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IFP
The Canadian Institute of Financial Planning
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Income Tax Planning
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CIFP - FINANCIAL PLANNING 2
M1C11V10 ITP 01/10
Income Tax Planning
The Canadian Institute of Financial Planning 3660 Hurontario, Suite 600 Mississauga, Ontario L5B 3C4 Tel: 1-866-635-5526 www.CIFP.ca
This printed text material is a facsimile of the online text. It is to be used in conjunction with the online course.
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Table of Contents
Unit 1: Introduction to Income Tax Planning.................................................... 1-1
Lesson 1: Money Management .....................................................................................................1-2 Lesson 2: Understanding Credit ..................................................................................................1-29 Lesson 3: Income Tax Basics .........................................................................................................1-43 Lesson 4: Completing an Income Tax Return.............................................................................1-47 Lesson 5: More on Completing an Income Tax Return .............................................................1-54 Lesson 6: Integrating Income Tax Planning and Financial Planning ......................................1-59
Unit 2: Proprietorships and Partnerships ........................................................... 2-1
Lesson 1: The Role of Businesses in Wealth Accumulation .....................................................2-2 Lesson 2: Partnerships ...................................................................................................................2-8 Lesson 3: Partnerships and Income Tax ......................................................................................2-16 Lesson 4: Limited Partnerships ....................................................................................................2-26 Lesson 5: Business Income ............................................................................................................2-35
Unit 3: Corporations ............................................................................................... 3-1
Lesson 1: Defining a Corporation ................................................................................................3-2 Lesson 2: Types of Business Corporations ..................................................................................3-6 Lesson 3: Shares and Shareholders ..............................................................................................3-12 Lesson 4: Organizational Structure of a Corporation................................................................3-18 Lesson 5: Corporate Taxation 1 ....................................................................................................3-25 Lesson 6: Corporate Taxation 2 ....................................................................................................3-41 Lesson 7: Taxation of Shareholders .............................................................................................3-52 Lesson 8: Corporations as Wealth Accumulation Vehicles for the Owner/Manager ..........3-58
Unit 4: Income Tax Planning and Research ....................................................... 4-1
Lesson 1: Residency and Installment Payments ........................................................................4-2 Lesson 2: Deadlines, Penalties, and Review ...............................................................................4-10 Lesson 3: Income Tax Planning and Research............................................................................4-21 Lesson 4: Miscellaneous Deductions ...........................................................................................4-28
Unit 5: Taxation of Employees and Alternative Minimum Tax .................... 5-1
Lesson 1: Types of Employment Income and Taxable Benefits ...............................................5-2 Lesson 2: Fringe Benefits not Included in Income .....................................................................5-13 Lesson 3: Employee Stock Option Plans .....................................................................................5-23 Lesson 4: Alternative Minimum Tax ...........................................................................................5-30
Unit 6: Taxation of Property Income ................................................................... 6-1
Lesson 1: Interest, Dividends, and Income Earned ...................................................................6-2 Lesson 2: Rental Income ................................................................................................................6-10 Lesson 3: Capital Cost Allowance ................................................................................................6-17 Lesson 4: Disposing of Depreciable Property.............................................................................6-26 Lesson 5: Other Deductions from Business and Property Income ..........................................6-36 Lesson 6: Income Attribution Rules.............................................................................................6-43
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Unit 7: Taxation of Capital Property ................................................................... 7-1
Lesson 1: The Role of Property in Wealth Accumulation .........................................................7-2 Lesson 2: Calculating Capital Gains and Losses ........................................................................7-10 Lesson 3: Dispositions ...................................................................................................................7-21 Lesson 4: Losses ..............................................................................................................................7-33 Lesson 5: Special Situations ..........................................................................................................7-41 Lesson 6: Capital Gains Exemptions ...........................................................................................7-49
Unit 8: Making Use of Tax Advantages .............................................................. 8-1
Lesson 1: Tax Advantages .............................................................................................................8-2 Lesson 2: Investment Benefits.......................................................................................................8-9 Lesson 3: Choosing the Right Tax Advantages ..........................................................................8-13
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Income Tax Planning
Preassessment
This Preassessment is an optional tool to help you make efficient use of your time. It allows you to test yourself before you start the course. You can use it to identify content that you are already familiar with, and areas where you will need to focus more attention. You will answer 100 questions covering the general areas of study. After you answer all of the questions, you can click Submit to see your score. Your score will not be tracked; it is for your information. If you would like to do the Preassessment now, click the Preassessment link. If you do not want to do the Preassessment, click Course Overview on the table of contents to start the course.
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Income Tax Planning
Course Overview
Welcome to the Income Tax Planning course. This course will provide you with the knowledge and judgment to guide your clients in managing their business and investment assets. This requires an understanding of the economic issues, business activities, investment products, their tax implications, and numerous management strategies. After completing this course, you will be familiar with the following: • • • • • • • various money management strategies and the different types of consumer credit the structure and taxation of various business forms, including proprietorships, partnerships, and corporations the deadlines for filing tax returns, the impact of filing late, and the major components of the federal and provincial tax legislation the taxation of employment income and benefits, including ways to increase an individual’s compensation without necessarily increasing his or her taxable income the taxation of investment income, including property income (interest, dividends, and rent) and capital gains as well as the important deductions available for various income sources how economics affect the accumulation of wealth how an individual can make use of the different tax strategies available to maximize his or her wealth accumulation
To continue, click the Next button in the bottom, right corner of the screen.
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I FP
Unit 1: Introduction to Income Tax Planning
Income Tax Planning
Unit 1: Introduction to Income Tax Planning
Welcome to Introduction to Income Tax Planning. In this unit, you will learn about money management strategies, the different types of consumer credit, and fundamental terminology associated with personal income taxation. You will also learn how to perform various tax calculations, as well as describe the implications of tax planning in financial planning. This unit takes approximately 4 hours to complete. You will learn about the following topics: • • • • • • Money Management Understanding Credit Income Tax Basics Completing an Income Tax Return More on Completing an Income Tax Return Integrating Income Tax Planning and Financial Planning
To start with the first lesson, click Money Management on the table of contents.
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Introduction to Income Tax Planning
Lesson 1: Money Management
Welcome to Money Management. In this lesson, you will learn about the different perceptions that different people have about money, and how those perceptions affect their money management decisions. You will also learn about how you can use money wisely through cash flow management, budgeting, and the cautious use of credit. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: • • • • • describe how people perceive money, and how those perceptions affect their management styles explain how various financial statements are used in the money management process identify typical money management strategies collect and analyze your client’s money management information, including statement of lifestyle expenditures and statement of cash flow assist your client in identifying money management objectives
Overview
Technically, money is a medium of exchange or a measure of value that you can use to pay for goods and services and to settle debts. Money in our society is, in its most basic sense, an economic necessity. You need money to purchase the things that you require for your survival and well being. However, money is also a motivator of human behaviour, and it means different things to different people. Depending on the person, money may symbolize power, security, freedom, self-respect, happiness or even love. The way that you perceive money significantly influences the way that you manage it. This influence can be either positive or negative, in that it may help or hinder your ability to meet your financial goals. The money management process is an essential component of any financial planning process. In fact, good money management mirrors the five-step financial planning process. Because the use of credit is so prevalent in our society, credit management is a critical component of sound money management. This lesson discusses the range of perceptions that people have about money, and how those perceptions affect their money management decisions. It also provides information on how you can use money wisely through cash flow management, budgeting and the cautious use of credit.
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Income Tax Planning
Personal Money Perceptions
Everyone has different values or perceptions about money and the role that it plays in their lives. Though most people have similar perspectives, some people have more extreme values and perspectives. Some examples of these extremes are: • Value of money: To some people, money means security, and the need to save money controls most of their financial decisions. To others, money means freedom and a way to do whatever they please, right now, today, without any thought of what is needed for tomorrow. Risk tolerance: Some people are so afraid of risking their future financial security that they shun all but the most conservative of savings vehicles, or even worse, keep their cash hidden away at home. Others are quite flamboyant about their investments, and are tantalized and tempted by get-rich schemes that are almost certainly doomed to failure. Credit: Some people consider credit to be a natural extension of their personal bank account. They believe that they must be in a strong financial position as long as someone is willing to advance them credit. Others refuse to enter into any kind of credit arrangement, even when it is justified for a modest house purchase, or when borrowing money for investment purposes makes good sense.
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As an adult, your own approach to money has likely been influenced by your parents, family members, cultural background, and your financial experiences. For example, if the lack of money was a frequent cause of bitter parental disputes when you were growing up, you may have come to believe that building your savings and financial security is a priority. On the other hand, if money never seemed to be a problem when you were growing up and your parents never discussed the issue in front of you, you might have developed a more carefree attitude towards money management. Caroline, a 35-year-old lawyer, is the only child of a successful professional couple. She works 60-hour weeks and has an income of $150,000 per year. She owns a beautiful home in an exclusive part of town, drives a BMW and belongs to the best clubs. However, she has a huge mortgage on her house and she leases her BMW. She has $250 in the bank, a $23,000 outstanding balance on her credit card and lives from paycheque to paycheque. In contrast, David is a 50-year-old engineer. He was born and raised along with his six siblings in rural Ontario, and he was always taught the value of saving. David is the president of an engineering company, and he also works very hard to earn $150,000 per year. He owns a comfortable home in a good part of town and drives a four year old Chevrolet. He has fully paid for both his house and car. He does not believe in credit cards and pays for everything in cash unless travelling on company business. David has always contributed the maximum to his RRSP and has invested other savings in blue chip stocks. As a result, he has built a portfolio worth $850,000. A fundamental underlying element of the money management process is understanding your own perceptions about money so that you can work to overcome any biases that may be hindering the achievement of your financial objectives.
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Introduction to Income Tax Planning
Financial Planning Process
As seen in other courses, the financial planning process consists of 6 basic steps.
Money Management and the Financial Planning Process
Money management is an essential component of any financial planning process. You need to have income to be able to sustain your lifestyle. Effective money management will help ensure that you will have some money left over, after paying for basic necessities and taxes to implement your long-term financial strategies. The money management process is similar to the 6-step financial process. However, in this lesson we will discuss the money management process from your perspective and eliminate the establishment of the client-planner relationship. The 5-steps of the money management process are as follows:
Although it is similar to the financial planning process, the focus of the money management process is narrower. It deals with the management of cash over the relatively short term (days, months or a few years) and it includes debt and credit management. It does not deal with many of the broader and longer term issues covered by a comprehensive financial plan, such as insurance, estate planning, the appreciation of capital assets or the tax implications of owning a second property. As with the financial planning process, the steps in the money management process are somewhat flexible and they occasionally overlap. Step 1 and Step 2 (setting objectives and data collection) are particularly inter-related. Each of these steps as it applies to money management is discussed further in the following sections.
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Income Tax Planning
Step 1: Defining Your Money Management Objectives
An objective is a financial state or position that you want to achieve. Well-defined objectives are critical to the success of any money management plan. They provide your plan with a sense of purpose, and a benchmark against which you can measure your progress.
When you develop a personal financial plan, your objectives tend to be long range and all encompassing. They may include building financial security, financing a larger home, minimizing life risks, planning for retirement or distributing your estate. When you develop a money management plan, your objectives are likely to be specifically oriented towards cash, and focused on a shorter time frame. Some examples of money management objectives include: • • • • paying off an outstanding credit card debt avoiding bank overdraft and NSF (non-sufficient funds) charges by improving the management of your income and expenses establishing an emergency fund or saving $1,000 over the next six months to pay for a vacation
Some money management objectives may relate directly to strategies in your broader financial plan, such as having sufficient money available each month to contribute towards your retirement. Two of Robert and Joanne Smiths’ financial objectives are for Robert to contribute $3,430 to a spousal RRSP and for Joanne to contribute $2,578 to her own RRSP. One of the Smiths’ money management objectives could therefore be to set aside sufficient cash each month to implement these strategies. Money management objectives must be realistic in view of your level of income and expenses. The objective of having $1,000 left over each month to put towards your savings when your annual household income before tax is $27,000 and you have two children and a mortgage is not realistic. However, objectives should also require some moderate effort on your part to be worthwhile. As with the broader financial planning process, it is imperative that you and your spouse or common-law partner agree on your money management objectives. Through discussion and compromise, you must both identify and establish priorities for your objectives, and agree to commit yourselves to your cash management plan.
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Introduction to Income Tax Planning
Step 2: Collecting and Analyzing Information
In order to determine if your objectives are realistic, you must have a good understanding of your current income and expenses. This exercise can also help you determine if you have any chronic money management problems, such as excessive use of credit cards or a consistently overdrawn bank account.
A number of common financial statements are useful in both the financial planning process and the money management process. These include the following: • • • • statement of net worth balance sheet statement of lifestyle expenditures statement of cash flow
Each statement is described in more detail on the following pages.
Statement of Net Worth
Net worth is the best single measurement of your financial condition and resources at a specific point in time.
By preparing a statement of net worth - also referred to as a statement of financial position- every year, you will be able to see the financial growth or decline that you have achieved. A statement of net worth includes a summary of your liquid assets, investment assets and personal assets, along with any related debt obligations, as shown in the example for Robert and Joanne Smith in the following table.
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Income Tax Planning Note: It is accepted industry practice that negative numbers in tables are indicated by parenthesis. For example, the short-term obligations: (6,200) in the table below. Sample Statement of Net Worth For Robert and Joanne Smith as at December 31st
The table also shows an equity ratio for each set of assets. An equity ratio is the ratio of net assets (assets – liabilities) to total assets.
The equity ratio for your liquid assets and short-term debts provides a measurement of your ability to pay short-term obligations as they come due. Your equity ratio for your investment assets indicates the extent to which you are leveraging your investments. If you can earn a higher rate of return on the funds that you borrowed than the cost of borrowing the funds, you are earning money with other people’s money. Your equity ratio for your personal assets is a measure of the extent to which you have borrowed to finance these purchases. The interest on these debts is usually not tax deductible. Robert and Joanne have personal assets worth $208,000, with outstanding loans of $106,000, the equity ratio for their personal assets is 49%, calculated as ((personal assets outstanding loans) ÷ personal assets) or (($208,000 - $106,000) ÷ $208,000).
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Introduction to Income Tax Planning In addition to providing an overall measure of your financial health, your statement of net worth documents the amount of cash or other liquid assets that are available to be managed.
Balance Sheet
The balance sheet is similar to a statement of net worth, although the information is presented in more detail and is organized somewhat differently, as shown in the example, below. Like the statement of net worth, your balance sheet provides an overview of your financial situation at a single point in time. The balance sheet is of limited use as a financial planning tool because it does not readily show how various strategies could affect your financial situation. However, it is useful in the money management process because it provides a clear picture of your assets and liabilities, including short-term debt obligations that are of particular concern in money management. The following table includes the Smiths’ balance sheet for two consecutive years, which shows how they have repositioned their assets and liabilities over that time. For example, they have: • • • • • made significant contributions to their RRSPs sold their cottage sold the rental property and used part of the proceeds to eliminate the mortgage on their house purchased another rental property with part of the purchase price provided by a mortgage loan increased the balance on their credit cards
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Income Tax Planning Balance Sheet Robert and Joanne Smith as at December 31st
Last Year ASSETS Liquid Assets Cash Short-term investments Other liquid investments $ 5,300 4,200 1,265 10,765 Investment and Business Assets RRSP – Robert RRSP – Joanne Registered Pension Plan Canada Savings Bonds Common shares Rental property Mutual funds Other investments 28,720 500 14,500 10,000 4,500 95,000 32,000 0 185,220 Personal Assets Residence Furnishings Vehicles – two cars Cottage Other personal assets 125,000 17,000 21,000 35,000 10,000 208,000 137,500 17,000 21,000 0 10,000 185,500 36,300 6,860 17,140 0 5,000 99,750 36,000 21,000 222,050 $ 3,392 0 2,776 6,168 This Year
Total Assets
$ 403,985
$ 413,718
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Introduction to Income Tax Planning
Tax Deduction for Interest Expense
Interest on a loan is deductible from taxable income if and only if the proceeds of the loan are used to produce business or investment income. In the case of Robert and Joanne Smith, their residence was not an income producing investment and therefore, the interest on the mortgage on their residence was not tax deductible. Similarly, had they simply taken out a loan secured by a mortgage on their previous rental property and used the proceeds to pay off the mortgage loan on their residence, the interest on this new loan would not be deductible because the proceeds were not directly used for investment purposes. The interest on their new mortgage loan however, is tax deductible because the proceeds were used to purchase a new investment property.
Exercise: Money Management
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Income Tax Planning
Statement of Lifestyle Expenditures
Your statement of lifestyle expenditures shows how much money you pay to sustain your current lifestyle. It also includes the interest charges that are associated with financing major capital purchases, such as a house or a car. However, it does not include income taxes or any capital transactions that increase or decrease your personal, business or investment assets. The following table provides the Smiths’ statement of lifestyle expenditures for two consecutive years. One of the major changes of note here is that, since they shifted their mortgage obligations from their home to their rental property, the interest expense no longer shows up on their statement of lifestyle expenditures. Also, in response to recommendations from their financial planner, they have increased their life and disability insurance coverage. Statement of Lifestyle Expenditures Robert and Joanne Smith for the Year Ending December 31st Last Year This Year
Mortgage (interest only) Property taxes Insurance Utilities Maintenance Garden Upkeep Housing Costs
$ 8,460 1,900 700 2,300 1,600 500 $15,460
$0 1,995 735 2,415 1,600 500 $ 7,245
Food Household expenses Telephone Personal care Clothing Other Food, Household, etc.
4,600 700 900 1,200 4,300 500 $12,200
4,830 735 900 1,260 4,500 500 $12,725
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Introduction to Income Tax Planning
Last Year Car payments (interest only) Insurance Gasoline Maintenance Public Transportation Transportation 1,400 700 2,100 1,200 500 $ 5,900
This Year 1,100 770 2,200 1,200 550 $ 5,820
Entertainment Eating out Gifts Fees, Accounting, etc. Holidays Other Discretionary
1,500 1,200 1,400 1,700 1,200 5,300 $12,300
1,500 1,200 1,400 1,800 1,200 0 $ 7,100
Medical expenses Life and disability insurance Payroll deductions (sundry) Bank Charges (including overdraft & NSF charges) Credit Card Interest Other Miscellaneous
600 300 1,800 240 580 1,320 $ 4,840
650 1,000 2,000 270 630 1,600 $ 6,150
Basic Lifestyle Expenditures
$ 50,700
$ 39,040
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Income Tax Planning
Statement of Cash Flow
Your statement of cash flow is perhaps the most important piece of information for money management purposes. It describes all money flows over a period of time, including all sources of income, taxes, lifestyle expenditures, investments, the interest expenses associated with those investments, mortgage, and loan principal repayments and money received from the sale of assets. It shows whether you have any cash left over at the end of the reporting period, and is a useful place to start when preparing a budget. The following table is the Smiths’ Statement of Cash Flow for two consecutive years. In addition to showing how their cash flow has been reallocated over the two years, it demonstrates that they have actually reduced their income tax by over $400, despite an increase in total income of over $4,500. This can largely be attributed to their RRSP contributions and the fact they shifted their mortgage obligation from their personal residence (where the interest expense is not tax deductible) to their rental property, (where the interest expense offsets rental income). Statement of Cash Flow Robert and Joanne Smith for the Year Ending December 31st Last Year This Year
Cash from Sources of Income Employment and self-employed income Pension income Dividends, interest, and rents $ 72,000 0 12,015 84,015 Cash Outlays for Expenses Income taxes Lifestyle expenditures Interest expense for investments Other cash outlays for expenses Unaccounted for difference in cash (17,520) (50,700) (5,160) 0 430 (72,950) (17,104) (39,040) (11,640) 0 44 (67,740) $ 76,500 0 12,045 88,545
Cash flow from income and expenses
11,065
20,805
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Introduction to Income Tax Planning
Cash Flow from Net Investment Assets RRSP – Robert RRSP – Joanne Registered Pension Plan Canada Savings Bonds Common shares Rental property Mutual Funds Other investments Investment Loans (2,420) (500) (1,080) 0 0 0 0 0 (500) (4,500) Cash Flow from Net Personal Assets Residence Furnishings Vehicles - two cars Cottage Other personal assets Loans to purchase personal assets 0 0 00 0 (500) (3,500) (4,000) 35,000 0 (96,200) (61,200) 0 0 (4,250) (5,818) (1,134) 10,000 0 0 0 (20,000) 54,000 32,798
Total Cash from All Activities
$ 2,565 $ (7,597)
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Income Tax Planning
How Much Information and How Often?
The amount of information that you compile (6 months’ worth or 3 years’ worth?) and the level of detail will depend on the quality of your records, the complexity of your situation, and the time and money you are willing to commit to the task. For example, in simple cash management cases, it may be sufficient to prepare a statement of cash flow on an annual basis. However, in situations where your income or your expenses may fluctuate significantly from month to month or season to season, or when you will be preparing a detailed budget, you may wish to document your cash flow on a monthly or quarterly basis. If you have trouble managing credit or discretionary spending, you may want to provide a very detailed breakdown of your expenditures.
Step 3: Identifying Money Management Strategies
The more Canadians earn, the more they tend to spend. Regardless of their income, many people tend to shy away from the financial planning process because they feel that they barely have enough money to meet their immediate needs, let alone extra money for investment or savings purposes. As a result, money management is a critical first step for many people undertaking the financial planning process. By adopting some of the money management strategies discussed in the next few pages, you may find that you do have discretionary cash to meet your financial objectives.
Pay yourself first Experience has shown that if you do not plan to save first, you will likely not save at all. Planning to save what is left over does not seem to work because there is rarely anything remaining after expenses. Therefore, one of the simplest and most successful money management strategies is to pay yourself first, which involves earmarking a portion of your income for savings before any expenses are paid. To reduce the temptation to spend, arrange to have the savings deducted directly from your pay or arrange to have the money transferred automatically from your chequing account to an investment account. This is called a preauthorized chequing arrangement or PAC. A PAC can also be used to purchase mutual funds.
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Introduction to Income Tax Planning Account for your expenditures Many people have only a vague idea of how they spend their money. When you collect the information on your expenses and cash flow, you may be surprised to learn how much you spend on incidentals like take-out food at lunchtime or magazines. Pay particular attention to those items that you tend to lump in the miscellaneous category. You may want to reconsider whether these miscellaneous expenditures are necessary to maintain your lifestyle.
Limit Available Cash
A large balance in your wallet or everyday bank account may be money that is "burning a hole in your pocket". Reduce the temptation to spend this money by transferring it to a savings vehicle, leaving only the cash necessary to cover your planned expenditures easily accessible. Do not be too strict on yourself While the strategies discussed to this point are effective and important, take care not to go overboard and deny yourself any discretionary expenses or make yourself accountable for every penny spent. A miscellaneous component is a realistic and essential part of any money management system, provided it is held to a reasonable and justifiable percentage of total expenditures. As in dieting, overly strict denial will doom your best intentions. Use credit wisely Credit has become a part of our everyday life as we can use it in one form or another to purchase just about every type of good or service available. While there is no doubt that credit is a convenient way to pay for transactions, when it is misused the buy now and pay later approach can lead to real problems. Credit can derail your financial plans by: • • • seducing you into buying things that you really do not need subjecting you to hefty interest charges reducing the amount of cash available for implementing financial planning strategies
If you use a credit card for a lot of small purchases or you buy major items on an installment basis, you should be sure that the required minimum payments are within your cash flow capacity. Ideally, you should be able to pay off all credit card balances when you receive your monthly statement. Credit experts recommend that maximum monthly credit payments should be kept to 20% of the after-tax income less any mortgage payments.
Pay Off Debts Quickly
Debt payments can put a significant dent in your cash flow, reducing the amount of money that you have available for implementing other financial strategies. Paying off debts therefore, can free up your cash flow. As important as cash flow management may be however, the most important reason for paying off your debts is because it may be the best financial investment that you can make. You can use your savings to pay down your debt or you can invest this money.
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Income Tax Planning
The following are factors to consider in determining the better choice: • • the rate of return that you can earn on your investment and the income taxes on your investment income the interest rates that you pay on the debt and the income tax implications of paying down debt
Investing the Money
If you invest the money, you will earn interest, dividends, rents, and/or capital gains and must pay tax on the income. Assume Robert’s marginal tax rate is 40%, and he has an extra $1,000 of cash. He might choose to purchase a Canada Savings Bond and maybe earn 3% or $30 in interest in the first year. The following are the specific calculations for the after-tax investment return: • • • • the interest on the Canada Savings Bond is $30, calculated as (the interest rate times the principal) or (3% × $1,000) the tax on the interest income is $12, calculated as (the marginal tax rate x the interest income) or (40% × $30) the after-tax income is $18, calculated as (the interest income - the taxes) or ($30 - $12) the after-tax return is 1.8%, calculated as (the after-tax income ÷ the principal) or ($18 ÷ $1,000)
The formula for deriving the after-tax income (ATI) from before-tax income (BTI) based upon the marginal tax rate (MTR) is:
These formulas express the investment returns as dollars. However, there are situations where it is useful to refer to investment returns as percentages, calculated as the investment returns in dollars divided by the principal or amount invested in dollars.
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Introduction to Income Tax Planning The formula for after-tax investment return (ATR) is:
Paying Down the Debt
You cannot deduct the interest expense for consumer purchases from your taxable income, so you have to pay the interest expense in after-tax dollars that are remaining after income taxes have been paid. If you pay down the debt, you will not have to pay interest. You will not have to pay income taxes on the interest that you saved. Now assume Robert also has an outstanding credit card balance of $1,000, and his card carries an interest charge of 18%. If he carried that $1,000 for one year, he would pay $180 in interest, using after-tax dollars. In fact, he would have to earn $300 to have the $180 left over to pay the interest. Therefore, if he used his spare $1,000 to pay off the credit card, he would save $300 in interest expense in one year, which is the same as a return on his investment of 30%. • • the interest on the loan is $180, calculated as (the interest rate x the principal) or (18% × $1,000) the interest on the loan is in after-tax dollars. Using formula (3), the amount of before-tax income required to pay the interest of $180, is $300, calculated as BTI = (ATI ÷ (1 – MTR)) or ($180 ÷ (1 – 40%)) the 18% interest rate is an after-tax rate. The before-tax rate is the rate of return you would need before-tax to have 18% left after-tax. Using formula (7), the equivalent before-tax rate of return is 30%, calculated as BTR = (ATR ÷ (1 – MTR)) (18% ÷ (1 – 40%))
•
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Income Tax Planning Choosing The primary consideration in deciding whether to invest or pay down debt is the after-tax return on the investment compared to the interest rate on the debt. So, Robert can earn 1.8% after-tax on his CSBs or save 18% after-tax by paying down the debt. Alternatively, you can consider the before-tax return on the investment compared to how much Robert would have to earn to pay the tax and then the debt. This is called the equivalent before-tax return. Robert can earn 3% before-tax on his CSBs, but will have to earn 30% before-tax to have 18% left to pay his debt.
Exercise: Paying Down Debt
Avoid Unnecessary Bank Charges
If you do not keep a close eye on your bank balance, you may run the risk of bouncing cheques, that is, writing cheques where there are insufficient funds in your account to cover the cheque. Not only can this hurt your reputation with creditors, it can be costly when the merchants turn to you to cover the NSF (non-sufficient funds) administration charges, which can run between $10 to $20 per incident. If you bounce checks frequently, or if you have an erratic cash flow pattern (e.g., you only get paid once per month, but your mortgage is paid every other week), you may benefit from overdraft protection offered by your bank. With overdraft protection, your bank will cover cheques and debits from your account, up to a prearranged credit limit. You may pay high daily interest on the credit extended by your bank, and administration fees, but you will not face NSF charges. Overdraft protection is only intended to cover brief periods (a few days) of negative cash balances. You should not rely on overdraft protection, as a source of long-term credit, because the interest charges will quickly accumulate and the interest rate charged is often quite high.
Establish an Emergency Fund
There are countless events that are almost impossible to plan for and that can seriously derail the best-formed cash management plan. These unexpected events can be moderately inconvenient, like a major car repair, to the potentially disastrous, like the death or disability of an income earner. Some of the problems can be moderated by life or disability insurance or unemployment benefits, but even in these cases there will be a financial impact.
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Introduction to Income Tax Planning Some form of emergency fund is critical to every cash management plan. The size of the emergency fund that is right for you will vary on your circumstances. You might want to consider questions such as: • • • • • How secure is your job? If you lost your job, how difficult would it be for you to find a new one? What would happen to your cash flow if you or your spouse became disabled? What is the condition of your car, your furnace and your major appliances? Could you handle unexpected travel expenses?
You should also consider saving to meet anticipated decreases in income or increases in your expenses, such as the addition of a new family member, children starting postsecondary education, or your own retirement. Many financial planners recommend that you set aside enough money in an emergency fund to cover four to six months’ worth of living expenses. If your family has an after-tax income of $24,000 and you are barely meeting your day-to-day expenses, setting aside $8,000 to $12,000 may seem next to impossible. However, you may be able to structure your assets so that you can get at them in an emergency, reducing the need for such a large stockpile of cash. For example, you might have mutual funds that you could sell, or RRSPs that you could draw on during periods of long unemployment, when your taxable income is reduced. Once you pass through the financial crisis, be sure to restore your assets to their previous levels. Withdrawing funds from RRSPs should be a last resort. You are limited in how much you can contribute in the first place and withdrawing funds does not restore your contribution room. So you can never really put these RRSP funds back, although you can make contributions based on future years’ income. Credit, in the form of overdraft protection, should not be used as a substitute for an emergency fund. Not only will you be obligated to repay any money that you borrowed with interest, you may get yourself into serious financial difficulty if your emergency lasts longer than you expected. A personal line of credit is considered to be an effective strategy to obtain funds in an emergency for those with stable incomes. Otherwise, the appropriate strategy is an appropriate amount invested in some form (such as Canada Savings Bonds, treasury bills or a money market fund) that can be readily converted to cash.
Income Tax Strategies
Income and taxes usually go hand-in-hand, but there are ways that you can improve your cash flow and your overall financial situation through proper planning and some creative paperwork: • Interest income is taxable. However, you can minimize the amount of tax paid on this income by registering investments that generate interest income in the name of the spouse with the lower income. The most desirable type of debt is when the interest cost is tax deductible. Interest on money borrowed for business or investment purposes may be deducted from your taxable income.
•
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Income Tax Planning Robert and Joanne Smith reduced their taxable income by switching the bulk of their mortgage obligations from their principal residence to their rental property (refer to Robert and Joanne's statement of cash flow). Although they still make similar total mortgage payments each month, the interest portion of the mortgage payment on their rental property is an expense that they can deduct from their rental income. It can make good financial sense to borrow money to contribute to an RRSP, provided that you arrange a short-term loan at an attractive interest rate and that you use the tax refund generated by the contribution and other savings to repay the loan as soon as possible.
Step 4: Implementation, Budgeting and Cash Management
Cash management refers to the routine, day-to-day administration of your cash resources. This administration may include a number of activities, such as: • • • preparing and following a budget setting up automatic payment of your bills automatically or manually repositioning cash from one account to another
Your cash management plan may range from very simplistic to very complex, depending on the variability of your cash flow, your spending habits and your own "money personality".
Simplified Cash Management Plan
A simplified cash management plan involves setting aside a certain portion of your income to help meet your objectives before you pay for current living expenses. This is useful in cases where you have good intentions to save each month, but there is rarely anything left to save. The simplified cash management approach works because it forces you to save for your goals first, applying the principle of "out of sight, out of mind". This approach may work for you if you are truly motivated and just need that extra push to help you save, rather than spend. If you have problems handling credit or controlling your spending habits, or if you have complex or irregular cash flow patterns, a comprehensive approach (discussed later) may be more appropriate. Before you develop your cash management plan, you must have completed Steps 1 through 3 of the money management process. You must have a good understanding of your current lifestyle expenditures, your income and other cash flow patterns, and you must have identified some money management objectives that are realistic in light of your financial situation. Finally, you must have selected some strategies for reaching your objectives.
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Introduction to Income Tax Planning James and Jody have a combined take-home pay of about $4,000 per month, and would like to set up an emergency fund of at least $10,000 (their objective – Step 1). Although they never have any problems meeting their mortgage and car loan payments or paying off their credit cards on time, etc., they never seemed to save any money. After reviewing their past spending patterns, they found that they tended to make a lot of impulse purchases, such as specialty tools, kitchen gadgets and extravagant dinners, whenever their bank balance was over $1,000 (data collection and analysis – Step 2). They decided that they could afford to divert $400 of their monthly income towards an emergency fund without seriously affecting their lifestyle (their strategy – Step 3). Jody’s employer offered a direct payment plan that directed money from her regular paycheque to a separate account (implementation-cash flow management – Step 4). Within one year, James and Jody were pleased to find that they had saved almost $5,000 (monitoring – Step 5).
A Workable Cash Management Plan
The graph below illustrates a slightly more complex cash flow plan that works for many people. The plan is as follows: 1. Initially, direct all of your income into a collection account. Ideally, this should be an interest bearing account, such as a money market mutual fund. 2. Transfer a fixed amount of money from the collection account to an investment account to fund your objectives. This transfer should be done monthly, (or more or less often, depending on the timing of your cash inflows). 3. Transfer a fixed amount from the collection account to your chequing account each month. This is the money you can use to meet your normal monthly expenses. You should not spend more than this amount by using credit cards. If there are significant timing differences between large cash inflows and outflows (you might get paid every two weeks, but pay your mortgage monthly), you may wish to divert some of your monthly allocation to an intermediate savings account to ensure that you do not spend it before the payment is due. 4. You can use any amount remaining in your collection account as your emergency fund. However, you should review the balance in this account semi-annually and transfer any excess from the emergency account into your investment account.
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Income Tax Planning
If, after working with your simplified plan for a while, you find that you do not have enough money to meet your lifestyle expenditures, you may have to adjust your distribution of income or consider whether you need to have a more comprehensive cash flow management plan.
Comprehensive Cash Management Plan
If a simplified cash flow plan does not give you enough structure to help you reach your objectives, or if you have erratic cash flow patterns, you may wish to develop a more comprehensive cash flow management plan. As with the simplified cash flow plan, the development of a comprehensive cash flow plan requires that you first complete Steps 1 through 3 of the money management process. In gathering and analyzing your historical cash flow information, you may uncover spending patterns that you were not aware of, such as excessive use of credit, frequent NSF charges or a large amount of money spent on take-out food. This in turn may lead to the identification of some general money management strategies, such as paying off your debt or taking control of your discretionary expenses. Once you have a clear picture of your existing cash flow, your next step is to project that cash flow pattern into the future in a way that reflects your new objectives and money management strategies. In order to do this, you will have to make some assumptions about: • • • • • your future income the rate of return on your investments your expected cash outflow non-recurring expenses the money you can set aside for savings or debt reduction
This cash flow projection then becomes your budget for the coming year. A budget is simply a plan for how you are going to allocate your money. The success of the budget depends largely on your willingness to stick to it.
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Introduction to Income Tax Planning
Budget
The level of detail in your budget will depend once again on your own circumstances and money personality. Some people can manage with annual or quarterly budgets, while others need monthly or even weekly breakdowns. Some people manage well with a simplified budget, with expenses broken down into broad categories (for example, housing, household expenses, food, transportation, clothing, miscellaneous, and so on). Other people need to account for every dollar spent. In this case, the categories should be broken down into subcategories (for example, food could be subdivided into home-prepared meals, work lunches, takeout and dining out; utilities could be subdivided into heat, electricity and telephone, and so on). Although it is natural to have some miscellaneous expenditures, do not let this category account for the bulk of your budget. The trick with any budget is to make it simple to develop, follow and maintain. Budgets that require hours of paperwork each week are doomed to failure. Several personal computer packages are available that can help you track your past expenditures and then use this information to develop and monitor a budget. These packages have the added advantage of being able to illustrate graphically where your money went, and how your actual expenditures compared to your budget. They also allow you to run various what-if scenarios that are particularly useful when developing new strategies. This is a budget for your lifestyle expenditures. It is an important part of your cash flow, but only part of it. The following table provides the Smith's monthly budget for January of next year. Robert and Joanne Smith Monthly Budget January of Next Year Housing costs Mortgage interest Property taxes Insurance Utilities Maintenance Garden upkeep Total Housing costs Food, household etc. Food Household expenses Telephone Personal care Clothing Other Total Food, household $ 0.00 166.25 61.25 201.25 133.33 41.66 603.74
402.50 61.25 75.00 105.00 375.00 41.66 1,060.41
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Income Tax Planning
Transportation Car payments (interest only) Insurance Gasoline Maintenance Public transportation Total Transportation Discretionary Entertainment Eating out Gifts Fees, accounting, etc. Holidays Other Total Discretionary Miscellaneous Medical expenses Life and disability insurance Payroll deductions Bank charges Credit card interest Other Total Miscellaneous
91.67 64.17 183.33 100.00 45.83 485.00
125.00 100.00 116.67 150.00 100.00 0.00 591.67
54.17 83.33 166.67 22.50 52.50 133.33 512.50
Total Expense
$3,253.32
Exercise: Cash Management Plan
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Step 5: Monitoring Your Results
Monitoring your progress is vital to the success of any money management plan. You need to know if your strategies are actually helping you achieve your objectives, and if they are not, why the strategies are not working. If you are implementing a simplified cash flow management plan, monitoring may simply consist of reviewing the annual increase in your investment account. If you have met your savings goals, you do not need to take any action beyond increasing the amount to be saved next year by an amount equal to inflation. If you have not been able to meet your savings goals, you should reconsider whether your original objectives were realistic, or whether you need to switch to a more comprehensive cash management approach to gain control of your expenditures.
If you are implementing a comprehensive cash flow management plan, you will have to be more diligent about comparing your actual expenditures to your budgeted amounts on a monthly or quarterly basis. You should break your credit card bill down according to expenditure category. If you notice regular discrepancies between your budgeted and actual expenses in any category, either your projected amounts were incorrect or you need to take greater care in your spending. In either case, you must take action if you want to achieve your objectives. Robert and Joanne also used their computer package to monitor their actual expenditures in comparison with their budget. The output is shown in the following table. Robert and Joanne Smith Monthly Budget Comparison Actual Versus Budget January of Next Year
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Introduction to Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Money Management. In this lesson, you have learned how to do the following: • • • • • describe how people perceive money differently, and how those perceptions affect their money management styles explain how various financial statements are used in the money management process identify typical money management strategies collect and analyze client’s money management information, including statement of lifestyle expenditures and statement of cash flow assist client in identifying money management objectives
If you are ready to move to the next lesson, click Understanding Credit on the table of contents.
Assessment
Now that you have completed Money Management, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 2: Understanding Credit
Welcome to Understanding Credit. In this lesson, you will learn about the general lending criteria, the different types of consumer credit, and the uses of refinancing, debt consolidation, insolvency, and bankruptcy. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: • • • explain the general lending criteria (collateral, capacity, character, credit history) and their impact on financial planning describe and compare the different types of consumer credit explain and describe the uses of refinancing, debt consolidation, insolvency, and bankruptcy
Understanding Credit
In our society, entering into debt should be considered a necessary evil. That is not to say that it should never be done. Often it is more convenient and safer to use credit cards than cash, and sometimes the high cost of a capital asset, like a car, may make a cash purchase unrealistic. However, once you decide to enter into debt, you should give priority to minimizing the cost of borrowing. This section examines the types of credit available, how to obtain them, avoid abusing them, and how to get out of trouble if the use of credit has got the best of you. There are two main credit systems available to consumers: revolving credit and consumer loans.
Revolving Credit
Revolving credit is credit that you can use from time to time to buy goods and services. Revolving credit can take the form of: • • • a credit card issued by a financial institution, such as VISA, or by a retailer, such as Sears a standing charge account (for example, with a grocery store or a taxi company) a line of credit with a financial institution
In each case, the revolving credit lender will set an upper limit on the total amount that you may borrow. In exchange for the credit privilege, you agree to pay an interest charge on
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Introduction to Income Tax Planning the outstanding balance each month, and you may also be required to pay a service fee and stipulated principal payments. Most credit cards will give you an initial credit limit of about $500. The lending institution will usually increase that limit as you develop a credit history. Lines of credit usually start at $10,000 and are often more difficult to arrange. Some types of revolving credit (like some lines of credit) may require security, while credit cards and store accounts are usually unsecured. In the case of a line of credit, you will receive a better interest rate if you are able to provide security. Revolving credit is popular because of its convenience and flexibility. Once you have established your account, you can use it when you need it and forget about it when you do not. However, this constant availability can be seductive. Because revolving credit can often be used as a substitute for cash, you may quickly find that you are overspending. Furthermore, if you are not required to pay the outstanding balance in full each month, you run the danger of accumulating a large outstanding balance, on which you will pay a relatively high rate of interest. You are usually required to repay revolving credit loans according to a minimum percentage of the outstanding balance, and you are free to pay off the full amount at any time you wish. The rate of interest may be variable (some lines of credit), fixed (credit cards and some loans) or fixed for short-term periods, in which case the rate is adjusted periodically.
Consumer Loans
Consumer loans (also often referred to as direct or fixed credit) are usually arranged for a specific purpose (e.g., a car loan repayable over four years). They are available through financial institutions such as banks, trust companies, credit unions and small loan companies. The lending institution may or may not require security (or collateral) for these loans, as discussed later. When you arrange a consumer loan, the lender usually allows you some choice in terms of a payback period (term) that best suits your circumstances. The lender then arranges a schedule of monthly payments that combines repayment of the principal with interest charges on the outstanding balance. Depending on your loan agreement, the interest rate may be fixed for the duration of the loan, or may vary as the lender’s rates rise and fall. Direct or fixed credit may be easier to control but, depending on your arrangement with your lender, it could lock you into making substantial monthly payments, sometimes at a rate of interest that is considerably higher than the current rate. If you are self-employed and your income fluctuates from month to month, you may not want to tie yourself down to a large fixed repayment obligation. In some cases, the payback terms may be inflexible, requiring you to pay a hefty penalty if you want to repay the loan in full before maturity. Other consumer loans, such as car loans, may be fully open, meaning that you may pay off the outstanding balance in full at any time without penalty.
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Income Tax Planning
Security
Credit is typically classified as either secured or unsecured. A secured loan is one that provides the lender with the right to seize or sell specified assets, or collateral, in the event that you default on your loan agreement. Lenders prefer collateral that is liquid. Liquidity refers to the ease with which assets or collateral can be converted into cash. Depending on your credit rating, age, job security, health, etc., your lender may require different types of security in granting a loan. Collateral for a secured loan usually takes one of two forms. Most commonly, you may be required to sign a chattel mortgage. This document will transfer the ownership of the collateral assets to the lender if you default on your debt. However, you will keep possession of the goods as long as you maintain the loan in good standing. One of the most common types of secured loans is a car loan, where your car is the collateral and you are required to assign a chattel mortgage to the lender. If you do not make the installment payments on your car loan, the lender may repossess the car and use the proceeds from its sale to satisfy the debt. A lien is similar to a chattel mortgage, but it is used where the goods or services are immovable. If you purchase a new furnace for your home and have it installed, it is for all practical purposes now a part of your home and impossible to repossess. So, a lien is registered against your home as security for payment and you cannot sell your home unless the loan is repaid and the lien discharged. In cases where you have a poor or unestablished credit history, or where you have insufficient collateral to secure the loan, the lender may require that your loan be guaranteed by a guarantor, a third party who agrees to repay any outstanding balance on the loan if you fail to do so. Alternatively, the lender may be satisfied if the loan is co-signed by a co-signer, who is equally responsible for the debt with the principal debtor, whether or not the principal debtor defaults on the loan. Frank and Ellen are living in a common-law relationship. They borrowed $10,000 from a bank to purchase a car. They signed the loan as co-signers. If the payments are not made, the lender can pursue either Frank or Ellen to obtain repayment of the entire loan. Frank and Ellen are equally responsible for the entire amount, not just a share of it. Initially, the bank was reluctant to lend them the money. Frank’s father guaranteed the loan. If the payments are not made, the bank can pursue the father to repay the loan if they have determined that neither Frank nor Ellen can repay it. Frank and his father are equally responsible for the loan. His father is responsible if Frank and Ellen default. You may agree to a wage assignment, which allows the lender to collect up to 20% of your gross wages directly from your employer, with the proceeds to be used for the purpose of paying your debt. Unsecured loans are loans made by a creditor based on your credit history, reputation and integrity to ensure payment. A debt incurred through the use of a credit card is often an unsecured loan. Another example is an unsecured promissory note, which is a written loan agreement signed by the borrower and specifying the name of the borrower, amount of the loan, interest rate, and terms of repayment. The lender may require nothing more than your signature to advance the requested funds. Usually, unsecured loans are only available to the lowest risk borrowers.
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Introduction to Income Tax Planning
Interest Charges
The rule here is borrower beware. Different lenders, particularly those issuing credit cards, calculate their interest charges in different ways. However, regulations do require lenders to provide full disclosure of the interest rate charged, including a description of how the interest costs are calculated. You have to read the small print on the contract. Debit cards The debit card is a method of payment, but not a form of credit. Instead of extending credit, the debit card is used to withdraw funds from the purchaser’s bank account. The debit card is physically similar to a credit card, but the user enters his Personal Identification Number (PIN) into a terminal to authorize the withdrawal from his bank account.
Credit Cards
There is a significant difference in how bank credit cards (for example, VISA and MasterCard) and retail store cards (for example, Sears or Canadian Tire) calculate their interest charges. Apart from user fees and grace period considerations, how and when interest rates are applied to outstanding balances are very important. Most credit cards offer a grace period of 15 to 21 days after the statement date. During the grace period, you will not be charged any interest provided you make payment in full by the end of the grace period. If you do not make payment within the grace period, or if you make only a partial payment, a bank credit card will typically charge interest on the full amount of the purchase from either the date of purchase or the date of posting. Interest charges are computed on a daily basis and partial payments are applied to the oldest outstanding debt first. Retail store cards typically only charge interest on the difference remaining on the balance effective after any partial payment has been credited. Compounding methods may also vary among different credit card issues. Bank cards tend to charge straight interest (for example, compounded annually, but calculated daily), while retail cards usually compound their interest monthly. Credit card issuers are required to provide you with a clear statement of how their interest charges are calculated. Consequently, balances carried over periods of several months and reflecting many purchases can result in wide differences in actual interest costs, even though the interest rates quoted by both lenders may seem to be similar when taken at face value. Sample disclosure statement This is a sample of a disclosure statement provided by a company operating in the four western provinces and Newfoundland & Labrador (the rates may no longer be valid, but the nature of the disclosure is still appropriate). A charge will be added to your account each month based on the previous month’s balance to the nearest dollar, as indicated in the table below. If 75% or more of the previous month’s balance is paid during the current month, no cost of credit will be added. If 50% or more of the previous balance is paid, the payment is first deducted before the cost of credit is calculated. The annual rate is 21.0% per annum on the monthly balance.
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Income Tax Planning For example:
Cost of Credit means Cost of Borrowing or Credit Charges as defined in the Statement of Information regarding cost of credit as required by The Consumer Protection Act (BC), The Credit and Loan Agreements Act (Alta.), The Cost of Credit Disclosure Act, 1967 (Sask.), The Consumer Protection Act, 1969 (Newfoundland) and The Consumer Protection Act (Man.).
Installment Loans
You are usually required to repay a consumer installment loan in fixed monthly payments, which consist of a blend of principal and interest. You negotiate a repayment, or amortization period, over which the payments will be spread. Most consumer installment loans are amortized over a 1- to 5-year period. Your monthly payment will be calculated using an amortization schedule, which is a table that shows how much of each blended payment is interest and how much is principal, along with the principal outstanding after each payment. An example of an amortization schedule for a consumer car loan of $10,000 over five years at 12% is provided in the table. Installment loans are front-end loaded with interest, which means that the payments in the early period of your loan consist mostly of interest. Towards the end of the loan, the payments are largely principal. The following table illustrates this effect. By choosing to make a principal repayment early in your loan repayment schedule, you effectively bypass some of the heavy interest payments.
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As shown in the table above, the payments are fixed over the amortization period. However, the interest component of each monthly payment is roughly equivalent to the outstanding balance multiplied by 1/12th of the annual interest rate. The remainder of each payment is applied against the principal. In the early stages of loan repayment, a significant component of the payment consists of interest. However, as the outstanding balance is reduced, the proportion of principal in each payment rises steadily. The interest rates on installment loans may be fixed or variable, or may be adjusted periodically. When the rate changes, a new amortization schedule is used, reflecting the remaining outstanding balance, the remaining amortization period and the new interest rate.
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Income Tax Planning
Exercise: Credit
Obtaining Credit
Lenders will usually look for four main criteria, referred to as the 4Cs, when assessing your credit application:
Your Credit Rating
Your credit rating is a historical record or file maintained by a local credit bureau that documents your credit history (usually over the past seven years). It allows a lender to assess your history of repaying loans and provides the lender with an indication of your repayment behavior in the future. The various credit bureaus share information, so a lender can usually just make a single inquiry and retrieve your credit history. Your credit file consists of a series of ratings provided by the lenders of previously- or currently-held loans and credit cards. If you always pay at least the minimum required payments on a loan or credit card, that particular loan will receive a rating of one. Each time you miss a payment, the rate declines until it reaches nine, which is the poorest rating. Your credit file only includes facts about payment patterns, and never includes opinions. It also does not include information about utility bill payments, bank accounts, student loans, bounced cheques or specific credit card purchases. While your credit file may include information from civil court proceedings, including bankruptcies or orders to pay, it does not include criminal court proceedings. Along with the information discussed above, your credit file will include a listing of everyone who has requested the file in the past. You are entitled to see your credit file as maintained by your local credit bureau. You should check your own credit file every year or so, or at least six months prior to any major loan application, to make sure that it doesn’t include erroneous information. If there are errors, you can usually work with the credit bureau or the original lender to correct them. Even if information is correct, you will usually be permitted to add an explanation about why the problem occurred.
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Your Capacity to Repay the Debt
Consumer lending institutions use a number of measures to evaluate a borrower’s capacity to repay debt. The total debt service ratio is very effective as it considers all debt obligations and fixed housing costs, and then compares these amounts to the gross income (before-tax income) of the family unit. We will use Total Debt Service Ratio (TDSR) for this purpose in this course and we will use the following definition (your financial institution may use a different one): The TDSR compares the amount of your mortgage and consumer debt payments to your income. The higher the TDSR, the more difficult it becomes to make your payments. The maximum acceptable TDSR according to the Credit Union Institute is 40% for most loans. Financial institutions generally set a maximum TDSR of 35% to 42%. For a homeowner, the formula for TDSR is:
For a renter, the formula for TDSR is:
Let's look at a TDSR calculation for Ben and Sarah Straw, a married couple, who are considering the purchase of a new van. They need a bank loan of $22,000 to finance the purchase. The interest rate would be 8% compounded monthly and the payments would be $537.08 per month at the end of each month for four years. The Straws have other consumer loan payments of $380.00 per month. They own their own home. Their annual costs for property taxes are $3,200, heating costs are $3,600, and mortgage principal and interest costs are $14,800. Their annual income before tax is $90,000. If the Straws purchase the van, their TDSR will be 36.23%, calculated as ((payment of principal and interest on mortgage + property taxes + heating costs + 50% of condominium fees + payments on other personal loans) ÷ gross income) or ((($14,800 + $3,200 + $3,600 + $0) + (($537.08 + $380.00) × 12)) ÷ $90,000). The TDSR is within 35% to 42% of their gross income, so Ben and Sarah will likely qualify for the loan based upon TDSR limits.
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Income Tax Planning Some credit advisors suggest that you limit your consumer debt payments, excluding mortgage payments to 20% of your take-home pay. The TDSR may be a better measurement because it considers all debt.
Collateral and Your Character
Collateral available for security As discussed earlier, some forms of credit are unsecured, such as debts incurred through the use of a credit card. However, most other lenders will insist on some form of collateral to secure loans. Because unsecured loans carry a higher risk of loss for the lender, the interest rate for those debts will usually be substantially higher than for a secured loan. In the case of secured loans, you may be able to negotiate a more favourable interest rate if you are able to provide more than the minimum collateral required by the lender. Your character In an industry based on facts and numbers, it is easy to come to believe that the individual does not matter. However, a wise lender takes into account a person's character. Your character is defined here as your moral quality or integrity, not your eccentricity. It is worth taking the time to develop a good working relationship with your banker, especially if your cash flow is in a constant state of flux. Also, be warned that it does not pay to embellish your credit application. If the lender discovers your deliberate misstatement, the lender will likely deny your application regardless of your credit rating, collateral, or capacity to pay. Furthermore, this indiscretion could haunt you from lender to lender, as your credit rating file will clearly show that the previous lender has requested a copy of your credit history. A cautious lender will wonder why other lenders have requested your history and have not advanced credit to you, and may contact the previous lenders for an explanation.
Exercise: Credit Rating
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Signs of Trouble
Some people rely too heavily on their misguided belief that if the lender is willing to advance credit, they must be able to afford it. Still others are simply unable to keep track of how their debt load is accumulating. You should be aware that you might have a credit problem if any of the following factors apply to you:
Getting Out of Trouble
If you do find that you have a credit problem, do not automatically despair. Most lenders realize that they stand a better chance of recovering their money if they work with you. Rather than just ignoring the problem by deferring payment on overdue bills, you should voluntarily approach your lender and explain your situation. In many cases, you may be able to renegotiate terms with your lender (this is where your good working relationship pays off). Some credit card companies will renegotiate their repayment schedules before referring you to a credit counsellor, a financial advisor who specializes in credit problems. A credit counsellor will help you find a source of money that you can use for debt repayment after your living expenses have been met. For example, she may suggest that you cut back
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Income Tax Planning on the amount you spend on clothes, rent, recreation, alcohol, or convenience foods. She may also suggest that you sell your car and switch to public transport. If you are too far in debt to recover simply by changing your lifestyle expenditures, a credit counsellor will help you consider other strategies for getting out of debt. You might be able to consolidate your debts by arranging a loan at a reasonable payment term and using the proceeds to pay off your various creditors or arrange with your creditors a repayment schedule that assures that you can handle the payments.
Insolvency and Bankruptcy
Some people may be unable to climb their way out of debt even with the help of a credit counsellor and by eliminating all but the bare necessities. These people will learn about the Federal Bankruptcy and Insolvency Act of 1992. According to this Act, you are insolvent if, you are not declared bankrupt, your obligations to your creditors exceed $1,000 and you: • • • are unable to meet your obligations as they typically come due have ceased paying your debt obligations have debts due and accruing which, in combination, exceed the reliable value of your assets
You are declared bankrupt if you are insolvent and you voluntarily declare yourself as bankrupt or if your creditors are successful in lodging a receiving order against you that forces you into bankruptcy. In both cases, your assets will be sold and the proceeds will be distributed to your creditors in an equitable manner. If a creditor has security on a specific asset, that creditor will be entitled to repayment from the proceeds of sale from that specific asset. If a creditor has no such security, his loan will be unsecured and he will be entitled to a proportionate share of the assets left after all the secured creditors have been satisfied.
Voluntary Bankruptcy
If you are insolvent and you do not owe more than $75,000 (excluding your mortgage on your principal residence), you may make a formal consumer proposal to your creditors requesting that they reduce your debt or extend the schedule for repayment of your debts. You must prepare this proposal with the assistance of a trustee or administrator who is licensed under the Bankruptcy and Insolvency Act. This trustee will be responsible for investigating your financial affairs and providing counselling. If, after receiving the proposal, your creditors do not request a meeting, they are assumed to have accepted your proposal. Once it is accepted, and provided you follow the proposal, you will be protected from further action by creditors, including having your apartment or home lease terminated by your landlord, or having your utilities shut off. If your proposal is not successful, or if you are unable to develop a feasible proposal, you may choose to declare yourself as bankrupt by making an assignment. This means that you file a petition with an official receiver as designated under the Act, accompanied by a sworn statement describing your property and your debts and creditors. The official receiver will then appoint a trustee and assign your property to that person for management. The trustee will be responsible for administering your estate. From that point on, you cease to have any right to dispose of, or deal with, your property.
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Introduction to Income Tax Planning During the last recession, many people assumed a cavalier attitude towards personal debt and thought that declaring personal bankruptcy was an easy way of getting around their financial obligations. These people often didn’t realize that all their assets, including art collections, antiques, family heirlooms, and so on, would be liquidated in an attempt to satisfy their creditors.
Forced into Bankruptcy
In some cases, a creditor or a group of creditors may file a petition with your local court to have you declared bankrupt. They may do this if you owe them more than $1,000 and if you have committed an act of bankruptcy in the past six months. Some examples of an act of bankruptcy include: • • • • • • assigning your assets to a trustee, in a manner that is not satisfactory to your creditors fraudulently transferring your assets to a third party in anticipation of bankruptcy, with the intention of withholding those assets from distribution to your creditors paying off one creditor in preference to the outstanding claims of other creditors (referred to as fraudulent preference) failing to give up goods that are to be seized from you under an execution order trying to depart secretly and suddenly, with the intention of defrauding your creditors failing to meet your liabilities as they come due
Note: You do not have to be insolvent before your creditors can petition to have you declared bankrupt. Committing an act of bankruptcy is sufficient grounds for such a petition. Bankruptcy proceedings are penal in nature. The petitioning creditors must meet the burden of proof before a court. You may oppose the petition by disputing the existence of the debt or the alleged act of bankruptcy. Even if the creditors are successful in proving their case, the court has the discretion of refusing the petition if they feel that you may be able to meet your obligations in a reasonable period if you are given a fair chance. If your creditors are successful with their petition, the court will make a receiving order, which effectively vests your property to a trustee appointed by the court. This trustee will be responsible for liquidating your assets and distributing the proceeds to your creditors in an equitable manner.
Protecting Yourself from Creditors
If you plan well enough in advance, there are ways to protect your personal assets from creditors, particularly if you are in business. Incorporating a business A common way to protect assets from creditors is to incorporate your business. A corporation’s liabilities are its own, and liability does not extend to its shareholders simply because they are shareholders. However, this strategy is not perfect: it is typical for many small business owners to give personal guarantees in order to obtain credit, which provides creditors with a claim against personal assets in the event of bankruptcy. Also, directors
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Income Tax Planning may be held personally liable for certain business expenses, including unpaid income taxes, wages, and vacation pay. Incorporation also may not protect an individual from professional negligence lawsuits. Family members hold title to assets Another tactic is to have other members of your family hold title to your property. However, this must be arranged long before you risk insolvency or bankruptcy. The Bankruptcy and Insolvency Act allows a bankruptcy trustee to recover any assets that you may have "gratuitously" transferred to someone else up to a year before bankruptcy. This period could be extended up to five years before bankruptcy if the trustee can show that you transferred the property with the intent to defraud your creditors or that you knew you would be unable to pay your debts if you no longer possessed the property. Other protection strategies Other protection tactics include the following: • purchasing life insurance products that include an annuity or RRSP component, with your spouse, your common-law partner, your child, your grandchild, or your parent named as a beneficiary setting up individual registered pension plans (RPPs), instead of investing in RRSPs because RPPs cannot be seized by creditors
•
Bankruptcy Discharge
A discharge under the Bankruptcy and Insolvency Act usually cancels the unpaid portion of any debts remaining after they have been reduced by proceeds from the liquidation of your estate. In other words, it gives you a fresh start. A discharge is an official act of court. The court may refuse to grant a discharge for a number of different reasons, including cases when: • • • • your assets were insufficient to pay your unsecured creditors at least 50% of your debt you have not kept adequate records you continued to do business after knowing that you were insolvent you caused the bankruptcy by rash speculation or extravagant living
If you are bankrupt and you have not yet obtained a discharge, you will be liable to a fine or imprisonment if you: • • obtain credit of more than $500, unless it is to supply the necessities of life for you or your family recommence your business without letting your suppliers know that you are an undischarged bankrupt
In order to obtain a discharge, you may be required to complete a process of counselling with a financial counsellor.
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Exercise: Insolvency and Bankruptcy
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Understanding Credit. In this lesson, you have learned how to do the following: • • • explain the general lending criteria (collateral, capacity, character, credit history) and their impact on financial planning describe and compare the different types of consumer credit explain and describe the use of refinancing, debt consolidation, insolvency, and bankruptcy
If you are ready to move to the next lesson, click Income Tax Basics on the table of contents.
Assessment
Now that you have completed Understanding Credit, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Income Tax Basics
Welcome to Income Tax Basics. In this lesson, you will learn about fundamental terminology associated with personal income taxation. This lesson takes 15 minutes to complete. At the end of this lesson, you will be able to do the following: • explain fundamental terminology associated with personal income taxation
Economic Development
The Canadian Government first collected income tax in 1917 as a temporary measure to help finance Canada’s costs in World War I. The federal and provincial governments collect taxes on personal income to provide revenue to cover the cost of the services provided by the government. Revenue from taxes on personal incomes has long been the main source of income for the Canadian federal and provincial governments. Direct taxes from individuals represent about 46% of the federal government’s revenue, and 33% of the provinces’ revenues. The Canadian government uses the income tax system to encourage investment in high-risk ventures or specific industries that have the potential to stimulate the country’s economy. When the housing industry was in a slump, the tax rules were changed to allow people to borrow from their RRSPs to buy a house. Sometimes tax rules intended to stimulate the economy have undesirable consequences. The result is often a change in the rules. Until 1994, Canadians had a lifetime capital gains exemption of $100,000. During the 1980s economic boom in Canada, this exemption encouraged investors to speculate in real estate. The result was escalating real estate prices. The federal government responded in March, 1992 by excluding capital gains from real estate investments from the $100,000 life-time capital gains exemption. Tax rules are sometimes changed in response to conditions in one part of the country and not others. The real estate boom in Ontario, for example, was not experienced in Atlantic Canada. Nevertheless, Atlantic Canada taxpayers were subject to the change in rules that excluded real estate from the lifetime capital gains exemption.
Tax Concepts
There are five important concepts to understand about taxes: • • • • • average tax rates marginal tax rates tax deductions tax credits refundable tax credits
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Average Tax Rates
The average tax rate is calculated as:
A taxpayer’s average tax rate is a somewhat crude measure because two taxpayers in the same province with the same total income can have different average tax rates. Louis has total income of $75,000, total income tax of $25,000, and no deduction for RRSP contributions. He has an average tax rate of 33.3%, calculated as (total income tax ÷ total income) or ($25,000 ÷ $75,000). If he contributed $10,000 to his RRSP and claimed a deduction, his total income is still $75,000 but his income taxes would drop to about $20,000. So, his average tax rate becomes 26.7%, calculated as (total income tax ÷ total income) or ($20,000 ÷ $75,000).
Marginal Tax Rates
The marginal tax rate (MTR) is the rate a taxpayer would pay on his or her next dollar of taxable income. Phrased another way, the marginal tax rate is the rate of tax paid on an individual’s highest dollar of income. Understanding the marginal tax rate concept is useful when making many decisions that have income tax implications. The marginal tax rate is calculated as:
Arun has $44,552.85 of taxable income. He is in a 25% tax bracket for calculating federal taxes. So, on the next dollar of taxable income he will pay 25¢ of basic federal tax. His federal marginal tax rate equals 25%. He is also required to pay provincial tax of 19.7% of taxable income. So, his MTR is 44.70%, calculated as (federal marginal tax rate + provincial marginal tax rate) or (25% + 19.7%). Various deductions can reduce total income.
Tax Deductions
A tax deduction is an amount that is deducted from a taxpayer's total income and is effectively not subject to tax. For example, an RRSP contribution of $5,000 can be deducted from the taxpayer's total income; by doing so, it essentially excludes $5,000 of income from being taxed. The effective tax savings from a tax deduction are the taxes that would be paid on an additional taxable income equal to the amount of the deduction.
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Income Tax Planning Kristin has a marginal tax rate of 38.6%. Assuming she makes a $5,000 contribution to her RRSP and this contribution does not reduce her taxable income to a lower federal or provincial tax bracket, she will reduce her taxes by $1,930, calculated as (tax deduction × MTR) or ($5,000 × 38.6%). There are a variety of tax deductions that can reduce a taxpayer's total income. Tax deductions and MTR The value of a tax deduction to an individual is dependent on his or her marginal tax rate: the higher the marginal tax rate of the taxpayer, the more his or her income taxes will be reduced as a result of the tax deduction. In the previous example, we learned that based on a 38.6% marginal tax rate and a $5,000 RRSP contribution, Kristin will reduce her taxes by $1,930. By contrast, if her husband Christian were to make an identical $5,000 contribution to his RRSP and claim a tax deduction based on his marginal tax rate of 43.2%, he will reduce his taxes by $2,160 calculated as (tax deduction × MTR) or ($5,000 × 43.2%).
Tax Credits
A tax credit is an amount that is deductible from income tax otherwise payable. Unlike a tax deduction, a tax credit reduces the taxpayer's income tax by the same amount regardless of his or her marginal tax rate. However, several provinces have income surtaxes, which would increase the value of a tax credit somewhat to an individual who is subject to an income surtax. Conversion rate for tax credits The conversion rate for tax credits is the rate that is applied to an eligible amount to calculate the amount of the tax credit. The conversion rate for most federal and provincial tax credits is the tax rate for the lowest tax bracket. In recent times, the lowest tax bracket has been: 16% for 2004, 15% for 2005, 15.25% for 2006 and 15.5% for 2007. The autumn 2007 Economic Statement proposed the lowest personal income tax rate be reduced to 15% retroactive to January 1, 2007. Justin and George both have medical expenses of $1,000 that are eligible for the medical expenses tax credit. Justin has a marginal tax rate of 44%; George has an MTR of 27%. Even though Justin and George are subject to different marginal tax rates, each individual can deduct a $150 tax credit against their taxes owing calculated as (medical expenses x conversion rate for tax credits) or ($1,000 x 15%) The value of a tax deduction increases with taxable income. The value of a tax credit is generally the same for all taxpayers. Refundable and non-refundable tax credits A non-refundable tax credit can be claimed by a taxpayer but only to the extent it reduces his or her tax liability to zero. This means, a non-refundable tax credit generally cannot be used by a taxpayer to obtain a payment from the government unless he or she has tax payable. Most tax credits can only be used to reduce the taxpayer's personal tax liability although, in limited circumstances, they can be transferred to a spouse or parent.
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Introduction to Income Tax Planning
Typically, the portion of a tax credit that cannot be claimed in a given year is lost however, exceptions, most notably with charitable donations, permit the unused portion to be carried forward and used in a future year subject to certain conditions. The majority of tax credits are non-refundable in nature. Justin has $100 in taxes owing and a $300 non-refundable tax credit. Justin can reduce his taxes owing to $0. However, the unused portion of the credit amounting to $200 calculated as ($100 – $300) is lost. Certain tax credits, such as the GST tax credit and certain provincial tax credits, are payable regardless of whether the taxpayer has any taxable income. These are called refundable tax credits. With refundable tax credits, even if the taxpayer has reduced his or her tax liability to zero, he or she will still be able to generate a refund from the government based on the excess portion of the refundable credit. George has $200 in taxes owing and a refundable tax credit of $500. George can use $200 of his tax credit to reduce his taxes to zero. Since the tax credit is refundable, the unused portion will trigger a $300 refund for George when he files his income tax return calculated as ($200 – $500).
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Income Tax Basics. In this lesson, you have learned how to do the following: • explain fundamental terminology associated with personal income taxation
If you are ready to move to the next lesson, click Completing an Income Tax Return on the table of contents.
Assessment
Now that you have completed Income Tax Basics, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 4: Completing an Income Tax Return
Welcome to Completing an Income Tax Return. In this lesson, you will learn about the types of income reported on a tax return and how to perform various tax calculations for your client. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • identify the types of income reported on a tax return identify all relevant personal information calculate total income, including components thereof calculate net income
The Layout of the Tax Return Form
The main tax return form is a four-page form, called the T1 General. This form is a summary statement divided into four parts: income, deductions, tax credits and tax calculations. Supporting documentation is required to prove to Canada Revenue Agency (CRA) that the declarations are true. For taxpayers who receive salary income, much of this documentation is provided on a T4 slip from their employers. Other documentation could include receipts for expenses, such as tuition fees. Commonly used forms are included in the General Income Tax Guide and Return, which is available at all Post Offices. Some forms are not included in the General Income Tax Guide and Return, and are available here on the CRA Web site.
To prepare a T1, one must fill out the following sections of the form: • • • • • Identification (Page 1) Goods and Services Tax (GST) Credit Application (Page 1) Total Income (Page 2) Net Income (Page 3) Taxable Income (Page 3)
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Introduction to Income Tax Planning • • Non-refundable Tax Credits (Schedule 1) Refund or Balance Owing (Page 4)
You are not expected to remember specific line numbers or dollar amount associated with the income tax return. You should however have a conceptual understanding of the tax concepts presented throughout this unit.
Identification
As you go through the next few pages, you will be able to explore the income tax form in detail. Click the highlighted areas to read about each of the tax form elements.
Goods and Services Tax (GST) Credit Application
How it works You apply for a GST credit on Page 1 of your General Tax Return. You must apply for it even it you received it in the preceding year. Your credit is based on your net income added to the net income of your spouse or common-law partner, for the year that just passed, as well as on the number of children you have.
CRA informs you in the following July how much you will receive, if any. Payments are made quarterly, in July and October, and then January and April of the next year. Dmitri is completing his tax return for this year. Even though he received the GST credit last year, he has to reapply for it each year. Accordingly, he checks the box on the first page of his tax return to apply for the GST credit. Assuming he qualifies, in July of next year, Dmitri will receive his first GST payment in addition to a notice telling him how much he will receive each quarter. For the four quarters effective July of next year, CRA will base his credit on the number of children he has and his net family income this year. You must inform CRA of any changes in the size of your family (i.e. those living with you) or your marital status because these could impact the amount of your GST credit (CRA is only concerned about a relationship breakdown after 90 days). CRA will adjust payments in the next quarter based upon any over- or under-payments made in the previous quarter.
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Income Tax Planning Eligibility You can apply for the GST credit if, at the beginning of the quarter in which CRA makes a payment, you were a resident of Canada and you meet ONE of the following eligibility requirements: • • • You are 19 years of age or older. You have (or previously had) a spouse or common-law partner. You are (or previously were) a parent and live (or previously lived) with your child.
If you have a spouse, only one of you can apply for the credit. No matter which one of you applies, the credit is the same because it is based on net family income. GST credit for children You can get the credit for each of your children if ALL of the following apply at the beginning of the quarter which CRA makes a payment. The child: • • • • is your child, or is dependent on you or your spouse or common-law partner for support is 18 or younger has never had a spouse or common-law partner has never been a parent of a child he or she lived with lives with you
Income thresholds The following table provides the family income limit according to the number of children in the family. If your family income is less than the income limit shown across from the number of your children, you should apply for the credit. Your family income is the total of your net income and, if applicable, your spouse's net income. Income levels are for the 2008 tax year for which GST/HST credit payments were payable as of July 2009.
Family Structure
Number of Income limit children 0 0 1 2 3 4 $39,872 $42,232 $44,832 $47,432 $50,032 $52,632
Single Married/Common-law Partner Single or Married/Common-law Partner Single or Married/Common-law Partner Single or Married/Common-law Partner Single or Married/Common-law Partner
The family income limits continue for five and more children, but are not provided here. The limits are available in the Income Tax Act or from CRA.
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Introduction to Income Tax Planning GST credit amounts For the 2008 tax year, for which GST/HST credit payments were payable as of July 2009, the basic GST credits were as follows: Basic credit for eligible adult Equivalent to spouse amount for single parents Credit for each qualified child under 19 Supplement for single adults Phase-in threshold for supplement for single adults without children Phase-out threshold $248 $248 $130 $130 $8,047 $32,312
Click here to see the most current calculation sheet and income thresholds.
Total Income
Schedule 3: Capital Gains (or Losses)
Income Tax Planning with Respect to Total Income
Having considered the items included in calculating total income, you can appreciate the wide net of the Income Tax Act in identifying income that will be taxed. Once income has been earned or received, it is part of your total income and there is no easy way to create deductions or tax credits to exclude it. However, there are still a few tax planning opportunities. Employment income Recognize that employment income and most benefits are fully taxable. Where non-taxable employment benefits are available, such as supplementary health insurance, take advantage of them. If employed by a corporation of which you are a major shareholder, have a tax specialist review your remuneration to determine whether salary or dividends are most tax effective, and whether excess income should be left in the corporation. Pension income Income from private pensions that is not currently required and that can be postponed and provide additional benefits, should be examined to determine whether the deferral of the tax and increase in benefits, is a good choice.
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Income Tax Planning
Investment income There are many investment strategies to consider in order to earn a good after-tax investment return with reasonable risk. In particular, you should take advantage of the opportunity to invest through RRSPs and other registered plans, which defer the taxation of investment income until funds are withdrawn. Within the rules of the Income Tax Act and sensible investment practices, you want to avoid producing taxable investment income. RRSP withdrawals Withdrawals should be avoided if possible because the withdrawn amount is fully taxable and the funds can only be recontributed to the RRSP if the taxpayer has eligilble contribution room.
Self-employed Income
You should ensure that all eligible expense deductions have been taken. If the income is not required for living expenses, the possibility of incorporating the business should be considered. Opportunities for income splitting between family members should also be considered.
Exercise: Total Income
Net Income
Schedule 4: Statement of Investment Income
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Introduction to Income Tax Planning
Exercise: Net Income
Income Tax Planning with Respect to Net Income
Having considered the deductions permitted in calculating net income, you can appreciate that they generally require an outlay of cash, and the deductions only result in the recovery of cash, equal to the tax you would have had to pay without the deductions. The tax planning opportunities with respect to the various types of deductions include: • RRSPs: Whenever possible make the maximum permissible RRSP contribution. The investment income is not taxed until the funds are withdrawn for retirement and a tax deduction is allowed for the contribution. Other deductions: The key tax planning opportunity is making sure you deduct eligible expenses.
•
Taxable Income
Your taxable income is calculated on the bottom of Page 3 of your T1 General Return as your net income from line 236, less various deductions and loss carryovers, including: • • • deductions for taxpayers who have an employee home relocation loan or who exercised an employee stock option carryovers of limited partnership losses, non-capital losses, and net capital losses of other years capital gains deductions for taxpayers disposing of qualifying small business or farm properties
These deductions and loss carryovers will be covered in detail later in the course.
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Income Tax Planning Income tax planning with respect to taxable income If you have losses that you can carry forward, you generally have a choice as to whether to claim them as a deduction in the current year or a future year. Depending on your current and anticipated future marginal tax rates, you will have to decide when is the best time to apply these loss carryovers. The calculation and application of the various types of loss carryovers are covered later in this course. Kim Chi Case Study – Part III Kim Chi did not have any additional deductions or loss carryovers, so she will report taxable income on line 260 of $29,125.06, the same as her net income reported on line 236. Make note of Kim Chi’s taxable income amount; you will require this number in the following lesson.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Completing an Income Tax Return. In this lesson, you have learned how to do the following: • • • • identify the types of income reported on a tax return identify all relevant personal information calculate total income, including components thereof calculate net income
If you are ready to move to the next lesson, click More on Completing an Income Tax Return on the table of contents.
Assessment
Now that you have completed Completing an Income Tax Return, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Introduction to Income Tax Planning
Lesson 5: More on Completing an Income Tax Return
Welcome to More on Completing an Income Tax Return. In this lesson, you will learn about non-refundable tax credits, common tax credits, deductions as they are reported on a tax return, and federal and provincial taxes. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • identify the deductions as they are reported on a tax return perform federal and provincial tax calculations identify non-refundable tax credits identify common tax credits such as the basic personal amount, age amount, and spousal amount
Non-refundable Tax Credits
As you go through this lesson, you will be able to explore the income tax form in detail. Click the highlighted areas to read about each of the tax form elements. Non-refundable tax credits are calculated on Schedule 1, Federal Tax. Non-refundable tax credits can only be used in the current tax year to the extent that they reduce net federal tax to zero. They cannot be used to generate a refund.
Exercise: Non-refundable Tax Credits
Federal Tax Calculation
Your federal tax is calculated using Schedule 1, which is reproduced below. Click the highlighted areas to read about the elements of the tax form.
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Income Tax Planning
The table shows the federal personal income tax rates. The federal tax rates can also be found by clicking here to visit the CRA Web site. Federal Income Tax Rates for 2009 Taxable Income, Base Amount up to $40,726 $40,727 - $81,452 $81,453 - $126,264 over $126,264 Federal Tax on Base Amount $0 $6,109 $15,069 $26,720 Marginal Rate on Taxable Income of Base Amount 15% 22% 26% 29%
Exercise: Schedule 1 Part 1—Calculation of Basic Federal Tax
Refundable Tax Credits
In addition to the non-refundable tax credits, Schedule 1 records several refundable tax credits, including those for federal political contributions and investments in laboursponsored investment funds. Click the highlighted areas to read about the elements of the tax form. Please note that the line number refers to the number to the left of the entry boxes.
Exercise: Schedule 1 Part 2—Calculation of Net Federal Tax
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Introduction to Income Tax Planning
Income Tax with Respect to Refund or Balance Owing
Most taxpayers are pleased to receive a tax refund. Moreover, the greater the amount of the refund, the greater the taxpayer’s satisfaction. However, it is important to understand exactly why the taxpayer is receiving a refund to begin with: he or she paid more taxes during the course of the year than was actually required. In essence, this amounts to the government holding and using the taxpayer’s funds without compensating the taxpayer with interest payments. On the other hand, had the taxpayer been able to retain the excess amount in his or her hands instead of remitting it to the government, he or she could have invested the funds, generated a rate of return and seen the funds grow in value. So, with proper tax planning, a taxpayer would actually prefer to eliminate or minimize a tax refund so the taxpayer is not using his or her money to provide the government with an interest-free loan. Ideally, the tax already paid during the year would equal the net federal tax owing and thereby avoid having a balance owing to the government. It would also eliminate the possibility of receiving a refund cheque but, the taxpayer would have use of his or her own funds during the course of the year.
Provincial Income Tax
All provinces, except Québec, levy provincial income tax as tax on income (TONI), which is applied by applying the province’s tax rates and brackets to taxable income as calculated under the Federal Income Tax Act, and then deducting the province’s version of tax credits. Québec has its own tax system. The provincial and territorial tax rates for 2008 can be viewed by clicking on the link to the Canada Revenue Agency website: http://www.cra-arc.gc.ca/tax/individuals/faq/taxratese.html#provincial NOTE: This information is strictly for reference. For purposes of the exam, you will not be required to know the tax rates for a specific province or territory.
Exercise: Refund or Balance Owing
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Income Tax Planning
Full Indexation
The personal income tax system was only partially indexed to changes in the consumer price index (CPI) since 1986. Under these rules, parameters of the personal income tax system were adjusted each year for the percentage change in the CPI exceeding 3%. Because inflation was below 3% in recent years, the personal income tax system has effectively not been indexed. The Federal Budget of February 28, 2000 reinstated full indexation effective January 1, 2000, for all amounts that were previously only partially indexed. The indexation factor for a given taxation year beginning January 1, 2000 is the percentage change in the average CPI for the 12-month period ending on September 30th of the previous year relative to the average CPI for the 12-month period ending on September 30th of the year earlier. The table lists the base amounts for the main personal federal non-refundable tax credits that are now fully indexed (with occasional exceptions) for 2009.
Personal Amounts that are fully indexed Indexing factor Basic personal amount Spousal/eligible dependant amount Reduced when spousal/dependant income exceeds Eliminated when spousal/dependant income exceeds Age amount (age 65 and older) Reduced when income exceeds Eliminated when income exceeds Disability amount Disability amount supplement (under age 18) Reduced when total child care/attendant expenses claimed exceed Eliminated when expenses exceed Infirm dependant amount (age 18 and over) Reduced when dependant’s income exceeds Eliminated when dependant’s income exceeds Caregiver amount Reduced when relative’s income exceeds Eliminated when relative’s income exceeds Pension income amount
2008 1.025 $10,320 $10,320 $0 $10,320 $6,408 $32,312 $75,032 $7,196 $4,198 $2,459 $6,657 $4,198 $5,956 $10,154 $4,198 $14,336 $18,534 Lesser of eligible pension income and $2,000 $1,044 Expenses in
Canada employment amount Medical expense tax credit
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excess of the lesser of 3% of net income and $2,011 Threshold income above which reduction or clawback tax applies: GST credit Old Age Security (OAS) benefit received
$32,312 $66,335
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed More on Completing an Income Tax Return. In this lesson, you have learned how to do the following: • • • • identify the deductions as they are reported on a tax return perform federal and provincial tax calculations identify non-refundable tax credits identify common tax credits such as the basic personal amount, age amount, and spousal amount
If you are ready to move to the next lesson, click Integrating Income Tax Planning and Financial Planning on the table of contents.
Assessment
Now that you have completed More on Completing an Income Tax Return, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 6: Integrating Income Tax Planning and Financial Planning
Welcome to Integrating Income Tax Planning and Financial Planning. In this lesson, you will learn about how the 6-step financial planning process relates to income tax planning. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the implications of tax planning in financial planning explain the 6-step financial planning process as it relates to income tax planning
Integrating Income Tax Planning and Financial Planning
Ideally, income tax planning is driven by overall financial planning, and is not an end in itself. While financial planners often perform consultations or engagements that are entirely tax oriented, tax planning as part of a financial planning engagement assumes integration with other aspects of the financial planning process. In addition, a tax projection is normally required to determine the cash flow that is available to fund objectives, regardless of any perceived need to apply tax planning strategies.
The Financial Planner's Role in Income Tax Planning
As a financial planner, you need to have a good understanding of how the Canadian income tax system can affect your client’s ability to meet their financial objectives. While we are not saying that you need to become an expert on the income tax system, you do need to acquire a fairly comprehensive knowledge of the tax system just to be able to identify the potential income tax issues that can affect your clients’ financial plans. However, you should be careful not to present yourself as a tax expert to your clients, and you must clearly indicate to each client, preferably within your letter of engagement, the level of tax compliance services that are included in the financial planning engagement. If you do not have a good working knowledge of income tax rules, or if you lack knowledge in a specific area that is important to your client (for example, cross-border taxation issues), you or your client should consult a qualified tax specialist.
Tax Planning and the Financial Planning Process
In some cases, your planning engagement could be limited to a review of the client’s tax situation with respect to his or her overall financial goals. The income tax planning process mirrors the basic personal financial planning process, with 6 main steps or stages.
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Introduction to Income Tax Planning
Step 1: Establish Client-Planner Engagement
In a financial planning engagement, the planner and client have to establish their contract.
Step 2: Establish Objectives
In a financial planning environment, income tax planning has two primary objectives: • • determining the effect of income tax expenditures on cash flow establishing tax-planning strategies to help satisfy your client’s overall financial planning objectives
You will usually need to prepare an initial projection of income tax liabilities in order to determine your client’s after-tax cash flow available to fund objectives. You may have to revise this projection after tax planning strategies and other financial planning strategies have been selected.
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Income Tax Planning
Step 3: Gather and Analyze Data
You must generally develop a core information base for tax planning purposes. This usually starts with copies of the last two or three years’ income tax returns. Additional information is gathered from the general data gathering documents used in the financial planning engagement.
Step 4: Identify Tax Planning Strategies
As a financial planner, you should consider the suitability of strategies in light of the overall financial objectives and risk tolerance of the client. It is important not to focus solely on how much tax can be saved to the exclusion of other factors.
Tax planning strategies include those designed to: • • • avoid or reduce tax (avoidance) by making use of various exemptions postpone the payment of taxes (deferral) by timing the receipt of income convert income to a form that is more favourably taxed (conversion), for example, by splitting income with family members with a lower marginal tax rate, or earning capital gains instead of interest income
These strategies are discussed in more detail later in the course. The benefit of a tax planning strategy should be compared with its cost. In addition to fees and direct implementation costs, consideration should also be given to indirect burdens, such as the time and effort the tax planning strategy requires from the client and the complexity the strategy adds to the client’s financial affairs.
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Introduction to Income Tax Planning
Step 5: Implement Tax Planning Strategies
As with all phases of financial planning, you may be asked to assist with the implementation of selected tax planning strategies. Examples include: reviewing proposed legal documents from a tax perspective and counseling clients about tax-related issues of which they should be aware such as tax-loss selling at the end of the year.
Step 6: Monitor and Update the Plan
Monitoring your client’s plan is an important part of the financial planning process and usually includes recognizing and advising the client of changes that have occurred that affect the plan. Of course, this means it is incumbent on you to keep abreast of changes in tax law and to understand how these changes can impact you client’s financial plan. The client should be made aware of the scope of your responsibility to identify changes in tax law and to make appropriate adjustments to the client’s financial plan. Generally, you should keep any monitoring and updating services as a separate engagement.
Tax Considerations Throughout Financial Planning
While some clients may want you to prepare an income tax plan, you will most often use your tax knowledge during other financial planning engagements. The following discussions identify how income tax considerations might be integrated within other financial plans, but the list is far from complete.
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Income Tax Planning For the remainder of this lesson we will look at different aspects of financial planning that are part of an overall financial plan. These strategies will be covered in detail in this or in other courses of the CFP™ program: • • • • • • cash flow planning education planning investment planning retirement planning risk management planning estate planning
Exercise: Tax Considerations Throughout Financial Planning
Cash Flow Planning
Paying income tax is typically one of the largest cash outlays a client will make during the year. The magnitude of this expenditure requires the planner to ensure it is dealt with adequately during the planning process. However, any reduction in income taxes should be co-ordinated with other parts of the financial planning process. Timing of income and expenses Generally, the most common tax planning technique used by financial planners is to time the receipt of income and the payment of expenses. Taking advantage of legitimate methods of reporting income and expenses that cover more than one year is crucial to this process. However, deferring income or accelerating deductions may not always be beneficial to every client. As always, you should consider the tax effect of these strategies before you recommend them. Whenever there are limitations on deductions and the client has the option of timing when the expense is paid or claimed, you should advise the client to time the payments so that they are made in the year that benefits them most. Some examples of these deductions are: • • • • medical expenses investment interest expenses charitable donations registered retirement savings plan contributions
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Introduction to Income Tax Planning Taxable income without cash flow There are also situations when there is taxable income, but there is little or no cash flow to pay the resulting income tax. In planning the transaction, your recommendation should provide enough cash to at least pay the projected tax on the income. A client may have investments in mutual funds and choose to reinvest all distributions, dividends, or capital gains. You should advise the client that funds to pay the outstanding taxes must come from other sources or from the redemption of some mutual fund units or shares. If the client does the latter, the capital gain or capital loss realized upon the redemption must also be considered in the planning process.
Education Planning
Education funding planning involves identifying the client’s objectives for educating children or others, quantifying the cost of achieving those objectives, and selecting the appropriate funding methods to provide for the costs of achieving those objectives. For example, using a registered education savings plan and taking advantage of the Canada Education Savings Grant can reduce the financial burden of funding a child’s education. Consistency with other objectives Most income tax planning comes into play in the quantification and selection phases of education financing: • If the client plans a pay-as-you go approach, how much pre-tax income will he or she have to earn in order to have sufficient after-tax cash flow to meet the education expenses? If the client plans to put aside money each year outside of a registered education savings plan, how will the taxation of the resulting investment income affect the growth of that investment? If the client plans to use a registered education savings plan, how will the proceeds be taxed upon withdrawal, and how does this affect the amount that must be accumulated within the plan in order to meet the education funding objectives?
•
•
However, you must be careful not to let the potential for income tax savings result in a decision that is inconsistent with other objectives that the client established in the initial objective identification stage. If your client is concerned that resources may be diverted to an unintended use, you may want to advise the client of the potential for a loss of control with any tax strategy suggested for education funding. Jasper is thinking of transferring some growth equities into a trust for the benefit of his infant daughter, with the thought that when she grows up, she will receive control over the assets and can sell them to fund her education. Any capital gain on property that has been transferred to a child is taxable to that child, not the transferor, so Jasper anticipates significant tax savings in this strategy. However, it also means he might give up control of the investments, and he must recognize that his daughter might choose to use the proceeds for something other than her education.
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Income Tax Planning
Investment Planning
The purpose of investment planning is to maximize the return on investment. Income taxes are a major expense that have a significant affect on returns, but preferential tax treatment alone does not necessarily make an good investment good. Choosing when to recognize capital gains and losses Most clients have investments with unrealized capital gains or losses. Investment advisers often encourage year-end selling to offset other realized gains or losses. While this approach could minimize taxes or decrease a capital loss carryover, it may not maximize the return on investment. Some clients feel compelled to use their unrealized gains and losses at the first available opportunity. However, economics, not taxes, should be the controlling factor. Avoidance, conversion, and deferral opportunities Investments can also be chosen for their potential for tax avoidance, deferral, or conversion. For example: • • Some investors may choose to invest in a qualified small business corporation in order to take advantage of the $750,000 capital gains exemption (avoidance). Some investors may choose to invest in growth equities, where capital gains are not realized until the investment is sold (deferral), and even then, only 50% of the capital gain is included in income (conversion).
We will be taking a look at opportunities for avoidance, conversion, and deferral in greater detail later. After-tax, risk-adjusted rate of return The rate of return should be adjusted for tax and risk. The after-tax yield gives you a better understanding of how much of the return on an investment you actually get to keep once you have paid your tax liability on the gain. The next step is to determine investment risk, which is the likelihood that the actual return of the investment will deviate from its expected return. An after-tax, risk-adjusted rate of return allows one to compare investments in a meaningful way.
Exercise: Tax Planning and the Financial Planning Process
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Introduction to Income Tax Planning
Retirement Planning
The retirement planning process begins with identifying and quantifying the client’s objectives on both a pre-tax and an after-tax basis. Remember, retirement expenses must be funded with after-tax dollars and some sources of retirement income are taxable, while others are not. Generally, estimated retirement expenses will exceed estimated retirement income. This shortfall, or retirement income gap, requires a client to choose an investment strategy for accumulating assets. Funding vehicles You will need to identify the various types of retirement plans available to your client. Distributions from retirement plans that accumulate income and capital gains on a taxdeferred basis are taxable. You should keep in mind how sensitive the various funding plans are to different income tax rate assumptions. In periods where clients are paying low tax rates, they may find that it is advantageous to fund the retirement income gap with a mixture of taxable and tax-deferred plans. Of course, if tax rates rise, using the taxdeferred plans is more advantageous. Timing and use of retirement funds All of the various ways in which retirement plan distributions can be received should be looked at in terms of when the funds are needed. If the funds are needed immediately to cover living expenses, the decision to withdraw appears to be easy, but the decision regarding which investment to withdraw first has significant tax implications. Should the client draw from registered or unregistered funds first? If they have to liquidate an asset, would it be better to choose an asset that belongs to the spouse with the higher marginal tax rate, or the lower one? During retirement, it is generally recommended that savings be accessed in the following order: I) II) III) IV) Use the first. Use the next. Use the Use the higher income spouse or common-law partner’s non-registered funds lower income spouse of common-law partner’s non-registered funds lower income spouse or common-law partner’s registered funds next. higher income spouse or common-law partner’s registered funds last.
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Risk Management Planning
Risk management involves identifying client risks; making informed decisions to retain, reduce, transfer, or avoid each significant risk; and implementing those decisions Risk identification Risk identification normally involves listing various risk categories with an initial subjective evaluation of the probability of its occurrence and the financial impact of the related loss event. When making the subjective evaluation of the financial impact of the risk, you should consider the income tax ramifications of each potential risk. For example, when assessing the expenses that a survivor might incur after your client’s death, you must realize that these expenses must be paid with after-tax dollars. Emergency funds While some large risks may be transferred or shared by using insurance, your clients may accept some risks in order to reduce the cost of their insurance, or simply because the risk is uninsurable. When a risk is retained, clients should create an emergency fund (e.g., a reserve of six months’ living expenses in case of a loss of income) to cover the immediate needs arising on a loss occurrence. Since safety of principal and liquidity are the overriding concerns, the emergency fund is usually not tax advantaged. And investment like a money market mutual fund generates inefficient (from a tax perspective) interest income nevertheless, it is an ideal investment as part of an emergency fund because of its security and accessibility. A simple calculation of after-tax yields on comparable quality cash equivalent investments can usually determine the appropriate investments for the emergency fund. Taxation of insurance Insurance policies can be used to transfer risk from the client to his or her insurance company in exchange for a premium. The client would obviously like to obtain as much coverage for as little cost as possible. The income tax treatment of premiums and insurance benefits payable upon occurrence of a loss are major considerations in this process. Ideally, clients want to structure their risk management plans to produce totally deductible insurance costs and totally excludable benefits. In practice, this is seldom possible. The client should accept and evaluate trade-offs. If, for example, a disability insurance premium is deductible, the benefit payments are normally taxable. Alternatively, an employee-client could reimburse the employer for the premium; this would result in tax-free benefits and a lower benefit requirement.
Estate Planning
Co-ordinating the income tax and transfer tax aspects of an estate plan is crucial to financial planning. Without this co-ordination, unforeseen income tax consequences can have a devastating impact on the estate plan. A few examples are discussed below. Deemed dispositions and spousal rollovers When your client dies, he or she is deemed to have disposed of all of his or her capital assets at their fair market value (FMV), except to the extent the assets can be rolled over to a spouse or common-law partner. This may result in significant taxable capital gains.
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Introduction to Income Tax Planning However, the realization of these gains can be deferred and transferred to the beneficiaries through the judicious use of spousal rollover provisions and through the implementation of estate freezes. Charitable giving Taxpayers who hope to combine philanthropic intentions with tax planning need to be aware of the limits of the charitable donation tax credit. Using trusts for income splitting A testamentary trust is a trust created upon death. Taxpayers who leave significant assets to their survivors via testamentary trusts need to be aware of how these trusts are taxed, and their potential use for income splitting among beneficiaries and trusts. An inter vivos trust is a trust created while still alive. Taxpayers who want to make use of inter vivos trusts to facilitate their estate plans need to be aware of the potential for income attribution, and the fact that income retained by an inter vivos trust is taxed at the highest marginal tax rate.
Small Businesses
While a financial planner may not be concerned about small business planning in terms of business plans, marketing studies, and so on, a planner does need to know how these businesses can be used to help achieve his or her clients’ goals. There are many tax planning opportunities with respect to small businesses that can help make a financial planner a valuable part of his or her clients’ financial plans. The following are some examples of these tax planning opportunities: • • • • the potential to split income with employed family members the potential to defer income through the timing of salary and bonus payments the opportunity to use the business to contribute to registered pension plans or to implement a private health care plan the use of the $750,000 lifetime capital gains exemption upon the disposition of a qualifying small business interest
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Integrating Income Tax Planning and Financial Planning. In this lesson, you have learned how to do the following: • • describe the implications of tax planning in financial planning explain the 6-step planning process as it relates to income tax planning
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Integrating Income Tax Planning and Financial Planning, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Introduction to Income Tax Planning
Review
Let’s look at the concepts covered in this unit: • • • • • • Money Management Understanding Credit Income Tax Basics Completing an Income Tax Return More on Completing an Income Tax Return Integrating Income Tax Planning and Financial Planning
You now have a good understanding of the basics of income tax planning. At this point in the course you can assist your client in identifying money management objectives, describe and compare the different types of consumer credit, and explain and incorporate fundamental terminology associated with personal income taxation. You can also explain the 6-step planning process as it relates to income tax planning as well as identify, calculate, and report various income tax information for your client. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 1: Introduction to Income Tax Planning, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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I FP
Unit 2: Proprietorships and Partnerships
Income Tax Planning
Unit 2: Proprietorships and Partnerships
Welcome to Proprietorships and Partnerships. In this unit, you will learn about the general characteristics of sole proprietorships, the various partnership forms, and their advantages and disadvantages. You will also learn how business income is calculated and taxed for these forms of businesses. This unit takes approximately 3 hours to complete. You will learn about the following topics: • • • • • The Role of Businesses in Wealth Accumulation Partnerships Partnerships and Income Tax Limited Partnerships Business Income
To start with the first lesson, click The Role of Businesses in Wealth Accumulation on the table of contents.
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Proprietorships and Partnerships
Lesson 1: The Role of Businesses in Wealth Accumulation
Welcome to The Role of Businesses in Wealth Accumulation. In this lesson, you will learn how your client can gain the greatest personal benefits from the wealth created through owning and managing a business, or investing in a business. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • describe the financial planning needs specific to a business owner/manager compare and contrast the various forms of partnerships and their implication to income tax planning describe the types of business income generated by a proprietorship or partnership
The Role of Businesses in Wealth Accumulation
The creation of wealth is the first step in any wealth accumulation process (other steps include preserving or conserving wealth). While individuals can create personal wealth by collecting rare stamps or winning a lottery, this is either incidental to the growth of the Canadian economy or merely a redistribution of existing wealth. The primary way that wealth is created in the Canadian economy is through business or economic activity. In the simplest terms, a business activity is any step in the process of creating, producing or delivering a good or service in exchange for payment in money or other valuable consideration. Business activities produce jobs for employees, profits for the owners and tax revenues for the various levels of government. This course concentrates on how an individual can gain the greatest personal benefits from the wealth created through owning and managing a business, or investing in a business. As a personal financial planner, you will have clients who own and manage their own businesses and other clients who invest in such businesses without taking an active role in that business. To serve the financial planning needs of your clients, you need to understand how businesses are structured, how they are taxed and how they are used as investments.
The Needs of Business Owners/Managers
As a financial planner, you will have clients who own their own businesses. Their financial situations are very different from your clients who are employees. Business owners are often totally reliant upon the business for their income and have most of their wealth invested in the business. When they want to retire, they have to find a way to liquidate the investment they have in the business by selling it or having a family member take over the business. Their personal and business affairs are so inextricably linked that every personal financial decision involves a business consideration. So, if you want to serve your owner/manager clients well, you must understand their business concerns.
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Income Tax Planning
The Needs of Other Investors
Many investments are simply extensions of credit where an investor lends money to a borrower (e.g., a corporation or government) through the purchase of bonds or debentures. These investments usually provide an annual return in the form of interest, plus a return of principal upon maturity. The security of such an investment depends largely upon the issuer. Stocks, especially common shares, are another important financial instrument because they represent ownership or equity in a corporation. To understand investing in stocks and bonds, you must understand how corporations are structured, governed, and taxed. Some of your high income clients may want to consider the purchase of tax shelters, such as mutual fund limited partnerships or flow-through mining shares. Tax shelters are often structured as limited partnerships, so you must understand how this business form works. Business forms for personal financial planners As a personal financial planner, you may be an employee of a financial institution. However, you may also be conducting your financial planning practice as an individual through a sole proprietorship, as a partner through a partnership or as a manager of a corporation. If this is the case, you will need to understand how proprietorships, partnerships, and corporations are structured, governed and taxed in order to select the best form of business for your own practice.
Exercise: Business and Wealth Accumulation
Sole Proprietorships
An individual can establish or purchase a business and operate it without any partners and without incorporating the business. Businesses that are unincorporated and owned by only one person are called sole proprietorships. The owner of a sole proprietorship is referred to as a sole proprietor. The sole proprietorship is the simplest form of business organization. A sole proprietor must run a business (carry out business activities) and not just make passive investments, such as holding guaranteed investment certificates. A business activity is any step in the process of creating, producing, or delivering a good or service in exchange for payment in money or other valuable consideration. While a sole proprietor may hire employees to help operate the business and even hire a manager to oversee the business operation, he or she is ultimately deriving his or her income from business activities. In contrast, an investor is not in business, because he or she is not carrying out any business activities. Instead, the investor holds property and derives income from the interest, dividends, rents, and capital gains that the property produces.
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Proprietorships and Partnerships
How a Sole Proprietorship is Created
A sole proprietorship is created by the simple act of a person commencing business activities for his or her own account without first taking steps to form some other form of business organization, such as a partnership or corporation. Similarly, a sole proprietorship ceases when the sole proprietor stops carrying out business activities, or upon his or her death.
Registrations and licenses Unlike corporations and some partnerships, there are no legal steps that must be taken to establish a sole proprietorship. However, in order to carry out certain types of business activities (for example, taxis, restaurants, car dealers, real estate agents), the sole proprietor may be required to obtain one or more licenses at the municipal, provincial or federal levels. In addition, each province has legislation (such as Ontario’s Business Names Act) that requires the sole proprietor to register any business name that does not contain his her own full name. The main reason for this requirement is to ensure that there is a public record of the true owner of the business, so that creditors and others can determine who is legally responsible for the debts and obligations of the business. Brian Sutton decided to offer his services as a fishing guide. If he offered his services under his own name, as Brian Sutton, Fishing Guide, or Brian Sutton’s Fishing Charters, he would not have to register the business name under the Business Names Act. However, if he chose to operate under a different name, such as Brian’s Bass Bonanza, or Fishing Frenzy Tours, he would have to register the business name.
Unlimited Liability
A sole proprietorship is not a separate legal entity from the owner. The proprietor is the sole owner of the business, so that all benefits flowing from the business accumulate to his or her exclusive enjoyment. However, this means that all obligations associated with the business are also the responsibility of the proprietor. Thus, all of the income or losses of the business, as well as all of the business assets and liabilities, belong to the proprietor. Because the sole proprietor is personally responsible for all debts and other liabilities incurred in the operation of the business, his or her personal property can be seized to cover such debts. This is why the business name must be registered if it is not the same as the proprietor’s name, so that the creditors know whose personal property they can go after if they are trying to collect on business debts.
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Income Tax Planning
Who Should Establish a Sole Proprietorship?
Because of the unlimited liability, sole proprietorships are generally suitable for business activities that: • • can be financed by an individual do not require sophisticated management
Some provinces prohibit certain professionals from incorporating their practices, so many individual lawyers, accountants, doctors and dentists practice as sole proprietors or partnerships. Andrew Lee graduated from Osgoode Law School in 1988, completed his articles shortly thereafter and was admitted to the Bar. He did not see great prospects of being accepted as a partner with the firm with which he articled, so he decided to practice copyright law as a sole practitioner. He would have preferred to incorporate his law practice, but was prohibited by provincial legislation. So, Andrew practices as a sole proprietor.
Exercise: Sole Proprietorships
How the Income Tax Act Views Sole Proprietorships
Under the Income Tax Act, the net income of the business (basically revenue less expenses) is the income of the sole proprietor. Thus, the net income of the business is taxable to the proprietor for the year it is earned, even if he or she leaves the money in the business bank account and does not make any cash withdrawals. Similarly, the property used by the business of a sole proprietor is considered to be the property of the sole proprietor. Accordingly, capital gains or losses on the disposal of property used in the business are treated in exactly the same way as capital gains or losses on any property owned by an individual. Tax implications of paying a salary to another individual The sole proprietor can pay a salary to anyone other than himself or herself, including a spouse, common-law partner, or children, for employment in the business provided that the work was necessary and the salary was reasonable in light of the work performed. If these conditions are not met, the salary is not deductible to the sole proprietor for income tax purposes. However, if these conditions are met, the salary is deducted as a business expense reducing the income reported by the proprietor and it is included in the taxable income of the recipient. Andrew Lee’s wife is a chartered accountant and she spends three days a month keeping the accounting records and producing invoices and financial statements for his law practice. He pays her a salary of $1,000 per month for her services. This amount is reasonable and he can deduct it from his business income.
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Proprietorships and Partnerships
The sole proprietor cannot pay himself or herself a salary because the sole proprietor and the business are one and the same entity. Instead, the sole proprietor records the net income of the business on his or her personal tax return. Reporting business income or losses If the net income is positive (if the business earned a profit), this amount will be added to the proprietor’s income for tax purposes. If the net income is negative (if the business recorded a loss), this amount is deducted from the proprietor’s other income, but only to the extent that it reduces net income to zero. Any excess loss that cannot be deducted in the current year can be carried over to be applied against income of other years within certain limitations, as discussed in the lesson titled Business Income. Business income or losses are reported and taxed in essentially the same way for sole proprietors and partners, so taxation of business income will be examined in greater detail after we review partnerships.
Exercise: Advantages and Disadvantages of Sole Proprietorships
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed The Role of Businesses in Wealth Accumulation. In this lesson, you have learned how to do the following: • • • describe the financial planning needs specific to a business owner/manager compare and contrast the various forms of proprietorships and their implication to income tax planning describe the types of business income generated by a proprietorship or partnership
If you are ready to move to the next lesson, click Partnerships on the table of contents.
Assessment
Now that you have completed The Role of Businesses in Wealth Accumulation, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Proprietorships and Partnerships
Lesson 2: Partnerships
Welcome to Partnerships. In this lesson, you will learn about the types of partnerships, partner roles and responsibilities, and the creation, dissolution, and liabilities of partnerships. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • compare and contrast proprietorships and partnerships describe the types of partnerships explain partner roles and responsibilities describe the creation, dissolution, and liabilities of partnerships
Partnerships
The various provincial Partnerships Acts define a partnership to be a relationship that exists between two or more individuals (where an individual could include either a person or a corporation) carrying on an unincorporated business in common with a view of profit. The owners of a partnership are called partners. Note: There is no requirement that the partnership actually earn a profit in any one year. However, the partnership should have a reasonable expectation of being able to earn a profit within a reasonable length of time, especially if the partners want to deduct their losses for income tax purposes. Requirement to carry on business activities As with a sole proprietorship, a partnership must carry on a business (perform business activities) and cannot simply consist of several individuals making passive investments. The partners ultimately derive taxable incomes from these business activities. No separation between partners and the partnership Unlike a corporation, a partnership is not a separate legal entity from the partners. Instead, it is merely a relationship between two or more individuals carrying on a common business. A person cannot be both a partner and an employee of the partnership because no person can enter into a contract with himself or herself. Similarly, in most cases a partner cannot be a creditor of the partnership because there is no legal separation between the partner and the partnership. Types of partnerships Partnerships can be further classified as general partnerships, limited partnerships, and limited liability partnerships. Because most of the features of general partnerships apply to the other partnership forms, we will begin with a discussion of general partnerships, and then we will compare how limited partnerships and limited liability partnerships differ from the general partnership. We will also take a brief look at joint ventures.
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Income Tax Planning
Establishing a General Partnership
A general partnership is the simplest form of partnership, and it can come into existence without any legal formalities, simply by the action of two or more people carrying out business activities together. A general partnership consists only of general partners. General partners are those who are entitled to take an active role in managing the business, and who have unlimited personal liability for the debts and obligations of the partnership. Alvin Fung and Fred Swinden both articled with the same chartered accountancy (CA) firm. Upon acquiring their CAs, they decided to go into business together offering accounting and auditing services to the public. They established a general partnership by setting up the business. In their province, they are not permitted to incorporate the business under the provincial laws regulating chartered accountants. The ease of setting up a general partnership In fact, it is so easy to establish a general partnership that some people may be operating a partnership, even if this was not their intention. A person who became a partner without realizing it could get a nasty surprise when he or she is called upon to cover debts incurred by the partnership. When Arnold was playing golf with Samantha, she explained her plans to develop a piece of property that one of her uncles owned. She only needed another $50,000 to go ahead and the investor would triple his money in 12 months. Arnold wrote out a cheque. Arnold does not realize it yet, but he is now a partner in a business involved in real estate development. When he does, he will still have no idea with whom or on what terms. The provincial Partnership Act, the terms of which may be totally unsuitable, will govern his business relationship with Samantha. He needs legal advice.
Unlimited Liability
Because a general partnership is not a separate legal entity from the partners, a person who is found to be a general partner is personally responsible for the total debts and obligations of the partnership. The liability includes debts incurred in the ordinary course of business of the partnership, but also includes liability for negligence and any wrongful act or the failure to act committed by any of the partners in the ordinary course of the partnership's business. General partners are jointly and severally liable Each general partner is said to be jointly and severally liable for the debts and liabilities of the partnership to the full extent of his or her personal assets, not just his or her investment in the partnership. This means that a creditor can obtain a judgement against the partnership and demand payment of the entire amount from any one or all of the partners. The creditor does not have to determine which partner owes what amounts. If one partner is required to make payment to a creditor, the partners then have to figure out among themselves who owes what amounts to each other.
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Proprietorships and Partnerships Kevin, Darren and Bryan operate a karate studio together as a partnership. The business is eight months behind on rent and bank loan payments, and owes $10,000 to equipment suppliers. The partners have agreed that the business is a bust and it is time to move on to something else. Darren and Bryan have little in the way of personal assets, but Kevin owns his own home, a cottage and numerous investments. Although all three partners are liable for the debts of the partnership that remain after the business assets are liquidated, the creditors will likely go after Kevin’s personal assets. Kevin will then have to seek reimbursement from Darren and Bryan. Because of this potential for personal financial liability that goes beyond the investment made by the partner, great risk can accompany a partnership interest.
Exercise: Partnerships
The Partnership as an Entity or an Aggregate
There are two ways to view a partnership: either as an entity or as an aggregate. As an entity, a partnership is separate and apart from its partners. This view is most accurate when the partnership is dealing with outsiders. For example, the partnership acts as an entity when it enters into a contract, sells partnership property or hires employees. As an aggregate, a partnership is a collection of individuals or proprietors engaged in the same business. This view predominates in the liability imposed on a partner. Bert and Andrea are partners in a retail store, called The Bookend. On one hand, the business is known in the trade as a very successful retail outlet and customers write cheques with the payee as The Bookend. On the other hand, Bert deals with the publishers as one of the owners and Andrea deals with the day-to-day operations as one of the owners. The Bookend is both an entity and an aggregate of two business partners.
The Partnership Acts
All of the common law provinces have very similar Partnership Acts, and these statutes set out the default rules governing partnerships in the absence of a partnership agreement. Partnership law in Quebec Québec has partnership law included in the Civil Code, and in many respects, the law is similar to that in the common law provinces. however, in Québec, partnerships can be either declared or undeclared. Declared partnerships are those that are registered with the province, and undeclared partnerships are similar to partnerships in other provinces, in that no registration is required. In the case of an undeclared partnership, only those partners who are known to a third party creditor are liable to that party. In a declared partnership, all of the partners are liable
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Income Tax Planning for all of the debts of the partnership, whether the third party was aware of each partner’s existence or not.
Exercise: Partnership Types
Partnership Agreements
The partners may, and frequently do, vary the terms of the partnership legislation by using a partnership agreement to develop a business relationship that better reflects their individual needs and the contribution of the partners. A partnership agreement can be an oral agreement or a written agreement. As with most agreements, however, a written partnership agreement offers more protection than an oral one. A partnership agreement can help to avoid costly legal battles later on. Default provisions In the absence of a partnership agreement, a partnership will be bound by the following default provisions set out by provincial legislation: • • All property contributed to the partnership or purchased with partnership funds is partnership property and not available for the personal use of a partner. All partners are legally entitled to share equally in the capital and profits of the business and must contribute equally towards losses. However, that legal entitlement to, and taxation of, profits are two different things. Every partner may take part in the management of the partnership business, but is not required to do so. No partner is entitled to remuneration for acting in the partnership business. The consent of all partners is required to admit a new partner. Each partner owes a duty of loyalty to the partnership and cannot carry on any business of the same nature and competing with that of the partnership.
• • •
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Proprietorships and Partnerships
Exercise: Partnership Agreement Default Provisions
Partner Roles and Responsibilities
The default rules specify that all partners are entitled to take an active role in managing the business. Furthermore, the rules specify that decisions in ordinary matters can be made by the majority of partners, but that major decisions such as changes to the nature of the business or the admittance of a new partner must be unanimous. Partnership agreements are often used to modify these requirements, especially for partnerships that are quite large where it might be difficult or impossible to gain a unanimous vote. The decision-making authority is often tied to the partners’ economic interests in the partnership. Routine decisions may be delegated to a committee, a single partner, or even an employee hired to manage some aspect of the business. By using the partnership agreement to delegate the decision-making abilities, the partners are not escaping their unlimited liability. They are still all personally liable to outside parties for the debts and obligations incurred as a result of the decisions of their partners. However, if partners can demonstrate that one partner was acting outside of his approved authority in making a particular decision that indebted the partnership, the remaining partners may have legal recourse to recover their loss from the erring partner, and perhaps to dissolve the partnership or expel the offending partner.
Expanding or Entering an Existing Partnership
In the absence of a partnership agreement, the default legislation requires that all partners must consent to the admission of a new partner. Other than the requirement for unanimous consent, the partnership legislation is typically silent about the requirements for admitting new partners. Some partnership agreements modify this requirement for unanimous agreement, perhaps leaving the decision to the most senior partners or those with the greatest capital investment. Therefore, a partnership agreement should be used to specify criteria for admission, such as years of experience or professional status. It should also discuss ownership issues, such as how much a new partner would be required to contribute in capital, and what his or her interest in the partnership capital and profits will be.
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Income Tax Planning
Dissolving a Partnership
Under the default rules, if one of the partners retires from the partnership, dies or becomes insolvent, the partnership is dissolved. Of course, the remaining partners would be free to establish a new partnership. Most partnership agreements override this mandatory dissolution, and specify some arrangement for how the departing partner will be compensated in terms of a return of his or her share of the capital and profits earned to date. Note: The default rules also forbid the expulsion of a partner, and this could seriously jeopardize a partnership that is being dragged down by an incompetent or careless partner. For this reason, most partnership agreements provide for the expulsion of a partner upon certain conditions, including the vote of a specified majority of the other partners.
Partnership Capital
The default rules say that all partnership capital must be shared equally by the partners. However, in many cases the partners will have contributed different amounts of capital, or provided different levels of effort in increasing the capital assets of the company. For these reasons, most partnership agreements provide for an alternate allocation of capital. It may cover: • • • • how much each partner is initially required to contribute how much a new partner would be required to contribute upon admittance to the firm how any requirements for new capital will be handled entitlements to capital upon dissolution of the partnership or withdrawal of a single partner
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Proprietorships and Partnerships
Distribution of Profits and Losses
The default rules specify that the profits and losses are to be shared equally between the partners, but this arrangement is often unsatisfactory given the differences that may occur in capital contributions, time spent managing the partnership, and so on. Many partnership agreements specify an alternate allocation that takes into account both direct and indirect contributions to the firm, such as: • • • • • capital contributions hours spent managing the firm hours billed or fees collected number of hours worked or billed by employees under a partner’s supervision number of new clients brought to the firm
Michael, William, Peter, and Jason owned and operated a retail outlet as a partnership. Michael had put up 70% of the capital, while William, Peter and Jason each put up 10%. William and Peter run the store six days a week, while Jason and Michael help out in the evenings and on Saturdays. Michael is also responsible for doing the books, while Jason looks after ordering supplies, marketing, and advertising. Obviously, it would be unfair if the partners shared the profits equally. They came up with an arrangement where the first $100,000 in profits would be divided according to their proportionate capital contributions, and the remaining profits would be divided based upon the number of hours worked. Allocation of profits and CRA The allocation is reviewed on an annual basis to determine if the formula is still equitable to everyone. The allocation specified in the partnership agreement sets out the legal entitlement to receive profits, but this allocation may not be accepted by Canada Revenue Agency (CRA) if the partners are not dealing at arm’s length, as discussed in the taxation unit. Fiduciary duty of partners In addition to the default rules, the partners owe each other a fiduciary duty under common law. This means that they must deal with each other and with the partnership as a whole in utmost good faith, and they must never put their personal interests ahead of the interests of the partnership.
Exercise: Partnership Agreements
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Partnerships. In this lesson, you have learned how to do the following: • • • • compare and contrast proprietorships and partnerships describe the types of partnerships explain partner roles and responsibilities describe the creation, dissolution, and liabilities of partnerships
If you are ready to move to the next lesson, click Partnerships and Income Tax on the table of contents.
Assessment
Now that you have completed Partnerships, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Proprietorships and Partnerships
Lesson 3: Partnerships and Income Tax
Welcome to Partnerships and Income Tax. In this lesson, you will learn about how the Income Tax Act views partnership income and how to perform various calculations related to partnerships. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • • • explain how the Income Tax Act views partnership income and income allocation calculate the adjusted cost base of a partnership interest calculate capital gains or losses upon disposition
How the Income Tax Act Views Partnership Income
Cash distributions vs. partnership profits In many cases, the partnership may write a regular cheque to each partner, much like an employee might receive a regular paycheque. These cash distributions or drawings do not represent the partner's share of partnership income for tax purposes, and they do not represent employment income because the partner is not an employee of the partnership. A partner is taxed on his or her share of partnership income, not on the cash distributions that he or she receives. Take note that each partner is required to include his or her share of the partnership profit or loss regardless of whether or not any distribution of cash or other assets has been received (ITA 96(1)(f) and (g)). Computation of partnership profit and losses The Income Tax Act states that when a taxpayer is a member of a partnership, his or her income or losses for a taxation year are to be computed as if: • • • the partnership was a separate person resident in Canada (ITA 96(1)(a)) income, losses and taxable capital gains and losses retain their character in respect of source and nature (ITA 96(1)(f)) the income, losses, etc. are then allocated to the partners according to their respective interests in the capital or income of the partnership (ITA 96(1)(f))
So, each individual partner must report his or her share of partnership income on his or her personal tax return, along with any capital gains realized upon disposition of his or her partnership interest. The partner then pays taxes based on his or her individual income tax rates. Each partner must file the financial statements of the partnership and a reconciliation of accounting income to income for tax purposes with his or her personal T1 General Return. Partnerships with five or more partners are required to file information returns.
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Income Tax Planning
Exercise: Distributions vs. Income, Part 1
Exercise: Distributions vs. Income, Part 2
Allocation of Income via a Partnership Agreement
The total income or loss of a partnership is allocated among the partners according to their partnership agreement. Generally, this allocation of income or loss determines each partner’s share of any single item of income, gain, loss, deduction or credit, unless a specific provision of the partnership agreement (a special allocation) covers the items. Phoebe and Monica intend to operate a restaurant and catering business as a partnership, and initially they thought they wanted a simple 50-50 partnership arrangement. This would give them each a 50% share of total income, but also a 50% share of any capital gain, 50% of any capital cost allowance (CCA) deductions, 50% of any tax credits and so on. The allocation of income or loss among partners should be established in the partnership agreement and it can be dependent upon the source of the income, loss or nature of deductions or tax credits. Phoebe and Monica intend to operate the restaurant in a house downtown that Monica will purchase for the partnership, while Phoebe has contributed all of the restaurant and catering equipment. Monica will be responsible for running the restaurant, while Phoebe will be in charge of catering. Because of the differences in the type of capital each contributed to the business, and the different roles each of them will play, they decided that a simple 50-50 partnership would not be appropriate. For example, Monica wants a higher portion of the income generated by the restaurant side of the business, while Phoebe wants a higher portion of the income generated by the catering activities. Also, in the event that the house is eventually sold, Monica wants 100% of the capital gain. Phoebe wants 100% of the CCA on the restaurant and catering equipment that she supplied.
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Proprietorships and Partnerships
Exercise: Partnership Income
How the Income Tax Act Views Income Allocations
Although the Income Tax Act does not contain specific provisions prescribing how income is to be allocated, it does contain two provisions that can override the allocation specified in a partnership agreement and deem the share of each partner to be an amount that is reasonable in the circumstances. These provisions override the allocation when: • • the principal reason for the agreement may reasonably be considered to be the reduction or postponement of income tax (ITA 103(1)) partners are not dealing at arm’s length and the allocation is not reasonable considering the capital invested, work performed or any other relevant factor (ITA 103 (1.1))
Exercise: Gifts or Loans Between Non-arms' Length Partners
Unusual Allocations
A taxpayer would be wise to seek professional advice and possibly a tax ruling by CRA before entering into a partnership agreement with unusual allocations. Fred and Barney formed a partnership, with Fred contributing $2,500 and his fulltime services and Barney contributing $100,000 cash, much of it to be used for research and development. In addition, Barney agreed to obtain a loan for any additional cash needed by the partnership. The partnership agreement allocates all research and development (R&D) expenses and deductions for interest expenses on any loans to Barney. Also, 90% of all partnership income or losses are allocated to Barney until he recovers the R&D costs, interest expense and his share of partnership losses. After this time, the income or loss will be split 50-50 between Fred and Barney. In this situation, because Barney actually bears the R&D and interest costs, the special allocation reflects the true economic circumstances of the partnership and should be an acceptable allocation.
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Income Tax Planning Tax-advantaged investments using the partnership vehicle may rely on special allocations to enhance the tax benefits for investors. The partnership agreement must be examined closely for special allocations. Do most of an investor’s benefits come from a special allocation? Is the special allocation only tax-motivated? If the answers are yes, the investor may not realize the promised tax benefits.
Capital Cost Allowance
Capital cost allowance (CCA) is a deduction permitted for tax purposes to recognize the wear and tear and obsolescence of property over time. The CCA on depreciable assets acquired by the partnership must be calculated at the partnership level. The partnership itself has the choice of claiming the maximum CCA or any other amount not exceeding the maximum. An individual partner may or may not want the CCA claimed currently on his her income tax return depending upon his her specific tax situation. The partners will have to negotiate the amount of the CCA claimed by the partnership if the maximum is not ideal for all. Bob, Jeff, and four other individuals operate a surveying business as a partnership, and they have equipment with undepreciated capital cost (UCC) of $80,000. The equipment falls within Class 10 and thus CCA may be claimed at a maximum rate of 30%, or $24,000 for the current year, calculated as (UCC x CCA rate) or ($80,000 × 30%). The business has not done very well this year, but business is expected to pick up significantly next year. Bob and Jeff already have relatively low taxable incomes, and they would prefer to claim less than the maximum allowable CCA this year, saving the deduction for a future year when they are in a higher tax bracket. However, the other partners have other jobs and have high marginal tax rates. The majority of partners voted to claim the maximum CCA. Therefore, Bob and Jeff’s shares of the partnership income is determined after the deduction of CCA, even though they would benefit more from the deduction if they could delay it until a future year.
How the Income Tax Act Views a Partnership Interest
A partnership interest can be acquired either by providing new capital to the partnership in the case of a new or expanding partnership, or by purchasing a partnership interest from a retiring partner in the case of an existing partnership. This partnership interest is a nondepreciable capital property of the partner. Because it is considered to be capital property, the sale or other disposition of a partnership interest can result in a capital gain to the extent that the proceeds of disposition exceed the sum of the partner’s adjusted cost base (ACB) and qualifying outlays and expenses. It can also result in a capital loss to the extent that the proceeds fall short of that sum. Frank wants to retire from the engineering firm where he has been a partner for the last 28 years. The ACB of Frank’s partnership interest is $60,000, and he expects selling expenses, including legal fees, to amount to $2,000. If Frank receives $90,000 for his partnership interest, he will realize a capital gain of $28,000, calculated as (proceeds - (ACB + costs of disposition)) or ($90,000 – ($60,000 + $2,000)). If he receives only $50,000, he will realize a loss of $12,000, calculated as (proceeds - (ACB + costs of disposition)) or ($50,000 – ($60,000 + $2,000)).
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Proprietorships and Partnerships So far, this sounds fairly straightforward. The difficulties arise when determining the adjusted cost base.
Calculating the Adjusted Cost Base
Many investors have not understood the tax treatment of the disposition of a partnership interest, particularly the manner in which the ACB is calculated. As a result they have discovered upon disposal of a partnership interest that they have simply deferred tax, not avoided it as they expected. The following example will explain how this could happen. Garry bought a partnership interest in an apartment building. The investment produced large rental losses because the mortgage interest expense exceeded the rental income. He wrote off these losses against his personal income. Five years later, the building was sold and he received exactly the same amount he had originally paid for the investment. He figured he had broken even and that was the end of it. He was shocked when his accountant told him he would have to pay tax on a capital gain, approximately equal to the sum of all the losses he had written off. The ACB of his partnership interest had been reduced by the losses that he had claimed. Additions to and deductions from the ACB The ACB of a partnership interest is calculated according to the same rules applied to other types of capital property, as set out in ITA 53(1). i) First, adjustments to the ACB are made for the contribution or withdrawal of capital. When she first joined the law firm of Saunders, Smith and Goldstein, Laura made a capital contribution of $60,000. Later in the year, she contributed another $30,000 when the partnership decided to buy a new office condominium. However, once the condominium deal closed, the partners realized that everyone had contributed too much, and returned $2,000 in capital to Laura. Based on these transactions, the ACB of Laura’s partnership interest is $88,000, calculated as (capital contributions - return of capital) or ($60,000 + $30,000 - $2,000). ii)In addition to a deduction for any capital withdrawals, the ACB is reduced by any partnership drawings during the year, even if that is in the form of regular paycheques. Remember, these regular payments are not employment earnings, but essentially a cash distribution. Over the course of the year, Laura received partnership drawings of $52,000, in 52 separate weekly cheques of $1,000 each. Her ACB would then be $36,000, calculated as (ACB of Laura's partnership interest - partnership drawings) or ($88,000 - $52,000). iii)Next, the ACB is adjusted to also account for the allocation of profits and losses. If the firm records a profit, each partner’s share of that profit is added to that partner’s ACB (ITA 53(1)(e)(i)), while his or her share of the losses are deducted from his or her ACB (ITA 53(2)(c)(i)). Saunders, Smith and Goldstein recorded a profit of $1,500,000 last year, and Laura’s share is 10%, or $150,000. Now her ACB is $186,000, calculated as (Laura's ACB + Laura's share of profits) or ($36,000 + $150,000).
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Income Tax Planning iv)Further adjustments may be made to avoid double taxation of income or double deduction of losses. The common adjustments are listed below. Additions to ACB (ITA 53(1)): • • • • capital contributed by the partner, excluding loans to the partnership the partner’s share of the partnership’s net income or profit the partner’s share of any capital dividends received the partner’s share of any assistance or benefit in respect of Canadian resource property or exploration or development expense incurred in Canada
Deductions from ACB (ITA 53(2)): • • • • the partner’s share of partnership drawings and capital distributions the partner’s share of losses of the partnership the partner’s share of exploration and development expenses (which are deducted by the partners personally) the partner’s share of the investment tax credits
Exercise: Calculating Adjusted Cost Base
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Proprietorships and Partnerships
Calculating Capital Gains or Losses Upon Disposition
The table below shows how a taxable capital gain would be calculated on disposition of a partnership interest and how double taxation of income left in the partnership would be avoided. On January 1st of last year, Jeremy acquired an interest in a business partnership making a cash contribution of $20,000. Last year, he received cash distributions of $32,000 and Jeremy’s share of the partnership income was $40,000. On January 1st of this year, he sold his partnership interest for $50,000 incurring legal expenses of $1,000. The calculation of Jeremy’s capital gain is illustrated in the following table. Capital Gain on Disposition of a Partnership Interest
So every partner should keep track of his ACB for the following reasons: • The ACB on the last day of the year is used to calculate the amount at-risk in a limited partnership (we will discuss limited partnerships shortly) and may limit the deduction of a partner’s share of losses. The ACB is used to determine the amount of capital gain or loss a partner realizes on sale or other disposition of his partnership interest.
•
Exercise: Calculating Capital Gains and Losses
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Income Tax Planning
Other Provisions
There are many other provisions in the Income Tax Act that ensure the fair and effective taxation of partnership income and investment activity. Professional, legal and tax advice is essential for any individual contemplating the purchase of a partnership interest. Some of these complexities are briefly described below. Gains on contributed property A partner may contribute depreciable or other capital property to a partnership, rather than cash. The transfer will normally be done at fair market value (FMV). However, this could result in the undesired realization of a capital gain, capital loss or a recapture because the transfer would be a deemed disposition for tax purposes. An election may be made to transfer (rollover) the property at the partner’s ACB or UCC without realizing any gain or loss. Because this rollover is permitted under ITA 97(1), it is often referred to as a Section 97 rollover. Refer to IT-413R, Election by members of a partnership under subsection 97(2) for more information about rollovers to a partnership. Tyler and Zachary wanted to start a business as a partnership. Zachary was going to contribute $150,000 in start-up capital, while Tyler was going to contribute a small office building currently valued at $150,000. Tyler’s ACB and UCC for the building are both $120,000. By contributing the building to the partnership, Tyler would realize a deemed disposition for tax purposes, which would result in a capital gain of $30,000, calculated as (FMV - ACB) or ($150,000 - $120,000), and 50% of this gain would have to be included in his income for the year. However, he could file a special election to rollover the property to the partnership at his ACB, to avoid realizing a capital gain.
Disposition of Partnership Interest
The admission or departure of a partner may, as a result of provincial legislation or the partnership agreement, result in the termination of the partnership and the formation of a new partnership. These reorganizations may result in the deemed disposition of a partnership interest for tax purposes. Reorganizations that have the potential to result in a deemed disposition of a partnership interest include: • • • • • • the the the the the the admission of a new partner retirement or withdrawal of a partner fact that a partner has ceased to be resident in Canada sale of a partnership interest death of a partner time when a partnership ceases to exist
These deemed dispositions have the potential to result in realized capital gains or losses for the partners. However, continuing partners may use rollover provisions to avoid the realization of capital gains or losses in such situations (ITA 98(3)). Refer to IT-338R2, Partnership Interests – Effects on Adjusted Cost Base Resulting from the Admission or Retirement of a Partner, for more information.
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Proprietorships and Partnerships Winding-up of a partnership The simplest way to end or wind-up a partnership is to liquidate the partnership assets, discharge any outstanding partnership liabilities, allocate the partnership income and distribute any remaining money. Property may also be distributed at fair market value. Alternatively, there are provisions for a partner to rollover a partnership interest to a corporation, another partnership, a sole proprietorship or personal ownership without realizing a capital gain or loss (ITA 98(1)).
Using a General Partnership for Wealth Accumulation
Like the sole proprietorship, the success of the general partnership as a wealth accumulation vehicle depends less upon the business form and more upon the ability of the partners to manage a profitable business. With one or two exceptions discussed below, a general partnership does not offer any special advantages in the form of tax deferral, conversion or avoidance, beyond perhaps the limited potential for partners to split income with any family members who are justifiably employed by the business. These limited advantages, coupled with the potential for unlimited personal liability for the debts and obligations of the partnership, should make people think twice about whether the general partnership is the best form for handling their business interest. Flow-through of losses and deductions The flow through of partnership losses and deductions can offer significant tax advantages in the right circumstances. If a corporation incurs a loss, the shareholders cannot deduct the loss on their personal tax returns. However, if a partnership incurs a loss, the partners can deduct the loss on their personal tax returns, offsetting other taxable income and reducing their overall tax liability. This is referred to as a flow-through of the loss. In order for CRA to accept the flow-through of losses, it must be convinced that the partnership was formed to carry on a business with the objective of making a profit. Other than the flow-through of losses, the taxation of income, losses and capital gains is fundamentally the same as it would be for an individual, with no particular additional tax advantages from avoidance, deferral or conversion.
Starting a Business
The partnership form may provide a tax advantage over a corporate form during the startup phase of a business, because losses are often incurred during the first few years before the business becomes profitable. If the business is incorporated, these losses can be carried forward and can be used to offset future business income, but they cannot be used by the shareholders to offset their other income during the start-up period year. If the business operates as a partnership, the partners can deduct the losses incurred during start-up against other income.
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Income Tax Planning General partnerships vs. corporations The advantages of running a business as a general partnership, as opposed to a corporation, are as follows: • • A partnership can be established without any legal formalities, simply by the action of two or more people undertaking business activities together. Any business losses or deductions flow-through to the partners for tax purposes and can be deducted from other income.
The main disadvantage of running a business as a partnership, as opposed to a corporation, is as follows: • A general partner is jointly and severally, personally liable for the debts and obligations of the partnership.
Exercise: Partnership Complexities
Reflection Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Partnerships and Income Tax. In this lesson, you have learned how to do the following: • • • explain how the Income Tax Act views partnership income, and income allocation calculate the adjusted cost base of a partnership interest calculate capital gains or losses upon disposition
If you are ready to move to the next lesson, click Limited Partnerships on the table of contents.
Assessment
Now that you have completed Partnerships and Income Tax, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Proprietorships and Partnerships
Lesson 4: Limited Partnerships
Welcome to Limited Partnerships. In this lesson, you will learn about the structure of limited partnerships and how they are established, the rights and responsibilities of general and limited partners, and the types of businesses structured as limited partnerships. You will also learn about how to use limited partnerships for financial planning. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • • describe the structure of limited partnerships and how they are established identify the rights and responsibilities of general and limited partners explain how to use limited partnerships for financial planning describe the types of businesses structured as limited partnerships describe the nature and role of a joint venture
Structure of a Limited Partnership
All provinces have legislation in the form of a Limited Partnership Act that permits the creation of a limited partnership (LP), where one or more of the partners have limited liability for the debts and liabilities of the partnership. A limited partnership must have at least one limited partner and one general partner. The limited partners are passive investors. They contribute capital, but are otherwise uninvolved in the operations of the business. The general partners conduct the management of the business and are personally liable for the obligations of the partnership. Three doctors are considering purchasing and developing a piece of land as a retirement community. They each have significant net income and net worth and they are concerned about the security of their personal assets if the venture fails. Dr. Arent insists on being a limited partner. The other two are not sure why, but they decide they should be limited partners too. However, they cannot form a limited partnership without a general partner. They need some legal advice. General partnerships vs. corporations It is possible for a limited partnership to have dozens of limited partners and only one general partner, usually a corporation that has no other assets, which in turn is often owned by the individual who thought up the business in the first place. This is often the case in limited partnerships that are especially set up as tax-advantaged investments. In this case, the general partner is also often the promoter. When a limited partnership is used as a tax-advantaged investment vehicle, the general partner is usually a corporation. This protects the sponsors from unlimited liability, and the corporation itself usually has a minimal net worth.
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Income Tax Planning
Extent of Limited Liability for LPs
The rights and obligations of the general partners in a limited partnership are the same as those for the partners in a general partnership, so the general partners can still be held personally liable for the debts of the partnership. Limited partners are not liable for the debts, obligations, or losses of the partnership provided they do not participate in the management of the partnership. In other words, the most a limited partner can lose in a partnership is his or her investment, just like a shareholder in a corporation. This limited liability makes the limited partnership an attractive investment vehicle. The limited partners must be careful not to become involved in the business, because once they take any active management role, they lose their limited liability status. Thus, the partnership agreement should specify that the only active role that the limited partners can play is to remove and replace the manager of the limited partnership in the event that he or she is found to be in breach of his or her obligations as general partner. The promoter of Evergreen Software has fled to Argentina. The forty limited partners in the venture have been called to a partners' meeting to discuss the situation. The promoter has been serving as the general partner through a corporation. Action has to be taken immediately to protect the limited partners' interest and salvage what is left of the business. Three of the limited partners agree to run the business. If they do so, they will lose their limited liability protection. For most situations, incorporating a company is a more effective way to obtain limited liability for the owners of a business.
Establishing a Limited Partnership
A limited partnership is formed when the partnership files a declaration containing prescribed information with the provincial registrar in accordance with the province’s Limited Partnership Act. The declaration must be signed by all of the general partners who desire to establish the limited partnership. Rights of general partners According to Section 8 of Ontario’s Limited Partnership Act, (which is representative of the legislation in other provinces): A general partner in a limited partnership has all the rights and powers and is subject to all the restrictions and liabilities of a partner in a partnership without limited partners, except that without the written consent to or ratification of the specific act by all the limited partners, a general partner has no authority to: • • • • • act in contravention of the partnership agreement act so as to make it impossible to carry on the ordinary business of the limited partnership consent to a judgement against the limited partnership possess limited partnership property, or assign any rights in specific partnership property, for other than a partnership purpose admit a person as a general partner
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Proprietorships and Partnerships • • admit a person as a limited partner, unless the right to do so is given in the partnership agreement continue the business of the limited partnership on the death, retirement or mental incompetence of a general partner or dissolution of a corporate general partner, unless the right to do so is given in the partnership agreement
Rights of limited partners The limited partner does not have the same rights afforded to general partners, but this is the trade-off that the limited partner makes for having limited liability. The rights of the limited partner are basically limited to giving him or her access to business information to ensure that the business is being managed satisfactorily. According to Sections 10 and 12(2) of Ontario’s Limited Partnership Act: (10) Rights of limited partner - A limited partner has the same right as a general partner: • • to inspect and make copies of or take extracts from the limited partnership books at all times to be given, on demand, true and full information concerning all matters affecting the limited partnership, and to be given a complete and formal account of the partnership affairs to obtain dissolution of the limited partnership by court order
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12.(2) Rights of limited partner - A limited partner may from time to time: • • • examine into the state and progress of the limited partnership business and may advise as to its management act as a contractor for, or agent or employee of, the limited partnership or of a general partner act as a surety for the limited partnership
Note: Advising as to management in Section 12(b) is not the same as taking an active management role, which involves making business decisions. Section 13(1) of the Ontario Partnership Act makes this clear by saying: 13.(1) Limited partner in control of business - A limited partner is not liable as a general partner unless, in addition to exercising rights and powers as a limited partner, the limited partner takes part in the control of the business.
Exercise: General and Limited Partnerships
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Income Tax Planning
How the Income Tax Act Views Limited Partnerships
In general, the Income Tax Act views limited partnerships in the same way as general partnerships. However, there are a few notable exceptions, discussed below. At-risk rules At one time, taxpayers were able to make creative use of tax shelters by structuring deals so that they would invest a certain sum of money but were subsequently allowed to take a tax deduction against current income for much more than the money invested. For example, a person used to be able to invest $5,000 as a limited partner, and then deduct his or her share of partnership losses or other deductions on his or her tax return. These deductions may end up being a significantly greater amount than the limited partner’s actual investment in the company. CRA considered these deals to be abusive and brought in a rule that the investor could never take deductions for more than the amount of money that the investor actually stood to lose, or the money at-risk. This is referred to as the at-risk rule (ITA 96(2.1) to (2.6)). The at-risk rules are complex and include grandparenting provisions for partnership interests that were already in place when the rules were introduced. Generally, however, the at-risk rules mean that the investor may only make deductions on his or her tax return with respect to a particular investment, to the extent that the deduction reduces his or her adjusted cost base (ACB) to zero dollars. Negative ACB balances are not permitted. As a limited partner, Romana invested $30,000 in a software partnership. She was able to write off the $30,000 over two years on her tax return as CCA claimed by the partnership. Her adjusted cost base (ACB) is now $0, calculated as ($30,000 - $30,000). This year the partnership expects to lose $100,000 of which her share is $10,000. However, because her ACB is $0, she has had no money at risk and she will not be able to deduct any loss. The company has asked her to guarantee unconditionally a bank loan of $10,000 for the company. If she did so, she would now be "at risk" $10,000, and she would be able to deduct the loss. Income attribution and limited partnerships Normally, the income attribution rules apply only to income from property, not business income. So, if a taxpayer loans money to his or her spouse or common-law partner, and that person starts up a business that earns a profit, that profit is taxed in his or her hands, not in the lender's hands. However, beginning in 1989, the income attribution rules were changed for cases where a taxpayer loans or transfers funds to a spouse, common-law partner, or other non-arm's length party and those funds are invested in a limited partnership. If this type of transaction occurs, the income from the limited partnership is considered to be income from property, not business income, and thus it will be attributed to the taxpayer (ITA 96(1.8)). Veronica has $50,000 that she wants to give to her husband to invest, because he has no income. If he invests in a business as a sole proprietor or general partner, there is no attribution of the business income to Veronica. If he invests as a limited partner, his share of any business income is deemed to be property income and is attributed to Veronica.
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Proprietorships and Partnerships
Using Limited Partnerships for Wealth Accumulation
Limited partnerships provide the flow-through of tax benefits of a partnership while at the same time providing investors with limited liability. This is just the combination an investor wants in a mass-marketed investment in which other participants are total strangers. A general partnership provides some tax benefit in the form of flow-through of income or losses, but not limited liability. A corporation provides limited liability but no flow-through of tax benefits. The corporation is a separate taxable entity from the shareholders, so it can only deduct CCA if it has income. The partnership is not a separate taxable entity and the CCA deduction flows through to the partners, and they can deduct it from their other income. For these reasons, many tax-advantaged investments take the form of a limited partnership, and this business form can be tailored to almost any activity.
Exercise: Income Tax and Limited Partnerships
Types of Businesses Structured as Limited Partnerships
The following are the most common tax-advantaged investments that are organized as limited partnerships along with a brief description of the features that make the limited partnership the investment vehicle of choice: • • • • • • Real estate: limited partners can obtain the benefit of deducting CCA and, in the case of leveraged investments, interest expenses. Oil and gas: the deduction for intangible drilling costs may be passed through to the limited partners and they are entitled to resource deductions. Farming and cattle: deductible expenses may pass through to limited partners, but special rules apply. Equipment leasing: limited partners may be able to reduce their taxable income by deducting the interest expense on leveraged equipment purchases. Theatrical endeavours (plays, recitals, and so on.): investors are protected with limited liability. Research and development: limited partners may be able to claim deductions related to the research and development costs.
Limited Liability Partnerships
A limited liability partnership (LLP) is very similar to a general partnership, with the exception that partners are not personally liable for the negligence of another partner. The partners remain personally liable for the general debts and obligations of the partnership, as well as their own negligence. This should not be confused with a limited partnership, where the limited partners are not personally liable for the debts and obligations of the partnership.
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Income Tax Planning A partner commits negligence if he or she omits to do something that a reasonable person would do or, if he or she commits an act that a reasonable person would not do given the same circumstances such that, his or her conduct falls below the standard of care expected of someone in a similar position.
Extent of Limited Liability for LLPs
Ontario’s Partnership Act was modified in July 1998 to permit the formation of limited liability partnerships (LLPs). With respect to liability, Sections 10(2) and 10(3) of this Act state that: S.10(2) Limited liability partnerships – Subject to subsection (3), a partner in a limited liability partnership is not liable, by means of indemnification, contribution, assessment or otherwise, for debts, obligations and liabilities of the partnership or any partner arising from negligent acts or omissions that another partner or an employee, agent or representative of the partnership commits in the course of the partnership business while the partnership is a limited liability partnership. S.10(3) Liability of negligent partner – Subsection (2) does not affect the liability of a partner in a limited liability partnership for the partner’s own negligence or the negligence of a person under the partner’s direct supervision or control. So, a limited liability partnership protects the remaining partners from personal liability when one of the partners is found to be liable for negligence. An LLP is a big improvement for professionals who operate a business together but who are prohibited by law from incorporating their practices. Note: While the other partners cannot be held personally liable for the negligence of one partner, the partnership itself can still be found liable, as per Section 11 of the Act: S.11 Liability of firm for wrongs – Where by any wrongful act or omission of a partner acting in the ordinary course of the business of the firm, or with the authority of the co-partners, loss or injury is caused to a person not being a partner of the firm, or any penalty is incurred, the firm is liable thereof to the same extent as the partner so acting or omitting to act. Also, the partners remain jointly liable for the other obligations of the partnership, as per Section 13 of the Act: S.13 Liability for wrongs joint and several – Except as provided in subsection 10(2) every partner is liable jointly with the co-partners and also severally for everything for which the firm, while the person is a partner therein, becomes liable under section 11 or 12. So, the partnership assets can still be seized to cover liabilities incurred as a result of one partner’s negligence, but the personal assets of the remaining partners cannot be seized.
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Proprietorships and Partnerships
How the Income Tax Act Views Limited Liability Partnerships
In general, the Income Tax Act does not differentiate between general partnerships and limited liability partnerships. A limited liability partnership would be subject to the at-risk rules for limited partnerships. Limited liability partnerships vs. professional corporations Some provinces permit certain professionals to incorporate their practices. One of the main advantages of the corporate form of business is the limited liability of the shareholders. However, in the case of professional corporations, the practicing professional still has unlimited liability, but can make use of some of the tax advantages of incorporation.
Exercise: Limited Liability Partnerships
Joint Ventures
A joint venture is a partnership-like entity that is usually formed to carry out one transaction or a series of related transactions over a short period of time. Is it a joint venture or a partnership? A joint venture can be distinguished from a partnership by the following characteristics: • • • A joint venture usually pursues a single business transaction, rather than general and continuous transactions. A joint venture can be formed without a profit motive and simply pursue social or recreational purposes. The agency relationship between members of a joint venture may be more limited than the agency relationship between partners. By this, we mean that whereas a partner may be able to make decisions on behalf of the entire partnership, the members of a joint venture are limited in terms of the actions they can undertake on behalf of the other members of the joint venture. A joint venture is more like an aggregate than an entity. When pursuing joint goals, corporations are more likely to form a joint venture than a partnership.
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Income Tax Planning
When Joint Ventures are Used
Where are you likely to find a joint venture? The following are some of the more common applications: • • A joint venture is often formed for the production or co-authorship of a play or some other theatrical endeavour. In real estate, a joint venture may be used for the subdivision and sale of a specific parcel of real property or for the construction of a specific building, housing project, or industrial complex. A mining venture may be put together as a joint venture to develop and operate the mineral property. Large oil companies frequently form joint ventures to share the risk of exploratory drilling.
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How the Income Tax Act views joint ventures Joint ventures are not treated as partnerships for tax purposes. Instead, they are taxed as business activities of the individual joint venturers, who may be individuals, corporations, partnerships, or trusts. So, joint ventures are similar to partnerships, but they are treated very differently for income tax purposes. Care is necessary in structuring a partnership or joint venture to ensure the courts and CRA will recognize them as such.
Exercise: Joint Ventures
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Proprietorships and Partnerships
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Limited Partnerships. In this lesson, you have learned how to do the following: • • • • • describe the structure of limited partnerships and how they are established identify the rights and responsibilities of general and limited partners explain how to use limited partnerships for financial planning describe the types of businesses structured as limited partnerships describe the nature and role of a joint venture
If you are ready to move to the next lesson, click Business Income on the table of contents.
Assessment
Now that you have completed Limited Partnerships, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 5: Business Income
Welcome to Business Income. In this lesson, you will learn about how business income is calculated and taxed for proprietorships and partnerships. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • identify and calculate business income, business deductions, and a partner’s income
Statement of Business Activities
Self-employed business people operating either as sole proprietors or partners, including commissioned salespeople, and individuals earning professional income (e.g. doctors, lawyers, dentists and accountants) must report their income on the Statement of Business or Professional Activities (Form T2125). Where an individual has both business and professional income, a separate Form T2125 must be completed to report each type of income. This lesson will refer to the Statement of Business or Professional Activities. You can access it by clicking here. Click the link to access the document. You can print the Statement of Business or Professional Activities as a reference or once you’ve clicked on the above link, you can keep the window open and toggle back to it as you work through this lesson.
Cash vs. Accrual Methods
Before we can complete a Statement of Business or Professional Activities, we have to determine whether the individual must use the cash or accrual method of accounting. In most cases, a self-employed person reports business income by using the accrual method of accounting. With this method, a taxpayer: • • reports income in the fiscal period earned, regardless of when the income was received in cash deducts expenses in the fiscal period incurred, whether paid in that period or not
Most people operating a business either as a sole proprietorship or a partnership, including professionals must use the accrual method of accounting for income tax purposes. A self-employed commission sales agent can use the cash method of reporting income and expenses, as long as it accurately shows income for the year. Under this method, a taxpayer: • • reports income in the year received in cash deducts expenses in the year paid
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Proprietorships and Partnerships
Identification
The first part of the form reports basic information that identifies the taxpayer, as well as the nature of the business and, if it is a partnership, the taxpayer’s percentage interest in that partnership.
Gross Business or Professional Income
If the taxpayer has business income, he or she must complete Part 1 of Form T2125; if the taxpayer has professional income, he or she must complete Part 2. Either Part 1 or Part 2 must be completed as the situation dictates—both sections cannot be completed on the same Statement of Business or Professional Activities. Part 1: Adjusted gross sales This amount includes net sales, commissions and fees after deducting any goods and services tax (GST), provincial sales taxes (PST) and any returns, allowances and discounts, if these have been included in sales. Part 2: Adjusted professional fees In Part 2 of Form T2125, the taxpayer's professional fees are reported. This amount is reduced by items that may include GST, PST and for certain professionals, work-inprogress. Part 3: Gross business or professional income This amount includes gross income, which is net sales plus any reserves deducted last year, such as a reserve for goods and services to be provided after the end of the year. This amount is transferred to the appropriate line on the taxpayer’s general tax return. Part 4: Cost of goods sold and gross profit In Part 4, the cost of goods sold is calculated and deducted from the taxpayer's gross business or professional income to arrive at the taxpayer's gross profit.
Exercise: Gross Business Income
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Income Tax Planning
Expenses
Expenses are deductible if, and only if, they were incurred to earn business income. In Part 5 of the Statement of Business or Professional Activities eligible deductible expenses are identified. The total business expenses are deducted from the gross profit to arrive at the net income or loss before adjustments. Eligible expenses include: • • • • • insurance: premiums for commercial insurance for buildings, machinery and equipment used in the business interest: on money borrowed to run the business; some limits can apply maintenance and repairs: includes the cost of labour and materials for any minor repairs or maintenance done to property used to earn income management and administration fees: when incurred to operate the business (does not include employees’ salaries, property taxes or rents paid) meals and entertainment: allowable to a maximum of 50% of business meals, beverages and the amount incurred when entertaining clients (meals paid for employees are fully deductible) motor vehicle expenses: includes license and registration fees, fuel costs, insurance, interest, maintenance and repairs, and leasing costs. (If a taxpayer uses a motor vehicle for business and for personal use, he or she can deduct only the portion of the expenses that he or she incurred to earn income.) office expenses: can include the cost of office supplies legal, accounting and other professional fees: includes fees for external professional advice or services, and accounting and legal fees for maintaining books and records salary, wages and benefits: includes salaries paid to employees, but not any withdrawals paid to a partner travel: includes expenses incurred to earn income, including public transportation fares, hotel accommodations and meals (in most cases, the 50% limit applies to the cost of meals, beverages and entertainment) telephone and utilities: includes gas, oil, electricity and water allowance on eligible capital property: includes items such as goodwill or a franchise capital cost allowance: refers to property, such as a building, motor vehicles or equipment, calculated at the partnership level
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Exercise: Business Expenses
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Proprietorships and Partnerships
Net Income or Loss
The taxpayer's net income or loss is calculated in Part 6 of the Statement of Business or Professional Activities. This amount includes the gross income minus the sum of all of the deductible expenses. If the taxpayer is a member of a partnership, this amount is the net business income of all partners. The Great Edmonton Clothing Company realized net income of $200,734 during the last fiscal year, which is calculated as the (gross profit minus the total business expenses) or ($426,400 - $225,666)
Calculating the Individual Partner's Net Income or Loss
The next section of the Statement of Business or Professional Activities recognizes the allocation of partnership income as well as any additional deductions that can be made at the individual partner level. Individual’s share of partnership income First, the taxpayer must report how much of the partnership’s net income or loss is allocated to him or her. This allocation will depend on the partnership agreement. In the absence of an agreement, the net income of the business will be divided equally between the partners. Based on the net income or loss before adjustments calculated in Part 5 of Form T2125, the taxpayer must identify his or her share of this amount in Part 6. Business-use-of-home expenses This includes allowable expenses for the business use-of-a workspace in the taxpayer’s home. These expenses are documented in more detail elsewhere on the Statement of Business Activities. The tax considerations for home-based businesses is discussed later in this course. Amounts deductible from individual’s share of partnership income Next, the taxpayer may be able to make additional deductions from his or her share of partnership income related to any extra expenses that he or she incurred to earn his or her share of the partnership income (or loss), such as the business portion of allowable motor vehicle expenses. These expenses must not have been claimed anywhere else on the form, and they can only be claimed if the partnership did not reimburse the taxpayer for the expense. Details of the other amounts deductible from the individual’s share of partnership income are recorded elsewhere on the Statement of Business or Professional Activities. Individual’s net income or loss Finally, the taxpayer’s net income or loss from the business is calculated as his or her share of the partnership income, minus any other deductible amounts, minus any business-useof-home expenses. This amount is then entered on the appropriate line of the taxpayer’s general income tax return.
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Income Tax Planning
Exercise: Net Income or Loss
Special Tax Considerations for Home-based Businesses
Many people establish home-based businesses for economic reasons, convenience, or family reasons. If a sole proprietor or partner runs a business from home, or maintains a qualifying home office in addition to his or her regular place of business, he or she may be able to claim a business-use-of-home expense to offset his or her business income. The deduction is made in Part 6 of the Statement of Business or Professional Activities as part of determining the taxpayer’s net income or loss. Refer to IT-514, Workspace in home expenses, for more information. When the deduction is allowed A taxpayer may be able to claim a business-use-of-home expense for a workspace in the taxpayer’s home, as long as one of these conditions is met (ITA 18(12)): • • it is the taxpayer’s principal place of business and he or she does not have a place of business elsewhere the taxpayer uses the space only to earn business income and uses it on a regular and ongoing basis to meet clients, customers or patients
This means that if the taxpayer’s principal place of business is in his or her home, the place within the home that is used for business does not have to be used exclusively for business purposes in order for the taxpayer to be able to claim a business-use-of-home deduction. However, if the taxpayer’s principal place of business is outside of the home, a businessuse-of-home deduction will only be permitted if a space within the home is used exclusively for business purposes. Harmony is a freelance technical writer and she uses the guest bedroom as her office, but she still uses the room to accommodate guests when needed. She spends about 70% of her time working for one client who supplies her with an office on-site. Although Harmony spends most of her time out of her home office, the client’s premises do not belong to her, so her home office is still her primary place of business. Because it is her principal place of business, she can claim a business-use-of-home deduction even though she does not use the spare room exclusively for business purposes. However, the amount that she can deduct will be prorated on a time basis to account for the dual purpose of the room. Martin, another taxpayer, is a massage therapist who runs a clinic downtown. He has also set aside one room in his house for the sole purpose of seeing several additional clients most evenings and on weekends. Because he uses the room only for business and he uses it on a regular and continuous basis, he will be able to claim a business-use-of-home expense.
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Proprietorships and Partnerships
Calculating the Deduction
The business-use-of-home expense includes a portion of all home-related expenses, including operation and maintenance costs such as heating, electricity, cleaning services, landscaping and lawn maintenance services. It also includes a portion of property taxes, mortgage interest, home insurance, and capital cost allowance (CCA). So, the first step is to calculate the total home-related expenses. While the Income Tax Act does not specify exactly how the business-use-of-home expense is to be calculated, administrative practice requires the total of the home-related expenses for the year to be prorated for business purposes based upon some reasonable calculation. Floor space method vs. number of rooms method The two commonly used methods are based on: • • the total floor area devoted to the business divided by the total floor area of the house the number of rooms devoted to the business divided by the total number of rooms in the house
When doing this calculation, the taxpayer only has to consider the main areas of the house, without counting common areas such as hallways and bathrooms. He she can choose whichever method is more favourable to him. Dominique operates a catering business based in her home. Her one-room home office measures 18 square metres. Dominique’s house has a total of 12 rooms and measures 135 square metres. She uses the home office three days each week – this space is not used for any other purpose. Based on the floor space method, Dominique would be eligible to deduct 13.33% of eligible home expenses calculated as (workspace-at-home ÷ total area of home) or (18 ÷ 135). Based on the number of rooms method, Dominique would be eligible to deduct 8.33% of eligible home expenses calculated as (number of rooms used for business ÷ total number of rooms in home) or (1 ÷ 12). Obviously, Dominique would be better served using the floor space method. The actual deduction will have to be prorated to account for the fact that the workspace-at-home is only used for business purposes for three days each week. Refer to the current version of CRA’s Business and Professional Income Tax Guide for more information.
Exercise: Business-Use-of-Home Deduction
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Income Tax Planning
Capital Cost Allowance
As mentioned, a taxpayer with a home-based business could elect to claim a portion of the CCA on the part of his or her home used for business, using up to the maximum rate specified by the Income Tax Act (ITA 20(1)(a)). However, if the taxpayer makes a deduction for CCA and later sells his or her home, he or she could face a capital gain or recapture of CCA on the business portion of the home (ITA 13(1)). For this reason, most people elect not to include CCA in the calculation of their business-use-of-home expense.
Limitations
The amount deducted for business-use-of-home expenses cannot be more than the taxpayer’s net income from the business before deducting these expenses (ITA 18(12)(b)). In other words, these expenses cannot create or increase a business loss that can then be used to offset the taxpayer’s other income. Jacob is employed as a machinist full time, earning $43,000 per year. He has also just started a woodworking business out of his house. His net income from the woodworking business before adjustments during the first year was $1,300. He determined that his business-use-of-home expense was $1,600. However, the most that he can claim is $1,300, because he cannot use the business-use-of-home expense to create a business loss. Jacob can carry the remaining loss of $300, calculated as (business-use of home expense - net income) or ($1,600 - $1,300) forward to a future year to be deducted from business income. Note: Some home office expenses, such as insurance on the business equipment or the cost of a separate business telephone line are strictly business expenses. The full amount of such expenses can be deducted from the gross profit calculated on the Statement of Business or Professional Activities when determining the net business income before adjustments. If these business expenses result in a net business loss, such a loss can be applied against the taxpayer's other income to the extent it reduces his or her other income to zero. Last year, Tanya earned $50,000 from her full-time job as a civil servant. She also earned $4,000 in gross profits from a home-based direct mail business. However, she spent $6,000 on postage, printing, and office supplies. She ran the business from a spare room, and determined that her business-use-of-home expense amounted to $800. Tanya will have a net business loss before adjustments of $2,000, calculated as (gross profits - expenses) or ($4,000 - $6,000), and she will be able to deduct this amount from her other taxable income. However, she will not be able to claim the business-use-of-home deduction to increase the business loss. Instead, she will have to carry the expense of $800 forward, and she will be able to apply it against net business income in a future year, assuming that she decides to continue the business.
Business Losses
If business expenses exceed revenue, the taxpayer has a net business loss, which is recorded as a negative number on the Statement of Business or Professional Activities. The business loss is transferred to the taxpayer’s T1 General Tax Return as a negative amount and it is effectively deducted from his or her other sources of income, including employment and investment income.
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Proprietorships and Partnerships Last year, Amanda opened a hairdressing salon. Although her business picked up during the last half of the year, she had a business loss of $14,000 for the taxation year, and she recorded this as a negative amount on her T1 return. She also had employment income of $5,000, net rental income of $3,000 and taxable capital gains of $1,500. Limitations on claiming business losses If the business loss is large enough to create a negative amount of total income, obviously the taxpayer cannot make full use of the loss. Amanda has total income of -$4,500, calculated as (employment income + net rental income + taxable capital gains - business loss) or ($5,000 + $3,000 + $1,500 $14,000). Non-capital losses If the business loss is large enough to create a negative amount of total income, the taxpayer may be able to use the excess to create or increase a non-capital loss. Non-capital losses include: • • • • unused losses from an office, employment, business or property unused allowable business investment losses (ABILs) the unused portion of the taxpayer’s share of partnership losses from business or property the unused portion of the taxpayer’s share of partnership ABILs
Loss Carryback and Carryforward
Non-capital losses may be deducted against income from all sources for the year in which they were incurred, in previous years, or in future years. For non-capital losses in taxation years after 2005, non-capital losses can be carried back for up to three years and forward for up to 20 years to be applied against any source of income in those years. A taxpayer is not required to deduct all available non-capital loss carryovers in any particular year. When carrying over a non-capital loss, the taxpayer should pay attention to his or her marginal tax rate during the year in which he or she is claiming the loss carried over, to optimize the value of the loss carryover. If the taxpayer expects to be in a high tax bracket for several years, he or she may only want to use enough of the loss in any one year to drop one tax bracket, saving the remaining loss for the next year. The taxpayer also would not want to use the loss carryover to reduce his taxable income below the point at which tax would otherwise not be payable actoring in the personal tax credit and other available credits. This year, Amanda has the option of reporting a non-capital loss carryover of $9,200. However, she allocated all of her revenues into the expansion of her business and as a result, only had taxable income of $6,400. Since her taxable income is well below the basic personal amount available to all taxpayers, it doesn’t make sense for Amanda to claim the loss carryover this year because her tax liability is already $0.
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Income Tax Planning To carry back a non-capital loss, the taxpayer may fill in form T1A, instead of submitting a revised return. To carry forward a non-capital loss, the taxpayer enters the amount on his or her T1 General Return. Refer to IT-232, Losses - Their Deductibility in the Loss Year or in Other Years, for more information about the deductibility of business losses.
Fiscal Year
So far in our examples, we have only looked at businesses where the fiscal year corresponds to the calendar year. However, this is not always the case, and this has tax implications as discussed below. A fiscal year is an accounting period that normally covers 365 consecutive days (366 days during a leap year), such that at the end of this period the business closes its books for the year and determines its profit or loss for that period. In contrast, a calendar year includes the 365 consecutive days (366 days during a leap year) extending from January 1st to December 31st. For individuals, the taxation year is based on the calendar year. Samantha has a business with a fiscal year-end of March 31st. The calendar year runs from January 1st through December 31st, but Samantha’s fiscal year runs from April 1st through March 31st of the following year.
In the past, a proprietorship or partnership was able to choose a fiscal period or taxation year that did not correspond to the calendar year. However, the sole proprietor or partner as an individual had to report personal income on a calendar year basis. This used to provide the opportunity to defer the reporting of business income. While certain new and existing businesses may still have a non-calendar year-end, the Income Tax Act imposes an alternative income inclusion calculation that eliminates the potential for a tax deferral (ITA 34.2(1)). Jonathan has been operating a commercial landscaping and snow removal business since 1982. He chose a fiscal year-end of April 15th because this is generally after his snow removal calls are finished for the year and before his landscaping calls begin. Anthony began operating a cross-country skiing clinic in January, and he chose April 30th as his year-end. Both Jonathan and Anthony may elect to have a non-calendar year-end, but the income inclusion provisions of the Income Tax Act will preclude any opportunity for tax deferral.
