What is double taxation?

If you live in one country but earn income from a payer in another country, sometimes that income is taxed by the foreign government. When you file your taxes in your home country, you must declare that income, and it may trigger tax in your home country as well. This situation is called double taxation, where you’re being taxed twice on an amount of income.

How to avoid double taxation

Canadian taxpayers avoid double-taxation by making a claim on their return for a foreign tax credit (FTC). That is to say, you get to claim a credit on your Canadian return for an amount of tax paid to a foreign country. The rest of this article is going to focus on the most common situation, which is paying US tax while living in Canada. However the general concepts hold for any country with which Canada has a tax treaty to avoid double taxation.

Related: Want to avoid paying US tax in the first place? Read about the W8BEN or check out our video.

Large FTC claims tend to trigger a review by CRA

When the amounts involved are small, say a few hundred dollars, the FTC claim is usually accepted on the honour system with no review from CRA.

But when amounts are significant, for example when you earn a full salary from a US payer and are taxed on it, CRA often won’t grant the FTC automatically. Instead, they will review the claim, and contact you to request supporting documentation showing the tax owing (federal and state), and the tax paid.

Related: How to handle a scary letter from CRA (video)

Why is my tax assessment so HIGH?

While CRA is reviewing your FTC claim, they suspend the credit. This means that they will issue an initial Notice of Assessment (NOA) showing the tax owing as if you haven’t paid any foreign tax at all. Naturally, this bill is very high. But assuming you have the supporting documentation available for CRA’s review, it is also temporary. After CRA has received and reviewed your supporting documentation they’ll issue a Notice of Reassessment, showing the revised tax bill with the foreign tax credit in place.

Supporting documentation you will need to provide

If your foreign tax credit (FTC) claim is chosen for review, you will usually need to send the following:

  • Copies of any tax slips from US payers, e.g. W2
  • A tax transcript from the American tax authorities, the Internal Revenue Service (IRS) for the tax year in question
  • If you also paid state tax, you’ll need a tax transcript from the state tax authorities as well

What is a W2?

A W2 is the tax slip showing your income from US salaries. It is equivalent to the Canadian T4.

What is a tax transcript?

A tax transcript is the IRS’s equivalent of a Notice of Assessment and a Statement of Account from CRA. Essentially, it serves to prove both what your tax liability was, and that you have paid it in full. This is the proof required in order for CRA to grant a FTC claim.

What to do if you need to make a FTC claim

If you have paid more than a few hundred dollars on US income and are therefore claiming a large foreign tax credit (FTC), file your return with the FTC claim and have your supporting documents ready in case of review.

What to do if you don’t have supporting documents yet

If you don’t have your tax transcript in time for tax season in Canada, just file your Canadian return on time anyway – and make the FTC claim — and arrange to obtain your transcript as soon as possible. It will take a while for CRA to ask for the supporting documents anyway, and with luck you’ll have it in hand by the time they contact you.

Only pay what you really owe

If your FTC claim is chosen for review, you’ll receive a large tax bill with the FTC temporarily disallowed. If you’re confident that the amounts of foreign tax paid were reported accurately, and that you have (or can obtain) the necessary proof to support those amounts, Do NOT pay the full tax bill. Just pay the portion you would owe if the FTC were in place.

Hang tight and don’t worry

CRA can be slow, so even after you submit the requested supporting documents you may be waiting several weeks for the FTC to be reviewed and granted. In the meantime, you may continue to receive Account Statements claiming you owe large amounts of tax, and interest accruing on those amounts. Don’t panic. The tax and the associated interest will be backed out, retroactive to April 30, once the FTC review is complete and accepted.

How to avoid an FTC review

In a word, you usually can’t. There is no way to avoid this (or any) review process if CRA decides to do it.

If you file your taxes electronically like most Canadians, you can’t just attach your supporting documents to the file even if you know ahead of time CRA is going to ask for them. Instead you just have to wait for CRA to request them, at which time you can submit them by mail or by CRA’s online document submission process.

If you wish to file your return on paper (by mail), you could include your supporting documentation with the package, and possibly avoid the interim step of being assessed without the FTC claim. But be aware:

  • Mailed-in returns must be assessed by hand, and usually take at least 8 weeks to be assessed (compared to electronically-filed returns, which usually take closer to two weeks)
  • Most professional tax preparation firms are required to file electronically and prohibited from filing on paper except in very limited circumstances

The best thing to do is file as usual and have your supporting documents handy. When CRA asks to see them, you’ll be able to pop them in the mail (or upload them electronically) as soon as you receive the request, speeding up the process significantly.