International income isn’t always tax-free

Advisor's Edge

2011-04-12


It’s common these days for nearly every financial advisor to have at least one client with a foreign connection. That could mean a client with a foreign parent living overseas or a child living in the United States. It could also be a client who has previously lived in Europe and then immigrated to Canada, but still has financial ties with the foreign jurisdiction.

A recent decision of the Federal Court of Appeal demonstrates just how difficult it can be to ascertain how the Canadian tax rules, which tax Canadian residents on their worldwide income, should be applied to foreign source amounts — which at first glance may appear to be tax-free.

The case (Woods v. The Queen, 2011 FCA 90) involved Sheila Woods, who was appealing an earlier decision of the Tax Court of Canada. The court heard the case on March 9, 2011.

Woods’s brother, Martin Kaye, died in the summer of 2004 while employed by QinetiQ Group PLC or QinetiQ Limited (the employer) in the United Kingdom. The employer had set up the QinetiQ Pension Scheme (the plan), which was a trust fund established to provide retirement benefits to its employees as well as the employees of associated employers. In addition, the plan provided for a death benefit equal to three times the employee’s annual salary at the date of death.

When Martin Kaye died, the plan’s trustees paid a death benefit of 110,466 British pounds sterling to his family members, of which Woods, a Canadian resident, received approximately $65,000 Canadian, which was equal to 25% of the total amount.

When Woods filed her 2004 tax return, she treated the $65,000 as non-taxable life insurance proceeds and thus did not pay tax on the amount received. The CRA disagreed and reassessed her to include the payment as income to her as a taxable superannuation or pension benefits.

The issue before the Appeal Court came down to whether the lower Tax Court judge made an error in concluding that the death benefits paid to Woods under the plan constituted superannuation or pension benefits rather than non-taxable life insurance proceeds. The lower court found the proceeds did not meet the criteria of a death benefit.

The Tax Court judge commented in his reasons that the death-benefits provision of the pension plan may serve as “the economical functional equivalent of life insurance.” Woods therefore argued that the Tax Court judge should have given more weight to her submission that “the payment was akin to the proceeds of a life insurance policy.”

According to Woods, “the judge elevated form over substance and erred in so doing.” Her basic argument was that just because the payment she received was paid under the provisions of the pension plan, does not mean that it cannot be considered to be a life-insurance benefit.

Citing an oft-quoted decision of the Supreme Court of Canada (Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622), the Federal Court of Appeal said that “economic realities will never take priority over the application of an unambiguous provision of the Act.

“The definition of ‘superannuation or pension benefit’ is found in (the Act) and includes ‘any amount received out of or under a superannuation or pension fund or plan.’ ”

The Federal Court found that since the only source of entitlement to the payments in this case can be found in the pension plan, the Tax Court’s finding should not be overturned since the death benefits set out in the plan “are inextricably tied to the more general retirement benefits” provided therein.

The case demonstrates that when it comes to matters of foreign jurisdiction, what may at first glance appear to be tax-free could be subject to tax in Canada under the plain reading and interpretation of our Income Tax Act.