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Proprietorships and Partnerships Filing deadlines The due date for filing personal income tax returns is June 15th for individuals who are partners or sole proprietors, and their spouses or common-law partners. However, any tax owing is still payable on April 30th each year and interest is charged from April 30th on unpaid taxes. Interest on tax refunds is still payable beginning 45 days after the later of April 30th and the date the return is filed.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Business Income. In this lesson, you have learned how to do the following: • identify and calculate business income, business deductions, and a partner’s income
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Business Income, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Review
Let’s look at the concepts covered in this unit: • • • • • The Role of Businesses in Wealth Accumulation Partnerships Partnerships and Income Tax Limited Partnerships Business Income
You now have a good understanding of the basics of proprietorships and partnerships. At this point in the course you can describe the types of business income generated by a proprietorship or partnership, describe the types of partnerships, and explain how the Income Tax Act views partnership income and income allocation. You can also describe the structure of limited partnerships and how they are established as well as identify and calculate business income, business deductions, and a partner’s income. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 2: Proprietorships and Partnerships, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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I FP
Unit 3: Corporations
Income Tax Planning
Unit 3: Corporations
Welcome to Corporations. In this unit, you will learn about the nature and different types of business corporations, the process of acquiring shares, and the role of the corporation in wealth accumulation. A basic understanding of the nature of corporations is very important because you will have clients who own, manage, and invest in corporations and you might chose to run your own financial planning business through a corporation. This unit takes approximately 4 hours to complete. You will learn about the following topics: • • • • • • • • Defining a Corporation Types of Business Corporations Shares and Shareholders Organizational Structure of a Corporation Corporate Taxation 1 Corporate Taxation 2 Taxation of Shareholders Corporations as Wealth Accumulation Vehicles for the Owner/Manager
To start with the first lesson, click Defining a Corporation on the table of contents.
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Corporations
Lesson 1: Defining a Corporation
Welcome to Defining a Corporation. In this lesson, you will learn about the nature, liability, and management of corporations. This lesson takes 15 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the general nature of corporations give examples of how corporations are governed or managed
Defining a Corporation
A corporation is a business form that is recognized by the legal system as being a nonhuman individual with its own rights and duties, defined by the following characteristics: • • • • • limited liability continuous existence separation of management and ownership ease of transfer of ownership no duty of loyalty from the owners
Unlike a partnership or sole proprietorship, there is no requirement for a corporation to carry on business activities. So, a corporation can be used to hold investments and, in fact, that is the purpose of a holding company. Benjamin and his wife, Sarah, each own 50% of the shares of 135792468 British Columbia Limited, a holding company that in turn owns a number of stocks and bonds, as well as shares in an operating company that Benjamin manages.
Limited Liability
A corporation is a distinct legal entity separate from its owners, who are called shareholders. If a corporation fails, the most that the shareholders can lose is the amount they invested in the corporation. They cannot be held personally liable for the debts or other obligations of the corporation. Because a corporation gives the shareholders limited liability, it is also called a limited company. Lenders and suppliers evaluate the credit worthiness of a corporation before lending funds or extending credit. They may require personal guarantees from the shareholders if the assets of the corporation are not considered adequate security for the debt. This is common in small corporations where there are only a few shareholders and the shareholders also manage the business. By obtaining this personal guarantee, creditors can also look to a shareholder personally for repayment of a specific debt of the corporation. However, this personal liability is a result of the personal guarantee, not the person’s role as director or shareholder. Stephan recently incorporated a new construction company called Build-All Limited. The business needed to purchase about $60,000 worth of capital equipment and tried to obtain a business loan. Because the company has no assets and no credit history, the bank would not approve a loan unless Stephan personally guaranteed the loan. If Build-All defaults on the loan, the bank can then try to recover the debt from Stephan personally.
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Income Tax Planning
Continuous Existence
Corporations are different from other forms of business in that they allow for continuous or perpetual existence even after the death or retirement of a shareholder or the transfer of shares to new owners. The ownership interest of each deceased shareholder would pass through his or her estate to his or her beneficiaries; the beneficiaries would become the new owners. Jason operated a mobile sharpening business, Surely Sharp, as a sole proprietor. When Jason died, the business ceased to exist. Marge, Selma, Louise and Lisa operate a law practice as a partnership. Their partnership agreement states that if any one of them dies, the surviving partners will pay the estate of the deceased a lump sum of $200,000 in exchange for the deceased’s partnership interest, such that the partnership would now have only three partners. Carl and his wife Sandra each owned 50% of the shares in Capital Basics Ltd., when they were both killed in a car accident. In accordance with their wills, all of their assets were divided equally between their four surviving children. Each child now owns a 25% interest in Capital Basics Ltd.
Separation of Management and Ownership
A corporation is different from a sole proprietorship or partnership in that its management is legally separate from its ownership. This allows the corporation to hire professional managers to run the business. While the owners of the corporation are often also the managers, there are many corporations where the owners take no active role in management. In these cases, processes are needed to ensure that management remains accountable to the shareholders for running the corporation profitably. Although Carl and Sandra owned Capital Basics before their death, they had retired three years ago and the company was managed by their oldest son, Richard. Owner/managers As a financial planner, you are likely to have many clients who are either the sole owner/manager of a corporation, or one of only a few shareholders of a closely held corporation. An owner/manager is the term that is often used to refer to a person who is a major shareholder of a corporation and who also takes an active role in running that corporation. The corporation has become a favourite business form for entrepreneurs, because it provides them with limited liability and some tax advantages as well. Bob owns 60% of Bulldog Security Ltd., while his wife owns 10% and his brother owns the remaining 30%. Bob is the general manager of the company, while his brother is in charge of the sales department. Bob’s wife does not take an active role in the business.
Ease of Transfer of Ownership
A shareholder can generally sell his or her shares of a corporation without the approval of the corporation. The corporation maintains a share register to keep track of the shareholders, but some shares are not necessarily registered in the name of the beneficial
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Corporations owner. Any owner of the shares is allowed to register them and become entitled to all the rights of a shareholder. John bought 100 shares in Skyjack Ltd. through his broker. If he wants to sell the shares, he does not need Skyjack’s permission. Since John’s brokerage firm handles a lot of Skyjack shares, it keeps an inventory of these shares, and the shares that John bought are actually registered in the name of the brokerage firm. No duty of loyalty Unlike a partner, a shareholder does not owe any duty of loyalty to a corporation. He or she can freely pursue his or her own interests in supplying goods or services to the corporation or in buying and selling shares to maximize his or her investment return. The shareholder can also operate a business in direct competition with the corporation, although that competition could affect the existing corporation and thus decrease the value of his or her holdings in that corporation. In contrast, a partner in a partnership owes a duty of loyalty to the partnership and cannot pursue his or her interests to the detriment of the partnership by carrying on a competing business. Janice owns 20% of the shares in Clean House Corp., an incorporated commercial cleaning and restoration service. Janice also operates a Steamatic steam cleaning franchise as a sole proprietor. Steamatic serves both residential and commercial customers. However, Janice is not prohibited from operating the Steamatic franchise simply because she owns shares in Clean House Corp.
Exercise: Defining a Corporation
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Defining a Corporation. In this lesson, you have learned how to do the following: • • describe the general nature of corporations give examples of how corporations are governed or managed
If you are ready to move to the next lesson, click Types of Business Corporations on the table of contents.
Assessment
Now that you have completed Defining a Corporation, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Lesson 2: Types of Business Corporations
Welcome to Types of Business Corporations. In this lesson, you will learn about the different types of business corporations and how they are established. This lesson takes 25 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the different types of business corporations and how they are established compare and contrast private, public, and investment corporations
Types of Business Corporations
Corporations can be classified according to their purpose and ownership, resulting in the categories of business corporations, government corporations and charitable corporations. In this course, we are concerned only with business corporations. There are three primary types of business corporations: • • • public corporations private corporations investment corporations
Each of these types will be discussed on the following pages.
Public Corporations
A public corporation is one that: • • has one or more classes of its shares listed on a prescribed stock exchange in Canada has elected, or has been designated by CRA, to be a public corporation and, among other conditions, its shares are held by at least 150 shareholders, each of whom holds at least $500 worth of shares (ITA 89(1))
Based in Waterloo, Ontario, Research in Motion (RIM) is a leading designer, manufacturer and marketer of innovative wireless solutions for the worldwide mobile communications market. RIM is a large Canadian public corporation. Some of RIM’s shareholders may own a relatively small number of shares and are only interested in the investment prospects of buying and selling shares to make a profit. Other RIM shareholders are employed by RIM and may receive shares as a part of RIM’s profit-sharing plan;these shareholders may eventually own a significant number of RIM shares. Still another group of shareholders may own large blocks of shares in RIM for the purpose of controlling the company. Together, all of these shareholders own RIM. The shares of RIM are traded on the Toronto Stock Exchange. RIM’s annual report, stating the financial status of the company and its profits or losses for the year, is made public and is available to anyone upon request. RIM’s financial dealings are made public so that shareholders can determine whether or not to continue to hold shares in the company and so that shareholders can determine whether or not to continue to hold shares in the
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Income Tax Planning company and so that potential shareholders can decide whether or not to purchase shares in the company.
Private Corporations
A private corporation is one that is resident in Canada, is not a public corporation, and is not controlled directly or indirectly by one or more public corporations (ITA 89(1)). Special income tax rules apply to private corporations. Canadian-controlled private corporation (CCPC) A Canadian-controlled private corporation (CCPC) is a Canadian private corporation that is not controlled directly or indirectly by one or more non-residents or public corporations (ITA 125(7)). Trevor Greeter studied graphic design at an arts school in Saskatoon. As a student, Trevor began a thriving small business making greeting cards, and he originally operated the business as a sole proprietorship. When Trevor graduated, he decided to continue his card-making enterprise and designed his first full line of greeting cards. Soon he had several stores selling his cards. Trevor incorporated his business when he started making large profits and he wanted to branch out. Trevor now has a chain of ten card and gift stores. His merchandise is also available in some department stores and he employs 150 people on either a part-time or full-time basis. Trevor’s business is a Canadian-controlled private corporation. Trevor, his wife, their parents, and his sister own the shares in Trevor’s company and they are all Canadian residents. The shares are not publicly traded. Trevor originally sold the shares to his family members when he needed to raise capital to open his first two stores.
Investment Corporations
An investment corporation sells shares to investors or subscribers and uses the proceeds to purchase financial securities. If the investment corporation’s portfolio increases in value, the value of the investors’ shares increase in value. The shareholders stand to gain through capital appreciation and dividends. There are two types of investment corporations: closed-end and open-end. Closed-end investment corporations A closed-end investment corporation has a fixed number of shares that are bought and sold on a stock exchange in the secondary securities market or in the over-the-counter market. The secondary market is the market for trading previously issued securities, and it includes the stock exchanges and the over-the-counter market. The over-the-counter market (OTC) refers to a computerized network of brokers and securities firms that specialize in trading stocks that are not listed on an exchange. Once all of the shares are sold, the investment corporation does not issue any new shares. The net asset value (NAV) of shares in either a closed-end or open-end investment corporation is calculated at a point in time as the fair market value of the investments held by the investment corporation divided by the number of shares issued by that corporation.
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Corporations
XYZ Investment Corp. initially issued 100,000 shares for $10 each. With the proceeds, XYZ created an investment portfolio that is currently worth $1.8 million. Thus XYZ currently has a NAV of $18 per share, calculated as (value of investment portfolio ÷ number of shares) or ($1.8 million ÷ 100,000). The shares of a closed-end investment corporation may trade at more or less than its net asset value (NAV), depending on market demand. Although the NAV of XYZ is currently $18 dollars per share, Henry believes that the investment corporation is going to continue to do well and he is willing to pay $19 per share. However, Henry must find an XYZ investor who is willing to sell her shares before he can purchase them, because XYZ will not issue any new shares. Open-end investment corporations An open-end investment corporation is usually called a mutual fund. Investors buy shares from the investment company and resell them to that same company when they no longer want to hold on to them. Shares in an open-end mutual fund are not traded on the open market. Instead, they are purchased directly from the investment corporation and they are sold back to the same corporation when the investor no longer wants them. The mutual fund corporation uses the money it receives from investors to invest in a portfolio of securities. If the portfolio does well, the NAV per share increases. Unlike a closed-end fund, the shares in a mutual fund company are purchased and sold at their net asset value. If the NAV increases, the investor can realize a gain when he or she redeems the shares. Unlike a closed-end investment corporation, an open-end investment corporation can issue any number of shares and will likely continue to do so as long as there is a demand for them.
Exercise: Types of Business Corporations
Establishing a Corporation
A company is incorporated in one of the following ways, depending on the nature and scope of the business: • • • • under the federal Canada Business Corporations Act (CBCA) if the business operates nationally under the provincial legislation that governs corporations, such as the Ontario Business Corporations Act under a special act of the provincial legislature by direct Royal Charter (in this century, this is only done in the special case of charitable organizations)
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Income Tax Planning In order to establish a corporation, the following documents must be filed with the appropriate branch of the federal or provincial government: • • • • • an application articles of incorporation a notice of directors a name search report the appropriate filing fee
Choosing a Federal or Provincial Charter
Federal charter A company must be incorporated under the Canada Business Corporations Act (i.e., obtain a federal charter) if it is being established to do business in any of the federally-regulated industries, such as banking, broadcasting or rail transportation. A company may obtain a federal charter even if its business is not federally regulated. A company with a federal charter is allowed to operate in any province of Canada without permission of any province, so most national corporations have a federal charter. Even though Q236 FM, a newly established rap music station, intends to broadcast only from Winnipeg, it had to incorporate under the Canada Business Corporations Act because its operation is federally regulated. Provincial charter If the business is going to operate only in one province and does not require a federal charter, it can obtain a provincial charter by applying to the appropriate provincial government department. A company incorporated in one province can establish a place of business in another province by registering and obtaining that province’s permission to do business there after filing certain basic information. Usually, it is not difficult to obtain that permission. When Gerry first incorporated Executive Mobility Inc., his executive training service in Nova Scotia, he did not anticipate operating outside of the province. However, his business has become very successful and he is planning to open training facilities in New Brunswick as well. He does not have to establish a new corporation in New Brunswick if he registers Executive Mobility Inc. with the province of New Brunswick and obtains their permission to operate there.
Incorporation Documents
Corporate name The corporation name must end in "Corporation", "Incorporated", "Inc.", "Limited" or "Ltd." to indicate clearly to the consumer that the organization is incorporated. The application for incorporation must be accompanied by a name search on the proposed corporate name because a new corporation cannot have a name that is too similar to an existing business name. Instead of incorporating under a specific name, a corporation can simply become a numbered company by allowing the registrar to assign the next number to the corporation, such as 124756 Canada Inc. or 745092 British Columbia Limited.
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Corporations
Notice of directors The notice of directors documents the names of the initial directors who will hold office until the first shareholders’ meeting. At that meeting, the shareholders will have the opportunity to elect a slate of directors. Articles of incorporation The application for incorporation is accompanied by the articles of incorporation, which document the fundamental characteristics of the corporation, including: • • • • the business name the number of directors the number and classes of shares that the corporation is authorized to issue any restrictions on the business activities that the corporation can undertake
The provisions set out by the articles of incorporation can only be amended by filing articles of amendment that have received the approval of the shareholders. Certificate of incorporation Once the appropriate government office has received the application, articles of incorporation and any required fees, it will issue a certificate of incorporation. The date of this certificate is the date the corporation comes into existence. Gerry submitted his application to incorporate Executive Mobility on June 15th. The government issued the certificate of incorporation on August 2nd. Prior to this date, Gerry was operating as a sole proprietor, because Executive Mobility Inc. was not established until the date the certificate was issued.
Exercise: Establishing a Corporation
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Types of Business Corporations. In this lesson, you have learned how to do the following: • • describe the different types of business corporations and how they are established compare and contrast private, public, and investment corporations
If you are ready to move to the next lesson, click Shares and Shareholders on the table of contents.
Assessment
Now that you have completed Types of Business Corporations, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Lesson 3: Shares and Shareholders
Welcome to Shares and Shareholders. In this lesson, you will learn about the process of acquiring shares, the different share structures, and the different types of dividends. This lesson takes 20 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • describe the process of acquiring shares explain the different share structures contrast and compare the different types of dividends calculate the tax impact of different types of dividends
Shares and Shareholders
Once the business is incorporated, the directors can pass a resolution to issue shares to raise capital. A share is a standard unit of equity or ownership in the corporation. The owners of the corporation are thus called shareholders. The shares are also referred to as stock in the company. Purchasing shares A shareholder purchases his or her share of the ownership of the corporation by contributing cash or property to the corporation. This cash or property is referred to as the shareholder’s capital. The extent of his or her ownership interest in the corporation is measured by the number of shares that he or she receives in exchange for his or her contribution, in relation to the total number of shares issued. Nancy purchased 1,000 shares in Newmark Inc., which has a total of 1,000,000 shares outstanding. Nancy has a 0.1% ownership interest in Newmark, calculated as (# of Nancy's Newmark shares ÷ total Newmark shares outstanding) or (1,000 ÷ 1,000,000). Nancy also purchased 1,000 shares in Oldmark Inc., which has only 10,000 shares outstanding. Nancy has a 10% interest in Oldmark Inc., calculated as (# of Nancy's Oldmark shares ÷ total Oldmark shares outstanding) or (1,000 ÷ 10,000). So, even though Nancy has 1,000 shares in each company, she has a much larger ownership interest in Oldmark Inc. because it has a smaller number of outstanding shares. Setting the initial share price The price per share is established by the corporation when it issues the shares. While there is no legislative provision governing the number of shares issued or the issue price, the number of shares that a corporation is authorized to issue may be set out in its corporate charter. The company will consider how much capital it wants to raise and try to set a share price that will attract a sufficient number of investors to raise that amount. If they price the stock too high, few investors may purchase the shares because it would require too large of a capital investment. However, if they price the shares too low, some investors may doubt the quality of the stock issue. In raising $1 million in capital, TriCorp might sell 1,000 shares at $1,000 each, while Pennystock Inc. might sell 2 million shares at 50 cents. The corporation will try to choose a price point that will appeal to investors.
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Income Tax Planning Effect of sales between investors Subsequently, the original purchaser may sell his or her shares to another investor. This transaction is between the two shareholders and does not involve the corporation other than registering the new shareholder. The only capital the corporation recognized is the cash or property it received when it originally sold the shares. Alice originally purchased 10 shares of TriCorp at $1,000 each. Unfortunately, the share price declined and she eventually sold her shares for $500 each. The fact that the shares traded at $500 each does not affect TriCorp’s finances, because it only recognizes the fact that it originally received $1,000 for each share.
Shareholders' Equity
The shareholders of a corporation initially contribute cash or other property to acquire their interest in the corporation. Their initial investment plus the earnings of the corporation that are retained (i.e., the profits that are left in the company after it pays dividends) is referred to as the shareholders’ equity. This amount is also called the book value of the shares per the financial statements of the corporation. This book value may differ significantly from the value that the market puts on the shares. When Amazing Corp. was first established, it issued 1,000 shares at $100 each, raising total shareholder capital of $100,000. After its first year of business, Amazing had net income after taxes of $80,000. It then paid out dividends of $50 per share, leaving retained earnings of $30,000, calculated as (net income after taxes - (dividend per share x number of shares)) or ($80,000 – ($50 × 1,000)). The shareholder’s equity at the end of the year is $130,000, calculated as (proceeds from issue of shares + retained earnings) or ($100,000 + $30,000). The book value of Amazing Corp. is now $130 per share, calculated as (shareholders' equity ÷ number of shares) or ($130,000 ÷ 1,000). However, the shares may trade for more or less than $130, depending on how investors feel about the future prospects of Amazing Corp.
Types of Shares
Corporations may issue common shares, preferred shares, or both. In addition, it may offer more than one class of common shares and more than one class of preferred shares. The different classes can be differentiated by name (such as Class A Common, Class B Common or Class A Preferred) or by voting rights (voting or non-voting). Common shares Common shares represent the true equity ownership of the corporation, with all the benefits and risks of such ownership. Canadian Tire has two classes of common shares, one class with voting rights, and one class without. The founding Billes family and the dealers control the corporation through ownership of the voting common shares.
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Corporations Preferred shares Preferred shares are a hybrid security in that they have some characteristics of common shares and some of bonds. Preferred shares usually have a specified dividend rate, such that the corporation will pay dividends at that rate as long as it is able. In most cases, preferred dividends must be paid before dividends can be paid to common shareholders. Preferred shareholders also have a preferred claim on the assets of the corporation. This means that if the corporation goes bankrupt and its assets are liquidated, the preferred shareholders will receive their investment back before the common shareholders. However, in exchange for these benefits, preferred shareholders may forfeit the equity growth in the company. The Bank of Nova Scotia offers six different classes of preferred shares with annual dividends ranging from $1.31 to $1.78 per share.
Exercise: Shares and Shareholders
Dividends
Shareholders can receive one or more of the following types of dividends: • • • • regular dividends capital dividends capital gains dividends stock dividends
Regular dividends Regular dividends are the portion of a corporation’s after-tax profit that is paid out periodically to the shareholders. The directors decide how much of the profit will be paid out as dividends. The total amount to be paid is divided among the shareholders on the basis of the number of shares owned. Dividends of a public corporation are usually paid on a quarterly basis. Some or all of a corporation’s profit can be retained in the business to finance future growth. The amount of profit kept in the business and not paid out as dividends is called retained earnings. True Corp. had an after-tax profit of $800,000 last year. It paid a quarterly dividend of $0.50 per share to each of its 250,000 shareholders, for total annual dividends paid of $500,000, calculated as ((number of shares x quarterly dividend) x quarters per year) or ((250,000 × $0.50) × 4). It kept the remaining $300,000, calculated as (after-tax profit annual dividends) or ($800,000 - $500,000) as retained earnings to finance plant expansion in the near future.
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Income Tax Planning Capital dividends Capital dividends are payments that the shareholders receive from a private corporation’s capital dividend account. The capital dividend account is not a bank account, rather it is a notional account on the corporation’s income tax return. It records the total of the tax-free 50% of capital gains, the tax-free portion of the death benefits from company-held life insurance policies, and the tax-free portion of sales of goodwill. This type of dividend is not paid regularly. Because the capital dividend account represents income or gains that are not otherwise taxable, the dividend income from the capital dividend account is not taxable to the shareholders when it is received (ITA 89(1), (83(2)). Example Inc., a private corporation, owned a lot of surplus land adjacent to its existing manufacturing operations. It managed to sever the surplus land and sell it, resulting in a capital gain of $240,000. Only 50% of this gain is subject to income tax, and the remaining $120,000, calculated as (capital gain x non-taxable portion of capital gain) or ($240,000 × 50%), was added to the corporation’s capital dividend account. At the end of the year, the directors of Example Inc. decided to distribute the $120,000 in this account to its shareholders as a capital dividend. The dividend is not taxable to the shareholders. Refer to IT-66R6, Capital Dividends, for more information. Capital gains dividends A capital gains dividend is the money distributed by an investment corporation when it realizes a capital gain on an investment. An investment corporation must distribute all income that it earns on its portfolio investments, including capital gains if it wants to avoid paying tax on that income. A capital gains dividend is reported by the shareholder for income tax purposes just as any other capital gain. So, although it is called a dividend, the capital gains dividend is really just another name for a payment of capital gains that flow through to the investors. When investment income flows through to an investor, it retains its character for tax purposes. So, capital gains that flow through to an investor are subject to a 50% income inclusion rate, while dividends from taxable Canadian corporations that flow through to an investor are eligible for the dividend gross-up and tax credit scheme. During the past year, the Alias Mutual Fund made many adjustments to its investment portfolio, resulting in net capital gains of $400,000. To avoid paying tax itself on those gains, Alias distributed the capital gain to its shareholders before the end of the year as a capital gains dividend of $1 per share. Michael holds 1,000 shares in Alias and thus he will have to report taxable capital gains of $500 on his tax return, calculated as ((capital gains dividend per share x number of shares) x capital gains inclusion rate) or (($1 x 1,000) x 50%). Michael must report $500 as part of his income, where he will pay tax based on his marginal rate.
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Corporations
Stock Dividends
A stock dividend is a dividend that is paid by a corporation in the form of additional stock in the payer corporation, accompanied by an increase in the paid-up capital of the corporation (ITA 248(1)). A dividend that is paid in the form of shares in another corporation is a dividend in kind, not a stock dividend. Stock dividends are often paid by rapidly growing companies that prefer to capitalize their retained earnings to finance future growth or by companies that have not realized sufficient cash flow to pay cash dividends. DEF Ltd. has 20,000 outstanding shares and existing paid-up capital of $10,000,000, or $500 per share, calculated as (paid up capital ÷ number of shares) or ($10,000,000 ÷ 20,000). This year it had an after-tax profit of $400,000. It could distribute this amount as a taxable dividend, or it could simply retain the funds, in which case the value of the existing shares would increase as a result of the corporation’s increased equity. Alternatively, it could elect to capitalize the retained earnings by adding it to its paid-up capital account and issuing a stock dividend. Stock split A stock dividend is not the same thing as a stock split. In a stock split, there is an increase in the number of shares accompanied by a proportional decrease in the paid-up capital per share, so that neither the total amount of paid-up capital nor the amount of surplus available for distribution as a dividend is altered. In a stock dividend, there is a distribution of shares accompanied by a capitalization of retained earnings or any other surplus account that was available for distribution as a dividend. ABC Inc. has ten shareholders, each with 100 shares, so each shareholder owns a 10% interest in the company, calculated as (number of shares held by one shareholder ÷ (number of shareholders x number of shares held by each shareholder)) (100 ÷ (10 × 100)). Each shareholder initially paid $500 per share, so ABC Inc. has paid-up capital of $500,000, calculated as (number of shareholders x number of shares held by each shareholder x paid up capital per share) or (10 × 100 × $500). If ABC Inc. issues 5% more shares to each shareholder without a corresponding capitalization of retained earnings, it will still have paid up capital of $500,000. However, there will now be 1,050 shares outstanding, calculated as (number of shareholders x number of original shares per shareholder x (100% + percentage of new shares issued) or ((10 × 100) × 105%). So, the value of each share after a stock split decreases, because the paid-up capital per share in this case has reduced to $476.19, calculated as (total shareholders' equity ÷ number of new shares outstanding) or ($500,000 ÷ 1,050).
Exercise: Dividends
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Shares and Shareholders. In this lesson, you have learned how to do the following: • • • • describe the process of acquiring shares explain the different share structures contrast and compare the different types of dividends calculate the tax impact of different types of dividends
If you are ready to move to the next lesson, click Organizational Structure of a Corporation on the table of contents.
Assessment
Now that you have completed Shares and Shareholders, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score.
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3-17
Corporations
Lesson 4: Organizational Structure of a Corporation
Welcome to Organizational Structure of a Corporation. In this lesson, you will learn about the roles and duties of the individuals involved in a corporation as well as the governing legislation of a corporation. This lesson takes 25 minutes to complete. At the end of this lesson, you will be able to do the following: • • • explain the roles and duties of the individuals involved in a corporation explain the role of the corporation itself describe the governing legislation of a corporation
Directors
Organizational structure of a corporation In the case of a corporation, ownership is separate from management. The shareholders do not necessarily control the operation of the corporation, or at least not directly. Instead, the corporation is controlled by directors and hired managers. Directors are individuals who are elected to manage the business and affairs of the corporation, where: • • the affairs of the corporation are the internal arrangements among those responsible for running the corporation and its main beneficiaries, the shareholders the business of the corporation refers to the external relations between a corporation and those who deal with it as a business enterprise, such as its customers, suppliers, employees, government regulators and society as a whole
A corporation must have at least one director. The first directors of a corporation are appointed by the notice of directors submitted at the time of incorporation and they hold office until the first shareholder’s meeting. Subsequently, the directors are elected by the shareholders at the annual shareholders’ meeting. Other than electing the directors, the shareholders have little say in the business and affairs of the corporation. While the directors may also be shareholders, they do not have to be shareholders. The shares of Big Box Enterprises Ltd. are held by over 3,000 different investors. However, the majority of these shareholders do not take an active role in managing the business and affairs of the corporation. Instead, these duties are performed by a board of ten directors. Seven of the directors hold shares in Big Box, but three do not.
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Income Tax Planning Directors’ powers Specific ongoing powers of the directors include the following: • • • • approving the issuance of shares in accordance with the corporation’s articles of incorporation declaring dividends adopting by-laws to govern the day-to-day affairs of the corporation calling shareholders’ meetings, which must be done at least annually
Directors’ duties Each director has several duties to the corporation, including the duty to: • • • • exercise care and skill in carrying out his or her responsibilities act in the best interests of the corporation refrain from abuse of corporate opportunities avoid insider trading, which is buying or selling the securities of the corporation while making use of confidential information
Corporate By-laws
One of the first jobs of the board of directors is to establish corporate by-laws that specify the approved arrangements for carrying out the business of the corporation. Some of the more common provisions specified in the by-laws include the following: • • • • how notice is to be given regarding meetings of directors or shareholders what constitutes a quorum for such a meeting whether or not auditors are appointed who may sign contracts on behalf of the corporation
While the by-laws are normally established by the initial slate of directors, they must be approved by the shareholders at their first meeting following their election of the directors. When Major Deals Ltd., first incorporated, there were a total of four people on the board of directors and 24 different shareholders. This board drafted the bylaws of the corporation and then called a meeting of the shareholders, at which time the shareholders approved the bylaws and voted for the current slate of directors. Closely held corporations A closely held corporation is a private corporation where there are only a few shareholders (or even only one shareholder) and where shares are not distributed to the public. In a closely held corporation, the Business Corporations Acts specify that there only needs to be one director and that director can also be the major shareholder and the manager of the business. A closely held corporation can have more than one director, but in any event, the minimum and maximum number of directors must be specified in the articles of incorporation. In a closely held corporation, it is likely that all of the shareholders will take an active role in the business and they will all want to be directors so that they can have control over the management of the corporation and the distribution of corporate profits.
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3-19
Corporations
Exercise: Directors of a Corporation
Rights of the Shareholder
Shareholders elect the directors of the company, and have a right to vote on major issues such as the sale or purchase of portions of the business or mergers or liquidation. Shareholders can be employed by the business, but do not have to be. Shareholders can also be directors and, in private corporations, the major shareholders are usually the directors. Shareholders’ meetings Shareholders’ meetings are held when necessary to attend to major issues, but they must be held at least annually in any event. The annual meeting is held to elect new directors, if necessary, and to discuss the corporation’s financial statements and the auditor’s report for the year if an auditor is appointed. An investor would be wise to take an interest in how the corporation is run because this could alert him or her to the future prospects of the investment. All voting shareholders are sent information regarding the date and place of shareholders’ meetings. They may also be sent a proxy form, which allows shareholders to send representatives to vote in their places if they are unable to attend. The issues that will be voted on are included in the information package, allowing the shareholders to indicate to their proxies how they wish them to vote on each issue. A minimum number of shareholders or their proxies must be in attendance at the shareholders’ meeting in order for votes to be taken. Shareholders’ agreements A shareholders’ agreement is similar to a partnership agreement in that it is intended to override or replace the default rules set out by provincial or federal legislation. The purpose of the agreement is to establish customized rules that will govern the corporation in question, thereby protecting the unique interests of the shareholders. A shareholders’ agreement is usually used when the corporation is owned by a small group of shareholders and the shareholders’ lawyers draft it when the corporation is first established. A shareholders’ agreement stipulates the roles of the shareholders in running the corporation, as well as their rights and responsibilities. It lists who will be the officers and directors of the corporation and their terms of office. For a small corporation, it might even stipulate details regarding salaries, bonuses, benefits, vacation policies and confidentiality agreements.
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Income Tax Planning Shareholders’ agreements usually address the following issues: • • • • • • • • • issuing more shares lending money to officers or shareholders determining the payment and amounts of dividends taking on new debt using any corporation assets as collateral for debts hiring family members transferring shares changing the nature or purpose of the business in any substantial way signing any major contracts or leases
Controls on Share Transfers
First right of refusal In the absence of any special agreements, shares in both public and private corporations are assumed to be freely transferable. They can be sold at the will of the existing shareholder as long as there is someone willing to purchase them. In corporations with only a few shareholders, all of the shareholders are concerned about the loss of control over the corporation that could occur if one of the existing shareholders should decide to sell his or her shares to an outsider. For this reason, most shareholders’ agreements also give the remaining shareholders the first right of refusal to buy the shares of a shareholder who has irreconcilable differences or who is unable to continue investing in the corporation due to disability, illness, death, retirement or bankruptcy. Doreen, Harry, Pearl and Mac each own 25% of the shares in Bluebird Ltd. When they first incorporated the business, they executed a shareholders’ agreement giving the remaining shareholders the first right of refusal to buy the shares of a departing or deceased member at the corporation’s book value. Pearl wants to retire and pass the shares on to her grandson, Jake. Doreen, Harry, and Mac all find Jake to be an annoying, irresponsible person, and they are very glad that they can keep Pearl from passing her interest on to Jake by purchasing her shares in the business. Shotgun buy-sell provision A shotgun buy-sell provision specifies that one shareholder can offer to buy the shares of another shareholder at a specific price. If exercised, the shareholder must either sell his or her shares or buy the shares of the first shareholder at that price. Shotgun buy-sell provisions are rarely used when there are more than two shareholders, as they become too complicated to arrange. Lawrence and Beverly each own 50% of the 100 outstanding shares in a software development company and they executed a shotgun buy-sell agreement at the time of incorporation. Beverly cannot stand working with Lawrence any more, so she offered to buy his shares for $50,000. Lawrence must either sell the shares to Beverly, or he must purchase her shares for $50,000. A share redemption plan is an agreement between the shareholders and the corporation that states that the corporation must purchase the interest of a shareholder at a fixed price or at a price determined by a formula included in the agreement. In the case of a deceased shareholder, this ensures that the deceased’s estate will get a fair price for his shares upon his death. It also ensures that the remaining shareholders do not have to worry about who
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Corporations the new owner might be. When a corporation redeems the shares of a deceased shareholder, the number of outstanding shares decreases by a corresponding amount and as a result, the proportionate ownership of the surviving shareholders increases. Fred, Wilma, Barney, and Betty were the only four shareholders in Rockaberry Beverages Ltd., with 250 shares each. So, they each had a 25% interest in the company, calculated as (number of shares held by one shareholder ÷ (number of shares held by each shareholder x number of shareholders)) or (250 ÷ (250 × 4)). They all entered into a share redemption agreement with Rockaberry that specified that if any one of them was to die, Rockaberry would purchase his or her shares at $1,000 per share. One unfortunate day, Barney was crushed by shifting boulders in a nearby quarry. Rockaberry paid $250,000 to Barney’s estate to acquire his shares. Now Fred, Wilma, and Betty each have a 331/3% interest in the company, calculated as (number of shares held by one shareholder ÷ (number of shares held by each shareholder x number of shareholders)) or (250 ÷ (250 × 3)). Share redemption plan In the case of a deceased shareholder, this ensures that the deceased’s estate will get a fair price for his or her shares upon his or her death.
Managers
While the directors have general control over the business and affairs of the corporation, they often delegate much of their decision making authority to one or more business managers, putting in place a management hierarchy that could include a chief executive officer (CEO), a president, and one or more vice presidents. While Big Box Ltd. has a 10-member board of directors who oversee the business, they hired Mr. McGaw to oversee the day-to-day operation of the business. Mr. McGaw is neither a shareholder nor a director. He is an employee of the corporation.
Governing Legislation
Corporations are established in accordance with either federal or provincial Business Corporations Acts. However, because corporations issue shares in order to raise capital, they may also be governed by provincial securities legislation.
Corporate Law
In addition to setting out the procedures for incorporating a business, the provincial and federal Business Corporation Acts lay out default rules that govern the relationship between the corporation and its shareholders. These default rules apply in the absence of any other rules being adopted by the corporation and its shareholders through articles, by-laws or a shareholders’ agreement.
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Income Tax Planning These default rules are in place primarily to protect the interests of shareholders by: • • • • limiting the shareholder’s liability, such that the most a shareholder can lose is the amount of his or her investment imposing standards of behaviour on managers to ensure they act in the best interests of the corporation and its shareholders, rather than in their own interests requiring regular shareholder meetings that follow a standard protocol making sure that the interests of minority shareholders are protected
Some of the default rules are also meant to protect people unconnected with the corporation, such as creditors. For example, corporate law dictates that a corporation may not pay dividends to its shareholders if it is insolvent, or would become insolvent if it made those dividend payments.
Securities Law
Because a public corporation by its very nature issues securities that may be traded in the marketplace, it is also governed by provincial securities laws. Securities laws serve to ensure that the marketplace operates honestly and that buyers and sellers have enough information to make informed decisions about their investments. It does this by requiring the disclosure of pertinent information by the issuing corporation on an ongoing basis, both to existing shareholders and to prospective shareholders. While corporate law requires a disclosure of information to existing shareholders, it does not require the disclosure of information to potential investors.
Exercise: Rights of the Shareholder and Governing Legislation
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3-23
Corporations
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Organizational Structure of a Corporation. In this lesson, you have learned how to do the following: • • • explain the roles and duties of the individuals involved in a corporation explain the role of the corporation itself describe the governing legislation of a corporation
If you are ready to move to the next lesson, click Corporate Taxation 1 on the table of contents.
Assessment
Now that you have completed Organizational Structure of a Corporation, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 5: Corporate Taxation 1
Welcome to Corporate Taxation 1. In this lesson, you will learn about a corporation’s accounting requirements. You will also learn how to calculate corporate tax elements such as dividends and deductions. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • • explain a corporation’s accounting requirements describe and calculate corporate tax elements such as dividends and deductions
Corporate Taxation
Corporations are legal and taxable entities that are separate and apart from their individual shareholders. Corporations must pay income tax on their profits before passing them on to their shareholders. When these after-tax profits are subsequently distributed to the shareholders in the form of dividends, they are then taxed a second time, resulting in double taxation. This double taxation has added much complexity to the Income Tax Act. We will try to keep it simple. Generally, the Income Tax Act tries to alleviate double taxation by integrating the corporate and individual tax systems. These two systems would be perfectly integrated if the tax that an individual taxpayer would pay on income earned directly is the same as the combined amount of personal and corporate tax that would be paid if the income is earned through a corporation. Integration of the corporate and individual tax systems is accomplished by reducing the effective tax rate in the corporation and the amount of tax that shareholders have to pay on dividends. If the shareholder is an individual, this reduction is accomplished by the dividend gross-up and tax credit scheme. If the shareholder is another corporation, it generally receives dividends from other corporations free from tax.
General Taxation Scheme
Generally, corporations resident in Canada are taxed on their world income with appropriate credit for taxes paid in other countries. The corporate tax return is similar to the individual tax return with supporting schedules and calculations of deductions. The following tables set out the steps taken in calculating the taxable income of Sidebar Inc., a Canadian corporation. Reconciling accounting income to net income for tax purposes The first step in this process involves reconciling the net accounting income recorded on the corporation’s financial statements with the net income that must be reported for income tax purposes. For example, depreciation expense is deducted to determine net accounting income on the corporation’s financial statements. Note: For each of the terms discussed below, the number that appears corresponds with the content of the table, which includes a sample Reconciliation of Accounting Income to Net Income for Tax Purposes for Sidebar Inc
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Corporations
Depreciation (1) or depreciation expense is an accounting concept that recognizes as an expense, an estimate of the decline in value of an asset used to produce income as the result of exhaustion, wear and tear, and obsolescence. Capital cost allowance (CCA) (2) is a tax concept that also recognizes that loss of value through depreciation occurs, but it does not necessarily measure it in the same way. The Income Tax Act sometimes allows CCA to be claimed at a higher rate than depreciation occurs in order to provide tax relief or incentives to certain industries or on certain capital purchases. So, when reconciling accounting income to net income for tax purposes, we must add back any depreciation expense, and deduct the corresponding CCA. Other adjustments are made to recognize that: • income taxes (3) and income tax penalties or interest (4) that were deducted to arrive at net accounting income must be added back to arrive at net income for tax purposes while the full gain on the sale of a capital asset is included in net accounting income, only 50% of that gain (5) has to be included in net income for tax purposes charitable donations (6) must be added back for the purpose of determining the allowable charitable donation deduction while capital dividends (7) received from a private Canadian corporation are included in net accounting income, they are not taxable so they can be deducted when determining net income for tax purposes
• • •
The table below includes a sample Reconciliation of Accounting Income to Net Income for Tax Purposes for Sidebar Inc. Sidebar’s net income for tax purposes is $384,050, even though its net accounting income was only $225,000. Reconciliation of Accounting Income to Net Income for Income Tax Purposes for Sidebar Inc. For the year ended December 31st Net income (loss) per financial statements Add: (3) Income tax provision $175,000 (1) Depreciation expense 35,250 (6) Charitable donations 4,000 (5) Taxable capital gains 10,500 (4) Interest and penalties on income taxes 2,300 Deduct: (Accounting) gain on disposal of assets (2) Capital cost allowance (7) Dividends not taxable under section 83 Net income for income tax purposes $21,000 32,000 15,000 (68,000) $484,050 $325,000
227,050
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Income Tax Planning
Exercise: Reconciling Accounting Income to Net Income
Calculating Taxable Income
Next, we have to calculate taxable income from net income for income tax purposes. We do this by making a number of deductions, as shown in the table below. Explanations of the deductions follow the table. For the year ended December 31st Net Income for income tax purposes (from Net Income for Income Tax Purposes table) Deduct: Charitable Donations (1) (maximum 75% of net income) Taxable Dividends
(2) (3)
$484,050
$4,000 2,000 13,000 3,000 (22,000) $462,050
Applicable loss of prior taxation years - Non-capital losses (4) - Net capital losses (5) Taxable income
(1) Charitable donations: the donations are less than 75% of net income, so we can deduct the entire amount.
(2) Dividends not taxable: regular taxable dividends received by a Canadian corporation from another Canadian corporation are not subject to Part I tax, so we can deduct them to arrive at taxable income (ITA 112).
(3) Applicable losses from prior taxation years: any losses carried forward from previous years can be deducted to reduce taxable income.
(4) Non-capital losses: primarily relate to business or property losses (i.e., rental losses) that were incurred in previous years and that have been carried forward to be deducted from taxable income in a future year.
(5) Net capital losses: arise when the losses incurred upon the sale of some of the corporation’s capital property exceed the capital gains realized upon the sale of other capital property. If the corporation cannot make use of a net capital loss in the current year, it can carry it forward and deduct it from taxable income in a future year.
Exercise: Calculating Taxable Income
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Corporations
Calculating Tax Payable
Basic federal corporate tax rate The basic federal rate on corporate income is 38% (ITA 123(1)). Effective 2008, the federal surtax of 1.2% which has been in place since 1996, has been eliminated. General rate reduction A general rate reduction1 is applied to any portion of full-rate taxable income for the taxation year (ITA 123.4(1), "general rate reduction"). Full-rate taxable income is income that does not receive any other form of preferential treatment under the Income Tax Act (e.g. small business deduction) (ITA 123.4(1), "full rate taxable income"). The general rate reduction provides the corporation with tax relief on income that would otherwise be subject to the full tax rate. The general rate reduction is prorated where the fiscal year-end falls within the calendar year. As per Budget 2006 and the 2007 federal Economic Statement, the aim of the government is to reduce corporate taxes to 15% by 2012 through annual tax reductions. In keeping with this plan, the general rate reduction rate has been incrementally increased in recent years such that effective 2009, it stands at 9%. Further increases of the general rate reduction percentage will take place in the years that follow. Given that manufacturing and processing income, investment income earned by a Canadian controlled private corporation (CCPC), income that is eligible for the small business deduction or income that is eligible for the accelerated general reduction are eligible for other types of reductions, the general rate reduction cannot be claimed (i.e. they are not sources of full-rate taxable income). Total Tax Payable for Sidebar Inc. For the Year Ended December 31st (ignoring the Small Business Deduction) Taxable Income (from the Calculating Taxable Income table) Tax at 38% Deduct: General rate reduction (1) in 2008: 8.5% [$462,050 x 8.5%] Federal tax abatement 10% (2) [$462,050 x 10%] Federal tax payable [$175,579 - $39,274 - $46,205] Provincial tax payable 10% of taxable income (3) [$462,050 x 10%] Total combined tax payable
(4)
$462,050 $175,579
($39,274) (46,205) $90,100 $46,205 $136,305
[$90,100 + $46,205]
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Income Tax Planning
Exercise: Calculating Tax Payable
Taxation Year
A corporation’s taxation year or fiscal year is a period of no more than 53 weeks at the end of which the corporation closes its books and determines a profit or loss for tax purposes. The company may arbitrarily select its fiscal year or taxation year when it is first incorporated, provided that no fiscal year exceeds 53 weeks. Once established, the fiscal period can only be changed with the consent of the Minister of National Revenue. The selection of a fiscal period that does not coincide with the calendar year can offer some tax deferral opportunities. The income paid out by a corporation as dividends is taxable to the receiving shareholder, who is an individual, in the calendar year in which it is received, which may or may not reflect the time period in which the profits were earned by the corporation. Bigwig Enterprises’ most recent fiscal year ran from January 15th of last year to January 14th of this year. During that time, it had after-tax profits of $1.2 million. At the end of its fiscal year, it declared a dividend to be payable on March 31st. As the major shareholder, Tony will receive $1 million in dividends. Although the dividends result from income that, for the most part, was earned by Bigwig last year, Tony does not have to include them in his taxable income until this year. Tony has realized a deferral of personal tax of almost one year. By comparison, had he received the income as employment income last year, instead of dividends this year, this income would have been taxable in the year it was received.
Canadian Corporations
A Canadian corporation is a corporation resident in Canada. The question of residence is important in determining whether a corporation is eligible for tax deductions such as the small business deduction. A taxable Canadian corporation is a Canadian corporation that is not exempt from tax. Exempt corporations include municipal and provincial corporations, registered charities, and certain non-profit corporations. The dividend gross-up and tax credit scheme is only available for dividends paid by a taxable Canadian corporation.
Taxation of Dividends
After a corporation pays tax on its net income, the directors decide how much of the aftertax income to distribute to shareholders in the form of dividends. Even though this income has already been taxed to the corporation, the dividends are also taxable to the shareholder. While this may sound like double taxation, the Income Tax Act imposes a scheme involving a dividend gross-up and tax credit (DTC) to mitigate the double taxation to some extent.
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Corporations Dividend gross-up and tax credit scheme The dividend tax credit depends on the kind of corporation paying the dividend. Canadian-controlled private corporation (CCPC) Dividends received from a Canadian-controlled private corporation (CCPC), to the extent that its income is taxable at the small business rate or is from a CCPC's investment income, are treated differently than dividends received from large public corporations. A Canadian-controlled private corporation (CCPC) is a Canadian corporation that is not controlled directly or indirectly by one or more non-residents or public corporations. This description fits most Canadian incorporated small businesses. Only CCPCs are eligible for the small business deduction. An individual who receives a dividend from a CCPC must include 125% of that dividend in taxable income for the year. This is referred to as the dividend gross-up. However, he or she can then claim a federal dividend tax credit of 13 1/3 % of the grossed-up dividend. A corresponding provincial dividend tax credit can also be claimed. Enhanced dividend tax credit Following the May 2006 federal budget, an enhanced dividend tax credit was introduced for dividends received after 2005 from: • • • public corporations resident in Canada other corporations resident in Canada that are not Canadian-controlled private corporations (CCPCs) and are subject to the general corporate tax rate CCPCs resident in Canada to the extent that their income is subject to tax at the general corporate tax rate, i.e. active business income above the small business deduction limit
With the enhanced dividend tax credit, 145% of the dividend received will be included in income. The result is a federal tax credit of approximately 18.97% *18.9655% is the exact percentage) of the taxable (grossed-up) dividend. Dividends received for which the enhanced dividend tax credit may be applied are referred to as eligible dividends. The provinces have their own corresponding enhanced dividend tax credit.
Exercise: Taxation of Dividends
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Income Tax Planning
Example: Enhanced Dividend Tax Credit
Example of Enhanced Dividend Gross-up and Credit Mechanism for Eligible Dividends received from a Public Corporation Assume you receive $100 in eligible dividends from a large public Canadian corporation. Other assumptions: Federal tax rate Federal dividend tax credit Provincial tax rate Provincial dividend tax credit 29.00% 18.97% 11.16% 6.50%
Illustration of tax paid on $100 of eligible dividend income Dividend received $100.00 Taxable dividend ($100 x 145%) $145.00 Federal income tax ($145 x 29%) $42.05 Less dividend tax credit ($145 x 18.97%) ($27.51) Net federal tax on $100 dividend $14.54 Provincial tax ($145 x 11.16%) Less provincial dividend tax credit ($145 x 6.50%) Net provincial tax on $100 dividend Total tax payable (provincial + federal) $16.18 ($9.43) $6.75 $21.29
Example: Taxation of Dividends
To illustrate the concepts in this section, we will use the example of two individuals, George and Sally, who are two of the shareholders of Sidebar Inc., a taxable Canadian corporation. George and Sally are Canadian residents, and the corporation has a fiscal year-end of December 31st. George and Sally will receive identical cash dividends that result from before-tax corporate profits of $10,000 per shareholder. Remember that dividends are paid from the corporation's after-tax income, so George and Sally will receive less than $10,000 in dividends. Assuming Sidebar Inc. can claim a general rate reduction of 9%, its corporate tax rate is 29%, calculated as (basic federal corporate tax rate - general rate reduction) or (38% 9%). If the corporation has before-tax profits of $10,000 per shareholder, the after-tax profits that can be distributed as dividends will be $7,100 per shareholder, calculated as [corporation's taxable income x (1- corporate tax rate)] or [$10,000 × (1 - 29%)]. If George receives a dividend of $7,100 from a taxable Canadian corporation, he will have to include $8,875 in his income, calculated as (cash dividend x gross up) or ($7,100 × 125%). He can then claim an offsetting federal tax credit of $1,183, calculated as (grossed-up dividend x federal dividend tax credit) or ($8,875 × 13 1/3%). This calculation also applies to Sally. George has a marginal tax rate of 21.05%, calculated as (federal marginal tax rate + provincial marginal tax rate) or (15% + 6.05%). Sally has a marginal tax rate of 43.7%, calculated as (federal marginal tax rate + provincial marginal tax rate) or (29% + 14.7%).
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Corporations The federal marginal tax rates for each individual (i.e. 15% for George; 29% for Sally) represents the lowest and highest marginal tax rates to which a taxpayer is subject. The provincial dividend tax credit in this province is 5.10% of the grossed-up dividend. If they both received the same cash dividend, the difference in the combined corporate and personal tax impact would be as shown in the table below. Remember that we said there is a certain level of integration between the individual and corporate tax systems to prevent or at least reduce double taxation. The success of the integration depends on the marginal tax rate of the individual taxpayer, and whether the corporation can make use of the small business deduction. The following table illustrates this point by comparing how much George and Sally will have left after all taxes are paid if they earn $10,000 directly, or if that same $10,000 is earned through a corporation that passes its after-tax profits on to its shareholders in the form of dividends. At this point, we will assume that the small business deduction is not available. In the case of both George and Sally, the tax burden is still significantly higher if they earn this income through the corporation instead of earning it directly. Although George's marginal tax rate is only 21.05%, by the time he receives the income through the corporation, it will essentially be taxed at a rate of 31.32%, calculated as [(income earned – amount remaining after tax) ÷ income earned] or (($10,000 $6,867.77) ÷ $10,000). Similarly, although Sally's marginal tax rate is 43.70%, the income she receives through the corporation is essentially taxed at a rate of 51.42%, calculated as [income earned – amount remaining after tax) ÷ income earned] or [($10,000 - $4,857.58) ÷ $10,000). After-tax income for income earned directly, compared to that same income flowing through a Corporation without using the Small Business Deduction Corporation George earns earns $10,000; $10,000 George directly receives after-tax profit
Marginal tax rate (federal rate + provincial rate) Income initially earned by corporation Income initially earned directly by taxpayer Less: corporate tax rate: 29% Equals: actual cash dividend Taxable / grossed-up dividend [cash dividend x 125% gross-up] Federal Tax: @ 15% [taxable dividend x 15%] @ 29% [taxable dividend x 29%] $ 1,331.25 n/a $ 1,500.00 n/a n/a $ 2,573.75 n/a $ 2,900.00 21.05% 21.05%
Corporation Sally earns earns $10,000; $10,000 Sally directly receives after-tax profit
43.70% 43.70%
$10,000.00 n/a ($ 2,900.00) $ 7,100.00 $ 8,875.00
n/a $10,000.00 n/a n/a n/a
$10,000.00 n/a ($ 2,900.00) $ 7,100.00 $ 8,875.00
n/a $10,000.00 n/a n/a n/a
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Income Tax Planning
Less: federal dividend tax credit [taxable dividend x 13 1/3%] Equals: basic federal tax Plus: provincial tax: @ 6.05% [taxable dividend x 6.05%] @ 14.70% [taxable dividend x 14.70%] Less: provincial dividend tax credit [taxable dividend x 5.10%] Equals: basic provincial tax
($ 1,183.33) $ 147.92
n/a $ 1,500.00
($ 1,183.33) $ 1,390.42
n/a $ 2,900.00
$
536.94 n/a
$
605.00 n/a
n/a $ 1,304,63
n/a $ 1,470.00
($ $
452.63) 84.31 $
n/a 605.00
($ $
452.63) 852.00
n/a $ 1,470.00
Total tax payable [federal tax + $ 232.23 $ 2,105.00 $ 2,242.42 $ 4,370.00 provincial tax] Amount remaining after tax $ 6,867.77 $ 7,895.00 $ 4,857.58 $ 5,630.00 [cash dividend or income – total tax payable] Combined corporate and 31.32% 21.05% 51.42% 43.70% individual tax rate [(initial cash dividend or income – amount remaining after tax) ÷ initial cash dividend or income]
So, the dividend gross-up and tax credit (DTC) scheme does not result in true integration if the corporate profits are taxed at 29%. Better integration is achieved if the corporation is eligible for the small business deduction, as discussed shortly.
Claiming the Small Business Deduction (SMABUD)
The combined federal and provincial corporate tax rate can be reduced in certain circumstances by making use of what is called the small business deduction. A corporation’s ability to make use of this deduction depends on the type of corporation and the source of its income. Public vs. private corporations Only certain private corporations are eligible for the small business deduction. It is never available to public corporations. Sleeman’s started out as a family-run microbrewery that took the form of a private corporation. As a result, it was able to make use of the small business deduction. However, when Sleeman’s went public in order to raise capital for expansion, it could no longer make use of the small business deduction. Canadian-controlled private corporations A Canadian-controlled private corporation (CCPC) is a Canadian corporation that is not controlled directly or indirectly by one or more non-residents or public corporations. This description fits most Canadian incorporated small businesses. Only CCPCs are eligible for the small business deduction.
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Corporations Bob is one of four shareholders in Bella Industries Ltd. Bella is not listed on any stock exchange and is considered to be a private corporation. However, one of the shareholders who owns 55% of the shares is a resident of the United States, not Canada, so Bella cannot take advantage of the small business deduction.
Types of Income Eligible for SMABUD
In deciding that some corporations should be eligible for special tax treatment, parliament also decided to restrict the treatment of income from certain types of corporate activities. The three types of corporate business income defined by ITA 125(7) are: • • • active business income income of a specified investment business income of a personal services business
Active business income An active business is any business carried on by a corporation other than a specified investment business or a personal services business (these will be discussed shortly) and it includes an adventure in the nature of trade (ITA 248(1)). Active business income includes any income pertaining to or incident to an active business, but does not include income from property (e.g. interest, dividends, rents and loyalties). This definition is very important, because a certain amount of active business income earned by a CCPC is eligible for the small business deduction, such that it is taxed at a federal rate of approximately 11% (ITA 125(1)). Specified investment business income A specified investment business is a business (other than a credit union or lessor of property other than real property) whose principal purpose is to derive income from property (including interest, dividends, rents or royalties), unless: • • the corporation employs more than five, full-time employees the corporation makes use of certain managerial or administrative services provided by an associated corporation, and the first corporation could have reasonably been expected to require more than five, full-time employees if those services had not been provided (ITA 248(1), 125(7))
Because the definition of an active business specifically excludes a specified investment business, specified investment income is not eligible for the small business deduction (ITA 125(7)). Personal services business income A personal services business refers to services that are provided by a specified shareholder of a corporation (or a relative of that specified shareholder) to another entity, such that the specified shareholder would have otherwise been deemed to be an employee of that entity if the corporation did not exist (ITA 248(1), 125 (7)). Since the definition of an active business specifically excludes a personal services business, personal service income is not eligible for the small business deduction and thus, it must be taxed at full corporate rates (ITA 125(7)). Any deductions for expenses other than salary,
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Income Tax Planning wages, and other remuneration paid to the individual who performs the services are disallowed. Hercules expects the Toronto Blue Jays to offer him a new contract for $14 million over three seasons. Hercules hates paying income tax, so he was looking for ways to reduce his tax liability. He decided to establish The Amazing Hercules Corporation (AHC), and have AHC enter into a contract with the Blue Jays for Hercules’ services. Hercules would be the majority shareholder, but he also decided to let his brother, sister, and mother each hold a 5% interest in AHC. Unfortunately for Hercules, according to the Income Tax Act, the $14 million over three years will be deemed to be income from a personal services business and it will not be eligible for the small business deduction. An exception to the personal services business rule occurs if the corporation employs more than five full-time employees including specified shareholders, or where the services are provided to an associated corporation. A single corporation could be carrying on a specified investment business or a professional services business along with an active business. Accordingly, the income of a Canadiancontrolled private corporation (CCPC) can be divided into several different categories: • • • • • • active business income from a business carried on primarily in Canada and eligible for the small business deduction income from a specified investment business income from a personal services business other investment income dividend income other income subject to tax at full rates with no special tax advantages
Rules and Limits Pertaining to SMABUD
The small business deduction (SMABUD) is a deduction that is available to Canadiancontrolled private corporations under ITA 125 for the purpose of reducing the tax payable on active business income between $200,000 and $500,000, depending on the taxation year. The following limits for active business income apply: Year before 2003 2003 2004 2005 and 2006 2007 and 2008 2009 SMABUD Limit $200,000 $225,000 $250,000 $300,000 $400,000 $500,000
This deduction is not restricted to small businesses, so the name is slightly deceptive. All corporations calculate their tax at the full basic federal tax rate on their entire income and then qualifying corporations claim a deduction on qualifying income as a tax reduction on federal tax otherwise payable. Therefore, the small business deduction is not calculated as a lower rate of tax on a specified amount of active business income.
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Corporations
The small business deduction recognizes the special financing difficulties and the higher cost of capital faced by small businesses and is intended to provide these corporations with more after-tax income for re-investment and expansion. Because the small business deduction is intended to benefit only small corporations, a large corporation's access to the deduction is restricted on the basis of its taxable capital employed in Canada. The small business deduction is phased out where corporate capital exceeds $10 million and it is eliminated where corporate capital exceeds $15 million. However, this does not mean that it cannot be used by some large businesses that have sufficiently low corporate capital with a large number of employees and a large corporate income, but then it will still be limited to the appropriate amount of active business income. In brief, the SMABUD rules are as follows: • • Only active business income earned in Canada by a Canadian-controlled private corporation qualifies for the deduction. Active business income includes the corporation's share of net active business income (or loss) from an active business carried on in Canada by a partnership of which the CCPC is a member. The annual maximum amount of active business income eligible for the small business deduction is $500,000 effective January 1, 2009. Associated corporations must share the annual business limit.
• •
Doublet Inc. is a CCPC with active business income from its own activities of $510,000. Doublet Inc. also holds a 50% interest in a partnership with Glovewear Corp., and a 25% interest in a partnership with Socks R Us Inc. The partnership with Glovewear had net active business income of $120,000, while the partnership with Socks R Us had a net loss from business activities of $44,000. Doublet's active business income for the purpose of calculating the small business deduction is $559,000, calculated as [Doublet's business income + (Glovewear's income x Doublet's interest in Glovewear + Socks R Us' business income x Doublet's interest in Socks R Us)] or [$510,000 + ($120,000 × 50%) - ($44,000 × 25%)]. Since Doublet has income that exceeds the small business deduction limit, Doublet will only be able to use the small business deduction on the first $500,000 of its total active business income. Associated corporations Two or more corporations are considered to be associated corporations if, at any time in the taxation year: • • • one corporation controlled the other corporation both of the corporations were controlled by the same person or group of persons the people or group of people who control each corporation were related to each other and at least one of them owns at least 25% of the shares in both corporations (ITA 256(1))
Associated corporations must share the annual business limit but they are free to negotiate how that limit is to be shared between them. The Income Tax Act does not impose a sharing formula.
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Income Tax Planning
Jeff, Lisa, and Aiden are siblings. Jeff owns 70% of Spicetrail Inc., while Lisa owns 30% of that company. Lisa owns 60% of Polarcap Limited, while Jeff owns 30% and Aiden owns 10%. Aiden owns 100% of Allicorp. Spicetrail and Polarcap are associated corporations because Jeff and Lisa are related, they each control one company (Jeff controls Spicetrail and Lisa controls Polarcap) and they each own at least 25% of the other corporation. Spicetrail and Polarcap will have to come to an agreement as to how they will share the small business deduction. Allicorp is not associated with either Spicetrail or Polarcap because Aiden's cross-ownership is less than 25%.
Calculating the Small Business Deduction
As per Budget 2006 and the 2007 Economic Statement, the small business deduction (SMABUD) rate was increased from 16% to 17% of eligible income, where eligible income is the lesser of • • • active business income taxable income the small business deduction limit currently set at $500,000
This reduces the net federal tax rate after the 10% abatement to 11%, calculated as (basic federal corporate tax rate – federal abatement – small business deduction) or (38% - 10% 17%). Provincial taxes – which vary depending on the jurisdiction -- then increase the tax rate typically by 10%, resulting in a total combined provincial and federal corporate tax rate of approximately 21%, calculated as (11% + 10%). Clearly, this is much more attractive to a corporation compared to having all of its income taxed at the full corporate rate of 38% or even the corporate rate of 29% if the 9% general rate reduction is taken into account. Armor and Sword Inc. is a CCPC; it had net income for federal income tax purposes in the amount of $565,000. All of the income it earns qualifies as active business income. Keeping in mind that the small business deduction only applies on the first $500,000 of active business income, to minimize Armor and Sword's tax liability, the owners should consider ways to reduce any active business income in excess of the small business deduction limit.
Reducing the active business income below the SMABD limit
If a corporation has active business income in excess of the annual limit, it may want to consider ways of reducing the amount of active business income. Payments that can reduce corporate income include those that result in expenses for the year: • • • • • bonuses and salaries deferred profit sharing plan (DPSP) contributions registered pension plan (RPP) contributions corporate-paid RRSP contributions deductible employee benefit programs
Assume the owners of Armor and Sword Inc. managed to reduce the company's active business income to $485,000 by paying out bonuses and making DPSP contributions to its employees. After making use of the SMABUD, the basic federal tax payable for Armor and Sword Inc. would be calculated as follows:
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Corporations Revised Basic Federal Tax Payable for Armor and Sword Inc. For the Year Ended December 31st Net Income for income tax purposes Deduct: Charitable donations Taxable dividends Applicable loss of prior taxation years - Non-capital losses - Net capital losses Taxable income Federal corporate tax @ 38% Deduct: Small Business deduction, calculated as 17% of the lesser of • active business income: $485,000 • taxable income: $463,000 and • SMABUD limit: $500,000 Federal taxable abatement of 10% of taxable income Federal tax payable (ignoring surtaxes) Provincial tax payable at 10% of taxable income Total tax payable Federal tax rate [federal tax payable ÷ taxable income] Combined federal and provincial tax rate [ total tax payable ÷ taxable income] $485,000
$4,000 $2,000 $13,000 $3,000 $22,000 ($22,000) $463,000 $175,940
($78,710)
($46,300) $50,930 $46,300 $97,230 11% 21%
Exercise: The Small Business Deduction
Combined Corporate and Individual Tax Burden for a CCPC
The combined corporate and individual tax burden for a CCPC with all of its active business income eligible for SMABUD is shown in the table below. Taxable income in excess of the annual limit is not eligible for the SMABUD, so it is taxed at 38% less any general rate reductions that apply.
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Income Tax Planning In the table below, we revisit the situation of George and Sally introduced earlier in this lesson (Example: Taxation of Dividends), This time however, George and Sally receive their dividends resulting from corporate income that is fully eligible for SMABUD. As illustrated in the table, the combined corporate and personal tax rate is very close to the marginal rate of income tax that the individuals would pay if they earned the income directly. So, the dividend gross-up and tax credit scheme does result in almost perfect integration of corporate and individual taxes for CCPCs with active business income under SMABUD active income limit. For public corporations, and for CCPCs with active business income over the annual limit or other ineligible forms of income, the scheme provides some tax relief, but certainly not true integration. After-tax income for income earned directly, compared to that same income flowing through a Corporation while making use of the Small Business Deduction
Corporation earns $10,000; George receives aftertax profit Marginal tax rate (federal 21.05% rate + provincial rate) George earns $10,000 directly Corporation Sally earns earns $10,000 $10,000; directly Sally receives after-tax profit 43.70% 43.70%
21.05%
Income initially earned by $10,000.00 n/a $10,000.00 n/a corporation Income initially earned n/a $10,000.00 n/a $10,000.00 directly by taxpayer Less: approximate combined ($ 2,100.00) n/a ($ 2,100.00) n/a federal and provincial corporate tax rate factoring in SMABUD: 21% Equals: actual cash dividend $ 7,900.00 n/a $ 7,900.00 n/a Taxable / grossed-up $ 9,875.00 n/a $ 9,875.00 n/a dividend [cash dividend x 125% gross-up] Federal Tax: @ 15% [taxable dividend x $ 1,481.25 $ 1,500.00 n/a n/a 15%] n/a n/a $ 2,863.75 $ 2,900.00 @ 29% [taxable dividend x 29%] Less: federal dividend tax ($ 1,316.67) n/a ($ 1,316.67) n/a credit [taxable dividend x 13 1 /3%] Equals: basic federal tax $ 164.58 $ 1,500.00 $ 1,547.08 $ 2,900.00 Plus: provincial tax: @ 6.05% [taxable dividend x 6.05%] @ 14.70% [taxable dividend x 14.70%] $ 597.44 n/a $ 605.00 n/a n/a $ 1,451.63 n/a $ 1,470.00
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Corporations
Less: provincial dividend tax credit [taxable dividend x 5.10%] Equals: basic provincial tax
($
503.63)
n/a
($
503.63)
n/a
$
93.82
$
605.00
$
948.00
$ 1,470.00
Total tax payable [federal tax + provincial tax] Amount remaining after tax [actual cash dividend or income (i.e. $7,900) – total tax payable] Combined corporate and individual tax rate [(cash dividend or income (i.e. $10,000) – amount remaining after tax) ÷ cash dividend or income]
$
258.40 $ 2,105.00 $ 2,495.08 $ 4,370.00
$ 7,641.60 $ 7,895.00 $ 5,404.92 $ 5,630.00
23.58%
21.05%
45.95%
43.70%
For more information on SMABUD, refer to IT-73R5, The Small Business Deduction.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Corporate Taxation 1. In this lesson, you have learned how to do the following: • • explain a corporation’s accounting requirements describe and calculate corporate tax elements such as dividends and deductions
If you are ready to move to the next lesson, click Corporate Taxation 2 on the table of contents.
Assessment
Now that you have completed Corporate Taxation 1, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 6: Corporate Taxation 2
Welcome to Corporate Taxation 2. In this lesson, you will learn about corporate tax elements such as tax advantages for the owner/manager as well as the process for filing a tax return. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • • calculate and describe corporate tax elements such as tax advantages for the owner/manager, tax shelters, and dividend income describe the process for filing a corporate tax return
Tax Advantages for the Owner/Manager
We have seen that the first portion of active business income up to the annual limit of a CCPC paid out to the shareholders as dividends is taxed at the same rates as if the income were earned directly by the shareholders. It sounds like the owner/manager would be in the same tax position regardless of whether he or she earned his or her business income within a corporation or directly through a sole proprietorship. However, the CCPC does offer the owner/manager several important tax advantages, including the potential for tax deferral and the potential to make use of the capital gains exemption for shares of qualified small business corporations.
Tax Deferral
If the owner/manager draws an employment salary, this amount is deducted from the corporation’s business income and is fully taxable to the taxpayer. The taxpayer could then use the after-tax amount to meet his or her living expenses or he or she could invest it outside of the corporation. Jack is the owner/manager of Troopers Ltd., a small business corporation, and he is already in a 50% marginal tax bracket without even considering any potential income from Troopers. Jack expects Troopers to earn business income of $100,000 this year. If Troopers pays Jack a salary of $100,000, the corporation will not have any taxable income, but Jack will pay tax of $50,000, calculated as (Jack's salary x marginal tax rate) or ($100,000 × 50%). Jack can invest the remaining amount of $50,000, calculated as (salary - tax paid) or ($100,000 - $50,000). However, if the owner/manager did not need the employment income, he or she could leave the income in the corporation. In this case, the business income would initially be taxed in the corporation at a rate of 19% calculated as (basic federal corporate tax rate – general rate reduction – federal tax abatement) or (38% – 9% – 10%). The corporation could then use the after-tax funds for business or investment purposes. Jack does not need any more employment income, so he could elect to leave the business income in the corporation. In this case, the corporation would pay tax of about $19,000, calculated as (business income x corporate tax rate) or ($100,000 × 19%). The corporation would then have $81,000 left to invest, calculated as (business income corporate income tax)) or ($100,000 - $19,000).
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Corporations
Eventually, the owner/manager could receive some of the retained earnings as dividends, which would be subject to the dividend gross-up and tax credit scheme. Investment income earned by a CCPC If the retained earnings are invested in a portfolio of securities, the resulting investment income is not active business income. As investment income earned by a CCPC, it is not eligible for the new general rate reduction, so it will be taxed at the federal corporate rate of 38% plus an additional tax on investment income of 62/3% (discussed later), less the 10% federal abatement. This will not provide further opportunities for tax deferral. Also, the corporation may then be subject to Part IV refundable tax, which will be discussed shortly.
Capital Gains Exemptions for Qualified Small Business Corporations
Instead of eventually receiving dividends, the owner/manager may be better off allowing the profits to be credited to the corporation’s retained earnings account, thereby building up the corporation’s equity and increasing the value of the shares of the owner/manager. When he eventually sells his shares in the business, the income is converted into capital gains and only 50% of such gains are taxable. Suppose Jack, as the sole owner, started Troopers Ltd. with an initial capital investment of $10,000, which is his adjusted cost base (ACB). Furthermore, for the last four years, Jack has not drawn a salary, leaving Trooper with significant funds to invest in the business, such that at the end of this year, Trooper will be worth $800,000. If Jack sells his shares in Trooper for its fair market value (FMV), he will have a capital gain of $790,000, calculated as (proceeds of sale - ACB) or ($800,000 - $10,000), and a taxable capital gain of $395,000, calculated as (capital gain x capital gains inclusion rate) or ($790,000 × 50%). Furthermore, he may be able to shelter all or part of his capital gain by making use of the capital gains exemption available to owners of qualifying Canadian small business corporations. Lifetime capital gains exemption limit Click the icon below to view the Capital Gains Exemption for Qualified Small Business Corporations.
The Income Tax Act provides relief for taxpayers who dispose of qualified property, including shares of a qualified small business corporation, in terms of a capital gains deduction that can exempt up to $500,000 of eligible capital gains from tax up to a specific threshold over the life of the taxpayer. Following Budget 2007, the lifetime capital gains exemption on qualified property was increased from $500,000 to $750,000.
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Income Tax Planning
The Johanson Example
Erik Johanson is the owner/manager of a qualified small business corporation and the business just had a tremendous year with after-tax profits of $200,000. Mr. Johanson has already received a salary from the corporation, and he does not want to receive any more than $100,000 in dividend income. He is unsure about what to do with the remaining $100,000 of after-tax profits. He decides to leave it in the corporation as retained earnings. As director, he can always declare dividends to be payable at some future time, or he can allow the retained earnings to build up the equity of the company. Prior to this year, Mr. Johanson held all of the 1,000 shares in the corporation and they were worth $40 each, so the total equity in the business was $40,000, calculated as (value of shares x number of shares) or ($40 × $1,000). His adjusted cost base for the shares was only $5 each, or $5,000 in total, calculated as (ACB per share x number of shares) or ($5 x 1,000). By allowing the corporation to keep after-tax profits of $100,000 to be used in the business, Mr. Johanson has increased the equity in the company to $140,000, and the value of his shares to $140 each, calculated as ((retained earnings + previous equity) ÷ number of outstanding shares) or (($100,000 + $40,000) ÷ 1,000). If he could sell the business at this point in time, he would realize a capital gain of $135,000, calculated as (FMV - ACB) or ($140,000 - $5,000). Mr. Johanson never made use of the $100,000 personal lifetime capital gains exemption while it was available; nor has he ever claimed an exemption with respect to qualified property. Thus, Mr. Johanson would be able to use the $750,000 capital gains exemption on qualified property, which includes shares in a qualified small business corporation, to eliminate the entire capital gain that he would otherwise realize upon the sale of his business. This obviously represents a significant tax saving for Mr. Johanson and it illustrates one of the main tax advantages of being the owner/manager of a corporation. Many small family-run businesses currently are qualified small business corporations or they could be restructured as such. Shareholders in these companies may be able to make use of the $750,000 lifetime capital gains exemption.
Other Advantages
As the owner/manager, an individual may be able to receive other tax advantages by directing the corporation to: • • make corporate contributions to deferred income plans such as registered pension plans (RPPs) pay for private health and group dental plans
Corinne owns and operates an incorporated financial planning practice. Through the corporation, she established an individual pension plan (IPP), and this allows her to make larger tax-deductible contributions to her retirement savings than if she was simply contributing to a personal RRSP. She may also be able to benefit from the personal use of a company car.
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Corporations
Exercise: Tax Advantages for the Owner/Manager
Dividend Income Received by a Corporation
We have discussed how a corporation receives special treatment on some of its active business income, but special treatment also applies to dividend income received by a corporation. Part I tax Dividends received by a corporation are included in its income, but unlike dividends received by an individual, when a corporation receives dividends there is no gross-up or dividend tax credit. However, dividends received from other taxable Canadian corporations, from corporations resident in Canada and controlled by the receiving corporation, and from certain non-resident corporations may then be deducted in computing the taxable income of the recipient corporation (ITA 112(1)). This means that in effect the recipient corporation does not have to pay ordinary income tax (referred to as Part I tax because it falls under Part I of the Income Tax Act) on the dividends and they pass tax free from one taxable corporation to another. However, private corporations may be subject to certain special refundable taxes on certain dividends received, discussed under the heading of Part IV tax. A corporation is generally not permitted to deduct dividend income from its taxable income if the corporation paying the dividend was not subject to Canadian tax. Conversely, if the corporation issuing the dividend was not subject to Canadian tax, the dividend will be subject to Part I tax when received by a Canadian corporation. Americo, an American corporation that is not subject to Canadian tax, paid dividends to Canco, a Canadian corporation subject to Canadian tax. Canco will not be able to deduct the dividends from its income and as a result, they will be subject to Part I tax.
Part IV Tax
ITA 186(1) includes provisions for a special tax, referred to as Part IV tax because it falls under Part IV of the Act, in the case of certain sources of dividend income. The purpose of Part IV tax is to discourage shareholders of private corporations from deferring or postponing tax by leaving dividend income from portfolio investments in the corporation. Portfolio investments are investments in a portfolio of stocks and bonds as opposed to the shares of a connected corporation, as defined shortly. Calculating Part IV tax The Part IV tax is calculated as 331/3% of dividends from portfolio investments (ITA 186(1)).
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Income Tax Planning Samples Incorporated, a taxable CCPC, had after-tax profits of $800,000. Instead of paying out any dividends, the profits were added to Samples Inc.’s retained earnings and the funds were invested in a variety of common shares of several taxable Canadian corporations that were unrelated to Samples Inc. Last year, Samples Inc. received dividends of $60,000 from those investments. Samples Inc. will not have to pay any Part I tax on those dividends, because they were received from taxable Canadian corporations. However, if it retains those dividends without passing them on to its shareholders, it will have to pay Part IV tax of $20,000, calculated as (dividend income x 331/3%) or ($60,000 × 331/3%). Refundable dividend tax on hand (RDTOH) account The amount of Part IV tax payable is credited to a notional tax account called refundable dividend tax on hand (RDTOH). When the corporation pays taxable dividends to its shareholders, the tax is refunded to the corporation at the rate of $1 for every $3 of dividends paid up to the balance in the RDTOH account (ITA 129(1)). When Samples Inc. keeps the dividends, it must pay Part IV tax of $20,000, and this amount is credited to the RTDOH account. If Samples Inc. now pays out $60,000 in dividends to its shareholders, it can receive a refund of $20,000, calculated as (dividends paid ÷ 3) or ($60,000 ÷ 3). Importance of Part IV tax The Part IV tax is very important because it means that an individual cannot make his or her portfolio investments through a corporation and receive a tax advantage on the taxation of the investment income. Fortunately, this scheme only prevents the deferral of tax on what are portfolio investments and not active business income or most dividends paid between connected corporations, as defined in the next section.
Connection Between Paying and Receiving Corporations
In order to determine whether Part IV tax applies, the first question to answer is whether the paying corporation is connected with the receiving corporation. The two corporations are deemed to be connected if, at the particular time in a taxation year of the recipient corporation: • • the payer corporation was controlled by the recipient corporation the recipient corporation owned more than 10% of the payer corporation (as measured by specific rules (ITA 186(4))
In the context of determining whether two corporations are connected for the purpose of determining Part IV tax, a corporation is controlled if more than 50% of its voting shares are held by another corporation or by persons with whom the other corporation does not deal at arm’s length (ITA 186(2), (4)).
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Corporations Part IV tax is levied as follows: • • where the recipient corporation is not connected, the recipient corporation must pay the 331/3% tax on the full dividend received where the recipient corporation is connected, the recipient corporation must pay the 331/3% tax to the extent that the payer corporation was entitled to a refund of Part IV tax as a result of paying the dividend
Top Dog Inc. owns 50% of PetPro Corp. PetPro has previously used some of its retained earnings to make a number of portfolio investments. Last year PetPro earned dividend income on those investments of $40,000. PetPro paid Part IV tax of $13,333, calculated as (dividend income x 331/3%) or ($40,000 × 331/3%) and this amount was credited to PetPro’s RDTOH account. PetPro subsequently paid dividends of $20,000 to its shareholders and Top Dog received half of this amount, or $10,000. PetPro could claim a refund of the RDTOH on the dividend paid to Top Dog of $3,333, calculated as (dividends paid ÷ 3) or ($10,000 ÷ 3) and the same amount on the dividends paid to its other shareholders. If PetPro does claim this refund, then Top Dog must pay Part IV tax of $3,333 on the dividend that it received from PetPro, calculated as (dividend income x 331/3%) or ($10,000 × 331/3%). If this rule concerning Part IV tax and connected corporations did not exist, corporation A could receive investment dividends from an unconnected corporation B, pay Part IV tax, then pay dividends to a connected corporation C, receive a refund of Part IV tax, and the recipient corporation C would pay no tax. This would allow corporations to avoid paying tax on investment dividends simply by setting up a holding company. Part IV tax on taxable dividends received by a private corporation are explained further in IT-269R3.
RDTOH Carry-forwards
ITA 129(3) was amended in 1995 so that RDTOH is now calculated on an annual basis, with a carry forward of RDTOH from the previous year. In an earlier example, Samples Inc. had to pay Part IV tax of $20,000 and this amount was credited to its RDTOH account. If Samples Inc. chooses not to issue dividends for that taxation year, the balance in the RDTOH account can be carried forward to a future year. So, if Samples Inc. decides to pay a $60,000 dividend next year, it can still make use of the balance in the RDTOH account to receive a refund of $20,000, calculated as (dividends paid ÷ 3) or ($60,000 ÷ 3).
Exercise: Dividend Income Received by a Corporation
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Income Tax Planning
Investment Income, Other than Dividends, Received by CCPCs
There is an additional refundable Part I tax of 6 2/3% on certain investment income, other than deductible dividends, earned by CCPCs (ITA 123.3). The calculation of the income subject to this refundable Part I tax is complex, but generally it includes the sum of: net capital gains plus property income, with some exceptions plus income from a specified investment business minus property losses minus specified investment business losses Mentor Ltd. is a CCPC with total taxable income of $900,000. Over the years, Mentor has invested some of its retained earnings in several portfolio investments, and it also receives some income in the form of rent for sharing its office space with another business. Mentor’s aggregate investment income, not including dividends is $92,000. Mentor must pay an additional refundable Part I tax of $6,133, calculated as (6 2/3% x nondividend investment income) or (6 2/3 % × $92,000) (ITA 123.3). Refer to IT-243R4, Dividend Refund to Private Corporations, for more information.
Refundable Tax
Other investment income received by a Canadian controlled private corporation (including receipts such as rents, royalties, interest and the taxable portion of capital gains, but not dividend income) does not normally qualify as active business income. As such, it is subject to tax at the rate of about 45%, calculated as 38% plus the additional tax of 6 2/3% on investment income. As a result, the combined corporate and individual taxes paid by a shareholder when these earnings are distributed as income would be as high as 63% if the Income Tax Act did not provide for some specific relief for this type of income. A scheme called refundable Part I tax has been developed to provide some relief. The corporation still has to pay Part I taxes of about 45% on all of this other investment income. However, it is then permitted to credit an amount equal to about 26 2/3% of the investment income (the specific formula is complex) to its RDTOH account (ITA 129(3)). If the corporation subsequently pays out taxable dividends, it can claim a refund of $1 for every $3 paid up to the balance in the RDTOH account. The practical effect of this scheme is to reduce the tax on investment income paid by the corporation by about 26% and the total tax burden by up to 13%. Like Part IV tax, the additional tax of 6 2/3 % and the refundable Part I tax mechanism is meant to discourage parking investment income in private corporations, by providing an incentive to pay that income out to shareholders as dividends.
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Corporations Trial Inc., a CCPC, had investment income of $240,000 including interests and rents but excluding dividends. Trial Inc. will have to pay total Part I tax of $107,200, calculated as (investment income x (basic Part I corporate tax rate + additional Part I tax rate on investment income)) or ($240,000 × (38% + 6 2/3%)), but it will be able to credit about $64,000 to its RDTOH account, calculated as (taxable income x 26 2/3%) or ($240,000 × 26 2/3%). Prior to this credit, the balance in Trial's RDTOH account was zero. If Trial pays the after-tax amount of $132,800, calculated as (taxable income - total Part I tax) or ($240,000 - $107,200), to its shareholders, it will receive a refund of $44,267, calculated as (the lesser of (the balance in its RDTOH account and (dividends paid ÷ 3))) or (the lesser of ($64,000 and ($132,800 ÷ 3))). Trial can pay the amount of $44,267 out as dividends in the following taxation year and the payment could give rise to an additional refund at that time as long as there is a balance in the RDTOH account. These dividends will of course be subject to the dividend gross-up and tax credit scheme when they are reported by the receiving individual shareholder.
Using CCPCs as Tax Shelters
We have seen how a corporation can provide a tax advantage for its shareholders through the deferral of income tax as a result of the lower tax rates on active business income earned in a CCPC. This provides shareholders the opportunity to accumulate wealth at a faster rate than they could if income were taxed at their full personal marginal tax rates (MTR). Max is the owner/manager of NewCorp, a CCPC that had active business income of $200,000. If Max has an MTR of 48% and he receives the business income as salary, he will have $104,000 left to invest, calculated as [salary x (1 – marginal tax rate)] or [$200,000 × (1 – 48%)]. If he leaves the money in the company, NewCorp will have $158,000 left to invest, calculated as [business income x (1 – (corporate tax rate – SMABUD rate))] or [$200,000 × (1 – (38% – 17%))]. Assuming in both cases investments earn 10%, at the end of one year, Max would have earned $10,400 if he had received a salary and invested the after-tax amount, calculated as (personal after-tax income x investment return) or ($104,000 × 10%). In contrast, NewCorp could have earned investment income of $15,800, calculated as (corporation's after-tax income x investment return) or ($158,000 × 10%). The table below includes Max and Newcorp's Income Statements. Max & NewCorp Income Statements Max Salary $200,000 (96,000)1 $104,000 $10,400 NewCorp No Salary $200,000 (42,000)2 $158,000 $15,800
Salary/Income Income Tax After-tax income Investment income @ 10%
1 calculated as (salary x marginal tax rate) or ($200,000 × 48%) 2 calculated as (business income x corporate tax rate) or ($200,000 × 22%)
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Public corporations and income other than active business income It is most important to note that the same deferral is not available for public corporations and other types of income, particularly investment income. Ball Bearing Ltd., a public corporation, had business income of $1.2 million, resulting in after-tax income of $852,000, calculated as [business income x (1 - (general corporate tax rate - rate reduction))] or [$1,200,000 × (1- (38% - 9%))]. So, it had $852,000 to invest in portfolio investments or to distribute as dividends. Tax implications For a CCPC, there should not be a significantly different tax burden on investment income earned through a corporation or earned directly by an individual taxpayer due to the RDTOH scheme. Therefore, from a tax perspective, it does not make sense for an individual to take tax-paid capital and invest it in a corporation, which in turn uses the capital to earn investment income. However, holding companies do have benefits apart from taxation, as discussed later.
Exercise: Investment Income Other than Dividends Received by a CCPC
Filing a Corporate Tax Return
The corporation income tax return is called a T2 income tax return, or simply a T2. All corporations other than registered charities must file a T2 for every taxation year, even if there was no tax payable for that year. Revamped corporate filing system CRA has introduced a new reporting format called the General Index of Financial Information, or GIFI, for the purpose of standardizing the reporting of financial statement information. The GIFI assigns a code number to items that are typically reported on financial statements and the corporation must enter all of its information using these codes. This standardized format will improve CRA’s processing efficiency and will also facilitate the introduction of electronic filing of corporate returns. If a corporation files a GIFI with its T2 return, it does not have to submit its financial statements.
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Corporations Filing deadlines Each corporation must file a T2 return within six months of the end of its taxation year. If the return is filed late, the ITA imposes a penalty of 5% of the unpaid tax that is due on the filing deadline, plus 1% of this unpaid tax for each complete month that the return is late, up to a maximum of 12 months. This penalty may increase to 10% plus 2% per month for a maximum of 20 months if: • • CRA issued a demand to file the return in accordance with ITA 150(2) the corporation was assessed a late filing penalty in any of the three previous taxation years (ITA 162(1) and (2))
Payment deadlines Prior to Budget 2007, a corporation usually had to pay income tax in monthly installments if its tax payable in the current or previous taxation year was greater than $1,000. With respect to corporate taxation years that begin after 2007, Budget 2007 increased the threshold above which corporations are required to pay corporate income tax by installment from $1,000 to $3,000. In addition, for eligible CCPCs that are required to pay tax by installment, Budget 2007 reduced the frequency of installment payments from monthly to quarterly. In order to pay by quarterly installment, the CCPC must meet certain conditions among which include having taxable corporate income for either the current or previous year that does not exceed the small business deduction limit and being eligible to claim SMABUD for either the current or previous year. Quarterly installments are due on the last day of each quarter of the corporation’s taxation year. If a corporation fails to make a quarterly installment payment by its due date, the payment frequency will be switched to monthly installments effective the following month. Budget 2007 did not amend the balance-due day for the final payment of corporate tax for a taxation year so, the balance of tax the corporation owes for a taxation year is usually due within two months of the end of that taxation year. However, in the case of some CCPCs claiming the small business deduction, this may be extended to three months, depending on the circumstances of the corporation. Refer to ITA 157(1) and IC 81-11R3 for more information on which companies qualify for the three-month payment deadline. Interest and penalties apply to late payments. Under ITA 161(2), interest is charged on overdue taxes at the prescribed rate as established by ITR 4301.
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Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Corporate Taxation 2. In this lesson, you have learned how to do the following: • • calculate and describe corporate tax elements such as tax advantages for the owner/manager, tax shelters, and dividend income describe the process for filing a corporate tax return
If you are ready to move to the next lesson, click Taxation of Shareholders on the table of contents.
Assessment
Now that you have completed Corporate Taxation 2, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Lesson 7: Taxation of Shareholders
Welcome to Taxation of Shareholders. In this lesson, you will learn about the ways that a shareholder can obtain funds from a corporation in which he or she holds shares. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • calculate and describe how funds received by shareholders are taxed, including dividends, salary, recovered loans or capital, and received loans
Taxation of Shareholders
There are only seven legitimate ways that a shareholder can obtain funds from a corporation in which he or she holds shares. By: • • • • • • • receiving regular dividends receiving capital dividends receiving stock dividends and then selling the stock receiving a salary or other employment benefits if he or she works for the corporation recovering loans that he or she made to the corporation recovering some of the capital he or she originally contributed to the corporation borrowing money from the corporation
Regular Dividends
Regular dividends are taxable income to the shareholder. If the dividends are paid by a Canadian-controlled public corporation (CCPC) to the extent that its income is taxed at the small business rate or is from the CCPC's investment income, the dividend gross-up and tax credit scheme is available. If the dividends are paid by a large public corporation, or by a CCPC to the extent that its income is not eligible for the small business rate, they are eligible for the enhanced dividend tax credit. If the dividends are paid by a corporation other than a taxable Canadian corporation, the full amount of the dividend is taxable to the shareholder, without either dividend gross-up and tax credit scheme. Dividends are not earned income for the purpose of calculating items such as RRSP contribution room, CPP contributions, or entitlements to CPP pensions. An owner/manager who opts to receive all of his or her compensation in the form of dividends, instead of salary, would find himself or herself with no RRSP contribution room. While this could also mean that he would not have to make any CPP contributions, this in turn would reduce or eliminate his or her entitlement to a CPP retirement pension.
Capital Dividends
Capital dividends are dividends that are issued to shareholders from the corporation's capital dividend account. These dividends result from certain types of income that were not taxable to the corporation, such as the tax-free 50% of capital gains or the death benefit of certain life insurance policies. As long as the corporation files an election declaring the dividends to be capital dividends, the dividends are not subject to tax and are not subject to
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Income Tax Planning the dividend gross-up and tax credit scheme. By doing this, the Income Tax Act preserves the non-taxable nature of the non-taxable portion of the capital gain. James is the sole shareholder of Snowy Retreats Inc. This year, Snowy Retreats sold some real estate for a capital gain of $24,000 and 50% of this gain, or $12,000, was included in Snowy Retreat’s taxable income as a taxable capital gain. The remaining $12,000 (the non-taxable portion of the capital gain) was credited to the corporation’s capital dividend account. Provided Snowy Retreat Inc. files an election, it can pay James a capital dividend of up to $12,000 (one-half of the realized capital gain). This amount will not be taxable to James and it will not be subject to the dividend gross-up and tax credit scheme.
Stock Dividends
Stock dividends are taxed just like any other dividend and they are eligible for the dividend gross-up and tax credit scheme. The amount of this deemed dividend is equal to the investors’ share of the increase in the paid-up capital associated with the stock dividend. DEF Ltd. has 20,000 outstanding shares and paid-up capital of $10,000,000, or $500 per share, calculated as (paid-up capital ÷ number of shares outstanding) or ($10,000,000 ÷ 20,000). This year it had an after-tax profit of $400,000. DEF Ltd. elected to capitalize its retained earnings of $400,000 and issue a stock dividend of 4%, calculated as (capitalized earnings ÷ existing paid-up capital) or ($400,000 ÷ $10,000,000). The amount of the deemed dividend will be $20 per share, calculated as (capitalized earnings ÷ number of shares outstanding) or ($400,000 ÷ 20,000). Calculating deemed acquisition cost If an investor acquires stock as a result of a stock dividend, his or her deemed acquisition cost is equal to the amount of the stock dividend at the time that he or she received it (ITA 52(3)). Delores is one of the investors in DEF Ltd. and she owned 100 shares before the stock dividend was declared. As a result of the 4% stock dividend, she is deemed to have received a dividend of $2,000, calculated as (number of shares owned x deemed dividend per share) or (100 × $20). It can also be calculated as ((number of shares owned ÷ total number of shares outstanding) x capitalized earnings) or ((100 ÷ 20,000) × $400,000). Delores will now own 104 shares in the corporation, calculated as (original number of shares + (original number of shares x dividend rate)) or (100 + (100 × 4%)). The cost of her four new shares is deemed to be the amount of the dividend, or $500 for each new share, calculated as (total deemed dividend ÷ number of new shares) or ($2,000 ÷ 4). Stock dividends paid between November 17, 1978 and May 24, 1985 were not taxable, so the shareholder is deemed to have acquired them at a cost of zero. Refer to IT-88R2, Stock Dividends, for more information.
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Corporations
Salary
A shareholder can also be an employee of the corporation, but he or she will have to include the full amount of his or her employment income in taxable income, while the same amount is a deductible expense to the corporation. Many owners set themselves a base salary with an annual bonus based on profits. This bonus can be paid after the corporation has calculated its income for the fiscal year. An individual is taxed only on employment income for the year in which the income is actually received. However, the corporation may claim the total salary and bonus as a deduction for the fiscal year even if the bonus is paid after the fiscal year-end, as long as the liability for the bonus existed before the year-end. All amounts claimed by the corporation as a deductible expense must be paid to the employee within 179 days of the corporation’s fiscal year-end. Amal was the owner/manager of a corporation with a fiscal year end of December 31st. For the fiscal year ending last year, the corporation paid Amal a base salary of $100,000. As the owner/manager and director, Amal decided that he would also take a bonus of $200,000 for his performance last year, but that the bonus would not be paid until April 30th of this year. The corporation can deduct a total of $300,000 as an employment expense for last year, but Amal does not have to report $200,000 of this income until he files his tax return for this year. The base salary of $100,000 must be reported on last year's return.
Exercise: Taxation of Shareholders, Part 1
Recovering Loans Made to the Corporation
Quite often in the case of closely-held corporations, a shareholder may lend money to the corporation. When the corporation eventually repays the loan, it cannot claim the repayment as a deductible expense and the repayment is not taxable to the shareholder. The loan agreement between the shareholder and the corporation may require the corporation to pay interest on the loaned amount. If this is the case, interest income is fully taxable to the shareholder and it is a deductible expense for the corporation.
Recovering Shareholder's Capital
Paid-up capital is generally the amount of money that a corporation receives in exchange for selling its shares and this amount is recorded in the corporation’s paid-up capital account (ITA 89(1)). It could also include the capitalized amount of retained earnings. The directors of a corporation can decide to return paid-up capital to the shareholders as long as that amount is subtracted from the paid-up capital account. Because this represents a return of the shareholders’ investment and not income of the corporation, the payment is
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Income Tax Planning not taxable. However, the shares will decrease in value after the repayment because the equity in the company will decrease. Blizzard Ltd. received $1,000,000 for the sale of 10,000 shares that were valued at $100 each at the time of sale. The company has done very well and the shares are currently trading at $230 each. The total shareholders’ equity, including the paid-up capital, is about $2,200,000. If the directors of Blizzard Ltd. agree to reduce the paid-up capital to $400,000 and to return $600,000 to the shareholders, no tax liability will arise for either Blizzard Ltd. or the shareholders as a result of this transaction. However, this would reduce the paid-up capital by a total of $600,000 or $60 per share, calculated as (paid-up capital reduction ÷ number of shares) or ($600,000 ÷ 10,000). Impact of tax-free distributions on the ACB If a corporation makes a tax-free distribution of paid up capital, the shareholders will also realize a corresponding decrease in the ACB of their shares (ITA 53(2)). Blair was one of the initial investors in Blizzard Inc., and the ACB of his shares used to be $100 each, calculated as (proceeds of initial share distribution ÷ number of shares) or ($1,000,000 ÷ 10,000). If Blizzard Ltd., reduces the paid-up capital by $600,000, Blair's ACB will be reduced by $60 per share, calculated as (reduction in paid-up capital ÷ number of shares) or ($600,000 ÷ 10,000), leaving him with an ACB of $40 per share, calculated as ($100 - $60).
Receiving Loans from a Corporation
While shareholders are welcome to lend money to a corporation, the Income Tax Act discourages corporations from lending money to shareholders, even if interest is charged. Under ITA 15(2), a corporation can make a loan to a shareholder if bona fide arrangements are established at the time the loan was made for repayment within a reasonable time and the loan was made: • • • • in the course of the lender’s ordinary business (which must be lending money) to facilitate a home purchase by an employee to facilitate the purchase of previously unissued shares of the corporation or a related corporation by an employee to facilitate the purchase of a car to be used in employment duties
These last three situations require the shareholder also to be an employee and the loan to be granted because of the shareholder’s employment with the corporation, and not because he or she is a shareholder. Brian is one of three shareholders in Northwest Engineering Services Inc. and he is also an employee. Brian borrowed $40,000 from Northwest to help finance his first home. At the time of the loan, Brian signed an agreement that said he would repay the loan plus interest in equal annual installments at the end of each of the following five years. All senior employees qualify for similar house purchase loans.
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Corporations Other scenarios regarding loans to a shareholder The Income Tax Act also permits a corporation to make a loan to a shareholder for any purpose if it is repaid within one year of the end of the corporation’s taxation year in which the loan was made, provided the loan is not part of a series of loans (ITA 15(2.6)). If a shareholder receives a loan under any other condition, it is deemed to be fully taxable income and the corporation receives no tax deduction for the loan. However, if the shareholder subsequently repays the loan he or she can receive a tax deduction to the extent that the loan amount was previously included in his or her income (ITA 20(1)(j)). Mary is a shareholder in New Market Inc., but she is not an employee. She borrowed $200,000 from New Market to finance her own business start-up. The loan is to be repaid over five years at an interest rate of 7%. Because the loan does not qualify according to the conditions set out above, Mary is deemed to have taxable income of $200,000, but New Market Inc. cannot deduct $200,000 from its business income. If Mary repays $25,000 of principal in the third year of the loan, she can deduct the repayment from her taxable income. If the interest rate charged by the corporation on a legitimate shareholder loan is less than CRA’s prescribed rate of interest, the shareholder is considered to be receiving a taxable benefit equivalent to interest at the prescribed rate less any interest charged (ITA 80.4(2)). The prescribed rate is established by ITR 4300 and 4301 and it is adjusted quarterly. Click here for the most current rate. For more information on shareholder loans, including low interest and interest free loans, refer to IT-119R4, Debts of shareholders, certain persons connected with shareholders, etc. and IT-421R2, Benefits to individuals, corporations and shareholders from loans or debt.
Exercise: Taxation of Shareholders, Part 2
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Taxation of Shareholders. In this lesson, you have learned how to do the following: • calculate and describe how funds received by shareholders are taxed, including dividends, salary, recovered loans or capital, and received loans
If you are ready to move to the next lesson, click Corporations as Wealth Accumulation Vehicles for the Owner/Manager on the table of contents.
Assessment
Now that you have completed Taxation of Shareholders, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Lesson 8: Corporations as Wealth Accumulation Vehicles for the Owner/Manager
Welcome to Corporations as Wealth Accumulation Vehicles for the Owner/Manager. In this lesson, you will learn about the role of the corporation in wealth accumulation. This lesson takes 35 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the nature and purpose of holding companies and incorporated professional practices explain how an individual can use the ownership/management of a corporation as a wealth accumulation vehicle
Corporations as Wealth Accumulation Vehicles for the Owner/Manager
The primary way that wealth is created in the Canadian economy is through business or economic activity and a large number of those businesses are structured as corporations. Thus, corporations play a large role in wealth accumulation. In this lesson, we will look at how the corporation can be used as a wealth accumulation vehicle for owner/managers. Passive investments in corporations by investors who do not take an active role in corporate management are discussed in another course. There are costs associated with establishing and operating a corporation and the Income Tax Act has many complexities to ensure that the conflicting objectives of Parliament are met. Nevertheless, many sophisticated investors and of course many businessmen and businesswomen use corporations to accumulate wealth because they have several advantages from a tax perspective. In the following sections, we will: • • • • examine how a shareholder can use a holding company to further his or her wealth accumulation objectives take a brief look at the incorporated professional practice review the advantages and disadvantages of running a business through a corporation as opposed to either a partnership or proprietorship compare corporations with other business forms
Holding Companies
Corporations that exist primarily for the purpose of holding or owning property are called holding companies. They may hold or own: • • • shares of an operating company (meaning a corporation carrying on an active business) investment portfolios other property
We will discuss a variety of ways that holding companies can be used in structuring investments. However, there is nothing in the Canada Business Corporations Act that prevents any company, including an operating company, from holding investments.
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Many texts use the short forms OPCO and HOLDCO to refer to the operating company and holding company, respectively.
To Hold Shares of an Operating Company
An operating company may be producing more income than it requires to fund the anticipated future growth of the business. However, in some cases, the shareholders do not require the dividends at the current time and would prefer not to have to include them in their current taxable incomes. In a closely held corporation, the owner/managers could decide to leave the excess funds in the operating company to obtain a tax deferral, but then the funds would be available to satisfy creditors of the operating company. In other cases, the shareholder may have no influence over when the dividends are paid, so the shareholder could end up receiving dividends at a time when he or she would prefer not to include them in his income. Tax-free dividends from Opco to Holdco Because dividends from one corporation are generally paid to another corporation without being taxed, a shareholder can incorporate a holding company to hold his or her shares of the operating company. The OPCO can then pass any excess funds to HOLDCO as tax-free dividends, protecting them from the OPCO’s creditors. HOLDCO does not have to pay Part IV tax on these dividends because the two companies are connected and the income is not considered to be income from portfolio investments. Therefore, the funds can be invested by HOLDCO for the benefit of the taxpayer without paying the income tax that would be required if the OPCO had paid the funds to the taxpayer personally. So, the HOLDCO would have a larger amount to invest. Reggie owns 75% of the outstanding 2,000 shares of Goodluck Ltd., a taxable Canadian corporation. He expects Goodluck to generate substantial dividends each year. However, he does not want to be taxed on that income just yet, so he owns the shares through his holding company, Regco Ltd. He is the sole shareholder of Regco. Dividends that flow from one taxable Canadian corporation to another are not subject to Part I tax. Regco and Goodluck are also connected corporations, so the dividends are not subject to Part IV tax either. Therefore, if Goodluck were to pay dividends of $10,000 to Regco, the holding company could reinvest the full $10,000. If Reggie had owned the shares outside of the holding company and if his income were in a 29% federal tax bracket, he would only have about $6,560 left to invest after tax, after the dividend gross-up and tax credit have been applied.
To Hold Investment Portfolios
A holding company often ends up holding an investment portfolio as the result of investing the earnings it has received from an operating company. Less frequently, an investor will provide tax-paid capital to a holding company of which he or she is a shareholder, and develop an investment portfolio. Dividends paid by a taxable Canadian corporation to a holding company are not subject to ordinary Part I tax. The holding company is permitted to disburse the income in whatever form will provide the best tax advantage for the investor. Usually, the income is paid out as a dividend so that the funds qualify for the dividend gross-up and tax credit scheme. The
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Corporations funds may also be paid out as salary or wages for work performed by the investor for the holding company. In this case, the holding company can claim an employment expense deduction and the employment income is fully taxable to the shareholder. If the holding company retains the investment income, the refundable Part IV and Part I taxes that we talked about earlier would apply. However, when the earnings are eventually paid out as dividends, the corporation will receive a refund of $1 for every $3 of dividends paid, up to the balance in its RDTOH account. Jerry set up HOLDCO to hold his shares in an operating company, OPCO. He used the dividends from OPCO to make additional investments within HOLDCO, primarily in the shares of public Canadian corporations and long-term government bonds. As a result of these portfolio investments, HOLDCO earned dividend income from taxable Canadian corporations of $10,000 and interest income of $3,000. The dividend income would not be subject to Part I tax within HOLDCO, but it would be subject to Part IV tax of $3,333.33, calculated as (dividends from portfolio investments x 331/3%) or ($10,000 × 331/3%), and this amount would also be credited to the RDTOH account. The interest income will result in Part I tax of $1,340, calculated as (interest income x (basic corporate tax rate + additional Part I tax on non-dividend investment income)) or ($3,000 × (38% + 62/3%)), and an amount of $800.00 would be credited to the RDTOH account, calculated as (interest income x 262/3%) or ($3,000 × 262/3%). This would bring the balance in the RDTOH account up to $4,133.33, calculated as (credit resulting from Part IV tax on dividend income + credit resulting from Part I tax on interest income) or ($3,333.33 + $800.00). If HOLDCO were subsequently to pay Jerry a dividend of $15,000, it would be able to claim a refund of $4,133.33, calculated as (the lesser of (the RDTOH balance and (dividends paid out ÷ 3))) or (the lesser of $4,133.33 and ($15,000 ÷ 3)).
For Estate Planning
When a holding company is used for estate planning and a shareholder of the holding company dies, his or her estate is not left with the steep administration fees of transferring diverse investment holdings. Only the holding company’s shares are passed on to the estate, to be passed on to the successors in accordance with the will or intestate succession laws. This usually simplifies the responsibilities of the estate’s executor or administrator. Emilio was a wealthy man with a large investment portfolio consisting of shares in over 120 different stocks, 20 different bonds and 10 treasury bills. Emilio wants his four children to benefit from the portfolio upon his death. Fortunately, Emilio’s portfolio is held within a holding company of which he holds all 100 shares. It will be relatively easy for the executor of Emilio’s estate to transfer ownership of the 100 shares in the holding company to Emilio’s children. If the portfolio had been outside of a holding company, the executor of Emilio’s estate would have had to decide which child would get which investments, or divide each of the 150 investments into four equal parts and arrange for 600 different transfers of ownership.
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Income Tax Planning
Exercise: Holding Companies
Estate Freezes Involving Corporations
An estate freeze is a tax planning strategy that freezes the value of an asset at the time the freeze is effected, such that any future growth in those assets will be passed on to the owner’s intended beneficiaries, ultimately to be taxed in their hands when they dispose of them. If the shareholder of a holding or operating company has accumulated enough wealth for personal use, he or she may wish to have future wealth generated by the corporation accumulate to his or her children or other family members. This financial objective can be met through an estate freeze. Common shareholders vs. preferred shareholders While the common shareholders of a corporation have an equity interest in the business and its assets, the preferred shareholders are only entitled to the specified dividend and a return of their capital investment. As a result, any increase in the value of the business or its assets accrues to the benefit of the common shareholders. This difference between preferred and common shareholders gives rise to a great tax-planning opportunity in the form of an estate freeze.
Reorganizing Share Structure of Existing Corporation
Section 85 and Section 86 rollovers In the case of a closely-held corporation, one method of effecting an estate freeze involves rearranging ownership so that the taxpayer exchanges his or her common shares for preferred shares of the same value. The taxpayer's intended beneficiaries, typically his or her children, acquire or subscribe to new common shares at a nominal cost. There are provisions in the Income Tax Act that permit the rollover of common shares for preferred shares without recognizing a disposition or the realization of capital gains (ITA 85(1) and 86(1)). As each year passes, the dividends on the preferred shares are paid to the original taxpayer and the remaining after-tax earnings and the appreciation of the corporation’s assets accumulate to the benefit of the common shareholders. Lucy is the sole shareholder of Belle Enterprises Ltd. She currently holds 10,000 common shares valued at $100 each, for a total of $1,000,000, calculated as (number of shares x value per share) or (10,000 x $100). She expects that Belle will continue to grow but she has enough money already set aside to meet all of her anticipated needs and she would like any future growth to accrue to her children, Ricky and Alice. Lucy exchanged her 10,000 common shares for 10,000 preferred shares valued at $100 each, such that her equity in the company remained at $1,000,000. Ricky and Alice then each subscribed to 5,000 new common shares by paying $0.10 per share.
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Corporations After the restructuring, Lucy can continue to receive dividends from Belle and she could redeem her preferred shares for $1,000,000 in cash if she finds that she needs the money. In the meantime, any future growth in the company will result in the appreciation of the common shares. So, for example, if Belle retains after-tax earnings of $200,000 next year, the value of Ricky’s and Alice’s shares will increase by $20 per share, calculated as (aftertax earnings ÷ number of common shares) or ($200,000 ÷ (5,000 + 5,000)).
Using a Holding Company
One way to freeze an estate with an operating company is to establish a holding company. In simplistic terms, the intended beneficiaries subscribe to the common shares of HOLDCO for a nominal cost. HOLDCO remains an empty shell. The shares of the operating company are then rolled over to the holding company at their fair market value. The original owner of the operating company then subscribes to preferred shares of the holding company in an amount equal to the fair market value of the shares of the operating company. A more detailed explanation of the mechanics of this type of estate freeze is discussed in another course. It can get much more complicated. Amanda is the sole shareholder of Opco Inc., which owns six fishing boats. She is 65 years of age and wishes to retire and leave the business to her six sons who work on the boats. They do not have the cash or credit to buy her interest. A new company, Holdco Inc., is incorporated with each son subscribing and paying for one common share at a cost of $1. Holdco acquires the shares of Opco for $500,000, their fair market value, and issues preferred shares to Alice with a fair market value of $500,000 and a 7% dividend rate. The preferred shares are given full voting rights, so Alice can still control the corporation. Alice retires.
Exercise: Estate Freezes Involving Corporations
Incorporated Professional Practices
Some provinces allow members of certain professions to incorporate. This gives them some distinct advantages in comparison to professionals in other provinces. Professional incorporation grants many of the same advantages enjoyed by other incorporated self-employed individuals. However, in some circumstances, incorporation does not mean these professionals enjoy limited liability. One important benefit of incorporation is the lower tax rate enjoyed by corporations. However, this benefit is only maximized if the income is not withdrawn from the company but is used to make capital and operating expenditures, and to repay debt.
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Income Tax Planning
Unlimited Liability
The limited liability of the shareholders of a corporation is one of the main advantages of a corporation. In Alberta, only practicing professionals can be shareholders of an incorporated professional practice and while they are not personally liable for the financial debts and obligations of the incorporated professional practice in which they hold shares, they still face unlimited liability for professional negligence. In British Columbia, family members of the practicing professional can become non-voting shareholders of the incorporated professional practice without assuming any liability. However, the practicing professional in a BC incorporated professional practice remains liable for his own professional negligence, as in Alberta. Henry and Fiona are Chartered Accountants in Alberta and they jointly operate a public accounting practice. They would like to incorporate their practice, but only Henry and Fiona can be shareholders of this new corporation. In addition, both Henry and Fiona will be liable for any professional negligence carried out under the umbrella of the practice. Elliot is a doctor in British Columbia and he operates a successful obstetrics clinic. Elliot would like to incorporate his practice and he would like his wife, Jennifer to own shares in the corporation because of the potential for income splitting. This is permitted in British Columbia and Jennifer can receive the benefit of being a shareholder without having any personal liability for the professional practice. However, Elliot will remain fully liable for professional negligence.
Tax Advantages
The greatest advantage of a professional corporation is tax reduction. The professional corporation does not offer its shareholders any tax advantages that are not available to the shareholders of any other corporation. It simply enables some professionals to incorporate their practices so they can benefit from those tax advantages, while preventing them from benefiting from the limited liability that is otherwise available to corporate shareholders. The idea is that professionals such as doctors and lawyers should be able to take advantage of the tax planning opportunities associated with the corporate form of business without being able to use that corporate veil to shield them in the event of their own professional negligence. Small business deduction In particular, there are potential tax savings for those professionals who do not require all of their professional earnings for current personal or family use. Most professional corporations will qualify for the small business deduction, reducing the effective corporate tax rate on active business income up to the SMABUD, to about 21% each year calculated as (general corporate tax rate – SMABUD rate) or (38% - 17%). Capital gains exemption The shares of a professional corporation that satisfies the requirements for an eligible small business corporation can qualify for the lifetime exemption of up to $750,000 of capital gains for shareholders upon the deemed or actual disposition of such shares.
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Corporations Income splitting Incorporated professionals can employ family members to perform management, clerical, maintenance or other services. In this way, a certain amount of income can be split between family members even if they are not permitted to be shareholders. Retirement planning The incorporated professional has more sophisticated retirement planning opportunities than one operating as a sole proprietor or partner. He can establish a defined-benefit registered pension plan (RPP), and this could result in higher deductible contributions and a higher retirement income than could be provided under RRSP limits. Benita, who has an incorporated professional practice, has employment income of $100,000. This year, the most that she can contribute to her RRSP is $20,000. However, because of her age, if Benita establishes an individual pension plan through her incorporated professional practice, her business would have to contribute $32,000 to the pension plan this year in order to fund the 2% per year of service pension benefit, and this $32,000 would be tax deductible to the corporation. We explain how these plans work and what the limits are in more detail in another course.
The Corporation vs. Other Business Forms
There are significant differences between corporations and partnerships, although both of them can be used to structure investments. The differences are summarized below: • The corporation offers limited legal liability whereas the general partnership does not. A limited partnership does offer limited liability, but it does not offer the deferral of income that is available to some CCPCs. The CCPC offers a deferral of personal income tax for active business income. In the case of a partnership, the income flows to the partners and cannot be deferred. A partnership allows business and capital losses to flow through to the partner, who can use these losses to offset other income. In a corporation, any net losses must be carried forward or back to another taxation year.
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Exercise: The Corporation vs. Other Business Forms
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Corporations as Wealth Accumulation Vehicles for the Owner/Manager. In this lesson, you have learned how to do the following: • • describe the nature and purpose of holding companies and incorporated professional practices explain how an individual can use the ownership/management of a corporation as a wealth accumulation vehicle
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Corporations as Wealth Accumulation Vehicles for the Owner/Manager, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Review
Let’s look at the concepts covered in this unit: • • • • • • • • Defining a Corporation Types of Business Corporations Shares and Shareholders Organizational Structure of a Corporation Corporate Taxation 1 Corporate Taxation 2 Taxation of Shareholders Corporations as Wealth Accumulation Vehicles for the Owner/Manager
You now have a good understanding of the nature of corporations. At this point in the course you can describe the nature and different types of business corporations, explain the rights and roles of shareholders, and describe the governing legislation of a corporation. You can also calculate various corporate tax elements and the taxation of shareholders as well as describe the purpose of holding companies and incorporated professional practices. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 3: Corporations, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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Unit 4: Income Tax Planning and Research
Income Tax Planning
Unit 4: Income Tax Planning and Research
Welcome to Income Tax Planning and Research. In this unit, you will learn about residency requirements and rules, filing deadlines, and the major components of the federal and provincial tax legislation. You will also learn about how to use various tax deductions to reduce the amount of income that is subject to tax. This unit takes approximately 2 hours and 15 minutes to complete. You will learn about the following topics: • • • • Residency and Installment Payments Deadlines, Penalties, and Reviews Income Tax Planning and Research Miscellaneous Deductions
To start with the first lesson, click Residency and Installment Payments on the table of contents.
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Income Tax Planning and Research
Lesson 1: Residency and Installment Payments
Welcome to Residency and Installment Payments. In this lesson, you will learn about residency requirements and rules as well as installment payments, penalties, and interest. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe residency requirements and rules calculate and explain when installments are required, payment options, penalties, and interest
Declaration of Taxpayer Rights
Tax compliance While the government likes to describe our tax administration system as a voluntary system of self assessment, the fact is that the Income Tax Act includes strict rules about who must pay tax and when. It also includes penalties for those who file their tax returns late or who fail to pay their taxes on time. The majority of the tax compliance rules are in Division I of the Income Tax Act, Returns, Assessments, Payment and Appeals. The declaration of taxpayer rights Canada Revenue Agency (CRA) was the first revenue administrator in the world to proclaim the rights of taxpayers, which it did in 1985 with the publication of The Declaration of Taxpayer Rights. The Declaration has been updated periodically to remain current with the law and societal needs, and is entrenched in the day-to-day operations of the Department. The Declaration is available from CRA’s income tax offices, and it is published on the back of the General Income Tax Guide. The current Declaration is shown in the following table. Declaration of Taxpayer Rights In your dealings with Canada Customs and Revenue Agency on income tax matters, you have important rights Fair treatment You have the right to expect us to apply the law fairly and impartially. Courtesy and consideration You have the right to be treated with courtesy, respect, and consideration. Privacy and confidentiality Information You have the right to get complete, accurate, and clear information about your rights, entitlements, and obligations. Entitlements You have the right to every benefit allowed under the law.
You have the right to expect that your Formal Review personal and financial information is protected against unauthorized use or If you believe you have not received disclosure. your full entitlements under the law,
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Income Tax Planning you have the right to a formal review of your file. If we cannot resolve the matter to your satisfaction, you have the right to appeal to the courts.
Bilingual service You have the right to be served in the official language of your choice at designated bilingual offices.
Source: CRA Web site ((http://www.cra-arc.gc.ca/agency/fairness/rights-e.html)
Residency
An individual who is a resident or deemed resident in Canada at any time in a taxation year may be subject to Canadian income tax on his or her taxable income (ITA 2(1)). An individual is resident in Canada for tax purposes if Canada is the place where the individual, in the settled routine of his life, regularly, normally, or customarily lives. Although Tassia is a citizen of Greece, she moved to Canada 12 years ago with her husband, who is a Canadian citizen. They have since had two children who are enrolled in the Canadian school system. Tassia visits Greece frequently for a few weeks each time, but she always returns to her home in Canada. Although Tassia is not a Canadian citizen, she has obviously made Canada her home and she is a resident of Canada for tax purposes. Note: Residency is not the same thing as citizenship. Citizenship refers to a national affiliation, not the place of residence. While Canada’s tax system is based on residency, the tax systems in some other countries, such as the United States, are based on citizenship. Refer to IT-221R2, Determination of an individual’s residence status, for more information.
Resident in Canada for Only Part of the Year
If an individual is a resident or deemed resident of Canada for only part of the calendar year, he or she only has to report the worldwide income that he or she earned during that period of Canadian residency for Canadian tax purposes (ITA 114). On November 15th of last year, Constance became a Canadian resident. She did not have any Canadian sourced income prior to her immigration. On her tax return for last year, she will only have to report her worldwide income earned from November 15th through December 31st, of last year. Sojourners A sojourner is someone who is temporarily present in Canada. If a sojourner is in Canada for a total of 183 days or more in any calendar year, the individual is deemed by the Income Tax Act to have been resident in Canada for the entire year, even if he or she is technically a resident of another country at the time (ITA 250(1)(a)). As a deemed resident, he or she will have to report worldwide income for Canadian tax purposes. For those whose travels to Canada vary from year to year, it is possible to be a deemed resident one year, but not the next, depending on whether the individual meets the 183-day criterion for each particular year. Three years ago, Simon severed all of his ties with Canada and moved to the U.S., such that he was a non-resident for Canadian tax purposes. Last year, he returned to Canada frequently for business purposes, such that he spent 195 days in Canada. He expects to spend 180 days in Canada this year.
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Income Tax Planning and Research
Simon was a deemed resident of Canada last year even though he was also a resident of the United States. This year, Simon is once again a non-resident of Canada. So, for last year, he will have to report his worldwide income for Canadian tax purposes, but for this year, he will only have to report his income from Canadian sources for Canadian tax purposes. Although Simon will have to report his worldwide income for last year for Canadian tax purposes, the Canada-United States Tax Convention may override and prevent Canada from taxing him on this income. Immigrants If an individual, other than a sojourner, enters Canada and establishes residential ties within Canada, he or she will be considered to have become a resident of Canada for tax purposes on the date he entered Canada (IT-221R2). On November 15th of last year, Constance immigrated to Canada from Italy. Even though she was in Canada for less than 183 days during the last taxation year, she is deemed to be a resident of Canada from the moment that she entered the country. Becoming a non-resident An individual is resident in Canada for tax purposes if Canada is the place where he or she, in the settled routine of his or her life, regularly, normally or customarily lives. If an individual resides in another country, even for a significant amount of time, CRA will still consider that person a Canadian resident for tax purposes if he or she maintains sufficient residential ties in Canada in the form of a: • • • dwelling place spouse or common-law partner dependants
Where an individual has not severed all of his or her residential ties with Canada, but is physically absent for several months or even years, CRA will consider factors such as intention to permanently sever residential ties, regularity and length of visits to Canada, and residential ties outside of Canada. No element is determinative in itself and CRA would decide on a case by case basis whether a person is resident in Canada for tax purposes while abroad. If a Canadian citizen becomes a non-resident for tax purposes, the only income that he she will have to report for Canadian tax purposes will be the income that he or she earns from Canadian sources, such as employment income while working in Canada or capital gains realized on the sale of Canadian real estate. Once the individual is a non-resident, the rest of his or her world income will be beyond the reach of the Canadian tax system. This is attractive to some Canadians. However, upon becoming a non-resident, he or she will face a deemed disposition of capital property at fair market value and that could result in a significant tax liability on departure.
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Income Tax Planning
Exercise: Taxpayer Rights and Residency
Paying by Installments
Tax withheld at source In the case of some types of income, such as employment income or certain RRSP withdrawals, some income tax is withheld at source and remitted directly to CRA. This helps the government spread its tax revenues over the course of the year, instead of waiting to receive it all on April 30th of the following year. If a taxpayer receives income that was not subject to a withholding tax or if not enough tax was withheld, the taxpayer might have to pay a large amount of tax when he or she files his or her return. This could easily happen if the taxpayer received bond interest, tips and gratuities, certain pension payments, rental, investment or self-employment income, or income from more than one job. Tony works part-time for two different employers, earning $25,000 from each of them. He is also self-employed and earns $50,000 in self-employment income. Both of his employers withhold taxes on the assumption that he earns $25,000 per year. No taxes are withheld on his self-employment income. So, over the course of the year Tony only pays a small portion of his taxes owing through withholdings. Tax by installments The Income Tax Act requires some taxpayers to pay income tax by installments. Installments are periodic payments of income tax that some taxpayers pay to CRA four times a year on March 15th, June 15th, September 15th and December 15th. If a taxpayer pays by installments, he or she reports the paid amount as a credit on his or her tax return, and it is deducted from to total tax payable of the taxpayer. Jerome has a full-time job and also has significant investment income. His total tax payable for last year was $18,400. His employer withheld $11,400 from his pay and he paid quarterly installments of $800. So, his total credits are $14,600, calculated as (employer's withholdings + (installment amount x number of installments)) or ($11,400 + ($800 × 4)). His balance owing is $3,800, calculated as (total tax payable - total credits) or ($18,400 $14,600)). Refer to CRA Guide P110(E), Paying Your Income Tax by Installments, for more information.
When Installments are Required
A taxpayer will have to make installment payments for the current tax year if his net tax owing is more than $2,000 for both the current tax year and either of the previous two years (ITA 156.1(1)). Net tax owing is the total of the taxpayer’s federal and provincial taxes payable minus all taxes deducted at source and minus refundable tax credits.
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Income Tax Planning and Research Simon just started his own business as a sole proprietor and he expects his net tax owing this year to be $3,200. For the last few years he has been employed full-time and his net tax owing was never more than $400. Simon does not have to pay his tax by installments this year, and he can pay all of his tax owing by April 30th of next year. However, if his net tax owing will be more than $2,000 next year as well, he will have to pay tax installments next year.
When Installments are Required
In previous years, a taxpayer was required to make installment payments if his or her net tax owing was more than $2,000 ($1,200 in Québec) for the current tax year and either of the previous two years (ITA 156.1(1)). Budget 2007, increased the personal income tax installment threshold from $2,000 to $3,000 (and from $1,200 to $1,800 in Québec) effective 2008. The balance due date for taxes still owing after all installments have been paid remains unchanged: April 30th of the following taxation year. Net tax owing is the total of the taxpayer’s federal and provincial taxes payable minus all taxes deducted at source and minus refundable tax credits. Simon just started his own business as a sole proprietor and he expects his net tax owing this year to be $3,200. For the last few years he has been employed full-time and his net tax owing was never more than $400. Simon does not have to pay his tax by installments this year and he can pay all of his tax owing by April 30th of next year. However, if his net tax owing for the next year again exceeds the $3,000 threshold, he will have to pay tax installments next year.
CPP Contributions
Most Canadian residents who are employed must contribute to the Canada Pension Plan based on their pensionable earnings. A taxpayer who is required to pay tax by installments may have to make installment payments for his or her CPP contributions at the same time, if all of the following conditions apply; he or she: • • • • is self-employed does not live in Québec on December 31st is 18 to 70 years of age during the year is not receiving CPP retirement or disability benefits
Sonja is self-employed and this is the first year that she will have to pay tax by installments. She will also have to pay her CPP contributions by installments. Kim is employed full-time and his employer withholds income tax from his pay based on his employment income. However, Kim also has significant investment income and he has to pay some tax by installments in addition to his employer’s withholdings. However, because Kim is not self-employed, he does not have to make CPP contributions by installments. CPP contributions are only required on pensionable employment earnings and his employer will have deducted Kim’s contributions from his pay.
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Income Tax Planning
Installment Payment Options
Canada Revenue Agency will notify a taxpayer if he or she is required to pay tax by installments based on the information CRA has on file. There are three ways to determine the amount of each installment payment. No-calculation option Under the no-calculation option, CRA determines how much the taxpayer must pay each quarter in the current taxation year based on its knowledge of the tax and CPP owing from the previous two years, and informs the taxpayer how much he or she must pay on an installment reminder. If the taxpayer uses the no-calculation option and makes the required payments on the due dates, he or she will not have to pay any installment interest or penalties, even if the payments are less than the total amount of tax owed at the end of the year. Prior-year option Under the prior-year option, for the current taxation year, the taxpayer would pay one quarter of his or her net tax owing and CPP payable based on the prior year on each installment due date (ITA 156(1)(a)(ii)). Any balance of tax still owing is due by April 30th of the year following the taxation year. As long as the installments are made on time and the taxpayer correctly calculated the required installments, he or she will not face any installment interest or penalties, even if the taxpayer’s payments are less than the total amount that he or she owes at the end of the year. However, if the taxpayer incorrectly calculates the required installments and his or her payments are too low, he or she may face a penalty and installment interest. Current-year option Under the current-year option, the taxpayer can pay one quarter of his or her estimated net tax owing and CPP contributions payable for the current taxation year on each installment date (ITA 156(1)(a)(i)). He or she can use Form T1033-WS, Worksheet for Calculating 2001 Installment Payments, to help the taxpayer calculate his or her required payments under this option. However, if a taxpayer uses this option and makes an error in estimating the taxes that he or she owes, the taxpayer will be charged installment interest and penalties when CRA assesses his or her return, as discussed later.
Installment Penalties and Interest
Taxpayers who are required to pay tax by installments may incur installment interest or penalties if their payments are late or are too small. Installment interest If the taxpayer pays the amount shown on the installment reminders that he or she receives from CRA on time, the taxpayer will not have to pay installment interest, even if the payments are less than the total amount of tax that he or she may owe at the end of the year.
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Income Tax Planning and Research
However, he or she may be charged installment interest if: • • any of his installment payments are late or the taxpayer chose to make his or her installment payments according to either the prior-year or current-year option and miscalculated the required installment payment, such that his or her payments were too low
A taxpayer can reduce or eliminate interest charges that he or she would otherwise incur as a result of late or deficient installments by overpaying other installments or paying them before their due date. Installment penalties A taxpayer may also incur an installment penalty if the installment payments are late or less than the required amount and if the installment interest charges for the taxation year are more than $1,000 (ITA 163.1).
Exercise: Paying By Installments
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Residency and Installment Payments. In this lesson, you have learned how to do the following: • • describe residency requirements and rules calculate and explain when installments are required, payment options, penalties, and interest
If you are ready to move to the next lesson, click Deadlines, Penalties, and Reviews on the table of contents.
Assessment
Now that you have completed Residency and Installment Payments, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning and Research
Lesson 2: Deadlines, Penalties, and Review
Welcome to Deadlines, Penalties, and Reviews. In this lesson, you will learn about the filing deadlines, the impact of filing late, and the components of the review process. This lesson takes 35 minutes to complete. At the end of this lesson, you will be able to do the following: • • • describe the filing deadlines calculate the impact of filing late describe the review process and its components
Filing Returns
The Income Tax Act sets rules for when taxpayers have to file tax returns and pay any tax owing, sometimes imposing interest charges and other penalties on those who do not comply. Each corporation (other than a registered charity) must file a tax return for the taxation year. An individual must file a tax return for the taxation year if the taxpayer: • • • • • has taxable income has a taxable capital gain has disposed of a capital property (ITA 150(1)) has a positive balance at the end of the year in his or her Home Buyers' Plan or Lifelong Learning Plan (ITA 150(1.1)) has received a written demand from CRA to file a return (ITA (150(2))
Filing deadlines The required filing date depends on the taxpayer: • • corporations must file within six months from the end of the corporation’s fiscal year-end (ITA 150(1)(a)) the representative of deceased individuals who die after October, but on or before the day that would otherwise be his or her filing date if he or she had not died, must file on or before the later of the normal filing date and six months after the day of death. This also applies to spouses or common-law partners of deceased individuals (ITA 150(1)(b) and (d)(iii)) trusts must file within 90 days from the end of the trust’s fiscal year (ITA 150(1)(c)) self-employed individuals and their spouses or common-law partners must file by June 15th (ITA 150(1)(d)(ii)) all other individuals must file by April 30th (ITA 150(1)(d)(i))
th
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Darren died on September 15th of last year. His executor must file his return by April 30 of this year.
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Income Tax Planning Eric was employed full time before he died on November 21st of last year. His executor has to file his return by May 21st of this year, calculated as [the later of (his normal filing deadline and six months after his date of death)] or [the later of (April 30th and May 21st]. June is self-employed and she died on November 18th of last year. Her executor has to file her return by June 15th of this year, calculated as [the later of (her normal filing deadline and six months after her date of death)] or [(the later of (June 15th and May 18th)]. An individual is generally considered to have filed his or her return by the deadline if he or she sends the return by first class mail or courier by that deadline, even though this lastminute filing means that CRA will not actually receive the return before the deadline. On April 30th of each year, some postal outlets will stay open until midnight so last-minute tax filers can drop off their returns and have them time stamped as being mailed by the deadline. Penalties for late filing or failing to file An individual who fails to file an income tax return on time faces a late-filing penalty of: • • 5% of the tax owing at the time the return was due 1% of the tax owing times the number of complete months that the return is not filed, to a maximum of 12 (ITA 162(1))
plus
Reggie was supposed to file his tax return on April 30th of this year, but he did not file it until October 18th of this year. When he did get around to completing his return, he found out that he owed $6,900 in taxes. It has been five complete months since the filing deadline (May, June, July, August, and September), so Reggie will have to pay a penalty of $690, calculated as [tax owing x (5% late filing penalty + (number of complete months late x 1%))] or [$6,900 × (5% + (5 × 1%))]. So, in practical effect there is no penalty for late filing unless you have a balance owing. The penalties get stiffer for repeat offenders (ITA 162(2)), and can include a jail term for the most blatant of tax abusers (ITA 238(1)).
Paying Taxes
In most cases, the government does not want to wait until the filing deadline to collect the tax that taxpayers owe. Depending on the type of income, the Income Tax Act may require some tax to be withheld at source and to be remitted on the taxpayer’s account. In other cases, the taxpayer will have to make installment tax payments. But even with these interim payments, many taxpayers find they still have a balance owing when they file their returns.
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Income Tax Planning and Research Payment deadlines The balance-due day is the day all taxes are due for the last taxation year and it varies depending on the taxpayer (ITA 248(1)): • • • a trust, 90 days after the end of the trust’s fiscal year an individual who died after October in the year and before May in the following taxation year, the day that is six months after the day of death for other individuals, April 30th in the following taxation year Last year, Fiona had taxable income. Her balance-due day is April 30th, of this year. A taxpayer, other than a corporation, is generally considered to have paid his or her taxes by the balance-due day if he or she sends the payment by first class mail or courier by that date. Note: Although self-employed individuals and their spouses or common-law partners do not have to file their tax returns until June 15th, they must still pay any taxes owing by the balance-due day. Payment penalties If a taxpayer fails to pay the balance owing by the balance-due date, he or she will be assessed interest on the outstanding amount at a rate prescribed by Regulation (ITA 161, ITR 4301). The prescribed interest rate for overdue taxes is adjusted quarterly. Click here for the current rate. Samantha was supposed to pay tax of $3,500 on April 30th, but she did not make the payment until 85 days later on July 24th. The prescribed nominal rate on overdue taxes was 10% during this entire time. Samantha will have to pay a combination of principal and interest of $3,582 on July 24th, calculated by entering P/YR = 365, ×P/YR = (85 ÷ 365), I/YR = 10%, PV = $3,500, PMT = $0 and solving for FV. So, Samantha must pay an interest penalty of $82, calculated as (combined principal and interest - principal) or ($3,582 - $3,500). Unlike interest expenses incurred for business or investment purposes, interest and penalties on late tax payments are not tax deductible (ITA 18(1)(t)).
Exercise: Deadlines, Penalties and Interest
The Review Process
Once the taxpayer has filed his or her income tax return, CRA begins its review, which could take a few weeks to several months. If there are no significant errors in his or her return and CRA does not require any additional information, it will send the taxpayer a Notice of Assessment. This document explains the details of his or her assessment and identifies any
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Income Tax Planning balance that he or she owes or that is owed to the taxpayer. If he or she has an outstanding balance, it explains how this amount can be paid. However, the Notice of Assessment is not necessarily the end of the matter, if one of the following situations applies: • • • • CRA decides to reassess his or her return the taxpayer decides to ask CRA to reassess his or her return based on new or missing information CRA audits his or her return the taxpayer decides to appeal a CRA assessment or reassessment
Reassessments
A reassessment is a re-evaluation of a return that has already been processed in light of errors, omissions, or new information. Reassessments can be done at CRA’s discretion or at the taxpayer’s request. At CRA’s discretion CRA can decide to reassess a taxpayer’s return within three years of the date that it issued the original Notice of Assessment, or even later if it can prove fraud or misrepresentation, or if the taxpayer signs a waiver (ITA 152(3.1), (4)). A reassessment may result from new information that CRA received through a request for information or a more formal audit, or discrepancies that were identified when CRA processed other returns related to the return in question, such as the return of the taxpayer’s spouse. When Jeannine filed her tax return, she made a claim for childcare expenses using the appropriate form, on which she listed the name and social insurance number of her babysitter, Nancy, along with the amount that she paid Nancy. Nancy mailed her tax return in March, but Jeannine waited until the last minute, so Nancy’s return was processed first. When Nancy filed her tax return, she forgot to include the money that she had made babysitting in her income. When CRA first processed her return, everything appeared fine and it issued Nancy a Notice of Assessment. After CRA processed Jeannine’s return, it identified the discrepancy and sent a request for information to Nancy. After Nancy confirmed that she had in fact forgotten to include the babysitting income, her return was reassessed. At the taxpayer’s request There are many situations that could arise that would prompt a taxpayer to request CRA to reassess a prior return. Rather that submitting a whole new return, the taxpayer should write a letter or complete Form T1-ADJ, Adjustment Request, and send it to his or her Taxation Office explaining the situation and including any supporting documentation. After filing his income tax return, Jacob found a receipt for a charitable donation of $5,000 that he forgot to consider when he completed his return. He can submit this new information to CRA and ask that his return be reassessed.
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Income Tax Planning and Research In July of last year, Mary sold her business property and realized a substantial taxable capital gain that she had to report on her tax return for last year. In January of this year, she bought a replacement property. According to the rules for former business properties, Mary can ask CRA to reassess her tax return for last year, reducing the tax liability that arose from the taxable capital gain. Time limit for reassessments CRA will typically reassess old returns at the taxpayer’s request at any time back to 1985, even beyond the three-year limit imposed on reassessments that it initiates itself (ITA 152(4.2)). CRA will issue a refund or reduce the amount owed on such a late request if it is satisfied that such a refund or reduction would have been made if the return or request had been on time. CRA will not agree to a reassessment if the taxpayer is merely changing his or her mind about an optional deduction, such as how much CCA to claim or whether to report a spouse’s dividends on his or her return. Refer to IC 92-3, Guidelines for refunds beyond the normal three year period, for more information.
Audits
While assessing a taxpayer’s return or at some point after the initial assessment, CRA may request any information that it needs to verify the accuracy of amounts reported on that tax return and to ensure that the taxpayer is in compliance with the Income Tax Act (ITA 231.2(1)). This verification procedure is referred to as an audit. Request for information The extent of CRA’s scrutiny may be limited to requesting the taxpayer to mail in supporting documentation or receipts. This is sometimes also referred to as a desk audit. Such a request does not necessarily mean that the taxpayer will have to pay additional tax, and it does not necessarily mean that CRA suspects the taxpayer of tax evasion. In an effort to control the amount of paper that must be processed, in many situations, the tax administration allows the taxpayer to make a claim or a deduction without providing supporting documentation or receipts. CRA routinely carries out spot checks on a portion of all returns with a request for information to verify that such claims are in fact legitimate. When Frieda filed her tax return, she claimed a deduction for childcare expenses. However, she did not have to provide receipts with her return. After she filed her return, she received a letter from CRA requesting that she provide copies of her receipts to verify her claim. As long as Frieda can provide the receipts, her original assessment will stand unchallenged. However, if she cannot provide the receipts or if the amounts on the receipts are different from the amount that Frieda reported on her return, her return will be reassessed.
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Income Tax Planning Field audits In the case of a field audit, CRA will send an auditor to the taxpayer’s residence or place of business, where the auditor will take a detailed look at the taxpayer’s records and receipts. Most field audits are done in relation to businesses, as opposed to individuals. Julio has been operating a retail operation as a sole proprietor for five years out of a building that he owns, but he has yet to realize a profit despite his high sales revenues. CRA may conduct a field audit to verify that Julio’s business revenues and expenses are indeed what he claims they are. While the thought of a field audit is terrifying to many people, audits should not be a cause for concern unless the taxpayer has been purposely evading taxes. It will be up to the auditor to decide if the deductions were reasonable, or whether the taxpayer was intentionally claiming unreasonable amounts to evade taxes.
Objections and Appeals
All taxpayers have the right to dispute an income tax assessment. The Income Tax Act includes several provisions for objections and appeals that a taxpayer can use to try to resolve a dispute. Refer to CRA Publication P148, Your Appeal Rights under the Income Tax Act, for more information. Initial objection If a taxpayer is not satisfied with his or her assessment, reassessment, or CRA’s interpretation of income tax law, he or she can file an objection. Filing an objection is the first step in the formal process of resolving a dispute. After the taxpayer files an objection, the Appeals Division will conduct an impartial review. Individuals and trustees filing on behalf of a testamentary trust can file an objection by the later of the following two dates: • • one year after the date of the return’s filing deadline 90 days after the day that CRA mailed the Notice of Assessment (ITA 165(1))
On April 13th of this year, David who is self-employed, filed his tax return for last year. On May 28th of this year, he received a Notice of Assessment. If he disagrees with the Notice of Assessment, he can file an objection as long as he does so by June 15th next year, which is calculated as (the later of (90 days after CRA mailed the Notice of Assessment and one year after his filing deadline)) or (the later of ((90 days after May 28th of this year) and (one year after his filing deadline of June 15th of this year)). The Appeals Division will review the objection and contact the taxpayer to discuss the matter. If the Chief of Appeals agrees with the taxpayer in whole or in part, CRA will adjust the taxpayer’s return and issue a Notice of Reassessment. However, if the Chief of Appeals disagrees, CRA will send the taxpayer a Notice of Confirmation confirming that the original assessment was correct.
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Income Tax Planning and Research
Appealing to the Tax Court of Canada
If the taxpayer does not agree with the Chief of Appeals’ decision regarding his or her objection, he can appeal to the Tax Court of Canada, which is an independent court of law that regularly conducts hearings in major centres across Canada. The taxpayer must apply to the Tax Court within 90 days from the date CRA mails its decision, whether it be a Notice of Reassessment or a Notice of Confirmation (ITA 169(1)). The taxpayer can also apply to the Tax Court for a decision if the Chief of Appeals has not provided a decision on the original objection within 90 days of it being filed. Informal vs. formal procedure The appeal can be heard by either a formal or informal procedure, depending on the nature and size of the dispute. In either case, there is a fee for hearing an appeal ($100 for informal procedure; $250 to $550 for formal procedure). Under the informal procedure, the judge can order CRA to pay part of the taxpayer’s legal costs if the taxpayer is more than 50% successful in his or her appeal, but the judge cannot order the taxpayer to pay part of CRA’s costs if the taxpayer is unsuccessful. Under the formal procedure, the court can order the unsuccessful party to pay some of the other party’s legal costs. Mark appealed his Notice of Reassessment to the Tax Court of Canada. Because of the amounts involved, he had no choice but to follow the formal procedure. Mark lost his appeal and the Court ordered him to pay $5,000 to CRA towards their legal fees. Further appeals A taxpayer can appeal a judgement of the Tax Court of Canada to the Federal Court of Appeal, provided the appeal is filed within 30 days of the date the Tax Court of Canada communicates its decision (ITA 180(1)). A taxpayer can appeal a judgement of the Federal Court of Appeal to the Supreme Court of Canada, provided he or she first obtains the Supreme Court’s permission to do so.
Exercise: The Review Process
Civil Penalties for Misrepresentations of Tax Matters by Third Parties
On the one hand, as a financial planner it is your role to help your clients achieve their financial objectives and that role may require you to give them tax advice, because minimizing taxes is a key component of wealth accumulation. On the other hand, the federal government has recently introduced civil penalties for advisors who advise or encourage their clients to misrepresent their tax situation.
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Income Tax Planning Canadian tax law already included both criminal and civil penalties that may apply to all taxpayers who misrepresent tax matters to ensure that all taxpayers pay their fair share of taxes. Tax avoidance vs. tax evasion Tax avoidance occurs when a taxpayer legitimately structures his or her affairs to realize a reduction in his or her overall tax liability by taking advantage of provisions contained in the Income Tax Act. Tax evasion occurs when a taxpayer misrepresents his or her financial circumstances such that it appears that the taxpayer owes less tax than he or she actually does. Criminal penalties may apply where a person participates in tax evasion in respect of his or her own taxes or another person’s taxes (ITA 239(1)). Civil penalties may apply where a taxpayer is shown to have knowingly, or in circumstances amounting to gross negligence, made false statements or omissions in the filing of the taxpayer’s own tax information (ITA 163(2)). However, until third-party civil penalties came into force on June 29, 2000, there was no civil penalty provision that applied to those who counsel others to file their returns based on false or misleading information, or who turn a blind eye to false information provided by their clients for tax purposes.
Culpable Conduct
The legislation applies the penalties only in cases of culpable conduct, which is defined as conduct, whether it be an act or a failure to act, that meets one of the following conditions: • • • is tantamount to intentional conduct shows an indifference as to whether the Act is complied with shows a willful, a reckless or a wanton disregard of the law (ITA 163.2(1))
The legislation also provides that an advisor will not be held responsible if he or she is relying in good faith upon information provided by the taxpayer (ITA 163.2(6)). Sasha was preparing a tax return for his client, Amanda, who had income of $82,000. Amanda told Sasha that she had incurred childcare expenses of $5,000 throughout the year, but that she forgot her receipts at home. She asked Sasha to prepare her return anyway, and that she would keep the receipts on file. Sasha had no reason to disbelieve her claim and prepared the return accordingly.
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Income Tax Planning and Research When CRA later requested copies of Amanda’s receipts, she admitted to Sasha that her childcare expenses had been only $2,000. Because Sasha was acting in good faith, he will not be subject to any penalty.
Penalty for Misrepresenting a Tax Planning Arrangement
The legislation calls for a civil penalty for misrepresentations in tax planning arrangements, to be applied to every advisor who makes, or causes another person to make, a statement that the advisor knows, or would reasonably be expected to know, but for circumstances amounting to culpable conduct, is a false statement that could be used by another person for the purpose of the Income Tax Act (ITA 163.2(2)). This is commonly referred to as the "Planner penalty". Planner Penalty The planner penalty is more likely to be applied to those who knowingly make a false statement, where the person or persons who could make use of that false statement may not actually be identified. Examples include: • • tax shelter promoters holding seminars or presentations to provide information in respect of a specific tax shelter appraisers and valuators preparing a report for a proposed scheme or shelter that could be used by unidentified investors
A false statement includes a direct falsehood, as well as a statement that is misleading because of an omission from the statement. The penalty for making, or causing another person to make, a false statement is as follows: • if the statement is made in the course of a planning or valuation activity, the greater of $1,000 and the total of the person's gross entitlements arising from the false statement in any other case, $1,000 (ITA163.2(3))
•
Penalty for Participating in a Misrepresentation
A similar penalty for participating in a misrepresentation applies if the advisor knowingly participates in, assents to or acquiesces in the making of a false statement by or on behalf of another person, or a statement that the advisor should have known was a false statement, but for circumstances amounting to culpable conduct (ITA 163.2(5)). This is commonly referred to as the "Preparer penalty". Preparer Penalty The preparer penalty is usually applied in situations where the work was performed for a specific taxpayer, or group of taxpayers who can be specifically identified. Examples would include: • • • a person preparing a tax return for a specific taxpayer a person providing tax advice to a specific taxpayer an appraiser or valuator preparing a report for a specific taxpayer or a number of persons who can be identified
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Income Tax Planning
In this case, the penalty is the greater of: • • $1,000 and the lesser of: i) the penalty to which the other person would be liable if the other person knowingly made the statement (i.e., the greater of $1,000 or that other person’s gross entitlement arising from the false statement) ii) $100,000 plus the advisor’s compensation for taking part in the scheme Aaron, an accountant, receives a box of personal and business receipts from Caleb and agrees to prepare a business expense statement for Caleb. Aaron includes the $5,000 cost of Caleb’s family vacation, which Aaron knew to be a non-deductible personal expense, as a business expense in Caleb’s tax return. Aaron finalized Caleb’s tax return and advised him that he will be receiving a significant tax refund. He charged Caleb $500 for his services. Caleb filed the return. CRA conducted a compliance audit and discovered the $5,000 of personal expenses deducted in Caleb’s tax return. It disallows the expense, resulting in an additional $2,500 in Caleb’s taxes, assuming a 50% marginal tax rate. Aaron knew of the false statement included in Caleb’s tax return and failed to inform Caleb of this fact. Therefore, Aaron is liable for a penalty of $2,500, calculated as the greater of: • • $1,000 and the lesser of:
(i) Caleb’s gross entitlement of $2,500, which is the tax that Caleb would have avoided if the deduction were permitted (ii) $100,500, calculated as the sum of $100,000 and Aaron’s compensation of $500 For more information on third-party civil penalties, refer to CRA Information Circular IC 01-1 Third-Party Civil Penalties.
Exercise: Civil Penalties for Misrepresentation
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Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Deadlines, Penalties, and Reviews. In this lesson, you have learned how to do the following: • • • describe the filing deadlines calculate the impact of filing late describe the review process and its components
If you are ready to move to the next lesson, click Income Tax Planning and Research on the table of contents.
Assessment
Now that you have completed Deadlines, Penalties, and Review, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Income Tax Planning and Research
Welcome to Income Tax Planning and Research. In this lesson, you will learn about the major components of federal and provincial tax legislation and the sources of additional tax information. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • • explain the major components of federal and provincial tax legislation select and access sources of additional information regarding tax legislation
Income Tax Planning and Research
While a taxpayer is not legally allowed to evade taxes, he or she can structure his or her affairs to avoid them. However, effective income tax planning requires a detailed knowledge of how the income tax system works, which sometimes requires research. Most of our tax rules can be found in the federal Income Tax Act (ITA). Amendments are routinely introduced as a result of the annual Federal Budgets, as well as Technical Amendment Bills that are passed from time to time. Unfortunately, these constant amendments have resulted in a patchwork tax system that is difficult to understand, making it even more difficult for financial planners to keep up to date. While financial planners should not have to be tax experts, they will need to understand the basics of the tax system and to know where to go when they need more information.
Federal Tax Legislation
Our federal tax laws are contained in the following three main pieces of legislation: • • • Income Tax Act Regulations to the Income Tax Act Income Tax Application Rules
Income Tax Act The majority of income tax law is documented in the Income Tax Act (ITA). This complex document is almost 1,900 pages and the table of contents alone is 43 pages. Regulations to the Income Tax Act The Income Tax Act is supplemented by numerous regulations, made under the authority of the ITA. These Regulations to the Income Tax Act (ITRs) are used for a variety of purposes, including setting out the working rules for the statutes and specifying relevant rates. While the Income Tax Act can only be amended by an Act of Parliament, the Regulations can be changed, added to or deleted by an Order-in-Council without formal legislative approval. The Income Tax Act gives CRA the authority to charge an interest penalty on unpaid taxes (ITA 161). However, the prescribed interest rate to be used in calculating that penalty is prescribed by a Regulation to the Income Tax Act (ITR 4301). This allows the government
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Income Tax Planning and Research to change the interest rate to reflect current economic conditions without first seeking approval from Parliament. Income tax application rules When the major overhaul of the tax system was done in 1972, the amending legislation contained a number of transitional rules called the Income Tax Application Rules, 1971, or ITARs. The ITARs cover topics such as the tax-free zone for capital gains on pre-1972 property and V-day values.
Roles of CRA and Finance Canada
Canada Revenue Agency (CRA) is responsible for administering federal tax legislation. CRA develops compliance strategies on sectoral, industrial, occupational, and geographic bases, and they include verification, service, and enforcement activities. These strategies help identify compliance problems, and combine information and education to reduce the cost of compliance, clarify the law, and suggest legislative changes. Finance Canada is the federal department that is responsible for developing tax policy and for drafting legislation.
How Tax Legislation is Introduced
While the primary purpose of the annual Federal Budget is supposed to be outlining the government's anticipated revenues and expenditures for the year, the Budget is also the source of most proposed major income tax changes. The Budget Speech generally provides an overview of what the government is trying to achieve. The supplementary information that is released with the Budget is often several hundred pages in length and describes the government's policy objectives and the purpose of specific legislative changes in more detail. The supplementary information may include Notice of Ways and Means Motions (NWMM), which summarize the proposed changes in plain language and serve to introduce the changes in the House of Commons. Grandparenting provisions When new legislation is introduced it may be applied retroactively to a specified date in time, but usually it is effective as of the date it is passed or as of the date of the Federal Budget that proposed the changes. In either case, there are often two sets of rules once changes are introduced. Under grandparenting provisions, the old rules still apply to situations that existed prior to the application date. The new rules only apply as of the application date. Under rules that came into effect in 1982, a family can only designate one home as their principal residence. Prior to 1982, one spouse could own and designate the family's usual home as his or her principal residence, and the other spouse could designate another property as his or her principal residence, provided each property met the test of being "ordinarily inhabited" by the owner. Because the change was not retroactive, under grandparenting provisions, a couple could still designate two properties as their principal residence for years prior to 1982 (ITA 40(6)).
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Income Tax Planning While these grandparenting provisions maintain some fairness to the tax system for those who entered into a particular financial situation on the merits of the tax regime in existence at that time, they also introduce enormous complexity to the tax system. The rules are complicated enough without worrying about whether a different set of rules applies because the taxpayer entered a particular financial situation before the rules changed.
Provincial Tax Legislation
Each province levies its own tax on taxable income (TONI) and each province operates slightly differently. The provinces also tend to introduce the majority of significant tax changes in their annual budgets. The provincial budgets can be found on the province’s official Web site. Depending on the province, the tax statutes may or may not be available free of charge over the Internet. Each province has a different method of publishing this information. As a financial planner, you should be aware of how the provincial tax system works in the province in which you practice even though, the major tax planning opportunities are evident at the federal level.
Exercise: Federal and Provincial Tax Legislation
Sources of Additional Information
The Income Tax Act and the Regulations are difficult to understand, partly because of the technical language used and partly because each section or subsection seems to refer to one or more other sections. The language style itself is a major stumbling block, with a single sentence often containing over 500 words. Most levels of government have made a commitment to use plain language in their publications and their statutes and some headway is being made. However, the day that the Income Tax Act is an easy read is still a long way away. Unless you have experience deciphering the Act, you will find it difficult to use the Act to answer your questions and concerns about tax planning for your clients. Fortunately, there are other sources of information to which you can turn when trying to understand the tax rules. We will examine some of the more useful and readily available sources in the following sections. The commercial presses offer some excellent resource materials for those trying to decipher our income tax system. Some of the professional accounting firms also publish tax information books and offer information on their Web sites. Some of these publications are intended to be professional reference sources, but others act to entice potential clients to retain the organization's services.
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Income Tax Planning and Research Contact information and a list of useful publications are provided in the following table.
Interpretation Bulletins
CRA issues Interpretation Bulletins (ITs) to outline its interpretation of specific sections or areas of income tax law, generally in something approximating plain language. In addition to explaining the basic rules, these bulletins often cover some of the more unique applications of, or exceptions to, the rules and sometimes provide useful illustrative examples. In this program of study, we often provide you with a reference to an IT bulletin, as a source for more information if you want to go beyond the basic rules that we provide in the text. The ITs are revised occasionally in response to either changes in interpretation or amendments to the Act, so once again you must make sure you are dealing with the most current version. There are currently over 500 IT bulletins available. The IT bulletins are published by some of the commercial presses described later and they are also available here on CRA's Web site.
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Income Tax Planning
Advance Tax Rulings
If a taxpayer is considering a particular transaction in the near future and wants to know its tax implications in advance, he or she can request CRA to provide him with a binding advance tax ruling (ATR) for that transaction. CRA will assess the transaction, interpret the provisions of the Income Tax Act, the Excise Tax Act, and related statutes, and establish its interpretation (for example, ATR-63, Donations to Agents of the Crown). CRA will prepare an advanced tax ruling on a cost-recovery, fee-for-service basis. ATR disclaimer The details of each advance tax ruling are public information and may be used to guide other taxpayers in similar situations. However, care must be taken to ensure that the situation is in fact comparable to the one discussed in the ATR. CRA includes the following disclaimer with each advance tax ruling: "Income tax rulings are published for the general information of taxpayers, but are considered to be binding on the Department only in respect of the taxpayer to whom the ruling was given. They are based on the particular facts in the ruling and on the law in force at the time the ruling is published and, therefore, will not be amended for subsequent changes in the law." Advanced tax rulings may be published by the commercial press along with the ITs and information circulars and they are also available here on CRA's Web site.
Technical or Explanatory Notes
The Department of Finance publishes technical notes (also referred to as explanatory notes) to explain the development and application of new tax policies. The technical notes are typically issued when draft legislation is released. While these notes themselves do not have the weight of law and are not intended to be an official interpretation of the draft legislation, the notes do provide valuable insights into the intention of the legislation. Technical notes for most legislative changes since 1995 are available here on Finance Canada's Web site. Carswell Thomson Professional Publishing offers a reference book called Technical Notes, which is an annotated consolidation of technical notes and other commentary from Finance Canada on a section by section basis of the Income Tax Act, going back as far as 1946. This reference is extremely useful when you are trying to decipher the intent of a particular passage of the Income Tax Act because it provides a history of how and why the legislation developed as it did.
Technical News
CRA periodically publishes a document called Technical News to explain changes in its administrative procedures or to announce new guidelines for the application of specific provisions of the Income Tax Act. Current and back issues of the Technical News are available here on CRA's Web site.
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Income Tax Planning and Research
Tax Guides and Brochures
CRA publishes a wide variety of tax guides each year to help taxpayers complete their income tax returns. The tax guides may have supplementary information that the taxpayer needs to complete his or her return, but that is not in the general income tax package. The tax guides are updated annually to reflect current legislation and to include the current set of tax forms. Thus, the tax guides tend to be more up-to-date than the Interpretation Bulletins, particularly with respect to changing rates or threshold amounts. The following are the more commonly used tax guides: • • • • • • • • • • Business and Professional Income, T4002 Rental Income Tax Guide, T4036 Childcare Expense Deduction, T778 RRSPs and Other Registered Plans for Retirement, T4040 Lifelong Learning Plan (LLP), RC4112 Employment Expenses, T4044 Capital Gains, T4037 Farming Income, T4003 Preparing Returns for Deceased Persons, T4011 Fishing Income, T4004
CRA also publishes a variety of informational brochures and pamphlets to provide taxpayers with general information about programs and policies that may be of interest to them. The following are examples of the brochures available: • • • • • • • • Home Buyers’ Plan (HBP) - For Participants, RC4135 Information Concerning People with Disabilities - RC4064 Registered Education Savings Plans (RESPs), RC4092 Using Your Home for Daycare, P134E When you Retire, P119 Support Payments, P102 Gifts and Income Tax, P113 Students and Income Tax, P105
All of CRA's tax guides, brochures and pamphlets are available free of charge from the District Taxation Offices, as well as here on CRA's Web site.
Budget Documents
Each year, the federal government issues a new Federal Budget that outlines proposed tax changes in conceptual terms. As public distribution has become easier with advances in Internet technology, the Budgets have become an accessible source of information for the taxpayer who wants to keep on top of proposed changes. Along with the Budget Speech, the government issues supporting and explanatory appendices that explain the rationale behind the budget proposals. The Budget Speech and supporting documentation are available the same day that the Budget is released here on Finance Canada's Web site.
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Income Tax Planning
Notice of Ways and Means Motions
The Notice of Ways and Means Motions (NWMM) summarize proposed income tax changes in plain language, and as such they can be useful when trying to interpret the intent and application of proposed legislation. The NWMMs may be included with other supplementary budget information, or they may be issued separately. Most NWMMs can be found by searching here on Finance Canada's Web site under the heading Ways and Means Motions, Draft Legislation, Legislative Proposals and Explanatory Notes.
Exercise: Sources of Additional Tax Information
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Income Tax Planning and Research. In this lesson, you have learned how to do the following: • • explain the major components of the federal and provincial tax legislation select and access sources of additional information regarding tax legislation
If you are ready to move to the next lesson, click Miscellaneous Deductions on the table of contents.
Assessment
Now that you have completed Income Tax Planning and Research, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning and Research
Lesson 4: Miscellaneous Deductions
Welcome to Miscellaneous Deductions. In this lesson, you will learn about how to use various tax deductions to reduce the amount of income that is subject to tax. This lesson takes 35 minutes to complete. At the end of this lesson, you will be able to do the following: • calculate and explain moving expenses, childcare expenses, capital losses, and noncapital losses
Deductions as a Tax Planning Tool
A taxpayer can use a tax deduction to reduce the amount of income that is subject to tax. Canada’s tax system is progressive, which means that as a taxpayer reaches a higher level of taxable income, the rate of taxation on that additional income increases. An example of a progressive tax system is as follows:
It is to the taxpayer’s advantage to use deductions to decrease his or her taxable income. The timing of deductions is important from a tax planning point of view, because the taxpayer would generally want to claim the deduction when his or her marginal tax rate is highest. For the purpose of this example, assume that the income thresholds and the marginal tax rates remain at the levels listed above. Fiona has taxable income of $43,836. Of this amount, $3,109 is subject to tax at the federal rate of 22%, calculated as (income – threshold for 22% tax bracket) or ($43,836– $40,727). Suppose Fiona makes an RRSP contribution of $7,500 for which she can claim a deduction. If she claims the entire deduction this year, she will save $1,342.63 in basic federal tax, calculated as [(income if deduction was not claimed that would have been in the 2nd tax bracket x tax rate for 2nd tax bracket) + (income if deduction was not claimed that would have been in the 1st tax bracket x tax rate for 1st tax bracket)] or [($3,109 × 22%) + (($7,500 – $3,109) × 15%)]. However, Fiona is not required to claim any or all of her RRSP deduction this year. If she claims a deduction of $3,109 this year, she will eliminate the income that is subject to the highest amount of tax, reducing her basic federal tax by $683.98, calculated as (amount claimed in 1st year x tax rate for 2nd tax bracket) or ($3,109 × 22%). She can claim the remaining $4,391 of her RRSP deduction in a future year, thereby saving another $966.02
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Income Tax Planning in basic federal tax, calculated as [(RRSP contribution – amount claimed in 1st year) x tax rate for 2nd tax bracket] or [($7,500 – $3,109) × 22%]. By spreading the deduction over two years, Fiona can reduce her basic federal tax by $1,650, calculated as ($683.98 + $966.02), compared to the $1,342.63 she would save by claiming it all in one year. Tax deductions vs. tax credits A tax deduction reduces the amount on which an individual pays tax. As illustrated in the example above, the value of a tax deduction is dependent on the marginal tax rate (MTR) of the taxpayer. In addition, with some tax deductions and to varying degrees, the taxpayer has flexibility regarding when he or she can elect to claim the deduction and how much of the deduction he or she must claim at that point. This flexibility gives rise to tax planning opportunities. In contrast, a taxpayer can use a tax credit to offset the amount of tax that he or she has to pay. The value of a tax credit is generally the same for all taxpayers regardless of his or her marginal tax rate. Beatrice made a charitable donation of $2,000 which resulted in a federal tax credit of $552, calculated as [(donation threshold of $200 x 15%) + ((charitable donation – donation threshold of $200) x 29%)] or [($200 × 15%) + (($2,000 – $200) × 29%)]. It does not really matter if Beatrice claims the credit this year, when her basic federal tax payable is $4,800 or next year when she expects her basic federal tax payable to be $5,600 because the value of the tax credit remains the same regardless of her marginal tax rate.
