2 July 2003 Internal T.I. 2003-0003087 - Article XXIX B (U.S. Treaty)

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.

Principal Issues: (i) Whether B.C. foreign tax credit is available in respect of U.S. estate tax? (ii) What portion of the Canadian tax otherwise payable is deductible for U.S. estate tax purposes in computing taxable estate? (iii) Whether subsection 152(4)(b)(iii) applies in a situation where the taxpayer reported his share of the income from a subchapter S corporation and claimed a FTC before the income was distributed to him?

Position: (i) No. (ii) That portion of the Canadian tax otherwise payable (after foreign tax credit) that was not creditable by the U.S. for U.S. estate tax purposes. (iii) No.

Reasons: (i) No provision in the Canada-United States Income Tax Convention, the Income Tax Act (Canada) or the Income Tax Act of B.C. provides that a provincial foreign tax credit should be granted in respect of U.S. estate tax. (ii) IRS's position. (iii) Problems with the meaning of the term "transaction", the fact whether the taxpayer was dealing at arm's length with the subchapter S corporation, and the interpretation of the term "as a consequence of" in subparagraph 152(4)(b)(iii) of the Income Tax Act.

July 2, 2003

Mr. Robert Thomson	Income Tax Rulings Directorate
	International Tax Division 	Trusts Division
	Burnaby-Fraser Tax Services Office	S. Leung
	9737 King George Highway, 5th Floor	952-4666
	Surrey Tower
	Surrey BC
	2003-000308

Article XXIX B of the Canada-United States Income Tax Convention (the "Convention")

We are writing in reply to your e-mail correspondence in which your requested our view as to whether British Columbia foreign tax credit is available for U.S. estate tax paid and what portion of Canadian tax otherwise payable can be deducted on the U.S. estate tax returns in computing taxable estate for U.S. estate tax purposes. In addition, you enquired whether a distribution from a U.S. subchapter S corporation to a Canadian resident shareholder or an amount incorrectly reported by the shareholder qualifies as a non-arm's length "transaction" within the meaning of subparagraph 152(4)(b)(iii) of the Income Tax Act (the "Act") in the situation described in the latter part of this memorandum.

Our Comments

In the following comments we attempt to answer your queries in the order they were raised in your email.

(I) B.C. Foreign Tax Credit

It is our view that no B.C. foreign tax credit is available in respect of U.S. estate taxes paid. The reasons are set out below.

1. From the Perspective of the Canada-United States Income Tax Convention

(a) An Agreement between Two Federal Governments Only

The Convention is an agreement between the Government of Canada and the Government of the United States of America. As such the Convention would generally not affect the taxation of a political subdivision (province or state) or a local authority (municipality or district) unless it is specifically stated otherwise (see below for an example). This is evidenced by how the terms "Canada tax" and "United States tax" are defined, respectively, in subparagraphs 1(c) and 1(d) of Article III of the Convention. Therefore, taxes referred to in the Convention generally mean federal income taxes unless it is stated otherwise in a provision of the Convention.

For example, paragraph 7 of Article XXIV of the Convention states, in part, that for the purposes of that Article, any reference to "income tax paid or accrued" to a Contracting State shall include ... taxes of general application which are paid or accrued to a political subdivision or local authority of that State. Another example can be found in paragraph 7 of Article XXIX B of the Convention which uses the phrase "for federal and provincial income taxes payable in Canada" (see below for further comments in this regard).

