TAXATION 1 NOTES - CALCULATIONS NET INCOME – Handouts # 2,4 and 6 outline inclusions and deductions. Go through question and list all inclusions and deductions in separate columns to arrive at the net income. If not included in Section 8, it’s not deductible. AUTOMOBILE ALLOWANCE - If employer pays a "reasonable" automobile allowance to its employee, it must be based on a kilometric amount - .37 cents for the 1st 5,000 km and .31 cents for amounts above 5,000 km. If the employee receives more than this amount the full allowance comes into income and he can deduct a reasonable expense. The employer will not be able to deduct the excess. This occurs when the employee owns the automobile. If employer owns the auto, the standby charge will be computed + operating costs – must be 90% business use plus less than 12,000 personal km for reduction. If the vehicle is driven for more than 50% business, the employee can elect 1/2 of standby charge or 16 cents per personal km driven. The difference is who owns the vehicle. It does not matter whether it is a commission salesperson. STANDBY CHARGE – automatically assigned for personal-use benefit of an employer- provided vehicle Employer owned: A/B x 2% of (C x D) OR Employer leased: A/B x 2/3 (E – F) x # of months (per class instruction) A = the lesser of personal use km during available time period (keep a log) OR 1,000 x (days available/30 – must be full month) B = 1,000 x (total days available/30) – to a maximum of 12,000 km (trying to determine the number of days available) C = original or capital cost of car, including GST and PST D = total days available when employer owned car/30 (number of full months as per class instruction) E = lease payments, including GST and PST, made by employer (but not insurance) F = insurance (because the insurance has to be paid regardless) AUTOMOBILE OPERATING EXPENSES BENEFIT - EITHER 1/2 of the standby charge OR 16 cents/ km on personal use km less any reimbursement to the employer whichever is less (the better benefit for the employee) DISABILITY BENEFIT – Total Disability Payments brought into income MINUS any disability premiums paid by the employee STOCK OPTIONS BENEFIT - Exercising a stock option will result in employment income if the price paid under the option is less than the FMV of the shares at the time of their purchase. The benefit equals the difference between the purchase price and FMV x the number of shares. INTEREST BENEFIT – input interest benefit, based on the number of days the employee has loan, charged 2% less than prescribed rate issued each quarter. For example: $20,000 x 90/365 x 4% = $197 + $20,000 x 91/365 x 3% = $150 + $10,000 (after $10,000 repayment) x 92/365 x 5% = $126 + $10,000 x 92/365 x 4% = $101. Total is $574 for the taxable interest benefit. HOME OFFICE DEDUCTIONS – Handout entitled “Taxation 1” dated January 21/02. 60% of business activities must be performed at home and space must be used exclusively for earning income, regular client meetings. Ordinary employees deduct maintenance expense for rental units and rent, repairs, supplies, telephone, utilities, home insurance, property tax for owned property. Commission employees rent, repairs, supplies, telephone, utilities, insurance, property tax. Both exclude capital cost allowance and mortgage interest as a deduction. Cannot create a loss in current year with home office deductions – carried forward to future years. No deductions for an office in the home for sales/negotiating employees. SALES/NEGOTIATING EMPLOYEE DEDUCTIONS – Remuneration must be must be part commission in order to apply deductions – non-taxable allowance cannot be received. Can’t deduct more than total commission. Employee must pay expenses as required by employment contract where employer does not reimburse. The nature or type of expenses is not restricted, except for capital nature - can’t deduct capital cost allowance (e.g. car or mortgage) or interest on car or house loans. No deductions for an office in the home or club dues. Only 50% of meals and entertainment are deductible. In order for travel expenses to be deductible, employee must ordinarily be required to travel away from the employer’s place of business. Un-reimbursed amounts included for meals and lodging while travelling away from home on the employer’s vehicles are allowed. If away from municipality where office is located more than 12 hours and 40km, personal meals are deductible. Pension plans, union dues, professional membership fees are all deductible, as well as advertising, phones and reasonable car expenses (noted above). GROSS UP ON DIVIDENDS (INDIVIDUAL) – Canadian corporations only (not foreign-owned companies). Gross-up or multiply dividend by 1.25 and apply tax credit of 13.33 after gross up to final amount to be included in income. PURE INSURANCE DEDUCTION – Since life insurance policy is not taxable and premiums are not deductible, the only part of the premium that will be deductible if policy used as collateral is the pure insurance, the deductible amount is based on the amount of the loan in relation to the policy. Loan/policy x pure insurance = deductible amount. Example: $50,000 loan with $200,000 insurance policy as collateral, $600 premium. 