Exercise: Deductions as a Tax Planning Tool
Moving expenses
A taxpayer can deduct eligible moving expenses from income that he or she earns at his or her new location if the taxpayer moves to a new location within Canada: • • to start a job or business or to attend courses as a full-time student at college, university or other postsecondary institution (ITA 62(1))
In addition, the taxpayer’s new home must be at least 40 kilometres closer to his or her new school or place of work than his or her previous home was. In order to claim a deduction for moving expenses, the taxpayer must complete form T1-M, Claim for Moving Expenses, and submit it with his or her tax return.
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Income Tax Planning and Research
Eligible Moving Expenses
Eligible moving expenses include the following (ITA 62(3)): • • • • • • • • • travelling expenses, including automobile expenses, meals and accommodations for the taxpayer and his or her family transportation and storage costs, such as packing, hauling, in-transit storage and insurance, for household effects costs for meals and temporary accommodations for the taxpayer and members of his or her household near either residence for up to 15 days lease cancellation fees the cost of selling the old residence, including advertising, legal fees, real estate commissions and, if the mortgage is discharged early, mortgage penalties the cost of carrying the old residence while attempting to sell it, to a limit of $5,000 legal fees and land transfer taxes payable in respect of the new residence, but only if the taxpayer or his or her spouse or common-law partner has sold an old residence as a result of the move the cost of changing the address on legal documents, or automobile permits and licences utility disconnections and hook-ups
Limitations against Deduction
Note: Moving expenses can only be deducted from income earned at the new location (ITA 62(1)(f)). To the extent that this income is less than the moving expenses, the undeducted expenses can be carried forward to be deducted from employment or self-employment income earned at the new location in the following years. Under no circumstances can the moving expenses be deducted from other types of income, such as investment income or Employment Insurance Benefits. On December 1st of last year, Barbara started a new job in Regina. In November of last year, she moved to Regina from Calgary, incurring moving expenses of $12,000. Barbara only earned income of $9,000 at the new location for the last taxation year. Last year Barbara could only deduct moving expenses of $9,000. This year, she will be able to deduct the remaining $3,000, calculated as (total moving expenses - amount deducted last year) or ($12,000 - $9,000), provided she earns at least $3,000 in income at the new location. Also, if the taxpayer is reimbursed by his or her employer for some or all of his or her moving expenses, the reimbursed amount cannot be deducted as a moving expense unless it is also included in the taxpayer’s income (ITA 62(1)). Paul’s employer transferred him to a new location and Paul incurred moving expenses of $8,000. The employer reimbursed Paul for $3,000 in moving expenses and this amount was not included in his taxable income. Paul can only claim a moving expense deduction for the remaining $5,000, calculated as (moving expenses - reimbursed amount) or ($8,000 - $3,000). Refer to T1-M, Claim for Moving Expenses, or IT-178R3, Moving Expenses, for more information.
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Income Tax Planning
Exercise: Moving Expenses
Childcare Expenses
A taxpayer may be able to deduct the amounts that he or she or another supporting person paid to have someone look after an eligible child, so that the taxpayer or the other supporting person could: • • • • earn income from employment carry on a business, either alone or as an active partner attend a qualifying educational program, including secondary school carry on research for which a grant was received (ITA 63(3))
An eligible child includes the child of the taxpayer or his or her spouse or common-law partner, or a child who was dependent on the taxpayer or his or her spouse or common-law partner and who had a net income of less than the basic personal amount (ITA 63(3)). The child must be under 16 years of age at some point during the taxation year, or must be dependent as a result of a mental or physical infirmity. Carl and his wife, Sharon, are the legal guardians of Carl’s 6-year-old nephew, Bart. Bart is financially dependent on Carl and has no income. Bart is an eligible child, so Carl or Sharon may be able to claim a childcare expense deduction for amounts they paid for Bart's care while they worked. In order to claim a childcare expense deduction, the taxpayer will have to complete Form T778, Childcare Expense Deduction, and submit that form with his or her tax return.
Eligible expenses
A childcare expense deduction can be claimed for payments made to the following: • • • • • • individuals who provide childcare services (other than the child’s parents or relatives under the age of 18) day nursery schools and daycare centres educational institutions for the part of the fees that relate to childcare services day camps and day sport schools boarding schools, overnight sports schools or camps where lodging is involved placement agencies or advertisers used to find a childcare provider
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Income Tax Planning and Research
Limits
There are several limits that restrict the deduction of childcare expenses. Basic limit for childcare The total childcare expense that can be claimed in any one year for an eligible child is limited to: • • • $10,000 per year for each child for whom the disability tax credit may be claimed $7,000 per year for each child who is under seven years of age at the end of the year, or who has a mental or physical impairment $4,000 per year for each other eligible child
Tanya is a single parent with 3-year old twins, Alexis and Timothy. She has hired a Nanny at a cost of $20,000 per year to care for the children while she works full-time, earning a salary of $120,000. Tanya can claim a childcare expense of $14,000, calculated as (the lesser of (actual costs and (annual maximum for children under 7 x number of children under 7))) or (the lesser of ($20,000 and ($7,000 × 2))). Limit for an overnight camp or boarding school Claims for payment made to an overnight camp or boarding school are limited to the following: • • • $250 per week of camp for each child for whom the disability tax credit may be claimed $175 per week of camp for an eligible child who is under seven years of age by the end of the year, or who has a mental or physical impairment or $100 per week of camp for all other eligible children (ITA 63(3)(c), draft ITA 63(3), periodic childcare amount)
Sandra has two children. Casey is 5 years old and Jordan is 8. She enrolled both of them in summer boarding camps at a cost of $150 per child per week, for four weeks. She can claim $600 for Casey, calculated as (the lesser of (actual costs and (maximum amount for a child under 7 x number of weeks))) or (the lesser of (($150 x 4) and ($175 x 4))). She can claim $400 for Jordan, calculated as (the lesser of (actual costs and (maximum amount for a child over 6 x number of weeks))) or (the lesser of (($150 x 4) and ($100 x 4))). Deduction limits
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Finally, a taxpayer can only deduct childcare expenses to the extent that they do not exceed /3 of his or her earned income (ITA 63(1)(e)).
Lucy is a single mother and she has just started a business that resulted in selfemployment income of $12,000. This is her only taxable income. While she is getting the business established, Lucy is supporting herself with personal savings. Lucy has two young children and she pays $9,000 per year in eligible childcare expenses. The most that Lucy can deduct as a childcare expense is $8,000, calculated as (the lesser of (her actual expenses and (earned income x (2 ÷ 3)))) or (the lesser of ($9,000 and ($12,000 × (2 ÷ 3)))).
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Income Tax Planning
Who Can Make the Deduction?
In most cases where there are two supporting persons, only the person with the lower net income can claim a deduction for childcare expenses. Carl and Sharon both work full-time and they pay $140 per week for Bart to be in daycare. Carl has net income of $38,000, while Sharon has net income of $46,000. Only Carl can claim the childcare expenses because he has the lower net income. When the higher income spouse can claim the deduction The only time the supporting person with the higher net income can claim the childcare expense is if the lower-income supporting person is: • • • • separated confined to a wheelchair or bed in prison enrolled at a secondary school or other designated educational institution either full-time or part-time (ITA 63(2))
If the lower-income supporting person is separated, confined to a wheelchair or bed, in prison, or in school full-time, the higher-income supporting person can claim childcare expenses only for those weeks where the conditions listed above are in effect, and the most that he or she can claim is: • • • $250 per week for a child for whom the disability tax credit may be claimed $175 per week for children who are under age seven or who are infirm $100 per week for other eligible children, (ITA 63(2)(b), draft ITA 63(3), periodic childcare amount)
Blair and Stephanie have two children, four-year old Rhianna and eight-year old Connie. Over the course of the year, they paid $6,000 in childcare expenses for Rhianna and $3,000 for Connie. Blair had an income of $102,000 and Stephanie had an income of $52,000, so normally Stephanie would be the one to claim the childcare expenses. However, Stephanie returned to school full-time for 16 weeks to finish off the MBA that she had been working on part-time for the last three years. Blair will be able to claim childcare expenses of $4,400 for the year, calculated as ((maximum amount for child under 7 + maximum amount for child over 6) x number of weeks of full-time study) or (($175 + $100) × 16). Stephanie will have to claim the remaining $4,600, calculated as ((amount paid for Rhianna + amount for Connie) - amount claimed by Blair) or ($3,000 + $6,000 - $4,400). Lower income spouse in school part-time The higher-income supporting person may also be able to claim childcare expenses for those weeks that the lower-income supporting person was in school on a part-time basis, but in this case the deduction is limited to: • • • $250 per month for a child for whom the disability tax credit may be claimed $175 per month for children who are under age seven or who are infirm $100 per month for other eligible children
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Income Tax Planning and Research Refer to T778, Childcare Expenses Deduction, or IT-495R2, Childcare Expenses, for more information.
Exercise: Childcare Expenses
Losses
Most types of losses can also be deducted from taxable income, but this is a complicated area because there are different rules for different types of losses. In this section we will provide an overview of the losses and how they are deducted on the taxpayer’s tax return. To illustrate the deductibility of losses, we will take a look at the situation of Gerri-Lou Lewis.
Non-capital losses
First of all, we will consider how a taxpayer could incur a loss as a result of an office, employment, business or property. Loss from employment If a taxpayer earns income from an office or employment, he or she may be able to deduct certain employment expenses from that income. If employment expenses exceed employment income, the taxpayer would have a loss from employment. Last year, Gerri-Lou had employment income of $15,000. She had employment expenses of only $350, so she does not have a loss just from employment or office. Loss from business If the taxpayer is self-employed and his or her gross business income is less than his or her business expenses, the taxpayer will have a business loss. Gerri-Lou quit her job in April and started a small business. On her Statement of Business or Professional Activities, she reported gross income of $4,600 and expenses of $17,314, so she had a business loss of $12,714, calculated as (gross income - expenses) or ($4,600 - $17,314). This loss is reported as a negative amount of income on her T1 return. Rental loss If the taxpayer has a rental property, it is possible to have a rental loss. Gerri-Lou also owns a rental property, but she was unable to find a tenant for five months of the year and she had to do some significant repairs. As a result, she had a rental loss of $3,200.
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Income Tax Planning Investment loss It is also possible to realize a loss on other investments if the carrying charges exceed the investment income. Several years ago, Gerri-Lou borrowed $20,000 to invest in Canadian equities. She had taxable dividend income of $500. However, she paid interest on her loan of $1,250. So, she has an investment loss of $750, calculated as (investment income - interest expense) or ($500 - $1,250). Using losses to offset income All of the losses that we have mentioned so far can be used to reduce the taxpayer’s income from any source, but only until that income is nil. Obviously, there is no benefit to reducing the taxable income to less than nil. If the losses are such that they exceed his or her income in the loss year, the taxpayer will have a non-capital loss. Non-capital losses generally include: • • • • unused losses from an office, employment, business or property unused allowable business investment losses (ABILs) the unused portion of the taxpayer’s share of partnership losses from business or property the unused portion of the taxpayer’s share of partnership ABILs (ITA 111(8))
Last year, Gerri-Lou had a non-capital loss of $2,014, calculated as (employment income + dividend income - business loss - rental loss - interest expense - employment expenses) or ($15,000 + $500 - $3,200 - $12,714 - $1,250 - $350).
Non-capital Loss Carryovers
For tax years ending after 2005, non-capital losses can be carried back for up to three years and carried forward for up to 20 years to be applied against any source of income in those years (ITA 111(1)(a)). If a non-capital loss that has been carried over is not used to offset other income within the 20-year window, the non-capital loss becomes a net capital loss and from that point forward, can only be used to offset taxable capital gains. Gerri-Lou can carry back her non-capital loss of $2,014 and deduct it from her taxable income in any of three years prior to last year, or she can carry it forward to be deducted from her taxable income in any of the next 20 years. In order to carry losses back, the taxpayer must submit a completed Form T1A, Request for Loss Carryback to CRA. To carry the losses forward, the taxpayer simply records the amount as a deduction on of a subsequent year’s tax return, under the heading of Noncapital losses of other years. Gerri-Lou decided to carry forward the non-capital loss to a future year. Flexibility as to claiming non-capital losses A taxpayer is not required to deduct all available non-capital loss carryovers in any particular year. When carrying over a non-capital loss, the taxpayer should pay attention to his or her marginal tax bracket during the year in which he or she is claiming the loss carried over, to optimize the use of the loss carryover. If the taxpayer expects to remain in
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Income Tax Planning and Research a high tax bracket, he or she might only want to use enough of the loss in any one year to drop one tax bracket, saving the remaining loss for the next year. The taxpayer also would not want to use the loss carryover to reduce his or her taxable income below the point at which no tax is payable anyway because of the personal tax credit and other available credits. Amanda had the option of reporting a non-capital loss carryover of $6,000. However, her taxable income was only $6,400. Because this will be offset by the basic personal amount of $9,600 that each taxpayer is entitled to claim, she would not want to claim the loss carryover because her tax liability is already $0.
Net Capital Losses
If a taxpayer realizes an allowable capital loss upon the disposition of capital property, that loss can only be deducted from taxable capital gains. In its most basic form, a net capital loss for a year is simply the sum of all allowable capital losses for the year minus all taxable capital gains (ITA 111(8)). The net capital loss is recorded as a negative amount on the bottom of Schedule 3, Capital Gains (or Losses). However, because it cannot be deducted from other sources of income, it does not show up on the taxpayer’s general tax return as a negative taxable capital gain. This year, Gerri-Lou Lewis sold a piece of land that had an adjusted cost base (ACB) of $160,000. She had net proceeds of $140,000. As a result, she had an allowable capital loss of $10,000, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($140,000 - $160,000) × 50%). She also sold some stocks that she bought many years ago that had an ACB of $1,200. She had net proceeds of $3,000. So, she had a taxable capital gain of $900, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($3,000 - $1,200) × 50%). Gerri-Lou has a net capital loss of $9,100, calculated as (allowable capital loss - taxable capital gain) or ($10,000 - $900). Because she cannot deduct this amount from her taxable income this year, it will not appear on Page 2 of her general return. However, she will still want to fill out a Schedule 3, Capital Gains (or Losses), and file it with her return, so that she can make use of the carry-over provisions. Net capital loss carryovers Net capital losses can be carried back for three years to be applied against taxable capital gains in those years, or they can be carried forward indefinitely to be used against taxable capital gains of other years (ITA 111(1)(c)). To carry the loss back, the taxpayer must submit Form T1A, Request for Loss Carryback. To carry the loss forward, the taxpayer simply enters the net capital loss carryover on his or her tax return when he or she wants to use it. Refer to IT-232R3, Losses - Their Deductibility in the Loss Year or in Other Years, for more information.
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Income Tax Planning
Exercise: Non-capital and Net-capital Losses
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Miscellaneous Deductions. In this lesson, you have learned how to do the following: • calculate and explain moving expenses, childcare expenses, capital losses, and non-capital losses
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Miscellaneous Deductions, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning and Research
Review
Let’s look at the concepts covered in this unit: • • • • Residency and Installment Payments Deadlines, Penalties, and Reviews Income Tax Planning and Research Miscellaneous Deductions
You now have a good understanding of income tax planning and research. At this point in the course you can describe residency requirements and rules, calculate the impact of filing late, and explain the major components of the federal and provincial tax legislation. You can also calculate and explain moving expenses, childcare expenses, capital losses, and noncapital losses. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 4: Income Tax Planning and Research, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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Unit 5: Taxation of Employees and Alternative Minimum Tax
Income Tax Planning
Unit 5: Taxation of Employees and Alternative Minimum Tax
Welcome to Taxation of Employees and Alternative Minimum Tax. In this unit, you will learn about the types of employment income as well as the impact of taxable benefits and fringe benefits not included in income on a client’s taxes. You will also learn about the tax treatment of employee stock options and alternative minimum tax (AMT). You need to understand how employment income is treated for tax purposes in order to understand how this income fits into your client's wealth accumulation plans. This unit takes approximately 2 hours and 30 minutes to complete. You will learn about the following topics: • • • • Types of Employment Income and Taxable Benefits Fringe Benefits not Included in Income Employee Stock Option Plans Alternative Minimum Tax
To start with the first lesson, click Types of Employment Income and Taxable Benefits on the table of contents.
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Taxation of Employees and Alternative Minimum Tax
Lesson 1: Types of Employment Income and Taxable Benefits
Welcome to Types of Employment Income and Taxable Benefits. In this lesson, you will learn about the types of employment income and the impact of taxable benefits on a client’s income. This lesson takes 50 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the types of employment income identify and calculate the impact of taxable benefits on a client’s income
Types of Employment Income
The Income Tax Act defines employment income to include salary, wages and other remuneration including gratuities, but it does not define all of these terms specifically (ITA 5(1)). Essentially, employment income includes anything a taxpayer receives in respect of an office or employment including salary, wages and other remuneration, such as gratuities. It also includes the value of certain fringe benefits. Salary or wages Salary or wages are defined as the income that a taxpayer receives from an office or employment including all fees received for services not rendered in the course of the taxpayer’s own business, but excluding pension benefits or retiring allowances (ITA 248(1)). Blair works as a project engineer for the City of Regina and he earns a salary of $62,000 per year. Flora works on the assembly line at Skyrock Mechanical Ltd., earning a wage of $17.55 per hour. Gratuities Gratuities include amounts that a taxpayer receives either from his or her employer or from others in respect of his or her service with that employer. Denang worked his way through college waiting tables at Angie’s Bar and Grill. In addition to his wage of $8.00 per hour, Denang usually earned tips of about $50 each night, and these gratuities must be included in his employment income. Kiesha is a marketing representative for Corral Software Systems, and in addition to her salary of $43,000 per year, Kiesha received a bonus of $2,500 last year for landing a major corporate account. Kiesha must include the bonus in her employment income. Other remuneration Any other amount that a taxpayer receives in respect of his or her employment or office would be included in his or her employment income as other remuneration. This could include directors’ fees, sales commissions, signing bonuses, or performance bonuses.
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Income Tax Planning Bayliss works as a sales clerk in an electronics store on a salary plus commission basis. Last year, he earned a salary of $28,000 plus commissions of $18,000. His total employment income was $46,000, calculated as (salary + commissions) or ($28,000 + $18,000). Income earned as an independent contractor However, the amount earned by a taxpayer as an independent contractor would not be employment income, but business income, because he or she would not be acting as an employee. Jacqueline provides her services as a technical illustrator to a variety of different design companies and she charges them $55 per hour plus expenses. Jacqueline does not have employment income; she has business income.
Taxation of Employment Income
Taxpayers must report employment income on a cash basis in the year the income is received, even if the income is in respect to services provided in a different year (ITA 5(1)). The employer must prepare a T4 tax slip reporting employment income and payroll deductions. The employer is not required to prepare a payroll as of December 31 of each year. The last pay period of a year may straddle the year–end. If so, the employment income for the last pay period is reported on a T4 in the subsequent year because it was not paid until that year. On January 3rd of this year, Sally received a paycheque for $2,300 covering her employment from December 20th of last year through January 2nd of this year. The amount will be reported on a T4 slip for this year and she must include the full $2,300 in her income for this year, even though most of the income was a result of employment for last year. Matthew’s employer, DEF Corp., declared a bonus in respect of his service for last year to be payable on May 15th of this year. Matthew will include the bonus in his income of this year even though it relates to his employment for last year.
Exercise: Taxation of Employment Income
Automobile Benefits
If an employee is allowed to use an employer’s vehicle for personal use, he or she may incur a taxable benefit. The amount of the taxable benefit is calculated as: • • • a standby charge plus an operating cost benefit minus any reimbursement the employee makes to his or her employer
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Taxation of Employees and Alternative Minimum Tax Standby charge The standby charge represents the benefit the employee enjoys by virtue of having the car available for personal use and it takes into account the cost of car ownership or leasing costs (ITA 6(1)(e) and 6(2)). The specific calculation is beyond the scope of this course. However, if the employee makes absolutely no use of the automobile for personal use, there is no taxable benefit in the form of a standby charge, even if the vehicle was available to the employee for the entire year. Jeannette was recently promoted to VP of marketing for a large corporation. One of the perks available to all VPs is the use of a luxury sedan for both personal and business use. Because Jeannette’s family already owns two large late model cars, she decided not to use the corporate vehicle for personal use. She will not have a taxable benefit in the form of a standby charge, even though she could have made use of the corporate vehicle if she had wanted to. Operating cost benefit The operating cost benefit is based on the number of kilometres the employee drives the car for personal use. For most employees, the operating cost benefit is calculated as 24 cents per kilometre, including PST and GST or HST (ITA 6(1)(k)). As one of the benefits of his employment, Simon was provided with a car for personal and business use during the taxation year. Simon's employer determined that the standby charge amounted to $3,200. In addition, Simon used his employer's car to travel 4,000 kilometres for personal use, so he has a taxable operating cost benefit of $960, calculated as (kilometres travelled for personal use x operating cost benefit rate) or (4,000 km × $0.24). Simon's total automobile benefit is $4,160, calculated as (standby charge + operating cost benefit) or ($3,200 + $960). Refer to IT-63R5, Benefits, Including Standby Charge for an Automobile, From the Personal Use of a Motor Vehicle Supplied by an Employer After 1992, for more information. Click here to visit CRA to view the latest facts about automobile benefits.
Employer-paid Education Expenses
Education that primarily benefits the employer If a taxpayer takes training or education courses that maintain or upgrade his or her employment-related skills and his or her employer pays for or reimburses the taxpayer for the cost of those courses, the taxpayer does not have a taxable benefit because the training is considered to primarily benefit the employer. In general, soft-skill courses such as stress management, time management, or first aid are also considered to be for the employer’s benefit and the costs of these training programs are not considered to be a taxable benefit. Education that primarily benefits the employee However, if his employer reimburses the taxpayer or pays directly for courses that are simply of personal interest or that provide or upgrade skills that are not directly related to the taxpayer’s job, those fees will be included in the taxpayer’s income (ITA 6(1)).
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Income Tax Planning Gordon is a press operator for a large manufacturing firm. He is taking night school courses in hotel management, and as a result of its liberal education policy, his employer reimburses him for the tuition costs associated with this program. Gordon has a taxable benefit in the amount of the money reimbursed to him because the education is obviously for his own benefit, not the benefit of his employer. Refer to CRA’s Income Tax Technical News No. 13 (May 7, 1998), for more information about the application of these rules.
Private Employment Insurance Benefits
A taxpayer may have a taxable employment benefit if he or she receives periodic payments in respect of the loss of all or part of his or her income from an office or employment under a private or group: • sickness or accident insurance plan • disability insurance plan • income maintenance insurance plan The benefit will be taxable if it comes from a plan for which the taxpayer’s employer paid the premium. The amount of the taxable benefit will be equal to the total of all amounts received by the taxpayer during the year minus any amounts that the taxpayer has contributed to the plan up to that time (ITA 6(1)(f)). Monica is a member of her employer’s group disability insurance plan. Her employer pays the premiums and those premiums are not treated as a taxable benefit. If Monica becomes disabled, any benefits that she receives from the plan will be considered to be a taxable employment benefit.
Exercise: Benefits, Part 1
Financial Counselling or Tax Planning Services
If a taxpayer receives financial counselling or income tax preparation services as a result of his or her employment or office, the value of those services are considered to be a taxable benefit. This does not apply to retirement planning services. Pearl works for JKL Corporation. JKL has a contract with an independent financial planner to provide eight hours of general financial planning services to each of its 50 employees, at a cost of $400 each. Pearl used this service and as a result, she has a taxable benefit of $400.
Forgiven Loans
If a taxpayer had a loan from his or her employer and all or part of that loan was forgiven, the forgiven amount would be included in the taxpayer's income (ITA 6(15)).
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Taxation of Employees and Alternative Minimum Tax Last year, Tanya borrowed $20,000 from her employer to finance a new car purchase. By June of this year, Tanya had repaid $6,000 of principal but her employer told her that she could discharge the loan by making one more payment of $4,000. If Tanya does this, she will have a taxable benefit of $10,000 for this year, calculated as (initial loan amount - total payments made) or ($20,000 - $6,000 - $4,000). Refer to IT-421R2, Benefits to individuals, corporations and shareholders from loans or debt, for more information.
Frequent Flyer Benefits
Under a frequent flyer program, which is usually sponsored by an airline, a frequent air traveller can accumulate credits that can be exchanged for additional air travel or other benefits. Where an employee accumulates such credits while travelling on employer-paid business trips and uses them to obtain air travel or other benefits for himself or herself or for his or her family, the employee must include the fair market value of that air travel or other benefits in his employment income (ITA 6(1)(a)). Ben is a quality assurance representative for a major manufacturing corporation that has plants across North America. As a result of his job, Ben travels extensively and has accumulated a large number of frequent flyer points. Last year, he used those points to fly himself and his family to Europe, and the fair market value of the flights was $8,000. As a result, Ben has additional taxable employment income of $8,000.
Interest-free and Low-interest Loans
If a taxpayer receives an interest-free or low-interest loan as a result of his or her employment or office, he or she is considered to have received a taxable benefit (ITA 6(9)). The value of that benefit is calculated as the amount of interest the employee would have paid if the loan had been made at the prescribed rate, minus the amount of interest that he or she actually paid in the year, or no later than 30 days after the end of the year (ITA 80.4(1)). Prescribed rate The prescribed rate is the rate set by ITR 4301 and it is adjusted quarterly. The prescribed rates for the last few years are as shown in the table below. Federal Prescribed Interest Rates for Employee and Shareholder Interest-free and Low-interest Loans 2005 January 1st to March 31st April 1st to June 30th July 1st to September 30th October 1st to December 31st 3% 3% 3% 3% 2006 3% 4% 4% 5% 2007 5% 5% 5% 5% 2008 4% 4% 3% 3% 2009 2% 1% 1% 1%
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Income Tax Planning Charles borrowed $30,000 from his employer on January 1st to purchase a new car. The loan is to be repaid in equal annual installments made at the end of each of three years, along with interest of 3%. For the purposes of this example, we will assume that the prescribed rate over the four quarters of the first year of Charles’ loan was 5%, 5.5%, 6% and 7%. Charles has a taxable benefit of $862.50, calculated as ((excess of prescribed rate over interest rate charged) x amount of the loan) or ((((5% - 3%) × ¼) + ((5.5% - 3%) × ¼) + ((6.0% - 3%) × ¼) + ((7.0% - 3%) × ¼)) × $30,000).
Home Purchase Loans and Home Relocation Loans
Home purchase loan A home purchase loan is one that the taxpayer uses to acquire a dwelling or a share in a cooperative housing corporation to live in, or that he or she uses to repay a loan that he or she previously incurred for such a purpose (ITA 80.4(7)). Home relocation loan A home relocation loan is a loan that the taxpayer uses to acquire a new home in a new location as a result of a change in his or her job location, provided that the distance between the old residence and the new work location is at least 40 kilometres greater than the distance between the new residence and the new work location (ITA 248(1)). When Jake worked for the head office of ABC Ltd., he lived in Bigtown about 8 km from the office. ABC transferred Jake to its regional office in Smalltown. The regional office is 56 km away from the head office and 52 km away from Jake’s home in Bigtown. Jake decided that he didn’t like commuting and he used a loan from ABC Ltd. to purchase a new house in Smalltown just 2 km away from the regional office. The change in the distance between homes and the new office is 50 km, calculated as (distance from old home to office - distance from new home to office) or (52 – 2). This change in the distance is greater than 40 km so Jake’s loan qualifies as a home relocation loan. The difference between a home purchase loan and a home relocation loan is important because, while both can give rise to a taxable benefit, in the case of a home relocation loan the taxpayer can claim an offsetting deduction, as discussed later in the section on Employment Deductions.
Loans to Earn Income
If the employee uses the funds to earn income from business, property or employment, he or she will be able to deduct the value of both the actual interest paid and the deemed interest benefit as an interest expense on Schedule 4 of his or her tax return. On January 1st, Marsha borrowed $20,000 from her employer at an interest rate of 3% compounded annually for investment purposes. The loan is to be repaid in a single lump sum at the end of two years. If the prescribed rate is 5%, Marsha has a taxable benefit of $400 in the first year, calculated as (loan x (prescribed rate - interest rate charged)) or ($20,000 × (5% - 3%)). She must also pay interest to her employer in the first year of $600, calculated as (loan x interest rate) or ($20,000 × 3%). Marsha can deduct an interest expense of $1,000, calculated as (employment benefit + interest paid) or ($400 + $600). Refer to IT-421R2, Benefits to individuals, corporations, and shareholders from loans or debt, for more information.
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Taxation of Employees and Alternative Minimum Tax
Exercise: Benefits, Part 2
Low Cost Housing, Board, and Lodging
Low-cost housing If, as a result of his or her employment or office, a taxpayer receives access to accommodations rent-free or for less than fair market value, he or she is considered to receive a taxable benefit equal to the value of those accommodations less any amount he or she paid (ITA 6(1)(a)). Peter works for Magnum Housing Corporation, a company that owns and manages executive townhouse and condominium complexes. In addition to his salary, Peter is able to rent one of the luxury townhouses for $1,000 per month, even though similar units rent for $1,800 per month. Peter has a taxable benefit of $800 per month, calculated as (FMV of rental accommodations - amount actually paid) or ($1,800 - $1,000). Board or lodging If, as a result of his or her employment or office, a taxpayer receives board or lodging, he or she is considered to receive a taxable benefit equal to the fair market value of those services less any amount he or she paid for them (ITA 6(1)(a)). Lodging refers to the provision of a place to live, while board refers to the provision of meals and other services. Helena is employed as a live-in nanny for the Robinson family. She receives a salary of $26,000 per year, and the Robinsons provide her with room and board for $200 per month. The fair market value of room and board of similar quality in that neighbourhood would be $700 per month. Helena has a taxable benefit of $500 per month, calculated as (FMV of room and board - amount actually paid) or ($700 - $200). Note: There is an exception to these rules for employees who work at remote locations or special work sites.
Merchandise Sold Below Cost or at a Discount
Merchandise below cost If a taxpayer is permitted to buy the employer’s merchandise below cost, he or she will have a taxable benefit to the extent of the difference between the fair market value of the merchandise and the price he or she paid for the merchandise (ITA 6(1)(a)). Barry works for an electronics retailer. Barry was permitted to buy a surroundsound stereo system for $300, even though his employer’s cost was $500 and the system normally sells for $1,000. Barry will have a taxable benefit of $700, calculated as (FMV actual purchase price) or ($1,000 - $300).
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Income Tax Planning Merchandise at a discount but not below cost If the taxpayer buys the merchandise at a discount but at an amount that is at least equal to the employer’s cost, there is usually not a taxable benefit, as long as all employees have the option of purchasing merchandise with the same discount. Barry would have been better off buying the stereo system for $500, because then he would not have a taxable benefit. Merchandise at a discount but only for select employees If only a select group of employees are able to buy merchandise at a discount, the difference between the fair market value and the purchase price is a taxable benefit. Fine Fashions gives its entire full-time senior sales staff a 25% discount on its merchandise, but it does not give the same discount to junior or part-time sales people. Margie is a full-time manager at Fine Fashions and she was able to buy a $4,000 fur coat for $3,000. She has a taxable benefit of $1,000, calculated as (FMV of merchandise - amount actually paid) or ($4,000 - $1,000).
Moving and Relocation Expenses
The following relocation benefits paid after February 23, 1998, by an employer to an employee who relocates because of an office or employment will be included as income: • any payment or reimbursement in excess of $5,000 made in respect of mortgage interest, property taxes, heat, hydro, property insurance, and grounds maintenance costs to keep up the old residence after the move, when all reasonable efforts to sell have not been successful any payment or reimbursement made in respect of financing, such as higher mortgage interest payments at the new residence, bridge financing and mortgage interest on the unsold former residence any payment or compensation made in respect of a loss on the sale of the former residence or a decrease in the value of the former residence, up to one-half of the amount that exceeds $15,000
•
•
Michael’s employer transferred him from Toronto to Québec last year. Michael had to sell his house and he incurred a loss of $35,000, for which his employer reimbursed him. This will result in taxable income of $10,000, calculated as ((loss on house - limit of $15,000) ÷ 2) or (($35,000 - $15,000) ÷ 2). Because house prices were higher at the new location, Michael had to take out a larger mortgage even though he bought a house that was comparable to his old house. Also, mortgage rates had gone up, so Michael ended up paying a total of $500 more in interest at the new location each month. Michael’s employer reimbursed him for this additional interest, resulting in a taxable benefit of $6,000 per year, calculated as (monthly interest paid by employer x months per year) or ($500 × 12).
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Taxation of Employees and Alternative Minimum Tax
Exercise: Benefits, Part 3
Premiums on Group Life Insurance Coverage
If the taxpayer is a member of a group life insurance plan and his or her employer pays the premiums on his or her behalf, those premiums are a taxable benefit to the extent that the taxpayer does not reimburse the employer either directly or through deductions from his or her pay (ITA 6(4)). Larry is a member of his employer’s group life insurance plan. His employer pays premiums of $150 per year for Larry’s coverage and the employer does not deduct any of these amounts from Larry’s pay. Larry has a taxable benefit of $150. Refer to IT-227R, Group term life insurance premiums, for more information.
Premiums under Provincial Health Care Plans
If an employer pays the premiums or contributes to a provincial hospital or medical care insurance plan for an employee, those premiums or contributions are considered to be a taxable benefit (ITA 6(1)(a)). This would be the case in provinces, such as Alberta, where the individual is normally responsible for paying these premiums, but the employer pays them on his or her behalf. In other provinces, such as Ontario, the provincial health care system is financed by a payroll tax such that the employer has no option but to contribute to the plan. In this case, the payroll tax is not considered to be a taxable benefit to the employee.
Premiums for Wage-loss Replacement Plans or Income Maintenance Plans
If the employer pays a premium for a wage-loss replacement plan or an income maintenance plan for an employee, the premium is a taxable benefit if it is paid to a nongroup plan that is either: • • • a sickness or accident insurance plan a disability insurance plan an income maintenance insurance plan
In this case, any benefits from the plan are not taxable. Wilderness Services pays the premiums on individual disability contracts for its three key managers, including Raymond. The company pays premiums of $1,600 for Raymond’s policy. Raymond has a taxable benefit of $1,600. However, if Raymond becomes disabled, any payments that he receives from the plan will not be taxable.
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Income Tax Planning If the premium is paid to a group plan, the premium is not a taxable benefit. However, if the employer pays the premium, any payments the employee receives under the plan will be taxable (ITA 6(1)(f)). Thomas belongs to his employer’s group disability plan, and his employer pays premiums of $400 per year to cover Thomas under the plan. Thomas does not have a taxable benefit. However, if Thomas becomes disabled, any payments he receives from the plan will be taxable.
Registered Retirement Savings Plans (RRSPs)
If an employer contributes to an employee’s RRSP, those contributions are considered to be a taxable benefit to the employee. This does not include an amount that an employer withholds from the employee’s pay and later contributes on behalf of that employee. Amanda belongs to a group RRSP established by her employer. Each year, with Amanda’s permission, her employer withholds 5% of her pay and contributes it to the RRSP. This is not a taxable benefit. Janet’s employer also has a group RRSP and it contributes $2,000 to the plan on behalf of each employee each year. Janet has a taxable benefit of $2,000. However, the employee can then claim a deduction for the RRSP contribution on Schedule 7 of his or her tax return. Although Janet has a taxable benefit, she can claim a deduction for a $2,000 RRSP contribution.
Exercise: Taxable Benefits
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Taxation of Employees and Alternative Minimum Tax
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Types of Employment Income and Taxable Benefits. In this lesson, you have learned how to do the following: • • describe the types of employment income identify and calculate the impact of taxable benefits on a client’s income
If you are ready to move to the next lesson, click Fringe Benefits not Included in Income on the table of contents.
Assessment
Now that you have completed Types of Employment Income and Taxable Benefits, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 2: Fringe Benefits not Included in Income
Welcome to Fringe Benefits not Included in Income. In this lesson, you will learn about the impact of fringe benefits not included in income on a client’s taxes. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • identify and calculate the impact of fringe benefits not included in income on a client’s taxes
Fringe Benefits Not Included in Income
The Income Tax Act specifically excludes from taxation as taxable benefits those benefits derived from the contributions that the employer makes on the employee’s behalf to: • • • • • a a a a a registered retirement pension plan group sickness or accident insurance plan private health services plan supplementary unemployment benefit plan deferred profit sharing plan (ITA 6(1)(a)(i))
Other benefits that are not taxable are discussed on the following pages.
Automobile Allowances
If an employee uses his or her personal vehicle for business use and his or her employer provides the employee with a reasonable per kilometre automobile allowance, that allowance will not be taxable (ITA 6(1)(a)(iii)). The reasonable amount is prescribed by ITR 7306. Currently, a reasonable automobile allowance has been set at: • • • $0.52 per kilometre for the first 5,000 kilometres $0.46 per kilometre thereafter To each category listed above, an additional $0.04 per kilometer is added for travel in the Yukon, Northwest Territories and Nunavut
If the allowance is not reasonable either because it is too high or too low, then the employee must include the full amount of the allowance in his or her income. However, he or she may then be able to claim a portion of the expenses with respect to that automobile from his or her employment income (ITA 8(1)(h.1)).
Exercise: Deductions from Employment Income, Part 1
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Taxation of Employees and Alternative Minimum Tax
Counselling Services
If a taxpayer receives counselling services by virtue of his or her employment or office, it will be exempt from tax if it relates to one of the following: • the mental or physical health of the taxpayer or someone related to the taxpayer. This includes programs for tobacco, drug and alcohol abuse, as well as stress management, but does not include amounts for using recreational or sporting facilities the taxpayer’s re-employment the taxpayer’s retirement (ITA 6(1)(a)(iv))
• •
Martin works for EFG Ltd. but his position is being terminated in eight weeks. EFG Ltd. has hired a career counsellor to help Martin explore his options and to assist him in preparing a new resume. EFG Ltd. is paying $600 to the career counsellor for these services, but this amount is not a taxable benefit to Martin.
Disability-related Employment Benefits
If a taxpayer is disabled and his or her employer provides benefits that help that taxpayer perform his or her duties, those benefits are not taxable (ITA 6(16)). These benefits could include, for example: • • reasonable transportation to and from work for employees who are blind or who have a severe physical impairment attendants such as readers for the blind, signers for the deaf or coaches for the mentally handicapped
Nathan has Tourette’s syndrome and Attention Deficit Disorder, but with the help of his local Association for Community Living (ACL), he has been able to get a job. In addition to paying Nathan’s wages, his employer pays ACL a fee for the assistant who helps Nathan keep on track at his job. While this amount is paid by the employer to help Nathan earn his wages, it is not a taxable benefit for Nathan.
Moving Expenses
If an employer reimburses an employee for moving expenses, some of those expenses will be considered to be a taxable benefit while others will not. Certain moving expenses will not be considered a taxable benefit provided the move is a result of one of the following: • • The taxpayer’s employer transferred him or her to a new location. The taxpayer has finished his or her duties at a remote work location and is moving back to civilization.
Some of the more common moving expenses that are not considered to be a taxable benefit include: • • • • the cost of house-hunting trips to the new location travelling costs for the employee and his or her family the cost of transporting or storing his or her household effects charges to connect or install utilities
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Income Tax Planning • • legal fees and land transfer taxes incurred in buying a new residence reasonable temporary living expenses while waiting to occupy the new residence
Sandra’s employer transferred her from Halifax to St. Johns and agreed to pay for her moving expenses. She paid $2,000 to the moving company, $300 to have her utilities connected at the new location, $3,200 in land transfer taxes, $400 in family travel expenses and $350 for two nights’ accommodation while the move took place. Although her employer reimbursed her for $6,250, calculated as (moving company fees + utility connection fees + land transfer taxes + family travel expenses + accommodation expenses) or ($2,000 + $300 + $3,200 + $400 + $350) Sandra does not have a taxable benefit.
Premiums under a Private Health Services Plan
A taxpayer will not be considered to have received a taxable benefit if his or her employer pays premiums under a private health services plan. A private health services plan includes an insurance contract that provides coverage of hospital expenses and medical expenses or any combination thereof (ITA 248(1)). Refer to IT-339R2, Meaning of private health services plan, for more information.
Professional Membership Dues
If a taxpayer pays professional membership dues and his or her employer reimburses the taxpayer for those dues, he or she will not be considered to have received a taxable benefit as long as membership in that association benefits the employer. Sonya is a professional engineer who works for a consulting engineering firm. Although Sonya pays her dues to Professional Engineers Ontario personally, her employer reimburses her. This is not a taxable benefit because Sonya needs her engineering designation to perform her job.
Exercise: Fringe Benefits
Deductions from Employment Income
There are two types of deductions an employee may be able to make from his or her employment income: • • deductible employment expenses deductions to offset the inclusion of taxable benefits in employment income
We will first look at deductible employment expenses.
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Taxation of Employees and Alternative Minimum Tax
Deductible Employment Expenses
In very limited situations, the Income Tax Act allows a taxpayer to deduct certain expenses from his or her income from an office or employment (ITA 8(1)). However, in order for the expense to be deductible, the Income Tax Act usually requires specific circumstances to be met. There may also be a limit on how much can be deducted, depending on the type of expense and whether the employee receives any commission income, as discussed in the various subsections. You will be looking at the following in more detail: • • • • • • legal fees motor vehicle expenses professional or association dues travel expenses workspace in home sales expenses and commissioned salepersons
Most of the information that we will be discussing in the following subsections is expanded upon in: • • • IT-352R2, Employee’s Expenses, Including Work Space in Home Expenses IT-522R, Vehicle, Travel and Sales Expenses of Employees CRA’s Guide T4044, Employment Expenses – Supplementary Income Tax Guide
Legal Fees
The Income Tax Act permits a taxpayer to deduct from his or her employment income any legal fees the taxpayer paid to collect or establish a right to salary or wages from his or her employer or former employer. To deduct the legal fees, the taxpayer must establish that an amount was owed, whether or not it is actually collected (ITA 8(1)(b)). The legal fees are deductible in the year incurred, while any recovered income is taxable in the year received, even if it relates to employment in a different year. Maxine worked for a less than reputable employer. In July of last year, not only was she out of a job, but her employer owed her $6,000 in salary. In October of last year, she hired a lawyer and paid him $900. In February of this year, her former employer finally paid her the $6,000 that was owing. Maxine was able to deduct the $900 in legal fees from her employment income for last year, but she had to include the recovered income in her taxable income for this year.
Motor Vehicle Expenses
If an employee uses his personal motor vehicle for his or her employer’s benefit, the employee can deduct his or her travel expenses from his or her employment income, provided (ITA 8(1)(h.1)): • • The employer requires the employee to travel away from the place of employment on business purposes. The employer requires the employee to pay for his or her own motor vehicle expenses and verifies this by filling out form T2200, Declaration of Conditions of Employment (ITA 8(10)).
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Income Tax Planning • • The employee has not, and is not entitled to, receive a non-taxable allowance related to the use of that motor vehicle. The expenses are applicable to the earning of income from the office or employment.
Doris Delay is a commissioned salesperson who is required by her employer to provide her own office space, supplies, motor vehicle, etc. Her employer has completed a Declaration of Employment. Calculating the deduction The amount of the deduction is calculated as the employee's total motor vehicle expenses for the year, prorated for the number of total business kilometres travelled during the year in comparison to the total of business and personal kilometres travelled during the year. Motor vehicle expenses include total operating expenses (including leasing charges, fuel, maintenance, repairs, car washes, licenses and insurance), interest on loans used to acquire the vehicle and Capital Cost Allowance (CCA). Doris Delay leases her vehicle and last year her total vehicle expenses amounted to $7,990. She drove a total of 20,000 km last year - 16,000 km in relation to her employment. Doris had an allowable motor vehicle expense of $6,392, calculated as (total vehicle expenses x (employment kilometres ÷ total kilometres)) or ($7,990 × (16,000 ÷ 20,000)).
Professional or Association Dues
If a taxpayer is required to maintain a membership in a professional association by statute or is a member of a trade association or trade union, the taxpayer can deduct any fees that he or she pays to maintain that membership from his or her employment income, to the extent that the taxpayer is not reimbursed by his or her employer (ITA 8(1)(i)(i) and (iv)). Shirley is a constable with a municipal police force and she is required to be a member of the local police association, a trade union, to which she must pay dues of $800 per year. Shirley can deduct the $800 from her employment income.
Travel Expenses
If an employee is required to travel for his or her employer's benefit, the employee can deduct his or her travel expenses from his or her employment income, provided (ITA 8(1)(h)): • • The employer requires the employee to travel away from the place of employment on business purposes. The employer requires the employee to pay for his or her travel expenses and verifies this by filling out form T2200, Declaration of Conditions of Employment (ITA 8(10)). The employee has not, and is not entitled to, receive reimbursement or a nontaxable travel allowance.
•
Travelling expenses include food, beverage, travel fares and lodging expenses, but not motor vehicle expenses. Food and beverage expenses can only be deductible if the
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Taxation of Employees and Alternative Minimum Tax employee is required to be away from the employer’s base of business for at least 12 hours, and even then, only 50% of the cost can be deducted. During his travelling as a quality assurance inspector, Casey frequently spends a night in a hotel near the plant that he is inspecting and he eats a large number of his meals in restaurants. His employer requires him to pay for all of his own travel expenses without reimbursement or a travel allowance. His total lodging costs for the year amounted to $3,250 and he spent $1,800 on take-out and restaurant food while travelling on the job. Casey can claim a travelling expense of $4,150, calculated as (lodging costs + (meal costs x 50%)) or ($3,250 + ($1,800 × 50%)).
Workspace-in-home
If you work from home, you may be able to claim a deduction for workspace-in-home expenses (ITA 8(13)). In order to make such a deduction, you: • • • must be required by your employment contract to work at home and pay for these expenses have not been reimbursed (and are not entitled to be reimbursed) have incurred these expenses solely for the purpose of earning income from employment
Even if these conditions are met, you may make deduct these expenses unless the workspace is either: • the place where you principally (more than 50% of the time) perform your office or employment duties; though, the space does not have to be devoted solely to employment or used exclusively to earn income from your office or employment and, on a regular and continuous basis, for meeting customers or other persons in the ordinary course of performing your office or employment duties
•
Frank is a commissioned life insurance agent and he is required by his employer to work out of his home four days a week and to attend a meeting at his head office one day a week. Frank has set up a spare bedroom as his office, but the room still contains a spare bed and is used every weekend by his mother-in-law. Frank has a legitimate home office and he can claim a workspace-in-home expense. In order to be able to make the deduction, the employee must obtain a form T2200, Declaration of Conditions of Employment from his or her employer (ITA 8(10), 8(1)(f), and 8(1)(ii) or (iii)).
Commissioned vs. Non-commissioned Employees
Deductible items for non-commissioned employees If the employee is someone other than a commissioned salesperson, he or she can deduct a reasonable portion of home maintenance expenses including fuel, electricity, light bulbs, cleaning materials, minor repairs and, if he or she does not own the dwelling, any rent. These are deductible because they are classified as supplies used to earn employment income (ITA 8(1)(i)(iii)). Such an employee cannot deduct a portion of capital cost allowance, property taxes, insurance, or mortgage interest.
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Income Tax Planning Deductible items for commissioned employees If the employee is a commissioned salesperson, he or she can deduct a reasonable portion of the home maintenance expenses listed above, plus a portion of property taxes and home insurance, because these amount are considered to be sales expenses (ITA 8(1)(f)). However, even a commissioned salesperson cannot claim a portion of mortgage interest or capital cost allowance. Frank is a life insurance agent for Big Money Insurers: he is an employee of the company and his remuneration is based entirely on commission income. Frank owns his own home, and his total home expenses for the year include $3,600 for heat and hydro, $1,200 for maintenance expenses, $8,000 in mortgage interest, $960 in home insurance and $2,900 in property taxes. Frank can claim a reasonable portion of his total expenses of $8,660, calculated as (heat and hydro + maintenance + home insurance + property taxes) or ($3,600 + $1,200 + $960 + $2,900). He cannot deduct a portion of his mortgage interest or CCA.
Calculating the Workspace-in-home Deduction
The total home expenses should be apportioned between employment and home use on some reasonable basis, such as the number of square metres of floor space used or the number of rooms devoted to employment use. If the space serves a dual purpose (for example, it serves as an office during the week and a spare bedroom on weekends), then this should also be taken into account (i.e. pro-rated for five days out of seven). If the space is used exclusively for employment use, it does not matter how many days of the week the individual works from home. The room that Frank uses as an office is 12 square metres and the total area of his home is 100 square metres. Remember that Frank only uses the office four days a week and the room also serves as a spare bedroom. Frank can deduct 6.86% of his total home expenses, calculated as ((office area ÷ total home area) x (number of days per week used as office ÷ number of days in a week)) or ((12 ÷ 100) × (4 ÷ 7)). So, he can deduct a total of $594, calculated as (total home expenses x deductible portion) or ($8,660 × 6.86%). Limits on claiming the deduction A taxpayer cannot use the workspace-in-home deduction to create a loss from employment (ITA 8(13)(b)). If the workspace-in-home expense exceeds his or her employment income prior to claiming the deduction, the excess amount can be carried forward to be deducted from employment income earned from the same source in the following year (ITA 8(13)(c)). Nancy is required by her employer to work out of her home. Her workspace-inhome expense amounted to $4,400 but her employment income was only $3,800. Nancy can use the deduction to reduce her employment income to nil, but she will have to carry the remaining $600 forward to the following year, calculated as (workspace-in-home expense - employment income) or ($4,400 - $3,800). If Nancy earns income from the same employer next year, she can deduct the unused expense at that time.
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Taxation of Employees and Alternative Minimum Tax
Sales Expenses, Commissioned Salespersons
Commissioned salespeople have the greatest flexibility in claiming employment expenses. A taxpayer who sells goods or negotiates contracts for an employer on a commission basis can deduct the sales expenses that he or she incurred to earn that commission income (ITA 8(1)(f)). The sales expenses include all amounts expended by the taxpayer in earning her employment income, so this definition includes many expenses that are not deductible by other employees, such as: • • • • advertising costs the cost of promotional gifts the cost of entertaining clients, subject to the 50% rule the cost of leasing computer or other business equipment
In order to be able to deduct all these expenses, the commissioned salesperson must meet all of the following conditions: • • • • The employment contract of the commissioned salesperson must require him or her to pay all expenses and his or her employer must complete Form T2200, Declaration of Conditions of Employment. The commissioned salesperson must be ordinarily required to work away from his or her employer’s place of business. The commissioned salesperson must be paid in whole or in part by commissions or similar amounts. The commissioned salesperson must not receive nor be entitled to receive a nontaxable allowance for travelling expenses.
Exercise: Deductions from Employment Income, Part 2
Other Deductions
In some cases where the Income Tax Act requires an employee to include a taxable benefit in his or her employment income, the Act also provides for an offsetting deduction, as discussed below. Home relocation loan deduction If a taxpayer had to report a taxable benefit because of a low-interest home relocation loan provided by his or her employer, that taxpayer can deduct the lesser of: • the amount of interest that he or she would have paid if the loan had been made at the prescribed rate, minus the amount of interest that he or she actually paid in the year, or no later than 30 days after the end of the year the interest on $25,000 at the prescribed rate
•
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Income Tax Planning • in cases where the employee has more than one loan from the employer, the total interest benefit for all loans (ITA 110(1)(j))
When Randy was transferred from Ottawa to Regina, his employer gave him a $60,000 loan at an interest rate of 2% to help finance his relocation. At the time the prescribed rate was 5%. Randy had a taxable benefit of $1,800, calculated as (relocation loan x (prescribed rate - interest rate charged)) or ($60,000 × (5% - 2%)). However, Randy could claim a home relocation loan deduction of $1,250, calculated as the lesser of: • • • $1,800 $1,250, calculated as ($25,000 × 5%) $1,800
The deduction for a home relocation loan is only available for the first five years of the loan. Deduction for registered pension plan contributions If a taxpayer is required to make a contribution to a registered pension plan established by his or her employer, the taxpayer can deduct that contribution amount from his or her employment income (ITA 8(1)(m), 147.2(4)). Tassia is a member of her employer’s defined-benefit pension plan, and she is required to contribute 7% of her salary to the plan. Last year, her salary was $62,000. So, Tassia was able to deduct $4,340 from her employment income, calculated as (salary x employee contribution rate) or ($62,000 × 7%). Deduction for CPP contributions by the self-employed Since January 1, 2001, self-employed individuals are allowed to deduct the portion of Canada Pension Plan and Québec Pension Plan contributions that represents the employer's share, rather than claim the amount for a tax credit. Raymond is self-employed and has net business income of $52,000. Assuming the CPP employer and employee contribution rates are both 4.95%, the YMPE is $46,300 and the YBE is $3,500, Raymond's CPP contribution as employee will $2,118.60 calculated as [((the lesser of pensionable earnings and YMPE) - YBE) x contribution rate] or [((the lesser of $52,000 and $46,300) - $3,500) x 4.95%]. Being self-employed, Raymond must also make a matching contribution as employer resulting in total CPP contributions of $4,237.20, calculated as (employee contribution + employer contribution) or $2,118.60 + $2,118.60). Based on his CPP contributions, Raymond can claim a business deduction for the employer portion and he can claim a nonrefundable tax credit for the employee portion.
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Taxation of Employees and Alternative Minimum Tax
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Fringe Benefits not Included in Income. In this lesson, you have learned how to do the following: • identify and calculate the impact of fringe benefits not included in income on a client’s taxes
If you are ready to move to the next lesson, click Employee Stock Option Plans on the table of contents.
Assessment
Now that you have completed Fringe Benefits not Included in Income, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Employee Stock Option Plans
Welcome to Employee Stock Option Plans. In this lesson, you will learn about the tax treatment of employee stock options. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • given a client with an employee stock option plan, identify and calculate any impact on the client’s taxes
Employee Stock Option Plans
Employee stock options refer to certain rights that a corporation may grant to its employees or to the employees of a non-arm’s length corporation that allow the employee to acquire shares of either of those corporations at a specified price. Some corporations issue stock options to employees as a type of bonus. At other times, a corporation may actually sell the stock options to its employees. These benefits are referred to as employee stock option plans (ESOPs). The tax treatment of employee stock options depends on the nature of the issuing corporation (public versus CCPC), and in the case of a public corporation, whether the shares are a qualifying acquisition. Refer to IT-113R4, Benefits to Employees – Stock Options, for more information.
General Rules
Benefits from a stock option are generally included in the individual’s employment income in the year in which he or she sells or exercises the option, rather than the year in which he or she acquires the option (ITA 7(1)). If the employee exercises the option, the taxable benefit is the difference between: • • the fair market value of the shares when the employee acquires them and the amount the employee actually pays for the shares (the exercise price of the stock option) plus the amount he or she paid for the option, if applicable
Three years ago, Philip’s employer gave him an option to acquire 100 shares in the public company at a price of $40 per share. This year, Philip exercised the option at a time when the shares were trading at $52 per share by purchasing 100 shares from the company at $40 per share. Under the general rules, Philip has a taxable benefit this year of $1,200, calculated as (number of shares purchased x (FMV at the time the options were exercised exercise price)) or (100 × ($52 – $40)). Calculating the ACB of the shares Once the option is exercised, the adjusted cost base of the shares is calculated as: • • • the amount the employee paid for the shares plus any amount the employee paid for the option plus the full amount of the taxable benefit included in income
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Taxation of Employees and Alternative Minimum Tax
The ACB of Phillip’s new shares is $5,200, calculated as ((number of shares x exercise price) + taxable benefit) or ((100 × $40) + $1,200).
Canadian-controlled Private Corporations
The employee does not have to include the benefit in income until he or she disposes of the shares that were acquired with the stock option in situations where: • • the corporation that issued the stock option is a Canadian-controlled private corporation the corporation is at arm’s length from the employee receiving the stock option (ITA 7 (1.1))
A Canadian-controlled private corporation (CCPC) is a Canadian private corporation that is not controlled directly or indirectly by one or more non-residents or public corporations (ITA 125(7)). Valerie is employed by Megacorp, a CCPC. Three years ago, she purchased an option to buy 200 Megacorp shares at an exercise price of $30 per share for a premium of $1 per share (the cost for each option). In June of last year, Valerie exercised the option when the shares were worth $44 per share. She sold the shares in March of this year for $52 per share. As a result of exercising the option, Valerie has a taxable benefit this year of $2,600, calculated as (number of shares purchased x (FMV at the time the options were exercised (exercise price + cost of acquiring the option))) or (200 × ($44 – ($30 + $1))). Calculating the ACB of the shares Once the option is exercised, the adjusted cost base of the shares is calculated as: • • • the amount the employee paid for the shares plus any amount the employee paid for the option plus the full amount of the taxable benefit included in income
The ACB of Valerie’s shares in Megacorp is $44 per share, calculated as (exercise price + cost of acquiring the option + taxable benefit) or ($30 + $1 + $13). So, when she sold her shares, Valerie realized a capital gain of $1,600, calculated as ((FMV - ACB) x number of shares) or (($52 - $44) × 200). If the employee sells the option itself, he or she will have a taxable employment benefit to the extent the proceeds of disposition exceed his or her cost for the option (ITA 7(1)(b)). Last year, Susan bought an option to purchase 5,000 shares of her employer’s corporation at an exercise price of $35 per share for a premium of $0.40 per share. This year, Susan sold the option for a premium of $1.00 per share and has taxable employment income of $3,000, calculated as (number of options x (sale price - cost of acquisition)) or (5,000 × ($1.00 - $0.40)).
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Income Tax Planning
Exercise: Employee Stock Option Plans in the Case of a CCPC
Qualifying Acquisitions in Public Corporations
The Federal Budget of 2000 extended to public corporations, the stock option deferral that was previously only available to CCPCs. More specifically, the Income Tax Act was amended to permit the deferral on up to $100,000 per year of qualifying employee stock options for publicly-listed shares. An employee who exercises an employee stock option in a public corporation or a mutual fund trust after February 27, 2000 may be able to defer recognition of the employment benefit until he or she disposes of the shares, provided that certain conditions are met (ITA 7(8)). In order to obtain the deferral, the employee must file an election with his or her employer by January 15th of the year after he or she exercises the option (ITA 7(10). Furthermore, the acquisition of new shares under the option agreement must be considered to be a qualifying acquisition (ITA 7(9)), which means: • • the acquisition occurred after February 27, 2000 (it does not matter when the option was granted) the amount paid by the employee to acquire the security (including any amount that he or she may have paid to acquire the option) must not be less than the fair market value of the security when the option was granted the employee must have been dealing at arm’s length with the employer if the security is a share, it must be a common share, and it must be listed on a prescribed stock exchange the employee must not be a specified shareholder as defined by ITA 248(1), which generally means that he or she must own less than 10% of the shares in the corporation
• • •
The $100,000 annual limit on the specified value of the options available for deferral applies to the year of vesting, not the year in which the option is granted, nor the year that the option is exercised. The year of vesting is the year in which the employee gains the right to exercise the option. The specified value is generally the FMV of the security at the same time that the option was issued (ITA 7(11)). This year, Beverly received 10,000 options from her employer, which is a publiclylisted corporation. The options give her the right to acquire shares at $50 each, which was the FMV of the shares at the time the option was issued. Next year, all of the options vest, which means that Beverly cannot exercise them until that time. The specified value of her options is $500,000, calculated as (exercise price x number of shares) or ($50 × 10,000), well in excess of the $100,000 annual limit. Assume Beverly exercises all of her options in five years, when the shares are trading at $120. Beverly can only elect to defer recognition of the employment benefit on 2,000 shares, calculated as
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Taxation of Employees and Alternative Minimum Tax (annual limit ÷ exercise price) or ($100,000 ÷ $50). In the year that she exercises her options, she would have to recognize an employment benefit of $560,000, calculated as ((FMV at the time the shares are exercised - exercise price) x (total number of shares acquired - number of shares on which deferral is available)) or (($120 – $50) × (10,000 – 2,000)). So, the vesting period can dramatically change the amount of benefit that can be deferred. Ideally, the employer should ensure that only options with a specified value of $100,000 vest each year. Suppose Beverly’s employer had granted her 10,000 options this year, but only 20% of the options vest in each year over the next five years. The specified value of the options that vested each year would be $100,000, calculated as [exercise price x (total number of options x portion of options that vest each year)] or [$50 × (10,000 × 20%)]. If Beverly exercised all of the options in five years, she would now be able to defer the employment benefit on all 10,000 shares.
Exercise: Qualifying Acquisitions in Public Corporations
Employee Stock Option Deduction
If an employee exercises or sells a stock option that he or she receives as a result of his or her employment or office, the employee might have a taxable benefit. However, the Income Tax Act may allow a deduction in the same year that he or she must report the taxable benefit (ITA 110(1)(d) and (d.1)). The deduction is equal to 50% of the amount of the taxable benefit. The conditions under which the deduction may be claimed are discussed below. This deduction is intended to reduce the employment benefit to the equivalent of a capital gain. General rules Generally, a person who has to report an employment benefit as a result of exercising an employee stock option may claim a deduction equal to 50% of the taxable benefit reported during the year, provided: • • • the shares are common shares the exercise price plus any amount the employee paid to acquire the option is not less than the fair market value of the shares at the time the option was granted the employee deals at arm’s length with the corporation (ITA 110(1)(d))
Two years ago, Charles received employee stock options to purchase 10,000 shares in Retold Inc. at $12 per share, which was the FMV of those shares at that time. This year, Charles exercised all of the options when the FMV of the shares was $30 per share. The shares do not qualify for a deferral of the employment benefit. This year, Charles has to report a taxable employment benefit of $180,000, calculated as (number of shares acquired x (FMV of shares when exercised - exercise price)) or (10,000 × ($30 - $12)). However,
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Income Tax Planning Charles will be able to claim a stock option deduction of $90,000, calculated as (taxable employment benefit x (1 - capital gains inclusion rate)) or ($180,000 x (1 - 50%)). Canadian-controlled private corporations Taxpayers who have exercised employee stock options in a CCPC do not have to report a taxable employment benefit until the year that they dispose of the shares. At that time, they may be able to claim an offsetting deduction of 50% of the taxable benefit, provided that the taxpayer has held the shares for at least two years as of the date of sale (ITA 110(1)(d.1)(ii)). If this condition is met, the taxpayer does not have to meet the first two conditions required under the general rules. So, in this case, shares are not restricted to common shares, and the total of the exercise price plus any amount paid to acquire the option does not have to be greater-than or equal to the FMV of the shares at the time the option is granted. It could be less than the FMV of the shares. These exceptions are intended to stimulate employee ownership of small businesses, and acknowledge that the valuation of shares in a private company may be difficult. Qualifying acquisitions in public corporations A taxpayer who makes a qualifying acquisition of common shares in a public corporation can defer recognition of the resulting taxable employment benefit until the year in which he or she disposes of the shares. At that time, the taxpayer can claim a deduction equal to 50% of the taxable benefit, provided that he or she meets all of the conditions described earlier under the general rules.
Exercise: Employee Stock Option Deduction
Cross-border Employment Income
With today’s global economy, people do not necessarily earn their employment income in the same country in which they live. Canadian residents employed outside of Canada A Canadian resident is taxed on or her world income, including any earnings he or she receives as a result of being employed outside of Canada (ITA 3(a)). If the individual is paid in foreign funds, those funds must first be converted into Canadian dollars before they are reported on his or her Canadian tax return. Sheila is a Canadian resident who spent four months working in the U.S. last year. She did not work during the remaining eight months of the year and she returned to Canada. As a result of her employment, she earned $12,000 U.S. at a time when the exchange rate was $0.68. Sheila will have to include $17,647 in her income for Canadian tax purposes, calculated as (employment income in U.S. dollars ÷ exchange rate) or ($12,000 ÷ $0.68).
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Taxation of Employees and Alternative Minimum Tax
In some cases, that employment income may also be taxable in the country in which the income was earned. If this is the case, the taxpayer may be able to claim a foreign tax credit to reduce the amount of Canadian tax payable (ITA 126(1)). Sheila will also have to report her employment income for U.S. tax purposes. However, she can claim a foreign tax credit on her Canadian tax return to offset the foreign tax that she paid on that income.
U.S. Citizens Employed in Canada
The tax system in the United States is based on citizenship, not residency. So, even if a U.S. citizen is a Canadian resident, he or she will face U.S. income tax on his or her Canadian income. As a Canadian resident, the individual will also face Canadian income tax on his or her worldwide income. A U.S. citizen who is a non–resident of Canada must report only his or her Canadian sourced income for Canadian tax purposes, including: • • • income from an office or employment carried out in Canada income from a business carried on by the non–resident in Canada taxable capital gains realized upon the disposition or deemed disposition of taxable Canadian capital property (ITA 115(1)(a))
The Canada-U.S. Tax Convention addresses some of the double taxation issues for crossborder employees, but those rules are outside the scope of this course. Refer to IT-171R2, Non–resident individuals – Computation of taxable income earned in Canada and non–refundable tax credits; IT-270R2, Foreign tax credit; and IT-497R3, Overseas employment tax credit, for more information.
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Employee Stock Option Plans. In this lesson, you have learned how to do the following: • given a client with an employee stock option plan, identify and calculate any impact on the client’s taxes
If you are ready to move to the next lesson, click Alternative Minimum Tax on the table of contents.
Assessment
Now that you have completed Employee Stock Options Plans, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Employees and Alternative Minimum Tax
Lesson 4: Alternative Minimum Tax
Welcome to Alternative Minimum Tax. In this lesson, you will learn how to identify if your client should be paying alternative minimum tax (AMT), as well as how AMT is calculated. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • identify if a client should be paying AMT calculate AMT for client
Alternative Minimum Tax
The Alternative Minimum Tax (AMT) is a scheme in the Income Tax Act that requires the calculation of an alternative amount of tax based upon the elimination of certain tax preferences. Tax preferences are deductions or tax credits that are not claimable for minimum tax purposes. CRA sometimes calls them tainted shelter deductions. The taxpayer is required to pay the greater of this alternative amount of tax and the regular amount of tax otherwise calculated. The AMT was introduced in December 1986, as a political solution to the perception that many high-income taxpayers were avoiding taxes through the use of tax shelters. For this reason, the AMT is relatively narrow in focus and concentrates on specific tax shelters and credits. In reality, few taxpayers are affected by the minimum tax. James is a 64 year-old widower. Last year, he sold his shares in Force Ten Enterprises, a CCPC, for a capital gain of $480,000. He receives a retirement allowance of $46,500, which he rolled over into an RRSP and he also contributed $13,500 to his RRSP. He earned a salary of $76,000 and he received $4,000 in dividends from Totem Inc., another taxable CCPC, in which James has a small ownership interest. The minimum tax is an alternative tax calculation. This means the taxpayer must prepare two returns: the General Tax Return (Form T1) and the Calculation of Minimum Tax (Form T691). The taxpayer must pay the higher of the two resulting amounts. The table below presents the calculations of the tax payable for James under the regular system. You may wish to print this page and refer to it as you go through the explanations that follow.
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Income Tax Planning
Tax Under Regular System
Before calculating AMT, the taxpayer must first calculate his or her taxable income and the basic federal tax under the regular system.
Total Income
Page 2 of the T1 general return starts with a calculation of total income, which includes (among other things) all employment income, taxable government benefits, the taxable amount of dividends and capital gains, support payments, RRSP income, and termination benefits. James reported the following sources of income on his T1 return: • • • • line 101: employment income of $76,000 line 120: taxable dividend income From Totem Inc. of $5,000, calculated as (cash dividend x gross up rate for dividend paid by a CCPC) or ($4,000 × 125%) line 127: taxable capital gains of $240,000, calculated as (capital gains x capital gains inclusion rate) or ($480,000 × 50%) line 130: retiring allowance of $46,500
Therefore, on line 150, James will report total income of $367,500, calculated as (employment income + taxable dividend income + taxable capital gain + retiring allowance) or ($76,000 + $5,000 + $240,000 + $46,500).
Net Income
Next, the taxpayer can deduct certain amounts to arrive at net income, including childcare or moving expenses, union dues, and contributions to registered pension plans or RRSPs. James was able to rollover his retiring allowance of $46,500 to his RRSP; he also made an RRSP contribution of $13,500. So, his total deductions on line 208 amounted to $60,000 calculated as ($46,500 + $13,500). James’ net income, as reported on line 235, was $307,500, calculated as (total income - total deductions) or ($367,500 - $60,000).
Taxable Income
Next, the taxpayer determines his or her taxable income deducting amounts for stock option deductions, losses carried forward from previous years, and capital gains deductions. James realized a capital gain of $480,000 when he sold his shares in Force Ten Enterprises. The shares of Force Ten qualified for the $750,000 capital gains exemption for (or a lifetime exemption of $375,000 of taxable capital gains) for qualified small business shares. Since James had not previously used any exemptions that had been available to him, he was able to shelter the entire capital gain and to claim a capital gains deduction of $240,000 on line 254 calculated as (capital gain x capital gain inclusion rate) or ($480,000 × 50%). This reduced James’ taxable income on line 260 to $67,500, calculated as (net income capital gains deduction) or ($307,500 - $240,000).
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Taxation of Employees and Alternative Minimum Tax
Basic Federal Tax
Finally, the taxpayer calculates the basic federal tax owing on his or her taxable income based on the applicable marginal tax rates. Federal Personal Tax Rates on Taxable Income
Taxable Income up to $40,726 $40,727 - $81,452 $81,453- $126,264 Over $126,264
Marginal Tax Rate 15% 22% 26% 29%
James has taxable income of $67,500. His federal tax payable on this amount is $11,999.18, calculated as [($40,726 x 15%( + (($67,500 - $40,726) x 22%)]. Like all taxpayers, James can claim a basic personal amount of $10,320, which will result in a non-refundable tax credit of $1,548, calculated as (basic personal amount x federal tax credit conversion rate of 15%) or ($10,320 x 16%). He can also claim a federal dividend tax credit of $667, calculated as (grossed-up dividend x federal dividend tax credit rate) or ($5,000 x 13 1/3%) Under the regular system, James owes basic federal tax in the amount of $9,784.18 calculated as (federal tax on taxable income - non-refundable tax credits - dividend tax credit) or ($11,999.18 - $1,548 - $667).
Subject to AMT
Your client may have to pay minimum tax if any of the following situations apply: 1. The taxpayer reported dividends from a taxable Canadian corporation. James reported a taxable dividend of $5,000 which is the $4,000 cash dividend he received from Totem Inc. – a taxable Canadian CCPC - grossed-up by 125%. James might be subject to AMT. 2. The taxpayer claimed any of the following tax credits: • • • • an investment tax credit an overseas employment tax credit a federal political contribution tax credit a labour-sponsored funds tax credit
3. The taxpayer reported a taxable capital gain.
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Income Tax Planning James reported a capital gain of $480,000 when he sold his business. He had a taxable capital gain of $240,000, calculated as (capital gain x capital gains inclusion rate) or ($480,000 × 50%). So, he might be subject to AMT. 4. The taxpayer claimed any of the following: • • • • • a deduction for an employee home relocation loan a loss resulting from, or increased by, claiming capital cost allowance or carrying charges on certified films, videotapes and rental properties losses from limited partnerships and related carrying charges a loss from resource properties resulting from, or increased by, claiming a depletion allowance, exploration expenses, development expenses, or Canadian oil and gas property expenses a deduction for employee stock option and shares
Calculating AMT
The minimum tax return is called a T691 and consists of four pages. AMT is calculated in several steps. The table below shows the calculation of James' tax payable under the AMT system. You may wish to print this page and refer to it as you go through the explanations that follow.
Adjusted Taxable Income
1. When calculating minimum tax, you start with the taxable income calculated under the regular method. James had taxable income of $67,500 under the regular method, so this is the starting point for determining his adjusted taxable income under the AMT system.
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Taxation of Employees and Alternative Minimum Tax 2. Then you have to add back certain deductions that were allowed on the T1 General Return, but that are not allowed for AMT purposes. These include: • • • • a portion of CCA claimed in certain film deals losses from various tax shelters carrying charges that were used to create or enhance a rental loss, or that were related to certain film deals, flow-through shares or resource properties some of the non-taxable portion of capital gains reported during the year, including gains eligible for exemption, calculated as 30% of the realized capital gain for dispositions after October 17, 2000. (A different rate applies for dispositions prior to this date) employee home relocation deductions employee stock option deductions
• •
James sold his shares in a CCPC and realized a gain of $480,000. Even though the shares qualify for the capital gains exemption, he has to add back $144,000 for AMT purpose, calculated as (capital gain x 30%) or ($480,000 × 30%). 3. You also deduct the gross-up on dividends from taxable Canadian corporations. For eligible dividends, deduct 31.0345% of the taxable dividend (i.e. the grossed up dividend); for other than eligible dividends, deduct20% of the taxable dividend. James received other than eligible dividends of $4,000 from Totem Inc. He reported a taxable dividend income of $5,000, calculated as (dividends x dividend gross-up rate of 125%) or ($4,000 × 125%) on line 120 of his T1 General Return. For purposes of the AMT calculations, he can deduct the gross-up of $1,000, calculated as (taxable dividend - cash dividend) or ($5,000 - $4,000). 4. The taxpayer’s adjusted taxable income is the sum of the net additions to taxable income plus taxable income. James’ adjusted taxable income is $210,500, calculated as (ordinary taxable income + capital gain add back - dividend gross-up) or ($67,500 + $144,000 - $1,000).
Net Adjusted Taxable Income
There is an AMT basic exemption of $40,000, which is deducted from the adjusted taxable income. So, effectively only adjusted taxable income in excess of $40,000 is subject to the alternative minimum tax. This means that someone can have up to $40,000 of adjusted taxable income and still pay no AMT. The net adjusted taxable income is taxable income plus net additions to taxable income minus the basic exemption. If this amount is negative, your client is not subject to minimum tax. James’ net adjusted taxable income is $170,500, calculated as (adjusted taxable income - AMT basic exemption of $40,000) or ($210,500 - $40,000). He is, therefore, subject to minimum tax.
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Income Tax Planning
Gross Minimum Amount
The Federal AMT rate is the rate for the lowest tax bracket under the normal tax system, so the AMT is not a progressive tax with three or four tax brackets. The net adjusted taxable income is multiplied by the federal AMT rate to give the gross minimum amount. As per the 2007 federal Economic Statement, the lowest personal income tax rate was reduced to 15% (from 15.5%), effective January 1, 2007. The gross minimum amount for James is $25,575, calculated as (his net adjusted taxable income × 15%) or ($170,500 × 15%).
Minimum Amount
Certain personal tax credits can be deducted from the gross minimum amount. The AMT system considers certain tax credits to be preferred, but not others. For minimum tax purposes, personal tax credits are allowed for the following amounts: • • • • • • • • • • • basic personal amount age amount spousal amount equivalent-to-spouse amount amounts for infirm dependants Canada and Québec Pension Plan contributions employment insurance premiums disability amount tuition fees and education amount medical expenses charitable donations
James claimed a basic personal amount of $10,320, that resulted in a nonrefundable tax credit of $1,548, calculated as (basic personal amount x federal tax credit conversion rate of 15%) or ($10,320 x 15%) from claiming the basic personal amount calculated as ($7,756 x 16%). The non-refundable tax credits added back for minimum tax purposes are those for the following amounts: • • • • pension income amount disability amount transferred from a dependant other than a spouse or commonlaw partner tuition, education and textbook amounts credits transferred from a child amounts transferred from a spouse or a common-law partner
Since the only non-refundable tax credit claimed by James was the basic personal amount, the entire $1,548 is allowed for minimum tax purposes. So, his alternative minimum tax is $24,027, calculated as (gross minimum amount - non-refundable tax credits) or ($25,575 - $1,548). If the resulting alternative minimum tax is higher than the taxpayer’s federal tax calculated normally, he or she must pay the minimum tax.
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Taxation of Employees and Alternative Minimum Tax The minimum tax payable for James is $24,027, calculated as [the greater of (the AMT and the regular basic federal tax)] or [the greater of ($24,027 and $9,784.18)].
Exercise: Alternative Minimum Tax
Minimum Tax Carryover
The minimum tax carry-over to subsequent years is any excess of the minimum amount over the amount that will be payable under the normal tax system. Returning to our scenario with respect to James, his minimum tax carry-over is $14,242.82, calculated as (his federal tax under the AMT system - his federal tax under the normal tax system) or ($24,027 - $9,784.18). A minimum tax carry-over can be used to reduce taxes payable under the normal tax system in any of the following seven years. However, the taxpayer always has to pay at least the amount of the AMT for each of the following years, so the carry-over cannot reduce the amount of tax payable below each of the following years’ minimum tax. The taxpayer calculates his or her tax for each of the following years under the normal and AMT systems. If the normal amount exceeds the AMT amount, the carry-over can reduce the normal amount, but not to an amount less than the AMT. Assume for next year, the regular tax owing for James is $23,459 and his minimum tax is $12,589. His regular tax exceeds his minimum tax by $10,870, calculated as ($23,459 – $12,589). He can use $10,870 of his carry-over of $14,242.82 from this year to reduce his regular tax to $12,589–the amount of his minimum tax for next year. This will reduce James’ minimum tax carry-over for future years to $3,372.82, calculated as (carry-over from this year – portion of carry-over used next year) or ($14,242.82 – $10,870).
Exercise: Minimum Tax Carryover
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Income Tax Planning
Changes Regarding Contributions to Registered Plans
Prior to 1998, the following deductions were considered to be tainted deductions for calculating minimum tax, so they had to be added back when calculating adjusted taxable income for AMT purposes: • • • • registered pension plan (RPP) contributions registered retirement savings plan (RRSP) contributions retiring allowances transferred to an RSP or an RPP transfers of periodic RPP or deferred profit sharing plan (DPSP) payments to an RRSP of a spouse or common-law partner
The ability to carry unused contribution room forward for RRSPs accounts for the increase in large, one-time RRSP contributions, and has exposed some taxpayers, who were not the original targets of AMT, to the alternative tax. The legislation to implement the changes proposed in the Federal Budget of February 24, 1998 exempted RRSP rollovers and contributions, as well as contributions to registered pension plans, from the AMT. This change is effective for 1998 and later years.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Alternative Minimum Tax. In this lesson, you have learned how to do the following: • • identify if a client should be paying AMT calculate AMT for client
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Alternative Minimum Tax, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Employees and Alternative Minimum Tax
Review
Let’s look at the concepts covered in this unit: • • • • Types of Employment Income and Taxable Benefits Fringe Benefits not Included in Income Employee Stock Option Plans Alternative Minimum Tax
You now have a good understanding of the basics of taxation of employees and alternative minimum tax. At this point in the course you can identify and calculate the impact of taxable benefits on your client’s income and the impact of fringe benefits not included in income on your client’s taxes. Given a client with an employee stock option plan, you can also identify and calculate any impact on your client’s taxes. Finally, you can identify if your client should be paying AMT as well as calculate AMT. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 5: Taxation of Employees and Alternative Minimum Tax, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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I FP
Unit 6: Taxation of Property Income
Income Tax Planning
Unit 6: Taxation of Property Income
Welcome to Taxation of Property Income. In this unit, you will learn about the deductions your client can use to make the most tax effective use of his or her business and property investments. You will learn how to identify, calculate, and describe any probable tax impact given a client with capital cost allowance, rental income, interest, dividends, and income earned. You can also calculate and describe any probable tax impact given a client who disposes of depreciable property as well as identify and calculate how property income and capital gains can be attributed to the taxpayer when he or she transfers property. This unit takes approximately 3 hours and 45 minutes to complete. You will learn about the following topics: • • • • • • Interest, Dividends, and Income Earned Rental Income Capital Cost Allowance Disposing of Depreciable Property Other Deductions from Business and Property Income Income Attribution Rules
To start with the first lesson, click Interest, Dividends, and Income Earned on the table of contents.
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Taxation of Property Income
Lesson 1: Interest, Dividends, and Income Earned
Welcome to Interest, Dividends, and Income Earned. In this lesson, you will learn about any probable tax impact given a client with interest, dividends, and income earned. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • identify, calculate, and describe any probable tax impact given a client with interest, dividends, and income earned
Interest Income
Interest is the compensation that a borrower pays a lender for the privilege of using borrowed funds. When a taxpayer takes out a mortgage or a car loan, for example, he or she is borrowing funds and must pay interest to the lender. When the taxpayer makes a bank deposit or purchases a debt instrument, such as a corporate bond or guaranteed investment certificate, the taxpayer is essentially making a loan to the issuer and he or she is entitled to receive compensation in the form of interest income. An investment contract includes almost any debt obligation, with the exception of certain debts related to employment (for example, salary deferral or retirement compensation arrangements) and some income or small business development bonds (ITA 12(11)).
Reporting Interest Income on Investment Contracts
Interest income is earned as time passes because it is compensation for lending money for a period of time. However, interest income is not necessarily paid on a regular basis. It may be paid daily, monthly, quarterly, annually, biannually, or on a totally random basis, either on its own or at the same time as the repayment of some or all of the principal. On October 1st of last year, Lindsey purchased a new $10,000 corporate bond from NewCorp Ltd. The bond will pay interest on the face amount at a nominal annual interest rate of 8% semi-annually, with the first interest payment of $400 due on March 31st of this year, calculated as [(face value x coupon) ÷ payments per year], or [($10,000 × 8%) ÷ 2]. The next payment would be due on September 30th of this year. Even though Lindsey will not receive any interest payments until March 31st of this year, she is earning interest each and every day from October 1st of last year, because NewCorp Ltd. has the use of her money each and every day until the debt is repaid. So when does Lindsey report the interest income for tax purposes? Cash basis vs. accrual basis The cash basis requires the taxpayer to report interest income when it is received in cash or in kind. The accrual basis requires the taxpayer to report interest income when it is earned. If a taxpayer accrues income, it means that he or she is reporting an amount of income that he or she has already earned for tax purposes, but has not yet received the income in cash or kind. An accrual is an amount that has been accrued (earned and reported for tax purposes, even though it has not yet been received in cash or kind).
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Income Tax Planning Gina has $2,000 in her savings account and the interest is credited to her account at the end of each month. She must report this income on a cash basis, so it will be included in her income for the year in which she receives it. Gina also has a 5-year strip bond. She bought it for $7,600 and it will mature in three years at which time she will receive $10,000. The difference between the purchase price and the face amount is considered to be interest income, and she earns a portion of that interest income as each day passes. Even though Gina will not receive the interest income for three years, she is earning interest income and it must be reported on an accrual basis. Calendar year vs. bond year The Income Tax Act imposes a reporting scheme that is a combination of the cash basis and the accrual basis, by using a combination of the calendar year and the bond year, depending on how frequently the interest is paid. A calendar year is the period from January 1st to December 31st of the same year, and for individuals, this is the same as their taxation year or fiscal year. A bond year is a period of 365 consecutive days (366 days over a leap year) beginning with the bond's original issue date (or the day after the anniversary day in subsequent years). A bond's anniversary day is the day that is one year after the day immediately preceding the date of issue of the contract, or the day that occurs at every successive one year interval from that date (ITA 12(11). On October 1st of last year, Lindsey purchased a new $10,000 corporate bond from NewCorp Ltd. Therefore, the anniversary day of Lindsey's Newcorp Ltd. bond is September 30th of each year because this is one year after the day that preceded the date of issue. She purchased her bond in the last calendar year and she will receive her first interest payment this calendar year. The first bond year runs from October 1st of last year until September 30th of this year.
Cash Method for Individuals
Under the cash basis of reporting interest income, an individual who is entitled to receive interest income must report it either when it is received (the cash method) or receivable, unless it has already been reported as taxable income in a previous year under the accrual method (ITA 12(1)(c)). Annual accrual method based on bond year for individuals While contract law may allow the debt to be structured such that interest is not payable until some date in the distant future, the government is not willing to wait that long to collect taxes on interest income that has been earned but not yet paid. The Income Tax Act requires interest earned on an investment contract to be reported as it is earned on an accrual basis, even if it is not received. Under the annual accrual basis of reporting interest income, if a taxpayer holds an investment contract on its anniversary day, he or she must include an amount in his or her taxable income for the taxation year in which the anniversary day falls (ITA 12(4)). The amount that must be included is equal to the total amount that has been earned by the taxpayer up until that anniversary day, but only to the extent that the interest has not been
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Taxation of Property Income otherwise included in computing the taxpayer’s income for the year or any preceding taxation year. Raymond lent $10,000 to his friend Jason on April 1, 2010 at 8%. The terms of their loan agreement stated that Jason would pay the accumulated interest along with the principal on March 31, 2013. On that day, Jason will pay Raymond a total of $12,597 calculated using your financial calculator by entering DISP = 0, P/YR = 1, xP/YR = 3, I/YR = 8%, PV = -$10,000, PMT = $0 and solving for FV. Of this amount, $2,597 represents interest income, calculated as ($12,597 - $10,000). In the meantime, Raymond will be earning interest, even though he will not actually receive it for three years. The first anniversary day of the debt contract between Raymond and Jason will be March 31, 2011, and this will fall within the 2011 taxation year. During this first bond year, Raymond will earn interest income of $800, calculated as (principal x interest rate), or ($10,000 × 8%). So, on his tax return for 2011, Raymond must report interest income of $800. By March 31, 2012, Raymond will have earned interest income of $1,664, calculated as [(principal x (1 + interest rate)2 – principal] or [($10,000 × (1 + 8%)2 - $10,000]. However, on his 2012 tax return, he would only report $864, calculated as (interest to March 31, 2012 - interest to March 31, 2011) or ($1,664 - $800) because he has already accrued income of $800 on his 2011 return. Triennial accrual method for individuals The annual accrual requirement was introduced in 1990. Under the triennial accrual basis of reporting interest income, a taxpayer who acquired an interest in an investment contract before 1990 is allowed to accrue the interest income every three years, as long as the taxpayer has done so since 1990 (ITA 12(11)). Annual accruals based on tax year for all other taxpayers Taxpayers who are not individuals (i.e., corporations, partnerships and trusts that have corporate beneficiaries) are not allowed to report interest income based on the bond year, as individuals are allowed to do. Under the accrual basis of reporting interest income, corporations must report: • • all interest earned to the end of its taxation year all interest income that is received or becomes receivable by the end of that year, but only to the extent that the interest income was not included in computing its income for a preceding year (ITA 12(3))
Exercise: Interest Income
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Income Tax Planning
Dividend Income, Gross-up and Tax Credit
Dividend income A dividend is a distribution of a corporation’s profits to its shareholders. Dividends from both resident corporations and non-resident corporations must be included in taxable income. However, dividends from resident corporations are subject to more favourable tax treatment. Dividend gross-up and tax credit scheme The dividend tax credit gives the taxpayer some tax relief on the dividend income he or she has received. The value of the dividend tax credit depends on the kind of taxable, Canadian corporation paying the dividend: in general terms, Canadian-controlled private corporations vs. large, public corporations. Other than eligible dividends received from a CCPC Dividends received from a Canadian-controlled private corporation (CCPC), to the extent that its income is taxable at the small business rate or is from a CCPC's investment income (i.e. non-active business income), are treated differently than dividends received from large public corporations. These types of dividends are called other than eligible dividends. An individual who receives a dividend from a CCPC must include 125% of that dividend in taxable income for the year. This is referred to as the dividend gross-up. A taxpayer can then claim a federal dividend tax credit equal to 2/3 of the 25% gross-up, which works out to 16 2/3% of the actual dividend, calculated as (2/3 × 25%), or 13 1/3% of the grossed-up dividend, calculated as (16 2/3% ÷ (1 + 25%)). The tax credit is intended to offset the tax the corporation is presumed to have paid. The taxpayer can also claim a provincial dividend tax credit.
Parvez receives a dividend of 4% on his shares of a CCPC. His marginal tax rate (MTR) is 48%. He resides in a province with a PDR of 7.70%. What is his after-tax return (ATR) on the dividend income? His marginal tax rate on dividends is 33.71%, calculated as (125% x (MTR – 13 1/3% + PDR))) or (125% × (48% - (13 1/3% + 7.70%))). His ATR on the dividend income is 2.65%, calculated as (4% × (1 - 33.71%)). Refer to IT-67R3, Taxable dividends from corporations resident in Canada, for more information.
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Taxation of Property Income Eligible dividends and the enhanced dividend tax credit The May 2006 federal budget proposed an enhanced dividend tax credit for dividends received after 2005 from: • • • public corporations resident in Canada other corporations resident in Canada that are not Canadian-controlled private corporations (CCPCs) and are subject to the general corporate tax rate CCPCs resident in Canada to the extent that their non-investment income is subject to tax at the general corporate tax rate, i.e. active business income above the small business deduction limit.
Dividends received for which the enhanced dividend tax credit may be applied are referred to as eligible dividends. With the enhanced dividend tax credit, 145% of the dividend received will be included in income. The result is a federal tax credit of approximately 18.97% of the taxable (grossedup) dividend (the precise number is 18.9655%), which is the same as 27.5% of the actual dividend. The provinces have their own corresponding enhanced dividend tax credit.
Exercise: Dividend Income
Stock Dividends
Stock dividends are dividends issued by a corporation that are paid by the issuance of shares of any class of the capital stock of that corporation (ITA 248(1)). Stock dividends received by a taxpayer in a year must be included in the taxpayer’s income for that year in the same manner as if the dividend had been received as cash. This means that the grossup and dividend tax credit rules also apply to stock dividends (ITA 12(1)(j)). The amount of the dividend, which is used for the gross-up calculation, is the increase in the paid-up capital of the corporation that results from the issue of the new shares (ITA 248(1) "amount", ITA 52(3)). The amount of paid-up capital is determined by the directors and reported to the shareholders. Effectively, the directors decided to transfer the amount of the dividend from the retained earnings of the corporation to the paid-up capital of the corporation. Telltale Corporation, a large public Canadian corporation, had retained earnings of $2 million last year. Instead of distributing a cash dividend, the directors decided to capitalize the retained earnings and issue 1 million new shares valued at a total of $2 million to the holders of the existing 1 million shares, thereby adding $2 million to its paid-up capital account.
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Income Tax Planning Before Telltale issued the stock dividend, Amanda held 8,000 shares in the corporation. Amanda will receive a stock dividend worth $16,000, calculated as ((# of shares held ÷ total shares outstanding) x capitalized earnings) or ((8,000 ÷ 1,000,000) × $2,000,000). Telltale informs Amanda that her dividend is an "eligible dividend" that is able to make use of the enhanced dividend credit. She will have to include $23,200 in her taxable income, calculated as (cash dividend x 145%) or ($16,000 × 145%). She will be able to claim both federal and provincial dividend tax credits on this amount. Calculating the ACB of the new shares If a shareholder acquires new shares as a result of a stock dividend, he or she is deemed to have acquired the shares at a cost equal to the deemed amount of the dividend. The adjusted cost base of the shares that Amanda received as a result of the stock dividend is $16,000. When she eventually disposes of these shares, the capital gain or loss will be based on this ACB. Refer to IT-88R2, Stock Dividends, for additional information.
Dividends from Non-resident Corporations and Trusts
Dividends from non-resident corporations Dividends received from non-resident corporations (i.e., corporations that do not have to pay Canadian income tax) are not eligible for the dividend gross-up and tax credit scheme. Instead, these dividends are fully taxable and must be included as foreign sourced income (ITA 12(1)(k) and ITA 90(1)). Dividends from trusts If a trust is resident in Canada throughout a taxation year in which it receives a taxable dividend from a taxable Canadian corporation, it may be able to designate that dividend as being included in a beneficiary’s income. Thus, it can flow through to the beneficiary and it is not included in the trust’s income (ITA 104(19)). In order to be able to make this designation, certain conditions must be met. If the trust makes this designation, then the dividend is deemed to have been received by the beneficiary, not by the trust. The beneficiary must include the grossed-up amount in his or her income, but he or she can then claim the federal and provincial dividend tax credits. Refer to IT-524, Trusts — Flow-through of taxable dividends to a beneficiary after 1987, for more information.
Dividends Received by a Spouse or Common-law Partner
If a taxpayer has a spouse with little or no income, he or she can claim that spouse as a dependant and receive the full amount of a spousal tax credit. The same rules apply to common-law partners. In previous years, the spouse or common-law partner tax credit was calculated on a base amount which was then reduced dollar-for-dollar by the net income of the dependent spouse or common-law partner in excess of a stipulated threshold. The income threshold was very low and it only took a small amount of grossed-up dividends to bring the spouse's income over the threshold, thereby reducing the taxpayer's claim for
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Taxation of Property Income the spouse or common-law partner tax credit. In addition, if the spouse did not have any other taxable income, he or she could not make use of the dividend tax credit. Budget 2007, increased the spouse or common-law partner amount to match the basic personal amount and also eliminated the threshold above which the dependant’s net income must be taken into account. Effective 2007, the spouse or common-law partner tax credit is calculated as the spouse or common-law partner amount less the spouse or common-law partner's net income. Assuming this results in a positive number, this amount is then multiplied by the conversion rate applicable to non-refundable tax credits (which is the lowest federal tax rate). If the spouse or common-law partner amount is $10,320, the spouse of commonlaw partner of the taxpayer had no net income and the conversion rate for non-refundable tax credits is 15%, the resulting maximum federal tax credit will be $1,548, calculated as [(spousal or common-law partner amount – net income of spouse) x conversion rate] or [($10,320 – $0) × 15%]. A taxpayer can elect to report all of his or her spouse's or common-law partner's taxable dividend income from taxable Canadian corporations on his or her own tax return, to avoid reducing the spousal tax credit. Note: All of the dividends must be reported; a partial election is not permitted (ITA 82(3)). There is no easy rule of thumb to determine which spouse should report the dividend income. Spouses will need to calculate their combined taxes payable under both scenarios to determine which scenario results in the least amount of tax. Note: This election is only available for a spouse or common-law partner, and is not available with respect to other dependants for whom the taxpayer claims an eligible dependant amount. Also, while an election to transfer the reporting of dividend income can be made, any expenses incurred by the original recipient to earn that dividend income cannot be transferred to the reporting taxpayer. Refer to IT-295R4, Taxable dividends received after 1987 by a spouse, for additional information.
Income for Specified Members
When a person is a member of a partnership, the income that is earned as a partner is normally considered to be business income. However, if the taxpayer is a specified member of that partnership, the income earned as a specified member is considered to be property income, not business income (ITA 96(1.8)). A specified member of a partnership includes: • • • a person who is a limited partner in a limited partnership a general partner who does not take an active role in the business activities, other than financing activities (a silent partner) a general partner in a partnership who does not carry out a business similar to, but separate from, that partnership
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Income Tax Planning
Statement of Investment Income
A taxpayer must report his or her investment income, including interest income, dividends from taxable Canadian corporations and income earned as a specified member of a partnership on a separate Statement of Investment Income (Schedule 4 of the General Tax Return). Note: This Schedule only documents income generated by non-tax-deferred investments. Income earned within an RRSP is not taxed until it is withdrawn, so it is not reported here. The Statement of Investment Income also records any deductible expenses related to the reported investment income. As a general rule, most reasonable expenses relating to earning investment income are deductible for tax purposes. Expenses such as interest paid on funds borrowed to buy investments, and carrying charges, such as fees for safekeeping either in a safety deposit box or other safe custody, fees for accounting, bookkeeping, recordkeeping, investment counselling, or fees for investment management by licensed advisors are deductible. The total amounts recorded on the Statement of Investment Income are then transferred to the appropriate lines of the general tax return.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Interest, Dividends, and Income Earned. In this lesson, you have learned how to do the following: • identify, calculate, and describe any probable tax impact given a client with interest, dividends, and income earned as a specified member
If you are ready to move to the next lesson, click Rental Income on the table of contents.
Assessment
Now that you have completed Interest, Dividends, and Income Earned, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Property Income
Lesson 2: Rental Income
Welcome to Rental Income. In this lesson, you will learn about any probable tax impact given a client with rental income. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • identify, calculate, and describe any probable tax impact given a client with rental income
Reporting Rental Income
Rental income is income that a taxpayer receives as compensation for allowing someone else to use his or her real property. Rental income after adjustments is fully taxable. Real property includes land and all property attached to the land, including buildings, trees, fences or any other physical improvements. Rental income may be received in cash, in kind or in services. The value of payments in kind or in services is deemed to be at fair market value. Rental income may also include amounts received for granting or extending a lease or sublease, permitting a sublease, or cancelling a lease or sublease. If an individual taxpayer holds a rental property, he or she must report the gross and net rental income in the section called Total Income on Page 2 of his or her personal tax return. The details of his or her rental enterprise must be provided on form T776, Statement of Real Estate Rentals. Rental income and expenses are generally reported on an accrual basis, although the cash basis may be acceptable in simple cases where there is virtually no difference in the amount of income that is reported compared to the amount of income using the accrual basis.
Potential Areas of Confusion
On the surface, rental income is fairly straightforward – if you rent out real property, the net income resulting from that rental is taxable. However, taxpayers generally run into the following four basic problems in calculating their rental income and expenses: • • Is the rental income considered to be business income or property income? Are expenditures fully deductible as a current expense or are they part of the capital cost of the property, such that they can only be deducted through capital cost allowance (CCA)? How much can be claimed as capital cost allowance and what are the future tax implications of claiming CCA? What happens when a rental property is sold?
• •
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Income Tax Planning
Property Income or Business Income?
Depending on the nature of the rental operation, the resulting rental income will be considered to be either property income or business income. The Income Tax Act does not provide a specific definition for either type of income; it just says that a taxpayer’s income from a business or property is the profit therefrom for the year (ITA 9(1)). While the Income Tax Act does not provide a precise definition of business income, it does say that a business includes a profession, calling, trade, manufacturing operation or undertaking of any kind, including an adventure or concern in the nature of trade (ITA 248(1)). Therefore, business income is income that is earned as a result of creating, producing, or delivering a good or service. If the income generated by renting property does not fit this description, then it is considered to be property income. There are areas of the Income Tax Act where property income is treated differently from business income, so it is important to distinguish whether rental income is income from property or business income. The main factor that will determine whether the rental income is property income or business income is the number and kinds of services provided for the tenants, rather than the management structure or the size of the rental operation. Generally speaking, the more services provided to the tenant, the more likely the rental income will be considered business income. A taxpayer who owns a hotel will be earning business income. If only basic accommodation services are provided in the rental arrangement, the resulting rental income will be considered to be income from property. The size or number of properties being rented, the extent to which their management or supervision occupies the owner’s time, whether the accommodation is rented bare or fully furnished – none of these factors are taken into account in determining if the rental operation is a business. If the owner hires someone to manage the property, the rental income is not necessarily business income. Also, because two individuals may own and manage a rental property jointly in what appears to be a partnership, does not mean that the rental income is business income. Refer to IT-434R, Rental of real property by an individual, for more information on deciding whether rental income is property or business income.
Current Expenses vs. Capital Expenditures
In general, a taxpayer may deduct any reasonable current expenses to the extent they were incurred to earn business or property income, including rental income (ITA 18(1)(a)). Current expenses are recurring expenses that provide a short-term benefit. For example, the cost of repairs to maintain the property in the same condition as when purchased is a current expense. In contrast, capital expenditures include the cost of acquiring the property used to produce income, or the cost of making lasting or permanent improvements. These costs can only be deducted from rental income over several years as capital cost allowance (CCA) or an eligible capital expenditure amount.
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Taxation of Property Income Max owns a rental property, and he recently replaced the wooden steps leading up to the front door with new wooden steps. This would be a current expense because he was restoring the property to its original condition. However, if Max had decided to replace the wooden steps with more durable concrete steps, it would not be a current expense, but a capital expenditure. If expenses are prepaid, only those expenses that relate to the current taxation year can be deducted at this time.
Soft Costs
Soft costs are expenses that relate specifically to the period in which the taxpayer was constructing, renovating or altering a building to make it more suitable for renting, including costs related to the ownership of land associated with the building. Soft costs typically include interest or other financing charges, legal fees related to the renovations (but not legal fees related to the purchase), accounting fees and property taxes. Soft costs are usually capitalized by adding them to the cost of the building (ITA 18(3.1)), but in very limited situations, they may be deductible as a current expense to the extent the taxpayer has rental income during the year (ITA 20(29)). Soft costs that relate to the building are considered capital expenditures and must be added to the cost of the building, to eventually be deducted as capital cost allowance. During the first year after Max purchased his rental property, it was about 50% vacant. He spent considerable time and money renovating the building so that it would be more suitable for renting. During the renovation period, Max incurred property taxes related to the building of $5,000, legal fees related to acquiring building permits of $800 and interest of $2,800 on the funds that he borrowed to complete the renovations. His soft costs amounted to a total of $8,600, calculated as (property taxes + legal fees + interest) or ($5,000 + $800 + $2,800). Because the soft costs were incurred during the renovation period for the specific purpose of carrying out the renovation, the costs would be added to the cost of the building.
Deductible and Non-deductible Expenses
Deductible expenses The owner’s deductible expenses as recorded on the Statement of Real Estate Rentals equal the total current expenses minus any personal portion of those expenses, in the event that some of those expenses relate to personal property. Non-deductible expenses The following expenses are not deductible as either current or capital expenditures: • • • principal repayments on a mortgage income tax penalties the value of the taxpayer's own labour
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Income Tax Planning Land transfer taxes are not deductible as a current expense, but they do form part of the capital cost of the property, are capitalized, and deducted as CCA over several years. CCA will be discussed in detail later in this unit. Net income (loss) before adjustments At this point, the owner should be able to calculate his or her net income or loss from the rental property before adjustments, as the gross rental income less deductible expenses.
Exercise: Rental Income
Adjustments to Net Rental Income
Up to this point, we have calculated net rental income before adjustments. Now, we have to make a few more adjustments to arrive at the amount that the individual taxpayer reports on his or her tax return as his or her net rental income or loss. Co-owner’s share If the rental property is owned by more than one taxpayer, the net rental income before adjustments is apportioned according to the relative ownership interests of each owner. Other expenses of co-owner Individual co-owners may have incurred expenses that only apply to their ownership interest, such as banking charges related to their share of the mortgage on the property, or the cost of obtaining independent legal advice. Elise and Marie are equal partners in a rental building. The partnership had net rental income of $228,000 last year, so Marie’s net rental income before adjustments is $114,000, calculated as (total partnership income x Marie's share of partnership income) or ($228,000 × 50%). Elise did all of the bookkeeping for the partnership, including the preparation of all of the annual financial statements. While Marie did not distrust Elise, she thought it wise to hire an accountant to review the statements before she completed her tax return, and she paid $250 for this service. Marie can deduct the accounting fees from her share of the net rental income. Recaptured CCA If the taxpayer sells some or all of his or her rental property and the proceeds of that disposition exceeded his or her undepreciated capital cost (UCC) for that property, the taxpayer would realize a recapture of CCA, and this amount must be added back into rental income.
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Taxation of Property Income Terminal loss Similarly, if a taxpayer sells some or all of his or her rental property and the proceeds of that disposition are less than his or her undepreciated capital cost (UCC) for that property, the taxpayer would realize a terminal loss that could be deducted from rental income.
Capital Cost Allowance
Rental property consists of one or more classes of depreciable property, including various types of buildings, equipment used to maintain the rental property, and in the case of furnished rental units, furniture, and appliances. Whenever a taxpayer acquires depreciable property for the purpose of earning business or property income, including rental income, he or she cannot deduct the full purchase price from that income in the year of purchase. Instead, the taxpayer can only deduct the cost over a period of time by claiming capital cost allowance. For now, it is enough for you to know that CCA can be deducted from rental income. Refer to IT-79R3, Capital cost allowance – Buildings and other structures, for more detailed information.
Restrictions on Claiming CCA for Rental Properties
There are several restrictions that may limit the deduction of CCA from rental income, the most important one being that a taxpayer cannot use CCA to create or increase a rental loss. The Income Tax Act restricts the amount of CCA that a taxpayer can claim on rental properties to the amount that would reduce his or her net rental income from all rental properties to $0 (ITR 1100(11)). Sabbir owns a duplex in Winnipeg. He collected rents of $5,520 and incurred deductible expenses of $1,955. Therefore, he cannot claim capital cost allowance in excess of $3,565, calculated as (rents - deductible expenses) or ($5,520 - $1,955). Francine owns a building from which she collected $8,940 in rent. She incurred $9,112 in deductible expenses. Francine will not be able to claim any capital cost allowance because she already has a rental loss. More than one class of rental properties If a taxpayer has more than one class of rental properties, the CCA restriction is not applied to the individual properties or even the individual class of rental properties, but rather to the total CCA that may be claimed against all of the taxpayer’s rental properties. The entire CCA claim for all properties must not exceed the total of the rental income from all properties less the total of rental losses from all properties (ITR 1100(11)).
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Income Tax Planning Trong owns two apartment buildings in Vancouver. His rental operations may be summarized as follows:
Trong may only claim capital cost allowance to a maximum of $1,800 which is his net combined rental income, calculated as (net rental income building 1 - net rental loss building 2) or ($2,600 - $800). Refer to IT-195R4, Rental Property – Capital Cost Allowance Restrictions, for additional information.
Exercise: Adjustments to Net Rental Income
Net Rental Income after Adjustments
The taxpayer’s net rental income or loss is calculated on the Statement of Real Estate Rentals as: 1. 2. 3. 4. 5. the individual’s share of net income (loss) before adjustments minus any expenses related to the individual’s ownership in the case of co-ownership plus any recaptured CCA minus any terminal losses minus CCA claimed
Renting out Part of One's Principal Residence
If a taxpayer rents out part of the building where he or she lives, a deduction can be made for 100% of all current expenses that relate to the rented part, plus a portion of current expenses that relate to the whole building. The latter portion is determined as a reasonable percentage of the whole building. It may be calculated on the basis of the number of rooms or the square footage. When Belinda and Michael first bought their 3,200 square foot home, they rented out the basement apartment, which was 800 square feet, to help make their mortgage payments. They were able to deduct 25%, calculated as (rented area ÷ total area of house) or (800 ÷ 3,200) of current expenses that related to the entire house (e.g., property taxes, insurance, utilities), plus 100% of any current expenses that related solely to the rental unit (e.g., an extra cable TV connection, if it is provided along with the rental). Note: While a taxpayer who rents out a portion of his or her home may claim CCA on the rented portion and thereby reduce net rental income, by doing so he or she may impair use
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Taxation of Property Income of the principal residence exemption. Also, if he or she sells the house or simply ceases renting out part of the house, all or part of the CCA claimed may be recaptured, and a capital gain or loss may arise. For these reasons, you may not wish to claim CCA when you rent out part of your house.
Rental Losses
If a taxpayer has a rental loss, he or she can deduct that loss from other sources of income, thereby reducing personal tax liability. Fiona owns a duplex, and she lives in one unit and rents out the other for $300 per month. After deducting her current expenses of $4,800, excluding CCA, Fiona had a rental loss of $1,200, calculated as ((monthly rent x number of months rented) - current expenses) or (($300 × 12) - $4,800). Fiona's only other source of income is her employment earnings of $48,000. She can use the rental loss to reduce her total income to $46,800, calculated as (other income - rental loss) or ($48,000 - $1,200). In order to be able to use a rental loss to offset other income, the taxpayer must have had a profit motive when renting out the property. While it is quite common for parents to charge adult children who still live at home rent to help meet living expenses, this is usually done without a profit motive. As a result, the taxpayer would not be able to claim a rental loss resulting from this activity, but also would not have to record the rent in his or her income. Instead of being a true rental arrangement, these family rentals are simply cost sharing arrangements.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Rental Income. In this lesson, you have learned how to do the following: • identify, calculate, and describe any probable tax impact given a client with rental income
If you are ready to move to the next lesson, click Capital Cost Allowance on the table of contents.
Assessment
Now that you have completed Rental Income, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Capital Cost Allowance
Welcome to Capital Cost Allowance. In this lesson, you will learn about how capital cost allowance (CCA) is calculated, including the application of the 50% rule and the available for use rule. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • identify, calculate, and describe any probable tax impact given a client with capital cost allowance
Capital Cost Allowance
When a taxpayer calculates his or her income from a business or property, the Income Tax Act allows a deduction with respect to the capital cost of a depreciable property used to earn that income (ITA 20(1)(a)). The amount that is allowed by Regulation is referred to as capital cost allowance or CCA. Capital expenditures include the cost of acquiring property used to produce income, plus the cost of making lasting or permanent improvements. Some of these capital expenditures will be for depreciable capital property and CCA may be claimed on this property. Other capital expenditures (for example, land, goodwill, or investments in stocks or bonds) do not qualify as depreciable capital property even though they are capital in nature, so CCA cannot be claimed on them. However, the Income Tax Act may permit a different deduction scheme for some types of non-depreciable capital property if they qualify as eligible capital expenditures. This will be discussed in the next section. Some capital expenditures do not qualify as either depreciable property or eligible capital expenditures (e.g. stocks or bonds or the family cottage); these are simply capital property. Throughout this lesson, we will be referring to the sample Capital Cost Allowance Schedule for Max Karowski’s rental property. Click the icon below if you would like to follow along with a copy of the Capital Cost Allowance Schedule for Max Karowski.
Calculating Capital Cost Allowance
The calculation of CCA varies depending on the type of depreciable property under consideration. Prescribed CCA classes Under Part XI of the Regulations to the Income Tax Act, depreciable property is grouped into prescribed CCA classes that are described in Schedule II of the Regulations, or by ITR 1101(1).
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Taxation of Property Income In total, there are over 40 prescribed classes, many with very detailed descriptions or exclusions. Click the icon below to view a summary of the most common classes encountered by taxpayers earning business or rental income. You may wish to print this page to refer to it.
CCA can only be claimed for depreciable property. Under the Regulations, a property is generally not considered to be depreciable property unless it fits into one of the prescribed classes. A tangible capital property that is not specifically covered in any other class may not be placed in what appears to be the most appropriate class. Instead, it must be included in class 8 of Schedule II of the Regulations, unless it is excluded by the specific exceptions noted for that class. Some of the more common types of tangible property that are specifically excluded from class 8 include: • • • • land or any part thereof or any interest therein an animal a tree, shrub, herb or similar plant a right of way (Reg. Sch. II, Cl. 8(i))
The items listed above are not considered to be depreciable property, so they are not eligible for CCA.
Prescribed CCA Rates
The maximum rate of CCA that the taxpayer can claim for each prescribed class in any one year is documented in ITR 1100(1), and it varies from 4% to 100%, depending on the class. The taxpayer is not required to claim the maximum amount or any amount in any taxation year. Jason runs a business and for the last taxation year, he would have been able to claim CCA of $32,000. However, this would leave Jason with a business loss and he does not have very much other income, so he is already in a low tax bracket. Jason decided not to claim any CCA for the last taxation year because he would rather be able to claim a larger amount in the future, once his business becomes successful and he has a greater need to reduce his tax liability. If a taxation year is less than 12 months, the CCA rate is prorated to account for the difference between a full fiscal year and the taxation year. If property is acquired in a taxation year that is shorter than a full fiscal period, the prorating rules apply to limit the CCA deduction.
CCA vs. Depreciation Expense
Capital cost allowance is a tax concept designed to provide tax relief by permitting a deduction that in part recognizes the wear or obsolescence of property over time. The amount of the permitted deduction may or may not reflect the true wear and tear on that property during the year, depending on the CCA rate permitted for that property. If the government is trying to stimulate economic development in a certain area, it might increase
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Income Tax Planning the maximum CCA rate for property commonly used by the sector or introduce additional allowances to allow businesses an opportunity to seek greater tax relief. The federal government was worried about the financial impact that the Year 2000 phenomenon might have on small businesses. The Department of Finance issued a special release (Release No. 98-057) on June 11, 1998, announcing that small- and medium-sized firms would be eligible for accelerated CCA of up to $50,000 for computer hardware and software acquired to replace systems that were not year 2000 compliant. As a result, businesses were able to deduct 100% of such eligible assets in the year of acquisition, if acquired between January 1, 1998 and October 31, 1999 (ITR 1100(1zg and 1zh)). In this way, the government has targeted tax relief for small- and medium-sized businesses. In contrast, depreciation is an accounting concept that is designed to take into account the true economic decrease in the value of property over time as a result of wear or obsolescence. A business might decide to claim the maximum amount of CCA to minimize its current tax liability. However, it might record a different amount as the depreciation expense on the company’s income statement, such that the balance sheet shows a value for the assets owned by the company at a particular point in time that is different from the UCC. In brief, CCA is a tax concept and the amount claimed may or may not be a true reflection of the wear and tear of a property during the year. George Swann Inc. has 10 photocopiers, purchased one year ago at $1,200 each.
The maximum CCA that can be claimed for Class 8: [($1,200 x 10) x 20%] = $2,400. On the other hand, depreciation is an accounting concept that provides a true reflection of the decrease in economic value of a property due to wear and tear. Depreciation equals the actual depreciation of the photocopiers. In the first year this may only work out to 15%. In this case, the company will record $1,800 calculated as [($1,200 x 10) x 15%] as an expense on its income statement.
The Diminishing Balance Basis vs. the Straight-line Basis
Two different methods of calculating CCA are available: • • diminishing balance basis the straight-line method
In most cases, CCA is calculated on a diminishing balance basis, which means that the maximum CCA rate is applied to the undepreciated capital cost (UCC) of the class at yearend. The classes to which the diminishing balance apply and the corresponding rates are prescribed by ITR 1100(1)(a).
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Taxation of Property Income
In the case of some types of property, the Income Tax Act may require CCA to be calculated using the straight-line method, in which case the maximum CCA rate is a fixed percentage of the original capital cost of the assets in the class, up to the remaining UCC in the class (ITR 1100(1)(b) through 1100(1)(zh)). Depending on the prescribed class, the CCA may also be limited by Regulation by the taxpayer’s income for the year from the property in question.
Exercise: Capital Cost Allowance
Undepreciated Capital Cost
In general terms, undepreciated capital cost (UCC) is calculated as: 1. the total capital cost of all the property in the class (whether or not it is still owned at year-end) minus 2. the total CCA claimed in that class for all previous years minus 3. the total of the lesser of net proceeds and capital costs from dispositions before that time of property included in the class Pratik runs a lawn care maintenance business and he has various pieces of equipment in class 8 with a total capital cost of $14,000. He has had all of this equipment for several years, during which time he had previously claimed CCA of $3,200. He also sold one of his pieces of equipment, which had a cost of $4,000, for $2,600. Pratik’s unadjusted UCC for his class 8 assets is $8,200, calculated as (total capital cost - previously claimed CCA - proceeds of sale) or ($14,000 - $3,200 - $2,600). There are special adjustments made for property acquired during the year, discussed later under the 50% rule.
Capital Cost of Property
In the context of CCA, the capital cost of property generally means the full cost to the taxpayer of acquiring the property, including legal, accounting, engineering or other fees incurred to acquire the property. If the taxpayer manufactured equipment for his or her own use, the capital cost includes material, labour and overhead costs reasonably attributed to the property, but nothing for any profit that might have been earned if the asset had been sold. Martin started up a metal working shop. He paid land transfer tax on the purchase of the building of $4,000 and he incurred legal fees of $2,000 during the purchase. The purchase price of the building was $260,000. The capital cost of the property for CCA purposes is $266,000, calculated as (purchase price + legal fees + land transfer tax) or ($260,000 + $2,000 + $4,000).
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Income Tax Planning One piece of equipment that Martin wanted was not readily available, so he purchased a standard unit for $4,200 and modified it to suit his needs. The modifications required additional supplies of $300, labour valued at a total of $1,200 and estimated overhead costs of $200. Martin believes he could easily sell the modified unit for $9,000. However, the capital cost of this piece of equipment for CCA purposes is only $5,900, calculated as (purchase price + parts costs + labour costs + overhead costs) or ($4,200 + $300 + $1,200 + $200). While the capital cost of property generally refers to the taxpayer’s acquisition cost, there are some adjustments that are made from time to time.
Capitalized Interest Costs and Soft Costs
When a taxpayer borrows money to acquire a depreciable asset, he or she may elect to add the interest costs to the capital cost of the asset rather than claiming a deduction for the interest expense in the year incurred (ITA 21(1)). Refer to IT-121R3, Election to capitalize cost of borrowed money, for more information on this subject. Soft costs By virtue of ITA 18(3.1) to ITA 18(3.7), the capital cost of a building may include soft costs related to a period of renovation, construction or alteration to the extent these costs were not deductible in calculating income. Refer to IT-285R2, Capital cost allowance – General comments, for more information on determining the capital cost of property.
Limits on Passenger Vehicles
If an individual uses a passenger vehicle to earn income from a business or from property, the Income Tax Act limits the amount of CCA that can be claimed for that vehicle (ITA 13(7)(g) and ITR 7307(1)). Vehicles acquired for more than the prescribed threshold amount are placed in class 10.1 at a capital cost equal to the prescribed threshold amount, with a maximum CCA rate of 30% (ITR 1100(1)(a)(x.1)). As a result, these vehicles are referred to as class 10.1 passenger vehicles. The prescribed threshold amount depends upon the date of acquisition, as follows: Automobile acquired on or after January 1, 1991 January 1, 1997 January 1, 1998 January 1, 2000 January 1, 2001 and later years Threshold amount
$24,000 $25,000 $26,000 $27,000 $30,000
+ + + + +
(PST (PST (PST (PST (PST
+ + + + +
GST GST GST GST GST
payable payable payable payable payable
on on on on on
$24,000) $25,000) $26,000) $27,000) $30,000)
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Taxation of Property Income The capital cost recorded in class 10.1 is net of any GST input tax credits. This can get complicated if the car is not used solely for business purposes. As long as the car is used 90% or more for business purposes, the GST input tax credit will offset the GST paid. Rob is self-employed and his business requires extensive travel. This year, he purchased a new luxury sedan solely for business purposes at a cost of $35,000 + 8% PST and 5% GST. Rob's new car will fall into class 10.1 at a capital cost of $32,400, calculated as [(the lesser of (actual cost and threshold)) x (1 + PST)) or [(the lesser of ($35,000 and $30,000)) × (1 + 8%)]. Refer to IT-521R, Motor Vehicle Expenses Claimed by Self-employed Individuals, for additional information.
Available for Use: Rental Buildings
A taxpayer can only add property to a CCA class and thus claim CCA on that property when it becomes available for use (ITA 13(26)). The date when it is deemed to be available for use varies with the type of property and is set out in the Income Tax Act (ITA 13(27) to 13(30)). If the property is a rental building, it is normally available for use when purchased, as long as it can be used immediately as a rental building. If it cannot be used for this purpose immediately, it is considered to be available for use on the earliest of: • • • the date the taxpayer rents out all or substantially all of the building (CRA normally considers a 90% occupancy rate to be substantially all) the second year after the year the taxpayer acquires the building the time immediately before the taxpayer disposes of the building
Available for Use: Buildings Under Construction or Renovation
If the building is under construction, renovation or alteration, it is considered to be available for use at the earliest of the three times mentioned above or the date the construction, renovation or alteration is completed (ITA 13(28)). Note: A taxpayer may still be able to claim CCA on a building that is under construction, renovation or alteration before it becomes available for use, but only to the extent that the taxpayer has net rental income from that building after having deducted any soft costs related to the work in progress (ITA 20(28) and 20(29)). According to the guidelines set out above, Max Karowski’s building was not available for use until the end of last year. However, Max had net rental income of $19,000 last year after accounting for the soft costs. So, Max could still claim some CCA on the building and furnishings, but only to the extent that it reduced his net rental income after adjustments to zero.
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Income Tax Planning
Available for Use: Property Other than Buildings
If the property is something other than a building, it is considered to be available for use on the earliest of: • • • • • the the the the the date the property is delivered and it is capable of being used date the taxpayer first uses it to earn income date all licenses and permits are received for a motor vehicle or aircraft second year after the year that the taxpayer acquires the property time immediately before the taxpayer disposes of the property
The fact that the property will be considered to be available for use no later than the second year after the year that the taxpayer acquires the property is sometimes referred to as the two-year rolling start rule. For long-term construction projects, the two-year rolling start rule effectively permits a partial deduction for construction costs starting in the third year of the project, even if the job has not been completed in the meantime.
Exercise: UCC, Capital Cost of Property & Available for Use
The 50% Rule
If a taxpayer acquires depreciable capital property during the taxation year, he or she can usually claim only one-half of the net additions to a CCA class for that year (ITR 1100(2)). Net additions are calculated as the capital cost of all new additions, minus the proceeds of any dispositions from that same class. When filling out the capital cost allowance schedule, the full cost of net additions is added to the UCC at the beginning of the year to arrive at the unadjusted UCC. The adjusted UCC is then calculated as the UCC at the beginning of the year plus 50% of net additions during the year. This is known as the 50% rule. The CCA rates are applied to the adjusted UCC, and the result (i.e., adjusted UCC × CCA rate claimed) is then subtracted from the unadjusted UCC to arrive at the UCC at the beginning of the following year. Refer back to the rental building owned by Max Karowski and his capital cost allowance schedule. Max bought new appliances for five of the rental units at a cost of $7,800 this year. He already had an undepreciated capital cost in class 8 (furniture and appliances) of $22,000 at the start of the year. He sold the old appliances from those units for a total of $1,000, for net additions of $6,800, calculated as (cost of new appliance - less proceeds on sale of old appliances) or ($7,800 - $1,000). The maximum CCA rate for class 8 is 20%. So, the total CCA that Max can claim this year is $5,080, calculated as (CCA rate for Class 8 x (UCC at beginning of year + (net additions ÷ 2))) or (20% × ($22,000 + ($6,800 ÷ 2)).
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Taxation of Property Income Max also claimed CCA of $32,800 on the building, calculated as (UCC of building at beginning of year x CCA rate for building) or ($820,000 × 4%). Therefore, the total CCA he claimed this year was $37,880, calculated as (CCA on building + CCA on appliances) or ($32,800 + $5,080). Note: For purposes of this rule specifically, there is no advantage or disadvantage as to the timing of a purchase and therefore, it is not really an issue of strategy or planning. The cumulative cost of purchases throughout the year is adjusted for cumulative dispositions and then 50% of the net additions are added to the UCC at the beginning of the year. If property is acquired in a taxation year that is shorter than a full fiscal period, both the 50% rule and the prorating rules apply to limit the CCA deduction.
How the Rules Interact
If property cannot be added to a CCA class one year because it does not meet the available for use rules, but it becomes available for use in a subsequent year, the 50% rule generally still applies to the year in which the property becomes available for use. At the beginning of last year, Don acquired a rental property and he spent the rest of the year fixing it up. During this time, the property remained vacant. Since it was not available for use until this year, Don could not claim any CCA last year. Furthermore, because he could not add the building to a CCA class until this year, the CCA that he can claim on that property will be limited by the 50% rule. An exception to this rule occurs if the property becomes available for use because of the two-year rolling start rule. In this situation only, the 50% rule does not apply in the year that the property is deemed to become available for use. Refer to IT-285R, Capital Cost Allowance - General Comments, for additional information on the 50% rule.
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Capital Cost Allowance. In this lesson, you have learned how to do the following: • identify, calculate, and describe any probable tax impact given a client with capital cost allowance
If you are ready to move to the next lesson, click Disposing of Depreciable Property on the table of contents.
Assessment
Now that you have completed Capital Cost Allowance, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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6-25
Taxation of Property Income
Lesson 4: Disposing of Depreciable Property
Welcome to Disposing of Depreciable Property. In this lesson, you will learn about the probable tax impact for a client who disposes of depreciable property. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • identify, calculate, and describe any probable tax impact given a client who disposes of depreciable property
Disposing of Depreciable Property
An actual disposition of depreciable property includes any transaction or event entitling the taxpayer to receive proceeds of disposition, whether those proceeds are payable in cash, in kind or in services. We will first discuss how actual dispositions of depreciable property can result in a recapture of CCA or a terminal loss in general terms, before we look at the special circumstances for deemed dispositions of depreciable property. When a taxpayer disposes of depreciable property, it is necessary to determine the capital cost, the undepreciated capital cost (UCC) and the net proceeds of disposition, because all of these are factors in determining the tax implications of the disposition. Capital cost is also referred to as adjusted cost base (ACB).
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Income Tax Planning
Recaptured CCA
Whenever a taxpayer disposes of depreciable property in a class, the UCC of that class changes in the formula: UCC after disposition = (UCC before disposition - lesser of (net proceeds and capital cost)). Neil owns a computer that is the only property in its class with a capital cost of $3,000 and a UCC at the beginning of the year of $800. He sold the machine this year for $1,200. Neil’s UCC at the end of the taxation year will be -$400, calculated as (UCC before disposition - (the lesser of (net proceeds and capital cost))) or ($800 – (the lesser of ($1,200 and $3,000)). Toni owns a rental property that she originally acquired for $280,000, with $200,000 of the cost attributed to the building and $80,000 to the land. Her UCC for the building at the beginning of this year was $184,320. This year, she sold the property for $326,000, with $226,000 allocated to the building and $100,000 to the land. She incurred selling expenses of $6,000 for the building and $2,000 for the land. The proceeds of disposition for the building are $220,000, calculated as (sale proceeds costs of disposition) or ($226,000 - $6,000). Her UCC after the disposition was -$15,680, calculated as (UCC before disposition - (the lesser of (net proceeds and capital cost)) or ($184,320 - (the lesser of ($220,000 and $200,000))). There will also be a capital gain on the building. Because the land is not a depreciable capital property, there is no potential for a recapture to be realized upon its disposition. Instead, Toni will realize a capital gain upon the sale of the land.
Recapture when UCC is Negative
If the UCC of a class of assets is negative as of the end of a taxation year, the amount must be included in the taxpayer’s income for the year as a recapture of CCA (ITA 13(1)). In the previous examples, Neil had a recapture of $400 that must be included in his income; while Toni had a recapture of $15,680 that must be included in her income. This occurs when the net proceeds of a property disposed of in the current taxation year exceed the UCC of its class as of the end of the preceding year.
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Taxation of Property Income
Example: Karen Lyons, Part 1
Karen is a financial planner. She has operated an independent practice for four years. In her first two years of business, she purchased items that fell into CCA class 8 as per the following table: Year Acquired years ago years ago years ago years ago Item Furniture Rugs Phone System Photocopier Capital Cost $2,000 $700 $400 $800
4 4 4 2
Last year, Karen sold the photocopier for $600. The next table has a summary of her CCA claims from four years ago through last year. Note: Because the proceeds of disposition exceed the cost of any additions to the class during the year, there is no need to make a further adjustment to arrive at the reduced UCC; Column E for last year is $0. Karen’s CCA Claims to Last Year C D E F (A + Greater (D - E) B– of $0 C) and (50% × (B – C))
A
B
G
H (F × G)
I (D – H)
4 years ago 3 years ago 2 years ago last year
0 3,100
0 3,100
1,550 1,550
20%
310
2,790
2,790
0
0 2,790
0 2,790
20%
558
2,232
2,232
800
0 3,032
400 2,632
20%
526
2,506
2,506
0
600 1,906
0 1,906
20%
381
1,525
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Income Tax Planning
Example: Karen Lyons, Part 2
Karen's financial planning practice has been extremely successful and later in this current fiscal year, she intends to move to a larger office and to furnish her new office at the same time. Assume she sells her old furniture and rugs for $2,400. If this ends up being her only transaction during the year in class 8, it would leave her with a negative balance and Karen would have a recapture of $875, as shown in the table. Karen’s CCA Claims For Last Year and This Year C D E F G H (A + Greater (D - E) (F × G) B– of $0 C) and (50% × (B – C))
A
B
I (D – H)
last 2,506 year this 1,525 year
0
600 1,906
0 0
1,906 20% -875 20%
381 0
1,525 -875
0 2,400 -875
Recapture can result from a property disposition whether or not other property remains in the class at the end of year. Karen still has her phone system. However, based on her transactions so far, she will incur a recapture of $875 and this amount must be added to her income for the current fiscal year. This recapture can be avoided, however, if depreciable property of the same class is acquired before the end of the fiscal year for an amount that is at least equal to the recaptured depreciation. The recapture is avoided because at the end of the fiscal year the balance in the class will have become positive again.
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Taxation of Property Income
Example: Karen Lyons, Part 3
Because Karen's business has been doing well, she decides to treat herself to better furniture at a cost of $5,000. By acquiring this new class 8 property, she will avoid the recapture. In fact, she will be able to make a CCA claim based on the reduced UCC at the end of the year. Both items are shown in the following table: Karen’s CCA Claims For Last Year and This Year C D E F G H I (A + Greater (D - E) (F × G) (D – H) B– of $0 C) and (50% × (B – C))
A
B
last 2,506 600 1,906 year this 1,525 5,000 2,400 4,125 year
0 1,300
1,906 20% 2,825 20%
381 565
1,525 3,560
Exercise: Disposing of Depreciable Property
Exercise: Acquiring Depreciable Property
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Income Tax Planning
Separate Classes for Rental Properties over $50,000
The Income Tax Act requires the taxpayer to record each rental property that he or she acquired after 1971 at a cost of $50,000 or more in a separate class for CCA purposes (ITR 1101(1ac)). The main objective of this rule is to force the recapture of CCA immediately upon the disposition of an individual building. Any new acquisition of an identical type of asset during the year does not defer taxation of the recapture because the asset acquired must also be included in a separate class.
Terminal Loss
A taxpayer may dispose of the last asset in a particular CCA class and the resulting balance in the class is still positive even after reducing it by the lesser of cost or proceeds. If this occurs, the taxpayer can deduct the remaining balance from his or her income as a terminal loss (ITA 20(16)). If there are assets remaining in the class at the end of the taxation year, the taxpayer will continue to apply the applicable rate of CCA on the balance. Suzanne, a graphic designer with her own practice, owns several older model computers. Last year, she decided to sell her existing computers and lease new ones. She purchased the computers three years ago for $8,000 and the UCC for her class 45 assets before the transaction was $4,200. She sold the old computers for $1,600, which left her with no other assets in class 45. Her UCC at the end of the year for class 45 would be $2,600, calculated as [UCC before disposition - (the lesser of (net proceeds and capital cost))] or [$4,200 - the lesser of ($1,600 and $8,000)]. Because she has a positive balance in class 45, but no class 45 assets, Suzanne can claim a terminal loss of $2,600 on her tax return for last year. Even when the proceeds of a disposition are lower than the original cost of a depreciable asset, the taxpayer does not claim a capital loss on the transaction. Instead, the taxpayer can claim a terminal loss. The disposition of depreciable capital property can never give rise to a capital loss.
Rationale Behind Recaptures and Terminal Losses
The Income Tax Act specifies a maximum rate of CCA that may be claimed for a depreciable asset included in a particular class. Each year, the taxpayer is entitled to claim up to the maximum amount of CCA available and the UCC of the class is reduced by that amount. If an asset is disposed of and a negative balance in the class results, it simply means that the taxpayer has claimed capital cost allowances that amount to more than the actual decline in the value of the asset. Thus, the excess amount of the CCA claimed is added back to income as recaptured income. On the other hand, a terminal loss means that the asset has depreciated in value faster than has been accounted for via the CCA system. The taxpayer is then entitled to deduct the amount of the excess of the decline in value of the asset over the CCA claimed as a terminal loss.
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6-31
Taxation of Property Income
Exercise: Terminal Losses
Exercise: Recapture and Terminal Loss
Deemed Dispositions
An actual disposition occurs when a taxpayer sells his or her depreciable property. However, the Income Tax Act recognizes a deemed disposition to have occurred for tax purposes in several circumstances, even if an actual purchase or sale did not take place. The circumstances that can give rise to a deemed disposition are: • • • • death certain inter vivos transfers, including a gift, charitable donation or transfer to a trust involuntary destruction or loss (for example, through theft or fire) when the use of the property changes
Each circumstance is discussed on the following pages.
Death
The proceeds of the deemed disposition of depreciable property upon death are deemed to be equal to the fair market value (FMV) of the property immediately prior to death. The deemed disposition upon death may result in either a recapture or terminal loss, depending on the UCC of the depreciable property. The applicable amount will be added or deducted when computing the deceased’s income on his or her final return. No CCA can be claimed in the year of the taxpayer’s death because the taxpayer is deemed to have disposed of all of his or her capital property immediately prior to death (ITA 70(5) and 70(6)).
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Income Tax Planning
Inter Vivos Transfers of Property and Exchanges of Property
An inter vivos transfer is any transfer of property that occurs while the transferor is still alive. However, the Income Tax Act provides: • • • the opportunity for a rollover to a spouse, common-law partner or spousal trust (ITA 73(1)) the opportunity for a rollover of depreciable farm property to a child or grandchild (ITA 73(3)) a deemed disposition at FMV in all other cases, which can give rise to a terminal loss or recapture (ITA 69(1))
Exchanges of Property The Income Tax Act allows for a deferral of all or part of the recapture of CCA upon disposition in two situations where the disposition is in fact part of an exchange of similar depreciable properties (ITA 13(4)). These two situations are: • • the exchange of former business properties the involuntary disposition of a depreciable property
Converting Income-producing Property into Non-income Producing Property
The Income Tax Act deals with situations in which a depreciable asset used for the purpose of producing income is used for some other purposes (e.g., a business asset is used for personal use (ITA 13(7))). When income-producing property is used for a non-income producing purpose, the Act provides that the property is deemed to have been disposed of at that time for its fair market value and immediately reacquired for that same amount. This deemed disposition could result in a recapture or terminal loss. When Sandy's brother died over ten years ago, Sandy inherited his house in New Brunswick. Because Sandy lived in Alberta at the time, she had no use for the house and decided to rent it out. She originally acquired the house at a capital cost of $140,000 and the current UCC is $98,000. Sandy is about to change jobs and she plans to move to New Brunswick and make the house her principal residence. The current FMV for the house is $144,000. As a result of the change in use, Sandy will incur a recapture of $42,000, calculated as (UCC before disposition - (the lesser of (net proceeds and capital cost))) or ($98,000 – (the lesser of ($144,000 and $140,000)). She will also realize a capital gain of $4,000, calculated as (net proceeds - capital cost) or ($144,000 - $140,000). This deemed disposition does not occur when there is simply a change in the type of income a property generates. Also, when a taxpayer ceases to use the property to earn income but keeps the property for a period of time without using it, he or she will not be deemed to have disposed of the property until such time as it begins to be used for another purpose.
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Taxation of Property Income
Converting Non-income producing Property into Income Producing Property
If the use of a property is changed from non-income to income-producing, the Income Tax Act also deems a disposition to have occurred (ITA 13(7)). When the property was nonincome producing, it would not have been eligible for CCA and so there is no potential for a terminal loss or recapture upon its deemed disposition. However, the deemed disposition could result in a capital gain or loss. Also, the deemed disposition affects the capital cost of the new income producing property for subsequent CCA purposes. When this conversion takes place, the taxpayer is deemed to have disposed of the property and immediately reacquired it. The cost of reacquisition is generally determined as follows: • • If the FMV is less than the original cost of the property, then the capital cost is deemed to be the FMV. If the current FMV is greater than the original cost, the deemed capital cost of the property at the time of its change of use will be increased to the aggregate of the original cost, plus the taxable portion of any capital gain resulting from the deemed disposition (ITA 13(7)(b)).
Gordon owns a cottage with a FMV of $132,000. He acquired it four years ago for $114,000. Because he is moving out of the province, he has decided to rent the property. This change of use will result in a deemed disposition and a capital gain of $18,000, calculated as (FMV at time of deemed disposition - original cost) or ($132,000 - $114,000). Only 50% of the capital gain is taxable. Once Gordon begins receiving rental income, he will be able to claim CCA based on a capital cost of $123,000, calculated as (original cost + taxable portion of capital gain) or ($114,000 + (50% × $18,000)). The rules get more complex if there is only a partial conversion (for example, he rents out only a portion of the property), but these rules are beyond the scope of this course. No-change-of-use election The deemed disposition can be avoided by electing that there has been no change of use (ITA 45(2)). If a taxpayer files such an election, the property is deemed to continue to be used for a non-income producing purpose; however, the taxpayer cannot claim any CCA. The resulting income is still taxable.
Exercise: Deemed Dispositions
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Disposing of Depreciable Property. In this lesson, you have learned how to do the following: • identify, calculate, and describe any probable tax impact given a client who disposes of depreciable property
If you are ready to move to the next lesson, click Other Deductions from Business and Property Income on the table of contents.
Assessment
Now that you have completed Disposing of Depreciable Property, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Property Income
Lesson 5: Other Deductions from Business and Property Income
Welcome to Other Deductions from Business and Property Income. In this lesson, you will learn about eligible capital expenditures that can serve as deductions as well as how much of an eligible capital expenditure can be deducted in any given year. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • identify eligible capital expenditures that can serve as deductions calculate how much of an eligible capital expenditure can be deducted in any given year
Eligible Capital Expenditures
A business may incur certain expenses, such as the purchase cost of a pizza franchise, that are not considered to be either current expenses or capital expenditures and consequently, they are not deductible from current income either as a current expense or through CCA. However, the Income Tax Act still provides some relief if the expense qualifies as an eligible capital expenditure. Eligible capital expenditures (or EC expenditures) can be broadly described as expenditures for intangible capital property (also called eligible capital property or EC property), such as goodwill and other nothings, the cost of which neither qualifies for capital cost allowance nor is deductible in the year of its acquisition as a current expense. A more specific and lengthy definition is provided in the Income Tax Act (ITA 14(5)). Despite the fact they cannot be deducted as a current expense or through CCA, EC expenditures receive special treatment under the Income Tax Act. Common EC expenditures are: • • • • • the cost of a franchise, right or licence for an indefinite period goodwill, which is the value of a business in excess of the fair market value of the net business assets incorporation, reorganization and amalgamation costs certain legal expenses, such as incorporation costs customer lists
For a more detailed discussion of what constitutes an eligible capital expenditure, refer to IT-143R2, Meaning of Eligible Capital Expenditure.
How an Eligible Capital Expenditure translates into a Deduction
When a taxpayer makes an eligible capital expenditure (ECE), 3/4 or 75% of this expenditure is added to a notional pool, called the cumulative eligible capital account or EC pool. For the purpose of adding eligible capital expenditures to the EC pool, the inclusion rate remains at 75%, even though the capital gains inclusion rate has dropped to 50%. The taxpayer can make a deduction from business income of up to 7% of any positive balance in the EC pool at the end of the year (ITA 20(1)(b)).
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Income Tax Planning George recently incorporated his business. He paid $225 to his provincial government as an incorporation fee, plus $500 to his lawyer. His total incorporation expense is $725, calculated as (incorporation fee + legal fee) or ($225 + $500). These expenses qualify as an eligible capital expenditure. George can credit $543.75 to his cumulative eligible capital account, calculated as (inclusion rate of 75% x eligible capital expenditure) or (75% x $725). This is the only amount in his EC pool at this time. In the first year, his corporation can deduct $38.06 from its business income, calculated as (rate of 7% x cumulative eligible capital account) or (7% x $543.75). The balance in the EC pool will be reduced to $505.69, calculated as (EC pool - ECE deduction) or ($543.75 - $38.06). In the second year, the corporation can deduct $35.40 from its business income, calculated as (rate of 7% x cumulative eligible capital account) or (7% x $505.69), and the balance in the EC pool will be reduced to $470.29, calculated as (EC pool - ECE deduction) or ($505.69 - $35.40). The corporation can continue to deduct a maximum of 7% of the declining balance each year until the EC pool reaches $0.
Dispositions of Eligible Capital Property
When a taxpayer disposes of an eligible capital property, it will result in an eligible capital amount or EC amount, which must be deducted from the EC pool. The EC amount is calculated as 75% of the excess of the proceeds of disposition over the costs associated with that disposition. This EC amount results in recapture of the deduction from the EC pool. The amount of recapture is taxable income. Henry disposed of a customer list, which is an eligible capital property, for proceeds of $120,000. He incurred costs of $4,000 for the disposition. His EC amount is $87,000, calculated as ((proceeds - costs of disposition) x inclusion rate) or (($120,000 - $4,000) × 75%). Before the sale, Henry had an EC pool balance of $15,000, and had deducted $6,000 from his EC pool. Henry must report recapture of $6,000 as taxable income. He will have an EC pool balance of -$66,000, calculated as ((his EC pool balance + recapture) - his EC amount) or (($15,000 + $6,000) - $87,000). Dispositions of eligible capital property include: • • • • the the the the sale of a franchise or license for an unlimited time sale of goodwill in connection with a business outright sale of a process sale of certain rights
Refer to IT-386R, Eligible capital amounts, for more information on which types of transactions would give rise to an eligible capital amount. Negative EC pool balance When the balance of an EC pool becomes negative following a disposition and remains negative at the end of the taxation year, a portion of the remaining amount must be included in the taxpayer’s business income (ITA 14(1)), similar to the tax treatment of recaptured depreciation.
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Taxation of Property Income If a taxpayer disposes of EC property such that the balance becomes negative at the end of the taxation year, 2/3 of the negative balance and the recapture amount are added into business income (ITA 14(1)). The factor of 2/3 ensures that only 50% of the gains on eligible capital property are included in income, calculated as (75% × 2/3). In this way, the system for taxing eligible capital property mirrors the taxation of capital gains. Practice Inc. had an EC pool balance of $10,000, and had deducted a total of $6,000 from the EC pool. Practice Inc. developed a new formula for a food seasoning mix, and it sold that formula and all rights to its use for net proceeds of $30,000. The formula and the associated rights constitute eligible capital property. This is the only transaction involving eligible capital property for the year. Practice Inc. will have recapture of the $6,000 deducted from the pool. The EC pool balance at the end of the year will be -$6,500, calculated as ((EC pool balance + recapture) - EC amount) or (($10,000 + $6,000) – (75% × $30,000)). Practice Inc. will have to include $10,333.33 in its income for the year, calculated as (recapture + taxable gain on eligible capital property) or ($6,000 + ($6,500 × 2/3)). Ceasing to carry on a business When a taxpayer ceases to carry on a business and has disposed of all eligible capital property, he or she may deduct any remaining positive balance of the cumulative eligible capital account for that business (ITA 24(1)). This is similar to the terminal loss rules in respect of depreciable property. Refer to IT-313R2, Eligible Capital Property – Rules Where a Taxpayer has Ceased Carrying on a Business or has Died, for further information.
Exercise: Eligible Capital Expenditures, Part 1
Exercise: Eligible Capital Expenditures, Part 2
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Income Tax Planning
Interest Expense
In certain situations, a taxpayer may be able to deduct his or her interest expense from taxable income, or he or she may be able to claim a tax credit on certain types of interest expenses. These situations include the following: • • loans used to earn business or property income interest on Canada student loans
Each situation is discussed on the following pages.
Loans used to Earn Business or Property Income
In general, the Income Tax Act allows a taxpayer to deduct the interest on loans that were used for the purpose of earning business or property income, as long as the taxpayer had a legal obligation to pay the interest (ITA 20(1)(c)). Phillip purchased a building for the purpose of earning rental income. He has a mortgage on the building and incurred interest expenses of $6,500 last year. He can deduct $6,500 on his Statement of Real Estate Rentals. Tanya borrowed $10,000 to invest in a portfolio of bonds, and she incurred an interest expense of $800 last year. She can deduct that interest expense on her Statement of Investment Income. Kyle borrowed $5,000 to invest in common shares with the objective of earning dividend income. He can deduct his interest expense of $400 on his Statement of Investment Income. Leanne borrowed $40,000 to help start up her business. She can deduct the interest expense of $3,600 on her Statement of Business Activities. Robert borrowed $160,000 to purchase his first home. He works outside of the home. He cannot deduct any of the interest expense related to his mortgage because the money that he borrowed is not being used to earn business or property income. It is not the collateral for the loan, but the use of the borrowed funds, that determines if the loan interest is deductible. Richard used a line of credit secured by his home equity to buy preferred shares. The interest on the home equity loan is deductible from his investment income. Brian wants to buy a new house at a cost of $200,000 and it requires a minimum downpayment of $20,000. He also needs $80,000 for the purpose of expanding his business. Brian has $100,000 in savings, but he is not sure whether he should use this amount for his downpayment on the house or whether he should invest it in the business. He figures that the rate on the business loan would be comparable to the mortgage rate of about 8%. If Brian invested the $80,000 in the business, he would not have to take out a business loan. However, he would have a mortgage of $180,000, incurring an interest expense of
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Taxation of Property Income about $14,400, calculated as (mortgage principal x interest rate) or ($180,000 × 8%). None of this interest expense would be deductible. If Brian made a downpayment of $100,000 on the house, he would have a mortgage of $100,000 incurring interest costs of $8,000, calculated as (mortgage principal x interest rate) or ($100,000 × 8%) and a business loan of $80,000, with an interest expense of $6,400, calculated as (principal of business loan x interest rate) or ($80,000 × 8%). Brian would have to pay the same amount of total interest, but he could deduct the $6,400 of interest on the business loan from his business income. Therefore, Brian should make the maximum downpayment on the house and take out a business loan to ensure as much of his interest expenses as is permissible are deductible.
Exclusions from Property Income
Capital gains The Income Tax Act excludes capital gains from the definition of property income (ITA 9(3)), so the potential capital appreciation of a property cannot be used to support an interest expense deduction under ITA 20(1)(c). Larry borrowed $50,000 to purchase a piece of land that he will likely be able to sell in the future for a substantial gain. He is not a developer and should be able to report the gain as a capital gain. However, because the land is not being used to earn business or property income, Larry cannot deduct the interest expense. As long as the investment has the potential to produce property income, the interest expense deduction will be permitted. Ben borrowed $10,000 to invest in a high-growth equity mutual fund. Although the main objective of the fund is capital appreciation, the potential exists for the fund to distribute dividend or interest income. As a result, Ben will be able to deduct the interest expense from his income. Investments within registered plans A taxpayer cannot deduct the interest expense on money borrowed for the purpose of investing within a registered plan (ITA 18(11)), including contributing to: • • • an RRSP a registered pension plan or deferred profit sharing plan a registered education savings plan (RESP)
Amanda borrowed $20,000 to make an RRSP catch-up contribution, and she will incur an interest expense of $1,500 on the loan. The RRSP funds are invested in GICs and other interest-bearing investments. The RRSP, not Amanda, is earning property income, and therefore she cannot deduct the interest expense.
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Income Tax Planning
Interest on Canada Student Loans
Taxpayers who have received student loans under a government student aid program (for example, Canada Student Loan or Ontario Student Loan) can claim a tax credit on the interest expense they incur during the year (ITA 118.62). To be eligible for the credit, the interest must have in fact been paid; it cannot be outstanding. Furthermore, only the student to whom the loan is made can claim the tax credit. A few years ago, Jody graduated from university. She is paying off her Canada Student Loan. This year, she made all required payments for the year, including principal of $2,600 and interest of $760. On this year's tax return, assuming a conversion rate of 15%, Jody can claim a federal tax credit of $114, calculated as (interest x conversion rate) or ($760 × 15%). She can also claim a provincial tax credit. If the taxpayer cannot use the tax credit during the year that the interest expense was incurred, or if he or she chooses not to claim the tax credit, the taxpayer can carry forward the unused credit and claim it in any of the following five years. This year, Alex did not have any taxable income, so he was unable to make use of the tax credit. However, he can carry the unused credit forward and use it to reduce his tax payable in any of the following five years.
Investment Counselling Fees
A taxpayer can deduct reasonable fees, other than commissions, paid for the following services: • • advice on buying or selling a share or security administration or management of the shares or securities for the taxpayer
In addition to account administration fees, the latter includes costs associated with the safekeeping of the securities (for example, the cost of a safety deposit box), and accounting fees. The fees must be paid to a person or business whose principal business is advising others to buy or sell specific investments or whose principal business includes the administration or management of shares or securities (ITA 20(1)(bb)). Fees paid for other types of financial advice, including financial counselling, financial planning, or tax planning are not deductible. Fees charged by the trustee of a registered retirement savings plan directly to the annuitant are not deductible because the shares or securities of the plan belong to the trust and not the annuitant (ITA 18(1)(u)). Refer to IT-238R2, Fees paid to investment counsel, for additional information.
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Taxation of Property Income
Exercise: Interest Expense
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Other Deductions from Business and Property Income. In this lesson, you have learned how to do the following: • • identify eligible capital expenditures that can serve as deductions calculate how much of an eligible capital expenditure can be deducted in any given year
If you are ready to move to the next lesson, click Income Attribution Rules on the table of contents.
Assessment
Now that you have completed Other Deductions from Business and Property Income, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 6: Income Attribution Rules
Welcome to Income Attribution Rules. In this lesson, you will learn about how property income and capital gains can be attributed to the taxpayer when he or she transfers property. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: • identify and calculate how property income and capital gains can be attributed to the taxpayer when he or she transfers property to a spouse or common-law partner, related minors, or certain other non-arm’s length individuals
Overview
Income splitting is the process of allocating investment or other income to the taxpayer’s spouse, common-law partner or children for tax purposes, thereby reducing the overall family tax bill. While there are still a few legitimate methods for income splitting between family members, there are also many rules in the Income Tax Act specifically designed to prevent income splitting. These rules, which are collectively called the income attribution rules, attribute income that a taxpayer would prefer to split with family members back to the taxpayer. This lesson reviews the three sets of income attribution rules as they relate to: • • • a spouse or common-law partner a related minor a non-arm’s length individual, other than a spouse, common-law partner or related minor
The income attribution rules as they apply to property income generally apply to any designated person, which is the spouse or common-law partner of the taxpayer, as well as any related minors (ITA 74.5(5)). To some extent, they also apply to other non-arm’s length parties. In most cases, capital gains are only attributed to the taxpayer in the case of transfers to a spouse, common-law partner or spousal trust, although in very limited situations they may also apply to transfers to the taxpayer’s child. In general, the rules become increasingly more stringent as the relationship with the taxpayer strengthens, moving from non-arm’s length to a related minor to a spouse or common-law partner. Note: The income attribution rules will still apply to transfers to a spouse or common-law partner at ACB, unless the transferor elects out of the automatic rollover provided for under ITA 73(1).
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Taxation of Property Income
Loans to Non-arm's Length Individual
The Income Tax Act includes rules to limit opportunities for income splitting between people who do not deal with each other at arm’s length. Attribution of property income If the taxpayer loans money or property to an individual and one of the main reasons for the loan was to reduce or avoid tax, any resulting property income is attributed to the taxpayer. This rule does not attribute property losses, capital gains or capital losses (ITA 56(4.1)). The rule applies to a taxpayer who does not deal at arm’s length with the particular individual. However, the rule does not apply to an individual who is a designated person. A designated person is the taxpayer’s spouse, common-law partner, or a related minor because there are more extensive income attribution rules for a spouse, common-law partner, or related minor. The rule applies to interest-free or low-interest loans, but not to loans for value (ITA 56(4.2)). It does not apply to transfers of property for FMV or any amount less than FMV, including gifts. Mort lives with his sister, Freda. He has an MTR of 50%; Freda has an MTR of 25%. Mort has $150,000 of tax-paid capital. He lends it to Freda at no interest, who invests it in a balanced mutual fund. One of the reasons for the loan was to reduce their total taxes. Any interest, dividends or rents are attributed to Mort. Any capital gains, capital losses or rental losses are not attributable. We will discuss the concept of loans for value a little later.
Non-arm's Length Persons
The terms, ‘arm’s length’ and ‘non-arm’s length’, are not precisely defined by the Income Tax Act. Related persons The Income Tax Act deems that related persons do not deal with each other at arm’s length (ITA 251). This is the case regardless of how they actually conduct their mutual business transactions. Related persons are individuals connected by blood, marriage or adoption. Therefore, individuals related to a taxpayer include his or her spouse or common-law partner, any of his or her direct descendants (children, grandchildren, etc.) and their spouses or common-law partners, and the taxpayer’s siblings and their spouses or commonlaw partners. However, the definition of related persons does not include nieces and nephews (ITA 251(2)). Unrelated persons Usually, unrelated persons deal with each other at arm's length; however, sometimes they do not, depending on the circumstances. Failure to carry out a transaction at fair market value may be indicative of a non-arm’s length transaction. However, such failure is not conclusive and, conversely, a transaction between unrelated persons at fair market value does not necessarily indicate an arm’s length situation.
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Income Tax Planning
The key factor in determining whether parties are dealing with each other at arm’s length is whether they have separate economic interests that reflect ordinary commercial dealings between parties acting in their separate interests. Therefore, a non-arm’s length person would include the taxpayer’s relatives (spouse, common-law partner, parents, grandparents, brothers, sisters, brothers-in-law, sisters-inlaw, children, adopted children, and grandchildren), as well as any other party with whom the taxpayer transacts, if their transactions do not reflect ordinary commercial dealings between parties acting in their separate interests. Barney and Kyle have been working together for the last five years. During that time, they have become very good friends. While Kyle will not admit it, Barney believes that Kyle has used his influence with their employer to secure Barney’s last promotion. If Barney gives Kyle an interest-free loan, they will be acting as non-arm’s length individuals. Refer to IT-419, Meaning of Arm’s Length, for further information.
Loans and Gifts to a Related Minor
For the purpose of income attribution rules, a related minor is a person who is under 18 years of age as of December 31st of the year and who: • • does not deal with the taxpayer at arm’s length (for example, a child or other descendant whether by blood or adoption) is the niece or nephew of the taxpayer (ITA 74.1(2))
Attribution of property income and property losses Property income and losses can be subject to attribution in the case of both loans and gifts to a related minor. Loans The income attribution rules for loans to a related minor are essentially the same as those for loans to a non-arm’s length party, except that: • • Gifts Because of the dependency relationship of the minor to the taxpayer, the property income attribution rules also apply to gifts. The Income Tax Act says that where a taxpayer has transferred or lent property, either, directly or indirectly, by means of a trust or by any means whatever, to or for the benefit of a related minor, any property income or property loss from the property is attributed to the taxpayer (ITA 74.1(2)). Joseph transferred a $10,000, 7% corporate bond to an inter vivos trust that names his 10-year old daughter, Tiffany, as the income beneficiary. The $700 in annual interest income, calculated as (face value x coupon) or ($10,000 x 7%) will be attributed to Joseph. they apply regardless of the reasons for the indebtedness the rules attribute both property income and property losses
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Taxation of Property Income
No Attribution of Capital Gains and Capital Losses
If a taxpayer transfers or loans property to a related minor, there is no opportunity to rollover the property as there is with transfers to a spouse or common-law partner. This means that there is usually a deemed disposition at FMV at the time of the transfer resulting in a capital gain (or loss) for the transferor, and the minor acquires the property at a cost equal to this FMV. For this reason, when the minor later sells the property, there is no attribution of capital gains or capital losses to the taxpayer. The exception to this rule is for certain farm transfers as noted in the next section. Sanwar decided to give his Newcorp shares to his 15-year-old son, Shafik. Sanwar’s ACB was $1,200 and the shares were worth $1,600 at the time of the transfer. Sanwar will realize a taxable capital gain of $200 as a result of the gift, calculated as ((deemed proceeds - ACB) x capital gains inclusion rate) or (($1,600 - $1,200) × 50%). Shafik will acquire the shares at a cost of $1,600. If Shafik later disposes of the shares for $2,400, he will realize a taxable capital gain of $400, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($2,400 - $1,600) × 50%), and this will not be attributed to Sanwar. Refer to IT-510, Transfers and loans of property made after May 1985 to a related minor, for further information about the attribution of property income.
Inter Vivos Farm Transfers to a Related Minor
If a taxpayer transfers certain farm property to a related minor for consideration less than FMV and that child disposes of the property prior to attaining the age of 18, any taxable capital gain or allowable capital loss resulting from that disposition will be attributed to the taxpayer (ITA 75.1). Refer to IT-268R3, Inter vivos transfer of farm property to a child, for further information.
Exercise: Loans to Non-arms Length Individuals
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Income Tax Planning
Loans and Gifts to a Spouse or Common-law Partner
A spouse is a person of the opposite sex who is married to the taxpayer. A common-law partner is a person of the same or opposite sex who has lived with the taxpayer in a conjugal relationship for at least 12 months, or someone who lives with the taxpayer in a conjugal relationship and with whom that taxpayer has had a child (ITA 252(4)). The Income Tax Act now treats spouses, same-sex common-law partners, and opposite-sex common-law partners in exactly the same way. The income attribution rules for loans and gifts to a spouse or common-law partner are essentially the same as those for loans and gifts to a related minor, except that: • capital gains and capital losses arising upon disposition of the property by the spouse or common-law partner are also attributed to the taxpayer
The rules apply to a person who is a taxpayer’s spouse or common-law partner at the time of the property loan or transfer, as well as a person who became the taxpayer’s spouse or common-law partner after the loan or transfer of property was made to that person. Gifts to adults, other than spouses or common-law partners, will not result in income attribution.
Attribution of Property Income and Losses and Capital Gains and Losses
The Income Tax Act essentially says that where a taxpayer has transferred or lent property either, directly or indirectly, by means of a trust or by any other means, whatever, to or for the benefit of the taxpayer’s spouse or common-law partner: • • • any property income or property loss from that property is attributed to the taxpayer (ITA 74.1) any net taxable capital gain or allowable capital loss from the disposition of the property shall be attributed to the taxpayer (ITA 74.2) any net taxable capital gain or allowable capital loss from listed personal property retains its nature when it is attributed to the taxpayer (ITA 74.2)
Sally earns substantially more than her spouse, Harry. She has an investment portfolio with an ACB of $100,000 and an FMV of $250,000. She gives it to Harry. Why capital gains are attributable on transfers to a spouse or common-law partner Any interest, dividends or rents, rental losses, business income as a specified member, business losses as a specified member, capital gains and capital losses are attributed to Sally. However, second-generation income (income on income) is taxable to Harry. Capital gains on property transferred to a spouse or common-law partner are normally attributed because the spousal rollover rule allows the transfer to take place at the ACB (for capital property) or at its UCC (for depreciable property). As a result, the recognition of any capital gains is deferred until the recipient disposes of the property (ITA 73(1)). If a taxpayer transfers or loans capital property to his or her spouse or common-law partner, any taxable capital gains or allowable capital losses arising from the eventual
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Taxation of Property Income disposition of the property by the recipient, or property substituted for it, are deemed to be the taxable capital gains or allowable capital losses of the taxpayer (ITA 74.2(1)(a) and (b)). There are a few exceptions to this income attribution rule, which will be discussed shortly. Don gave his shares in Blueblood Inc. to his wife, Helena. Don’s ACB for the Blueblood shares was $1,400, and the shares were rolled over to Helena at the same ACB. Helena kept the shares for three years and then she sold them for $5,400. Don will have a taxable capital gain of $2,000, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($5,400 - $1,400) × 50%), because the gain will be attributed to him. Refer to IT-511R, Interspousal and Certain Other Transfers and Loans of Property, for further information.
Specific Rules for a Spouse, Common-law Partner and Related Minors
The Income Tax Act includes a number of definitions and other provisions that apply to persons who are spouses, common-law partners, and related minors, but not to other nonarm’s length parties, dealing with: • • • • • • transfers of property substituted property transferred or loaned property loans and transfers to a trust repayments loan guarantees
Exercise: Attribution Rules
Provisions that Apply to all Transactions
For all three sets of income attribution rules, the following provisions apply with respect to: • • • • property income versus business income income from income or second-generation income dividend income liability for payment of tax
More information is provided on each of these.
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Income Tax Planning
Property Income vs. Business Income
The income attribution rules do not apply to active business income or losses, even if a nonarm’s length person earns that business income by using property obtained from the taxpayer. Therefore, it is important to determine whether the designated person is earning business income or property income. Rental income For the purpose of the income attribution rules, property income includes interest, dividends, rents and passive business income earned by a specified member of a partnership. Property losses include rental losses and business losses incurred by a specified member of a partnership. There are two important situations that arise frequently where this distinction may not be so readily apparent. The first is in the case of a rental operation, where the rental income may be considered to be business income, instead of property income, if the rental arrangements include the provision of services. Corrine gave her husband, Jack $400,000 to establish Getaway Lodge, a retreat in cottage country. Getaway Lodge consists of 12 cabins, a recreational centre, a swimming pool and a dining hall, as well as waterfront features. A family of four can rent one of the cottages for $1,600 per week, and this entitles them to the use of all of the lodge facilities, daily housekeeping services, and three buffet meals a day. Jack is earning business income, not property income, so it is not subject to attribution. Income earned by a specified member of a partnership The second case occurs when an individual is a specified member of a partnership. A specified member of a partnership includes: • • • a person who is a limited partner in a limited partnership a general partner who does not take an active role in the business activities, other than financing activities (a silent partner) a general partner in a partnership who does not carry out a business similar to, but separate from, that partnership
Income that a specified member of a partnership earns from that partnership or a loss is considered to be property income or a property loss, not business income or a business loss, and thus it is subject to attribution (ITA 96(1.8)). Bill gave $50,000 to his spouse, Martha, and she in turn acquired an interest in a limited partnership. Last year she earned $10,000 of partnership income. However, this is considered to be property income because she was not actively involved in the business and thus the income will be attributed to Bill.
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Taxation of Property Income
Income from Income
If a taxpayer transfers or loans property to a person and that property earns income, the original property income is attributed to the taxpayer. However, if the individual uses that income to earn additional property income, that additional property income, also referred to as second-generation income, is not subject to attribution and is taxable to the individual. Anthony gave GICs worth $10,000 to his wife, Mary. During the first year, the GICs earned interest income of $350, and while Mary received the income, it was attributed to Anthony. Mary used the $350 to purchase another GIC. During the second year, the original GICs earned another $350 of interest income, which was attributed to Anthony. The new GIC earned interest income of $12.25; this amount was taxed in Mary’s hands.
Dividend Income
If the property income subject to attribution is in the form of dividends from a Canadiancontrolled private corporation (CCPC), the taxpayer must include the grossed-up dividend in his or her income. He or she will also be entitled to claim the dividend tax credit. Jamie gave $10,000 to his spouse, Michelle, who used the money to invest in shares of a taxable Canadian corporation. Michelle received dividend income of $500, which is subject to attribution. So, Jamie must report taxable dividend income of $625, calculated as (cash dividend x dividend gross-up) or ($500 × 125%), and he can claim a federal dividend tax credit of $83.33, calculated as (grossed-up dividend x federal dividend tax credit) or ($625 × 131/3%). Jamie will also be able to claim a provincial dividend tax credit.
Liability for Payment of Tax
If a taxpayer must include some property income in his or her income because of the application of the income attribution rules with respect to property that he or she loaned or transferred to another taxpayer, both taxpayers are jointly and severally liable for any increase in the transferor’s tax liability resulting from the inclusion of that amount in income (ITA 160(1)(d)). Henry gave his wife, Sheila, $10,000 to invest. Sheila earned investment income of $750, and this amount was attributed to Henry. Because Henry has a marginal tax rate of 43%, he will have to pay $322.50 in tax, calculated as (taxable income x marginal tax rate) or ($750 × 43%). However, Henry and Sheila are both liable for this tax, and if Henry cannot pay it, Sheila will become liable for the entire amount.
Exceptions to the Attribution Rules
There are several situations where the attribution rules for spouses, common-law partners, and related minors will not apply, including: • • • • • transfers at fair market value loans for value spouses or common-law partners who are living apart changes in circumstances situations where an anti-avoidance rule applies
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Income Tax Planning
Transfers at Fair Market Value
If a taxpayer transfers property to a designated person, the resulting property income or loss, or capital gain or capital loss will generally not be attributed to the taxpayer if the designated person paid fair market value for the property (ITA 74.5). Janice owned a $5,000, 8% corporate bond for several years. She sold the bond to her 16-year-old son, Mark, for its FMV of $5,600. Because Mark paid FMV for the bond, the annual interest income will not be attributed to Janice, but will be taxed in Mark’s hands. However, in the case of a sale to a spouse or common-law partner at FMV, the taxpayer must also elect not to have the automatic spousal rollover rules apply if he or she wants to avoid income attribution (ITA 73(1)). The taxpayer’s spouse or common-law partner does not have to elect out of the rollover; only the taxpayer is required to make the election. George owns a Government of Canada bond that generates interest income of $9,000 each year. He sold the bond to his common-law partner, Sylvia, for $100,000, which was the fair market value of the bond at the time. His ACB was $90,000. Sylvia paid George $100,000 in cash. George elected not to have the spousal rollover apply and had to recognize a capital gain of $10,000, calculated as (proceeds - ACB) or ($100,000 $90,000). Sylvia will now be entitled to receive the annual interest payments of $9,000 per year. Because she purchased the bond for its FMV and George elected out of the rollover, the income will not be attributed to George.
Loans for Value
If a taxpayer loans property to a designated person, the resulting property income or loss will not be attributed to the taxpayer if the loan was made for value (ITA 74.5(2)). A loan is a loan for value if: • interest is charged at a rate equal to or greater than the lesser of: • the prescribed rate as set by ITR 4301 • a rate that would have otherwise been considered reasonable for parties dealing at arm’s length the designated person actually pays the interest to the taxpayer no later than 30 days after the end of the taxation year the designated person has consistently paid the interest owing no later than 30 days after the end of previous taxation years
• •
We will refer to a tainted loan as any loan that is not a loan for value. Marge loaned Homer $10,000 for investment purposes, on the condition that he pay her interest of 6% each year and that the loan be repaid in full in five years. The rate on a 5-year bank loan is 8%, and the rate prescribed by ITR 4301 is 5%. Provided that Homer actually pays the required interest on time, the loan would be considered a loan for value because the interest rate that Homer has to pay (6%) is greater than 5%, calculated as (the lesser of (the prescribed rate and the reasonable rate between arm’s length parties) or (the lesser of (5% and 8%)). Any property income that Homer earns from the $10,000 will be taxed in his hands. Homer can deduct the interest that he pays to Marge. Marge must report the interest income on her tax return.
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Taxation of Property Income If a designated person acquires property via a valid loan for value and subsequently repays the loan, the income attribution rules will not apply to income earned on the property after the loan is repaid. However, if a loan that originally satisfied the requirements is forgiven, the exemption ceases to apply. If Homer continues to pay the required interest on time and he eventually repays the loan in full, any future income that he earns as a result of investments that he made with the $10,000 will continue to be taxable to him. However, if Homer pays the required interest on time for the duration of the loan, and at the end of the loan, Marge tells him that he does not have to repay the principal, the exemption to the attribution rules will then cease to apply and any future property income will be attributed to Marge. Note: A similar rule applies to loans for value made to other non-arm’s length individuals (ITA 56(4.2)).
Spouses or Common-law Partners Living Apart
Property income If a taxpayer transfers or loans property to his or her spouse or common-law partner, there will be no attribution of property income or loss during the period when they are living separate and apart by reason of a breakdown of their relationship (74.5(3)(a)). Lindsey and Randy recently separated, and in accordance with their separation agreement, Randy provided Lindsey with a lump sum of $50,000. Lindsey placed the money in a money market fund until she needed it, and she earned interest income of $1,200 during the taxation year. Normally this amount would have been attributed to Randy, but because they were living separate and apart as a result of a breakdown in their relationship, the amount will be taxable to Lindsey. Capital gains However, during the period of separation, the capital gains attribution rules still apply, unless the taxpayer and his spouse or common-law partner jointly file an election not to have the capital gains attribution rules apply (ITA 74.5(3)(b)). Once the separation or divorce is finalized, attribution of capital gains or losses will cease only if the election has been made. However, in practice, a decree of divorce would likely not be granted unless this election has been made, to avoid attribution of capital gains years after a couple has divorced. Common law couples however would need to make certain that they opt out of these attribution rules, or else face possible attribution long after their relationship has come to an end. Carol and Mike were married for 18 years before they separated earlier this year. As part of their separation agreement, Mike transferred stocks with an ACB of $22,000 and a FMV of $60,000 to Carol. They did not file any elections, so Mike was able to rollover the stocks to Carol at his ACB. If Carol sells the stock for $65,000 before the divorce is finalized, a capital gain of $43,000 will be attributed to Mike, calculated as (proceeds - ACB) or ($65,000 - $22,000). However, if Carol does not sell the stocks until after the divorce is finalized, and as part of those
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Income Tax Planning divorce proceedings, they jointly opt out of the capital gains attribution provisions, any resulting capital gain will be attributed to Carol. Other changes in circumstances All attribution rules will also cease to apply upon several other changes in circumstances, including: • • • when the taxpayer ceases to be a resident of Canada either the taxpayer or the designated person dies in the case of the related minor, if the designated person turns 18 years of age before the end of the year (ITA 74.1(2)
Anti-avoidance Rule
The attribution rules do not apply where one of the main reasons for a transfer or loan of property is to reduce the amount of income tax that would be payable on the income (ITA 74.5(11)). Paul is in a low marginal tax bracket. He borrowed $10,000 from the bank and used the proceeds to purchase a Government of Canada bond. He then sold the bond to his wife, Charlene, at slightly less than fair market value and he used the proceeds to pay off his loan. Charlene is in a high marginal tax bracket, and the bond earned interest income of $800. Even though Charlene is the one earning the income, they would prefer to have the investment income attributed to Paul because he has a lower marginal tax rate. However, under the anti-avoidance rule, the income will not be attributed to Paul and it will be taxed in Charlene’s hands at her marginal tax rate.
Exercise: Income Attribution Provisions and Exceptions
Dividends Earned by Minor Shareholders
New rules to discourage income splitting with minor children were enacted in 2000. While it is not an income attribution rule, per se, it has a significant impact on the taxation of some property income earned by minors. The new provisions take the form of an income splitting tax, which imposes the top federal tax rate of 29%, instead of the normal graduated rates, on certain income earned by specified individuals, beginning in 2000 (ITA 120.4(2)). A specified individual is someone who: • • • will not attain the age of 18 during the taxation year is resident in Canada throughout the year has a parent who is resident in Canada at any time in the year (ITA 120.4(1))
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Taxation of Property Income
The types of income that will fall prey to this tax are referred to as split income, and include taxable dividends and other shareholder benefits on unlisted shares of Canadian and foreign companies, including those received directly or through a trust or partnership (ITA 120.4(1)).
Income Splitting Tax
Income that is subject to this tax is not eligible for any deductions or credits other than the dividend tax credit and foreign tax credit (ITA 120.4(3)). This means that the split income tax cannot be offset by the personal tax credit. An offsetting deduction in computing taxable income is permitted to ensure that income that is subject to this tax is not also subject to ordinary income tax (ITA 20(1)(ww)). In addition, income that is taxed under this measure is not subject to the attribution rules (ITA 74.5(13)). Ned Wright owns and operates a successful private Canadian manufacturing corporation. Four years ago, he rolled his shares in the business to a holding company, in equal shares to the common shareholders, which include Ned, his wife Mary, and a trust for his minor child, Nathan. This year, the holding company paid out a dividend of $60,000, so Mary and the trust for Nathan each had dividend income of $20,000, calculated as (total dividend ÷ number of shareholders) or ($60,000 ÷ 3). Neither Mary, nor the trust for Nathan, has any other source of income. Assume this year, the lowest tax bracket (and therefore, the conversion rate) is 15%, and the basic personal amount is $9,600. Since the dividend was received from a CCPC, as a result of the dividend payment, Mary had taxable income of $25,000, calculated as (cash dividend x dividend gross-up) or ($20,000 × 125%). Since Mary has no other source of income she remains in the lowest tax bracket. This will result in federal tax, before any applicable tax credits, of $3,750, calculated as (taxable income x lowest marginal tax rate) or ($25,000 × 15%). Mary can then use the federal dividend tax credit, ($25,000 x 13 1/3%) and the basic personal amount tax credit, ($9,600 x 15%) to reduce her federal tax. In her case, this would reduce her basic federal tax to nil, calculated as [the greater of (nil and (federal tax (dividend tax credit + basic personal tax credit)))] or [the greater of (nil and ($3,750 (($25,000 x 13 1/3%) + ($9,600 x 15%))))]. Let's look at the results for Nathan. Nathan's taxes are not as straightforward because he has split income. Nathan will also have taxable dividend income of $25,000, calculated as (cash dividend x dividend gross-up) or ($20,000 × 125%). However, since he is a minor with split income, there is an offsetting deduction of $25,000 to ensure that the split income is not taxed in the normal fashion. Nathan's split income of $25,000 will result in federal tax of $7,250, calculated as (taxable income x highest marginal tax rate) or ($25,000 × 29%). Nathan may claim the federal dividend tax credit. However, unlike Mary, he may not reduce this tax on split income by using personal tax credits. So, Nathan has to pay federal tax of $3,916.67, calculated as (federal tax - dividend tax credit) or ($7,250 - ($25,000 x 13 1/3%)). Nathan's mother did not have to pay any tax on her dividend. The provinces also impose special tax rates on split income. Most provinces tax split income at the highest provincial tax rate, but at least one province imposes an even higher tax rate.
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Income Tax Planning Dividends received on any listed shares will not be subject to these rules because the income flow is less susceptible to manipulation. Further, income from property acquired on the death of a parent of the individual will be exempt from the measure (ITA 120.4(1), excluded amount). While it is the child who is technically liable for this new income splitting tax, the legislation provides for the parents to be held jointly and severally liable (ITA 160(1.2)). While it is the child who is technically liable for this new income splitting tax, the legislation provides for the parents to be held jointly and severally liable (ITA 160(1.2)).
Exercise: Income Attribution
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Income Attribution Rules. In this lesson, you have learned how to do the following: • identify and calculate how property income and capital gains can be attributed to the taxpayer when he or she transfers property to a spouse or common-law partner, related minors, or certain other non-arm’s length individuals
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Income Attribution Rules, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Property Income
Review
Let’s look at the concepts covered in this unit: • • • • • • Interest, Dividends, and Income Earned Rental Income Capital Cost Allowance Disposing of Depreciable Property Other Deductions from Business and Property Income Income Attribution Rules
You now have a good understanding of the taxation of property income. At this point in the course you can identify, calculate, and describe any likely tax impact given a client with capital cost allowance, rental income, interest, dividends, and income earned. You can also calculate and describe any likely tax impact given a client who disposes of depreciable property as well as identify eligible capital expenditures that can serve as deductions. Finally, you can identify and calculate how property income and capital gains can be attributed to the taxpayer when he or she transfers property. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 6: Taxation of Property Income, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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Unit 7: Taxation of Capital Property
Income Tax Planning
Unit 7: Taxation of Capital Property
Welcome to Taxation of Capital Property. In this unit, you will learn about the role of property in tax planning and wealth accumulation, how to calculate capital gains and losses, as well as how to calculate the impact of disposition. You will also learn how to integrate the use of applicable exemptions as well as other factors when calculating capital gains or losses. This unit takes approximately 3 hours and 45 minutes to complete. You will learn about the following topics: • • • • • • The Role of Property in Wealth Accumulation Calculating Capital Gains and Losses Dispositions Losses Special Situations Capital Gains Exemptions
To start with the first lesson, click The Role of Property in Wealth Accumulation on the table of contents.
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Taxation of Capital Property
Lesson 1: The Role of Property in Wealth Accumulation
Welcome to The Role of Property in Wealth Accumulation. In this lesson, you will learn about the role of property in tax planning and wealth accumulation as well as the appreciation and depreciation of capital property. You will also learn how to calculate the taxation of capital appreciation. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • • • explain the role of property in tax planning and wealth accumulation calculate the appreciation and depreciation of capital property calculate the taxation of capital appreciation
The Role of Property in Wealth Accumulation
All property has three distinct roles in wealth accumulation. First, property stores the wealth that the investor has earned. Sometimes the storage vehicle is something tangible, such as a piece of real estate or a piece of collectible artwork. In other cases, the storage vehicle takes the form of a financial instrument, such as a bond or a share in a corporation. In any case, the property stores wealth until such time as the investor decides to liquidate the property and use the proceeds for some other purpose, such as living expenses. Secondly, property can be a source of income by producing interest, dividends, or rents. To the extent that the investor does not use this income to meet expenses, it increases his or her wealth. Finally, the property itself may be a source of wealth, in that it may appreciate in value over time due to a number of factors, which we will discuss shortly.
Appreciation and Depreciation of Capital Property
In this lesson, we will be concentrating on the role of property as a source of wealth through capital appreciation. Appreciation is simply the unrealized increase in the value of an asset over time. A person who holds capital property does not realize the accumulated appreciation until he or she disposes of an asset. In contrast, depreciation is the decrease in the value of an asset over time, and accumulated depreciation is also only realized when the investor disposes of the asset. Appreciation can be influenced by a number of factors, including: • • • • • supply and demand the accumulation of business income natural growth the changing present value of future cash flows inflation
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Income Tax Planning
Supply and Demand
The current value of any property is strongly influenced by the market demand for that particular type of asset. This demand can be influenced by demographics, consumer tastes, or even psychological expectations about future values. If an investor expects that a stock is going to skyrocket in value, he or she will be willing to pay more for it now. If enough investors have the same expectations, that will have the effect of driving up the stock price.
Accumulation of Business Income
If a corporation has retained earnings as a result of after-tax profits that have not been paid out as dividends, its shareholders’ equity has increased and shares in a corporation will usually increase in value. Bluebell Corp. has 1 million outstanding shares. During the last fiscal year, it had after-tax profits of $15 million and it paid out a dividend of $3 million or $3 per share. It therefore had retained earnings of $12 million, which it plans to use to pay off some corporate debts and to finance new equipment acquisitions, thereby increasing the net assets of the corporation by $12 million. The share price should increase by about $12 per share to reflect the increase in shareholders’ equity.
Natural Growth and Cash Flows
Some types of property in the resource and agricultural sectors increase in value because of natural growth. For example, property with associated timber rights or farmland with a cash crop of Christmas trees will increase in value as the crop matures. Cash flows The present value of a series of fixed cash flows (for example, a bond with a regular coupon) will vary over time as interest rates change. Jenny bought a $10,000 10-year 9.5% semi-annual bond when it was first issued at par seven years ago. The bond will mature in another three years and interest rates on other three-year bonds of comparable risk are 6%. Jenny’s bond has increased in value to $10,948, calculated by entering DISP = 0, P/YR = 2, ×P/YR = 3, I/YR = 6%, PMT = $475, calculated as ((face amount x coupon) ÷ 2) or (($10,000 × 9.5%) ÷ 2), FV = $10,000, MODE = END and solving for PV.
Inflation
Part of the increase in an asset’s price over time may be due to inflation, which in turn is a more general manifestation of the increase in market demand relative to supply. While we typically measure inflation in terms of the Consumer Price Index, the general CPI reflects the increase in the price of a standard basket of consumer goods over time, and this may or may not be reflected in the value of a particular asset over time. In August 2006, the 12-month CPI was 2.1%. This means that In August 2006, the prices paid by consumers were 2.1% higher than in August 2005, due mainly to the rise in gasoline prices over that period. However, during that time homeowners' replacement costs rose by 8.1%, whereas prices for computer equipment and supplies fell by 18%. Inflation also varies across the country due to regional differences.
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Taxation of Capital Property
Click here to view the most current CPI on the Statistics Canada Web site.
Taxation of Capital Appreciation
Prior to 1971, capital appreciation was not taxable in Canada, and many countries still do not tax it. For those countries that do tax capital appreciation, they generally make some allowance for inflation by either indexing the cost base for the asset or using an income inclusion rate of less than 100%. Canada uses the latter approach by including only 50% of capital gains in income. However, this reduced inclusion rate fails to adequately account for inflation in those cases where an investor may have held the asset for ten, 20 or even more years. If capital appreciation is taxed, many countries try to ease the burden that this taxation imposes on the economy by providing for certain exemptions and rollovers, which add enormously to the complexity of the tax system.
Accrual vs. Appreciation
Unlike property income, which generally must be accrued annually for tax purposes even if the taxpayer has not yet received it, accumulated appreciation is not taxed until the taxpayer disposes, or is deemed to have disposed, of the asset. Fenita purchased a piece of land in 1975 at a cost of $40,000 and it is now worth over $1 million. However, there are no tax consequences to Fenita at this time and she will not have a taxable capital gain until she disposes of the property. Holding capital property provides a taxpayer with one of the few tax deferral opportunities still available. However, the fact that appreciation is not taxed until the investor disposes of an asset affects the markets because an individual may hold on to an investment longer than he or she otherwise might have so as to avoid taxation. Harold holds shares in a mutual fund currently worth $400,000 and his adjusted cost base is $150,000. He does not like the expected performance of the fund and would like to sell his shares and move on to something else. However, Harold has a 50% marginal tax rate and if he does sell his shares, he would have to pay tax of $62,500, calculated as (((proceeds - ACB) x capital gains inclusion rate) x marginal tax rate) or ((($400,000 $150,000) × 50%) × 50%). This would leave him with only $337,500 to reinvest, calculated as (proceeds - taxes paid) or ($400,000 - $62,500).
Deflation
While some income tax systems are quite ready to tax capital appreciation, they do not like to provide tax relief for deflation. While a portion of capital gains may have to be included in taxable income, if an asset goes down in value, the resulting loss is usually not deductible from most other types of income. Capital gains on personal-use property, such as a cottage are taxable, but capital losses on such property are not deductible. Jordon purchased shares of a corporation in 1988 for $120,000 and he recently sold them for $105,000, for a loss of $15,000, calculated as (proceeds - cost) or ($105,000 $120,000). Jordon does not have any other capital gains and he cannot deduct the capital loss from his other sources of income.
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Income Tax Planning
Sam purchased a cottage in 1986 for $120,000 and he recently sold it for $105,000 for a capital loss of $15,000, calculated as (proceeds - cost) or ($105,000 - $120,000). Sam cannot deduct the loss because the cottage was personal-use property.
Exercise: Appreciation of Capital Property
Gains and Losses
If a taxpayer disposes of any property during the taxation year, he or she will realize a gain to the extent that the proceeds of the disposition exceed the adjusted cost base of the property and any outlays or expenses that he or she incurred for the purpose of making the disposition (ITA 40(1)(a)). Similarly, a taxpayer will realize a loss to the extent that the sum of the adjusted cost base of the property and any outlays or expenses that he or she incurred for the purpose of making the disposition exceed the proceeds of the disposition (ITA 40(1)(b)). We will look at how the adjusted cost base and proceeds of disposition are determined shortly. So far, the concepts are simple enough. If you sell something for more than you paid for it, you have a gain; if you sell it for less than you paid for it, you have a loss. Nancy sold an antique dresser for $2,400; she purchased it for $2,000. Nancy has a gain of $400, calculated as (proceeds - cost) or ($2,400 - $2,000). Frank sold some shares for $500; he paid $800 for those same shares. Frank has a loss of $300, calculated as (proceeds - cost) or ($800 - $500). Losses on personal-use property One exception to this rule is a loss upon the disposition of personal-use property. Personaluse property is any property that is owned by the taxpayer and used primarily for his or her enjoyment or for the use or enjoyment of one or more individuals related to the taxpayer. If one sells personal-use property for less than its original cost, the Income Tax Act deems the loss to be nil. Personal-use property is discussed in more detail later in the course. But when does a gain become a capital gain, and what does this mean in terms of tax treatment?
Capital Property
The Income Tax Act defines property to be property of any kind, whether real or personal, tangible or intangible (ITA 248(1)). Property therefore includes stocks, bonds, partnership interests, real estate, money, art objects, and many more things.
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Taxation of Capital Property Capital property is defined as any depreciable property of the taxpayer, plus any property (other than depreciable property) that could result in a capital gain or capital loss when the taxpayer disposes of it (ITA 54). A gain resulting from the disposition of most types of property will be considered a capital gain as long as that gain is not included in the taxpayer's income under any other provision of the Income Tax Act (ITA 39(1)(a)). This definition of capital gain specifically excludes gains on the disposition of certain types of property, including: • • • • eligible capital property gains on inventory (i.e., profits on goods held for resale) the unpaid interest on bonds that are sold between coupon dates insurance policies (except for gains on related segregated funds)
Similarly, a loss resulting from the disposition of most types of property will be considered a capital loss, unless it is deductible from the taxpayer’s income under anyther provision of the Income Tax Act (ITA 39(1)(b)). In this case, the definition of a capital loss excludes losses on those properties listed above, plus losses on any depreciable capital property. These definitions appear to be circular, in that: • • If the taxpayer incurs a capital gain or loss upon the disposition of that property, it is considered to be capital property. The taxpayer only incurs a capital gain or capital loss on the disposition of property if those gains and losses are not specifically included in, or deducted from, income in accordance with some other provision of the Income Tax Act.
Generally speaking, most types of property can be considered capital property in most circumstances. The trick here is to understand when gains or losses are included or deducted from income under other parts of the Income Tax Act because then they are not treated as capital gains or losses.
Depreciable Property
Depreciable property is any tangible or intangible property that generally fits into one of the prescribed classes for which CCA can be claimed. When a taxpayer disposes of a depreciable property, he or she can realize both a recapture and a capital gain, or he or she could realize a terminal loss. However, under no circumstances can the taxpayer realize a capital loss because depreciable property is specifically excluded from the definition of a capital loss (ITA 39(1)(b)). So, from the point of view of potential capital gains, depreciable property is capital property, but from the point of view of capital losses, it is not. Capital property, other than depreciable property, is sometimes referred to as nondepreciable capital property or simply non-depreciable property.
Eligible Capital Property
Eligible capital property includes goodwill and other nothings, the cost of which does not qualify for capital cost allowance and is not deductible in the year of its acquisition as a current expense. The definitions of capital gains and capital losses specifically exclude gains and losses realized upon disposition of eligible capital property.
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Income Tax Planning So, despite its name, eligible capital property is not truly considered to be capital property. The reason it is excluded is that it is already subject to something similar to capital gains treatment. This is discussed further in the unit titled Taxation of Property Income.
Inventory, Part 1
If the cost or value of property is relevant in computing a taxpayer’s income from a business for a taxation year, that property is said to be inventory and not capital property (ITA 248(1)). The disposition of inventory will give rise to business income, not capital gains. In some cases, it seems obvious that the property is inventory and not capital property. A common example of inventory is goods that a store purchases for resale. In this case, the taxpayer will almost certainly realize a gain on the sale of the property, but this gain is business income, not a capital gain. However, in other cases, it is not so clear whether the disposition should result in income or a capital gain, or whether the property is inventory or capital property. Nancy recently realized a gain when she sold a piece of antique furniture. If this is her only antique and she sold it because it no longer fit in with her household décor, it would probably be considered to be capital property, and her gain would be a capital gain. However, if Nancy is in the business of buying and selling antiques, the dresser would be considered to be inventory, and the resulting gain would be business income. The distinction is important, because only 50% of capital gains are included in taxable income, while 100% of business gains are included in taxable income. Taxpayers often go to great lengths to have their transactions treated as capital transactions, instead of sales of inventory because of the more favourable tax treatment.
Inventory, Part 2
Another example of how inventory plays a role in defining capital property is described below. Mark likes to buy houses, renovate them and sell them for a profit. Last year, he did this with three houses. He bought the first house for $120,000 and sold it for net proceeds of $140,000. He bought the second house for $135,000 and sold it for $150,000. He bought the third house for $110,000 and sold it for net proceeds of $118,000. Mark’s total gain for the year was $43,000, calculated as (the sum of ((proceeds - cost) for each property)) or (($140,000 - $120,000) + ($150,000 - $135,000) + ($118,000 - $110,000)). Mark has a 50% marginal tax rate. Mark would prefer to have his transactions treated as dispositions of capital property, because then his taxable income would be $21,500, calculated as (total gain x capital gains inclusion rate) or ($43,000 × 50%) and he would still have $32,250 left after tax, calculated as (total gain - (taxable capital gain x marginal tax rate)) or ($43,000 - ($21,500 × 50%)). However, Mark may be deemed to be in the business of buying and selling houses and the resulting income may be treated as business income. As such, the full amount would be subject to tax and he would only have $21,500 left after tax, calculated as (total income x (1 - marginal tax rate)) or ($43,000 × (1 - 50%)). Mark would pay $10,750 more in taxes if the income is considered business income instead of capital gains, calculated as (tax payable if income is treated as business income - tax payable if income is treated as a capital gain) or ($32,250 - $21,500).
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Taxation of Capital Property
In many cases, the taxpayer ends up taking the matter to the Tax Courts to determine whether their income is eligible for capital gains treatment. Over the years, the Courts have held that the disposal of a true investment (one that yields a return such as interest or rent, or that offers a reasonable expectation of a return in the foreseeable future) is a capital transaction. On the other hand, activities of a speculative nature have often been regarded as adventures in the nature of trade, which give rise to business income. The argument over whether the disposition should result in income or capital gains is most often brought up with respect to real estate transactions. Some of the main factors that the Courts have considered when deciding whether a profit is a capital gain or business income include: • • • intention of the taxpayer the number and frequency of transactions the relationship to the taxpayer’s business (for example, real estate transactions by a realtor might be business income, instead of capital gains)
Refer to IT-218R, Profit, capital gains and losses from the sale of real estate, for additional information.
Exercise: Capital Property
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed The Role of Property in Wealth Accumulation. In this lesson, you have learned how to do the following: • • • explain the role of property in tax planning and wealth accumulation calculate the appreciation and depreciation of capital property calculate the taxation of capital appreciation
If you are ready to move to the next lesson, click Calculating Capital Gains and Losses on the table of contents.
Assessment
Now that you have completed The Role of Property in Wealth Accumulation, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Capital Property
Lesson 2: Calculating Capital Gains and Losses
Welcome to Calculating Capital Gains and Losses. In this lesson, you will learn how to calculate and report capital gains and losses. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • calculate capital gains and losses, including the adjusted cost base, outlays and expenses, taxable capital gains, allowable capital losses, and capital gains reserves
Calculating Capital Gains and Losses
If a taxpayer disposes of capital property during the taxation year, he or she will realize a capital gain to the extent that the proceeds of the disposition exceed the adjusted cost base of the capital property and any outlays or expenses the taxpayer incurred for the purpose of making the disposition (ITA 40(1)(a) and (39(1)(a)). Similarly, if a taxpayer disposes of capital property, he or she will realize a capital loss to the extent that the sum of the adjusted cost base of the capital property and any outlays or expenses the taxpayer incurred for the purpose of making the disposition exceed the proceeds of the disposition (ITA 40(1)(b) and 39(1)(b)). Before we proceed, we need to be able to determine what are the proceeds of disposition, and what is the adjusted cost base.
Proceeds of Disposition
The proceeds of disposition of property includes the sale price of the property that has been sold, as well as compensation for property that has been expropriated, stolen, or lost (ITA 54). In the case of insurance coverage on property that has been damaged, the insurance proceeds will be considered to be proceeds of disposition unless the proceeds are used to repair the damage within a reasonable amount of time. Sally sold her house for $180,000. The proceeds of her disposition are $180,000. Jason’s boat was destroyed in a fire. His insurance company covered his loss to a maximum of $8,000, even though the fair market value of the boat was $10,000. The proceeds of his disposition are $8,000. Deemed proceeds of disposition Deemed proceeds of disposition are the amount that the taxpayer is deemed to have received as a result of the many rules contained in the Income Tax Act. The deemed proceeds are generally equal to the fair market value (FMV) of the property at the time of the disposition or deemed disposition. Fair market value is the price at which the property could have reasonably been expected to be sold if it was sold in an open market. Harry gave 500 shares of TooGood Corp. to a friend as a wedding present. At the time of the gift, the shares were worth $375. Even though Harry did not actually receive anything, he is deemed to have received proceeds of $375.
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Income Tax Planning
Adjusted Cost Base
The adjusted cost base, or ACB, is the taxpayer’s cost for the property for tax purposes. In most cases, the ACB is the actual cost of the property, but in a few cases, the ACB may be modified by factors like adjustments for V-day values. The ACB includes all of the costs associated with the acquisition, including the purchase price, commissions or brokerage fees and non-deductible legal fees. Morgan purchased a piece of real estate at a price of $160,000. To close the transaction, she paid non-deductible legal fees of $2,000. Her ACB is $162,000, calculated as (purchase price + legal fees) or ($160,000 + $2,000).
Deemed ACB
Some of the situations where the ACB is deemed to be different from the acquisition cost include the following: • • If a taxpayer acquires property from a non-arm’s length person for more than its fair market value, the taxpayer’s ACB will be deemed to be FMV (ITA 69(1)(a)). If a taxpayer receives a dividend in any form other than cash or shares, the ACB will be deemed to be the FMV of the property at the time it is received (ITA 52(2) and (3)). If an individual immigrates to Canada after 1971, the ACB of each capital property (with some exceptions) is deemed to be the FMV at the time of immigration (ITA 128.1(1)(b)). If an individual has previously elected to use the lifetime capital gains exemption, the ACB will be the deemed cost of reacquisition at the time of the notional disposition (ITA 110.6(19)). For property held on December 31, 1971, the ACB will be determined using the tax-free zone method, unless the taxpayer elects to use the V-Day value (ITAR 26(3) and 26(7)).
•
•
•
We will discuss these situations in more detail.
Other Adjustments to ACB
In other situations, the acquisition cost must be adjusted by certain additions or deductions to arrive at the ACB (ITA 54). Deductions from the acquisition cost Examples of some of the more common items that must be deducted from the acquisition cost to arrive at the ACB include (ITA 53(2)): • In the case of shares in a corporation, tax-deferred dividends, generally received before 1979 (other than capital dividends), that the taxpayer received from that corporation must be deducted from the ACB of those shares. In the case of a partnership interest, the taxpayer’s share of partnership losses and drawings must be deducted from the ACB of his or her partnership interest.
•
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Taxation of Capital Property • If the taxpayer receives government grants or subsidies related to the acquisition of a particular property, the amount of those grants or subsidies must be deducted from the ACB for the property.
Additions to the acquisition cost Examples of some of the more common items that must be added to the acquisition cost to arrive at the ACB include (ITA 53(1)): • • Certain contributions of capital made to a corporation in which the taxpayer holds shares should be added to the cost of those shares. In the case of a partnership interest, the taxpayer’s share of partnership profits or additional contributions of capital must be added to the ACB of his or her partnership interest. Interest and property taxes may be added to the ACB of land if they cannot be used as a deduction in computing income. The cost of surveying or valuing property during acquisition or disposition may be added to its ACB. In some cases, distributions from a mutual fund may create income without a distribution of cash proceeds, in which case the designated amount should be added to the ACB of the shares or units.
• • •
We will be discussing some of these additions and deductions throughout the course. For additional information, refer to IT-456R, Capital property, some adjustments to cost base. In the case of depreciable property, the ACB is the capital cost of property (ITA 54). The capital cost of property generally means the full cost to the taxpayer of acquiring the property, including legal, accounting, engineering or other fees incurred to acquire the property.
Lifetime Capital Gains Exemption
Prior to February 22, 1994, each taxpayer had a lifetime capital gains exemption (LCGE) that would shelter $100,000 of capital gains from taxation (or $75,000 of taxable capital gains, because the capital gains inclusion rate was 75% at that time). A taxpayer who disposed of capital property prior to this time would record the taxable capital gain, but then, he or she would be eligible to claim an offsetting deduction, up to the lifetime maximum deduction of $75,000 (which would exempt $100,000 of capital gains). The Federal Budget of February 22, 1994 called for the demise of the LCGE, but allowed taxpayers one last chance to make use of the exemption by electing a notional disposition and immediate reacquisition of capital property on February 22, 1994 at any amount between the ACB and FMV (ITA 110.6(19)), as long as the resulting gain could be covered by the exemption. Note: Taxpayers were also permitted to make the election with respect to depreciable property and eligible capital property. Sarah owned a cottage on February 22, 1994. She originally bought the cottage for $58,000 and it was worth $123,000 on February 22, 1994. Sarah had previously used some of her LCGE to offset the gain on various stock transactions, but she had a LCGE of $44,000 remaining.
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Income Tax Planning
Sarah elected to recognize a notional disposition of the cottage at $102,000, calculated as (the lesser of (FMV February 22, 1994 and (ACB + remaining LCGE))) or (the lesser of ($123,000 and ($58,000 + $44,000))). As a result of the election, she had to record a capital gain of $44,000 and a taxable capital gain of $33,000, calculated as (capital gain x capital gains inclusion rate in 1994) or ($44,000 × 75%), but she was also able to claim a capital gains deduction of $33,000. As a result of the election, Sarah is deemed to have reacquired the cottage on February 24, 1994 for $102,000. The effect of this election was to increase the taxpayer’s ACB, such that any future disposition would result in a smaller capital gain. Sarah later sold her cottage for $136,000. As a result of her earlier election, her ACB for the cottage is $102,000. She realized a capital gain of $34,000 when she sold the cottage, calculated as (proceeds - ACB) or ($136,000 - $102,000). While the LCGE election could be filed in some circumstances as late as 1998, everyone who was permitted to make use of this election must have done so by now, and their ACBs would have been adjusted accordingly. Why the $100,000 LCGE is still relevant While a taxpayer can no longer make use of the LCGE, you must be aware that it existed and whether or not your clients have ever made use of it. It may affect the ACB on some of their capital property that dates back to when the exemption was still in force and it may have implications when the taxpayer eventually disposes of that property. The $100,000 LCGE and the extent to which it was used may also affect how much in capital gains a taxpayer can shelter under the current rules which allow for a lifetime capital gains exemption in the amount of $750,000 ($375,000 of taxable capital gains) on the disposition of certain small business corporation shares and farm and fishing property. The lifetime capital gains exemption in its present form is addressed later in this unit.
Outlays and Expenses
Outlays and expenses related to the acquisition of capital property are added to its ACB. In a similar manner, outlays and expenses incurred during the disposition of that property are aggregated with the ACB before the capital gain or loss is determined. However, the costs of disposition are not part of the ACB. Remember that a gain is calculated as the excess of the proceeds of the disposition over the sum of the ACB and the expenses associated with that disposition. Similarly, a loss is the excess of the sum of the ACB and the expenses associated with a disposition over the proceeds of that disposition. Morgan bought 100 common shares at a price of $13 each, plus a commission of 2%. Her ACB for the shares is $1,326, calculated as ((number of shares x price) x (1 + commission)) or ((100 × $13) × (1 + 2%)). Morgan later sold those shares for $840, and she incurred another transaction charge of 2%, or $16.80, calculated as (proceeds x commission) or ($840 × 2%). The proceeds of her disposition are $840. Morgan’s capital loss is $502.80, calculated as (proceeds of disposition – (ACB + commission)) or ($840 – ($1,326 + $16.80)).
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Taxation of Capital Property
Exercise: Capital Gains and Losses, Part 1
Taxable Capital Gains
Since 1971, Canadian individuals and corporations have been taxed on gains realized upon the disposition of capital property. While the tax is commonly referred to as capital gains tax, it is important to note that there is not a specific, special tax on capital gains. Rather, the taxable portion of capital gains is treated as income, and taxed according to the taxpayer’s marginal tax rate. A taxpayer incurs a capital gain in the taxation year in which he or she disposes (or is deemed to have disposed) of capital property. A portion of the capital gain then becomes a taxable capital gain. That portion is determined by the inclusion rate, which is currently set at 50% for almost all dispositions of capital property (ITA 38(a)). When Sarah sold her cottage, she realized a capital gain of $34,000. This will result in a taxable capital gain of $17,000, calculated as (capital gain x capital gains inclusion rate) or ($34,000 × 50%).
Historical and Current Capital Gains Inclusion Rates
When the concept of taxing capital gains was first introduced in 1971, the inclusion rate was 50%. It was increased to two-thirds for 1988 and 1989 and to three-quarters or 75% beginning in 1990. It dropped back to two-thirds as a result of the Federal Budget of February 28, 2000. There was a further drop in the inclusion rate to 50% for dispositions after October 17, 2000. The following table includes the historical capital gains inclusion rates.
Unless otherwise stated, for the purpose of this course, we assume all dispositions take place after October 17, 2000, such that a 50% capital gains inclusion rate applies. However, the old inclusion rates are still relevant because they are factored into the calculation of the capital gains deduction on shares of qualified small business corporations or qualified farm and fishing properties, as well as the application of net capital loss carryovers, as we will discuss later.
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Income Tax Planning
Allowable Capital Loss
The same inclusion rate applies to capital losses, such that 50% of capital losses become allowable capital losses. They are not referred to as taxable capital losses. Morgan had a capital loss of $502.80 when she sold her 100 common shares. Morgan has realized an allowable capital loss of $251.40, calculated as (capital loss x capital gains inclusion rate) or ($502.80 × 50%). A taxpayer that incurs an allowable capital loss can use that loss to offset taxable capital gains that he or she may have realized. However, other than under certain circumstances in the year of death and / or the year prior to death, allowable capital losses cannot be used to reduce any other source of income such as interest, dividends, rental income or employment income. An allowable capital loss must first be used to offset taxable capital gains realized in the same tax year. However, the taxpayer does have flexibility as to when he or she can claim the portion of allowable capital losses that exceeds the taxable capital gains in a year (i.e. net capital loss) or the allowable capital losses that have been carried forward from previous years. In such cases, allowable capital losses can be carried back three tax years and used to reduce taxable capital gains (up to the total of the allowable capital losses) claimed in any or all of those years. If more beneficial, the taxpayer can instead elect to carry forward the allowable capital losses indefinitely and use them to offset taxable capital gains in a future year. Earlier this year, Arvinder disposed of a rental property and realized a capital gain of $80,000 and a taxable capital gain of $40,000 calculated as (capital gain x capital gains inclusion rate) or ($80,000 x 50%). He also sold three underperforming technology stocks from his investment portfolio and triggered a cumulative capital loss of $110,000 and an allowable capital loss of $55,000 calculated as (capital loss x capital gains inclusion rate) or ($110,000 x 50%). If Arvinder does not undertake any further transactions for the remainder of this year, he will have a net capital loss of $15,000 calculated as (taxable capital gains – allowable capital losses) or ($40,000 – $55,000). Since Arvinder does not have any further taxable capital gains in the current year, he can carry the $15,000 net capital loss back three tax years to offset taxable capital gains realized in any or all of those years up to a maximum of $15,000. He also has the option to carry the net capital loss forward indefinitely and use it to offset taxable capital gains realized in a future year.
Reporting Capital Gains and Losses
In determining the taxpayer’s income for a taxation year under a simple scenario, the taxpayer must determine the amount, if any, by which his or her taxable capital gains exceed allowable capital losses (ITA 3(b)), to arrive at the net taxable capital gain or net capital loss (ITA 111(8)). Note: The Income Tax Act does not call this a net allowable capital loss. Note: A taxpayer must deduct his or her allowable capital losses from his or her income to the extent that the taxpayer is permitted in the year they arise, or he or she will forfeit the right to do so (ITA 3).
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Taxation of Capital Property
This year, Fred had a taxable capital gain of $6,000, along with an allowable capital loss of $3,000. Fred is in a low marginal tax rate, and he would prefer to carry his allowable capital loss forward to next year, when he expects his marginal tax rate to be higher and when he also expects to have taxable capital gains. However, he must deduct the allowable capital loss from his taxable capital gain this year, or he will forfeit the right to deduct the loss. So, Fred will have a net taxable capital gain of $3,000, calculated as (taxable capital gain - allowable capital loss) or ($6,000 - $3,000). A taxpayer must report his or her net taxable capital gains or net capital losses on an annual basis on page 2 of the tax return, under total income. The claim must be supported by a completed Schedule 3, Capital Gains (or Losses) in Year. Benjamin Leyland disposed of shares in three different corporations last year. A summary of his transactions is provided below.
Ben's net capital gain resulting from the disposition of the shares was $1,989, calculated as (capital gain on ACB Corp. - capital loss on DEF Ltd. + capital gain on GHI Inc.) or ($870 $194 + $1,313). Ben also sold his cottage for $124,000, incurring real estate commissions and legal fees of $7,440. He had purchased the property in 1989 for $46,000. Ben never used his LCGE on this property, so its ACB is $46,000. His capital gain on the property is $70,560, calculated as ((proceeds - ACB - selling expenses)) or ($124,000 – $46,000 - $7,440)). Ben’s total capital gain as recorded on Schedule 3 of his income tax return is $72,549, calculated as (net capital gain from stock transactions + capital gain from cottage) or ($1,989 + $70,560). Ben has a taxable capital gain of $36,275 for last year, calculated as (total capital gain x capital gains inclusion rate) or ($72,549 × 50%), and he must enter this on page 2 of his income tax return.
Exercise: Capital Gains and Losses, Part 2
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Income Tax Planning
Exercise: Capital Gains and Losses, Part 3
Exercise: Capital Gains and Losses, Part 4
Capital Gains Reserves
When a taxpayer sells a capital property, he or she usually receives full payment at that time. However, sometimes the taxpayer will receive the proceeds in installments over a number of years. This is called an installment sale. When this situation occurs, the taxpayer may claim a capital gains reserve that allows him or her to defer, within limits, reporting a portion of the capital gain to the year in which the proceeds of the disposition are received. Sam sold a capital property for $50,000. He received $10,000 at the time of the sale, and he will receive the remaining $40,000 over a period of four years. The sale resulted in a capital gain of $30,000, so Sam would like to claim a reserve to defer some of the tax until future years as he receives the proceeds. If a taxpayer wants to claim a reserve, he or she still calculates his capital gain in the regular way, as the proceeds of the disposition minus the sum of the ACB and any outlays or expenses. From this amount, the taxpayer deducts the amount of reserve that he or she is claiming for the year. The result is the amount that the taxpayer must report as his or her capital gain for the year of disposition.
Most Types of Property
For most types of property, a reserve can be claimed for up to a maximum of four years (ITA 40(1)(a)(iii)). The maximum reserve that can be claimed in each year is restricted to the lesser of: a)
b)
where: n is the number of years since the property was sold.
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Taxation of Capital Property
Charles sold a property this year for $200,000. His ACB for the property was $120,000, so he has a capital gain of $80,000, calculated as (proceeds - ACB) or ($200,000 - $120,000). He took cash of $50,000 as a downpayment and will receive the remaining $150,000 in five annual installments of $30,000, commencing next year. Note: Any interest on the mortgage is taxable to Charles in the year of receipt and does not affect the reserve calculations. For this taxation year, the maximum capital gains reserve that Charles can claim is the lesser of: a) ($150,000 ÷ $200,000) x $80,000 = $60,000 b) (1/5 × $80,000 × (4 - 0)) = $64,000 Because the lesser amount is $60,000, it becomes the capital gains reserve. Charles must report a capital gain for the current year of $20,000, calculated as (capital gain - reserve) or ($80,000 - $60,000). If the taxpayer claims a reserve during any one taxation year, he or she must add it to his or her capital gains in the following year. However, if the taxpayer still has an amount that is payable to him or her in a future year, he or she can calculate and deduct a new reserve based on the new outstanding balance, as shown in this table.
1. 2. 3. 4.
a = [(outstanding proceeds ÷ total proceeds) × original capital gain] b = 1/5 of original capital gain × (4 – n) calculated as capital gain reported – maximum reserve If the taxpayer claims a reserve in one taxation year, he or she must report it as a capital gain in the next year. However, if some of the proceeds are still outstanding, he or she can calculate and deduct a new reserve based on the new outstanding balance.
Even if sale proceeds are not received within five years from the year of disposition, part (b) of the formula will cause the maximum reserve to be $0 four years after the year of disposition. Or, stated another way, part (b) of the formula ensures that at least 1/5 of the capital gain must be reported every year for a five year period. Thus, it is not possible to
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Income Tax Planning spread a capital gain over more than five years by claiming a reserve. If the sale proceeds are received in less than five years, part (a) of the formula will cause the gain to be reported in full by the time total proceeds have been received.
Farm Property and Small Business Corporation Shares Sold to Taxpayer's Child
There are exceptions to the rule that a capital gain cannot be spread over a period greater than five years. The exceptions relate to qualified shares of a small business corporation and qualified farm and fishing property that are disposed of to a child of the taxpayer. In this case, the capital gain may be spread over a 10-year period provided that the sale proceeds are not received in less than 10 years (ITA 40(1.1)). For these types of property, the maximum reserve that can be claimed in any one year is restricted to the lesser of: a)
b)
where: n is the number of years since the property was sold.
Exercise: Capital Gains Reserves
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7-19
Taxation of Capital Property
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Calculating Capital Gains and Losses. In this lesson, you have learned how to do the following: • calculate capital gains and losses, including adjusted cost base, outlays and expenses, taxable capital gains, allowable capital loss, and capital gains reserves
If you are ready to move to the next lesson, click Dispositions on the table of contents.
Assessment
Now that you have completed Calculating Capital Gains and Losses, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Dispositions
Welcome to Dispositions. In this lesson, you will learn about a variety of deemed dispositions including inter vivos transfers, death, changes of use, emigration, and donations. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • given a client who could have capital gains or losses upon disposition, calculate the impact of disposition including such factors as gifts, residence in Canada, and transfers
Dispositions
A taxpayer only realizes a capital gain or loss when he or she disposes of capital property, or when he or she is deemed to have disposed of that property. ITA 54 defines a disposition of property as any transaction or event that entitles a taxpayer to proceeds of disposition, as well as: • • • any redemption or cancellation of a taxpayer’s interest in shares, bonds, debentures, notes, certificates, mortgages, agreements of sale, or similar property any expiration of options held by the taxpayer to acquire or dispose of property any transfer of property to a trust, including transfers to RRSPs, deferred profit sharing plans, employees’ profit sharing plans, or registered retirement income funds
A disposition does not include transfers where the only purpose of the transfer is to secure a debt or a loan. It also does not include transfers of legal ownership where there is not also a transfer of beneficial ownership, with the exception of the trusts mentioned above. Angela has shares with a FMV of $2,000 and an ACB of $1,000 that she wants to transfer to her RRSP. An RRSP is a form of trust and the trustee has legal ownership of the trust assets, but as the beneficiary of the trust, Angela has beneficial ownership. However, under the rules mentioned above, Angela will be deemed to have disposed of the shares at FMV if she transfers them to an RRSP. In addition to the actual dispositions contemplated by ITA 54, in many cases, the Income Tax Act presumes a disposition to have taken place. These deemed dispositions generally involve transactions that do not give rise to proceeds. Examples of deemed dispositions include: • • • • • terminating Canadian residency (i.e., emigration) changing the use of property (e.g., from rental property to principal residence) death of the property owner transferring property by way of gift or donation involuntary transfers via theft, fire, etc.
We will discuss the most common actual and deemed dispositions in the following pages.
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Taxation of Capital Property
Sale
When property is sold, the proceeds of disposition are generally the sale price (ITA 54), so this amount is used to determine the capital gain or loss. Amanda sold corporate shares for $4,000. Her ACB is $3,000 and there were no costs associated with the disposition. Her capital gain is $1,000, calculated as (proceeds ACB) or ($4,000 - $3,000). Sale for proceeds less than FMV If a taxpayer disposes of anything to a person with whom he or she does not deal at arm’s length for proceeds less than FMV, the taxpayer is deemed to have received proceeds equal to FMV (ITA 69 (1)(b)(i)). In this case, the buyer is deemed to acquire the property for the price that he or she paid for it. So, this could lead to double taxation. Joanne owns a cottage with an ACB of $96,000 and a current FMV of $162,000. She plans to sell the cottage to her sister, Nancy for $120,000. If she follows through with this plan, Joanne will realize a capital gain of $66,000, calculated as (FMV at the time of the sale - ACB) or ($162,000 - $96,000). Nancy would acquire the property with an ACB of $120,000. If Nancy turned around and sold the property for $162,000, she would realize a capital gain of $42,000, calculated as (actual proceeds - ACB) or ($162,000 - $120,000). Sale for proceeds more than FMV If a taxpayer disposes of property to someone with whom he or she does not deal at arm’s length for proceeds in excess of FMV, he or she is deemed to have received proceeds equal to the sale price. However, the person who acquired the property is deemed to do so at FMV. So, the same gain may be taxed twice. Chandler has decided to sell stock valued at $1,200 to his father, Michael, for $1,600. Chandler’s ACB is $800. Chandler will have a capital gain of $800, calculated as (actual proceeds - Chandler's ACB) or ($1,600 - $800). While Chandler is deemed to have received proceeds of $1,600, Michael is deemed to have acquired the shares at their FMV of $1,200. So, if the share price rises and Michael disposes of them for $1,800, he will realize a gain of $600, calculated as (actual proceeds - Michael's ACB) or ($1,800 - $1,200).
Gifts
The Income Tax Act provides that when a taxpayer disposes of property to any person by way of an inter vivos gift, including a donation, he or she is deemed to have received proceeds of disposition equal to the FMV at the time of the gift (ITA 69(1)(b)(ii)). The recipient is deemed to have acquired the property for the same amount. June gave her shares valued at $1,200 to her brother, Ian. The shares have an ACB of $1,400. June will be deemed to have received proceeds of $1,200, and she will realize a capital loss of $200, calculated as (FMV at time of deemed disposition - ACB) or ($1,200 – $1,400). Ian will acquire the shares at an ACB of $1,200.
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Income Tax Planning
Transfers to Inter Vivos Trusts
The Income Tax Act provides that if a taxpayer transfers property to an inter vivos trust, he or she is deemed to have disposed of it for proceeds equal to FMV (ITA 69(1)(b)(ii)). There are exceptions with respect to property transferred to a spousal trust, as we will discuss shortly. Larry established an inter vivos trust for the benefit of his son, Luke. Larry transferred shares with a FMV of $4,230 to the trust at a time when the ACB of those shares was $2,618. Larry realized a capital gain of $1,612 as a result of the transfer, calculated as (FMV at time of deemed disposition - ACB) or ($4,230 - $2,618), and this will increase his taxable income by $806, calculated as (capital gain x capital gains inclusion rate) or ($1,612 × 50%).
Death
The proceeds of the deemed disposition of depreciable property upon death are deemed to be equal to the fair market value (FMV) of the property immediately prior to death. The deemed disposition upon death may result in either a recapture or terminal loss, depending on the UCC of the depreciable property. The applicable amount will be added or deducted when computing the deceased’s income on his or her final return. No CCA can be claimed in the year of the taxpayer’s death because the taxpayer is deemed to have disposed of all of his or her capital property immediately prior to death (ITA 70(5) and 70(6)).
Change of Use
If a taxpayer owns property that was originally purchased for one purpose and later changes its use for the purpose of gaining or producing income, he or she is deemed to have disposed of that property for FMV. Similarly, if a taxpayer owns property that was originally acquired for the purpose of gaining or producing income and the taxpayer later changes the use of that property to some other purpose, he or she is deemed to have disposed of that property for FMV (ITA 45(1)). In either case, the taxpayer is deemed to have immediately reacquired the property for FMV at the time of the change of use. This deemed disposition may result in a capital gain or loss, and it will result in a new ACB for the purpose of calculating gains or losses on future dispositions of that property. Fiona owns a cottage that she originally acquired for $42,000 for her personal enjoyment; it is currently worth $95,600. Because she is moving out of the province, she decided to turn the cottage into a rental property. As a result of this change in use, she will be deemed to have disposed of the property for $95,600, and this will result in a taxable capital gain of $26,800, calculated as ((FMV at time of deemed disposition - ACB) x capital gains inclusion rate) or (($95,600 - $42,000) × 50%). Upon the change of use of the cottage, she is deemed to have immediately reacquired the property for $95,600. The new ACB of the cottage is $95,600.
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Taxation of Capital Property
Involuntary Dispositions
If a taxpayer receives compensation, including an insurance recovery, for property that has been stolen, destroyed or expropriated, that compensation is deemed to be proceeds of disposition for the purpose of determining capital gains or losses (ITA 54). If the compensation is for property that has been damaged, the compensation could be considered to be proceeds of disposition if the compensation is not used to repair the damaged property within a reasonable length of time. Daniel owned an office building that was destroyed by fire. He never claimed any CCA with respect to the building and his ACB was $84,000. His insurance company covered the loss and gave Daniel $102,000, the replacement cost of the building. Daniel has deemed proceeds of $102,000. This would result in a capital gain of $18,000, calculated as (insurance proceeds - ACB) or ($102,000 - $84,000).
Replacement Properties
The Income Tax Act provides for a deferral of all or part of a capital gain that results from the proceeds of disposition related to property that has been stolen, destroyed, or expropriated. In order to take advantage of this deferral, the taxpayer must acquire a replacement property by the end of the second taxation year following the year of the deemed disposition (ITA 44(1)). The taxpayer is still required to report the taxable capital gain resulting from the deemed disposition for the taxation year in which the disposition took place. However, as long as a replacement property is acquired within the time limit, the taxpayer can request that his or her income tax return for the year of disposition be reassessed to generate a refund in respect of the income taxes paid. This is as a result of the taxable capital gain that arose on the deemed disposition. Brian owned a country vacation property and the ACB of the building was $120,000. Last year, the building was destroyed by fire and his insurance company covered the replacement value of $160,000. For last year, Brian had to report a taxable capital gain of $20,000, calculated as ((insurance proceeds - ACB) x capital gains inclusion rate) or (($160,000 - $120,000) × 50%). However, Brian intends to use the insurance proceeds to have a new building constructed. As long as the new building is constructed before the end of next year, Brian will be able to request a reassessment for last year's tax return. Refer to IT-259R3, Exchanges of Property, for additional information.
Exercise: Dispositions
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Income Tax Planning
Entering or Leaving Canada
Generally, the Income Tax Act imposes tax on 50% of the capital gains realized by Canadian residents on the disposition of all types of capital property regardless of whether it is located in Canada or elsewhere. However, in the case of non-residents, the Act can only impose tax on the gains realized on the disposition of a subset of property known as Taxable Canadian Property, or TCP. TCP is generally privately owned property that is located in Canada and therefore, is within the reach of CRA. The most common forms of TCP are Canadian real estate, unlisted shares of companies resident in Canada and substantial interests (25% or more of the class) in certain shares listed on a prescribed stock exchange (ITA 115(1)(b)). Individuals who emigrate from Canada are treated as having disposed of all of their property, other than TCP, at the time of emigration. This is supposed to ensure that Canada always taxes gains that accumulate while an individual is resident in Canada, and is based on the different treatment of TCP and non-TCP in the hands of non-residents. Because nonTCP leaves the Canadian tax system when its owner emigrates, accumulated gains on nonTCP must be taxed before the individual leaves Canada. In contrast, because TCP remains in the Canadian tax system even when it is held by a non-resident, there has historically been no need, from the point of view of the Income Tax Act, to subject TCP to a deemed disposition when a taxpayer emigrates. In the following sections, we will discuss the existing rules for deemed dispositions upon immigration and emigration. Then we will provide you with an overview of the proposed changes that are intended to address the fact that tax treaties significantly limit Canada’s taxation of the TCP of non-residents. Refer to IT-176R2, Taxable Canadian property – Interests in and options on real property and shares, for more information about what constitutes TCP.
Entering Canada
A taxpayer who becomes a resident of Canada (in other words, immigrates) is generally treated as having disposed of and reacquired all of his or her property at fair market value (ITA 128.1(1)(b)). This ensures that Canada will tax only that part of any gain on the property that accumulates after the person becomes resident here. Taxable Canadian property is not subject to this deemed disposition because the property is still located in Canada and therefore, still within the reach of CRA. The Income Tax Act subjects these gains to tax when the property is actually disposed. Last year, Kyle moved to Canada from England. At the time, Kyle owned one apartment in England and one in Canada. Each property cost Kyle the equivalent of $275,000 Canadian; each property had an FMV of $400,000 at the time of his move. For Canadian tax purposes, Kyle was deemed to have disposed of the apartment in England (i.e. his non-TCP) and to have immediately reacquired the property for $400,000 before becoming a resident of Canada. His ACB for this apartment is therefore $400,000. In January of this year, Kyle sold both apartments for $525,000 each. This year, Kyle will incur a taxable capital gain for Canadian tax purposes of $62,500 as a result of actually disposing of the apartment in England, calculated as [(actual proceeds – ACB) x capital gains inclusion rate] or [($525,000 – $400,000) × 50%]. This relates to the portion of the total gain that accumulated while he was a resident of Canada.
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Taxation of Capital Property
Since the Canadian apartment is TCP, Kyle was not treated as having disposed of it when he became resident in Canada. As a result, the ACB of this apartment for Canadian tax purposes is still $275,000. His taxable capital gain upon its disposition is $125,000, calculated as [(actual proceeds – ACB) x capital gains inclusion rate] or [($525,000 – $275,000) × 50%].
Leaving Canada
If an individual taxpayer or a trust ceases to be a resident of Canada (in other words, emigrates), he or she is deemed to have disposed of his or her property at FMV prior to departure and immediately reacquired it for the same amount (ITA 128.1(4)). Under the existing legislation, this deemed disposition applies to all of the taxpayer’s property, other than TCP, stock options, and certain pension and similar rights. This deemed disposition could result in a capital loss or a capital gain that is fondly referred to as the departure tax. Individuals, other than trusts, can elect to be treated as having disposed of any TCP at the time of emigration (ITA 128.1(4)(d)). Chelsea moved to Italy from Canada in 1995. At the time of the move, she owned one apartment in Italy and one in Canada. The cost of each property was the equivalent of $75,000 in Canadian dollars, and each had an FMV of $100,000 at the time of her emigration. For Canadian tax purposes, Chelsea was deemed to have disposed of the apartment in Italy (i.e. her non-TCP) and to have immediately reacquired the property for $100,000 before she ceased being a resident of Canada. Canada then taxed the taxable capital gain of $18,750, calculated as [($100,000 – $75,000) × 75%], on the Italian apartment while she was a resident of Canada. Keep in mind, the capital gains inclusion rate was 75% at the time of Chelsea's emigration in 1995. Chelsea sold both apartments this year for $120,000 each. Canada cannot tax the postdeparture taxable capital gain of $10,000 on the Italian apartment, calculated as [($120,000 – $100,000) × 50%]. Since the Canadian apartment is TCP, Chelsea was not treated as having disposed of it in 1995. So, Canada will tax the full taxable capital gain of $22,500, calculated as [($120,000 – $75,000) × 50%], this year.
Legislative Changes
Canada has tax treaties with many sovereign countries, which are agreements between the two countries as to how transactions involving the disposition of capital property in either country are to be taxed. These tax treaties significantly limit Canada's taxation of the TCP of non-residents. Treaties generally provide that only a taxpayer's country of residence can tax most gains. The most important exception is gains on real estate, which the source country can usually tax. Since Canada's tax system is based on residency. Residents of Canada are taxed on their worldwide income, while non-residents are only subject to taxation on certain types of Canadian source income. Historically, a taxpayer could emigrate from Canada and not be taxed on taxable Canadian property, such as shares in a Canadian company. Canada, however, wanted to tax gains accrued when he or she was a resident. To address this problem, the federal government initially proposed changes to the departure tax via a
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Income Tax Planning Notice of Ways and Means Motion on October 2nd, 1996. These proposals underwent discussion and several revisions, until legislation was finally enacted in June, 2001. The new system greatly expanded the reach of the departure tax to include Canadian assets held at the time of departure. The following table summarizes the old and new taxation of certain types of property upon emigration. The changes impacted mainly small business owners, as well as investors in Canadian public companies, mutual funds, and foreign real estate. Taxpayer Migration - Old and New Rules Property Are nonresident’s gains taxable in Canada? Yes (always). Old Rule New Rule
Canadian real estate
No deemed No change. disposition on emigration; Canada taxes when disposed of. No change.
RRSPs and Pension Gains not taxed as No deemed Rights such; income taxed disposition on when received. emigration. Life insurance policy Death benefit not taxable. No deemed disposition on emigration.
No change.
Unlisted shares Yes (subject to (e.g., small private treaty). company)
No deemed Deemed disposition disposition on on emigration; tax emigration; if assessed to extent treaty permits, $750,000 capital Canada taxes when gains exemption disposed of. not available; can defer actual payment of tax by providing security. Deemed disposition Same as unlisted on emigration; can shares (except avoid deemed $750,000 capital disposition by gains exemption is choosing to treat not available) as TCP and provide security – Canada then taxes both pre-and postdeparture gains, if treaty permits, when disposed of.
Listed shares (if No. (If emigrant taxpayer owns less chooses to treat as than 25% of class) TCP, Canada can • Foreign real tax, subject to estate treaty.) • Canadian mutual fund units (if taxpayer owns less than 25%)
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Taxation of Capital Property
Exercise: Leaving or Entering Canada, Part 1
Exercise: Leaving or Entering Canada, Part 2
Transfers Between Spouses
If a taxpayer transfers non-depreciable capital property via gift or sale, or as a result of a settlement agreement or award to the following: • • • his or her spouse or former spouse his or her common-law partner or former common-law partner a spousal trust or common-law partner trust
then that transfer is deemed to have occurred at the taxpayer’s ACB, unless the taxpayer elects otherwise. So, unlike other transfers for less than FMV, a gift or sale of property to a spouse or common-law partner for less than FMV will not result in a deemed disposition at FMV. Similarly, if the taxpayer disposes of depreciable capital property to his or her current or former spouse or common-law partner, or to a spousal trust, the transfer is deemed to have occurred at the UCC of the transferred asset (or cost amount if there are multiple properties in the same class) (ITA 73(1)). Spousal or common-law partner trust A spousal or common-law partner trust is any trust created by the taxpayer under which: • • His or her spouse or common-law partner is entitled to receive all of the income of the trust that arises before his or her death. No person except the taxpayer's spouse or common-law partner may, before the spouse's death, receive or otherwise obtain the use of any of the income or capital of the trust (ITA 73(1)(c)).
Spousal rollover rule This transfer at ACB or UCC is commonly referred to as the spousal rollover rule. The effect of the rollover is to defer the recognition of any capital gains until the recipient spouse or common-law partner disposes of the property.
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Income Tax Planning Sheldon has shares in Corplex Inc, with an ACB of $1,400 and an FMV of $2,000. As part of his divorce settlement, he transferred the shares to his ex-wife, Belinda. Sheldon is deemed to have received proceeds of disposition of $1,400, so he will not realize a capital gain at the time of the transfer. Belinda acquires the shares with an ACB of $1,400. If Belinda later sells the shares for $2,200, she will realize a taxable capital gain of $400, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($2,200 - $1,400) × 50%). Note: The rollover is automatic, and the taxpayer, but not the other spouse or common-law partner, must file an election to opt out of the rollover. A taxpayer might want to opt out of the rollover if he or she had capital losses to offset, if he or she could make use of a capital gains exemption to shelter the gain, or if he or she wanted to avoid subsequent income attribution. In the same year, Sheldon had a capital loss of $600. Sheldon could file an election to opt out of the rollover, in which case he would realize a capital gain of $600, calculated as (FMV at time of transfer - ACB) or ($2,000 - $1,400). This gain would be offset by his capital loss. Belinda would then acquire the property at an ACB of $2,000, such that when she later sells the shares for $2,200, she will realize a taxable capital gain of only $100, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($2,200 - $2,000) × 50%).
Transfers of Farm and Fishing Property
In an effort to maintain the role of the family farm in the Canadian economy, the Income Tax Act permits a tax-deferred rollover to a child (as well as the deferral of any potential capital cost allowance recapture) until the child eventually disposes of the property. Two conditions must be met in order to be eligible for the tax-deferred rollover: i) ii) The child must be a resident of Canada just before the transfer. The property is an active farm in which the taxpayer, his or her spouse or common-law partner and their children were actively engaged in the farming operation on a regular and ongoing basis before the transfer.
Farm property includes land and depreciable property used in the business of farming (ITA 73(3)), as well as capital stock of a family farm corporation or an interest in a family farm partnership (ITA 73(4)). The definition of a child includes a child of the taxpayer, a stepchild, an adopted child (including a child adopted in fact), a grandchild, a greatgrandchild, or the spouse or common-law partner of any child as previously defined. Electing the transfer price For most farming property, the transfer price can be any amount between the ACB of the property and its fair market value (FMV). For depreciable property, the transfer price can be any amount between its undepreciated capital cost (UCC) and its FMV. Transfer of farm property to a child on death of a parent A tax-deferred rollover of a Canadian farm property to a child is also permitted in the year a parent dies subject to the same conditions as an inter vivos transfer (i.e. while the transferor is alive). In most cases, the transfer must take place no later than 36 months following the death of the parent.
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Taxation of Capital Property
Refer to IT-268R4, Inter Vivos Transfer of Farm Property to a Child, or IT-349R3, Intergenerational transfers of farm property on death, for more information. Transfers of fishing property The 2006 Federal budget extended the tax-deferred intergenerational rollover applicable to qualified farm properties to families involved in a qualified fishing business. The conditions that apply to the rollover of farm properties also apply to the rollover of fishing property. Qualified fishing property includes real property or a fishing vessel used principally in the business of fishing as well as a share of the capital stock of a family fishing corporation or an interest in a family fishing partnership.
Transfers to Corporations or Partnerships
In some cases, a taxpayer may want to transfer capital property to a corporation or partnership in which he or she is involved. While this is a deemed disposition of capital property, the Income Tax Act may allow the taxpayer and the business to elect deemed proceeds of disposition that are less than FMV, as long as certain conditions are met. Property that can be rolled over generally includes all capital property, including depreciable property, but excluding land inventory (ITA 85(1)). These deemed proceeds then become the cost of acquisition for the corporation, such that the corporation is assuming the taxpayer’s potential income tax liabilities for the property (ITA 85(1)(a)). This is commonly referred to as a Section 85 rollover. In the case of corporations, a taxpayer will transfer capital property to the corporation in exchange for some consideration, which could include shares in the corporation and other non-share consideration. The non-share consideration can consist of cash or a promissory note for any amount between the ACB and the FMV of the property disposed. By taking back a promissory note, the taxpayer can later redeem the note for cash without realizing a capital gain.
Section 85 Rollover: Upper and Lower Limits
There are three basic scenarios under which a Section 85 rollover can take place where the taxpayer and the corporation can elect deemed proceeds within an upper limit (equal to the FMV of the property transferred to the corporation) and a lower limit as detailed in the following table. The table also shows the impact of the upper and lower limits on the taxpayer and the corporation.
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Income Tax Planning Lower Limits for Section 85 Rollovers Situation Lower Limit Outcome Taxpayer cannot elect to generate a capital loss. Taxpayer can choose to defer recognition of capital gain. To the extent that the deemed proceeds are less than the FMV of the transferred property, the burden of taxation on capital appreciation is shifted to the corporation. Scenario 2: property with a the FMV of the nonFMV equal to or greater than share consideration its ACB is transferred to a corporation in exchange for at least one share in that corporation, plus some nonshare consideration between the FMV and ACB of the property transferred to the corporation Taxpayer cannot elect to generate a capital loss. Taxpayer can choose to defer recognition of capital gain. To the extent that the deemed proceeds are less than the FMV of the transferred property, the burden of taxation on capital appreciation is shifted to the corporation. Taxpayer is forced to recognize a gain to the extent that the FMV of the non-share consideration exceeds the ACB. Scenario 3: property with a the FMV of the FMV less than its ACB is property transferred transferred to a corporation in to the corporation exchange for at least one share in that corporation, plus some non-share consideration between the FMV and ACB of the property transferred to the corporation The taxpayer is forced to realize a loss if the FMV of the transferred property is less than its ACB. Any subsequent recovery in the value of the transferred property will be taxable to the corporation.
Scenario 1: property is the ACB of the transferred to a corporation in property transferred exchange for share to the corporation consideration only
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Taxation of Capital Property
Exercise: Transfers to Corporations or Partnerships
Section 97 Rollover to a Partnership
The Income Tax Act also allows a taxpayer to dispose of capital property to a partnership on a rollover basis, provided that he or she executes a joint election with all of the other partners in the partnership and that part of his or her compensation includes an interest in the partnership (ITA 97(2)). The transfer of capital property to a corporation or partnership can become fairly complex; we will not deal with it further here. It is sufficient for you to be aware that such transfers are allowed with no immediate tax consequence to the transferor, but that if so desired, gains can be triggered if the elected transfer price exceeds the cost base of the property.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Dispositions. In this lesson, you have learned how to do the following: • given a client who could have capital gains or losses upon disposition, calculate the impact of disposition including such factors as gifts, residence in Canada, and transfers
If you are ready to move to the next lesson, click Losses on the table of contents.
Assessment
Now that you have completed Dispositions, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 4: Losses
Welcome to Losses. In this lesson, you will learn how the taxpayer can use capital losses to reduce his or her tax liability in the year of disposition or in other years, and special rules for losses that result from deemed dispositions upon death. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • calculate capital losses, including such factors as allowable business investment losses, net capital loss carryovers, superficial losses, and stop-loss rules
Losses and Net Capital Losses
If a taxpayer disposes of an asset for proceeds less than the sum of the adjusted cost base and the expenses related to disposition, he or she will realize a capital loss, and the allowable capital loss is 50% of the capital loss. While this seems simple enough, the Income Tax Act then sets out a series of rules governing the deductibility of capital losses. In order to help you as you go through this lesson, we have created a short scenario and accompanying table, to define and give examples of each of the types of losses and gains that we discuss in the lesson. Click the icon to view Jane's Gains and Losses.
Feel free to print the PDF file and use it as a reference tool as you go through this lesson. Net capital losses The net capital loss for a year, in its most basic form, is simply the sum of all allowable capital losses for the year minus all taxable capital gains for the year (ITA 111(8)). Stephanie disposed of 100 shares in ABC Corp., which resulted in a taxable capital gain of $1,025. She also disposed of 200 shares in DEF Inc, which resulted in an allowable capital loss of $1,240. Stephanie had a net capital loss of $215, calculated as (taxable capital gains – allowable capital losses) or ($1,025 - $1,240). Allowable capital losses may generally only be applied to offset taxable capital gains, either in the same year or as a net capital loss carryover, according to the rules outlined in a later section. Stephanie cannot apply the net capital loss of $215 against her other sources of income for the year. Instead, she must carryover the net capital loss. While the basic form of a net capital loss is fairly straightforward, there is a further adjustment to the net capital loss amount in the case of certain unused allowable business investment losses (ABILs).
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Taxation of Capital Property
Allowable Business Investment Losses (ABILs)
There is an exception to the general rule that allowable capital losses cannot be deducted against ordinary income. It applies to an allowable business investment loss incurred by investing in a small business corporation, and it is meant to give taxpayers an incentive to invest in private Canadian businesses. Unlike other capital losses, when calculating taxable income for the year, a taxpayer can deduct an allowable business investment loss (ABIL) from any other source of income for the year (ITA 3(d)). An allowable business investment loss is a type of allowable capital loss that is calculated as 50% of a business investment loss (ITA 38(c)). A taxpayer may realize a business investment loss if he or she disposes of shares of a small business corporation or a debt owed to him or her by a Canadian-controlled private corporation (CCPC) for proceeds less than ACB plus expenses, as long as: • that disposition is to an arm’s length person • that disposition is deemed to have occurred as a result of the recognition of a bad debt or shares of an insolvent company (ITA 50(1)) A taxpayer is generally deemed to have a disposition under ITA 50(1) if: • • in the case of a debt owed to him or her at the end of the taxation year, the debt is established to have become a bad debt during the year in the case of shares in a corporation, the corporation has become bankrupt, is winding up, or has become insolvent, such that the FMV of its shares has become nil the taxpayer makes an election to have ITA 50(1) apply
•
If the taxpayer makes this election, he or she is deemed to have disposed of the debt or shares at the end of the year and to have reacquired it immediately after the end of the year at a cost of nil. Shelley held shares in Defunct Corporation, which went bankrupt last year. Her shares had an ACB of $14,600. Shelley elected to have ITA 50(1) apply, so she will have an allowable business investment loss of $7,300, calculated as ((proceeds - ACB) x capital gains inclusion rate) or ((0 - $14,600) × 50%). The amount of ABIL will be reduced if the taxpayer has claimed capital gains deductions in prior years.
Non-capital Losses
If a taxpayer has an ABIL that is greater than his or her other income for the year, he or she will not be able to deduct all of the ABIL in the year it arises, and the remainder is treated as a non-capital loss. A non-capital loss is generally the sum of any losses from business, employment, or property (including rental losses), as well as any allowable business investment losses that could not be deducted from other income in the year of the loss. A taxpayer can carry non-capital losses back three years and forward 20 years to be deducted from all other sources of income when calculating the taxable income of those years.
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Income Tax Planning Unused ABILs form a part of an individual's non-capital losses at any given time, however, ABILs may only be carried forward 10 years, whereas non-capital losses may be carried forward for 20 years. So, what constitutes an individual's non-capital losses will depend on whether any unused ABILs are still within their carryover period. An ABIL that is not deducted as a non-capital loss by the end of the tenth year of its carryforward period becomes a net capital loss at the end of that tenth year. This treatment allows the loss to be carried forward indefinitely, but to be deducted only against taxable capital gains beginning in the eleventh year. In 1997, Marie incurred an ABIL. She was unable to deduct the entire loss from all of her sources of income by the end of 2007 – the end of the 10-year carryforward period for ABILs – so, the loss became a net capital loss in 2007. Marie can now carry the remainder of her loss forward indefinitely however, she can only deduct it against taxable capital gains realized in 2008 and later years. Refer to IT-484R2, Business Investment Losses, and IT-159, Capital Debts Established to be Bad Debts, for more information about ABILs.
Net Capital Loss Carryovers
So, a net capital loss is more accurately defined as the sum of all allowable capital losses for the year minus all taxable capital gains for the year, plus any ABILs that were not deducted as a non-capital loss by the expiry of the carry-forward period. A net capital loss may be carried back three years to offset taxable capital gains in any or all of those years (up to the amount of the net capital loss). Alternatively, a net capital loss may be carried forward indefinitely to offset taxable capital gains realized in future years (ITA 111(1)(b)). A taxpayer will have to determine whether it is to his or her advantage to carry a net capital loss back or to save it for a future year. The anticipated marginal tax rate of the taxpayer in future years will play a big role in this decision. Michael has a net capital loss of $6,000. He could carry the loss back to apply it against net taxable capital gains in the previous three years, or he could carry it forward indefinitely. During the last three years, Michael did have net taxable capital gains, but his marginal tax rate during those three years was only 33%. Next year, Michael anticipates having a large capital gain and a marginal tax rate of 52%. So, Michael would be better off carrying the net capital loss forward to next year. Refer to IT-232R3, Losses – Their Deductibility in the Loss Year or in Other Years, for additional information.
Exercise: Losses
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Taxation of Capital Property
Accounting for Different Capital Gains Inclusion Rates
Since capital gains first became subject to tax in 1972, the inclusion rate has changed four times. This must be accounted for when capital losses that were realized at one inclusion rate are used to offset capital gains that were realized at a different inclusion rate. There are many provisions of the Income Tax Act that deal with gross capital losses or gross capital gains, instead of allowable capital losses and taxable capital gains. For example, the capital gains exemption for qualified small business shares and qualified farm and fishing property is intended to exempt gross capital gains of up to $750,000 during the taxpayer’s lifetime, but it is implemented by a deduction calculated at the current inclusion rate. Therefore, you need to be aware of how the inclusion rate has changed over time. Similarly, adjustments may be required when using the provisions for a net capital loss carryover between years with different inclusion rates. Jason had a net capital loss of $7,500 in 1996, which he carried forward and wanted to apply against a taxable capital gain of $16,000 realized this year. In 1996, the capital gains inclusion rate was 75%, so Jason’s net capital loss of $7,500 resulted from a gross capital loss of $10,000, calculated as (allowable capital loss ÷ capital gains inclusion rate in 1996) or ($7,500 ÷ 75%). Let's look at what occurred in another way: • In 1996, Jason sold some shares for a capital loss of $10,000. The inclusion rate at this time was 75%, so Jason had an allowable capital loss of $7,500 calculated as ($10,000 x 75%). In 1996, Jason did not have any taxable capital gains so for the year he ended up with a net capital loss of $7,500 and a net capital loss carryover of the same amount.
•
Currently, the capital gains inclusion rate is 50%. This means Jason’s taxable capital gain of $16,000 resulted from a capital gain of $32,000, calculated as (taxable capital gain ÷ current capital gains inclusion rate) or ($16,000 ÷ 50%). To make sure we account for these different inclusion rates during the carryover process, we carry forward the gross capital loss of $10,000 and deduct it from the gross capital gain of $32,000. Jason’s remaining taxable capital gain after the carry forward is $11,000, calculated as [(gross capital gain - gross capital loss) x current capital gains inclusion rate)] or [($32,000 - $10,000) × 50%]. Let's look at what occurred in another way: • This year, Jason sold some shares and realized a capital gain of $32,000. The inclusion rate at the time was 50%, so Jason had a taxable capital gain of $16,000 calculated as ($32,000 x 50%). Jason would like to offset some of these gains using his net capital loss carryover of $7,500. However, he has to account for the two different inclusion rates involved in the transaction.
•
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Income Tax Planning • • Jason must first carry forward his capital loss of $10,000 and deduct it from his capital gain of $32,000. This means Jason has a taxable capital gain of $11,000 calculated as [($32,000 $10,000) x 50%].
Superficial Losses
To prevent abuses of the deductibility of allowable capital losses, the Income Tax Act prohibits the deduction of a superficial loss by effectively declaring the loss to be nil (ITA 40(2)(g)). A taxpayer will incur a superficial loss if: • he or she disposes of a capital property and the taxpayer or an affiliated person acquires a substituted property (which includes the same property or an identical property) during a period that begins 30 days before and ends 30 days after the disposition at the end of that period, the taxpayer or an affiliated person still owns or had a right to acquire the substituted property (ITA 54)
•
Under the superficial loss rules, a taxpayer will only be able to claim a loss if the taxpayer or an affiliated person does not acquire the same or identical capital property—shares in the same company, for example—at any time within the 61-day window (the day of disposition, plus 30 days before the disposition and 30 days after the disposition). So in order for the loss to be fully deductible, the same or identical property must be acquired at least 31 days before or 31 days after the disposition. Ron disposed of 400 shares of MXT Inc. with an ACB of $1,600 on July 1st for net proceeds of $1,260. His wife, Carla, purchased 400 shares of MXT on June 15th of the same year for $1,300 and she still held them on July 31st. Ron’s loss of $340, calculated as, (proceeds - ACB) or ($1,260 - $1,600) is a superficial loss, so his allowable capital loss is nil. While the taxpayer who disposed of the property is prohibited from deducting the loss, the affiliated person who acquires the substituted property can add the superficial loss to the ACB of the substituted property (ITA 53(1)(f)). Continuing on from the previous example, Carla’s ACB for her MXT shares is $1,640, calculated as (superficial loss + purchase price) or ($340 + $1,300). Affiliated persons or persons affiliated with each other generally include the following (ITA 251.1): • • • the taxpayer and his or her spouse or common-law partner a corporation controlled by the taxpayer or his or her spouse or common-law partner a partnership in which the taxpayer or his or her spouse has a majority interest
Also inherent in this definition is the fact that a taxpayer is affiliated with himself or herself, so two corporations or partnerships are affiliated if they are controlled by the same person.
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Taxation of Capital Property
Exceptions to the Superficial Loss Rule
The superficial loss rule does not apply in the case of deemed dispositions that occur upon: • • • • • emigration death expiry of an option change of use of property the recognition of a bad debt
Horace purchased 200 shares of Badnews Corp. on March 15th. The shares had an ACB of $500. Horace died on April 3rd, and the FMV of the shares at the time of his death was $460. Horace’s executors elected to transfer the shares to Horace’s wife at fair market value. Even though Horace is deemed to have disposed of his shares immediately prior to death for FMV and his death occurred within the specified window, he has not incurred a superficial loss, but an allowable capital loss.
Stop-Loss Rules
Capital dividends are payments that a shareholder may receive from a private corporation’s capital dividend account, which records the total of the tax-free portion of capital gains, the gains from company-held life insurance policies and the tax-free portion of sales of goodwill. Capital dividends are not taxable to the shareholder when they are received, and as with other dividends, they are paid at the discretion of the directors of the corporation. The Income Tax Act has a stop-loss rule that prevents the creation of the capital loss when shares of a corporation with a balance in its capital dividend account are sold. Ivan bought all of the shares of ABC Inc. for their current FMV of $100,000. ABC Inc. had $75,000 in cash and $75,000 in its capital dividend account. In his role as a director of ABC Inc., Ivan directed the corporation to pay him a tax-free capital dividend of $75,000, thereby depleting the corporation's cash to $0 and its FMV to $25,000, calculated as (original FMV - tax-free capital dividend) or ($100,000 - $75,000). Ivan then sold his ABC shares for their new FMV of $25,000 and tried to claim a loss of $75,000, calculated as (proceeds - ACB) or ($25,000 - $100,000). However, under the stop-loss rules, Ivan will be denied the loss, because he has not really suffered a loss. The stop-loss rule says that if an individual taxpayer who has control over a private corporation that paid him or her capital dividends subsequently disposes of those shares and that disposition results in a capital loss, that loss is reduced by the lesser of: • • the sum of all capital dividends received by the taxpayer on those shares the loss minus all taxable dividends received by the taxpayer on those shares (ITA 112(3)(a))
Therefore, in the previous example, Ivan will have a capital loss of $0, because his apparent loss of $75,000 upon the sale of his shares will be reduced by the capital dividend of $75,000 that he had received. Effectively, the stop-loss rules disallow a capital loss arising from payment of a capital dividend, but allow a capital loss arising from the payment of a taxable dividend.
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Income Tax Planning The stop-loss rules are intended to ensure that taxpayers who have control over a private corporation cannot cause the corporation to both pay out a tax-free dividend and claim a loss when disposing of the shares when that loss could be attributed, at least in part, to the dividend distribution. As a result, the stop-loss rules do not apply if both of the following conditions are met: • the capital dividends were received by the taxpayer at a time when he or she and persons with whom he or she did not deal at arm’s length owned not more than 5% of the shares of any class of capital stock in the corporation the capital dividends were received on shares that the taxpayer owned throughout the 365-day period that ended immediately before the disposition (ITA 112(3.01))
•
Refer to IT-328R3, Losses on shares on which dividends have been received, for more information.
Exercise: Inclusion Rates/Losses, Part 1
Exercise: Inclusion Rates/Losses, Part 2
Exercise: Inclusion Rates/Losses, Part 3
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Taxation of Capital Property
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Losses. In this lesson, you have learned how to do the following: • calculate capital losses, including such factors as allowable business investment losses, net capital loss carryovers, superficial losses, and stop-loss rules
If you are ready to move to the next lesson, click Special Situations on the table of contents.
Assessment
Now that you have completed Losses, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 5: Special Situations
Welcome to Special Situations. In this lesson, you will learn about how capital gains and losses are determined with respect to specific types of property, including depreciable property, personal property, debts, and foreign currencies. So far, we have covered the basics of capital gains taxation, including situations where the deemed proceeds of disposition may be something other than FMV. Now we will look at how these rules are applied to a number of special situations, many of which are governed by their own variations of the rules discussed so far. This lesson takes 35 minutes to complete. At the end of this lesson, you will be able to do the following: • integrate depreciable and personal-use property, stock dividends, debts, and foreign currencies when calculating capital gains or losses
Depreciable Property
Depreciable property is a special type of capital property on which capital cost allowance can be claimed. A taxpayer can realize a capital gain when he or she disposes of depreciable property, but he or she cannot realize a capital loss. Capital gains on depreciable property The capital gain on the disposition of depreciable capital property is calculated as the excess of the net proceeds of disposition over the aggregate of the adjusted cost base and the costs of disposition. In the case of depreciable property, the ACB is simply the capital cost of the property (ITA 54). If the proceeds exceed the capital cost, which in turn exceeds the undepreciated capital cost, the difference between the ACB and the UCC will be a recapture of CCA. Sarah owns a rental building that she acquired at a capital cost of $94,300. The building is situated on leased land, so we do not have to worry about the land at this point. She has claimed CCA on the building over a period of years such that her UCC is $72,000. Sarah sells the building for $110,000. She has a recapture of CCA of $22,300, calculated as (UCC before disposition - (the lesser of (net proceeds and capital cost)) or ($72,000 – (the lesser of $110,000 and $94,300)). The full amount of this recapture must be included in her income for the year of disposition. Sarah also has a taxable capital gain of $7,850, calculated as ((proceeds - capital cost) x capital gains inclusion rate) or (($110,000 $94,300) x 50%). Losses on depreciable property However, a taxpayer cannot realize a capital loss when he or she disposes of a depreciable property (ITA 39(1)(b)). This is because the cost of depreciable property is already deductible from income under the CCA and terminal loss rules. If the proceeds of disposition are less than the taxpayer’s UCC, the difference is deductible from his or her business or property income as a terminal loss.
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Taxation of Capital Property
Disposition of Land and Building
A taxpayer may sell a real property consisting of a building and land. The sale of the building, being a depreciable property, might give rise to a terminal loss or recapture depending upon the proceeds, as well as a capital gain. The sale of the land, being a nondepreciable asset, can give rise only to a capital gain or capital loss depending upon the proceeds. If the property is sold, and the sale of the building results in a terminal loss, but the sale of the land results in a capital gain, the terminal loss will be reduced to the extent of any capital gain on the land (ITA 13(21.1)). The effect of this adjustment is to convert all or part of the terminal loss to a capital loss deductible at the 50% inclusion rate, rather than the 100% rate for terminal losses. Refer to IT-220R2, Capital cost allowance – proceeds of disposition of capital property, for further information.
Personal-use Property
Personal-use property is any property that is owned by the taxpayer and used primarily for his or her enjoyment or for the use or enjoyment of one or more individuals related to the taxpayer. Gains on disposals of personal-use property are taxable in the same manner as other capital gains, but losses on personal-use property are not deductible, even to offset personal-use property gains. Instead, the losses are assumed to be nil (ITA 40(2)(g)(iii)).
$1,000 Floor Rule
To eliminate the nuisance factor involved in keeping track of gains and losses on small items, the Income Tax Act provides a $1,000 floor rule for personal-use property. Under this rule, when a taxpayer calculates a capital gain on personal-use property, the adjusted cost base is deemed to be the greater of the actual ACB and $1,000. Similarly, proceeds of disposition are deemed to be the greater of actual proceeds and $1,000 (ITA 46(1)). Philip sold his comic book collection for $1,200 and his ACB was $500. The deemed proceeds of disposition of his comic book collection is $1,200 calculated as [the greater of (actual proceeds and floor limit)] or [the greater of ($1,200 and $1,000)]. The ACB of the property is deemed to be $1,000 calculated as [the greater of (actual ACB and floor limit)] or [the greater of ($500 and $1,000)]. Philip's taxable capital gain is $100, calculated as [(deemed proceeds – deemed ACB) x capital gains inclusion rate] or [($1,200 – $1,000) × 50%]. Jamie sold his canoe for $900; he purchased it for $1,500. The deemed proceeds of disposition of his canoe is $1,000 calculated as [the greater of (actual proceeds and floor limit)] or [the greater of ($900 and $1,000)]. The ACB of the property is deemed to be $1,500 calculated as [the greater of (actual ACB and floor limit)] or [the greater of ($1,500 and $1,000)]. Jamie's loss is $500, calculated as (deemed proceeds – deemed ACB) or ($1,000 – $1,500). Under ITA 40(2)(g)(iii) his loss for tax purposes is deemed to be $0. So, there are no tax consequences as a result of this transaction.
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Income Tax Planning If the actual proceeds and the actual ACB are both less than $1,000, no capital gain or loss can arise because the deemed proceeds and the deemed ACB will both be $1,000. Refer to IT-332R, Personal-use property, for additional information.
Listed Personal Property
Listed personal property is a subset of personal-use property that includes only the following items (ITA 54): • • • • • a print, etching, drawing, painting, sculpture, or similar work of art jewellery a rare folio, rare manuscript or rare book a stamp a coin
Because listed personal property is a form of personal-use property, the $1,000 floor rule applies. After applying the floor rule, capital gains are taxed as normal. Unlike losses realized on other personal-use property, losses on dispositions of listed personal property can be applied to reduce gains on the disposition of other listed personal property arising in the same taxation year (ITA 41(2)). Any resulting net loss may be carried back against net listed personal property gains of the previous three taxation years and carried forward against such gains in the subsequent seven taxation years. Hannah enjoys collecting paintings to decorate her home, but she tires of them and changes them often. This year, she sold three paintings, as follows: • • • painting #1 resulted in a capital gain of $800 painting #2 resulted in a capital loss of $1,200 painting #3 resulted in a capital gain of $0
Hannah has a net capital loss of $400 from listed personal property, calculated as (capital gain on painting #1 - capital loss on painting #2 + capital gain on painting #3) or ($800 $1,200 + $0). She can carry this loss back three years or forward seven years to apply it against other gains from listed personal property. Refer to IT-332R, Personal-use property, for additional information.
Exercise: Special Situations
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Taxation of Capital Property
Stock Dividends
A stock dividend is a distribution of corporate profits to shareholders in the form of additional shares of the company, rather than as cash, accompanied by an increase in the paid-up capital of the corporation. Tracey originally purchased 1,000 shares of NewCorp Ltd., a CCPC, at a cost of $8.40 per share. When NewCorp distributed a 5% stock dividend, Tracey received 50 additional shares in the company instead of cash. Stock dividends declared and paid after May 23, 1985 are treated as taxable dividends in the year of receipt — subject, of course, to the gross-up and dividend tax credit. For the recipient, the actual amount of the dividend (prior to gross-up) becomes the ACB of the stock (ITA 52(3)). The amount of the stock dividend is the increase in the paid-up capital of the corporation (ITA 248(1) amount). When Tracey received the stock dividend, the increase in the paid-up capital of the stock was $12.45 per share. So, Tracey had dividend income of $622.50, calculated as (additional shares x FMV) or (50 × $12.45), and this amount was subject to the gross-up and dividend tax credit. So, Tracey had taxable dividend income of $778.13, calculated as (dividend income x gross-up) or ($622.50 × 125%). Tracey recently sold all of her shares in NewCorp for $16.70 per share for a capital gain of $8,512.50, calculated as (proceeds - ACB) or ((1,050 × $16.70) – ((1,000 × $8.40) + (50 × $12.45))).
Debts
The Income Tax Act includes special rules for situations where debts are no longer collectable or when the creditor forgives the debt. In the following pages we will look at: • • • capital debts established to be bad debts bad debts on personal-use property forgiven debts
Capital Debts Established to be Bad Debts
A taxpayer may take on the role of creditor if he or she loans property to someone, or sells an asset to someone and has not yet received payment in full. A capital debt receivable is a debt receivable, other than an account receivable, acquired by the taxpayer: • • for the purpose of producing non-exempt income from a business or property as consideration for the disposition of capital property
These capital debts receivable are considered to be capital property, so they can give rise to a capital gain or loss upon their disposition if the taxpayer gets back more or less principal than he or she loaned out. If the taxpayer is virtually certain that he or she will not be able to collect the debts owing, he or she can elect to recognize the debt as a bad debt. The Income Tax Act may offer
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Income Tax Planning some relief to taxpayers who incur bad debts by allowing the resulting loss to be treated as a capital loss for tax purposes. If a taxpayer determines that he or she has a bad debt at the end of a taxation year, he or she can elect to recognize a deemed disposition of that debt at the end of the year for proceeds equal to nil (ITA 50(1)(a)). The taxpayer will also be deemed to have reacquired the debt immediately after the end of the year at a cost equal to nil. Armando made an unsecured loan of $10,000 to ABC Corp. for a five-year period at an annual interest rate of 16%, with the principal to be repaid in a lump sum at the end of the five years. Armando received the interest payments for the first three years and he included that interest in his income as it was received. At the end of the third year, ABC Corp. went bankrupt and Armando learned that his $10,000 would not be repaid. Armando has a bad debt and he can elect under ITA 50(1) to be deemed to have disposed of that debt for proceeds of $0. This will result in a loss of $10,000, calculated as (deemed proceeds - ACB) or ($0 - $10,000). If an actual or deemed disposition of debt gives rise to a loss, that loss will be considered to be a capital loss (ITA 40(2)(g)(ii)), in either of the following situations: • • the taxpayer made the loan for the purpose of gaining or producing income the debt was consideration for disposition of capital property in an arm’s length transaction
Because Armando made the loan for the purpose of earning a high rate of interest, his loss of $10,000 will be considered to be a capital loss, and therefore, he has an allowable capital loss of $5,000, calculated as (capital loss x capital gains inclusion rate) or ($10,000 × 50%). Burton bought a piece of land for $20,000 and last year he sold it to Mr. Bradford for $60,000. He included the taxable capital gain of $20,000 in his income for the year of sale, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($60,000 - $20,000) × 50%). He received a downpayment of $12,000, with the balance to be paid in four annual installments of $12,000. Mr. Bradford subsequently went bankrupt and Burton realized he would not receive any of the four installments. If Burton makes an election under ITA 50(1) to recognize the bad debt, he will have an allowable capital loss of $24,000, calculated as ((deemed proceeds - ACB of remaining payments) x capital gains inclusion rate) or (($0 – (4 × $12,000)) × 50%). If the taxpayer made an error in declaring a debt to be a bad debt, the fact that he or she is deemed to reacquire the debt at a cost of nil at the beginning of the next year will correct his or her oversight. Any recovery will then be a capital gain. Last year, Tina elected to declare a $10,000 debt receivable to be a bad debt, resulting in an allowable capital loss of $5,000, calculated as ((deemed proceeds - ACB) x capital gains inclusion rate) or (($0 - $10,000) × 50%). As a result, she is deemed to reacquire the debt at a cost of $0. In January this year, Tina received proceeds of $6,000 in partial satisfaction of the debt. This year, Tina will have a taxable capital gain of $3,000, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($6,000 - $0) × 50%). Refer to IT-159R3, Capital debts established to be bad debts, for more information.
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Taxation of Capital Property
Bad Debts on Personal-Use Property
If the taxpayer has a bad debt that results from the disposition of personal-use property to an arm’s length person, the Income Tax Act allows the taxpayer to elect a deemed disposition and reacquisition of the debt that will result in a capital loss (ITA 50(2)). However, the capital loss cannot exceed the capital gain that was realized when the property was disposed of. Tracy sold an antique with an ACB of $3,000 to Mr. Crawford, an arm’s length person, for $5,000. This resulted in a capital gain of $2,000, calculated as (proceeds - ACB) or ($5,000 - $3,000). Tracy accepted a downpayment of $1,400, with the balance to be paid in 12 monthly installments of $300. So, the ACB of Tracy’s loan was $3,600, calculated as (number of payments x amount of each payment) or (12 × $300). Tracy never heard from Mr. Crawford again and she was unable to track him down, so she elected to recognize the debt as a bad debt. Although this would give rise to an apparent loss of $3,600, calculated as (deemed proceeds - ACB) or ($0 - $3,600), Tracy can only recognize a capital loss of $2,000, calculated as (the lesser of (the apparent loss and the capital gain that she realized when she sold the property)) or (the lesser of ($3,600 and $2,000)).
Forgiven Debts
If a taxpayer owes money to a creditor, and the creditor forgives the loan completely or allows it to be settled for less than the amount outstanding, the taxpayer may be required to recognize the forgiven amount as a gain for tax purposes. Gains realized when debts are settled or extinguished are often referred to as Section 80 gains because they fall within section 80 of the Income Tax Act, which lays out special tax consequences for debtors with respect to the forgiven amount. For the purpose of applying the forgiveness rules, the forgiven amount is generally calculated as the principal amount of the loan, reduced by any amount paid at the time of settlement in satisfaction of the principal amount. If the taxpayer has a forgiven amount, the Income Tax Act requires this amount to first be applied against non-capital loss and net capital loss carryovers. The taxpayer can elect to use any remaining amount to reduce the capital cost and UCC of certain depreciable property or the ACB of certain property, essentially allowing the taxpayer to defer recognition of the forgiven amount until he or she disposes of that property. Finally, if he or she still has an unused forgiven amount, then 50% of that amount must be included in the taxpayer’s income (ITA 80). Stacey owed $10,000 to Camp Stove Inc., but the corporation forgave her debt. This results in a gain of $10,000 for Stacey. Stacey had a non-capital loss carryover of $3,900. Stacey must use the gain to reduce her non-capital loss carryover to $0, which leaves her with a gain of $6,100, calculated as (total gain - non-capital loss carryover) or ($10,000 - $3,900). This means that Stacey will not be able to use the non-capital loss carryover to offset her other sources of income. The only capital or depreciable property that Stacey owns is a piece of land with an ACB of $44,000 and a current FMV of $80,000. Stacey has two choices. Stacey could choose to
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Income Tax Planning reduce the ACB to $37,900, calculated as (original ACB - remaining gain from the forgiven debt) or ($44,000 - $6,100), and this would result in a higher capital gain when she eventually disposes of the property. Rather than deducting the gain from the ACB of her capital property, Stacey can choose to include $3,050 in her income now, calculated as (remaining gain from the forgiven debt x capital gains inclusion rate) or ($6,100 × 50%). However, she would be able to defer tax if she deducts the amount from the ACB of her capital property because she would not have to recognize the gain until she disposes of that property.
Exercise: Forgiven Debts
Foreign Currencies
A taxpayer who owns assets denominated in a foreign currency can realize a foreign exchange gain or loss as a result of fluctuations in the foreign exchange rate. In some cases, these gains and losses may be considered to be capital gains and losses; in others, they may be considered to be business income. The distinction is important, because gains that are capital in nature are only subject to a 50% inclusion rate. There is also a $200 exemption for capital gains or losses resulting from foreign currency exchanges. Normally, if a taxpayer has transactions in foreign currencies that do not form part of business operations, or that are merely the result of sundry dispositions of foreign currency, the resulting gain or loss will be deemed to be capital in nature. For transactions that are deemed to be capital in nature, foreign exchange gains and losses in excess of $200 are deemed to be capital gains and losses (ITA 39(2)). Janice bought a US $10,000 strip bond for $9,500 U.S., at a time when the exchange rate was 0.71. When the bond matured, the exchange rate was 0.68. When Janice bought the bond, it cost her $13,380 Canadian, calculated as (purchase price ÷ purchase exchange rate) or ($9,500 ÷ 0.71). If the exchange rate had not changed, she would have received the equivalent of $14,085 Canadian, calculated as (face value ÷ purchase exchange rate) or ($10,000 ÷ 0.71). The difference of $705, calculated as (face value at purchase exchange rate - purchase price at purchase exchange rate) or ($14,085 $13,380), is considered to be interest income. In fact, Janice received the equivalent of $14,706 Canadian upon maturity, calculated as (face value ÷ maturity exchange rate) or ($10,000 ÷ 0.68). The foreign exchange gain is $621, calculated as (actual proceeds proceeds at purchase exchange rate) or ($14,706 - $14,085). Janice’s taxable capital gain is $210.50, calculated as ((foreign exchange gain - exemption of $200) x capital gains inclusion rate) or (($621 - $200) × 50%). However, if a foreign exchange gain or loss arises as a direct consequence of the purchase or sale of goods abroad, and such goods or services are used in the business operations of the taxpayer, the gain or loss will be considered to be in the nature of income, subject to inclusion at 100%. Refer to IT 95R, Foreign Exchange Gains and Losses, for additional information.
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Taxation of Capital Property
Exercise: Foreign Currencies
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Special Situations. In this lesson, you have learned how to do the following: • integrate depreciable and personal-use property, stock dividends, debts, and foreign currencies when calculating capital gains or losses
If you are ready to move to the next lesson, click Capital Gains Exemptions on the table of contents.
Assessment
Now that you have completed Special Situations, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 6: Capital Gains Exemptions
Welcome to Capital Gains Exemptions. In this lesson, you will learn about how to integrate the use of applicable exemptions when calculating capital gains or losses. This lesson takes 50 minutes to complete. At the end of this lesson, you will be able to do the following: • integrate the use of applicable exemptions such as capital gains exemptions, principal residence, and former business properties
Capital Gains Exemptions
The Income Tax Act provides relief for taxpayers who dispose of shares of a qualified small business corporation or qualified farm property, in terms of a capital gains deduction that can effectively exempt up to $500,000 of eligible capital gains ($250,000 of taxable capital gains) from tax over the taxpayer's lifetime. The 2006 Federal Budget extended this lifetime capital gains exemption to qualified fishing property. As per the 2007 Federal Budget, the lifetime capital gains exemption was increased from $500,000 to $750,000 ($375,000 of taxable capital gains). This measure took effect on capital gains realized as of March 19, 2007. If a taxpayer is able to make use of the capital gains deduction, he or she is still required to report the taxable capital gains, net of allowable capital losses, as part of his or her income for the year on line 127 of the T1 General tax return. However, the taxpayer may then claim a deduction from his or her taxable income (ITA 110.6) on line 254. Sharon acquired her shares in Pellam Corp., a qualified small business corporation, for $100,000, and she sold them for $980,000. Sharon has never previously used any type of personal tax exemption. Sharon realized a taxable capital gain of $440,000, calculated as [(proceeds – ACB) x capital gains inclusion rate] or [($980,000 – $100,000) × 50%] and she had to include this amount in her income for the year. However, Sharon could then claim a deduction of $375,000, calculated as (unused lifetime capital gains exemption x capital gains inclusion rate) or ($750,000 × 50%), effectively exempting the first $750,000 of her total $880,000 capital gain from tax. What constitutes qualified farm and fishing property was detailed earlier in this unit. A definition of a qualified small business corporation follows.
Qualified Small Business Corporation Shares
A capital gains deduction may be available to any individual, but not a trust, who disposes of a qualified small business corporation share in the current taxation year, or at any time after June 17, 1987. That individual must have been resident in Canada throughout the year (ITA 110.6(2.1)).
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Taxation of Capital Property The definition for a qualified small business corporation offered by ITA 110.6 is extremely complex, but basically it is a Canadian-controlled private corporation that meets the following conditions: • • • All or substantially all (90%) of its assets are used in an active business carried on in Canada. It is owned by the taxpayer, his or her spouse or common-law partner, or a related partnership. During the previous 24-month period, it was not owned by an unrelated person, and more than 50% of the fair market value of the assets of the corporation during that time could be attributed to assets that are used in an active business carried on primarily in Canada.
Shares in a holding company which held all or substantially all (at least 90%) of its assets in the form of qualified small business corporation shares, will be considered to be qualified small business corporation shares. In order to prevent shareholders of a company that seeks to go public from losing out on the extra exemption, shareholders can elect a notional disposition for proceeds anywhere between the ACB and the FMV of the shares and an immediate reacquisition of the shares just before the company goes public (ITA 48.1(1)).
Calculating the Capital Gains Deduction
A taxpayer may be able to claim a capital gains deduction for the current taxation year if he or she has included in his or her income any taxable capital gains that have resulted from the disposition of either qualified farm or fishing property or qualified small business corporation shares (ITA 110.6). In this lesson we will be looking at the different ways of calculating the capital gains deduction, taking into account the taxpayer's unused lifetime limit and cumulative net investment loss (CNIL). Unused lifetime limit The deduction rules will exempt a maximum cumulative lifetime amount of all qualifying capital gains of $750,000, including gains on dispositions of qualifying farm or fishing property, qualifying small business shares, and to the extent the $100,000 LCGE was still available, personal property (ITA 110.6). This translates into a maximum deduction of $375,000 based on the current capital gains inclusion rate of 50%, calculated as (maximum exemption x capital gains inclusion rate) or ($750,000 × 50%). 'So, the taxpayer's ability to claim a capital gains deduction for the current year is limited to his or her unused lifetime limit. This is the deduction that corresponds to the portion of the maximum lifetime capital gain exemption that he or she has not yet used, or 50% of the amount of capital gains for which the taxpayer has not yet claimed an exemption. Maxine is the majority shareholder of Maxicorp, a qualified small business corporation. When she started the business several years ago with capital of $100,000, she was the sole shareholder of the company's 10,000 outstanding shares. The ACB per share is $10 calculated as (capital ÷ # of outstanding shares) or ($100,000 ÷ 10,000). Last year, when the shares were valued at $120, she sold 2,000 shares to her brother, Richard. This
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Income Tax Planning resulted in a taxable capital gain of $110,000, calculated as [((proceeds per share – ACB per share) x # of shares) x capital gains inclusion rate] or [(($120 – $10) × 2,000) × 50%]; she claimed an offsetting capital gains deduction of $110,000. As a result, Maxine's unused lifetime limit at the beginning of this year was $265,000, calculated as (maximum lifetime limit – previous deductions) or ($375,000 – $110,000). This means that she can exempt further capital gains upon the sale of more of her small business shares of up to $530,000, calculated as (unused lifetime limit ÷ capital gains inclusion rate) or ($265,000 ÷ 50%). Later this year, Maxine sells another 2,000 shares to Richard when the shares are valued at $300. This will result in a taxable capital gain of $290,000, calculated as [((proceeds per share – ACB per share) x # of shares) x capital gains inclusion rate] or [(($300 – $10) × 2,000) × 50%]. Since Maxine's unused lifetime limit is only $265,000, she can claim a maximum capital gains deduction of $265,000. Maxine will have to pay tax on $25,000, calculated as [taxable capital gain – unused lifetime limit] or [$290,000 – $265,000].
Cumulative Net Investment Loss (CNIL)
The cumulative net investment loss (CNIL, pronounced "senile") rules were established in 1988 to limit the benefits of the capital gains exemption by preventing an individual from claiming deductions for interest on loans and other investment expenses, as well as claiming the capital gains exemption. For example, if a taxpayer borrowed money and used the proceeds to buy an investment that increased in value, policymakers felt it unfair that he or she had both a deduction for the interest expense and a capital gains exemption. Although the $100,000 lifetime capital gains exemption was eliminated in 1994, the CNIL regulations are still applicable upon dispositions of qualified small business corporation shares or qualified farm or fishing property. The capital gains deduction is, in effect, reduced by the amount of the cumulative net investment loss. In other words, the taxpayer has to pay tax on an amount of taxable capital gains equal to his or her CNIL before he or she can use the capital gains deduction. A taxpayer’s cumulative net investment loss is defined as the amount by which the aggregate of investment expenses exceeds the aggregate of investment income for all taxation years after 1987. In general, investment income includes property income (i.e., dividends, interest and rent), recaptured capital cost allowance, and taxable capital gains that do not qualify for exemption. Investment expenses generally include allowable deductions from property income and rental losses. Several years ago, Jack borrowed $100,000 to invest in equity funds that focused on long-term capital appreciation. In the four years since he made this investment, he has received cumulative taxable income from the fund of $6,000, and has deducted cumulative interest expenses of $31,000 on his tax returns. Jack’s CNIL balance is $25,000, calculated as (cumulative interest expenses - cumulative taxable income) or ($31,000 - $6,000). CNIL was designed to ensure that a taxpayer cannot deduct the expenses of carrying capital property and then also avoid taxation of the gains realized when he sells that property by making use of a capital gains exemption.
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Taxation of Capital Property When the investment is sold, the taxpayer must reduce the resulting taxable capital gain by the CNIL balance before applying the capital gains deduction, to arrive at the amount of the taxable capital gain that qualifies for the taxable capital gains deduction. Joyce borrowed $400,000 to invest in a qualified small business. Over the next five years, she deducted interest expenses of $160,000, but did not receive any investment income. Therefore, she created a CNIL balance of $160,000. She then sold her small business shares for $850,000, resulting in a taxable capital gain of $225,000, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($850,000 - $400,000) × 50%). Without the CNIL rules, Joyce would have been able to exempt the entire $225,000 from tax by using the capital gains deduction in addition to receiving $160,000 in deductions due to her interest expenses. However, the maximum deduction that she can claim is $65,000, calculated as [the lesser of (taxable capital gain and unused lifetime limit) – CNIL balance] or [the lesser of ($225,000 and $375,000) – $160,000]. She will have to pay tax on $160,000, calculated as (taxable capital gain – eligible exemption) or ($225,000 – $65,000). The CNIL balance does not have to result from an investment in a qualified small business corporation in order to impact the taxpayer’s ability to claim the capital gains deduction upon the sale of those business shares. Amanda has a leveraged investment portfolio consisting primarily of growth equity funds, and as a result she has accumulated a CNIL balance of $80,000. Amanda is also the sole shareholder of a qualified small business corporation. She sells her shares in the business and realizes a taxable capital gain of $190,000. As a result, the maximum capital gains deduction that she can claim would be $110,000, calculated as (taxable capital gain CNIL) or ($190,000 - $80,000). If the taxpayer realizes a taxable capital gain, such that it exceeds the maximum capital gains deduction of $370,000 by an amount that is greater than his or her CNIL balance, his or her ability to claim the full deduction will not be impaired. David sold qualifying small business shares with an ACB of $100,000 and an FMV of $1 million, resulting in a taxable capital gain of $450,000, calculated as [(proceeds – ACB) x capital gains inclusion rate] or [($1 million – $100,000) × 50%]. David has a CNIL balance of $67,000; he must deduct this amount from his taxable capital gain before he can determine the amount of his gain that is eligible for exemption. The maximum capital gain deduction that he can claim is $375,000, calculated as [the lesser of (unused lifetime capital gains exemption and (taxable capital gain – CNIL))] or [the lesser of ($375,000 and ($450,000 – $67,000))].
Qualified Farm and Fishing Properties
A capital gains deduction may be available to any individual, but not a trust, who disposes of qualifying farm or fishing property (ITA 110.6(2)). Qualified farm property includes real property (land and buildings, but not machinery) used in a farming business in Canada, shares of a family farm corporation and interests in a family farm partnership (ITA 110.6(1)).
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Income Tax Planning Qualified fishing property includes real property or a fishing vessel used principally in the business of fishing as well as a share of the capital stock of a family fishing corporation or an interest in a family fishing partnership. In order to be eligible as qualified farm or fishing property, certain conditions regarding prior use must be met. The intent of these requirements is to allow the exemption only to individuals for whom farming or fishing is their main activity. Further information about qualified farm and fishing property was provided earlier in this unit.
Exercise: Capital Gains Exemptions/CNIL, Part 1
Exercise: Capital Gains Exemptions/CNIL, Part 2
Principal Residence
In Canada, capital gains on the sale of a principal residence are generally tax exempt. A principal residence is any accommodation owned by the taxpayer (either alone or jointly) and ordinarily inhabited by the taxpayer, his or her spouse or common-law partner, former spouse or common-law partner, or child (ITA 54). A property is ordinarily inhabited by the taxpayer if the taxpayer or his or her family primarily use it for accommodation purposes, as opposed to some other purpose. This does not mean that the taxpayer has to live there for any specified period per year, but merely that the primary purpose should be accommodation instead of producing business or rental income. As long as the taxpayer spends more time living in the residence than renting it or using it for business purposes, it would likely be considered to be primarily used for accommodation purposes. Tammy rents an apartment in Vancouver and she owns a chalet in Whistler. She spends about ten weekends at the chalet throughout the year, plus another four weeks in the summer. She rents the chalet out for two weeks each year. Tammy can still designate the chalet as her principal residence, even though it is not where she normally lives, and even though she receives incidental rental income.
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Taxation of Capital Property In the following pages we will look at: • • • • • • • Type of accommodation Limit of one principal residence per family unit Claiming the exemption Two residences prior to choosing which property to designate Change of use Renting out a principal residence Changing a rental building into a principal residence
Type of Accommodation
Many different types of dwellings can be designated as a principal residence, including a house, a farm, a condominium or a share in a co-operative housing corporation. A principal residence includes not only the building, but also the land on which it is located, usually up to a limit of ½ hectare, although larger lots may be considered in certain circumstances. Limit of one principal residence per family unit From the time capital gains first became taxable after 1971, each individual has been able to claim only one property as his or her principal residence at any one time. So, if a taxpayer owns two properties, only one of them may be designated as his or her principal residence for a particular year. Originally, it was possible for each spouse or common-law partner to designate a different property as his and her principal residence. However, for taxation years after 1981, only one property per family unit can be designated as a principal residence. The family unit generally includes the taxpayer, his or her spouse or common-law partner and his or her children (unless they are married or over 18 years of age). Where spouses or common-law partners own their home jointly, each will have to designate his or her share of the property as a principal residence for the eventual gain on re-sale to be exempt from tax.
Claiming the Exemption
A taxpayer does not have to designate a property as his or her principal residence from year to year, but only when he or she disposes of the property. To determine if a taxable capital gain will arise, the taxpayer must first calculate the capital gain. As with any capital property, the capital gain is calculated as the proceeds of disposition minus the sum of the adjusted cost base and the costs of disposition. He or she can then reduce the gain by a principal residence exemption, which is calculated using the following formula (ITA 40(2)(b)):
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Income Tax Planning Calculating the number of years between two dates The number of years between two dates is calculated as (most recent year – earliest year + 1). The plus one factor in the numerator of the principle residence exemption formula is a bonus feature designed to allow for the situation where an individual sells one house and buys another house in the same taxation year. While a taxpayer cannot designate both houses as a principal residence in the same taxation year, the bonus feature in fact gives them a year of overlap. No portion of the gain will be taxable unless the property failed to qualify as a principal residence in more than one taxation year after 1971. In 1993, Fern purchased a house for $126,000. Early in 2010, she sold it for $410,000, resulting in a capital gain of $284,000, calculated as (proceeds – ACB) or ($410,000 – $126,000). In 2004, Fern sold a cottage, and designated the cottage as her principal residence from 1991 to 2003. She can only designate the house as her principal residence from 2004 to 2010, or seven years, calculated as (2010 – 2004 + 1) even though she has owned the house for 18 full or partial years, calculated as (2010 – 1993 + 1). Fern can exempt $126,222 of the capital gain on her house, calculated as [((N1 + 1) ÷ N2) x capital gain] or [((7 + 1) ÷ 18) × $284,000]. In 2010, Fern must report a taxable capital gain of $78,889, calculated as [(capital gain – principal residence exemption) x capital gains inclusion rate] or [($284,000 – $126,222) × 50%]. Refer to IT-120R4, Principal Residence, for more information. Sheltering the entire capital gain The entire capital gain realized from the sale of a principle residence can be exempt from taxation if the number of years the property is designated as a principal residence after 1971 equals the number of years of ownership after 1971 minus 1.
Two Residences Prior to 1982
Until 1982, one spouse could own and designate the family’s usual home as a principal residence, and the other spouse could designate another property as his or her principal residence, provided each property met the test of being ordinarily inhabited by the owner. The rules changed such that beginning in 1982, each family unit could only designate one property as their principal residence. However, this change was not retroactive, so a couple can still designate two properties prior to 1982. Frank and Regina are married; they bought their house in 1973 and a cottage in 1979. They sold both properties in 2010. Frank and Regina can designate their house as a principal residence for the nine years from 1973 to 1981, calculated as (1981 – 1973 + 1). They can also designate their cottage as a principal residence for the three years from 1979 to 1981, calculated as (1981 – 1979 + 1). However, for the 29 years between 1982 and 2010, calculated as (2010 – 1982 + 1). Frank and Regina–being a family unit–can only designate one property as a principal residence at
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Taxation of Capital Property any given time. They must decide which dwelling should be designated as their principal residence in order to maximize the value of the exemption.
Choosing which Property to Designate
If a taxpayer and his or her spouse owned more than one property after 1982, they can only designate one property as their principal residence for any given taxation year. However, they do not have to designate their place of normal residence as their principal residence. They can choose to designate a second vacation property as their principal residence, provided that they occupy it occasionally throughout the year. They also do not have to designate consistently the same property as their principal residence from year to year. They may split the principal residence exemption between the two properties if it is to their advantage. A principle to remember is: in a year when there is a choice as to which property to designate as a principal residence, select the one with the higher average annual appreciation.
Exercise: Principal Residence
Change of Use: Principal Residence
A change of use of property, from non-income producing to income producing or vice versa, would normally give rise to a deemed disposition at FMV. However, special rules may apply when that property is or was the taxpayer’s principal residence. Renting out a principal residence If a taxpayer wants to move out of his or her principal residence, rent it out, and perhaps later re-occupy the property, he or she can file an election to continue to have the property considered a personal-use property and thus continue to designate the property as his or her principal residence (ITA 45(2)). This election avoids a deemed disposal at fair market value when the principal residence becomes a rental property and a second deemed disposal when the property is re-occupied and again becomes a principal residence. The taxpayer can designate the property as his or her principal residence for up to an additional four years, even though the taxpayer does not live in it, provided he or she remains resident (or is deemed to remain resident) in Canada and does not designate some other property as his or her principal residence. The only restriction is that while the election is in effect, the taxpayer cannot claim any capital cost allowance (CCA) on the property to offset any rental income received (ITA 54, Principal Residence, (d)). In 1993, Tiffany purchased a house in Nova Scotia. She lived there continuously until 2006 at which time, she decided to attend a graduate studies course at the University of Toronto. She decided to rent out her house in Nova Scotia and take a rental apartment in
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Income Tax Planning Toronto for the three-year study period. As long as Tiffany files a no-change-of-use election under ITA 45(2) and does not claim any CCA from the rental income generated by her house in Nova Scotia, she can continue to designate the house as her principal residence until and including 2010, calculated as (2006 + 4). The taxpayer does not have to reoccupy the house at the end of the four years in order to validate the original election. Beyond the four years, the no-change-of-use election will continue to apply unless the taxpayer revokes it; there is no deemed disposition at that time, but the principal residence designation normally ceases. So, when the taxpayer disposes of the property at a later date, part of the resulting gain may be taxable.
Change of Use: Rental Residence
It is important to remember that the no-change-of-use election under ITA 45(2) can only be made if the property was initially a non-income producing property. If the property was purchased as a rental property and then later occupied by the owner, a deemed disposition at fair market value will occur at the date the property ceases to be a rental property (ITA 45(1)). However, the Income Tax Act allows the taxpayer to file an election that designates the rental property as his or her residence for up to four years prior to the year in which he or she actually occupied it, as long as the taxpayer has met the following conditions: • • • The taxpayer has not claimed any CCA on the property after 1984. The taxpayer has not designated another property as his or her principal residence during that time. The taxpayer was resident in Canada during the election period (ITA 45(3)).
Jeremy bought a house in 1998 for $162,000 and rented it to a third party until June 30, 2007. The following month he moved into the house in filed a no-change-of-use election under ITA 45(3). In 2010, Jeremy sold the house for $232,000, realizing a capital gain of $70,000, calculated as (proceeds of disposition – ACB) or ($232,000 – $162,000). Jeremy owned the house for a total of 13 years, calculated as (2010 – 1998 + 1). He can designate the house as his principal residence for the four years that he actually inhabited the house, calculated as (2010 – 2007 + 1). He can also file an election designating the house as his principal residence for a maximum of four years prior to the year it became his principal residence, from 2003 through 2006. So, Jeremy can claim a principal residence exemption of $48,462, calculated as [((N1 + 1) ÷ N2) x capital gain] or [(((4 + 4) + 1) ÷ 13) × $70,000]. He will have a taxable capital gain of $10,769, calculated as [(capital gain – principal residence exemption) x capital gains inclusion rate] or [($70,000 – $48,462) × 50%].
Former Business Properties
The Income Tax Act allows for a deferral of all or part of the capital gain upon disposition if the disposition is in fact an exchange of business properties (ITA 44(1)). The Income Tax Act defines a former business property as real property (i.e., real estate), other than certain rental properties, that is used primarily by the taxpayer or someone related to the taxpayer for the purpose of earning business income (ITA 248(1)). If a taxpayer disposes of a former business property, he or she may be able to defer the capital gain that would otherwise occur if he or she purchases a replacement property by no later
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Taxation of Capital Property than the end of the following taxation year. The capital gain is deferred to the extent that the proceeds of disposition are used to acquire the replacement property. Jeff runs a financial planning practice, but he needs to move it to another city because his wife has been transferred. His existing office had an ACB of $146,000 and he sold it for $199,000. Normally this would result in a capital gain of $53,000, calculated as (proceeds - ACB) or ($199,000 - $146,000). However, Jeff purchased a new office in the new location for $180,000. Jeff can defer part of his capital gain under the rollover provision of ITA 44(1), but because his new office cost less than the amount he received for his old office, he will have to report a capital gain of $19,000, calculated as (proceeds from sale of old business property - cost of new business property) or ($199,000 - $180,000). He can defer the remaining capital gain of $34,000, calculated as (cost of new property - ACB of old property) or ($180,000 $146,000). The adjusted cost base of the replacement property is reduced by the amount of the capital gain on the former property that would otherwise be determined, minus any capital gain that the taxpayer is required to report. The ACB of Jeff’s replacement office for the purpose of calculating future capital gains or losses upon its disposition is $146,000, calculated as (cost of new property - (total capital gain on old property - reported capital gain)) or ($180,000 – ($53,000 - $19,000)). Refer to IT-259, Exchanges of property and IT-491, Former business property, for additional information.
Capital Property Owned Dec 31, 1971
Prior to 1972, capital gains were not subject to tax. A taxpayer may own property that was acquired prior to 1972, and the Income Tax Act recognizes the gains and losses that may have occurred prior to the introduction of capital gains tax. In order to recognize that a capital asset held at the start of the capital gains system on January 1, 1972 might have had a FMV that was significantly different than its original cost, the government designated two valuation days (V-Days): • • December 22, 1971, for publicly-traded common and preferred shares, rights, warrants and convertible bonds December 31, 1971 for all other capital property
CRA publishes a booklet called Valuation Day Prices of Publicly Traded Shares for taxpayers who need to determine the value of their stock holdings on December 22, 1971. This information is also included in Schedule VII of the Regulations to the Income Tax Act. When the property is subsequently sold, the V-Day value is used in determining the deemed ACB of property that was owned at the end of 1971. The default method imposed by the Income Tax Act makes use of the concept of the tax-free zone: essentially, the spread in price between the original cost and the V-day value. Using the tax-free zone method, the ACB will be the median (or middle) amount of these three amounts: cost, V-day value and proceeds of disposition (ITAR 26(3)). To illustrate, let us look at four different situations.
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Income Tax Planning Tax-free Zone Method Property Proceeds of disposition Original Cost V-Day Value Deemed ACB A $130 $100 $120 $120 B $115 $100 $120 $115 C $95 $100 $120 $100 D $95 $120 $100 $100
In situation A, the property had increased in value by $20 between the time of acquisition and the introduction of the capital gains system. Under the tax-free zone method, the ACB is the V-day value of $120, and the resulting capital gain on disposition is $10, calculated as (proceeds - deemed ACB) or ($130 - $120). As a result, the $20 gain that occurred between the time of purchase and the introduction of the capital gains system is exempt from tax. In situation B, the property had also increased in value by $20 between the time of acquisition and the introduction of the capital gains system, but since that time it has dropped in value. The ACB is deemed to be the middle value of $115, which happens to be the proceeds of disposition. Because the proceeds of disposition and the deemed cost are the same, no gain will result. In situation C, the property once again increased in value by $20 between the time of acquisition and V-Day, but then it dropped significantly to below the original cost. The ACB is the middle value of $100, which is the same as the original cost. The owner will realize a capital loss of $5, calculated as (proceeds - deemed ACB) or ($95 - $100), even though the property dropped in value by $25 since V-Day. So, while the tax-free zone method effectively exempts gains earned prior to 1972, it will not recognize post-1971 losses until they exceed the pre-1972 gains. In situation D, the property decreased in value from the time of acquisition until V-Day, and continued to decline in value after that time. The V-Day value of $100 is the median amount, so it is the ACB. Even though the taxpayer suffered an overall loss of $25 (based on $120 original cost), he can only claim a capital loss of $5, calculated as (proceeds deemed ACB) or ($95 - $100). The median rule cannot be used for an interest in a partnership or depreciable property. For these properties, the taxpayer must use the V-day value. Refer to IT-84, Capital property owned on December 31, 1971 – Median rule (tax-free zone), for additional information.
Election to use V-Day Values
The tax-free zone method is the default method for calculating the ACB of property owned on December 31, 1971. However, an individual can elect to have the ACB for each capital property owned at the end of 1971 to be equal to its V-Day value instead of the amount arrived at under the tax-free zone method (ITAR 26(7)). As a general rule, where properties held at the end of 1971 had values above their original costs, the use of the election is likely to be advantageous. However, the election must be made with the individual’s tax return for the first taxation year after 1971 in which he or she disposes of any of his or her pre-1972 holdings. If the taxpayer does not make the election, he or she must use the tax-free zone method for all pre-1972 holdings. If the election is made, he or she cannot later revert to the tax-free zone method.
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Taxation of Capital Property Note: The election to use V-Day values only applies to individuals. Corporations must use the tax-free zone method.
Identical Properties
Identical properties are properties that are the same in all material respects, such that a prospective buyer would not have a preference for one as opposed to another. The most obvious example is shares in a corporation, but other examples include gold bullion and gold certificates, or bonds and debentures with the same terms and time to maturity, or units or shares in a mutual fund. Other examples of identical properties are discussed in IT-387R2, Meaning of Identical Properties. Sometimes a taxpayer acquires identical properties at different times at different costs. Special rules are applicable to determine the ACB of identical properties for purposes of determining any capital gain or loss on their disposition. The rules depend on whether any of the property was acquired prior to 1972. There are two types of identical properties: • • identical properties acquired after 1971 identical properties acquired prior to 1972
Identical Properties Acquired After 1971
The cost of each identical property acquired after 1971 is calculated on a moving average basis, which means that a new average cost for each property is calculated at the time of each purchase. Two years ago, Jack purchased his first 100 shares of Sample Corp. at a cost of $25 per share. At that time, his average cost per share was $25. Last year, he bought another 200 shares of Sample Corp. at a cost of $26 per share and earlier this year, he bought another 150 shares at a cost of $28 per share. His average cost per share is $26.44, calculated as [(number of shares x purchase price per share) ÷ total number of shares] or [((100 × $25) + (200 × $26) + (150 × $28)) ÷ (100 + 200 + 150)]. If Jack wants to sell some of his shares, it does not matter which ones he sells, because the shares are identical properties. If he sells 200 shares at $30 per share, he will realize a capital gain of $712, calculated as [(proceeds per share – ACB per share) x number of shares] or [($30 – $26.44) × 200]. His remaining shares would still have an ACB of $26.44 per share because dispositions do not affect the average cost of the shares.
Identical Properties Acquired Prior to 1972
It gets more complicated when some or all of the identical properties were acquired prior to V-day. When someone has identical properties, some of which were acquired prior to 1972 and some after 1971, the Income Tax Act assumes there are two separate pools of properties: one that was held on December 31, 1971, and one that consists of properties acquired after that date. Dispositions made after December 31, 1971 are considered to be from the pre-1972 pool first, and from the pool of post-1971 properties only after the pre1972 pool is exhausted.
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Income Tax Planning David currently holds a total of 550 shares in Combat Inc. and he acquired the shares as follows: Pre-1972 • 300 shares with an average cost of $12.33
Post-1971 • • for $2,400, he purchased 150 shares in 1973 at $16 each for $1,800, he purchased 100 shares in 1974 at $18 each
Furthermore, the V-Day value of the shares is $15 per share. David must use the tax-free zone to determine the deemed cost when he disposes of the shares. His ACB for his post-1971 pool is $16.80 per share, calculated as ((number of shares x purchase price per share) ÷ total number of shares) or ((150 × $16) + (100 × $18)) ÷ (150 + 100)). If David sells 400 shares in Combat Inc. at $32 per share, his deemed cost for his pre-1972 pool will be $15, calculated as the median of the proceeds ($32), the V-Day value ($15), and the average cost ($12.33). Harry is deemed to have sold all of his pre-1972 shares first, so 300 of the 400 shares that he sold have a deemed cost of $15, and the remaining 100 shares have a deemed cost of $16.80. Harry will realize a capital gain of $6,620, calculated as ((proceeds - ACB) or ((400 × $32) – ((300 × $15) + (100 × $16.80))). Refer to IT-78, Capital property owned on December 31, 1971 – Identical Properties, for additional information.
Exercise: Identical Properties
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Taxation of Capital Property
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Capital Gains Exemptions. In this lesson, you have learned how to do the following: • integrate the use of applicable exemptions such as capital gains exemptions, principal residence, and former business properties
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Capital Gains Exemptions, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Review
Let’s look at the concepts covered in this unit: • • • • • • The Role of Property in Wealth Accumulation Calculating Capital Gains and Losses Dispositions Losses Special Situations Capital Gains Exemptions
You now have a good understanding of the taxation of capital property. At this point in the course you can explain the role of property in tax planning and wealth accumulation, calculate capital gains and losses, and calculate the impact of disposition. You can also integrate the use of applicable exemptions as well as other factors when calculating capital gains or losses. Click Assessment on the table of contents to test your understanding
Assessment
Now that you have completed Unit 7: Taxation of Capital Property, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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I FP
Unit 8: Making Use of Tax Advantages
Income Tax Planning
Unit 8: Making Use of Tax Advantages
Welcome to Making Use of Tax Advantages. In this unit, you will learn about the types of tax advantages that an investment can generate and the trade-offs that exist between various benefits. You will also learn how to calculate the benefits of tax advantages for a client. This unit takes approximately 2 hours to complete. You will learn about the following topics: • • • Tax Advantages Investment Benefits Choosing the Right Tax Advantages
To start with the first lesson, click Tax Advantages on the table of contents.
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Making Use of Tax Advantages
Lesson 1: Tax Advantages
Welcome to Tax Advantages. In this lesson, you will learn about the methods of using tax advantages and the benefits of tax advantages for your client. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • compare and contrast tax evasion and tax avoidance describe methods of using tax advantages assess and calculate the benefits of tax advantages for a client
Tax Advantages
A tax-disadvantaged investment is an investment that generates income that is fully taxable in the taxation period, regardless of whether the income has actually been received in cash, or has been earned but not yet paid. It offers no deductions other than those representing cash expenses during the taxation period. Marie is currently in a 50% marginal tax bracket. In January, she invested $200,000 in a money market fund. She earned interest income of $14,000 by the end of the year, or 7% before tax, calculated as (before-tax income ÷ amount invested) or ($14,000 ÷ $200,000). After-tax, Marie will only have $7,000 left, calculated as (taxable income x (1marginal tax rate)) or ($14,000 × (1 – 50%)). So, her after-tax return is 3.5%, calculated as (after-tax income ÷ amount invested) or ($4,000 ÷ $200,000). Marie has made a tax-disadvantaged investment, because the full amount of the interest income must be included in her taxable income for the current tax year. Marie had no way of avoiding taxation because there are no tax exemptions for interest income. She had no choice but to report the income in the current year, and the full amount of the income is subject to tax at her marginal rate. Could Marie have chosen a different investment with tax advantages? The answer is, of course, yes. Different investments can offer one or more of the following tax advantages: • • • avoidance conversion deferral
Therefore, a tax-advantaged investment is an investment that enables the investor to avoid, convert, or defer taxable income. We will look at each of these characteristics in turn.
Avoidance
Tax avoidance vs. tax evasion There is a difference between tax avoidance and tax evasion. Tax evasion is the commission or omission of an act knowingly with the intent to deceive so that the tax reported by the taxpayer is less than the tax payable under the law, or a conspiracy to commit such an offence (IC-73-10R3, Tax Evasion). This may be accomplished by the deliberate omission of revenue, the fraudulent claiming of expenses or allowances, and the deliberate
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Income Tax Planning misrepresentation, concealment, or withholding of material facts. Tax evasion is a criminal act and it can result in criminal charges (ITA 239(1)). In cases of legitimate tax avoidance, a taxpayer, in seeking a beneficial result, has merely implemented a certain course of action that is either clearly provided for, or not specifically prohibited, in law. Investments that provide an opportunity for tax avoidance are taxadvantaged. Avoidance through capital gains exemptions The primary way of avoiding taxes is making use of the capital gains exemptions provided in the Income Tax Act, for capital gains realized upon the disposition of: • • • a principal residence shares in a qualified small business corporation qualifying farm or fishing property
Marie purchased a house for $200,000 that served as her principal residence. If she sold the house for net proceeds of $214,000 at the end of the year, as in the previous example, she would realize a 7% before-tax return, calculated as ((proceeds - ACB) ÷ ACB) or (($214,000 - $200,000) ÷ $200,000). However, in this instance, the full amount of the gain would be exempt from taxation. Therefore, her after-tax return would also be 7%. Avoidance through Life Insurance Other avoidance possibilities are presented by life insurance. The beneficiary of a life insurance policy can avoid income tax on the mortality gain reflected in a matured policy’s proceeds. Unfortunately, an investor must die to avoid tax through life insurance.
Conversion: Capital Gains
Conversion refers to an investment that changes highly taxed income into more favourably taxed income. The conversion of ordinary income to capital gains usually requires an investment that produces deductions that offset ordinary income and produces capital gains on its eventual sale. In other words, the ordinary income from the investment that escapes tax through deductions comes back later as a capital gain on the sale of the investment. On January 1st, last year, Sean borrowed $100,000 to invest in equity mutual funds. The interest rate on the loan was 8% and his interest expense for last year was $8,000, calculated as (amount of loan x interest rate) or ($100,000 × 8%). This interest expense can be deducted from any of his other sources of income. Sean's employment income for last year was $120,000 and his marginal tax rate was 40%. So, he saved $3,200 in income tax, calculated as (interest expense x marginal tax rate) or ($8,000 × 40%), due to the interest expense deduction. This year, Sean plans to sell his shares in the mutual fund and he expects to realize a capital gain of $15,000. This will result in a taxable capital gain of $7,500, calculated as (capital gain x capital gains inclusion rate) or ($15,000 × 50%). If his marginal tax rate remains at 40%, he will pay $3,000 of income tax, calculated as (taxable capital gain x marginal tax rate) or ($7,500 × 40%).
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Making Use of Tax Advantages
Therefore, by deducting the interest expense last year and reporting a taxable capital gain this year, Sean will effectively convert some of his employment income, which is 100% taxable, into capital gains, which are only 50% taxable. He will also achieve an element of deferral, which we will discuss later.
Conversion: Shifting Tax Brackets
Conversion can also refer to any movement of income from a high marginal tax bracket to a lower marginal tax bracket. If a taxpayer can time the receipt of income to fall in a lowincome year, then it will be subject to a lower tax rate. It is January and Jerome expects to have $92,000 of taxable income taxed at a marginal tax rate of 37% this year. He will retire at the end of the year. He has $45,000 in a savings account that pays 3% annual interest. If he leaves this amount in the savings account, he will have $1,350 of taxable interest income this year, calculated as (principal x interest rate) or ($45,000 × 3%). Jerome is planning to retire on December 20th. Next year, he expects to have $27,000 of taxable income taxed at a marginal tax rate of 22%. He can convert the interest income from a 37% tax rate to a 22% rate if he can postpone the taxation of the income until the following year. All he has to do is purchase a one-year $45,000 strip bond that matures next year. The interest will accrue annually according to the bond's anniversary day, so the interest will not be taxable until next year. By doing so, he has realized both conversion and deferral.
Exercise: Tax Avoidance and Conversion
Deferral
Tax deferral is postponing the recognition of income and thereby deferring the payment of income taxes. It is similar to an interest-free loan from the government. There are several ways to achieve tax deferral: • • • • • timing of receipts capital appreciation deductions from current income registered savings present value of future taxes
We will discuss each of these methods in more detail on the following pages.
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Income Tax Planning
Timing of Receipts
It is sometimes possible to take advantage of the accrual rules to defer the receipt or the recognition of income to a following year. It is January 2nd and Phoebe has $100,000 to invest. She could put the money in a money market fund that will pay interest income of 5%. This year, she would have to report approximately $5,000 of taxable income, calculated as (principal x interest rate) or ($100,000 × 5%). Alternatively, Phoebe could purchase a new one-year bond (or GIC) with a 5% coupon. If the bond only pays interest annually, Phoebe would not have to report the interest income of $5,000 until she receives it next year.
Capital Appreciation
Capital appreciation provides a significant opportunity for deferral. While a capital asset may appreciate in value year by year, that appreciation does not become taxable income until the asset is sold and the gain is realized, which may be many years following the date of purchase. Several years ago, Bill purchased 1,000 shares of Blueblood Inc. at $26 per share for a total cost of $26,000. The shares are currently trading at $78 per share and have a fair market value of $78,000. Although Bill has an apparent gain of $52,000, calculated as (FMV – ACB) or ($78,000 – $26,000), it is an unrealized gain and this appreciation will not be taxable until he disposes of the shares.
Deductions from Current Income
In several situations, the Income Tax Act allows an investor to make deductions from current income, even though the investment is not producing any current income and may not produce any income until a future gain is realized. By taking advantage of these deductions, the taxpayer can defer tax on current income to a future time. We will examine some of the more common deductions that can be used to realize a tax deferral: • • • partnership losses capital cost allowance interest expense
Partnership losses When a partnership realizes a loss, each partner can deduct his or her share of the loss from his or her current income, thereby reducing his or her current taxable income. However, by doing so the partner decreases the adjusted cost base of his or her partnership interest, which will increase his or her gain (or at least decrease the extent of his or her loss) when he or she eventually disposes of the partnership interest.
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Making Use of Tax Advantages George, who has an MTR of 40%, acquired an interest in a partnership for $200,000. During the first three years of business, the partnership operated at a loss and George's share of the loss was a total of $26,000 per year. Each year, George was able to deduct $26,000 from his other sources of income, thereby saving $10,400 in income taxes each year, calculated as (loss deducted x marginal tax rate) or ($26,000 × 40%). However, by realizing the losses, George also reduced the ACB of his partnership interest to $122,000, calculated as (original ACB - total losses deducted) or ($200,000 - ($26,000 × 3)). George sold his interest in the partnership at the end of the third year for $180,000. This resulted in a capital gain of $58,000, calculated as (proceeds - adjusted ACB) or ($180,000 - $122,000), of which only 50% would be subject to tax. Therefore, George realized both a deferral and conversion. Capital cost allowance 'If a taxpayer acquires a depreciable capital property, he or she is not able to deduct the full cost of that property from his or her income as a current expense. Instead, the taxpayer is allowed to deduct a maximum amount of capital cost allowance (CCA) based on the undepreciated capital cost (UCC) of the asset at the beginning of the year. By claiming CCA, the taxpayer reduces his or her current taxable income. However, the taxpayer also reduces his or her UCC, and if he or she later sells the asset for an amount greater than the UCC, he or she will realize a recapture and possibly also a capital gain. Mario originally purchased a rental property for $800,000, with $500,000 attributed to the building. Over the period that he owned the building, he claimed CCA of $132,000. Because he had a 50% marginal tax rate, this saved him about $66,000 in taxes, calculated as (CCA deductions x marginal tax rate) or ($132,000 × 50%). Mario recently sold the property for $780,000 with $480,000 attributed to the building. His UCC for the building is $368,000, calculated as (capital cost - CCA deducted) or ($500,000 $132,000). Mario will realize a recapture of $112,000, calculated as (proceeds - UCC) or ($480,000 - $368,000), and this full amount will be taxed at his marginal rate. Mario has achieved deferral, but not conversion. Interest expenses If a taxpayer borrows money to acquire property that has the potential to produce business or property income, the interest expense is deductible from any of his or her current sources of income. Henry borrowed $100,000 to invest in an equity mutual fund. Although the primary objective of the fund is capital appreciation, he can deduct the interest expense from his current income because the mutual fund can potentially provide him with dividends or interest income (both forms of property income). If Henry later sells the shares in the fund for $160,000, he will have to include $30,000 in his taxable income, calculated as (proceeds - ACB) x capital gains inclusion rate) or (($160,000 - $100,000) × 50%). Henry has achieved deferral and conversion.
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Income Tax Planning
Registered Savings
Registered savings plans, including RRSPs, registered pension plans, deferred profit sharing plans, and some annuities also provide an excellent deferral opportunity. Money contributed to a registered plan and earnings on plan assets are not subject to tax until they are withdrawn. If the taxpayer is in a lower tax bracket when the funds are withdrawn, he can also achieve an element of conversion. Fiona has an MTR of 43%. If she contributes $10,000 of her employment income to an RRSP, she will save $4,300 in tax, calculated as (RRSP contribution x marginal tax rate) or ($10,000 × 43%). Any income earned by her contribution while it is in the plan will not be subject to tax. If Fiona leaves the money in the plan for ten years and it earns 8% before tax, she will have $21,590 in the plan, calculated by entering DISP = 0, P/YR = 1, ×P/YR = 10, I/YR = 8%, PV = -$10,000, PMT = $0 and solving for FV. If Fiona withdraws the entire amount and her MTR during retirement is 27%, she will pay $5,829 in tax at that time, calculated as (taxable withdrawal x marginal tax rate) or ($21,590 × 27%).
Exercise: Tax Deferral
Present Value of Future Taxes
It is true that deferral does not avoid taxes; it simply postpones them until some time in the future. How can we be sure this really saves the investor money in the long run? We have to consider the present value of both the taxes avoided and the taxes that will have to be paid. Marvin contributed $20,000 to his RRSP at a time when his MTR was 43%. Because of the resulting deduction, he was able to save $8,600 in income taxes on his current tax return, calculated as (RRSP contribution x marginal tax rate) or ($20,000 × 43%). Marvin expects to retire in another 20 years. Let us suppose that he is still in a 43% marginal tax bracket when he retires, and that he withdraws $20,000. At that time, he will have to pay tax of $8,600. On the surface, it looks like Marvin did not save anything. However, the present value of those future taxes, assuming a conservative discount rate of 4%, is $3,925, calculated by entering DISP = 0, P/YR = 1, ×P/YR = 20, I/YR = 4%, PMT = $0, FV = $8,600 and solving for PV. The value of Marvin’s deferral is $4,675, calculated as (present value of current taxes - present value of future taxes) or ($8,600 - $3,925). If he is in a lower tax bracket during retirement, he will realize conversion as well.
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8-7
Making Use of Tax Advantages
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Tax Advantages. In this lesson, you have learned how to do the following: • • • compare and contrast tax evasion and tax avoidance describe methods of using tax advantages assess and calculate the benefits of tax advantages for a client situation
If you are ready to move to the next lesson, click Investment Benefits on the table of contents.
Assessment
Now that you have completed Tax Advantages, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 2: Investment Benefits
Welcome to Investment Benefits. In this lesson, you will learn about the benefits that can be provided by an investment, including cash flow, tax benefits, and appreciation. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the benefits of different investments and their respective trade-offs calculate the potential relationship between different investment benefits for a given situation or strategy
Investment Benefits
Investments can also be categorized according to the benefits they provide to the investor. The benefits to the investor will come in three forms: • Cash flow is the actual after-tax cash distributed to or realized by the investor while he or she holds the investment and when he or she liquidates the investment. Tax benefits are the tax savings generated by the investment. These benefits flow from the initial deductions provided by many tax-advantaged investments, as well as deductions generated over the life of the investment, such as interest costs, depreciation, and depletion allowance. Appreciation is the actual rise in the value of an investment.
•
•
All successful tax-advantaged investments will provide some combination of these three benefits.
Trade-offs Between Investment Benefits
The three investment benefits (cash flow, tax benefits, and appreciation) are interrelated, such that an increase in one benefit is usually achieved to the detriment of the other two. When looking for a new investment for a wealth accumulation plan, the investor will have to decide whether he or she wants: • • • an increase in cash flow accompanied by a reduction in tax benefits and appreciation an increase in tax benefits accompanied by a reduction in cash flow and appreciation an increase in the potential for appreciation accompanied by a reduction in cash flow and tax benefits
Exercise: Investment Benefits
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Making Use of Tax Advantages
Looking For Tax Advantages
Different investments offer different benefits and tax advantages to the investor. At what point, should an investor consider looking for tax-advantaged investments? This is not really the right question to be asking. The true test of whether anyone should invest in tax-advantaged investments is whether the end result will be a greater increase in wealth than with alternative investments. A taxadvantaged investment is, after all, an investment and must be judged in the same way as any other investment. Tax advantages are considerations among many other considerations that must be taken into account in judging the potential final return of an investment. While there is no special rule that specifies when a taxpayer should seek out taxadvantaged investments, there are many factors to be considered when trying to match the right investment to a specific taxpayer.
Investor's Income
The first step in deciding whether a particular individual should consider tax-advantaged investments is a careful evaluation of that individual’s income. Income level Obviously, a person who requires every after-tax dollar to maintain his or her lifestyle is not a candidate for any type of investment; he or she does not have to worry about tax advantages just yet. His or her first goal should be to restructure his or her spending habits and to start a regular savings program. Income stability The predictability of a potential investor’s income is also an important consideration. An investor should have a good idea of what his or her income will be for the next several years. Many tax-advantaged investments, particularly real estate, require payments over several years. Investors who are unsure of future income should exercise caution before committing to a vehicle that may require several years of investment. Start simply There are alternatives to using complex tax-advantaged investments as tax-saving strategies. Strategies such as income splitting through partnerships and retirement savings plans may provide all the tax advantages a particular investor needs or will be able to use. Delilah earns $32,000 a year and after meeting all of her current needs, she has $2,000 of discretionary income remaining. An RRSP probably provides all the tax advantages she can use.
Liquidity
In addition to income level, a potential investor’s liquidity must also be assessed before embarking on a tax-advantaged investment program. Liquid assets, such as cash or marketable securities, should not be diverted to tax-advantaged investments if the investor needs access to these funds in an emergency.
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Income Tax Planning Many tax-advantaged investments are, as a rule, highly illiquid: • • In order to preserve their partnership tax status, many limited partnerships restrict the right of partners to freely transfer their partnership interests. Securities laws restrict the transfer of unregistered securities, and most taxadvantaged investment interests obtained through private placements are unregistered securities. There is no secondary market for most tax-advantaged investments. Even if there are no legal restrictions on its sale, most investors will have difficulty finding a buyer for an interest in a tax-advantaged investment.
•
Sandra is self-employed. She has $40,000 in a money-market fund as an emergency fund in case her business takes a bad turn. She is thinking about using the $40,000 as a downpayment on a rental property. Through CCA and the interest on the mortgage, she is confident she will be able to reduce her taxable rental income to zero. However, Sandra should think twice about pursuing this strategy. If her self-employment income declines and she requires additional funds, she will have difficulty withdrawing her money from the rental property due to its lack of liquidity. Adding to the issue of liquidity, is the possible adverse tax consequences from a premature disposal of a tax-advantaged investment. Even a tax-advantaged investment that makes both tax sense and economic sense, may not be the right investment for an individual who may need his or her assets to be liquid for emergencies or other purposes.
Risk
Tax-advantaged investments are, as a general rule, riskier than other forms of investment. If this were not so, there would be no need for the tax advantage offered by these investments. If an investor cannot afford to potentially lose the money invested in a taxadvantaged investment, it may be more prudent for the investor to pay his or her taxes and invest the balance in safer alternative investments.
Psychology
Just as some investors do not have the risk tolerance needed to invest in the stock market, some investors are psychologically unsuited for tax-advantaged investments. Beside the ever-present risk of losing one’s investment, by holding a tax-advantaged investment, the taxpayer may increase the chances of being audited by Canada Revenue Agency. Some investors may not be comfortable with the greater likelihood of an audit due to the writeoffs associated with tax-advantaged investments. An investor who cannot accept this increased risk is not a candidate for tax-advantaged investments.
What's so Different?
Of course, all these considerations – income, liquidity, risk, and psychology – are present in any investment decision. Therefore, when looking for an investment that provides tax advantages, we return to evaluating the suitability of the investment in light of the investor's tax profile. The degree to which the various considerations influence an investment decision may vary, but the basic considerations are the same.
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Making Use of Tax Advantages
Exercise: Looking for Tax Advantages
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Investment Benefits. In this lesson, you have learned how to do the following: • • describe the benefits of different investments and their respective trade-offs calculate the potential relationship between different investment benefits for a given situation or strategy
If you are ready to move to the next lesson, click Choosing the Right Tax Advantages on the table of contents.
Assessment
Now that you have completed Investment Benefits, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Choosing the Right Tax Advantages
Welcome to Choosing the Right Tax Advantages. In this lesson, you will learn about the factors you should consider when determining what tax advantages to look for on behalf of your client. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: • recommend a particular type of investment strategy given a client’s objectives and financial information
Choosing the Right Tax Advantages
All successful tax-advantaged investments will provide some combination of cash flow, tax benefits, and appreciation. An investor can choose: • • • an investment that will yield greater cash flow but with a reduction in tax benefits and appreciation one that will yield greater tax benefits but with a reduction in cash flow and appreciation one that will yield greater potential for appreciation but with a reduction in cash flow and tax benefits
The choice, of course, will depend on the particular investor’s investment objectives. Also, an investor can choose a selection of different types of tax-advantaged investments to provide a balance of cash flow, tax benefits and potential for appreciation.
Investor's Objectives
In order to choose among the types of tax-advantaged investments that offer varying degrees of cash flow, tax benefits, and appreciation, an investor must know what he or she wants to accomplish with an investment program. Generally, an investor embarking on a tax-advantaged investment program will have one or more of the following objectives in mind: • • • • avoiding taxes deferring a tax liability providing current funds building equity for the future
Avoiding Taxes
Many investors simply dislike paying taxes, regardless of the rate at which those taxes are imposed. Given a choice between a tax-advantaged investment and an alternative investment that offers a similar after-tax return, these investors would choose the investment that results in a smaller tax liability. This is obviously a short-sighted investment objective. How much an investor pays in taxes should not matter, as long as that investor gets to keep more than he or she would from an alternative investment. In any event, an
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Making Use of Tax Advantages investor seeking to avoid taxes will choose tax-advantaged investments in which the tax benefits predominate.
Deferring a Tax Liability
An investor who is paying taxes at the highest marginal rates may want to defer a portion of his or her tax liability to some point in the future when he or she will have a lower income and a lower marginal tax rate. Cash flow is obviously a secondary consideration for this type of investor. They will concentrate on tax-advantaged investments that offer more in the way of tax benefits such as deductions from current income and the potential for capital appreciation. Deferral shelters that offer front-end deductions, such as flow-through shares and some real estate deals, may help this type of investor achieve his or her objective. Another possibility is some longer-term investment that offers write-offs to offset current income and the chance for appreciation that will be taxed as a capital gain. Conventional real estate is a possible choice.
Providing Current Funds
An investor who is looking for current spendable income will have cash flow uppermost in his or her mind. This type of investor will want an investment that produces current income while offering current deductions to shelter this income from taxation. This objective can often be met through residential or commercial real estate. Shafik has $200,000 to invest. He would like the investment to generate current income because he has an extravagant lifestyle. However, he is already in a high marginal tax bracket, so he prefers a situation where any additional cash flow will not be subject to tax at this time. If Shafik invested the money in bonds at 8%, he could get current income of $16,000, calculated as (principal x coupon rate) or ($200,000 x 8%), but the entire amount of this interest income would be taxed in the year it is earned or received. Instead, Shafik could use the money to purchase a rental property, with perhaps $150,000 allocated to the building and $50,000 to the land. If Shafik could rent this property for $1,333 per month, he would have the same income of $16,000 that he could get by investing in the bond, calculated as (monthly rental income x 12 months) or ($1,333 x 12). However, in this instance, he could claim CCA of about $6,000, thereby sheltering at least some of the rental income from tax.
Building Equity for the Future
An investor who wants to build equity for the future may have to forego cash flow and tax benefits. An investor with this objective in mind is usually not overly concerned with current income or write-offs to reduce taxable income from other sources. The investor will be looking for investments that will grow in value. Again, certain real estate investments may be what this investor wants to achieve his or her objective. Equity investments, including mutual funds that concentrate on long-term capital growth, may also be appropriate.
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Income Tax Planning
Exercise: Investor's Objectives
Investor's Tax Profile
The four possible objectives of a tax-advantaged investment program are not mutually exclusive. An investor may have more than one objective, in which case he or she will look for a mix of investments that will produce the right blend of tax avoidance, tax deferral, current income, and equity growth based on his or her individual tax profile. Once an investor has determined the objectives for the tax-advantaged investment program, he or she must take a careful look at his or her tax profile. Having certain objectives is one thing, but achieving those objectives can be profoundly influenced by the investor’s tax situation. Because every taxpayer is in a different situation, a tax-advantaged investment that can achieve a certain objective for one investor will not necessarily achieve the same objective for another investor. An investor’s tax profile is simply all the factors that affect the calculation of that investor’s tax liability. Obviously, the investor’s marginal tax rate, and not just the investor’s tax bracket for the current year, is of prime importance. Also, their expected marginal rates for future years up to the time a tax-advantaged investment program ends must be taken into account as should federal and provincial income tax rates. In addition to tax rates, all the tax mechanisms that affect tax advantages must be considered. This entails looking at not only total current income but also the sources and types of that income. For example, tax preferences can subject an individual to the alternative minimum tax. An investor with tax preferred income may want to avoid additional investments that will produce more tax preferences.
High-Income Investors
An individual with passive income currently taxed at the top marginal rate may want to consider tax-advantaged investments that offer the most in the way of tax benefits. The investor who expects to remain in the highest brackets for many years should consider some longer-term investment that offers a high degree of shelter. A possible choice is certain commercial real estate that offers tax benefits in the early years and requires investors to commit themselves for many years.
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Making Use of Tax Advantages Alternative Minimum Tax (AMT) The intent of AMT is to ensure that high-income taxpayers pay their fair share of taxes in any given year by limiting the tax effect of certain tax preferences. These tax preferences result from the special tax treatment provided to: • • • • CCA claimed on Canadian films depletion and resource allowances from mining and oil and gas capital gains dividends from taxable Canadian corporations
Although a carryforward of AMT is provided, additional investments that generate tax preferences may not make sense for an investor who is already subject to AMT. There are tax advantages that do not incur AMT treatment. These include interest expense deductions, CCA on properties other than films, and many others. The investor usually has control over the timing of when capital gains are realized. Accordingly, a range of tax advantages is still available, but they must be carefully managed to avoid any penalties from the AMT.
Special Windfalls
An investor may be faced with a large amount of income at one time but may not expect future income to remain at such high levels. Although this investor may be subject to the same tax rates as the high-income investor, at least for the current year, he or she is not going to be attracted to nor will they have the need for the same investments as the investor who expects to remain taxed at a high rate for many years. This investor will want to avoid the kinds of investments that are attractive to the long-term, high-income individual, so long-term investments are not an option. Rather, this investor will be looking to find tax advantages in short-term deferral investments.
Approaching Retirement
For many people, their peak earning years will be the years just before retirement. These people face the prospect of high taxes for several years, followed by a substantial reduction in their income upon retirement. The tax-advantaged investment program for such an individual can not only defer current taxes but can also provide some appreciation that can be realized in his or her post-retirement years. By deferring the realization of income to their retirement years, when the taxpayer will presumably be in a lower tax bracket, he or she will also realize a degree of conversion. A blend of tax-advantaged investments may be the best approach for this investor.
Loss Carryovers
Occasionally, an individual suffers a major capital loss. Under the Income Tax Act, the amount of capital losses an individual can deduct in a year is limited to the amount of capital gains realized. If an investor is faced with a capital loss carryover that will likely never be used up, investing in tax-advantaged investments with the potential for significant capital gains may be a prudent choice.
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Income Tax Planning
In Summary
There are many different tax profiles; each will affect the choice of the tax advantages that will best suit the investor’s needs. The appropriate choice of investment depends on the investor's particular tax profile. You must carefully analyze this profile to see how different types of tax-advantaged investments can accommodate the particular investment objectives of the investor.
Exercise: Investor's Tax Profile
Picking the Particular Investments
Once investors establish the types of tax-advantaged investments that best suit their needs, they are ready for the hard part of the selection process — picking the particular investments out of the many available in both public offerings and private placements. There are good, bad, and sometimes even fraudulent investments available for every type of tax-advantaged investment. The true test of an investment is whether it provides a greater return in line with the investor’s objectives than other investments, taking into account the effect of the investor’s tax profile on an after-tax basis. In other words, no investment should be selected unless it is likely to enhance the investor’s wealth and well-being. But how does an investor measure the return from a tax-advantaged investment? In some cases, an investment may yield current taxable income; in other circumstances, it may yield current deductions and future capital gains, or some other mixture of benefits. How do you compare these investments? Many measures of return are available but perhaps the simplest and best method is to compare the net present value of alternative investments.
Calculating the NPV
In order to use net present value (NPV) as the measure of worth of a tax-advantaged investment, all costs and benefits are converted to their present value at some assumed interest rate. The interest rate could be one of the following: • or • a rate similar to the return on the investor’s typical portfolio the after-tax rate of return on safe investments
The latter approach allows the investor to compare a proposed tax-advantaged investment with his or her current return. Following this procedure, an investor can tell if a taxadvantaged investment makes economic sense if the investment performs as advertised. If
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Making Use of Tax Advantages the investment cannot beat its current return by performing as advertised, then it can be eliminated from consideration.
Exercise: Calculating NPV, Part 1
Exercise: Calculating NPV, Part 2
Exercise: Calculating NPV, Part 3
Exercise: Calculating NPV, Part 4
Exercise: Calculating NPV, Part 5
The Limitations of Net Present Value
The evaluation in the previous exercise, Calculating the Net Present Value of an Investment, was straightforward. This evaluation can become much more complicated if the investor’s tax profile changes over time. This can occur, for example, if his or her marginal tax rate fluctuates over the period that he or she holds and redeems the investment.
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Income Tax Planning
Reducing cash flows to net present value provides a method for gauging the economic merits of a proposed investment as well as a method of comparing competing investments. The method, however, does not provide the ultimate answer as to whether an investor should or should not invest. An investor still must evaluate the economic and tax risks of a proposed tax-advantaged investment and their own tax situation. Only then will the investor be able to decide which tax-advantaged investment, if any, is best.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Choosing the Right Tax Advantages. In this lesson, you have learned how to do the following: • recommend a particular type of investment strategy given a client’s objective(s) and financial information
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Choosing the Right Tax Advantages, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Making Use of Tax Advantages
Review
Let’s look at the concepts covered in this unit: • • • Tax Advantages Investment Benefits Choosing the Right Tax Advantages
You now have a good understanding of how to make use of tax advantages. At this point in the course you can assess and calculate the benefits of tax advantages for a client situation, describe methods of using tax advantages, and describe the benefits of different investments and their respective trade-offs. You can now recommend a particular type of investment strategy given your client’s objective(s) and financial information. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 8: Making Use of Tax Advantages, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Reviewing the Course Learning Objectives
Click the link to see a list of learning objectives for the course in the order that they have been presented.
Each learning objective is part of the performance expected of you as a financial planner and of the objectives have been derived from the Financial Planning Standards Council’s required performance objectives. Reading through the list helps you remember the content of the lessons. But in order to improve your skills there is more to it than that. Follow these steps: 1. 2. 3. 4. Review each of the learning objectives one at a time. Ask yourself if you can achieve it. If you are confident, move on to the next one. If you are not sure, mark it for review.
If you recognize that there is a learning need associated with the learning objective, then go back to that content and do the exercises again.
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Income Tax Planning
Assessment
Now that you have completed the Income Tax Planning course, you are ready to assess your knowledge. You will be asked a series of 100 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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The Canadian Institute of Financial Planning
Now owned and operated by Financial Planners
Income Tax Planning
(FP2ITP)
CIFP - FINANCIAL PLANNING 2
M1C11V10 ITP 01/10
Income Tax Planning
The Canadian Institute of Financial Planning 3660 Hurontario, Suite 600 Mississauga, Ontario L5B 3C4 Tel: 1-866-635-5526 www.CIFP.ca
This printed text material is a facsimile of the online text. It is to be used in conjunction with the online course.
© 2010, Canadian Institute of Financial Planning All rights reserved. No part of this publication may be reproduced in any form without written permission from the Canadian Institute of Financial Planning.
