19 April 2011 Internal T.I. 2011-0398741I7 - Foreign Tax Credit on 10% additional US tax

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 or not the 10% additional US tax payable on the early withdrawal from an Individual Retirement Arrangement qualifies as a non-business-income tax.

Position: Yes

Reasons: The 10% additional US tax is an income or profits tax.

							April 19, 2011

Dave Turner						HEADQUARTERS
Manager
Tax Appeals Directorate				Income Tax Rulings
Canada Revenue Agency				Directorate
250 Albert Street					Bing Zhang
Ottawa ON  K1A 0L5				(613) 957-2095

							2011-039874

XXXXXXXXXX (the "Taxpayer") - 2008 Notice of Objection

This is in reply to your memorandum of March 3, 2011 wherein you requested our comments with respect to the Taxpayer's 2008 Notice of Objection and Income Tax Rulings' opinion in file E9330140 and E9304595. Unless otherwise stated, all statutory references in this letter are references to the provisions of the Income Tax Act, R.S.C. 1985 (5th supp.) c. 1, as amended ("ITA").

Background

The Taxpayer is a resident of Canada and is not a resident or a citizen of the United States ("US"). The Taxpayer has reported in his 2008 Canadian income tax return an amount that is a withdrawal from an Individual Retirement Arrangement ("IRA"). His US 1040NR shows a normal US tax payable and a 10% additional US tax payable of the withdrawal. The Taxpayer has claimed a foreign tax credit pursuant to subsection 126(1) for both these US taxes paid. The Canada Revenue Agency ("CRA") has disallowed the 10% additional US tax payable. This additional US tax payable results from the early withdrawal from the IRA.

You would like to know whether this additional US tax paid by the Taxpayer to the Government of the United States ("US") under the Internal Revenue Code (the "IRC"), is eligible for the foreign tax credit ("FTC"). XXXXXXXXXX

TSO's Position

Under the Canada-US Treaty ("Treaty"), tax on periodic pensions is limited to 15%. A withdrawal from an IRA is a lump sum payment and is therefore not subject to the 15% limitation.

The additional tax is a 10% tax payable as a result of the early withdrawal from the IRA. CRA's policy, as per TOM 19(25)(431).513(2), is to regard the additional tax as a penalty. It is therefore not considered to be a foreign tax paid.

The CRA's website "Foreign Countries Tax profiles" also states the 10% tax is not considered a tax paid for purposes of the FTC.

A FTC was allowed, which was the normal tax on the withdrawal.

The additional 10% tax was not allowed as a FTC deduction in calculating the Taxpayer's FTC.

Taxpayer's Representations

The Taxpayer objects to the reassessment on the basis that the 10% addition tax paid in the US on the IRA withdrawal is not a penalty but an additional tax imposed under IRC.

This additional tax on early withdrawal is levied under section 72(t) of the IRC. That section clearly indicates that it is an additional tax and is not a penalty.

Section 72(t) is included in Chapter 1 -Normal taxes and surtaxes of the IRC.

Penalties under the IRC are included under the Subtitle F - Procedure and Administration of the IRC.

The additional tax is clearly within the scope of the Treaty as Article II(1) of the Treaty provides that the Treaty shall apply to taxes on income and on capital imposed on behalf of each Contracting State, irrespective of the manner in which they are levied.

Article XVIII(2) of the Treaty does not apply to this IRA withdrawal because the payment was a lump-sum payment and not a periodic payment. As a result, the FTC claimed on the IRA withdrawal is not limited to 15%. Accordingly, the full amount must be allowed as a FTC.

HQ Appeals' Comments

It is your opinion that the re-assessment should be reversed and that the Taxpayer should be allowed to claim the full amount of the 10% additional US tax payable on the IRA withdrawal.

The payment on the withdrawal of the IRA meets the definition of a tax for the following reasons:

Nelson v. the Queen allows this payment as the tax is not voluntary but compulsory, enforceable by law, imposed by a public body under legislative authority for a public purpose. In addition the amount received by the Appellant was a retirement compensation arrangement which is normally included in the computation of income under the ITA.

