian is a member of a US LLC, which is treated as a partnership for US tax purposes, and US tax is paid without any income inclusion for Canadian tax purposes? This could be the case in situation where there is no actual distribution made by the LLC. Furthermore, it is assumed that the LLC is not a “controlled foreign affiliate” of the Canadian resident earning “foreign accrual property income” (“FAPI”), and the LLC is not resident in Canada.
If there is no US source income in the relevant year, a FTC cannot be claimed, and a NBIT cannot be carried over into another taxation year-so it is a matter of “use it or lose it” in the year paid.
Fortunately, the Act does provide a mechanism under which some relief may be claimed for the US tax (this can include both federal, as well as state, income taxes).
Namely, subsection 20(12) can allow a deduction for the tax in computing income. Admittedly, not as good as a FTC, but a lot better than nothing! In Ontario, this can result in an effective recovery of up to 53.5% of the US taxes paid for an individual taxpayer.
Subsection 20(12) can also apply to allow a deduction for a Canadian member of a US LLC that is a corporation. However, the CRA would take the position that it is not available if the LLC is a “foreign affiliate” of the Canadian corporation (generally, where 10% or more owned).
Subsection 20(12) of the Act states as follows:
“In computing the income of a taxpayer who is resident in Canada at any time in a taxation year from a business or property for the year, there may be deducted any amount that the taxpayer claims that does not exceed the non-business income tax paid by the taxpayer for the year to the government of a country other than Canada (within the meaning assigned by subsection 126(7) read without reference to paragraphs (c) and (e) of the definition “non-business income tax” in that subsection) in respect of that income, other than any of those taxes paid that can, in whole or in part, reasonably be regarded as having been paid by a corporation in respect of income from a share of the capital stock of a foreign affiliate of the corporation.”
There are a couple of key interpretive issues that can be raised in connection with the ability to claim a deduction under this provision with respect to taxes paid in respect of the LLC in such situations.
Firstly, since the amount is deducted “in computing income from a business or property” (in this case, “property”) can it be claimed if there is no income generated in the year? Presumably, this would result in a loss from property.
Secondly, is the relevant tax a NBIT at all, given that no income is generated for tax purposes?
Various Technical Interpretations that have been issued by the CRA over the years answer both questions in the affirmative. Of particular interest is recently released CRA Document 2014-56037117, which even extends this interpretation to situations where the interest in the LLC is held by the Canadian resident via a “Unlimited Liability Company” (“ULC”), which is treated as being a fiscally transparent entity for US tax purposes.
As I wrote, certainly a lot better than nothing! However, before settling for that, we should consider that the fact that the US taxes paid by the Canadian resident would be viewed as a NBIT does raise the possibility that a FTC could actually be claimed with respect to such taxes, if the taxpayer has some form of US source income. As long as it is income from a source other than carrying on business in the US, it could possibly be included in the relevant formula to allow for a FTC claim.
Thinking in this direction, one might look at various forms of US income that have not been subject to US taxes, since this would allow “room” to claim a FTC with respect to the taxes related to the LLC. For example, what about US source interest income, or taxable capital gains from trading stocks on a US exchange?
Unfortunately, neither of these two types of income will work for this purpose, since they are exempt from taxation under the Canada-US Tax Convention[1], and the rules in section 126 generally preclude the inclusion of treaty-exempt income as foreign income in the numerator of the relevant formula[2].
However, other possible sources that might be eligible would be the following:
- US-source pension income that is subject to US tax
- Dividends from US corporations[3], and
- Income from employment in the US that is subject to US tax
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[1] Under Articles XIII(4) and XI(1), respectively.
[2] Only “qualifying incomes” may be included in the basic calculation in subsection 126(1); under subparagraph 126(9)(a)(iii), “tax-exempt income” is excluded from “qualifying incomes”; under subsection 126(7), “tax-exempt income” includes income that is tax exempt under a treaty.
[3] In my view, the 15% limitation on FTC with respect to this type of income should not apply to the taxes resulting from the interest in the LLC, since such taxes would not have been “paid in respect of an amount that has been included in computing the taxpayer’s income for the year from the property” as contemplated in paragraph 20(11)(a) of the Act. Thus, the fact that the taxpayer may be making a claim for the normal 15% US tax withheld should not preclude using the LLC-related tax to claim an additional FTC claim. This might be challenging for certain tax return preparation software!
ABOUT THE AUTHOR OF THIS ARTICLE
Michael I. Atlas, CPA,CA,CPA(ILL),TEP
Michael Atlas is one of the most prominent international tax experts in Canada. He advises accounting and law firms all across Canada, as well as select private clients (corporate and personal) worldwide. He can be reached by phone (416.860.9175) or email (matlas@TaxCA.com).
