CVITP Assist: Foreign Tax Credit

FOREIGN TAX CREDIT

Canadians pay income tax based on worldwide income. The foreign tax credit helps to prevent double taxation. Without the credit a person might be taxed twice on the same income - once by a foreign government and again by Canada.

The credit can apply to employment income, business income, pension income, and investment income.

How much is the credit:

The credit is the lesser of (i) the amount of foreign tax paid, and (ii) the amount of Canadian tax payable on the foreign income.

For example, suppose a person earned $10,000 of foreign income and paid $2,000 in foreign tax. If the Canadian tax on the same income is $1,500 then the credit is limited to $1,500.

However, if there is a tax treaty with the foreign country, the treaty may determine the extent to which the foreign tax credit can be claimed. These treaties also prevent countries from taxing the same income twice by defining where tax is taxable.

The federal credit is calculated in Form T2209 and the Ontario credit is calculated in Form T2036.

Carryforward and carryback provisions:

If some or all of a foreign tax credit isn’t used, it can generally be carried forward up to 10 years or carried back up to 3 years.

ETFs with U.S. exposure in non-registered account:

A Canadian can have exposure to U.S. stock through an ETF in one of four ways:

1. By purchasing a Canadian ETF that directly buys U.S. stock.

(a) In a non-registered account:

When dividends are paid, the underlying U.S. companies apply a 15% withholding tax. The net amount (85%) is paid to the ETF company, which in turn pays that amount to the investor. The investor will receive a t-slip that will report 100% of the dividend as income (not the net 85% amount), but the 15% withholding tax is also reported on the t-slip. Here is an example of the impact on taxes:

Gross foreign dividend amount	$1,000
Withholding tax (A)	$150
Amount received	$850
Gross foreign income reported on Canadian tax return	$1,000
Canadian federal and Ontario tax payable at marginal rate (for example, 31% for RK in 2024)	$310
Foreign tax credit	($150)
Net Canadian taxes payable (B)	$160
Total foreign and Canadian taxes payable (A + B)	$310
Marginal tax rate	31%

Looking at RK’s 2024 return, $213 of “foreign non business income tax” was paid, which is withholding tax. This amount is reported on line 40500 and is deducted from federal tax. Therefore, in the end, RK is paying his marginal rate on dividends, and the withholding tax has no impact.

(b) In an RRSP account:

A 15% withholding tax is applied and is not recoverable.

2. By purchasing a Canadian ETF that holds a U.S. listed ETF, which in turn holds U.S. stock

(a) In a non-registered account.

This is sometimes referred to as a wrap or “fund of fund” structure. The U.S. ETF company will apply a 15% tax, such that the Canadian ETF company receives 85% of the dividend. This net dividend is then distributed to Canadian investors. Just as with the first structure, the investor will receive a t-slip report 100% of the dividend as income (not the net 85% amount), but the 15% withholding tax is also reported on the t-slip. The ultimate effect is that tax is paid at the investor’s marginal rate, just like other income.

(b) In an RRSP account:

A 15% withholding tax is applied and is not recoverable. But it’s important to keep the withholding tax issue in perspective. The S&P 500 Index typically pays low dividends, less than 2%. Subtracting withholding tax of 15 per cent is a small loss.

A 15% withholding tax is applied and is not recoverable.

3. By purchasing a U.S. ETF (from a U.S. stock exchange) that holds U.S. stock

(a) In a non-registered account.

When dividends are paid, the U.S. ETF company applies a 15% withholding tax. The net amount (85%) is paid to the investor. The investor will receive a t-slip which will report 100% of the dividend as income (not the net 85% amount), but the 15% withholding tax is also reported on the t-slip. A foreign tax credit can be claimed.

(b) In an RRSP account:

No withholding tax is applied.

A 15% withholding tax is applied and is not recoverable.

4. By purchasing an ETF that uses derivatives

An example is HXS (now Global X S&P 500 Index Corporate Class ETF). The structure is very complicated. It uses derivatives—such as total return swaps—alongside some collateral arrangements to replicate the S&P 500 total return index. No dividends are paid.

(a) Non-registered account

The investor effectively pays a 15% withholding tax. The net dividend is effectively taxed as a capital gain when the stock is sold. Although the 15% dividend tax credit is not avoided, the ETF is considered tax efficient because only 50% of capital gain is taxed, which is a benefit that more than compensates for the 15% tax. Overall, less tax is paid.

(b) RRSP account

The investor effectively pays a 15% withholding tax and it is not recoverable.

Difference between a T5 and a T3:

A T5 is a statement of investment income. For the most part, T5s report interest from bonds and savings accounts; dividends issued directly by Canadian or foreign corporations. Foreign income is reported in box 15 and foreign tax is reported in box 16.

A T3 is a statement of trust income disbursed to beneficiaries. T3 slips report investment income from mutual funds and ETFs, including capital gains, interest, eligible and non-eligible dividends, return of capital, and foreign income. Foreign non-business income is reported in Box 25 and foreign non-business income tax is reported in box 34.

References:

Income Tax Folio S5-F2-C1