B
U
S
I
N
E
S
S
A
D
V
I
C
E
W
I
T
H
F
O
C
U
S
Borrowing to invest in your corporation
U
nder the Income Tax Act, interest paid on borrowed money is deductible if the money is used for the purpose of earning income from a business or property. Accordingly, if you borrow money and invest it in your corporation by way of a loan to the corporation or by purchasing shares in the corporation, you must show that the borrowed money was used for the purpose of earning income from a business or property. If you borrow money to invest in common shares in your corporation, the Canada Customs and Revenue Agency (CCRA) normally allows a full deduction for the interest on the borrowed money, on the grounds that the shares may generate investment income in the form of future dividends on the shares. Normally, the interest will be fully deductible even if the shares are not expected to generate dividends for several years. If you borrow money to invest in preferred shares in your corporation,
the CCRA generally takes the view that the interest deduction on the borrowing is limited to the amount included in your income from the dividends received on the shares (including the 25% gross-up). An exception to this rule, where the CCRA allows a full deduction of interest regardless of the amount of dividend income earned on the preferred shares, is outlined in the section below.
The partnership of Prenick Langer LLP and VenturEdge Corporation helps small and medium-sized business achieve their financial target with accounting, auditing, tax and business advisory services using cutting-edge methodologies.
Borrowing to make a loan to your corporation
Interest expense on your borrowed money is fully deductible if the money is in turn loaned to your corporation at a reasonable rate of interest. In this regard, the CCRA normally allows a full deduction for the interest on your personal borrowing if the interest charged to your corporation equals or exceeds the interest rate on your personal borrowing. The CCRA has taken the view that a loan to your corporation will not
See BORROWING on page 2
We have moved!
By the time you receive this issue of Focus, we will have settled in our new premises, both in Toronto and Brampton. Our new addresses are: Please note that all Brampton Office Toronto Office phone numbers and 50 Queen Street West 4711 Yonge Street email addresses Brampton, Ontario Suite 1105 remain the same. Canada L6X 4H3 Toronto, Ontario (T) 905-793-8114 Canada M2N 6K8 (T) 416-224-2000 (F) 416-224-2376
SECOND QUARTER I 2001
BORROWING (continued from page 1) normally be at a reasonable rate of interest if it is less than the interest rate on your personal borrowing. Despite this view, the CCRA has, in the past, indicated that the interest on your personal borrowing may be deductible to the extent of the interest that you charge on the loan to your corporation. For example, under this view, if you borrowed money at 8% and relent it to your corporation at 6%, your personal interest deduction would be limited to 6%.
full deduction for the shareholder’s interest on the borrowing if adequate consideration was given to the shareholder for guaranteeing the loan. Adequate consideration generally means a guarantee fee that is equal to what would be charged in an arm’s-length transaction. If no guarantee fee was paid to the shareholder, the CCRA may deny the interest deduction on the borrowing. money, so long as the above conditions are met. However, the CCRA allows a full deduction for the interest on the borrowing in circumstances similar to those described in the section above (dealing with low or nointerest loans made to a corporation). In general terms, where a person borrows money to make a payment under a guarantee that was given for inadequate consideration, in respect of a loan taken by a Canadian corporation of which the person is a shareholder, the CCRA will permit a full deduction for the interest if the following conditions are met: a. the corporation used the loaned funds in order to produce income from a business or property, or re-loaned the funds to its Canadian subsidiary in turn to be used to produce income from a business or property, and b. the corporation could not obtain the loan (without the guarantee of the shareholder) at interest rates at which the shareholder could borrow.
Fortunately, the CCRA allows an exception for low-interest (or interest-free) loans made to your corporation, and allows a full deduction for the interest on your borrowed money that is loaned to the corporation, if the following conditions are met: a. the money will be used by the corporation to produce income from a business or property which will be taxable in Canada, or will be used by that corporation to lend money to its Canadian subsidiary at less than a reasonable rate of interest to be used by that corporation to produce income from a business or property which will be taxable in Canada. b. the corporation has made every effort to borrow money through the usual lending markets but it cannot obtain a loan (without your personal guarantee) at the interest rates at which you can personally borrow, and c. the transaction does not result in any undue tax advantage for you or the corporation. The CCRA has indicated that a similar exception will apply in the case of borrowed money used to purchase preferred shares in your corporation. Accordingly, a full interest deduction will be allowed even if you receive little or no dividends on the preferred shares purchased with the borrowed
The position on interest deductibility may be changing
In some cases, shareholders have argued that interest-free loans made to their corporations allow the corporations to earn business income that may generate dividends to the shareholders in the future. On this basis, the argument goes, the interest-free loans should be viewed as having been made for the purpose of earning income from a business or property, regardless of whether the CCRA exception outlined above applies.
