The ability to claim credits for foreign taxes (“foreign tax credits”) (“FTC”) is the most fundamental and common way of avoiding double tax in connection with cross-border transactions.
Both Canada and the U.S. have well-developed, and often complex, provisions within their tax laws to provide such credits where appropriate.
Contrary to what many people think, both of these countries grant FTCs to their residents “unilaterally” as a result of their domestic tax laws-it does not necessitate the existence and operation of a tax treaty for FTCs to be available[1].
Usually, the systems in both countries work pretty well, but, like everything of this nature, there are always some quirks.
My purpose in writing this article is to review one of those quirks that can often arise in connection with Canada-U.S. tax planning, as well as a little-known feature of the Canada-U.S. Tax Convention (“the Treaty”) that can be applied to remedy the anomaly that would otherwise result.
Over the years I have found that relatively few tax advisors on both sides of the border are aware of this feature, and even many tax practitioners in large firms that deal with Canada-U.S. tax planning often are not aware of the “fix”.
The following hypothetical example will illustrate the issue:
Canco is a private Canadian corporation that has been operating a very profitable manufacturing business for many years.
50% of its shares are owned by Mr. X, a Canadian resident individual; the other 50% is owned by Mr. Y, an unrelated individual resident in the U.S.
The parties have decided that Mr. X will buy-out Mr. Y’s shares. Because the purchase price of the shares will be many millions of dollars, Mr. X does not want to use his own after-tax funds to buy the shares.
In order to achieve that, his accountant, Tom CPA, tells him that he can just have Canco purchase Mr. Y’s shares for cancellation. After that, Mr. X would be the sole shareholder, and the money can come out the retained earnings of Canco.
Mr. X proposes that to Mr. Y, and Mr. Y speaks to his accountant in the U.S., Dick CPA. He says that there is no problem with that-the sale will be treated as a long-term capital gain in the U.S. in the same way as if the shares were sold to Mr. X.
As they get near to the closing date, Tom CPA mentions to Mr. X that Canco will have to withhold 15% for Canadian tax from the purchase price, because it will be treated as a dividend for Canadian tax purposes [2]. Tom CPA says that Mr. Y should not have any real problem with that, since he will be able to claim a FTC in the U.S. for that tax. Other than the fact that a prepayment for a few months may result, it should just be a “wash”.
Mr. Y becomes aware of that, and mentions it to Dick CPA. Dick CPA does some research and concludes that Mr. Y would not be able to claim a FTC in the U.S. for the Canadian tax. This is because of the fact that, under the IRC, his gain on the Canco shares will be considered to be sourced in the U.S.-not in Canada[3]. It is possible that he may be able to get some tax recovery in the U.S. by claiming the Canadian tax as an “itemized deduction”, but that would result in a maximum recovery of less than half of the tax.
Mr. Y then says that he does not want to be double-taxed on the gain, and if Mr. X needs to do it that way, Mr. X will have to “eat” any additional tax cost he will incur.
Mr. X certainly does not want to absorb any of the Canadian tax cost, and he certainly does not want to fund the purchase with his personal funds either.
He and Tom CPA decide to have a conference call with the corporate lawyer on the case, Harry. Although Harry is not a tax lawyer, he has been involved with many purchases and sales of businesses over the years. He suggests an approach that he has seen used in numerous occasions, which he thinks could solve the problem here.
Namely, Mr. X would incorporate a new corporation (“XCo”) to be the buyer of Mr. Y’s shares. That way, there would be no deemed dividend that would be subject to the 15% Canadian tax. Furthermore, XCo would issue a note for the purchase price on closing, and then it would immediately be amalgamated with Canco. That would mean that the purchase price would still be effectively funded by Canco’s retained earnings.
Although this would cost thousands of dollars in extra professional fees, Mr. X is happy to go through this process as a way of getting the issue resolved to everybody’s satisfaction.
What I have outlined above is an example of what I like to describe as “The Blind Leading the Bewildered”.
In actually fact, there was no real problem and no need to go to the added expense of the extra steps.
All that was needed was an understanding of the ability to apply the special sourcing rules that are found in Article XXIV(3) of the Treaty. Based on that, Mr. Y would have been able to claim a FTC in the U.S. for the 15% Canadian tax if the original plan had been followed.
Article XXIV(3) of the Treaty augments the general principles outlined in Articles XXIV(1) and XXIV(2). Namely that each of the U.S. and Canada should avoid double taxation by allowing FTCs.
Looked at in isolation, these provisions are really not much different than the usual ones in tax treaties that refer to FTCs. For the most part, these are generally useless since they are qualified by being subject to the laws of the respective state.
But what makes Article XXIV of the treaty uniquely important in this regard is that it provides a rule which is clearly intended to override the FTC provision of the domestic tax laws of the U.S. and Canada.
Namely, Article XXIV(3) provides a sourcing rule for the purposes of the treaty that can be used in lieu of any souring rules that would otherwise apply under domestic law.
The Technical Notes that were issued by the U.S. Treasury in 1984 leave no doubt about the fact that U.S. residents may use this rule, rather the rules in the Code, to claim FTCs for Canadian taxes.
The notes state:
“A taxpayer claiming credits for Canadian taxes under the Convention must apply the source rules of the Convention, and must apply those source rules in their entirety. Similarly, a taxpayer claiming credit for Canadian taxes which are creditable under the Code and who wishes to use the source rules of the Convention in computing that credit must apply the source rules of the Convention in their entirety.”
However, using the rules in Treaty is clearly optional
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As the notes also indicate:
“A taxpayer may, for any year, claim a credit pursuant to the rules of the Code. In such case, the taxpayer would be subject to the limitations established in the Code, and would forgo the rules of the Convention that determine where taxable income arises. In addition, any Canadian taxes covered by paragraph 1 which are not creditable under the Code would not be credited.”
Now, to turn to the sourcing rule in Article XXIV(3) as it applies from the perspective of a U.S. resident taxpayer:
In essence, under this rule, if Canada is allowed, under the terms of the Treaty, to tax an item of income, it is deemed to be Canadian source; if not, it is deemed to be U.S source.
Going back to our example with Mr. Y and the purchase for cancellation of his shares by Canco, it is clear that Canada has the right to tax the proceeds as a deemed dividend (albeit at a reduced treaty rate of 15%) under Article X(2) of the Treaty. In this regard, it is significant to note that, even though the payment on the purchase for cancellation of his Common shares would not be a “dividend” under corporate law, it would be for the purposes of Article X. This is because of the expanded definition of “dividend” in Article X(3). This includes “income that is subject to the same taxation treatment as income from shares under the laws of the State of which the payer is resident”.
Given that, the gain that Mr. Y will report from the sale of his shares to Canco should be Canadian-source under the rule in Article XXIV(3), which should lead to him being able to claim a FTC for the Canadian tax.
It should be noted that the sourcing rule discussed above could conceivably also apply to a Canadian resident looking to claim a FTC for U.S. taxes.
I have not personally encountered any situation where this was done, and I have not been able to find any published statements from the CRA regarding a situation where it was applicable.
Unlike the U.S., Canada does not have codified sourcing rules for FTC purposes. Instead, ours are based on principles that have been developed and applied over the years[4].
Perhaps, because of that, there is less likelihood that a tax paid by a Canadian resident to the U.S. would not be treated as being derived from U.S. sources under our rules.
I tried to think of a situation where a FTC for U.S. taxes might not be allowed were it not for the application of the sourcing rule in the Treaty, and here is one that I thought of:
Holdco is Canadian holding company, and it is the sole owner of R Inc., a U.S corporation. The assets of R Inc. consist almost entirely of interests in several shopping malls in the U.S.
Mr. C, who is the sole shareholder of Holdco, has decided that Holdco should sell its shares in R Inc.
Mr. C is elderly and in poor health. In addition, he has a fear of flying.
As a result of this, he is unwilling to travel to the U.S. to negotiate with any potential buyers. Rather, he insists that they come to Canada, and that the ultimate closing on the transaction should occur in his lawyer’s office in Montreal.
Mallco Inc., a big American real estate company jumps at the chance to buy the shares of R Inc. It has no qualms about sending a few of its top executives to Montreal to negotiate the terms of the sale, and attend to the closing there.
Because R Inc. is a “U.S. real property holding corporation”, Holdco’s gain on the sale will be subject to U.S. tax under the “FIRPTA” provisions of the IRC. This is permitted by virtue of Articles XIII(1) and XIII(3)(a) of the Treaty.
However, when it comes time to file Holdco’s corporate tax return in Canada, the accountants preparing the return express concern that, the way the sale was consummated, the CRA could view the gain as being sourced in Canada[5].
Even if that is true, for reasons indicated above, Article XXIV(3) of the Treaty should deem it to be U.S. source for the purposes of the Treaty, and allow the FTC to be claimed in Canada.
[1] For a Canadian perspective on this issue, see my blog posting at https://taxca.com/blog-2016-28/
[2] Other than the portion represented by the “paid-up capital” of the purchased shares, which is assumed to be a nominal amount. This results from the application of subsection 84(3) of the ITA.
[3] Section 865(a) of the IRC.
[4] See particularly Paragraphs 1.52-1.68 of Income Tax Folio S5-F2-C1 for a summary of CRA’s view’s on this subject.
[5] Ibid., paragraph 1.65
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).
