A CPA brings you a client file: $50,000 in US dividend income, $3,000 in US withholding tax paid. She calculates the foreign tax credit using the full $50,000 as foreign income. But there's $40,000 in interest expense on a loan that was used to buy those US stocks.
Should that interest expense reduce the net foreign income? The answer is yes — and it will dramatically change the foreign tax credit calculation, potentially eliminating the credit entirely.
This guide explains the sourcing rules for foreign tax credit calculations and provides a practical framework for defending your position if CRA questions your approach.
Why Expense Allocation Matters
The foreign tax credit formula has two components, and the one that limits most credits is:
(Net Foreign Income ÷ Modified Net Income) × Tax Otherwise Payable
Notice it says "Net Foreign Income"—not gross. Every dollar of expense you source against foreign income reduces that numerator, which reduces your foreign tax credit limitation.
Here's the impact:
Scenario A: No expense sourcing
• Foreign income: $50,000
• Canadian limitation: Assume $15,000
• Foreign tax paid: $7,500
• Credit claimed: $7,500 (gets full credit)
Scenario B: With $40,000 expense sourcing
• Net foreign income: $10,000 ($50,000 - $40,000)
• Canadian limitation: $3,000
• Foreign tax paid: $7,500
• Credit claimed: $3,000 (limited, $4,500 lost)
The difference? $4,500 in lost credits, simply because expenses were properly sourced. This is why understanding allocation rules is critical.
The Fundamental Principle: Direct Traceability
The basic rule is straightforward: expenses that can be directly traced to earning specific foreign income must be deducted against that foreign income.
As the seminar instructor explained: "Interest expense on a loan that was taken out to purchase, for example, foreign bonds or shares...that interest expense can be traced specifically to the income and should be sourced against the income."
This is not optional. If you can trace an expense to foreign income, you must allocate it. CRA will adjust returns that fail to do this properly.
Category 1: MUST Source (Direct Traceability)
These expenses have clear, direct connection to earning foreign income and must be allocated:
Interest Expense on Foreign Investment Loans
This is the most common and most significant expense requiring allocation.
When to Source:
- Loan specifically taken out to purchase foreign stocks
- Loan to purchase foreign bonds or GICs
- Margin account interest on foreign securities
- Loan to invest in foreign partnership or business
- Line of credit used specifically for foreign investments
How to Source: Calculate the specific interest paid on the portion of the loan related to foreign investments. If the loan was entirely for foreign investments, all interest is sourced. If partially for foreign and partially for Canadian, allocate proportionately.
Example:
Client has US dividend income of $20,000. They took out a loan of $300,000 at 4% interest specifically to purchase US stocks. Annual interest expense: $12,000.
Calculation:
• Gross US dividend income: $20,000
• Less: Interest expense on US investment loan: ($12,000)
• Net US foreign income: $8,000
This $8,000—not $20,000—goes into the foreign tax credit formula. With $3,000 of US withholding tax paid, the client may not receive full credit because the Canadian tax on only $8,000 of income could be less than $3,000.
Foreign Business Expenses
If you operate a business in a foreign country, all ordinary business expenses must be deducted to arrive at net foreign business income:
- Salaries and wages paid abroad
- Rent on foreign office space
- Foreign advertising and marketing
- Travel related to foreign business operations
- Professional fees related to foreign business
- Supplies and inventory costs
- Depreciation on foreign business assets
These follow normal business expense rules but are sourced specifically to the foreign business activity.
Foreign Property Operating Expenses
For foreign rental properties (common with US real estate):
- Property management fees
- Repairs and maintenance
- Property taxes
- Insurance
- Utilities (if paid by landlord)
- Depreciation (capital cost allowance)
- Mortgage interest on the foreign property
Important Distinction: If the property is owned personally, mortgage interest is sourced against rental income. If you borrowed in Canada to purchase the foreign property, that Canadian loan interest is also sourced against the foreign rental income through tracing.
Category 2: SHOULD Source on Reasonable Basis (Indirect But Related)
These expenses aren't directly traceable to one income source but have a reasonable connection to foreign income:
Investment Management Fees
The seminar instructor noted: "Probably investment management fees should be sourced on some reasonable basis to the foreign income."
When to Allocate:
- Advisor fees on portfolio including foreign securities
- Discretionary management fees covering foreign investments
- Wrap fees or account fees covering foreign holdings
Reasonable Allocation Methods:
- Pro-rata by market value: If 40% of portfolio is foreign securities, allocate 40% of management fees
- Pro-rata by income generated: If foreign investments generate 30% of total investment income, allocate 30% of fees
- Activity-based: If advisor spends disproportionate time on foreign holdings, weight accordingly
Document your methodology. CRA will accept reasonable approaches but expects consistency.
Safe Deposit Box Fees
If used to store foreign securities or foreign investment documents, allocate proportionately. Most CPAs allocate based on the percentage of box space or percentage of portfolio value.
Custodial or Account Fees
Fees charged by institutions for holding foreign securities should be allocated to foreign income. If the account holds both Canadian and foreign securities, allocate proportionately.
Category 3: DO NOT Source (No Connection)
Many expenses are not sourced at all because they lack direct connection to foreign income. The instructor specifically mentioned these:
RRSP Contributions
Never source RRSP contributions against foreign income. These are personal deductions unrelated to earning specific investment income.
Child Care Expenses
Personal deductions with no connection to foreign income source.
Moving Expenses
Unless the move was specifically to take up foreign employment (which would be foreign business income), don't source moving expenses.
