3 March 1997 Internal T.I. 9641327 - SUBSECTION 20(11) AND TAX TREATIES

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

Interaction of subsection 20(11) with tax treaties

Position:

Excess tax over what is required in accordance with the treaties is not deductible under subsection 20(11) except for U.S. tax paid by U.S. citizens resident in Canada on interest, dividend or royalties.

Reasons:

Not an income or profits tax paid except for paragraph 5 of Article XXIV of the Canada-U.S. Income Tax Convention

		March 3, 1997

R. Léger	International Section
	Director	S. Leung
	Saint John Tax Services Office	957-2115

Attention: Louise Bolduc, Client Services

		964132

Subsection 20(11) of the Income Tax Act

We are writing in response to your memorandum of December 11, 1996 in which you requested our interpretation of subsection 20(11) of the Income Tax Act (the "Act") in relation to the income tax treaties that Canada has with other countries. Under these treaties the taxation by the other countries of certain types of income (such as interest) received by a resident of Canada from sources in those countries is usually limited to a certain percentage¹ of the gross amount of such income (the "Treaty Rate"). You enquired that if income taxes otherwise payable to those countries (before foreign tax credits, if any, granted by those countries) by an individual resident in Canada on such income exceed 15% of such income, whether the excess income tax is eligible for a deduction under subsection 20(11) of the Act.

Subsection 20(11) of the Act -- General Principles

In general, an amount is deductible under subsection 20(11) of the Act if

it is an income or profits tax paid to a country other than Canada in respect of an amount that has been included in computing the income of an individual from a property other than real property; and

it is that portion of the tax referred to in (i) that exceeds 15% of the amount that has been included in computing income referred to in (i).

Hence, among other things, in order for an amount to be deductible under subsection 20(11) of the Act, it must be an income or profits tax paid to a foreign country in respect of income from a property (other than real property) that an individual has included in computing his income in Canada.

Certain Income Is Not Income from Property

Only foreign income or profits tax in respect of income from a property (other than real property) is eligible for the subsection 20(11) deduction. Hence, foreign taxes in respect of employment income, business income, pension income, annuity income, alimony payments, social security payments, capital gains, etc. are not eligible for the deduction because such income is not income from a property.

Tax in Excess of Treaty Rate Is Not an Income or Profits Tax

Whether or not a resident of Canada opts out of a tax treaty that Canada has with another contracting state, generally, income tax paid to the other contracting state in excess of what is required under the tax treaty is considered to be a voluntary payment,² not an income or profits tax for purposes of subsection 20(11) or the definition of "non-business-income tax" or "business-income tax" in subsection 126(7) of the Act. This is because the treaty has removed the obligation to pay income tax to that contracting state in excess of the Treaty Rate. Hence, the taxpayer is entitled to a refund of such excess tax from that contracting state. For example, if an individual taxpayer resident in Canada who is not a U.S. citizen receives periodic pension income or dividend income from sources in the U.S., under the Canada-U.S. Income Tax Convention (the "Convention"), U.S. tax is limited to 15% of the gross amount of such income. If such taxpayer opts out of the Convention or simply pays U.S. tax on such income in excess of 15% of such income, the excess U.S. tax is not deductible under subsection 20(11) or 20(12) of the Act and is not eligible for a foreign tax credit in Canada. The U.S. should refund the amount of the excess tax.

If under a tax treaty that Canada has with a contracting state the Treaty Rate on certain item of income, such as royalties, is 10% of the gross amount of such income, the amount by which the tax paid to the foreign country in excess of 15% of the gross amount of such income is not deductible under subsection 20(11) of the Act and the amount by which the foreign tax paid in excess of 10% of such income is not deductible under subsection 20(12) of the Act and is not eligible for a foreign tax credit in Canada.

U.S. Citizens Resident in Canada

If the individual is a U.S. citizen resident in Canada, paragraph 5 of Article XXIV of the Convention provides for an exception to the rule described above in respect of dividends, interest or royalties which are sourced to the U.S. (within the meaning of paragraph 3 of Article XXIV of the Convention) and received by the individual.³ Paragraph 5 of Article XXIV of the Convention requires that as long as the law in force in Canada allows a deduction in computing income for the portion of any foreign tax paid in respect of such items of income which exceeds 15% of the amount thereof, the deduction so allowed by Canada shall not be reduced by the amount of the U.S. credit for Canadian tax paid or accrued on such items of income. In other words, that paragraph provides that a deduction equivalent to the subsection 20(11) deduction must be computed on the amount of the U.S. tax otherwise payable on the particular item of income before the U.S. tax credit is granted in spite of the fact that a lower amount of U.S. tax is actually paid after the U.S. foreign tax credit.⁴ This is illustrated in the example in Appendix A attached.

