CRA Foreign tax credit review and US capital gains distribution

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Question

Hi Phil

I follow you on social media and one day would love to be one of your clients once I can afford the extra tax accounting costs. In the meantime I wonder if you can help me with a tax problem I’m having.

I prepare my own Canadian return and my brother (he lives in the US) prepares my US return. In the past it’s been relatively straight forward and I haven’t had any issues with my US or Canadian tax filings. I should also mention that I’m fully caught up on my FBAR filings.

In early 2020 I received an inheritance from a late relative. The inheritance was a portion of a US investment account that was split between me and my brother. I did report all the income from the 1099-INT, 1099-Div and 1099-B on my Canadian returns (after converting it to Canadian) and my brother reported the amounts on my US tax return. I’m not sure if I did it right but I claimed a foreign tax credit on my Canadian tax return for all the tax my brother calculated.

In late 2021 CRA audited my Canadian tax return after I replied to them with information they requested and made a bunch of changes I really don’t understand and I seem to owe a lot more tax. Here are the changes they made:

  • They reduced my foreign tax credit by a significant amount
  • They didn’t allow me to claim the capital gains distribution I received on my 1099-Div and taxed it like interest

I hesitate just pay CRA in case they are actually wrong in their assessment.

I know you probably can’t fully solve this over email but hoping you can provide some thoughts?

thanks

Answer

Hi XXXXXX

Thanks for your questions. I’ll do my best to provide some insights but I’ll need to review CRA’s original letter and subsequent notice of reassessment to fully understand what they did.

So, it sounds like CRA sent you either a pre-assessment or post-assessment review. This is not necessarily an audit, but rather just a review of calculation on your tax returns for specific information.

The review was likely with respect to your foreign tax credit claim. They tend to send lots of these out. Considering they made changes, your foreign tax credit calculation was likely wrong. Also, I think I know what happened to the capital gains distribution:

The following is all very technical but hopefully this helps a little:

You don’t necessarily get a foreign tax credit for tax paid in the US on all sources of income. For example: US dividends will be a maximum of 15%, capital gains on public investments will only be taxable in Canada (in most cases), interest will only be taxable in Canada and capital gains distributions will be fully taxable in Canada without preferential capital gains treatment (taxed at 100%).

What likely happened was that your brother didn’t properly calculate foreign tax credits on the US 1040 return. He would have needed to use form 1116 to properly claim a re-source foreign tax credit on any tax on capital gains, interest and any tax on dividends over 15%

If that was the case and you claimed a foreign tax credit for all the US taxes you paid your foreign tax credit is likely over stated.

Not only that, but the capital gain distribution should have been fully taxable in Canada and not treated like a “capital gain”.

I can imagine that the information laid out above will likely be quite difficult to understand. Let’s arrange for a consult to work through this in more detail.

Also, you didn’t mentioned T1135 filings in your original email. In most cases I advise clients to move their US investments up to Canada to reduce cost and complexity and potential save on tax.

Cheers

Phil

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