Table of Contents
Unit 1: Introduction to Income Tax Planning.................................................... 1-1
Lesson 1: Money Management .....................................................................................................1-2 Lesson 2: Understanding Credit ..................................................................................................1-29 Lesson 3: Income Tax Basics .........................................................................................................1-43 Lesson 4: Completing an Income Tax Return.............................................................................1-47 Lesson 5: More on Completing an Income Tax Return .............................................................1-54 Lesson 6: Integrating Income Tax Planning and Financial Planning ......................................1-59
Unit 2: Proprietorships and Partnerships ........................................................... 2-1
Lesson 1: The Role of Businesses in Wealth Accumulation .....................................................2-2 Lesson 2: Partnerships ...................................................................................................................2-8 Lesson 3: Partnerships and Income Tax ......................................................................................2-16 Lesson 4: Limited Partnerships ....................................................................................................2-26 Lesson 5: Business Income ............................................................................................................2-35
Unit 3: Corporations ............................................................................................... 3-1
Lesson 1: Defining a Corporation ................................................................................................3-2 Lesson 2: Types of Business Corporations ..................................................................................3-6 Lesson 3: Shares and Shareholders ..............................................................................................3-12 Lesson 4: Organizational Structure of a Corporation................................................................3-18 Lesson 5: Corporate Taxation 1 ....................................................................................................3-25 Lesson 6: Corporate Taxation 2 ....................................................................................................3-41 Lesson 7: Taxation of Shareholders .............................................................................................3-52 Lesson 8: Corporations as Wealth Accumulation Vehicles for the Owner/Manager ..........3-58
Unit 4: Income Tax Planning and Research ....................................................... 4-1
Lesson 1: Residency and Installment Payments ........................................................................4-2 Lesson 2: Deadlines, Penalties, and Review ...............................................................................4-10 Lesson 3: Income Tax Planning and Research............................................................................4-21 Lesson 4: Miscellaneous Deductions ...........................................................................................4-28
Unit 5: Taxation of Employees and Alternative Minimum Tax .................... 5-1
Lesson 1: Types of Employment Income and Taxable Benefits ...............................................5-2 Lesson 2: Fringe Benefits not Included in Income .....................................................................5-13 Lesson 3: Employee Stock Option Plans .....................................................................................5-23 Lesson 4: Alternative Minimum Tax ...........................................................................................5-30
Unit 6: Taxation of Property Income ................................................................... 6-1
Lesson 1: Interest, Dividends, and Income Earned ...................................................................6-2 Lesson 2: Rental Income ................................................................................................................6-10 Lesson 3: Capital Cost Allowance ................................................................................................6-17 Lesson 4: Disposing of Depreciable Property.............................................................................6-26 Lesson 5: Other Deductions from Business and Property Income ..........................................6-36 Lesson 6: Income Attribution Rules.............................................................................................6-43
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Unit 7: Taxation of Capital Property ................................................................... 7-1
Lesson 1: The Role of Property in Wealth Accumulation .........................................................7-2 Lesson 2: Calculating Capital Gains and Losses ........................................................................7-10 Lesson 3: Dispositions ...................................................................................................................7-21 Lesson 4: Losses ..............................................................................................................................7-33 Lesson 5: Special Situations ..........................................................................................................7-41 Lesson 6: Capital Gains Exemptions ...........................................................................................7-49
Unit 8: Making Use of Tax Advantages .............................................................. 8-1
Lesson 1: Tax Advantages .............................................................................................................8-2 Lesson 2: Investment Benefits.......................................................................................................8-9 Lesson 3: Choosing the Right Tax Advantages ..........................................................................8-13
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Income Tax Planning
Preassessment
This Preassessment is an optional tool to help you make efficient use of your time. It allows you to test yourself before you start the course. You can use it to identify content that you are already familiar with, and areas where you will need to focus more attention. You will answer 100 questions covering the general areas of study. After you answer all of the questions, you can click Submit to see your score. Your score will not be tracked; it is for your information. If you would like to do the Preassessment now, click the Preassessment link. If you do not want to do the Preassessment, click Course Overview on the table of contents to start the course.
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Income Tax Planning
Course Overview
Welcome to the Income Tax Planning course. This course will provide you with the knowledge and judgment to guide your clients in managing their business and investment assets. This requires an understanding of the economic issues, business activities, investment products, their tax implications, and numerous management strategies. After completing this course, you will be familiar with the following: • • • • • • • various money management strategies and the different types of consumer credit the structure and taxation of various business forms, including proprietorships, partnerships, and corporations the deadlines for filing tax returns, the impact of filing late, and the major components of the federal and provincial tax legislation the taxation of employment income and benefits, including ways to increase an individual’s compensation without necessarily increasing his or her taxable income the taxation of investment income, including property income (interest, dividends, and rent) and capital gains as well as the important deductions available for various income sources how economics affect the accumulation of wealth how an individual can make use of the different tax strategies available to maximize his or her wealth accumulation
To continue, click the Next button in the bottom, right corner of the screen.
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I FP
Unit 1: Introduction to Income Tax Planning
Income Tax Planning
Unit 1: Introduction to Income Tax Planning
Welcome to Introduction to Income Tax Planning. In this unit, you will learn about money management strategies, the different types of consumer credit, and fundamental terminology associated with personal income taxation. You will also learn how to perform various tax calculations, as well as describe the implications of tax planning in financial planning. This unit takes approximately 4 hours to complete. You will learn about the following topics: • • • • • • Money Management Understanding Credit Income Tax Basics Completing an Income Tax Return More on Completing an Income Tax Return Integrating Income Tax Planning and Financial Planning
To start with the first lesson, click Money Management on the table of contents.
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Introduction to Income Tax Planning
Lesson 1: Money Management
Welcome to Money Management. In this lesson, you will learn about the different perceptions that different people have about money, and how those perceptions affect their money management decisions. You will also learn about how you can use money wisely through cash flow management, budgeting, and the cautious use of credit. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: • • • • • describe how people perceive money, and how those perceptions affect their management styles explain how various financial statements are used in the money management process identify typical money management strategies collect and analyze your client’s money management information, including statement of lifestyle expenditures and statement of cash flow assist your client in identifying money management objectives
Overview
Technically, money is a medium of exchange or a measure of value that you can use to pay for goods and services and to settle debts. Money in our society is, in its most basic sense, an economic necessity. You need money to purchase the things that you require for your survival and well being. However, money is also a motivator of human behaviour, and it means different things to different people. Depending on the person, money may symbolize power, security, freedom, self-respect, happiness or even love. The way that you perceive money significantly influences the way that you manage it. This influence can be either positive or negative, in that it may help or hinder your ability to meet your financial goals. The money management process is an essential component of any financial planning process. In fact, good money management mirrors the five-step financial planning process. Because the use of credit is so prevalent in our society, credit management is a critical component of sound money management. This lesson discusses the range of perceptions that people have about money, and how those perceptions affect their money management decisions. It also provides information on how you can use money wisely through cash flow management, budgeting and the cautious use of credit.
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Income Tax Planning
Personal Money Perceptions
Everyone has different values or perceptions about money and the role that it plays in their lives. Though most people have similar perspectives, some people have more extreme values and perspectives. Some examples of these extremes are: • Value of money: To some people, money means security, and the need to save money controls most of their financial decisions. To others, money means freedom and a way to do whatever they please, right now, today, without any thought of what is needed for tomorrow. Risk tolerance: Some people are so afraid of risking their future financial security that they shun all but the most conservative of savings vehicles, or even worse, keep their cash hidden away at home. Others are quite flamboyant about their investments, and are tantalized and tempted by get-rich schemes that are almost certainly doomed to failure. Credit: Some people consider credit to be a natural extension of their personal bank account. They believe that they must be in a strong financial position as long as someone is willing to advance them credit. Others refuse to enter into any kind of credit arrangement, even when it is justified for a modest house purchase, or when borrowing money for investment purposes makes good sense.
•
•
As an adult, your own approach to money has likely been influenced by your parents, family members, cultural background, and your financial experiences. For example, if the lack of money was a frequent cause of bitter parental disputes when you were growing up, you may have come to believe that building your savings and financial security is a priority. On the other hand, if money never seemed to be a problem when you were growing up and your parents never discussed the issue in front of you, you might have developed a more carefree attitude towards money management. Caroline, a 35-year-old lawyer, is the only child of a successful professional couple. She works 60-hour weeks and has an income of $150,000 per year. She owns a beautiful home in an exclusive part of town, drives a BMW and belongs to the best clubs. However, she has a huge mortgage on her house and she leases her BMW. She has $250 in the bank, a $23,000 outstanding balance on her credit card and lives from paycheque to paycheque. In contrast, David is a 50-year-old engineer. He was born and raised along with his six siblings in rural Ontario, and he was always taught the value of saving. David is the president of an engineering company, and he also works very hard to earn $150,000 per year. He owns a comfortable home in a good part of town and drives a four year old Chevrolet. He has fully paid for both his house and car. He does not believe in credit cards and pays for everything in cash unless travelling on company business. David has always contributed the maximum to his RRSP and has invested other savings in blue chip stocks. As a result, he has built a portfolio worth $850,000. A fundamental underlying element of the money management process is understanding your own perceptions about money so that you can work to overcome any biases that may be hindering the achievement of your financial objectives.
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Introduction to Income Tax Planning
Financial Planning Process
As seen in other courses, the financial planning process consists of 6 basic steps.
Money Management and the Financial Planning Process
Money management is an essential component of any financial planning process. You need to have income to be able to sustain your lifestyle. Effective money management will help ensure that you will have some money left over, after paying for basic necessities and taxes to implement your long-term financial strategies. The money management process is similar to the 6-step financial process. However, in this lesson we will discuss the money management process from your perspective and eliminate the establishment of the client-planner relationship. The 5-steps of the money management process are as follows:
Although it is similar to the financial planning process, the focus of the money management process is narrower. It deals with the management of cash over the relatively short term (days, months or a few years) and it includes debt and credit management. It does not deal with many of the broader and longer term issues covered by a comprehensive financial plan, such as insurance, estate planning, the appreciation of capital assets or the tax implications of owning a second property. As with the financial planning process, the steps in the money management process are somewhat flexible and they occasionally overlap. Step 1 and Step 2 (setting objectives and data collection) are particularly inter-related. Each of these steps as it applies to money management is discussed further in the following sections.
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Income Tax Planning
Step 1: Defining Your Money Management Objectives
An objective is a financial state or position that you want to achieve. Well-defined objectives are critical to the success of any money management plan. They provide your plan with a sense of purpose, and a benchmark against which you can measure your progress.
When you develop a personal financial plan, your objectives tend to be long range and all encompassing. They may include building financial security, financing a larger home, minimizing life risks, planning for retirement or distributing your estate. When you develop a money management plan, your objectives are likely to be specifically oriented towards cash, and focused on a shorter time frame. Some examples of money management objectives include: • • • • paying off an outstanding credit card debt avoiding bank overdraft and NSF (non-sufficient funds) charges by improving the management of your income and expenses establishing an emergency fund or saving $1,000 over the next six months to pay for a vacation
Some money management objectives may relate directly to strategies in your broader financial plan, such as having sufficient money available each month to contribute towards your retirement. Two of Robert and Joanne Smiths’ financial objectives are for Robert to contribute $3,430 to a spousal RRSP and for Joanne to contribute $2,578 to her own RRSP. One of the Smiths’ money management objectives could therefore be to set aside sufficient cash each month to implement these strategies. Money management objectives must be realistic in view of your level of income and expenses. The objective of having $1,000 left over each month to put towards your savings when your annual household income before tax is $27,000 and you have two children and a mortgage is not realistic. However, objectives should also require some moderate effort on your part to be worthwhile. As with the broader financial planning process, it is imperative that you and your spouse or common-law partner agree on your money management objectives. Through discussion and compromise, you must both identify and establish priorities for your objectives, and agree to commit yourselves to your cash management plan.
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Introduction to Income Tax Planning
Step 2: Collecting and Analyzing Information
In order to determine if your objectives are realistic, you must have a good understanding of your current income and expenses. This exercise can also help you determine if you have any chronic money management problems, such as excessive use of credit cards or a consistently overdrawn bank account.
A number of common financial statements are useful in both the financial planning process and the money management process. These include the following: • • • • statement of net worth balance sheet statement of lifestyle expenditures statement of cash flow
Each statement is described in more detail on the following pages.
Statement of Net Worth
Net worth is the best single measurement of your financial condition and resources at a specific point in time.
By preparing a statement of net worth - also referred to as a statement of financial position- every year, you will be able to see the financial growth or decline that you have achieved. A statement of net worth includes a summary of your liquid assets, investment assets and personal assets, along with any related debt obligations, as shown in the example for Robert and Joanne Smith in the following table.
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Income Tax Planning Note: It is accepted industry practice that negative numbers in tables are indicated by parenthesis. For example, the short-term obligations: (6,200) in the table below. Sample Statement of Net Worth For Robert and Joanne Smith as at December 31st
The table also shows an equity ratio for each set of assets. An equity ratio is the ratio of net assets (assets – liabilities) to total assets.
The equity ratio for your liquid assets and short-term debts provides a measurement of your ability to pay short-term obligations as they come due. Your equity ratio for your investment assets indicates the extent to which you are leveraging your investments. If you can earn a higher rate of return on the funds that you borrowed than the cost of borrowing the funds, you are earning money with other people’s money. Your equity ratio for your personal assets is a measure of the extent to which you have borrowed to finance these purchases. The interest on these debts is usually not tax deductible. Robert and Joanne have personal assets worth $208,000, with outstanding loans of $106,000, the equity ratio for their personal assets is 49%, calculated as ((personal assets outstanding loans) ÷ personal assets) or (($208,000 - $106,000) ÷ $208,000).
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Introduction to Income Tax Planning In addition to providing an overall measure of your financial health, your statement of net worth documents the amount of cash or other liquid assets that are available to be managed.
Balance Sheet
The balance sheet is similar to a statement of net worth, although the information is presented in more detail and is organized somewhat differently, as shown in the example, below. Like the statement of net worth, your balance sheet provides an overview of your financial situation at a single point in time. The balance sheet is of limited use as a financial planning tool because it does not readily show how various strategies could affect your financial situation. However, it is useful in the money management process because it provides a clear picture of your assets and liabilities, including short-term debt obligations that are of particular concern in money management. The following table includes the Smiths’ balance sheet for two consecutive years, which shows how they have repositioned their assets and liabilities over that time. For example, they have: • • • • • made significant contributions to their RRSPs sold their cottage sold the rental property and used part of the proceeds to eliminate the mortgage on their house purchased another rental property with part of the purchase price provided by a mortgage loan increased the balance on their credit cards
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Income Tax Planning Balance Sheet Robert and Joanne Smith as at December 31st
Last Year ASSETS Liquid Assets Cash Short-term investments Other liquid investments $ 5,300 4,200 1,265 10,765 Investment and Business Assets RRSP – Robert RRSP – Joanne Registered Pension Plan Canada Savings Bonds Common shares Rental property Mutual funds Other investments 28,720 500 14,500 10,000 4,500 95,000 32,000 0 185,220 Personal Assets Residence Furnishings Vehicles – two cars Cottage Other personal assets 125,000 17,000 21,000 35,000 10,000 208,000 137,500 17,000 21,000 0 10,000 185,500 36,300 6,860 17,140 0 5,000 99,750 36,000 21,000 222,050 $ 3,392 0 2,776 6,168 This Year
Total Assets
$ 403,985
$ 413,718
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Introduction to Income Tax Planning
Tax Deduction for Interest Expense
Interest on a loan is deductible from taxable income if and only if the proceeds of the loan are used to produce business or investment income. In the case of Robert and Joanne Smith, their residence was not an income producing investment and therefore, the interest on the mortgage on their residence was not tax deductible. Similarly, had they simply taken out a loan secured by a mortgage on their previous rental property and used the proceeds to pay off the mortgage loan on their residence, the interest on this new loan would not be deductible because the proceeds were not directly used for investment purposes. The interest on their new mortgage loan however, is tax deductible because the proceeds were used to purchase a new investment property.
Exercise: Money Management
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Income Tax Planning
Statement of Lifestyle Expenditures
Your statement of lifestyle expenditures shows how much money you pay to sustain your current lifestyle. It also includes the interest charges that are associated with financing major capital purchases, such as a house or a car. However, it does not include income taxes or any capital transactions that increase or decrease your personal, business or investment assets. The following table provides the Smiths’ statement of lifestyle expenditures for two consecutive years. One of the major changes of note here is that, since they shifted their mortgage obligations from their home to their rental property, the interest expense no longer shows up on their statement of lifestyle expenditures. Also, in response to recommendations from their financial planner, they have increased their life and disability insurance coverage. Statement of Lifestyle Expenditures Robert and Joanne Smith for the Year Ending December 31st Last Year This Year
Mortgage (interest only) Property taxes Insurance Utilities Maintenance Garden Upkeep Housing Costs
$ 8,460 1,900 700 2,300 1,600 500 $15,460
$0 1,995 735 2,415 1,600 500 $ 7,245
Food Household expenses Telephone Personal care Clothing Other Food, Household, etc.
4,600 700 900 1,200 4,300 500 $12,200
4,830 735 900 1,260 4,500 500 $12,725
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Last Year Car payments (interest only) Insurance Gasoline Maintenance Public Transportation Transportation 1,400 700 2,100 1,200 500 $ 5,900
This Year 1,100 770 2,200 1,200 550 $ 5,820
Entertainment Eating out Gifts Fees, Accounting, etc. Holidays Other Discretionary
1,500 1,200 1,400 1,700 1,200 5,300 $12,300
1,500 1,200 1,400 1,800 1,200 0 $ 7,100
Medical expenses Life and disability insurance Payroll deductions (sundry) Bank Charges (including overdraft & NSF charges) Credit Card Interest Other Miscellaneous
600 300 1,800 240 580 1,320 $ 4,840
650 1,000 2,000 270 630 1,600 $ 6,150
Basic Lifestyle Expenditures
$ 50,700
$ 39,040
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Statement of Cash Flow
Your statement of cash flow is perhaps the most important piece of information for money management purposes. It describes all money flows over a period of time, including all sources of income, taxes, lifestyle expenditures, investments, the interest expenses associated with those investments, mortgage, and loan principal repayments and money received from the sale of assets. It shows whether you have any cash left over at the end of the reporting period, and is a useful place to start when preparing a budget. The following table is the Smiths’ Statement of Cash Flow for two consecutive years. In addition to showing how their cash flow has been reallocated over the two years, it demonstrates that they have actually reduced their income tax by over $400, despite an increase in total income of over $4,500. This can largely be attributed to their RRSP contributions and the fact they shifted their mortgage obligation from their personal residence (where the interest expense is not tax deductible) to their rental property, (where the interest expense offsets rental income). Statement of Cash Flow Robert and Joanne Smith for the Year Ending December 31st Last Year This Year
Cash from Sources of Income Employment and self-employed income Pension income Dividends, interest, and rents $ 72,000 0 12,015 84,015 Cash Outlays for Expenses Income taxes Lifestyle expenditures Interest expense for investments Other cash outlays for expenses Unaccounted for difference in cash (17,520) (50,700) (5,160) 0 430 (72,950) (17,104) (39,040) (11,640) 0 44 (67,740) $ 76,500 0 12,045 88,545
Cash flow from income and expenses
11,065
20,805
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Cash Flow from Net Investment Assets RRSP – Robert RRSP – Joanne Registered Pension Plan Canada Savings Bonds Common shares Rental property Mutual Funds Other investments Investment Loans (2,420) (500) (1,080) 0 0 0 0 0 (500) (4,500) Cash Flow from Net Personal Assets Residence Furnishings Vehicles - two cars Cottage Other personal assets Loans to purchase personal assets 0 0 00 0 (500) (3,500) (4,000) 35,000 0 (96,200) (61,200) 0 0 (4,250) (5,818) (1,134) 10,000 0 0 0 (20,000) 54,000 32,798
Total Cash from All Activities
$ 2,565 $ (7,597)
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How Much Information and How Often?
The amount of information that you compile (6 months’ worth or 3 years’ worth?) and the level of detail will depend on the quality of your records, the complexity of your situation, and the time and money you are willing to commit to the task. For example, in simple cash management cases, it may be sufficient to prepare a statement of cash flow on an annual basis. However, in situations where your income or your expenses may fluctuate significantly from month to month or season to season, or when you will be preparing a detailed budget, you may wish to document your cash flow on a monthly or quarterly basis. If you have trouble managing credit or discretionary spending, you may want to provide a very detailed breakdown of your expenditures.
Step 3: Identifying Money Management Strategies
The more Canadians earn, the more they tend to spend. Regardless of their income, many people tend to shy away from the financial planning process because they feel that they barely have enough money to meet their immediate needs, let alone extra money for investment or savings purposes. As a result, money management is a critical first step for many people undertaking the financial planning process. By adopting some of the money management strategies discussed in the next few pages, you may find that you do have discretionary cash to meet your financial objectives.
Pay yourself first Experience has shown that if you do not plan to save first, you will likely not save at all. Planning to save what is left over does not seem to work because there is rarely anything remaining after expenses. Therefore, one of the simplest and most successful money management strategies is to pay yourself first, which involves earmarking a portion of your income for savings before any expenses are paid. To reduce the temptation to spend, arrange to have the savings deducted directly from your pay or arrange to have the money transferred automatically from your chequing account to an investment account. This is called a preauthorized chequing arrangement or PAC. A PAC can also be used to purchase mutual funds.
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Introduction to Income Tax Planning Account for your expenditures Many people have only a vague idea of how they spend their money. When you collect the information on your expenses and cash flow, you may be surprised to learn how much you spend on incidentals like take-out food at lunchtime or magazines. Pay particular attention to those items that you tend to lump in the miscellaneous category. You may want to reconsider whether these miscellaneous expenditures are necessary to maintain your lifestyle.
Limit Available Cash
A large balance in your wallet or everyday bank account may be money that is "burning a hole in your pocket". Reduce the temptation to spend this money by transferring it to a savings vehicle, leaving only the cash necessary to cover your planned expenditures easily accessible. Do not be too strict on yourself While the strategies discussed to this point are effective and important, take care not to go overboard and deny yourself any discretionary expenses or make yourself accountable for every penny spent. A miscellaneous component is a realistic and essential part of any money management system, provided it is held to a reasonable and justifiable percentage of total expenditures. As in dieting, overly strict denial will doom your best intentions. Use credit wisely Credit has become a part of our everyday life as we can use it in one form or another to purchase just about every type of good or service available. While there is no doubt that credit is a convenient way to pay for transactions, when it is misused the buy now and pay later approach can lead to real problems. Credit can derail your financial plans by: • • • seducing you into buying things that you really do not need subjecting you to hefty interest charges reducing the amount of cash available for implementing financial planning strategies
If you use a credit card for a lot of small purchases or you buy major items on an installment basis, you should be sure that the required minimum payments are within your cash flow capacity. Ideally, you should be able to pay off all credit card balances when you receive your monthly statement. Credit experts recommend that maximum monthly credit payments should be kept to 20% of the after-tax income less any mortgage payments.
Pay Off Debts Quickly
Debt payments can put a significant dent in your cash flow, reducing the amount of money that you have available for implementing other financial strategies. Paying off debts therefore, can free up your cash flow. As important as cash flow management may be however, the most important reason for paying off your debts is because it may be the best financial investment that you can make. You can use your savings to pay down your debt or you can invest this money.
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The following are factors to consider in determining the better choice: • • the rate of return that you can earn on your investment and the income taxes on your investment income the interest rates that you pay on the debt and the income tax implications of paying down debt
Investing the Money
If you invest the money, you will earn interest, dividends, rents, and/or capital gains and must pay tax on the income. Assume Robert’s marginal tax rate is 40%, and he has an extra $1,000 of cash. He might choose to purchase a Canada Savings Bond and maybe earn 3% or $30 in interest in the first year. The following are the specific calculations for the after-tax investment return: • • • • the interest on the Canada Savings Bond is $30, calculated as (the interest rate times the principal) or (3% × $1,000) the tax on the interest income is $12, calculated as (the marginal tax rate x the interest income) or (40% × $30) the after-tax income is $18, calculated as (the interest income - the taxes) or ($30 - $12) the after-tax return is 1.8%, calculated as (the after-tax income ÷ the principal) or ($18 ÷ $1,000)
The formula for deriving the after-tax income (ATI) from before-tax income (BTI) based upon the marginal tax rate (MTR) is:
These formulas express the investment returns as dollars. However, there are situations where it is useful to refer to investment returns as percentages, calculated as the investment returns in dollars divided by the principal or amount invested in dollars.
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Introduction to Income Tax Planning The formula for after-tax investment return (ATR) is:
Paying Down the Debt
You cannot deduct the interest expense for consumer purchases from your taxable income, so you have to pay the interest expense in after-tax dollars that are remaining after income taxes have been paid. If you pay down the debt, you will not have to pay interest. You will not have to pay income taxes on the interest that you saved. Now assume Robert also has an outstanding credit card balance of $1,000, and his card carries an interest charge of 18%. If he carried that $1,000 for one year, he would pay $180 in interest, using after-tax dollars. In fact, he would have to earn $300 to have the $180 left over to pay the interest. Therefore, if he used his spare $1,000 to pay off the credit card, he would save $300 in interest expense in one year, which is the same as a return on his investment of 30%. • • the interest on the loan is $180, calculated as (the interest rate x the principal) or (18% × $1,000) the interest on the loan is in after-tax dollars. Using formula (3), the amount of before-tax income required to pay the interest of $180, is $300, calculated as BTI = (ATI ÷ (1 – MTR)) or ($180 ÷ (1 – 40%)) the 18% interest rate is an after-tax rate. The before-tax rate is the rate of return you would need before-tax to have 18% left after-tax. Using formula (7), the equivalent before-tax rate of return is 30%, calculated as BTR = (ATR ÷ (1 – MTR)) (18% ÷ (1 – 40%))
•
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Income Tax Planning Choosing The primary consideration in deciding whether to invest or pay down debt is the after-tax return on the investment compared to the interest rate on the debt. So, Robert can earn 1.8% after-tax on his CSBs or save 18% after-tax by paying down the debt. Alternatively, you can consider the before-tax return on the investment compared to how much Robert would have to earn to pay the tax and then the debt. This is called the equivalent before-tax return. Robert can earn 3% before-tax on his CSBs, but will have to earn 30% before-tax to have 18% left to pay his debt.
Exercise: Paying Down Debt
Avoid Unnecessary Bank Charges
If you do not keep a close eye on your bank balance, you may run the risk of bouncing cheques, that is, writing cheques where there are insufficient funds in your account to cover the cheque. Not only can this hurt your reputation with creditors, it can be costly when the merchants turn to you to cover the NSF (non-sufficient funds) administration charges, which can run between $10 to $20 per incident. If you bounce checks frequently, or if you have an erratic cash flow pattern (e.g., you only get paid once per month, but your mortgage is paid every other week), you may benefit from overdraft protection offered by your bank. With overdraft protection, your bank will cover cheques and debits from your account, up to a prearranged credit limit. You may pay high daily interest on the credit extended by your bank, and administration fees, but you will not face NSF charges. Overdraft protection is only intended to cover brief periods (a few days) of negative cash balances. You should not rely on overdraft protection, as a source of long-term credit, because the interest charges will quickly accumulate and the interest rate charged is often quite high.
Establish an Emergency Fund
There are countless events that are almost impossible to plan for and that can seriously derail the best-formed cash management plan. These unexpected events can be moderately inconvenient, like a major car repair, to the potentially disastrous, like the death or disability of an income earner. Some of the problems can be moderated by life or disability insurance or unemployment benefits, but even in these cases there will be a financial impact.
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Introduction to Income Tax Planning Some form of emergency fund is critical to every cash management plan. The size of the emergency fund that is right for you will vary on your circumstances. You might want to consider questions such as: • • • • • How secure is your job? If you lost your job, how difficult would it be for you to find a new one? What would happen to your cash flow if you or your spouse became disabled? What is the condition of your car, your furnace and your major appliances? Could you handle unexpected travel expenses?
You should also consider saving to meet anticipated decreases in income or increases in your expenses, such as the addition of a new family member, children starting postsecondary education, or your own retirement. Many financial planners recommend that you set aside enough money in an emergency fund to cover four to six months’ worth of living expenses. If your family has an after-tax income of $24,000 and you are barely meeting your day-to-day expenses, setting aside $8,000 to $12,000 may seem next to impossible. However, you may be able to structure your assets so that you can get at them in an emergency, reducing the need for such a large stockpile of cash. For example, you might have mutual funds that you could sell, or RRSPs that you could draw on during periods of long unemployment, when your taxable income is reduced. Once you pass through the financial crisis, be sure to restore your assets to their previous levels. Withdrawing funds from RRSPs should be a last resort. You are limited in how much you can contribute in the first place and withdrawing funds does not restore your contribution room. So you can never really put these RRSP funds back, although you can make contributions based on future years’ income. Credit, in the form of overdraft protection, should not be used as a substitute for an emergency fund. Not only will you be obligated to repay any money that you borrowed with interest, you may get yourself into serious financial difficulty if your emergency lasts longer than you expected. A personal line of credit is considered to be an effective strategy to obtain funds in an emergency for those with stable incomes. Otherwise, the appropriate strategy is an appropriate amount invested in some form (such as Canada Savings Bonds, treasury bills or a money market fund) that can be readily converted to cash.
Income Tax Strategies
Income and taxes usually go hand-in-hand, but there are ways that you can improve your cash flow and your overall financial situation through proper planning and some creative paperwork: • Interest income is taxable. However, you can minimize the amount of tax paid on this income by registering investments that generate interest income in the name of the spouse with the lower income. The most desirable type of debt is when the interest cost is tax deductible. Interest on money borrowed for business or investment purposes may be deducted from your taxable income.
•
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Income Tax Planning Robert and Joanne Smith reduced their taxable income by switching the bulk of their mortgage obligations from their principal residence to their rental property (refer to Robert and Joanne's statement of cash flow). Although they still make similar total mortgage payments each month, the interest portion of the mortgage payment on their rental property is an expense that they can deduct from their rental income. It can make good financial sense to borrow money to contribute to an RRSP, provided that you arrange a short-term loan at an attractive interest rate and that you use the tax refund generated by the contribution and other savings to repay the loan as soon as possible.
Step 4: Implementation, Budgeting and Cash Management
Cash management refers to the routine, day-to-day administration of your cash resources. This administration may include a number of activities, such as: • • • preparing and following a budget setting up automatic payment of your bills automatically or manually repositioning cash from one account to another
Your cash management plan may range from very simplistic to very complex, depending on the variability of your cash flow, your spending habits and your own "money personality".
Simplified Cash Management Plan
A simplified cash management plan involves setting aside a certain portion of your income to help meet your objectives before you pay for current living expenses. This is useful in cases where you have good intentions to save each month, but there is rarely anything left to save. The simplified cash management approach works because it forces you to save for your goals first, applying the principle of "out of sight, out of mind". This approach may work for you if you are truly motivated and just need that extra push to help you save, rather than spend. If you have problems handling credit or controlling your spending habits, or if you have complex or irregular cash flow patterns, a comprehensive approach (discussed later) may be more appropriate. Before you develop your cash management plan, you must have completed Steps 1 through 3 of the money management process. You must have a good understanding of your current lifestyle expenditures, your income and other cash flow patterns, and you must have identified some money management objectives that are realistic in light of your financial situation. Finally, you must have selected some strategies for reaching your objectives.
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Introduction to Income Tax Planning James and Jody have a combined take-home pay of about $4,000 per month, and would like to set up an emergency fund of at least $10,000 (their objective – Step 1). Although they never have any problems meeting their mortgage and car loan payments or paying off their credit cards on time, etc., they never seemed to save any money. After reviewing their past spending patterns, they found that they tended to make a lot of impulse purchases, such as specialty tools, kitchen gadgets and extravagant dinners, whenever their bank balance was over $1,000 (data collection and analysis – Step 2). They decided that they could afford to divert $400 of their monthly income towards an emergency fund without seriously affecting their lifestyle (their strategy – Step 3). Jody’s employer offered a direct payment plan that directed money from her regular paycheque to a separate account (implementation-cash flow management – Step 4). Within one year, James and Jody were pleased to find that they had saved almost $5,000 (monitoring – Step 5).
A Workable Cash Management Plan
The graph below illustrates a slightly more complex cash flow plan that works for many people. The plan is as follows: 1. Initially, direct all of your income into a collection account. Ideally, this should be an interest bearing account, such as a money market mutual fund. 2. Transfer a fixed amount of money from the collection account to an investment account to fund your objectives. This transfer should be done monthly, (or more or less often, depending on the timing of your cash inflows). 3. Transfer a fixed amount from the collection account to your chequing account each month. This is the money you can use to meet your normal monthly expenses. You should not spend more than this amount by using credit cards. If there are significant timing differences between large cash inflows and outflows (you might get paid every two weeks, but pay your mortgage monthly), you may wish to divert some of your monthly allocation to an intermediate savings account to ensure that you do not spend it before the payment is due. 4. You can use any amount remaining in your collection account as your emergency fund. However, you should review the balance in this account semi-annually and transfer any excess from the emergency account into your investment account.
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If, after working with your simplified plan for a while, you find that you do not have enough money to meet your lifestyle expenditures, you may have to adjust your distribution of income or consider whether you need to have a more comprehensive cash flow management plan.
Comprehensive Cash Management Plan
If a simplified cash flow plan does not give you enough structure to help you reach your objectives, or if you have erratic cash flow patterns, you may wish to develop a more comprehensive cash flow management plan. As with the simplified cash flow plan, the development of a comprehensive cash flow plan requires that you first complete Steps 1 through 3 of the money management process. In gathering and analyzing your historical cash flow information, you may uncover spending patterns that you were not aware of, such as excessive use of credit, frequent NSF charges or a large amount of money spent on take-out food. This in turn may lead to the identification of some general money management strategies, such as paying off your debt or taking control of your discretionary expenses. Once you have a clear picture of your existing cash flow, your next step is to project that cash flow pattern into the future in a way that reflects your new objectives and money management strategies. In order to do this, you will have to make some assumptions about: • • • • • your future income the rate of return on your investments your expected cash outflow non-recurring expenses the money you can set aside for savings or debt reduction
This cash flow projection then becomes your budget for the coming year. A budget is simply a plan for how you are going to allocate your money. The success of the budget depends largely on your willingness to stick to it.
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Introduction to Income Tax Planning
Budget
The level of detail in your budget will depend once again on your own circumstances and money personality. Some people can manage with annual or quarterly budgets, while others need monthly or even weekly breakdowns. Some people manage well with a simplified budget, with expenses broken down into broad categories (for example, housing, household expenses, food, transportation, clothing, miscellaneous, and so on). Other people need to account for every dollar spent. In this case, the categories should be broken down into subcategories (for example, food could be subdivided into home-prepared meals, work lunches, takeout and dining out; utilities could be subdivided into heat, electricity and telephone, and so on). Although it is natural to have some miscellaneous expenditures, do not let this category account for the bulk of your budget. The trick with any budget is to make it simple to develop, follow and maintain. Budgets that require hours of paperwork each week are doomed to failure. Several personal computer packages are available that can help you track your past expenditures and then use this information to develop and monitor a budget. These packages have the added advantage of being able to illustrate graphically where your money went, and how your actual expenditures compared to your budget. They also allow you to run various what-if scenarios that are particularly useful when developing new strategies. This is a budget for your lifestyle expenditures. It is an important part of your cash flow, but only part of it. The following table provides the Smith's monthly budget for January of next year. Robert and Joanne Smith Monthly Budget January of Next Year Housing costs Mortgage interest Property taxes Insurance Utilities Maintenance Garden upkeep Total Housing costs Food, household etc. Food Household expenses Telephone Personal care Clothing Other Total Food, household $ 0.00 166.25 61.25 201.25 133.33 41.66 603.74
402.50 61.25 75.00 105.00 375.00 41.66 1,060.41
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Transportation Car payments (interest only) Insurance Gasoline Maintenance Public transportation Total Transportation Discretionary Entertainment Eating out Gifts Fees, accounting, etc. Holidays Other Total Discretionary Miscellaneous Medical expenses Life and disability insurance Payroll deductions Bank charges Credit card interest Other Total Miscellaneous
91.67 64.17 183.33 100.00 45.83 485.00
125.00 100.00 116.67 150.00 100.00 0.00 591.67
54.17 83.33 166.67 22.50 52.50 133.33 512.50
Total Expense
$3,253.32
Exercise: Cash Management Plan
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Step 5: Monitoring Your Results
Monitoring your progress is vital to the success of any money management plan. You need to know if your strategies are actually helping you achieve your objectives, and if they are not, why the strategies are not working. If you are implementing a simplified cash flow management plan, monitoring may simply consist of reviewing the annual increase in your investment account. If you have met your savings goals, you do not need to take any action beyond increasing the amount to be saved next year by an amount equal to inflation. If you have not been able to meet your savings goals, you should reconsider whether your original objectives were realistic, or whether you need to switch to a more comprehensive cash management approach to gain control of your expenditures.
If you are implementing a comprehensive cash flow management plan, you will have to be more diligent about comparing your actual expenditures to your budgeted amounts on a monthly or quarterly basis. You should break your credit card bill down according to expenditure category. If you notice regular discrepancies between your budgeted and actual expenses in any category, either your projected amounts were incorrect or you need to take greater care in your spending. In either case, you must take action if you want to achieve your objectives. Robert and Joanne also used their computer package to monitor their actual expenditures in comparison with their budget. The output is shown in the following table. Robert and Joanne Smith Monthly Budget Comparison Actual Versus Budget January of Next Year
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Introduction to Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Money Management. In this lesson, you have learned how to do the following: • • • • • describe how people perceive money differently, and how those perceptions affect their money management styles explain how various financial statements are used in the money management process identify typical money management strategies collect and analyze client’s money management information, including statement of lifestyle expenditures and statement of cash flow assist client in identifying money management objectives
If you are ready to move to the next lesson, click Understanding Credit on the table of contents.
Assessment
Now that you have completed Money Management, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 2: Understanding Credit
Welcome to Understanding Credit. In this lesson, you will learn about the general lending criteria, the different types of consumer credit, and the uses of refinancing, debt consolidation, insolvency, and bankruptcy. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: • • • explain the general lending criteria (collateral, capacity, character, credit history) and their impact on financial planning describe and compare the different types of consumer credit explain and describe the uses of refinancing, debt consolidation, insolvency, and bankruptcy
Understanding Credit
In our society, entering into debt should be considered a necessary evil. That is not to say that it should never be done. Often it is more convenient and safer to use credit cards than cash, and sometimes the high cost of a capital asset, like a car, may make a cash purchase unrealistic. However, once you decide to enter into debt, you should give priority to minimizing the cost of borrowing. This section examines the types of credit available, how to obtain them, avoid abusing them, and how to get out of trouble if the use of credit has got the best of you. There are two main credit systems available to consumers: revolving credit and consumer loans.
Revolving Credit
Revolving credit is credit that you can use from time to time to buy goods and services. Revolving credit can take the form of: • • • a credit card issued by a financial institution, such as VISA, or by a retailer, such as Sears a standing charge account (for example, with a grocery store or a taxi company) a line of credit with a financial institution
In each case, the revolving credit lender will set an upper limit on the total amount that you may borrow. In exchange for the credit privilege, you agree to pay an interest charge on
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Introduction to Income Tax Planning the outstanding balance each month, and you may also be required to pay a service fee and stipulated principal payments. Most credit cards will give you an initial credit limit of about $500. The lending institution will usually increase that limit as you develop a credit history. Lines of credit usually start at $10,000 and are often more difficult to arrange. Some types of revolving credit (like some lines of credit) may require security, while credit cards and store accounts are usually unsecured. In the case of a line of credit, you will receive a better interest rate if you are able to provide security. Revolving credit is popular because of its convenience and flexibility. Once you have established your account, you can use it when you need it and forget about it when you do not. However, this constant availability can be seductive. Because revolving credit can often be used as a substitute for cash, you may quickly find that you are overspending. Furthermore, if you are not required to pay the outstanding balance in full each month, you run the danger of accumulating a large outstanding balance, on which you will pay a relatively high rate of interest. You are usually required to repay revolving credit loans according to a minimum percentage of the outstanding balance, and you are free to pay off the full amount at any time you wish. The rate of interest may be variable (some lines of credit), fixed (credit cards and some loans) or fixed for short-term periods, in which case the rate is adjusted periodically.
Consumer Loans
Consumer loans (also often referred to as direct or fixed credit) are usually arranged for a specific purpose (e.g., a car loan repayable over four years). They are available through financial institutions such as banks, trust companies, credit unions and small loan companies. The lending institution may or may not require security (or collateral) for these loans, as discussed later. When you arrange a consumer loan, the lender usually allows you some choice in terms of a payback period (term) that best suits your circumstances. The lender then arranges a schedule of monthly payments that combines repayment of the principal with interest charges on the outstanding balance. Depending on your loan agreement, the interest rate may be fixed for the duration of the loan, or may vary as the lender’s rates rise and fall. Direct or fixed credit may be easier to control but, depending on your arrangement with your lender, it could lock you into making substantial monthly payments, sometimes at a rate of interest that is considerably higher than the current rate. If you are self-employed and your income fluctuates from month to month, you may not want to tie yourself down to a large fixed repayment obligation. In some cases, the payback terms may be inflexible, requiring you to pay a hefty penalty if you want to repay the loan in full before maturity. Other consumer loans, such as car loans, may be fully open, meaning that you may pay off the outstanding balance in full at any time without penalty.
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Income Tax Planning
Security
Credit is typically classified as either secured or unsecured. A secured loan is one that provides the lender with the right to seize or sell specified assets, or collateral, in the event that you default on your loan agreement. Lenders prefer collateral that is liquid. Liquidity refers to the ease with which assets or collateral can be converted into cash. Depending on your credit rating, age, job security, health, etc., your lender may require different types of security in granting a loan. Collateral for a secured loan usually takes one of two forms. Most commonly, you may be required to sign a chattel mortgage. This document will transfer the ownership of the collateral assets to the lender if you default on your debt. However, you will keep possession of the goods as long as you maintain the loan in good standing. One of the most common types of secured loans is a car loan, where your car is the collateral and you are required to assign a chattel mortgage to the lender. If you do not make the installment payments on your car loan, the lender may repossess the car and use the proceeds from its sale to satisfy the debt. A lien is similar to a chattel mortgage, but it is used where the goods or services are immovable. If you purchase a new furnace for your home and have it installed, it is for all practical purposes now a part of your home and impossible to repossess. So, a lien is registered against your home as security for payment and you cannot sell your home unless the loan is repaid and the lien discharged. In cases where you have a poor or unestablished credit history, or where you have insufficient collateral to secure the loan, the lender may require that your loan be guaranteed by a guarantor, a third party who agrees to repay any outstanding balance on the loan if you fail to do so. Alternatively, the lender may be satisfied if the loan is co-signed by a co-signer, who is equally responsible for the debt with the principal debtor, whether or not the principal debtor defaults on the loan. Frank and Ellen are living in a common-law relationship. They borrowed $10,000 from a bank to purchase a car. They signed the loan as co-signers. If the payments are not made, the lender can pursue either Frank or Ellen to obtain repayment of the entire loan. Frank and Ellen are equally responsible for the entire amount, not just a share of it. Initially, the bank was reluctant to lend them the money. Frank’s father guaranteed the loan. If the payments are not made, the bank can pursue the father to repay the loan if they have determined that neither Frank nor Ellen can repay it. Frank and his father are equally responsible for the loan. His father is responsible if Frank and Ellen default. You may agree to a wage assignment, which allows the lender to collect up to 20% of your gross wages directly from your employer, with the proceeds to be used for the purpose of paying your debt. Unsecured loans are loans made by a creditor based on your credit history, reputation and integrity to ensure payment. A debt incurred through the use of a credit card is often an unsecured loan. Another example is an unsecured promissory note, which is a written loan agreement signed by the borrower and specifying the name of the borrower, amount of the loan, interest rate, and terms of repayment. The lender may require nothing more than your signature to advance the requested funds. Usually, unsecured loans are only available to the lowest risk borrowers.
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Interest Charges
The rule here is borrower beware. Different lenders, particularly those issuing credit cards, calculate their interest charges in different ways. However, regulations do require lenders to provide full disclosure of the interest rate charged, including a description of how the interest costs are calculated. You have to read the small print on the contract. Debit cards The debit card is a method of payment, but not a form of credit. Instead of extending credit, the debit card is used to withdraw funds from the purchaser’s bank account. The debit card is physically similar to a credit card, but the user enters his Personal Identification Number (PIN) into a terminal to authorize the withdrawal from his bank account.
Credit Cards
There is a significant difference in how bank credit cards (for example, VISA and MasterCard) and retail store cards (for example, Sears or Canadian Tire) calculate their interest charges. Apart from user fees and grace period considerations, how and when interest rates are applied to outstanding balances are very important. Most credit cards offer a grace period of 15 to 21 days after the statement date. During the grace period, you will not be charged any interest provided you make payment in full by the end of the grace period. If you do not make payment within the grace period, or if you make only a partial payment, a bank credit card will typically charge interest on the full amount of the purchase from either the date of purchase or the date of posting. Interest charges are computed on a daily basis and partial payments are applied to the oldest outstanding debt first. Retail store cards typically only charge interest on the difference remaining on the balance effective after any partial payment has been credited. Compounding methods may also vary among different credit card issues. Bank cards tend to charge straight interest (for example, compounded annually, but calculated daily), while retail cards usually compound their interest monthly. Credit card issuers are required to provide you with a clear statement of how their interest charges are calculated. Consequently, balances carried over periods of several months and reflecting many purchases can result in wide differences in actual interest costs, even though the interest rates quoted by both lenders may seem to be similar when taken at face value. Sample disclosure statement This is a sample of a disclosure statement provided by a company operating in the four western provinces and Newfoundland & Labrador (the rates may no longer be valid, but the nature of the disclosure is still appropriate). A charge will be added to your account each month based on the previous month’s balance to the nearest dollar, as indicated in the table below. If 75% or more of the previous month’s balance is paid during the current month, no cost of credit will be added. If 50% or more of the previous balance is paid, the payment is first deducted before the cost of credit is calculated. The annual rate is 21.0% per annum on the monthly balance.
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Income Tax Planning For example:
Cost of Credit means Cost of Borrowing or Credit Charges as defined in the Statement of Information regarding cost of credit as required by The Consumer Protection Act (BC), The Credit and Loan Agreements Act (Alta.), The Cost of Credit Disclosure Act, 1967 (Sask.), The Consumer Protection Act, 1969 (Newfoundland) and The Consumer Protection Act (Man.).
Installment Loans
You are usually required to repay a consumer installment loan in fixed monthly payments, which consist of a blend of principal and interest. You negotiate a repayment, or amortization period, over which the payments will be spread. Most consumer installment loans are amortized over a 1- to 5-year period. Your monthly payment will be calculated using an amortization schedule, which is a table that shows how much of each blended payment is interest and how much is principal, along with the principal outstanding after each payment. An example of an amortization schedule for a consumer car loan of $10,000 over five years at 12% is provided in the table. Installment loans are front-end loaded with interest, which means that the payments in the early period of your loan consist mostly of interest. Towards the end of the loan, the payments are largely principal. The following table illustrates this effect. By choosing to make a principal repayment early in your loan repayment schedule, you effectively bypass some of the heavy interest payments.
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As shown in the table above, the payments are fixed over the amortization period. However, the interest component of each monthly payment is roughly equivalent to the outstanding balance multiplied by 1/12th of the annual interest rate. The remainder of each payment is applied against the principal. In the early stages of loan repayment, a significant component of the payment consists of interest. However, as the outstanding balance is reduced, the proportion of principal in each payment rises steadily. The interest rates on installment loans may be fixed or variable, or may be adjusted periodically. When the rate changes, a new amortization schedule is used, reflecting the remaining outstanding balance, the remaining amortization period and the new interest rate.
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Income Tax Planning
Exercise: Credit
Obtaining Credit
Lenders will usually look for four main criteria, referred to as the 4Cs, when assessing your credit application:
Your Credit Rating
Your credit rating is a historical record or file maintained by a local credit bureau that documents your credit history (usually over the past seven years). It allows a lender to assess your history of repaying loans and provides the lender with an indication of your repayment behavior in the future. The various credit bureaus share information, so a lender can usually just make a single inquiry and retrieve your credit history. Your credit file consists of a series of ratings provided by the lenders of previously- or currently-held loans and credit cards. If you always pay at least the minimum required payments on a loan or credit card, that particular loan will receive a rating of one. Each time you miss a payment, the rate declines until it reaches nine, which is the poorest rating. Your credit file only includes facts about payment patterns, and never includes opinions. It also does not include information about utility bill payments, bank accounts, student loans, bounced cheques or specific credit card purchases. While your credit file may include information from civil court proceedings, including bankruptcies or orders to pay, it does not include criminal court proceedings. Along with the information discussed above, your credit file will include a listing of everyone who has requested the file in the past. You are entitled to see your credit file as maintained by your local credit bureau. You should check your own credit file every year or so, or at least six months prior to any major loan application, to make sure that it doesn’t include erroneous information. If there are errors, you can usually work with the credit bureau or the original lender to correct them. Even if information is correct, you will usually be permitted to add an explanation about why the problem occurred.
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Introduction to Income Tax Planning
Your Capacity to Repay the Debt
Consumer lending institutions use a number of measures to evaluate a borrower’s capacity to repay debt. The total debt service ratio is very effective as it considers all debt obligations and fixed housing costs, and then compares these amounts to the gross income (before-tax income) of the family unit. We will use Total Debt Service Ratio (TDSR) for this purpose in this course and we will use the following definition (your financial institution may use a different one): The TDSR compares the amount of your mortgage and consumer debt payments to your income. The higher the TDSR, the more difficult it becomes to make your payments. The maximum acceptable TDSR according to the Credit Union Institute is 40% for most loans. Financial institutions generally set a maximum TDSR of 35% to 42%. For a homeowner, the formula for TDSR is:
For a renter, the formula for TDSR is:
Let's look at a TDSR calculation for Ben and Sarah Straw, a married couple, who are considering the purchase of a new van. They need a bank loan of $22,000 to finance the purchase. The interest rate would be 8% compounded monthly and the payments would be $537.08 per month at the end of each month for four years. The Straws have other consumer loan payments of $380.00 per month. They own their own home. Their annual costs for property taxes are $3,200, heating costs are $3,600, and mortgage principal and interest costs are $14,800. Their annual income before tax is $90,000. If the Straws purchase the van, their TDSR will be 36.23%, calculated as ((payment of principal and interest on mortgage + property taxes + heating costs + 50% of condominium fees + payments on other personal loans) ÷ gross income) or ((($14,800 + $3,200 + $3,600 + $0) + (($537.08 + $380.00) × 12)) ÷ $90,000). The TDSR is within 35% to 42% of their gross income, so Ben and Sarah will likely qualify for the loan based upon TDSR limits.
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Income Tax Planning Some credit advisors suggest that you limit your consumer debt payments, excluding mortgage payments to 20% of your take-home pay. The TDSR may be a better measurement because it considers all debt.
Collateral and Your Character
Collateral available for security As discussed earlier, some forms of credit are unsecured, such as debts incurred through the use of a credit card. However, most other lenders will insist on some form of collateral to secure loans. Because unsecured loans carry a higher risk of loss for the lender, the interest rate for those debts will usually be substantially higher than for a secured loan. In the case of secured loans, you may be able to negotiate a more favourable interest rate if you are able to provide more than the minimum collateral required by the lender. Your character In an industry based on facts and numbers, it is easy to come to believe that the individual does not matter. However, a wise lender takes into account a person's character. Your character is defined here as your moral quality or integrity, not your eccentricity. It is worth taking the time to develop a good working relationship with your banker, especially if your cash flow is in a constant state of flux. Also, be warned that it does not pay to embellish your credit application. If the lender discovers your deliberate misstatement, the lender will likely deny your application regardless of your credit rating, collateral, or capacity to pay. Furthermore, this indiscretion could haunt you from lender to lender, as your credit rating file will clearly show that the previous lender has requested a copy of your credit history. A cautious lender will wonder why other lenders have requested your history and have not advanced credit to you, and may contact the previous lenders for an explanation.
Exercise: Credit Rating
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Signs of Trouble
Some people rely too heavily on their misguided belief that if the lender is willing to advance credit, they must be able to afford it. Still others are simply unable to keep track of how their debt load is accumulating. You should be aware that you might have a credit problem if any of the following factors apply to you:
Getting Out of Trouble
If you do find that you have a credit problem, do not automatically despair. Most lenders realize that they stand a better chance of recovering their money if they work with you. Rather than just ignoring the problem by deferring payment on overdue bills, you should voluntarily approach your lender and explain your situation. In many cases, you may be able to renegotiate terms with your lender (this is where your good working relationship pays off). Some credit card companies will renegotiate their repayment schedules before referring you to a credit counsellor, a financial advisor who specializes in credit problems. A credit counsellor will help you find a source of money that you can use for debt repayment after your living expenses have been met. For example, she may suggest that you cut back
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Income Tax Planning on the amount you spend on clothes, rent, recreation, alcohol, or convenience foods. She may also suggest that you sell your car and switch to public transport. If you are too far in debt to recover simply by changing your lifestyle expenditures, a credit counsellor will help you consider other strategies for getting out of debt. You might be able to consolidate your debts by arranging a loan at a reasonable payment term and using the proceeds to pay off your various creditors or arrange with your creditors a repayment schedule that assures that you can handle the payments.
Insolvency and Bankruptcy
Some people may be unable to climb their way out of debt even with the help of a credit counsellor and by eliminating all but the bare necessities. These people will learn about the Federal Bankruptcy and Insolvency Act of 1992. According to this Act, you are insolvent if, you are not declared bankrupt, your obligations to your creditors exceed $1,000 and you: • • • are unable to meet your obligations as they typically come due have ceased paying your debt obligations have debts due and accruing which, in combination, exceed the reliable value of your assets
You are declared bankrupt if you are insolvent and you voluntarily declare yourself as bankrupt or if your creditors are successful in lodging a receiving order against you that forces you into bankruptcy. In both cases, your assets will be sold and the proceeds will be distributed to your creditors in an equitable manner. If a creditor has security on a specific asset, that creditor will be entitled to repayment from the proceeds of sale from that specific asset. If a creditor has no such security, his loan will be unsecured and he will be entitled to a proportionate share of the assets left after all the secured creditors have been satisfied.
Voluntary Bankruptcy
If you are insolvent and you do not owe more than $75,000 (excluding your mortgage on your principal residence), you may make a formal consumer proposal to your creditors requesting that they reduce your debt or extend the schedule for repayment of your debts. You must prepare this proposal with the assistance of a trustee or administrator who is licensed under the Bankruptcy and Insolvency Act. This trustee will be responsible for investigating your financial affairs and providing counselling. If, after receiving the proposal, your creditors do not request a meeting, they are assumed to have accepted your proposal. Once it is accepted, and provided you follow the proposal, you will be protected from further action by creditors, including having your apartment or home lease terminated by your landlord, or having your utilities shut off. If your proposal is not successful, or if you are unable to develop a feasible proposal, you may choose to declare yourself as bankrupt by making an assignment. This means that you file a petition with an official receiver as designated under the Act, accompanied by a sworn statement describing your property and your debts and creditors. The official receiver will then appoint a trustee and assign your property to that person for management. The trustee will be responsible for administering your estate. From that point on, you cease to have any right to dispose of, or deal with, your property.
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Introduction to Income Tax Planning During the last recession, many people assumed a cavalier attitude towards personal debt and thought that declaring personal bankruptcy was an easy way of getting around their financial obligations. These people often didn’t realize that all their assets, including art collections, antiques, family heirlooms, and so on, would be liquidated in an attempt to satisfy their creditors.
Forced into Bankruptcy
In some cases, a creditor or a group of creditors may file a petition with your local court to have you declared bankrupt. They may do this if you owe them more than $1,000 and if you have committed an act of bankruptcy in the past six months. Some examples of an act of bankruptcy include: • • • • • • assigning your assets to a trustee, in a manner that is not satisfactory to your creditors fraudulently transferring your assets to a third party in anticipation of bankruptcy, with the intention of withholding those assets from distribution to your creditors paying off one creditor in preference to the outstanding claims of other creditors (referred to as fraudulent preference) failing to give up goods that are to be seized from you under an execution order trying to depart secretly and suddenly, with the intention of defrauding your creditors failing to meet your liabilities as they come due
Note: You do not have to be insolvent before your creditors can petition to have you declared bankrupt. Committing an act of bankruptcy is sufficient grounds for such a petition. Bankruptcy proceedings are penal in nature. The petitioning creditors must meet the burden of proof before a court. You may oppose the petition by disputing the existence of the debt or the alleged act of bankruptcy. Even if the creditors are successful in proving their case, the court has the discretion of refusing the petition if they feel that you may be able to meet your obligations in a reasonable period if you are given a fair chance. If your creditors are successful with their petition, the court will make a receiving order, which effectively vests your property to a trustee appointed by the court. This trustee will be responsible for liquidating your assets and distributing the proceeds to your creditors in an equitable manner.
Protecting Yourself from Creditors
If you plan well enough in advance, there are ways to protect your personal assets from creditors, particularly if you are in business. Incorporating a business A common way to protect assets from creditors is to incorporate your business. A corporation’s liabilities are its own, and liability does not extend to its shareholders simply because they are shareholders. However, this strategy is not perfect: it is typical for many small business owners to give personal guarantees in order to obtain credit, which provides creditors with a claim against personal assets in the event of bankruptcy. Also, directors
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Income Tax Planning may be held personally liable for certain business expenses, including unpaid income taxes, wages, and vacation pay. Incorporation also may not protect an individual from professional negligence lawsuits. Family members hold title to assets Another tactic is to have other members of your family hold title to your property. However, this must be arranged long before you risk insolvency or bankruptcy. The Bankruptcy and Insolvency Act allows a bankruptcy trustee to recover any assets that you may have "gratuitously" transferred to someone else up to a year before bankruptcy. This period could be extended up to five years before bankruptcy if the trustee can show that you transferred the property with the intent to defraud your creditors or that you knew you would be unable to pay your debts if you no longer possessed the property. Other protection strategies Other protection tactics include the following: • purchasing life insurance products that include an annuity or RRSP component, with your spouse, your common-law partner, your child, your grandchild, or your parent named as a beneficiary setting up individual registered pension plans (RPPs), instead of investing in RRSPs because RPPs cannot be seized by creditors
•
Bankruptcy Discharge
A discharge under the Bankruptcy and Insolvency Act usually cancels the unpaid portion of any debts remaining after they have been reduced by proceeds from the liquidation of your estate. In other words, it gives you a fresh start. A discharge is an official act of court. The court may refuse to grant a discharge for a number of different reasons, including cases when: • • • • your assets were insufficient to pay your unsecured creditors at least 50% of your debt you have not kept adequate records you continued to do business after knowing that you were insolvent you caused the bankruptcy by rash speculation or extravagant living
If you are bankrupt and you have not yet obtained a discharge, you will be liable to a fine or imprisonment if you: • • obtain credit of more than $500, unless it is to supply the necessities of life for you or your family recommence your business without letting your suppliers know that you are an undischarged bankrupt
In order to obtain a discharge, you may be required to complete a process of counselling with a financial counsellor.
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Introduction to Income Tax Planning
Exercise: Insolvency and Bankruptcy
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Understanding Credit. In this lesson, you have learned how to do the following: • • • explain the general lending criteria (collateral, capacity, character, credit history) and their impact on financial planning describe and compare the different types of consumer credit explain and describe the use of refinancing, debt consolidation, insolvency, and bankruptcy
If you are ready to move to the next lesson, click Income Tax Basics on the table of contents.
Assessment
Now that you have completed Understanding Credit, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Income Tax Basics
Welcome to Income Tax Basics. In this lesson, you will learn about fundamental terminology associated with personal income taxation. This lesson takes 15 minutes to complete. At the end of this lesson, you will be able to do the following: • explain fundamental terminology associated with personal income taxation
Economic Development
The Canadian Government first collected income tax in 1917 as a temporary measure to help finance Canada’s costs in World War I. The federal and provincial governments collect taxes on personal income to provide revenue to cover the cost of the services provided by the government. Revenue from taxes on personal incomes has long been the main source of income for the Canadian federal and provincial governments. Direct taxes from individuals represent about 46% of the federal government’s revenue, and 33% of the provinces’ revenues. The Canadian government uses the income tax system to encourage investment in high-risk ventures or specific industries that have the potential to stimulate the country’s economy. When the housing industry was in a slump, the tax rules were changed to allow people to borrow from their RRSPs to buy a house. Sometimes tax rules intended to stimulate the economy have undesirable consequences. The result is often a change in the rules. Until 1994, Canadians had a lifetime capital gains exemption of $100,000. During the 1980s economic boom in Canada, this exemption encouraged investors to speculate in real estate. The result was escalating real estate prices. The federal government responded in March, 1992 by excluding capital gains from real estate investments from the $100,000 life-time capital gains exemption. Tax rules are sometimes changed in response to conditions in one part of the country and not others. The real estate boom in Ontario, for example, was not experienced in Atlantic Canada. Nevertheless, Atlantic Canada taxpayers were subject to the change in rules that excluded real estate from the lifetime capital gains exemption.
Tax Concepts
There are five important concepts to understand about taxes: • • • • • average tax rates marginal tax rates tax deductions tax credits refundable tax credits
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Introduction to Income Tax Planning
Average Tax Rates
The average tax rate is calculated as:
A taxpayer’s average tax rate is a somewhat crude measure because two taxpayers in the same province with the same total income can have different average tax rates. Louis has total income of $75,000, total income tax of $25,000, and no deduction for RRSP contributions. He has an average tax rate of 33.3%, calculated as (total income tax ÷ total income) or ($25,000 ÷ $75,000). If he contributed $10,000 to his RRSP and claimed a deduction, his total income is still $75,000 but his income taxes would drop to about $20,000. So, his average tax rate becomes 26.7%, calculated as (total income tax ÷ total income) or ($20,000 ÷ $75,000).
Marginal Tax Rates
The marginal tax rate (MTR) is the rate a taxpayer would pay on his or her next dollar of taxable income. Phrased another way, the marginal tax rate is the rate of tax paid on an individual’s highest dollar of income. Understanding the marginal tax rate concept is useful when making many decisions that have income tax implications. The marginal tax rate is calculated as:
Arun has $44,552.85 of taxable income. He is in a 25% tax bracket for calculating federal taxes. So, on the next dollar of taxable income he will pay 25¢ of basic federal tax. His federal marginal tax rate equals 25%. He is also required to pay provincial tax of 19.7% of taxable income. So, his MTR is 44.70%, calculated as (federal marginal tax rate + provincial marginal tax rate) or (25% + 19.7%). Various deductions can reduce total income.
Tax Deductions
A tax deduction is an amount that is deducted from a taxpayer's total income and is effectively not subject to tax. For example, an RRSP contribution of $5,000 can be deducted from the taxpayer's total income; by doing so, it essentially excludes $5,000 of income from being taxed. The effective tax savings from a tax deduction are the taxes that would be paid on an additional taxable income equal to the amount of the deduction.
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Income Tax Planning Kristin has a marginal tax rate of 38.6%. Assuming she makes a $5,000 contribution to her RRSP and this contribution does not reduce her taxable income to a lower federal or provincial tax bracket, she will reduce her taxes by $1,930, calculated as (tax deduction × MTR) or ($5,000 × 38.6%). There are a variety of tax deductions that can reduce a taxpayer's total income. Tax deductions and MTR The value of a tax deduction to an individual is dependent on his or her marginal tax rate: the higher the marginal tax rate of the taxpayer, the more his or her income taxes will be reduced as a result of the tax deduction. In the previous example, we learned that based on a 38.6% marginal tax rate and a $5,000 RRSP contribution, Kristin will reduce her taxes by $1,930. By contrast, if her husband Christian were to make an identical $5,000 contribution to his RRSP and claim a tax deduction based on his marginal tax rate of 43.2%, he will reduce his taxes by $2,160 calculated as (tax deduction × MTR) or ($5,000 × 43.2%).
Tax Credits
A tax credit is an amount that is deductible from income tax otherwise payable. Unlike a tax deduction, a tax credit reduces the taxpayer's income tax by the same amount regardless of his or her marginal tax rate. However, several provinces have income surtaxes, which would increase the value of a tax credit somewhat to an individual who is subject to an income surtax. Conversion rate for tax credits The conversion rate for tax credits is the rate that is applied to an eligible amount to calculate the amount of the tax credit. The conversion rate for most federal and provincial tax credits is the tax rate for the lowest tax bracket. In recent times, the lowest tax bracket has been: 16% for 2004, 15% for 2005, 15.25% for 2006 and 15.5% for 2007. The autumn 2007 Economic Statement proposed the lowest personal income tax rate be reduced to 15% retroactive to January 1, 2007. Justin and George both have medical expenses of $1,000 that are eligible for the medical expenses tax credit. Justin has a marginal tax rate of 44%; George has an MTR of 27%. Even though Justin and George are subject to different marginal tax rates, each individual can deduct a $150 tax credit against their taxes owing calculated as (medical expenses x conversion rate for tax credits) or ($1,000 x 15%) The value of a tax deduction increases with taxable income. The value of a tax credit is generally the same for all taxpayers. Refundable and non-refundable tax credits A non-refundable tax credit can be claimed by a taxpayer but only to the extent it reduces his or her tax liability to zero. This means, a non-refundable tax credit generally cannot be used by a taxpayer to obtain a payment from the government unless he or she has tax payable. Most tax credits can only be used to reduce the taxpayer's personal tax liability although, in limited circumstances, they can be transferred to a spouse or parent.
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Introduction to Income Tax Planning
Typically, the portion of a tax credit that cannot be claimed in a given year is lost however, exceptions, most notably with charitable donations, permit the unused portion to be carried forward and used in a future year subject to certain conditions. The majority of tax credits are non-refundable in nature. Justin has $100 in taxes owing and a $300 non-refundable tax credit. Justin can reduce his taxes owing to $0. However, the unused portion of the credit amounting to $200 calculated as ($100 – $300) is lost. Certain tax credits, such as the GST tax credit and certain provincial tax credits, are payable regardless of whether the taxpayer has any taxable income. These are called refundable tax credits. With refundable tax credits, even if the taxpayer has reduced his or her tax liability to zero, he or she will still be able to generate a refund from the government based on the excess portion of the refundable credit. George has $200 in taxes owing and a refundable tax credit of $500. George can use $200 of his tax credit to reduce his taxes to zero. Since the tax credit is refundable, the unused portion will trigger a $300 refund for George when he files his income tax return calculated as ($200 – $500).
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Income Tax Basics. In this lesson, you have learned how to do the following: • explain fundamental terminology associated with personal income taxation
If you are ready to move to the next lesson, click Completing an Income Tax Return on the table of contents.
Assessment
Now that you have completed Income Tax Basics, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 4: Completing an Income Tax Return
Welcome to Completing an Income Tax Return. In this lesson, you will learn about the types of income reported on a tax return and how to perform various tax calculations for your client. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • identify the types of income reported on a tax return identify all relevant personal information calculate total income, including components thereof calculate net income
The Layout of the Tax Return Form
The main tax return form is a four-page form, called the T1 General. This form is a summary statement divided into four parts: income, deductions, tax credits and tax calculations. Supporting documentation is required to prove to Canada Revenue Agency (CRA) that the declarations are true. For taxpayers who receive salary income, much of this documentation is provided on a T4 slip from their employers. Other documentation could include receipts for expenses, such as tuition fees. Commonly used forms are included in the General Income Tax Guide and Return, which is available at all Post Offices. Some forms are not included in the General Income Tax Guide and Return, and are available here on the CRA Web site.
To prepare a T1, one must fill out the following sections of the form: • • • • • Identification (Page 1) Goods and Services Tax (GST) Credit Application (Page 1) Total Income (Page 2) Net Income (Page 3) Taxable Income (Page 3)
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Introduction to Income Tax Planning • • Non-refundable Tax Credits (Schedule 1) Refund or Balance Owing (Page 4)
You are not expected to remember specific line numbers or dollar amount associated with the income tax return. You should however have a conceptual understanding of the tax concepts presented throughout this unit.
Identification
As you go through the next few pages, you will be able to explore the income tax form in detail. Click the highlighted areas to read about each of the tax form elements.
Goods and Services Tax (GST) Credit Application
How it works You apply for a GST credit on Page 1 of your General Tax Return. You must apply for it even it you received it in the preceding year. Your credit is based on your net income added to the net income of your spouse or common-law partner, for the year that just passed, as well as on the number of children you have.
CRA informs you in the following July how much you will receive, if any. Payments are made quarterly, in July and October, and then January and April of the next year. Dmitri is completing his tax return for this year. Even though he received the GST credit last year, he has to reapply for it each year. Accordingly, he checks the box on the first page of his tax return to apply for the GST credit. Assuming he qualifies, in July of next year, Dmitri will receive his first GST payment in addition to a notice telling him how much he will receive each quarter. For the four quarters effective July of next year, CRA will base his credit on the number of children he has and his net family income this year. You must inform CRA of any changes in the size of your family (i.e. those living with you) or your marital status because these could impact the amount of your GST credit (CRA is only concerned about a relationship breakdown after 90 days). CRA will adjust payments in the next quarter based upon any over- or under-payments made in the previous quarter.
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Income Tax Planning Eligibility You can apply for the GST credit if, at the beginning of the quarter in which CRA makes a payment, you were a resident of Canada and you meet ONE of the following eligibility requirements: • • • You are 19 years of age or older. You have (or previously had) a spouse or common-law partner. You are (or previously were) a parent and live (or previously lived) with your child.
If you have a spouse, only one of you can apply for the credit. No matter which one of you applies, the credit is the same because it is based on net family income. GST credit for children You can get the credit for each of your children if ALL of the following apply at the beginning of the quarter which CRA makes a payment. The child: • • • • is your child, or is dependent on you or your spouse or common-law partner for support is 18 or younger has never had a spouse or common-law partner has never been a parent of a child he or she lived with lives with you
Income thresholds The following table provides the family income limit according to the number of children in the family. If your family income is less than the income limit shown across from the number of your children, you should apply for the credit. Your family income is the total of your net income and, if applicable, your spouse's net income. Income levels are for the 2008 tax year for which GST/HST credit payments were payable as of July 2009.
Family Structure
Number of Income limit children 0 0 1 2 3 4 $39,872 $42,232 $44,832 $47,432 $50,032 $52,632
Single Married/Common-law Partner Single or Married/Common-law Partner Single or Married/Common-law Partner Single or Married/Common-law Partner Single or Married/Common-law Partner
The family income limits continue for five and more children, but are not provided here. The limits are available in the Income Tax Act or from CRA.
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Introduction to Income Tax Planning GST credit amounts For the 2008 tax year, for which GST/HST credit payments were payable as of July 2009, the basic GST credits were as follows: Basic credit for eligible adult Equivalent to spouse amount for single parents Credit for each qualified child under 19 Supplement for single adults Phase-in threshold for supplement for single adults without children Phase-out threshold $248 $248 $130 $130 $8,047 $32,312
Click here to see the most current calculation sheet and income thresholds.
Total Income
Schedule 3: Capital Gains (or Losses)
Income Tax Planning with Respect to Total Income
Having considered the items included in calculating total income, you can appreciate the wide net of the Income Tax Act in identifying income that will be taxed. Once income has been earned or received, it is part of your total income and there is no easy way to create deductions or tax credits to exclude it. However, there are still a few tax planning opportunities. Employment income Recognize that employment income and most benefits are fully taxable. Where non-taxable employment benefits are available, such as supplementary health insurance, take advantage of them. If employed by a corporation of which you are a major shareholder, have a tax specialist review your remuneration to determine whether salary or dividends are most tax effective, and whether excess income should be left in the corporation. Pension income Income from private pensions that is not currently required and that can be postponed and provide additional benefits, should be examined to determine whether the deferral of the tax and increase in benefits, is a good choice.
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Investment income There are many investment strategies to consider in order to earn a good after-tax investment return with reasonable risk. In particular, you should take advantage of the opportunity to invest through RRSPs and other registered plans, which defer the taxation of investment income until funds are withdrawn. Within the rules of the Income Tax Act and sensible investment practices, you want to avoid producing taxable investment income. RRSP withdrawals Withdrawals should be avoided if possible because the withdrawn amount is fully taxable and the funds can only be recontributed to the RRSP if the taxpayer has eligilble contribution room.
Self-employed Income
You should ensure that all eligible expense deductions have been taken. If the income is not required for living expenses, the possibility of incorporating the business should be considered. Opportunities for income splitting between family members should also be considered.
Exercise: Total Income
Net Income
Schedule 4: Statement of Investment Income
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Introduction to Income Tax Planning
Exercise: Net Income
Income Tax Planning with Respect to Net Income
Having considered the deductions permitted in calculating net income, you can appreciate that they generally require an outlay of cash, and the deductions only result in the recovery of cash, equal to the tax you would have had to pay without the deductions. The tax planning opportunities with respect to the various types of deductions include: • RRSPs: Whenever possible make the maximum permissible RRSP contribution. The investment income is not taxed until the funds are withdrawn for retirement and a tax deduction is allowed for the contribution. Other deductions: The key tax planning opportunity is making sure you deduct eligible expenses.
•
Taxable Income
Your taxable income is calculated on the bottom of Page 3 of your T1 General Return as your net income from line 236, less various deductions and loss carryovers, including: • • • deductions for taxpayers who have an employee home relocation loan or who exercised an employee stock option carryovers of limited partnership losses, non-capital losses, and net capital losses of other years capital gains deductions for taxpayers disposing of qualifying small business or farm properties
These deductions and loss carryovers will be covered in detail later in the course.
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Income Tax Planning Income tax planning with respect to taxable income If you have losses that you can carry forward, you generally have a choice as to whether to claim them as a deduction in the current year or a future year. Depending on your current and anticipated future marginal tax rates, you will have to decide when is the best time to apply these loss carryovers. The calculation and application of the various types of loss carryovers are covered later in this course. Kim Chi Case Study – Part III Kim Chi did not have any additional deductions or loss carryovers, so she will report taxable income on line 260 of $29,125.06, the same as her net income reported on line 236. Make note of Kim Chi’s taxable income amount; you will require this number in the following lesson.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Completing an Income Tax Return. In this lesson, you have learned how to do the following: • • • • identify the types of income reported on a tax return identify all relevant personal information calculate total income, including components thereof calculate net income
If you are ready to move to the next lesson, click More on Completing an Income Tax Return on the table of contents.
Assessment
Now that you have completed Completing an Income Tax Return, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Introduction to Income Tax Planning
Lesson 5: More on Completing an Income Tax Return
Welcome to More on Completing an Income Tax Return. In this lesson, you will learn about non-refundable tax credits, common tax credits, deductions as they are reported on a tax return, and federal and provincial taxes. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • identify the deductions as they are reported on a tax return perform federal and provincial tax calculations identify non-refundable tax credits identify common tax credits such as the basic personal amount, age amount, and spousal amount
Non-refundable Tax Credits
As you go through this lesson, you will be able to explore the income tax form in detail. Click the highlighted areas to read about each of the tax form elements. Non-refundable tax credits are calculated on Schedule 1, Federal Tax. Non-refundable tax credits can only be used in the current tax year to the extent that they reduce net federal tax to zero. They cannot be used to generate a refund.
Exercise: Non-refundable Tax Credits
Federal Tax Calculation
Your federal tax is calculated using Schedule 1, which is reproduced below. Click the highlighted areas to read about the elements of the tax form.
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Income Tax Planning
The table shows the federal personal income tax rates. The federal tax rates can also be found by clicking here to visit the CRA Web site. Federal Income Tax Rates for 2009 Taxable Income, Base Amount up to $40,726 $40,727 - $81,452 $81,453 - $126,264 over $126,264 Federal Tax on Base Amount $0 $6,109 $15,069 $26,720 Marginal Rate on Taxable Income of Base Amount 15% 22% 26% 29%
Exercise: Schedule 1 Part 1—Calculation of Basic Federal Tax
Refundable Tax Credits
In addition to the non-refundable tax credits, Schedule 1 records several refundable tax credits, including those for federal political contributions and investments in laboursponsored investment funds. Click the highlighted areas to read about the elements of the tax form. Please note that the line number refers to the number to the left of the entry boxes.
Exercise: Schedule 1 Part 2—Calculation of Net Federal Tax
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Income Tax with Respect to Refund or Balance Owing
Most taxpayers are pleased to receive a tax refund. Moreover, the greater the amount of the refund, the greater the taxpayer’s satisfaction. However, it is important to understand exactly why the taxpayer is receiving a refund to begin with: he or she paid more taxes during the course of the year than was actually required. In essence, this amounts to the government holding and using the taxpayer’s funds without compensating the taxpayer with interest payments. On the other hand, had the taxpayer been able to retain the excess amount in his or her hands instead of remitting it to the government, he or she could have invested the funds, generated a rate of return and seen the funds grow in value. So, with proper tax planning, a taxpayer would actually prefer to eliminate or minimize a tax refund so the taxpayer is not using his or her money to provide the government with an interest-free loan. Ideally, the tax already paid during the year would equal the net federal tax owing and thereby avoid having a balance owing to the government. It would also eliminate the possibility of receiving a refund cheque but, the taxpayer would have use of his or her own funds during the course of the year.
Provincial Income Tax
All provinces, except Québec, levy provincial income tax as tax on income (TONI), which is applied by applying the province’s tax rates and brackets to taxable income as calculated under the Federal Income Tax Act, and then deducting the province’s version of tax credits. Québec has its own tax system. The provincial and territorial tax rates for 2008 can be viewed by clicking on the link to the Canada Revenue Agency website: http://www.cra-arc.gc.ca/tax/individuals/faq/taxratese.html#provincial NOTE: This information is strictly for reference. For purposes of the exam, you will not be required to know the tax rates for a specific province or territory.
Exercise: Refund or Balance Owing
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Full Indexation
The personal income tax system was only partially indexed to changes in the consumer price index (CPI) since 1986. Under these rules, parameters of the personal income tax system were adjusted each year for the percentage change in the CPI exceeding 3%. Because inflation was below 3% in recent years, the personal income tax system has effectively not been indexed. The Federal Budget of February 28, 2000 reinstated full indexation effective January 1, 2000, for all amounts that were previously only partially indexed. The indexation factor for a given taxation year beginning January 1, 2000 is the percentage change in the average CPI for the 12-month period ending on September 30th of the previous year relative to the average CPI for the 12-month period ending on September 30th of the year earlier. The table lists the base amounts for the main personal federal non-refundable tax credits that are now fully indexed (with occasional exceptions) for 2009.
Personal Amounts that are fully indexed Indexing factor Basic personal amount Spousal/eligible dependant amount Reduced when spousal/dependant income exceeds Eliminated when spousal/dependant income exceeds Age amount (age 65 and older) Reduced when income exceeds Eliminated when income exceeds Disability amount Disability amount supplement (under age 18) Reduced when total child care/attendant expenses claimed exceed Eliminated when expenses exceed Infirm dependant amount (age 18 and over) Reduced when dependant’s income exceeds Eliminated when dependant’s income exceeds Caregiver amount Reduced when relative’s income exceeds Eliminated when relative’s income exceeds Pension income amount
2008 1.025 $10,320 $10,320 $0 $10,320 $6,408 $32,312 $75,032 $7,196 $4,198 $2,459 $6,657 $4,198 $5,956 $10,154 $4,198 $14,336 $18,534 Lesser of eligible pension income and $2,000 $1,044 Expenses in
Canada employment amount Medical expense tax credit
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excess of the lesser of 3% of net income and $2,011 Threshold income above which reduction or clawback tax applies: GST credit Old Age Security (OAS) benefit received
$32,312 $66,335
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed More on Completing an Income Tax Return. In this lesson, you have learned how to do the following: • • • • identify the deductions as they are reported on a tax return perform federal and provincial tax calculations identify non-refundable tax credits identify common tax credits such as the basic personal amount, age amount, and spousal amount
If you are ready to move to the next lesson, click Integrating Income Tax Planning and Financial Planning on the table of contents.
Assessment
Now that you have completed More on Completing an Income Tax Return, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Lesson 6: Integrating Income Tax Planning and Financial Planning
Welcome to Integrating Income Tax Planning and Financial Planning. In this lesson, you will learn about how the 6-step financial planning process relates to income tax planning. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the implications of tax planning in financial planning explain the 6-step financial planning process as it relates to income tax planning
Integrating Income Tax Planning and Financial Planning
Ideally, income tax planning is driven by overall financial planning, and is not an end in itself. While financial planners often perform consultations or engagements that are entirely tax oriented, tax planning as part of a financial planning engagement assumes integration with other aspects of the financial planning process. In addition, a tax projection is normally required to determine the cash flow that is available to fund objectives, regardless of any perceived need to apply tax planning strategies.
The Financial Planner's Role in Income Tax Planning
As a financial planner, you need to have a good understanding of how the Canadian income tax system can affect your client’s ability to meet their financial objectives. While we are not saying that you need to become an expert on the income tax system, you do need to acquire a fairly comprehensive knowledge of the tax system just to be able to identify the potential income tax issues that can affect your clients’ financial plans. However, you should be careful not to present yourself as a tax expert to your clients, and you must clearly indicate to each client, preferably within your letter of engagement, the level of tax compliance services that are included in the financial planning engagement. If you do not have a good working knowledge of income tax rules, or if you lack knowledge in a specific area that is important to your client (for example, cross-border taxation issues), you or your client should consult a qualified tax specialist.
Tax Planning and the Financial Planning Process
In some cases, your planning engagement could be limited to a review of the client’s tax situation with respect to his or her overall financial goals. The income tax planning process mirrors the basic personal financial planning process, with 6 main steps or stages.
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Introduction to Income Tax Planning
Step 1: Establish Client-Planner Engagement
In a financial planning engagement, the planner and client have to establish their contract.
Step 2: Establish Objectives
In a financial planning environment, income tax planning has two primary objectives: • • determining the effect of income tax expenditures on cash flow establishing tax-planning strategies to help satisfy your client’s overall financial planning objectives
You will usually need to prepare an initial projection of income tax liabilities in order to determine your client’s after-tax cash flow available to fund objectives. You may have to revise this projection after tax planning strategies and other financial planning strategies have been selected.
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Step 3: Gather and Analyze Data
You must generally develop a core information base for tax planning purposes. This usually starts with copies of the last two or three years’ income tax returns. Additional information is gathered from the general data gathering documents used in the financial planning engagement.
Step 4: Identify Tax Planning Strategies
As a financial planner, you should consider the suitability of strategies in light of the overall financial objectives and risk tolerance of the client. It is important not to focus solely on how much tax can be saved to the exclusion of other factors.
Tax planning strategies include those designed to: • • • avoid or reduce tax (avoidance) by making use of various exemptions postpone the payment of taxes (deferral) by timing the receipt of income convert income to a form that is more favourably taxed (conversion), for example, by splitting income with family members with a lower marginal tax rate, or earning capital gains instead of interest income
These strategies are discussed in more detail later in the course. The benefit of a tax planning strategy should be compared with its cost. In addition to fees and direct implementation costs, consideration should also be given to indirect burdens, such as the time and effort the tax planning strategy requires from the client and the complexity the strategy adds to the client’s financial affairs.
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Step 5: Implement Tax Planning Strategies
As with all phases of financial planning, you may be asked to assist with the implementation of selected tax planning strategies. Examples include: reviewing proposed legal documents from a tax perspective and counseling clients about tax-related issues of which they should be aware such as tax-loss selling at the end of the year.
Step 6: Monitor and Update the Plan
Monitoring your client’s plan is an important part of the financial planning process and usually includes recognizing and advising the client of changes that have occurred that affect the plan. Of course, this means it is incumbent on you to keep abreast of changes in tax law and to understand how these changes can impact you client’s financial plan. The client should be made aware of the scope of your responsibility to identify changes in tax law and to make appropriate adjustments to the client’s financial plan. Generally, you should keep any monitoring and updating services as a separate engagement.
Tax Considerations Throughout Financial Planning
While some clients may want you to prepare an income tax plan, you will most often use your tax knowledge during other financial planning engagements. The following discussions identify how income tax considerations might be integrated within other financial plans, but the list is far from complete.
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Income Tax Planning For the remainder of this lesson we will look at different aspects of financial planning that are part of an overall financial plan. These strategies will be covered in detail in this or in other courses of the CFP™ program: • • • • • • cash flow planning education planning investment planning retirement planning risk management planning estate planning
Exercise: Tax Considerations Throughout Financial Planning
Cash Flow Planning
Paying income tax is typically one of the largest cash outlays a client will make during the year. The magnitude of this expenditure requires the planner to ensure it is dealt with adequately during the planning process. However, any reduction in income taxes should be co-ordinated with other parts of the financial planning process. Timing of income and expenses Generally, the most common tax planning technique used by financial planners is to time the receipt of income and the payment of expenses. Taking advantage of legitimate methods of reporting income and expenses that cover more than one year is crucial to this process. However, deferring income or accelerating deductions may not always be beneficial to every client. As always, you should consider the tax effect of these strategies before you recommend them. Whenever there are limitations on deductions and the client has the option of timing when the expense is paid or claimed, you should advise the client to time the payments so that they are made in the year that benefits them most. Some examples of these deductions are: • • • • medical expenses investment interest expenses charitable donations registered retirement savings plan contributions
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Introduction to Income Tax Planning Taxable income without cash flow There are also situations when there is taxable income, but there is little or no cash flow to pay the resulting income tax. In planning the transaction, your recommendation should provide enough cash to at least pay the projected tax on the income. A client may have investments in mutual funds and choose to reinvest all distributions, dividends, or capital gains. You should advise the client that funds to pay the outstanding taxes must come from other sources or from the redemption of some mutual fund units or shares. If the client does the latter, the capital gain or capital loss realized upon the redemption must also be considered in the planning process.
Education Planning
Education funding planning involves identifying the client’s objectives for educating children or others, quantifying the cost of achieving those objectives, and selecting the appropriate funding methods to provide for the costs of achieving those objectives. For example, using a registered education savings plan and taking advantage of the Canada Education Savings Grant can reduce the financial burden of funding a child’s education. Consistency with other objectives Most income tax planning comes into play in the quantification and selection phases of education financing: • If the client plans a pay-as-you go approach, how much pre-tax income will he or she have to earn in order to have sufficient after-tax cash flow to meet the education expenses? If the client plans to put aside money each year outside of a registered education savings plan, how will the taxation of the resulting investment income affect the growth of that investment? If the client plans to use a registered education savings plan, how will the proceeds be taxed upon withdrawal, and how does this affect the amount that must be accumulated within the plan in order to meet the education funding objectives?
•
•
However, you must be careful not to let the potential for income tax savings result in a decision that is inconsistent with other objectives that the client established in the initial objective identification stage. If your client is concerned that resources may be diverted to an unintended use, you may want to advise the client of the potential for a loss of control with any tax strategy suggested for education funding. Jasper is thinking of transferring some growth equities into a trust for the benefit of his infant daughter, with the thought that when she grows up, she will receive control over the assets and can sell them to fund her education. Any capital gain on property that has been transferred to a child is taxable to that child, not the transferor, so Jasper anticipates significant tax savings in this strategy. However, it also means he might give up control of the investments, and he must recognize that his daughter might choose to use the proceeds for something other than her education.
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Income Tax Planning
Investment Planning
The purpose of investment planning is to maximize the return on investment. Income taxes are a major expense that have a significant affect on returns, but preferential tax treatment alone does not necessarily make an good investment good. Choosing when to recognize capital gains and losses Most clients have investments with unrealized capital gains or losses. Investment advisers often encourage year-end selling to offset other realized gains or losses. While this approach could minimize taxes or decrease a capital loss carryover, it may not maximize the return on investment. Some clients feel compelled to use their unrealized gains and losses at the first available opportunity. However, economics, not taxes, should be the controlling factor. Avoidance, conversion, and deferral opportunities Investments can also be chosen for their potential for tax avoidance, deferral, or conversion. For example: • • Some investors may choose to invest in a qualified small business corporation in order to take advantage of the $750,000 capital gains exemption (avoidance). Some investors may choose to invest in growth equities, where capital gains are not realized until the investment is sold (deferral), and even then, only 50% of the capital gain is included in income (conversion).
We will be taking a look at opportunities for avoidance, conversion, and deferral in greater detail later. After-tax, risk-adjusted rate of return The rate of return should be adjusted for tax and risk. The after-tax yield gives you a better understanding of how much of the return on an investment you actually get to keep once you have paid your tax liability on the gain. The next step is to determine investment risk, which is the likelihood that the actual return of the investment will deviate from its expected return. An after-tax, risk-adjusted rate of return allows one to compare investments in a meaningful way.
Exercise: Tax Planning and the Financial Planning Process
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Retirement Planning
The retirement planning process begins with identifying and quantifying the client’s objectives on both a pre-tax and an after-tax basis. Remember, retirement expenses must be funded with after-tax dollars and some sources of retirement income are taxable, while others are not. Generally, estimated retirement expenses will exceed estimated retirement income. This shortfall, or retirement income gap, requires a client to choose an investment strategy for accumulating assets. Funding vehicles You will need to identify the various types of retirement plans available to your client. Distributions from retirement plans that accumulate income and capital gains on a taxdeferred basis are taxable. You should keep in mind how sensitive the various funding plans are to different income tax rate assumptions. In periods where clients are paying low tax rates, they may find that it is advantageous to fund the retirement income gap with a mixture of taxable and tax-deferred plans. Of course, if tax rates rise, using the taxdeferred plans is more advantageous. Timing and use of retirement funds All of the various ways in which retirement plan distributions can be received should be looked at in terms of when the funds are needed. If the funds are needed immediately to cover living expenses, the decision to withdraw appears to be easy, but the decision regarding which investment to withdraw first has significant tax implications. Should the client draw from registered or unregistered funds first? If they have to liquidate an asset, would it be better to choose an asset that belongs to the spouse with the higher marginal tax rate, or the lower one? During retirement, it is generally recommended that savings be accessed in the following order: I) II) III) IV) Use the first. Use the next. Use the Use the higher income spouse or common-law partner’s non-registered funds lower income spouse of common-law partner’s non-registered funds lower income spouse or common-law partner’s registered funds next. higher income spouse or common-law partner’s registered funds last.
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Income Tax Planning
Risk Management Planning
Risk management involves identifying client risks; making informed decisions to retain, reduce, transfer, or avoid each significant risk; and implementing those decisions Risk identification Risk identification normally involves listing various risk categories with an initial subjective evaluation of the probability of its occurrence and the financial impact of the related loss event. When making the subjective evaluation of the financial impact of the risk, you should consider the income tax ramifications of each potential risk. For example, when assessing the expenses that a survivor might incur after your client’s death, you must realize that these expenses must be paid with after-tax dollars. Emergency funds While some large risks may be transferred or shared by using insurance, your clients may accept some risks in order to reduce the cost of their insurance, or simply because the risk is uninsurable. When a risk is retained, clients should create an emergency fund (e.g., a reserve of six months’ living expenses in case of a loss of income) to cover the immediate needs arising on a loss occurrence. Since safety of principal and liquidity are the overriding concerns, the emergency fund is usually not tax advantaged. And investment like a money market mutual fund generates inefficient (from a tax perspective) interest income nevertheless, it is an ideal investment as part of an emergency fund because of its security and accessibility. A simple calculation of after-tax yields on comparable quality cash equivalent investments can usually determine the appropriate investments for the emergency fund. Taxation of insurance Insurance policies can be used to transfer risk from the client to his or her insurance company in exchange for a premium. The client would obviously like to obtain as much coverage for as little cost as possible. The income tax treatment of premiums and insurance benefits payable upon occurrence of a loss are major considerations in this process. Ideally, clients want to structure their risk management plans to produce totally deductible insurance costs and totally excludable benefits. In practice, this is seldom possible. The client should accept and evaluate trade-offs. If, for example, a disability insurance premium is deductible, the benefit payments are normally taxable. Alternatively, an employee-client could reimburse the employer for the premium; this would result in tax-free benefits and a lower benefit requirement.
Estate Planning
Co-ordinating the income tax and transfer tax aspects of an estate plan is crucial to financial planning. Without this co-ordination, unforeseen income tax consequences can have a devastating impact on the estate plan. A few examples are discussed below. Deemed dispositions and spousal rollovers When your client dies, he or she is deemed to have disposed of all of his or her capital assets at their fair market value (FMV), except to the extent the assets can be rolled over to a spouse or common-law partner. This may result in significant taxable capital gains.
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Introduction to Income Tax Planning However, the realization of these gains can be deferred and transferred to the beneficiaries through the judicious use of spousal rollover provisions and through the implementation of estate freezes. Charitable giving Taxpayers who hope to combine philanthropic intentions with tax planning need to be aware of the limits of the charitable donation tax credit. Using trusts for income splitting A testamentary trust is a trust created upon death. Taxpayers who leave significant assets to their survivors via testamentary trusts need to be aware of how these trusts are taxed, and their potential use for income splitting among beneficiaries and trusts. An inter vivos trust is a trust created while still alive. Taxpayers who want to make use of inter vivos trusts to facilitate their estate plans need to be aware of the potential for income attribution, and the fact that income retained by an inter vivos trust is taxed at the highest marginal tax rate.
Small Businesses
While a financial planner may not be concerned about small business planning in terms of business plans, marketing studies, and so on, a planner does need to know how these businesses can be used to help achieve his or her clients’ goals. There are many tax planning opportunities with respect to small businesses that can help make a financial planner a valuable part of his or her clients’ financial plans. The following are some examples of these tax planning opportunities: • • • • the potential to split income with employed family members the potential to defer income through the timing of salary and bonus payments the opportunity to use the business to contribute to registered pension plans or to implement a private health care plan the use of the $750,000 lifetime capital gains exemption upon the disposition of a qualifying small business interest
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Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Integrating Income Tax Planning and Financial Planning. In this lesson, you have learned how to do the following: • • describe the implications of tax planning in financial planning explain the 6-step planning process as it relates to income tax planning
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Integrating Income Tax Planning and Financial Planning, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Review
Let’s look at the concepts covered in this unit: • • • • • • Money Management Understanding Credit Income Tax Basics Completing an Income Tax Return More on Completing an Income Tax Return Integrating Income Tax Planning and Financial Planning
You now have a good understanding of the basics of income tax planning. At this point in the course you can assist your client in identifying money management objectives, describe and compare the different types of consumer credit, and explain and incorporate fundamental terminology associated with personal income taxation. You can also explain the 6-step planning process as it relates to income tax planning as well as identify, calculate, and report various income tax information for your client. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 1: Introduction to Income Tax Planning, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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Unit 2: Proprietorships and Partnerships
Income Tax Planning
Unit 2: Proprietorships and Partnerships
Welcome to Proprietorships and Partnerships. In this unit, you will learn about the general characteristics of sole proprietorships, the various partnership forms, and their advantages and disadvantages. You will also learn how business income is calculated and taxed for these forms of businesses. This unit takes approximately 3 hours to complete. You will learn about the following topics: • • • • • The Role of Businesses in Wealth Accumulation Partnerships Partnerships and Income Tax Limited Partnerships Business Income
To start with the first lesson, click The Role of Businesses in Wealth Accumulation on the table of contents.
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Proprietorships and Partnerships
Lesson 1: The Role of Businesses in Wealth Accumulation
Welcome to The Role of Businesses in Wealth Accumulation. In this lesson, you will learn how your client can gain the greatest personal benefits from the wealth created through owning and managing a business, or investing in a business. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • describe the financial planning needs specific to a business owner/manager compare and contrast the various forms of partnerships and their implication to income tax planning describe the types of business income generated by a proprietorship or partnership
The Role of Businesses in Wealth Accumulation
The creation of wealth is the first step in any wealth accumulation process (other steps include preserving or conserving wealth). While individuals can create personal wealth by collecting rare stamps or winning a lottery, this is either incidental to the growth of the Canadian economy or merely a redistribution of existing wealth. The primary way that wealth is created in the Canadian economy is through business or economic activity. In the simplest terms, a business activity is any step in the process of creating, producing or delivering a good or service in exchange for payment in money or other valuable consideration. Business activities produce jobs for employees, profits for the owners and tax revenues for the various levels of government. This course concentrates on how an individual can gain the greatest personal benefits from the wealth created through owning and managing a business, or investing in a business. As a personal financial planner, you will have clients who own and manage their own businesses and other clients who invest in such businesses without taking an active role in that business. To serve the financial planning needs of your clients, you need to understand how businesses are structured, how they are taxed and how they are used as investments.
The Needs of Business Owners/Managers
As a financial planner, you will have clients who own their own businesses. Their financial situations are very different from your clients who are employees. Business owners are often totally reliant upon the business for their income and have most of their wealth invested in the business. When they want to retire, they have to find a way to liquidate the investment they have in the business by selling it or having a family member take over the business. Their personal and business affairs are so inextricably linked that every personal financial decision involves a business consideration. So, if you want to serve your owner/manager clients well, you must understand their business concerns.
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Income Tax Planning
The Needs of Other Investors
Many investments are simply extensions of credit where an investor lends money to a borrower (e.g., a corporation or government) through the purchase of bonds or debentures. These investments usually provide an annual return in the form of interest, plus a return of principal upon maturity. The security of such an investment depends largely upon the issuer. Stocks, especially common shares, are another important financial instrument because they represent ownership or equity in a corporation. To understand investing in stocks and bonds, you must understand how corporations are structured, governed, and taxed. Some of your high income clients may want to consider the purchase of tax shelters, such as mutual fund limited partnerships or flow-through mining shares. Tax shelters are often structured as limited partnerships, so you must understand how this business form works. Business forms for personal financial planners As a personal financial planner, you may be an employee of a financial institution. However, you may also be conducting your financial planning practice as an individual through a sole proprietorship, as a partner through a partnership or as a manager of a corporation. If this is the case, you will need to understand how proprietorships, partnerships, and corporations are structured, governed and taxed in order to select the best form of business for your own practice.
Exercise: Business and Wealth Accumulation
Sole Proprietorships
An individual can establish or purchase a business and operate it without any partners and without incorporating the business. Businesses that are unincorporated and owned by only one person are called sole proprietorships. The owner of a sole proprietorship is referred to as a sole proprietor. The sole proprietorship is the simplest form of business organization. A sole proprietor must run a business (carry out business activities) and not just make passive investments, such as holding guaranteed investment certificates. A business activity is any step in the process of creating, producing, or delivering a good or service in exchange for payment in money or other valuable consideration. While a sole proprietor may hire employees to help operate the business and even hire a manager to oversee the business operation, he or she is ultimately deriving his or her income from business activities. In contrast, an investor is not in business, because he or she is not carrying out any business activities. Instead, the investor holds property and derives income from the interest, dividends, rents, and capital gains that the property produces.
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Proprietorships and Partnerships
How a Sole Proprietorship is Created
A sole proprietorship is created by the simple act of a person commencing business activities for his or her own account without first taking steps to form some other form of business organization, such as a partnership or corporation. Similarly, a sole proprietorship ceases when the sole proprietor stops carrying out business activities, or upon his or her death.
Registrations and licenses Unlike corporations and some partnerships, there are no legal steps that must be taken to establish a sole proprietorship. However, in order to carry out certain types of business activities (for example, taxis, restaurants, car dealers, real estate agents), the sole proprietor may be required to obtain one or more licenses at the municipal, provincial or federal levels. In addition, each province has legislation (such as Ontario’s Business Names Act) that requires the sole proprietor to register any business name that does not contain his her own full name. The main reason for this requirement is to ensure that there is a public record of the true owner of the business, so that creditors and others can determine who is legally responsible for the debts and obligations of the business. Brian Sutton decided to offer his services as a fishing guide. If he offered his services under his own name, as Brian Sutton, Fishing Guide, or Brian Sutton’s Fishing Charters, he would not have to register the business name under the Business Names Act. However, if he chose to operate under a different name, such as Brian’s Bass Bonanza, or Fishing Frenzy Tours, he would have to register the business name.
Unlimited Liability
A sole proprietorship is not a separate legal entity from the owner. The proprietor is the sole owner of the business, so that all benefits flowing from the business accumulate to his or her exclusive enjoyment. However, this means that all obligations associated with the business are also the responsibility of the proprietor. Thus, all of the income or losses of the business, as well as all of the business assets and liabilities, belong to the proprietor. Because the sole proprietor is personally responsible for all debts and other liabilities incurred in the operation of the business, his or her personal property can be seized to cover such debts. This is why the business name must be registered if it is not the same as the proprietor’s name, so that the creditors know whose personal property they can go after if they are trying to collect on business debts.
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Income Tax Planning
Who Should Establish a Sole Proprietorship?
Because of the unlimited liability, sole proprietorships are generally suitable for business activities that: • • can be financed by an individual do not require sophisticated management
Some provinces prohibit certain professionals from incorporating their practices, so many individual lawyers, accountants, doctors and dentists practice as sole proprietors or partnerships. Andrew Lee graduated from Osgoode Law School in 1988, completed his articles shortly thereafter and was admitted to the Bar. He did not see great prospects of being accepted as a partner with the firm with which he articled, so he decided to practice copyright law as a sole practitioner. He would have preferred to incorporate his law practice, but was prohibited by provincial legislation. So, Andrew practices as a sole proprietor.
Exercise: Sole Proprietorships
How the Income Tax Act Views Sole Proprietorships
Under the Income Tax Act, the net income of the business (basically revenue less expenses) is the income of the sole proprietor. Thus, the net income of the business is taxable to the proprietor for the year it is earned, even if he or she leaves the money in the business bank account and does not make any cash withdrawals. Similarly, the property used by the business of a sole proprietor is considered to be the property of the sole proprietor. Accordingly, capital gains or losses on the disposal of property used in the business are treated in exactly the same way as capital gains or losses on any property owned by an individual. Tax implications of paying a salary to another individual The sole proprietor can pay a salary to anyone other than himself or herself, including a spouse, common-law partner, or children, for employment in the business provided that the work was necessary and the salary was reasonable in light of the work performed. If these conditions are not met, the salary is not deductible to the sole proprietor for income tax purposes. However, if these conditions are met, the salary is deducted as a business expense reducing the income reported by the proprietor and it is included in the taxable income of the recipient. Andrew Lee’s wife is a chartered accountant and she spends three days a month keeping the accounting records and producing invoices and financial statements for his law practice. He pays her a salary of $1,000 per month for her services. This amount is reasonable and he can deduct it from his business income.
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Proprietorships and Partnerships
The sole proprietor cannot pay himself or herself a salary because the sole proprietor and the business are one and the same entity. Instead, the sole proprietor records the net income of the business on his or her personal tax return. Reporting business income or losses If the net income is positive (if the business earned a profit), this amount will be added to the proprietor’s income for tax purposes. If the net income is negative (if the business recorded a loss), this amount is deducted from the proprietor’s other income, but only to the extent that it reduces net income to zero. Any excess loss that cannot be deducted in the current year can be carried over to be applied against income of other years within certain limitations, as discussed in the lesson titled Business Income. Business income or losses are reported and taxed in essentially the same way for sole proprietors and partners, so taxation of business income will be examined in greater detail after we review partnerships.
Exercise: Advantages and Disadvantages of Sole Proprietorships
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed The Role of Businesses in Wealth Accumulation. In this lesson, you have learned how to do the following: • • • describe the financial planning needs specific to a business owner/manager compare and contrast the various forms of proprietorships and their implication to income tax planning describe the types of business income generated by a proprietorship or partnership
If you are ready to move to the next lesson, click Partnerships on the table of contents.
Assessment
Now that you have completed The Role of Businesses in Wealth Accumulation, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Proprietorships and Partnerships
Lesson 2: Partnerships
Welcome to Partnerships. In this lesson, you will learn about the types of partnerships, partner roles and responsibilities, and the creation, dissolution, and liabilities of partnerships. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • compare and contrast proprietorships and partnerships describe the types of partnerships explain partner roles and responsibilities describe the creation, dissolution, and liabilities of partnerships
Partnerships
The various provincial Partnerships Acts define a partnership to be a relationship that exists between two or more individuals (where an individual could include either a person or a corporation) carrying on an unincorporated business in common with a view of profit. The owners of a partnership are called partners. Note: There is no requirement that the partnership actually earn a profit in any one year. However, the partnership should have a reasonable expectation of being able to earn a profit within a reasonable length of time, especially if the partners want to deduct their losses for income tax purposes. Requirement to carry on business activities As with a sole proprietorship, a partnership must carry on a business (perform business activities) and cannot simply consist of several individuals making passive investments. The partners ultimately derive taxable incomes from these business activities. No separation between partners and the partnership Unlike a corporation, a partnership is not a separate legal entity from the partners. Instead, it is merely a relationship between two or more individuals carrying on a common business. A person cannot be both a partner and an employee of the partnership because no person can enter into a contract with himself or herself. Similarly, in most cases a partner cannot be a creditor of the partnership because there is no legal separation between the partner and the partnership. Types of partnerships Partnerships can be further classified as general partnerships, limited partnerships, and limited liability partnerships. Because most of the features of general partnerships apply to the other partnership forms, we will begin with a discussion of general partnerships, and then we will compare how limited partnerships and limited liability partnerships differ from the general partnership. We will also take a brief look at joint ventures.
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Income Tax Planning
Establishing a General Partnership
A general partnership is the simplest form of partnership, and it can come into existence without any legal formalities, simply by the action of two or more people carrying out business activities together. A general partnership consists only of general partners. General partners are those who are entitled to take an active role in managing the business, and who have unlimited personal liability for the debts and obligations of the partnership. Alvin Fung and Fred Swinden both articled with the same chartered accountancy (CA) firm. Upon acquiring their CAs, they decided to go into business together offering accounting and auditing services to the public. They established a general partnership by setting up the business. In their province, they are not permitted to incorporate the business under the provincial laws regulating chartered accountants. The ease of setting up a general partnership In fact, it is so easy to establish a general partnership that some people may be operating a partnership, even if this was not their intention. A person who became a partner without realizing it could get a nasty surprise when he or she is called upon to cover debts incurred by the partnership. When Arnold was playing golf with Samantha, she explained her plans to develop a piece of property that one of her uncles owned. She only needed another $50,000 to go ahead and the investor would triple his money in 12 months. Arnold wrote out a cheque. Arnold does not realize it yet, but he is now a partner in a business involved in real estate development. When he does, he will still have no idea with whom or on what terms. The provincial Partnership Act, the terms of which may be totally unsuitable, will govern his business relationship with Samantha. He needs legal advice.
Unlimited Liability
Because a general partnership is not a separate legal entity from the partners, a person who is found to be a general partner is personally responsible for the total debts and obligations of the partnership. The liability includes debts incurred in the ordinary course of business of the partnership, but also includes liability for negligence and any wrongful act or the failure to act committed by any of the partners in the ordinary course of the partnership's business. General partners are jointly and severally liable Each general partner is said to be jointly and severally liable for the debts and liabilities of the partnership to the full extent of his or her personal assets, not just his or her investment in the partnership. This means that a creditor can obtain a judgement against the partnership and demand payment of the entire amount from any one or all of the partners. The creditor does not have to determine which partner owes what amounts. If one partner is required to make payment to a creditor, the partners then have to figure out among themselves who owes what amounts to each other.
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Proprietorships and Partnerships Kevin, Darren and Bryan operate a karate studio together as a partnership. The business is eight months behind on rent and bank loan payments, and owes $10,000 to equipment suppliers. The partners have agreed that the business is a bust and it is time to move on to something else. Darren and Bryan have little in the way of personal assets, but Kevin owns his own home, a cottage and numerous investments. Although all three partners are liable for the debts of the partnership that remain after the business assets are liquidated, the creditors will likely go after Kevin’s personal assets. Kevin will then have to seek reimbursement from Darren and Bryan. Because of this potential for personal financial liability that goes beyond the investment made by the partner, great risk can accompany a partnership interest.
Exercise: Partnerships
The Partnership as an Entity or an Aggregate
There are two ways to view a partnership: either as an entity or as an aggregate. As an entity, a partnership is separate and apart from its partners. This view is most accurate when the partnership is dealing with outsiders. For example, the partnership acts as an entity when it enters into a contract, sells partnership property or hires employees. As an aggregate, a partnership is a collection of individuals or proprietors engaged in the same business. This view predominates in the liability imposed on a partner. Bert and Andrea are partners in a retail store, called The Bookend. On one hand, the business is known in the trade as a very successful retail outlet and customers write cheques with the payee as The Bookend. On the other hand, Bert deals with the publishers as one of the owners and Andrea deals with the day-to-day operations as one of the owners. The Bookend is both an entity and an aggregate of two business partners.
The Partnership Acts
All of the common law provinces have very similar Partnership Acts, and these statutes set out the default rules governing partnerships in the absence of a partnership agreement. Partnership law in Quebec Québec has partnership law included in the Civil Code, and in many respects, the law is similar to that in the common law provinces. however, in Québec, partnerships can be either declared or undeclared. Declared partnerships are those that are registered with the province, and undeclared partnerships are similar to partnerships in other provinces, in that no registration is required. In the case of an undeclared partnership, only those partners who are known to a third party creditor are liable to that party. In a declared partnership, all of the partners are liable
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Income Tax Planning for all of the debts of the partnership, whether the third party was aware of each partner’s existence or not.
Exercise: Partnership Types
Partnership Agreements
The partners may, and frequently do, vary the terms of the partnership legislation by using a partnership agreement to develop a business relationship that better reflects their individual needs and the contribution of the partners. A partnership agreement can be an oral agreement or a written agreement. As with most agreements, however, a written partnership agreement offers more protection than an oral one. A partnership agreement can help to avoid costly legal battles later on. Default provisions In the absence of a partnership agreement, a partnership will be bound by the following default provisions set out by provincial legislation: • • All property contributed to the partnership or purchased with partnership funds is partnership property and not available for the personal use of a partner. All partners are legally entitled to share equally in the capital and profits of the business and must contribute equally towards losses. However, that legal entitlement to, and taxation of, profits are two different things. Every partner may take part in the management of the partnership business, but is not required to do so. No partner is entitled to remuneration for acting in the partnership business. The consent of all partners is required to admit a new partner. Each partner owes a duty of loyalty to the partnership and cannot carry on any business of the same nature and competing with that of the partnership.
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Proprietorships and Partnerships
Exercise: Partnership Agreement Default Provisions
Partner Roles and Responsibilities
The default rules specify that all partners are entitled to take an active role in managing the business. Furthermore, the rules specify that decisions in ordinary matters can be made by the majority of partners, but that major decisions such as changes to the nature of the business or the admittance of a new partner must be unanimous. Partnership agreements are often used to modify these requirements, especially for partnerships that are quite large where it might be difficult or impossible to gain a unanimous vote. The decision-making authority is often tied to the partners’ economic interests in the partnership. Routine decisions may be delegated to a committee, a single partner, or even an employee hired to manage some aspect of the business. By using the partnership agreement to delegate the decision-making abilities, the partners are not escaping their unlimited liability. They are still all personally liable to outside parties for the debts and obligations incurred as a result of the decisions of their partners. However, if partners can demonstrate that one partner was acting outside of his approved authority in making a particular decision that indebted the partnership, the remaining partners may have legal recourse to recover their loss from the erring partner, and perhaps to dissolve the partnership or expel the offending partner.
Expanding or Entering an Existing Partnership
In the absence of a partnership agreement, the default legislation requires that all partners must consent to the admission of a new partner. Other than the requirement for unanimous consent, the partnership legislation is typically silent about the requirements for admitting new partners. Some partnership agreements modify this requirement for unanimous agreement, perhaps leaving the decision to the most senior partners or those with the greatest capital investment. Therefore, a partnership agreement should be used to specify criteria for admission, such as years of experience or professional status. It should also discuss ownership issues, such as how much a new partner would be required to contribute in capital, and what his or her interest in the partnership capital and profits will be.
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Income Tax Planning
Dissolving a Partnership
Under the default rules, if one of the partners retires from the partnership, dies or becomes insolvent, the partnership is dissolved. Of course, the remaining partners would be free to establish a new partnership. Most partnership agreements override this mandatory dissolution, and specify some arrangement for how the departing partner will be compensated in terms of a return of his or her share of the capital and profits earned to date. Note: The default rules also forbid the expulsion of a partner, and this could seriously jeopardize a partnership that is being dragged down by an incompetent or careless partner. For this reason, most partnership agreements provide for the expulsion of a partner upon certain conditions, including the vote of a specified majority of the other partners.
Partnership Capital
The default rules say that all partnership capital must be shared equally by the partners. However, in many cases the partners will have contributed different amounts of capital, or provided different levels of effort in increasing the capital assets of the company. For these reasons, most partnership agreements provide for an alternate allocation of capital. It may cover: • • • • how much each partner is initially required to contribute how much a new partner would be required to contribute upon admittance to the firm how any requirements for new capital will be handled entitlements to capital upon dissolution of the partnership or withdrawal of a single partner
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Proprietorships and Partnerships
Distribution of Profits and Losses
The default rules specify that the profits and losses are to be shared equally between the partners, but this arrangement is often unsatisfactory given the differences that may occur in capital contributions, time spent managing the partnership, and so on. Many partnership agreements specify an alternate allocation that takes into account both direct and indirect contributions to the firm, such as: • • • • • capital contributions hours spent managing the firm hours billed or fees collected number of hours worked or billed by employees under a partner’s supervision number of new clients brought to the firm
Michael, William, Peter, and Jason owned and operated a retail outlet as a partnership. Michael had put up 70% of the capital, while William, Peter and Jason each put up 10%. William and Peter run the store six days a week, while Jason and Michael help out in the evenings and on Saturdays. Michael is also responsible for doing the books, while Jason looks after ordering supplies, marketing, and advertising. Obviously, it would be unfair if the partners shared the profits equally. They came up with an arrangement where the first $100,000 in profits would be divided according to their proportionate capital contributions, and the remaining profits would be divided based upon the number of hours worked. Allocation of profits and CRA The allocation is reviewed on an annual basis to determine if the formula is still equitable to everyone. The allocation specified in the partnership agreement sets out the legal entitlement to receive profits, but this allocation may not be accepted by Canada Revenue Agency (CRA) if the partners are not dealing at arm’s length, as discussed in the taxation unit. Fiduciary duty of partners In addition to the default rules, the partners owe each other a fiduciary duty under common law. This means that they must deal with each other and with the partnership as a whole in utmost good faith, and they must never put their personal interests ahead of the interests of the partnership.
Exercise: Partnership Agreements
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Partnerships. In this lesson, you have learned how to do the following: • • • • compare and contrast proprietorships and partnerships describe the types of partnerships explain partner roles and responsibilities describe the creation, dissolution, and liabilities of partnerships
If you are ready to move to the next lesson, click Partnerships and Income Tax on the table of contents.
Assessment
Now that you have completed Partnerships, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Proprietorships and Partnerships
Lesson 3: Partnerships and Income Tax
Welcome to Partnerships and Income Tax. In this lesson, you will learn about how the Income Tax Act views partnership income and how to perform various calculations related to partnerships. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • • • explain how the Income Tax Act views partnership income and income allocation calculate the adjusted cost base of a partnership interest calculate capital gains or losses upon disposition
How the Income Tax Act Views Partnership Income
Cash distributions vs. partnership profits In many cases, the partnership may write a regular cheque to each partner, much like an employee might receive a regular paycheque. These cash distributions or drawings do not represent the partner's share of partnership income for tax purposes, and they do not represent employment income because the partner is not an employee of the partnership. A partner is taxed on his or her share of partnership income, not on the cash distributions that he or she receives. Take note that each partner is required to include his or her share of the partnership profit or loss regardless of whether or not any distribution of cash or other assets has been received (ITA 96(1)(f) and (g)). Computation of partnership profit and losses The Income Tax Act states that when a taxpayer is a member of a partnership, his or her income or losses for a taxation year are to be computed as if: • • • the partnership was a separate person resident in Canada (ITA 96(1)(a)) income, losses and taxable capital gains and losses retain their character in respect of source and nature (ITA 96(1)(f)) the income, losses, etc. are then allocated to the partners according to their respective interests in the capital or income of the partnership (ITA 96(1)(f))
So, each individual partner must report his or her share of partnership income on his or her personal tax return, along with any capital gains realized upon disposition of his or her partnership interest. The partner then pays taxes based on his or her individual income tax rates. Each partner must file the financial statements of the partnership and a reconciliation of accounting income to income for tax purposes with his or her personal T1 General Return. Partnerships with five or more partners are required to file information returns.
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Income Tax Planning
Exercise: Distributions vs. Income, Part 1
Exercise: Distributions vs. Income, Part 2
Allocation of Income via a Partnership Agreement
The total income or loss of a partnership is allocated among the partners according to their partnership agreement. Generally, this allocation of income or loss determines each partner’s share of any single item of income, gain, loss, deduction or credit, unless a specific provision of the partnership agreement (a special allocation) covers the items. Phoebe and Monica intend to operate a restaurant and catering business as a partnership, and initially they thought they wanted a simple 50-50 partnership arrangement. This would give them each a 50% share of total income, but also a 50% share of any capital gain, 50% of any capital cost allowance (CCA) deductions, 50% of any tax credits and so on. The allocation of income or loss among partners should be established in the partnership agreement and it can be dependent upon the source of the income, loss or nature of deductions or tax credits. Phoebe and Monica intend to operate the restaurant in a house downtown that Monica will purchase for the partnership, while Phoebe has contributed all of the restaurant and catering equipment. Monica will be responsible for running the restaurant, while Phoebe will be in charge of catering. Because of the differences in the type of capital each contributed to the business, and the different roles each of them will play, they decided that a simple 50-50 partnership would not be appropriate. For example, Monica wants a higher portion of the income generated by the restaurant side of the business, while Phoebe wants a higher portion of the income generated by the catering activities. Also, in the event that the house is eventually sold, Monica wants 100% of the capital gain. Phoebe wants 100% of the CCA on the restaurant and catering equipment that she supplied.
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Proprietorships and Partnerships
Exercise: Partnership Income
How the Income Tax Act Views Income Allocations
Although the Income Tax Act does not contain specific provisions prescribing how income is to be allocated, it does contain two provisions that can override the allocation specified in a partnership agreement and deem the share of each partner to be an amount that is reasonable in the circumstances. These provisions override the allocation when: • • the principal reason for the agreement may reasonably be considered to be the reduction or postponement of income tax (ITA 103(1)) partners are not dealing at arm’s length and the allocation is not reasonable considering the capital invested, work performed or any other relevant factor (ITA 103 (1.1))
Exercise: Gifts or Loans Between Non-arms' Length Partners
Unusual Allocations
A taxpayer would be wise to seek professional advice and possibly a tax ruling by CRA before entering into a partnership agreement with unusual allocations. Fred and Barney formed a partnership, with Fred contributing $2,500 and his fulltime services and Barney contributing $100,000 cash, much of it to be used for research and development. In addition, Barney agreed to obtain a loan for any additional cash needed by the partnership. The partnership agreement allocates all research and development (R&D) expenses and deductions for interest expenses on any loans to Barney. Also, 90% of all partnership income or losses are allocated to Barney until he recovers the R&D costs, interest expense and his share of partnership losses. After this time, the income or loss will be split 50-50 between Fred and Barney. In this situation, because Barney actually bears the R&D and interest costs, the special allocation reflects the true economic circumstances of the partnership and should be an acceptable allocation.
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Income Tax Planning Tax-advantaged investments using the partnership vehicle may rely on special allocations to enhance the tax benefits for investors. The partnership agreement must be examined closely for special allocations. Do most of an investor’s benefits come from a special allocation? Is the special allocation only tax-motivated? If the answers are yes, the investor may not realize the promised tax benefits.
Capital Cost Allowance
Capital cost allowance (CCA) is a deduction permitted for tax purposes to recognize the wear and tear and obsolescence of property over time. The CCA on depreciable assets acquired by the partnership must be calculated at the partnership level. The partnership itself has the choice of claiming the maximum CCA or any other amount not exceeding the maximum. An individual partner may or may not want the CCA claimed currently on his her income tax return depending upon his her specific tax situation. The partners will have to negotiate the amount of the CCA claimed by the partnership if the maximum is not ideal for all. Bob, Jeff, and four other individuals operate a surveying business as a partnership, and they have equipment with undepreciated capital cost (UCC) of $80,000. The equipment falls within Class 10 and thus CCA may be claimed at a maximum rate of 30%, or $24,000 for the current year, calculated as (UCC x CCA rate) or ($80,000 × 30%). The business has not done very well this year, but business is expected to pick up significantly next year. Bob and Jeff already have relatively low taxable incomes, and they would prefer to claim less than the maximum allowable CCA this year, saving the deduction for a future year when they are in a higher tax bracket. However, the other partners have other jobs and have high marginal tax rates. The majority of partners voted to claim the maximum CCA. Therefore, Bob and Jeff’s shares of the partnership income is determined after the deduction of CCA, even though they would benefit more from the deduction if they could delay it until a future year.
How the Income Tax Act Views a Partnership Interest
A partnership interest can be acquired either by providing new capital to the partnership in the case of a new or expanding partnership, or by purchasing a partnership interest from a retiring partner in the case of an existing partnership. This partnership interest is a nondepreciable capital property of the partner. Because it is considered to be capital property, the sale or other disposition of a partnership interest can result in a capital gain to the extent that the proceeds of disposition exceed the sum of the partner’s adjusted cost base (ACB) and qualifying outlays and expenses. It can also result in a capital loss to the extent that the proceeds fall short of that sum. Frank wants to retire from the engineering firm where he has been a partner for the last 28 years. The ACB of Frank’s partnership interest is $60,000, and he expects selling expenses, including legal fees, to amount to $2,000. If Frank receives $90,000 for his partnership interest, he will realize a capital gain of $28,000, calculated as (proceeds - (ACB + costs of disposition)) or ($90,000 – ($60,000 + $2,000)). If he receives only $50,000, he will realize a loss of $12,000, calculated as (proceeds - (ACB + costs of disposition)) or ($50,000 – ($60,000 + $2,000)).
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Proprietorships and Partnerships So far, this sounds fairly straightforward. The difficulties arise when determining the adjusted cost base.
Calculating the Adjusted Cost Base
Many investors have not understood the tax treatment of the disposition of a partnership interest, particularly the manner in which the ACB is calculated. As a result they have discovered upon disposal of a partnership interest that they have simply deferred tax, not avoided it as they expected. The following example will explain how this could happen. Garry bought a partnership interest in an apartment building. The investment produced large rental losses because the mortgage interest expense exceeded the rental income. He wrote off these losses against his personal income. Five years later, the building was sold and he received exactly the same amount he had originally paid for the investment. He figured he had broken even and that was the end of it. He was shocked when his accountant told him he would have to pay tax on a capital gain, approximately equal to the sum of all the losses he had written off. The ACB of his partnership interest had been reduced by the losses that he had claimed. Additions to and deductions from the ACB The ACB of a partnership interest is calculated according to the same rules applied to other types of capital property, as set out in ITA 53(1). i) First, adjustments to the ACB are made for the contribution or withdrawal of capital. When she first joined the law firm of Saunders, Smith and Goldstein, Laura made a capital contribution of $60,000. Later in the year, she contributed another $30,000 when the partnership decided to buy a new office condominium. However, once the condominium deal closed, the partners realized that everyone had contributed too much, and returned $2,000 in capital to Laura. Based on these transactions, the ACB of Laura’s partnership interest is $88,000, calculated as (capital contributions - return of capital) or ($60,000 + $30,000 - $2,000). ii)In addition to a deduction for any capital withdrawals, the ACB is reduced by any partnership drawings during the year, even if that is in the form of regular paycheques. Remember, these regular payments are not employment earnings, but essentially a cash distribution. Over the course of the year, Laura received partnership drawings of $52,000, in 52 separate weekly cheques of $1,000 each. Her ACB would then be $36,000, calculated as (ACB of Laura's partnership interest - partnership drawings) or ($88,000 - $52,000). iii)Next, the ACB is adjusted to also account for the allocation of profits and losses. If the firm records a profit, each partner’s share of that profit is added to that partner’s ACB (ITA 53(1)(e)(i)), while his or her share of the losses are deducted from his or her ACB (ITA 53(2)(c)(i)). Saunders, Smith and Goldstein recorded a profit of $1,500,000 last year, and Laura’s share is 10%, or $150,000. Now her ACB is $186,000, calculated as (Laura's ACB + Laura's share of profits) or ($36,000 + $150,000).
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Income Tax Planning iv)Further adjustments may be made to avoid double taxation of income or double deduction of losses. The common adjustments are listed below. Additions to ACB (ITA 53(1)): • • • • capital contributed by the partner, excluding loans to the partnership the partner’s share of the partnership’s net income or profit the partner’s share of any capital dividends received the partner’s share of any assistance or benefit in respect of Canadian resource property or exploration or development expense incurred in Canada
Deductions from ACB (ITA 53(2)): • • • • the partner’s share of partnership drawings and capital distributions the partner’s share of losses of the partnership the partner’s share of exploration and development expenses (which are deducted by the partners personally) the partner’s share of the investment tax credits
Exercise: Calculating Adjusted Cost Base
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Proprietorships and Partnerships
Calculating Capital Gains or Losses Upon Disposition
The table below shows how a taxable capital gain would be calculated on disposition of a partnership interest and how double taxation of income left in the partnership would be avoided. On January 1st of last year, Jeremy acquired an interest in a business partnership making a cash contribution of $20,000. Last year, he received cash distributions of $32,000 and Jeremy’s share of the partnership income was $40,000. On January 1st of this year, he sold his partnership interest for $50,000 incurring legal expenses of $1,000. The calculation of Jeremy’s capital gain is illustrated in the following table. Capital Gain on Disposition of a Partnership Interest
So every partner should keep track of his ACB for the following reasons: • The ACB on the last day of the year is used to calculate the amount at-risk in a limited partnership (we will discuss limited partnerships shortly) and may limit the deduction of a partner’s share of losses. The ACB is used to determine the amount of capital gain or loss a partner realizes on sale or other disposition of his partnership interest.
•
Exercise: Calculating Capital Gains and Losses
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Income Tax Planning
Other Provisions
There are many other provisions in the Income Tax Act that ensure the fair and effective taxation of partnership income and investment activity. Professional, legal and tax advice is essential for any individual contemplating the purchase of a partnership interest. Some of these complexities are briefly described below. Gains on contributed property A partner may contribute depreciable or other capital property to a partnership, rather than cash. The transfer will normally be done at fair market value (FMV). However, this could result in the undesired realization of a capital gain, capital loss or a recapture because the transfer would be a deemed disposition for tax purposes. An election may be made to transfer (rollover) the property at the partner’s ACB or UCC without realizing any gain or loss. Because this rollover is permitted under ITA 97(1), it is often referred to as a Section 97 rollover. Refer to IT-413R, Election by members of a partnership under subsection 97(2) for more information about rollovers to a partnership. Tyler and Zachary wanted to start a business as a partnership. Zachary was going to contribute $150,000 in start-up capital, while Tyler was going to contribute a small office building currently valued at $150,000. Tyler’s ACB and UCC for the building are both $120,000. By contributing the building to the partnership, Tyler would realize a deemed disposition for tax purposes, which would result in a capital gain of $30,000, calculated as (FMV - ACB) or ($150,000 - $120,000), and 50% of this gain would have to be included in his income for the year. However, he could file a special election to rollover the property to the partnership at his ACB, to avoid realizing a capital gain.
Disposition of Partnership Interest
The admission or departure of a partner may, as a result of provincial legislation or the partnership agreement, result in the termination of the partnership and the formation of a new partnership. These reorganizations may result in the deemed disposition of a partnership interest for tax purposes. Reorganizations that have the potential to result in a deemed disposition of a partnership interest include: • • • • • • the the the the the the admission of a new partner retirement or withdrawal of a partner fact that a partner has ceased to be resident in Canada sale of a partnership interest death of a partner time when a partnership ceases to exist
These deemed dispositions have the potential to result in realized capital gains or losses for the partners. However, continuing partners may use rollover provisions to avoid the realization of capital gains or losses in such situations (ITA 98(3)). Refer to IT-338R2, Partnership Interests – Effects on Adjusted Cost Base Resulting from the Admission or Retirement of a Partner, for more information.
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Proprietorships and Partnerships Winding-up of a partnership The simplest way to end or wind-up a partnership is to liquidate the partnership assets, discharge any outstanding partnership liabilities, allocate the partnership income and distribute any remaining money. Property may also be distributed at fair market value. Alternatively, there are provisions for a partner to rollover a partnership interest to a corporation, another partnership, a sole proprietorship or personal ownership without realizing a capital gain or loss (ITA 98(1)).
Using a General Partnership for Wealth Accumulation
Like the sole proprietorship, the success of the general partnership as a wealth accumulation vehicle depends less upon the business form and more upon the ability of the partners to manage a profitable business. With one or two exceptions discussed below, a general partnership does not offer any special advantages in the form of tax deferral, conversion or avoidance, beyond perhaps the limited potential for partners to split income with any family members who are justifiably employed by the business. These limited advantages, coupled with the potential for unlimited personal liability for the debts and obligations of the partnership, should make people think twice about whether the general partnership is the best form for handling their business interest. Flow-through of losses and deductions The flow through of partnership losses and deductions can offer significant tax advantages in the right circumstances. If a corporation incurs a loss, the shareholders cannot deduct the loss on their personal tax returns. However, if a partnership incurs a loss, the partners can deduct the loss on their personal tax returns, offsetting other taxable income and reducing their overall tax liability. This is referred to as a flow-through of the loss. In order for CRA to accept the flow-through of losses, it must be convinced that the partnership was formed to carry on a business with the objective of making a profit. Other than the flow-through of losses, the taxation of income, losses and capital gains is fundamentally the same as it would be for an individual, with no particular additional tax advantages from avoidance, deferral or conversion.
Starting a Business
The partnership form may provide a tax advantage over a corporate form during the startup phase of a business, because losses are often incurred during the first few years before the business becomes profitable. If the business is incorporated, these losses can be carried forward and can be used to offset future business income, but they cannot be used by the shareholders to offset their other income during the start-up period year. If the business operates as a partnership, the partners can deduct the losses incurred during start-up against other income.
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Income Tax Planning General partnerships vs. corporations The advantages of running a business as a general partnership, as opposed to a corporation, are as follows: • • A partnership can be established without any legal formalities, simply by the action of two or more people undertaking business activities together. Any business losses or deductions flow-through to the partners for tax purposes and can be deducted from other income.
The main disadvantage of running a business as a partnership, as opposed to a corporation, is as follows: • A general partner is jointly and severally, personally liable for the debts and obligations of the partnership.
Exercise: Partnership Complexities
Reflection Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Partnerships and Income Tax. In this lesson, you have learned how to do the following: • • • explain how the Income Tax Act views partnership income, and income allocation calculate the adjusted cost base of a partnership interest calculate capital gains or losses upon disposition
If you are ready to move to the next lesson, click Limited Partnerships on the table of contents.
Assessment
Now that you have completed Partnerships and Income Tax, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Proprietorships and Partnerships
Lesson 4: Limited Partnerships
Welcome to Limited Partnerships. In this lesson, you will learn about the structure of limited partnerships and how they are established, the rights and responsibilities of general and limited partners, and the types of businesses structured as limited partnerships. You will also learn about how to use limited partnerships for financial planning. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • • describe the structure of limited partnerships and how they are established identify the rights and responsibilities of general and limited partners explain how to use limited partnerships for financial planning describe the types of businesses structured as limited partnerships describe the nature and role of a joint venture
Structure of a Limited Partnership
All provinces have legislation in the form of a Limited Partnership Act that permits the creation of a limited partnership (LP), where one or more of the partners have limited liability for the debts and liabilities of the partnership. A limited partnership must have at least one limited partner and one general partner. The limited partners are passive investors. They contribute capital, but are otherwise uninvolved in the operations of the business. The general partners conduct the management of the business and are personally liable for the obligations of the partnership. Three doctors are considering purchasing and developing a piece of land as a retirement community. They each have significant net income and net worth and they are concerned about the security of their personal assets if the venture fails. Dr. Arent insists on being a limited partner. The other two are not sure why, but they decide they should be limited partners too. However, they cannot form a limited partnership without a general partner. They need some legal advice. General partnerships vs. corporations It is possible for a limited partnership to have dozens of limited partners and only one general partner, usually a corporation that has no other assets, which in turn is often owned by the individual who thought up the business in the first place. This is often the case in limited partnerships that are especially set up as tax-advantaged investments. In this case, the general partner is also often the promoter. When a limited partnership is used as a tax-advantaged investment vehicle, the general partner is usually a corporation. This protects the sponsors from unlimited liability, and the corporation itself usually has a minimal net worth.
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Income Tax Planning
Extent of Limited Liability for LPs
The rights and obligations of the general partners in a limited partnership are the same as those for the partners in a general partnership, so the general partners can still be held personally liable for the debts of the partnership. Limited partners are not liable for the debts, obligations, or losses of the partnership provided they do not participate in the management of the partnership. In other words, the most a limited partner can lose in a partnership is his or her investment, just like a shareholder in a corporation. This limited liability makes the limited partnership an attractive investment vehicle. The limited partners must be careful not to become involved in the business, because once they take any active management role, they lose their limited liability status. Thus, the partnership agreement should specify that the only active role that the limited partners can play is to remove and replace the manager of the limited partnership in the event that he or she is found to be in breach of his or her obligations as general partner. The promoter of Evergreen Software has fled to Argentina. The forty limited partners in the venture have been called to a partners' meeting to discuss the situation. The promoter has been serving as the general partner through a corporation. Action has to be taken immediately to protect the limited partners' interest and salvage what is left of the business. Three of the limited partners agree to run the business. If they do so, they will lose their limited liability protection. For most situations, incorporating a company is a more effective way to obtain limited liability for the owners of a business.
Establishing a Limited Partnership
A limited partnership is formed when the partnership files a declaration containing prescribed information with the provincial registrar in accordance with the province’s Limited Partnership Act. The declaration must be signed by all of the general partners who desire to establish the limited partnership. Rights of general partners According to Section 8 of Ontario’s Limited Partnership Act, (which is representative of the legislation in other provinces): A general partner in a limited partnership has all the rights and powers and is subject to all the restrictions and liabilities of a partner in a partnership without limited partners, except that without the written consent to or ratification of the specific act by all the limited partners, a general partner has no authority to: • • • • • act in contravention of the partnership agreement act so as to make it impossible to carry on the ordinary business of the limited partnership consent to a judgement against the limited partnership possess limited partnership property, or assign any rights in specific partnership property, for other than a partnership purpose admit a person as a general partner
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Proprietorships and Partnerships • • admit a person as a limited partner, unless the right to do so is given in the partnership agreement continue the business of the limited partnership on the death, retirement or mental incompetence of a general partner or dissolution of a corporate general partner, unless the right to do so is given in the partnership agreement
Rights of limited partners The limited partner does not have the same rights afforded to general partners, but this is the trade-off that the limited partner makes for having limited liability. The rights of the limited partner are basically limited to giving him or her access to business information to ensure that the business is being managed satisfactorily. According to Sections 10 and 12(2) of Ontario’s Limited Partnership Act: (10) Rights of limited partner - A limited partner has the same right as a general partner: • • to inspect and make copies of or take extracts from the limited partnership books at all times to be given, on demand, true and full information concerning all matters affecting the limited partnership, and to be given a complete and formal account of the partnership affairs to obtain dissolution of the limited partnership by court order
•
12.(2) Rights of limited partner - A limited partner may from time to time: • • • examine into the state and progress of the limited partnership business and may advise as to its management act as a contractor for, or agent or employee of, the limited partnership or of a general partner act as a surety for the limited partnership
Note: Advising as to management in Section 12(b) is not the same as taking an active management role, which involves making business decisions. Section 13(1) of the Ontario Partnership Act makes this clear by saying: 13.(1) Limited partner in control of business - A limited partner is not liable as a general partner unless, in addition to exercising rights and powers as a limited partner, the limited partner takes part in the control of the business.
Exercise: General and Limited Partnerships
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Income Tax Planning
How the Income Tax Act Views Limited Partnerships
In general, the Income Tax Act views limited partnerships in the same way as general partnerships. However, there are a few notable exceptions, discussed below. At-risk rules At one time, taxpayers were able to make creative use of tax shelters by structuring deals so that they would invest a certain sum of money but were subsequently allowed to take a tax deduction against current income for much more than the money invested. For example, a person used to be able to invest $5,000 as a limited partner, and then deduct his or her share of partnership losses or other deductions on his or her tax return. These deductions may end up being a significantly greater amount than the limited partner’s actual investment in the company. CRA considered these deals to be abusive and brought in a rule that the investor could never take deductions for more than the amount of money that the investor actually stood to lose, or the money at-risk. This is referred to as the at-risk rule (ITA 96(2.1) to (2.6)). The at-risk rules are complex and include grandparenting provisions for partnership interests that were already in place when the rules were introduced. Generally, however, the at-risk rules mean that the investor may only make deductions on his or her tax return with respect to a particular investment, to the extent that the deduction reduces his or her adjusted cost base (ACB) to zero dollars. Negative ACB balances are not permitted. As a limited partner, Romana invested $30,000 in a software partnership. She was able to write off the $30,000 over two years on her tax return as CCA claimed by the partnership. Her adjusted cost base (ACB) is now $0, calculated as ($30,000 - $30,000). This year the partnership expects to lose $100,000 of which her share is $10,000. However, because her ACB is $0, she has had no money at risk and she will not be able to deduct any loss. The company has asked her to guarantee unconditionally a bank loan of $10,000 for the company. If she did so, she would now be "at risk" $10,000, and she would be able to deduct the loss. Income attribution and limited partnerships Normally, the income attribution rules apply only to income from property, not business income. So, if a taxpayer loans money to his or her spouse or common-law partner, and that person starts up a business that earns a profit, that profit is taxed in his or her hands, not in the lender's hands. However, beginning in 1989, the income attribution rules were changed for cases where a taxpayer loans or transfers funds to a spouse, common-law partner, or other non-arm's length party and those funds are invested in a limited partnership. If this type of transaction occurs, the income from the limited partnership is considered to be income from property, not business income, and thus it will be attributed to the taxpayer (ITA 96(1.8)). Veronica has $50,000 that she wants to give to her husband to invest, because he has no income. If he invests in a business as a sole proprietor or general partner, there is no attribution of the business income to Veronica. If he invests as a limited partner, his share of any business income is deemed to be property income and is attributed to Veronica.
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Proprietorships and Partnerships
Using Limited Partnerships for Wealth Accumulation
Limited partnerships provide the flow-through of tax benefits of a partnership while at the same time providing investors with limited liability. This is just the combination an investor wants in a mass-marketed investment in which other participants are total strangers. A general partnership provides some tax benefit in the form of flow-through of income or losses, but not limited liability. A corporation provides limited liability but no flow-through of tax benefits. The corporation is a separate taxable entity from the shareholders, so it can only deduct CCA if it has income. The partnership is not a separate taxable entity and the CCA deduction flows through to the partners, and they can deduct it from their other income. For these reasons, many tax-advantaged investments take the form of a limited partnership, and this business form can be tailored to almost any activity.
Exercise: Income Tax and Limited Partnerships
Types of Businesses Structured as Limited Partnerships
The following are the most common tax-advantaged investments that are organized as limited partnerships along with a brief description of the features that make the limited partnership the investment vehicle of choice: • • • • • • Real estate: limited partners can obtain the benefit of deducting CCA and, in the case of leveraged investments, interest expenses. Oil and gas: the deduction for intangible drilling costs may be passed through to the limited partners and they are entitled to resource deductions. Farming and cattle: deductible expenses may pass through to limited partners, but special rules apply. Equipment leasing: limited partners may be able to reduce their taxable income by deducting the interest expense on leveraged equipment purchases. Theatrical endeavours (plays, recitals, and so on.): investors are protected with limited liability. Research and development: limited partners may be able to claim deductions related to the research and development costs.
Limited Liability Partnerships
A limited liability partnership (LLP) is very similar to a general partnership, with the exception that partners are not personally liable for the negligence of another partner. The partners remain personally liable for the general debts and obligations of the partnership, as well as their own negligence. This should not be confused with a limited partnership, where the limited partners are not personally liable for the debts and obligations of the partnership.
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Income Tax Planning A partner commits negligence if he or she omits to do something that a reasonable person would do or, if he or she commits an act that a reasonable person would not do given the same circumstances such that, his or her conduct falls below the standard of care expected of someone in a similar position.
Extent of Limited Liability for LLPs
Ontario’s Partnership Act was modified in July 1998 to permit the formation of limited liability partnerships (LLPs). With respect to liability, Sections 10(2) and 10(3) of this Act state that: S.10(2) Limited liability partnerships – Subject to subsection (3), a partner in a limited liability partnership is not liable, by means of indemnification, contribution, assessment or otherwise, for debts, obligations and liabilities of the partnership or any partner arising from negligent acts or omissions that another partner or an employee, agent or representative of the partnership commits in the course of the partnership business while the partnership is a limited liability partnership. S.10(3) Liability of negligent partner – Subsection (2) does not affect the liability of a partner in a limited liability partnership for the partner’s own negligence or the negligence of a person under the partner’s direct supervision or control. So, a limited liability partnership protects the remaining partners from personal liability when one of the partners is found to be liable for negligence. An LLP is a big improvement for professionals who operate a business together but who are prohibited by law from incorporating their practices. Note: While the other partners cannot be held personally liable for the negligence of one partner, the partnership itself can still be found liable, as per Section 11 of the Act: S.11 Liability of firm for wrongs – Where by any wrongful act or omission of a partner acting in the ordinary course of the business of the firm, or with the authority of the co-partners, loss or injury is caused to a person not being a partner of the firm, or any penalty is incurred, the firm is liable thereof to the same extent as the partner so acting or omitting to act. Also, the partners remain jointly liable for the other obligations of the partnership, as per Section 13 of the Act: S.13 Liability for wrongs joint and several – Except as provided in subsection 10(2) every partner is liable jointly with the co-partners and also severally for everything for which the firm, while the person is a partner therein, becomes liable under section 11 or 12. So, the partnership assets can still be seized to cover liabilities incurred as a result of one partner’s negligence, but the personal assets of the remaining partners cannot be seized.
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Proprietorships and Partnerships
How the Income Tax Act Views Limited Liability Partnerships
In general, the Income Tax Act does not differentiate between general partnerships and limited liability partnerships. A limited liability partnership would be subject to the at-risk rules for limited partnerships. Limited liability partnerships vs. professional corporations Some provinces permit certain professionals to incorporate their practices. One of the main advantages of the corporate form of business is the limited liability of the shareholders. However, in the case of professional corporations, the practicing professional still has unlimited liability, but can make use of some of the tax advantages of incorporation.
Exercise: Limited Liability Partnerships
Joint Ventures
A joint venture is a partnership-like entity that is usually formed to carry out one transaction or a series of related transactions over a short period of time. Is it a joint venture or a partnership? A joint venture can be distinguished from a partnership by the following characteristics: • • • A joint venture usually pursues a single business transaction, rather than general and continuous transactions. A joint venture can be formed without a profit motive and simply pursue social or recreational purposes. The agency relationship between members of a joint venture may be more limited than the agency relationship between partners. By this, we mean that whereas a partner may be able to make decisions on behalf of the entire partnership, the members of a joint venture are limited in terms of the actions they can undertake on behalf of the other members of the joint venture. A joint venture is more like an aggregate than an entity. When pursuing joint goals, corporations are more likely to form a joint venture than a partnership.
• •
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Income Tax Planning
When Joint Ventures are Used
Where are you likely to find a joint venture? The following are some of the more common applications: • • A joint venture is often formed for the production or co-authorship of a play or some other theatrical endeavour. In real estate, a joint venture may be used for the subdivision and sale of a specific parcel of real property or for the construction of a specific building, housing project, or industrial complex. A mining venture may be put together as a joint venture to develop and operate the mineral property. Large oil companies frequently form joint ventures to share the risk of exploratory drilling.
• •
How the Income Tax Act views joint ventures Joint ventures are not treated as partnerships for tax purposes. Instead, they are taxed as business activities of the individual joint venturers, who may be individuals, corporations, partnerships, or trusts. So, joint ventures are similar to partnerships, but they are treated very differently for income tax purposes. Care is necessary in structuring a partnership or joint venture to ensure the courts and CRA will recognize them as such.
Exercise: Joint Ventures
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Proprietorships and Partnerships
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Limited Partnerships. In this lesson, you have learned how to do the following: • • • • • describe the structure of limited partnerships and how they are established identify the rights and responsibilities of general and limited partners explain how to use limited partnerships for financial planning describe the types of businesses structured as limited partnerships describe the nature and role of a joint venture
If you are ready to move to the next lesson, click Business Income on the table of contents.
Assessment
Now that you have completed Limited Partnerships, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 5: Business Income
Welcome to Business Income. In this lesson, you will learn about how business income is calculated and taxed for proprietorships and partnerships. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • identify and calculate business income, business deductions, and a partner’s income
Statement of Business Activities
Self-employed business people operating either as sole proprietors or partners, including commissioned salespeople, and individuals earning professional income (e.g. doctors, lawyers, dentists and accountants) must report their income on the Statement of Business or Professional Activities (Form T2125). Where an individual has both business and professional income, a separate Form T2125 must be completed to report each type of income. This lesson will refer to the Statement of Business or Professional Activities. You can access it by clicking here. Click the link to access the document. You can print the Statement of Business or Professional Activities as a reference or once you’ve clicked on the above link, you can keep the window open and toggle back to it as you work through this lesson.
Cash vs. Accrual Methods
Before we can complete a Statement of Business or Professional Activities, we have to determine whether the individual must use the cash or accrual method of accounting. In most cases, a self-employed person reports business income by using the accrual method of accounting. With this method, a taxpayer: • • reports income in the fiscal period earned, regardless of when the income was received in cash deducts expenses in the fiscal period incurred, whether paid in that period or not
Most people operating a business either as a sole proprietorship or a partnership, including professionals must use the accrual method of accounting for income tax purposes. A self-employed commission sales agent can use the cash method of reporting income and expenses, as long as it accurately shows income for the year. Under this method, a taxpayer: • • reports income in the year received in cash deducts expenses in the year paid
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Proprietorships and Partnerships
Identification
The first part of the form reports basic information that identifies the taxpayer, as well as the nature of the business and, if it is a partnership, the taxpayer’s percentage interest in that partnership.
Gross Business or Professional Income
If the taxpayer has business income, he or she must complete Part 1 of Form T2125; if the taxpayer has professional income, he or she must complete Part 2. Either Part 1 or Part 2 must be completed as the situation dictates—both sections cannot be completed on the same Statement of Business or Professional Activities. Part 1: Adjusted gross sales This amount includes net sales, commissions and fees after deducting any goods and services tax (GST), provincial sales taxes (PST) and any returns, allowances and discounts, if these have been included in sales. Part 2: Adjusted professional fees In Part 2 of Form T2125, the taxpayer's professional fees are reported. This amount is reduced by items that may include GST, PST and for certain professionals, work-inprogress. Part 3: Gross business or professional income This amount includes gross income, which is net sales plus any reserves deducted last year, such as a reserve for goods and services to be provided after the end of the year. This amount is transferred to the appropriate line on the taxpayer’s general tax return. Part 4: Cost of goods sold and gross profit In Part 4, the cost of goods sold is calculated and deducted from the taxpayer's gross business or professional income to arrive at the taxpayer's gross profit.
Exercise: Gross Business Income
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Income Tax Planning
Expenses
Expenses are deductible if, and only if, they were incurred to earn business income. In Part 5 of the Statement of Business or Professional Activities eligible deductible expenses are identified. The total business expenses are deducted from the gross profit to arrive at the net income or loss before adjustments. Eligible expenses include: • • • • • insurance: premiums for commercial insurance for buildings, machinery and equipment used in the business interest: on money borrowed to run the business; some limits can apply maintenance and repairs: includes the cost of labour and materials for any minor repairs or maintenance done to property used to earn income management and administration fees: when incurred to operate the business (does not include employees’ salaries, property taxes or rents paid) meals and entertainment: allowable to a maximum of 50% of business meals, beverages and the amount incurred when entertaining clients (meals paid for employees are fully deductible) motor vehicle expenses: includes license and registration fees, fuel costs, insurance, interest, maintenance and repairs, and leasing costs. (If a taxpayer uses a motor vehicle for business and for personal use, he or she can deduct only the portion of the expenses that he or she incurred to earn income.) office expenses: can include the cost of office supplies legal, accounting and other professional fees: includes fees for external professional advice or services, and accounting and legal fees for maintaining books and records salary, wages and benefits: includes salaries paid to employees, but not any withdrawals paid to a partner travel: includes expenses incurred to earn income, including public transportation fares, hotel accommodations and meals (in most cases, the 50% limit applies to the cost of meals, beverages and entertainment) telephone and utilities: includes gas, oil, electricity and water allowance on eligible capital property: includes items such as goodwill or a franchise capital cost allowance: refers to property, such as a building, motor vehicles or equipment, calculated at the partnership level
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Exercise: Business Expenses
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Proprietorships and Partnerships
Net Income or Loss
The taxpayer's net income or loss is calculated in Part 6 of the Statement of Business or Professional Activities. This amount includes the gross income minus the sum of all of the deductible expenses. If the taxpayer is a member of a partnership, this amount is the net business income of all partners. The Great Edmonton Clothing Company realized net income of $200,734 during the last fiscal year, which is calculated as the (gross profit minus the total business expenses) or ($426,400 - $225,666)
Calculating the Individual Partner's Net Income or Loss
The next section of the Statement of Business or Professional Activities recognizes the allocation of partnership income as well as any additional deductions that can be made at the individual partner level. Individual’s share of partnership income First, the taxpayer must report how much of the partnership’s net income or loss is allocated to him or her. This allocation will depend on the partnership agreement. In the absence of an agreement, the net income of the business will be divided equally between the partners. Based on the net income or loss before adjustments calculated in Part 5 of Form T2125, the taxpayer must identify his or her share of this amount in Part 6. Business-use-of-home expenses This includes allowable expenses for the business use-of-a workspace in the taxpayer’s home. These expenses are documented in more detail elsewhere on the Statement of Business Activities. The tax considerations for home-based businesses is discussed later in this course. Amounts deductible from individual’s share of partnership income Next, the taxpayer may be able to make additional deductions from his or her share of partnership income related to any extra expenses that he or she incurred to earn his or her share of the partnership income (or loss), such as the business portion of allowable motor vehicle expenses. These expenses must not have been claimed anywhere else on the form, and they can only be claimed if the partnership did not reimburse the taxpayer for the expense. Details of the other amounts deductible from the individual’s share of partnership income are recorded elsewhere on the Statement of Business or Professional Activities. Individual’s net income or loss Finally, the taxpayer’s net income or loss from the business is calculated as his or her share of the partnership income, minus any other deductible amounts, minus any business-useof-home expenses. This amount is then entered on the appropriate line of the taxpayer’s general income tax return.
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Income Tax Planning
Exercise: Net Income or Loss
Special Tax Considerations for Home-based Businesses
Many people establish home-based businesses for economic reasons, convenience, or family reasons. If a sole proprietor or partner runs a business from home, or maintains a qualifying home office in addition to his or her regular place of business, he or she may be able to claim a business-use-of-home expense to offset his or her business income. The deduction is made in Part 6 of the Statement of Business or Professional Activities as part of determining the taxpayer’s net income or loss. Refer to IT-514, Workspace in home expenses, for more information. When the deduction is allowed A taxpayer may be able to claim a business-use-of-home expense for a workspace in the taxpayer’s home, as long as one of these conditions is met (ITA 18(12)): • • it is the taxpayer’s principal place of business and he or she does not have a place of business elsewhere the taxpayer uses the space only to earn business income and uses it on a regular and ongoing basis to meet clients, customers or patients
This means that if the taxpayer’s principal place of business is in his or her home, the place within the home that is used for business does not have to be used exclusively for business purposes in order for the taxpayer to be able to claim a business-use-of-home deduction. However, if the taxpayer’s principal place of business is outside of the home, a businessuse-of-home deduction will only be permitted if a space within the home is used exclusively for business purposes. Harmony is a freelance technical writer and she uses the guest bedroom as her office, but she still uses the room to accommodate guests when needed. She spends about 70% of her time working for one client who supplies her with an office on-site. Although Harmony spends most of her time out of her home office, the client’s premises do not belong to her, so her home office is still her primary place of business. Because it is her principal place of business, she can claim a business-use-of-home deduction even though she does not use the spare room exclusively for business purposes. However, the amount that she can deduct will be prorated on a time basis to account for the dual purpose of the room. Martin, another taxpayer, is a massage therapist who runs a clinic downtown. He has also set aside one room in his house for the sole purpose of seeing several additional clients most evenings and on weekends. Because he uses the room only for business and he uses it on a regular and continuous basis, he will be able to claim a business-use-of-home expense.
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Proprietorships and Partnerships
Calculating the Deduction
The business-use-of-home expense includes a portion of all home-related expenses, including operation and maintenance costs such as heating, electricity, cleaning services, landscaping and lawn maintenance services. It also includes a portion of property taxes, mortgage interest, home insurance, and capital cost allowance (CCA). So, the first step is to calculate the total home-related expenses. While the Income Tax Act does not specify exactly how the business-use-of-home expense is to be calculated, administrative practice requires the total of the home-related expenses for the year to be prorated for business purposes based upon some reasonable calculation. Floor space method vs. number of rooms method The two commonly used methods are based on: • • the total floor area devoted to the business divided by the total floor area of the house the number of rooms devoted to the business divided by the total number of rooms in the house
When doing this calculation, the taxpayer only has to consider the main areas of the house, without counting common areas such as hallways and bathrooms. He she can choose whichever method is more favourable to him. Dominique operates a catering business based in her home. Her one-room home office measures 18 square metres. Dominique’s house has a total of 12 rooms and measures 135 square metres. She uses the home office three days each week – this space is not used for any other purpose. Based on the floor space method, Dominique would be eligible to deduct 13.33% of eligible home expenses calculated as (workspace-at-home ÷ total area of home) or (18 ÷ 135). Based on the number of rooms method, Dominique would be eligible to deduct 8.33% of eligible home expenses calculated as (number of rooms used for business ÷ total number of rooms in home) or (1 ÷ 12). Obviously, Dominique would be better served using the floor space method. The actual deduction will have to be prorated to account for the fact that the workspace-at-home is only used for business purposes for three days each week. Refer to the current version of CRA’s Business and Professional Income Tax Guide for more information.
Exercise: Business-Use-of-Home Deduction
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Income Tax Planning
Capital Cost Allowance
As mentioned, a taxpayer with a home-based business could elect to claim a portion of the CCA on the part of his or her home used for business, using up to the maximum rate specified by the Income Tax Act (ITA 20(1)(a)). However, if the taxpayer makes a deduction for CCA and later sells his or her home, he or she could face a capital gain or recapture of CCA on the business portion of the home (ITA 13(1)). For this reason, most people elect not to include CCA in the calculation of their business-use-of-home expense.
Limitations
The amount deducted for business-use-of-home expenses cannot be more than the taxpayer’s net income from the business before deducting these expenses (ITA 18(12)(b)). In other words, these expenses cannot create or increase a business loss that can then be used to offset the taxpayer’s other income. Jacob is employed as a machinist full time, earning $43,000 per year. He has also just started a woodworking business out of his house. His net income from the woodworking business before adjustments during the first year was $1,300. He determined that his business-use-of-home expense was $1,600. However, the most that he can claim is $1,300, because he cannot use the business-use-of-home expense to create a business loss. Jacob can carry the remaining loss of $300, calculated as (business-use of home expense - net income) or ($1,600 - $1,300) forward to a future year to be deducted from business income. Note: Some home office expenses, such as insurance on the business equipment or the cost of a separate business telephone line are strictly business expenses. The full amount of such expenses can be deducted from the gross profit calculated on the Statement of Business or Professional Activities when determining the net business income before adjustments. If these business expenses result in a net business loss, such a loss can be applied against the taxpayer's other income to the extent it reduces his or her other income to zero. Last year, Tanya earned $50,000 from her full-time job as a civil servant. She also earned $4,000 in gross profits from a home-based direct mail business. However, she spent $6,000 on postage, printing, and office supplies. She ran the business from a spare room, and determined that her business-use-of-home expense amounted to $800. Tanya will have a net business loss before adjustments of $2,000, calculated as (gross profits - expenses) or ($4,000 - $6,000), and she will be able to deduct this amount from her other taxable income. However, she will not be able to claim the business-use-of-home deduction to increase the business loss. Instead, she will have to carry the expense of $800 forward, and she will be able to apply it against net business income in a future year, assuming that she decides to continue the business.
Business Losses
If business expenses exceed revenue, the taxpayer has a net business loss, which is recorded as a negative number on the Statement of Business or Professional Activities. The business loss is transferred to the taxpayer’s T1 General Tax Return as a negative amount and it is effectively deducted from his or her other sources of income, including employment and investment income.
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Proprietorships and Partnerships Last year, Amanda opened a hairdressing salon. Although her business picked up during the last half of the year, she had a business loss of $14,000 for the taxation year, and she recorded this as a negative amount on her T1 return. She also had employment income of $5,000, net rental income of $3,000 and taxable capital gains of $1,500. Limitations on claiming business losses If the business loss is large enough to create a negative amount of total income, obviously the taxpayer cannot make full use of the loss. Amanda has total income of -$4,500, calculated as (employment income + net rental income + taxable capital gains - business loss) or ($5,000 + $3,000 + $1,500 $14,000). Non-capital losses If the business loss is large enough to create a negative amount of total income, the taxpayer may be able to use the excess to create or increase a non-capital loss. Non-capital losses include: • • • • unused losses from an office, employment, business or property unused allowable business investment losses (ABILs) the unused portion of the taxpayer’s share of partnership losses from business or property the unused portion of the taxpayer’s share of partnership ABILs
Loss Carryback and Carryforward
Non-capital losses may be deducted against income from all sources for the year in which they were incurred, in previous years, or in future years. For non-capital losses in taxation years after 2005, non-capital losses can be carried back for up to three years and forward for up to 20 years to be applied against any source of income in those years. A taxpayer is not required to deduct all available non-capital loss carryovers in any particular year. When carrying over a non-capital loss, the taxpayer should pay attention to his or her marginal tax rate during the year in which he or she is claiming the loss carried over, to optimize the value of the loss carryover. If the taxpayer expects to be in a high tax bracket for several years, he or she may only want to use enough of the loss in any one year to drop one tax bracket, saving the remaining loss for the next year. The taxpayer also would not want to use the loss carryover to reduce his taxable income below the point at which tax would otherwise not be payable actoring in the personal tax credit and other available credits. This year, Amanda has the option of reporting a non-capital loss carryover of $9,200. However, she allocated all of her revenues into the expansion of her business and as a result, only had taxable income of $6,400. Since her taxable income is well below the basic personal amount available to all taxpayers, it doesn’t make sense for Amanda to claim the loss carryover this year because her tax liability is already $0.
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Income Tax Planning To carry back a non-capital loss, the taxpayer may fill in form T1A, instead of submitting a revised return. To carry forward a non-capital loss, the taxpayer enters the amount on his or her T1 General Return. Refer to IT-232, Losses - Their Deductibility in the Loss Year or in Other Years, for more information about the deductibility of business losses.
Fiscal Year
So far in our examples, we have only looked at businesses where the fiscal year corresponds to the calendar year. However, this is not always the case, and this has tax implications as discussed below. A fiscal year is an accounting period that normally covers 365 consecutive days (366 days during a leap year), such that at the end of this period the business closes its books for the year and determines its profit or loss for that period. In contrast, a calendar year includes the 365 consecutive days (366 days during a leap year) extending from January 1st to December 31st. For individuals, the taxation year is based on the calendar year. Samantha has a business with a fiscal year-end of March 31st. The calendar year runs from January 1st through December 31st, but Samantha’s fiscal year runs from April 1st through March 31st of the following year.
In the past, a proprietorship or partnership was able to choose a fiscal period or taxation year that did not correspond to the calendar year. However, the sole proprietor or partner as an individual had to report personal income on a calendar year basis. This used to provide the opportunity to defer the reporting of business income. While certain new and existing businesses may still have a non-calendar year-end, the Income Tax Act imposes an alternative income inclusion calculation that eliminates the potential for a tax deferral (ITA 34.2(1)). Jonathan has been operating a commercial landscaping and snow removal business since 1982. He chose a fiscal year-end of April 15th because this is generally after his snow removal calls are finished for the year and before his landscaping calls begin. Anthony began operating a cross-country skiing clinic in January, and he chose April 30th as his year-end. Both Jonathan and Anthony may elect to have a non-calendar year-end, but the income inclusion provisions of the Income Tax Act will preclude any opportunity for tax deferral.