For U.S. source income other than dividends, interest or royalties, such as pension or annuity income, received by a U.S. citizen resident in Canada, paragraph 4 instead of paragraph 5 of Article XXIV of the Convention applies and the U.S. tax in respect of such item of income is limited to the amount of income tax in respect of that item of income that the U.S. would be allowed to collect if the person who is a resident of Canada were not a U.S. citizen. Canada is only obliged to grant a tax credit for U.S. tax to the extent of the tax that the U.S. would be allowed to collect under the Convention if the person who is a resident of Canada were not a U.S. citizen. In the case of periodic pension payments sourced to the U.S., the maximum credit Canada is required to grant for U.S. income taxes paid on such income is 15% of the gross amount of such income. The U.S. is obliged to grant a credit against its tax for Canadian tax paid or accrued after the credit that Canada has granted for U.S. tax.⁵

You enquired whether paragraph 2 of Article XXIX of the Convention would allow the U.S. to tax its citizens without limit and whether Canada has to provide foreign tax credits for those U.S. taxes paid by U.S. citizens. It should be noted that paragraph 2 of Article XXIX of the Convention shall not, by virtue of paragraph 3 of that Article, affect the obligations undertaken by the U.S. under Article XXIV of the Convention. Therefore, in the case of U.S. citizens resident in Canada, for U.S. foreign tax credit purposes, the U.S. is required under paragraphs 4(b) and 5(c) of Article XXIV of the Convention to grant a tax credit for Canadian tax paid (after Canadian tax credit) such that the U.S. tax after the tax credit is generally reduced to the amount of the tax that would have been paid if the individual were not a U.S. citizen notwithstanding paragraph 2 of Article XXIX of the Convention.⁶

Income from Property Arises in Non-Treaty Countries

Since a non-treaty country is not obligated under a tax treaty with Canada to limit its taxation on any income received by the individual resident in Canada from that country, that portion of the income tax paid to the government of that country in respect of income from a property (other than real property) received by that individual which exceeds 15% of such income is deductible under subsection 20(11) of the Act. The remaining 15% of such income is eligible to be used as foreign tax credit under subsection 126(1) of the Act or as a deduction under subsection 20(12) of the Act.

We trust you will find the above to be of assistance. If you have any question regarding the above, please do not hesitate to contact either Simon Leung (phone number: (613) 957-2115) or Ken Major (phone number: (613) 957-2124) of this Directorate.

for Director
Reorganizations and International Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

APPENDIX A

The following example is a modified version of Example C in the commentary on Article XXIV in the Technical Explanation to the Convention which is adopted here to illustrate that

U.S. tax otherwise payable (before foreign tax credit)⁷ is required to be determined on each item of U.S. source income;

Once the U.S. tax otherwise payable (before foreign tax credit) of a particular item of income is determined, one needs to compare that with the tax that the U.S. would be allowed to collect under the Convention if the taxpayer who is a resident of Canada were not a U.S. citizen. Canada is only obliged to grant a tax credit for the lesser of these rates.

The tax that the U.S. would be allowed to collect on a particular item of income if the taxpayer were not a U.S. citizen is the lesser of the U.S. income tax on such item of income of such a person under the Internal Revenue Code and the U.S. income tax permitted on such item of income of such a person under the Convention; and

If the item of income is dividend, interest or royalty which is sourced to the U.S. under the Convention and which is subject to a positive rate of tax under the Internal Revenue Code if the taxpayer were not a U.S. citizen, Canada is required to grant an equivalent to the subsection 20(11) deduction based on the U.S. tax otherwise payable (before foreign tax credit) in respect of that item of income as referred to in (a) above.

