25 May 2004 External T.I. 2003-0051241E5 - Foreign Business Income 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: (i) Where a corporate taxpayer has permanent establishments in several provinces and in a foreign country, whether the formula in section 400 of the Income Tax Regulations and Schedule 5 of the T2 should be used to allocate taxable income to the provinces and the foreign country for the purposes of computing the provincial abatement under subsection 124(1) of the Income Tax Act (the "Act")? (ii) Where foreign tax paid is for a period not coincided with the taxation year of the taxpayer, whether the foreign tax paid should be apportioned to the period in the taxation year? (iii) For purposes of computing foreign business tax credit under subsection 126(2) of the Act, whether the amount of the net qualifying income referred to in subparagraph 126(2.1)(a)(i) would be the amount of the taxable income allocated to the foreign branch computed in accordance with the formula in section 400 of the Income Tax Regulations?

Position: (i) Yes. (ii) Yes. (iii) No.

Reasons: (i) Interpretation of the law. (ii) This is a reasonable and acceptable practice. (iii) The amount of taxable income allocated to the foreign branch for the purposes of computing the provincial abatement under subsection 124(1) of the Act does not have any bearing on the computation of the qualifying income for the purposes of computing foreign tax credit under subsections 126(2) and 126(2.1) of the Act.

XXXXXXXXXX 2003-005124
S. Leung
May 25, 2004

Dear XXXXXXXXXX:

Re: Foreign Business Income Tax Credit Issues

We are writing in reply to your letter of November 26, 2003 in which you requested our views on the application of subsections 124(1) and 126(2) of the Income Tax Act (the "Act") and section 400 of the Income Tax Regulations (the "ITR") to the hypothetical situation outlined in your letter and our confirmation of the tax implications of such application described in your letter.

Hypothetical Situation

1. A Canadian corporation ("Canco") carries on an active business through permanent establishments in several provinces in Canada and in a foreign country ("Country A").

2. Canco's normal taxation year-end for Canadian tax purposes is August 31.

3. The tax laws of Country A require all taxpayers, including non-resident corporations such as Canco, to report their income earned in that country and to pay tax thereon on a December 31 calendar year basis.

4. Canco commences carrying on business through a permanent establishment in Country A on March 1 of Year 1.

5. From March 1 to August 31 of Year 1, net income from Canco's foreign branch operations in Country A calculated in accordance with Canadian generally accepted accounting principles ("GAAP") and the Act is $1.2 million.

6. Canco's total taxable income for the twelve-month fiscal period ending August 31 of Year 1 from all sources is $3 million.

7. Canco's net income attributable to the foreign branch has a much greater gross profit margin than does its domestic operations.

8. The gross revenue/salaries and wages allocation of taxable income of Canco in accordance with section 400 of the ITR and Schedule 5 of the T2 Corporation Income Tax Return ("T2 Schedule 5") allocates $2.7 million of taxable income to the provinces and $0.3 million to the foreign branch for the year ended August 31 of Year 1.

9. The applicable tax rate in Country A is significantly higher than the Canadian federal tax rate in Canada before deducting the provincial abatement under subsection 124(1) of the Act.

10. Because Country A requires tax reporting on a calendar year basis, no foreign tax is paid for the period from March 1 to August 31 of Year 1.

11. From March 1 to December 31 of Year 1, foreign net income calculated in accordance with Canadian GAAP and the Act is $2 million. Foreign tax payable thereon is $900,000, which is paid by February 28 of Year 2.

You requested that we confirm the following:

(a) For the purposes of calculating taxable income earned in a province and the 10% provincial abatement as well as calculating provincial tax payable, the formula in section 400 of the ITR and T2 Schedule 5 must be applied. As a result, the provinces will obtain substantial tax revenues on $900,000 of net foreign income allocated to the provinces. Similarly, the federal government will be granting a 10% provincial abatement on $900,000 of net foreign income that will be deemed to be earned in a province and in respect of which federal foreign tax credit will also be given. Since the provinces do not grant foreign tax credits in respect of foreign business income attributable to a foreign permanent establishment as determined in accordance with section 400 of the ITR and T2 Schedule 5, Canco will incur additional tax on the $900,000 of net foreign income allocated to the provinces.

(b) For purposes of determining "business-income tax" (as defined in subsection 126(7) of the Act) paid for foreign tax credit purposes for the year ended August 31 of Year 1, Canco can prorate the foreign tax calculated and paid in respect of the period from March 1 to December 31 of Year 1. Because the amount of foreign taxes paid would not have been determined at the time that Canco would have filed its Canadian tax return for the year ended August 31 of Year 1, Canco would initially file its August 31 Year 1 T2 tax return without claiming a foreign tax credit. After the appropriate foreign tax amounts have been determined and paid, Canco would amend its return for Year 1 and claim a foreign tax credit in respect of a prorata portion of the foreign tax paid as described above. Any amount of the prorated foreign tax that was not eligible to be claimed would be added back to the unallocated portion of the foreign taxes paid for purposes of calculating the foreign tax credit at August 31 of Year 2. A similar procedure would be followed in subsequent years.