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Proprietorships and Partnerships Filing deadlines The due date for filing personal income tax returns is June 15th for individuals who are partners or sole proprietors, and their spouses or common-law partners. However, any tax owing is still payable on April 30th each year and interest is charged from April 30th on unpaid taxes. Interest on tax refunds is still payable beginning 45 days after the later of April 30th and the date the return is filed.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Business Income. In this lesson, you have learned how to do the following: • identify and calculate business income, business deductions, and a partner’s income
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Business Income, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Review
Let’s look at the concepts covered in this unit: • • • • • The Role of Businesses in Wealth Accumulation Partnerships Partnerships and Income Tax Limited Partnerships Business Income
You now have a good understanding of the basics of proprietorships and partnerships. At this point in the course you can describe the types of business income generated by a proprietorship or partnership, describe the types of partnerships, and explain how the Income Tax Act views partnership income and income allocation. You can also describe the structure of limited partnerships and how they are established as well as identify and calculate business income, business deductions, and a partner’s income. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 2: Proprietorships and Partnerships, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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I FP
Unit 3: Corporations
Income Tax Planning
Unit 3: Corporations
Welcome to Corporations. In this unit, you will learn about the nature and different types of business corporations, the process of acquiring shares, and the role of the corporation in wealth accumulation. A basic understanding of the nature of corporations is very important because you will have clients who own, manage, and invest in corporations and you might chose to run your own financial planning business through a corporation. This unit takes approximately 4 hours to complete. You will learn about the following topics: • • • • • • • • Defining a Corporation Types of Business Corporations Shares and Shareholders Organizational Structure of a Corporation Corporate Taxation 1 Corporate Taxation 2 Taxation of Shareholders Corporations as Wealth Accumulation Vehicles for the Owner/Manager
To start with the first lesson, click Defining a Corporation on the table of contents.
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Corporations
Lesson 1: Defining a Corporation
Welcome to Defining a Corporation. In this lesson, you will learn about the nature, liability, and management of corporations. This lesson takes 15 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the general nature of corporations give examples of how corporations are governed or managed
Defining a Corporation
A corporation is a business form that is recognized by the legal system as being a nonhuman individual with its own rights and duties, defined by the following characteristics: • • • • • limited liability continuous existence separation of management and ownership ease of transfer of ownership no duty of loyalty from the owners
Unlike a partnership or sole proprietorship, there is no requirement for a corporation to carry on business activities. So, a corporation can be used to hold investments and, in fact, that is the purpose of a holding company. Benjamin and his wife, Sarah, each own 50% of the shares of 135792468 British Columbia Limited, a holding company that in turn owns a number of stocks and bonds, as well as shares in an operating company that Benjamin manages.
Limited Liability
A corporation is a distinct legal entity separate from its owners, who are called shareholders. If a corporation fails, the most that the shareholders can lose is the amount they invested in the corporation. They cannot be held personally liable for the debts or other obligations of the corporation. Because a corporation gives the shareholders limited liability, it is also called a limited company. Lenders and suppliers evaluate the credit worthiness of a corporation before lending funds or extending credit. They may require personal guarantees from the shareholders if the assets of the corporation are not considered adequate security for the debt. This is common in small corporations where there are only a few shareholders and the shareholders also manage the business. By obtaining this personal guarantee, creditors can also look to a shareholder personally for repayment of a specific debt of the corporation. However, this personal liability is a result of the personal guarantee, not the person’s role as director or shareholder. Stephan recently incorporated a new construction company called Build-All Limited. The business needed to purchase about $60,000 worth of capital equipment and tried to obtain a business loan. Because the company has no assets and no credit history, the bank would not approve a loan unless Stephan personally guaranteed the loan. If Build-All defaults on the loan, the bank can then try to recover the debt from Stephan personally.
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Income Tax Planning
Continuous Existence
Corporations are different from other forms of business in that they allow for continuous or perpetual existence even after the death or retirement of a shareholder or the transfer of shares to new owners. The ownership interest of each deceased shareholder would pass through his or her estate to his or her beneficiaries; the beneficiaries would become the new owners. Jason operated a mobile sharpening business, Surely Sharp, as a sole proprietor. When Jason died, the business ceased to exist. Marge, Selma, Louise and Lisa operate a law practice as a partnership. Their partnership agreement states that if any one of them dies, the surviving partners will pay the estate of the deceased a lump sum of $200,000 in exchange for the deceased’s partnership interest, such that the partnership would now have only three partners. Carl and his wife Sandra each owned 50% of the shares in Capital Basics Ltd., when they were both killed in a car accident. In accordance with their wills, all of their assets were divided equally between their four surviving children. Each child now owns a 25% interest in Capital Basics Ltd.
Separation of Management and Ownership
A corporation is different from a sole proprietorship or partnership in that its management is legally separate from its ownership. This allows the corporation to hire professional managers to run the business. While the owners of the corporation are often also the managers, there are many corporations where the owners take no active role in management. In these cases, processes are needed to ensure that management remains accountable to the shareholders for running the corporation profitably. Although Carl and Sandra owned Capital Basics before their death, they had retired three years ago and the company was managed by their oldest son, Richard. Owner/managers As a financial planner, you are likely to have many clients who are either the sole owner/manager of a corporation, or one of only a few shareholders of a closely held corporation. An owner/manager is the term that is often used to refer to a person who is a major shareholder of a corporation and who also takes an active role in running that corporation. The corporation has become a favourite business form for entrepreneurs, because it provides them with limited liability and some tax advantages as well. Bob owns 60% of Bulldog Security Ltd., while his wife owns 10% and his brother owns the remaining 30%. Bob is the general manager of the company, while his brother is in charge of the sales department. Bob’s wife does not take an active role in the business.
Ease of Transfer of Ownership
A shareholder can generally sell his or her shares of a corporation without the approval of the corporation. The corporation maintains a share register to keep track of the shareholders, but some shares are not necessarily registered in the name of the beneficial
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Corporations owner. Any owner of the shares is allowed to register them and become entitled to all the rights of a shareholder. John bought 100 shares in Skyjack Ltd. through his broker. If he wants to sell the shares, he does not need Skyjack’s permission. Since John’s brokerage firm handles a lot of Skyjack shares, it keeps an inventory of these shares, and the shares that John bought are actually registered in the name of the brokerage firm. No duty of loyalty Unlike a partner, a shareholder does not owe any duty of loyalty to a corporation. He or she can freely pursue his or her own interests in supplying goods or services to the corporation or in buying and selling shares to maximize his or her investment return. The shareholder can also operate a business in direct competition with the corporation, although that competition could affect the existing corporation and thus decrease the value of his or her holdings in that corporation. In contrast, a partner in a partnership owes a duty of loyalty to the partnership and cannot pursue his or her interests to the detriment of the partnership by carrying on a competing business. Janice owns 20% of the shares in Clean House Corp., an incorporated commercial cleaning and restoration service. Janice also operates a Steamatic steam cleaning franchise as a sole proprietor. Steamatic serves both residential and commercial customers. However, Janice is not prohibited from operating the Steamatic franchise simply because she owns shares in Clean House Corp.
Exercise: Defining a Corporation
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Defining a Corporation. In this lesson, you have learned how to do the following: • • describe the general nature of corporations give examples of how corporations are governed or managed
If you are ready to move to the next lesson, click Types of Business Corporations on the table of contents.
Assessment
Now that you have completed Defining a Corporation, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Lesson 2: Types of Business Corporations
Welcome to Types of Business Corporations. In this lesson, you will learn about the different types of business corporations and how they are established. This lesson takes 25 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the different types of business corporations and how they are established compare and contrast private, public, and investment corporations
Types of Business Corporations
Corporations can be classified according to their purpose and ownership, resulting in the categories of business corporations, government corporations and charitable corporations. In this course, we are concerned only with business corporations. There are three primary types of business corporations: • • • public corporations private corporations investment corporations
Each of these types will be discussed on the following pages.
Public Corporations
A public corporation is one that: • • has one or more classes of its shares listed on a prescribed stock exchange in Canada has elected, or has been designated by CRA, to be a public corporation and, among other conditions, its shares are held by at least 150 shareholders, each of whom holds at least $500 worth of shares (ITA 89(1))
Based in Waterloo, Ontario, Research in Motion (RIM) is a leading designer, manufacturer and marketer of innovative wireless solutions for the worldwide mobile communications market. RIM is a large Canadian public corporation. Some of RIM’s shareholders may own a relatively small number of shares and are only interested in the investment prospects of buying and selling shares to make a profit. Other RIM shareholders are employed by RIM and may receive shares as a part of RIM’s profit-sharing plan;these shareholders may eventually own a significant number of RIM shares. Still another group of shareholders may own large blocks of shares in RIM for the purpose of controlling the company. Together, all of these shareholders own RIM. The shares of RIM are traded on the Toronto Stock Exchange. RIM’s annual report, stating the financial status of the company and its profits or losses for the year, is made public and is available to anyone upon request. RIM’s financial dealings are made public so that shareholders can determine whether or not to continue to hold shares in the company and so that shareholders can determine whether or not to continue to hold shares in the
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Income Tax Planning company and so that potential shareholders can decide whether or not to purchase shares in the company.
Private Corporations
A private corporation is one that is resident in Canada, is not a public corporation, and is not controlled directly or indirectly by one or more public corporations (ITA 89(1)). Special income tax rules apply to private corporations. Canadian-controlled private corporation (CCPC) A Canadian-controlled private corporation (CCPC) is a Canadian private corporation that is not controlled directly or indirectly by one or more non-residents or public corporations (ITA 125(7)). Trevor Greeter studied graphic design at an arts school in Saskatoon. As a student, Trevor began a thriving small business making greeting cards, and he originally operated the business as a sole proprietorship. When Trevor graduated, he decided to continue his card-making enterprise and designed his first full line of greeting cards. Soon he had several stores selling his cards. Trevor incorporated his business when he started making large profits and he wanted to branch out. Trevor now has a chain of ten card and gift stores. His merchandise is also available in some department stores and he employs 150 people on either a part-time or full-time basis. Trevor’s business is a Canadian-controlled private corporation. Trevor, his wife, their parents, and his sister own the shares in Trevor’s company and they are all Canadian residents. The shares are not publicly traded. Trevor originally sold the shares to his family members when he needed to raise capital to open his first two stores.
Investment Corporations
An investment corporation sells shares to investors or subscribers and uses the proceeds to purchase financial securities. If the investment corporation’s portfolio increases in value, the value of the investors’ shares increase in value. The shareholders stand to gain through capital appreciation and dividends. There are two types of investment corporations: closed-end and open-end. Closed-end investment corporations A closed-end investment corporation has a fixed number of shares that are bought and sold on a stock exchange in the secondary securities market or in the over-the-counter market. The secondary market is the market for trading previously issued securities, and it includes the stock exchanges and the over-the-counter market. The over-the-counter market (OTC) refers to a computerized network of brokers and securities firms that specialize in trading stocks that are not listed on an exchange. Once all of the shares are sold, the investment corporation does not issue any new shares. The net asset value (NAV) of shares in either a closed-end or open-end investment corporation is calculated at a point in time as the fair market value of the investments held by the investment corporation divided by the number of shares issued by that corporation.
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Corporations
XYZ Investment Corp. initially issued 100,000 shares for $10 each. With the proceeds, XYZ created an investment portfolio that is currently worth $1.8 million. Thus XYZ currently has a NAV of $18 per share, calculated as (value of investment portfolio ÷ number of shares) or ($1.8 million ÷ 100,000). The shares of a closed-end investment corporation may trade at more or less than its net asset value (NAV), depending on market demand. Although the NAV of XYZ is currently $18 dollars per share, Henry believes that the investment corporation is going to continue to do well and he is willing to pay $19 per share. However, Henry must find an XYZ investor who is willing to sell her shares before he can purchase them, because XYZ will not issue any new shares. Open-end investment corporations An open-end investment corporation is usually called a mutual fund. Investors buy shares from the investment company and resell them to that same company when they no longer want to hold on to them. Shares in an open-end mutual fund are not traded on the open market. Instead, they are purchased directly from the investment corporation and they are sold back to the same corporation when the investor no longer wants them. The mutual fund corporation uses the money it receives from investors to invest in a portfolio of securities. If the portfolio does well, the NAV per share increases. Unlike a closed-end fund, the shares in a mutual fund company are purchased and sold at their net asset value. If the NAV increases, the investor can realize a gain when he or she redeems the shares. Unlike a closed-end investment corporation, an open-end investment corporation can issue any number of shares and will likely continue to do so as long as there is a demand for them.
Exercise: Types of Business Corporations
Establishing a Corporation
A company is incorporated in one of the following ways, depending on the nature and scope of the business: • • • • under the federal Canada Business Corporations Act (CBCA) if the business operates nationally under the provincial legislation that governs corporations, such as the Ontario Business Corporations Act under a special act of the provincial legislature by direct Royal Charter (in this century, this is only done in the special case of charitable organizations)
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Income Tax Planning In order to establish a corporation, the following documents must be filed with the appropriate branch of the federal or provincial government: • • • • • an application articles of incorporation a notice of directors a name search report the appropriate filing fee
Choosing a Federal or Provincial Charter
Federal charter A company must be incorporated under the Canada Business Corporations Act (i.e., obtain a federal charter) if it is being established to do business in any of the federally-regulated industries, such as banking, broadcasting or rail transportation. A company may obtain a federal charter even if its business is not federally regulated. A company with a federal charter is allowed to operate in any province of Canada without permission of any province, so most national corporations have a federal charter. Even though Q236 FM, a newly established rap music station, intends to broadcast only from Winnipeg, it had to incorporate under the Canada Business Corporations Act because its operation is federally regulated. Provincial charter If the business is going to operate only in one province and does not require a federal charter, it can obtain a provincial charter by applying to the appropriate provincial government department. A company incorporated in one province can establish a place of business in another province by registering and obtaining that province’s permission to do business there after filing certain basic information. Usually, it is not difficult to obtain that permission. When Gerry first incorporated Executive Mobility Inc., his executive training service in Nova Scotia, he did not anticipate operating outside of the province. However, his business has become very successful and he is planning to open training facilities in New Brunswick as well. He does not have to establish a new corporation in New Brunswick if he registers Executive Mobility Inc. with the province of New Brunswick and obtains their permission to operate there.
Incorporation Documents
Corporate name The corporation name must end in "Corporation", "Incorporated", "Inc.", "Limited" or "Ltd." to indicate clearly to the consumer that the organization is incorporated. The application for incorporation must be accompanied by a name search on the proposed corporate name because a new corporation cannot have a name that is too similar to an existing business name. Instead of incorporating under a specific name, a corporation can simply become a numbered company by allowing the registrar to assign the next number to the corporation, such as 124756 Canada Inc. or 745092 British Columbia Limited.
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Corporations
Notice of directors The notice of directors documents the names of the initial directors who will hold office until the first shareholders’ meeting. At that meeting, the shareholders will have the opportunity to elect a slate of directors. Articles of incorporation The application for incorporation is accompanied by the articles of incorporation, which document the fundamental characteristics of the corporation, including: • • • • the business name the number of directors the number and classes of shares that the corporation is authorized to issue any restrictions on the business activities that the corporation can undertake
The provisions set out by the articles of incorporation can only be amended by filing articles of amendment that have received the approval of the shareholders. Certificate of incorporation Once the appropriate government office has received the application, articles of incorporation and any required fees, it will issue a certificate of incorporation. The date of this certificate is the date the corporation comes into existence. Gerry submitted his application to incorporate Executive Mobility on June 15th. The government issued the certificate of incorporation on August 2nd. Prior to this date, Gerry was operating as a sole proprietor, because Executive Mobility Inc. was not established until the date the certificate was issued.
Exercise: Establishing a Corporation
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Types of Business Corporations. In this lesson, you have learned how to do the following: • • describe the different types of business corporations and how they are established compare and contrast private, public, and investment corporations
If you are ready to move to the next lesson, click Shares and Shareholders on the table of contents.
Assessment
Now that you have completed Types of Business Corporations, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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3-11
Corporations
Lesson 3: Shares and Shareholders
Welcome to Shares and Shareholders. In this lesson, you will learn about the process of acquiring shares, the different share structures, and the different types of dividends. This lesson takes 20 minutes to complete. At the end of this lesson, you will be able to do the following: • • • • describe the process of acquiring shares explain the different share structures contrast and compare the different types of dividends calculate the tax impact of different types of dividends
Shares and Shareholders
Once the business is incorporated, the directors can pass a resolution to issue shares to raise capital. A share is a standard unit of equity or ownership in the corporation. The owners of the corporation are thus called shareholders. The shares are also referred to as stock in the company. Purchasing shares A shareholder purchases his or her share of the ownership of the corporation by contributing cash or property to the corporation. This cash or property is referred to as the shareholder’s capital. The extent of his or her ownership interest in the corporation is measured by the number of shares that he or she receives in exchange for his or her contribution, in relation to the total number of shares issued. Nancy purchased 1,000 shares in Newmark Inc., which has a total of 1,000,000 shares outstanding. Nancy has a 0.1% ownership interest in Newmark, calculated as (# of Nancy's Newmark shares ÷ total Newmark shares outstanding) or (1,000 ÷ 1,000,000). Nancy also purchased 1,000 shares in Oldmark Inc., which has only 10,000 shares outstanding. Nancy has a 10% interest in Oldmark Inc., calculated as (# of Nancy's Oldmark shares ÷ total Oldmark shares outstanding) or (1,000 ÷ 10,000). So, even though Nancy has 1,000 shares in each company, she has a much larger ownership interest in Oldmark Inc. because it has a smaller number of outstanding shares. Setting the initial share price The price per share is established by the corporation when it issues the shares. While there is no legislative provision governing the number of shares issued or the issue price, the number of shares that a corporation is authorized to issue may be set out in its corporate charter. The company will consider how much capital it wants to raise and try to set a share price that will attract a sufficient number of investors to raise that amount. If they price the stock too high, few investors may purchase the shares because it would require too large of a capital investment. However, if they price the shares too low, some investors may doubt the quality of the stock issue. In raising $1 million in capital, TriCorp might sell 1,000 shares at $1,000 each, while Pennystock Inc. might sell 2 million shares at 50 cents. The corporation will try to choose a price point that will appeal to investors.
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Income Tax Planning Effect of sales between investors Subsequently, the original purchaser may sell his or her shares to another investor. This transaction is between the two shareholders and does not involve the corporation other than registering the new shareholder. The only capital the corporation recognized is the cash or property it received when it originally sold the shares. Alice originally purchased 10 shares of TriCorp at $1,000 each. Unfortunately, the share price declined and she eventually sold her shares for $500 each. The fact that the shares traded at $500 each does not affect TriCorp’s finances, because it only recognizes the fact that it originally received $1,000 for each share.
Shareholders' Equity
The shareholders of a corporation initially contribute cash or other property to acquire their interest in the corporation. Their initial investment plus the earnings of the corporation that are retained (i.e., the profits that are left in the company after it pays dividends) is referred to as the shareholders’ equity. This amount is also called the book value of the shares per the financial statements of the corporation. This book value may differ significantly from the value that the market puts on the shares. When Amazing Corp. was first established, it issued 1,000 shares at $100 each, raising total shareholder capital of $100,000. After its first year of business, Amazing had net income after taxes of $80,000. It then paid out dividends of $50 per share, leaving retained earnings of $30,000, calculated as (net income after taxes - (dividend per share x number of shares)) or ($80,000 – ($50 × 1,000)). The shareholder’s equity at the end of the year is $130,000, calculated as (proceeds from issue of shares + retained earnings) or ($100,000 + $30,000). The book value of Amazing Corp. is now $130 per share, calculated as (shareholders' equity ÷ number of shares) or ($130,000 ÷ 1,000). However, the shares may trade for more or less than $130, depending on how investors feel about the future prospects of Amazing Corp.
Types of Shares
Corporations may issue common shares, preferred shares, or both. In addition, it may offer more than one class of common shares and more than one class of preferred shares. The different classes can be differentiated by name (such as Class A Common, Class B Common or Class A Preferred) or by voting rights (voting or non-voting). Common shares Common shares represent the true equity ownership of the corporation, with all the benefits and risks of such ownership. Canadian Tire has two classes of common shares, one class with voting rights, and one class without. The founding Billes family and the dealers control the corporation through ownership of the voting common shares.
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Corporations Preferred shares Preferred shares are a hybrid security in that they have some characteristics of common shares and some of bonds. Preferred shares usually have a specified dividend rate, such that the corporation will pay dividends at that rate as long as it is able. In most cases, preferred dividends must be paid before dividends can be paid to common shareholders. Preferred shareholders also have a preferred claim on the assets of the corporation. This means that if the corporation goes bankrupt and its assets are liquidated, the preferred shareholders will receive their investment back before the common shareholders. However, in exchange for these benefits, preferred shareholders may forfeit the equity growth in the company. The Bank of Nova Scotia offers six different classes of preferred shares with annual dividends ranging from $1.31 to $1.78 per share.
Exercise: Shares and Shareholders
Dividends
Shareholders can receive one or more of the following types of dividends: • • • • regular dividends capital dividends capital gains dividends stock dividends
Regular dividends Regular dividends are the portion of a corporation’s after-tax profit that is paid out periodically to the shareholders. The directors decide how much of the profit will be paid out as dividends. The total amount to be paid is divided among the shareholders on the basis of the number of shares owned. Dividends of a public corporation are usually paid on a quarterly basis. Some or all of a corporation’s profit can be retained in the business to finance future growth. The amount of profit kept in the business and not paid out as dividends is called retained earnings. True Corp. had an after-tax profit of $800,000 last year. It paid a quarterly dividend of $0.50 per share to each of its 250,000 shareholders, for total annual dividends paid of $500,000, calculated as ((number of shares x quarterly dividend) x quarters per year) or ((250,000 × $0.50) × 4). It kept the remaining $300,000, calculated as (after-tax profit annual dividends) or ($800,000 - $500,000) as retained earnings to finance plant expansion in the near future.
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Income Tax Planning Capital dividends Capital dividends are payments that the shareholders receive from a private corporation’s capital dividend account. The capital dividend account is not a bank account, rather it is a notional account on the corporation’s income tax return. It records the total of the tax-free 50% of capital gains, the tax-free portion of the death benefits from company-held life insurance policies, and the tax-free portion of sales of goodwill. This type of dividend is not paid regularly. Because the capital dividend account represents income or gains that are not otherwise taxable, the dividend income from the capital dividend account is not taxable to the shareholders when it is received (ITA 89(1), (83(2)). Example Inc., a private corporation, owned a lot of surplus land adjacent to its existing manufacturing operations. It managed to sever the surplus land and sell it, resulting in a capital gain of $240,000. Only 50% of this gain is subject to income tax, and the remaining $120,000, calculated as (capital gain x non-taxable portion of capital gain) or ($240,000 × 50%), was added to the corporation’s capital dividend account. At the end of the year, the directors of Example Inc. decided to distribute the $120,000 in this account to its shareholders as a capital dividend. The dividend is not taxable to the shareholders. Refer to IT-66R6, Capital Dividends, for more information. Capital gains dividends A capital gains dividend is the money distributed by an investment corporation when it realizes a capital gain on an investment. An investment corporation must distribute all income that it earns on its portfolio investments, including capital gains if it wants to avoid paying tax on that income. A capital gains dividend is reported by the shareholder for income tax purposes just as any other capital gain. So, although it is called a dividend, the capital gains dividend is really just another name for a payment of capital gains that flow through to the investors. When investment income flows through to an investor, it retains its character for tax purposes. So, capital gains that flow through to an investor are subject to a 50% income inclusion rate, while dividends from taxable Canadian corporations that flow through to an investor are eligible for the dividend gross-up and tax credit scheme. During the past year, the Alias Mutual Fund made many adjustments to its investment portfolio, resulting in net capital gains of $400,000. To avoid paying tax itself on those gains, Alias distributed the capital gain to its shareholders before the end of the year as a capital gains dividend of $1 per share. Michael holds 1,000 shares in Alias and thus he will have to report taxable capital gains of $500 on his tax return, calculated as ((capital gains dividend per share x number of shares) x capital gains inclusion rate) or (($1 x 1,000) x 50%). Michael must report $500 as part of his income, where he will pay tax based on his marginal rate.
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Corporations
Stock Dividends
A stock dividend is a dividend that is paid by a corporation in the form of additional stock in the payer corporation, accompanied by an increase in the paid-up capital of the corporation (ITA 248(1)). A dividend that is paid in the form of shares in another corporation is a dividend in kind, not a stock dividend. Stock dividends are often paid by rapidly growing companies that prefer to capitalize their retained earnings to finance future growth or by companies that have not realized sufficient cash flow to pay cash dividends. DEF Ltd. has 20,000 outstanding shares and existing paid-up capital of $10,000,000, or $500 per share, calculated as (paid up capital ÷ number of shares) or ($10,000,000 ÷ 20,000). This year it had an after-tax profit of $400,000. It could distribute this amount as a taxable dividend, or it could simply retain the funds, in which case the value of the existing shares would increase as a result of the corporation’s increased equity. Alternatively, it could elect to capitalize the retained earnings by adding it to its paid-up capital account and issuing a stock dividend. Stock split A stock dividend is not the same thing as a stock split. In a stock split, there is an increase in the number of shares accompanied by a proportional decrease in the paid-up capital per share, so that neither the total amount of paid-up capital nor the amount of surplus available for distribution as a dividend is altered. In a stock dividend, there is a distribution of shares accompanied by a capitalization of retained earnings or any other surplus account that was available for distribution as a dividend. ABC Inc. has ten shareholders, each with 100 shares, so each shareholder owns a 10% interest in the company, calculated as (number of shares held by one shareholder ÷ (number of shareholders x number of shares held by each shareholder)) (100 ÷ (10 × 100)). Each shareholder initially paid $500 per share, so ABC Inc. has paid-up capital of $500,000, calculated as (number of shareholders x number of shares held by each shareholder x paid up capital per share) or (10 × 100 × $500). If ABC Inc. issues 5% more shares to each shareholder without a corresponding capitalization of retained earnings, it will still have paid up capital of $500,000. However, there will now be 1,050 shares outstanding, calculated as (number of shareholders x number of original shares per shareholder x (100% + percentage of new shares issued) or ((10 × 100) × 105%). So, the value of each share after a stock split decreases, because the paid-up capital per share in this case has reduced to $476.19, calculated as (total shareholders' equity ÷ number of new shares outstanding) or ($500,000 ÷ 1,050).
Exercise: Dividends
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Shares and Shareholders. In this lesson, you have learned how to do the following: • • • • describe the process of acquiring shares explain the different share structures contrast and compare the different types of dividends calculate the tax impact of different types of dividends
If you are ready to move to the next lesson, click Organizational Structure of a Corporation on the table of contents.
Assessment
Now that you have completed Shares and Shareholders, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score.
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3-17
Corporations
Lesson 4: Organizational Structure of a Corporation
Welcome to Organizational Structure of a Corporation. In this lesson, you will learn about the roles and duties of the individuals involved in a corporation as well as the governing legislation of a corporation. This lesson takes 25 minutes to complete. At the end of this lesson, you will be able to do the following: • • • explain the roles and duties of the individuals involved in a corporation explain the role of the corporation itself describe the governing legislation of a corporation
Directors
Organizational structure of a corporation In the case of a corporation, ownership is separate from management. The shareholders do not necessarily control the operation of the corporation, or at least not directly. Instead, the corporation is controlled by directors and hired managers. Directors are individuals who are elected to manage the business and affairs of the corporation, where: • • the affairs of the corporation are the internal arrangements among those responsible for running the corporation and its main beneficiaries, the shareholders the business of the corporation refers to the external relations between a corporation and those who deal with it as a business enterprise, such as its customers, suppliers, employees, government regulators and society as a whole
A corporation must have at least one director. The first directors of a corporation are appointed by the notice of directors submitted at the time of incorporation and they hold office until the first shareholder’s meeting. Subsequently, the directors are elected by the shareholders at the annual shareholders’ meeting. Other than electing the directors, the shareholders have little say in the business and affairs of the corporation. While the directors may also be shareholders, they do not have to be shareholders. The shares of Big Box Enterprises Ltd. are held by over 3,000 different investors. However, the majority of these shareholders do not take an active role in managing the business and affairs of the corporation. Instead, these duties are performed by a board of ten directors. Seven of the directors hold shares in Big Box, but three do not.
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Income Tax Planning Directors’ powers Specific ongoing powers of the directors include the following: • • • • approving the issuance of shares in accordance with the corporation’s articles of incorporation declaring dividends adopting by-laws to govern the day-to-day affairs of the corporation calling shareholders’ meetings, which must be done at least annually
Directors’ duties Each director has several duties to the corporation, including the duty to: • • • • exercise care and skill in carrying out his or her responsibilities act in the best interests of the corporation refrain from abuse of corporate opportunities avoid insider trading, which is buying or selling the securities of the corporation while making use of confidential information
Corporate By-laws
One of the first jobs of the board of directors is to establish corporate by-laws that specify the approved arrangements for carrying out the business of the corporation. Some of the more common provisions specified in the by-laws include the following: • • • • how notice is to be given regarding meetings of directors or shareholders what constitutes a quorum for such a meeting whether or not auditors are appointed who may sign contracts on behalf of the corporation
While the by-laws are normally established by the initial slate of directors, they must be approved by the shareholders at their first meeting following their election of the directors. When Major Deals Ltd., first incorporated, there were a total of four people on the board of directors and 24 different shareholders. This board drafted the bylaws of the corporation and then called a meeting of the shareholders, at which time the shareholders approved the bylaws and voted for the current slate of directors. Closely held corporations A closely held corporation is a private corporation where there are only a few shareholders (or even only one shareholder) and where shares are not distributed to the public. In a closely held corporation, the Business Corporations Acts specify that there only needs to be one director and that director can also be the major shareholder and the manager of the business. A closely held corporation can have more than one director, but in any event, the minimum and maximum number of directors must be specified in the articles of incorporation. In a closely held corporation, it is likely that all of the shareholders will take an active role in the business and they will all want to be directors so that they can have control over the management of the corporation and the distribution of corporate profits.
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3-19
Corporations
Exercise: Directors of a Corporation
Rights of the Shareholder
Shareholders elect the directors of the company, and have a right to vote on major issues such as the sale or purchase of portions of the business or mergers or liquidation. Shareholders can be employed by the business, but do not have to be. Shareholders can also be directors and, in private corporations, the major shareholders are usually the directors. Shareholders’ meetings Shareholders’ meetings are held when necessary to attend to major issues, but they must be held at least annually in any event. The annual meeting is held to elect new directors, if necessary, and to discuss the corporation’s financial statements and the auditor’s report for the year if an auditor is appointed. An investor would be wise to take an interest in how the corporation is run because this could alert him or her to the future prospects of the investment. All voting shareholders are sent information regarding the date and place of shareholders’ meetings. They may also be sent a proxy form, which allows shareholders to send representatives to vote in their places if they are unable to attend. The issues that will be voted on are included in the information package, allowing the shareholders to indicate to their proxies how they wish them to vote on each issue. A minimum number of shareholders or their proxies must be in attendance at the shareholders’ meeting in order for votes to be taken. Shareholders’ agreements A shareholders’ agreement is similar to a partnership agreement in that it is intended to override or replace the default rules set out by provincial or federal legislation. The purpose of the agreement is to establish customized rules that will govern the corporation in question, thereby protecting the unique interests of the shareholders. A shareholders’ agreement is usually used when the corporation is owned by a small group of shareholders and the shareholders’ lawyers draft it when the corporation is first established. A shareholders’ agreement stipulates the roles of the shareholders in running the corporation, as well as their rights and responsibilities. It lists who will be the officers and directors of the corporation and their terms of office. For a small corporation, it might even stipulate details regarding salaries, bonuses, benefits, vacation policies and confidentiality agreements.
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Income Tax Planning Shareholders’ agreements usually address the following issues: • • • • • • • • • issuing more shares lending money to officers or shareholders determining the payment and amounts of dividends taking on new debt using any corporation assets as collateral for debts hiring family members transferring shares changing the nature or purpose of the business in any substantial way signing any major contracts or leases
Controls on Share Transfers
First right of refusal In the absence of any special agreements, shares in both public and private corporations are assumed to be freely transferable. They can be sold at the will of the existing shareholder as long as there is someone willing to purchase them. In corporations with only a few shareholders, all of the shareholders are concerned about the loss of control over the corporation that could occur if one of the existing shareholders should decide to sell his or her shares to an outsider. For this reason, most shareholders’ agreements also give the remaining shareholders the first right of refusal to buy the shares of a shareholder who has irreconcilable differences or who is unable to continue investing in the corporation due to disability, illness, death, retirement or bankruptcy. Doreen, Harry, Pearl and Mac each own 25% of the shares in Bluebird Ltd. When they first incorporated the business, they executed a shareholders’ agreement giving the remaining shareholders the first right of refusal to buy the shares of a departing or deceased member at the corporation’s book value. Pearl wants to retire and pass the shares on to her grandson, Jake. Doreen, Harry, and Mac all find Jake to be an annoying, irresponsible person, and they are very glad that they can keep Pearl from passing her interest on to Jake by purchasing her shares in the business. Shotgun buy-sell provision A shotgun buy-sell provision specifies that one shareholder can offer to buy the shares of another shareholder at a specific price. If exercised, the shareholder must either sell his or her shares or buy the shares of the first shareholder at that price. Shotgun buy-sell provisions are rarely used when there are more than two shareholders, as they become too complicated to arrange. Lawrence and Beverly each own 50% of the 100 outstanding shares in a software development company and they executed a shotgun buy-sell agreement at the time of incorporation. Beverly cannot stand working with Lawrence any more, so she offered to buy his shares for $50,000. Lawrence must either sell the shares to Beverly, or he must purchase her shares for $50,000. A share redemption plan is an agreement between the shareholders and the corporation that states that the corporation must purchase the interest of a shareholder at a fixed price or at a price determined by a formula included in the agreement. In the case of a deceased shareholder, this ensures that the deceased’s estate will get a fair price for his shares upon his death. It also ensures that the remaining shareholders do not have to worry about who
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Corporations the new owner might be. When a corporation redeems the shares of a deceased shareholder, the number of outstanding shares decreases by a corresponding amount and as a result, the proportionate ownership of the surviving shareholders increases. Fred, Wilma, Barney, and Betty were the only four shareholders in Rockaberry Beverages Ltd., with 250 shares each. So, they each had a 25% interest in the company, calculated as (number of shares held by one shareholder ÷ (number of shares held by each shareholder x number of shareholders)) or (250 ÷ (250 × 4)). They all entered into a share redemption agreement with Rockaberry that specified that if any one of them was to die, Rockaberry would purchase his or her shares at $1,000 per share. One unfortunate day, Barney was crushed by shifting boulders in a nearby quarry. Rockaberry paid $250,000 to Barney’s estate to acquire his shares. Now Fred, Wilma, and Betty each have a 331/3% interest in the company, calculated as (number of shares held by one shareholder ÷ (number of shares held by each shareholder x number of shareholders)) or (250 ÷ (250 × 3)). Share redemption plan In the case of a deceased shareholder, this ensures that the deceased’s estate will get a fair price for his or her shares upon his or her death.
Managers
While the directors have general control over the business and affairs of the corporation, they often delegate much of their decision making authority to one or more business managers, putting in place a management hierarchy that could include a chief executive officer (CEO), a president, and one or more vice presidents. While Big Box Ltd. has a 10-member board of directors who oversee the business, they hired Mr. McGaw to oversee the day-to-day operation of the business. Mr. McGaw is neither a shareholder nor a director. He is an employee of the corporation.
Governing Legislation
Corporations are established in accordance with either federal or provincial Business Corporations Acts. However, because corporations issue shares in order to raise capital, they may also be governed by provincial securities legislation.
Corporate Law
In addition to setting out the procedures for incorporating a business, the provincial and federal Business Corporation Acts lay out default rules that govern the relationship between the corporation and its shareholders. These default rules apply in the absence of any other rules being adopted by the corporation and its shareholders through articles, by-laws or a shareholders’ agreement.
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Income Tax Planning These default rules are in place primarily to protect the interests of shareholders by: • • • • limiting the shareholder’s liability, such that the most a shareholder can lose is the amount of his or her investment imposing standards of behaviour on managers to ensure they act in the best interests of the corporation and its shareholders, rather than in their own interests requiring regular shareholder meetings that follow a standard protocol making sure that the interests of minority shareholders are protected
Some of the default rules are also meant to protect people unconnected with the corporation, such as creditors. For example, corporate law dictates that a corporation may not pay dividends to its shareholders if it is insolvent, or would become insolvent if it made those dividend payments.
Securities Law
Because a public corporation by its very nature issues securities that may be traded in the marketplace, it is also governed by provincial securities laws. Securities laws serve to ensure that the marketplace operates honestly and that buyers and sellers have enough information to make informed decisions about their investments. It does this by requiring the disclosure of pertinent information by the issuing corporation on an ongoing basis, both to existing shareholders and to prospective shareholders. While corporate law requires a disclosure of information to existing shareholders, it does not require the disclosure of information to potential investors.
Exercise: Rights of the Shareholder and Governing Legislation
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Corporations
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Organizational Structure of a Corporation. In this lesson, you have learned how to do the following: • • • explain the roles and duties of the individuals involved in a corporation explain the role of the corporation itself describe the governing legislation of a corporation
If you are ready to move to the next lesson, click Corporate Taxation 1 on the table of contents.
Assessment
Now that you have completed Organizational Structure of a Corporation, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 5: Corporate Taxation 1
Welcome to Corporate Taxation 1. In this lesson, you will learn about a corporation’s accounting requirements. You will also learn how to calculate corporate tax elements such as dividends and deductions. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • • explain a corporation’s accounting requirements describe and calculate corporate tax elements such as dividends and deductions
Corporate Taxation
Corporations are legal and taxable entities that are separate and apart from their individual shareholders. Corporations must pay income tax on their profits before passing them on to their shareholders. When these after-tax profits are subsequently distributed to the shareholders in the form of dividends, they are then taxed a second time, resulting in double taxation. This double taxation has added much complexity to the Income Tax Act. We will try to keep it simple. Generally, the Income Tax Act tries to alleviate double taxation by integrating the corporate and individual tax systems. These two systems would be perfectly integrated if the tax that an individual taxpayer would pay on income earned directly is the same as the combined amount of personal and corporate tax that would be paid if the income is earned through a corporation. Integration of the corporate and individual tax systems is accomplished by reducing the effective tax rate in the corporation and the amount of tax that shareholders have to pay on dividends. If the shareholder is an individual, this reduction is accomplished by the dividend gross-up and tax credit scheme. If the shareholder is another corporation, it generally receives dividends from other corporations free from tax.
General Taxation Scheme
Generally, corporations resident in Canada are taxed on their world income with appropriate credit for taxes paid in other countries. The corporate tax return is similar to the individual tax return with supporting schedules and calculations of deductions. The following tables set out the steps taken in calculating the taxable income of Sidebar Inc., a Canadian corporation. Reconciling accounting income to net income for tax purposes The first step in this process involves reconciling the net accounting income recorded on the corporation’s financial statements with the net income that must be reported for income tax purposes. For example, depreciation expense is deducted to determine net accounting income on the corporation’s financial statements. Note: For each of the terms discussed below, the number that appears corresponds with the content of the table, which includes a sample Reconciliation of Accounting Income to Net Income for Tax Purposes for Sidebar Inc
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Corporations
Depreciation (1) or depreciation expense is an accounting concept that recognizes as an expense, an estimate of the decline in value of an asset used to produce income as the result of exhaustion, wear and tear, and obsolescence. Capital cost allowance (CCA) (2) is a tax concept that also recognizes that loss of value through depreciation occurs, but it does not necessarily measure it in the same way. The Income Tax Act sometimes allows CCA to be claimed at a higher rate than depreciation occurs in order to provide tax relief or incentives to certain industries or on certain capital purchases. So, when reconciling accounting income to net income for tax purposes, we must add back any depreciation expense, and deduct the corresponding CCA. Other adjustments are made to recognize that: • income taxes (3) and income tax penalties or interest (4) that were deducted to arrive at net accounting income must be added back to arrive at net income for tax purposes while the full gain on the sale of a capital asset is included in net accounting income, only 50% of that gain (5) has to be included in net income for tax purposes charitable donations (6) must be added back for the purpose of determining the allowable charitable donation deduction while capital dividends (7) received from a private Canadian corporation are included in net accounting income, they are not taxable so they can be deducted when determining net income for tax purposes
• • •
The table below includes a sample Reconciliation of Accounting Income to Net Income for Tax Purposes for Sidebar Inc. Sidebar’s net income for tax purposes is $384,050, even though its net accounting income was only $225,000. Reconciliation of Accounting Income to Net Income for Income Tax Purposes for Sidebar Inc. For the year ended December 31st Net income (loss) per financial statements Add: (3) Income tax provision $175,000 (1) Depreciation expense 35,250 (6) Charitable donations 4,000 (5) Taxable capital gains 10,500 (4) Interest and penalties on income taxes 2,300 Deduct: (Accounting) gain on disposal of assets (2) Capital cost allowance (7) Dividends not taxable under section 83 Net income for income tax purposes $21,000 32,000 15,000 (68,000) $484,050 $325,000
227,050
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Income Tax Planning
Exercise: Reconciling Accounting Income to Net Income
Calculating Taxable Income
Next, we have to calculate taxable income from net income for income tax purposes. We do this by making a number of deductions, as shown in the table below. Explanations of the deductions follow the table. For the year ended December 31st Net Income for income tax purposes (from Net Income for Income Tax Purposes table) Deduct: Charitable Donations (1) (maximum 75% of net income) Taxable Dividends
(2) (3)
$484,050
$4,000 2,000 13,000 3,000 (22,000) $462,050
Applicable loss of prior taxation years - Non-capital losses (4) - Net capital losses (5) Taxable income
(1) Charitable donations: the donations are less than 75% of net income, so we can deduct the entire amount.
(2) Dividends not taxable: regular taxable dividends received by a Canadian corporation from another Canadian corporation are not subject to Part I tax, so we can deduct them to arrive at taxable income (ITA 112).
(3) Applicable losses from prior taxation years: any losses carried forward from previous years can be deducted to reduce taxable income.
(4) Non-capital losses: primarily relate to business or property losses (i.e., rental losses) that were incurred in previous years and that have been carried forward to be deducted from taxable income in a future year.
(5) Net capital losses: arise when the losses incurred upon the sale of some of the corporation’s capital property exceed the capital gains realized upon the sale of other capital property. If the corporation cannot make use of a net capital loss in the current year, it can carry it forward and deduct it from taxable income in a future year.
Exercise: Calculating Taxable Income
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Corporations
Calculating Tax Payable
Basic federal corporate tax rate The basic federal rate on corporate income is 38% (ITA 123(1)). Effective 2008, the federal surtax of 1.2% which has been in place since 1996, has been eliminated. General rate reduction A general rate reduction1 is applied to any portion of full-rate taxable income for the taxation year (ITA 123.4(1), "general rate reduction"). Full-rate taxable income is income that does not receive any other form of preferential treatment under the Income Tax Act (e.g. small business deduction) (ITA 123.4(1), "full rate taxable income"). The general rate reduction provides the corporation with tax relief on income that would otherwise be subject to the full tax rate. The general rate reduction is prorated where the fiscal year-end falls within the calendar year. As per Budget 2006 and the 2007 federal Economic Statement, the aim of the government is to reduce corporate taxes to 15% by 2012 through annual tax reductions. In keeping with this plan, the general rate reduction rate has been incrementally increased in recent years such that effective 2009, it stands at 9%. Further increases of the general rate reduction percentage will take place in the years that follow. Given that manufacturing and processing income, investment income earned by a Canadian controlled private corporation (CCPC), income that is eligible for the small business deduction or income that is eligible for the accelerated general reduction are eligible for other types of reductions, the general rate reduction cannot be claimed (i.e. they are not sources of full-rate taxable income). Total Tax Payable for Sidebar Inc. For the Year Ended December 31st (ignoring the Small Business Deduction) Taxable Income (from the Calculating Taxable Income table) Tax at 38% Deduct: General rate reduction (1) in 2008: 8.5% [$462,050 x 8.5%] Federal tax abatement 10% (2) [$462,050 x 10%] Federal tax payable [$175,579 - $39,274 - $46,205] Provincial tax payable 10% of taxable income (3) [$462,050 x 10%] Total combined tax payable
(4)
$462,050 $175,579
($39,274) (46,205) $90,100 $46,205 $136,305
[$90,100 + $46,205]
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Income Tax Planning
Exercise: Calculating Tax Payable
Taxation Year
A corporation’s taxation year or fiscal year is a period of no more than 53 weeks at the end of which the corporation closes its books and determines a profit or loss for tax purposes. The company may arbitrarily select its fiscal year or taxation year when it is first incorporated, provided that no fiscal year exceeds 53 weeks. Once established, the fiscal period can only be changed with the consent of the Minister of National Revenue. The selection of a fiscal period that does not coincide with the calendar year can offer some tax deferral opportunities. The income paid out by a corporation as dividends is taxable to the receiving shareholder, who is an individual, in the calendar year in which it is received, which may or may not reflect the time period in which the profits were earned by the corporation. Bigwig Enterprises’ most recent fiscal year ran from January 15th of last year to January 14th of this year. During that time, it had after-tax profits of $1.2 million. At the end of its fiscal year, it declared a dividend to be payable on March 31st. As the major shareholder, Tony will receive $1 million in dividends. Although the dividends result from income that, for the most part, was earned by Bigwig last year, Tony does not have to include them in his taxable income until this year. Tony has realized a deferral of personal tax of almost one year. By comparison, had he received the income as employment income last year, instead of dividends this year, this income would have been taxable in the year it was received.
Canadian Corporations
A Canadian corporation is a corporation resident in Canada. The question of residence is important in determining whether a corporation is eligible for tax deductions such as the small business deduction. A taxable Canadian corporation is a Canadian corporation that is not exempt from tax. Exempt corporations include municipal and provincial corporations, registered charities, and certain non-profit corporations. The dividend gross-up and tax credit scheme is only available for dividends paid by a taxable Canadian corporation.
Taxation of Dividends
After a corporation pays tax on its net income, the directors decide how much of the aftertax income to distribute to shareholders in the form of dividends. Even though this income has already been taxed to the corporation, the dividends are also taxable to the shareholder. While this may sound like double taxation, the Income Tax Act imposes a scheme involving a dividend gross-up and tax credit (DTC) to mitigate the double taxation to some extent.
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Corporations Dividend gross-up and tax credit scheme The dividend tax credit depends on the kind of corporation paying the dividend. Canadian-controlled private corporation (CCPC) Dividends received from a Canadian-controlled private corporation (CCPC), to the extent that its income is taxable at the small business rate or is from a CCPC's investment income, are treated differently than dividends received from large public corporations. A Canadian-controlled private corporation (CCPC) is a Canadian corporation that is not controlled directly or indirectly by one or more non-residents or public corporations. This description fits most Canadian incorporated small businesses. Only CCPCs are eligible for the small business deduction. An individual who receives a dividend from a CCPC must include 125% of that dividend in taxable income for the year. This is referred to as the dividend gross-up. However, he or she can then claim a federal dividend tax credit of 13 1/3 % of the grossed-up dividend. A corresponding provincial dividend tax credit can also be claimed. Enhanced dividend tax credit Following the May 2006 federal budget, an enhanced dividend tax credit was introduced for dividends received after 2005 from: • • • public corporations resident in Canada other corporations resident in Canada that are not Canadian-controlled private corporations (CCPCs) and are subject to the general corporate tax rate CCPCs resident in Canada to the extent that their income is subject to tax at the general corporate tax rate, i.e. active business income above the small business deduction limit
With the enhanced dividend tax credit, 145% of the dividend received will be included in income. The result is a federal tax credit of approximately 18.97% *18.9655% is the exact percentage) of the taxable (grossed-up) dividend. Dividends received for which the enhanced dividend tax credit may be applied are referred to as eligible dividends. The provinces have their own corresponding enhanced dividend tax credit.
Exercise: Taxation of Dividends
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Income Tax Planning
Example: Enhanced Dividend Tax Credit
Example of Enhanced Dividend Gross-up and Credit Mechanism for Eligible Dividends received from a Public Corporation Assume you receive $100 in eligible dividends from a large public Canadian corporation. Other assumptions: Federal tax rate Federal dividend tax credit Provincial tax rate Provincial dividend tax credit 29.00% 18.97% 11.16% 6.50%
Illustration of tax paid on $100 of eligible dividend income Dividend received $100.00 Taxable dividend ($100 x 145%) $145.00 Federal income tax ($145 x 29%) $42.05 Less dividend tax credit ($145 x 18.97%) ($27.51) Net federal tax on $100 dividend $14.54 Provincial tax ($145 x 11.16%) Less provincial dividend tax credit ($145 x 6.50%) Net provincial tax on $100 dividend Total tax payable (provincial + federal) $16.18 ($9.43) $6.75 $21.29
Example: Taxation of Dividends
To illustrate the concepts in this section, we will use the example of two individuals, George and Sally, who are two of the shareholders of Sidebar Inc., a taxable Canadian corporation. George and Sally are Canadian residents, and the corporation has a fiscal year-end of December 31st. George and Sally will receive identical cash dividends that result from before-tax corporate profits of $10,000 per shareholder. Remember that dividends are paid from the corporation's after-tax income, so George and Sally will receive less than $10,000 in dividends. Assuming Sidebar Inc. can claim a general rate reduction of 9%, its corporate tax rate is 29%, calculated as (basic federal corporate tax rate - general rate reduction) or (38% 9%). If the corporation has before-tax profits of $10,000 per shareholder, the after-tax profits that can be distributed as dividends will be $7,100 per shareholder, calculated as [corporation's taxable income x (1- corporate tax rate)] or [$10,000 × (1 - 29%)]. If George receives a dividend of $7,100 from a taxable Canadian corporation, he will have to include $8,875 in his income, calculated as (cash dividend x gross up) or ($7,100 × 125%). He can then claim an offsetting federal tax credit of $1,183, calculated as (grossed-up dividend x federal dividend tax credit) or ($8,875 × 13 1/3%). This calculation also applies to Sally. George has a marginal tax rate of 21.05%, calculated as (federal marginal tax rate + provincial marginal tax rate) or (15% + 6.05%). Sally has a marginal tax rate of 43.7%, calculated as (federal marginal tax rate + provincial marginal tax rate) or (29% + 14.7%).
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Corporations The federal marginal tax rates for each individual (i.e. 15% for George; 29% for Sally) represents the lowest and highest marginal tax rates to which a taxpayer is subject. The provincial dividend tax credit in this province is 5.10% of the grossed-up dividend. If they both received the same cash dividend, the difference in the combined corporate and personal tax impact would be as shown in the table below. Remember that we said there is a certain level of integration between the individual and corporate tax systems to prevent or at least reduce double taxation. The success of the integration depends on the marginal tax rate of the individual taxpayer, and whether the corporation can make use of the small business deduction. The following table illustrates this point by comparing how much George and Sally will have left after all taxes are paid if they earn $10,000 directly, or if that same $10,000 is earned through a corporation that passes its after-tax profits on to its shareholders in the form of dividends. At this point, we will assume that the small business deduction is not available. In the case of both George and Sally, the tax burden is still significantly higher if they earn this income through the corporation instead of earning it directly. Although George's marginal tax rate is only 21.05%, by the time he receives the income through the corporation, it will essentially be taxed at a rate of 31.32%, calculated as [(income earned – amount remaining after tax) ÷ income earned] or (($10,000 $6,867.77) ÷ $10,000). Similarly, although Sally's marginal tax rate is 43.70%, the income she receives through the corporation is essentially taxed at a rate of 51.42%, calculated as [income earned – amount remaining after tax) ÷ income earned] or [($10,000 - $4,857.58) ÷ $10,000). After-tax income for income earned directly, compared to that same income flowing through a Corporation without using the Small Business Deduction Corporation George earns earns $10,000; $10,000 George directly receives after-tax profit
Marginal tax rate (federal rate + provincial rate) Income initially earned by corporation Income initially earned directly by taxpayer Less: corporate tax rate: 29% Equals: actual cash dividend Taxable / grossed-up dividend [cash dividend x 125% gross-up] Federal Tax: @ 15% [taxable dividend x 15%] @ 29% [taxable dividend x 29%] $ 1,331.25 n/a $ 1,500.00 n/a n/a $ 2,573.75 n/a $ 2,900.00 21.05% 21.05%
Corporation Sally earns earns $10,000; $10,000 Sally directly receives after-tax profit
43.70% 43.70%
$10,000.00 n/a ($ 2,900.00) $ 7,100.00 $ 8,875.00
n/a $10,000.00 n/a n/a n/a
$10,000.00 n/a ($ 2,900.00) $ 7,100.00 $ 8,875.00
n/a $10,000.00 n/a n/a n/a
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Income Tax Planning
Less: federal dividend tax credit [taxable dividend x 13 1/3%] Equals: basic federal tax Plus: provincial tax: @ 6.05% [taxable dividend x 6.05%] @ 14.70% [taxable dividend x 14.70%] Less: provincial dividend tax credit [taxable dividend x 5.10%] Equals: basic provincial tax
($ 1,183.33) $ 147.92
n/a $ 1,500.00
($ 1,183.33) $ 1,390.42
n/a $ 2,900.00
$
536.94 n/a
$
605.00 n/a
n/a $ 1,304,63
n/a $ 1,470.00
($ $
452.63) 84.31 $
n/a 605.00
($ $
452.63) 852.00
n/a $ 1,470.00
Total tax payable [federal tax + $ 232.23 $ 2,105.00 $ 2,242.42 $ 4,370.00 provincial tax] Amount remaining after tax $ 6,867.77 $ 7,895.00 $ 4,857.58 $ 5,630.00 [cash dividend or income – total tax payable] Combined corporate and 31.32% 21.05% 51.42% 43.70% individual tax rate [(initial cash dividend or income – amount remaining after tax) ÷ initial cash dividend or income]
So, the dividend gross-up and tax credit (DTC) scheme does not result in true integration if the corporate profits are taxed at 29%. Better integration is achieved if the corporation is eligible for the small business deduction, as discussed shortly.
Claiming the Small Business Deduction (SMABUD)
The combined federal and provincial corporate tax rate can be reduced in certain circumstances by making use of what is called the small business deduction. A corporation’s ability to make use of this deduction depends on the type of corporation and the source of its income. Public vs. private corporations Only certain private corporations are eligible for the small business deduction. It is never available to public corporations. Sleeman’s started out as a family-run microbrewery that took the form of a private corporation. As a result, it was able to make use of the small business deduction. However, when Sleeman’s went public in order to raise capital for expansion, it could no longer make use of the small business deduction. Canadian-controlled private corporations A Canadian-controlled private corporation (CCPC) is a Canadian corporation that is not controlled directly or indirectly by one or more non-residents or public corporations. This description fits most Canadian incorporated small businesses. Only CCPCs are eligible for the small business deduction.
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Corporations Bob is one of four shareholders in Bella Industries Ltd. Bella is not listed on any stock exchange and is considered to be a private corporation. However, one of the shareholders who owns 55% of the shares is a resident of the United States, not Canada, so Bella cannot take advantage of the small business deduction.
Types of Income Eligible for SMABUD
In deciding that some corporations should be eligible for special tax treatment, parliament also decided to restrict the treatment of income from certain types of corporate activities. The three types of corporate business income defined by ITA 125(7) are: • • • active business income income of a specified investment business income of a personal services business
Active business income An active business is any business carried on by a corporation other than a specified investment business or a personal services business (these will be discussed shortly) and it includes an adventure in the nature of trade (ITA 248(1)). Active business income includes any income pertaining to or incident to an active business, but does not include income from property (e.g. interest, dividends, rents and loyalties). This definition is very important, because a certain amount of active business income earned by a CCPC is eligible for the small business deduction, such that it is taxed at a federal rate of approximately 11% (ITA 125(1)). Specified investment business income A specified investment business is a business (other than a credit union or lessor of property other than real property) whose principal purpose is to derive income from property (including interest, dividends, rents or royalties), unless: • • the corporation employs more than five, full-time employees the corporation makes use of certain managerial or administrative services provided by an associated corporation, and the first corporation could have reasonably been expected to require more than five, full-time employees if those services had not been provided (ITA 248(1), 125(7))
Because the definition of an active business specifically excludes a specified investment business, specified investment income is not eligible for the small business deduction (ITA 125(7)). Personal services business income A personal services business refers to services that are provided by a specified shareholder of a corporation (or a relative of that specified shareholder) to another entity, such that the specified shareholder would have otherwise been deemed to be an employee of that entity if the corporation did not exist (ITA 248(1), 125 (7)). Since the definition of an active business specifically excludes a personal services business, personal service income is not eligible for the small business deduction and thus, it must be taxed at full corporate rates (ITA 125(7)). Any deductions for expenses other than salary,
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Income Tax Planning wages, and other remuneration paid to the individual who performs the services are disallowed. Hercules expects the Toronto Blue Jays to offer him a new contract for $14 million over three seasons. Hercules hates paying income tax, so he was looking for ways to reduce his tax liability. He decided to establish The Amazing Hercules Corporation (AHC), and have AHC enter into a contract with the Blue Jays for Hercules’ services. Hercules would be the majority shareholder, but he also decided to let his brother, sister, and mother each hold a 5% interest in AHC. Unfortunately for Hercules, according to the Income Tax Act, the $14 million over three years will be deemed to be income from a personal services business and it will not be eligible for the small business deduction. An exception to the personal services business rule occurs if the corporation employs more than five full-time employees including specified shareholders, or where the services are provided to an associated corporation. A single corporation could be carrying on a specified investment business or a professional services business along with an active business. Accordingly, the income of a Canadiancontrolled private corporation (CCPC) can be divided into several different categories: • • • • • • active business income from a business carried on primarily in Canada and eligible for the small business deduction income from a specified investment business income from a personal services business other investment income dividend income other income subject to tax at full rates with no special tax advantages
Rules and Limits Pertaining to SMABUD
The small business deduction (SMABUD) is a deduction that is available to Canadiancontrolled private corporations under ITA 125 for the purpose of reducing the tax payable on active business income between $200,000 and $500,000, depending on the taxation year. The following limits for active business income apply: Year before 2003 2003 2004 2005 and 2006 2007 and 2008 2009 SMABUD Limit $200,000 $225,000 $250,000 $300,000 $400,000 $500,000
This deduction is not restricted to small businesses, so the name is slightly deceptive. All corporations calculate their tax at the full basic federal tax rate on their entire income and then qualifying corporations claim a deduction on qualifying income as a tax reduction on federal tax otherwise payable. Therefore, the small business deduction is not calculated as a lower rate of tax on a specified amount of active business income.
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Corporations
The small business deduction recognizes the special financing difficulties and the higher cost of capital faced by small businesses and is intended to provide these corporations with more after-tax income for re-investment and expansion. Because the small business deduction is intended to benefit only small corporations, a large corporation's access to the deduction is restricted on the basis of its taxable capital employed in Canada. The small business deduction is phased out where corporate capital exceeds $10 million and it is eliminated where corporate capital exceeds $15 million. However, this does not mean that it cannot be used by some large businesses that have sufficiently low corporate capital with a large number of employees and a large corporate income, but then it will still be limited to the appropriate amount of active business income. In brief, the SMABUD rules are as follows: • • Only active business income earned in Canada by a Canadian-controlled private corporation qualifies for the deduction. Active business income includes the corporation's share of net active business income (or loss) from an active business carried on in Canada by a partnership of which the CCPC is a member. The annual maximum amount of active business income eligible for the small business deduction is $500,000 effective January 1, 2009. Associated corporations must share the annual business limit.
• •
Doublet Inc. is a CCPC with active business income from its own activities of $510,000. Doublet Inc. also holds a 50% interest in a partnership with Glovewear Corp., and a 25% interest in a partnership with Socks R Us Inc. The partnership with Glovewear had net active business income of $120,000, while the partnership with Socks R Us had a net loss from business activities of $44,000. Doublet's active business income for the purpose of calculating the small business deduction is $559,000, calculated as [Doublet's business income + (Glovewear's income x Doublet's interest in Glovewear + Socks R Us' business income x Doublet's interest in Socks R Us)] or [$510,000 + ($120,000 × 50%) - ($44,000 × 25%)]. Since Doublet has income that exceeds the small business deduction limit, Doublet will only be able to use the small business deduction on the first $500,000 of its total active business income. Associated corporations Two or more corporations are considered to be associated corporations if, at any time in the taxation year: • • • one corporation controlled the other corporation both of the corporations were controlled by the same person or group of persons the people or group of people who control each corporation were related to each other and at least one of them owns at least 25% of the shares in both corporations (ITA 256(1))
Associated corporations must share the annual business limit but they are free to negotiate how that limit is to be shared between them. The Income Tax Act does not impose a sharing formula.
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Income Tax Planning
Jeff, Lisa, and Aiden are siblings. Jeff owns 70% of Spicetrail Inc., while Lisa owns 30% of that company. Lisa owns 60% of Polarcap Limited, while Jeff owns 30% and Aiden owns 10%. Aiden owns 100% of Allicorp. Spicetrail and Polarcap are associated corporations because Jeff and Lisa are related, they each control one company (Jeff controls Spicetrail and Lisa controls Polarcap) and they each own at least 25% of the other corporation. Spicetrail and Polarcap will have to come to an agreement as to how they will share the small business deduction. Allicorp is not associated with either Spicetrail or Polarcap because Aiden's cross-ownership is less than 25%.
Calculating the Small Business Deduction
As per Budget 2006 and the 2007 Economic Statement, the small business deduction (SMABUD) rate was increased from 16% to 17% of eligible income, where eligible income is the lesser of • • • active business income taxable income the small business deduction limit currently set at $500,000
This reduces the net federal tax rate after the 10% abatement to 11%, calculated as (basic federal corporate tax rate – federal abatement – small business deduction) or (38% - 10% 17%). Provincial taxes – which vary depending on the jurisdiction -- then increase the tax rate typically by 10%, resulting in a total combined provincial and federal corporate tax rate of approximately 21%, calculated as (11% + 10%). Clearly, this is much more attractive to a corporation compared to having all of its income taxed at the full corporate rate of 38% or even the corporate rate of 29% if the 9% general rate reduction is taken into account. Armor and Sword Inc. is a CCPC; it had net income for federal income tax purposes in the amount of $565,000. All of the income it earns qualifies as active business income. Keeping in mind that the small business deduction only applies on the first $500,000 of active business income, to minimize Armor and Sword's tax liability, the owners should consider ways to reduce any active business income in excess of the small business deduction limit.
Reducing the active business income below the SMABD limit
If a corporation has active business income in excess of the annual limit, it may want to consider ways of reducing the amount of active business income. Payments that can reduce corporate income include those that result in expenses for the year: • • • • • bonuses and salaries deferred profit sharing plan (DPSP) contributions registered pension plan (RPP) contributions corporate-paid RRSP contributions deductible employee benefit programs
Assume the owners of Armor and Sword Inc. managed to reduce the company's active business income to $485,000 by paying out bonuses and making DPSP contributions to its employees. After making use of the SMABUD, the basic federal tax payable for Armor and Sword Inc. would be calculated as follows:
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Corporations Revised Basic Federal Tax Payable for Armor and Sword Inc. For the Year Ended December 31st Net Income for income tax purposes Deduct: Charitable donations Taxable dividends Applicable loss of prior taxation years - Non-capital losses - Net capital losses Taxable income Federal corporate tax @ 38% Deduct: Small Business deduction, calculated as 17% of the lesser of • active business income: $485,000 • taxable income: $463,000 and • SMABUD limit: $500,000 Federal taxable abatement of 10% of taxable income Federal tax payable (ignoring surtaxes) Provincial tax payable at 10% of taxable income Total tax payable Federal tax rate [federal tax payable ÷ taxable income] Combined federal and provincial tax rate [ total tax payable ÷ taxable income] $485,000
$4,000 $2,000 $13,000 $3,000 $22,000 ($22,000) $463,000 $175,940
($78,710)
($46,300) $50,930 $46,300 $97,230 11% 21%
Exercise: The Small Business Deduction
Combined Corporate and Individual Tax Burden for a CCPC
The combined corporate and individual tax burden for a CCPC with all of its active business income eligible for SMABUD is shown in the table below. Taxable income in excess of the annual limit is not eligible for the SMABUD, so it is taxed at 38% less any general rate reductions that apply.
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Income Tax Planning In the table below, we revisit the situation of George and Sally introduced earlier in this lesson (Example: Taxation of Dividends), This time however, George and Sally receive their dividends resulting from corporate income that is fully eligible for SMABUD. As illustrated in the table, the combined corporate and personal tax rate is very close to the marginal rate of income tax that the individuals would pay if they earned the income directly. So, the dividend gross-up and tax credit scheme does result in almost perfect integration of corporate and individual taxes for CCPCs with active business income under SMABUD active income limit. For public corporations, and for CCPCs with active business income over the annual limit or other ineligible forms of income, the scheme provides some tax relief, but certainly not true integration. After-tax income for income earned directly, compared to that same income flowing through a Corporation while making use of the Small Business Deduction
Corporation earns $10,000; George receives aftertax profit Marginal tax rate (federal 21.05% rate + provincial rate) George earns $10,000 directly Corporation Sally earns earns $10,000 $10,000; directly Sally receives after-tax profit 43.70% 43.70%
21.05%
Income initially earned by $10,000.00 n/a $10,000.00 n/a corporation Income initially earned n/a $10,000.00 n/a $10,000.00 directly by taxpayer Less: approximate combined ($ 2,100.00) n/a ($ 2,100.00) n/a federal and provincial corporate tax rate factoring in SMABUD: 21% Equals: actual cash dividend $ 7,900.00 n/a $ 7,900.00 n/a Taxable / grossed-up $ 9,875.00 n/a $ 9,875.00 n/a dividend [cash dividend x 125% gross-up] Federal Tax: @ 15% [taxable dividend x $ 1,481.25 $ 1,500.00 n/a n/a 15%] n/a n/a $ 2,863.75 $ 2,900.00 @ 29% [taxable dividend x 29%] Less: federal dividend tax ($ 1,316.67) n/a ($ 1,316.67) n/a credit [taxable dividend x 13 1 /3%] Equals: basic federal tax $ 164.58 $ 1,500.00 $ 1,547.08 $ 2,900.00 Plus: provincial tax: @ 6.05% [taxable dividend x 6.05%] @ 14.70% [taxable dividend x 14.70%] $ 597.44 n/a $ 605.00 n/a n/a $ 1,451.63 n/a $ 1,470.00
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Corporations
Less: provincial dividend tax credit [taxable dividend x 5.10%] Equals: basic provincial tax
($
503.63)
n/a
($
503.63)
n/a
$
93.82
$
605.00
$
948.00
$ 1,470.00
Total tax payable [federal tax + provincial tax] Amount remaining after tax [actual cash dividend or income (i.e. $7,900) – total tax payable] Combined corporate and individual tax rate [(cash dividend or income (i.e. $10,000) – amount remaining after tax) ÷ cash dividend or income]
$
258.40 $ 2,105.00 $ 2,495.08 $ 4,370.00
$ 7,641.60 $ 7,895.00 $ 5,404.92 $ 5,630.00
23.58%
21.05%
45.95%
43.70%
For more information on SMABUD, refer to IT-73R5, The Small Business Deduction.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Corporate Taxation 1. In this lesson, you have learned how to do the following: • • explain a corporation’s accounting requirements describe and calculate corporate tax elements such as dividends and deductions
If you are ready to move to the next lesson, click Corporate Taxation 2 on the table of contents.
Assessment
Now that you have completed Corporate Taxation 1, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 6: Corporate Taxation 2
Welcome to Corporate Taxation 2. In this lesson, you will learn about corporate tax elements such as tax advantages for the owner/manager as well as the process for filing a tax return. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • • calculate and describe corporate tax elements such as tax advantages for the owner/manager, tax shelters, and dividend income describe the process for filing a corporate tax return
Tax Advantages for the Owner/Manager
We have seen that the first portion of active business income up to the annual limit of a CCPC paid out to the shareholders as dividends is taxed at the same rates as if the income were earned directly by the shareholders. It sounds like the owner/manager would be in the same tax position regardless of whether he or she earned his or her business income within a corporation or directly through a sole proprietorship. However, the CCPC does offer the owner/manager several important tax advantages, including the potential for tax deferral and the potential to make use of the capital gains exemption for shares of qualified small business corporations.
Tax Deferral
If the owner/manager draws an employment salary, this amount is deducted from the corporation’s business income and is fully taxable to the taxpayer. The taxpayer could then use the after-tax amount to meet his or her living expenses or he or she could invest it outside of the corporation. Jack is the owner/manager of Troopers Ltd., a small business corporation, and he is already in a 50% marginal tax bracket without even considering any potential income from Troopers. Jack expects Troopers to earn business income of $100,000 this year. If Troopers pays Jack a salary of $100,000, the corporation will not have any taxable income, but Jack will pay tax of $50,000, calculated as (Jack's salary x marginal tax rate) or ($100,000 × 50%). Jack can invest the remaining amount of $50,000, calculated as (salary - tax paid) or ($100,000 - $50,000). However, if the owner/manager did not need the employment income, he or she could leave the income in the corporation. In this case, the business income would initially be taxed in the corporation at a rate of 19% calculated as (basic federal corporate tax rate – general rate reduction – federal tax abatement) or (38% – 9% – 10%). The corporation could then use the after-tax funds for business or investment purposes. Jack does not need any more employment income, so he could elect to leave the business income in the corporation. In this case, the corporation would pay tax of about $19,000, calculated as (business income x corporate tax rate) or ($100,000 × 19%). The corporation would then have $81,000 left to invest, calculated as (business income corporate income tax)) or ($100,000 - $19,000).
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Corporations
Eventually, the owner/manager could receive some of the retained earnings as dividends, which would be subject to the dividend gross-up and tax credit scheme. Investment income earned by a CCPC If the retained earnings are invested in a portfolio of securities, the resulting investment income is not active business income. As investment income earned by a CCPC, it is not eligible for the new general rate reduction, so it will be taxed at the federal corporate rate of 38% plus an additional tax on investment income of 62/3% (discussed later), less the 10% federal abatement. This will not provide further opportunities for tax deferral. Also, the corporation may then be subject to Part IV refundable tax, which will be discussed shortly.
Capital Gains Exemptions for Qualified Small Business Corporations
Instead of eventually receiving dividends, the owner/manager may be better off allowing the profits to be credited to the corporation’s retained earnings account, thereby building up the corporation’s equity and increasing the value of the shares of the owner/manager. When he eventually sells his shares in the business, the income is converted into capital gains and only 50% of such gains are taxable. Suppose Jack, as the sole owner, started Troopers Ltd. with an initial capital investment of $10,000, which is his adjusted cost base (ACB). Furthermore, for the last four years, Jack has not drawn a salary, leaving Trooper with significant funds to invest in the business, such that at the end of this year, Trooper will be worth $800,000. If Jack sells his shares in Trooper for its fair market value (FMV), he will have a capital gain of $790,000, calculated as (proceeds of sale - ACB) or ($800,000 - $10,000), and a taxable capital gain of $395,000, calculated as (capital gain x capital gains inclusion rate) or ($790,000 × 50%). Furthermore, he may be able to shelter all or part of his capital gain by making use of the capital gains exemption available to owners of qualifying Canadian small business corporations. Lifetime capital gains exemption limit Click the icon below to view the Capital Gains Exemption for Qualified Small Business Corporations.
The Income Tax Act provides relief for taxpayers who dispose of qualified property, including shares of a qualified small business corporation, in terms of a capital gains deduction that can exempt up to $500,000 of eligible capital gains from tax up to a specific threshold over the life of the taxpayer. Following Budget 2007, the lifetime capital gains exemption on qualified property was increased from $500,000 to $750,000.
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Income Tax Planning
The Johanson Example
Erik Johanson is the owner/manager of a qualified small business corporation and the business just had a tremendous year with after-tax profits of $200,000. Mr. Johanson has already received a salary from the corporation, and he does not want to receive any more than $100,000 in dividend income. He is unsure about what to do with the remaining $100,000 of after-tax profits. He decides to leave it in the corporation as retained earnings. As director, he can always declare dividends to be payable at some future time, or he can allow the retained earnings to build up the equity of the company. Prior to this year, Mr. Johanson held all of the 1,000 shares in the corporation and they were worth $40 each, so the total equity in the business was $40,000, calculated as (value of shares x number of shares) or ($40 × $1,000). His adjusted cost base for the shares was only $5 each, or $5,000 in total, calculated as (ACB per share x number of shares) or ($5 x 1,000). By allowing the corporation to keep after-tax profits of $100,000 to be used in the business, Mr. Johanson has increased the equity in the company to $140,000, and the value of his shares to $140 each, calculated as ((retained earnings + previous equity) ÷ number of outstanding shares) or (($100,000 + $40,000) ÷ 1,000). If he could sell the business at this point in time, he would realize a capital gain of $135,000, calculated as (FMV - ACB) or ($140,000 - $5,000). Mr. Johanson never made use of the $100,000 personal lifetime capital gains exemption while it was available; nor has he ever claimed an exemption with respect to qualified property. Thus, Mr. Johanson would be able to use the $750,000 capital gains exemption on qualified property, which includes shares in a qualified small business corporation, to eliminate the entire capital gain that he would otherwise realize upon the sale of his business. This obviously represents a significant tax saving for Mr. Johanson and it illustrates one of the main tax advantages of being the owner/manager of a corporation. Many small family-run businesses currently are qualified small business corporations or they could be restructured as such. Shareholders in these companies may be able to make use of the $750,000 lifetime capital gains exemption.
Other Advantages
As the owner/manager, an individual may be able to receive other tax advantages by directing the corporation to: • • make corporate contributions to deferred income plans such as registered pension plans (RPPs) pay for private health and group dental plans
Corinne owns and operates an incorporated financial planning practice. Through the corporation, she established an individual pension plan (IPP), and this allows her to make larger tax-deductible contributions to her retirement savings than if she was simply contributing to a personal RRSP. She may also be able to benefit from the personal use of a company car.
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Corporations
Exercise: Tax Advantages for the Owner/Manager
Dividend Income Received by a Corporation
We have discussed how a corporation receives special treatment on some of its active business income, but special treatment also applies to dividend income received by a corporation. Part I tax Dividends received by a corporation are included in its income, but unlike dividends received by an individual, when a corporation receives dividends there is no gross-up or dividend tax credit. However, dividends received from other taxable Canadian corporations, from corporations resident in Canada and controlled by the receiving corporation, and from certain non-resident corporations may then be deducted in computing the taxable income of the recipient corporation (ITA 112(1)). This means that in effect the recipient corporation does not have to pay ordinary income tax (referred to as Part I tax because it falls under Part I of the Income Tax Act) on the dividends and they pass tax free from one taxable corporation to another. However, private corporations may be subject to certain special refundable taxes on certain dividends received, discussed under the heading of Part IV tax. A corporation is generally not permitted to deduct dividend income from its taxable income if the corporation paying the dividend was not subject to Canadian tax. Conversely, if the corporation issuing the dividend was not subject to Canadian tax, the dividend will be subject to Part I tax when received by a Canadian corporation. Americo, an American corporation that is not subject to Canadian tax, paid dividends to Canco, a Canadian corporation subject to Canadian tax. Canco will not be able to deduct the dividends from its income and as a result, they will be subject to Part I tax.
Part IV Tax
ITA 186(1) includes provisions for a special tax, referred to as Part IV tax because it falls under Part IV of the Act, in the case of certain sources of dividend income. The purpose of Part IV tax is to discourage shareholders of private corporations from deferring or postponing tax by leaving dividend income from portfolio investments in the corporation. Portfolio investments are investments in a portfolio of stocks and bonds as opposed to the shares of a connected corporation, as defined shortly. Calculating Part IV tax The Part IV tax is calculated as 331/3% of dividends from portfolio investments (ITA 186(1)).
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Income Tax Planning Samples Incorporated, a taxable CCPC, had after-tax profits of $800,000. Instead of paying out any dividends, the profits were added to Samples Inc.’s retained earnings and the funds were invested in a variety of common shares of several taxable Canadian corporations that were unrelated to Samples Inc. Last year, Samples Inc. received dividends of $60,000 from those investments. Samples Inc. will not have to pay any Part I tax on those dividends, because they were received from taxable Canadian corporations. However, if it retains those dividends without passing them on to its shareholders, it will have to pay Part IV tax of $20,000, calculated as (dividend income x 331/3%) or ($60,000 × 331/3%). Refundable dividend tax on hand (RDTOH) account The amount of Part IV tax payable is credited to a notional tax account called refundable dividend tax on hand (RDTOH). When the corporation pays taxable dividends to its shareholders, the tax is refunded to the corporation at the rate of $1 for every $3 of dividends paid up to the balance in the RDTOH account (ITA 129(1)). When Samples Inc. keeps the dividends, it must pay Part IV tax of $20,000, and this amount is credited to the RTDOH account. If Samples Inc. now pays out $60,000 in dividends to its shareholders, it can receive a refund of $20,000, calculated as (dividends paid ÷ 3) or ($60,000 ÷ 3). Importance of Part IV tax The Part IV tax is very important because it means that an individual cannot make his or her portfolio investments through a corporation and receive a tax advantage on the taxation of the investment income. Fortunately, this scheme only prevents the deferral of tax on what are portfolio investments and not active business income or most dividends paid between connected corporations, as defined in the next section.
Connection Between Paying and Receiving Corporations
In order to determine whether Part IV tax applies, the first question to answer is whether the paying corporation is connected with the receiving corporation. The two corporations are deemed to be connected if, at the particular time in a taxation year of the recipient corporation: • • the payer corporation was controlled by the recipient corporation the recipient corporation owned more than 10% of the payer corporation (as measured by specific rules (ITA 186(4))
In the context of determining whether two corporations are connected for the purpose of determining Part IV tax, a corporation is controlled if more than 50% of its voting shares are held by another corporation or by persons with whom the other corporation does not deal at arm’s length (ITA 186(2), (4)).
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Corporations Part IV tax is levied as follows: • • where the recipient corporation is not connected, the recipient corporation must pay the 331/3% tax on the full dividend received where the recipient corporation is connected, the recipient corporation must pay the 331/3% tax to the extent that the payer corporation was entitled to a refund of Part IV tax as a result of paying the dividend
Top Dog Inc. owns 50% of PetPro Corp. PetPro has previously used some of its retained earnings to make a number of portfolio investments. Last year PetPro earned dividend income on those investments of $40,000. PetPro paid Part IV tax of $13,333, calculated as (dividend income x 331/3%) or ($40,000 × 331/3%) and this amount was credited to PetPro’s RDTOH account. PetPro subsequently paid dividends of $20,000 to its shareholders and Top Dog received half of this amount, or $10,000. PetPro could claim a refund of the RDTOH on the dividend paid to Top Dog of $3,333, calculated as (dividends paid ÷ 3) or ($10,000 ÷ 3) and the same amount on the dividends paid to its other shareholders. If PetPro does claim this refund, then Top Dog must pay Part IV tax of $3,333 on the dividend that it received from PetPro, calculated as (dividend income x 331/3%) or ($10,000 × 331/3%). If this rule concerning Part IV tax and connected corporations did not exist, corporation A could receive investment dividends from an unconnected corporation B, pay Part IV tax, then pay dividends to a connected corporation C, receive a refund of Part IV tax, and the recipient corporation C would pay no tax. This would allow corporations to avoid paying tax on investment dividends simply by setting up a holding company. Part IV tax on taxable dividends received by a private corporation are explained further in IT-269R3.
RDTOH Carry-forwards
ITA 129(3) was amended in 1995 so that RDTOH is now calculated on an annual basis, with a carry forward of RDTOH from the previous year. In an earlier example, Samples Inc. had to pay Part IV tax of $20,000 and this amount was credited to its RDTOH account. If Samples Inc. chooses not to issue dividends for that taxation year, the balance in the RDTOH account can be carried forward to a future year. So, if Samples Inc. decides to pay a $60,000 dividend next year, it can still make use of the balance in the RDTOH account to receive a refund of $20,000, calculated as (dividends paid ÷ 3) or ($60,000 ÷ 3).
Exercise: Dividend Income Received by a Corporation
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Income Tax Planning
Investment Income, Other than Dividends, Received by CCPCs
There is an additional refundable Part I tax of 6 2/3% on certain investment income, other than deductible dividends, earned by CCPCs (ITA 123.3). The calculation of the income subject to this refundable Part I tax is complex, but generally it includes the sum of: net capital gains plus property income, with some exceptions plus income from a specified investment business minus property losses minus specified investment business losses Mentor Ltd. is a CCPC with total taxable income of $900,000. Over the years, Mentor has invested some of its retained earnings in several portfolio investments, and it also receives some income in the form of rent for sharing its office space with another business. Mentor’s aggregate investment income, not including dividends is $92,000. Mentor must pay an additional refundable Part I tax of $6,133, calculated as (6 2/3% x nondividend investment income) or (6 2/3 % × $92,000) (ITA 123.3). Refer to IT-243R4, Dividend Refund to Private Corporations, for more information.
Refundable Tax
Other investment income received by a Canadian controlled private corporation (including receipts such as rents, royalties, interest and the taxable portion of capital gains, but not dividend income) does not normally qualify as active business income. As such, it is subject to tax at the rate of about 45%, calculated as 38% plus the additional tax of 6 2/3% on investment income. As a result, the combined corporate and individual taxes paid by a shareholder when these earnings are distributed as income would be as high as 63% if the Income Tax Act did not provide for some specific relief for this type of income. A scheme called refundable Part I tax has been developed to provide some relief. The corporation still has to pay Part I taxes of about 45% on all of this other investment income. However, it is then permitted to credit an amount equal to about 26 2/3% of the investment income (the specific formula is complex) to its RDTOH account (ITA 129(3)). If the corporation subsequently pays out taxable dividends, it can claim a refund of $1 for every $3 paid up to the balance in the RDTOH account. The practical effect of this scheme is to reduce the tax on investment income paid by the corporation by about 26% and the total tax burden by up to 13%. Like Part IV tax, the additional tax of 6 2/3 % and the refundable Part I tax mechanism is meant to discourage parking investment income in private corporations, by providing an incentive to pay that income out to shareholders as dividends.
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Corporations Trial Inc., a CCPC, had investment income of $240,000 including interests and rents but excluding dividends. Trial Inc. will have to pay total Part I tax of $107,200, calculated as (investment income x (basic Part I corporate tax rate + additional Part I tax rate on investment income)) or ($240,000 × (38% + 6 2/3%)), but it will be able to credit about $64,000 to its RDTOH account, calculated as (taxable income x 26 2/3%) or ($240,000 × 26 2/3%). Prior to this credit, the balance in Trial's RDTOH account was zero. If Trial pays the after-tax amount of $132,800, calculated as (taxable income - total Part I tax) or ($240,000 - $107,200), to its shareholders, it will receive a refund of $44,267, calculated as (the lesser of (the balance in its RDTOH account and (dividends paid ÷ 3))) or (the lesser of ($64,000 and ($132,800 ÷ 3))). Trial can pay the amount of $44,267 out as dividends in the following taxation year and the payment could give rise to an additional refund at that time as long as there is a balance in the RDTOH account. These dividends will of course be subject to the dividend gross-up and tax credit scheme when they are reported by the receiving individual shareholder.
Using CCPCs as Tax Shelters
We have seen how a corporation can provide a tax advantage for its shareholders through the deferral of income tax as a result of the lower tax rates on active business income earned in a CCPC. This provides shareholders the opportunity to accumulate wealth at a faster rate than they could if income were taxed at their full personal marginal tax rates (MTR). Max is the owner/manager of NewCorp, a CCPC that had active business income of $200,000. If Max has an MTR of 48% and he receives the business income as salary, he will have $104,000 left to invest, calculated as [salary x (1 – marginal tax rate)] or [$200,000 × (1 – 48%)]. If he leaves the money in the company, NewCorp will have $158,000 left to invest, calculated as [business income x (1 – (corporate tax rate – SMABUD rate))] or [$200,000 × (1 – (38% – 17%))]. Assuming in both cases investments earn 10%, at the end of one year, Max would have earned $10,400 if he had received a salary and invested the after-tax amount, calculated as (personal after-tax income x investment return) or ($104,000 × 10%). In contrast, NewCorp could have earned investment income of $15,800, calculated as (corporation's after-tax income x investment return) or ($158,000 × 10%). The table below includes Max and Newcorp's Income Statements. Max & NewCorp Income Statements Max Salary $200,000 (96,000)1 $104,000 $10,400 NewCorp No Salary $200,000 (42,000)2 $158,000 $15,800
Salary/Income Income Tax After-tax income Investment income @ 10%
1 calculated as (salary x marginal tax rate) or ($200,000 × 48%) 2 calculated as (business income x corporate tax rate) or ($200,000 × 22%)
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Income Tax Planning
Public corporations and income other than active business income It is most important to note that the same deferral is not available for public corporations and other types of income, particularly investment income. Ball Bearing Ltd., a public corporation, had business income of $1.2 million, resulting in after-tax income of $852,000, calculated as [business income x (1 - (general corporate tax rate - rate reduction))] or [$1,200,000 × (1- (38% - 9%))]. So, it had $852,000 to invest in portfolio investments or to distribute as dividends. Tax implications For a CCPC, there should not be a significantly different tax burden on investment income earned through a corporation or earned directly by an individual taxpayer due to the RDTOH scheme. Therefore, from a tax perspective, it does not make sense for an individual to take tax-paid capital and invest it in a corporation, which in turn uses the capital to earn investment income. However, holding companies do have benefits apart from taxation, as discussed later.
Exercise: Investment Income Other than Dividends Received by a CCPC
Filing a Corporate Tax Return
The corporation income tax return is called a T2 income tax return, or simply a T2. All corporations other than registered charities must file a T2 for every taxation year, even if there was no tax payable for that year. Revamped corporate filing system CRA has introduced a new reporting format called the General Index of Financial Information, or GIFI, for the purpose of standardizing the reporting of financial statement information. The GIFI assigns a code number to items that are typically reported on financial statements and the corporation must enter all of its information using these codes. This standardized format will improve CRA’s processing efficiency and will also facilitate the introduction of electronic filing of corporate returns. If a corporation files a GIFI with its T2 return, it does not have to submit its financial statements.
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Corporations Filing deadlines Each corporation must file a T2 return within six months of the end of its taxation year. If the return is filed late, the ITA imposes a penalty of 5% of the unpaid tax that is due on the filing deadline, plus 1% of this unpaid tax for each complete month that the return is late, up to a maximum of 12 months. This penalty may increase to 10% plus 2% per month for a maximum of 20 months if: • • CRA issued a demand to file the return in accordance with ITA 150(2) the corporation was assessed a late filing penalty in any of the three previous taxation years (ITA 162(1) and (2))
Payment deadlines Prior to Budget 2007, a corporation usually had to pay income tax in monthly installments if its tax payable in the current or previous taxation year was greater than $1,000. With respect to corporate taxation years that begin after 2007, Budget 2007 increased the threshold above which corporations are required to pay corporate income tax by installment from $1,000 to $3,000. In addition, for eligible CCPCs that are required to pay tax by installment, Budget 2007 reduced the frequency of installment payments from monthly to quarterly. In order to pay by quarterly installment, the CCPC must meet certain conditions among which include having taxable corporate income for either the current or previous year that does not exceed the small business deduction limit and being eligible to claim SMABUD for either the current or previous year. Quarterly installments are due on the last day of each quarter of the corporation’s taxation year. If a corporation fails to make a quarterly installment payment by its due date, the payment frequency will be switched to monthly installments effective the following month. Budget 2007 did not amend the balance-due day for the final payment of corporate tax for a taxation year so, the balance of tax the corporation owes for a taxation year is usually due within two months of the end of that taxation year. However, in the case of some CCPCs claiming the small business deduction, this may be extended to three months, depending on the circumstances of the corporation. Refer to ITA 157(1) and IC 81-11R3 for more information on which companies qualify for the three-month payment deadline. Interest and penalties apply to late payments. Under ITA 161(2), interest is charged on overdue taxes at the prescribed rate as established by ITR 4301.
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Corporate Taxation 2. In this lesson, you have learned how to do the following: • • calculate and describe corporate tax elements such as tax advantages for the owner/manager, tax shelters, and dividend income describe the process for filing a corporate tax return
If you are ready to move to the next lesson, click Taxation of Shareholders on the table of contents.
Assessment
Now that you have completed Corporate Taxation 2, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Lesson 7: Taxation of Shareholders
Welcome to Taxation of Shareholders. In this lesson, you will learn about the ways that a shareholder can obtain funds from a corporation in which he or she holds shares. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • calculate and describe how funds received by shareholders are taxed, including dividends, salary, recovered loans or capital, and received loans
Taxation of Shareholders
There are only seven legitimate ways that a shareholder can obtain funds from a corporation in which he or she holds shares. By: • • • • • • • receiving regular dividends receiving capital dividends receiving stock dividends and then selling the stock receiving a salary or other employment benefits if he or she works for the corporation recovering loans that he or she made to the corporation recovering some of the capital he or she originally contributed to the corporation borrowing money from the corporation
Regular Dividends
Regular dividends are taxable income to the shareholder. If the dividends are paid by a Canadian-controlled public corporation (CCPC) to the extent that its income is taxed at the small business rate or is from the CCPC's investment income, the dividend gross-up and tax credit scheme is available. If the dividends are paid by a large public corporation, or by a CCPC to the extent that its income is not eligible for the small business rate, they are eligible for the enhanced dividend tax credit. If the dividends are paid by a corporation other than a taxable Canadian corporation, the full amount of the dividend is taxable to the shareholder, without either dividend gross-up and tax credit scheme. Dividends are not earned income for the purpose of calculating items such as RRSP contribution room, CPP contributions, or entitlements to CPP pensions. An owner/manager who opts to receive all of his or her compensation in the form of dividends, instead of salary, would find himself or herself with no RRSP contribution room. While this could also mean that he would not have to make any CPP contributions, this in turn would reduce or eliminate his or her entitlement to a CPP retirement pension.
Capital Dividends
Capital dividends are dividends that are issued to shareholders from the corporation's capital dividend account. These dividends result from certain types of income that were not taxable to the corporation, such as the tax-free 50% of capital gains or the death benefit of certain life insurance policies. As long as the corporation files an election declaring the dividends to be capital dividends, the dividends are not subject to tax and are not subject to
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Income Tax Planning the dividend gross-up and tax credit scheme. By doing this, the Income Tax Act preserves the non-taxable nature of the non-taxable portion of the capital gain. James is the sole shareholder of Snowy Retreats Inc. This year, Snowy Retreats sold some real estate for a capital gain of $24,000 and 50% of this gain, or $12,000, was included in Snowy Retreat’s taxable income as a taxable capital gain. The remaining $12,000 (the non-taxable portion of the capital gain) was credited to the corporation’s capital dividend account. Provided Snowy Retreat Inc. files an election, it can pay James a capital dividend of up to $12,000 (one-half of the realized capital gain). This amount will not be taxable to James and it will not be subject to the dividend gross-up and tax credit scheme.
Stock Dividends
Stock dividends are taxed just like any other dividend and they are eligible for the dividend gross-up and tax credit scheme. The amount of this deemed dividend is equal to the investors’ share of the increase in the paid-up capital associated with the stock dividend. DEF Ltd. has 20,000 outstanding shares and paid-up capital of $10,000,000, or $500 per share, calculated as (paid-up capital ÷ number of shares outstanding) or ($10,000,000 ÷ 20,000). This year it had an after-tax profit of $400,000. DEF Ltd. elected to capitalize its retained earnings of $400,000 and issue a stock dividend of 4%, calculated as (capitalized earnings ÷ existing paid-up capital) or ($400,000 ÷ $10,000,000). The amount of the deemed dividend will be $20 per share, calculated as (capitalized earnings ÷ number of shares outstanding) or ($400,000 ÷ 20,000). Calculating deemed acquisition cost If an investor acquires stock as a result of a stock dividend, his or her deemed acquisition cost is equal to the amount of the stock dividend at the time that he or she received it (ITA 52(3)). Delores is one of the investors in DEF Ltd. and she owned 100 shares before the stock dividend was declared. As a result of the 4% stock dividend, she is deemed to have received a dividend of $2,000, calculated as (number of shares owned x deemed dividend per share) or (100 × $20). It can also be calculated as ((number of shares owned ÷ total number of shares outstanding) x capitalized earnings) or ((100 ÷ 20,000) × $400,000). Delores will now own 104 shares in the corporation, calculated as (original number of shares + (original number of shares x dividend rate)) or (100 + (100 × 4%)). The cost of her four new shares is deemed to be the amount of the dividend, or $500 for each new share, calculated as (total deemed dividend ÷ number of new shares) or ($2,000 ÷ 4). Stock dividends paid between November 17, 1978 and May 24, 1985 were not taxable, so the shareholder is deemed to have acquired them at a cost of zero. Refer to IT-88R2, Stock Dividends, for more information.
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Corporations
Salary
A shareholder can also be an employee of the corporation, but he or she will have to include the full amount of his or her employment income in taxable income, while the same amount is a deductible expense to the corporation. Many owners set themselves a base salary with an annual bonus based on profits. This bonus can be paid after the corporation has calculated its income for the fiscal year. An individual is taxed only on employment income for the year in which the income is actually received. However, the corporation may claim the total salary and bonus as a deduction for the fiscal year even if the bonus is paid after the fiscal year-end, as long as the liability for the bonus existed before the year-end. All amounts claimed by the corporation as a deductible expense must be paid to the employee within 179 days of the corporation’s fiscal year-end. Amal was the owner/manager of a corporation with a fiscal year end of December 31st. For the fiscal year ending last year, the corporation paid Amal a base salary of $100,000. As the owner/manager and director, Amal decided that he would also take a bonus of $200,000 for his performance last year, but that the bonus would not be paid until April 30th of this year. The corporation can deduct a total of $300,000 as an employment expense for last year, but Amal does not have to report $200,000 of this income until he files his tax return for this year. The base salary of $100,000 must be reported on last year's return.
Exercise: Taxation of Shareholders, Part 1
Recovering Loans Made to the Corporation
Quite often in the case of closely-held corporations, a shareholder may lend money to the corporation. When the corporation eventually repays the loan, it cannot claim the repayment as a deductible expense and the repayment is not taxable to the shareholder. The loan agreement between the shareholder and the corporation may require the corporation to pay interest on the loaned amount. If this is the case, interest income is fully taxable to the shareholder and it is a deductible expense for the corporation.
Recovering Shareholder's Capital
Paid-up capital is generally the amount of money that a corporation receives in exchange for selling its shares and this amount is recorded in the corporation’s paid-up capital account (ITA 89(1)). It could also include the capitalized amount of retained earnings. The directors of a corporation can decide to return paid-up capital to the shareholders as long as that amount is subtracted from the paid-up capital account. Because this represents a return of the shareholders’ investment and not income of the corporation, the payment is
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Income Tax Planning not taxable. However, the shares will decrease in value after the repayment because the equity in the company will decrease. Blizzard Ltd. received $1,000,000 for the sale of 10,000 shares that were valued at $100 each at the time of sale. The company has done very well and the shares are currently trading at $230 each. The total shareholders’ equity, including the paid-up capital, is about $2,200,000. If the directors of Blizzard Ltd. agree to reduce the paid-up capital to $400,000 and to return $600,000 to the shareholders, no tax liability will arise for either Blizzard Ltd. or the shareholders as a result of this transaction. However, this would reduce the paid-up capital by a total of $600,000 or $60 per share, calculated as (paid-up capital reduction ÷ number of shares) or ($600,000 ÷ 10,000). Impact of tax-free distributions on the ACB If a corporation makes a tax-free distribution of paid up capital, the shareholders will also realize a corresponding decrease in the ACB of their shares (ITA 53(2)). Blair was one of the initial investors in Blizzard Inc., and the ACB of his shares used to be $100 each, calculated as (proceeds of initial share distribution ÷ number of shares) or ($1,000,000 ÷ 10,000). If Blizzard Ltd., reduces the paid-up capital by $600,000, Blair's ACB will be reduced by $60 per share, calculated as (reduction in paid-up capital ÷ number of shares) or ($600,000 ÷ 10,000), leaving him with an ACB of $40 per share, calculated as ($100 - $60).
Receiving Loans from a Corporation
While shareholders are welcome to lend money to a corporation, the Income Tax Act discourages corporations from lending money to shareholders, even if interest is charged. Under ITA 15(2), a corporation can make a loan to a shareholder if bona fide arrangements are established at the time the loan was made for repayment within a reasonable time and the loan was made: • • • • in the course of the lender’s ordinary business (which must be lending money) to facilitate a home purchase by an employee to facilitate the purchase of previously unissued shares of the corporation or a related corporation by an employee to facilitate the purchase of a car to be used in employment duties
These last three situations require the shareholder also to be an employee and the loan to be granted because of the shareholder’s employment with the corporation, and not because he or she is a shareholder. Brian is one of three shareholders in Northwest Engineering Services Inc. and he is also an employee. Brian borrowed $40,000 from Northwest to help finance his first home. At the time of the loan, Brian signed an agreement that said he would repay the loan plus interest in equal annual installments at the end of each of the following five years. All senior employees qualify for similar house purchase loans.
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Corporations Other scenarios regarding loans to a shareholder The Income Tax Act also permits a corporation to make a loan to a shareholder for any purpose if it is repaid within one year of the end of the corporation’s taxation year in which the loan was made, provided the loan is not part of a series of loans (ITA 15(2.6)). If a shareholder receives a loan under any other condition, it is deemed to be fully taxable income and the corporation receives no tax deduction for the loan. However, if the shareholder subsequently repays the loan he or she can receive a tax deduction to the extent that the loan amount was previously included in his or her income (ITA 20(1)(j)). Mary is a shareholder in New Market Inc., but she is not an employee. She borrowed $200,000 from New Market to finance her own business start-up. The loan is to be repaid over five years at an interest rate of 7%. Because the loan does not qualify according to the conditions set out above, Mary is deemed to have taxable income of $200,000, but New Market Inc. cannot deduct $200,000 from its business income. If Mary repays $25,000 of principal in the third year of the loan, she can deduct the repayment from her taxable income. If the interest rate charged by the corporation on a legitimate shareholder loan is less than CRA’s prescribed rate of interest, the shareholder is considered to be receiving a taxable benefit equivalent to interest at the prescribed rate less any interest charged (ITA 80.4(2)). The prescribed rate is established by ITR 4300 and 4301 and it is adjusted quarterly. Click here for the most current rate. For more information on shareholder loans, including low interest and interest free loans, refer to IT-119R4, Debts of shareholders, certain persons connected with shareholders, etc. and IT-421R2, Benefits to individuals, corporations and shareholders from loans or debt.
Exercise: Taxation of Shareholders, Part 2
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Taxation of Shareholders. In this lesson, you have learned how to do the following: • calculate and describe how funds received by shareholders are taxed, including dividends, salary, recovered loans or capital, and received loans
If you are ready to move to the next lesson, click Corporations as Wealth Accumulation Vehicles for the Owner/Manager on the table of contents.
Assessment
Now that you have completed Taxation of Shareholders, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Lesson 8: Corporations as Wealth Accumulation Vehicles for the Owner/Manager
Welcome to Corporations as Wealth Accumulation Vehicles for the Owner/Manager. In this lesson, you will learn about the role of the corporation in wealth accumulation. This lesson takes 35 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the nature and purpose of holding companies and incorporated professional practices explain how an individual can use the ownership/management of a corporation as a wealth accumulation vehicle
Corporations as Wealth Accumulation Vehicles for the Owner/Manager
The primary way that wealth is created in the Canadian economy is through business or economic activity and a large number of those businesses are structured as corporations. Thus, corporations play a large role in wealth accumulation. In this lesson, we will look at how the corporation can be used as a wealth accumulation vehicle for owner/managers. Passive investments in corporations by investors who do not take an active role in corporate management are discussed in another course. There are costs associated with establishing and operating a corporation and the Income Tax Act has many complexities to ensure that the conflicting objectives of Parliament are met. Nevertheless, many sophisticated investors and of course many businessmen and businesswomen use corporations to accumulate wealth because they have several advantages from a tax perspective. In the following sections, we will: • • • • examine how a shareholder can use a holding company to further his or her wealth accumulation objectives take a brief look at the incorporated professional practice review the advantages and disadvantages of running a business through a corporation as opposed to either a partnership or proprietorship compare corporations with other business forms
Holding Companies
Corporations that exist primarily for the purpose of holding or owning property are called holding companies. They may hold or own: • • • shares of an operating company (meaning a corporation carrying on an active business) investment portfolios other property
We will discuss a variety of ways that holding companies can be used in structuring investments. However, there is nothing in the Canada Business Corporations Act that prevents any company, including an operating company, from holding investments.
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Many texts use the short forms OPCO and HOLDCO to refer to the operating company and holding company, respectively.
To Hold Shares of an Operating Company
An operating company may be producing more income than it requires to fund the anticipated future growth of the business. However, in some cases, the shareholders do not require the dividends at the current time and would prefer not to have to include them in their current taxable incomes. In a closely held corporation, the owner/managers could decide to leave the excess funds in the operating company to obtain a tax deferral, but then the funds would be available to satisfy creditors of the operating company. In other cases, the shareholder may have no influence over when the dividends are paid, so the shareholder could end up receiving dividends at a time when he or she would prefer not to include them in his income. Tax-free dividends from Opco to Holdco Because dividends from one corporation are generally paid to another corporation without being taxed, a shareholder can incorporate a holding company to hold his or her shares of the operating company. The OPCO can then pass any excess funds to HOLDCO as tax-free dividends, protecting them from the OPCO’s creditors. HOLDCO does not have to pay Part IV tax on these dividends because the two companies are connected and the income is not considered to be income from portfolio investments. Therefore, the funds can be invested by HOLDCO for the benefit of the taxpayer without paying the income tax that would be required if the OPCO had paid the funds to the taxpayer personally. So, the HOLDCO would have a larger amount to invest. Reggie owns 75% of the outstanding 2,000 shares of Goodluck Ltd., a taxable Canadian corporation. He expects Goodluck to generate substantial dividends each year. However, he does not want to be taxed on that income just yet, so he owns the shares through his holding company, Regco Ltd. He is the sole shareholder of Regco. Dividends that flow from one taxable Canadian corporation to another are not subject to Part I tax. Regco and Goodluck are also connected corporations, so the dividends are not subject to Part IV tax either. Therefore, if Goodluck were to pay dividends of $10,000 to Regco, the holding company could reinvest the full $10,000. If Reggie had owned the shares outside of the holding company and if his income were in a 29% federal tax bracket, he would only have about $6,560 left to invest after tax, after the dividend gross-up and tax credit have been applied.
To Hold Investment Portfolios
A holding company often ends up holding an investment portfolio as the result of investing the earnings it has received from an operating company. Less frequently, an investor will provide tax-paid capital to a holding company of which he or she is a shareholder, and develop an investment portfolio. Dividends paid by a taxable Canadian corporation to a holding company are not subject to ordinary Part I tax. The holding company is permitted to disburse the income in whatever form will provide the best tax advantage for the investor. Usually, the income is paid out as a dividend so that the funds qualify for the dividend gross-up and tax credit scheme. The
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Corporations funds may also be paid out as salary or wages for work performed by the investor for the holding company. In this case, the holding company can claim an employment expense deduction and the employment income is fully taxable to the shareholder. If the holding company retains the investment income, the refundable Part IV and Part I taxes that we talked about earlier would apply. However, when the earnings are eventually paid out as dividends, the corporation will receive a refund of $1 for every $3 of dividends paid, up to the balance in its RDTOH account. Jerry set up HOLDCO to hold his shares in an operating company, OPCO. He used the dividends from OPCO to make additional investments within HOLDCO, primarily in the shares of public Canadian corporations and long-term government bonds. As a result of these portfolio investments, HOLDCO earned dividend income from taxable Canadian corporations of $10,000 and interest income of $3,000. The dividend income would not be subject to Part I tax within HOLDCO, but it would be subject to Part IV tax of $3,333.33, calculated as (dividends from portfolio investments x 331/3%) or ($10,000 × 331/3%), and this amount would also be credited to the RDTOH account. The interest income will result in Part I tax of $1,340, calculated as (interest income x (basic corporate tax rate + additional Part I tax on non-dividend investment income)) or ($3,000 × (38% + 62/3%)), and an amount of $800.00 would be credited to the RDTOH account, calculated as (interest income x 262/3%) or ($3,000 × 262/3%). This would bring the balance in the RDTOH account up to $4,133.33, calculated as (credit resulting from Part IV tax on dividend income + credit resulting from Part I tax on interest income) or ($3,333.33 + $800.00). If HOLDCO were subsequently to pay Jerry a dividend of $15,000, it would be able to claim a refund of $4,133.33, calculated as (the lesser of (the RDTOH balance and (dividends paid out ÷ 3))) or (the lesser of $4,133.33 and ($15,000 ÷ 3)).
For Estate Planning
When a holding company is used for estate planning and a shareholder of the holding company dies, his or her estate is not left with the steep administration fees of transferring diverse investment holdings. Only the holding company’s shares are passed on to the estate, to be passed on to the successors in accordance with the will or intestate succession laws. This usually simplifies the responsibilities of the estate’s executor or administrator. Emilio was a wealthy man with a large investment portfolio consisting of shares in over 120 different stocks, 20 different bonds and 10 treasury bills. Emilio wants his four children to benefit from the portfolio upon his death. Fortunately, Emilio’s portfolio is held within a holding company of which he holds all 100 shares. It will be relatively easy for the executor of Emilio’s estate to transfer ownership of the 100 shares in the holding company to Emilio’s children. If the portfolio had been outside of a holding company, the executor of Emilio’s estate would have had to decide which child would get which investments, or divide each of the 150 investments into four equal parts and arrange for 600 different transfers of ownership.
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Exercise: Holding Companies
Estate Freezes Involving Corporations
An estate freeze is a tax planning strategy that freezes the value of an asset at the time the freeze is effected, such that any future growth in those assets will be passed on to the owner’s intended beneficiaries, ultimately to be taxed in their hands when they dispose of them. If the shareholder of a holding or operating company has accumulated enough wealth for personal use, he or she may wish to have future wealth generated by the corporation accumulate to his or her children or other family members. This financial objective can be met through an estate freeze. Common shareholders vs. preferred shareholders While the common shareholders of a corporation have an equity interest in the business and its assets, the preferred shareholders are only entitled to the specified dividend and a return of their capital investment. As a result, any increase in the value of the business or its assets accrues to the benefit of the common shareholders. This difference between preferred and common shareholders gives rise to a great tax-planning opportunity in the form of an estate freeze.
Reorganizing Share Structure of Existing Corporation
Section 85 and Section 86 rollovers In the case of a closely-held corporation, one method of effecting an estate freeze involves rearranging ownership so that the taxpayer exchanges his or her common shares for preferred shares of the same value. The taxpayer's intended beneficiaries, typically his or her children, acquire or subscribe to new common shares at a nominal cost. There are provisions in the Income Tax Act that permit the rollover of common shares for preferred shares without recognizing a disposition or the realization of capital gains (ITA 85(1) and 86(1)). As each year passes, the dividends on the preferred shares are paid to the original taxpayer and the remaining after-tax earnings and the appreciation of the corporation’s assets accumulate to the benefit of the common shareholders. Lucy is the sole shareholder of Belle Enterprises Ltd. She currently holds 10,000 common shares valued at $100 each, for a total of $1,000,000, calculated as (number of shares x value per share) or (10,000 x $100). She expects that Belle will continue to grow but she has enough money already set aside to meet all of her anticipated needs and she would like any future growth to accrue to her children, Ricky and Alice. Lucy exchanged her 10,000 common shares for 10,000 preferred shares valued at $100 each, such that her equity in the company remained at $1,000,000. Ricky and Alice then each subscribed to 5,000 new common shares by paying $0.10 per share.
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Corporations After the restructuring, Lucy can continue to receive dividends from Belle and she could redeem her preferred shares for $1,000,000 in cash if she finds that she needs the money. In the meantime, any future growth in the company will result in the appreciation of the common shares. So, for example, if Belle retains after-tax earnings of $200,000 next year, the value of Ricky’s and Alice’s shares will increase by $20 per share, calculated as (aftertax earnings ÷ number of common shares) or ($200,000 ÷ (5,000 + 5,000)).
Using a Holding Company
One way to freeze an estate with an operating company is to establish a holding company. In simplistic terms, the intended beneficiaries subscribe to the common shares of HOLDCO for a nominal cost. HOLDCO remains an empty shell. The shares of the operating company are then rolled over to the holding company at their fair market value. The original owner of the operating company then subscribes to preferred shares of the holding company in an amount equal to the fair market value of the shares of the operating company. A more detailed explanation of the mechanics of this type of estate freeze is discussed in another course. It can get much more complicated. Amanda is the sole shareholder of Opco Inc., which owns six fishing boats. She is 65 years of age and wishes to retire and leave the business to her six sons who work on the boats. They do not have the cash or credit to buy her interest. A new company, Holdco Inc., is incorporated with each son subscribing and paying for one common share at a cost of $1. Holdco acquires the shares of Opco for $500,000, their fair market value, and issues preferred shares to Alice with a fair market value of $500,000 and a 7% dividend rate. The preferred shares are given full voting rights, so Alice can still control the corporation. Alice retires.
Exercise: Estate Freezes Involving Corporations
Incorporated Professional Practices
Some provinces allow members of certain professions to incorporate. This gives them some distinct advantages in comparison to professionals in other provinces. Professional incorporation grants many of the same advantages enjoyed by other incorporated self-employed individuals. However, in some circumstances, incorporation does not mean these professionals enjoy limited liability. One important benefit of incorporation is the lower tax rate enjoyed by corporations. However, this benefit is only maximized if the income is not withdrawn from the company but is used to make capital and operating expenditures, and to repay debt.
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Unlimited Liability
The limited liability of the shareholders of a corporation is one of the main advantages of a corporation. In Alberta, only practicing professionals can be shareholders of an incorporated professional practice and while they are not personally liable for the financial debts and obligations of the incorporated professional practice in which they hold shares, they still face unlimited liability for professional negligence. In British Columbia, family members of the practicing professional can become non-voting shareholders of the incorporated professional practice without assuming any liability. However, the practicing professional in a BC incorporated professional practice remains liable for his own professional negligence, as in Alberta. Henry and Fiona are Chartered Accountants in Alberta and they jointly operate a public accounting practice. They would like to incorporate their practice, but only Henry and Fiona can be shareholders of this new corporation. In addition, both Henry and Fiona will be liable for any professional negligence carried out under the umbrella of the practice. Elliot is a doctor in British Columbia and he operates a successful obstetrics clinic. Elliot would like to incorporate his practice and he would like his wife, Jennifer to own shares in the corporation because of the potential for income splitting. This is permitted in British Columbia and Jennifer can receive the benefit of being a shareholder without having any personal liability for the professional practice. However, Elliot will remain fully liable for professional negligence.
Tax Advantages
The greatest advantage of a professional corporation is tax reduction. The professional corporation does not offer its shareholders any tax advantages that are not available to the shareholders of any other corporation. It simply enables some professionals to incorporate their practices so they can benefit from those tax advantages, while preventing them from benefiting from the limited liability that is otherwise available to corporate shareholders. The idea is that professionals such as doctors and lawyers should be able to take advantage of the tax planning opportunities associated with the corporate form of business without being able to use that corporate veil to shield them in the event of their own professional negligence. Small business deduction In particular, there are potential tax savings for those professionals who do not require all of their professional earnings for current personal or family use. Most professional corporations will qualify for the small business deduction, reducing the effective corporate tax rate on active business income up to the SMABUD, to about 21% each year calculated as (general corporate tax rate – SMABUD rate) or (38% - 17%). Capital gains exemption The shares of a professional corporation that satisfies the requirements for an eligible small business corporation can qualify for the lifetime exemption of up to $750,000 of capital gains for shareholders upon the deemed or actual disposition of such shares.
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Corporations Income splitting Incorporated professionals can employ family members to perform management, clerical, maintenance or other services. In this way, a certain amount of income can be split between family members even if they are not permitted to be shareholders. Retirement planning The incorporated professional has more sophisticated retirement planning opportunities than one operating as a sole proprietor or partner. He can establish a defined-benefit registered pension plan (RPP), and this could result in higher deductible contributions and a higher retirement income than could be provided under RRSP limits. Benita, who has an incorporated professional practice, has employment income of $100,000. This year, the most that she can contribute to her RRSP is $20,000. However, because of her age, if Benita establishes an individual pension plan through her incorporated professional practice, her business would have to contribute $32,000 to the pension plan this year in order to fund the 2% per year of service pension benefit, and this $32,000 would be tax deductible to the corporation. We explain how these plans work and what the limits are in more detail in another course.
The Corporation vs. Other Business Forms
There are significant differences between corporations and partnerships, although both of them can be used to structure investments. The differences are summarized below: • The corporation offers limited legal liability whereas the general partnership does not. A limited partnership does offer limited liability, but it does not offer the deferral of income that is available to some CCPCs. The CCPC offers a deferral of personal income tax for active business income. In the case of a partnership, the income flows to the partners and cannot be deferred. A partnership allows business and capital losses to flow through to the partner, who can use these losses to offset other income. In a corporation, any net losses must be carried forward or back to another taxation year.
•
•
Exercise: The Corporation vs. Other Business Forms
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Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Corporations as Wealth Accumulation Vehicles for the Owner/Manager. In this lesson, you have learned how to do the following: • • describe the nature and purpose of holding companies and incorporated professional practices explain how an individual can use the ownership/management of a corporation as a wealth accumulation vehicle
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Corporations as Wealth Accumulation Vehicles for the Owner/Manager, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Corporations
Review
Let’s look at the concepts covered in this unit: • • • • • • • • Defining a Corporation Types of Business Corporations Shares and Shareholders Organizational Structure of a Corporation Corporate Taxation 1 Corporate Taxation 2 Taxation of Shareholders Corporations as Wealth Accumulation Vehicles for the Owner/Manager
You now have a good understanding of the nature of corporations. At this point in the course you can describe the nature and different types of business corporations, explain the rights and roles of shareholders, and describe the governing legislation of a corporation. You can also calculate various corporate tax elements and the taxation of shareholders as well as describe the purpose of holding companies and incorporated professional practices. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 3: Corporations, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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Unit 4: Income Tax Planning and Research
Income Tax Planning
Unit 4: Income Tax Planning and Research
Welcome to Income Tax Planning and Research. In this unit, you will learn about residency requirements and rules, filing deadlines, and the major components of the federal and provincial tax legislation. You will also learn about how to use various tax deductions to reduce the amount of income that is subject to tax. This unit takes approximately 2 hours and 15 minutes to complete. You will learn about the following topics: • • • • Residency and Installment Payments Deadlines, Penalties, and Reviews Income Tax Planning and Research Miscellaneous Deductions
To start with the first lesson, click Residency and Installment Payments on the table of contents.
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Income Tax Planning and Research
Lesson 1: Residency and Installment Payments
Welcome to Residency and Installment Payments. In this lesson, you will learn about residency requirements and rules as well as installment payments, penalties, and interest. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe residency requirements and rules calculate and explain when installments are required, payment options, penalties, and interest
Declaration of Taxpayer Rights
Tax compliance While the government likes to describe our tax administration system as a voluntary system of self assessment, the fact is that the Income Tax Act includes strict rules about who must pay tax and when. It also includes penalties for those who file their tax returns late or who fail to pay their taxes on time. The majority of the tax compliance rules are in Division I of the Income Tax Act, Returns, Assessments, Payment and Appeals. The declaration of taxpayer rights Canada Revenue Agency (CRA) was the first revenue administrator in the world to proclaim the rights of taxpayers, which it did in 1985 with the publication of The Declaration of Taxpayer Rights. The Declaration has been updated periodically to remain current with the law and societal needs, and is entrenched in the day-to-day operations of the Department. The Declaration is available from CRA’s income tax offices, and it is published on the back of the General Income Tax Guide. The current Declaration is shown in the following table. Declaration of Taxpayer Rights In your dealings with Canada Customs and Revenue Agency on income tax matters, you have important rights Fair treatment You have the right to expect us to apply the law fairly and impartially. Courtesy and consideration You have the right to be treated with courtesy, respect, and consideration. Privacy and confidentiality Information You have the right to get complete, accurate, and clear information about your rights, entitlements, and obligations. Entitlements You have the right to every benefit allowed under the law.
You have the right to expect that your Formal Review personal and financial information is protected against unauthorized use or If you believe you have not received disclosure. your full entitlements under the law,
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Income Tax Planning you have the right to a formal review of your file. If we cannot resolve the matter to your satisfaction, you have the right to appeal to the courts.
Bilingual service You have the right to be served in the official language of your choice at designated bilingual offices.
Source: CRA Web site ((http://www.cra-arc.gc.ca/agency/fairness/rights-e.html)
Residency
An individual who is a resident or deemed resident in Canada at any time in a taxation year may be subject to Canadian income tax on his or her taxable income (ITA 2(1)). An individual is resident in Canada for tax purposes if Canada is the place where the individual, in the settled routine of his life, regularly, normally, or customarily lives. Although Tassia is a citizen of Greece, she moved to Canada 12 years ago with her husband, who is a Canadian citizen. They have since had two children who are enrolled in the Canadian school system. Tassia visits Greece frequently for a few weeks each time, but she always returns to her home in Canada. Although Tassia is not a Canadian citizen, she has obviously made Canada her home and she is a resident of Canada for tax purposes. Note: Residency is not the same thing as citizenship. Citizenship refers to a national affiliation, not the place of residence. While Canada’s tax system is based on residency, the tax systems in some other countries, such as the United States, are based on citizenship. Refer to IT-221R2, Determination of an individual’s residence status, for more information.
Resident in Canada for Only Part of the Year
If an individual is a resident or deemed resident of Canada for only part of the calendar year, he or she only has to report the worldwide income that he or she earned during that period of Canadian residency for Canadian tax purposes (ITA 114). On November 15th of last year, Constance became a Canadian resident. She did not have any Canadian sourced income prior to her immigration. On her tax return for last year, she will only have to report her worldwide income earned from November 15th through December 31st, of last year. Sojourners A sojourner is someone who is temporarily present in Canada. If a sojourner is in Canada for a total of 183 days or more in any calendar year, the individual is deemed by the Income Tax Act to have been resident in Canada for the entire year, even if he or she is technically a resident of another country at the time (ITA 250(1)(a)). As a deemed resident, he or she will have to report worldwide income for Canadian tax purposes. For those whose travels to Canada vary from year to year, it is possible to be a deemed resident one year, but not the next, depending on whether the individual meets the 183-day criterion for each particular year. Three years ago, Simon severed all of his ties with Canada and moved to the U.S., such that he was a non-resident for Canadian tax purposes. Last year, he returned to Canada frequently for business purposes, such that he spent 195 days in Canada. He expects to spend 180 days in Canada this year.
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Income Tax Planning and Research
Simon was a deemed resident of Canada last year even though he was also a resident of the United States. This year, Simon is once again a non-resident of Canada. So, for last year, he will have to report his worldwide income for Canadian tax purposes, but for this year, he will only have to report his income from Canadian sources for Canadian tax purposes. Although Simon will have to report his worldwide income for last year for Canadian tax purposes, the Canada-United States Tax Convention may override and prevent Canada from taxing him on this income. Immigrants If an individual, other than a sojourner, enters Canada and establishes residential ties within Canada, he or she will be considered to have become a resident of Canada for tax purposes on the date he entered Canada (IT-221R2). On November 15th of last year, Constance immigrated to Canada from Italy. Even though she was in Canada for less than 183 days during the last taxation year, she is deemed to be a resident of Canada from the moment that she entered the country. Becoming a non-resident An individual is resident in Canada for tax purposes if Canada is the place where he or she, in the settled routine of his or her life, regularly, normally or customarily lives. If an individual resides in another country, even for a significant amount of time, CRA will still consider that person a Canadian resident for tax purposes if he or she maintains sufficient residential ties in Canada in the form of a: • • • dwelling place spouse or common-law partner dependants
Where an individual has not severed all of his or her residential ties with Canada, but is physically absent for several months or even years, CRA will consider factors such as intention to permanently sever residential ties, regularity and length of visits to Canada, and residential ties outside of Canada. No element is determinative in itself and CRA would decide on a case by case basis whether a person is resident in Canada for tax purposes while abroad. If a Canadian citizen becomes a non-resident for tax purposes, the only income that he she will have to report for Canadian tax purposes will be the income that he or she earns from Canadian sources, such as employment income while working in Canada or capital gains realized on the sale of Canadian real estate. Once the individual is a non-resident, the rest of his or her world income will be beyond the reach of the Canadian tax system. This is attractive to some Canadians. However, upon becoming a non-resident, he or she will face a deemed disposition of capital property at fair market value and that could result in a significant tax liability on departure.
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Income Tax Planning
Exercise: Taxpayer Rights and Residency
Paying by Installments
Tax withheld at source In the case of some types of income, such as employment income or certain RRSP withdrawals, some income tax is withheld at source and remitted directly to CRA. This helps the government spread its tax revenues over the course of the year, instead of waiting to receive it all on April 30th of the following year. If a taxpayer receives income that was not subject to a withholding tax or if not enough tax was withheld, the taxpayer might have to pay a large amount of tax when he or she files his or her return. This could easily happen if the taxpayer received bond interest, tips and gratuities, certain pension payments, rental, investment or self-employment income, or income from more than one job. Tony works part-time for two different employers, earning $25,000 from each of them. He is also self-employed and earns $50,000 in self-employment income. Both of his employers withhold taxes on the assumption that he earns $25,000 per year. No taxes are withheld on his self-employment income. So, over the course of the year Tony only pays a small portion of his taxes owing through withholdings. Tax by installments The Income Tax Act requires some taxpayers to pay income tax by installments. Installments are periodic payments of income tax that some taxpayers pay to CRA four times a year on March 15th, June 15th, September 15th and December 15th. If a taxpayer pays by installments, he or she reports the paid amount as a credit on his or her tax return, and it is deducted from to total tax payable of the taxpayer. Jerome has a full-time job and also has significant investment income. His total tax payable for last year was $18,400. His employer withheld $11,400 from his pay and he paid quarterly installments of $800. So, his total credits are $14,600, calculated as (employer's withholdings + (installment amount x number of installments)) or ($11,400 + ($800 × 4)). His balance owing is $3,800, calculated as (total tax payable - total credits) or ($18,400 $14,600)). Refer to CRA Guide P110(E), Paying Your Income Tax by Installments, for more information.
When Installments are Required
A taxpayer will have to make installment payments for the current tax year if his net tax owing is more than $2,000 for both the current tax year and either of the previous two years (ITA 156.1(1)). Net tax owing is the total of the taxpayer’s federal and provincial taxes payable minus all taxes deducted at source and minus refundable tax credits.
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Income Tax Planning and Research Simon just started his own business as a sole proprietor and he expects his net tax owing this year to be $3,200. For the last few years he has been employed full-time and his net tax owing was never more than $400. Simon does not have to pay his tax by installments this year, and he can pay all of his tax owing by April 30th of next year. However, if his net tax owing will be more than $2,000 next year as well, he will have to pay tax installments next year.
When Installments are Required
In previous years, a taxpayer was required to make installment payments if his or her net tax owing was more than $2,000 ($1,200 in Québec) for the current tax year and either of the previous two years (ITA 156.1(1)). Budget 2007, increased the personal income tax installment threshold from $2,000 to $3,000 (and from $1,200 to $1,800 in Québec) effective 2008. The balance due date for taxes still owing after all installments have been paid remains unchanged: April 30th of the following taxation year. Net tax owing is the total of the taxpayer’s federal and provincial taxes payable minus all taxes deducted at source and minus refundable tax credits. Simon just started his own business as a sole proprietor and he expects his net tax owing this year to be $3,200. For the last few years he has been employed full-time and his net tax owing was never more than $400. Simon does not have to pay his tax by installments this year and he can pay all of his tax owing by April 30th of next year. However, if his net tax owing for the next year again exceeds the $3,000 threshold, he will have to pay tax installments next year.
CPP Contributions
Most Canadian residents who are employed must contribute to the Canada Pension Plan based on their pensionable earnings. A taxpayer who is required to pay tax by installments may have to make installment payments for his or her CPP contributions at the same time, if all of the following conditions apply; he or she: • • • • is self-employed does not live in Québec on December 31st is 18 to 70 years of age during the year is not receiving CPP retirement or disability benefits
Sonja is self-employed and this is the first year that she will have to pay tax by installments. She will also have to pay her CPP contributions by installments. Kim is employed full-time and his employer withholds income tax from his pay based on his employment income. However, Kim also has significant investment income and he has to pay some tax by installments in addition to his employer’s withholdings. However, because Kim is not self-employed, he does not have to make CPP contributions by installments. CPP contributions are only required on pensionable employment earnings and his employer will have deducted Kim’s contributions from his pay.
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Income Tax Planning
Installment Payment Options
Canada Revenue Agency will notify a taxpayer if he or she is required to pay tax by installments based on the information CRA has on file. There are three ways to determine the amount of each installment payment. No-calculation option Under the no-calculation option, CRA determines how much the taxpayer must pay each quarter in the current taxation year based on its knowledge of the tax and CPP owing from the previous two years, and informs the taxpayer how much he or she must pay on an installment reminder. If the taxpayer uses the no-calculation option and makes the required payments on the due dates, he or she will not have to pay any installment interest or penalties, even if the payments are less than the total amount of tax owed at the end of the year. Prior-year option Under the prior-year option, for the current taxation year, the taxpayer would pay one quarter of his or her net tax owing and CPP payable based on the prior year on each installment due date (ITA 156(1)(a)(ii)). Any balance of tax still owing is due by April 30th of the year following the taxation year. As long as the installments are made on time and the taxpayer correctly calculated the required installments, he or she will not face any installment interest or penalties, even if the taxpayer’s payments are less than the total amount that he or she owes at the end of the year. However, if the taxpayer incorrectly calculates the required installments and his or her payments are too low, he or she may face a penalty and installment interest. Current-year option Under the current-year option, the taxpayer can pay one quarter of his or her estimated net tax owing and CPP contributions payable for the current taxation year on each installment date (ITA 156(1)(a)(i)). He or she can use Form T1033-WS, Worksheet for Calculating 2001 Installment Payments, to help the taxpayer calculate his or her required payments under this option. However, if a taxpayer uses this option and makes an error in estimating the taxes that he or she owes, the taxpayer will be charged installment interest and penalties when CRA assesses his or her return, as discussed later.
Installment Penalties and Interest
Taxpayers who are required to pay tax by installments may incur installment interest or penalties if their payments are late or are too small. Installment interest If the taxpayer pays the amount shown on the installment reminders that he or she receives from CRA on time, the taxpayer will not have to pay installment interest, even if the payments are less than the total amount of tax that he or she may owe at the end of the year.
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Income Tax Planning and Research
However, he or she may be charged installment interest if: • • any of his installment payments are late or the taxpayer chose to make his or her installment payments according to either the prior-year or current-year option and miscalculated the required installment payment, such that his or her payments were too low
A taxpayer can reduce or eliminate interest charges that he or she would otherwise incur as a result of late or deficient installments by overpaying other installments or paying them before their due date. Installment penalties A taxpayer may also incur an installment penalty if the installment payments are late or less than the required amount and if the installment interest charges for the taxation year are more than $1,000 (ITA 163.1).
Exercise: Paying By Installments
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Residency and Installment Payments. In this lesson, you have learned how to do the following: • • describe residency requirements and rules calculate and explain when installments are required, payment options, penalties, and interest
If you are ready to move to the next lesson, click Deadlines, Penalties, and Reviews on the table of contents.
Assessment
Now that you have completed Residency and Installment Payments, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning and Research
Lesson 2: Deadlines, Penalties, and Review
Welcome to Deadlines, Penalties, and Reviews. In this lesson, you will learn about the filing deadlines, the impact of filing late, and the components of the review process. This lesson takes 35 minutes to complete. At the end of this lesson, you will be able to do the following: • • • describe the filing deadlines calculate the impact of filing late describe the review process and its components
Filing Returns
The Income Tax Act sets rules for when taxpayers have to file tax returns and pay any tax owing, sometimes imposing interest charges and other penalties on those who do not comply. Each corporation (other than a registered charity) must file a tax return for the taxation year. An individual must file a tax return for the taxation year if the taxpayer: • • • • • has taxable income has a taxable capital gain has disposed of a capital property (ITA 150(1)) has a positive balance at the end of the year in his or her Home Buyers' Plan or Lifelong Learning Plan (ITA 150(1.1)) has received a written demand from CRA to file a return (ITA (150(2))
Filing deadlines The required filing date depends on the taxpayer: • • corporations must file within six months from the end of the corporation’s fiscal year-end (ITA 150(1)(a)) the representative of deceased individuals who die after October, but on or before the day that would otherwise be his or her filing date if he or she had not died, must file on or before the later of the normal filing date and six months after the day of death. This also applies to spouses or common-law partners of deceased individuals (ITA 150(1)(b) and (d)(iii)) trusts must file within 90 days from the end of the trust’s fiscal year (ITA 150(1)(c)) self-employed individuals and their spouses or common-law partners must file by June 15th (ITA 150(1)(d)(ii)) all other individuals must file by April 30th (ITA 150(1)(d)(i))
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• • •
Darren died on September 15th of last year. His executor must file his return by April 30 of this year.
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Income Tax Planning Eric was employed full time before he died on November 21st of last year. His executor has to file his return by May 21st of this year, calculated as [the later of (his normal filing deadline and six months after his date of death)] or [the later of (April 30th and May 21st]. June is self-employed and she died on November 18th of last year. Her executor has to file her return by June 15th of this year, calculated as [the later of (her normal filing deadline and six months after her date of death)] or [(the later of (June 15th and May 18th)]. An individual is generally considered to have filed his or her return by the deadline if he or she sends the return by first class mail or courier by that deadline, even though this lastminute filing means that CRA will not actually receive the return before the deadline. On April 30th of each year, some postal outlets will stay open until midnight so last-minute tax filers can drop off their returns and have them time stamped as being mailed by the deadline. Penalties for late filing or failing to file An individual who fails to file an income tax return on time faces a late-filing penalty of: • • 5% of the tax owing at the time the return was due 1% of the tax owing times the number of complete months that the return is not filed, to a maximum of 12 (ITA 162(1))
plus
Reggie was supposed to file his tax return on April 30th of this year, but he did not file it until October 18th of this year. When he did get around to completing his return, he found out that he owed $6,900 in taxes. It has been five complete months since the filing deadline (May, June, July, August, and September), so Reggie will have to pay a penalty of $690, calculated as [tax owing x (5% late filing penalty + (number of complete months late x 1%))] or [$6,900 × (5% + (5 × 1%))]. So, in practical effect there is no penalty for late filing unless you have a balance owing. The penalties get stiffer for repeat offenders (ITA 162(2)), and can include a jail term for the most blatant of tax abusers (ITA 238(1)).
Paying Taxes
In most cases, the government does not want to wait until the filing deadline to collect the tax that taxpayers owe. Depending on the type of income, the Income Tax Act may require some tax to be withheld at source and to be remitted on the taxpayer’s account. In other cases, the taxpayer will have to make installment tax payments. But even with these interim payments, many taxpayers find they still have a balance owing when they file their returns.
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Income Tax Planning and Research Payment deadlines The balance-due day is the day all taxes are due for the last taxation year and it varies depending on the taxpayer (ITA 248(1)): • • • a trust, 90 days after the end of the trust’s fiscal year an individual who died after October in the year and before May in the following taxation year, the day that is six months after the day of death for other individuals, April 30th in the following taxation year Last year, Fiona had taxable income. Her balance-due day is April 30th, of this year. A taxpayer, other than a corporation, is generally considered to have paid his or her taxes by the balance-due day if he or she sends the payment by first class mail or courier by that date. Note: Although self-employed individuals and their spouses or common-law partners do not have to file their tax returns until June 15th, they must still pay any taxes owing by the balance-due day. Payment penalties If a taxpayer fails to pay the balance owing by the balance-due date, he or she will be assessed interest on the outstanding amount at a rate prescribed by Regulation (ITA 161, ITR 4301). The prescribed interest rate for overdue taxes is adjusted quarterly. Click here for the current rate. Samantha was supposed to pay tax of $3,500 on April 30th, but she did not make the payment until 85 days later on July 24th. The prescribed nominal rate on overdue taxes was 10% during this entire time. Samantha will have to pay a combination of principal and interest of $3,582 on July 24th, calculated by entering P/YR = 365, ×P/YR = (85 ÷ 365), I/YR = 10%, PV = $3,500, PMT = $0 and solving for FV. So, Samantha must pay an interest penalty of $82, calculated as (combined principal and interest - principal) or ($3,582 - $3,500). Unlike interest expenses incurred for business or investment purposes, interest and penalties on late tax payments are not tax deductible (ITA 18(1)(t)).
Exercise: Deadlines, Penalties and Interest
The Review Process
Once the taxpayer has filed his or her income tax return, CRA begins its review, which could take a few weeks to several months. If there are no significant errors in his or her return and CRA does not require any additional information, it will send the taxpayer a Notice of Assessment. This document explains the details of his or her assessment and identifies any
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Income Tax Planning balance that he or she owes or that is owed to the taxpayer. If he or she has an outstanding balance, it explains how this amount can be paid. However, the Notice of Assessment is not necessarily the end of the matter, if one of the following situations applies: • • • • CRA decides to reassess his or her return the taxpayer decides to ask CRA to reassess his or her return based on new or missing information CRA audits his or her return the taxpayer decides to appeal a CRA assessment or reassessment
Reassessments
A reassessment is a re-evaluation of a return that has already been processed in light of errors, omissions, or new information. Reassessments can be done at CRA’s discretion or at the taxpayer’s request. At CRA’s discretion CRA can decide to reassess a taxpayer’s return within three years of the date that it issued the original Notice of Assessment, or even later if it can prove fraud or misrepresentation, or if the taxpayer signs a waiver (ITA 152(3.1), (4)). A reassessment may result from new information that CRA received through a request for information or a more formal audit, or discrepancies that were identified when CRA processed other returns related to the return in question, such as the return of the taxpayer’s spouse. When Jeannine filed her tax return, she made a claim for childcare expenses using the appropriate form, on which she listed the name and social insurance number of her babysitter, Nancy, along with the amount that she paid Nancy. Nancy mailed her tax return in March, but Jeannine waited until the last minute, so Nancy’s return was processed first. When Nancy filed her tax return, she forgot to include the money that she had made babysitting in her income. When CRA first processed her return, everything appeared fine and it issued Nancy a Notice of Assessment. After CRA processed Jeannine’s return, it identified the discrepancy and sent a request for information to Nancy. After Nancy confirmed that she had in fact forgotten to include the babysitting income, her return was reassessed. At the taxpayer’s request There are many situations that could arise that would prompt a taxpayer to request CRA to reassess a prior return. Rather that submitting a whole new return, the taxpayer should write a letter or complete Form T1-ADJ, Adjustment Request, and send it to his or her Taxation Office explaining the situation and including any supporting documentation. After filing his income tax return, Jacob found a receipt for a charitable donation of $5,000 that he forgot to consider when he completed his return. He can submit this new information to CRA and ask that his return be reassessed.
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Income Tax Planning and Research In July of last year, Mary sold her business property and realized a substantial taxable capital gain that she had to report on her tax return for last year. In January of this year, she bought a replacement property. According to the rules for former business properties, Mary can ask CRA to reassess her tax return for last year, reducing the tax liability that arose from the taxable capital gain. Time limit for reassessments CRA will typically reassess old returns at the taxpayer’s request at any time back to 1985, even beyond the three-year limit imposed on reassessments that it initiates itself (ITA 152(4.2)). CRA will issue a refund or reduce the amount owed on such a late request if it is satisfied that such a refund or reduction would have been made if the return or request had been on time. CRA will not agree to a reassessment if the taxpayer is merely changing his or her mind about an optional deduction, such as how much CCA to claim or whether to report a spouse’s dividends on his or her return. Refer to IC 92-3, Guidelines for refunds beyond the normal three year period, for more information.
Audits
While assessing a taxpayer’s return or at some point after the initial assessment, CRA may request any information that it needs to verify the accuracy of amounts reported on that tax return and to ensure that the taxpayer is in compliance with the Income Tax Act (ITA 231.2(1)). This verification procedure is referred to as an audit. Request for information The extent of CRA’s scrutiny may be limited to requesting the taxpayer to mail in supporting documentation or receipts. This is sometimes also referred to as a desk audit. Such a request does not necessarily mean that the taxpayer will have to pay additional tax, and it does not necessarily mean that CRA suspects the taxpayer of tax evasion. In an effort to control the amount of paper that must be processed, in many situations, the tax administration allows the taxpayer to make a claim or a deduction without providing supporting documentation or receipts. CRA routinely carries out spot checks on a portion of all returns with a request for information to verify that such claims are in fact legitimate. When Frieda filed her tax return, she claimed a deduction for childcare expenses. However, she did not have to provide receipts with her return. After she filed her return, she received a letter from CRA requesting that she provide copies of her receipts to verify her claim. As long as Frieda can provide the receipts, her original assessment will stand unchallenged. However, if she cannot provide the receipts or if the amounts on the receipts are different from the amount that Frieda reported on her return, her return will be reassessed.
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Income Tax Planning Field audits In the case of a field audit, CRA will send an auditor to the taxpayer’s residence or place of business, where the auditor will take a detailed look at the taxpayer’s records and receipts. Most field audits are done in relation to businesses, as opposed to individuals. Julio has been operating a retail operation as a sole proprietor for five years out of a building that he owns, but he has yet to realize a profit despite his high sales revenues. CRA may conduct a field audit to verify that Julio’s business revenues and expenses are indeed what he claims they are. While the thought of a field audit is terrifying to many people, audits should not be a cause for concern unless the taxpayer has been purposely evading taxes. It will be up to the auditor to decide if the deductions were reasonable, or whether the taxpayer was intentionally claiming unreasonable amounts to evade taxes.
Objections and Appeals
All taxpayers have the right to dispute an income tax assessment. The Income Tax Act includes several provisions for objections and appeals that a taxpayer can use to try to resolve a dispute. Refer to CRA Publication P148, Your Appeal Rights under the Income Tax Act, for more information. Initial objection If a taxpayer is not satisfied with his or her assessment, reassessment, or CRA’s interpretation of income tax law, he or she can file an objection. Filing an objection is the first step in the formal process of resolving a dispute. After the taxpayer files an objection, the Appeals Division will conduct an impartial review. Individuals and trustees filing on behalf of a testamentary trust can file an objection by the later of the following two dates: • • one year after the date of the return’s filing deadline 90 days after the day that CRA mailed the Notice of Assessment (ITA 165(1))
On April 13th of this year, David who is self-employed, filed his tax return for last year. On May 28th of this year, he received a Notice of Assessment. If he disagrees with the Notice of Assessment, he can file an objection as long as he does so by June 15th next year, which is calculated as (the later of (90 days after CRA mailed the Notice of Assessment and one year after his filing deadline)) or (the later of ((90 days after May 28th of this year) and (one year after his filing deadline of June 15th of this year)). The Appeals Division will review the objection and contact the taxpayer to discuss the matter. If the Chief of Appeals agrees with the taxpayer in whole or in part, CRA will adjust the taxpayer’s return and issue a Notice of Reassessment. However, if the Chief of Appeals disagrees, CRA will send the taxpayer a Notice of Confirmation confirming that the original assessment was correct.
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Income Tax Planning and Research
Appealing to the Tax Court of Canada
If the taxpayer does not agree with the Chief of Appeals’ decision regarding his or her objection, he can appeal to the Tax Court of Canada, which is an independent court of law that regularly conducts hearings in major centres across Canada. The taxpayer must apply to the Tax Court within 90 days from the date CRA mails its decision, whether it be a Notice of Reassessment or a Notice of Confirmation (ITA 169(1)). The taxpayer can also apply to the Tax Court for a decision if the Chief of Appeals has not provided a decision on the original objection within 90 days of it being filed. Informal vs. formal procedure The appeal can be heard by either a formal or informal procedure, depending on the nature and size of the dispute. In either case, there is a fee for hearing an appeal ($100 for informal procedure; $250 to $550 for formal procedure). Under the informal procedure, the judge can order CRA to pay part of the taxpayer’s legal costs if the taxpayer is more than 50% successful in his or her appeal, but the judge cannot order the taxpayer to pay part of CRA’s costs if the taxpayer is unsuccessful. Under the formal procedure, the court can order the unsuccessful party to pay some of the other party’s legal costs. Mark appealed his Notice of Reassessment to the Tax Court of Canada. Because of the amounts involved, he had no choice but to follow the formal procedure. Mark lost his appeal and the Court ordered him to pay $5,000 to CRA towards their legal fees. Further appeals A taxpayer can appeal a judgement of the Tax Court of Canada to the Federal Court of Appeal, provided the appeal is filed within 30 days of the date the Tax Court of Canada communicates its decision (ITA 180(1)). A taxpayer can appeal a judgement of the Federal Court of Appeal to the Supreme Court of Canada, provided he or she first obtains the Supreme Court’s permission to do so.
Exercise: The Review Process
Civil Penalties for Misrepresentations of Tax Matters by Third Parties
On the one hand, as a financial planner it is your role to help your clients achieve their financial objectives and that role may require you to give them tax advice, because minimizing taxes is a key component of wealth accumulation. On the other hand, the federal government has recently introduced civil penalties for advisors who advise or encourage their clients to misrepresent their tax situation.
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Income Tax Planning Canadian tax law already included both criminal and civil penalties that may apply to all taxpayers who misrepresent tax matters to ensure that all taxpayers pay their fair share of taxes. Tax avoidance vs. tax evasion Tax avoidance occurs when a taxpayer legitimately structures his or her affairs to realize a reduction in his or her overall tax liability by taking advantage of provisions contained in the Income Tax Act. Tax evasion occurs when a taxpayer misrepresents his or her financial circumstances such that it appears that the taxpayer owes less tax than he or she actually does. Criminal penalties may apply where a person participates in tax evasion in respect of his or her own taxes or another person’s taxes (ITA 239(1)). Civil penalties may apply where a taxpayer is shown to have knowingly, or in circumstances amounting to gross negligence, made false statements or omissions in the filing of the taxpayer’s own tax information (ITA 163(2)). However, until third-party civil penalties came into force on June 29, 2000, there was no civil penalty provision that applied to those who counsel others to file their returns based on false or misleading information, or who turn a blind eye to false information provided by their clients for tax purposes.
Culpable Conduct
The legislation applies the penalties only in cases of culpable conduct, which is defined as conduct, whether it be an act or a failure to act, that meets one of the following conditions: • • • is tantamount to intentional conduct shows an indifference as to whether the Act is complied with shows a willful, a reckless or a wanton disregard of the law (ITA 163.2(1))
The legislation also provides that an advisor will not be held responsible if he or she is relying in good faith upon information provided by the taxpayer (ITA 163.2(6)). Sasha was preparing a tax return for his client, Amanda, who had income of $82,000. Amanda told Sasha that she had incurred childcare expenses of $5,000 throughout the year, but that she forgot her receipts at home. She asked Sasha to prepare her return anyway, and that she would keep the receipts on file. Sasha had no reason to disbelieve her claim and prepared the return accordingly.
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Income Tax Planning and Research When CRA later requested copies of Amanda’s receipts, she admitted to Sasha that her childcare expenses had been only $2,000. Because Sasha was acting in good faith, he will not be subject to any penalty.
Penalty for Misrepresenting a Tax Planning Arrangement
The legislation calls for a civil penalty for misrepresentations in tax planning arrangements, to be applied to every advisor who makes, or causes another person to make, a statement that the advisor knows, or would reasonably be expected to know, but for circumstances amounting to culpable conduct, is a false statement that could be used by another person for the purpose of the Income Tax Act (ITA 163.2(2)). This is commonly referred to as the "Planner penalty". Planner Penalty The planner penalty is more likely to be applied to those who knowingly make a false statement, where the person or persons who could make use of that false statement may not actually be identified. Examples include: • • tax shelter promoters holding seminars or presentations to provide information in respect of a specific tax shelter appraisers and valuators preparing a report for a proposed scheme or shelter that could be used by unidentified investors
A false statement includes a direct falsehood, as well as a statement that is misleading because of an omission from the statement. The penalty for making, or causing another person to make, a false statement is as follows: • if the statement is made in the course of a planning or valuation activity, the greater of $1,000 and the total of the person's gross entitlements arising from the false statement in any other case, $1,000 (ITA163.2(3))
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Penalty for Participating in a Misrepresentation
A similar penalty for participating in a misrepresentation applies if the advisor knowingly participates in, assents to or acquiesces in the making of a false statement by or on behalf of another person, or a statement that the advisor should have known was a false statement, but for circumstances amounting to culpable conduct (ITA 163.2(5)). This is commonly referred to as the "Preparer penalty". Preparer Penalty The preparer penalty is usually applied in situations where the work was performed for a specific taxpayer, or group of taxpayers who can be specifically identified. Examples would include: • • • a person preparing a tax return for a specific taxpayer a person providing tax advice to a specific taxpayer an appraiser or valuator preparing a report for a specific taxpayer or a number of persons who can be identified
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Income Tax Planning
In this case, the penalty is the greater of: • • $1,000 and the lesser of: i) the penalty to which the other person would be liable if the other person knowingly made the statement (i.e., the greater of $1,000 or that other person’s gross entitlement arising from the false statement) ii) $100,000 plus the advisor’s compensation for taking part in the scheme Aaron, an accountant, receives a box of personal and business receipts from Caleb and agrees to prepare a business expense statement for Caleb. Aaron includes the $5,000 cost of Caleb’s family vacation, which Aaron knew to be a non-deductible personal expense, as a business expense in Caleb’s tax return. Aaron finalized Caleb’s tax return and advised him that he will be receiving a significant tax refund. He charged Caleb $500 for his services. Caleb filed the return. CRA conducted a compliance audit and discovered the $5,000 of personal expenses deducted in Caleb’s tax return. It disallows the expense, resulting in an additional $2,500 in Caleb’s taxes, assuming a 50% marginal tax rate. Aaron knew of the false statement included in Caleb’s tax return and failed to inform Caleb of this fact. Therefore, Aaron is liable for a penalty of $2,500, calculated as the greater of: • • $1,000 and the lesser of:
(i) Caleb’s gross entitlement of $2,500, which is the tax that Caleb would have avoided if the deduction were permitted (ii) $100,500, calculated as the sum of $100,000 and Aaron’s compensation of $500 For more information on third-party civil penalties, refer to CRA Information Circular IC 01-1 Third-Party Civil Penalties.
Exercise: Civil Penalties for Misrepresentation
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Income Tax Planning and Research
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Deadlines, Penalties, and Reviews. In this lesson, you have learned how to do the following: • • • describe the filing deadlines calculate the impact of filing late describe the review process and its components
If you are ready to move to the next lesson, click Income Tax Planning and Research on the table of contents.
Assessment
Now that you have completed Deadlines, Penalties, and Review, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Income Tax Planning and Research
Welcome to Income Tax Planning and Research. In this lesson, you will learn about the major components of federal and provincial tax legislation and the sources of additional tax information. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • • explain the major components of federal and provincial tax legislation select and access sources of additional information regarding tax legislation
Income Tax Planning and Research
While a taxpayer is not legally allowed to evade taxes, he or she can structure his or her affairs to avoid them. However, effective income tax planning requires a detailed knowledge of how the income tax system works, which sometimes requires research. Most of our tax rules can be found in the federal Income Tax Act (ITA). Amendments are routinely introduced as a result of the annual Federal Budgets, as well as Technical Amendment Bills that are passed from time to time. Unfortunately, these constant amendments have resulted in a patchwork tax system that is difficult to understand, making it even more difficult for financial planners to keep up to date. While financial planners should not have to be tax experts, they will need to understand the basics of the tax system and to know where to go when they need more information.
Federal Tax Legislation
Our federal tax laws are contained in the following three main pieces of legislation: • • • Income Tax Act Regulations to the Income Tax Act Income Tax Application Rules
Income Tax Act The majority of income tax law is documented in the Income Tax Act (ITA). This complex document is almost 1,900 pages and the table of contents alone is 43 pages. Regulations to the Income Tax Act The Income Tax Act is supplemented by numerous regulations, made under the authority of the ITA. These Regulations to the Income Tax Act (ITRs) are used for a variety of purposes, including setting out the working rules for the statutes and specifying relevant rates. While the Income Tax Act can only be amended by an Act of Parliament, the Regulations can be changed, added to or deleted by an Order-in-Council without formal legislative approval. The Income Tax Act gives CRA the authority to charge an interest penalty on unpaid taxes (ITA 161). However, the prescribed interest rate to be used in calculating that penalty is prescribed by a Regulation to the Income Tax Act (ITR 4301). This allows the government
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Income Tax Planning and Research to change the interest rate to reflect current economic conditions without first seeking approval from Parliament. Income tax application rules When the major overhaul of the tax system was done in 1972, the amending legislation contained a number of transitional rules called the Income Tax Application Rules, 1971, or ITARs. The ITARs cover topics such as the tax-free zone for capital gains on pre-1972 property and V-day values.
Roles of CRA and Finance Canada
Canada Revenue Agency (CRA) is responsible for administering federal tax legislation. CRA develops compliance strategies on sectoral, industrial, occupational, and geographic bases, and they include verification, service, and enforcement activities. These strategies help identify compliance problems, and combine information and education to reduce the cost of compliance, clarify the law, and suggest legislative changes. Finance Canada is the federal department that is responsible for developing tax policy and for drafting legislation.
How Tax Legislation is Introduced
While the primary purpose of the annual Federal Budget is supposed to be outlining the government's anticipated revenues and expenditures for the year, the Budget is also the source of most proposed major income tax changes. The Budget Speech generally provides an overview of what the government is trying to achieve. The supplementary information that is released with the Budget is often several hundred pages in length and describes the government's policy objectives and the purpose of specific legislative changes in more detail. The supplementary information may include Notice of Ways and Means Motions (NWMM), which summarize the proposed changes in plain language and serve to introduce the changes in the House of Commons. Grandparenting provisions When new legislation is introduced it may be applied retroactively to a specified date in time, but usually it is effective as of the date it is passed or as of the date of the Federal Budget that proposed the changes. In either case, there are often two sets of rules once changes are introduced. Under grandparenting provisions, the old rules still apply to situations that existed prior to the application date. The new rules only apply as of the application date. Under rules that came into effect in 1982, a family can only designate one home as their principal residence. Prior to 1982, one spouse could own and designate the family's usual home as his or her principal residence, and the other spouse could designate another property as his or her principal residence, provided each property met the test of being "ordinarily inhabited" by the owner. Because the change was not retroactive, under grandparenting provisions, a couple could still designate two properties as their principal residence for years prior to 1982 (ITA 40(6)).
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Income Tax Planning While these grandparenting provisions maintain some fairness to the tax system for those who entered into a particular financial situation on the merits of the tax regime in existence at that time, they also introduce enormous complexity to the tax system. The rules are complicated enough without worrying about whether a different set of rules applies because the taxpayer entered a particular financial situation before the rules changed.
Provincial Tax Legislation
Each province levies its own tax on taxable income (TONI) and each province operates slightly differently. The provinces also tend to introduce the majority of significant tax changes in their annual budgets. The provincial budgets can be found on the province’s official Web site. Depending on the province, the tax statutes may or may not be available free of charge over the Internet. Each province has a different method of publishing this information. As a financial planner, you should be aware of how the provincial tax system works in the province in which you practice even though, the major tax planning opportunities are evident at the federal level.
Exercise: Federal and Provincial Tax Legislation
Sources of Additional Information
The Income Tax Act and the Regulations are difficult to understand, partly because of the technical language used and partly because each section or subsection seems to refer to one or more other sections. The language style itself is a major stumbling block, with a single sentence often containing over 500 words. Most levels of government have made a commitment to use plain language in their publications and their statutes and some headway is being made. However, the day that the Income Tax Act is an easy read is still a long way away. Unless you have experience deciphering the Act, you will find it difficult to use the Act to answer your questions and concerns about tax planning for your clients. Fortunately, there are other sources of information to which you can turn when trying to understand the tax rules. We will examine some of the more useful and readily available sources in the following sections. The commercial presses offer some excellent resource materials for those trying to decipher our income tax system. Some of the professional accounting firms also publish tax information books and offer information on their Web sites. Some of these publications are intended to be professional reference sources, but others act to entice potential clients to retain the organization's services.
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Income Tax Planning and Research Contact information and a list of useful publications are provided in the following table.
Interpretation Bulletins
CRA issues Interpretation Bulletins (ITs) to outline its interpretation of specific sections or areas of income tax law, generally in something approximating plain language. In addition to explaining the basic rules, these bulletins often cover some of the more unique applications of, or exceptions to, the rules and sometimes provide useful illustrative examples. In this program of study, we often provide you with a reference to an IT bulletin, as a source for more information if you want to go beyond the basic rules that we provide in the text. The ITs are revised occasionally in response to either changes in interpretation or amendments to the Act, so once again you must make sure you are dealing with the most current version. There are currently over 500 IT bulletins available. The IT bulletins are published by some of the commercial presses described later and they are also available here on CRA's Web site.
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Income Tax Planning
Advance Tax Rulings
If a taxpayer is considering a particular transaction in the near future and wants to know its tax implications in advance, he or she can request CRA to provide him with a binding advance tax ruling (ATR) for that transaction. CRA will assess the transaction, interpret the provisions of the Income Tax Act, the Excise Tax Act, and related statutes, and establish its interpretation (for example, ATR-63, Donations to Agents of the Crown). CRA will prepare an advanced tax ruling on a cost-recovery, fee-for-service basis. ATR disclaimer The details of each advance tax ruling are public information and may be used to guide other taxpayers in similar situations. However, care must be taken to ensure that the situation is in fact comparable to the one discussed in the ATR. CRA includes the following disclaimer with each advance tax ruling: "Income tax rulings are published for the general information of taxpayers, but are considered to be binding on the Department only in respect of the taxpayer to whom the ruling was given. They are based on the particular facts in the ruling and on the law in force at the time the ruling is published and, therefore, will not be amended for subsequent changes in the law." Advanced tax rulings may be published by the commercial press along with the ITs and information circulars and they are also available here on CRA's Web site.
Technical or Explanatory Notes
The Department of Finance publishes technical notes (also referred to as explanatory notes) to explain the development and application of new tax policies. The technical notes are typically issued when draft legislation is released. While these notes themselves do not have the weight of law and are not intended to be an official interpretation of the draft legislation, the notes do provide valuable insights into the intention of the legislation. Technical notes for most legislative changes since 1995 are available here on Finance Canada's Web site. Carswell Thomson Professional Publishing offers a reference book called Technical Notes, which is an annotated consolidation of technical notes and other commentary from Finance Canada on a section by section basis of the Income Tax Act, going back as far as 1946. This reference is extremely useful when you are trying to decipher the intent of a particular passage of the Income Tax Act because it provides a history of how and why the legislation developed as it did.
Technical News
CRA periodically publishes a document called Technical News to explain changes in its administrative procedures or to announce new guidelines for the application of specific provisions of the Income Tax Act. Current and back issues of the Technical News are available here on CRA's Web site.
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Income Tax Planning and Research
Tax Guides and Brochures
CRA publishes a wide variety of tax guides each year to help taxpayers complete their income tax returns. The tax guides may have supplementary information that the taxpayer needs to complete his or her return, but that is not in the general income tax package. The tax guides are updated annually to reflect current legislation and to include the current set of tax forms. Thus, the tax guides tend to be more up-to-date than the Interpretation Bulletins, particularly with respect to changing rates or threshold amounts. The following are the more commonly used tax guides: • • • • • • • • • • Business and Professional Income, T4002 Rental Income Tax Guide, T4036 Childcare Expense Deduction, T778 RRSPs and Other Registered Plans for Retirement, T4040 Lifelong Learning Plan (LLP), RC4112 Employment Expenses, T4044 Capital Gains, T4037 Farming Income, T4003 Preparing Returns for Deceased Persons, T4011 Fishing Income, T4004
CRA also publishes a variety of informational brochures and pamphlets to provide taxpayers with general information about programs and policies that may be of interest to them. The following are examples of the brochures available: • • • • • • • • Home Buyers’ Plan (HBP) - For Participants, RC4135 Information Concerning People with Disabilities - RC4064 Registered Education Savings Plans (RESPs), RC4092 Using Your Home for Daycare, P134E When you Retire, P119 Support Payments, P102 Gifts and Income Tax, P113 Students and Income Tax, P105
All of CRA's tax guides, brochures and pamphlets are available free of charge from the District Taxation Offices, as well as here on CRA's Web site.
Budget Documents
Each year, the federal government issues a new Federal Budget that outlines proposed tax changes in conceptual terms. As public distribution has become easier with advances in Internet technology, the Budgets have become an accessible source of information for the taxpayer who wants to keep on top of proposed changes. Along with the Budget Speech, the government issues supporting and explanatory appendices that explain the rationale behind the budget proposals. The Budget Speech and supporting documentation are available the same day that the Budget is released here on Finance Canada's Web site.
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Income Tax Planning
Notice of Ways and Means Motions
The Notice of Ways and Means Motions (NWMM) summarize proposed income tax changes in plain language, and as such they can be useful when trying to interpret the intent and application of proposed legislation. The NWMMs may be included with other supplementary budget information, or they may be issued separately. Most NWMMs can be found by searching here on Finance Canada's Web site under the heading Ways and Means Motions, Draft Legislation, Legislative Proposals and Explanatory Notes.
Exercise: Sources of Additional Tax Information
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Income Tax Planning and Research. In this lesson, you have learned how to do the following: • • explain the major components of the federal and provincial tax legislation select and access sources of additional information regarding tax legislation
If you are ready to move to the next lesson, click Miscellaneous Deductions on the table of contents.
Assessment
Now that you have completed Income Tax Planning and Research, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning and Research
Lesson 4: Miscellaneous Deductions
Welcome to Miscellaneous Deductions. In this lesson, you will learn about how to use various tax deductions to reduce the amount of income that is subject to tax. This lesson takes 35 minutes to complete. At the end of this lesson, you will be able to do the following: • calculate and explain moving expenses, childcare expenses, capital losses, and noncapital losses
Deductions as a Tax Planning Tool
A taxpayer can use a tax deduction to reduce the amount of income that is subject to tax. Canada’s tax system is progressive, which means that as a taxpayer reaches a higher level of taxable income, the rate of taxation on that additional income increases. An example of a progressive tax system is as follows:
It is to the taxpayer’s advantage to use deductions to decrease his or her taxable income. The timing of deductions is important from a tax planning point of view, because the taxpayer would generally want to claim the deduction when his or her marginal tax rate is highest. For the purpose of this example, assume that the income thresholds and the marginal tax rates remain at the levels listed above. Fiona has taxable income of $43,836. Of this amount, $3,109 is subject to tax at the federal rate of 22%, calculated as (income – threshold for 22% tax bracket) or ($43,836– $40,727). Suppose Fiona makes an RRSP contribution of $7,500 for which she can claim a deduction. If she claims the entire deduction this year, she will save $1,342.63 in basic federal tax, calculated as [(income if deduction was not claimed that would have been in the 2nd tax bracket x tax rate for 2nd tax bracket) + (income if deduction was not claimed that would have been in the 1st tax bracket x tax rate for 1st tax bracket)] or [($3,109 × 22%) + (($7,500 – $3,109) × 15%)]. However, Fiona is not required to claim any or all of her RRSP deduction this year. If she claims a deduction of $3,109 this year, she will eliminate the income that is subject to the highest amount of tax, reducing her basic federal tax by $683.98, calculated as (amount claimed in 1st year x tax rate for 2nd tax bracket) or ($3,109 × 22%). She can claim the remaining $4,391 of her RRSP deduction in a future year, thereby saving another $966.02
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Income Tax Planning in basic federal tax, calculated as [(RRSP contribution – amount claimed in 1st year) x tax rate for 2nd tax bracket] or [($7,500 – $3,109) × 22%]. By spreading the deduction over two years, Fiona can reduce her basic federal tax by $1,650, calculated as ($683.98 + $966.02), compared to the $1,342.63 she would save by claiming it all in one year. Tax deductions vs. tax credits A tax deduction reduces the amount on which an individual pays tax. As illustrated in the example above, the value of a tax deduction is dependent on the marginal tax rate (MTR) of the taxpayer. In addition, with some tax deductions and to varying degrees, the taxpayer has flexibility regarding when he or she can elect to claim the deduction and how much of the deduction he or she must claim at that point. This flexibility gives rise to tax planning opportunities. In contrast, a taxpayer can use a tax credit to offset the amount of tax that he or she has to pay. The value of a tax credit is generally the same for all taxpayers regardless of his or her marginal tax rate. Beatrice made a charitable donation of $2,000 which resulted in a federal tax credit of $552, calculated as [(donation threshold of $200 x 15%) + ((charitable donation – donation threshold of $200) x 29%)] or [($200 × 15%) + (($2,000 – $200) × 29%)]. It does not really matter if Beatrice claims the credit this year, when her basic federal tax payable is $4,800 or next year when she expects her basic federal tax payable to be $5,600 because the value of the tax credit remains the same regardless of her marginal tax rate.
Exercise: Deductions as a Tax Planning Tool
Moving expenses
A taxpayer can deduct eligible moving expenses from income that he or she earns at his or her new location if the taxpayer moves to a new location within Canada: • • to start a job or business or to attend courses as a full-time student at college, university or other postsecondary institution (ITA 62(1))
In addition, the taxpayer’s new home must be at least 40 kilometres closer to his or her new school or place of work than his or her previous home was. In order to claim a deduction for moving expenses, the taxpayer must complete form T1-M, Claim for Moving Expenses, and submit it with his or her tax return.