Example

Assume the following in respect of a U.S. citizen resident in Canada:

• Employment income sourced to Canada is $200;
• Dividend income sourced to the U.S. is $100;
• Taxable income in U.S. after taking into account the foreign earned income exclusion (Code Sec. 911) is $220;
• U.S. income tax otherwise payable (before foreign tax credit) on such taxable income is $92;
• Canadian income tax (before foreign tax credit) on taxable income of $273.18 (after allowing a section 20(11) deduction) is $130;
• Ignore foreign exchange and U.S. alternative minimum tax.

First we need to determine the U.S. tax otherwise payable (before foreign tax credit) for each item of U.S. source income not resourced to Canada. In this example the portion of the U.S. tax otherwise payable (before foreign tax credit) attributable to U.S. source dividend income is:

= $100 x $92 = $41.82
$220

Then we need to compare this amount to the tax that the U.S. would be allowed to collect on such item of income if the taxpayer were not a U.S. citizen. If the taxpayer were not a U.S. citizen, the U.S. source dividend which is not effectively connected with the conduct of a U.S. trade or business is subject to a U.S. withholding tax of $30 (i.e., 30% of $100) under the Internal Revenue Code. However, under paragraph 2 of Article X of the Convention, the U.S. tax on such item of income is limited to $15 (i.e., 15% of $100) if the taxpayer were not a U.S. citizen. Hence, Canada is not required to grant a tax credit of more than $15 (i.e., the lesser of $30 and $15) against its income tax otherwise payable (before foreign tax credit) on such dividend income for taxes paid or accrued to the U.S.

Canada allows an equivalent to the subsection 20(11) deduction of $26.82 (i.e., U.S. tax otherwise payable (before foreign tax credit) of $41.82 in respect of such dividend income minus $15). Canadian taxable income is thus equal to $273.18 (i.e., $300 - $26.82). Canadian tax on such taxable income is $130 as referred to in the assumptions above. Canada provides a credit of $15 resulting in net Canadian tax (i.e., after foreign tax credit) of $115.

The U.S. will provide a credit for Canadian taxes paid on the dividend after the tax credit for U.S. taxes but such a credit will not reduce the equivalent to the subsection 20(11) deduction or U.S. tax below 15% of the gross amount of the dividend.

ENDNOTES

¹ typically 15% or less

² U.S. alternative minimum taxes paid by U.S. citizens resident in Canada may not be considered to be voluntary payments. A separate paper dealing with U.S. alternative minimum taxes will soon be issued by this Directorate.

³ Note that after 1995, as a result of the entering into force of the Third Protocol to the Convention, paragraph 5 of Article XXIV only applies where the dividends, interest or royalties which arise in the U.S. (within the meaning of paragraph 3 of Article XXIV) are subject to a positive rate of tax in the U.S. if the individual were not a U.S. citizen. Hence, if the individual is not liable to U.S. tax on such items of income had the individual not been a U.S. citizen (for example, interest on deposit in a U.S. savings and loan association which is not effectively connected with the conduct of a trade or business in the U.S.), any U.S. tax paid on such income is considered to be a voluntary tax, not an income or profits tax. Canada is not obliged to allow an equivalent to the subsection 20(11) deduction or a tax credit for such tax. However, for the same situation but prior to 1996, Canada is obliged to allow an equivalent to the subsection 20(11) deduction and to grant a tax credit for U.S. tax otherwise payable (before U.S. tax credit) which exceeds 15% of the gross amount of such income.

⁴ Because of this peculiarity, the deduction referred to in subparagraph 5(a) of Article XXIV of the Convention is not in respect of income taxes paid and is, therefore, referred to as an equivalent to the subsection 20(11) deduction.

⁵ At the present time U.S. citizens resident in Canada are subject to U.S. alternative minimum tax and such tax may increase the amount of the tax credit given by Canada on U.S. source pension income.

⁶ The U.S. presently applies U.S. alternative minimum tax ("AMT") to its citizens resident in Canada. In Canada's view, the AMT rule that restricts the foreign tax credit to a maximum of 90% of the tentative minimum tax (before the credit) is in contravention of the Convention.

⁷ Such tax otherwise payable is generally the amount of U.S. tax shown on line 40 of Form 1040 U.S. Individual Income Tax Return (for 1995 taxation year) less all the credits on line 41 (Credit for Child and Dependent Care Expense), line 42 (Credit for Elderly or the Disabled), and line 44(b) (Mortgage Interest Credit from Form 8396) of Form 1040.