50,000/200,000 x 600 = $ 150 deduction. The other $ 450 must be added back into income. FARM INCOME DEDUCTION - $8,750 is the maximum you can deduct. However you cannot deduct more losses than you incurred so the best may to apply the formula is as follows: $2,500 + 1/2 (loss incurred - $2,500) - the amount in bracket cannot exceed $12,500. This will account for losses that are less than the 12,500. In the year of the loss it can be deducted from any type of income. The balance can be carried back 3 years or forward 10 years to reduce any farming income reported in those years. PREPAID AMOUNTS – Prepaid amounts (rent, insurance, etc.) not yet used but paid for during the taxation year must be added back into income (they are not deductible until used – matching principle). CAPITAL COST ALLOWANCE - Only applies to non-depreciable property (inventory, receivables, land, investments, personal use property and LPP) – cannot have a capital loss on depreciable property (buildings, cars, fixtures, furniture, which use the straight-line depreciation method) or eligible capital property (goodwill, customer lists). Class ends when you sell the asset. Example: Class 8 Asset – rate of 20% CCA. 1999: $200,000 x 20% = $40,000 CCA (maximum deduction for the year) and balance of UCC = $160,000 (Undepreciated Capital Cost) for the following year. 2000: $160,000 x 20% = $32,000 CCA and balance of UCC = $128,000. Have to allocate between land (non- depreciable) and building (depreciable). Vehicles have a maximum of $ 30,000 UCC 50% RULE – only 50% of the net addition to the same class (combination of all additions and dispositions) is taxable in the year of acquisition. Example: 2000 UCC = $60,000 with additions of $40,000 and dispositions of $10,000 in the same class. Net addition is $30,000 and is only 50% taxable ($15,000). Therefor the amount subject to CCA is $60,000 + 15,000 = $75,000 x 20% CCA rate = $15,000. Closing UCC = $75,000 – $15,000 CCA + $15,000 not subject to CCA (must be added back for closing UCC total) = $75,000. Exceptions to the 50% rule are certain class 12 property and class 14 property. Also does not apply to a negative net acquisition (amount must be positive) OR straight line depreciation. ADJUSTED COST BASE – includes all associated costs in purchasing the asset (i.e. legal & accounting fees, commissions on sales, etc.) RECAPTURE – If an asset within a particular CCA class is sold for more than the outstanding UCC balance (i.e. a profit is made), 100% of the difference is added back into income – usually 50% as income and 50% as a capital gain (with only 1/2 the amount subject to tax). TERMINAL LOSS – If an asset within a particular CCA class is sold for less than the outstanding UCC balance (i.e. a loss is incurred), 100% of the loss can be applied to any sort of income. No capital loss on depreciable property. IDENTICAL PROPERTIES – Used for a group of identical properties acquired over time at different capital costs (e.g. stocks in a particular corporation) – must be averaged out and calculated upon disposition. First, calculate the total paid for the shares divided by number of shares for the ACB. Secondly, multiple the Proceeds of Disposition by the number of shares, then subtract (the number of shares multiplied by the averaged ACB). If this is a capital loss, 50% can be deducted. If this is a capital gain, 50% is included in income. LEASEHOLD IMPROVEMENTS - Used to adhere to the matching principle. Lesser of: 1/5 of capital cost OR capital cost/lease + 1 renewal option. Cannot be greater than 40 years. CAPITAL GAIN RESERVE – To provide a break to companies where money is owing to them for a capital gain with the tax on the capital gain payable. Recalculated each year for a maximum of 5 years @ 20% each year, with the reserve added back from previous year and current year reserve deducted. First, calculate the maximum reserve - Receivable amount/proceeds x capital gains. 