Editor’s note, Sept. 2018: This article was written in 2010 and many of the specifics may be outdated. This article, from 2017, is more updated.
The strong loonie has many Canadians shopping for foreign investment opportunities. But Canadian residents are required to pay tax on their worldwide income. That is, income earned by a resident of Canada is subject to Canadian income tax, regardless of the country in which the income is originally earned.
Determining Canadian tax liability essentially comes down to a question of residency – Canadian taxes are based on Canadian residency, rather than Canadian citizenship. Although the rules regarding Canadian residency can be complex, largely it’s a matter of establishing residential ties in Canada.
For example, consider a married couple where one spouse lives and works in Canada, while the other works on a cruise ship in the Caribbean. Even though the spouse working on the ship may be earning a tax-free income, that income still needs to be reported and a Canadian tax return filed.
Similarly, when residents of Canada hold foreign investments – say, a security on a U.S. stock exchange – there are Canadian tax consequences. In particular, any income, dividends or capital gains generated by such foreign investments must be reported to the CRA, and corresponding taxes must be paid.
Taxation of foreign investments
Canadian residents who hold shares traded on foreign exchanges are typically not required to file income tax returns in those countries. Instead, all income, dividends and capital gains related to the foreign investments must be reported on a Canadian income tax return. Note this is only the case for shares held in non-registered accounts. If foreign shares are held in a registered account, such as an RRSP or RRIF, the investment returns are effectively denatured, and all investment earnings are taxed as regular income upon withdrawal.
This opens the door to possible discussions around client strategies, such as which investments should be held inside vs. outside an RRSP.
To determine the correct amount to include in a tax return, income and dividends earned from foreign investments must first be converted to Canadian dollars.
There are two options available for the conversion: The exchange rate on the date the foreign dividend or income is actually received by the investor; or The average annual exchange rate published by the Bank of Canada for all income and dividends received throughout the year.
When calculating capital gains, the adjusted cost base of foreign stocks must also be converted to Canadian dollars. Note as well that when shares in foreign corporations are bought or sold, the corresponding purchase and sale prices must be converted to Canadian dollars using the official exchange rate on the trade date, as opposed to the settlement date.
Foreign tax credit
When Canadian taxpayers declare foreign investment income, they’re required to pay any corresponding taxes to the CRA. However, this can present a problem of double taxation if taxes have also been levied on the income by the foreign country in question.
This issue can often be solved, in part or in whole, by claiming a foreign tax credit when filing a Canadian tax return. Essentially, the T2209 – Federal Foreign Tax Credit is a means of protecting Canadians against double taxation when investment earnings are generated from foreign sources.
In particular, the foreign tax credit provides investors with a credit for withholding taxes previously paid to another country, up to 15%.
If the credit is insufficient — that is, if the credit is less than the foreign tax paid – investors may also be able to claim a provincial (or territorial) tax credit via a T2036 – Provincial Foreign Tax Credit.
Amounts over $100,000
Of particular importance is the ownership, by any individual or legal entity (business, corporation, trust or partnership), of foreign property where the total cost, at any point in the year, was more than CDN$100,000. In this case, there’s an additional filing requirement: T1135 – Foreign Income Verification Statement.
Consider the case of an individual who owns shares of Coca-Cola on the New York Stock Exchange with a total cost amount of CDN$170,000.
Since the cost of the shares exceeds CDN$100,000, the investor must file a T1135, regardless of whether the shares are held with a Canadian dealer or not. But there are cases where a T1135 is not required: if, say, the investor held the same shares in an RRSP.
Likewise, consider a retired Canadian who owns a condominium in Florida with a cost of $130,000. If the condo is considered a personal-use property, a T1135 is not required. However, if the condo is used as a rental property, with an expectation of profit, a T1135 must be filed.
As with most anything else, penalties are imposed by the CRA if the proper documentation isn’t filed, or is filed incorrectly.
Risks for taxpayers
Countries that apply either very low tax rates or no tax whatsoever often attract investors from all over the world.
Despite the negative association with illegal activity in many tax havens, there are often valid reasons for pursuing such strategies, and the CRA generally has no concerns about where Canadians invest, provided those investments comply with the law in Canada.
On the other hand, investors partaking in tax-avoidance or tax-evasion schemes are asking for trouble. One of the fundamental principles of the Canadian tax system is that we, as Canadians, are required to report income earned anywhere in the world. Subsequently, we must pay taxes on that income, regardless of where it was earned. Failure to do so immediately puts investors offside with the CRA, and offside with the law.
In short, failing to report all sources of income, and evading tax, is a serious crime with serious consequences.
Michael Callahan, CFP, helps families, individuals and business owners develop and implement long-term financial strategies.