Borrowing to honour a guarantee of a corporation’s loan
If a shareholder of a corporation borrows money for the purpose of honouring a guarantee of a loan of the corporation, the CCRA allows a
Top ten ways to keep your computer in working order
1. Back up your data frequently. 2. Do not open unsolicited email or email from strangers. 3. Never open attachments, including jokes from friends, without a virus scan. 4. Update your virus scanner as frequently as you can. 5. Do not install software that you don’t use. 6. Remove old software that your don’t need, but only with the Add/Remove tools on the Control Panel 7. Shut off your computer properly. 8. Run scandisk weekly and Disk Defragmenter monthly. 9. Install memory hungry programs like games on a separate computer. 10. Call a professional when trouble starts, friends often make it worse.
2
Saving for children’s education
T
he cost of university education has been rising steadily over the past few years. In some provinces, professional schools such as law and medicine are now charging upwards of $10,000 per year for tuition alone. More than ever before, plans must be made by all but the most affluent families so that funds will be available for their children to attend college or university. If you have young children, you can hardly afford to ignore this concern.
way in). The income generated by the contributions is taxed in the beneficiary’s hands when it is paid out. Since most students typically have little income, they pay little or no tax on the RESPsheltered income. The income is only available to the beneficiary if he or she attends post-secondary education full-time at a qualifying institution. (Full-time enrollment in distance education courses will also qualify.) Otherwise, the income can often be transferred to a brother or sister who is attending. Alternatively, the income can in some cases be returned to the contributor and deposited in the contributor’s RRSP, or taxed as income in the contributor’s hands, subject to an additional 20% tax to take into account the tax-free growth over the years. The limit on contributions for any one beneficiary is $4,000 per year, and $42,000 lifetime. Contributions are allowed until the end of the 21st year from when the plan is set up. The RESP must be collapsed and paid out by the end of the 25th year after the year it is set up. Since 1998, contributions to RESPs are encouraged by the “Canada Education Savings Grant” (CESG). The CESG is an additional 20% grant contributed by the federal government on up to $2,000 per year of contributions (i.e., up to $400 of grant per year). There is a lifetime maximum of $7,200 (18 years x $400). The grant is
paid directly to the RESP and can be invested within the RESP along with other funds. It is available for beneficiaries up to and including age 17. Unused contribution room can be carried forward to future years when contributions are made. The CESG will be included in the student’s income when funds are paid out of the RESP to the student. However, as with other income earned in the RESP, it will be received by a student who may be in a very low tax bracket, and little or no tax may thus need to be paid on it. If the student does not attend higher education, the CESG must be repaid to the government. Self-directed RESPs can now be set up through many investment brokers. These are an attractive alternative to the large group plans that have been around for many years, one reason being that the subscriber can control the investments, just as with a self-directed RRSP or RRIF. Because of the new 20% CESG, RESPs are now highly recommended for families with children who are likely to attend university or college.
Registered Education Savings Plans
RESPs have been around for many years, but were never particularly popular. A series of enhancements in 1996, 1997 and 1998 have made them much more attractive than in the past. A RESP is set up by a “subscriber” (usually a parent or grandparent of the child) who contributes funds to the plan and names a “beneficiary” (or more than one beneficiary), who must be related to the subscriber. Additional contributions can be made over the years by the subscriber or another family member. The “beneficiary” is the child who, it is hoped, will attend college or university some years down the road. Unlike a registered retirement savings plan (RRSP), a RESP does not offer the subscriber (contributor) any deduction from income for the amount contributed. Thus, there is no immediate tax saving for contributing to a RESP. However, as with an RRSP, the income earned in a RESP is not subject to tax as long as it accumulates within the RESP. This tax-free compounding allows substantial growth in the fund for many years. The capital contributed comes out free of tax (since, after all, no deduction was available on the
Trusts and “In Trust For” Accounts
RESPs are not the only method of saving for a child’s future needs. A trust, or an “in trust for” account at a bank or broker, can be a worthwhile alternative – with no penalty if the child does not attend university or college. A formal family trust is a very flexible structure, which will allow the trustees (possibly the parents) to control the trust assets for virtually any period of time they choose, and to control future decisions as to which of the children receive
See SAVING on page 4
SECOND QUARTER
I
2001
3
SAVING (continued from page 3) the funds. However, a trust can be expensive to set up, as it normally requires detailed legal advice. In addition, the trust must file a tax return every year, and great care must be taken to avoid the high tax rates that normally apply to a trust (as opposed to a RESP, where the income is completely tax-free). With the introduction of the so-called “kiddie tax” last year, certain kinds of income, such as income derived from private corporation dividends, will be taxed at high rates in the child’s hands. In addition, the “attribution” rules can apply to require the parents who contributed the funds to pay tax on income earned by the trust or by the children. Very careful planning is needed before setting up a family trust!
