29 March 2004 External T.I. 2003-0040581E5 - Section 110.5 and Foreign Tax Credit

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.

Principal Issues: Whether section 110.5 can be used to create foreign source income for foreign tax credit purposes in order to solve the timing problem of recongizing income?

Position: No.

Reasons: It was not designed for that

XXXXXXXXXX 		2003-004058
S. Leung
March 29, 2004

Dear XXXXXXXXXX:

Re: Section 110.5 of the Income Tax Act (the "Act")

We are writing in reply to your letter of September 15, 2003 in which you requested our opinion regarding the application of section 110.5 of the Act to the following situation outlined in your letter.

Canco, a taxable Canadian corporation within the meaning of subsection 89(1) of the Act, realized a gain on the sale of real property situated in the U.S. For Canadian income tax purposes, the gain was realized in year 1 but for U.S. tax purposes, because of the instalment sale rules, the gain was only realized in year 10.

It is your understanding that under subsection 126(2) of the Act a foreign tax credit ("FTC") would only be granted in year 10 for U.S. tax paid for that year if Canco has U.S. source income in that year. You requested our opinion as to whether, if Canco was to increase its taxable income under section 110.5 of the Act in year 10, such increase in taxable income would be considered U.S. source income for Canadian FTC purposes.

Our Comments

The situation outlined in your letter appears to relate to an actual situation involving an identifiable taxpayer. Accordingly, the applicable Tax Services Office should be consulted with respect to the income tax liabilities of such a taxpayer. However, we can offer the following general comments.

Section 110.5 of the Act was designed to permit a corporation to increase its taxable income in order to avoid the wastage of the foreign tax credit in a year when a loss incurred by the corporation reduces its net adjusted income (i.e., the denominator of the formula for the computation of that proportion of the tax for the year otherwise payable under Part I which is attributable to the foreign source income, whether for purposes of paragraph 126(1)(b) or for purposes of paragraph 126(2)(b) and subsection 126(2.1) of the Act, as the case may be) to an amount that is less than its foreign source income. It was not designed to produce or increase the corporation's foreign source income and specifically it was not designed to resolve the timing problem of recognizing income in Canada and in a foreign country. That is why under section 110.5 of the Act an amount is added only to taxable income, not foreign source income. Also, please refer to clause 126(1)(b)(ii)(B) (for purposes of the FTC computed under subsection 126(1)) and to clause 126(2.1)(a)(ii)(B) (for purposes of the FTC computed under subsection 126(2)) as further support.

In the situation outlined in your letter, since there is no foreign source income for Canadian tax purposes in year 10, Canco would not be entitled to add an amount to its taxable income under section 110.5 of the Act. Section 110.5 only allows a corporation to add an amount to taxable income to the extent that the addition increases any amount deductible by the corporation under subsection 126(1) or 126(2) for the year. Where there is no foreign source income in a particular year for Canadian tax purposes, it is not possible for an amount to be deductible under either subsection 126(1) or 126(2) of the Act.

If the foreign tax paid for year 10 is a business-income tax within the meaning assigned by subsection 126(7) of the Act, any unused amount would become "unused foreign tax credit" (defined under subsection 126(7) of the Act) which can be carried back three years or carried forward seven years. If Canco is carrying on a business in the U.S., we would assume that it would have U.S. source business income in other years so that it could utilize the unused foreign tax credit. If the foreign tax paid for year 10 is a non-business-income tax within the meaning assigned by subsection 126(7) of the Act, Canco would not be entitled to a deduction under subsection 20(12) of the Act where the tax is in respect of a capital gain.

There is no relief provided by the Canada-United States Income Tax Convention (the "Convention") with respect to the timing problem described in the situation above where the taxpayer is a corporation (e.g., paragraph 7 of Article XIII of the Convention only applies to a taxpayer who is an individual). You may want to consult a U.S. tax advisor to find out if you can accelerate the recognition of income from year 10 to year 1 in the U.S. so as to solve this problem due to the timing of recognizing income in the two countries.

We trust you will find the above to be of assistance.

Yours truly,

Jim Wilson
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Planning Branch

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