How does the foreign tax credit work in Canada?

What the credit does and where it is claimed

Canada taxes residents on worldwide income and then gives relief for tax paid elsewhere. The foreign tax credit is that relief: a dollar-for-dollar reduction of Canadian tax for foreign income tax paid on income that Canada is also taxing. If the US took 15% on your dividends and Canada would have charged 30%, the credit wipes out the first 15% and you pay Canada the remaining 15%. If the foreign rate was higher than Canada's, the credit stops at the Canadian amount and the excess is not refunded.

The claim runs through two forms. Form T2209 calculates the federal credit. Any non-business foreign tax the federal credit could not absorb flows to Form T2036, which calculates the Ontario credit that appears on Form ON428. The order is fixed: federal first, then provincial on whatever remains. Business foreign tax is federal only; Ontario does not offer a provincial credit for it.

Only income tax qualifies. Foreign sales taxes, property taxes and estate taxes are not creditable. US Social Security and Medicare payroll taxes do qualify as non-business income tax, which matters for anyone working across the border.

The two baskets: business and non-business, one country at a time

The credit is computed in separate compartments, and tax in one cannot rescue income in another:

• Non-business income tax covers foreign tax on employment, pensions, interest, dividends, rent and capital gains. Each country gets its own calculation.
• Business income tax covers foreign tax on income from carrying on a business in that country, again country by country.

Within each basket the credit is the lesser of two numbers: the foreign tax actually paid, and the Canadian tax on that foreign income. The second number comes from a proportion, roughly your net foreign income from that country divided by your total net income, multiplied by your Canadian tax before credits. The formula means the credit is limited by your average Canadian rate, not your marginal rate, so people with large deductions or low total income often find the credit smaller than expected.

A worked example with round numbers. Suppose you earned $10,000 of US dividends, converted to Canadian dollars, and the US withheld the treaty rate of 15%, or $1,500. Your combined federal and Ontario tax on that $10,000, at your average rate, comes to $2,800. The federal T2209 credit absorbs most of the $1,500, the Ontario T2036 credit covers the rest, and you owe Canada the remaining $1,300. Had the US withheld 30% because no W-8BEN was on file, only $1,500 would be creditable; the other $1,500 is recovered from the IRS, not from Canada.

The 15% cap on investment income and the deductions that catch the excess

For foreign tax on income from property, meaning interest, dividends and similar returns but not rental income from real estate, the credit is limited to 15% of the income. Anything above 15% is not lost; it becomes a deduction from income under section 20(11), which is worth your marginal rate on that amount rather than dollar for dollar. Rental income from foreign real property and employment income are not subject to this cap, so US tax on a Florida rental at 22% is creditable in full up to the Canadian tax on that rent.

A second deduction under section 20(12) lets you deduct non-business foreign tax instead of crediting it. It is the fallback when the credit formula produces little or nothing, for example in a year with a large capital loss that pushes total Canadian tax down. We compute both routes each year, because the better one changes with your other income.

Non-business credits that go unused in the year are gone; there is no carryover. Business foreign tax credits are different: unused amounts carry back three years and forward ten years, which is why we track them on a schedule for owners with US operations.

What the CRA wants to see before it allows the credit

The credit is for foreign tax actually and finally paid, and the CRA checks. Where tax was only withheld at source, the slip is enough: a 1042-S, a 1099 showing backup withholding, or a W-2. Where you filed a foreign return, the CRA wants that return and the assessment or account transcript showing the final liability, since a refund from the IRS reduces the creditable amount. Practical rules that follow:

• Convert the foreign tax at the same exchange rate you used for the income.
• Claim only the treaty rate. Withholding above what the treaty allows is not creditable in Canada; it is recovered by filing a US return or fixing the withholding form.
• If the US return is not finished when the Canadian deadline arrives, file the T1 with your best estimate and amend the T2209 when the 1040 is assessed. Do not skip the claim.
• Keep the documents for six years. Foreign tax credits are among the most frequently reviewed lines on a Canadian return.

The same principles apply to Americans living in Canada, who face the credit from the other side when they file their 1040. We compare their options in foreign earned income exclusion or foreign tax credit. Canadians with US wages will find the two-country picture in do Canadians working in the US pay tax in both countries, and the income-reporting side in how to report foreign income on a Canadian return.

How we handle foreign tax credits

We treat the US and Canadian returns as one calculation, because the credit on one side depends on the final number from the other. We prepare the US filing first where the income is US-source, carry the assessed tax into Form T2209 and Form T2036 by country and basket, run the section 20(11) and 20(12) comparisons, and keep a running schedule of any business credits carried forward. When the CRA asks for support, the file already contains the slips, returns and rate calculations. This is standard in our cross-border tax services and in the US tax preparation we do for Canadian residents.

Source: CRA — Form T2209, Federal Foreign Tax Credits; CRA — Form T2036, Provincial or Territorial Foreign Tax Credit.