residents (e.g., grandparents who live abroad) are contributed to the ITF account, no attribution will apply. Otherwise, if you have contributed the funds, the income earned on them will be taxed in your hands rather than the child’s, until the year in which the child turns 18. Attribution does not apply to capital gains, however; one technique for reducing tax is therefore to invest in growth-oriented mutual funds, which will generate capital gains but not interest or dividend income. Any realized capital gains can then be taxed at low rates in your child’s hands. Finally, there is a possible problem with subsection 75(2) of the Income Tax Act, which can deem the income or gains from the ITF account to be taxed in your hands, if you retain the power to undo the trust or to change who the beneficiaries are. The documentation you sign when you set up the ITF account should not give you the right to “un-ITF” it, or you will run into a problem. As you can see, there are many options available in planning for a child’s education, and careful consideration of the tax effects of each option is a must.
NEWS IN THE FIRM NEW PARTNER Demetria Chios is our newest partner and has also assumed the role of managing partner. We welcome her and wish her continued success in her new positions. She has been responsible for developing and maintaining our firm’s technical standard and quality control over the past years NEW DESIGNATION Harvey Taraday has recently obtained the designation of TEP. The Society of Trust and Estate Practitioners (STEP) is made up of professionals involved in trusts and estates practice worldwide. Members of STEP are by definition, the most experienced and senior group of Trust and Estate professionals practicing today. OTHER ACHIEVEMENTS Gerald Prenick, one of our founding partners, was named to the Business Class 2000 by the North York Chambers of Commerce and was profiled in the May issue of the Review Business magazine. Morris Langer continues his commitment to the Forest Hill Lions Club after serving as the president. He also authored an article “The Bottom Line of Business Financing” that was published in the March issue of the Review Business magazine. David Hui recently returned from Kansas City after attending the 2001 managing partner workshop of INPACT Americas, our international affiliate. As a founding member of The Rotary Club of York, David holds the position of treasurer on the executive board. Lina Guddemi is on maternity leave after giving birth to her second son, Christopher Michael. Congratulation to the Guddemi family.
A much simpler alternative is to open a bank or brokerage account in your name, but “in trust for” your child. These are sometimes called “in trust for”, or ITF, acccounts. You remain the legal owner of the account, but your child is the beneficial owner. An ITF account probably becomes your child’s property when the child turns 18. You should therefore be careful about doing this if you are concerned that the child may take the funds and waste them soon after turning 18. (A formal trust, on the other hand, can run for many decades if you wish it to.) The attribution rules are also a concern. If only Child Tax Benefit cheques and/or gifts from non-
is a quarterly publication from Prenick Langer LLP and VenturEdge Corporation.
• 4 7 1 1 Yo n g e S t re e t , S u i t e 1 1 0 5 , To ro n t o , O n t a r i o , C a n a d a M 2 N 6 K 8 • 4 1 6 - 2 2 4 - 2 0 0 0 • 5 0 Q u e e n S t re e t We s t , B r a m p t o n , O n t a r i o C a n a d a L 6 X 4 H 3 • B y a p p o i n t m e n t • 9 0 5 - 7 9 3 - 8 1 1 4 • e m a i l : i n f o @ p re n i c k l a n g e r. c o m • i n f o @ v e n t u re d g e . c o m • We b s i t e s : w w w. p re n i c k l a n g e r. c o m • w w w. v e n t u re d g e . c o m • F a x 4 1 6 - 2 2 4 - 2 3 7 6
w
This newsletter describes current tax issues and other developments of interest to business. It is general information only and accordingly professional advice should be obtained before acting on any comments in this document.
4