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Citation: 2005TCC479
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Date: 20050728
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Docket: 2004-883(IT)I
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BETWEEN:
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GERALD MICHEAL KARAKOCHUK,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Woods J.
[1] This appeal concerns the calculation of tax payable by a dual resident and involves the interaction between the Income Tax Act and the Canada-Australia Income Tax Convention.[1] The appellant, Gerald Micheal Karakochuk, emigrated from Canada to Australia on January 31, 1997.
[2] The appeal was subject to the informal procedure, and because the appellant lives in Australia it was dealt with in writing. The written material included an agreed statement of facts, submissions on the law, copies of the 1997 Canadian and Australian income tax returns, and copies of the various Canadian reassessments and notices of objection. The procedure is similar to the one approved of by Rip J. in Merrins v. The Queen, 2002 D.T.C. 1848 (T.C.C.).
[3] The parties' agreed statement of facts, which is included as an appendix to these reasons, does not provide a detailed explanation for the basis of the assessment. The relevant part of the agreed statement reads: "Although a resident of Australia, the Appellant was determined to be a factual resident of Canada [...] for the period of January 31, 1997 to December 31, 1997."
[4] Regardless of what "factual resident" means, it is clear from the manner in which Mr. Karakochuk was assessed that he was determined to be a dual resident for the 11-month period beginning January 31, 1997. That is, during this period he was a resident of Canada for purposes of the Act and a resident of Australia for purposes of the Convention. The parties informed me during a conference call that they both agree with the dual residence approach. Counsel for the Crown stated that this is how the tax return was filed and that the facts supported this treatment. Mr. Karakochuk stated that he believed that dual residence was more favourable to him than if he were taxed as a non-resident of Canada for all purposes.
[5] In the relevant taxation year, Mr. Karakochuk received income from several sources, one of which was pension income from the Canadian forces. To the extent that the pension income was received on or after January 31, 1997, it is eligible for a maximum tax rate of 15 percent pursuant to Article 18 of the Convention. The eligible amount is agreed to be $30,965 and the tax thereon is agreed to be $4,644 (15 percent). The dispute does not concern this amount. Essentially, the issue is the proper amount of tax payable on other sources of income.
[6] The relevant part of the Convention is Article 18 which reads:
(2) Pensions and annuities arising in a Contracting State in a year of income or taxation year may be taxed in that State and according to the law of that State but the tax so charged shall not exceed the lesser of:
(a) 15 per cent of the pension or annuity received in the year;
[...]
[7] In most cases, treaty provisions such as Article 18 are applied to persons who are not residents of Canada for purposes of the Act as well as the Convention. These situations do not present the difficulty that arises in the appeal which is to determine the tax payable by the individual as a resident of Canada under the Act while at the same time limiting tax on certain sources of income to 15 percent. There do not appear to be specific rules in either the Convention or the Act regarding how to compute the tax in these circumstances. In the absence of specific legislation, an approach that is reasonable in the circumstances should be taken.
[8] The Crown submits that the tax should be computed by a series of steps which is described in paragraph 16 of the agreed statement of facts. According to counsel, this is the standard approach used by the Canada Revenue Agency in dual residence situations. The general intent appears to be to first allocate tax computed in accordance with Part I of the Act to all sources of worldwide income, and then to reduce the tax allocated to pension income to 15 percent.
[9] Mr. Karakochuk proposes a different method that involves separate computations of tax for pension income and other income. He suggests that tax on the other income be computed in accordance with Part I of the Act and then the 15 percent tax on the pension income be added to it.
[10] Looking at Mr. Karakochuk's proposal first, it seems at first blush to be a reasonable approach to take. The question, though, is whether it is reasonable to exclude pension income from the computation of income under Part I of the Act. It can be argued that there is nothing in the Convention that allows, explicitly or implicitly, pension income to be excluded from Part I tax and that its exclusion results in an understatement of tax on other sources of income. The reason for the understatement is partly because the other sources of income are taxed in lower marginal tax brackets and partly because tax credits are allocated entirely to other sources of income.
[11] Mr. Karakochuk suggests that his approach results in the appropriate marginal tax rates being applied to other income because the pension income would, absent the Convention, be taxed at the highest marginal tax rate. I do not agree. It would be wrong to conclude that items of income are taxed at particular marginal tax rates. Section 117 of the Act imposes tax at progressive rates on different levels of income. The Act does not distinguish tax rates between sources of income and there is no reasonable basis to conclude that there is an ordering of sources of income for the purpose of applying marginal rates. For this reason, it is only reasonable to conclude that all sources of income bear a pro rata portion of the total tax payable.