Paragraph 56(1)(x) provides that any amount received, including the return of contributions under a retirement compensation arrangement, is included in income.

As the additional amount of US tax would not be payable, were it not for the withdrawal from the IRA and its inclusion in income, it therefore meets the definition of a "non-business-income tax" under 126(7).

The tax is not voluntary and is only payable by the taxpayer due to the fact that an amount was withdrawn from an IRA, the gross amount of which was included in the computation of his income.

Article II(1) of the Treaty states - "this convention shall apply to taxes on income and on capital imposed on behalf of each Contracting State, irrespective of the manner in which they are levied." This amount is considered a tax by the IRS code, and therefore should be allowed as a foreign tax credit, thereby eliminating double taxation.

The reply from Justice on the Nelson case stated that the impact of this decision is that early withdrawal payments made by Americans will have to be viewed as taxes paid, not as a penalty.

Article XVIII(2) of the Treaty does not apply to this IRA withdrawal because the payment was a lump-sum payment and not a periodic payment. As a result, the foreign tax credit claimed on the IRA withdrawal is not limited to 15%, and the full amount can be allowed.

Our Comments

We agree with your opinion that the re-assessment should be reversed. We conclude that the position we established in E9330140 and E9304595 regarding the 10% additional tax is not supportable in law. The 10% additional tax is in our view acceptable as a non-business income tax for the purposes of FTC for the reasons given below.

In Lawson [1931] S.C.R. 357, the Supreme Court of Canada said:

"A tax is a levy, enforceable by law imposed under the authority of a legislature, imposed by a public body and levied for a public purpose."

This judicial interpretation has been cited on several occasions including in the Nelson case. As the 10% additional tax meets all the characteristics of the definition, we agree with the following comments in the Nelson decision:

"Albeit it might be a penalty or a tax with a different name, but it certainly is a tax here."

To qualify for FTC purposes, a payment of tax must be an "income or profits tax" pursuant to subsection 126(7). Although the term "income or profits tax" is not defined in the ITA, the interpretation bulletin IT -270R3 provides some guidance: If a particular tax imposed by a foreign country is specifically identified, in an "elimination of double tax" article of an income tax treaty between Canada and that country, as a tax for which Canada must grant a deduction from Canadian taxes on profits, income or gains which arose in that other country and which gave rise to the foreign tax in question, the foreign tax will qualify as an income or profits tax when applying section 126 in conjunction with that treaty article.

Article XXIV(2)(a) of the Treaty states: ... Income tax paid or accrued to the United States on profits, income or gains arising in the United States, ...shall be deducted from any Canadian tax payable in respect of such profits, income or gains;

Subsection 72(t) of Chapter 1 (Normal Taxes and Surtaxes) of the IRC provides as follows:

If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974(c)), the taxpayer's tax for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.

The taxes to which the Treaty applies are stated to include the Federal income taxes imposed by the IRC of 1986 (Article II (2)(b)). Article XXIV(2)(a)(i) of the Treaty provides that income tax paid or accrued to US on profits, income or gains arising in US shall be deducted from any Canadian tax payable so as to avoid double taxation. Therefore the 10% additional tax is an income tax paid to the US on income arising in the US that is deductible in accordance with paragraph 2(a) of Article XXIV of the Treaty.

As the amount that was withdrawn early is a retirement compensation arrangement payment, it is normally included in the computation of income under the ITA. In addition, Paragraph 56(1)(x) says that any amount including the return of contributions received under a retirement compensation arrangement is considered income and normally subject to Canadian income tax. As the income is taxable in Canada, it is our view that the 10% additional tax is eligible for the purposes of FTC in accordance with IT-270R3.

We trust the above comments will be of assistance.

Yours truly,

Alain Godin, Manager
for Director
International and trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch