4 June 2002 Internal T.I. 2002-0120377 - Foreign tax credit on State tax refund

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: Whether a claim for a Canadian foreign tax credit on U.S. federal tax attributable to a refund of state tax should be denied.

Position: It should not be systematically denied.

Reasons: It is reasonable to assume (unless indicated otherwise) that the state tax refund was not claimed as a Canadian foreign tax credit in the prior year.

			June 4, 2002

	HEADQUARTERS	HEADQUARTERS
	Individual Returns	Income Tax Rulings Directorate
	  & Payment Processing Directorate	S.E. Thomson
	Validations Section

Attention: Lance Lavigne
2002-012037

Foreign Tax Credit on U.S. Federal Tax Attributable to a State Tax Refund

This is in response to your email of January 25, 2002, in which you ask for clarification of our position on claiming a foreign tax credit for U.S. federal tax paid that is attributable to a U.S. state tax refund. (State tax refunds are usually taken into U.S. income in the year of receipt.) In our documents E9629001 and E9630137, we stated that such U.S. federal tax should be disallowed as a foreign tax credit in Canada, since it was likely that the U.S. state tax would have been claimed as a foreign tax credit in a prior year.

The position may be illustrated as follows:

1999
2000

Federal income per 1040
$1,000
$1,000
State tax received (paid) in year
(100)
100
Federal taxable income per 1040
900
1,100
Tax rate
x .30
x .30
U.S. federal tax
270
330
U.S. state tax
100
-
Total U.S. tax available for Canadian foreign tax credit
$370
$330

U.S. tax allowed as a Canadian foreign tax credit
$370
$300

Note that $30 has been disallowed as a foreign tax credit in year 2000 in order to compensate for an over-credit of $100 in 1999.

Our views in E9629001 and E9630137 were based on the assumption that the prior year (i.e., 1999 in the above example) state tax paid in the year ($100) was the final determination of state tax for that prior year, and that a refund arose only in rare cases where the prior year state tax return was reassessed. We had made the assumption that the taxpayer would not have refiled his Canadian return to reflect the reassessment. Therefore, disallowing the U.S. federal taxes relating to the refund in the current year was an expedient, although not perfect, way to compensate for an over-credit in a prior year.

Further, (although it is not evident in our documents), the position was meant to apply only to U.S. citizens resident in Canada. The rules in Article XXIV of the Canada-U.S. Income Tax Convention require that the income of a U.S. citizen resident in Canada be separated into separate "items of income" for purposes of calculating the maximum amount that Canada will grant as a foreign tax credit. (As noted in our document E9826226, U.S. citizens resident in Canada are subject to special rules for the relief of double taxation by virtue of paragraphs 4, 5 and 6 of Article XXIV.). Our view in E9629001 and E9630137 was that since the federal U.S. tax on the state tax refund was going to be disallowed, it was not necessary to determine the "items of income" to which such federal U.S. tax related.

You have incorporated our position in your TOM 19(25) T1 Processing Review Manual in the chapter dealing with foreign tax credit claims, and have had questions from Tax Centres regarding the position. Taxpayers are objecting to this treatment, claiming that they have not claimed the state tax that was refunded as a foreign tax credit in a prior year, so they should not be disallowed the foreign tax credit for the federal U.S. tax attributable to the state tax refund in the current year.

After further review, we are no longer are of the view that such U.S. federal tax should be systematically denied as a foreign tax credit in the calculation of tax payable in Canada, since it is reasonable to assume (unless you have evidence to the contrary) that the state tax that was refunded was not claimed as a foreign tax credit in the prior year. As you point out, the Canada Customs and Revenue Agency's position on foreign tax credits (which is supported by the legislation and the courts) is set out in IT-270R2 Foreign Tax Credit. Paragraph 21 of IT-270R2 states:

Where a taxpayer's foreign tax liability is settled by an amount withheld by the payer of the related income (i.e., analogous to tax under Part XIII), a copy of the foreign tax information slip is usually satisfactory. In most other cases, a copy of the tax return filed with the foreign government is required together with copies of receipts or documents establishing payment. Any change in the amount of foreign tax paid as a result of an assessment or reassessment subsequent to the time of filing should be reported to the Department. ...

Paragraph 13 of IT-270R2 states:

Before an amount of foreign tax can be considered in the calculation of a foreign tax credit, it must be "paid...for the year", whether paid before, during or after the year in question. ... An amount of tax paid which will be refunded to the taxpayer is not considered to be tax paid for the year. ...

The U.S. mechanism for dealing with state tax payments and refunds is explained in the Instructions for Forms 1040 and 1040NR. In the most common case, a U.S. taxpayer may claim a deduction for state tax paid in the year (as an itemized deduction on Schedule A), and must include in income state tax refunds received in the year, on a cash-flow basis. The instructions go on to say that the deduction should not be reduced for a state tax refund that the taxpayer expects to receive for the current year. This refund will be reported to the taxpayer on form 1099-G in the following year, and must be taken into income at that time (if it was deducted in a prior year).

However, in the preparation of the Canadian return, the taxpayer is required to use only the final state tax liability (as explained in IT-270R2) when calculating foreign taxes paid for the purposes of claiming a foreign tax credit or deduction in Canada. To use the example above, the taxpayer may claim only $270 as foreign tax paid for 1999, since the $100 state tax will be refunded.

Based on the above, it is our view that the portion of the U.S. federal tax payable on a refund of state tax should not be systematically disallowed from the calculation of foreign taxes credits in Canada.

For U.S. citizens resident in Canada, we suggest that if the state tax was not related to any particular source or type of income, the U.S. federal tax otherwise payable should be allocated pro-ratably to the various items of income of the current year. For example, consider the following simple example of a 1040 U.S. Individual Income Tax Return:

Canadian source income
$15,000
U.S. source income
25,000
State tax refund
1,000
Total adjusted gross income
41,000
Less itemized deductions
(10,000)
Taxable income
$31,000
Tax rate
x .40
U.S. federal tax
$12,400

The U.S. federal tax of $12,400 would be allocated to the various items of income as follows:

- Canadian source income $15,000/$40,000 X $12,400 = $4,650

- U.S. source income $25,000/$40,000 X $12,400 = $7,750

We trust that our comments have been helpful.

Olli Laurikainen,
for Director
International and Trusts Division
Income Tax Rulings Directorate