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Income Tax Planning and Research
Eligible Moving Expenses
Eligible moving expenses include the following (ITA 62(3)): • • • • • • • • • travelling expenses, including automobile expenses, meals and accommodations for the taxpayer and his or her family transportation and storage costs, such as packing, hauling, in-transit storage and insurance, for household effects costs for meals and temporary accommodations for the taxpayer and members of his or her household near either residence for up to 15 days lease cancellation fees the cost of selling the old residence, including advertising, legal fees, real estate commissions and, if the mortgage is discharged early, mortgage penalties the cost of carrying the old residence while attempting to sell it, to a limit of $5,000 legal fees and land transfer taxes payable in respect of the new residence, but only if the taxpayer or his or her spouse or common-law partner has sold an old residence as a result of the move the cost of changing the address on legal documents, or automobile permits and licences utility disconnections and hook-ups
Limitations against Deduction
Note: Moving expenses can only be deducted from income earned at the new location (ITA 62(1)(f)). To the extent that this income is less than the moving expenses, the undeducted expenses can be carried forward to be deducted from employment or self-employment income earned at the new location in the following years. Under no circumstances can the moving expenses be deducted from other types of income, such as investment income or Employment Insurance Benefits. On December 1st of last year, Barbara started a new job in Regina. In November of last year, she moved to Regina from Calgary, incurring moving expenses of $12,000. Barbara only earned income of $9,000 at the new location for the last taxation year. Last year Barbara could only deduct moving expenses of $9,000. This year, she will be able to deduct the remaining $3,000, calculated as (total moving expenses - amount deducted last year) or ($12,000 - $9,000), provided she earns at least $3,000 in income at the new location. Also, if the taxpayer is reimbursed by his or her employer for some or all of his or her moving expenses, the reimbursed amount cannot be deducted as a moving expense unless it is also included in the taxpayer’s income (ITA 62(1)). Paul’s employer transferred him to a new location and Paul incurred moving expenses of $8,000. The employer reimbursed Paul for $3,000 in moving expenses and this amount was not included in his taxable income. Paul can only claim a moving expense deduction for the remaining $5,000, calculated as (moving expenses - reimbursed amount) or ($8,000 - $3,000). Refer to T1-M, Claim for Moving Expenses, or IT-178R3, Moving Expenses, for more information.
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Income Tax Planning
Exercise: Moving Expenses
Childcare Expenses
A taxpayer may be able to deduct the amounts that he or she or another supporting person paid to have someone look after an eligible child, so that the taxpayer or the other supporting person could: • • • • earn income from employment carry on a business, either alone or as an active partner attend a qualifying educational program, including secondary school carry on research for which a grant was received (ITA 63(3))
An eligible child includes the child of the taxpayer or his or her spouse or common-law partner, or a child who was dependent on the taxpayer or his or her spouse or common-law partner and who had a net income of less than the basic personal amount (ITA 63(3)). The child must be under 16 years of age at some point during the taxation year, or must be dependent as a result of a mental or physical infirmity. Carl and his wife, Sharon, are the legal guardians of Carl’s 6-year-old nephew, Bart. Bart is financially dependent on Carl and has no income. Bart is an eligible child, so Carl or Sharon may be able to claim a childcare expense deduction for amounts they paid for Bart's care while they worked. In order to claim a childcare expense deduction, the taxpayer will have to complete Form T778, Childcare Expense Deduction, and submit that form with his or her tax return.
Eligible expenses
A childcare expense deduction can be claimed for payments made to the following: • • • • • • individuals who provide childcare services (other than the child’s parents or relatives under the age of 18) day nursery schools and daycare centres educational institutions for the part of the fees that relate to childcare services day camps and day sport schools boarding schools, overnight sports schools or camps where lodging is involved placement agencies or advertisers used to find a childcare provider
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Income Tax Planning and Research
Limits
There are several limits that restrict the deduction of childcare expenses. Basic limit for childcare The total childcare expense that can be claimed in any one year for an eligible child is limited to: • • • $10,000 per year for each child for whom the disability tax credit may be claimed $7,000 per year for each child who is under seven years of age at the end of the year, or who has a mental or physical impairment $4,000 per year for each other eligible child
Tanya is a single parent with 3-year old twins, Alexis and Timothy. She has hired a Nanny at a cost of $20,000 per year to care for the children while she works full-time, earning a salary of $120,000. Tanya can claim a childcare expense of $14,000, calculated as (the lesser of (actual costs and (annual maximum for children under 7 x number of children under 7))) or (the lesser of ($20,000 and ($7,000 × 2))). Limit for an overnight camp or boarding school Claims for payment made to an overnight camp or boarding school are limited to the following: • • • $250 per week of camp for each child for whom the disability tax credit may be claimed $175 per week of camp for an eligible child who is under seven years of age by the end of the year, or who has a mental or physical impairment or $100 per week of camp for all other eligible children (ITA 63(3)(c), draft ITA 63(3), periodic childcare amount)
Sandra has two children. Casey is 5 years old and Jordan is 8. She enrolled both of them in summer boarding camps at a cost of $150 per child per week, for four weeks. She can claim $600 for Casey, calculated as (the lesser of (actual costs and (maximum amount for a child under 7 x number of weeks))) or (the lesser of (($150 x 4) and ($175 x 4))). She can claim $400 for Jordan, calculated as (the lesser of (actual costs and (maximum amount for a child over 6 x number of weeks))) or (the lesser of (($150 x 4) and ($100 x 4))). Deduction limits
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Finally, a taxpayer can only deduct childcare expenses to the extent that they do not exceed /3 of his or her earned income (ITA 63(1)(e)).
Lucy is a single mother and she has just started a business that resulted in selfemployment income of $12,000. This is her only taxable income. While she is getting the business established, Lucy is supporting herself with personal savings. Lucy has two young children and she pays $9,000 per year in eligible childcare expenses. The most that Lucy can deduct as a childcare expense is $8,000, calculated as (the lesser of (her actual expenses and (earned income x (2 ÷ 3)))) or (the lesser of ($9,000 and ($12,000 × (2 ÷ 3)))).
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Income Tax Planning
Who Can Make the Deduction?
In most cases where there are two supporting persons, only the person with the lower net income can claim a deduction for childcare expenses. Carl and Sharon both work full-time and they pay $140 per week for Bart to be in daycare. Carl has net income of $38,000, while Sharon has net income of $46,000. Only Carl can claim the childcare expenses because he has the lower net income. When the higher income spouse can claim the deduction The only time the supporting person with the higher net income can claim the childcare expense is if the lower-income supporting person is: • • • • separated confined to a wheelchair or bed in prison enrolled at a secondary school or other designated educational institution either full-time or part-time (ITA 63(2))
If the lower-income supporting person is separated, confined to a wheelchair or bed, in prison, or in school full-time, the higher-income supporting person can claim childcare expenses only for those weeks where the conditions listed above are in effect, and the most that he or she can claim is: • • • $250 per week for a child for whom the disability tax credit may be claimed $175 per week for children who are under age seven or who are infirm $100 per week for other eligible children, (ITA 63(2)(b), draft ITA 63(3), periodic childcare amount)
Blair and Stephanie have two children, four-year old Rhianna and eight-year old Connie. Over the course of the year, they paid $6,000 in childcare expenses for Rhianna and $3,000 for Connie. Blair had an income of $102,000 and Stephanie had an income of $52,000, so normally Stephanie would be the one to claim the childcare expenses. However, Stephanie returned to school full-time for 16 weeks to finish off the MBA that she had been working on part-time for the last three years. Blair will be able to claim childcare expenses of $4,400 for the year, calculated as ((maximum amount for child under 7 + maximum amount for child over 6) x number of weeks of full-time study) or (($175 + $100) × 16). Stephanie will have to claim the remaining $4,600, calculated as ((amount paid for Rhianna + amount for Connie) - amount claimed by Blair) or ($3,000 + $6,000 - $4,400). Lower income spouse in school part-time The higher-income supporting person may also be able to claim childcare expenses for those weeks that the lower-income supporting person was in school on a part-time basis, but in this case the deduction is limited to: • • • $250 per month for a child for whom the disability tax credit may be claimed $175 per month for children who are under age seven or who are infirm $100 per month for other eligible children
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Income Tax Planning and Research Refer to T778, Childcare Expenses Deduction, or IT-495R2, Childcare Expenses, for more information.
Exercise: Childcare Expenses
Losses
Most types of losses can also be deducted from taxable income, but this is a complicated area because there are different rules for different types of losses. In this section we will provide an overview of the losses and how they are deducted on the taxpayer’s tax return. To illustrate the deductibility of losses, we will take a look at the situation of Gerri-Lou Lewis.
Non-capital losses
First of all, we will consider how a taxpayer could incur a loss as a result of an office, employment, business or property. Loss from employment If a taxpayer earns income from an office or employment, he or she may be able to deduct certain employment expenses from that income. If employment expenses exceed employment income, the taxpayer would have a loss from employment. Last year, Gerri-Lou had employment income of $15,000. She had employment expenses of only $350, so she does not have a loss just from employment or office. Loss from business If the taxpayer is self-employed and his or her gross business income is less than his or her business expenses, the taxpayer will have a business loss. Gerri-Lou quit her job in April and started a small business. On her Statement of Business or Professional Activities, she reported gross income of $4,600 and expenses of $17,314, so she had a business loss of $12,714, calculated as (gross income - expenses) or ($4,600 - $17,314). This loss is reported as a negative amount of income on her T1 return. Rental loss If the taxpayer has a rental property, it is possible to have a rental loss. Gerri-Lou also owns a rental property, but she was unable to find a tenant for five months of the year and she had to do some significant repairs. As a result, she had a rental loss of $3,200.
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Income Tax Planning Investment loss It is also possible to realize a loss on other investments if the carrying charges exceed the investment income. Several years ago, Gerri-Lou borrowed $20,000 to invest in Canadian equities. She had taxable dividend income of $500. However, she paid interest on her loan of $1,250. So, she has an investment loss of $750, calculated as (investment income - interest expense) or ($500 - $1,250). Using losses to offset income All of the losses that we have mentioned so far can be used to reduce the taxpayer’s income from any source, but only until that income is nil. Obviously, there is no benefit to reducing the taxable income to less than nil. If the losses are such that they exceed his or her income in the loss year, the taxpayer will have a non-capital loss. Non-capital losses generally include: • • • • unused losses from an office, employment, business or property unused allowable business investment losses (ABILs) the unused portion of the taxpayer’s share of partnership losses from business or property the unused portion of the taxpayer’s share of partnership ABILs (ITA 111(8))
Last year, Gerri-Lou had a non-capital loss of $2,014, calculated as (employment income + dividend income - business loss - rental loss - interest expense - employment expenses) or ($15,000 + $500 - $3,200 - $12,714 - $1,250 - $350).
Non-capital Loss Carryovers
For tax years ending after 2005, non-capital losses can be carried back for up to three years and carried forward for up to 20 years to be applied against any source of income in those years (ITA 111(1)(a)). If a non-capital loss that has been carried over is not used to offset other income within the 20-year window, the non-capital loss becomes a net capital loss and from that point forward, can only be used to offset taxable capital gains. Gerri-Lou can carry back her non-capital loss of $2,014 and deduct it from her taxable income in any of three years prior to last year, or she can carry it forward to be deducted from her taxable income in any of the next 20 years. In order to carry losses back, the taxpayer must submit a completed Form T1A, Request for Loss Carryback to CRA. To carry the losses forward, the taxpayer simply records the amount as a deduction on of a subsequent year’s tax return, under the heading of Noncapital losses of other years. Gerri-Lou decided to carry forward the non-capital loss to a future year. Flexibility as to claiming non-capital losses A taxpayer is not required to deduct all available non-capital loss carryovers in any particular year. When carrying over a non-capital loss, the taxpayer should pay attention to his or her marginal tax bracket during the year in which he or she is claiming the loss carried over, to optimize the use of the loss carryover. If the taxpayer expects to remain in
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Income Tax Planning and Research a high tax bracket, he or she might only want to use enough of the loss in any one year to drop one tax bracket, saving the remaining loss for the next year. The taxpayer also would not want to use the loss carryover to reduce his or her taxable income below the point at which no tax is payable anyway because of the personal tax credit and other available credits. Amanda had the option of reporting a non-capital loss carryover of $6,000. However, her taxable income was only $6,400. Because this will be offset by the basic personal amount of $9,600 that each taxpayer is entitled to claim, she would not want to claim the loss carryover because her tax liability is already $0.
Net Capital Losses
If a taxpayer realizes an allowable capital loss upon the disposition of capital property, that loss can only be deducted from taxable capital gains. In its most basic form, a net capital loss for a year is simply the sum of all allowable capital losses for the year minus all taxable capital gains (ITA 111(8)). The net capital loss is recorded as a negative amount on the bottom of Schedule 3, Capital Gains (or Losses). However, because it cannot be deducted from other sources of income, it does not show up on the taxpayer’s general tax return as a negative taxable capital gain. This year, Gerri-Lou Lewis sold a piece of land that had an adjusted cost base (ACB) of $160,000. She had net proceeds of $140,000. As a result, she had an allowable capital loss of $10,000, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($140,000 - $160,000) × 50%). She also sold some stocks that she bought many years ago that had an ACB of $1,200. She had net proceeds of $3,000. So, she had a taxable capital gain of $900, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($3,000 - $1,200) × 50%). Gerri-Lou has a net capital loss of $9,100, calculated as (allowable capital loss - taxable capital gain) or ($10,000 - $900). Because she cannot deduct this amount from her taxable income this year, it will not appear on Page 2 of her general return. However, she will still want to fill out a Schedule 3, Capital Gains (or Losses), and file it with her return, so that she can make use of the carry-over provisions. Net capital loss carryovers Net capital losses can be carried back for three years to be applied against taxable capital gains in those years, or they can be carried forward indefinitely to be used against taxable capital gains of other years (ITA 111(1)(c)). To carry the loss back, the taxpayer must submit Form T1A, Request for Loss Carryback. To carry the loss forward, the taxpayer simply enters the net capital loss carryover on his or her tax return when he or she wants to use it. Refer to IT-232R3, Losses - Their Deductibility in the Loss Year or in Other Years, for more information.
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Income Tax Planning
Exercise: Non-capital and Net-capital Losses
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Miscellaneous Deductions. In this lesson, you have learned how to do the following: • calculate and explain moving expenses, childcare expenses, capital losses, and non-capital losses
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Miscellaneous Deductions, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning and Research
Review
Let’s look at the concepts covered in this unit: • • • • Residency and Installment Payments Deadlines, Penalties, and Reviews Income Tax Planning and Research Miscellaneous Deductions
You now have a good understanding of income tax planning and research. At this point in the course you can describe residency requirements and rules, calculate the impact of filing late, and explain the major components of the federal and provincial tax legislation. You can also calculate and explain moving expenses, childcare expenses, capital losses, and noncapital losses. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 4: Income Tax Planning and Research, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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I FP
Unit 5: Taxation of Employees and Alternative Minimum Tax
Income Tax Planning
Unit 5: Taxation of Employees and Alternative Minimum Tax
Welcome to Taxation of Employees and Alternative Minimum Tax. In this unit, you will learn about the types of employment income as well as the impact of taxable benefits and fringe benefits not included in income on a client’s taxes. You will also learn about the tax treatment of employee stock options and alternative minimum tax (AMT). You need to understand how employment income is treated for tax purposes in order to understand how this income fits into your client's wealth accumulation plans. This unit takes approximately 2 hours and 30 minutes to complete. You will learn about the following topics: • • • • Types of Employment Income and Taxable Benefits Fringe Benefits not Included in Income Employee Stock Option Plans Alternative Minimum Tax
To start with the first lesson, click Types of Employment Income and Taxable Benefits on the table of contents.
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Taxation of Employees and Alternative Minimum Tax
Lesson 1: Types of Employment Income and Taxable Benefits
Welcome to Types of Employment Income and Taxable Benefits. In this lesson, you will learn about the types of employment income and the impact of taxable benefits on a client’s income. This lesson takes 50 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the types of employment income identify and calculate the impact of taxable benefits on a client’s income
Types of Employment Income
The Income Tax Act defines employment income to include salary, wages and other remuneration including gratuities, but it does not define all of these terms specifically (ITA 5(1)). Essentially, employment income includes anything a taxpayer receives in respect of an office or employment including salary, wages and other remuneration, such as gratuities. It also includes the value of certain fringe benefits. Salary or wages Salary or wages are defined as the income that a taxpayer receives from an office or employment including all fees received for services not rendered in the course of the taxpayer’s own business, but excluding pension benefits or retiring allowances (ITA 248(1)). Blair works as a project engineer for the City of Regina and he earns a salary of $62,000 per year. Flora works on the assembly line at Skyrock Mechanical Ltd., earning a wage of $17.55 per hour. Gratuities Gratuities include amounts that a taxpayer receives either from his or her employer or from others in respect of his or her service with that employer. Denang worked his way through college waiting tables at Angie’s Bar and Grill. In addition to his wage of $8.00 per hour, Denang usually earned tips of about $50 each night, and these gratuities must be included in his employment income. Kiesha is a marketing representative for Corral Software Systems, and in addition to her salary of $43,000 per year, Kiesha received a bonus of $2,500 last year for landing a major corporate account. Kiesha must include the bonus in her employment income. Other remuneration Any other amount that a taxpayer receives in respect of his or her employment or office would be included in his or her employment income as other remuneration. This could include directors’ fees, sales commissions, signing bonuses, or performance bonuses.
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Income Tax Planning Bayliss works as a sales clerk in an electronics store on a salary plus commission basis. Last year, he earned a salary of $28,000 plus commissions of $18,000. His total employment income was $46,000, calculated as (salary + commissions) or ($28,000 + $18,000). Income earned as an independent contractor However, the amount earned by a taxpayer as an independent contractor would not be employment income, but business income, because he or she would not be acting as an employee. Jacqueline provides her services as a technical illustrator to a variety of different design companies and she charges them $55 per hour plus expenses. Jacqueline does not have employment income; she has business income.
Taxation of Employment Income
Taxpayers must report employment income on a cash basis in the year the income is received, even if the income is in respect to services provided in a different year (ITA 5(1)). The employer must prepare a T4 tax slip reporting employment income and payroll deductions. The employer is not required to prepare a payroll as of December 31 of each year. The last pay period of a year may straddle the year–end. If so, the employment income for the last pay period is reported on a T4 in the subsequent year because it was not paid until that year. On January 3rd of this year, Sally received a paycheque for $2,300 covering her employment from December 20th of last year through January 2nd of this year. The amount will be reported on a T4 slip for this year and she must include the full $2,300 in her income for this year, even though most of the income was a result of employment for last year. Matthew’s employer, DEF Corp., declared a bonus in respect of his service for last year to be payable on May 15th of this year. Matthew will include the bonus in his income of this year even though it relates to his employment for last year.
Exercise: Taxation of Employment Income
Automobile Benefits
If an employee is allowed to use an employer’s vehicle for personal use, he or she may incur a taxable benefit. The amount of the taxable benefit is calculated as: • • • a standby charge plus an operating cost benefit minus any reimbursement the employee makes to his or her employer
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Taxation of Employees and Alternative Minimum Tax Standby charge The standby charge represents the benefit the employee enjoys by virtue of having the car available for personal use and it takes into account the cost of car ownership or leasing costs (ITA 6(1)(e) and 6(2)). The specific calculation is beyond the scope of this course. However, if the employee makes absolutely no use of the automobile for personal use, there is no taxable benefit in the form of a standby charge, even if the vehicle was available to the employee for the entire year. Jeannette was recently promoted to VP of marketing for a large corporation. One of the perks available to all VPs is the use of a luxury sedan for both personal and business use. Because Jeannette’s family already owns two large late model cars, she decided not to use the corporate vehicle for personal use. She will not have a taxable benefit in the form of a standby charge, even though she could have made use of the corporate vehicle if she had wanted to. Operating cost benefit The operating cost benefit is based on the number of kilometres the employee drives the car for personal use. For most employees, the operating cost benefit is calculated as 24 cents per kilometre, including PST and GST or HST (ITA 6(1)(k)). As one of the benefits of his employment, Simon was provided with a car for personal and business use during the taxation year. Simon's employer determined that the standby charge amounted to $3,200. In addition, Simon used his employer's car to travel 4,000 kilometres for personal use, so he has a taxable operating cost benefit of $960, calculated as (kilometres travelled for personal use x operating cost benefit rate) or (4,000 km × $0.24). Simon's total automobile benefit is $4,160, calculated as (standby charge + operating cost benefit) or ($3,200 + $960). Refer to IT-63R5, Benefits, Including Standby Charge for an Automobile, From the Personal Use of a Motor Vehicle Supplied by an Employer After 1992, for more information. Click here to visit CRA to view the latest facts about automobile benefits.
Employer-paid Education Expenses
Education that primarily benefits the employer If a taxpayer takes training or education courses that maintain or upgrade his or her employment-related skills and his or her employer pays for or reimburses the taxpayer for the cost of those courses, the taxpayer does not have a taxable benefit because the training is considered to primarily benefit the employer. In general, soft-skill courses such as stress management, time management, or first aid are also considered to be for the employer’s benefit and the costs of these training programs are not considered to be a taxable benefit. Education that primarily benefits the employee However, if his employer reimburses the taxpayer or pays directly for courses that are simply of personal interest or that provide or upgrade skills that are not directly related to the taxpayer’s job, those fees will be included in the taxpayer’s income (ITA 6(1)).
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Income Tax Planning Gordon is a press operator for a large manufacturing firm. He is taking night school courses in hotel management, and as a result of its liberal education policy, his employer reimburses him for the tuition costs associated with this program. Gordon has a taxable benefit in the amount of the money reimbursed to him because the education is obviously for his own benefit, not the benefit of his employer. Refer to CRA’s Income Tax Technical News No. 13 (May 7, 1998), for more information about the application of these rules.
Private Employment Insurance Benefits
A taxpayer may have a taxable employment benefit if he or she receives periodic payments in respect of the loss of all or part of his or her income from an office or employment under a private or group: • sickness or accident insurance plan • disability insurance plan • income maintenance insurance plan The benefit will be taxable if it comes from a plan for which the taxpayer’s employer paid the premium. The amount of the taxable benefit will be equal to the total of all amounts received by the taxpayer during the year minus any amounts that the taxpayer has contributed to the plan up to that time (ITA 6(1)(f)). Monica is a member of her employer’s group disability insurance plan. Her employer pays the premiums and those premiums are not treated as a taxable benefit. If Monica becomes disabled, any benefits that she receives from the plan will be considered to be a taxable employment benefit.
Exercise: Benefits, Part 1
Financial Counselling or Tax Planning Services
If a taxpayer receives financial counselling or income tax preparation services as a result of his or her employment or office, the value of those services are considered to be a taxable benefit. This does not apply to retirement planning services. Pearl works for JKL Corporation. JKL has a contract with an independent financial planner to provide eight hours of general financial planning services to each of its 50 employees, at a cost of $400 each. Pearl used this service and as a result, she has a taxable benefit of $400.
Forgiven Loans
If a taxpayer had a loan from his or her employer and all or part of that loan was forgiven, the forgiven amount would be included in the taxpayer's income (ITA 6(15)).
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Taxation of Employees and Alternative Minimum Tax Last year, Tanya borrowed $20,000 from her employer to finance a new car purchase. By June of this year, Tanya had repaid $6,000 of principal but her employer told her that she could discharge the loan by making one more payment of $4,000. If Tanya does this, she will have a taxable benefit of $10,000 for this year, calculated as (initial loan amount - total payments made) or ($20,000 - $6,000 - $4,000). Refer to IT-421R2, Benefits to individuals, corporations and shareholders from loans or debt, for more information.
Frequent Flyer Benefits
Under a frequent flyer program, which is usually sponsored by an airline, a frequent air traveller can accumulate credits that can be exchanged for additional air travel or other benefits. Where an employee accumulates such credits while travelling on employer-paid business trips and uses them to obtain air travel or other benefits for himself or herself or for his or her family, the employee must include the fair market value of that air travel or other benefits in his employment income (ITA 6(1)(a)). Ben is a quality assurance representative for a major manufacturing corporation that has plants across North America. As a result of his job, Ben travels extensively and has accumulated a large number of frequent flyer points. Last year, he used those points to fly himself and his family to Europe, and the fair market value of the flights was $8,000. As a result, Ben has additional taxable employment income of $8,000.
Interest-free and Low-interest Loans
If a taxpayer receives an interest-free or low-interest loan as a result of his or her employment or office, he or she is considered to have received a taxable benefit (ITA 6(9)). The value of that benefit is calculated as the amount of interest the employee would have paid if the loan had been made at the prescribed rate, minus the amount of interest that he or she actually paid in the year, or no later than 30 days after the end of the year (ITA 80.4(1)). Prescribed rate The prescribed rate is the rate set by ITR 4301 and it is adjusted quarterly. The prescribed rates for the last few years are as shown in the table below. Federal Prescribed Interest Rates for Employee and Shareholder Interest-free and Low-interest Loans 2005 January 1st to March 31st April 1st to June 30th July 1st to September 30th October 1st to December 31st 3% 3% 3% 3% 2006 3% 4% 4% 5% 2007 5% 5% 5% 5% 2008 4% 4% 3% 3% 2009 2% 1% 1% 1%
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Income Tax Planning Charles borrowed $30,000 from his employer on January 1st to purchase a new car. The loan is to be repaid in equal annual installments made at the end of each of three years, along with interest of 3%. For the purposes of this example, we will assume that the prescribed rate over the four quarters of the first year of Charles’ loan was 5%, 5.5%, 6% and 7%. Charles has a taxable benefit of $862.50, calculated as ((excess of prescribed rate over interest rate charged) x amount of the loan) or ((((5% - 3%) × ¼) + ((5.5% - 3%) × ¼) + ((6.0% - 3%) × ¼) + ((7.0% - 3%) × ¼)) × $30,000).
Home Purchase Loans and Home Relocation Loans
Home purchase loan A home purchase loan is one that the taxpayer uses to acquire a dwelling or a share in a cooperative housing corporation to live in, or that he or she uses to repay a loan that he or she previously incurred for such a purpose (ITA 80.4(7)). Home relocation loan A home relocation loan is a loan that the taxpayer uses to acquire a new home in a new location as a result of a change in his or her job location, provided that the distance between the old residence and the new work location is at least 40 kilometres greater than the distance between the new residence and the new work location (ITA 248(1)). When Jake worked for the head office of ABC Ltd., he lived in Bigtown about 8 km from the office. ABC transferred Jake to its regional office in Smalltown. The regional office is 56 km away from the head office and 52 km away from Jake’s home in Bigtown. Jake decided that he didn’t like commuting and he used a loan from ABC Ltd. to purchase a new house in Smalltown just 2 km away from the regional office. The change in the distance between homes and the new office is 50 km, calculated as (distance from old home to office - distance from new home to office) or (52 – 2). This change in the distance is greater than 40 km so Jake’s loan qualifies as a home relocation loan. The difference between a home purchase loan and a home relocation loan is important because, while both can give rise to a taxable benefit, in the case of a home relocation loan the taxpayer can claim an offsetting deduction, as discussed later in the section on Employment Deductions.
Loans to Earn Income
If the employee uses the funds to earn income from business, property or employment, he or she will be able to deduct the value of both the actual interest paid and the deemed interest benefit as an interest expense on Schedule 4 of his or her tax return. On January 1st, Marsha borrowed $20,000 from her employer at an interest rate of 3% compounded annually for investment purposes. The loan is to be repaid in a single lump sum at the end of two years. If the prescribed rate is 5%, Marsha has a taxable benefit of $400 in the first year, calculated as (loan x (prescribed rate - interest rate charged)) or ($20,000 × (5% - 3%)). She must also pay interest to her employer in the first year of $600, calculated as (loan x interest rate) or ($20,000 × 3%). Marsha can deduct an interest expense of $1,000, calculated as (employment benefit + interest paid) or ($400 + $600). Refer to IT-421R2, Benefits to individuals, corporations, and shareholders from loans or debt, for more information.
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Taxation of Employees and Alternative Minimum Tax
Exercise: Benefits, Part 2
Low Cost Housing, Board, and Lodging
Low-cost housing If, as a result of his or her employment or office, a taxpayer receives access to accommodations rent-free or for less than fair market value, he or she is considered to receive a taxable benefit equal to the value of those accommodations less any amount he or she paid (ITA 6(1)(a)). Peter works for Magnum Housing Corporation, a company that owns and manages executive townhouse and condominium complexes. In addition to his salary, Peter is able to rent one of the luxury townhouses for $1,000 per month, even though similar units rent for $1,800 per month. Peter has a taxable benefit of $800 per month, calculated as (FMV of rental accommodations - amount actually paid) or ($1,800 - $1,000). Board or lodging If, as a result of his or her employment or office, a taxpayer receives board or lodging, he or she is considered to receive a taxable benefit equal to the fair market value of those services less any amount he or she paid for them (ITA 6(1)(a)). Lodging refers to the provision of a place to live, while board refers to the provision of meals and other services. Helena is employed as a live-in nanny for the Robinson family. She receives a salary of $26,000 per year, and the Robinsons provide her with room and board for $200 per month. The fair market value of room and board of similar quality in that neighbourhood would be $700 per month. Helena has a taxable benefit of $500 per month, calculated as (FMV of room and board - amount actually paid) or ($700 - $200). Note: There is an exception to these rules for employees who work at remote locations or special work sites.
Merchandise Sold Below Cost or at a Discount
Merchandise below cost If a taxpayer is permitted to buy the employer’s merchandise below cost, he or she will have a taxable benefit to the extent of the difference between the fair market value of the merchandise and the price he or she paid for the merchandise (ITA 6(1)(a)). Barry works for an electronics retailer. Barry was permitted to buy a surroundsound stereo system for $300, even though his employer’s cost was $500 and the system normally sells for $1,000. Barry will have a taxable benefit of $700, calculated as (FMV actual purchase price) or ($1,000 - $300).
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Income Tax Planning Merchandise at a discount but not below cost If the taxpayer buys the merchandise at a discount but at an amount that is at least equal to the employer’s cost, there is usually not a taxable benefit, as long as all employees have the option of purchasing merchandise with the same discount. Barry would have been better off buying the stereo system for $500, because then he would not have a taxable benefit. Merchandise at a discount but only for select employees If only a select group of employees are able to buy merchandise at a discount, the difference between the fair market value and the purchase price is a taxable benefit. Fine Fashions gives its entire full-time senior sales staff a 25% discount on its merchandise, but it does not give the same discount to junior or part-time sales people. Margie is a full-time manager at Fine Fashions and she was able to buy a $4,000 fur coat for $3,000. She has a taxable benefit of $1,000, calculated as (FMV of merchandise - amount actually paid) or ($4,000 - $1,000).
Moving and Relocation Expenses
The following relocation benefits paid after February 23, 1998, by an employer to an employee who relocates because of an office or employment will be included as income: • any payment or reimbursement in excess of $5,000 made in respect of mortgage interest, property taxes, heat, hydro, property insurance, and grounds maintenance costs to keep up the old residence after the move, when all reasonable efforts to sell have not been successful any payment or reimbursement made in respect of financing, such as higher mortgage interest payments at the new residence, bridge financing and mortgage interest on the unsold former residence any payment or compensation made in respect of a loss on the sale of the former residence or a decrease in the value of the former residence, up to one-half of the amount that exceeds $15,000
•
•
Michael’s employer transferred him from Toronto to Québec last year. Michael had to sell his house and he incurred a loss of $35,000, for which his employer reimbursed him. This will result in taxable income of $10,000, calculated as ((loss on house - limit of $15,000) ÷ 2) or (($35,000 - $15,000) ÷ 2). Because house prices were higher at the new location, Michael had to take out a larger mortgage even though he bought a house that was comparable to his old house. Also, mortgage rates had gone up, so Michael ended up paying a total of $500 more in interest at the new location each month. Michael’s employer reimbursed him for this additional interest, resulting in a taxable benefit of $6,000 per year, calculated as (monthly interest paid by employer x months per year) or ($500 × 12).
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Taxation of Employees and Alternative Minimum Tax
Exercise: Benefits, Part 3
Premiums on Group Life Insurance Coverage
If the taxpayer is a member of a group life insurance plan and his or her employer pays the premiums on his or her behalf, those premiums are a taxable benefit to the extent that the taxpayer does not reimburse the employer either directly or through deductions from his or her pay (ITA 6(4)). Larry is a member of his employer’s group life insurance plan. His employer pays premiums of $150 per year for Larry’s coverage and the employer does not deduct any of these amounts from Larry’s pay. Larry has a taxable benefit of $150. Refer to IT-227R, Group term life insurance premiums, for more information.
Premiums under Provincial Health Care Plans
If an employer pays the premiums or contributes to a provincial hospital or medical care insurance plan for an employee, those premiums or contributions are considered to be a taxable benefit (ITA 6(1)(a)). This would be the case in provinces, such as Alberta, where the individual is normally responsible for paying these premiums, but the employer pays them on his or her behalf. In other provinces, such as Ontario, the provincial health care system is financed by a payroll tax such that the employer has no option but to contribute to the plan. In this case, the payroll tax is not considered to be a taxable benefit to the employee.
Premiums for Wage-loss Replacement Plans or Income Maintenance Plans
If the employer pays a premium for a wage-loss replacement plan or an income maintenance plan for an employee, the premium is a taxable benefit if it is paid to a nongroup plan that is either: • • • a sickness or accident insurance plan a disability insurance plan an income maintenance insurance plan
In this case, any benefits from the plan are not taxable. Wilderness Services pays the premiums on individual disability contracts for its three key managers, including Raymond. The company pays premiums of $1,600 for Raymond’s policy. Raymond has a taxable benefit of $1,600. However, if Raymond becomes disabled, any payments that he receives from the plan will not be taxable.
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Income Tax Planning If the premium is paid to a group plan, the premium is not a taxable benefit. However, if the employer pays the premium, any payments the employee receives under the plan will be taxable (ITA 6(1)(f)). Thomas belongs to his employer’s group disability plan, and his employer pays premiums of $400 per year to cover Thomas under the plan. Thomas does not have a taxable benefit. However, if Thomas becomes disabled, any payments he receives from the plan will be taxable.
Registered Retirement Savings Plans (RRSPs)
If an employer contributes to an employee’s RRSP, those contributions are considered to be a taxable benefit to the employee. This does not include an amount that an employer withholds from the employee’s pay and later contributes on behalf of that employee. Amanda belongs to a group RRSP established by her employer. Each year, with Amanda’s permission, her employer withholds 5% of her pay and contributes it to the RRSP. This is not a taxable benefit. Janet’s employer also has a group RRSP and it contributes $2,000 to the plan on behalf of each employee each year. Janet has a taxable benefit of $2,000. However, the employee can then claim a deduction for the RRSP contribution on Schedule 7 of his or her tax return. Although Janet has a taxable benefit, she can claim a deduction for a $2,000 RRSP contribution.
Exercise: Taxable Benefits
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Taxation of Employees and Alternative Minimum Tax
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Types of Employment Income and Taxable Benefits. In this lesson, you have learned how to do the following: • • describe the types of employment income identify and calculate the impact of taxable benefits on a client’s income
If you are ready to move to the next lesson, click Fringe Benefits not Included in Income on the table of contents.
Assessment
Now that you have completed Types of Employment Income and Taxable Benefits, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 2: Fringe Benefits not Included in Income
Welcome to Fringe Benefits not Included in Income. In this lesson, you will learn about the impact of fringe benefits not included in income on a client’s taxes. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • identify and calculate the impact of fringe benefits not included in income on a client’s taxes
Fringe Benefits Not Included in Income
The Income Tax Act specifically excludes from taxation as taxable benefits those benefits derived from the contributions that the employer makes on the employee’s behalf to: • • • • • a a a a a registered retirement pension plan group sickness or accident insurance plan private health services plan supplementary unemployment benefit plan deferred profit sharing plan (ITA 6(1)(a)(i))
Other benefits that are not taxable are discussed on the following pages.
Automobile Allowances
If an employee uses his or her personal vehicle for business use and his or her employer provides the employee with a reasonable per kilometre automobile allowance, that allowance will not be taxable (ITA 6(1)(a)(iii)). The reasonable amount is prescribed by ITR 7306. Currently, a reasonable automobile allowance has been set at: • • • $0.52 per kilometre for the first 5,000 kilometres $0.46 per kilometre thereafter To each category listed above, an additional $0.04 per kilometer is added for travel in the Yukon, Northwest Territories and Nunavut
If the allowance is not reasonable either because it is too high or too low, then the employee must include the full amount of the allowance in his or her income. However, he or she may then be able to claim a portion of the expenses with respect to that automobile from his or her employment income (ITA 8(1)(h.1)).
Exercise: Deductions from Employment Income, Part 1
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Taxation of Employees and Alternative Minimum Tax
Counselling Services
If a taxpayer receives counselling services by virtue of his or her employment or office, it will be exempt from tax if it relates to one of the following: • the mental or physical health of the taxpayer or someone related to the taxpayer. This includes programs for tobacco, drug and alcohol abuse, as well as stress management, but does not include amounts for using recreational or sporting facilities the taxpayer’s re-employment the taxpayer’s retirement (ITA 6(1)(a)(iv))
• •
Martin works for EFG Ltd. but his position is being terminated in eight weeks. EFG Ltd. has hired a career counsellor to help Martin explore his options and to assist him in preparing a new resume. EFG Ltd. is paying $600 to the career counsellor for these services, but this amount is not a taxable benefit to Martin.
Disability-related Employment Benefits
If a taxpayer is disabled and his or her employer provides benefits that help that taxpayer perform his or her duties, those benefits are not taxable (ITA 6(16)). These benefits could include, for example: • • reasonable transportation to and from work for employees who are blind or who have a severe physical impairment attendants such as readers for the blind, signers for the deaf or coaches for the mentally handicapped
Nathan has Tourette’s syndrome and Attention Deficit Disorder, but with the help of his local Association for Community Living (ACL), he has been able to get a job. In addition to paying Nathan’s wages, his employer pays ACL a fee for the assistant who helps Nathan keep on track at his job. While this amount is paid by the employer to help Nathan earn his wages, it is not a taxable benefit for Nathan.
Moving Expenses
If an employer reimburses an employee for moving expenses, some of those expenses will be considered to be a taxable benefit while others will not. Certain moving expenses will not be considered a taxable benefit provided the move is a result of one of the following: • • The taxpayer’s employer transferred him or her to a new location. The taxpayer has finished his or her duties at a remote work location and is moving back to civilization.
Some of the more common moving expenses that are not considered to be a taxable benefit include: • • • • the cost of house-hunting trips to the new location travelling costs for the employee and his or her family the cost of transporting or storing his or her household effects charges to connect or install utilities
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Income Tax Planning • • legal fees and land transfer taxes incurred in buying a new residence reasonable temporary living expenses while waiting to occupy the new residence
Sandra’s employer transferred her from Halifax to St. Johns and agreed to pay for her moving expenses. She paid $2,000 to the moving company, $300 to have her utilities connected at the new location, $3,200 in land transfer taxes, $400 in family travel expenses and $350 for two nights’ accommodation while the move took place. Although her employer reimbursed her for $6,250, calculated as (moving company fees + utility connection fees + land transfer taxes + family travel expenses + accommodation expenses) or ($2,000 + $300 + $3,200 + $400 + $350) Sandra does not have a taxable benefit.
Premiums under a Private Health Services Plan
A taxpayer will not be considered to have received a taxable benefit if his or her employer pays premiums under a private health services plan. A private health services plan includes an insurance contract that provides coverage of hospital expenses and medical expenses or any combination thereof (ITA 248(1)). Refer to IT-339R2, Meaning of private health services plan, for more information.
Professional Membership Dues
If a taxpayer pays professional membership dues and his or her employer reimburses the taxpayer for those dues, he or she will not be considered to have received a taxable benefit as long as membership in that association benefits the employer. Sonya is a professional engineer who works for a consulting engineering firm. Although Sonya pays her dues to Professional Engineers Ontario personally, her employer reimburses her. This is not a taxable benefit because Sonya needs her engineering designation to perform her job.
Exercise: Fringe Benefits
Deductions from Employment Income
There are two types of deductions an employee may be able to make from his or her employment income: • • deductible employment expenses deductions to offset the inclusion of taxable benefits in employment income
We will first look at deductible employment expenses.
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Taxation of Employees and Alternative Minimum Tax
Deductible Employment Expenses
In very limited situations, the Income Tax Act allows a taxpayer to deduct certain expenses from his or her income from an office or employment (ITA 8(1)). However, in order for the expense to be deductible, the Income Tax Act usually requires specific circumstances to be met. There may also be a limit on how much can be deducted, depending on the type of expense and whether the employee receives any commission income, as discussed in the various subsections. You will be looking at the following in more detail: • • • • • • legal fees motor vehicle expenses professional or association dues travel expenses workspace in home sales expenses and commissioned salepersons
Most of the information that we will be discussing in the following subsections is expanded upon in: • • • IT-352R2, Employee’s Expenses, Including Work Space in Home Expenses IT-522R, Vehicle, Travel and Sales Expenses of Employees CRA’s Guide T4044, Employment Expenses – Supplementary Income Tax Guide
Legal Fees
The Income Tax Act permits a taxpayer to deduct from his or her employment income any legal fees the taxpayer paid to collect or establish a right to salary or wages from his or her employer or former employer. To deduct the legal fees, the taxpayer must establish that an amount was owed, whether or not it is actually collected (ITA 8(1)(b)). The legal fees are deductible in the year incurred, while any recovered income is taxable in the year received, even if it relates to employment in a different year. Maxine worked for a less than reputable employer. In July of last year, not only was she out of a job, but her employer owed her $6,000 in salary. In October of last year, she hired a lawyer and paid him $900. In February of this year, her former employer finally paid her the $6,000 that was owing. Maxine was able to deduct the $900 in legal fees from her employment income for last year, but she had to include the recovered income in her taxable income for this year.
Motor Vehicle Expenses
If an employee uses his personal motor vehicle for his or her employer’s benefit, the employee can deduct his or her travel expenses from his or her employment income, provided (ITA 8(1)(h.1)): • • The employer requires the employee to travel away from the place of employment on business purposes. The employer requires the employee to pay for his or her own motor vehicle expenses and verifies this by filling out form T2200, Declaration of Conditions of Employment (ITA 8(10)).
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Income Tax Planning • • The employee has not, and is not entitled to, receive a non-taxable allowance related to the use of that motor vehicle. The expenses are applicable to the earning of income from the office or employment.
Doris Delay is a commissioned salesperson who is required by her employer to provide her own office space, supplies, motor vehicle, etc. Her employer has completed a Declaration of Employment. Calculating the deduction The amount of the deduction is calculated as the employee's total motor vehicle expenses for the year, prorated for the number of total business kilometres travelled during the year in comparison to the total of business and personal kilometres travelled during the year. Motor vehicle expenses include total operating expenses (including leasing charges, fuel, maintenance, repairs, car washes, licenses and insurance), interest on loans used to acquire the vehicle and Capital Cost Allowance (CCA). Doris Delay leases her vehicle and last year her total vehicle expenses amounted to $7,990. She drove a total of 20,000 km last year - 16,000 km in relation to her employment. Doris had an allowable motor vehicle expense of $6,392, calculated as (total vehicle expenses x (employment kilometres ÷ total kilometres)) or ($7,990 × (16,000 ÷ 20,000)).
Professional or Association Dues
If a taxpayer is required to maintain a membership in a professional association by statute or is a member of a trade association or trade union, the taxpayer can deduct any fees that he or she pays to maintain that membership from his or her employment income, to the extent that the taxpayer is not reimbursed by his or her employer (ITA 8(1)(i)(i) and (iv)). Shirley is a constable with a municipal police force and she is required to be a member of the local police association, a trade union, to which she must pay dues of $800 per year. Shirley can deduct the $800 from her employment income.
Travel Expenses
If an employee is required to travel for his or her employer's benefit, the employee can deduct his or her travel expenses from his or her employment income, provided (ITA 8(1)(h)): • • The employer requires the employee to travel away from the place of employment on business purposes. The employer requires the employee to pay for his or her travel expenses and verifies this by filling out form T2200, Declaration of Conditions of Employment (ITA 8(10)). The employee has not, and is not entitled to, receive reimbursement or a nontaxable travel allowance.
•
Travelling expenses include food, beverage, travel fares and lodging expenses, but not motor vehicle expenses. Food and beverage expenses can only be deductible if the
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Taxation of Employees and Alternative Minimum Tax employee is required to be away from the employer’s base of business for at least 12 hours, and even then, only 50% of the cost can be deducted. During his travelling as a quality assurance inspector, Casey frequently spends a night in a hotel near the plant that he is inspecting and he eats a large number of his meals in restaurants. His employer requires him to pay for all of his own travel expenses without reimbursement or a travel allowance. His total lodging costs for the year amounted to $3,250 and he spent $1,800 on take-out and restaurant food while travelling on the job. Casey can claim a travelling expense of $4,150, calculated as (lodging costs + (meal costs x 50%)) or ($3,250 + ($1,800 × 50%)).
Workspace-in-home
If you work from home, you may be able to claim a deduction for workspace-in-home expenses (ITA 8(13)). In order to make such a deduction, you: • • • must be required by your employment contract to work at home and pay for these expenses have not been reimbursed (and are not entitled to be reimbursed) have incurred these expenses solely for the purpose of earning income from employment
Even if these conditions are met, you may make deduct these expenses unless the workspace is either: • the place where you principally (more than 50% of the time) perform your office or employment duties; though, the space does not have to be devoted solely to employment or used exclusively to earn income from your office or employment and, on a regular and continuous basis, for meeting customers or other persons in the ordinary course of performing your office or employment duties
•
Frank is a commissioned life insurance agent and he is required by his employer to work out of his home four days a week and to attend a meeting at his head office one day a week. Frank has set up a spare bedroom as his office, but the room still contains a spare bed and is used every weekend by his mother-in-law. Frank has a legitimate home office and he can claim a workspace-in-home expense. In order to be able to make the deduction, the employee must obtain a form T2200, Declaration of Conditions of Employment from his or her employer (ITA 8(10), 8(1)(f), and 8(1)(ii) or (iii)).
Commissioned vs. Non-commissioned Employees
Deductible items for non-commissioned employees If the employee is someone other than a commissioned salesperson, he or she can deduct a reasonable portion of home maintenance expenses including fuel, electricity, light bulbs, cleaning materials, minor repairs and, if he or she does not own the dwelling, any rent. These are deductible because they are classified as supplies used to earn employment income (ITA 8(1)(i)(iii)). Such an employee cannot deduct a portion of capital cost allowance, property taxes, insurance, or mortgage interest.
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Income Tax Planning Deductible items for commissioned employees If the employee is a commissioned salesperson, he or she can deduct a reasonable portion of the home maintenance expenses listed above, plus a portion of property taxes and home insurance, because these amount are considered to be sales expenses (ITA 8(1)(f)). However, even a commissioned salesperson cannot claim a portion of mortgage interest or capital cost allowance. Frank is a life insurance agent for Big Money Insurers: he is an employee of the company and his remuneration is based entirely on commission income. Frank owns his own home, and his total home expenses for the year include $3,600 for heat and hydro, $1,200 for maintenance expenses, $8,000 in mortgage interest, $960 in home insurance and $2,900 in property taxes. Frank can claim a reasonable portion of his total expenses of $8,660, calculated as (heat and hydro + maintenance + home insurance + property taxes) or ($3,600 + $1,200 + $960 + $2,900). He cannot deduct a portion of his mortgage interest or CCA.
Calculating the Workspace-in-home Deduction
The total home expenses should be apportioned between employment and home use on some reasonable basis, such as the number of square metres of floor space used or the number of rooms devoted to employment use. If the space serves a dual purpose (for example, it serves as an office during the week and a spare bedroom on weekends), then this should also be taken into account (i.e. pro-rated for five days out of seven). If the space is used exclusively for employment use, it does not matter how many days of the week the individual works from home. The room that Frank uses as an office is 12 square metres and the total area of his home is 100 square metres. Remember that Frank only uses the office four days a week and the room also serves as a spare bedroom. Frank can deduct 6.86% of his total home expenses, calculated as ((office area ÷ total home area) x (number of days per week used as office ÷ number of days in a week)) or ((12 ÷ 100) × (4 ÷ 7)). So, he can deduct a total of $594, calculated as (total home expenses x deductible portion) or ($8,660 × 6.86%). Limits on claiming the deduction A taxpayer cannot use the workspace-in-home deduction to create a loss from employment (ITA 8(13)(b)). If the workspace-in-home expense exceeds his or her employment income prior to claiming the deduction, the excess amount can be carried forward to be deducted from employment income earned from the same source in the following year (ITA 8(13)(c)). Nancy is required by her employer to work out of her home. Her workspace-inhome expense amounted to $4,400 but her employment income was only $3,800. Nancy can use the deduction to reduce her employment income to nil, but she will have to carry the remaining $600 forward to the following year, calculated as (workspace-in-home expense - employment income) or ($4,400 - $3,800). If Nancy earns income from the same employer next year, she can deduct the unused expense at that time.
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Taxation of Employees and Alternative Minimum Tax
Sales Expenses, Commissioned Salespersons
Commissioned salespeople have the greatest flexibility in claiming employment expenses. A taxpayer who sells goods or negotiates contracts for an employer on a commission basis can deduct the sales expenses that he or she incurred to earn that commission income (ITA 8(1)(f)). The sales expenses include all amounts expended by the taxpayer in earning her employment income, so this definition includes many expenses that are not deductible by other employees, such as: • • • • advertising costs the cost of promotional gifts the cost of entertaining clients, subject to the 50% rule the cost of leasing computer or other business equipment
In order to be able to deduct all these expenses, the commissioned salesperson must meet all of the following conditions: • • • • The employment contract of the commissioned salesperson must require him or her to pay all expenses and his or her employer must complete Form T2200, Declaration of Conditions of Employment. The commissioned salesperson must be ordinarily required to work away from his or her employer’s place of business. The commissioned salesperson must be paid in whole or in part by commissions or similar amounts. The commissioned salesperson must not receive nor be entitled to receive a nontaxable allowance for travelling expenses.
Exercise: Deductions from Employment Income, Part 2
Other Deductions
In some cases where the Income Tax Act requires an employee to include a taxable benefit in his or her employment income, the Act also provides for an offsetting deduction, as discussed below. Home relocation loan deduction If a taxpayer had to report a taxable benefit because of a low-interest home relocation loan provided by his or her employer, that taxpayer can deduct the lesser of: • the amount of interest that he or she would have paid if the loan had been made at the prescribed rate, minus the amount of interest that he or she actually paid in the year, or no later than 30 days after the end of the year the interest on $25,000 at the prescribed rate
•
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Income Tax Planning • in cases where the employee has more than one loan from the employer, the total interest benefit for all loans (ITA 110(1)(j))
When Randy was transferred from Ottawa to Regina, his employer gave him a $60,000 loan at an interest rate of 2% to help finance his relocation. At the time the prescribed rate was 5%. Randy had a taxable benefit of $1,800, calculated as (relocation loan x (prescribed rate - interest rate charged)) or ($60,000 × (5% - 2%)). However, Randy could claim a home relocation loan deduction of $1,250, calculated as the lesser of: • • • $1,800 $1,250, calculated as ($25,000 × 5%) $1,800
The deduction for a home relocation loan is only available for the first five years of the loan. Deduction for registered pension plan contributions If a taxpayer is required to make a contribution to a registered pension plan established by his or her employer, the taxpayer can deduct that contribution amount from his or her employment income (ITA 8(1)(m), 147.2(4)). Tassia is a member of her employer’s defined-benefit pension plan, and she is required to contribute 7% of her salary to the plan. Last year, her salary was $62,000. So, Tassia was able to deduct $4,340 from her employment income, calculated as (salary x employee contribution rate) or ($62,000 × 7%). Deduction for CPP contributions by the self-employed Since January 1, 2001, self-employed individuals are allowed to deduct the portion of Canada Pension Plan and Québec Pension Plan contributions that represents the employer's share, rather than claim the amount for a tax credit. Raymond is self-employed and has net business income of $52,000. Assuming the CPP employer and employee contribution rates are both 4.95%, the YMPE is $46,300 and the YBE is $3,500, Raymond's CPP contribution as employee will $2,118.60 calculated as [((the lesser of pensionable earnings and YMPE) - YBE) x contribution rate] or [((the lesser of $52,000 and $46,300) - $3,500) x 4.95%]. Being self-employed, Raymond must also make a matching contribution as employer resulting in total CPP contributions of $4,237.20, calculated as (employee contribution + employer contribution) or $2,118.60 + $2,118.60). Based on his CPP contributions, Raymond can claim a business deduction for the employer portion and he can claim a nonrefundable tax credit for the employee portion.
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Taxation of Employees and Alternative Minimum Tax
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Fringe Benefits not Included in Income. In this lesson, you have learned how to do the following: • identify and calculate the impact of fringe benefits not included in income on a client’s taxes
If you are ready to move to the next lesson, click Employee Stock Option Plans on the table of contents.
Assessment
Now that you have completed Fringe Benefits not Included in Income, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Employee Stock Option Plans
Welcome to Employee Stock Option Plans. In this lesson, you will learn about the tax treatment of employee stock options. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • given a client with an employee stock option plan, identify and calculate any impact on the client’s taxes
Employee Stock Option Plans
Employee stock options refer to certain rights that a corporation may grant to its employees or to the employees of a non-arm’s length corporation that allow the employee to acquire shares of either of those corporations at a specified price. Some corporations issue stock options to employees as a type of bonus. At other times, a corporation may actually sell the stock options to its employees. These benefits are referred to as employee stock option plans (ESOPs). The tax treatment of employee stock options depends on the nature of the issuing corporation (public versus CCPC), and in the case of a public corporation, whether the shares are a qualifying acquisition. Refer to IT-113R4, Benefits to Employees – Stock Options, for more information.
General Rules
Benefits from a stock option are generally included in the individual’s employment income in the year in which he or she sells or exercises the option, rather than the year in which he or she acquires the option (ITA 7(1)). If the employee exercises the option, the taxable benefit is the difference between: • • the fair market value of the shares when the employee acquires them and the amount the employee actually pays for the shares (the exercise price of the stock option) plus the amount he or she paid for the option, if applicable
Three years ago, Philip’s employer gave him an option to acquire 100 shares in the public company at a price of $40 per share. This year, Philip exercised the option at a time when the shares were trading at $52 per share by purchasing 100 shares from the company at $40 per share. Under the general rules, Philip has a taxable benefit this year of $1,200, calculated as (number of shares purchased x (FMV at the time the options were exercised exercise price)) or (100 × ($52 – $40)). Calculating the ACB of the shares Once the option is exercised, the adjusted cost base of the shares is calculated as: • • • the amount the employee paid for the shares plus any amount the employee paid for the option plus the full amount of the taxable benefit included in income
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Taxation of Employees and Alternative Minimum Tax
The ACB of Phillip’s new shares is $5,200, calculated as ((number of shares x exercise price) + taxable benefit) or ((100 × $40) + $1,200).
Canadian-controlled Private Corporations
The employee does not have to include the benefit in income until he or she disposes of the shares that were acquired with the stock option in situations where: • • the corporation that issued the stock option is a Canadian-controlled private corporation the corporation is at arm’s length from the employee receiving the stock option (ITA 7 (1.1))
A Canadian-controlled private corporation (CCPC) is a Canadian private corporation that is not controlled directly or indirectly by one or more non-residents or public corporations (ITA 125(7)). Valerie is employed by Megacorp, a CCPC. Three years ago, she purchased an option to buy 200 Megacorp shares at an exercise price of $30 per share for a premium of $1 per share (the cost for each option). In June of last year, Valerie exercised the option when the shares were worth $44 per share. She sold the shares in March of this year for $52 per share. As a result of exercising the option, Valerie has a taxable benefit this year of $2,600, calculated as (number of shares purchased x (FMV at the time the options were exercised (exercise price + cost of acquiring the option))) or (200 × ($44 – ($30 + $1))). Calculating the ACB of the shares Once the option is exercised, the adjusted cost base of the shares is calculated as: • • • the amount the employee paid for the shares plus any amount the employee paid for the option plus the full amount of the taxable benefit included in income
The ACB of Valerie’s shares in Megacorp is $44 per share, calculated as (exercise price + cost of acquiring the option + taxable benefit) or ($30 + $1 + $13). So, when she sold her shares, Valerie realized a capital gain of $1,600, calculated as ((FMV - ACB) x number of shares) or (($52 - $44) × 200). If the employee sells the option itself, he or she will have a taxable employment benefit to the extent the proceeds of disposition exceed his or her cost for the option (ITA 7(1)(b)). Last year, Susan bought an option to purchase 5,000 shares of her employer’s corporation at an exercise price of $35 per share for a premium of $0.40 per share. This year, Susan sold the option for a premium of $1.00 per share and has taxable employment income of $3,000, calculated as (number of options x (sale price - cost of acquisition)) or (5,000 × ($1.00 - $0.40)).
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Income Tax Planning
Exercise: Employee Stock Option Plans in the Case of a CCPC
Qualifying Acquisitions in Public Corporations
The Federal Budget of 2000 extended to public corporations, the stock option deferral that was previously only available to CCPCs. More specifically, the Income Tax Act was amended to permit the deferral on up to $100,000 per year of qualifying employee stock options for publicly-listed shares. An employee who exercises an employee stock option in a public corporation or a mutual fund trust after February 27, 2000 may be able to defer recognition of the employment benefit until he or she disposes of the shares, provided that certain conditions are met (ITA 7(8)). In order to obtain the deferral, the employee must file an election with his or her employer by January 15th of the year after he or she exercises the option (ITA 7(10). Furthermore, the acquisition of new shares under the option agreement must be considered to be a qualifying acquisition (ITA 7(9)), which means: • • the acquisition occurred after February 27, 2000 (it does not matter when the option was granted) the amount paid by the employee to acquire the security (including any amount that he or she may have paid to acquire the option) must not be less than the fair market value of the security when the option was granted the employee must have been dealing at arm’s length with the employer if the security is a share, it must be a common share, and it must be listed on a prescribed stock exchange the employee must not be a specified shareholder as defined by ITA 248(1), which generally means that he or she must own less than 10% of the shares in the corporation
• • •
The $100,000 annual limit on the specified value of the options available for deferral applies to the year of vesting, not the year in which the option is granted, nor the year that the option is exercised. The year of vesting is the year in which the employee gains the right to exercise the option. The specified value is generally the FMV of the security at the same time that the option was issued (ITA 7(11)). This year, Beverly received 10,000 options from her employer, which is a publiclylisted corporation. The options give her the right to acquire shares at $50 each, which was the FMV of the shares at the time the option was issued. Next year, all of the options vest, which means that Beverly cannot exercise them until that time. The specified value of her options is $500,000, calculated as (exercise price x number of shares) or ($50 × 10,000), well in excess of the $100,000 annual limit. Assume Beverly exercises all of her options in five years, when the shares are trading at $120. Beverly can only elect to defer recognition of the employment benefit on 2,000 shares, calculated as
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Taxation of Employees and Alternative Minimum Tax (annual limit ÷ exercise price) or ($100,000 ÷ $50). In the year that she exercises her options, she would have to recognize an employment benefit of $560,000, calculated as ((FMV at the time the shares are exercised - exercise price) x (total number of shares acquired - number of shares on which deferral is available)) or (($120 – $50) × (10,000 – 2,000)). So, the vesting period can dramatically change the amount of benefit that can be deferred. Ideally, the employer should ensure that only options with a specified value of $100,000 vest each year. Suppose Beverly’s employer had granted her 10,000 options this year, but only 20% of the options vest in each year over the next five years. The specified value of the options that vested each year would be $100,000, calculated as [exercise price x (total number of options x portion of options that vest each year)] or [$50 × (10,000 × 20%)]. If Beverly exercised all of the options in five years, she would now be able to defer the employment benefit on all 10,000 shares.
Exercise: Qualifying Acquisitions in Public Corporations
Employee Stock Option Deduction
If an employee exercises or sells a stock option that he or she receives as a result of his or her employment or office, the employee might have a taxable benefit. However, the Income Tax Act may allow a deduction in the same year that he or she must report the taxable benefit (ITA 110(1)(d) and (d.1)). The deduction is equal to 50% of the amount of the taxable benefit. The conditions under which the deduction may be claimed are discussed below. This deduction is intended to reduce the employment benefit to the equivalent of a capital gain. General rules Generally, a person who has to report an employment benefit as a result of exercising an employee stock option may claim a deduction equal to 50% of the taxable benefit reported during the year, provided: • • • the shares are common shares the exercise price plus any amount the employee paid to acquire the option is not less than the fair market value of the shares at the time the option was granted the employee deals at arm’s length with the corporation (ITA 110(1)(d))
Two years ago, Charles received employee stock options to purchase 10,000 shares in Retold Inc. at $12 per share, which was the FMV of those shares at that time. This year, Charles exercised all of the options when the FMV of the shares was $30 per share. The shares do not qualify for a deferral of the employment benefit. This year, Charles has to report a taxable employment benefit of $180,000, calculated as (number of shares acquired x (FMV of shares when exercised - exercise price)) or (10,000 × ($30 - $12)). However,
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Income Tax Planning Charles will be able to claim a stock option deduction of $90,000, calculated as (taxable employment benefit x (1 - capital gains inclusion rate)) or ($180,000 x (1 - 50%)). Canadian-controlled private corporations Taxpayers who have exercised employee stock options in a CCPC do not have to report a taxable employment benefit until the year that they dispose of the shares. At that time, they may be able to claim an offsetting deduction of 50% of the taxable benefit, provided that the taxpayer has held the shares for at least two years as of the date of sale (ITA 110(1)(d.1)(ii)). If this condition is met, the taxpayer does not have to meet the first two conditions required under the general rules. So, in this case, shares are not restricted to common shares, and the total of the exercise price plus any amount paid to acquire the option does not have to be greater-than or equal to the FMV of the shares at the time the option is granted. It could be less than the FMV of the shares. These exceptions are intended to stimulate employee ownership of small businesses, and acknowledge that the valuation of shares in a private company may be difficult. Qualifying acquisitions in public corporations A taxpayer who makes a qualifying acquisition of common shares in a public corporation can defer recognition of the resulting taxable employment benefit until the year in which he or she disposes of the shares. At that time, the taxpayer can claim a deduction equal to 50% of the taxable benefit, provided that he or she meets all of the conditions described earlier under the general rules.
Exercise: Employee Stock Option Deduction
Cross-border Employment Income
With today’s global economy, people do not necessarily earn their employment income in the same country in which they live. Canadian residents employed outside of Canada A Canadian resident is taxed on or her world income, including any earnings he or she receives as a result of being employed outside of Canada (ITA 3(a)). If the individual is paid in foreign funds, those funds must first be converted into Canadian dollars before they are reported on his or her Canadian tax return. Sheila is a Canadian resident who spent four months working in the U.S. last year. She did not work during the remaining eight months of the year and she returned to Canada. As a result of her employment, she earned $12,000 U.S. at a time when the exchange rate was $0.68. Sheila will have to include $17,647 in her income for Canadian tax purposes, calculated as (employment income in U.S. dollars ÷ exchange rate) or ($12,000 ÷ $0.68).
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Taxation of Employees and Alternative Minimum Tax
In some cases, that employment income may also be taxable in the country in which the income was earned. If this is the case, the taxpayer may be able to claim a foreign tax credit to reduce the amount of Canadian tax payable (ITA 126(1)). Sheila will also have to report her employment income for U.S. tax purposes. However, she can claim a foreign tax credit on her Canadian tax return to offset the foreign tax that she paid on that income.
U.S. Citizens Employed in Canada
The tax system in the United States is based on citizenship, not residency. So, even if a U.S. citizen is a Canadian resident, he or she will face U.S. income tax on his or her Canadian income. As a Canadian resident, the individual will also face Canadian income tax on his or her worldwide income. A U.S. citizen who is a non–resident of Canada must report only his or her Canadian sourced income for Canadian tax purposes, including: • • • income from an office or employment carried out in Canada income from a business carried on by the non–resident in Canada taxable capital gains realized upon the disposition or deemed disposition of taxable Canadian capital property (ITA 115(1)(a))
The Canada-U.S. Tax Convention addresses some of the double taxation issues for crossborder employees, but those rules are outside the scope of this course. Refer to IT-171R2, Non–resident individuals – Computation of taxable income earned in Canada and non–refundable tax credits; IT-270R2, Foreign tax credit; and IT-497R3, Overseas employment tax credit, for more information.
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Employee Stock Option Plans. In this lesson, you have learned how to do the following: • given a client with an employee stock option plan, identify and calculate any impact on the client’s taxes
If you are ready to move to the next lesson, click Alternative Minimum Tax on the table of contents.
Assessment
Now that you have completed Employee Stock Options Plans, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Employees and Alternative Minimum Tax
Lesson 4: Alternative Minimum Tax
Welcome to Alternative Minimum Tax. In this lesson, you will learn how to identify if your client should be paying alternative minimum tax (AMT), as well as how AMT is calculated. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • identify if a client should be paying AMT calculate AMT for client
Alternative Minimum Tax
The Alternative Minimum Tax (AMT) is a scheme in the Income Tax Act that requires the calculation of an alternative amount of tax based upon the elimination of certain tax preferences. Tax preferences are deductions or tax credits that are not claimable for minimum tax purposes. CRA sometimes calls them tainted shelter deductions. The taxpayer is required to pay the greater of this alternative amount of tax and the regular amount of tax otherwise calculated. The AMT was introduced in December 1986, as a political solution to the perception that many high-income taxpayers were avoiding taxes through the use of tax shelters. For this reason, the AMT is relatively narrow in focus and concentrates on specific tax shelters and credits. In reality, few taxpayers are affected by the minimum tax. James is a 64 year-old widower. Last year, he sold his shares in Force Ten Enterprises, a CCPC, for a capital gain of $480,000. He receives a retirement allowance of $46,500, which he rolled over into an RRSP and he also contributed $13,500 to his RRSP. He earned a salary of $76,000 and he received $4,000 in dividends from Totem Inc., another taxable CCPC, in which James has a small ownership interest. The minimum tax is an alternative tax calculation. This means the taxpayer must prepare two returns: the General Tax Return (Form T1) and the Calculation of Minimum Tax (Form T691). The taxpayer must pay the higher of the two resulting amounts. The table below presents the calculations of the tax payable for James under the regular system. You may wish to print this page and refer to it as you go through the explanations that follow.
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Income Tax Planning
Tax Under Regular System
Before calculating AMT, the taxpayer must first calculate his or her taxable income and the basic federal tax under the regular system.
Total Income
Page 2 of the T1 general return starts with a calculation of total income, which includes (among other things) all employment income, taxable government benefits, the taxable amount of dividends and capital gains, support payments, RRSP income, and termination benefits. James reported the following sources of income on his T1 return: • • • • line 101: employment income of $76,000 line 120: taxable dividend income From Totem Inc. of $5,000, calculated as (cash dividend x gross up rate for dividend paid by a CCPC) or ($4,000 × 125%) line 127: taxable capital gains of $240,000, calculated as (capital gains x capital gains inclusion rate) or ($480,000 × 50%) line 130: retiring allowance of $46,500
Therefore, on line 150, James will report total income of $367,500, calculated as (employment income + taxable dividend income + taxable capital gain + retiring allowance) or ($76,000 + $5,000 + $240,000 + $46,500).
Net Income
Next, the taxpayer can deduct certain amounts to arrive at net income, including childcare or moving expenses, union dues, and contributions to registered pension plans or RRSPs. James was able to rollover his retiring allowance of $46,500 to his RRSP; he also made an RRSP contribution of $13,500. So, his total deductions on line 208 amounted to $60,000 calculated as ($46,500 + $13,500). James’ net income, as reported on line 235, was $307,500, calculated as (total income - total deductions) or ($367,500 - $60,000).
Taxable Income
Next, the taxpayer determines his or her taxable income deducting amounts for stock option deductions, losses carried forward from previous years, and capital gains deductions. James realized a capital gain of $480,000 when he sold his shares in Force Ten Enterprises. The shares of Force Ten qualified for the $750,000 capital gains exemption for (or a lifetime exemption of $375,000 of taxable capital gains) for qualified small business shares. Since James had not previously used any exemptions that had been available to him, he was able to shelter the entire capital gain and to claim a capital gains deduction of $240,000 on line 254 calculated as (capital gain x capital gain inclusion rate) or ($480,000 × 50%). This reduced James’ taxable income on line 260 to $67,500, calculated as (net income capital gains deduction) or ($307,500 - $240,000).
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Taxation of Employees and Alternative Minimum Tax
Basic Federal Tax
Finally, the taxpayer calculates the basic federal tax owing on his or her taxable income based on the applicable marginal tax rates. Federal Personal Tax Rates on Taxable Income
Taxable Income up to $40,726 $40,727 - $81,452 $81,453- $126,264 Over $126,264
Marginal Tax Rate 15% 22% 26% 29%
James has taxable income of $67,500. His federal tax payable on this amount is $11,999.18, calculated as [($40,726 x 15%( + (($67,500 - $40,726) x 22%)]. Like all taxpayers, James can claim a basic personal amount of $10,320, which will result in a non-refundable tax credit of $1,548, calculated as (basic personal amount x federal tax credit conversion rate of 15%) or ($10,320 x 16%). He can also claim a federal dividend tax credit of $667, calculated as (grossed-up dividend x federal dividend tax credit rate) or ($5,000 x 13 1/3%) Under the regular system, James owes basic federal tax in the amount of $9,784.18 calculated as (federal tax on taxable income - non-refundable tax credits - dividend tax credit) or ($11,999.18 - $1,548 - $667).
Subject to AMT
Your client may have to pay minimum tax if any of the following situations apply: 1. The taxpayer reported dividends from a taxable Canadian corporation. James reported a taxable dividend of $5,000 which is the $4,000 cash dividend he received from Totem Inc. – a taxable Canadian CCPC - grossed-up by 125%. James might be subject to AMT. 2. The taxpayer claimed any of the following tax credits: • • • • an investment tax credit an overseas employment tax credit a federal political contribution tax credit a labour-sponsored funds tax credit
3. The taxpayer reported a taxable capital gain.
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Income Tax Planning James reported a capital gain of $480,000 when he sold his business. He had a taxable capital gain of $240,000, calculated as (capital gain x capital gains inclusion rate) or ($480,000 × 50%). So, he might be subject to AMT. 4. The taxpayer claimed any of the following: • • • • • a deduction for an employee home relocation loan a loss resulting from, or increased by, claiming capital cost allowance or carrying charges on certified films, videotapes and rental properties losses from limited partnerships and related carrying charges a loss from resource properties resulting from, or increased by, claiming a depletion allowance, exploration expenses, development expenses, or Canadian oil and gas property expenses a deduction for employee stock option and shares
Calculating AMT
The minimum tax return is called a T691 and consists of four pages. AMT is calculated in several steps. The table below shows the calculation of James' tax payable under the AMT system. You may wish to print this page and refer to it as you go through the explanations that follow.
Adjusted Taxable Income
1. When calculating minimum tax, you start with the taxable income calculated under the regular method. James had taxable income of $67,500 under the regular method, so this is the starting point for determining his adjusted taxable income under the AMT system.
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Taxation of Employees and Alternative Minimum Tax 2. Then you have to add back certain deductions that were allowed on the T1 General Return, but that are not allowed for AMT purposes. These include: • • • • a portion of CCA claimed in certain film deals losses from various tax shelters carrying charges that were used to create or enhance a rental loss, or that were related to certain film deals, flow-through shares or resource properties some of the non-taxable portion of capital gains reported during the year, including gains eligible for exemption, calculated as 30% of the realized capital gain for dispositions after October 17, 2000. (A different rate applies for dispositions prior to this date) employee home relocation deductions employee stock option deductions
• •
James sold his shares in a CCPC and realized a gain of $480,000. Even though the shares qualify for the capital gains exemption, he has to add back $144,000 for AMT purpose, calculated as (capital gain x 30%) or ($480,000 × 30%). 3. You also deduct the gross-up on dividends from taxable Canadian corporations. For eligible dividends, deduct 31.0345% of the taxable dividend (i.e. the grossed up dividend); for other than eligible dividends, deduct20% of the taxable dividend. James received other than eligible dividends of $4,000 from Totem Inc. He reported a taxable dividend income of $5,000, calculated as (dividends x dividend gross-up rate of 125%) or ($4,000 × 125%) on line 120 of his T1 General Return. For purposes of the AMT calculations, he can deduct the gross-up of $1,000, calculated as (taxable dividend - cash dividend) or ($5,000 - $4,000). 4. The taxpayer’s adjusted taxable income is the sum of the net additions to taxable income plus taxable income. James’ adjusted taxable income is $210,500, calculated as (ordinary taxable income + capital gain add back - dividend gross-up) or ($67,500 + $144,000 - $1,000).
Net Adjusted Taxable Income
There is an AMT basic exemption of $40,000, which is deducted from the adjusted taxable income. So, effectively only adjusted taxable income in excess of $40,000 is subject to the alternative minimum tax. This means that someone can have up to $40,000 of adjusted taxable income and still pay no AMT. The net adjusted taxable income is taxable income plus net additions to taxable income minus the basic exemption. If this amount is negative, your client is not subject to minimum tax. James’ net adjusted taxable income is $170,500, calculated as (adjusted taxable income - AMT basic exemption of $40,000) or ($210,500 - $40,000). He is, therefore, subject to minimum tax.
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Income Tax Planning
Gross Minimum Amount
The Federal AMT rate is the rate for the lowest tax bracket under the normal tax system, so the AMT is not a progressive tax with three or four tax brackets. The net adjusted taxable income is multiplied by the federal AMT rate to give the gross minimum amount. As per the 2007 federal Economic Statement, the lowest personal income tax rate was reduced to 15% (from 15.5%), effective January 1, 2007. The gross minimum amount for James is $25,575, calculated as (his net adjusted taxable income × 15%) or ($170,500 × 15%).
Minimum Amount
Certain personal tax credits can be deducted from the gross minimum amount. The AMT system considers certain tax credits to be preferred, but not others. For minimum tax purposes, personal tax credits are allowed for the following amounts: • • • • • • • • • • • basic personal amount age amount spousal amount equivalent-to-spouse amount amounts for infirm dependants Canada and Québec Pension Plan contributions employment insurance premiums disability amount tuition fees and education amount medical expenses charitable donations
James claimed a basic personal amount of $10,320, that resulted in a nonrefundable tax credit of $1,548, calculated as (basic personal amount x federal tax credit conversion rate of 15%) or ($10,320 x 15%) from claiming the basic personal amount calculated as ($7,756 x 16%). The non-refundable tax credits added back for minimum tax purposes are those for the following amounts: • • • • pension income amount disability amount transferred from a dependant other than a spouse or commonlaw partner tuition, education and textbook amounts credits transferred from a child amounts transferred from a spouse or a common-law partner
Since the only non-refundable tax credit claimed by James was the basic personal amount, the entire $1,548 is allowed for minimum tax purposes. So, his alternative minimum tax is $24,027, calculated as (gross minimum amount - non-refundable tax credits) or ($25,575 - $1,548). If the resulting alternative minimum tax is higher than the taxpayer’s federal tax calculated normally, he or she must pay the minimum tax.
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Taxation of Employees and Alternative Minimum Tax The minimum tax payable for James is $24,027, calculated as [the greater of (the AMT and the regular basic federal tax)] or [the greater of ($24,027 and $9,784.18)].
Exercise: Alternative Minimum Tax
Minimum Tax Carryover
The minimum tax carry-over to subsequent years is any excess of the minimum amount over the amount that will be payable under the normal tax system. Returning to our scenario with respect to James, his minimum tax carry-over is $14,242.82, calculated as (his federal tax under the AMT system - his federal tax under the normal tax system) or ($24,027 - $9,784.18). A minimum tax carry-over can be used to reduce taxes payable under the normal tax system in any of the following seven years. However, the taxpayer always has to pay at least the amount of the AMT for each of the following years, so the carry-over cannot reduce the amount of tax payable below each of the following years’ minimum tax. The taxpayer calculates his or her tax for each of the following years under the normal and AMT systems. If the normal amount exceeds the AMT amount, the carry-over can reduce the normal amount, but not to an amount less than the AMT. Assume for next year, the regular tax owing for James is $23,459 and his minimum tax is $12,589. His regular tax exceeds his minimum tax by $10,870, calculated as ($23,459 – $12,589). He can use $10,870 of his carry-over of $14,242.82 from this year to reduce his regular tax to $12,589–the amount of his minimum tax for next year. This will reduce James’ minimum tax carry-over for future years to $3,372.82, calculated as (carry-over from this year – portion of carry-over used next year) or ($14,242.82 – $10,870).
Exercise: Minimum Tax Carryover
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Income Tax Planning
Changes Regarding Contributions to Registered Plans
Prior to 1998, the following deductions were considered to be tainted deductions for calculating minimum tax, so they had to be added back when calculating adjusted taxable income for AMT purposes: • • • • registered pension plan (RPP) contributions registered retirement savings plan (RRSP) contributions retiring allowances transferred to an RSP or an RPP transfers of periodic RPP or deferred profit sharing plan (DPSP) payments to an RRSP of a spouse or common-law partner
The ability to carry unused contribution room forward for RRSPs accounts for the increase in large, one-time RRSP contributions, and has exposed some taxpayers, who were not the original targets of AMT, to the alternative tax. The legislation to implement the changes proposed in the Federal Budget of February 24, 1998 exempted RRSP rollovers and contributions, as well as contributions to registered pension plans, from the AMT. This change is effective for 1998 and later years.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Alternative Minimum Tax. In this lesson, you have learned how to do the following: • • identify if a client should be paying AMT calculate AMT for client
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Alternative Minimum Tax, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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5-37
Taxation of Employees and Alternative Minimum Tax
Review
Let’s look at the concepts covered in this unit: • • • • Types of Employment Income and Taxable Benefits Fringe Benefits not Included in Income Employee Stock Option Plans Alternative Minimum Tax
You now have a good understanding of the basics of taxation of employees and alternative minimum tax. At this point in the course you can identify and calculate the impact of taxable benefits on your client’s income and the impact of fringe benefits not included in income on your client’s taxes. Given a client with an employee stock option plan, you can also identify and calculate any impact on your client’s taxes. Finally, you can identify if your client should be paying AMT as well as calculate AMT. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 5: Taxation of Employees and Alternative Minimum Tax, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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I FP
Unit 6: Taxation of Property Income
Income Tax Planning
Unit 6: Taxation of Property Income
Welcome to Taxation of Property Income. In this unit, you will learn about the deductions your client can use to make the most tax effective use of his or her business and property investments. You will learn how to identify, calculate, and describe any probable tax impact given a client with capital cost allowance, rental income, interest, dividends, and income earned. You can also calculate and describe any probable tax impact given a client who disposes of depreciable property as well as identify and calculate how property income and capital gains can be attributed to the taxpayer when he or she transfers property. This unit takes approximately 3 hours and 45 minutes to complete. You will learn about the following topics: • • • • • • Interest, Dividends, and Income Earned Rental Income Capital Cost Allowance Disposing of Depreciable Property Other Deductions from Business and Property Income Income Attribution Rules
To start with the first lesson, click Interest, Dividends, and Income Earned on the table of contents.
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Taxation of Property Income
Lesson 1: Interest, Dividends, and Income Earned
Welcome to Interest, Dividends, and Income Earned. In this lesson, you will learn about any probable tax impact given a client with interest, dividends, and income earned. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • identify, calculate, and describe any probable tax impact given a client with interest, dividends, and income earned
Interest Income
Interest is the compensation that a borrower pays a lender for the privilege of using borrowed funds. When a taxpayer takes out a mortgage or a car loan, for example, he or she is borrowing funds and must pay interest to the lender. When the taxpayer makes a bank deposit or purchases a debt instrument, such as a corporate bond or guaranteed investment certificate, the taxpayer is essentially making a loan to the issuer and he or she is entitled to receive compensation in the form of interest income. An investment contract includes almost any debt obligation, with the exception of certain debts related to employment (for example, salary deferral or retirement compensation arrangements) and some income or small business development bonds (ITA 12(11)).
Reporting Interest Income on Investment Contracts
Interest income is earned as time passes because it is compensation for lending money for a period of time. However, interest income is not necessarily paid on a regular basis. It may be paid daily, monthly, quarterly, annually, biannually, or on a totally random basis, either on its own or at the same time as the repayment of some or all of the principal. On October 1st of last year, Lindsey purchased a new $10,000 corporate bond from NewCorp Ltd. The bond will pay interest on the face amount at a nominal annual interest rate of 8% semi-annually, with the first interest payment of $400 due on March 31st of this year, calculated as [(face value x coupon) ÷ payments per year], or [($10,000 × 8%) ÷ 2]. The next payment would be due on September 30th of this year. Even though Lindsey will not receive any interest payments until March 31st of this year, she is earning interest each and every day from October 1st of last year, because NewCorp Ltd. has the use of her money each and every day until the debt is repaid. So when does Lindsey report the interest income for tax purposes? Cash basis vs. accrual basis The cash basis requires the taxpayer to report interest income when it is received in cash or in kind. The accrual basis requires the taxpayer to report interest income when it is earned. If a taxpayer accrues income, it means that he or she is reporting an amount of income that he or she has already earned for tax purposes, but has not yet received the income in cash or kind. An accrual is an amount that has been accrued (earned and reported for tax purposes, even though it has not yet been received in cash or kind).
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Income Tax Planning Gina has $2,000 in her savings account and the interest is credited to her account at the end of each month. She must report this income on a cash basis, so it will be included in her income for the year in which she receives it. Gina also has a 5-year strip bond. She bought it for $7,600 and it will mature in three years at which time she will receive $10,000. The difference between the purchase price and the face amount is considered to be interest income, and she earns a portion of that interest income as each day passes. Even though Gina will not receive the interest income for three years, she is earning interest income and it must be reported on an accrual basis. Calendar year vs. bond year The Income Tax Act imposes a reporting scheme that is a combination of the cash basis and the accrual basis, by using a combination of the calendar year and the bond year, depending on how frequently the interest is paid. A calendar year is the period from January 1st to December 31st of the same year, and for individuals, this is the same as their taxation year or fiscal year. A bond year is a period of 365 consecutive days (366 days over a leap year) beginning with the bond's original issue date (or the day after the anniversary day in subsequent years). A bond's anniversary day is the day that is one year after the day immediately preceding the date of issue of the contract, or the day that occurs at every successive one year interval from that date (ITA 12(11). On October 1st of last year, Lindsey purchased a new $10,000 corporate bond from NewCorp Ltd. Therefore, the anniversary day of Lindsey's Newcorp Ltd. bond is September 30th of each year because this is one year after the day that preceded the date of issue. She purchased her bond in the last calendar year and she will receive her first interest payment this calendar year. The first bond year runs from October 1st of last year until September 30th of this year.
Cash Method for Individuals
Under the cash basis of reporting interest income, an individual who is entitled to receive interest income must report it either when it is received (the cash method) or receivable, unless it has already been reported as taxable income in a previous year under the accrual method (ITA 12(1)(c)). Annual accrual method based on bond year for individuals While contract law may allow the debt to be structured such that interest is not payable until some date in the distant future, the government is not willing to wait that long to collect taxes on interest income that has been earned but not yet paid. The Income Tax Act requires interest earned on an investment contract to be reported as it is earned on an accrual basis, even if it is not received. Under the annual accrual basis of reporting interest income, if a taxpayer holds an investment contract on its anniversary day, he or she must include an amount in his or her taxable income for the taxation year in which the anniversary day falls (ITA 12(4)). The amount that must be included is equal to the total amount that has been earned by the taxpayer up until that anniversary day, but only to the extent that the interest has not been
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Taxation of Property Income otherwise included in computing the taxpayer’s income for the year or any preceding taxation year. Raymond lent $10,000 to his friend Jason on April 1, 2010 at 8%. The terms of their loan agreement stated that Jason would pay the accumulated interest along with the principal on March 31, 2013. On that day, Jason will pay Raymond a total of $12,597 calculated using your financial calculator by entering DISP = 0, P/YR = 1, xP/YR = 3, I/YR = 8%, PV = -$10,000, PMT = $0 and solving for FV. Of this amount, $2,597 represents interest income, calculated as ($12,597 - $10,000). In the meantime, Raymond will be earning interest, even though he will not actually receive it for three years. The first anniversary day of the debt contract between Raymond and Jason will be March 31, 2011, and this will fall within the 2011 taxation year. During this first bond year, Raymond will earn interest income of $800, calculated as (principal x interest rate), or ($10,000 × 8%). So, on his tax return for 2011, Raymond must report interest income of $800. By March 31, 2012, Raymond will have earned interest income of $1,664, calculated as [(principal x (1 + interest rate)2 – principal] or [($10,000 × (1 + 8%)2 - $10,000]. However, on his 2012 tax return, he would only report $864, calculated as (interest to March 31, 2012 - interest to March 31, 2011) or ($1,664 - $800) because he has already accrued income of $800 on his 2011 return. Triennial accrual method for individuals The annual accrual requirement was introduced in 1990. Under the triennial accrual basis of reporting interest income, a taxpayer who acquired an interest in an investment contract before 1990 is allowed to accrue the interest income every three years, as long as the taxpayer has done so since 1990 (ITA 12(11)). Annual accruals based on tax year for all other taxpayers Taxpayers who are not individuals (i.e., corporations, partnerships and trusts that have corporate beneficiaries) are not allowed to report interest income based on the bond year, as individuals are allowed to do. Under the accrual basis of reporting interest income, corporations must report: • • all interest earned to the end of its taxation year all interest income that is received or becomes receivable by the end of that year, but only to the extent that the interest income was not included in computing its income for a preceding year (ITA 12(3))
Exercise: Interest Income
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Income Tax Planning
Dividend Income, Gross-up and Tax Credit
Dividend income A dividend is a distribution of a corporation’s profits to its shareholders. Dividends from both resident corporations and non-resident corporations must be included in taxable income. However, dividends from resident corporations are subject to more favourable tax treatment. Dividend gross-up and tax credit scheme The dividend tax credit gives the taxpayer some tax relief on the dividend income he or she has received. The value of the dividend tax credit depends on the kind of taxable, Canadian corporation paying the dividend: in general terms, Canadian-controlled private corporations vs. large, public corporations. Other than eligible dividends received from a CCPC Dividends received from a Canadian-controlled private corporation (CCPC), to the extent that its income is taxable at the small business rate or is from a CCPC's investment income (i.e. non-active business income), are treated differently than dividends received from large public corporations. These types of dividends are called other than eligible dividends. An individual who receives a dividend from a CCPC must include 125% of that dividend in taxable income for the year. This is referred to as the dividend gross-up. A taxpayer can then claim a federal dividend tax credit equal to 2/3 of the 25% gross-up, which works out to 16 2/3% of the actual dividend, calculated as (2/3 × 25%), or 13 1/3% of the grossed-up dividend, calculated as (16 2/3% ÷ (1 + 25%)). The tax credit is intended to offset the tax the corporation is presumed to have paid. The taxpayer can also claim a provincial dividend tax credit.
Parvez receives a dividend of 4% on his shares of a CCPC. His marginal tax rate (MTR) is 48%. He resides in a province with a PDR of 7.70%. What is his after-tax return (ATR) on the dividend income? His marginal tax rate on dividends is 33.71%, calculated as (125% x (MTR – 13 1/3% + PDR))) or (125% × (48% - (13 1/3% + 7.70%))). His ATR on the dividend income is 2.65%, calculated as (4% × (1 - 33.71%)). Refer to IT-67R3, Taxable dividends from corporations resident in Canada, for more information.
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Taxation of Property Income Eligible dividends and the enhanced dividend tax credit The May 2006 federal budget proposed an enhanced dividend tax credit for dividends received after 2005 from: • • • public corporations resident in Canada other corporations resident in Canada that are not Canadian-controlled private corporations (CCPCs) and are subject to the general corporate tax rate CCPCs resident in Canada to the extent that their non-investment income is subject to tax at the general corporate tax rate, i.e. active business income above the small business deduction limit.
Dividends received for which the enhanced dividend tax credit may be applied are referred to as eligible dividends. With the enhanced dividend tax credit, 145% of the dividend received will be included in income. The result is a federal tax credit of approximately 18.97% of the taxable (grossedup) dividend (the precise number is 18.9655%), which is the same as 27.5% of the actual dividend. The provinces have their own corresponding enhanced dividend tax credit.
Exercise: Dividend Income
Stock Dividends
Stock dividends are dividends issued by a corporation that are paid by the issuance of shares of any class of the capital stock of that corporation (ITA 248(1)). Stock dividends received by a taxpayer in a year must be included in the taxpayer’s income for that year in the same manner as if the dividend had been received as cash. This means that the grossup and dividend tax credit rules also apply to stock dividends (ITA 12(1)(j)). The amount of the dividend, which is used for the gross-up calculation, is the increase in the paid-up capital of the corporation that results from the issue of the new shares (ITA 248(1) "amount", ITA 52(3)). The amount of paid-up capital is determined by the directors and reported to the shareholders. Effectively, the directors decided to transfer the amount of the dividend from the retained earnings of the corporation to the paid-up capital of the corporation. Telltale Corporation, a large public Canadian corporation, had retained earnings of $2 million last year. Instead of distributing a cash dividend, the directors decided to capitalize the retained earnings and issue 1 million new shares valued at a total of $2 million to the holders of the existing 1 million shares, thereby adding $2 million to its paid-up capital account.
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Income Tax Planning Before Telltale issued the stock dividend, Amanda held 8,000 shares in the corporation. Amanda will receive a stock dividend worth $16,000, calculated as ((# of shares held ÷ total shares outstanding) x capitalized earnings) or ((8,000 ÷ 1,000,000) × $2,000,000). Telltale informs Amanda that her dividend is an "eligible dividend" that is able to make use of the enhanced dividend credit. She will have to include $23,200 in her taxable income, calculated as (cash dividend x 145%) or ($16,000 × 145%). She will be able to claim both federal and provincial dividend tax credits on this amount. Calculating the ACB of the new shares If a shareholder acquires new shares as a result of a stock dividend, he or she is deemed to have acquired the shares at a cost equal to the deemed amount of the dividend. The adjusted cost base of the shares that Amanda received as a result of the stock dividend is $16,000. When she eventually disposes of these shares, the capital gain or loss will be based on this ACB. Refer to IT-88R2, Stock Dividends, for additional information.
Dividends from Non-resident Corporations and Trusts
Dividends from non-resident corporations Dividends received from non-resident corporations (i.e., corporations that do not have to pay Canadian income tax) are not eligible for the dividend gross-up and tax credit scheme. Instead, these dividends are fully taxable and must be included as foreign sourced income (ITA 12(1)(k) and ITA 90(1)). Dividends from trusts If a trust is resident in Canada throughout a taxation year in which it receives a taxable dividend from a taxable Canadian corporation, it may be able to designate that dividend as being included in a beneficiary’s income. Thus, it can flow through to the beneficiary and it is not included in the trust’s income (ITA 104(19)). In order to be able to make this designation, certain conditions must be met. If the trust makes this designation, then the dividend is deemed to have been received by the beneficiary, not by the trust. The beneficiary must include the grossed-up amount in his or her income, but he or she can then claim the federal and provincial dividend tax credits. Refer to IT-524, Trusts — Flow-through of taxable dividends to a beneficiary after 1987, for more information.
Dividends Received by a Spouse or Common-law Partner
If a taxpayer has a spouse with little or no income, he or she can claim that spouse as a dependant and receive the full amount of a spousal tax credit. The same rules apply to common-law partners. In previous years, the spouse or common-law partner tax credit was calculated on a base amount which was then reduced dollar-for-dollar by the net income of the dependent spouse or common-law partner in excess of a stipulated threshold. The income threshold was very low and it only took a small amount of grossed-up dividends to bring the spouse's income over the threshold, thereby reducing the taxpayer's claim for
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Taxation of Property Income the spouse or common-law partner tax credit. In addition, if the spouse did not have any other taxable income, he or she could not make use of the dividend tax credit. Budget 2007, increased the spouse or common-law partner amount to match the basic personal amount and also eliminated the threshold above which the dependant’s net income must be taken into account. Effective 2007, the spouse or common-law partner tax credit is calculated as the spouse or common-law partner amount less the spouse or common-law partner's net income. Assuming this results in a positive number, this amount is then multiplied by the conversion rate applicable to non-refundable tax credits (which is the lowest federal tax rate). If the spouse or common-law partner amount is $10,320, the spouse of commonlaw partner of the taxpayer had no net income and the conversion rate for non-refundable tax credits is 15%, the resulting maximum federal tax credit will be $1,548, calculated as [(spousal or common-law partner amount – net income of spouse) x conversion rate] or [($10,320 – $0) × 15%]. A taxpayer can elect to report all of his or her spouse's or common-law partner's taxable dividend income from taxable Canadian corporations on his or her own tax return, to avoid reducing the spousal tax credit. Note: All of the dividends must be reported; a partial election is not permitted (ITA 82(3)). There is no easy rule of thumb to determine which spouse should report the dividend income. Spouses will need to calculate their combined taxes payable under both scenarios to determine which scenario results in the least amount of tax. Note: This election is only available for a spouse or common-law partner, and is not available with respect to other dependants for whom the taxpayer claims an eligible dependant amount. Also, while an election to transfer the reporting of dividend income can be made, any expenses incurred by the original recipient to earn that dividend income cannot be transferred to the reporting taxpayer. Refer to IT-295R4, Taxable dividends received after 1987 by a spouse, for additional information.
Income for Specified Members
When a person is a member of a partnership, the income that is earned as a partner is normally considered to be business income. However, if the taxpayer is a specified member of that partnership, the income earned as a specified member is considered to be property income, not business income (ITA 96(1.8)). A specified member of a partnership includes: • • • a person who is a limited partner in a limited partnership a general partner who does not take an active role in the business activities, other than financing activities (a silent partner) a general partner in a partnership who does not carry out a business similar to, but separate from, that partnership
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Income Tax Planning
Statement of Investment Income
A taxpayer must report his or her investment income, including interest income, dividends from taxable Canadian corporations and income earned as a specified member of a partnership on a separate Statement of Investment Income (Schedule 4 of the General Tax Return). Note: This Schedule only documents income generated by non-tax-deferred investments. Income earned within an RRSP is not taxed until it is withdrawn, so it is not reported here. The Statement of Investment Income also records any deductible expenses related to the reported investment income. As a general rule, most reasonable expenses relating to earning investment income are deductible for tax purposes. Expenses such as interest paid on funds borrowed to buy investments, and carrying charges, such as fees for safekeeping either in a safety deposit box or other safe custody, fees for accounting, bookkeeping, recordkeeping, investment counselling, or fees for investment management by licensed advisors are deductible. The total amounts recorded on the Statement of Investment Income are then transferred to the appropriate lines of the general tax return.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Interest, Dividends, and Income Earned. In this lesson, you have learned how to do the following: • identify, calculate, and describe any probable tax impact given a client with interest, dividends, and income earned as a specified member
If you are ready to move to the next lesson, click Rental Income on the table of contents.
Assessment
Now that you have completed Interest, Dividends, and Income Earned, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Property Income
Lesson 2: Rental Income
Welcome to Rental Income. In this lesson, you will learn about any probable tax impact given a client with rental income. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • identify, calculate, and describe any probable tax impact given a client with rental income
Reporting Rental Income
Rental income is income that a taxpayer receives as compensation for allowing someone else to use his or her real property. Rental income after adjustments is fully taxable. Real property includes land and all property attached to the land, including buildings, trees, fences or any other physical improvements. Rental income may be received in cash, in kind or in services. The value of payments in kind or in services is deemed to be at fair market value. Rental income may also include amounts received for granting or extending a lease or sublease, permitting a sublease, or cancelling a lease or sublease. If an individual taxpayer holds a rental property, he or she must report the gross and net rental income in the section called Total Income on Page 2 of his or her personal tax return. The details of his or her rental enterprise must be provided on form T776, Statement of Real Estate Rentals. Rental income and expenses are generally reported on an accrual basis, although the cash basis may be acceptable in simple cases where there is virtually no difference in the amount of income that is reported compared to the amount of income using the accrual basis.
Potential Areas of Confusion
On the surface, rental income is fairly straightforward – if you rent out real property, the net income resulting from that rental is taxable. However, taxpayers generally run into the following four basic problems in calculating their rental income and expenses: • • Is the rental income considered to be business income or property income? Are expenditures fully deductible as a current expense or are they part of the capital cost of the property, such that they can only be deducted through capital cost allowance (CCA)? How much can be claimed as capital cost allowance and what are the future tax implications of claiming CCA? What happens when a rental property is sold?
• •
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Income Tax Planning
Property Income or Business Income?
Depending on the nature of the rental operation, the resulting rental income will be considered to be either property income or business income. The Income Tax Act does not provide a specific definition for either type of income; it just says that a taxpayer’s income from a business or property is the profit therefrom for the year (ITA 9(1)). While the Income Tax Act does not provide a precise definition of business income, it does say that a business includes a profession, calling, trade, manufacturing operation or undertaking of any kind, including an adventure or concern in the nature of trade (ITA 248(1)). Therefore, business income is income that is earned as a result of creating, producing, or delivering a good or service. If the income generated by renting property does not fit this description, then it is considered to be property income. There are areas of the Income Tax Act where property income is treated differently from business income, so it is important to distinguish whether rental income is income from property or business income. The main factor that will determine whether the rental income is property income or business income is the number and kinds of services provided for the tenants, rather than the management structure or the size of the rental operation. Generally speaking, the more services provided to the tenant, the more likely the rental income will be considered business income. A taxpayer who owns a hotel will be earning business income. If only basic accommodation services are provided in the rental arrangement, the resulting rental income will be considered to be income from property. The size or number of properties being rented, the extent to which their management or supervision occupies the owner’s time, whether the accommodation is rented bare or fully furnished – none of these factors are taken into account in determining if the rental operation is a business. If the owner hires someone to manage the property, the rental income is not necessarily business income. Also, because two individuals may own and manage a rental property jointly in what appears to be a partnership, does not mean that the rental income is business income. Refer to IT-434R, Rental of real property by an individual, for more information on deciding whether rental income is property or business income.
Current Expenses vs. Capital Expenditures
In general, a taxpayer may deduct any reasonable current expenses to the extent they were incurred to earn business or property income, including rental income (ITA 18(1)(a)). Current expenses are recurring expenses that provide a short-term benefit. For example, the cost of repairs to maintain the property in the same condition as when purchased is a current expense. In contrast, capital expenditures include the cost of acquiring the property used to produce income, or the cost of making lasting or permanent improvements. These costs can only be deducted from rental income over several years as capital cost allowance (CCA) or an eligible capital expenditure amount.
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Taxation of Property Income Max owns a rental property, and he recently replaced the wooden steps leading up to the front door with new wooden steps. This would be a current expense because he was restoring the property to its original condition. However, if Max had decided to replace the wooden steps with more durable concrete steps, it would not be a current expense, but a capital expenditure. If expenses are prepaid, only those expenses that relate to the current taxation year can be deducted at this time.
Soft Costs
Soft costs are expenses that relate specifically to the period in which the taxpayer was constructing, renovating or altering a building to make it more suitable for renting, including costs related to the ownership of land associated with the building. Soft costs typically include interest or other financing charges, legal fees related to the renovations (but not legal fees related to the purchase), accounting fees and property taxes. Soft costs are usually capitalized by adding them to the cost of the building (ITA 18(3.1)), but in very limited situations, they may be deductible as a current expense to the extent the taxpayer has rental income during the year (ITA 20(29)). Soft costs that relate to the building are considered capital expenditures and must be added to the cost of the building, to eventually be deducted as capital cost allowance. During the first year after Max purchased his rental property, it was about 50% vacant. He spent considerable time and money renovating the building so that it would be more suitable for renting. During the renovation period, Max incurred property taxes related to the building of $5,000, legal fees related to acquiring building permits of $800 and interest of $2,800 on the funds that he borrowed to complete the renovations. His soft costs amounted to a total of $8,600, calculated as (property taxes + legal fees + interest) or ($5,000 + $800 + $2,800). Because the soft costs were incurred during the renovation period for the specific purpose of carrying out the renovation, the costs would be added to the cost of the building.
Deductible and Non-deductible Expenses
Deductible expenses The owner’s deductible expenses as recorded on the Statement of Real Estate Rentals equal the total current expenses minus any personal portion of those expenses, in the event that some of those expenses relate to personal property. Non-deductible expenses The following expenses are not deductible as either current or capital expenditures: • • • principal repayments on a mortgage income tax penalties the value of the taxpayer's own labour
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Income Tax Planning Land transfer taxes are not deductible as a current expense, but they do form part of the capital cost of the property, are capitalized, and deducted as CCA over several years. CCA will be discussed in detail later in this unit. Net income (loss) before adjustments At this point, the owner should be able to calculate his or her net income or loss from the rental property before adjustments, as the gross rental income less deductible expenses.
Exercise: Rental Income
Adjustments to Net Rental Income
Up to this point, we have calculated net rental income before adjustments. Now, we have to make a few more adjustments to arrive at the amount that the individual taxpayer reports on his or her tax return as his or her net rental income or loss. Co-owner’s share If the rental property is owned by more than one taxpayer, the net rental income before adjustments is apportioned according to the relative ownership interests of each owner. Other expenses of co-owner Individual co-owners may have incurred expenses that only apply to their ownership interest, such as banking charges related to their share of the mortgage on the property, or the cost of obtaining independent legal advice. Elise and Marie are equal partners in a rental building. The partnership had net rental income of $228,000 last year, so Marie’s net rental income before adjustments is $114,000, calculated as (total partnership income x Marie's share of partnership income) or ($228,000 × 50%). Elise did all of the bookkeeping for the partnership, including the preparation of all of the annual financial statements. While Marie did not distrust Elise, she thought it wise to hire an accountant to review the statements before she completed her tax return, and she paid $250 for this service. Marie can deduct the accounting fees from her share of the net rental income. Recaptured CCA If the taxpayer sells some or all of his or her rental property and the proceeds of that disposition exceeded his or her undepreciated capital cost (UCC) for that property, the taxpayer would realize a recapture of CCA, and this amount must be added back into rental income.
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Taxation of Property Income Terminal loss Similarly, if a taxpayer sells some or all of his or her rental property and the proceeds of that disposition are less than his or her undepreciated capital cost (UCC) for that property, the taxpayer would realize a terminal loss that could be deducted from rental income.
Capital Cost Allowance
Rental property consists of one or more classes of depreciable property, including various types of buildings, equipment used to maintain the rental property, and in the case of furnished rental units, furniture, and appliances. Whenever a taxpayer acquires depreciable property for the purpose of earning business or property income, including rental income, he or she cannot deduct the full purchase price from that income in the year of purchase. Instead, the taxpayer can only deduct the cost over a period of time by claiming capital cost allowance. For now, it is enough for you to know that CCA can be deducted from rental income. Refer to IT-79R3, Capital cost allowance – Buildings and other structures, for more detailed information.
Restrictions on Claiming CCA for Rental Properties
There are several restrictions that may limit the deduction of CCA from rental income, the most important one being that a taxpayer cannot use CCA to create or increase a rental loss. The Income Tax Act restricts the amount of CCA that a taxpayer can claim on rental properties to the amount that would reduce his or her net rental income from all rental properties to $0 (ITR 1100(11)). Sabbir owns a duplex in Winnipeg. He collected rents of $5,520 and incurred deductible expenses of $1,955. Therefore, he cannot claim capital cost allowance in excess of $3,565, calculated as (rents - deductible expenses) or ($5,520 - $1,955). Francine owns a building from which she collected $8,940 in rent. She incurred $9,112 in deductible expenses. Francine will not be able to claim any capital cost allowance because she already has a rental loss. More than one class of rental properties If a taxpayer has more than one class of rental properties, the CCA restriction is not applied to the individual properties or even the individual class of rental properties, but rather to the total CCA that may be claimed against all of the taxpayer’s rental properties. The entire CCA claim for all properties must not exceed the total of the rental income from all properties less the total of rental losses from all properties (ITR 1100(11)).
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Income Tax Planning Trong owns two apartment buildings in Vancouver. His rental operations may be summarized as follows:
Trong may only claim capital cost allowance to a maximum of $1,800 which is his net combined rental income, calculated as (net rental income building 1 - net rental loss building 2) or ($2,600 - $800). Refer to IT-195R4, Rental Property – Capital Cost Allowance Restrictions, for additional information.
Exercise: Adjustments to Net Rental Income
Net Rental Income after Adjustments
The taxpayer’s net rental income or loss is calculated on the Statement of Real Estate Rentals as: 1. 2. 3. 4. 5. the individual’s share of net income (loss) before adjustments minus any expenses related to the individual’s ownership in the case of co-ownership plus any recaptured CCA minus any terminal losses minus CCA claimed
Renting out Part of One's Principal Residence
If a taxpayer rents out part of the building where he or she lives, a deduction can be made for 100% of all current expenses that relate to the rented part, plus a portion of current expenses that relate to the whole building. The latter portion is determined as a reasonable percentage of the whole building. It may be calculated on the basis of the number of rooms or the square footage. When Belinda and Michael first bought their 3,200 square foot home, they rented out the basement apartment, which was 800 square feet, to help make their mortgage payments. They were able to deduct 25%, calculated as (rented area ÷ total area of house) or (800 ÷ 3,200) of current expenses that related to the entire house (e.g., property taxes, insurance, utilities), plus 100% of any current expenses that related solely to the rental unit (e.g., an extra cable TV connection, if it is provided along with the rental). Note: While a taxpayer who rents out a portion of his or her home may claim CCA on the rented portion and thereby reduce net rental income, by doing so he or she may impair use
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Taxation of Property Income of the principal residence exemption. Also, if he or she sells the house or simply ceases renting out part of the house, all or part of the CCA claimed may be recaptured, and a capital gain or loss may arise. For these reasons, you may not wish to claim CCA when you rent out part of your house.
Rental Losses
If a taxpayer has a rental loss, he or she can deduct that loss from other sources of income, thereby reducing personal tax liability. Fiona owns a duplex, and she lives in one unit and rents out the other for $300 per month. After deducting her current expenses of $4,800, excluding CCA, Fiona had a rental loss of $1,200, calculated as ((monthly rent x number of months rented) - current expenses) or (($300 × 12) - $4,800). Fiona's only other source of income is her employment earnings of $48,000. She can use the rental loss to reduce her total income to $46,800, calculated as (other income - rental loss) or ($48,000 - $1,200). In order to be able to use a rental loss to offset other income, the taxpayer must have had a profit motive when renting out the property. While it is quite common for parents to charge adult children who still live at home rent to help meet living expenses, this is usually done without a profit motive. As a result, the taxpayer would not be able to claim a rental loss resulting from this activity, but also would not have to record the rent in his or her income. Instead of being a true rental arrangement, these family rentals are simply cost sharing arrangements.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Rental Income. In this lesson, you have learned how to do the following: • identify, calculate, and describe any probable tax impact given a client with rental income
If you are ready to move to the next lesson, click Capital Cost Allowance on the table of contents.
Assessment
Now that you have completed Rental Income, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Capital Cost Allowance
Welcome to Capital Cost Allowance. In this lesson, you will learn about how capital cost allowance (CCA) is calculated, including the application of the 50% rule and the available for use rule. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • identify, calculate, and describe any probable tax impact given a client with capital cost allowance
Capital Cost Allowance
When a taxpayer calculates his or her income from a business or property, the Income Tax Act allows a deduction with respect to the capital cost of a depreciable property used to earn that income (ITA 20(1)(a)). The amount that is allowed by Regulation is referred to as capital cost allowance or CCA. Capital expenditures include the cost of acquiring property used to produce income, plus the cost of making lasting or permanent improvements. Some of these capital expenditures will be for depreciable capital property and CCA may be claimed on this property. Other capital expenditures (for example, land, goodwill, or investments in stocks or bonds) do not qualify as depreciable capital property even though they are capital in nature, so CCA cannot be claimed on them. However, the Income Tax Act may permit a different deduction scheme for some types of non-depreciable capital property if they qualify as eligible capital expenditures. This will be discussed in the next section. Some capital expenditures do not qualify as either depreciable property or eligible capital expenditures (e.g. stocks or bonds or the family cottage); these are simply capital property. Throughout this lesson, we will be referring to the sample Capital Cost Allowance Schedule for Max Karowski’s rental property. Click the icon below if you would like to follow along with a copy of the Capital Cost Allowance Schedule for Max Karowski.
Calculating Capital Cost Allowance
The calculation of CCA varies depending on the type of depreciable property under consideration. Prescribed CCA classes Under Part XI of the Regulations to the Income Tax Act, depreciable property is grouped into prescribed CCA classes that are described in Schedule II of the Regulations, or by ITR 1101(1).
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Taxation of Property Income In total, there are over 40 prescribed classes, many with very detailed descriptions or exclusions. Click the icon below to view a summary of the most common classes encountered by taxpayers earning business or rental income. You may wish to print this page to refer to it.
CCA can only be claimed for depreciable property. Under the Regulations, a property is generally not considered to be depreciable property unless it fits into one of the prescribed classes. A tangible capital property that is not specifically covered in any other class may not be placed in what appears to be the most appropriate class. Instead, it must be included in class 8 of Schedule II of the Regulations, unless it is excluded by the specific exceptions noted for that class. Some of the more common types of tangible property that are specifically excluded from class 8 include: • • • • land or any part thereof or any interest therein an animal a tree, shrub, herb or similar plant a right of way (Reg. Sch. II, Cl. 8(i))
The items listed above are not considered to be depreciable property, so they are not eligible for CCA.
Prescribed CCA Rates
The maximum rate of CCA that the taxpayer can claim for each prescribed class in any one year is documented in ITR 1100(1), and it varies from 4% to 100%, depending on the class. The taxpayer is not required to claim the maximum amount or any amount in any taxation year. Jason runs a business and for the last taxation year, he would have been able to claim CCA of $32,000. However, this would leave Jason with a business loss and he does not have very much other income, so he is already in a low tax bracket. Jason decided not to claim any CCA for the last taxation year because he would rather be able to claim a larger amount in the future, once his business becomes successful and he has a greater need to reduce his tax liability. If a taxation year is less than 12 months, the CCA rate is prorated to account for the difference between a full fiscal year and the taxation year. If property is acquired in a taxation year that is shorter than a full fiscal period, the prorating rules apply to limit the CCA deduction.
CCA vs. Depreciation Expense
Capital cost allowance is a tax concept designed to provide tax relief by permitting a deduction that in part recognizes the wear or obsolescence of property over time. The amount of the permitted deduction may or may not reflect the true wear and tear on that property during the year, depending on the CCA rate permitted for that property. If the government is trying to stimulate economic development in a certain area, it might increase
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Income Tax Planning the maximum CCA rate for property commonly used by the sector or introduce additional allowances to allow businesses an opportunity to seek greater tax relief. The federal government was worried about the financial impact that the Year 2000 phenomenon might have on small businesses. The Department of Finance issued a special release (Release No. 98-057) on June 11, 1998, announcing that small- and medium-sized firms would be eligible for accelerated CCA of up to $50,000 for computer hardware and software acquired to replace systems that were not year 2000 compliant. As a result, businesses were able to deduct 100% of such eligible assets in the year of acquisition, if acquired between January 1, 1998 and October 31, 1999 (ITR 1100(1zg and 1zh)). In this way, the government has targeted tax relief for small- and medium-sized businesses. In contrast, depreciation is an accounting concept that is designed to take into account the true economic decrease in the value of property over time as a result of wear or obsolescence. A business might decide to claim the maximum amount of CCA to minimize its current tax liability. However, it might record a different amount as the depreciation expense on the company’s income statement, such that the balance sheet shows a value for the assets owned by the company at a particular point in time that is different from the UCC. In brief, CCA is a tax concept and the amount claimed may or may not be a true reflection of the wear and tear of a property during the year. George Swann Inc. has 10 photocopiers, purchased one year ago at $1,200 each.
The maximum CCA that can be claimed for Class 8: [($1,200 x 10) x 20%] = $2,400. On the other hand, depreciation is an accounting concept that provides a true reflection of the decrease in economic value of a property due to wear and tear. Depreciation equals the actual depreciation of the photocopiers. In the first year this may only work out to 15%. In this case, the company will record $1,800 calculated as [($1,200 x 10) x 15%] as an expense on its income statement.
The Diminishing Balance Basis vs. the Straight-line Basis
Two different methods of calculating CCA are available: • • diminishing balance basis the straight-line method
In most cases, CCA is calculated on a diminishing balance basis, which means that the maximum CCA rate is applied to the undepreciated capital cost (UCC) of the class at yearend. The classes to which the diminishing balance apply and the corresponding rates are prescribed by ITR 1100(1)(a).
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Taxation of Property Income
In the case of some types of property, the Income Tax Act may require CCA to be calculated using the straight-line method, in which case the maximum CCA rate is a fixed percentage of the original capital cost of the assets in the class, up to the remaining UCC in the class (ITR 1100(1)(b) through 1100(1)(zh)). Depending on the prescribed class, the CCA may also be limited by Regulation by the taxpayer’s income for the year from the property in question.
Exercise: Capital Cost Allowance
Undepreciated Capital Cost
In general terms, undepreciated capital cost (UCC) is calculated as: 1. the total capital cost of all the property in the class (whether or not it is still owned at year-end) minus 2. the total CCA claimed in that class for all previous years minus 3. the total of the lesser of net proceeds and capital costs from dispositions before that time of property included in the class Pratik runs a lawn care maintenance business and he has various pieces of equipment in class 8 with a total capital cost of $14,000. He has had all of this equipment for several years, during which time he had previously claimed CCA of $3,200. He also sold one of his pieces of equipment, which had a cost of $4,000, for $2,600. Pratik’s unadjusted UCC for his class 8 assets is $8,200, calculated as (total capital cost - previously claimed CCA - proceeds of sale) or ($14,000 - $3,200 - $2,600). There are special adjustments made for property acquired during the year, discussed later under the 50% rule.
Capital Cost of Property
In the context of CCA, the capital cost of property generally means the full cost to the taxpayer of acquiring the property, including legal, accounting, engineering or other fees incurred to acquire the property. If the taxpayer manufactured equipment for his or her own use, the capital cost includes material, labour and overhead costs reasonably attributed to the property, but nothing for any profit that might have been earned if the asset had been sold. Martin started up a metal working shop. He paid land transfer tax on the purchase of the building of $4,000 and he incurred legal fees of $2,000 during the purchase. The purchase price of the building was $260,000. The capital cost of the property for CCA purposes is $266,000, calculated as (purchase price + legal fees + land transfer tax) or ($260,000 + $2,000 + $4,000).
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Income Tax Planning One piece of equipment that Martin wanted was not readily available, so he purchased a standard unit for $4,200 and modified it to suit his needs. The modifications required additional supplies of $300, labour valued at a total of $1,200 and estimated overhead costs of $200. Martin believes he could easily sell the modified unit for $9,000. However, the capital cost of this piece of equipment for CCA purposes is only $5,900, calculated as (purchase price + parts costs + labour costs + overhead costs) or ($4,200 + $300 + $1,200 + $200). While the capital cost of property generally refers to the taxpayer’s acquisition cost, there are some adjustments that are made from time to time.
Capitalized Interest Costs and Soft Costs
When a taxpayer borrows money to acquire a depreciable asset, he or she may elect to add the interest costs to the capital cost of the asset rather than claiming a deduction for the interest expense in the year incurred (ITA 21(1)). Refer to IT-121R3, Election to capitalize cost of borrowed money, for more information on this subject. Soft costs By virtue of ITA 18(3.1) to ITA 18(3.7), the capital cost of a building may include soft costs related to a period of renovation, construction or alteration to the extent these costs were not deductible in calculating income. Refer to IT-285R2, Capital cost allowance – General comments, for more information on determining the capital cost of property.
Limits on Passenger Vehicles
If an individual uses a passenger vehicle to earn income from a business or from property, the Income Tax Act limits the amount of CCA that can be claimed for that vehicle (ITA 13(7)(g) and ITR 7307(1)). Vehicles acquired for more than the prescribed threshold amount are placed in class 10.1 at a capital cost equal to the prescribed threshold amount, with a maximum CCA rate of 30% (ITR 1100(1)(a)(x.1)). As a result, these vehicles are referred to as class 10.1 passenger vehicles. The prescribed threshold amount depends upon the date of acquisition, as follows: Automobile acquired on or after January 1, 1991 January 1, 1997 January 1, 1998 January 1, 2000 January 1, 2001 and later years Threshold amount
$24,000 $25,000 $26,000 $27,000 $30,000
+ + + + +
(PST (PST (PST (PST (PST
+ + + + +
GST GST GST GST GST
payable payable payable payable payable
on on on on on
$24,000) $25,000) $26,000) $27,000) $30,000)
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Taxation of Property Income The capital cost recorded in class 10.1 is net of any GST input tax credits. This can get complicated if the car is not used solely for business purposes. As long as the car is used 90% or more for business purposes, the GST input tax credit will offset the GST paid. Rob is self-employed and his business requires extensive travel. This year, he purchased a new luxury sedan solely for business purposes at a cost of $35,000 + 8% PST and 5% GST. Rob's new car will fall into class 10.1 at a capital cost of $32,400, calculated as [(the lesser of (actual cost and threshold)) x (1 + PST)) or [(the lesser of ($35,000 and $30,000)) × (1 + 8%)]. Refer to IT-521R, Motor Vehicle Expenses Claimed by Self-employed Individuals, for additional information.
Available for Use: Rental Buildings
A taxpayer can only add property to a CCA class and thus claim CCA on that property when it becomes available for use (ITA 13(26)). The date when it is deemed to be available for use varies with the type of property and is set out in the Income Tax Act (ITA 13(27) to 13(30)). If the property is a rental building, it is normally available for use when purchased, as long as it can be used immediately as a rental building. If it cannot be used for this purpose immediately, it is considered to be available for use on the earliest of: • • • the date the taxpayer rents out all or substantially all of the building (CRA normally considers a 90% occupancy rate to be substantially all) the second year after the year the taxpayer acquires the building the time immediately before the taxpayer disposes of the building
Available for Use: Buildings Under Construction or Renovation
If the building is under construction, renovation or alteration, it is considered to be available for use at the earliest of the three times mentioned above or the date the construction, renovation or alteration is completed (ITA 13(28)). Note: A taxpayer may still be able to claim CCA on a building that is under construction, renovation or alteration before it becomes available for use, but only to the extent that the taxpayer has net rental income from that building after having deducted any soft costs related to the work in progress (ITA 20(28) and 20(29)). According to the guidelines set out above, Max Karowski’s building was not available for use until the end of last year. However, Max had net rental income of $19,000 last year after accounting for the soft costs. So, Max could still claim some CCA on the building and furnishings, but only to the extent that it reduced his net rental income after adjustments to zero.
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Income Tax Planning
Available for Use: Property Other than Buildings
If the property is something other than a building, it is considered to be available for use on the earliest of: • • • • • the the the the the date the property is delivered and it is capable of being used date the taxpayer first uses it to earn income date all licenses and permits are received for a motor vehicle or aircraft second year after the year that the taxpayer acquires the property time immediately before the taxpayer disposes of the property
The fact that the property will be considered to be available for use no later than the second year after the year that the taxpayer acquires the property is sometimes referred to as the two-year rolling start rule. For long-term construction projects, the two-year rolling start rule effectively permits a partial deduction for construction costs starting in the third year of the project, even if the job has not been completed in the meantime.
Exercise: UCC, Capital Cost of Property & Available for Use
The 50% Rule
If a taxpayer acquires depreciable capital property during the taxation year, he or she can usually claim only one-half of the net additions to a CCA class for that year (ITR 1100(2)). Net additions are calculated as the capital cost of all new additions, minus the proceeds of any dispositions from that same class. When filling out the capital cost allowance schedule, the full cost of net additions is added to the UCC at the beginning of the year to arrive at the unadjusted UCC. The adjusted UCC is then calculated as the UCC at the beginning of the year plus 50% of net additions during the year. This is known as the 50% rule. The CCA rates are applied to the adjusted UCC, and the result (i.e., adjusted UCC × CCA rate claimed) is then subtracted from the unadjusted UCC to arrive at the UCC at the beginning of the following year. Refer back to the rental building owned by Max Karowski and his capital cost allowance schedule. Max bought new appliances for five of the rental units at a cost of $7,800 this year. He already had an undepreciated capital cost in class 8 (furniture and appliances) of $22,000 at the start of the year. He sold the old appliances from those units for a total of $1,000, for net additions of $6,800, calculated as (cost of new appliance - less proceeds on sale of old appliances) or ($7,800 - $1,000). The maximum CCA rate for class 8 is 20%. So, the total CCA that Max can claim this year is $5,080, calculated as (CCA rate for Class 8 x (UCC at beginning of year + (net additions ÷ 2))) or (20% × ($22,000 + ($6,800 ÷ 2)).
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6-23
Taxation of Property Income Max also claimed CCA of $32,800 on the building, calculated as (UCC of building at beginning of year x CCA rate for building) or ($820,000 × 4%). Therefore, the total CCA he claimed this year was $37,880, calculated as (CCA on building + CCA on appliances) or ($32,800 + $5,080). Note: For purposes of this rule specifically, there is no advantage or disadvantage as to the timing of a purchase and therefore, it is not really an issue of strategy or planning. The cumulative cost of purchases throughout the year is adjusted for cumulative dispositions and then 50% of the net additions are added to the UCC at the beginning of the year. If property is acquired in a taxation year that is shorter than a full fiscal period, both the 50% rule and the prorating rules apply to limit the CCA deduction.
How the Rules Interact
If property cannot be added to a CCA class one year because it does not meet the available for use rules, but it becomes available for use in a subsequent year, the 50% rule generally still applies to the year in which the property becomes available for use. At the beginning of last year, Don acquired a rental property and he spent the rest of the year fixing it up. During this time, the property remained vacant. Since it was not available for use until this year, Don could not claim any CCA last year. Furthermore, because he could not add the building to a CCA class until this year, the CCA that he can claim on that property will be limited by the 50% rule. An exception to this rule occurs if the property becomes available for use because of the two-year rolling start rule. In this situation only, the 50% rule does not apply in the year that the property is deemed to become available for use. Refer to IT-285R, Capital Cost Allowance - General Comments, for additional information on the 50% rule.
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Capital Cost Allowance. In this lesson, you have learned how to do the following: • identify, calculate, and describe any probable tax impact given a client with capital cost allowance
If you are ready to move to the next lesson, click Disposing of Depreciable Property on the table of contents.
Assessment
Now that you have completed Capital Cost Allowance, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Property Income
Lesson 4: Disposing of Depreciable Property
Welcome to Disposing of Depreciable Property. In this lesson, you will learn about the probable tax impact for a client who disposes of depreciable property. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • identify, calculate, and describe any probable tax impact given a client who disposes of depreciable property
Disposing of Depreciable Property
An actual disposition of depreciable property includes any transaction or event entitling the taxpayer to receive proceeds of disposition, whether those proceeds are payable in cash, in kind or in services. We will first discuss how actual dispositions of depreciable property can result in a recapture of CCA or a terminal loss in general terms, before we look at the special circumstances for deemed dispositions of depreciable property. When a taxpayer disposes of depreciable property, it is necessary to determine the capital cost, the undepreciated capital cost (UCC) and the net proceeds of disposition, because all of these are factors in determining the tax implications of the disposition. Capital cost is also referred to as adjusted cost base (ACB).
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Income Tax Planning
Recaptured CCA
Whenever a taxpayer disposes of depreciable property in a class, the UCC of that class changes in the formula: UCC after disposition = (UCC before disposition - lesser of (net proceeds and capital cost)). Neil owns a computer that is the only property in its class with a capital cost of $3,000 and a UCC at the beginning of the year of $800. He sold the machine this year for $1,200. Neil’s UCC at the end of the taxation year will be -$400, calculated as (UCC before disposition - (the lesser of (net proceeds and capital cost))) or ($800 – (the lesser of ($1,200 and $3,000)). Toni owns a rental property that she originally acquired for $280,000, with $200,000 of the cost attributed to the building and $80,000 to the land. Her UCC for the building at the beginning of this year was $184,320. This year, she sold the property for $326,000, with $226,000 allocated to the building and $100,000 to the land. She incurred selling expenses of $6,000 for the building and $2,000 for the land. The proceeds of disposition for the building are $220,000, calculated as (sale proceeds costs of disposition) or ($226,000 - $6,000). Her UCC after the disposition was -$15,680, calculated as (UCC before disposition - (the lesser of (net proceeds and capital cost)) or ($184,320 - (the lesser of ($220,000 and $200,000))). There will also be a capital gain on the building. Because the land is not a depreciable capital property, there is no potential for a recapture to be realized upon its disposition. Instead, Toni will realize a capital gain upon the sale of the land.
Recapture when UCC is Negative
If the UCC of a class of assets is negative as of the end of a taxation year, the amount must be included in the taxpayer’s income for the year as a recapture of CCA (ITA 13(1)). In the previous examples, Neil had a recapture of $400 that must be included in his income; while Toni had a recapture of $15,680 that must be included in her income. This occurs when the net proceeds of a property disposed of in the current taxation year exceed the UCC of its class as of the end of the preceding year.
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Taxation of Property Income
Example: Karen Lyons, Part 1
Karen is a financial planner. She has operated an independent practice for four years. In her first two years of business, she purchased items that fell into CCA class 8 as per the following table: Year Acquired years ago years ago years ago years ago Item Furniture Rugs Phone System Photocopier Capital Cost $2,000 $700 $400 $800
4 4 4 2
Last year, Karen sold the photocopier for $600. The next table has a summary of her CCA claims from four years ago through last year. Note: Because the proceeds of disposition exceed the cost of any additions to the class during the year, there is no need to make a further adjustment to arrive at the reduced UCC; Column E for last year is $0. Karen’s CCA Claims to Last Year C D E F (A + Greater (D - E) B– of $0 C) and (50% × (B – C))
A
B
G
H (F × G)
I (D – H)
4 years ago 3 years ago 2 years ago last year
0 3,100
0 3,100
1,550 1,550
20%
310
2,790
2,790
0
0 2,790
0 2,790
20%
558
2,232
2,232
800
0 3,032
400 2,632
20%
526
2,506
2,506
0
600 1,906
0 1,906
20%
381
1,525
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Income Tax Planning
Example: Karen Lyons, Part 2
Karen's financial planning practice has been extremely successful and later in this current fiscal year, she intends to move to a larger office and to furnish her new office at the same time. Assume she sells her old furniture and rugs for $2,400. If this ends up being her only transaction during the year in class 8, it would leave her with a negative balance and Karen would have a recapture of $875, as shown in the table. Karen’s CCA Claims For Last Year and This Year C D E F G H (A + Greater (D - E) (F × G) B– of $0 C) and (50% × (B – C))
A
B
I (D – H)
last 2,506 year this 1,525 year
0
600 1,906
0 0
1,906 20% -875 20%
381 0
1,525 -875
0 2,400 -875
Recapture can result from a property disposition whether or not other property remains in the class at the end of year. Karen still has her phone system. However, based on her transactions so far, she will incur a recapture of $875 and this amount must be added to her income for the current fiscal year. This recapture can be avoided, however, if depreciable property of the same class is acquired before the end of the fiscal year for an amount that is at least equal to the recaptured depreciation. The recapture is avoided because at the end of the fiscal year the balance in the class will have become positive again.
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Taxation of Property Income
Example: Karen Lyons, Part 3
Because Karen's business has been doing well, she decides to treat herself to better furniture at a cost of $5,000. By acquiring this new class 8 property, she will avoid the recapture. In fact, she will be able to make a CCA claim based on the reduced UCC at the end of the year. Both items are shown in the following table: Karen’s CCA Claims For Last Year and This Year C D E F G H I (A + Greater (D - E) (F × G) (D – H) B– of $0 C) and (50% × (B – C))
A
B
last 2,506 600 1,906 year this 1,525 5,000 2,400 4,125 year
0 1,300
1,906 20% 2,825 20%
381 565
1,525 3,560
Exercise: Disposing of Depreciable Property
Exercise: Acquiring Depreciable Property
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Income Tax Planning
Separate Classes for Rental Properties over $50,000
The Income Tax Act requires the taxpayer to record each rental property that he or she acquired after 1971 at a cost of $50,000 or more in a separate class for CCA purposes (ITR 1101(1ac)). The main objective of this rule is to force the recapture of CCA immediately upon the disposition of an individual building. Any new acquisition of an identical type of asset during the year does not defer taxation of the recapture because the asset acquired must also be included in a separate class.
Terminal Loss
A taxpayer may dispose of the last asset in a particular CCA class and the resulting balance in the class is still positive even after reducing it by the lesser of cost or proceeds. If this occurs, the taxpayer can deduct the remaining balance from his or her income as a terminal loss (ITA 20(16)). If there are assets remaining in the class at the end of the taxation year, the taxpayer will continue to apply the applicable rate of CCA on the balance. Suzanne, a graphic designer with her own practice, owns several older model computers. Last year, she decided to sell her existing computers and lease new ones. She purchased the computers three years ago for $8,000 and the UCC for her class 45 assets before the transaction was $4,200. She sold the old computers for $1,600, which left her with no other assets in class 45. Her UCC at the end of the year for class 45 would be $2,600, calculated as [UCC before disposition - (the lesser of (net proceeds and capital cost))] or [$4,200 - the lesser of ($1,600 and $8,000)]. Because she has a positive balance in class 45, but no class 45 assets, Suzanne can claim a terminal loss of $2,600 on her tax return for last year. Even when the proceeds of a disposition are lower than the original cost of a depreciable asset, the taxpayer does not claim a capital loss on the transaction. Instead, the taxpayer can claim a terminal loss. The disposition of depreciable capital property can never give rise to a capital loss.
Rationale Behind Recaptures and Terminal Losses
The Income Tax Act specifies a maximum rate of CCA that may be claimed for a depreciable asset included in a particular class. Each year, the taxpayer is entitled to claim up to the maximum amount of CCA available and the UCC of the class is reduced by that amount. If an asset is disposed of and a negative balance in the class results, it simply means that the taxpayer has claimed capital cost allowances that amount to more than the actual decline in the value of the asset. Thus, the excess amount of the CCA claimed is added back to income as recaptured income. On the other hand, a terminal loss means that the asset has depreciated in value faster than has been accounted for via the CCA system. The taxpayer is then entitled to deduct the amount of the excess of the decline in value of the asset over the CCA claimed as a terminal loss.
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6-31
Taxation of Property Income
Exercise: Terminal Losses
Exercise: Recapture and Terminal Loss
Deemed Dispositions
An actual disposition occurs when a taxpayer sells his or her depreciable property. However, the Income Tax Act recognizes a deemed disposition to have occurred for tax purposes in several circumstances, even if an actual purchase or sale did not take place. The circumstances that can give rise to a deemed disposition are: • • • • death certain inter vivos transfers, including a gift, charitable donation or transfer to a trust involuntary destruction or loss (for example, through theft or fire) when the use of the property changes
Each circumstance is discussed on the following pages.
Death
The proceeds of the deemed disposition of depreciable property upon death are deemed to be equal to the fair market value (FMV) of the property immediately prior to death. The deemed disposition upon death may result in either a recapture or terminal loss, depending on the UCC of the depreciable property. The applicable amount will be added or deducted when computing the deceased’s income on his or her final return. No CCA can be claimed in the year of the taxpayer’s death because the taxpayer is deemed to have disposed of all of his or her capital property immediately prior to death (ITA 70(5) and 70(6)).
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Income Tax Planning
Inter Vivos Transfers of Property and Exchanges of Property
An inter vivos transfer is any transfer of property that occurs while the transferor is still alive. However, the Income Tax Act provides: • • • the opportunity for a rollover to a spouse, common-law partner or spousal trust (ITA 73(1)) the opportunity for a rollover of depreciable farm property to a child or grandchild (ITA 73(3)) a deemed disposition at FMV in all other cases, which can give rise to a terminal loss or recapture (ITA 69(1))
Exchanges of Property The Income Tax Act allows for a deferral of all or part of the recapture of CCA upon disposition in two situations where the disposition is in fact part of an exchange of similar depreciable properties (ITA 13(4)). These two situations are: • • the exchange of former business properties the involuntary disposition of a depreciable property
Converting Income-producing Property into Non-income Producing Property
The Income Tax Act deals with situations in which a depreciable asset used for the purpose of producing income is used for some other purposes (e.g., a business asset is used for personal use (ITA 13(7))). When income-producing property is used for a non-income producing purpose, the Act provides that the property is deemed to have been disposed of at that time for its fair market value and immediately reacquired for that same amount. This deemed disposition could result in a recapture or terminal loss. When Sandy's brother died over ten years ago, Sandy inherited his house in New Brunswick. Because Sandy lived in Alberta at the time, she had no use for the house and decided to rent it out. She originally acquired the house at a capital cost of $140,000 and the current UCC is $98,000. Sandy is about to change jobs and she plans to move to New Brunswick and make the house her principal residence. The current FMV for the house is $144,000. As a result of the change in use, Sandy will incur a recapture of $42,000, calculated as (UCC before disposition - (the lesser of (net proceeds and capital cost))) or ($98,000 – (the lesser of ($144,000 and $140,000)). She will also realize a capital gain of $4,000, calculated as (net proceeds - capital cost) or ($144,000 - $140,000). This deemed disposition does not occur when there is simply a change in the type of income a property generates. Also, when a taxpayer ceases to use the property to earn income but keeps the property for a period of time without using it, he or she will not be deemed to have disposed of the property until such time as it begins to be used for another purpose.
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Taxation of Property Income
Converting Non-income producing Property into Income Producing Property
If the use of a property is changed from non-income to income-producing, the Income Tax Act also deems a disposition to have occurred (ITA 13(7)). When the property was nonincome producing, it would not have been eligible for CCA and so there is no potential for a terminal loss or recapture upon its deemed disposition. However, the deemed disposition could result in a capital gain or loss. Also, the deemed disposition affects the capital cost of the new income producing property for subsequent CCA purposes. When this conversion takes place, the taxpayer is deemed to have disposed of the property and immediately reacquired it. The cost of reacquisition is generally determined as follows: • • If the FMV is less than the original cost of the property, then the capital cost is deemed to be the FMV. If the current FMV is greater than the original cost, the deemed capital cost of the property at the time of its change of use will be increased to the aggregate of the original cost, plus the taxable portion of any capital gain resulting from the deemed disposition (ITA 13(7)(b)).
Gordon owns a cottage with a FMV of $132,000. He acquired it four years ago for $114,000. Because he is moving out of the province, he has decided to rent the property. This change of use will result in a deemed disposition and a capital gain of $18,000, calculated as (FMV at time of deemed disposition - original cost) or ($132,000 - $114,000). Only 50% of the capital gain is taxable. Once Gordon begins receiving rental income, he will be able to claim CCA based on a capital cost of $123,000, calculated as (original cost + taxable portion of capital gain) or ($114,000 + (50% × $18,000)). The rules get more complex if there is only a partial conversion (for example, he rents out only a portion of the property), but these rules are beyond the scope of this course. No-change-of-use election The deemed disposition can be avoided by electing that there has been no change of use (ITA 45(2)). If a taxpayer files such an election, the property is deemed to continue to be used for a non-income producing purpose; however, the taxpayer cannot claim any CCA. The resulting income is still taxable.
Exercise: Deemed Dispositions
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Disposing of Depreciable Property. In this lesson, you have learned how to do the following: • identify, calculate, and describe any probable tax impact given a client who disposes of depreciable property
If you are ready to move to the next lesson, click Other Deductions from Business and Property Income on the table of contents.
Assessment
Now that you have completed Disposing of Depreciable Property, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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6-35
Taxation of Property Income
Lesson 5: Other Deductions from Business and Property Income
Welcome to Other Deductions from Business and Property Income. In this lesson, you will learn about eligible capital expenditures that can serve as deductions as well as how much of an eligible capital expenditure can be deducted in any given year. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • identify eligible capital expenditures that can serve as deductions calculate how much of an eligible capital expenditure can be deducted in any given year
Eligible Capital Expenditures
A business may incur certain expenses, such as the purchase cost of a pizza franchise, that are not considered to be either current expenses or capital expenditures and consequently, they are not deductible from current income either as a current expense or through CCA. However, the Income Tax Act still provides some relief if the expense qualifies as an eligible capital expenditure. Eligible capital expenditures (or EC expenditures) can be broadly described as expenditures for intangible capital property (also called eligible capital property or EC property), such as goodwill and other nothings, the cost of which neither qualifies for capital cost allowance nor is deductible in the year of its acquisition as a current expense. A more specific and lengthy definition is provided in the Income Tax Act (ITA 14(5)). Despite the fact they cannot be deducted as a current expense or through CCA, EC expenditures receive special treatment under the Income Tax Act. Common EC expenditures are: • • • • • the cost of a franchise, right or licence for an indefinite period goodwill, which is the value of a business in excess of the fair market value of the net business assets incorporation, reorganization and amalgamation costs certain legal expenses, such as incorporation costs customer lists
For a more detailed discussion of what constitutes an eligible capital expenditure, refer to IT-143R2, Meaning of Eligible Capital Expenditure.
How an Eligible Capital Expenditure translates into a Deduction
When a taxpayer makes an eligible capital expenditure (ECE), 3/4 or 75% of this expenditure is added to a notional pool, called the cumulative eligible capital account or EC pool. For the purpose of adding eligible capital expenditures to the EC pool, the inclusion rate remains at 75%, even though the capital gains inclusion rate has dropped to 50%. The taxpayer can make a deduction from business income of up to 7% of any positive balance in the EC pool at the end of the year (ITA 20(1)(b)).
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Income Tax Planning George recently incorporated his business. He paid $225 to his provincial government as an incorporation fee, plus $500 to his lawyer. His total incorporation expense is $725, calculated as (incorporation fee + legal fee) or ($225 + $500). These expenses qualify as an eligible capital expenditure. George can credit $543.75 to his cumulative eligible capital account, calculated as (inclusion rate of 75% x eligible capital expenditure) or (75% x $725). This is the only amount in his EC pool at this time. In the first year, his corporation can deduct $38.06 from its business income, calculated as (rate of 7% x cumulative eligible capital account) or (7% x $543.75). The balance in the EC pool will be reduced to $505.69, calculated as (EC pool - ECE deduction) or ($543.75 - $38.06). In the second year, the corporation can deduct $35.40 from its business income, calculated as (rate of 7% x cumulative eligible capital account) or (7% x $505.69), and the balance in the EC pool will be reduced to $470.29, calculated as (EC pool - ECE deduction) or ($505.69 - $35.40). The corporation can continue to deduct a maximum of 7% of the declining balance each year until the EC pool reaches $0.
Dispositions of Eligible Capital Property
When a taxpayer disposes of an eligible capital property, it will result in an eligible capital amount or EC amount, which must be deducted from the EC pool. The EC amount is calculated as 75% of the excess of the proceeds of disposition over the costs associated with that disposition. This EC amount results in recapture of the deduction from the EC pool. The amount of recapture is taxable income. Henry disposed of a customer list, which is an eligible capital property, for proceeds of $120,000. He incurred costs of $4,000 for the disposition. His EC amount is $87,000, calculated as ((proceeds - costs of disposition) x inclusion rate) or (($120,000 - $4,000) × 75%). Before the sale, Henry had an EC pool balance of $15,000, and had deducted $6,000 from his EC pool. Henry must report recapture of $6,000 as taxable income. He will have an EC pool balance of -$66,000, calculated as ((his EC pool balance + recapture) - his EC amount) or (($15,000 + $6,000) - $87,000). Dispositions of eligible capital property include: • • • • the the the the sale of a franchise or license for an unlimited time sale of goodwill in connection with a business outright sale of a process sale of certain rights
Refer to IT-386R, Eligible capital amounts, for more information on which types of transactions would give rise to an eligible capital amount. Negative EC pool balance When the balance of an EC pool becomes negative following a disposition and remains negative at the end of the taxation year, a portion of the remaining amount must be included in the taxpayer’s business income (ITA 14(1)), similar to the tax treatment of recaptured depreciation.
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Taxation of Property Income If a taxpayer disposes of EC property such that the balance becomes negative at the end of the taxation year, 2/3 of the negative balance and the recapture amount are added into business income (ITA 14(1)). The factor of 2/3 ensures that only 50% of the gains on eligible capital property are included in income, calculated as (75% × 2/3). In this way, the system for taxing eligible capital property mirrors the taxation of capital gains. Practice Inc. had an EC pool balance of $10,000, and had deducted a total of $6,000 from the EC pool. Practice Inc. developed a new formula for a food seasoning mix, and it sold that formula and all rights to its use for net proceeds of $30,000. The formula and the associated rights constitute eligible capital property. This is the only transaction involving eligible capital property for the year. Practice Inc. will have recapture of the $6,000 deducted from the pool. The EC pool balance at the end of the year will be -$6,500, calculated as ((EC pool balance + recapture) - EC amount) or (($10,000 + $6,000) – (75% × $30,000)). Practice Inc. will have to include $10,333.33 in its income for the year, calculated as (recapture + taxable gain on eligible capital property) or ($6,000 + ($6,500 × 2/3)). Ceasing to carry on a business When a taxpayer ceases to carry on a business and has disposed of all eligible capital property, he or she may deduct any remaining positive balance of the cumulative eligible capital account for that business (ITA 24(1)). This is similar to the terminal loss rules in respect of depreciable property. Refer to IT-313R2, Eligible Capital Property – Rules Where a Taxpayer has Ceased Carrying on a Business or has Died, for further information.
Exercise: Eligible Capital Expenditures, Part 1
Exercise: Eligible Capital Expenditures, Part 2
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Income Tax Planning
Interest Expense
In certain situations, a taxpayer may be able to deduct his or her interest expense from taxable income, or he or she may be able to claim a tax credit on certain types of interest expenses. These situations include the following: • • loans used to earn business or property income interest on Canada student loans
Each situation is discussed on the following pages.
Loans used to Earn Business or Property Income
In general, the Income Tax Act allows a taxpayer to deduct the interest on loans that were used for the purpose of earning business or property income, as long as the taxpayer had a legal obligation to pay the interest (ITA 20(1)(c)). Phillip purchased a building for the purpose of earning rental income. He has a mortgage on the building and incurred interest expenses of $6,500 last year. He can deduct $6,500 on his Statement of Real Estate Rentals. Tanya borrowed $10,000 to invest in a portfolio of bonds, and she incurred an interest expense of $800 last year. She can deduct that interest expense on her Statement of Investment Income. Kyle borrowed $5,000 to invest in common shares with the objective of earning dividend income. He can deduct his interest expense of $400 on his Statement of Investment Income. Leanne borrowed $40,000 to help start up her business. She can deduct the interest expense of $3,600 on her Statement of Business Activities. Robert borrowed $160,000 to purchase his first home. He works outside of the home. He cannot deduct any of the interest expense related to his mortgage because the money that he borrowed is not being used to earn business or property income. It is not the collateral for the loan, but the use of the borrowed funds, that determines if the loan interest is deductible. Richard used a line of credit secured by his home equity to buy preferred shares. The interest on the home equity loan is deductible from his investment income. Brian wants to buy a new house at a cost of $200,000 and it requires a minimum downpayment of $20,000. He also needs $80,000 for the purpose of expanding his business. Brian has $100,000 in savings, but he is not sure whether he should use this amount for his downpayment on the house or whether he should invest it in the business. He figures that the rate on the business loan would be comparable to the mortgage rate of about 8%. If Brian invested the $80,000 in the business, he would not have to take out a business loan. However, he would have a mortgage of $180,000, incurring an interest expense of
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Taxation of Property Income about $14,400, calculated as (mortgage principal x interest rate) or ($180,000 × 8%). None of this interest expense would be deductible. If Brian made a downpayment of $100,000 on the house, he would have a mortgage of $100,000 incurring interest costs of $8,000, calculated as (mortgage principal x interest rate) or ($100,000 × 8%) and a business loan of $80,000, with an interest expense of $6,400, calculated as (principal of business loan x interest rate) or ($80,000 × 8%). Brian would have to pay the same amount of total interest, but he could deduct the $6,400 of interest on the business loan from his business income. Therefore, Brian should make the maximum downpayment on the house and take out a business loan to ensure as much of his interest expenses as is permissible are deductible.
Exclusions from Property Income
Capital gains The Income Tax Act excludes capital gains from the definition of property income (ITA 9(3)), so the potential capital appreciation of a property cannot be used to support an interest expense deduction under ITA 20(1)(c). Larry borrowed $50,000 to purchase a piece of land that he will likely be able to sell in the future for a substantial gain. He is not a developer and should be able to report the gain as a capital gain. However, because the land is not being used to earn business or property income, Larry cannot deduct the interest expense. As long as the investment has the potential to produce property income, the interest expense deduction will be permitted. Ben borrowed $10,000 to invest in a high-growth equity mutual fund. Although the main objective of the fund is capital appreciation, the potential exists for the fund to distribute dividend or interest income. As a result, Ben will be able to deduct the interest expense from his income. Investments within registered plans A taxpayer cannot deduct the interest expense on money borrowed for the purpose of investing within a registered plan (ITA 18(11)), including contributing to: • • • an RRSP a registered pension plan or deferred profit sharing plan a registered education savings plan (RESP)
Amanda borrowed $20,000 to make an RRSP catch-up contribution, and she will incur an interest expense of $1,500 on the loan. The RRSP funds are invested in GICs and other interest-bearing investments. The RRSP, not Amanda, is earning property income, and therefore she cannot deduct the interest expense.
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Income Tax Planning
Interest on Canada Student Loans
Taxpayers who have received student loans under a government student aid program (for example, Canada Student Loan or Ontario Student Loan) can claim a tax credit on the interest expense they incur during the year (ITA 118.62). To be eligible for the credit, the interest must have in fact been paid; it cannot be outstanding. Furthermore, only the student to whom the loan is made can claim the tax credit. A few years ago, Jody graduated from university. She is paying off her Canada Student Loan. This year, she made all required payments for the year, including principal of $2,600 and interest of $760. On this year's tax return, assuming a conversion rate of 15%, Jody can claim a federal tax credit of $114, calculated as (interest x conversion rate) or ($760 × 15%). She can also claim a provincial tax credit. If the taxpayer cannot use the tax credit during the year that the interest expense was incurred, or if he or she chooses not to claim the tax credit, the taxpayer can carry forward the unused credit and claim it in any of the following five years. This year, Alex did not have any taxable income, so he was unable to make use of the tax credit. However, he can carry the unused credit forward and use it to reduce his tax payable in any of the following five years.
Investment Counselling Fees
A taxpayer can deduct reasonable fees, other than commissions, paid for the following services: • • advice on buying or selling a share or security administration or management of the shares or securities for the taxpayer
In addition to account administration fees, the latter includes costs associated with the safekeeping of the securities (for example, the cost of a safety deposit box), and accounting fees. The fees must be paid to a person or business whose principal business is advising others to buy or sell specific investments or whose principal business includes the administration or management of shares or securities (ITA 20(1)(bb)). Fees paid for other types of financial advice, including financial counselling, financial planning, or tax planning are not deductible. Fees charged by the trustee of a registered retirement savings plan directly to the annuitant are not deductible because the shares or securities of the plan belong to the trust and not the annuitant (ITA 18(1)(u)). Refer to IT-238R2, Fees paid to investment counsel, for additional information.
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Taxation of Property Income
Exercise: Interest Expense
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Other Deductions from Business and Property Income. In this lesson, you have learned how to do the following: • • identify eligible capital expenditures that can serve as deductions calculate how much of an eligible capital expenditure can be deducted in any given year
If you are ready to move to the next lesson, click Income Attribution Rules on the table of contents.
Assessment
Now that you have completed Other Deductions from Business and Property Income, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 6: Income Attribution Rules
Welcome to Income Attribution Rules. In this lesson, you will learn about how property income and capital gains can be attributed to the taxpayer when he or she transfers property. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: • identify and calculate how property income and capital gains can be attributed to the taxpayer when he or she transfers property to a spouse or common-law partner, related minors, or certain other non-arm’s length individuals
Overview
Income splitting is the process of allocating investment or other income to the taxpayer’s spouse, common-law partner or children for tax purposes, thereby reducing the overall family tax bill. While there are still a few legitimate methods for income splitting between family members, there are also many rules in the Income Tax Act specifically designed to prevent income splitting. These rules, which are collectively called the income attribution rules, attribute income that a taxpayer would prefer to split with family members back to the taxpayer. This lesson reviews the three sets of income attribution rules as they relate to: • • • a spouse or common-law partner a related minor a non-arm’s length individual, other than a spouse, common-law partner or related minor
The income attribution rules as they apply to property income generally apply to any designated person, which is the spouse or common-law partner of the taxpayer, as well as any related minors (ITA 74.5(5)). To some extent, they also apply to other non-arm’s length parties. In most cases, capital gains are only attributed to the taxpayer in the case of transfers to a spouse, common-law partner or spousal trust, although in very limited situations they may also apply to transfers to the taxpayer’s child. In general, the rules become increasingly more stringent as the relationship with the taxpayer strengthens, moving from non-arm’s length to a related minor to a spouse or common-law partner. Note: The income attribution rules will still apply to transfers to a spouse or common-law partner at ACB, unless the transferor elects out of the automatic rollover provided for under ITA 73(1).
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Taxation of Property Income
Loans to Non-arm's Length Individual
The Income Tax Act includes rules to limit opportunities for income splitting between people who do not deal with each other at arm’s length. Attribution of property income If the taxpayer loans money or property to an individual and one of the main reasons for the loan was to reduce or avoid tax, any resulting property income is attributed to the taxpayer. This rule does not attribute property losses, capital gains or capital losses (ITA 56(4.1)). The rule applies to a taxpayer who does not deal at arm’s length with the particular individual. However, the rule does not apply to an individual who is a designated person. A designated person is the taxpayer’s spouse, common-law partner, or a related minor because there are more extensive income attribution rules for a spouse, common-law partner, or related minor. The rule applies to interest-free or low-interest loans, but not to loans for value (ITA 56(4.2)). It does not apply to transfers of property for FMV or any amount less than FMV, including gifts. Mort lives with his sister, Freda. He has an MTR of 50%; Freda has an MTR of 25%. Mort has $150,000 of tax-paid capital. He lends it to Freda at no interest, who invests it in a balanced mutual fund. One of the reasons for the loan was to reduce their total taxes. Any interest, dividends or rents are attributed to Mort. Any capital gains, capital losses or rental losses are not attributable. We will discuss the concept of loans for value a little later.
Non-arm's Length Persons
The terms, ‘arm’s length’ and ‘non-arm’s length’, are not precisely defined by the Income Tax Act. Related persons The Income Tax Act deems that related persons do not deal with each other at arm’s length (ITA 251). This is the case regardless of how they actually conduct their mutual business transactions. Related persons are individuals connected by blood, marriage or adoption. Therefore, individuals related to a taxpayer include his or her spouse or common-law partner, any of his or her direct descendants (children, grandchildren, etc.) and their spouses or common-law partners, and the taxpayer’s siblings and their spouses or commonlaw partners. However, the definition of related persons does not include nieces and nephews (ITA 251(2)). Unrelated persons Usually, unrelated persons deal with each other at arm's length; however, sometimes they do not, depending on the circumstances. Failure to carry out a transaction at fair market value may be indicative of a non-arm’s length transaction. However, such failure is not conclusive and, conversely, a transaction between unrelated persons at fair market value does not necessarily indicate an arm’s length situation.
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Income Tax Planning
The key factor in determining whether parties are dealing with each other at arm’s length is whether they have separate economic interests that reflect ordinary commercial dealings between parties acting in their separate interests. Therefore, a non-arm’s length person would include the taxpayer’s relatives (spouse, common-law partner, parents, grandparents, brothers, sisters, brothers-in-law, sisters-inlaw, children, adopted children, and grandchildren), as well as any other party with whom the taxpayer transacts, if their transactions do not reflect ordinary commercial dealings between parties acting in their separate interests. Barney and Kyle have been working together for the last five years. During that time, they have become very good friends. While Kyle will not admit it, Barney believes that Kyle has used his influence with their employer to secure Barney’s last promotion. If Barney gives Kyle an interest-free loan, they will be acting as non-arm’s length individuals. Refer to IT-419, Meaning of Arm’s Length, for further information.
Loans and Gifts to a Related Minor
For the purpose of income attribution rules, a related minor is a person who is under 18 years of age as of December 31st of the year and who: • • does not deal with the taxpayer at arm’s length (for example, a child or other descendant whether by blood or adoption) is the niece or nephew of the taxpayer (ITA 74.1(2))
Attribution of property income and property losses Property income and losses can be subject to attribution in the case of both loans and gifts to a related minor. Loans The income attribution rules for loans to a related minor are essentially the same as those for loans to a non-arm’s length party, except that: • • Gifts Because of the dependency relationship of the minor to the taxpayer, the property income attribution rules also apply to gifts. The Income Tax Act says that where a taxpayer has transferred or lent property, either, directly or indirectly, by means of a trust or by any means whatever, to or for the benefit of a related minor, any property income or property loss from the property is attributed to the taxpayer (ITA 74.1(2)). Joseph transferred a $10,000, 7% corporate bond to an inter vivos trust that names his 10-year old daughter, Tiffany, as the income beneficiary. The $700 in annual interest income, calculated as (face value x coupon) or ($10,000 x 7%) will be attributed to Joseph. they apply regardless of the reasons for the indebtedness the rules attribute both property income and property losses
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Taxation of Property Income
No Attribution of Capital Gains and Capital Losses
If a taxpayer transfers or loans property to a related minor, there is no opportunity to rollover the property as there is with transfers to a spouse or common-law partner. This means that there is usually a deemed disposition at FMV at the time of the transfer resulting in a capital gain (or loss) for the transferor, and the minor acquires the property at a cost equal to this FMV. For this reason, when the minor later sells the property, there is no attribution of capital gains or capital losses to the taxpayer. The exception to this rule is for certain farm transfers as noted in the next section. Sanwar decided to give his Newcorp shares to his 15-year-old son, Shafik. Sanwar’s ACB was $1,200 and the shares were worth $1,600 at the time of the transfer. Sanwar will realize a taxable capital gain of $200 as a result of the gift, calculated as ((deemed proceeds - ACB) x capital gains inclusion rate) or (($1,600 - $1,200) × 50%). Shafik will acquire the shares at a cost of $1,600. If Shafik later disposes of the shares for $2,400, he will realize a taxable capital gain of $400, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($2,400 - $1,600) × 50%), and this will not be attributed to Sanwar. Refer to IT-510, Transfers and loans of property made after May 1985 to a related minor, for further information about the attribution of property income.
Inter Vivos Farm Transfers to a Related Minor
If a taxpayer transfers certain farm property to a related minor for consideration less than FMV and that child disposes of the property prior to attaining the age of 18, any taxable capital gain or allowable capital loss resulting from that disposition will be attributed to the taxpayer (ITA 75.1). Refer to IT-268R3, Inter vivos transfer of farm property to a child, for further information.
Exercise: Loans to Non-arms Length Individuals
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Income Tax Planning
Loans and Gifts to a Spouse or Common-law Partner
A spouse is a person of the opposite sex who is married to the taxpayer. A common-law partner is a person of the same or opposite sex who has lived with the taxpayer in a conjugal relationship for at least 12 months, or someone who lives with the taxpayer in a conjugal relationship and with whom that taxpayer has had a child (ITA 252(4)). The Income Tax Act now treats spouses, same-sex common-law partners, and opposite-sex common-law partners in exactly the same way. The income attribution rules for loans and gifts to a spouse or common-law partner are essentially the same as those for loans and gifts to a related minor, except that: • capital gains and capital losses arising upon disposition of the property by the spouse or common-law partner are also attributed to the taxpayer
The rules apply to a person who is a taxpayer’s spouse or common-law partner at the time of the property loan or transfer, as well as a person who became the taxpayer’s spouse or common-law partner after the loan or transfer of property was made to that person. Gifts to adults, other than spouses or common-law partners, will not result in income attribution.
Attribution of Property Income and Losses and Capital Gains and Losses
The Income Tax Act essentially says that where a taxpayer has transferred or lent property either, directly or indirectly, by means of a trust or by any other means, whatever, to or for the benefit of the taxpayer’s spouse or common-law partner: • • • any property income or property loss from that property is attributed to the taxpayer (ITA 74.1) any net taxable capital gain or allowable capital loss from the disposition of the property shall be attributed to the taxpayer (ITA 74.2) any net taxable capital gain or allowable capital loss from listed personal property retains its nature when it is attributed to the taxpayer (ITA 74.2)
Sally earns substantially more than her spouse, Harry. She has an investment portfolio with an ACB of $100,000 and an FMV of $250,000. She gives it to Harry. Why capital gains are attributable on transfers to a spouse or common-law partner Any interest, dividends or rents, rental losses, business income as a specified member, business losses as a specified member, capital gains and capital losses are attributed to Sally. However, second-generation income (income on income) is taxable to Harry. Capital gains on property transferred to a spouse or common-law partner are normally attributed because the spousal rollover rule allows the transfer to take place at the ACB (for capital property) or at its UCC (for depreciable property). As a result, the recognition of any capital gains is deferred until the recipient disposes of the property (ITA 73(1)). If a taxpayer transfers or loans capital property to his or her spouse or common-law partner, any taxable capital gains or allowable capital losses arising from the eventual
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Taxation of Property Income disposition of the property by the recipient, or property substituted for it, are deemed to be the taxable capital gains or allowable capital losses of the taxpayer (ITA 74.2(1)(a) and (b)). There are a few exceptions to this income attribution rule, which will be discussed shortly. Don gave his shares in Blueblood Inc. to his wife, Helena. Don’s ACB for the Blueblood shares was $1,400, and the shares were rolled over to Helena at the same ACB. Helena kept the shares for three years and then she sold them for $5,400. Don will have a taxable capital gain of $2,000, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($5,400 - $1,400) × 50%), because the gain will be attributed to him. Refer to IT-511R, Interspousal and Certain Other Transfers and Loans of Property, for further information.
Specific Rules for a Spouse, Common-law Partner and Related Minors
The Income Tax Act includes a number of definitions and other provisions that apply to persons who are spouses, common-law partners, and related minors, but not to other nonarm’s length parties, dealing with: • • • • • • transfers of property substituted property transferred or loaned property loans and transfers to a trust repayments loan guarantees
Exercise: Attribution Rules
Provisions that Apply to all Transactions
For all three sets of income attribution rules, the following provisions apply with respect to: • • • • property income versus business income income from income or second-generation income dividend income liability for payment of tax
More information is provided on each of these.
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Income Tax Planning
Property Income vs. Business Income
The income attribution rules do not apply to active business income or losses, even if a nonarm’s length person earns that business income by using property obtained from the taxpayer. Therefore, it is important to determine whether the designated person is earning business income or property income. Rental income For the purpose of the income attribution rules, property income includes interest, dividends, rents and passive business income earned by a specified member of a partnership. Property losses include rental losses and business losses incurred by a specified member of a partnership. There are two important situations that arise frequently where this distinction may not be so readily apparent. The first is in the case of a rental operation, where the rental income may be considered to be business income, instead of property income, if the rental arrangements include the provision of services. Corrine gave her husband, Jack $400,000 to establish Getaway Lodge, a retreat in cottage country. Getaway Lodge consists of 12 cabins, a recreational centre, a swimming pool and a dining hall, as well as waterfront features. A family of four can rent one of the cottages for $1,600 per week, and this entitles them to the use of all of the lodge facilities, daily housekeeping services, and three buffet meals a day. Jack is earning business income, not property income, so it is not subject to attribution. Income earned by a specified member of a partnership The second case occurs when an individual is a specified member of a partnership. A specified member of a partnership includes: • • • a person who is a limited partner in a limited partnership a general partner who does not take an active role in the business activities, other than financing activities (a silent partner) a general partner in a partnership who does not carry out a business similar to, but separate from, that partnership
Income that a specified member of a partnership earns from that partnership or a loss is considered to be property income or a property loss, not business income or a business loss, and thus it is subject to attribution (ITA 96(1.8)). Bill gave $50,000 to his spouse, Martha, and she in turn acquired an interest in a limited partnership. Last year she earned $10,000 of partnership income. However, this is considered to be property income because she was not actively involved in the business and thus the income will be attributed to Bill.
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Taxation of Property Income
Income from Income
If a taxpayer transfers or loans property to a person and that property earns income, the original property income is attributed to the taxpayer. However, if the individual uses that income to earn additional property income, that additional property income, also referred to as second-generation income, is not subject to attribution and is taxable to the individual. Anthony gave GICs worth $10,000 to his wife, Mary. During the first year, the GICs earned interest income of $350, and while Mary received the income, it was attributed to Anthony. Mary used the $350 to purchase another GIC. During the second year, the original GICs earned another $350 of interest income, which was attributed to Anthony. The new GIC earned interest income of $12.25; this amount was taxed in Mary’s hands.
Dividend Income
If the property income subject to attribution is in the form of dividends from a Canadiancontrolled private corporation (CCPC), the taxpayer must include the grossed-up dividend in his or her income. He or she will also be entitled to claim the dividend tax credit. Jamie gave $10,000 to his spouse, Michelle, who used the money to invest in shares of a taxable Canadian corporation. Michelle received dividend income of $500, which is subject to attribution. So, Jamie must report taxable dividend income of $625, calculated as (cash dividend x dividend gross-up) or ($500 × 125%), and he can claim a federal dividend tax credit of $83.33, calculated as (grossed-up dividend x federal dividend tax credit) or ($625 × 131/3%). Jamie will also be able to claim a provincial dividend tax credit.