[12] Turning to the Crown's proposal, it appears at first blush to be a rather complicated way to implement a simple treaty provision. It is one thing to apply a complicated formula mandated by Parliament. It is quite another to impose one when the legislation is silent.
[13] The main problem that I have with the Crown's approach, though, is that it does not produce an accurate result. If the Crown rejects the appellant's simple approach on grounds that it does not correctly apply Part I of the Act, the Crown should have an alternative that does.
[14] The formula proposed by the Crown for allocating Part I tax to pension income is:
where: A is pension income eligible for the reduced tax rate,
B is taxable income, and
C is tax otherwise payable under Part I of the Act.
[15] The problem with this formula is that it is too simplistic; the complexity of the Act does not lend itself to a standard approach. The following two examples illustrate the problem.
[16] The denominator, "B," in the fraction above is taxable income. This figure includes all income and takes into account all deductions regardless of whether the deductions relate to a source of income or not. In my view it is inappropriate to include deductions in the denominator unless those deductions reasonably relate to particular sources of income. For example, if a taxpayer is allowed a deduction for support payments to a former spouse, that deduction logically should not be included in the denominator because the result would not be a pro rata allocation of tax to sources of income.
[17] Another problem with the formula concerns tax credits. The formula has the effect of allocating tax credits among all sources of income. This might be appropriate for some tax credits (e.g. medical tax credits) but arguably it would not be appropriate for others (e.g. foreign tax credits).
[18] If the pro rata approach suggested by the Crown is accepted, it should take a taxpayer's specific circumstances into account. This would involve a careful review of all items of income, deductions and credits in order to reasonably allocate Part I tax to various sources of income. It is not apparent from the Crown's submission that this was done in Mr. Karakochuk's case.
[19] In these circumstances, I have concluded that it is appropriate to accept the approach taken by Mr. Karakochuk in this appeal. It is not necessary that I decide the difficult question of whether it would be more reasonable to undertake the more complex approach of allocating Part I tax to various sources of income as suggested by the Crown. I do not have a sufficient understanding of the necessary facts to embark on this analysis and I have not had the benefit of argument by the parties on it.
[20] As a final comment, I would note that the calculations provided to me included both federal and provincial tax. This Court has no jurisdiction over provincial tax and no breakdown was provided of the federal tax alone. From the documents filed, it appears that the federal assessment includes only a pro rata portion of the 15 percent tax because it was allocated between the two jurisdictions. I do not consider that it is necessary for purposes of this appeal that I consider whether this allocation is proper. Neither party raised it as an issue.
[21] For the above reasons, Mr. Karakochuk's appeal will be allowed and the assessment will be referred back to the Minister of National Revenue for reconsideration and reassessment in accordance with these reasons.
Signed at Edmonton, Alberta, this 28th day of July, 2005.
Woods J.
APPENDIX
AGREED STATEMENT OF FACTS
The parties hereto admit the following facts, provided that the admissions are made only for the purpose of determining the issues in the appeal before the Court.
1. On January 31, 1997 the Appellant left Canada and emigrated to Australia.
2. Although a resident of Australia, the Appellant was determined to be a factual resident of Canada subject to tax in Canada on his worldwide income for the period of January 31, 1997 to December 31, 1997, pursuant to section 2 of the Income Tax Act (the "ITA").
3. For the 1997 taxation year, the Appellant filed a return of income, form T1 General 1997.
4. The Appellant reported income in the following amounts:
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Type of Income
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Line
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Amount
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Canadian Forces Pension Income which comprised of:
Canadian Forces Pension Income earned before January 31, 1997
Canadian Forces Pension Income earned after January 31, 1997
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115
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$33,235
$2,275
$30,960
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Employment Income earned in Canada
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101
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$49,714
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Employment Income earned in Australia
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104
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$51,118
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Retiring Allowance received before leaving Canada
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130
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$81,365
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Interest
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121
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$215
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Taxable Capital Gain
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127
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$10
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Total:
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150
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$215,657
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5. The Appellant also claimed the following deductions with respect to the 1997 taxation year in the following amounts:
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Type of Income
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Line
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Amount
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RRSP Contributions
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208
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$54,000
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Pension Contributions
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207
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$10
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Investment Charges
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221
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$407
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Canadian Forces Pension earned after January 31,1997
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232
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$30,960
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Total:
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233
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$85,378
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6. As a result, the Appellant reported taxable income in the amount of $130,281 for the 1997 taxation year.
7. The Minister of National Revenue (the "Minister") initially assessed the Appellant for the 1997 taxation year on May 24, 2002 and disallowed a deduction in relation to the Appellant's pension income in the amount of $30,960.
8. The Appellant objected to the May 24, 2002 assessment by filing a Notice of Objection dated August 15, 2002, in which he requested to be considered a non-resident of Canada for tax purposes from January 31, 1997 based on article IV of the Canada-Australia Income Tax Convention ("the Convention").
9. The Minister reassessed the Appellant's income tax liability for the 1997 taxation year by Notice of Reassessment dated March 6, 2003.
10. In that reassessment, the Minister determined that the Appellant's income earned in Australia in the amount of $51,343, was not subject to tax in Canada pursuant to subparagraph 110(1)(f)(i) of the Income Tax Act (the "ITA") and the Convention. He also disallowed the Federal Foreign Tax Credit of $12,775 and the Provincial Foreign Tax Credit of $2,591 and assessed the Appellant's revised taxable income was $109,897.
11. The Appellant objected to the March 6, 2003 Reassessment by filing a Notice of Objection dated June 30, 2003.
12. On October 15, 2003, the Appellant was further reassessed for the 1997 taxation year on the basis that the amount of Canadian Forces pension of $2,270 earned before January 31, 1997 was subject to tax pursuant to Part I of the ITA and the Canadian Forces Pension (the "Pension") income earned after January 31, 1997 in the amount of $30,965 was also subject to Part I tax but restricted to an income tax rate of 15% based on Article XVIII of the Convention.
13. In order to establish the tax payable on the Pension income, the Minister segregated from the Appellant's income, the amount of Pension income earned after January 31, 1997, to calculate the 15% tax attributable to it.
14. Although the Pension income earned after January 31, 1997 was segregated for the purpose of calculating the reduced tax rate, it remained in the calculation of the Appellant's taxable income of $109,897. Although not taxed again, the Pension income was included in the computation of taxes payable pursuant to Section 117 of the ITA.
15. Therefore, the Appellant's tax liability for the 1997 taxation year was determined to be $34,660 (which includes an additional Canada Pension Plan contribution of $24.22, in addition to the federal and provincial taxes payable) rather than the $41,790.28, he would be liable for had he not been entitled to reduced tax rate of 15% of his Pension income.
16. In order to arrive at a tax liability of $34,660, the Minister made the following calculations. Starting with the amount of taxes of $41,790.28 that would normally be payable, the Minister determined the amount of tax attributable to the Pension income and arrived at a figure of $11,755 (Step 1). The Minister then applied Article XVIII of the Convention to determine the tax payable on the Pension income (Step 2). The Minister then subtracted the amount of tax payable on the Pension income with the 15% limitation from the amount of tax attributable to the Pension income without the 15% limitation; the difference was $7,130 (Step 3). The Appellant's total tax liability with the 15%
limitation on the Pension income was determined by subtracting the difference of $7,130 from the amount of taxes normally payable for a tax liability of $34,660 (Step 4).
Step 1 ($30,965/$109,897) x $41,790 = $11,774
Step 2 $30,965 x 15% = $4,664
Step 3 $11,774 - $4,644 = $7,130
Step 4 $41,790 - $7,130 = $34,660
17. The Appellant disagreed with the Minister's calculation method in determining the taxes attributable to the Pension income of $30,965 prior to the 15% Convention rate limitation, and therefore objected to the October 15, 2003 reassessment by filing a Notice of Objection dated November 13, 2003.
18. On January 28, 2004, the Minister confirmed the Appellant's tax liability for the 1997 taxation year as reassessed on October 15, 2003.
The Appellant and the Respondent agree to file the following documents or copies thereof as follows:
a) Appellant's 1997 Income Tax Return;
b) Notice of Assessment dated May 24, 2002;
c) Notice of Objection dated August 15, 2002;
d) Notice of Reassessment dated March 6, 2003;
e) Notice of Objection dated June 30, 2003;
f) Notice of Reassessment dated October 15, 2003;
g) Notice of Objection dated November 13, 2003; and
h) Notification of Confirmation dated January 28, 2004.
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