First of all… what is a CIE?
As you may know, Canada grants a “foreign tax credit” (FTC) to Canadian residents, with the aim of minimizing the double taxation of foreign-source income.
However, the rules governing CIE can be quite complex. Generally speaking, Canada grants a credit to a Canadian resident for any foreign income tax paid on foreign-source income, up to the amount of Canadian tax payable on that income.
As a result, you pay a total tax equal to that resulting from the application of the higher of the two tax rates (Canadian and foreign) to the foreign-source income.
For example, suppose you earn $1,000 in dividends on a U.S. company stock, and the U.S. company withholds $150 in tax. (We ignore exchange rate issues in this example, and assume that all amounts are in Canadian dollars.) Assuming you are in a 40% tax bracket, you pay Canadian tax of $400 on these $1,000 in dividends.
In this example, Canada will give you a foreign tax credit of $150 on your Canadian tax return, so you’ll pay only $250 in Canadian tax on the dividends. The total tax ($150 in the U.S. and $250 in Canada) will be equal to the $400 Canadian tax you would have paid had there been no foreign tax. (Most developed countries have similar rules).
Caution! The CIE has three traps!
1. One you should be aware of is that foreign tax must be compulsory. If you could avoid paying foreign tax, or reclaim it from the foreign government, you cannot claim a corresponding foreign tax credit.
Suppose, for example, that your U.S.-source income consists of interest rather than dividends, and that the interest is exempt from U.S. tax under the Canada-U.S. tax treaty. If the U.S. payer has withheld U.S. tax, and you can recover that tax from the U.S. government by claiming treaty relief, the tax you paid in the U.S. does not qualify for the foreign tax credit, because Canada will consider it a “voluntary” payment to the U.S. rather than a foreign tax. Instead of claiming a foreign tax credit, you may have no choice but to apply to the U.S. Internal Revenue Service for a refund of the tax improperly levied.
This interpretation was confirmed in the Meyer (2004) and Marchan (2008) judgments of the Tax Court of Canada (TCC).
2. Note also that the foreign tax credit applies only to “income or profits tax”. It does not apply to social security contributions other than those paid in the United States. Most payments made in the U.S. under the Federal Insurance Contributions Act (FICA) qualify under a specific provision of the Canada-U.S. tax treaty).
3. Finally, note that the foreign tax credit on “non-business income” is based on the amount of foreign tax you actually paid, but after deducting any refunds such as the U.S. child tax credit, as confirmed by the Federal Court of Appeal in Zhang (2008).
If you have any questions, don’t hesitate to write to our experts.