900,000 owing/1,000,000 net sale x 600,000 capital gain = $540,000 (being paid at $100,000 per year) Second, calculate the allowable reserve for current year – 20% x (4-0) x capital gain 20% x (4-0) x 600,000 = $480,000 - therefore capital gain – reserve = taxable capital gain (600,000 – 480,000 = 120,000, with $60,000 being taxable) NEXT YEAR: 800,000 owing/1,000,000 net sale x 600,000 = $480,000 maximum reserve 20% x (4-1) x 600,000 = $360,000 - therefore capital gain – reserve = taxable capital gain (480,000 – 360,000 = 120,000, with $ 60,000 being taxable) Repeat for the next 3 years. SUPERFICIAL LOSS – To close loophole and prevent a lower ACB. Loss on sale of similar assets (e.g. stocks) must be added back to the new ACB of the second purchase. “INTRODUCTION TO FEDERAL INCOME TAXATION IN CANADA” Beam, Laiken, Barnett Distillation by Kathryn Nimetz e-mail: email@example.com CHAPTER 1 – INTRO Constitution Act, 1867, granted authority for taxation separating federal and provincial powers to impose taxes 1917 – Temporary war measures act – implemented to raise revenues for the war effort (class notes in blue) 1988 – Bill C-139 - Phase 2 – replaced federal sales tax with GST, effective January 1, 1991 Good tax system: raise revenues (tax on income, tax on consumption, stable), economic influence (low tax stimulates activity, investment tax credits, CCA), fair (social and economic aspects), equitable vertical/horizontal, simple (compliance – based on self assessment in Canada – individuals determine how much they owe and the government relies on them to be honest), neutral (not in Canada due to corporate and child tax credits), competitive internationally (wages, prices, transfer price – being able to move income from a company in one country to another), balanced (individual vs. corporate), Canadian priorities (Foreign accrual property income – there’s a tax on investments outside of Canada), transitional implementation Types: head, wealth, user, tariff, transfer, direct and indirect incidence, proportional, progressive, regressive Defined: who pays, base, rates applied to base, exemptions & deductions, selective measures (how & when paid) Changes: draft legislation, application rules, tax treaties, regulations, judicial decisions, CCRA publications Defining income: economist (wages, salary, rent), GAAP (CAA is declining/depreciation is straight line), doctrine of constructive receipt Income vs. Capital: only 2/3 gains are income (p. 16); only 1/2 is taxable; capital asset is tree; fruit is income Computation: Aggregation (regardless of geography) & Sourcing (deductions apply to each source independently) Enforcement: individual onus of proof, appeals (notice, tax court, supreme), D of Finance – policy; CCRA – control through 30 district offices; evasion (reporting less), avoidance (legal, but not real facts), planning (legal) Tax planning: unilateral (altering the timing of tax payments or altering the tax character or nature of the receipt of expenditure) and multilateral (analyzing the proposed transaction in an effort to reduce the total amount of taxes paid by all parties) After tax values: current (applies to investments or other transactions whose income is taxed in each tax period; sale of principal resident is exempt); deferred (not all income is taxed in the year it is earned – e.g. unrealized capital gains tax-free roll-over); RRSP (initial contribution is tax-deductible and the tax on the investment income is deferred until the pension is paid) Structure of Income Tax Act: Part 1 – straightforward rules with common uses of words from dictionary meanings. Some words need to be defined. Sections are broken down into subsections (need to know which subsections the deductions are located in), paragraphs, sub- paragraphs, clauses and sub-clauses. Regulations can only be changed in Parliament. To avoid this time-consuming process, the Minister of Finance goes to the “Order of Council” for quick changes CHAPTER 2 – LIABILITY Taxable entities – individuals, corporations, trusts (investments), estates (intervivos for a living person) and testamentary (the result of someone’s death and dictates of his will), Deferred Plans, Charities (to insure compliance) and Non-Profit Organizations. Taxpayers are residents of a country. We pay taxes when employed, receiving a pension, carrying on a business, property income (investments – shares, bonds, currency), capital gains, selling real estate (except principal residence) – dispose of taxable Canadian property. There are no inheritance taxes in Canada. Individual - full time residence considerations - lives and works here minimum of 183 aggregate days (“Sojourn” in the country – e.g. athletes); a dwelling suitable for year-round occupancy; immediate family members remaining in Canada; maintaining personal property and social ties (i.e. furniture, clothing, car, bank accounts and credit cards, provincial hospitalization and medical insurance payments, a seasonal residence and eligibility of child tax benefit payments. Taxed on worldwide income with reciprocal tax treaties with other countries (you receive a credit for tax paid in other countries). Not based on citizenship, but residency – you can be a citizen, but not a resident. Employment taxes are withheldstat source, along with CPP and EI. Individuals have a calendar year end (December 31 ) and must file an income tax return before April 30, otherwise subject to a late penalty of 5% plus 1% per month (applies to corporations as well). Diplomats and armed forces personnel don’t live in Canada, but are considered residents. Main concern is when individual leaves the country. Within two