2014-0525231I7 Foreign tax credit

Principal Issues: Can a foreign tax credit be claimed against Canadian income tax on a deemed gain arising under ss.40(3) in the circumstances described?

Position: No.

Reasons: Foreign tax is likely a voluntary payment and not a “tax” within the meaning of ss. 126(1); ss. 40(3) deemed gain is not foreign source income.

Author: Belova, Julia
Section: 126(1); 2; 3; 4; 12(1); 90(1); 113(1); 40(3); 108(5)

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                                                                                                                                         Income Tax Rulings
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      XXXXXXXXXX TSO                                                                                                  Julia Belova
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                                                                                                                                         2014-052523
      Foreign Tax Credit

We are writing in response to your email dated March 24, 2014, in which you asked for our views regarding a Canadian corporation’s ability to claim a foreign tax credit (“FTC”) in the circumstances described below.

Unless otherwise stated, all references to a statute are to the Income Tax Act (Canada), R.S.C.  1985, c.1 (5th Supp.), as amended to the date of this letter (the “Act”) and every reference herein to a section, subsection, paragraph, subparagraph or clause is a reference to the relevant provisions of the Act.

Our understanding of the facts relevant to your question is as follows:
1.    The taxpayer (“Canco”) is a taxable Canadian corporation.
2.    During its XXXXXXXXXX taxation year Canco received a dividend from a Japanese resident company (“Forco”), in which it held a XXXXXXXXXX% interest.
3.    The dividend from Forco was subject to Japanese withholding tax.
4.    Forco is a foreign affiliate of Canco for purposes of the Act.
5.    As a result of a CRA audit it was determined that a portion of the dividend was paid from the pre-acquisition surplus of Forco and resulted in a deemed capital gain under subsection 40(3). Canco will be subject to Canadian income tax on the taxable portion of the gain.
6.    The Japanese withholding tax paid on the dividend (described in paragraph 3 above) was taken into account under paragraph 92(2)(d) in computing the reduction of the adjusted cost base of Forco’s shares under subsection 92(2). The withholding tax does not qualify for a FTC under subsection 126(1).
7.    Subsequent to the receipt of the dividend described in paragraph 2 above, in the same taxation year, Canco disposed of the shares of Forco by way of a dividend distribution to its non-resident parent company.
Canco paid Japanese income tax on the capital gain realized on the disposition of Forco’s shares and reported a capital gain for Canadian tax purposes.
8.    Canco subsequently determined that the fair market value of Forco’s shares at the time of the disposition was nil such that the disposition did not result in a taxable capital gain for Canadian tax purposes. The CRA accepted the revised valuation.
9.    Despite the significant disparity between the revised value of Forco’s shares and the value initially used in computing the capital gain for Japanese tax purposes, the taxpayer decided not to pursue a refund of tax from the Japanese tax authorities and instead decided to rely on the Canadian domestic legislation to claim a FTC against the Canadian income tax payable on the taxable portion of the subsection 40(3) gain described in paragraph 5 above.
10.   Canco had no income during the taxation year from a source in Japan.  At issue is the source of the subsection 40(3) gain described in paragraph 5 above, which the taxpayer purports to have arisen in Japan.

You asked us to consider whether Canco can claim a FTC under subsection 126(1) in respect of the Japanese income tax paid on the capital gain on the disposition of Forco’s shares against Canadian income tax payable on the deemed gain under subsection 40(3) that arose earlier in the taxation year as a result of the receipt of the pre-acquisition surplus dividend from Forco in excess of the adjusted cost base (“ACB”) of Forco’s shares. More specifically, you asked us to consider whether the deemed gain should be considered to be Canadian-source income.

Our Comments

We are of the view that subsection 126(1) will not apply to permit a FTC in respect of the Japanese income tax paid on the disposition of the shares of Forco.

Your question focused on the territorial source of the deemed gain.  However, even without the consideration of the source it is likely that a FTC will not be available on the basis that the tax paid to the Japanese tax authorities was a voluntary payment and not “tax” within the meaning of subsection 126(1).  In Meyer (footnote 1) the court found that U.S. tax paid in excess of the reduced Treaty rate was not a “tax”.  This finding was largely based on the following CRA submissions:

21. A mistaken excessive payment cannot be a tax. It lacks the necessary element of compulsion - the source of the overpayment was not the U.S. taxing authority but rather the Appellant himself.

22. Moreover, the excessive payment should be refundable. Admittedly, there is no evidence supporting this contention. However, there is also no evidence before the Court that the U.S. would be unwilling to refund the excessive payment once properly informed of the mistake.

23. If the Appellant has missed the limitation period and cannot receive a refund due to inaction on his part, that does not make the initial mistaken payment compulsory.

24. For these reasons the excessive payment by the Appellant was not a tax and therefore cannot be included in the definition of “non-business-income tax”.

Having reviewed the CRA submissions and the relevant case law (footnote 2) Justice Hershfield stated:

While I have some reservations in accepting the notion that the CCRA can determine if a foreign tax paid is a voluntary payment and therefore not a “tax”, on the facts of this case, based on the authorities cited by the Respondent, I accept that the amount in dispute was not a “tax” paid to the foreign jurisdiction in question. That is not to say however that all voluntary payments are not a “tax”. For example, that one might not claim discretionary deductions and voluntarily increase the tax in a foreign jurisdiction would not entitle the CCRA to deny a credit on that basis. Nor should the CCRA dictate any foreign filing position on a resident taxpayer. However, where the resident taxpayer has approached his foreign filing position without regard to providing the information necessary to determine the tax payable, such as not submitting required forms or return information to claim a Treaty entitlement, and has refused to correct the error or establish that it was not in error, the resultant overpayment can be regarded as an amount paid other than as a “tax”.