Carrying Charges NOT Related to Foreign Income
- Interest on personal loans (mortgage on principal residence, car loans)
- Accounting fees for general tax preparation
- Financial planning fees unrelated to foreign investment decisions
The seminar emphasized: "Some items don't get sourced at all, such as RRSP contributions, child care expenses, moving expenses, et cetera. So there will always be some approximations in how you calculate the net foreign income."
The Grey Area: Accounting and Professional Fees
This is where judgment enters.
The instructor's guidance: "What about investment management fees? Probably investment management fees should be sourced on some reasonable basis to the foreign income. But certainly things like accounting fees were not sourced."
When NOT to Source Accounting Fees:
- General tax return preparation
- Bookkeeping services
- Routine tax planning advice
- Compilation or review engagements
These are general services not specifically related to earning foreign income.
When TO SOURCE Accounting/Professional Fees:
- Tax advice specific to foreign tax credit calculations
- Professional fees related to foreign partnership returns
- Consultants hired to navigate foreign compliance
- Tax preparation of foreign corporate returns (if applicable)
- Legal fees to acquire or sell foreign business
Practical Approach: Most CPAs don't source general accounting fees. If specific work was done related to foreign income (like preparing T1135 or researching foreign tax treaties), you could allocate those specific costs, but this is rare in practice.
Special Situations
Foreign Exchange Losses
Foreign exchange losses on foreign income or foreign investments are deductible and should be sourced against foreign income if they relate to that specific investment.
Capital Losses on Foreign Securities
Capital losses don't directly reduce current income but can affect overall tax planning. They're not typically "sourced" in the foreign tax credit calculation but are relevant in overall return preparation.
Partnership Allocations
If you're a partner in a partnership earning foreign income, expenses flow through to you proportionately. The partnership should identify which expenses relate to foreign vs Canadian income. As the partner, you report the net foreign income after partnership-level expenses.
Calculating Net Foreign Income: Step-by-Step
Here's the practical process:
Step 1: Identify all gross foreign income from a specific country and type (business or non-business)
Step 2: List all expenses with DIRECT traceability
- Interest on foreign investment loans
- Foreign business operating expenses
- Foreign property expenses
- Subtract these fully
Step 3: List expenses with INDIRECT connection
- Investment management fees
- Safe deposit fees
- Custodial fees
- Allocate on reasonable basis (document your method)
Step 4: Ignore expenses with NO connection
- RRSP contributions
- Personal expenses
- General accounting fees
- Don't subtract these
Step 5: Calculate net foreign income
Gross foreign income - Direct expenses - Allocated indirect expenses = Net foreign income
Step 6: Use this net amount in your FTC formula
Real-World Calculation Example
Let's work through a complete scenario:
Client Profile:
• US dividend income: $35,000
• US interest income: $10,000
• Canadian dividend income: $25,000
• Total investment portfolio value: $1,200,000 (US: $450,000, Canadian: $750,000)
Expenses:
• Interest on loan for US stock purchase: $15,000
• Investment advisory fees: $6,000 (covers entire portfolio)
• Accounting fees for tax return: $2,500
• RRSP contribution: $10,000
Calculation:
Gross US Income:
• Dividends: $35,000
• Interest: $10,000
• Total: $45,000
Direct Expenses:
• Interest on US investment loan: $15,000
• Subtotal after direct expenses: $30,000
Indirect Expenses (Advisory Fees):
• US portion of portfolio: $450,000 ÷ $1,200,000 = 37.5%
• Allocated advisory fees: $6,000 × 37.5% = $2,250
• Subtotal after indirect expenses: $27,750
Expenses NOT Sourced:
• Accounting fees: $2,500 - NOT deducted (general service)
• RRSP contribution: $10,000 - NOT deducted (personal deduction)
Net US Foreign Non-Business Income: $27,750
This $27,750 is what goes into the foreign tax credit limitation formula—not the $45,000 gross income.
If US withholding tax was $6,750 (15% of $45,000), the client won't receive full credit. The Canadian tax on $27,750 of income will be less than $6,750, so the excess is lost.
Documentation Requirements
CRA almost universally verifies foreign tax credits, even small amounts. Document your expense allocation:
Maintain These Records:
- Loan agreements showing purpose of borrowing
- Investment statements showing foreign holdings
- Fee statements from advisors/custodians
- Calculations showing allocation methodology
- T5008 slips showing foreign security transactions
- Foreign tax slips (1099s, etc.)
Create a Working Paper:
I recommend creating a simple working paper for each client with foreign income:
This proves to CRA that you applied a thoughtful, consistent approach.
Common CRA Questions
Based on the instructor's extensive experience, CRA reviewers commonly ask:
"Why wasn't [expense] deducted against foreign income?"
Response: Show it has no direct traceability to foreign income specifically, or that it's a personal deduction not subject to sourcing rules.
"How did you allocate [advisory fees]?"
Response: Explain your reasonable basis (pro-rata by value, by income, etc.) and show the calculation.
"Where's the documentation for the interest expense?"
Response: Provide the loan agreement and investment purchase documents showing use of proceeds.
The seminar emphasized that CRA is often wrong in their reassessments but extremely difficult to deal with. Solid documentation is your best defense.
Key Takeaways
Proper expense allocation is essential for accurate foreign tax credit calculations:
- Interest expense on foreign investment loans must be fully sourced - this is the most common and impactful allocation
- Investment management fees should be allocated on a reasonable, documented basis - proportionate to foreign holdings
- General personal expenses and accounting fees are typically not sourced - RRSP contributions, child care, and routine accounting are excluded
- Net foreign income can be dramatically lower than gross foreign income - significantly limiting the foreign tax credit
- Document your methodology and keep supporting records - CRA will verify, and solid documentation wins disputes