(c) For purposes of determining the amount of foreign business income for calculating foreign tax credits, such net foreign business income would be determined in accordance with Canadian GAAP and the Act. In particular, the amount of foreign business income for foreign tax credit purposes would not be that portion of the taxable income allocated to the foreign branch in accordance with the rules set out in section 400 of the ITR and T2 Schedule 5.

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.

With respect to your comments in (a) above, we agree with your view that section 400 of the ITR and T2 Schedule 5 must be used to determine the portion of the taxable income earned in the year in a particular province for the purpose of computing the 10% provincial abatement under subsection 124(1) of the Act. As a result, in the hypothetical situation outlined in your letter, a portion of the foreign business income could be allocated to a province as taxable income earned in that province where the formula described in section 400 of the ITR and T2 Schedule 5 is followed. The 10% provincial abatement under subsection 124(1) of the Act would be granted for such taxable income earned in a province. In the event that the business-income tax was not fully absorbed by the federal foreign tax credit (as the case would be because the applicable tax rate in Country A is significantly higher than the Canadian federal tax rate before deducting the provincial abatement), such business-income tax, to the extent it exceeds the foreign tax credit, would become the "unused foreign tax credit" (as defined in subsection 126(7) of the Act) of Canco for the taxation year ending August 31 of Year 1 and would be allowed to be carried back 3 years and forward 7 years.

With respect to your comments in (b) above, we agree that it is reasonable to prorate the foreign tax paid in respect of the period from March 1 to December 31 of Year 1 to determine the amount of foreign tax paid for Canadian foreign tax credit purposes for the taxation year ended August 31 of Year 1 as long as the business is not a seasonal one (i.e., revenue is earned evenly throughout the year). If the business cycle is seasonal, it may be more reasonable to prorate the foreign tax paid based on gross profit or net income earned during the relevant period than on the number of days during that period. On another matter, we do not agree with your comments that any amount of the prorated business-income tax that was not claimed because the foreign tax rate significantly exceeds the Canadian tax rate would be added back to the unallocated portion of the foreign taxes paid for purposes of calculating the foreign tax credit for the year ended August 31 of Year 2. It is our view that such amount should not be added back to the unallocated portion of the foreign taxes paid but would become the unused foreign tax credit of Canco for the taxation year ending August 31 of Year 1 that would be eligible to be carried back 3 years and forward 7 years. Even though Canco's unused foreign tax credit for the taxation year ending August 31 of Year 1 likely cannot be carried back in the fact situation described and would be available for the purposes of calculating the foreign tax credit for the year ending August 31 of Year 2 (see paragraph 126(2)(a)), the distinction may be relevant for purposes of subsection 126(2.3) of the Act.

With respect to your comments in (c) above, for the purpose of computing foreign tax credit under subsection 126(2) of the Act, the net foreign business income should be determined, as stated by Iacobucci, J. in Canderal Limited v. The Queen¹ , under a method of computation which (i) is not inconsistent with the Act or established rules of law, (ii) is consistent with well-accepted business principles, and (iii) will yield an accurate picture of the taxpayer's foreign income for the year in question. In R. v. Metropolitan Properties Co Limited² , the Court held that GAAP should normally be applied for taxation purposes, as representing a true picture of a corporation's profit or loss for a given year, and that it is only where it is justified or required by the legislation or if contrary to commonly accepted business or commercial practice that GAAP need not be followed. Therefore, your comments about determining income in accordance with Canadian GAAP and the Act may not be correct. Commonly accepted business or commercial practice should also be considered. On another matter, it is our view that, for federal foreign tax credit purposes, the net foreign business income (i.e., the amount by which the total of the qualifying incomes exceeds the total of the qualifying losses referred to in subparagraph 126(2.1)(a)(i) of the Act) would be that as computed under subsection 126(9) of the Act and would not be the amount that is the portion of the taxable income allocated to the foreign branch computed in accordance with section 400 of the ITR and T2 Schedule 5.

We trust you will find the above to be of assistance. As stated in paragraph 22 of Information Circular 70-6R5 dated May 17, 2002, the opinions expressed in this letter are not rulings and are consequently not binding on the Canada Revenue Agency.

Yours truly,

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

ENDNOTES

¹ 98 DTC 6100 (SCC), at 6109.

² 85 DTC 5128 (FCTD).

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