Foreign Tax Credit on Form 1116

[cfn2007]

Hi everybody,

I am a United States citizen that moved to Canada and I'm trying to figure out the form 1116. I am leaning towards using tax credits for all my Canadian income (including salary) to offset US tax because there does not seem to be any particular advantage of using the exclusion (form 2555), as Canadian rates are generally higher than US federal rates. Besides, I'll need to learn 1116 anyways for passive income. (Please correct me if I'm wrong about there being no benefit to 2555 over 1116.)

At a high level I understand how the 1116 works but cannot figure out how to portion my Canadian taxes into the 1116 categories (general limitation, passive, etc.)

Perhaps it is easiest to ask my question by way of an example. Let's assume a Canadian resident made $55,000 in salary, $10,000 in capital gains, $10,000 in dividends (on US securities). I punched this into a Canadian online tax calculator (for Alberta) and it yielded the following Canadian taxes:

Federal: $10,801
Alberta: $5,186
CPP: $1,990
EI: $720
Therefore, total Canada tax = $18,697

The average Canadian tax rate is 24.93% (18,697 / 75,000), so can I just multiply this amount by each income category? For example, 24.93% x 55,000 earned income = $13,711 and 24.93% x 10,000 capital gains = $2,493. I would then use these amounts on the 1116 for general limitation and passive respectively.

This method seems straightforward enough except that you can argue that the CPP and EI are specific to the salary. Likewise, you can argue that capital gains are taxed at a lower rate than income. (Also, I'm not sure what if anything can be done with the Canadian tax on the US stock dividends.)

What is the right way to portion the Canadian taxes to the different 1116 categories? Thank you.

[nelsona]

Your opening statement is generally correct. It is always good to run the numbers both ways however. Only your wages are eligible for 2555, so you will be doing 1116's for at least some income.

First on how to divvy up the pie.

Your CPP/EI should only be used against your wages. Your cap gains income is only half of the total, so you should only apportion the tax based on that.

Your US dividends are not immediately eligible for FTC, since they are US sourced. The initial remedy is on your Cdn tax return's foreign credit. It gets more complicated, becuase Cdanada by treaty limits the credit they give on US dividends to 15%. It is unlikley that you will reach this limit, since your effective taxrate in US will not be that large. If it were you would be eligible to 're-source' some of the dividends to forign on a 1116 to allow the claim to be bumped up to make up the difference (just keep this in mind for other years, or for other US income that you might make in future).

So, your US dividends will be fully taxed in US, with whatever your initial effective taxrate is (before any of the FTCs are calculated) would be used as a credit on your Cdn return, upto 15%. If your effective rate is greater than 15%, come back for more explanation on 're-sourcing'.

[cfn2007]

Do I use the average Canadian tax rate and then adjust for things like CPP/EI, etc. Or do I start with earned income and then "stack" (I think that's the term) passive income at my marginal rate? I'm guessing average rate???

If I go back to my simplified example, the average tax rate (not counting CPP/EI and only counting CG's at 50% inclusion) would be: (10801 Fed + 5186 AB) / (55,000 wage + 5,000 CG + 10,000 Div) = 22.84%

Using this rate, Cdn tax eligible for credit on general limitation would be:(0.2284 x 55,000) + 1990 CPP + 720 EI = 15,272

Cdn tax on passive would be: 0.2284 x (10,000 Div + 5,000 CG) = 3,426

Does this make sense as far as methodology goes?

The same question applies in calculating the US taxes on the US source dividends that are eligible for FTC on Canadian return. As I understand the US system, tax rates are applied to earned income first followed by passive income (sort of a stacking system). I'm not sure if this would apply to Canadian FTCs or not.

If I run this example through the US US 2007 tax tables, standard deduction and 1 exemption for single filer, assume that half the dividends are "qualified" for 15% rate and the other half are not qualified, assume that half the capital gains are ST and half LT, I get total US federal tax of 11,986 for an average rate of 15.98%. (This compares to a marginal tax on the passive income of $2,000 or 20%.... (half the passive income at favourable 15% rate and half at marginal 25% rate.) In this case, do I go with the 15.98% average or 20% marginal tax? [Note: It seems that either way, I'm over the 15% FTC cap allowed by treaty on my Canadian return.]

Thank you.

[nelsona]

You don't use marginal rates for anything.
Rather than trying to figure taxrates for all your income, simply come up with the tax for each type of income. After all, it is the tax amount that you will put on the 1116s. You pay $10,000 tax, divvy up the tax for each type of income as I described above, and use those ammounts.

Same for your US tax. Since you don't need to divvy it up between diff types of income, you are only intersted in US-source and Cdn-source. You have two piles, divide the tax between the two piles, proportioanally.

[cfn2007]

Sounds like I might have been making things more complicated than necessary. From what you're saying, I really don't need to be concerned with things like ST vs. LT capital gains or qualified vs. non-qualified dividends when allocating US tax for FTC purposes... I would treat all these income sources the same. Likewise, when allocating Canadian taxes by source, I should treat Canadian dividends that are eligible for preferred rates (due to Cdn dividend tax credit) the same as, say, rental income (which is fully taxed). Is that a fair conclusion?

Thanks so much for your help.

[nelsona]

Your cap gains are not considered US-source when you live in canada. Only your dividends and interest from US sources are.

You will only be claiming credit for US tax on your US-sourced dividends, as I said in my initial response.

For your Cdn-source dividends, you will ignore the gross up (in determining the income on 1040) and the dividend credit will in effect be spread across the board, and apportioned on the 1116.

Don't overthink this.

[cfn2007]

Thank you Nelsona. That makes a lot of sense.

The only situation that is still really grey for me is how to handle capital gains where I have a different cost basis in US and Canada. As I understand it, my Canadian cost basis was set the day I became a Canadian resident. This is much higher than my US basis.

Any stocks I sell in the near future is likely to have a high US capital gain and a Canadian capital loss. I understand that capital gains/losses are considered Canadian sourced but what amount can be used as a FTC on my US 1116? If I apportion my Cdn taxes based on Cdn definition of income, I guess the answer is zero FTC. However, I would think the IRS would want me to use the US defintion of income... this would result in my spreading the Canadian taxes over a larger overall income number for positive FTCs on CGs. What's the process for this situation??? Thanks.

[nelsona]

Again, you will calcualte the income on your 1040 the way IRS wants you to, and you will reprt the Cdn tax that you paid. the fact that you paid little cdn tax on the money means just that: you will have little Cdn tax -- or in your case, none -- to get credit for.

This makes perfect sense doesn't it. You really owe US for the growth your made before leaving US, and now you will pay it.

Your alternative would have been to sell these off before leaving US, which would have incurred slightly less gain, and no FTC, and would have incurred it back then, instead of defrring it til now, when you sell.

Works out the same, as it should.