(b) Article XXIX B of the Convention Applies to Federal Income Tax Only

The pre-amble of paragraph 6 of Article XXIX B begins with these words: "[I]n determining the amount of Canadian tax payable ...". As noted above, the term "Canada tax" is defined in subparagraph 1(c) of Article III of the Convention to mean taxes referred to in Article II that are imposed on income by Canada. Pursuant to subparagraph 2(a) of Article II, those taxes refer to the taxes imposed by the Government of Canada under the Income Tax Act. It is therefore apparent that provincial taxes are not taken into consideration in paragraph 6 of Article XXIX B of the Convention. This is apparent when the phrase "for federal and provincial income taxes payable in Canada" is used in paragraph 7 of Article XXIX B of the Convention. Otherwise, the term "Canadian tax payable" as used in paragraph 6 of that Article could have been used if that term has already included provincial income taxes. As a result, a province of Canada is not obliged to provide a foreign tax credit under paragraph 6 of Article XXIX B of the Convention.

2. From the Perspective of the British Columbia Income Tax Act

(a) U.S. Estate Tax is Not a Non-business Income Tax

Under section 4.71 of the Income Tax Act of the Province of British Columbia (the "B.C. Act"), a foreign tax credit is provided to an individual who resided in British Columbia on the last day of the taxation year and who had income for the year that included income earned in a country other than Canada in respect of which non-business income tax was paid by the individual to the government of a country other than Canada. Under paragraph 5 of that section, the term "non-business income tax" has the same meaning as that defined under subsection 126(7) of the Act. Under that subsection of the Act, a non-business income tax must be an income or profits tax. It is clear that the U.S. estate tax is not an income or profits tax, rather it is a tax on the decedent based on the value of the decedent's estate. Therefore, section 4.71 of the BC Act does not apply to provide a foreign tax credit for US estate taxes.

(b) No Provision of the B.C. Act Provides a Foreign Tax Credit for U.S. Estate Tax

We are not able to find any other provisions in the B.C. Act that would provide a credit for U.S. estate taxes against B.C. provincial income taxes.

(II) The Portion of Canadian Income Tax Payable Deductible in Computing Taxable Estate for U.S. Estate Tax Purposes

For U.S. estate tax purposes, certain deductions from "gross estate" are allowed in computing "taxable estate". A tax rate is then applied to the taxable estate to calculate the estate tax against which certain credits (such as unified credit and foreign death tax credit) are provided. One of the deductions allowed in computing taxable estate is the amount of the debts of the decedent outstanding at the time of death (see line 14 under Part 5 of Form 706 United States Estate (and Generation -Skipping Transfer) Tax Return). Canadian federal and provincial income taxes owing by the decedent are debts of the decedent and are therefore deductible from gross estate in computing taxable estate. However, we would like to point out that the assessment of U.S. estate tax is the responsibility of the Internal Revenue Services of the U.S. ("IRS"). The role of the Canada Customs and Revenue Agency (the "CCRA") is to ensure that the amount of the U.S. estate tax shown on the U.S. estate tax return is reasonable for the purposes of providing a Canadian tax credit for such tax in accordance with Article XXIX B of the Convention and also to ensure that, if the deceased taxpayer was a U.S. citizen, the credit that Canada provides would not exceed the amount of U.S. estate tax that would have been payable had the deceased taxpayer not been a U.S. citizen.

In this regard, the IRS has informed us that that portion of the Canadian tax otherwise payable that is eligible for a U.S. foreign death tax credit against U.S. estate tax pursuant to paragraph 7 of Article XXIX B of the Convention is not deductible because it would be double counted if a deduction is allowed for the Canadian tax payable in computing taxable estate in the U.S. and a credit is provided by the U.S. for such Canadian tax against U.S. estate tax at the same time. In the situation at hand, it is our understanding that the estate is not eligible for the U.S. foreign death tax credit because no Canadian tax is paid on the deemed disposition of non-U.S. situs property as a consequence of death of the deceased taxpayer due to the tax-free rollover treatment accorded to all of the non-U.S. situs property under subsection 70(6) of the Act.

