How to Claim Tax Treaty Benefits to Avoid Double Taxation

Wanderer
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“We’re going to need to see a Japanese tax return.”

“You want a what?!?” I sputtered.

There are lots of things FIRECracker and I pictured when we started down the path of becoming published authors. Coffee-powered days (and nights) of writing and editing? Sure. Media interviews and book tours? Why not. But reading and re-reading the dense, obscure legalise of international tax treaties until our eyes bled? That didn’t show up anywhere on our becoming-a-writer BINGO card.

When we first published Quit Like a Millionaire back in 2019, our agent extraordinaire Andrea Somberg went around selling translation rights to about half a dozen other countries. Our book is now published not just in the US, Canada, and the UK, but also translated into German, Spanish, Korean, Vietnamese, Japanese, and Chinese.

Pretty cool, right? But it also means every year, our tax situation is now super complicated, as we have to report income coming from (potentially) 8 different tax jurisdictions on our Canadian tax return.

Here’s a fun fact about foreign income. If you live in a country with a worldwide-income taxation system, such as Canada or the US, you have to report any income you make, no matter where you make it, to the tax authorities in your home country.

However, before you get that money, the country where it came from also wants their cut, so they will often impose withholding taxes at source. This amount varies by country, but generally you only see the amount after withholding taxes are already deducted.

This creates a problem when you file your return. If that income were reported as if it were any other income, it would be double-taxed. The source country taxed that income before you got it, and then your home country taxes it again when you file your tax return.

To avoid this, many countries have bilateral tax treaties between them that both cap the withholding taxes each country is allowed to take, and contains provisions that allow the taxpayer to claim taxes paid to one country and use it to offset taxes paid to the other country. Theoretically, this should eliminate any situations of double taxation. In practice, this is a little more complicated to actually use.

Foreign Tax Deductions vs. Foreign Tax Credit

For one thing, many people don’t report their withholding taxes correctly.

Here’s an example. Say you have $10,000 of foreign income in the form of royalties. Royalty income is the situation that applied to me, but this situation can also apply to people with foreign interest, dividends, or rental income.

This foreign country takes a 10% withholding tax, so what you actually get is a check for $9000.

Many taxpayers would report $9000 on their tax return as foreign income and leave it at that. What they’ve effectively done is report their foreign taxes as a deduction, since this is the same as reporting the gross $10,000 as income, and then deducting $1,000 in foreign taxes withheld.

Here’s why this isn’t the best way to do that.

Let’s say that your home country has a 20% marginal tax rate on the same income at your tax bracket. Ideally, a solution that avoids double taxation would apply the higher of the two countries’ tax rates, so in this case 20%.

But by claiming the 10% withholding tax as a deduction, this is what happens instead.

Gross Foreign Income$10,000
Foreign Withholding Tax (10%)$10,000 x 10% = $1,000
Home Country Taxable Income$10,000 – $1,000 (deducted) = $9,000
Home Country Taxes (20%)$9,000 x 20% = $1,800
Home Country Net Income$9,000 – $1,800 = $7,200

Right away you can see how something’s gone wrong here. Our original $10,000 income has turned into $7,200? That means we’ve paid $2,800 in taxes, for an effective tax rate of 28%! That’s way higher than 20%!

This is what happens if you claim the withheld tax as a deduction. It reduces the amount of taxable income you have to report, but then your home country takes a bite out of the remaining amount without taking into account the fact that you’re not supposed to be double-taxed on the rest.

Now let’s see what happens if you claim the foreign tax withheld as a Foreign Tax Credit instead.

Gross Foreign Income$10,000
Foreign Tax Withheld (10%)$10,000 x 10% = $1,000
Home Country Taxable Income$10,000
Home Country Taxes (20%)$10,000 x 20% = $2,000
Foreign Tax Credit$1,000
Home Country Tax Payable$2,000 – $1,000 = $1,000
Net Income$10,000 – $1,000 – $1,000 = $8,000

A few big differences here. First of all, one big difference is that rather than report the post-tax income to our home country’s tax authorities, we’re actually reporting the gross (pre-tax) income instead.

Both CRA and IRS guidelines specify that you should be generally reporting your gross income rather than your net, but most people in this situation report the net income after withholding taxes because it’s a lower number. Counterintuitively, not only is this the wrong thing to do from a strict rule-following perspective, but it makes the outcome worse because the formulas that are designed to prevent double-taxation don’t kick in properly.

Next, we are explicitly claiming the $1,000 tax withheld as a Foreign Tax Credit. FTC’s get credited against your taxes owing dollar-for-dollar, but you have to explicitly tell your tax software that it’s a Foreign Tax Credit for this to work.

Done this way, your total take-home amount is $8,000, which represents a 20% total effective tax rate. The first 10% is withheld by the foreign country’s tax authorities, and the remaining 10% is remitted to your home country’s tax office. Double-taxation is avoided and, more importantly, you get to keep more of your hard-earned cash.

Interestingly, the American tax system allows you to claim foreign taxes as either a deduction or a credit, but in order to claim it as a deduction you have to itemize your deductions. Claiming this as a credit is almost always worth more, because the FTC is more advantageous as I showed above, and claiming it as a credit doesn’t interfere with your ability to take the standard non-itemized deduction on your tax return, so you get both benefits if you do it this way.

How To Claim

OK so how do you actually claim this amount?

First, you have to report your gross income before withholding taxes. How you do this depends on the type of foreign income you have (interest, dividends, royalties, etc.) and whether the foreign country issued a tax slip. If you have a tax slip, great. Just enter the number in the boxes like any other income and your tax software should be able to figure it out.

If you’re like me and you never got a tax slip, however, you have to manually enter it. For me, royalty income is entered on a Canadian tax return under line 10400: Other income. On my tax software, I was able to enter it as “Tips, Royalties, Occasional Earnings, Etc.” Americans can report it under Form 1040: Schedule E (Supplemental Income and Loss From rental real estate, royalties, partnerships, S corporations, estates, trusts, REMICs, etc.)

Now, the withholding tax. These should be explicitly reported as a Foreign Tax Credit. In Canada, this is done using form T2209 (Federal Foreign Tax Credit) and T2036 (Provincial and Territorial Foreign Tax Credit). I was able to enter it into my tax software as a Foreign Non-Business Tax Credit.

Americans have to submit a separate form in order to claim the FTC. If your total FTC claim is over $300 ($600 for married joint filers), you’re going to need to attach Form 1116. Make sure your tax software is preparing this form correctly, and make sure you’re also deducting the standard deduction if you do this to get both benefits.

Defending Your Claim

OK so now that we’ve entered the information into the right boxes, we should be on easy street, right? That’s what I thought, until my tax return got flagged for review.

Foreign Tax Credit claims are not part of most people’s returns, so this may get you some extra scrutiny. I certainly got some, which is how I ended up on the phone with a CRA auditor demanding a Japanese tax return to support my claim.

“But I’m not a Japanese tax resident. Why should I have to file a Japanese tax return?” I asked.

“Well, you have to show us something official to justify this claim, or we’re going to disallow it.”

I hung up, dejected. A few days later, I got a notice from the CRA that my return had been reassessed, disallowing my FTC claim and demanding more money to cover the additional taxes, plus interest, fees, and penalties.

Fan-fricking-tastic. This is not what I signed up for when I became an author.

What followed was a protracted battle with the tax authorities, with me trying to explain how my claim was legally sound, and them insisting that I provide the relevant provision in a tax law somewhere to back it up. Unfortunately, this meant I had to deep-dive into the text of the Canada-Japan Tax Treaty, which is written in such dense language that I often had to read each sentence five times in order to understand it. If you thought that tax laws are confusing, try reading tax laws written by diplomats.

In the end, I ended up finding the two articles in the act to make my case. The first was Article 12, para 1, 2, which established the 10% withholding rate that the Japanese tax authorities kept:

Article 12

  1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other Contracting State.
  • However, such royalties may also be taxed in the Contracting State in which they arise and according to the laws of that Contracting State, but if the beneficial owner of the royalties is a resident of the other Contracting State, the tax so charged shall not exceed 10 per cent of the gross amount of the royalties.

And article 21, para 1.a, which established why I was claiming that 10% amount as a Foreign Tax Credit as part of the Tax Treaty:

Article 21

  1. In the case of Canada, double taxation shall be avoided as follows:
    1. Subject to the existing provisions of the laws of Canada regarding the deduction from tax payable in Canada of foreign tax paid and to any subsequent modification of those provisions which shall not affect the general principle hereof, and unless a greater deduction or relief is provided under the laws of Canada, tax payable in Japan on profits, income or gains arising in Japan shall be deducted from any Canadian tax payable in respect of such profits, income or gains.

I nervously sent my letter off to the tax office and waited. Days passed, then weeks, then months. No response. All the while, my tax bill kept ticking up as interest accrued. I’d better win this claim, I told FIRECracker, or this is going to be a really expensive waste of time.

Finally, over 6 months after my account got initially flagged for review, I received the following letter.


Hello,

Subject: 2022 income tax and benefit return

We completed our review of your return. Based on the documents you sent us, we allowed the claim(s) under review.

Thank you for your cooperation.


PHEW. Pop the champagne, they allowed my claim!

A day later, I got another notice saying my tax owing had been reduced to $0, and all the interest, fees, and penalties were reversed.

That evening, as FIRECracker and I celebrated over dinner, she asked me whether it was worth the fight, and at the time I wasn’t sure, but now that I look back on it, it absolutely was. Not only did I end up saving thousands of dollars, I learned a valuable new skill, which was how to defend this claim if challenged in the future.

Plus, she suggested wryly, this would probably make a good article.

Conclusion

So there you have it. While this turned out to be a frustrating experience that wasted a lot of time, it was nice to be vindicated at the end. Hopefully someone will read this story and benefit from my experience.

Or at the very least, find it entertaining, in a nerdy, tax-optimizing way.


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30 thoughts on “How to Claim Tax Treaty Benefits to Avoid Double Taxation”

    1. That’s actually a really great point. If I had to work, take care of a kid, AND deal with the CRA on this, I think I would have just given up. FIRE for the win again!

  1. Love this article, and very applicable to our situation as hubby has just started selling books, some of them outside the US. Just a question: did your Japanese royalty income show up on a document from your publisher? and did it show up as 10k or 9k?
    Thanks!

    1. Hey, congrats to your hubby on getting published!

      We got a statement from our agent (since our agent kept foreign rights) that broke out the different line items. So it shows our gross, then agent commissions, then foreign taxes.

  2. Holy Cow Wanderer! BRAVOOO!! What a story! LOL Kristy is right. This is a good article with ups and downs and especially for those who are into nerdy and tax-optimizing reading. Foreign tax law and policy sounds so complicated that it almost makes me want to throw up. You did a great job explaining it in a simple manner. Also, glad you survive and came out winning! 🙂

  3. confused . why Japan …. . you are resident in Canada ?? paying rent in Toronto ?

    anyway . i am similar i think .. i have all my investments back in Canada and moved to UK last year

    there is a double taxation agreement with UK .. not sure how it helps ?

    another new thing …. our funds are automatically deducted 15% every dividend payment for CRA … BUT every May we should get some refund for the ROC portion and eligible dividends ??

    yet to file first UK return

  4. Wow, that’s one of those situations where hiring an accountant might be worthwhile.

    How does this apply to withholding taxes on ETF dividends? I know there’s an optimization based on which account (RRSP, Margin, TFSA, FHSA) the securities are held in but I hadn’t considered the filing details.

    1. The most common scenario for Canadians is US-listed ETFs (like VTI) held by a Canadian taxpayer, in which case the best place to put those is in an RRSP, as the tax treaty recognizes this account as a retirement account and sets the withholding tax rate at 0%.

      If you hold US-listed ETFs in your non-registered account, you will get charged a 15% withholding on foreign dividends, but those dividends are claimable as a foreign tax credit against other taxes owing.

      1. Thanks Wanderer, that’s what I’ve been doing. It’s good to know that it’s specifically the retirement account, so they likely won’t recognize the FHSA. And any Canadian ETFs in the TFSA. And rest of world in margin.

        Cheers

  5. What about if the opposite occurs? The foreign country withholds 20% tax and your tax rate in Canada is 10%.

    I assume that you lose the difference.

  6. Glad you won that fight… I lost. My parents get very small pensions from Germany. A portion of this is taxable in Germany and a portion in Canada. The tax treaty related to German pensions is very complex (based on 50% of the original pension amount in Euro’s – in my dad’s case dating back decades – updated to the tax year’s average annual exchange rate). I sent them the tax treaty and explained how I was following the rules. They wanted original documentation from Germany, officially translated into English. Here’s the rub – my parents are low-income seniors and would owe $0 in taxes EVEN IF we include the full German pension as taxable in Canada. I gave up trying to convince the CRA and just put in the full pension as taxable. What a stupid, stressful, waste of everyone’s time and energy. If anyone had better luck dealing with Germany, please let me know!

    1. Ugh, that sounds really annoying. My understanding is that you still have to report foreign pensions as taxable income in Canada, but the withheld taxes should be claimable against other Canadian income. Did they not let you claim the FTC?

  7. As a Canadian who is a permanent resident of Japan, I still have dividend income from my non-RRSP accounts, so I can kind of identify with what you’re saying about avoiding double taxation with the tax treaties between countries.

  8. Wow, that was legendary that you went through all that! Thanks for posting about it. Great explanation.

    I hate complication, and will try to avoid any situations where I have to invoke a tax treaty!

  9. Unfortunately, you have to deal with a revenue agent who has no knowledge of international tax laws and also is too lazy to do any research. Fortunately, you are FIRE’d and have nothing better to do than to play with foreign tax treaties. LOL!

    1. The CRA agents were courteous and professional, but it’s a truism amongst tax offices everywhere that they are always intimately familiar with the rules that say YOU have to give THEM more money. The rules that say the opposite, however, you have to figure out yourself.

  10. Oh man, I didn’t realize that Canada was also stupid and unfair like the US for taxing on world wide income…I’m seriously considering resign my citizenship now that I’m living in Costa Rica

    1. Yeah, I understand the temptation, but please keep your US citizenship. You never know when shit’s going to hit the fan in South America. Just ask Ecuador.

  11. our tax rate when we lived in BC canada was only 8% as a retired couple living off dividend income .

    now we have the 15% witholding tax .. so i have reduced our income by not investing in dividend funds as much … why pay more tax on money i dont need ??

    UK tax is 8% if i can keep under a certain amount .

    BUT .. we will get a refund every May for the portion of the dividends that are ROC ..

    its a process

  12. Amazing work! The patience and persistence to sort that out is next level. Even the CRA didn’t know that was there. 🙂

    This is why I pay accountants in each of the countries I file a return in… the more countries the more complicated and the more likely something like this will come up and cost me thousands.

  13. I’m wondering if you sent CRA the statement from Japan showing your Japanese royalties and Japanese taxes paid? My experience with supporting foreign tax credit claims is that CRA wants to see paperwork showing the foreign taxes withheld and paid to the foreign country, which may be in the form of a foreign tax return but could also be other documentation showing the foreign taxes paid.

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