5 July 2002 Internal T.I. 2002-0144257 - 20(12) Deduction & Accrual Basis Income

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues:

Can an individual who pays Canadian tax on interest income over the course of 3 years (on an accrual basis) and foreign withholding tax on the total amount of the income in one year (when the income is actually paid) make use of the 20(12) deduction to offset any of the foreign tax not absorbed by a FTC?

Position: Generally, yes, however, in some cases the 20(12) deduction will not be sufficient to account for all of the foreign tax.

Reasons: Although in practice a subsection 20(12) deduction is only taken after all possible FTCs have been claimed, technically FTCs are calculated after taking into account any subsection 20(12) deduction (subsection 126(1) and the definition of "non-business-income tax" in subsection 126(7)). Therefore, it is possible to take the maximum 20(12) deduction (which is limited to the foreign tax paid that relates to the amount of foreign income actually included in income in the particular year) and then claim the FTC for whatever "non-business-income tax" was not deducted under 20(12). See the example in the memo.

July 5, 2002

Ms. Sheila Barnard Eliza Erskine

Individual Returns and Payments 952-1361
Processing Directorate
25 McArthur Road, 8th Floor, Tower C
2002-014425

Interaction Between the Foreign Tax Credit ("FTC") Calculated Under Subsection 126(1) of the Income Tax Act (the "Act") and the Deduction Available Under Subsection 20(12) of the Act (the "20(12) Deduction"), Where the Foreign-Source Income is Taxed in Canada on an Accrual Basis and Taxed in the Foreign Country on a Cash Basis

We are writing in response to your email letters to us of May 27, 2002 (the "May Email Letter"), and June 6, 2002 (the "June Email Letter"), regarding the above-noted subject. We also acknowledge our telephone conversation with you of June 19, 2002 (Wilson/Barnard). We understand from the June Email Letter that you are now aware of our position that the expression "for the year", for purposes of subsections 126(1), (2) and (7) of the Act, means for the year in which the relevant foreign tax is exigible in the foreign country.

Issue

The basic scenario that you outlined in the May Email Letter is as follows:

? A Canadian resident individual reported interest income from XXXXXXXXXX annually as it accrued, in accordance with the Act.

? XXXXXXXXXX did not tax the interest income until that income was actually paid to the individual, at which point a 15% withholding tax was exigible in accordance with XXXXXXXXXX tax law and the terms of the Canada-XXXXXXXXXX Income Tax Convention.

? The individual's Canadian tax payable for the year in which he actually received the interest income, with respect to the amount of the interest income included in his total income for that year, was less than the XXXXXXXXXX withholding tax that he paid on the interest income.

The issue is what FTC and 20(12) Deduction the individual is eligible for under these circumstances and whether there is a potential double-taxation problem.

Comments

The simplest way to explain what FTC and 20(12) Deduction is available to the individual is to use a numerical example. Assume the following facts:

? The individual included $10,000 of XXXXXXXXXX-source interest income is his total income for purposes of computing his Canadian income tax in each of 1999, 2000, and 2001.

? The whole of the $30,000 of interest income was actually paid to the individual in 2001, and the XXXXXXXXXX withholding tax was therefore $4,500.

? The individual's Canadian tax rate was 30% for each of 1999, 2000, and 2001, therefore, his Canadian tax payable for each of those taxation years with respect to the XXXXXXXXXX-source interest income was $3,000 (i.e., he paid a total of $9,000 in Canadian tax on the interest income).

The individual is only allowed to claim a FTC up to the amount of the Canadian tax paid with respect to XXXXXXXXXX-source income for the year in which the XXXXXXXXXX withholding tax was actually exigible, that is, 2001. Thus, the individual is limited to a FTC of $3,000, which does not fully account for the $4,500 of XXXXXXXXXX withholding tax paid, even though the individual actually paid $9,000 in Canadian tax with respect to the interest income.

Can the individual deduct the whole of the remaining $1,500 of XXXXXXXXXX withholding tax (the "Excess Foreign Tax") as a 20(12) Deduction in 2001? In our view, he can. Subsection 20(12) of the Act refers to a deduction in computing income "for a taxation year ... not exceeding the non-business income tax paid by the taxpayer for the year ... in respect of that income". The XXXXXXXXXX -source income for Canadian tax purposes for 2001 is $10,000, and the amount of XXXXXXXXXX withholding tax paid in respect of that income is $1,500. Therefore, in computing his Canadian tax payable for 2001, the individual can claim a FTC of $3,000 and a 20(12) Deduction of $1,500.

In reaching our conclusion, we considered whether the Excess Foreign Tax could be allocated entirely to the 2001 taxation year, or whether it had to be allocated in equal portions between each of the relevant taxation years, such that only $500 was actually available in 2001 as a 20(12) Deduction. We concluded that the whole $1,500 could be allocated to the 2001 taxation year, based on the interaction between subsections 20(12) and 126(1) of the Act, and the definition of "non-business income tax" in subsection 126(7) of the Act. According to this definition, a "non-business income tax" (which is the basis on which the non-business income FTC is calculated) is an income or profits tax paid to the government of a country other than Canada that, among other things, "was not deducted by virtue of subsection 20(12) of the Act in computing the taxpayer's income for the year". The result is that the 20(12) Deduction is to be taken before the FTC is claimed (i.e., the definition of "non-business income tax" is in part an ordering provision). Applying this ordering to the scenario set out above, the taxpayer would first elect to take a $1,500 20(12) Deduction and then claim the FTC. By taking the $1,500 20(12) Deduction first, there is no question that the whole of the $1,500 relates to foreign tax paid on foreign income received in the particular year (i.e., 2001).

We recognize that a 20(12) Deduction does not provide a taxpayer with full relief from double-taxation. We also recognize that, in some situations, the restrictions on the amount of the FTC and the 20(12) Deduction will be such that there will be no relief from double-taxation with respect to at least some of the foreign taxes paid (for example, if the individual's tax rate were 25%, instead of 30%, in the example discussed above, $500 of XXXXXXXXXX withholding tax would be unaccounted for). In our view, despite these problems, the combination of the FTC system and subsection 20(12) generally provides a reasonable level of relief from double-taxation in situations like the one discussed in this letter, given the immense complexities of coordinating the income tax schemes of two different countries. In this regard, we note that the 20(12) Deduction was intended to provide some (but not complete) relief from double-taxation for individuals paying foreign taxes not otherwise eligible for our FTC system, specifically, foreign taxes paid on income that we consider, under our laws, to be Canadian-source income. In this context, the 20(12) Deduction can be seen to be a significant concession to the taxpayer, even though it provides only partial relief from double-taxation.

The 20(12) Deduction is also available where the FTC system is applicable but the foreign taxes are not fully absorbed by the FTC, although, as we understand it, this was not necessarily the original intent of the provision. Generally, foreign taxes will not be fully absorbed by the FTC where foreign tax rates exceed Canadian tax rates or where there are timing problems (such as in the situation discussed in this letter). In the situation where the foreign tax rate exceeds the Canadian tax rate, the 20(12) Deduction actually reduces the taxpayer's overall tax liability. In our view, the 20(12) Deduction was not intended to be applied in this way, as there is no policy reason for Canada to give any relief for taxes paid to a foreign country where there is no double-taxation issue, however, the wording of subsection 20(12) allows the deduction in these circumstances. It is a different matter where a taxpayer must rely on the 20(12) Deduction because of timing problems, as there will often be unintended, unrelieved double taxation. However, in our view, this is not a problem that can generally be resolved through amendments to the Act, as timing problems usually arise out of tax-system-specific differences that are probably best resolved, if possible, on a country-by-country basis through specially designed articles in Canada's income tax conventions. Examples of such articles in the Canada-United States Income Tax Convention are Articles XIII(7) and (8), dealing with capital gains, and Article XXIX(5), dealing with the taxation of Canadian resident shareholders of so-called U.S. "S-Corps".

We trust that our comments will be useful to you. If you have any further questions about the issues discussed in this letter, please contact the officer noted above.

Jim Wilson
for Director
International and Trusts Division
Income Tax Rulings Directorate