Liability for Payment of Tax
If a taxpayer must include some property income in his or her income because of the application of the income attribution rules with respect to property that he or she loaned or transferred to another taxpayer, both taxpayers are jointly and severally liable for any increase in the transferor’s tax liability resulting from the inclusion of that amount in income (ITA 160(1)(d)). Henry gave his wife, Sheila, $10,000 to invest. Sheila earned investment income of $750, and this amount was attributed to Henry. Because Henry has a marginal tax rate of 43%, he will have to pay $322.50 in tax, calculated as (taxable income x marginal tax rate) or ($750 × 43%). However, Henry and Sheila are both liable for this tax, and if Henry cannot pay it, Sheila will become liable for the entire amount.
Exceptions to the Attribution Rules
There are several situations where the attribution rules for spouses, common-law partners, and related minors will not apply, including: • • • • • transfers at fair market value loans for value spouses or common-law partners who are living apart changes in circumstances situations where an anti-avoidance rule applies
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Income Tax Planning
Transfers at Fair Market Value
If a taxpayer transfers property to a designated person, the resulting property income or loss, or capital gain or capital loss will generally not be attributed to the taxpayer if the designated person paid fair market value for the property (ITA 74.5). Janice owned a $5,000, 8% corporate bond for several years. She sold the bond to her 16-year-old son, Mark, for its FMV of $5,600. Because Mark paid FMV for the bond, the annual interest income will not be attributed to Janice, but will be taxed in Mark’s hands. However, in the case of a sale to a spouse or common-law partner at FMV, the taxpayer must also elect not to have the automatic spousal rollover rules apply if he or she wants to avoid income attribution (ITA 73(1)). The taxpayer’s spouse or common-law partner does not have to elect out of the rollover; only the taxpayer is required to make the election. George owns a Government of Canada bond that generates interest income of $9,000 each year. He sold the bond to his common-law partner, Sylvia, for $100,000, which was the fair market value of the bond at the time. His ACB was $90,000. Sylvia paid George $100,000 in cash. George elected not to have the spousal rollover apply and had to recognize a capital gain of $10,000, calculated as (proceeds - ACB) or ($100,000 $90,000). Sylvia will now be entitled to receive the annual interest payments of $9,000 per year. Because she purchased the bond for its FMV and George elected out of the rollover, the income will not be attributed to George.
Loans for Value
If a taxpayer loans property to a designated person, the resulting property income or loss will not be attributed to the taxpayer if the loan was made for value (ITA 74.5(2)). A loan is a loan for value if: • interest is charged at a rate equal to or greater than the lesser of: • the prescribed rate as set by ITR 4301 • a rate that would have otherwise been considered reasonable for parties dealing at arm’s length the designated person actually pays the interest to the taxpayer no later than 30 days after the end of the taxation year the designated person has consistently paid the interest owing no later than 30 days after the end of previous taxation years
• •
We will refer to a tainted loan as any loan that is not a loan for value. Marge loaned Homer $10,000 for investment purposes, on the condition that he pay her interest of 6% each year and that the loan be repaid in full in five years. The rate on a 5-year bank loan is 8%, and the rate prescribed by ITR 4301 is 5%. Provided that Homer actually pays the required interest on time, the loan would be considered a loan for value because the interest rate that Homer has to pay (6%) is greater than 5%, calculated as (the lesser of (the prescribed rate and the reasonable rate between arm’s length parties) or (the lesser of (5% and 8%)). Any property income that Homer earns from the $10,000 will be taxed in his hands. Homer can deduct the interest that he pays to Marge. Marge must report the interest income on her tax return.
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Taxation of Property Income If a designated person acquires property via a valid loan for value and subsequently repays the loan, the income attribution rules will not apply to income earned on the property after the loan is repaid. However, if a loan that originally satisfied the requirements is forgiven, the exemption ceases to apply. If Homer continues to pay the required interest on time and he eventually repays the loan in full, any future income that he earns as a result of investments that he made with the $10,000 will continue to be taxable to him. However, if Homer pays the required interest on time for the duration of the loan, and at the end of the loan, Marge tells him that he does not have to repay the principal, the exemption to the attribution rules will then cease to apply and any future property income will be attributed to Marge. Note: A similar rule applies to loans for value made to other non-arm’s length individuals (ITA 56(4.2)).
Spouses or Common-law Partners Living Apart
Property income If a taxpayer transfers or loans property to his or her spouse or common-law partner, there will be no attribution of property income or loss during the period when they are living separate and apart by reason of a breakdown of their relationship (74.5(3)(a)). Lindsey and Randy recently separated, and in accordance with their separation agreement, Randy provided Lindsey with a lump sum of $50,000. Lindsey placed the money in a money market fund until she needed it, and she earned interest income of $1,200 during the taxation year. Normally this amount would have been attributed to Randy, but because they were living separate and apart as a result of a breakdown in their relationship, the amount will be taxable to Lindsey. Capital gains However, during the period of separation, the capital gains attribution rules still apply, unless the taxpayer and his spouse or common-law partner jointly file an election not to have the capital gains attribution rules apply (ITA 74.5(3)(b)). Once the separation or divorce is finalized, attribution of capital gains or losses will cease only if the election has been made. However, in practice, a decree of divorce would likely not be granted unless this election has been made, to avoid attribution of capital gains years after a couple has divorced. Common law couples however would need to make certain that they opt out of these attribution rules, or else face possible attribution long after their relationship has come to an end. Carol and Mike were married for 18 years before they separated earlier this year. As part of their separation agreement, Mike transferred stocks with an ACB of $22,000 and a FMV of $60,000 to Carol. They did not file any elections, so Mike was able to rollover the stocks to Carol at his ACB. If Carol sells the stock for $65,000 before the divorce is finalized, a capital gain of $43,000 will be attributed to Mike, calculated as (proceeds - ACB) or ($65,000 - $22,000). However, if Carol does not sell the stocks until after the divorce is finalized, and as part of those
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Income Tax Planning divorce proceedings, they jointly opt out of the capital gains attribution provisions, any resulting capital gain will be attributed to Carol. Other changes in circumstances All attribution rules will also cease to apply upon several other changes in circumstances, including: • • • when the taxpayer ceases to be a resident of Canada either the taxpayer or the designated person dies in the case of the related minor, if the designated person turns 18 years of age before the end of the year (ITA 74.1(2)
Anti-avoidance Rule
The attribution rules do not apply where one of the main reasons for a transfer or loan of property is to reduce the amount of income tax that would be payable on the income (ITA 74.5(11)). Paul is in a low marginal tax bracket. He borrowed $10,000 from the bank and used the proceeds to purchase a Government of Canada bond. He then sold the bond to his wife, Charlene, at slightly less than fair market value and he used the proceeds to pay off his loan. Charlene is in a high marginal tax bracket, and the bond earned interest income of $800. Even though Charlene is the one earning the income, they would prefer to have the investment income attributed to Paul because he has a lower marginal tax rate. However, under the anti-avoidance rule, the income will not be attributed to Paul and it will be taxed in Charlene’s hands at her marginal tax rate.
Exercise: Income Attribution Provisions and Exceptions
Dividends Earned by Minor Shareholders
New rules to discourage income splitting with minor children were enacted in 2000. While it is not an income attribution rule, per se, it has a significant impact on the taxation of some property income earned by minors. The new provisions take the form of an income splitting tax, which imposes the top federal tax rate of 29%, instead of the normal graduated rates, on certain income earned by specified individuals, beginning in 2000 (ITA 120.4(2)). A specified individual is someone who: • • • will not attain the age of 18 during the taxation year is resident in Canada throughout the year has a parent who is resident in Canada at any time in the year (ITA 120.4(1))
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Taxation of Property Income
The types of income that will fall prey to this tax are referred to as split income, and include taxable dividends and other shareholder benefits on unlisted shares of Canadian and foreign companies, including those received directly or through a trust or partnership (ITA 120.4(1)).
Income Splitting Tax
Income that is subject to this tax is not eligible for any deductions or credits other than the dividend tax credit and foreign tax credit (ITA 120.4(3)). This means that the split income tax cannot be offset by the personal tax credit. An offsetting deduction in computing taxable income is permitted to ensure that income that is subject to this tax is not also subject to ordinary income tax (ITA 20(1)(ww)). In addition, income that is taxed under this measure is not subject to the attribution rules (ITA 74.5(13)). Ned Wright owns and operates a successful private Canadian manufacturing corporation. Four years ago, he rolled his shares in the business to a holding company, in equal shares to the common shareholders, which include Ned, his wife Mary, and a trust for his minor child, Nathan. This year, the holding company paid out a dividend of $60,000, so Mary and the trust for Nathan each had dividend income of $20,000, calculated as (total dividend ÷ number of shareholders) or ($60,000 ÷ 3). Neither Mary, nor the trust for Nathan, has any other source of income. Assume this year, the lowest tax bracket (and therefore, the conversion rate) is 15%, and the basic personal amount is $9,600. Since the dividend was received from a CCPC, as a result of the dividend payment, Mary had taxable income of $25,000, calculated as (cash dividend x dividend gross-up) or ($20,000 × 125%). Since Mary has no other source of income she remains in the lowest tax bracket. This will result in federal tax, before any applicable tax credits, of $3,750, calculated as (taxable income x lowest marginal tax rate) or ($25,000 × 15%). Mary can then use the federal dividend tax credit, ($25,000 x 13 1/3%) and the basic personal amount tax credit, ($9,600 x 15%) to reduce her federal tax. In her case, this would reduce her basic federal tax to nil, calculated as [the greater of (nil and (federal tax (dividend tax credit + basic personal tax credit)))] or [the greater of (nil and ($3,750 (($25,000 x 13 1/3%) + ($9,600 x 15%))))]. Let's look at the results for Nathan. Nathan's taxes are not as straightforward because he has split income. Nathan will also have taxable dividend income of $25,000, calculated as (cash dividend x dividend gross-up) or ($20,000 × 125%). However, since he is a minor with split income, there is an offsetting deduction of $25,000 to ensure that the split income is not taxed in the normal fashion. Nathan's split income of $25,000 will result in federal tax of $7,250, calculated as (taxable income x highest marginal tax rate) or ($25,000 × 29%). Nathan may claim the federal dividend tax credit. However, unlike Mary, he may not reduce this tax on split income by using personal tax credits. So, Nathan has to pay federal tax of $3,916.67, calculated as (federal tax - dividend tax credit) or ($7,250 - ($25,000 x 13 1/3%)). Nathan's mother did not have to pay any tax on her dividend. The provinces also impose special tax rates on split income. Most provinces tax split income at the highest provincial tax rate, but at least one province imposes an even higher tax rate.
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Income Tax Planning Dividends received on any listed shares will not be subject to these rules because the income flow is less susceptible to manipulation. Further, income from property acquired on the death of a parent of the individual will be exempt from the measure (ITA 120.4(1), excluded amount). While it is the child who is technically liable for this new income splitting tax, the legislation provides for the parents to be held jointly and severally liable (ITA 160(1.2)). While it is the child who is technically liable for this new income splitting tax, the legislation provides for the parents to be held jointly and severally liable (ITA 160(1.2)).
Exercise: Income Attribution
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Income Attribution Rules. In this lesson, you have learned how to do the following: • identify and calculate how property income and capital gains can be attributed to the taxpayer when he or she transfers property to a spouse or common-law partner, related minors, or certain other non-arm’s length individuals
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Income Attribution Rules, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Property Income
Review
Let’s look at the concepts covered in this unit: • • • • • • Interest, Dividends, and Income Earned Rental Income Capital Cost Allowance Disposing of Depreciable Property Other Deductions from Business and Property Income Income Attribution Rules
You now have a good understanding of the taxation of property income. At this point in the course you can identify, calculate, and describe any likely tax impact given a client with capital cost allowance, rental income, interest, dividends, and income earned. You can also calculate and describe any likely tax impact given a client who disposes of depreciable property as well as identify eligible capital expenditures that can serve as deductions. Finally, you can identify and calculate how property income and capital gains can be attributed to the taxpayer when he or she transfers property. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 6: Taxation of Property Income, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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Unit 7: Taxation of Capital Property
Income Tax Planning
Unit 7: Taxation of Capital Property
Welcome to Taxation of Capital Property. In this unit, you will learn about the role of property in tax planning and wealth accumulation, how to calculate capital gains and losses, as well as how to calculate the impact of disposition. You will also learn how to integrate the use of applicable exemptions as well as other factors when calculating capital gains or losses. This unit takes approximately 3 hours and 45 minutes to complete. You will learn about the following topics: • • • • • • The Role of Property in Wealth Accumulation Calculating Capital Gains and Losses Dispositions Losses Special Situations Capital Gains Exemptions
To start with the first lesson, click The Role of Property in Wealth Accumulation on the table of contents.
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Taxation of Capital Property
Lesson 1: The Role of Property in Wealth Accumulation
Welcome to The Role of Property in Wealth Accumulation. In this lesson, you will learn about the role of property in tax planning and wealth accumulation as well as the appreciation and depreciation of capital property. You will also learn how to calculate the taxation of capital appreciation. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • • • explain the role of property in tax planning and wealth accumulation calculate the appreciation and depreciation of capital property calculate the taxation of capital appreciation
The Role of Property in Wealth Accumulation
All property has three distinct roles in wealth accumulation. First, property stores the wealth that the investor has earned. Sometimes the storage vehicle is something tangible, such as a piece of real estate or a piece of collectible artwork. In other cases, the storage vehicle takes the form of a financial instrument, such as a bond or a share in a corporation. In any case, the property stores wealth until such time as the investor decides to liquidate the property and use the proceeds for some other purpose, such as living expenses. Secondly, property can be a source of income by producing interest, dividends, or rents. To the extent that the investor does not use this income to meet expenses, it increases his or her wealth. Finally, the property itself may be a source of wealth, in that it may appreciate in value over time due to a number of factors, which we will discuss shortly.
Appreciation and Depreciation of Capital Property
In this lesson, we will be concentrating on the role of property as a source of wealth through capital appreciation. Appreciation is simply the unrealized increase in the value of an asset over time. A person who holds capital property does not realize the accumulated appreciation until he or she disposes of an asset. In contrast, depreciation is the decrease in the value of an asset over time, and accumulated depreciation is also only realized when the investor disposes of the asset. Appreciation can be influenced by a number of factors, including: • • • • • supply and demand the accumulation of business income natural growth the changing present value of future cash flows inflation
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Income Tax Planning
Supply and Demand
The current value of any property is strongly influenced by the market demand for that particular type of asset. This demand can be influenced by demographics, consumer tastes, or even psychological expectations about future values. If an investor expects that a stock is going to skyrocket in value, he or she will be willing to pay more for it now. If enough investors have the same expectations, that will have the effect of driving up the stock price.
Accumulation of Business Income
If a corporation has retained earnings as a result of after-tax profits that have not been paid out as dividends, its shareholders’ equity has increased and shares in a corporation will usually increase in value. Bluebell Corp. has 1 million outstanding shares. During the last fiscal year, it had after-tax profits of $15 million and it paid out a dividend of $3 million or $3 per share. It therefore had retained earnings of $12 million, which it plans to use to pay off some corporate debts and to finance new equipment acquisitions, thereby increasing the net assets of the corporation by $12 million. The share price should increase by about $12 per share to reflect the increase in shareholders’ equity.
Natural Growth and Cash Flows
Some types of property in the resource and agricultural sectors increase in value because of natural growth. For example, property with associated timber rights or farmland with a cash crop of Christmas trees will increase in value as the crop matures. Cash flows The present value of a series of fixed cash flows (for example, a bond with a regular coupon) will vary over time as interest rates change. Jenny bought a $10,000 10-year 9.5% semi-annual bond when it was first issued at par seven years ago. The bond will mature in another three years and interest rates on other three-year bonds of comparable risk are 6%. Jenny’s bond has increased in value to $10,948, calculated by entering DISP = 0, P/YR = 2, ×P/YR = 3, I/YR = 6%, PMT = $475, calculated as ((face amount x coupon) ÷ 2) or (($10,000 × 9.5%) ÷ 2), FV = $10,000, MODE = END and solving for PV.
Inflation
Part of the increase in an asset’s price over time may be due to inflation, which in turn is a more general manifestation of the increase in market demand relative to supply. While we typically measure inflation in terms of the Consumer Price Index, the general CPI reflects the increase in the price of a standard basket of consumer goods over time, and this may or may not be reflected in the value of a particular asset over time. In August 2006, the 12-month CPI was 2.1%. This means that In August 2006, the prices paid by consumers were 2.1% higher than in August 2005, due mainly to the rise in gasoline prices over that period. However, during that time homeowners' replacement costs rose by 8.1%, whereas prices for computer equipment and supplies fell by 18%. Inflation also varies across the country due to regional differences.
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Taxation of Capital Property
Click here to view the most current CPI on the Statistics Canada Web site.
Taxation of Capital Appreciation
Prior to 1971, capital appreciation was not taxable in Canada, and many countries still do not tax it. For those countries that do tax capital appreciation, they generally make some allowance for inflation by either indexing the cost base for the asset or using an income inclusion rate of less than 100%. Canada uses the latter approach by including only 50% of capital gains in income. However, this reduced inclusion rate fails to adequately account for inflation in those cases where an investor may have held the asset for ten, 20 or even more years. If capital appreciation is taxed, many countries try to ease the burden that this taxation imposes on the economy by providing for certain exemptions and rollovers, which add enormously to the complexity of the tax system.
Accrual vs. Appreciation
Unlike property income, which generally must be accrued annually for tax purposes even if the taxpayer has not yet received it, accumulated appreciation is not taxed until the taxpayer disposes, or is deemed to have disposed, of the asset. Fenita purchased a piece of land in 1975 at a cost of $40,000 and it is now worth over $1 million. However, there are no tax consequences to Fenita at this time and she will not have a taxable capital gain until she disposes of the property. Holding capital property provides a taxpayer with one of the few tax deferral opportunities still available. However, the fact that appreciation is not taxed until the investor disposes of an asset affects the markets because an individual may hold on to an investment longer than he or she otherwise might have so as to avoid taxation. Harold holds shares in a mutual fund currently worth $400,000 and his adjusted cost base is $150,000. He does not like the expected performance of the fund and would like to sell his shares and move on to something else. However, Harold has a 50% marginal tax rate and if he does sell his shares, he would have to pay tax of $62,500, calculated as (((proceeds - ACB) x capital gains inclusion rate) x marginal tax rate) or ((($400,000 $150,000) × 50%) × 50%). This would leave him with only $337,500 to reinvest, calculated as (proceeds - taxes paid) or ($400,000 - $62,500).
Deflation
While some income tax systems are quite ready to tax capital appreciation, they do not like to provide tax relief for deflation. While a portion of capital gains may have to be included in taxable income, if an asset goes down in value, the resulting loss is usually not deductible from most other types of income. Capital gains on personal-use property, such as a cottage are taxable, but capital losses on such property are not deductible. Jordon purchased shares of a corporation in 1988 for $120,000 and he recently sold them for $105,000, for a loss of $15,000, calculated as (proceeds - cost) or ($105,000 $120,000). Jordon does not have any other capital gains and he cannot deduct the capital loss from his other sources of income.
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Income Tax Planning
Sam purchased a cottage in 1986 for $120,000 and he recently sold it for $105,000 for a capital loss of $15,000, calculated as (proceeds - cost) or ($105,000 - $120,000). Sam cannot deduct the loss because the cottage was personal-use property.
Exercise: Appreciation of Capital Property
Gains and Losses
If a taxpayer disposes of any property during the taxation year, he or she will realize a gain to the extent that the proceeds of the disposition exceed the adjusted cost base of the property and any outlays or expenses that he or she incurred for the purpose of making the disposition (ITA 40(1)(a)). Similarly, a taxpayer will realize a loss to the extent that the sum of the adjusted cost base of the property and any outlays or expenses that he or she incurred for the purpose of making the disposition exceed the proceeds of the disposition (ITA 40(1)(b)). We will look at how the adjusted cost base and proceeds of disposition are determined shortly. So far, the concepts are simple enough. If you sell something for more than you paid for it, you have a gain; if you sell it for less than you paid for it, you have a loss. Nancy sold an antique dresser for $2,400; she purchased it for $2,000. Nancy has a gain of $400, calculated as (proceeds - cost) or ($2,400 - $2,000). Frank sold some shares for $500; he paid $800 for those same shares. Frank has a loss of $300, calculated as (proceeds - cost) or ($800 - $500). Losses on personal-use property One exception to this rule is a loss upon the disposition of personal-use property. Personaluse property is any property that is owned by the taxpayer and used primarily for his or her enjoyment or for the use or enjoyment of one or more individuals related to the taxpayer. If one sells personal-use property for less than its original cost, the Income Tax Act deems the loss to be nil. Personal-use property is discussed in more detail later in the course. But when does a gain become a capital gain, and what does this mean in terms of tax treatment?
Capital Property
The Income Tax Act defines property to be property of any kind, whether real or personal, tangible or intangible (ITA 248(1)). Property therefore includes stocks, bonds, partnership interests, real estate, money, art objects, and many more things.
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Taxation of Capital Property Capital property is defined as any depreciable property of the taxpayer, plus any property (other than depreciable property) that could result in a capital gain or capital loss when the taxpayer disposes of it (ITA 54). A gain resulting from the disposition of most types of property will be considered a capital gain as long as that gain is not included in the taxpayer's income under any other provision of the Income Tax Act (ITA 39(1)(a)). This definition of capital gain specifically excludes gains on the disposition of certain types of property, including: • • • • eligible capital property gains on inventory (i.e., profits on goods held for resale) the unpaid interest on bonds that are sold between coupon dates insurance policies (except for gains on related segregated funds)
Similarly, a loss resulting from the disposition of most types of property will be considered a capital loss, unless it is deductible from the taxpayer’s income under anyther provision of the Income Tax Act (ITA 39(1)(b)). In this case, the definition of a capital loss excludes losses on those properties listed above, plus losses on any depreciable capital property. These definitions appear to be circular, in that: • • If the taxpayer incurs a capital gain or loss upon the disposition of that property, it is considered to be capital property. The taxpayer only incurs a capital gain or capital loss on the disposition of property if those gains and losses are not specifically included in, or deducted from, income in accordance with some other provision of the Income Tax Act.
Generally speaking, most types of property can be considered capital property in most circumstances. The trick here is to understand when gains or losses are included or deducted from income under other parts of the Income Tax Act because then they are not treated as capital gains or losses.
Depreciable Property
Depreciable property is any tangible or intangible property that generally fits into one of the prescribed classes for which CCA can be claimed. When a taxpayer disposes of a depreciable property, he or she can realize both a recapture and a capital gain, or he or she could realize a terminal loss. However, under no circumstances can the taxpayer realize a capital loss because depreciable property is specifically excluded from the definition of a capital loss (ITA 39(1)(b)). So, from the point of view of potential capital gains, depreciable property is capital property, but from the point of view of capital losses, it is not. Capital property, other than depreciable property, is sometimes referred to as nondepreciable capital property or simply non-depreciable property.
Eligible Capital Property
Eligible capital property includes goodwill and other nothings, the cost of which does not qualify for capital cost allowance and is not deductible in the year of its acquisition as a current expense. The definitions of capital gains and capital losses specifically exclude gains and losses realized upon disposition of eligible capital property.
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Income Tax Planning So, despite its name, eligible capital property is not truly considered to be capital property. The reason it is excluded is that it is already subject to something similar to capital gains treatment. This is discussed further in the unit titled Taxation of Property Income.
Inventory, Part 1
If the cost or value of property is relevant in computing a taxpayer’s income from a business for a taxation year, that property is said to be inventory and not capital property (ITA 248(1)). The disposition of inventory will give rise to business income, not capital gains. In some cases, it seems obvious that the property is inventory and not capital property. A common example of inventory is goods that a store purchases for resale. In this case, the taxpayer will almost certainly realize a gain on the sale of the property, but this gain is business income, not a capital gain. However, in other cases, it is not so clear whether the disposition should result in income or a capital gain, or whether the property is inventory or capital property. Nancy recently realized a gain when she sold a piece of antique furniture. If this is her only antique and she sold it because it no longer fit in with her household décor, it would probably be considered to be capital property, and her gain would be a capital gain. However, if Nancy is in the business of buying and selling antiques, the dresser would be considered to be inventory, and the resulting gain would be business income. The distinction is important, because only 50% of capital gains are included in taxable income, while 100% of business gains are included in taxable income. Taxpayers often go to great lengths to have their transactions treated as capital transactions, instead of sales of inventory because of the more favourable tax treatment.
Inventory, Part 2
Another example of how inventory plays a role in defining capital property is described below. Mark likes to buy houses, renovate them and sell them for a profit. Last year, he did this with three houses. He bought the first house for $120,000 and sold it for net proceeds of $140,000. He bought the second house for $135,000 and sold it for $150,000. He bought the third house for $110,000 and sold it for net proceeds of $118,000. Mark’s total gain for the year was $43,000, calculated as (the sum of ((proceeds - cost) for each property)) or (($140,000 - $120,000) + ($150,000 - $135,000) + ($118,000 - $110,000)). Mark has a 50% marginal tax rate. Mark would prefer to have his transactions treated as dispositions of capital property, because then his taxable income would be $21,500, calculated as (total gain x capital gains inclusion rate) or ($43,000 × 50%) and he would still have $32,250 left after tax, calculated as (total gain - (taxable capital gain x marginal tax rate)) or ($43,000 - ($21,500 × 50%)). However, Mark may be deemed to be in the business of buying and selling houses and the resulting income may be treated as business income. As such, the full amount would be subject to tax and he would only have $21,500 left after tax, calculated as (total income x (1 - marginal tax rate)) or ($43,000 × (1 - 50%)). Mark would pay $10,750 more in taxes if the income is considered business income instead of capital gains, calculated as (tax payable if income is treated as business income - tax payable if income is treated as a capital gain) or ($32,250 - $21,500).
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Taxation of Capital Property
In many cases, the taxpayer ends up taking the matter to the Tax Courts to determine whether their income is eligible for capital gains treatment. Over the years, the Courts have held that the disposal of a true investment (one that yields a return such as interest or rent, or that offers a reasonable expectation of a return in the foreseeable future) is a capital transaction. On the other hand, activities of a speculative nature have often been regarded as adventures in the nature of trade, which give rise to business income. The argument over whether the disposition should result in income or capital gains is most often brought up with respect to real estate transactions. Some of the main factors that the Courts have considered when deciding whether a profit is a capital gain or business income include: • • • intention of the taxpayer the number and frequency of transactions the relationship to the taxpayer’s business (for example, real estate transactions by a realtor might be business income, instead of capital gains)
Refer to IT-218R, Profit, capital gains and losses from the sale of real estate, for additional information.
Exercise: Capital Property
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Income Tax Planning
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed The Role of Property in Wealth Accumulation. In this lesson, you have learned how to do the following: • • • explain the role of property in tax planning and wealth accumulation calculate the appreciation and depreciation of capital property calculate the taxation of capital appreciation
If you are ready to move to the next lesson, click Calculating Capital Gains and Losses on the table of contents.
Assessment
Now that you have completed The Role of Property in Wealth Accumulation, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Taxation of Capital Property
Lesson 2: Calculating Capital Gains and Losses
Welcome to Calculating Capital Gains and Losses. In this lesson, you will learn how to calculate and report capital gains and losses. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: • calculate capital gains and losses, including the adjusted cost base, outlays and expenses, taxable capital gains, allowable capital losses, and capital gains reserves
Calculating Capital Gains and Losses
If a taxpayer disposes of capital property during the taxation year, he or she will realize a capital gain to the extent that the proceeds of the disposition exceed the adjusted cost base of the capital property and any outlays or expenses the taxpayer incurred for the purpose of making the disposition (ITA 40(1)(a) and (39(1)(a)). Similarly, if a taxpayer disposes of capital property, he or she will realize a capital loss to the extent that the sum of the adjusted cost base of the capital property and any outlays or expenses the taxpayer incurred for the purpose of making the disposition exceed the proceeds of the disposition (ITA 40(1)(b) and 39(1)(b)). Before we proceed, we need to be able to determine what are the proceeds of disposition, and what is the adjusted cost base.
Proceeds of Disposition
The proceeds of disposition of property includes the sale price of the property that has been sold, as well as compensation for property that has been expropriated, stolen, or lost (ITA 54). In the case of insurance coverage on property that has been damaged, the insurance proceeds will be considered to be proceeds of disposition unless the proceeds are used to repair the damage within a reasonable amount of time. Sally sold her house for $180,000. The proceeds of her disposition are $180,000. Jason’s boat was destroyed in a fire. His insurance company covered his loss to a maximum of $8,000, even though the fair market value of the boat was $10,000. The proceeds of his disposition are $8,000. Deemed proceeds of disposition Deemed proceeds of disposition are the amount that the taxpayer is deemed to have received as a result of the many rules contained in the Income Tax Act. The deemed proceeds are generally equal to the fair market value (FMV) of the property at the time of the disposition or deemed disposition. Fair market value is the price at which the property could have reasonably been expected to be sold if it was sold in an open market. Harry gave 500 shares of TooGood Corp. to a friend as a wedding present. At the time of the gift, the shares were worth $375. Even though Harry did not actually receive anything, he is deemed to have received proceeds of $375.
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Income Tax Planning
Adjusted Cost Base
The adjusted cost base, or ACB, is the taxpayer’s cost for the property for tax purposes. In most cases, the ACB is the actual cost of the property, but in a few cases, the ACB may be modified by factors like adjustments for V-day values. The ACB includes all of the costs associated with the acquisition, including the purchase price, commissions or brokerage fees and non-deductible legal fees. Morgan purchased a piece of real estate at a price of $160,000. To close the transaction, she paid non-deductible legal fees of $2,000. Her ACB is $162,000, calculated as (purchase price + legal fees) or ($160,000 + $2,000).
Deemed ACB
Some of the situations where the ACB is deemed to be different from the acquisition cost include the following: • • If a taxpayer acquires property from a non-arm’s length person for more than its fair market value, the taxpayer’s ACB will be deemed to be FMV (ITA 69(1)(a)). If a taxpayer receives a dividend in any form other than cash or shares, the ACB will be deemed to be the FMV of the property at the time it is received (ITA 52(2) and (3)). If an individual immigrates to Canada after 1971, the ACB of each capital property (with some exceptions) is deemed to be the FMV at the time of immigration (ITA 128.1(1)(b)). If an individual has previously elected to use the lifetime capital gains exemption, the ACB will be the deemed cost of reacquisition at the time of the notional disposition (ITA 110.6(19)). For property held on December 31, 1971, the ACB will be determined using the tax-free zone method, unless the taxpayer elects to use the V-Day value (ITAR 26(3) and 26(7)).
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•
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We will discuss these situations in more detail.
Other Adjustments to ACB
In other situations, the acquisition cost must be adjusted by certain additions or deductions to arrive at the ACB (ITA 54). Deductions from the acquisition cost Examples of some of the more common items that must be deducted from the acquisition cost to arrive at the ACB include (ITA 53(2)): • In the case of shares in a corporation, tax-deferred dividends, generally received before 1979 (other than capital dividends), that the taxpayer received from that corporation must be deducted from the ACB of those shares. In the case of a partnership interest, the taxpayer’s share of partnership losses and drawings must be deducted from the ACB of his or her partnership interest.
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Taxation of Capital Property • If the taxpayer receives government grants or subsidies related to the acquisition of a particular property, the amount of those grants or subsidies must be deducted from the ACB for the property.
Additions to the acquisition cost Examples of some of the more common items that must be added to the acquisition cost to arrive at the ACB include (ITA 53(1)): • • Certain contributions of capital made to a corporation in which the taxpayer holds shares should be added to the cost of those shares. In the case of a partnership interest, the taxpayer’s share of partnership profits or additional contributions of capital must be added to the ACB of his or her partnership interest. Interest and property taxes may be added to the ACB of land if they cannot be used as a deduction in computing income. The cost of surveying or valuing property during acquisition or disposition may be added to its ACB. In some cases, distributions from a mutual fund may create income without a distribution of cash proceeds, in which case the designated amount should be added to the ACB of the shares or units.
• • •
We will be discussing some of these additions and deductions throughout the course. For additional information, refer to IT-456R, Capital property, some adjustments to cost base. In the case of depreciable property, the ACB is the capital cost of property (ITA 54). The capital cost of property generally means the full cost to the taxpayer of acquiring the property, including legal, accounting, engineering or other fees incurred to acquire the property.
Lifetime Capital Gains Exemption
Prior to February 22, 1994, each taxpayer had a lifetime capital gains exemption (LCGE) that would shelter $100,000 of capital gains from taxation (or $75,000 of taxable capital gains, because the capital gains inclusion rate was 75% at that time). A taxpayer who disposed of capital property prior to this time would record the taxable capital gain, but then, he or she would be eligible to claim an offsetting deduction, up to the lifetime maximum deduction of $75,000 (which would exempt $100,000 of capital gains). The Federal Budget of February 22, 1994 called for the demise of the LCGE, but allowed taxpayers one last chance to make use of the exemption by electing a notional disposition and immediate reacquisition of capital property on February 22, 1994 at any amount between the ACB and FMV (ITA 110.6(19)), as long as the resulting gain could be covered by the exemption. Note: Taxpayers were also permitted to make the election with respect to depreciable property and eligible capital property. Sarah owned a cottage on February 22, 1994. She originally bought the cottage for $58,000 and it was worth $123,000 on February 22, 1994. Sarah had previously used some of her LCGE to offset the gain on various stock transactions, but she had a LCGE of $44,000 remaining.
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Income Tax Planning
Sarah elected to recognize a notional disposition of the cottage at $102,000, calculated as (the lesser of (FMV February 22, 1994 and (ACB + remaining LCGE))) or (the lesser of ($123,000 and ($58,000 + $44,000))). As a result of the election, she had to record a capital gain of $44,000 and a taxable capital gain of $33,000, calculated as (capital gain x capital gains inclusion rate in 1994) or ($44,000 × 75%), but she was also able to claim a capital gains deduction of $33,000. As a result of the election, Sarah is deemed to have reacquired the cottage on February 24, 1994 for $102,000. The effect of this election was to increase the taxpayer’s ACB, such that any future disposition would result in a smaller capital gain. Sarah later sold her cottage for $136,000. As a result of her earlier election, her ACB for the cottage is $102,000. She realized a capital gain of $34,000 when she sold the cottage, calculated as (proceeds - ACB) or ($136,000 - $102,000). While the LCGE election could be filed in some circumstances as late as 1998, everyone who was permitted to make use of this election must have done so by now, and their ACBs would have been adjusted accordingly. Why the $100,000 LCGE is still relevant While a taxpayer can no longer make use of the LCGE, you must be aware that it existed and whether or not your clients have ever made use of it. It may affect the ACB on some of their capital property that dates back to when the exemption was still in force and it may have implications when the taxpayer eventually disposes of that property. The $100,000 LCGE and the extent to which it was used may also affect how much in capital gains a taxpayer can shelter under the current rules which allow for a lifetime capital gains exemption in the amount of $750,000 ($375,000 of taxable capital gains) on the disposition of certain small business corporation shares and farm and fishing property. The lifetime capital gains exemption in its present form is addressed later in this unit.
Outlays and Expenses
Outlays and expenses related to the acquisition of capital property are added to its ACB. In a similar manner, outlays and expenses incurred during the disposition of that property are aggregated with the ACB before the capital gain or loss is determined. However, the costs of disposition are not part of the ACB. Remember that a gain is calculated as the excess of the proceeds of the disposition over the sum of the ACB and the expenses associated with that disposition. Similarly, a loss is the excess of the sum of the ACB and the expenses associated with a disposition over the proceeds of that disposition. Morgan bought 100 common shares at a price of $13 each, plus a commission of 2%. Her ACB for the shares is $1,326, calculated as ((number of shares x price) x (1 + commission)) or ((100 × $13) × (1 + 2%)). Morgan later sold those shares for $840, and she incurred another transaction charge of 2%, or $16.80, calculated as (proceeds x commission) or ($840 × 2%). The proceeds of her disposition are $840. Morgan’s capital loss is $502.80, calculated as (proceeds of disposition – (ACB + commission)) or ($840 – ($1,326 + $16.80)).
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7-13
Taxation of Capital Property
Exercise: Capital Gains and Losses, Part 1
Taxable Capital Gains
Since 1971, Canadian individuals and corporations have been taxed on gains realized upon the disposition of capital property. While the tax is commonly referred to as capital gains tax, it is important to note that there is not a specific, special tax on capital gains. Rather, the taxable portion of capital gains is treated as income, and taxed according to the taxpayer’s marginal tax rate. A taxpayer incurs a capital gain in the taxation year in which he or she disposes (or is deemed to have disposed) of capital property. A portion of the capital gain then becomes a taxable capital gain. That portion is determined by the inclusion rate, which is currently set at 50% for almost all dispositions of capital property (ITA 38(a)). When Sarah sold her cottage, she realized a capital gain of $34,000. This will result in a taxable capital gain of $17,000, calculated as (capital gain x capital gains inclusion rate) or ($34,000 × 50%).
Historical and Current Capital Gains Inclusion Rates
When the concept of taxing capital gains was first introduced in 1971, the inclusion rate was 50%. It was increased to two-thirds for 1988 and 1989 and to three-quarters or 75% beginning in 1990. It dropped back to two-thirds as a result of the Federal Budget of February 28, 2000. There was a further drop in the inclusion rate to 50% for dispositions after October 17, 2000. The following table includes the historical capital gains inclusion rates.
Unless otherwise stated, for the purpose of this course, we assume all dispositions take place after October 17, 2000, such that a 50% capital gains inclusion rate applies. However, the old inclusion rates are still relevant because they are factored into the calculation of the capital gains deduction on shares of qualified small business corporations or qualified farm and fishing properties, as well as the application of net capital loss carryovers, as we will discuss later.
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Income Tax Planning
Allowable Capital Loss
The same inclusion rate applies to capital losses, such that 50% of capital losses become allowable capital losses. They are not referred to as taxable capital losses. Morgan had a capital loss of $502.80 when she sold her 100 common shares. Morgan has realized an allowable capital loss of $251.40, calculated as (capital loss x capital gains inclusion rate) or ($502.80 × 50%). A taxpayer that incurs an allowable capital loss can use that loss to offset taxable capital gains that he or she may have realized. However, other than under certain circumstances in the year of death and / or the year prior to death, allowable capital losses cannot be used to reduce any other source of income such as interest, dividends, rental income or employment income. An allowable capital loss must first be used to offset taxable capital gains realized in the same tax year. However, the taxpayer does have flexibility as to when he or she can claim the portion of allowable capital losses that exceeds the taxable capital gains in a year (i.e. net capital loss) or the allowable capital losses that have been carried forward from previous years. In such cases, allowable capital losses can be carried back three tax years and used to reduce taxable capital gains (up to the total of the allowable capital losses) claimed in any or all of those years. If more beneficial, the taxpayer can instead elect to carry forward the allowable capital losses indefinitely and use them to offset taxable capital gains in a future year. Earlier this year, Arvinder disposed of a rental property and realized a capital gain of $80,000 and a taxable capital gain of $40,000 calculated as (capital gain x capital gains inclusion rate) or ($80,000 x 50%). He also sold three underperforming technology stocks from his investment portfolio and triggered a cumulative capital loss of $110,000 and an allowable capital loss of $55,000 calculated as (capital loss x capital gains inclusion rate) or ($110,000 x 50%). If Arvinder does not undertake any further transactions for the remainder of this year, he will have a net capital loss of $15,000 calculated as (taxable capital gains – allowable capital losses) or ($40,000 – $55,000). Since Arvinder does not have any further taxable capital gains in the current year, he can carry the $15,000 net capital loss back three tax years to offset taxable capital gains realized in any or all of those years up to a maximum of $15,000. He also has the option to carry the net capital loss forward indefinitely and use it to offset taxable capital gains realized in a future year.
Reporting Capital Gains and Losses
In determining the taxpayer’s income for a taxation year under a simple scenario, the taxpayer must determine the amount, if any, by which his or her taxable capital gains exceed allowable capital losses (ITA 3(b)), to arrive at the net taxable capital gain or net capital loss (ITA 111(8)). Note: The Income Tax Act does not call this a net allowable capital loss. Note: A taxpayer must deduct his or her allowable capital losses from his or her income to the extent that the taxpayer is permitted in the year they arise, or he or she will forfeit the right to do so (ITA 3).
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7-15
Taxation of Capital Property
This year, Fred had a taxable capital gain of $6,000, along with an allowable capital loss of $3,000. Fred is in a low marginal tax rate, and he would prefer to carry his allowable capital loss forward to next year, when he expects his marginal tax rate to be higher and when he also expects to have taxable capital gains. However, he must deduct the allowable capital loss from his taxable capital gain this year, or he will forfeit the right to deduct the loss. So, Fred will have a net taxable capital gain of $3,000, calculated as (taxable capital gain - allowable capital loss) or ($6,000 - $3,000). A taxpayer must report his or her net taxable capital gains or net capital losses on an annual basis on page 2 of the tax return, under total income. The claim must be supported by a completed Schedule 3, Capital Gains (or Losses) in Year. Benjamin Leyland disposed of shares in three different corporations last year. A summary of his transactions is provided below.
Ben's net capital gain resulting from the disposition of the shares was $1,989, calculated as (capital gain on ACB Corp. - capital loss on DEF Ltd. + capital gain on GHI Inc.) or ($870 $194 + $1,313). Ben also sold his cottage for $124,000, incurring real estate commissions and legal fees of $7,440. He had purchased the property in 1989 for $46,000. Ben never used his LCGE on this property, so its ACB is $46,000. His capital gain on the property is $70,560, calculated as ((proceeds - ACB - selling expenses)) or ($124,000 – $46,000 - $7,440)). Ben’s total capital gain as recorded on Schedule 3 of his income tax return is $72,549, calculated as (net capital gain from stock transactions + capital gain from cottage) or ($1,989 + $70,560). Ben has a taxable capital gain of $36,275 for last year, calculated as (total capital gain x capital gains inclusion rate) or ($72,549 × 50%), and he must enter this on page 2 of his income tax return.
Exercise: Capital Gains and Losses, Part 2
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Income Tax Planning
Exercise: Capital Gains and Losses, Part 3
Exercise: Capital Gains and Losses, Part 4
Capital Gains Reserves
When a taxpayer sells a capital property, he or she usually receives full payment at that time. However, sometimes the taxpayer will receive the proceeds in installments over a number of years. This is called an installment sale. When this situation occurs, the taxpayer may claim a capital gains reserve that allows him or her to defer, within limits, reporting a portion of the capital gain to the year in which the proceeds of the disposition are received. Sam sold a capital property for $50,000. He received $10,000 at the time of the sale, and he will receive the remaining $40,000 over a period of four years. The sale resulted in a capital gain of $30,000, so Sam would like to claim a reserve to defer some of the tax until future years as he receives the proceeds. If a taxpayer wants to claim a reserve, he or she still calculates his capital gain in the regular way, as the proceeds of the disposition minus the sum of the ACB and any outlays or expenses. From this amount, the taxpayer deducts the amount of reserve that he or she is claiming for the year. The result is the amount that the taxpayer must report as his or her capital gain for the year of disposition.
Most Types of Property
For most types of property, a reserve can be claimed for up to a maximum of four years (ITA 40(1)(a)(iii)). The maximum reserve that can be claimed in each year is restricted to the lesser of: a)
b)
where: n is the number of years since the property was sold.
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7-17
Taxation of Capital Property
Charles sold a property this year for $200,000. His ACB for the property was $120,000, so he has a capital gain of $80,000, calculated as (proceeds - ACB) or ($200,000 - $120,000). He took cash of $50,000 as a downpayment and will receive the remaining $150,000 in five annual installments of $30,000, commencing next year. Note: Any interest on the mortgage is taxable to Charles in the year of receipt and does not affect the reserve calculations. For this taxation year, the maximum capital gains reserve that Charles can claim is the lesser of: a) ($150,000 ÷ $200,000) x $80,000 = $60,000 b) (1/5 × $80,000 × (4 - 0)) = $64,000 Because the lesser amount is $60,000, it becomes the capital gains reserve. Charles must report a capital gain for the current year of $20,000, calculated as (capital gain - reserve) or ($80,000 - $60,000). If the taxpayer claims a reserve during any one taxation year, he or she must add it to his or her capital gains in the following year. However, if the taxpayer still has an amount that is payable to him or her in a future year, he or she can calculate and deduct a new reserve based on the new outstanding balance, as shown in this table.
1. 2. 3. 4.
a = [(outstanding proceeds ÷ total proceeds) × original capital gain] b = 1/5 of original capital gain × (4 – n) calculated as capital gain reported – maximum reserve If the taxpayer claims a reserve in one taxation year, he or she must report it as a capital gain in the next year. However, if some of the proceeds are still outstanding, he or she can calculate and deduct a new reserve based on the new outstanding balance.
Even if sale proceeds are not received within five years from the year of disposition, part (b) of the formula will cause the maximum reserve to be $0 four years after the year of disposition. Or, stated another way, part (b) of the formula ensures that at least 1/5 of the capital gain must be reported every year for a five year period. Thus, it is not possible to
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Income Tax Planning spread a capital gain over more than five years by claiming a reserve. If the sale proceeds are received in less than five years, part (a) of the formula will cause the gain to be reported in full by the time total proceeds have been received.
Farm Property and Small Business Corporation Shares Sold to Taxpayer's Child
There are exceptions to the rule that a capital gain cannot be spread over a period greater than five years. The exceptions relate to qualified shares of a small business corporation and qualified farm and fishing property that are disposed of to a child of the taxpayer. In this case, the capital gain may be spread over a 10-year period provided that the sale proceeds are not received in less than 10 years (ITA 40(1.1)). For these types of property, the maximum reserve that can be claimed in any one year is restricted to the lesser of: a)
b)
where: n is the number of years since the property was sold.
Exercise: Capital Gains Reserves
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7-19
Taxation of Capital Property
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Calculating Capital Gains and Losses. In this lesson, you have learned how to do the following: • calculate capital gains and losses, including adjusted cost base, outlays and expenses, taxable capital gains, allowable capital loss, and capital gains reserves
If you are ready to move to the next lesson, click Dispositions on the table of contents.
Assessment
Now that you have completed Calculating Capital Gains and Losses, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 3: Dispositions
Welcome to Dispositions. In this lesson, you will learn about a variety of deemed dispositions including inter vivos transfers, death, changes of use, emigration, and donations. This lesson takes 45 minutes to complete. At the end of this lesson, you will be able to do the following: • given a client who could have capital gains or losses upon disposition, calculate the impact of disposition including such factors as gifts, residence in Canada, and transfers
Dispositions
A taxpayer only realizes a capital gain or loss when he or she disposes of capital property, or when he or she is deemed to have disposed of that property. ITA 54 defines a disposition of property as any transaction or event that entitles a taxpayer to proceeds of disposition, as well as: • • • any redemption or cancellation of a taxpayer’s interest in shares, bonds, debentures, notes, certificates, mortgages, agreements of sale, or similar property any expiration of options held by the taxpayer to acquire or dispose of property any transfer of property to a trust, including transfers to RRSPs, deferred profit sharing plans, employees’ profit sharing plans, or registered retirement income funds
A disposition does not include transfers where the only purpose of the transfer is to secure a debt or a loan. It also does not include transfers of legal ownership where there is not also a transfer of beneficial ownership, with the exception of the trusts mentioned above. Angela has shares with a FMV of $2,000 and an ACB of $1,000 that she wants to transfer to her RRSP. An RRSP is a form of trust and the trustee has legal ownership of the trust assets, but as the beneficiary of the trust, Angela has beneficial ownership. However, under the rules mentioned above, Angela will be deemed to have disposed of the shares at FMV if she transfers them to an RRSP. In addition to the actual dispositions contemplated by ITA 54, in many cases, the Income Tax Act presumes a disposition to have taken place. These deemed dispositions generally involve transactions that do not give rise to proceeds. Examples of deemed dispositions include: • • • • • terminating Canadian residency (i.e., emigration) changing the use of property (e.g., from rental property to principal residence) death of the property owner transferring property by way of gift or donation involuntary transfers via theft, fire, etc.
We will discuss the most common actual and deemed dispositions in the following pages.
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7-21
Taxation of Capital Property
Sale
When property is sold, the proceeds of disposition are generally the sale price (ITA 54), so this amount is used to determine the capital gain or loss. Amanda sold corporate shares for $4,000. Her ACB is $3,000 and there were no costs associated with the disposition. Her capital gain is $1,000, calculated as (proceeds ACB) or ($4,000 - $3,000). Sale for proceeds less than FMV If a taxpayer disposes of anything to a person with whom he or she does not deal at arm’s length for proceeds less than FMV, the taxpayer is deemed to have received proceeds equal to FMV (ITA 69 (1)(b)(i)). In this case, the buyer is deemed to acquire the property for the price that he or she paid for it. So, this could lead to double taxation. Joanne owns a cottage with an ACB of $96,000 and a current FMV of $162,000. She plans to sell the cottage to her sister, Nancy for $120,000. If she follows through with this plan, Joanne will realize a capital gain of $66,000, calculated as (FMV at the time of the sale - ACB) or ($162,000 - $96,000). Nancy would acquire the property with an ACB of $120,000. If Nancy turned around and sold the property for $162,000, she would realize a capital gain of $42,000, calculated as (actual proceeds - ACB) or ($162,000 - $120,000). Sale for proceeds more than FMV If a taxpayer disposes of property to someone with whom he or she does not deal at arm’s length for proceeds in excess of FMV, he or she is deemed to have received proceeds equal to the sale price. However, the person who acquired the property is deemed to do so at FMV. So, the same gain may be taxed twice. Chandler has decided to sell stock valued at $1,200 to his father, Michael, for $1,600. Chandler’s ACB is $800. Chandler will have a capital gain of $800, calculated as (actual proceeds - Chandler's ACB) or ($1,600 - $800). While Chandler is deemed to have received proceeds of $1,600, Michael is deemed to have acquired the shares at their FMV of $1,200. So, if the share price rises and Michael disposes of them for $1,800, he will realize a gain of $600, calculated as (actual proceeds - Michael's ACB) or ($1,800 - $1,200).
Gifts
The Income Tax Act provides that when a taxpayer disposes of property to any person by way of an inter vivos gift, including a donation, he or she is deemed to have received proceeds of disposition equal to the FMV at the time of the gift (ITA 69(1)(b)(ii)). The recipient is deemed to have acquired the property for the same amount. June gave her shares valued at $1,200 to her brother, Ian. The shares have an ACB of $1,400. June will be deemed to have received proceeds of $1,200, and she will realize a capital loss of $200, calculated as (FMV at time of deemed disposition - ACB) or ($1,200 – $1,400). Ian will acquire the shares at an ACB of $1,200.
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Income Tax Planning
Transfers to Inter Vivos Trusts
The Income Tax Act provides that if a taxpayer transfers property to an inter vivos trust, he or she is deemed to have disposed of it for proceeds equal to FMV (ITA 69(1)(b)(ii)). There are exceptions with respect to property transferred to a spousal trust, as we will discuss shortly. Larry established an inter vivos trust for the benefit of his son, Luke. Larry transferred shares with a FMV of $4,230 to the trust at a time when the ACB of those shares was $2,618. Larry realized a capital gain of $1,612 as a result of the transfer, calculated as (FMV at time of deemed disposition - ACB) or ($4,230 - $2,618), and this will increase his taxable income by $806, calculated as (capital gain x capital gains inclusion rate) or ($1,612 × 50%).
Death
The proceeds of the deemed disposition of depreciable property upon death are deemed to be equal to the fair market value (FMV) of the property immediately prior to death. The deemed disposition upon death may result in either a recapture or terminal loss, depending on the UCC of the depreciable property. The applicable amount will be added or deducted when computing the deceased’s income on his or her final return. No CCA can be claimed in the year of the taxpayer’s death because the taxpayer is deemed to have disposed of all of his or her capital property immediately prior to death (ITA 70(5) and 70(6)).
Change of Use
If a taxpayer owns property that was originally purchased for one purpose and later changes its use for the purpose of gaining or producing income, he or she is deemed to have disposed of that property for FMV. Similarly, if a taxpayer owns property that was originally acquired for the purpose of gaining or producing income and the taxpayer later changes the use of that property to some other purpose, he or she is deemed to have disposed of that property for FMV (ITA 45(1)). In either case, the taxpayer is deemed to have immediately reacquired the property for FMV at the time of the change of use. This deemed disposition may result in a capital gain or loss, and it will result in a new ACB for the purpose of calculating gains or losses on future dispositions of that property. Fiona owns a cottage that she originally acquired for $42,000 for her personal enjoyment; it is currently worth $95,600. Because she is moving out of the province, she decided to turn the cottage into a rental property. As a result of this change in use, she will be deemed to have disposed of the property for $95,600, and this will result in a taxable capital gain of $26,800, calculated as ((FMV at time of deemed disposition - ACB) x capital gains inclusion rate) or (($95,600 - $42,000) × 50%). Upon the change of use of the cottage, she is deemed to have immediately reacquired the property for $95,600. The new ACB of the cottage is $95,600.
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7-23
Taxation of Capital Property
Involuntary Dispositions
If a taxpayer receives compensation, including an insurance recovery, for property that has been stolen, destroyed or expropriated, that compensation is deemed to be proceeds of disposition for the purpose of determining capital gains or losses (ITA 54). If the compensation is for property that has been damaged, the compensation could be considered to be proceeds of disposition if the compensation is not used to repair the damaged property within a reasonable length of time. Daniel owned an office building that was destroyed by fire. He never claimed any CCA with respect to the building and his ACB was $84,000. His insurance company covered the loss and gave Daniel $102,000, the replacement cost of the building. Daniel has deemed proceeds of $102,000. This would result in a capital gain of $18,000, calculated as (insurance proceeds - ACB) or ($102,000 - $84,000).
Replacement Properties
The Income Tax Act provides for a deferral of all or part of a capital gain that results from the proceeds of disposition related to property that has been stolen, destroyed, or expropriated. In order to take advantage of this deferral, the taxpayer must acquire a replacement property by the end of the second taxation year following the year of the deemed disposition (ITA 44(1)). The taxpayer is still required to report the taxable capital gain resulting from the deemed disposition for the taxation year in which the disposition took place. However, as long as a replacement property is acquired within the time limit, the taxpayer can request that his or her income tax return for the year of disposition be reassessed to generate a refund in respect of the income taxes paid. This is as a result of the taxable capital gain that arose on the deemed disposition. Brian owned a country vacation property and the ACB of the building was $120,000. Last year, the building was destroyed by fire and his insurance company covered the replacement value of $160,000. For last year, Brian had to report a taxable capital gain of $20,000, calculated as ((insurance proceeds - ACB) x capital gains inclusion rate) or (($160,000 - $120,000) × 50%). However, Brian intends to use the insurance proceeds to have a new building constructed. As long as the new building is constructed before the end of next year, Brian will be able to request a reassessment for last year's tax return. Refer to IT-259R3, Exchanges of Property, for additional information.
Exercise: Dispositions
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Income Tax Planning
Entering or Leaving Canada
Generally, the Income Tax Act imposes tax on 50% of the capital gains realized by Canadian residents on the disposition of all types of capital property regardless of whether it is located in Canada or elsewhere. However, in the case of non-residents, the Act can only impose tax on the gains realized on the disposition of a subset of property known as Taxable Canadian Property, or TCP. TCP is generally privately owned property that is located in Canada and therefore, is within the reach of CRA. The most common forms of TCP are Canadian real estate, unlisted shares of companies resident in Canada and substantial interests (25% or more of the class) in certain shares listed on a prescribed stock exchange (ITA 115(1)(b)). Individuals who emigrate from Canada are treated as having disposed of all of their property, other than TCP, at the time of emigration. This is supposed to ensure that Canada always taxes gains that accumulate while an individual is resident in Canada, and is based on the different treatment of TCP and non-TCP in the hands of non-residents. Because nonTCP leaves the Canadian tax system when its owner emigrates, accumulated gains on nonTCP must be taxed before the individual leaves Canada. In contrast, because TCP remains in the Canadian tax system even when it is held by a non-resident, there has historically been no need, from the point of view of the Income Tax Act, to subject TCP to a deemed disposition when a taxpayer emigrates. In the following sections, we will discuss the existing rules for deemed dispositions upon immigration and emigration. Then we will provide you with an overview of the proposed changes that are intended to address the fact that tax treaties significantly limit Canada’s taxation of the TCP of non-residents. Refer to IT-176R2, Taxable Canadian property – Interests in and options on real property and shares, for more information about what constitutes TCP.
Entering Canada
A taxpayer who becomes a resident of Canada (in other words, immigrates) is generally treated as having disposed of and reacquired all of his or her property at fair market value (ITA 128.1(1)(b)). This ensures that Canada will tax only that part of any gain on the property that accumulates after the person becomes resident here. Taxable Canadian property is not subject to this deemed disposition because the property is still located in Canada and therefore, still within the reach of CRA. The Income Tax Act subjects these gains to tax when the property is actually disposed. Last year, Kyle moved to Canada from England. At the time, Kyle owned one apartment in England and one in Canada. Each property cost Kyle the equivalent of $275,000 Canadian; each property had an FMV of $400,000 at the time of his move. For Canadian tax purposes, Kyle was deemed to have disposed of the apartment in England (i.e. his non-TCP) and to have immediately reacquired the property for $400,000 before becoming a resident of Canada. His ACB for this apartment is therefore $400,000. In January of this year, Kyle sold both apartments for $525,000 each. This year, Kyle will incur a taxable capital gain for Canadian tax purposes of $62,500 as a result of actually disposing of the apartment in England, calculated as [(actual proceeds – ACB) x capital gains inclusion rate] or [($525,000 – $400,000) × 50%]. This relates to the portion of the total gain that accumulated while he was a resident of Canada.
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7-25
Taxation of Capital Property
Since the Canadian apartment is TCP, Kyle was not treated as having disposed of it when he became resident in Canada. As a result, the ACB of this apartment for Canadian tax purposes is still $275,000. His taxable capital gain upon its disposition is $125,000, calculated as [(actual proceeds – ACB) x capital gains inclusion rate] or [($525,000 – $275,000) × 50%].
Leaving Canada
If an individual taxpayer or a trust ceases to be a resident of Canada (in other words, emigrates), he or she is deemed to have disposed of his or her property at FMV prior to departure and immediately reacquired it for the same amount (ITA 128.1(4)). Under the existing legislation, this deemed disposition applies to all of the taxpayer’s property, other than TCP, stock options, and certain pension and similar rights. This deemed disposition could result in a capital loss or a capital gain that is fondly referred to as the departure tax. Individuals, other than trusts, can elect to be treated as having disposed of any TCP at the time of emigration (ITA 128.1(4)(d)). Chelsea moved to Italy from Canada in 1995. At the time of the move, she owned one apartment in Italy and one in Canada. The cost of each property was the equivalent of $75,000 in Canadian dollars, and each had an FMV of $100,000 at the time of her emigration. For Canadian tax purposes, Chelsea was deemed to have disposed of the apartment in Italy (i.e. her non-TCP) and to have immediately reacquired the property for $100,000 before she ceased being a resident of Canada. Canada then taxed the taxable capital gain of $18,750, calculated as [($100,000 – $75,000) × 75%], on the Italian apartment while she was a resident of Canada. Keep in mind, the capital gains inclusion rate was 75% at the time of Chelsea's emigration in 1995. Chelsea sold both apartments this year for $120,000 each. Canada cannot tax the postdeparture taxable capital gain of $10,000 on the Italian apartment, calculated as [($120,000 – $100,000) × 50%]. Since the Canadian apartment is TCP, Chelsea was not treated as having disposed of it in 1995. So, Canada will tax the full taxable capital gain of $22,500, calculated as [($120,000 – $75,000) × 50%], this year.
Legislative Changes
Canada has tax treaties with many sovereign countries, which are agreements between the two countries as to how transactions involving the disposition of capital property in either country are to be taxed. These tax treaties significantly limit Canada's taxation of the TCP of non-residents. Treaties generally provide that only a taxpayer's country of residence can tax most gains. The most important exception is gains on real estate, which the source country can usually tax. Since Canada's tax system is based on residency. Residents of Canada are taxed on their worldwide income, while non-residents are only subject to taxation on certain types of Canadian source income. Historically, a taxpayer could emigrate from Canada and not be taxed on taxable Canadian property, such as shares in a Canadian company. Canada, however, wanted to tax gains accrued when he or she was a resident. To address this problem, the federal government initially proposed changes to the departure tax via a
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Income Tax Planning Notice of Ways and Means Motion on October 2nd, 1996. These proposals underwent discussion and several revisions, until legislation was finally enacted in June, 2001. The new system greatly expanded the reach of the departure tax to include Canadian assets held at the time of departure. The following table summarizes the old and new taxation of certain types of property upon emigration. The changes impacted mainly small business owners, as well as investors in Canadian public companies, mutual funds, and foreign real estate. Taxpayer Migration - Old and New Rules Property Are nonresident’s gains taxable in Canada? Yes (always). Old Rule New Rule
Canadian real estate
No deemed No change. disposition on emigration; Canada taxes when disposed of. No change.
RRSPs and Pension Gains not taxed as No deemed Rights such; income taxed disposition on when received. emigration. Life insurance policy Death benefit not taxable. No deemed disposition on emigration.
No change.
Unlisted shares Yes (subject to (e.g., small private treaty). company)
No deemed Deemed disposition disposition on on emigration; tax emigration; if assessed to extent treaty permits, $750,000 capital Canada taxes when gains exemption disposed of. not available; can defer actual payment of tax by providing security. Deemed disposition Same as unlisted on emigration; can shares (except avoid deemed $750,000 capital disposition by gains exemption is choosing to treat not available) as TCP and provide security – Canada then taxes both pre-and postdeparture gains, if treaty permits, when disposed of.
Listed shares (if No. (If emigrant taxpayer owns less chooses to treat as than 25% of class) TCP, Canada can • Foreign real tax, subject to estate treaty.) • Canadian mutual fund units (if taxpayer owns less than 25%)
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7-27
Taxation of Capital Property
Exercise: Leaving or Entering Canada, Part 1
Exercise: Leaving or Entering Canada, Part 2
Transfers Between Spouses
If a taxpayer transfers non-depreciable capital property via gift or sale, or as a result of a settlement agreement or award to the following: • • • his or her spouse or former spouse his or her common-law partner or former common-law partner a spousal trust or common-law partner trust
then that transfer is deemed to have occurred at the taxpayer’s ACB, unless the taxpayer elects otherwise. So, unlike other transfers for less than FMV, a gift or sale of property to a spouse or common-law partner for less than FMV will not result in a deemed disposition at FMV. Similarly, if the taxpayer disposes of depreciable capital property to his or her current or former spouse or common-law partner, or to a spousal trust, the transfer is deemed to have occurred at the UCC of the transferred asset (or cost amount if there are multiple properties in the same class) (ITA 73(1)). Spousal or common-law partner trust A spousal or common-law partner trust is any trust created by the taxpayer under which: • • His or her spouse or common-law partner is entitled to receive all of the income of the trust that arises before his or her death. No person except the taxpayer's spouse or common-law partner may, before the spouse's death, receive or otherwise obtain the use of any of the income or capital of the trust (ITA 73(1)(c)).
Spousal rollover rule This transfer at ACB or UCC is commonly referred to as the spousal rollover rule. The effect of the rollover is to defer the recognition of any capital gains until the recipient spouse or common-law partner disposes of the property.
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Income Tax Planning Sheldon has shares in Corplex Inc, with an ACB of $1,400 and an FMV of $2,000. As part of his divorce settlement, he transferred the shares to his ex-wife, Belinda. Sheldon is deemed to have received proceeds of disposition of $1,400, so he will not realize a capital gain at the time of the transfer. Belinda acquires the shares with an ACB of $1,400. If Belinda later sells the shares for $2,200, she will realize a taxable capital gain of $400, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($2,200 - $1,400) × 50%). Note: The rollover is automatic, and the taxpayer, but not the other spouse or common-law partner, must file an election to opt out of the rollover. A taxpayer might want to opt out of the rollover if he or she had capital losses to offset, if he or she could make use of a capital gains exemption to shelter the gain, or if he or she wanted to avoid subsequent income attribution. In the same year, Sheldon had a capital loss of $600. Sheldon could file an election to opt out of the rollover, in which case he would realize a capital gain of $600, calculated as (FMV at time of transfer - ACB) or ($2,000 - $1,400). This gain would be offset by his capital loss. Belinda would then acquire the property at an ACB of $2,000, such that when she later sells the shares for $2,200, she will realize a taxable capital gain of only $100, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($2,200 - $2,000) × 50%).
Transfers of Farm and Fishing Property
In an effort to maintain the role of the family farm in the Canadian economy, the Income Tax Act permits a tax-deferred rollover to a child (as well as the deferral of any potential capital cost allowance recapture) until the child eventually disposes of the property. Two conditions must be met in order to be eligible for the tax-deferred rollover: i) ii) The child must be a resident of Canada just before the transfer. The property is an active farm in which the taxpayer, his or her spouse or common-law partner and their children were actively engaged in the farming operation on a regular and ongoing basis before the transfer.
Farm property includes land and depreciable property used in the business of farming (ITA 73(3)), as well as capital stock of a family farm corporation or an interest in a family farm partnership (ITA 73(4)). The definition of a child includes a child of the taxpayer, a stepchild, an adopted child (including a child adopted in fact), a grandchild, a greatgrandchild, or the spouse or common-law partner of any child as previously defined. Electing the transfer price For most farming property, the transfer price can be any amount between the ACB of the property and its fair market value (FMV). For depreciable property, the transfer price can be any amount between its undepreciated capital cost (UCC) and its FMV. Transfer of farm property to a child on death of a parent A tax-deferred rollover of a Canadian farm property to a child is also permitted in the year a parent dies subject to the same conditions as an inter vivos transfer (i.e. while the transferor is alive). In most cases, the transfer must take place no later than 36 months following the death of the parent.
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Taxation of Capital Property
Refer to IT-268R4, Inter Vivos Transfer of Farm Property to a Child, or IT-349R3, Intergenerational transfers of farm property on death, for more information. Transfers of fishing property The 2006 Federal budget extended the tax-deferred intergenerational rollover applicable to qualified farm properties to families involved in a qualified fishing business. The conditions that apply to the rollover of farm properties also apply to the rollover of fishing property. Qualified fishing property includes real property or a fishing vessel used principally in the business of fishing as well as a share of the capital stock of a family fishing corporation or an interest in a family fishing partnership.
Transfers to Corporations or Partnerships
In some cases, a taxpayer may want to transfer capital property to a corporation or partnership in which he or she is involved. While this is a deemed disposition of capital property, the Income Tax Act may allow the taxpayer and the business to elect deemed proceeds of disposition that are less than FMV, as long as certain conditions are met. Property that can be rolled over generally includes all capital property, including depreciable property, but excluding land inventory (ITA 85(1)). These deemed proceeds then become the cost of acquisition for the corporation, such that the corporation is assuming the taxpayer’s potential income tax liabilities for the property (ITA 85(1)(a)). This is commonly referred to as a Section 85 rollover. In the case of corporations, a taxpayer will transfer capital property to the corporation in exchange for some consideration, which could include shares in the corporation and other non-share consideration. The non-share consideration can consist of cash or a promissory note for any amount between the ACB and the FMV of the property disposed. By taking back a promissory note, the taxpayer can later redeem the note for cash without realizing a capital gain.
Section 85 Rollover: Upper and Lower Limits
There are three basic scenarios under which a Section 85 rollover can take place where the taxpayer and the corporation can elect deemed proceeds within an upper limit (equal to the FMV of the property transferred to the corporation) and a lower limit as detailed in the following table. The table also shows the impact of the upper and lower limits on the taxpayer and the corporation.
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Income Tax Planning Lower Limits for Section 85 Rollovers Situation Lower Limit Outcome Taxpayer cannot elect to generate a capital loss. Taxpayer can choose to defer recognition of capital gain. To the extent that the deemed proceeds are less than the FMV of the transferred property, the burden of taxation on capital appreciation is shifted to the corporation. Scenario 2: property with a the FMV of the nonFMV equal to or greater than share consideration its ACB is transferred to a corporation in exchange for at least one share in that corporation, plus some nonshare consideration between the FMV and ACB of the property transferred to the corporation Taxpayer cannot elect to generate a capital loss. Taxpayer can choose to defer recognition of capital gain. To the extent that the deemed proceeds are less than the FMV of the transferred property, the burden of taxation on capital appreciation is shifted to the corporation. Taxpayer is forced to recognize a gain to the extent that the FMV of the non-share consideration exceeds the ACB. Scenario 3: property with a the FMV of the FMV less than its ACB is property transferred transferred to a corporation in to the corporation exchange for at least one share in that corporation, plus some non-share consideration between the FMV and ACB of the property transferred to the corporation The taxpayer is forced to realize a loss if the FMV of the transferred property is less than its ACB. Any subsequent recovery in the value of the transferred property will be taxable to the corporation.
Scenario 1: property is the ACB of the transferred to a corporation in property transferred exchange for share to the corporation consideration only
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7-31
Taxation of Capital Property
Exercise: Transfers to Corporations or Partnerships
Section 97 Rollover to a Partnership
The Income Tax Act also allows a taxpayer to dispose of capital property to a partnership on a rollover basis, provided that he or she executes a joint election with all of the other partners in the partnership and that part of his or her compensation includes an interest in the partnership (ITA 97(2)). The transfer of capital property to a corporation or partnership can become fairly complex; we will not deal with it further here. It is sufficient for you to be aware that such transfers are allowed with no immediate tax consequence to the transferor, but that if so desired, gains can be triggered if the elected transfer price exceeds the cost base of the property.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Dispositions. In this lesson, you have learned how to do the following: • given a client who could have capital gains or losses upon disposition, calculate the impact of disposition including such factors as gifts, residence in Canada, and transfers
If you are ready to move to the next lesson, click Losses on the table of contents.
Assessment
Now that you have completed Dispositions, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 4: Losses
Welcome to Losses. In this lesson, you will learn how the taxpayer can use capital losses to reduce his or her tax liability in the year of disposition or in other years, and special rules for losses that result from deemed dispositions upon death. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • calculate capital losses, including such factors as allowable business investment losses, net capital loss carryovers, superficial losses, and stop-loss rules
Losses and Net Capital Losses
If a taxpayer disposes of an asset for proceeds less than the sum of the adjusted cost base and the expenses related to disposition, he or she will realize a capital loss, and the allowable capital loss is 50% of the capital loss. While this seems simple enough, the Income Tax Act then sets out a series of rules governing the deductibility of capital losses. In order to help you as you go through this lesson, we have created a short scenario and accompanying table, to define and give examples of each of the types of losses and gains that we discuss in the lesson. Click the icon to view Jane's Gains and Losses.
Feel free to print the PDF file and use it as a reference tool as you go through this lesson. Net capital losses The net capital loss for a year, in its most basic form, is simply the sum of all allowable capital losses for the year minus all taxable capital gains for the year (ITA 111(8)). Stephanie disposed of 100 shares in ABC Corp., which resulted in a taxable capital gain of $1,025. She also disposed of 200 shares in DEF Inc, which resulted in an allowable capital loss of $1,240. Stephanie had a net capital loss of $215, calculated as (taxable capital gains – allowable capital losses) or ($1,025 - $1,240). Allowable capital losses may generally only be applied to offset taxable capital gains, either in the same year or as a net capital loss carryover, according to the rules outlined in a later section. Stephanie cannot apply the net capital loss of $215 against her other sources of income for the year. Instead, she must carryover the net capital loss. While the basic form of a net capital loss is fairly straightforward, there is a further adjustment to the net capital loss amount in the case of certain unused allowable business investment losses (ABILs).
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7-33
Taxation of Capital Property
Allowable Business Investment Losses (ABILs)
There is an exception to the general rule that allowable capital losses cannot be deducted against ordinary income. It applies to an allowable business investment loss incurred by investing in a small business corporation, and it is meant to give taxpayers an incentive to invest in private Canadian businesses. Unlike other capital losses, when calculating taxable income for the year, a taxpayer can deduct an allowable business investment loss (ABIL) from any other source of income for the year (ITA 3(d)). An allowable business investment loss is a type of allowable capital loss that is calculated as 50% of a business investment loss (ITA 38(c)). A taxpayer may realize a business investment loss if he or she disposes of shares of a small business corporation or a debt owed to him or her by a Canadian-controlled private corporation (CCPC) for proceeds less than ACB plus expenses, as long as: • that disposition is to an arm’s length person • that disposition is deemed to have occurred as a result of the recognition of a bad debt or shares of an insolvent company (ITA 50(1)) A taxpayer is generally deemed to have a disposition under ITA 50(1) if: • • in the case of a debt owed to him or her at the end of the taxation year, the debt is established to have become a bad debt during the year in the case of shares in a corporation, the corporation has become bankrupt, is winding up, or has become insolvent, such that the FMV of its shares has become nil the taxpayer makes an election to have ITA 50(1) apply
•
If the taxpayer makes this election, he or she is deemed to have disposed of the debt or shares at the end of the year and to have reacquired it immediately after the end of the year at a cost of nil. Shelley held shares in Defunct Corporation, which went bankrupt last year. Her shares had an ACB of $14,600. Shelley elected to have ITA 50(1) apply, so she will have an allowable business investment loss of $7,300, calculated as ((proceeds - ACB) x capital gains inclusion rate) or ((0 - $14,600) × 50%). The amount of ABIL will be reduced if the taxpayer has claimed capital gains deductions in prior years.
Non-capital Losses
If a taxpayer has an ABIL that is greater than his or her other income for the year, he or she will not be able to deduct all of the ABIL in the year it arises, and the remainder is treated as a non-capital loss. A non-capital loss is generally the sum of any losses from business, employment, or property (including rental losses), as well as any allowable business investment losses that could not be deducted from other income in the year of the loss. A taxpayer can carry non-capital losses back three years and forward 20 years to be deducted from all other sources of income when calculating the taxable income of those years.
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Income Tax Planning Unused ABILs form a part of an individual's non-capital losses at any given time, however, ABILs may only be carried forward 10 years, whereas non-capital losses may be carried forward for 20 years. So, what constitutes an individual's non-capital losses will depend on whether any unused ABILs are still within their carryover period. An ABIL that is not deducted as a non-capital loss by the end of the tenth year of its carryforward period becomes a net capital loss at the end of that tenth year. This treatment allows the loss to be carried forward indefinitely, but to be deducted only against taxable capital gains beginning in the eleventh year. In 1997, Marie incurred an ABIL. She was unable to deduct the entire loss from all of her sources of income by the end of 2007 – the end of the 10-year carryforward period for ABILs – so, the loss became a net capital loss in 2007. Marie can now carry the remainder of her loss forward indefinitely however, she can only deduct it against taxable capital gains realized in 2008 and later years. Refer to IT-484R2, Business Investment Losses, and IT-159, Capital Debts Established to be Bad Debts, for more information about ABILs.
Net Capital Loss Carryovers
So, a net capital loss is more accurately defined as the sum of all allowable capital losses for the year minus all taxable capital gains for the year, plus any ABILs that were not deducted as a non-capital loss by the expiry of the carry-forward period. A net capital loss may be carried back three years to offset taxable capital gains in any or all of those years (up to the amount of the net capital loss). Alternatively, a net capital loss may be carried forward indefinitely to offset taxable capital gains realized in future years (ITA 111(1)(b)). A taxpayer will have to determine whether it is to his or her advantage to carry a net capital loss back or to save it for a future year. The anticipated marginal tax rate of the taxpayer in future years will play a big role in this decision. Michael has a net capital loss of $6,000. He could carry the loss back to apply it against net taxable capital gains in the previous three years, or he could carry it forward indefinitely. During the last three years, Michael did have net taxable capital gains, but his marginal tax rate during those three years was only 33%. Next year, Michael anticipates having a large capital gain and a marginal tax rate of 52%. So, Michael would be better off carrying the net capital loss forward to next year. Refer to IT-232R3, Losses – Their Deductibility in the Loss Year or in Other Years, for additional information.
Exercise: Losses
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7-35
Taxation of Capital Property
Accounting for Different Capital Gains Inclusion Rates
Since capital gains first became subject to tax in 1972, the inclusion rate has changed four times. This must be accounted for when capital losses that were realized at one inclusion rate are used to offset capital gains that were realized at a different inclusion rate. There are many provisions of the Income Tax Act that deal with gross capital losses or gross capital gains, instead of allowable capital losses and taxable capital gains. For example, the capital gains exemption for qualified small business shares and qualified farm and fishing property is intended to exempt gross capital gains of up to $750,000 during the taxpayer’s lifetime, but it is implemented by a deduction calculated at the current inclusion rate. Therefore, you need to be aware of how the inclusion rate has changed over time. Similarly, adjustments may be required when using the provisions for a net capital loss carryover between years with different inclusion rates. Jason had a net capital loss of $7,500 in 1996, which he carried forward and wanted to apply against a taxable capital gain of $16,000 realized this year. In 1996, the capital gains inclusion rate was 75%, so Jason’s net capital loss of $7,500 resulted from a gross capital loss of $10,000, calculated as (allowable capital loss ÷ capital gains inclusion rate in 1996) or ($7,500 ÷ 75%). Let's look at what occurred in another way: • In 1996, Jason sold some shares for a capital loss of $10,000. The inclusion rate at this time was 75%, so Jason had an allowable capital loss of $7,500 calculated as ($10,000 x 75%). In 1996, Jason did not have any taxable capital gains so for the year he ended up with a net capital loss of $7,500 and a net capital loss carryover of the same amount.
•
Currently, the capital gains inclusion rate is 50%. This means Jason’s taxable capital gain of $16,000 resulted from a capital gain of $32,000, calculated as (taxable capital gain ÷ current capital gains inclusion rate) or ($16,000 ÷ 50%). To make sure we account for these different inclusion rates during the carryover process, we carry forward the gross capital loss of $10,000 and deduct it from the gross capital gain of $32,000. Jason’s remaining taxable capital gain after the carry forward is $11,000, calculated as [(gross capital gain - gross capital loss) x current capital gains inclusion rate)] or [($32,000 - $10,000) × 50%]. Let's look at what occurred in another way: • This year, Jason sold some shares and realized a capital gain of $32,000. The inclusion rate at the time was 50%, so Jason had a taxable capital gain of $16,000 calculated as ($32,000 x 50%). Jason would like to offset some of these gains using his net capital loss carryover of $7,500. However, he has to account for the two different inclusion rates involved in the transaction.
•
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Income Tax Planning • • Jason must first carry forward his capital loss of $10,000 and deduct it from his capital gain of $32,000. This means Jason has a taxable capital gain of $11,000 calculated as [($32,000 $10,000) x 50%].
Superficial Losses
To prevent abuses of the deductibility of allowable capital losses, the Income Tax Act prohibits the deduction of a superficial loss by effectively declaring the loss to be nil (ITA 40(2)(g)). A taxpayer will incur a superficial loss if: • he or she disposes of a capital property and the taxpayer or an affiliated person acquires a substituted property (which includes the same property or an identical property) during a period that begins 30 days before and ends 30 days after the disposition at the end of that period, the taxpayer or an affiliated person still owns or had a right to acquire the substituted property (ITA 54)
•
Under the superficial loss rules, a taxpayer will only be able to claim a loss if the taxpayer or an affiliated person does not acquire the same or identical capital property—shares in the same company, for example—at any time within the 61-day window (the day of disposition, plus 30 days before the disposition and 30 days after the disposition). So in order for the loss to be fully deductible, the same or identical property must be acquired at least 31 days before or 31 days after the disposition. Ron disposed of 400 shares of MXT Inc. with an ACB of $1,600 on July 1st for net proceeds of $1,260. His wife, Carla, purchased 400 shares of MXT on June 15th of the same year for $1,300 and she still held them on July 31st. Ron’s loss of $340, calculated as, (proceeds - ACB) or ($1,260 - $1,600) is a superficial loss, so his allowable capital loss is nil. While the taxpayer who disposed of the property is prohibited from deducting the loss, the affiliated person who acquires the substituted property can add the superficial loss to the ACB of the substituted property (ITA 53(1)(f)). Continuing on from the previous example, Carla’s ACB for her MXT shares is $1,640, calculated as (superficial loss + purchase price) or ($340 + $1,300). Affiliated persons or persons affiliated with each other generally include the following (ITA 251.1): • • • the taxpayer and his or her spouse or common-law partner a corporation controlled by the taxpayer or his or her spouse or common-law partner a partnership in which the taxpayer or his or her spouse has a majority interest
Also inherent in this definition is the fact that a taxpayer is affiliated with himself or herself, so two corporations or partnerships are affiliated if they are controlled by the same person.
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Taxation of Capital Property
Exceptions to the Superficial Loss Rule
The superficial loss rule does not apply in the case of deemed dispositions that occur upon: • • • • • emigration death expiry of an option change of use of property the recognition of a bad debt
Horace purchased 200 shares of Badnews Corp. on March 15th. The shares had an ACB of $500. Horace died on April 3rd, and the FMV of the shares at the time of his death was $460. Horace’s executors elected to transfer the shares to Horace’s wife at fair market value. Even though Horace is deemed to have disposed of his shares immediately prior to death for FMV and his death occurred within the specified window, he has not incurred a superficial loss, but an allowable capital loss.
Stop-Loss Rules
Capital dividends are payments that a shareholder may receive from a private corporation’s capital dividend account, which records the total of the tax-free portion of capital gains, the gains from company-held life insurance policies and the tax-free portion of sales of goodwill. Capital dividends are not taxable to the shareholder when they are received, and as with other dividends, they are paid at the discretion of the directors of the corporation. The Income Tax Act has a stop-loss rule that prevents the creation of the capital loss when shares of a corporation with a balance in its capital dividend account are sold. Ivan bought all of the shares of ABC Inc. for their current FMV of $100,000. ABC Inc. had $75,000 in cash and $75,000 in its capital dividend account. In his role as a director of ABC Inc., Ivan directed the corporation to pay him a tax-free capital dividend of $75,000, thereby depleting the corporation's cash to $0 and its FMV to $25,000, calculated as (original FMV - tax-free capital dividend) or ($100,000 - $75,000). Ivan then sold his ABC shares for their new FMV of $25,000 and tried to claim a loss of $75,000, calculated as (proceeds - ACB) or ($25,000 - $100,000). However, under the stop-loss rules, Ivan will be denied the loss, because he has not really suffered a loss. The stop-loss rule says that if an individual taxpayer who has control over a private corporation that paid him or her capital dividends subsequently disposes of those shares and that disposition results in a capital loss, that loss is reduced by the lesser of: • • the sum of all capital dividends received by the taxpayer on those shares the loss minus all taxable dividends received by the taxpayer on those shares (ITA 112(3)(a))
Therefore, in the previous example, Ivan will have a capital loss of $0, because his apparent loss of $75,000 upon the sale of his shares will be reduced by the capital dividend of $75,000 that he had received. Effectively, the stop-loss rules disallow a capital loss arising from payment of a capital dividend, but allow a capital loss arising from the payment of a taxable dividend.
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Income Tax Planning The stop-loss rules are intended to ensure that taxpayers who have control over a private corporation cannot cause the corporation to both pay out a tax-free dividend and claim a loss when disposing of the shares when that loss could be attributed, at least in part, to the dividend distribution. As a result, the stop-loss rules do not apply if both of the following conditions are met: • the capital dividends were received by the taxpayer at a time when he or she and persons with whom he or she did not deal at arm’s length owned not more than 5% of the shares of any class of capital stock in the corporation the capital dividends were received on shares that the taxpayer owned throughout the 365-day period that ended immediately before the disposition (ITA 112(3.01))
•
Refer to IT-328R3, Losses on shares on which dividends have been received, for more information.
Exercise: Inclusion Rates/Losses, Part 1
Exercise: Inclusion Rates/Losses, Part 2
Exercise: Inclusion Rates/Losses, Part 3
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7-39
Taxation of Capital Property
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Losses. In this lesson, you have learned how to do the following: • calculate capital losses, including such factors as allowable business investment losses, net capital loss carryovers, superficial losses, and stop-loss rules
If you are ready to move to the next lesson, click Special Situations on the table of contents.
Assessment
Now that you have completed Losses, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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www.CIFP.ca @ 2010
Income Tax Planning
Lesson 5: Special Situations
Welcome to Special Situations. In this lesson, you will learn about how capital gains and losses are determined with respect to specific types of property, including depreciable property, personal property, debts, and foreign currencies. So far, we have covered the basics of capital gains taxation, including situations where the deemed proceeds of disposition may be something other than FMV. Now we will look at how these rules are applied to a number of special situations, many of which are governed by their own variations of the rules discussed so far. This lesson takes 35 minutes to complete. At the end of this lesson, you will be able to do the following: • integrate depreciable and personal-use property, stock dividends, debts, and foreign currencies when calculating capital gains or losses
Depreciable Property
Depreciable property is a special type of capital property on which capital cost allowance can be claimed. A taxpayer can realize a capital gain when he or she disposes of depreciable property, but he or she cannot realize a capital loss. Capital gains on depreciable property The capital gain on the disposition of depreciable capital property is calculated as the excess of the net proceeds of disposition over the aggregate of the adjusted cost base and the costs of disposition. In the case of depreciable property, the ACB is simply the capital cost of the property (ITA 54). If the proceeds exceed the capital cost, which in turn exceeds the undepreciated capital cost, the difference between the ACB and the UCC will be a recapture of CCA. Sarah owns a rental building that she acquired at a capital cost of $94,300. The building is situated on leased land, so we do not have to worry about the land at this point. She has claimed CCA on the building over a period of years such that her UCC is $72,000. Sarah sells the building for $110,000. She has a recapture of CCA of $22,300, calculated as (UCC before disposition - (the lesser of (net proceeds and capital cost)) or ($72,000 – (the lesser of $110,000 and $94,300)). The full amount of this recapture must be included in her income for the year of disposition. Sarah also has a taxable capital gain of $7,850, calculated as ((proceeds - capital cost) x capital gains inclusion rate) or (($110,000 $94,300) x 50%). Losses on depreciable property However, a taxpayer cannot realize a capital loss when he or she disposes of a depreciable property (ITA 39(1)(b)). This is because the cost of depreciable property is already deductible from income under the CCA and terminal loss rules. If the proceeds of disposition are less than the taxpayer’s UCC, the difference is deductible from his or her business or property income as a terminal loss.
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7-41
Taxation of Capital Property
Disposition of Land and Building
A taxpayer may sell a real property consisting of a building and land. The sale of the building, being a depreciable property, might give rise to a terminal loss or recapture depending upon the proceeds, as well as a capital gain. The sale of the land, being a nondepreciable asset, can give rise only to a capital gain or capital loss depending upon the proceeds. If the property is sold, and the sale of the building results in a terminal loss, but the sale of the land results in a capital gain, the terminal loss will be reduced to the extent of any capital gain on the land (ITA 13(21.1)). The effect of this adjustment is to convert all or part of the terminal loss to a capital loss deductible at the 50% inclusion rate, rather than the 100% rate for terminal losses. Refer to IT-220R2, Capital cost allowance – proceeds of disposition of capital property, for further information.
Personal-use Property
Personal-use property is any property that is owned by the taxpayer and used primarily for his or her enjoyment or for the use or enjoyment of one or more individuals related to the taxpayer. Gains on disposals of personal-use property are taxable in the same manner as other capital gains, but losses on personal-use property are not deductible, even to offset personal-use property gains. Instead, the losses are assumed to be nil (ITA 40(2)(g)(iii)).
$1,000 Floor Rule
To eliminate the nuisance factor involved in keeping track of gains and losses on small items, the Income Tax Act provides a $1,000 floor rule for personal-use property. Under this rule, when a taxpayer calculates a capital gain on personal-use property, the adjusted cost base is deemed to be the greater of the actual ACB and $1,000. Similarly, proceeds of disposition are deemed to be the greater of actual proceeds and $1,000 (ITA 46(1)). Philip sold his comic book collection for $1,200 and his ACB was $500. The deemed proceeds of disposition of his comic book collection is $1,200 calculated as [the greater of (actual proceeds and floor limit)] or [the greater of ($1,200 and $1,000)]. The ACB of the property is deemed to be $1,000 calculated as [the greater of (actual ACB and floor limit)] or [the greater of ($500 and $1,000)]. Philip's taxable capital gain is $100, calculated as [(deemed proceeds – deemed ACB) x capital gains inclusion rate] or [($1,200 – $1,000) × 50%]. Jamie sold his canoe for $900; he purchased it for $1,500. The deemed proceeds of disposition of his canoe is $1,000 calculated as [the greater of (actual proceeds and floor limit)] or [the greater of ($900 and $1,000)]. The ACB of the property is deemed to be $1,500 calculated as [the greater of (actual ACB and floor limit)] or [the greater of ($1,500 and $1,000)]. Jamie's loss is $500, calculated as (deemed proceeds – deemed ACB) or ($1,000 – $1,500). Under ITA 40(2)(g)(iii) his loss for tax purposes is deemed to be $0. So, there are no tax consequences as a result of this transaction.
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Income Tax Planning If the actual proceeds and the actual ACB are both less than $1,000, no capital gain or loss can arise because the deemed proceeds and the deemed ACB will both be $1,000. Refer to IT-332R, Personal-use property, for additional information.
Listed Personal Property
Listed personal property is a subset of personal-use property that includes only the following items (ITA 54): • • • • • a print, etching, drawing, painting, sculpture, or similar work of art jewellery a rare folio, rare manuscript or rare book a stamp a coin
Because listed personal property is a form of personal-use property, the $1,000 floor rule applies. After applying the floor rule, capital gains are taxed as normal. Unlike losses realized on other personal-use property, losses on dispositions of listed personal property can be applied to reduce gains on the disposition of other listed personal property arising in the same taxation year (ITA 41(2)). Any resulting net loss may be carried back against net listed personal property gains of the previous three taxation years and carried forward against such gains in the subsequent seven taxation years. Hannah enjoys collecting paintings to decorate her home, but she tires of them and changes them often. This year, she sold three paintings, as follows: • • • painting #1 resulted in a capital gain of $800 painting #2 resulted in a capital loss of $1,200 painting #3 resulted in a capital gain of $0
Hannah has a net capital loss of $400 from listed personal property, calculated as (capital gain on painting #1 - capital loss on painting #2 + capital gain on painting #3) or ($800 $1,200 + $0). She can carry this loss back three years or forward seven years to apply it against other gains from listed personal property. Refer to IT-332R, Personal-use property, for additional information.
Exercise: Special Situations
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Taxation of Capital Property
Stock Dividends
A stock dividend is a distribution of corporate profits to shareholders in the form of additional shares of the company, rather than as cash, accompanied by an increase in the paid-up capital of the corporation. Tracey originally purchased 1,000 shares of NewCorp Ltd., a CCPC, at a cost of $8.40 per share. When NewCorp distributed a 5% stock dividend, Tracey received 50 additional shares in the company instead of cash. Stock dividends declared and paid after May 23, 1985 are treated as taxable dividends in the year of receipt — subject, of course, to the gross-up and dividend tax credit. For the recipient, the actual amount of the dividend (prior to gross-up) becomes the ACB of the stock (ITA 52(3)). The amount of the stock dividend is the increase in the paid-up capital of the corporation (ITA 248(1) amount). When Tracey received the stock dividend, the increase in the paid-up capital of the stock was $12.45 per share. So, Tracey had dividend income of $622.50, calculated as (additional shares x FMV) or (50 × $12.45), and this amount was subject to the gross-up and dividend tax credit. So, Tracey had taxable dividend income of $778.13, calculated as (dividend income x gross-up) or ($622.50 × 125%). Tracey recently sold all of her shares in NewCorp for $16.70 per share for a capital gain of $8,512.50, calculated as (proceeds - ACB) or ((1,050 × $16.70) – ((1,000 × $8.40) + (50 × $12.45))).
Debts
The Income Tax Act includes special rules for situations where debts are no longer collectable or when the creditor forgives the debt. In the following pages we will look at: • • • capital debts established to be bad debts bad debts on personal-use property forgiven debts
Capital Debts Established to be Bad Debts
A taxpayer may take on the role of creditor if he or she loans property to someone, or sells an asset to someone and has not yet received payment in full. A capital debt receivable is a debt receivable, other than an account receivable, acquired by the taxpayer: • • for the purpose of producing non-exempt income from a business or property as consideration for the disposition of capital property
These capital debts receivable are considered to be capital property, so they can give rise to a capital gain or loss upon their disposition if the taxpayer gets back more or less principal than he or she loaned out. If the taxpayer is virtually certain that he or she will not be able to collect the debts owing, he or she can elect to recognize the debt as a bad debt. The Income Tax Act may offer
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Income Tax Planning some relief to taxpayers who incur bad debts by allowing the resulting loss to be treated as a capital loss for tax purposes. If a taxpayer determines that he or she has a bad debt at the end of a taxation year, he or she can elect to recognize a deemed disposition of that debt at the end of the year for proceeds equal to nil (ITA 50(1)(a)). The taxpayer will also be deemed to have reacquired the debt immediately after the end of the year at a cost equal to nil. Armando made an unsecured loan of $10,000 to ABC Corp. for a five-year period at an annual interest rate of 16%, with the principal to be repaid in a lump sum at the end of the five years. Armando received the interest payments for the first three years and he included that interest in his income as it was received. At the end of the third year, ABC Corp. went bankrupt and Armando learned that his $10,000 would not be repaid. Armando has a bad debt and he can elect under ITA 50(1) to be deemed to have disposed of that debt for proceeds of $0. This will result in a loss of $10,000, calculated as (deemed proceeds - ACB) or ($0 - $10,000). If an actual or deemed disposition of debt gives rise to a loss, that loss will be considered to be a capital loss (ITA 40(2)(g)(ii)), in either of the following situations: • • the taxpayer made the loan for the purpose of gaining or producing income the debt was consideration for disposition of capital property in an arm’s length transaction
Because Armando made the loan for the purpose of earning a high rate of interest, his loss of $10,000 will be considered to be a capital loss, and therefore, he has an allowable capital loss of $5,000, calculated as (capital loss x capital gains inclusion rate) or ($10,000 × 50%). Burton bought a piece of land for $20,000 and last year he sold it to Mr. Bradford for $60,000. He included the taxable capital gain of $20,000 in his income for the year of sale, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($60,000 - $20,000) × 50%). He received a downpayment of $12,000, with the balance to be paid in four annual installments of $12,000. Mr. Bradford subsequently went bankrupt and Burton realized he would not receive any of the four installments. If Burton makes an election under ITA 50(1) to recognize the bad debt, he will have an allowable capital loss of $24,000, calculated as ((deemed proceeds - ACB of remaining payments) x capital gains inclusion rate) or (($0 – (4 × $12,000)) × 50%). If the taxpayer made an error in declaring a debt to be a bad debt, the fact that he or she is deemed to reacquire the debt at a cost of nil at the beginning of the next year will correct his or her oversight. Any recovery will then be a capital gain. Last year, Tina elected to declare a $10,000 debt receivable to be a bad debt, resulting in an allowable capital loss of $5,000, calculated as ((deemed proceeds - ACB) x capital gains inclusion rate) or (($0 - $10,000) × 50%). As a result, she is deemed to reacquire the debt at a cost of $0. In January this year, Tina received proceeds of $6,000 in partial satisfaction of the debt. This year, Tina will have a taxable capital gain of $3,000, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($6,000 - $0) × 50%). Refer to IT-159R3, Capital debts established to be bad debts, for more information.
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Taxation of Capital Property
Bad Debts on Personal-Use Property
If the taxpayer has a bad debt that results from the disposition of personal-use property to an arm’s length person, the Income Tax Act allows the taxpayer to elect a deemed disposition and reacquisition of the debt that will result in a capital loss (ITA 50(2)). However, the capital loss cannot exceed the capital gain that was realized when the property was disposed of. Tracy sold an antique with an ACB of $3,000 to Mr. Crawford, an arm’s length person, for $5,000. This resulted in a capital gain of $2,000, calculated as (proceeds - ACB) or ($5,000 - $3,000). Tracy accepted a downpayment of $1,400, with the balance to be paid in 12 monthly installments of $300. So, the ACB of Tracy’s loan was $3,600, calculated as (number of payments x amount of each payment) or (12 × $300). Tracy never heard from Mr. Crawford again and she was unable to track him down, so she elected to recognize the debt as a bad debt. Although this would give rise to an apparent loss of $3,600, calculated as (deemed proceeds - ACB) or ($0 - $3,600), Tracy can only recognize a capital loss of $2,000, calculated as (the lesser of (the apparent loss and the capital gain that she realized when she sold the property)) or (the lesser of ($3,600 and $2,000)).
Forgiven Debts
If a taxpayer owes money to a creditor, and the creditor forgives the loan completely or allows it to be settled for less than the amount outstanding, the taxpayer may be required to recognize the forgiven amount as a gain for tax purposes. Gains realized when debts are settled or extinguished are often referred to as Section 80 gains because they fall within section 80 of the Income Tax Act, which lays out special tax consequences for debtors with respect to the forgiven amount. For the purpose of applying the forgiveness rules, the forgiven amount is generally calculated as the principal amount of the loan, reduced by any amount paid at the time of settlement in satisfaction of the principal amount. If the taxpayer has a forgiven amount, the Income Tax Act requires this amount to first be applied against non-capital loss and net capital loss carryovers. The taxpayer can elect to use any remaining amount to reduce the capital cost and UCC of certain depreciable property or the ACB of certain property, essentially allowing the taxpayer to defer recognition of the forgiven amount until he or she disposes of that property. Finally, if he or she still has an unused forgiven amount, then 50% of that amount must be included in the taxpayer’s income (ITA 80). Stacey owed $10,000 to Camp Stove Inc., but the corporation forgave her debt. This results in a gain of $10,000 for Stacey. Stacey had a non-capital loss carryover of $3,900. Stacey must use the gain to reduce her non-capital loss carryover to $0, which leaves her with a gain of $6,100, calculated as (total gain - non-capital loss carryover) or ($10,000 - $3,900). This means that Stacey will not be able to use the non-capital loss carryover to offset her other sources of income. The only capital or depreciable property that Stacey owns is a piece of land with an ACB of $44,000 and a current FMV of $80,000. Stacey has two choices. Stacey could choose to
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Income Tax Planning reduce the ACB to $37,900, calculated as (original ACB - remaining gain from the forgiven debt) or ($44,000 - $6,100), and this would result in a higher capital gain when she eventually disposes of the property. Rather than deducting the gain from the ACB of her capital property, Stacey can choose to include $3,050 in her income now, calculated as (remaining gain from the forgiven debt x capital gains inclusion rate) or ($6,100 × 50%). However, she would be able to defer tax if she deducts the amount from the ACB of her capital property because she would not have to recognize the gain until she disposes of that property.
Exercise: Forgiven Debts
Foreign Currencies
A taxpayer who owns assets denominated in a foreign currency can realize a foreign exchange gain or loss as a result of fluctuations in the foreign exchange rate. In some cases, these gains and losses may be considered to be capital gains and losses; in others, they may be considered to be business income. The distinction is important, because gains that are capital in nature are only subject to a 50% inclusion rate. There is also a $200 exemption for capital gains or losses resulting from foreign currency exchanges. Normally, if a taxpayer has transactions in foreign currencies that do not form part of business operations, or that are merely the result of sundry dispositions of foreign currency, the resulting gain or loss will be deemed to be capital in nature. For transactions that are deemed to be capital in nature, foreign exchange gains and losses in excess of $200 are deemed to be capital gains and losses (ITA 39(2)). Janice bought a US $10,000 strip bond for $9,500 U.S., at a time when the exchange rate was 0.71. When the bond matured, the exchange rate was 0.68. When Janice bought the bond, it cost her $13,380 Canadian, calculated as (purchase price ÷ purchase exchange rate) or ($9,500 ÷ 0.71). If the exchange rate had not changed, she would have received the equivalent of $14,085 Canadian, calculated as (face value ÷ purchase exchange rate) or ($10,000 ÷ 0.71). The difference of $705, calculated as (face value at purchase exchange rate - purchase price at purchase exchange rate) or ($14,085 $13,380), is considered to be interest income. In fact, Janice received the equivalent of $14,706 Canadian upon maturity, calculated as (face value ÷ maturity exchange rate) or ($10,000 ÷ 0.68). The foreign exchange gain is $621, calculated as (actual proceeds proceeds at purchase exchange rate) or ($14,706 - $14,085). Janice’s taxable capital gain is $210.50, calculated as ((foreign exchange gain - exemption of $200) x capital gains inclusion rate) or (($621 - $200) × 50%). However, if a foreign exchange gain or loss arises as a direct consequence of the purchase or sale of goods abroad, and such goods or services are used in the business operations of the taxpayer, the gain or loss will be considered to be in the nature of income, subject to inclusion at 100%. Refer to IT 95R, Foreign Exchange Gains and Losses, for additional information.
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Taxation of Capital Property
Exercise: Foreign Currencies
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Special Situations. In this lesson, you have learned how to do the following: • integrate depreciable and personal-use property, stock dividends, debts, and foreign currencies when calculating capital gains or losses
If you are ready to move to the next lesson, click Capital Gains Exemptions on the table of contents.
Assessment
Now that you have completed Special Situations, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Lesson 6: Capital Gains Exemptions
Welcome to Capital Gains Exemptions. In this lesson, you will learn about how to integrate the use of applicable exemptions when calculating capital gains or losses. This lesson takes 50 minutes to complete. At the end of this lesson, you will be able to do the following: • integrate the use of applicable exemptions such as capital gains exemptions, principal residence, and former business properties
Capital Gains Exemptions
The Income Tax Act provides relief for taxpayers who dispose of shares of a qualified small business corporation or qualified farm property, in terms of a capital gains deduction that can effectively exempt up to $500,000 of eligible capital gains ($250,000 of taxable capital gains) from tax over the taxpayer's lifetime. The 2006 Federal Budget extended this lifetime capital gains exemption to qualified fishing property. As per the 2007 Federal Budget, the lifetime capital gains exemption was increased from $500,000 to $750,000 ($375,000 of taxable capital gains). This measure took effect on capital gains realized as of March 19, 2007. If a taxpayer is able to make use of the capital gains deduction, he or she is still required to report the taxable capital gains, net of allowable capital losses, as part of his or her income for the year on line 127 of the T1 General tax return. However, the taxpayer may then claim a deduction from his or her taxable income (ITA 110.6) on line 254. Sharon acquired her shares in Pellam Corp., a qualified small business corporation, for $100,000, and she sold them for $980,000. Sharon has never previously used any type of personal tax exemption. Sharon realized a taxable capital gain of $440,000, calculated as [(proceeds – ACB) x capital gains inclusion rate] or [($980,000 – $100,000) × 50%] and she had to include this amount in her income for the year. However, Sharon could then claim a deduction of $375,000, calculated as (unused lifetime capital gains exemption x capital gains inclusion rate) or ($750,000 × 50%), effectively exempting the first $750,000 of her total $880,000 capital gain from tax. What constitutes qualified farm and fishing property was detailed earlier in this unit. A definition of a qualified small business corporation follows.
Qualified Small Business Corporation Shares
A capital gains deduction may be available to any individual, but not a trust, who disposes of a qualified small business corporation share in the current taxation year, or at any time after June 17, 1987. That individual must have been resident in Canada throughout the year (ITA 110.6(2.1)).
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Taxation of Capital Property The definition for a qualified small business corporation offered by ITA 110.6 is extremely complex, but basically it is a Canadian-controlled private corporation that meets the following conditions: • • • All or substantially all (90%) of its assets are used in an active business carried on in Canada. It is owned by the taxpayer, his or her spouse or common-law partner, or a related partnership. During the previous 24-month period, it was not owned by an unrelated person, and more than 50% of the fair market value of the assets of the corporation during that time could be attributed to assets that are used in an active business carried on primarily in Canada.
Shares in a holding company which held all or substantially all (at least 90%) of its assets in the form of qualified small business corporation shares, will be considered to be qualified small business corporation shares. In order to prevent shareholders of a company that seeks to go public from losing out on the extra exemption, shareholders can elect a notional disposition for proceeds anywhere between the ACB and the FMV of the shares and an immediate reacquisition of the shares just before the company goes public (ITA 48.1(1)).
Calculating the Capital Gains Deduction
A taxpayer may be able to claim a capital gains deduction for the current taxation year if he or she has included in his or her income any taxable capital gains that have resulted from the disposition of either qualified farm or fishing property or qualified small business corporation shares (ITA 110.6). In this lesson we will be looking at the different ways of calculating the capital gains deduction, taking into account the taxpayer's unused lifetime limit and cumulative net investment loss (CNIL). Unused lifetime limit The deduction rules will exempt a maximum cumulative lifetime amount of all qualifying capital gains of $750,000, including gains on dispositions of qualifying farm or fishing property, qualifying small business shares, and to the extent the $100,000 LCGE was still available, personal property (ITA 110.6). This translates into a maximum deduction of $375,000 based on the current capital gains inclusion rate of 50%, calculated as (maximum exemption x capital gains inclusion rate) or ($750,000 × 50%). 'So, the taxpayer's ability to claim a capital gains deduction for the current year is limited to his or her unused lifetime limit. This is the deduction that corresponds to the portion of the maximum lifetime capital gain exemption that he or she has not yet used, or 50% of the amount of capital gains for which the taxpayer has not yet claimed an exemption. Maxine is the majority shareholder of Maxicorp, a qualified small business corporation. When she started the business several years ago with capital of $100,000, she was the sole shareholder of the company's 10,000 outstanding shares. The ACB per share is $10 calculated as (capital ÷ # of outstanding shares) or ($100,000 ÷ 10,000). Last year, when the shares were valued at $120, she sold 2,000 shares to her brother, Richard. This
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Income Tax Planning resulted in a taxable capital gain of $110,000, calculated as [((proceeds per share – ACB per share) x # of shares) x capital gains inclusion rate] or [(($120 – $10) × 2,000) × 50%]; she claimed an offsetting capital gains deduction of $110,000. As a result, Maxine's unused lifetime limit at the beginning of this year was $265,000, calculated as (maximum lifetime limit – previous deductions) or ($375,000 – $110,000). This means that she can exempt further capital gains upon the sale of more of her small business shares of up to $530,000, calculated as (unused lifetime limit ÷ capital gains inclusion rate) or ($265,000 ÷ 50%). Later this year, Maxine sells another 2,000 shares to Richard when the shares are valued at $300. This will result in a taxable capital gain of $290,000, calculated as [((proceeds per share – ACB per share) x # of shares) x capital gains inclusion rate] or [(($300 – $10) × 2,000) × 50%]. Since Maxine's unused lifetime limit is only $265,000, she can claim a maximum capital gains deduction of $265,000. Maxine will have to pay tax on $25,000, calculated as [taxable capital gain – unused lifetime limit] or [$290,000 – $265,000].
Cumulative Net Investment Loss (CNIL)
The cumulative net investment loss (CNIL, pronounced "senile") rules were established in 1988 to limit the benefits of the capital gains exemption by preventing an individual from claiming deductions for interest on loans and other investment expenses, as well as claiming the capital gains exemption. For example, if a taxpayer borrowed money and used the proceeds to buy an investment that increased in value, policymakers felt it unfair that he or she had both a deduction for the interest expense and a capital gains exemption. Although the $100,000 lifetime capital gains exemption was eliminated in 1994, the CNIL regulations are still applicable upon dispositions of qualified small business corporation shares or qualified farm or fishing property. The capital gains deduction is, in effect, reduced by the amount of the cumulative net investment loss. In other words, the taxpayer has to pay tax on an amount of taxable capital gains equal to his or her CNIL before he or she can use the capital gains deduction. A taxpayer’s cumulative net investment loss is defined as the amount by which the aggregate of investment expenses exceeds the aggregate of investment income for all taxation years after 1987. In general, investment income includes property income (i.e., dividends, interest and rent), recaptured capital cost allowance, and taxable capital gains that do not qualify for exemption. Investment expenses generally include allowable deductions from property income and rental losses. Several years ago, Jack borrowed $100,000 to invest in equity funds that focused on long-term capital appreciation. In the four years since he made this investment, he has received cumulative taxable income from the fund of $6,000, and has deducted cumulative interest expenses of $31,000 on his tax returns. Jack’s CNIL balance is $25,000, calculated as (cumulative interest expenses - cumulative taxable income) or ($31,000 - $6,000). CNIL was designed to ensure that a taxpayer cannot deduct the expenses of carrying capital property and then also avoid taxation of the gains realized when he sells that property by making use of a capital gains exemption.
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Taxation of Capital Property When the investment is sold, the taxpayer must reduce the resulting taxable capital gain by the CNIL balance before applying the capital gains deduction, to arrive at the amount of the taxable capital gain that qualifies for the taxable capital gains deduction. Joyce borrowed $400,000 to invest in a qualified small business. Over the next five years, she deducted interest expenses of $160,000, but did not receive any investment income. Therefore, she created a CNIL balance of $160,000. She then sold her small business shares for $850,000, resulting in a taxable capital gain of $225,000, calculated as ((proceeds - ACB) x capital gains inclusion rate) or (($850,000 - $400,000) × 50%). Without the CNIL rules, Joyce would have been able to exempt the entire $225,000 from tax by using the capital gains deduction in addition to receiving $160,000 in deductions due to her interest expenses. However, the maximum deduction that she can claim is $65,000, calculated as [the lesser of (taxable capital gain and unused lifetime limit) – CNIL balance] or [the lesser of ($225,000 and $375,000) – $160,000]. She will have to pay tax on $160,000, calculated as (taxable capital gain – eligible exemption) or ($225,000 – $65,000). The CNIL balance does not have to result from an investment in a qualified small business corporation in order to impact the taxpayer’s ability to claim the capital gains deduction upon the sale of those business shares. Amanda has a leveraged investment portfolio consisting primarily of growth equity funds, and as a result she has accumulated a CNIL balance of $80,000. Amanda is also the sole shareholder of a qualified small business corporation. She sells her shares in the business and realizes a taxable capital gain of $190,000. As a result, the maximum capital gains deduction that she can claim would be $110,000, calculated as (taxable capital gain CNIL) or ($190,000 - $80,000). If the taxpayer realizes a taxable capital gain, such that it exceeds the maximum capital gains deduction of $370,000 by an amount that is greater than his or her CNIL balance, his or her ability to claim the full deduction will not be impaired. David sold qualifying small business shares with an ACB of $100,000 and an FMV of $1 million, resulting in a taxable capital gain of $450,000, calculated as [(proceeds – ACB) x capital gains inclusion rate] or [($1 million – $100,000) × 50%]. David has a CNIL balance of $67,000; he must deduct this amount from his taxable capital gain before he can determine the amount of his gain that is eligible for exemption. The maximum capital gain deduction that he can claim is $375,000, calculated as [the lesser of (unused lifetime capital gains exemption and (taxable capital gain – CNIL))] or [the lesser of ($375,000 and ($450,000 – $67,000))].
Qualified Farm and Fishing Properties
A capital gains deduction may be available to any individual, but not a trust, who disposes of qualifying farm or fishing property (ITA 110.6(2)). Qualified farm property includes real property (land and buildings, but not machinery) used in a farming business in Canada, shares of a family farm corporation and interests in a family farm partnership (ITA 110.6(1)).
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Income Tax Planning Qualified fishing property includes real property or a fishing vessel used principally in the business of fishing as well as a share of the capital stock of a family fishing corporation or an interest in a family fishing partnership. In order to be eligible as qualified farm or fishing property, certain conditions regarding prior use must be met. The intent of these requirements is to allow the exemption only to individuals for whom farming or fishing is their main activity. Further information about qualified farm and fishing property was provided earlier in this unit.
Exercise: Capital Gains Exemptions/CNIL, Part 1
Exercise: Capital Gains Exemptions/CNIL, Part 2
Principal Residence
In Canada, capital gains on the sale of a principal residence are generally tax exempt. A principal residence is any accommodation owned by the taxpayer (either alone or jointly) and ordinarily inhabited by the taxpayer, his or her spouse or common-law partner, former spouse or common-law partner, or child (ITA 54). A property is ordinarily inhabited by the taxpayer if the taxpayer or his or her family primarily use it for accommodation purposes, as opposed to some other purpose. This does not mean that the taxpayer has to live there for any specified period per year, but merely that the primary purpose should be accommodation instead of producing business or rental income. As long as the taxpayer spends more time living in the residence than renting it or using it for business purposes, it would likely be considered to be primarily used for accommodation purposes. Tammy rents an apartment in Vancouver and she owns a chalet in Whistler. She spends about ten weekends at the chalet throughout the year, plus another four weeks in the summer. She rents the chalet out for two weeks each year. Tammy can still designate the chalet as her principal residence, even though it is not where she normally lives, and even though she receives incidental rental income.
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Taxation of Capital Property In the following pages we will look at: • • • • • • • Type of accommodation Limit of one principal residence per family unit Claiming the exemption Two residences prior to choosing which property to designate Change of use Renting out a principal residence Changing a rental building into a principal residence
Type of Accommodation
Many different types of dwellings can be designated as a principal residence, including a house, a farm, a condominium or a share in a co-operative housing corporation. A principal residence includes not only the building, but also the land on which it is located, usually up to a limit of ½ hectare, although larger lots may be considered in certain circumstances. Limit of one principal residence per family unit From the time capital gains first became taxable after 1971, each individual has been able to claim only one property as his or her principal residence at any one time. So, if a taxpayer owns two properties, only one of them may be designated as his or her principal residence for a particular year. Originally, it was possible for each spouse or common-law partner to designate a different property as his and her principal residence. However, for taxation years after 1981, only one property per family unit can be designated as a principal residence. The family unit generally includes the taxpayer, his or her spouse or common-law partner and his or her children (unless they are married or over 18 years of age). Where spouses or common-law partners own their home jointly, each will have to designate his or her share of the property as a principal residence for the eventual gain on re-sale to be exempt from tax.
Claiming the Exemption
A taxpayer does not have to designate a property as his or her principal residence from year to year, but only when he or she disposes of the property. To determine if a taxable capital gain will arise, the taxpayer must first calculate the capital gain. As with any capital property, the capital gain is calculated as the proceeds of disposition minus the sum of the adjusted cost base and the costs of disposition. He or she can then reduce the gain by a principal residence exemption, which is calculated using the following formula (ITA 40(2)(b)):
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Income Tax Planning Calculating the number of years between two dates The number of years between two dates is calculated as (most recent year – earliest year + 1). The plus one factor in the numerator of the principle residence exemption formula is a bonus feature designed to allow for the situation where an individual sells one house and buys another house in the same taxation year. While a taxpayer cannot designate both houses as a principal residence in the same taxation year, the bonus feature in fact gives them a year of overlap. No portion of the gain will be taxable unless the property failed to qualify as a principal residence in more than one taxation year after 1971. In 1993, Fern purchased a house for $126,000. Early in 2010, she sold it for $410,000, resulting in a capital gain of $284,000, calculated as (proceeds – ACB) or ($410,000 – $126,000). In 2004, Fern sold a cottage, and designated the cottage as her principal residence from 1991 to 2003. She can only designate the house as her principal residence from 2004 to 2010, or seven years, calculated as (2010 – 2004 + 1) even though she has owned the house for 18 full or partial years, calculated as (2010 – 1993 + 1). Fern can exempt $126,222 of the capital gain on her house, calculated as [((N1 + 1) ÷ N2) x capital gain] or [((7 + 1) ÷ 18) × $284,000]. In 2010, Fern must report a taxable capital gain of $78,889, calculated as [(capital gain – principal residence exemption) x capital gains inclusion rate] or [($284,000 – $126,222) × 50%]. Refer to IT-120R4, Principal Residence, for more information. Sheltering the entire capital gain The entire capital gain realized from the sale of a principle residence can be exempt from taxation if the number of years the property is designated as a principal residence after 1971 equals the number of years of ownership after 1971 minus 1.
Two Residences Prior to 1982
Until 1982, one spouse could own and designate the family’s usual home as a principal residence, and the other spouse could designate another property as his or her principal residence, provided each property met the test of being ordinarily inhabited by the owner. The rules changed such that beginning in 1982, each family unit could only designate one property as their principal residence. However, this change was not retroactive, so a couple can still designate two properties prior to 1982. Frank and Regina are married; they bought their house in 1973 and a cottage in 1979. They sold both properties in 2010. Frank and Regina can designate their house as a principal residence for the nine years from 1973 to 1981, calculated as (1981 – 1973 + 1). They can also designate their cottage as a principal residence for the three years from 1979 to 1981, calculated as (1981 – 1979 + 1). However, for the 29 years between 1982 and 2010, calculated as (2010 – 1982 + 1). Frank and Regina–being a family unit–can only designate one property as a principal residence at
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Taxation of Capital Property any given time. They must decide which dwelling should be designated as their principal residence in order to maximize the value of the exemption.
Choosing which Property to Designate
If a taxpayer and his or her spouse owned more than one property after 1982, they can only designate one property as their principal residence for any given taxation year. However, they do not have to designate their place of normal residence as their principal residence. They can choose to designate a second vacation property as their principal residence, provided that they occupy it occasionally throughout the year. They also do not have to designate consistently the same property as their principal residence from year to year. They may split the principal residence exemption between the two properties if it is to their advantage. A principle to remember is: in a year when there is a choice as to which property to designate as a principal residence, select the one with the higher average annual appreciation.
Exercise: Principal Residence
Change of Use: Principal Residence
A change of use of property, from non-income producing to income producing or vice versa, would normally give rise to a deemed disposition at FMV. However, special rules may apply when that property is or was the taxpayer’s principal residence. Renting out a principal residence If a taxpayer wants to move out of his or her principal residence, rent it out, and perhaps later re-occupy the property, he or she can file an election to continue to have the property considered a personal-use property and thus continue to designate the property as his or her principal residence (ITA 45(2)). This election avoids a deemed disposal at fair market value when the principal residence becomes a rental property and a second deemed disposal when the property is re-occupied and again becomes a principal residence. The taxpayer can designate the property as his or her principal residence for up to an additional four years, even though the taxpayer does not live in it, provided he or she remains resident (or is deemed to remain resident) in Canada and does not designate some other property as his or her principal residence. The only restriction is that while the election is in effect, the taxpayer cannot claim any capital cost allowance (CCA) on the property to offset any rental income received (ITA 54, Principal Residence, (d)). In 1993, Tiffany purchased a house in Nova Scotia. She lived there continuously until 2006 at which time, she decided to attend a graduate studies course at the University of Toronto. She decided to rent out her house in Nova Scotia and take a rental apartment in
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Income Tax Planning Toronto for the three-year study period. As long as Tiffany files a no-change-of-use election under ITA 45(2) and does not claim any CCA from the rental income generated by her house in Nova Scotia, she can continue to designate the house as her principal residence until and including 2010, calculated as (2006 + 4). The taxpayer does not have to reoccupy the house at the end of the four years in order to validate the original election. Beyond the four years, the no-change-of-use election will continue to apply unless the taxpayer revokes it; there is no deemed disposition at that time, but the principal residence designation normally ceases. So, when the taxpayer disposes of the property at a later date, part of the resulting gain may be taxable.
Change of Use: Rental Residence
It is important to remember that the no-change-of-use election under ITA 45(2) can only be made if the property was initially a non-income producing property. If the property was purchased as a rental property and then later occupied by the owner, a deemed disposition at fair market value will occur at the date the property ceases to be a rental property (ITA 45(1)). However, the Income Tax Act allows the taxpayer to file an election that designates the rental property as his or her residence for up to four years prior to the year in which he or she actually occupied it, as long as the taxpayer has met the following conditions: • • • The taxpayer has not claimed any CCA on the property after 1984. The taxpayer has not designated another property as his or her principal residence during that time. The taxpayer was resident in Canada during the election period (ITA 45(3)).
Jeremy bought a house in 1998 for $162,000 and rented it to a third party until June 30, 2007. The following month he moved into the house in filed a no-change-of-use election under ITA 45(3). In 2010, Jeremy sold the house for $232,000, realizing a capital gain of $70,000, calculated as (proceeds of disposition – ACB) or ($232,000 – $162,000). Jeremy owned the house for a total of 13 years, calculated as (2010 – 1998 + 1). He can designate the house as his principal residence for the four years that he actually inhabited the house, calculated as (2010 – 2007 + 1). He can also file an election designating the house as his principal residence for a maximum of four years prior to the year it became his principal residence, from 2003 through 2006. So, Jeremy can claim a principal residence exemption of $48,462, calculated as [((N1 + 1) ÷ N2) x capital gain] or [(((4 + 4) + 1) ÷ 13) × $70,000]. He will have a taxable capital gain of $10,769, calculated as [(capital gain – principal residence exemption) x capital gains inclusion rate] or [($70,000 – $48,462) × 50%].
Former Business Properties
The Income Tax Act allows for a deferral of all or part of the capital gain upon disposition if the disposition is in fact an exchange of business properties (ITA 44(1)). The Income Tax Act defines a former business property as real property (i.e., real estate), other than certain rental properties, that is used primarily by the taxpayer or someone related to the taxpayer for the purpose of earning business income (ITA 248(1)). If a taxpayer disposes of a former business property, he or she may be able to defer the capital gain that would otherwise occur if he or she purchases a replacement property by no later
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Taxation of Capital Property than the end of the following taxation year. The capital gain is deferred to the extent that the proceeds of disposition are used to acquire the replacement property. Jeff runs a financial planning practice, but he needs to move it to another city because his wife has been transferred. His existing office had an ACB of $146,000 and he sold it for $199,000. Normally this would result in a capital gain of $53,000, calculated as (proceeds - ACB) or ($199,000 - $146,000). However, Jeff purchased a new office in the new location for $180,000. Jeff can defer part of his capital gain under the rollover provision of ITA 44(1), but because his new office cost less than the amount he received for his old office, he will have to report a capital gain of $19,000, calculated as (proceeds from sale of old business property - cost of new business property) or ($199,000 - $180,000). He can defer the remaining capital gain of $34,000, calculated as (cost of new property - ACB of old property) or ($180,000 $146,000). The adjusted cost base of the replacement property is reduced by the amount of the capital gain on the former property that would otherwise be determined, minus any capital gain that the taxpayer is required to report. The ACB of Jeff’s replacement office for the purpose of calculating future capital gains or losses upon its disposition is $146,000, calculated as (cost of new property - (total capital gain on old property - reported capital gain)) or ($180,000 – ($53,000 - $19,000)). Refer to IT-259, Exchanges of property and IT-491, Former business property, for additional information.
Capital Property Owned Dec 31, 1971
Prior to 1972, capital gains were not subject to tax. A taxpayer may own property that was acquired prior to 1972, and the Income Tax Act recognizes the gains and losses that may have occurred prior to the introduction of capital gains tax. In order to recognize that a capital asset held at the start of the capital gains system on January 1, 1972 might have had a FMV that was significantly different than its original cost, the government designated two valuation days (V-Days): • • December 22, 1971, for publicly-traded common and preferred shares, rights, warrants and convertible bonds December 31, 1971 for all other capital property
CRA publishes a booklet called Valuation Day Prices of Publicly Traded Shares for taxpayers who need to determine the value of their stock holdings on December 22, 1971. This information is also included in Schedule VII of the Regulations to the Income Tax Act. When the property is subsequently sold, the V-Day value is used in determining the deemed ACB of property that was owned at the end of 1971. The default method imposed by the Income Tax Act makes use of the concept of the tax-free zone: essentially, the spread in price between the original cost and the V-day value. Using the tax-free zone method, the ACB will be the median (or middle) amount of these three amounts: cost, V-day value and proceeds of disposition (ITAR 26(3)). To illustrate, let us look at four different situations.
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Income Tax Planning Tax-free Zone Method Property Proceeds of disposition Original Cost V-Day Value Deemed ACB A $130 $100 $120 $120 B $115 $100 $120 $115 C $95 $100 $120 $100 D $95 $120 $100 $100
In situation A, the property had increased in value by $20 between the time of acquisition and the introduction of the capital gains system. Under the tax-free zone method, the ACB is the V-day value of $120, and the resulting capital gain on disposition is $10, calculated as (proceeds - deemed ACB) or ($130 - $120). As a result, the $20 gain that occurred between the time of purchase and the introduction of the capital gains system is exempt from tax. In situation B, the property had also increased in value by $20 between the time of acquisition and the introduction of the capital gains system, but since that time it has dropped in value. The ACB is deemed to be the middle value of $115, which happens to be the proceeds of disposition. Because the proceeds of disposition and the deemed cost are the same, no gain will result. In situation C, the property once again increased in value by $20 between the time of acquisition and V-Day, but then it dropped significantly to below the original cost. The ACB is the middle value of $100, which is the same as the original cost. The owner will realize a capital loss of $5, calculated as (proceeds - deemed ACB) or ($95 - $100), even though the property dropped in value by $25 since V-Day. So, while the tax-free zone method effectively exempts gains earned prior to 1972, it will not recognize post-1971 losses until they exceed the pre-1972 gains. In situation D, the property decreased in value from the time of acquisition until V-Day, and continued to decline in value after that time. The V-Day value of $100 is the median amount, so it is the ACB. Even though the taxpayer suffered an overall loss of $25 (based on $120 original cost), he can only claim a capital loss of $5, calculated as (proceeds deemed ACB) or ($95 - $100). The median rule cannot be used for an interest in a partnership or depreciable property. For these properties, the taxpayer must use the V-day value. Refer to IT-84, Capital property owned on December 31, 1971 – Median rule (tax-free zone), for additional information.
Election to use V-Day Values
The tax-free zone method is the default method for calculating the ACB of property owned on December 31, 1971. However, an individual can elect to have the ACB for each capital property owned at the end of 1971 to be equal to its V-Day value instead of the amount arrived at under the tax-free zone method (ITAR 26(7)). As a general rule, where properties held at the end of 1971 had values above their original costs, the use of the election is likely to be advantageous. However, the election must be made with the individual’s tax return for the first taxation year after 1971 in which he or she disposes of any of his or her pre-1972 holdings. If the taxpayer does not make the election, he or she must use the tax-free zone method for all pre-1972 holdings. If the election is made, he or she cannot later revert to the tax-free zone method.
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Taxation of Capital Property Note: The election to use V-Day values only applies to individuals. Corporations must use the tax-free zone method.
Identical Properties
Identical properties are properties that are the same in all material respects, such that a prospective buyer would not have a preference for one as opposed to another. The most obvious example is shares in a corporation, but other examples include gold bullion and gold certificates, or bonds and debentures with the same terms and time to maturity, or units or shares in a mutual fund. Other examples of identical properties are discussed in IT-387R2, Meaning of Identical Properties. Sometimes a taxpayer acquires identical properties at different times at different costs. Special rules are applicable to determine the ACB of identical properties for purposes of determining any capital gain or loss on their disposition. The rules depend on whether any of the property was acquired prior to 1972. There are two types of identical properties: • • identical properties acquired after 1971 identical properties acquired prior to 1972
Identical Properties Acquired After 1971
The cost of each identical property acquired after 1971 is calculated on a moving average basis, which means that a new average cost for each property is calculated at the time of each purchase. Two years ago, Jack purchased his first 100 shares of Sample Corp. at a cost of $25 per share. At that time, his average cost per share was $25. Last year, he bought another 200 shares of Sample Corp. at a cost of $26 per share and earlier this year, he bought another 150 shares at a cost of $28 per share. His average cost per share is $26.44, calculated as [(number of shares x purchase price per share) ÷ total number of shares] or [((100 × $25) + (200 × $26) + (150 × $28)) ÷ (100 + 200 + 150)]. If Jack wants to sell some of his shares, it does not matter which ones he sells, because the shares are identical properties. If he sells 200 shares at $30 per share, he will realize a capital gain of $712, calculated as [(proceeds per share – ACB per share) x number of shares] or [($30 – $26.44) × 200]. His remaining shares would still have an ACB of $26.44 per share because dispositions do not affect the average cost of the shares.
Identical Properties Acquired Prior to 1972
It gets more complicated when some or all of the identical properties were acquired prior to V-day. When someone has identical properties, some of which were acquired prior to 1972 and some after 1971, the Income Tax Act assumes there are two separate pools of properties: one that was held on December 31, 1971, and one that consists of properties acquired after that date. Dispositions made after December 31, 1971 are considered to be from the pre-1972 pool first, and from the pool of post-1971 properties only after the pre1972 pool is exhausted.
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Income Tax Planning David currently holds a total of 550 shares in Combat Inc. and he acquired the shares as follows: Pre-1972 • 300 shares with an average cost of $12.33
Post-1971 • • for $2,400, he purchased 150 shares in 1973 at $16 each for $1,800, he purchased 100 shares in 1974 at $18 each
Furthermore, the V-Day value of the shares is $15 per share. David must use the tax-free zone to determine the deemed cost when he disposes of the shares. His ACB for his post-1971 pool is $16.80 per share, calculated as ((number of shares x purchase price per share) ÷ total number of shares) or ((150 × $16) + (100 × $18)) ÷ (150 + 100)). If David sells 400 shares in Combat Inc. at $32 per share, his deemed cost for his pre-1972 pool will be $15, calculated as the median of the proceeds ($32), the V-Day value ($15), and the average cost ($12.33). Harry is deemed to have sold all of his pre-1972 shares first, so 300 of the 400 shares that he sold have a deemed cost of $15, and the remaining 100 shares have a deemed cost of $16.80. Harry will realize a capital gain of $6,620, calculated as ((proceeds - ACB) or ((400 × $32) – ((300 × $15) + (100 × $16.80))). Refer to IT-78, Capital property owned on December 31, 1971 – Identical Properties, for additional information.
Exercise: Identical Properties
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Taxation of Capital Property
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Capital Gains Exemptions. In this lesson, you have learned how to do the following: • integrate the use of applicable exemptions such as capital gains exemptions, principal residence, and former business properties
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Capital Gains Exemptions, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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Income Tax Planning
Review
Let’s look at the concepts covered in this unit: • • • • • • The Role of Property in Wealth Accumulation Calculating Capital Gains and Losses Dispositions Losses Special Situations Capital Gains Exemptions
You now have a good understanding of the taxation of capital property. At this point in the course you can explain the role of property in tax planning and wealth accumulation, calculate capital gains and losses, and calculate the impact of disposition. You can also integrate the use of applicable exemptions as well as other factors when calculating capital gains or losses. Click Assessment on the table of contents to test your understanding
Assessment
Now that you have completed Unit 7: Taxation of Capital Property, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
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I FP
Unit 8: Making Use of Tax Advantages
Income Tax Planning
Unit 8: Making Use of Tax Advantages
Welcome to Making Use of Tax Advantages. In this unit, you will learn about the types of tax advantages that an investment can generate and the trade-offs that exist between various benefits. You will also learn how to calculate the benefits of tax advantages for a client. This unit takes approximately 2 hours to complete. You will learn about the following topics: • • • Tax Advantages Investment Benefits Choosing the Right Tax Advantages
To start with the first lesson, click Tax Advantages on the table of contents.
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Making Use of Tax Advantages
Lesson 1: Tax Advantages
Welcome to Tax Advantages. In this lesson, you will learn about the methods of using tax advantages and the benefits of tax advantages for your client. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • • compare and contrast tax evasion and tax avoidance describe methods of using tax advantages assess and calculate the benefits of tax advantages for a client
Tax Advantages
A tax-disadvantaged investment is an investment that generates income that is fully taxable in the taxation period, regardless of whether the income has actually been received in cash, or has been earned but not yet paid. It offers no deductions other than those representing cash expenses during the taxation period. Marie is currently in a 50% marginal tax bracket. In January, she invested $200,000 in a money market fund. She earned interest income of $14,000 by the end of the year, or 7% before tax, calculated as (before-tax income ÷ amount invested) or ($14,000 ÷ $200,000). After-tax, Marie will only have $7,000 left, calculated as (taxable income x (1marginal tax rate)) or ($14,000 × (1 – 50%)). So, her after-tax return is 3.5%, calculated as (after-tax income ÷ amount invested) or ($4,000 ÷ $200,000). Marie has made a tax-disadvantaged investment, because the full amount of the interest income must be included in her taxable income for the current tax year. Marie had no way of avoiding taxation because there are no tax exemptions for interest income. She had no choice but to report the income in the current year, and the full amount of the income is subject to tax at her marginal rate. Could Marie have chosen a different investment with tax advantages? The answer is, of course, yes. Different investments can offer one or more of the following tax advantages: • • • avoidance conversion deferral
Therefore, a tax-advantaged investment is an investment that enables the investor to avoid, convert, or defer taxable income. We will look at each of these characteristics in turn.
Avoidance
Tax avoidance vs. tax evasion There is a difference between tax avoidance and tax evasion. Tax evasion is the commission or omission of an act knowingly with the intent to deceive so that the tax reported by the taxpayer is less than the tax payable under the law, or a conspiracy to commit such an offence (IC-73-10R3, Tax Evasion). This may be accomplished by the deliberate omission of revenue, the fraudulent claiming of expenses or allowances, and the deliberate
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Income Tax Planning misrepresentation, concealment, or withholding of material facts. Tax evasion is a criminal act and it can result in criminal charges (ITA 239(1)). In cases of legitimate tax avoidance, a taxpayer, in seeking a beneficial result, has merely implemented a certain course of action that is either clearly provided for, or not specifically prohibited, in law. Investments that provide an opportunity for tax avoidance are taxadvantaged. Avoidance through capital gains exemptions The primary way of avoiding taxes is making use of the capital gains exemptions provided in the Income Tax Act, for capital gains realized upon the disposition of: • • • a principal residence shares in a qualified small business corporation qualifying farm or fishing property
Marie purchased a house for $200,000 that served as her principal residence. If she sold the house for net proceeds of $214,000 at the end of the year, as in the previous example, she would realize a 7% before-tax return, calculated as ((proceeds - ACB) ÷ ACB) or (($214,000 - $200,000) ÷ $200,000). However, in this instance, the full amount of the gain would be exempt from taxation. Therefore, her after-tax return would also be 7%. Avoidance through Life Insurance Other avoidance possibilities are presented by life insurance. The beneficiary of a life insurance policy can avoid income tax on the mortality gain reflected in a matured policy’s proceeds. Unfortunately, an investor must die to avoid tax through life insurance.
Conversion: Capital Gains
Conversion refers to an investment that changes highly taxed income into more favourably taxed income. The conversion of ordinary income to capital gains usually requires an investment that produces deductions that offset ordinary income and produces capital gains on its eventual sale. In other words, the ordinary income from the investment that escapes tax through deductions comes back later as a capital gain on the sale of the investment. On January 1st, last year, Sean borrowed $100,000 to invest in equity mutual funds. The interest rate on the loan was 8% and his interest expense for last year was $8,000, calculated as (amount of loan x interest rate) or ($100,000 × 8%). This interest expense can be deducted from any of his other sources of income. Sean's employment income for last year was $120,000 and his marginal tax rate was 40%. So, he saved $3,200 in income tax, calculated as (interest expense x marginal tax rate) or ($8,000 × 40%), due to the interest expense deduction. This year, Sean plans to sell his shares in the mutual fund and he expects to realize a capital gain of $15,000. This will result in a taxable capital gain of $7,500, calculated as (capital gain x capital gains inclusion rate) or ($15,000 × 50%). If his marginal tax rate remains at 40%, he will pay $3,000 of income tax, calculated as (taxable capital gain x marginal tax rate) or ($7,500 × 40%).
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Making Use of Tax Advantages
Therefore, by deducting the interest expense last year and reporting a taxable capital gain this year, Sean will effectively convert some of his employment income, which is 100% taxable, into capital gains, which are only 50% taxable. He will also achieve an element of deferral, which we will discuss later.
Conversion: Shifting Tax Brackets
Conversion can also refer to any movement of income from a high marginal tax bracket to a lower marginal tax bracket. If a taxpayer can time the receipt of income to fall in a lowincome year, then it will be subject to a lower tax rate. It is January and Jerome expects to have $92,000 of taxable income taxed at a marginal tax rate of 37% this year. He will retire at the end of the year. He has $45,000 in a savings account that pays 3% annual interest. If he leaves this amount in the savings account, he will have $1,350 of taxable interest income this year, calculated as (principal x interest rate) or ($45,000 × 3%). Jerome is planning to retire on December 20th. Next year, he expects to have $27,000 of taxable income taxed at a marginal tax rate of 22%. He can convert the interest income from a 37% tax rate to a 22% rate if he can postpone the taxation of the income until the following year. All he has to do is purchase a one-year $45,000 strip bond that matures next year. The interest will accrue annually according to the bond's anniversary day, so the interest will not be taxable until next year. By doing so, he has realized both conversion and deferral.
Exercise: Tax Avoidance and Conversion
Deferral
Tax deferral is postponing the recognition of income and thereby deferring the payment of income taxes. It is similar to an interest-free loan from the government. There are several ways to achieve tax deferral: • • • • • timing of receipts capital appreciation deductions from current income registered savings present value of future taxes
We will discuss each of these methods in more detail on the following pages.
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Income Tax Planning
Timing of Receipts
It is sometimes possible to take advantage of the accrual rules to defer the receipt or the recognition of income to a following year. It is January 2nd and Phoebe has $100,000 to invest. She could put the money in a money market fund that will pay interest income of 5%. This year, she would have to report approximately $5,000 of taxable income, calculated as (principal x interest rate) or ($100,000 × 5%). Alternatively, Phoebe could purchase a new one-year bond (or GIC) with a 5% coupon. If the bond only pays interest annually, Phoebe would not have to report the interest income of $5,000 until she receives it next year.
Capital Appreciation
Capital appreciation provides a significant opportunity for deferral. While a capital asset may appreciate in value year by year, that appreciation does not become taxable income until the asset is sold and the gain is realized, which may be many years following the date of purchase. Several years ago, Bill purchased 1,000 shares of Blueblood Inc. at $26 per share for a total cost of $26,000. The shares are currently trading at $78 per share and have a fair market value of $78,000. Although Bill has an apparent gain of $52,000, calculated as (FMV – ACB) or ($78,000 – $26,000), it is an unrealized gain and this appreciation will not be taxable until he disposes of the shares.
Deductions from Current Income
In several situations, the Income Tax Act allows an investor to make deductions from current income, even though the investment is not producing any current income and may not produce any income until a future gain is realized. By taking advantage of these deductions, the taxpayer can defer tax on current income to a future time. We will examine some of the more common deductions that can be used to realize a tax deferral: • • • partnership losses capital cost allowance interest expense
Partnership losses When a partnership realizes a loss, each partner can deduct his or her share of the loss from his or her current income, thereby reducing his or her current taxable income. However, by doing so the partner decreases the adjusted cost base of his or her partnership interest, which will increase his or her gain (or at least decrease the extent of his or her loss) when he or she eventually disposes of the partnership interest.
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Making Use of Tax Advantages George, who has an MTR of 40%, acquired an interest in a partnership for $200,000. During the first three years of business, the partnership operated at a loss and George's share of the loss was a total of $26,000 per year. Each year, George was able to deduct $26,000 from his other sources of income, thereby saving $10,400 in income taxes each year, calculated as (loss deducted x marginal tax rate) or ($26,000 × 40%). However, by realizing the losses, George also reduced the ACB of his partnership interest to $122,000, calculated as (original ACB - total losses deducted) or ($200,000 - ($26,000 × 3)). George sold his interest in the partnership at the end of the third year for $180,000. This resulted in a capital gain of $58,000, calculated as (proceeds - adjusted ACB) or ($180,000 - $122,000), of which only 50% would be subject to tax. Therefore, George realized both a deferral and conversion. Capital cost allowance 'If a taxpayer acquires a depreciable capital property, he or she is not able to deduct the full cost of that property from his or her income as a current expense. Instead, the taxpayer is allowed to deduct a maximum amount of capital cost allowance (CCA) based on the undepreciated capital cost (UCC) of the asset at the beginning of the year. By claiming CCA, the taxpayer reduces his or her current taxable income. However, the taxpayer also reduces his or her UCC, and if he or she later sells the asset for an amount greater than the UCC, he or she will realize a recapture and possibly also a capital gain. Mario originally purchased a rental property for $800,000, with $500,000 attributed to the building. Over the period that he owned the building, he claimed CCA of $132,000. Because he had a 50% marginal tax rate, this saved him about $66,000 in taxes, calculated as (CCA deductions x marginal tax rate) or ($132,000 × 50%). Mario recently sold the property for $780,000 with $480,000 attributed to the building. His UCC for the building is $368,000, calculated as (capital cost - CCA deducted) or ($500,000 $132,000). Mario will realize a recapture of $112,000, calculated as (proceeds - UCC) or ($480,000 - $368,000), and this full amount will be taxed at his marginal rate. Mario has achieved deferral, but not conversion. Interest expenses If a taxpayer borrows money to acquire property that has the potential to produce business or property income, the interest expense is deductible from any of his or her current sources of income. Henry borrowed $100,000 to invest in an equity mutual fund. Although the primary objective of the fund is capital appreciation, he can deduct the interest expense from his current income because the mutual fund can potentially provide him with dividends or interest income (both forms of property income). If Henry later sells the shares in the fund for $160,000, he will have to include $30,000 in his taxable income, calculated as (proceeds - ACB) x capital gains inclusion rate) or (($160,000 - $100,000) × 50%). Henry has achieved deferral and conversion.
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Income Tax Planning
Registered Savings
Registered savings plans, including RRSPs, registered pension plans, deferred profit sharing plans, and some annuities also provide an excellent deferral opportunity. Money contributed to a registered plan and earnings on plan assets are not subject to tax until they are withdrawn. If the taxpayer is in a lower tax bracket when the funds are withdrawn, he can also achieve an element of conversion. Fiona has an MTR of 43%. If she contributes $10,000 of her employment income to an RRSP, she will save $4,300 in tax, calculated as (RRSP contribution x marginal tax rate) or ($10,000 × 43%). Any income earned by her contribution while it is in the plan will not be subject to tax. If Fiona leaves the money in the plan for ten years and it earns 8% before tax, she will have $21,590 in the plan, calculated by entering DISP = 0, P/YR = 1, ×P/YR = 10, I/YR = 8%, PV = -$10,000, PMT = $0 and solving for FV. If Fiona withdraws the entire amount and her MTR during retirement is 27%, she will pay $5,829 in tax at that time, calculated as (taxable withdrawal x marginal tax rate) or ($21,590 × 27%).
Exercise: Tax Deferral
Present Value of Future Taxes
It is true that deferral does not avoid taxes; it simply postpones them until some time in the future. How can we be sure this really saves the investor money in the long run? We have to consider the present value of both the taxes avoided and the taxes that will have to be paid. Marvin contributed $20,000 to his RRSP at a time when his MTR was 43%. Because of the resulting deduction, he was able to save $8,600 in income taxes on his current tax return, calculated as (RRSP contribution x marginal tax rate) or ($20,000 × 43%). Marvin expects to retire in another 20 years. Let us suppose that he is still in a 43% marginal tax bracket when he retires, and that he withdraws $20,000. At that time, he will have to pay tax of $8,600. On the surface, it looks like Marvin did not save anything. However, the present value of those future taxes, assuming a conservative discount rate of 4%, is $3,925, calculated by entering DISP = 0, P/YR = 1, ×P/YR = 20, I/YR = 4%, PMT = $0, FV = $8,600 and solving for PV. The value of Marvin’s deferral is $4,675, calculated as (present value of current taxes - present value of future taxes) or ($8,600 - $3,925). If he is in a lower tax bracket during retirement, he will realize conversion as well.
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8-7
Making Use of Tax Advantages
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Tax Advantages. In this lesson, you have learned how to do the following: • • • compare and contrast tax evasion and tax avoidance describe methods of using tax advantages assess and calculate the benefits of tax advantages for a client situation
If you are ready to move to the next lesson, click Investment Benefits on the table of contents.
Assessment
Now that you have completed Tax Advantages, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
8-8
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Income Tax Planning
Lesson 2: Investment Benefits
Welcome to Investment Benefits. In this lesson, you will learn about the benefits that can be provided by an investment, including cash flow, tax benefits, and appreciation. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: • • describe the benefits of different investments and their respective trade-offs calculate the potential relationship between different investment benefits for a given situation or strategy
Investment Benefits
Investments can also be categorized according to the benefits they provide to the investor. The benefits to the investor will come in three forms: • Cash flow is the actual after-tax cash distributed to or realized by the investor while he or she holds the investment and when he or she liquidates the investment. Tax benefits are the tax savings generated by the investment. These benefits flow from the initial deductions provided by many tax-advantaged investments, as well as deductions generated over the life of the investment, such as interest costs, depreciation, and depletion allowance. Appreciation is the actual rise in the value of an investment.
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All successful tax-advantaged investments will provide some combination of these three benefits.
Trade-offs Between Investment Benefits
The three investment benefits (cash flow, tax benefits, and appreciation) are interrelated, such that an increase in one benefit is usually achieved to the detriment of the other two. When looking for a new investment for a wealth accumulation plan, the investor will have to decide whether he or she wants: • • • an increase in cash flow accompanied by a reduction in tax benefits and appreciation an increase in tax benefits accompanied by a reduction in cash flow and appreciation an increase in the potential for appreciation accompanied by a reduction in cash flow and tax benefits
Exercise: Investment Benefits
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8-9
Making Use of Tax Advantages
Looking For Tax Advantages
Different investments offer different benefits and tax advantages to the investor. At what point, should an investor consider looking for tax-advantaged investments? This is not really the right question to be asking. The true test of whether anyone should invest in tax-advantaged investments is whether the end result will be a greater increase in wealth than with alternative investments. A taxadvantaged investment is, after all, an investment and must be judged in the same way as any other investment. Tax advantages are considerations among many other considerations that must be taken into account in judging the potential final return of an investment. While there is no special rule that specifies when a taxpayer should seek out taxadvantaged investments, there are many factors to be considered when trying to match the right investment to a specific taxpayer.
Investor's Income
The first step in deciding whether a particular individual should consider tax-advantaged investments is a careful evaluation of that individual’s income. Income level Obviously, a person who requires every after-tax dollar to maintain his or her lifestyle is not a candidate for any type of investment; he or she does not have to worry about tax advantages just yet. His or her first goal should be to restructure his or her spending habits and to start a regular savings program. Income stability The predictability of a potential investor’s income is also an important consideration. An investor should have a good idea of what his or her income will be for the next several years. Many tax-advantaged investments, particularly real estate, require payments over several years. Investors who are unsure of future income should exercise caution before committing to a vehicle that may require several years of investment. Start simply There are alternatives to using complex tax-advantaged investments as tax-saving strategies. Strategies such as income splitting through partnerships and retirement savings plans may provide all the tax advantages a particular investor needs or will be able to use. Delilah earns $32,000 a year and after meeting all of her current needs, she has $2,000 of discretionary income remaining. An RRSP probably provides all the tax advantages she can use.
Liquidity
In addition to income level, a potential investor’s liquidity must also be assessed before embarking on a tax-advantaged investment program. Liquid assets, such as cash or marketable securities, should not be diverted to tax-advantaged investments if the investor needs access to these funds in an emergency.
8-10
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Income Tax Planning Many tax-advantaged investments are, as a rule, highly illiquid: • • In order to preserve their partnership tax status, many limited partnerships restrict the right of partners to freely transfer their partnership interests. Securities laws restrict the transfer of unregistered securities, and most taxadvantaged investment interests obtained through private placements are unregistered securities. There is no secondary market for most tax-advantaged investments. Even if there are no legal restrictions on its sale, most investors will have difficulty finding a buyer for an interest in a tax-advantaged investment.
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Sandra is self-employed. She has $40,000 in a money-market fund as an emergency fund in case her business takes a bad turn. She is thinking about using the $40,000 as a downpayment on a rental property. Through CCA and the interest on the mortgage, she is confident she will be able to reduce her taxable rental income to zero. However, Sandra should think twice about pursuing this strategy. If her self-employment income declines and she requires additional funds, she will have difficulty withdrawing her money from the rental property due to its lack of liquidity. Adding to the issue of liquidity, is the possible adverse tax consequences from a premature disposal of a tax-advantaged investment. Even a tax-advantaged investment that makes both tax sense and economic sense, may not be the right investment for an individual who may need his or her assets to be liquid for emergencies or other purposes.
Risk
Tax-advantaged investments are, as a general rule, riskier than other forms of investment. If this were not so, there would be no need for the tax advantage offered by these investments. If an investor cannot afford to potentially lose the money invested in a taxadvantaged investment, it may be more prudent for the investor to pay his or her taxes and invest the balance in safer alternative investments.
Psychology
Just as some investors do not have the risk tolerance needed to invest in the stock market, some investors are psychologically unsuited for tax-advantaged investments. Beside the ever-present risk of losing one’s investment, by holding a tax-advantaged investment, the taxpayer may increase the chances of being audited by Canada Revenue Agency. Some investors may not be comfortable with the greater likelihood of an audit due to the writeoffs associated with tax-advantaged investments. An investor who cannot accept this increased risk is not a candidate for tax-advantaged investments.
What's so Different?
Of course, all these considerations – income, liquidity, risk, and psychology – are present in any investment decision. Therefore, when looking for an investment that provides tax advantages, we return to evaluating the suitability of the investment in light of the investor's tax profile. The degree to which the various considerations influence an investment decision may vary, but the basic considerations are the same.
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8-11
Making Use of Tax Advantages
Exercise: Looking for Tax Advantages
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Investment Benefits. In this lesson, you have learned how to do the following: • • describe the benefits of different investments and their respective trade-offs calculate the potential relationship between different investment benefits for a given situation or strategy
If you are ready to move to the next lesson, click Choosing the Right Tax Advantages on the table of contents.
Assessment
Now that you have completed Investment Benefits, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
8-12
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Income Tax Planning
Lesson 3: Choosing the Right Tax Advantages
Welcome to Choosing the Right Tax Advantages. In this lesson, you will learn about the factors you should consider when determining what tax advantages to look for on behalf of your client. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: • recommend a particular type of investment strategy given a client’s objectives and financial information
Choosing the Right Tax Advantages
All successful tax-advantaged investments will provide some combination of cash flow, tax benefits, and appreciation. An investor can choose: • • • an investment that will yield greater cash flow but with a reduction in tax benefits and appreciation one that will yield greater tax benefits but with a reduction in cash flow and appreciation one that will yield greater potential for appreciation but with a reduction in cash flow and tax benefits
The choice, of course, will depend on the particular investor’s investment objectives. Also, an investor can choose a selection of different types of tax-advantaged investments to provide a balance of cash flow, tax benefits and potential for appreciation.
Investor's Objectives
In order to choose among the types of tax-advantaged investments that offer varying degrees of cash flow, tax benefits, and appreciation, an investor must know what he or she wants to accomplish with an investment program. Generally, an investor embarking on a tax-advantaged investment program will have one or more of the following objectives in mind: • • • • avoiding taxes deferring a tax liability providing current funds building equity for the future
Avoiding Taxes
Many investors simply dislike paying taxes, regardless of the rate at which those taxes are imposed. Given a choice between a tax-advantaged investment and an alternative investment that offers a similar after-tax return, these investors would choose the investment that results in a smaller tax liability. This is obviously a short-sighted investment objective. How much an investor pays in taxes should not matter, as long as that investor gets to keep more than he or she would from an alternative investment. In any event, an
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8-13
Making Use of Tax Advantages investor seeking to avoid taxes will choose tax-advantaged investments in which the tax benefits predominate.
Deferring a Tax Liability
An investor who is paying taxes at the highest marginal rates may want to defer a portion of his or her tax liability to some point in the future when he or she will have a lower income and a lower marginal tax rate. Cash flow is obviously a secondary consideration for this type of investor. They will concentrate on tax-advantaged investments that offer more in the way of tax benefits such as deductions from current income and the potential for capital appreciation. Deferral shelters that offer front-end deductions, such as flow-through shares and some real estate deals, may help this type of investor achieve his or her objective. Another possibility is some longer-term investment that offers write-offs to offset current income and the chance for appreciation that will be taxed as a capital gain. Conventional real estate is a possible choice.
Providing Current Funds
An investor who is looking for current spendable income will have cash flow uppermost in his or her mind. This type of investor will want an investment that produces current income while offering current deductions to shelter this income from taxation. This objective can often be met through residential or commercial real estate. Shafik has $200,000 to invest. He would like the investment to generate current income because he has an extravagant lifestyle. However, he is already in a high marginal tax bracket, so he prefers a situation where any additional cash flow will not be subject to tax at this time. If Shafik invested the money in bonds at 8%, he could get current income of $16,000, calculated as (principal x coupon rate) or ($200,000 x 8%), but the entire amount of this interest income would be taxed in the year it is earned or received. Instead, Shafik could use the money to purchase a rental property, with perhaps $150,000 allocated to the building and $50,000 to the land. If Shafik could rent this property for $1,333 per month, he would have the same income of $16,000 that he could get by investing in the bond, calculated as (monthly rental income x 12 months) or ($1,333 x 12). However, in this instance, he could claim CCA of about $6,000, thereby sheltering at least some of the rental income from tax.
Building Equity for the Future
An investor who wants to build equity for the future may have to forego cash flow and tax benefits. An investor with this objective in mind is usually not overly concerned with current income or write-offs to reduce taxable income from other sources. The investor will be looking for investments that will grow in value. Again, certain real estate investments may be what this investor wants to achieve his or her objective. Equity investments, including mutual funds that concentrate on long-term capital growth, may also be appropriate.
8-14
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Income Tax Planning
Exercise: Investor's Objectives
Investor's Tax Profile
The four possible objectives of a tax-advantaged investment program are not mutually exclusive. An investor may have more than one objective, in which case he or she will look for a mix of investments that will produce the right blend of tax avoidance, tax deferral, current income, and equity growth based on his or her individual tax profile. Once an investor has determined the objectives for the tax-advantaged investment program, he or she must take a careful look at his or her tax profile. Having certain objectives is one thing, but achieving those objectives can be profoundly influenced by the investor’s tax situation. Because every taxpayer is in a different situation, a tax-advantaged investment that can achieve a certain objective for one investor will not necessarily achieve the same objective for another investor. An investor’s tax profile is simply all the factors that affect the calculation of that investor’s tax liability. Obviously, the investor’s marginal tax rate, and not just the investor’s tax bracket for the current year, is of prime importance. Also, their expected marginal rates for future years up to the time a tax-advantaged investment program ends must be taken into account as should federal and provincial income tax rates. In addition to tax rates, all the tax mechanisms that affect tax advantages must be considered. This entails looking at not only total current income but also the sources and types of that income. For example, tax preferences can subject an individual to the alternative minimum tax. An investor with tax preferred income may want to avoid additional investments that will produce more tax preferences.
High-Income Investors
An individual with passive income currently taxed at the top marginal rate may want to consider tax-advantaged investments that offer the most in the way of tax benefits. The investor who expects to remain in the highest brackets for many years should consider some longer-term investment that offers a high degree of shelter. A possible choice is certain commercial real estate that offers tax benefits in the early years and requires investors to commit themselves for many years.
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8-15
Making Use of Tax Advantages Alternative Minimum Tax (AMT) The intent of AMT is to ensure that high-income taxpayers pay their fair share of taxes in any given year by limiting the tax effect of certain tax preferences. These tax preferences result from the special tax treatment provided to: • • • • CCA claimed on Canadian films depletion and resource allowances from mining and oil and gas capital gains dividends from taxable Canadian corporations
Although a carryforward of AMT is provided, additional investments that generate tax preferences may not make sense for an investor who is already subject to AMT. There are tax advantages that do not incur AMT treatment. These include interest expense deductions, CCA on properties other than films, and many others. The investor usually has control over the timing of when capital gains are realized. Accordingly, a range of tax advantages is still available, but they must be carefully managed to avoid any penalties from the AMT.
Special Windfalls
An investor may be faced with a large amount of income at one time but may not expect future income to remain at such high levels. Although this investor may be subject to the same tax rates as the high-income investor, at least for the current year, he or she is not going to be attracted to nor will they have the need for the same investments as the investor who expects to remain taxed at a high rate for many years. This investor will want to avoid the kinds of investments that are attractive to the long-term, high-income individual, so long-term investments are not an option. Rather, this investor will be looking to find tax advantages in short-term deferral investments.
Approaching Retirement
For many people, their peak earning years will be the years just before retirement. These people face the prospect of high taxes for several years, followed by a substantial reduction in their income upon retirement. The tax-advantaged investment program for such an individual can not only defer current taxes but can also provide some appreciation that can be realized in his or her post-retirement years. By deferring the realization of income to their retirement years, when the taxpayer will presumably be in a lower tax bracket, he or she will also realize a degree of conversion. A blend of tax-advantaged investments may be the best approach for this investor.
Loss Carryovers
Occasionally, an individual suffers a major capital loss. Under the Income Tax Act, the amount of capital losses an individual can deduct in a year is limited to the amount of capital gains realized. If an investor is faced with a capital loss carryover that will likely never be used up, investing in tax-advantaged investments with the potential for significant capital gains may be a prudent choice.
8-16
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Income Tax Planning
In Summary
There are many different tax profiles; each will affect the choice of the tax advantages that will best suit the investor’s needs. The appropriate choice of investment depends on the investor's particular tax profile. You must carefully analyze this profile to see how different types of tax-advantaged investments can accommodate the particular investment objectives of the investor.
Exercise: Investor's Tax Profile
Picking the Particular Investments
Once investors establish the types of tax-advantaged investments that best suit their needs, they are ready for the hard part of the selection process — picking the particular investments out of the many available in both public offerings and private placements. There are good, bad, and sometimes even fraudulent investments available for every type of tax-advantaged investment. The true test of an investment is whether it provides a greater return in line with the investor’s objectives than other investments, taking into account the effect of the investor’s tax profile on an after-tax basis. In other words, no investment should be selected unless it is likely to enhance the investor’s wealth and well-being. But how does an investor measure the return from a tax-advantaged investment? In some cases, an investment may yield current taxable income; in other circumstances, it may yield current deductions and future capital gains, or some other mixture of benefits. How do you compare these investments? Many measures of return are available but perhaps the simplest and best method is to compare the net present value of alternative investments.
Calculating the NPV
In order to use net present value (NPV) as the measure of worth of a tax-advantaged investment, all costs and benefits are converted to their present value at some assumed interest rate. The interest rate could be one of the following: • or • a rate similar to the return on the investor’s typical portfolio the after-tax rate of return on safe investments
The latter approach allows the investor to compare a proposed tax-advantaged investment with his or her current return. Following this procedure, an investor can tell if a taxadvantaged investment makes economic sense if the investment performs as advertised. If
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8-17
Making Use of Tax Advantages the investment cannot beat its current return by performing as advertised, then it can be eliminated from consideration.
Exercise: Calculating NPV, Part 1
Exercise: Calculating NPV, Part 2
Exercise: Calculating NPV, Part 3
Exercise: Calculating NPV, Part 4
Exercise: Calculating NPV, Part 5
The Limitations of Net Present Value
The evaluation in the previous exercise, Calculating the Net Present Value of an Investment, was straightforward. This evaluation can become much more complicated if the investor’s tax profile changes over time. This can occur, for example, if his or her marginal tax rate fluctuates over the period that he or she holds and redeems the investment.
8-18
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Income Tax Planning
Reducing cash flows to net present value provides a method for gauging the economic merits of a proposed investment as well as a method of comparing competing investments. The method, however, does not provide the ultimate answer as to whether an investor should or should not invest. An investor still must evaluate the economic and tax risks of a proposed tax-advantaged investment and their own tax situation. Only then will the investor be able to decide which tax-advantaged investment, if any, is best.
Reflection
Take a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.
Review
You have completed Choosing the Right Tax Advantages. In this lesson, you have learned how to do the following: • recommend a particular type of investment strategy given a client’s objective(s) and financial information
If you are ready to move to the next lesson, click Review on the table of contents.
Assessment
Now that you have completed Choosing the Right Tax Advantages, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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8-19
Making Use of Tax Advantages
Review
Let’s look at the concepts covered in this unit: • • • Tax Advantages Investment Benefits Choosing the Right Tax Advantages
You now have a good understanding of how to make use of tax advantages. At this point in the course you can assess and calculate the benefits of tax advantages for a client situation, describe methods of using tax advantages, and describe the benefits of different investments and their respective trade-offs. You can now recommend a particular type of investment strategy given your client’s objective(s) and financial information. Click Assessment on the table of contents to test your understanding.
Assessment
Now that you have completed Unit 8: Making Use of Tax Advantages, you are ready to assess your knowledge. You will be asked a series of 20 questions. When you have finished answering the questions, click Submit to see your score. Remember, the unit assessments count towards your final grade. When you are ready to start, click the Go to Assessment link.
8-20
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Income Tax Planning
Reviewing the Course Learning Objectives
Click the link to see a list of learning objectives for the course in the order that they have been presented.
Each learning objective is part of the performance expected of you as a financial planner and of the objectives have been derived from the Financial Planning Standards Council’s required performance objectives. Reading through the list helps you remember the content of the lessons. But in order to improve your skills there is more to it than that. Follow these steps: 1. 2. 3. 4. Review each of the learning objectives one at a time. Ask yourself if you can achieve it. If you are confident, move on to the next one. If you are not sure, mark it for review.
If you recognize that there is a learning need associated with the learning objective, then go back to that content and do the exercises again.
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Income Tax Planning
Assessment
Now that you have completed the Income Tax Planning course, you are ready to assess your knowledge. You will be asked a series of 100 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.
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