13 June 1997 Income Tax Severed Letter 9629001 - U.S. STATE INCOME TAXES

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:

(i) credit for U.S. state income taxes on California pension income and (ii) treatment of taxable refunds of state income tax

Position:

(i) creditable in Canada but should not affect U.S. federal tax credit that the U.S. is required to provide under Article XXIV (4)(b) of the Canada-U.S. Income Tax Convention. (ii) Where tax credit has been previous granted for the U.S. state tax, our position is that no adjustment to the Canadian tax return need be made and the portion of the U.S. federal tax allocatable to the taxable refunds of state tax should be ignored in computing Canadian tax credit for the year of the refunds.

Reasons:

see memo to file

Memo to File

file number 962900
Simon Leung
June 13, 1997

We have considered two issues as follows:

Issue #1:Foreign Tax Credit for California State Income Tax on Pension Income sourced to California

Issue:Is the California State income tax on periodic pension payment received from California by a U.S. citizen resident in Canada creditable for Canadian foreign tax credit purposes?

Position:Yes but generally such Canadian tax credit should not affect the U.S. federal tax credit that the U.S. is required to grant under paragraph 4(b) of Article XXIV of the Canada-U.S. Income Tax Convention (the "Convention")

RationaleIt is because the California State income tax on the periodic pension payment is an income or profits tax under the definition "non-business-income tax" in subsection 126(7) of the Income Tax Act (the "Act").

Analysis:

California levies income tax on pension payment sourced to the State of California. It does not matter whether the recipient of the pension payment is a resident or a non-resident of the State of California or whether or not he or she is a U.S. citizen at the time he or she receives the pension payment.¹

Periodic pension payment is not income from business or from a property. Hence, foreign income tax paid on periodic pension payment is not eligible for a deduction under either subsection 20(11) or 20(12) of the Act.

For a U.S. citizen resident in Canada, paragraphs 4 and 5 of Article XXIV of the Convention govern the provision of tax credits by each Contracting State for income taxes paid or accrued to the other Contracting State. Under paragraph 4(a) of Article XXIV, Canada is obliged to provide a credit for tax paid or accrued to the U.S. on income, profits or gains (other than those described in paragraph 5 of that Article) arising in the U.S. (within the meaning of paragraph 3 of Article XXIV). Income taxes paid or accrued to the U.S. include, by virtue of paragraph 7 of Article XXIV for the purposes of that Article, any taxes of general application which are paid or accrued to a political subdivision or local authority of the U.S. which are not imposed by the political subdivision or local authority in a manner inconsistent with the provisions of the Convention and which are substantially similar to the U.S. taxes (as defined in Article III of the Convention). Paragraph 7 of Article XXIV of the Convention is the only reference to "state or local income taxes" in the Convention.

It is our view that for purposes of paragraph 7 of Article XXIV of the Convention if the total U.S. federal and state income taxes on periodic pension payment exceed 15% of the gross amount of such payment, the portion of the state tax that represents the excess would not be considered to be a tax imposed in the manner consistent with the provisions of the Convention since the provisions of the Convention limit the U.S. tax rate on periodic pension payment to 15% of such payment. As such, the excess state tax would not be considered to be "tax paid or accrued to the U.S." as that term is used in paragraph 4(a) of Article XXIV of the Convention. For example, if U.S. federal income tax on the periodic pension payment is at 13% of the gross amount of such payment and the California State tax is at 5%, California State tax equal to 3% of the pension payment would not be considered to be part of the taxes paid or accrued to the U.S. for purposes of paragraph 4(a) of Article XXIV and thus would not be creditable in Canada under that paragraph.

Under paragraph 4(b) of Article XXIV, the U.S. is obliged to grant a credit for Canadian tax paid after the deduction from Canadian tax payable referred to in paragraph 4(a) of Article XXIV. Consequently, the U.S. is obliged to provide a tax credit for Canadian tax paid after Canada grants a tax credit for U.S. taxes (federal and state) paid up to 15% of the periodic pension payment (i.e., not including credit for the excess 3% state tax).

If the U.S. federal income tax on the periodic pension payment is 15% of the payment or greater, paragraphs 4(a) and 4(b) of Article XXIV would apply before taking into account the credit that Canada would grant under the Act for the state income tax on such pension payment.

However, since the excess state tax is an income or profits tax paid to a foreign country, it qualifies as a non-business income tax eligible for foreign tax credit in Canada. Such credit should not reduce Canadian income tax for the purposes of the credit for foreign taxes which the U.S. must provide under paragraph 4(b) of Article XXIV of the Convention. This results from the fact that the U.S. must grant a credit for Canadian taxes after Canada grants credit only for U.S. and state taxes paid in accordance with the Convention.

The following examples would help to illustrate the application of such credits.