…I wish to emphasize that it is always open to the taxpayer to bring evidence that the foreign tax paid was not gratuitously paid without basis under the laws of the foreign jurisdiction. That is a question this Court can determine but the onus is on the taxpayer. The Appellant chose to ignore that onus and simply wanted the CCRA to work it out with the U.S. Treasury or Internal Revenue Service and leave him out of it. This is not an acceptable position in my view. That is, while the language of section 126 does not ultimately permit the CCRA to deny a credit because it has reason to believe that the foreign tax has been erroneously calculated under the laws of that foreign jurisdiction or is limited by provisions of the tax Treaty between that jurisdiction and Canada, nothing prevents it from taking that position and putting the onus on the taxpayer to show that such belief is not well-founded.

Given that the taxpayer chose not to advise the Japanese tax authorities of the revised valuation and did not attempt to obtain a refund of tax, the case law would lend support to the position that absent any evidence to the contrary the tax paid to the Japanese tax authorities was voluntary and as such, should not be considered to be a “tax” within the meaning of subsection 126(1).

Source of the deemed gain

Canadian residents are taxable on world-wide income, including a taxable capital gain from the disposition of property, regardless of the source of the gain. (footnote 3)  However, where a foreign jurisdiction imposes tax on such a gain, for purposes of determining the entitlement to a FTC, it may be necessary to determine the territorial source of the gain, i.e. whether it arises in Canada or the foreign jurisdiction. With regard to the territorial source of a gain on the disposition of shares, it is generally established based on the place where the sale occurs. Paragraph 1.65 of the CRA “Foreign Tax Credit” folio (footnote 4) provides the following guidance in this respect:

1.65 Generally, the place where a stock or bond is sold is the securities or stock exchange in which it is sold, regardless of the location of the security issuer’s transfer office. Where a sale is not made through a securities or stock exchange, a number of factors (weighted in favour of those factors less susceptible to manipulation) must be considered in establishing where the sale is made. These include:

*     the location, residence, or place of business of:
o     the issuer;
o     the issuer’s transfer office;
o     the owner of the security; or
o     the owner’s selling agent;
o     where the title is transferred;
*     where the contract is negotiated, signed, and executed;
*     where the shares are located;
*     where payment is made; and
*     any relevant provisions in the governing corporate statutes.

This has been CRA’s long-standing position in respect of actual dispositions of shares and has been consistently relied upon by the CRA. (footnote 5)  However, it has been CRA’s position that a taxable capital gain resulting from a deemed disposition of property is considered to be Canadian-source income, which therefore cannot be included in the foreign non-business income for purposes of claiming a FTC under subsection 126(1). (footnote 6)  This position is supported by the fact that from the foreign jurisdiction’s perspective no taxable event occurs as a result of a deemed disposition in Canada and thus no conflict arises in respect of determining a territorial source of a deemed gain and which state ultimately has the right to tax such a gain. Therefore, the place of a deemed disposition and the territorial source of the capital gain default to Canada.

We understand that the taxpayer attempted to apply the criteria established to determine the place of the actual sale of shares (discussed above) to the deemed disposition and concluded that the gain from the deemed disposition should be sourced to Japan because at the time of the dividend payment Forco’s shares were located in Japan and the issuer’s location, residence and place of business were in Japan. In our opinion, it is not necessary to consider such criteria in respect of a deemed disposition; furthermore, the criteria established for determining the place of the actual sale of shares cannot be applied in a meaningful way to a deemed disposition.

Bilateral tax treaties generally have rules intended to alleviate incidents of double taxation. Article 21 of the Canada-Japan tax treaty is such a rule.  Article 21 deems gains of a resident of Canada, which are taxed in Japan under the Convention, to arise from a source in Japan and requires Canada to provide a credit in respect of such Japanese tax against any Canadian tax payable on such gains (footnote 7)  However, Article 21 does not apply in this case to re-source the deemed gain to Japan because the deemed gain was not taxed in Japan.  Moreover, the amount of the subsequent gain on the disposition of Forco shares which was taxed in Japan was nil for the purposes of the Act.  Therefore, Article 21 of Canada-Japan tax treaty has no bearing on the determination of Canco’s FTC or the source of the deemed gain.

For the reasons stated above, Canco would not be entitled to a FTC on one of the following bases: the payment to the Japanese tax authorities was voluntary and is not a “tax” within the meaning of subsection 126(1) or the subsection 40(3) deemed gain is not income from a source in Japan for the purposes of the definition of “qualifying income” in subsection 126(7).

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

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  Meyer v. R., [2004] 2 C.T.C. 2934 (TCC [Informal Procedure]). Since the case was decided under informal procedure, it may not have value as a precedent, however the court based its decision on other cases.
2  Canada (Attorney General) v. British Columbia (Registrar of Titles of Vancouver Land Registration District), 1934 Carswell BC 55 (B.C. C.A.);  Kempe v. R. (2000), 2000 CarswellNat 2271 (T.C.C.[Informal Procedure]); Lawson v. British Columbia (Interior Tree Fruit & Vegetable Committee of Direction) (1930); Yates v.R. (2001), 2001 CarswellNat 1369 (T.C.C. [Informal Procedure]).
3  Section 2 and subsection 3(b).
4  Folio S5-F2-C1: Foreign Tax Credit.
5  For example, see CRA documents 57633, June 2, 1989 and 2013-0512581E5.
6  Supra note 4, paragraph 1.63.
7  Article 21 of Canada-Japan tax treaty.

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