Also, in one of the files that we encountered (document E9811566) we notice that the IRS did not allow a deduction from gross estate in computing taxable estate that portion of the Canadian taxes paid in respect of U.S. situs property as a consequence of death because it appears that the IRS has assumed that Canada would have provided a tax credit against such tax for the U.S. estate tax paid. Therefore, notwithstanding what was stated in document E9604996), the amount of the Canadian tax payable that is deductible in computing taxable estate for U.S. estate tax purposes would be the actual Canadian federal and provincial income taxes paid (i.e., after the federal foreign tax credit for U.S. estate tax) in respect of U.S. situs property as a consequence of death, minus that portion of such taxes for which the U.S. would provide a foreign death tax credit under paragraph 7 of Article XXIX B of the Convention.

It should be noted that in computing the Canadian foreign tax credit for U.S. estate tax for a U.S. citizen under paragraph 6 of Article XXIX B of the Convention, the U.S. estate tax payable cannot exceed the tax that would have been payable if the decedent were not a U.S. citizen. If the decedent were not a U.S. citizen, U.S. foreign death tax credit under paragraph 7 of that Article would not be available (because it is only available where the taxpayer is a resident or citizen of the U.S.) and the amount of the deductions from gross estate in computing taxable estate for U.S. estate tax purposes would have to be prorated based on the value of the gross estate situated in the U.S. at the time of death that bears to the value of the decedent's entire gross estate wherever situated. In this case, the amount of the deduction of Canadian tax payable in computing taxable estate would only be that portion of the Canadian tax payable (after the federal foreign tax credit) that the value of the gross estate situated in the U.S. bears to the value of the entire estate. It is our understanding that in the situation at hand you have carried out such procedures in computing US estate tax for Canadian foreign tax credit purposes as if the deceased taxpayer were not a US citizen. If you have any questions regarding the above, please contact Simon Leung at (613) 952-4666.

(III) Subparagraph 152(4)(b)(iii) of the Act

You stated in your e-mail that for the years XXXXXXXXXX to XXXXXXXXXX Canadian foreign tax credits were claimed by a Canadian resident taxpayer for U.S. income taxes paid on his share of a subchapter S corporation's income earned but not distributed to the taxpayer. These foreign tax credits were processed as claimed and the returns for those years are now statute-barred. The taxpayer did not make a request to the competent authority of Canada pursuant to paragraph 5 of Article XXIX of the Convention but reported his share of the income of the S corporation which he treated as foreign business income on his tax returns even though he did not receive any distribution from the S corporation in those years in question. You enquired whether subparagraph 152(4)(b)(iii) of the Act would apply to allow the CCRA to reassess the tax returns of the taxpayer for those years. Specifically, you enquired whether an amount incorrectly reported by the taxpayer could be treated as a non-arm's length "transaction" for the purpose of subparagraph 152(4)(b)(iii) of the Act. In addition, you also enquired whether a subsequent distribution from the subchapter S corporation to the taxpayer could trigger the application of that subparagraph with respect to the wrongful claims of foreign tax credits in prior years.

Subparagraph 152(4)(b)(iii) of the Act reads in part as follows:

"The Minister may at any time make an assessment, reassessment or additional assessment of tax for a taxation year ..., except that an assessment, reassessment or additional assessment may be made after the taxpayer's normal reassessment period in respect of the year only if

(a) ...

(b) the assessment, reassessment or additional assessment is made before the day that is
3 years after the end of the normal reassessment period for the taxpayer in respect of the year and

(i) ...

(ii) ...

(iii) is made as a consequence of a transaction involving the taxpayer and a non-
resident person with whom the taxpayer was not dealing at arm's length,

..."