Example I:

Ignore the foreign exchange between Canada and the U.S. and assume the following:

-Periodic pension payment from sources in California is $10,000;
-Canadian tax before foreign tax credit on such income is at 40% or $4,000;
-U.S. federal tax before foreign tax credit is at 28% or $2,800;
-California State tax is at 5% or $500;

Under the Convention, Canadian foreign tax credit would be $1,500 (i.e., 15% of the periodic pension payment of $10,000) which is the amount of the tax paid or accrued to the U.S. if the taxpayer were not a U.S. citizen. Because U.S. federal tax has already exceeded 15% of the gross amount of the periodic pension payment, the California State tax on such income is not considered to be imposed consistently with the provisions of the Convention and as such is not treated as part of the "taxes paid or accrued to" the U.S. for purposes of paragraph 4(a) of Article XXIV. Therefore, Canada is not obliged to grant a credit for such state tax under the Convention.

U.S. tax credit for Canadian tax paid would be $1,300 because U.S. federal tax after the tax credit could not be reduced to an amount less than the amount that the U.S. would be able to tax if the recipient of the periodic pension payment were not a U.S. citizen (i.e., the U.S. source basis tax). Therefore, the maximum U.S. tax credit is $1,300 which is equal to the U.S. federal tax of $2,800 less the source basis tax of $1,500.

As a result, the taxpayer's tax liability on the periodic pension payment is

Canadian tax before credit for state
income tax  ($4,000 - $1,500)               $2,500
Less: credit for state income tax	  $ (500)
								  $2,000
U.S. federal tax before foreign tax credit  $2,800
Less: U.S. foreign tax credit which is the
lesser of $2,500 (Canadian tax
before credit for state income tax)
and $1,300 (U.S. federal tax of
$2,800 less the U.S. source basis
tax of $1,500)					  $1,300
								  $1,500
California State income tax		  $  500
Total						  $4,000  

Example II:

Assume the same facts as in Example I except that the U.S. federal income tax on the periodic pension payment is $1,300 instead of $2,800.

Because U.S. federal income tax is only $1,300 which is less than 15% of the periodic pension payment, $200 of the California tax of $500 would be considered to be taxes paid or accrued to the U.S. for purposes of paragraph 4(a) of Article XXIV. Therefore, Canada is obliged to grant a credit of $1,500 under that paragraph. The tax liability of the taxpayer would be:

Canadian income tax before credit for excess
state income tax   ($4,000 - $1,500)           $2,500
Less: credit for excess state income tax       $ (300)
     $2,200
U.S. federal income tax (since U.S. federal tax
is less than U.S. source basis tax, there is no
U.S. tax credit in this case		     $1,300
California State income tax		     $  500
Total						     $4,000 

Example III:

Assume the same facts as in Example I except that the Canadian income tax on the periodic pension payment is $3,000 instead of $4,000.

In this example, you will see that although the net Canadian tax after credit for U.S. state income tax is only $1,000, the Canadian tax before the credit for state income tax is $1,500. The U.S. is required to grant a tax credit of $1,300 against its federal tax.

The total tax liability of the taxpayer would be:

Canadian income tax before credit for state
	income tax  ($3,000 - $1,500)              $1,500
Less: Credit for state income tax          $ (500)
								 $1,000
U.S. federal income tax before tax credit  $2,800
	Less: U.S. foreign tax credit which is
	the lesser of $1,500 (Canadian tax
	before credit for state income tax)
	and $1,300 (U.S. federal tax of
	$2,800 less U.S. source basis tax
	of $1,500)					 $1,300
								 $1,500
	California State income tax		 $  500
Total						 $3,000 

Issue # 2: Taxable Refund of State Income Tax

Another issue is whether U.S. federal income tax on taxable refund of state income tax is creditable for Canadian foreign tax credit purposes.

Taxable refund arises as a result of a refund of an overpayment of state income tax of the preceding year. Since the amount of the state income tax has been allowed as part of the itemized deductions for U.S. federal income tax purposes in the preceding year, the refund of such tax is required to be included in income for U.S. federal income tax purposes in the year it is received. In the preceding year when itemized deductions have been overstated because of the overstatement of state income tax, U.S. federal income tax for Canadian foreign tax credit purposes would be understated resulting in an understatement of Canadian tax credit for U.S. federal income tax. However, Canada has probably granted a foreign tax credit for the overstated state income tax in the preceding year, and such an overstatement of credit for state income tax would exceed the understatement of credit for U.S. federal income tax so that the taxpayer has most likely been granted too much Canadian foreign tax credit in that year.

Position

Where a Canadian tax credit has been granted in the preceding year, our position is that no adjustment to the Canadian tax return of the preceding year need be made and the portion of the U.S. federal income tax otherwise payable on the taxable refund of state income tax should be ignored for Canadian foreign tax purposes as too much tax credit has already been granted in the preceding year.

endnotes

¹ See California State publication FTB PUB.1005 "Pension and Annuity Guidelines" and "California Forms & Instructions -- Nonresident or Part-Year Resident -- 1995 Personal Income Tax Booklet".