years, you must dispose of all ties with no intention to return, otherwise you are deemed a resident. Once deemed a resident, you have to prove you are no longer a resident. Part-time residence - taxed in Canada on his worldwide income earned during the part of the year in which he was resident in Canada. Deductions in the computation of taxable income are allocated to the period of part-time residence. To establish part-time, facts show that the person made either a “clean break” or a “fresh start”. Residency is determined on a yearly basis (if coming or going mid-year, you are taxed on income earned in Canada in that year (like a non-resident). Non-resident - employment income, carries on a business or disposes of taxable Canadian property at any time in the year or a previous year is liable to pay income tax. Income is taxable where it is earned. Carrying on business in Canada – “continuous business activity, an adventure or concern in the nature of trade”. Merely soliciting orders makes a non-resident person liable to be deemed carrying on business. The greater the independence from the supplier and the greater the degree of responsibility, the greater the likelihood the situation involves a non-resident supplier selling to an independent contractor and therefor not taxable in Canada on business income earned in Canada. If there is no permanent home, personal/economic ties then habitual abode, then citizenship determine the residency. Treaties: Canadian/US treaty most important for our purposes. It exempts a resident of Canada from US taxation on salaries, wages and other similar remuneration derived from employment in the US provided it does not exceed $10,000 US and that the employee is not present in the US for an aggregate of 183 days. Corporate Liability: prior to April 26, 1965 – residence is determined where the corporate mind and mgmt is located – who makes the corporate decisions? After this date, corporation is deemed a Canadian resident if operating within Canada (doesn’t matter where the board meets). Companies want to be determined non-residents to avoid paying taxes here (since the tax rate is so high). No part-time concept - A non-resident corporation may be taxable in Canada on its Canadian source income. A US enterprise is not subject to taxation in Canada on its “business profits” unless the enterprise carries on business in Canada through a “permanent establishment” located in Canada, defined as a fixed place or business or a person who habitually exercises authority to contract. Has a fiscal year end. Tax returns must be filed within 6 months of the fiscal year end. Trust – Considered a resident if deceased was a resident of Canada, had assets in Canada and has beneficiaries in Canada. Look who has control - if executor has no discretionary powers, it is a Canadian trust. Intervivos trust has a December 31 year-end and return must be filed in 90 days. Intervivos trusts are set up to avoid taxes for children. Testamentary trust is the date of death and the return must be filed by April 30 of the next year or within 6 months (whichever is longer). Income is due on income and capital gains. There are 4 tax returns to file upon death – best to file all 4 since the same tax credits can be claimed on each type. Final T1 Return – income received. Capital gains and losses and income earned but not yet received can be moved to Rights and Things Return (e.g. a term deposit maturing after death). You receive the same tax credits all over again. Final two returns are Business and Trusts. All taxes have to be paid before the estate can be settled. GST was implemented on January 1, 1991 as final tax on consumption of goods and services. Tax on any supplies (commodities) bought and sold. Goods are classified as taxable, exempt (glasses, food, juice, childcare, educational supplies, financial services, sales of residential housing and residential rentals) or “zero rated” (subject to GST but not taxed – drugs, medical supplies, groceries). A person who is engaged in a commercial activity (not hobbies) in Canada is required to register for GST purposes. Small suppliers, persons whose revenues from taxable supplies do not exceed $30,000 in the four preceding calendar quarters, are exempt from registration and are not required to collect. A business that is carried on is an adventure or concern in the nature of trade and supply of real property. Business is defined broadly to include a profession, calling, trade, manufacture or undertaking of any kind whatever, regardless of whether the activity is engaged in for profit. Permanent establishment is defined as a fixed place of business, including a place of management, branch, office, factory, workshop, mine, oil or gas well, quarry, timberland or other place of extraction of mineral resources through which supplies are made. The point to remember is that the GST is a tax on consumption or value added and not on