In the case at hand, it is not clear what the advantage would be in reassessing the tax returns of those years in question. For example, since the taxpayer did not make a request to the competent authority of Canada pursuant to paragraph 5 of Article XXIX of the Convention, a double tax situation has resulted and likely cannot be avoided (i.e. the underlying income of the subchapter S corporation will be subject to tax in the U.S. in the year it is earned and then such income will be taxed again by Canada in a subsequent year when distributed as a dividend). Had the taxpayer filed his return correctly (i.e. had he not reported U.S. source income in that year), he would not be subject to any additional tax in Canada and his non-business income tax (i.e. the U.S. tax on his share of the S Corp income) would not have been credible against Canadian tax payable since there was likely no U.S. source income reported on his Canadian tax return. As it stands now, we assume that the taxpayer has not been subject to any additional tax in Canada because the federal tax payable on the income that he has incorrectly reported would likely be offset by a foreign tax credit in respect of the U.S. taxes paid. Accordingly it is not clear to us what the overall advantage will be to the taxpayer or to the CCRA for a reassessment. The double tax problem will still be present regardless of whether you reassess or not. We would be glad to consider this further if you provide more details regarding the relevant tax returns. However, we have provided comments below on the assumption that a reassessment would be of some advantage.

In document #2002-0157937 we opined that the word "transaction" as used in subparagraph 152(4)(b)(iii) of the Act should not, without an extended meaning as that word is defined in subsection 233.1(1), 245(1) or 247(1) of the Act, be given a meaning so wide as to include all dealings in relation to a business or property. Otherwise, Parliament would have provided the extended meaning of the word "transaction" to the whole Act rather than only for the purposes of certain provisions of the Act. For a detailed analysis of the meaning of the word "transaction", please refer to that document. In the situation at hand, we do not feel that making an incorrect claim for foreign tax credits on the taxpayer's tax returns in those years in question would amount to a "transaction" involving the taxpayer and a non-resident person with whom the taxpayer was not dealing at arm's length.

As to whether a distribution from the S corporation to the taxpayer would be considered a non-arm's length transaction, it depends on whether or not the taxpayer was dealing with the S corporation at arm's length. For a determination of this, one has to examine all the facts and circumstances of the situation including the taxpayer's shareholding in the S corporation, the relationship between the taxpayer and all the other shareholders of the S corporation, any significant influence that the taxpayer has on the affairs of the S corporation, and the position held by the taxpayer in the S corporation (e.g., as a managing director). Even if it can be shown that the taxpayer was not dealing at arm's length with the S corporation, we do not think that we can satisfy the court that the reassessments of the tax returns in those years in question are made as a consequence of the distributions from the S corporation to the taxpayer. For example, whether a distribution was made in a subsequent year or not, the taxpayer's initial tax returns were filed incorrectly and should have been reassessed. Therefore, how can we argue that the reassessment is as a consequence of the subsequent distribution?

We have also considered whether subparagraph 152(4)(b)(iv) of the Act would apply to the situation at hand and concluded that the potential reassessment, if any, cannot be said to be made as a consequence of a payment or reimbursement of any income or profits tax to or by the government of the U.S. or the government of a state, province or other political subdivision of the U.S. as the amount of the U.S. tax was correctly paid at that time and the potential reassessment, if any, can only be said to be made as a consequence of the wrong claim for foreign tax credits.

(IV) Other

XXXXXXXXXX

Summary

It is our view that :

(a) No B.C. foreign tax credit is available for U.S. estate tax;

(b) The amount by which the Canadian tax otherwise payable (i.e., after the Canadian federal tax credit for U.S estate tax) exceeds the amount of the U.S. foreign death tax credit for Canadian tax otherwise payable is available, after converting into U.S. currency, as a deduction from gross estate in computing taxable estate for U.S. estate tax purposes; and

(c) Subparagraph 152(4)(b)(iii) of the Act would not apply to the wrongful claims for foreign tax credits in the years from XXXXXXXXXX to XXXXXXXXXX.

We trust you will find the above to be of assistance.

For your information a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the CCRA's electronic library. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the electronic library version or they may request a copy severed using the Privacy Act criteria which does not remove client identity. Request for this latter version should be made by you to Jackie Page at (819) 994-2898. A copy will be sent to you for delivery to the client.

Jim Wilson
Section Manager
for Division Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch

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