12 April 2005 Internal T.I. 2004-0081151I7 - Foreign tax credit - tax exempt 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.

Principal Issues:

1. What is the correct exchange rate to use to convert pension income and foreign tax paid?

2. Is interest income from a foreign source included in "tax exempt income" if it is not taxable in the foreign country?

Position:

1. The Bank of Canada average annual exchange rate is acceptable.

2. Yes if the interest income is exempt under the treaty. No if it is not exempt under the treaty.

Reasons:

1. Administrative practice.

2. Even though the interest income was not taxed in the foreign country, it is not included in "tax exempt income" unless it is exempt under the treaty.

 			April 12, 2005

	ASSESSMENT & CLIENT SERVICES BRANCH	HEADQUARTERS
	Individual Returns & Payments Processing Directorate	Income Tax Rulings
			  Directorate

	Attn:  	Sheila Barnard	S.E. Thomson
		Legislation Section	(613) 957-2122
			2004-008115

		XXXXXXXXXX , 2001 T1

We are writing in response to your email of June 11, 2004 on behalf of XXXXXXXXXX (the "Taxpayer"). We apologize for the delay in responding to your query. Your query arose from a request by the Surrey Tax Centre with regard to the Taxpayer's 2001 T1 return.

The Taxpayer is a resident of Canada, and received pension and interest income from South Africa in 2001. His 2001 T1 return has been reassessed several times, but we understand that the final figures to which you and the Taxpayer agree are:

	Pension Income 	SAR XXXXXXXXXX
	Foreign Tax Paid	SAR	XXXXXXXXXX 

The Taxpayer converted the Pension Income to Canadian dollars using the Bank of Canada average annual exchange rate for 2001, which was .1823. From that amount, he has deducted $XXXXXXXXXX, which is explained further below. Therefore, in 2001, the Taxpayer's Pension Income as reported by him was:

	SAR XXXXXXXXXX  x .1823 =	$XXXXXXXXXX
	Less		   XXXXXXXXXX
	Total Pension Income	$XXXXXXXXXX 

Effectively, then, the Taxpayer has translated the Pension Income at a rate of XXXXXXXXXX / XXXXXXXXXX = .16.

The Taxpayer also converted the Foreign Tax Paid to Canadian dollars at .1823. Therefore, the Foreign Tax Paid was SAR XXXXXXXXXX x .1823 = $XXXXXXXXXX.

In addition, the Taxpayer received Interest Income from South Africa. We understand that you have agreed that this amount is $XXXXXXXXXX. The Taxpayer did not pay tax in South Africa on the Interest Income.

When computing his foreign tax credit in Canada, the Taxpayer has included both the Pension Income and the Interest Income in "qualifying incomes", as that term is used in paragraph 126(1)(b) of the Income Tax Act (the "Act").

You would like to know:

1. Has the Taxpayer translated the Pension Income and the Foreign Tax Paid using the correct foreign currency rate?

2. Is the Taxpayer correct to include the Interest Income in "qualifying incomes"?

OUR COMMENTS

1. Foreign Currency Translation Rate

Paragraph 16 of new IT-270R3 Foreign Tax Credit sets out the rates to use when converting foreign income to Canadian dollars. While pension income is not specifically mentioned, we would suggest that you could accept the rates that would be applicable to investment income or salaries or wages. Note that the instructions for completing Line 115 of the 2004 T1 on the Canada Revenue Agency (the "CRA") website state:

Use the exchange rate that was in effect on the day you received the pension. If the amount was paid at various times throughout the year, use the average annual exchange rate. The average monthly rate as well as the daily rate are available by accessing the Bank of Canada website.

We would accept that the rate of .1823 was an acceptable rate to use for 2001.

However, the Taxpayer has deducted $XXXXXXXXXX from his Pension Income. His representative, XXXXXXXXXX, explains that this is a "loss of repatriation to Canada". We presume from this that the Taxpayer deposited his Pension Income in a bank account in South Africa, and then at some later date was able to transfer the money to Canada. If our assumption is correct, the $XXXXXXXXXX loss results from the difference in the exchange rate between those two dates. We do not have enough detail to determine whether this amount is computed correctly or not, but in any case, it would be a capital loss in accordance with subsection 39(2) of the Act, not a reduction of Pension Income. More information may be found in paragraph 13 of IT-95R Foreign Exchange Gains & Losses.

To summarize, the Taxpayer has Pension Income of $XXXXXXXXXX, and a capital loss of $XXXXXXXXXX less $XXXXXXXXXX.

The Taxpayer has used the Bank of Canada average annual exchange rate for 2001 to convert the Foreign Tax Paid to Canadian dollars. This appears to be an acceptable rate, since it is the same rate used to convert the Pension Income. Paragraph 16 of IT-270R3 states:

"...an amount in respect of income taxes which is payable to a foreign government in a foreign currency should be converted to Canadian dollars at the rate at which the income itself (other than capital gains) was converted."

2. Tax Exempt Income

Subsection 126(1) of the Act sets out a limit to the amount of foreign taxes that may be used to reduce Canadian taxes. In particular, paragraph 126(1)(b) limits the credit to (in general terms):

	Qualifying incomes	x	Canadian tax otherwise payable
	  World Income

The term "qualifying incomes" from sources in a country is defined in subsection 126(7) of the Act, and computed in subsection 126(9). For more information, see paragraph 1 of IT-270R3. Subparagraph 126(9)(a)(iii) excludes from "qualifying incomes" any income or loss from a source in the country if any income of the Taxpayer from the source would be "tax exempt income".

The term "tax exempt income" is defined in subsection 126(7) of the Act, to mean income from a source in a country in respect of which:

(a) the Taxpayer is, because of a tax treaty with that country, entitled to an exemption from all income or profits taxes in that country to which the treaty applies, and

(b) no other income or profits tax is imposed in any country other than Canada (for example, no state taxes are imposed).

Because of the word "and" between paragraphs (a) and (b) of the definition, both paragraph (a) and (b) must be met in order for the income to be "tax exempt income".

The Taxpayer did not pay tax in South Africa on the Interest Income. Article 11 of the Canada-Republic of South Africa Income Tax Convention (the "Treaty") sets out the rules governing the treatment of interest paid from a source in a state to a resident of the other state. For example, paragraph 3(b)(i) of Article 11 provides that interest arising in South Africa shall be taxable only in Canada if it is paid in respect of indebtedness of the government of South Africa.

We do not have enough information to determine whether the Interest Income received by the Taxpayer is exempt from tax in South Africa under the Treaty or not. The Taxpayer did not pay tax in South Africa on the Interest Income, but we do not know if that is because it is not taxable under South African domestic law, or because it is exempt under the Treaty. If it is exempt under the Treaty, and no other foreign income or profits tax is imposed, then the Interest Income would be "tax exempt income", and would not be included in "qualifying incomes". If, however, the Interest Income is not exempt under the Treaty (even though it is not taxed under South African domestic rules), then the Interest Income would not be "tax exempt income", and would be included in "qualifying incomes". As a result, the Taxpayer would include the Interest Income in the qualifying incomes from a source in the computing the limits to the foreign tax credit.

We trust that our comments have been helpful.

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