CRA doubts that Canco can claim an FTC for a US sub’s distribution that produces a capital gain but is treated under the Code as a distribution out of E&P subject to US withholding tax

The repurchase by a US subsidiary (“USCo”) of shares of USCo held by its Canadian parent (“CanCo”) gave rise to a capital gain for Canadian purposes and to a dividend subject to 5% withholding tax for U.S. purposes. Could CanCo claim a foreign tax credit “FTC”) under s. 126(1) for such tax?

CRA noted two conditions for the FTC. First, there must be “qualifying income” from a source in the US. Second, it must not be a foreign tax that “can reasonably be regarded as having been paid by the taxpayer in respect of income from a share of the capital stock of a foreign affiliate of the taxpayer.”

Regarding the first condition, as the distribution was taxed as a dividend by the US, Art. X(3) of the Treaty indicated that it could be taxed by the US as such. Therefore, the dividend was deemed to “arise” in the US by Art. XXIV(2)(a) of the Treaty. Although that provision begins with the words “subject to the provisions of the law of Canada regarding the deduction from tax payable in Canada of tax paid in [the US],” the “arising” sourcing language in Art. XXIV(2)(a) is similar to the “qualifying incomes” domestic definition referring to income “from sources” in the US – leading to the conclusions that the first condition was met.

The second condition was to be interpreted in light of its main objective, of preventing a taxpayer from claiming relief from taxation under the Act twice respecting the same source of income – once as a s. 113(1) deduction and again through an FTC. Here, if the US tax was based on earnings and profits, and those earnings were also captured in a surplus account in Canada, thereby supporting a s. 113 deduction, there would be such a resulting double benefit, and CRA would deny the deduction.

Neal Armstrong. Summary of 13 May 2026 IFA Roundtable, Q.6 under s. 126(1).