22 July 2008 Internal T.I. 2008-0284351I7 - Subsection 20(12)

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 a subsection 20(12) deduction is available in the year with respect to U.S. income tax paid for the year on the taxpayer's share of income of an S Corporation where there is no distribution of income by the S Corporation in the year?

Position: Yes.

Reasons: There is no restriction on the deductibility of foreign tax under subsection 20(12) to the actual amount of gross income received from property.

								July 22, 2008

	Calgary Tax Services Office			HEADQUARTERS
	Viviane Desrochers				Income Tax Rulings
	International Tax Auditor	  		Directorate
S. Leung, CA
(613) 952-4666

								2008-028435

Subsection 20(12) of the Income Tax Act (the "Act")
XXXXXXXXXX (the "taxpayer")

We are writing in reply to your memorandum of June 26, 2008 in which you requested our opinion as to whether the taxpayer is entitled to a deduction under subsection 20(12) of the Act in the following fact situation outlined in your memorandum.

A Canadian resident individual taxpayer owns 100% of the shares of a U.S. S Corporation. The individual reported the income of the S Corporation in his U.S. tax return in 2006. No distribution was made by the S Corporation to the taxpayer in 2006. Initially the taxpayer made a request to the competent authority of Canada pursuant to paragraph 5 of Article XXIX of the Canada-United States Income Tax Convention (the "Convention") to apply the rules specified in that paragraph and reported the income of the S Corporation as foreign accrual property income ("FAPI") in his 2006 T1 tax return. Since then the taxpayer refused to enter into an agreement with the competent authority of Canada and consequently he amended his 2006 T1 tax return to delete the FAPI and the consequential foreign tax credit. In their places, the taxpayer claimed a deduction under subsection 20(12) of the Act with respect to the U.S. tax that he paid on the S Corporation income in 2006.

You have provided us with a document containing the result of your research and analysis of the situation. In particular, you have analyzed the text of subsection 20(12) and the definitions of "business-income tax" and "non-business-income tax" in subsection 126(7) of the Act, Rulings Documents E9706145 and 2000-0043615, and IT-506 and IT-270R3, and made certain conclusions on each of them.

Our Comments

It should be noted that our following comments presumed that all the income of the S Corporation is "active business income" within the meaning of that term in subsection 95(1) of the Act; otherwise FAPI of the S Corporation would be required under section 91 of the Act to be included in computing the taxpayer's income in 2006 regardless of whether paragraph 5 of Article XXIX of the Convention would or would not apply, because the S Corporation is a controlled foreign affiliate of the taxpayer.

As stated in Rulings Documents 2003-0051851E5 (dated February 23, 2004), E931190B (dated October 17, 1996) and E9300776 (dated February 10, 1993), it is our view that a deduction in a taxation year under subsection 20(12) of the Act for U.S. tax paid by the taxpayer for the year in respect of his share of income of an S Corporation is not to be denied even though the taxpayer does not receive a distribution from the S Corporation in the year. It should be noted that the above view is not just an administrative position, as you indicated in your memorandum, ignoring the words of the provision of subsection 20(12) but it is a correct interpretation of that provision and is supported by the Department of Finance. When the expressions "from a business or property" and "in respect of that income" were added in subsection 20(12) of the Act by S.C. 1994, c. 7, Schedule VIII, s. 9(3), the Department of Finance's technical notes in respect of that amendment stated that:

"This amendment, which applies to 1992 and subsequent taxation years, provides that a deduction under subsection 20(12) is available only with respect to foreign taxes paid in respect of income from a business or property, and also clarifies that any amount claimed under that subsection is to be deducted in computing income from the source to which that tax relates."

The above-noted amendment followed the Tax Court of Canada's decision in Edgar F. Kaiser Jr. v. M.N.R. (91 DTC 1057 (TCC)). In that case the taxpayer tried to convince the Tax Court that foreign taxes paid on employment income were deductible under subsection 20(12) of the Act. The Tax Court rejected the taxpayer's contention. However, the Department of Finance did not want to leave any chance that foreign tax paid on income other than income from a business or property could be construed as being deductible under section 20(12) of the Act. As a result, the above-mentioned amendment to subsection 20(12) of the Act was made to clarify that non-business-income taxes have to relate to the business or property income being computed. Therefore, the intended use of the expression "in respect of that income" in subsection 20(12) of the Act was to clarify that non-business-income taxes paid on income from sources other than business or property (e.g., employment income) are not deductible under that subsection.

Hence, there is no doubt about the intention of the amendment to subsection 20(12) of the Act in 1994. It is not that the taxpayer is required to earn and report gross income from a business or property before a deduction of non-business-income taxes under subsection 20(12) can be allowed. All that is required is that there is a potential source of income from a business or property and that the non-business-income taxes relate to that source of income. Consequentially, the non-business-income taxes that are deducted under subsection 20(12) would reduce the income of that source for the purposes of computing foreign tax credits under subsection 126(1) of the Act. Therefore, as expressed in the Rulings Documents mentioned above, it has been Rulings' long-standing position that a loss may be created after the deduction of non-business-income taxes under subsection 20(12) as long as the foreign taxes sought to be deducted relate to an income source which is income from a business or property, even if there is no gross income from that source in the year the foreign tax is liable to be paid or if gross income from that source is less than the foreign tax paid.

With respect to the interpretation of the term "paid ... for the year" in subsections 20(11), 20(12), 126(1) and 126(2), as well as in the definitions of "business-income tax" and "non-business-income tax" in subsection 126(7) of the Act, our position as was documented in Documents E9422397 and 2005-0119421A11 is that that term relates to the year for which the foreign income or profit tax is exigible (i.e., liable to be paid). In other words, it relates to the year for which the taxpayer is liable to pay tax to the foreign jurisdiction for the income which is considered to have been earned under the tax law of the foreign jurisdiction even though the income may not be realized in Canada in the year for which the foreign tax is paid.

Because of the above interpretation, double taxation may result when the taxation year of the income inclusion in Canada and the taxation year for which the foreign tax is paid are different. This is particularly true in respect of the recognition of income (dividends) from an S Corporation by a shareholder and the payment of foreign taxes in respect of the shareholder's share of the S Corporation income. To remedy this timing problem, paragraph 5 of Article XXIX of the Convention was introduced which applies to a Canadian taxpayer who enters into an agreement with the Canadian competent authority. The effect of the agreement which is subject to certain terms and conditions is basically that all the income of the S Corporation will be treated as FAPI and the Canadian taxpayer's share thereof is included in his income for Canadian tax purposes under the provision of section 91 of the Act in the year it is earned by the S Corporation. FAPI is income from a share (i.e., U.S. source property income) for the purposes of section 126 of the Act. Accordingly, the taxpayer who enters into the competent authority agreement and has paid U.S. tax on the income of an S Corporation can then claim a foreign tax credit under section 126 of the Act. When dividends are later paid by the S Corporation, the agreement will provide that they will be excluded from the taxpayer's income. The agreement simply removes the timing problem that would otherwise exist and facilitates the operation of the Canadian foreign tax credit provisions so as to eliminate double taxation.

We trust you will find the above satisfactory. However, if you have any questions regarding the above, please do not hesitate to contact Simon Leung by email or phone (613-952-4666).

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Canada Revenue Agency's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Request for this latter version should be made by you to Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Yours truly,

Olli Laurikainen, CA
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch