In 2014-0525231I7, a Canadian company (Canco) received a dividend from its foreign affiliate (FA) in Japan then sold the shares of FA at no gain.  Canco had no other income from a source in Japan.  The pre-sale dividend was subject to withholding tax (WHT) in Japan and the question was whether this WHT qualified for a foreign tax credit (FTC) in Canada under s. 126(1).  It did not.

  1. The dividend was paid from FA’s preacquisition surplus, with the result that an amount equal to the dividend less the WHT reduced Canco’s ACB of its FA shares under s. 92(2).
  2. This reduction drove Canco’s ACB of its FA shares negative, resulting in a deemed capital gain to Canco under s. 40(3).
  3. The CRA’s longstanding position is that a gain under s. 40(3) isCanadian-sourced.  As a result, the WHT paid in Japan could not give rise to a FTC under s. 126(1).
  4. Article 21 of Canada-Japan tax treaty was of no assistance to Canco because the deemed gain under s. 40(3) was not taxed in Japan.