Canadian Foreign Tax Credits and withdrawals from U.S. IRA

In a recent tax ruling, the Canada Revenue Agency (“CRA”) allowed a taxpayer to claim as foreign tax credit a 10 percent income tax surcharge levied under the U.S. Internal Revenue Code on the withdrawals from U.S. Individual Retirement Arrangement (“IRA”) accounts.

This view represents a reversal of the previous CRA policies stated in prior interpretations issued by the CRA in 1993 in doc. no. 9330140 and 9304595. The prior position was based on the view that the 10 percent surcharge on the IRA withdrawals is a tax imposed on the taxpayer because he prematurely withdraws funds from the IRA, prior to the legislatively mandated age of 59 y.o.  Further, the CRA noted that, in case of a U.S. citizen or resident, the 10 percnet surcharge would be payable even if the amount of taxable income would be nil. Accordingly, the CRA did not view the 10 percent surcharge as “income tax” for the purposes of the Canadian foreign tax credit rules.

In the ruling, the CRA agreed with the taxpayer’s submission that the 10 percent surcharge imposed under the Internal Revenue Code (“IRC”) is not a penalty but rather an income tax. In particular, the provisions in section 72(5) dealing with the surcharge are found in Chapter 1 -Normal taxes and surtaxes of the IRC, rather than Subtile F – Procedure and Administration of the IRC.

Consequently, the CRA found that the surcharge clearly falls within the scope of Article II(1) of the Canada-U.S. Tax Treaty, which provides that the Treaty applies to taxes on income and on capital imposed on behalf of each Contracting State,irrespective of the manner in which they are levied. In other words, even though the 10 percent surcharge may not be, due to its features, an “income tax” for the purposes of section 126, the negative result should be overturned by the broader provisions in Article II(1) of the Treaty, which makes the particular surcharge to fall within the scope of the relieving provision in the Treaty, including in particular Article XXIV (Foreign Tax Credit), requires that income tax paid or accrued to US on profits, income or gains arising in US be deducted from any Canadian tax payable

The ruling is relevant for Canadian residents who used to reside in the U.S. and in the course of their employment in the U.S. contributed to a U.S. IRA.  The penalty-like 10 percent surcharge will not be fully creditable in computing the amount of Canadian tax due on the amount of the withdrawal.  As the ruling deals with Canadian residents who are neither U.S. resident or U.S. citizen, such individuals may not be able to obtain benefit outlined in the above ruling.

Please contact one of our tax lawyers if you need a copy of the ruling (CRA Internal Interpretation no.  2011-0398741I7 (E) Foreign Tax Credit on 10% additional US tax)  or require more information about the application of Canadian foreign tax credit rules or the creditability of income and other foreign taxes in computing Canadian tax liability.