Canadian Foreign Tax Credit on IRA Distribution

Question

Hi Phil

I think I need some help with a tax matter that has developed.

I have an IRA in the US that I’ve just started taking distributions from. I move to Victoria from Colorado 10 years ago and I plan on staying in Canada until my final days.

I filed my Canadian return with a Vancouver CPA and he referred me to a US CPA to help file my US tax return. I was fine paying both accountants to help me file as I understand most do not file both styles of returns but I was surprised to receive a letter from CRA asking me for more money on my 2019 tax return. I’ve attached the recent letter to this email.

To summarize the situation I received a letter from CRA asking for clarification on the Canadian CPA’s foreign tax credit calculations. The Canadian CPA sent in a response.

A month later I received another letter from CRA explaining that they reduced the foreign tax credit significantly and that I owed extra Canadian tax.

I spoke to the Canadian accountant and they claimed that the foreign tax credit was correct and explained that is would cost a lot in fees to fight CRA on the matter.

I’m really frustrated that I feel like I’m being left hanging after spending so much money in accounting fees to file my return. ‘

Have you run into this situation before? I would love to hear your thoughts on the matter.

Thanks

XXXXXX

Answer

Hi XXXXX

Thanks for the email and I’m sorry to hear about the trouble you’re having. It’s not entirely clear from the email below what happened, but I have a pretty good idea what may have been the issue.

To give you some background on foreign tax credits on IRAs paid to a resident of Canada (that is also an American citizen):

IRA distributions paid to an American citizen living in Canada will be reported as income both in the US and Canada on each respective tax returns. Let’s say the amount is $100,000 just to make the example easier to explain:

• As mentioned above the $100,000 will be reported both on the Canadian tax return as well as the US 1040 income tax return
• Tax will be calculated on both the 1040 and T1 return on this amount
• Under the Canada/US income tax treaty the IRA distributions (pension income) will be taxed at a maximum rate of 15% in the US and it will be fully taxable in Canada at your actual tax rate
• Based on your email below I’m assuming that your average US income tax rate is over 15%.
• Let’s say, for illustration purposes that your average US rate was 20% and this was the rate of tax applied to the IRA distribution.
• Because the treaty rate on US pension income is 15% as discussed above, the proper way of reporting the income and tax on the 1040 return would have been to apply for a 5% “resourced foreign tax credit” on form 1116 to reduce the amount of tax on the IRA down to 15%. How to actually do this on the 1040 is being the scope of this email, however the result will be that the US government would only receive 15% tax on the IRA distribution.
• You would then claim a foreign tax credit in Canada for the 15% US income tax you paid to the US. Assuming your Canadian average rate of tax is above 15% you would have fully absorbed the US tax on your Canadian return essentially only paying the Canadian rate on this IRA income.

We will need to verify this, however likely what happened was that the US accountant did not “resource down” the US tax on the IRA distribution to 15% and ended up paying more than 15% tax on the US return. The Canadian accountant tried to claim the full amount of US tax (more than the maximum 15%) on the Canadian return. When CRA reviewed the return they disallowed any foreign tax credit in excess of 15%. This is likely why you now have a balance owing for Canadian purposes.

Looks like both accountants made an error in judgment. The US accountant should have recognized that the IRA tax should have been resourced to 15% and the Canadian accountant should have realized that CRA would have only given you credit for 15%.

This underscores the importance of having a CPA that understands both Canadian and US income tax rules as well as a deep knowledge of the treaty.

I hope that helps and let me know if you have further questions.

Cheers

Phil