income. Partnership, unincorporated society, club, association or organization (or branch), the entity is deemed to be a resident in Canada if a majority of its members, having management and control, are resident in Canada at that time. Businesses receive an input tax credit on GST they pay. Responsibility for collecting and remitting GST generally lies with the supplier. Every recipient of a taxable supply made in Canada is required to pay a tax of 7% (or 0% for zero- rated supplies). A taxable supply made in the course of a commercial activity. Intangible personal property includes that which has no intrinsic marketable value, but is merely evidence of value, enforceable by law, such as contractual rights, stock certificates, intellectual property (including patents, trademarks, industrial designs, etc.). Non-resident: A supply of goods or services made in Canada by a non-resident is deemed to be made in Canada if: the supply is made in the course of business carried on in Canada, the non-resident is registered for GST purposes at the time the supply is made or an amusement/seminar. As a general rule, a supply made in Canada will only be subject to GST if it is made by a resident. Sources of Income: Office (elected officials), Employment (salary and wages, Section 5 – 8), Business (companies, fishing, farm income), Property (rent, interest), Other (pensions, alimony, maintenances, EI). It is important to source out income – any excess deductions will be lost. Net Income (Handout # 2) - The total of: Paragraph 3(A) (office, employment, business, property, other - must all be positive, otherwise the amount is nil) + Paragraph 3(B) (taxable capital gains PLUS taxable net gain on Listed Personal Property LPP (coins, art) MINUS allowable capital losses (excluding Allowable Business Investment Losses (ABILs). Capital losses can only be applied to capital gains and can be carried back 3 years or carried forward 7 years. - Subsection 3(C) (deductions – cannot exceed A + B) - Subsection 3(D) (amount by which 3(C) exceeds losses from office, employment, business, property, ABILs. When there is no excess amount at paragraph D, the taxpayer’s income is deemed to equal zero. CHAPTER 3 - EMPLOYMENT INCOME T1 return is not net - return separates employment inclusions from deductions Employed vs. Self Employed: The economic reality test examines several factors relating to the nature of the relationship: control (If the individual’s time and activities directed, the employer sets the terms of employment); ownership of the tools (if the company provides the tools, individual is likely an employee); income (is the individual dependent on the company as the sole source of income?); chance of profit and risk of loss; integration (is individual allowed to work for other people?), specific result (defined objective & freedom to complete). Employees have limited, regular income and benefits – contracts have no deductions for tax and no benefits. People can be an employee of each company they work for. Self-employed expenses cannot be applied to employment income. If not included in Sections 5 – 8 (Income from Employment and Business, Benefits, Stock Options, Deductions), it’s not employment income. Net amount cannot be negative – only 0. Inclusions: Salary and wages are terms in common use, but remuneration includes such items as bonuses, tips and honoraria. All amounts received by an individual in his capacity as an employee both from his employer and others by reason of employment must be included in income. “Received” means employee must report employment income on a cash basis. Thus, deferring a payment such as a bonus will affect the level of income for a given year. A corporate director holds an “office” - fee must be included in income. Value of board of lodging: taxable benefit and must be valued for tax purposes at the fair market value (FMV) less any amount charged to the employee. Unless a special work site or remote location cannot be expected to travel daily from residence and the board and lodging is necessary for not less than 36 hours. Reasonable, temporary living expenses while the employee is waiting to occupy permanent accommodations are also exempt. Government has a prescribed rate on the market assessment that can be claimed. Whatever expenses the employee pays for personally is deducted from the lodging benefit Fringe Benefits: Generally non-cash: parking, meals, transportation, taxi, car, lodging (at FMV), holidays, loans, investment plans – these are taxed to equalize the tax structure). Frequent flyer programs accumulated through employer-paid business trips for personal use are included. Financial and tax return counseling are included. Employee cannot claim a deduction if the employer is claiming the deduction – generally the end user pays the tax. Strike a deal with an employee for non-taxable benefits as part of the salary. It is the employee’s obligation to claim taxable benefits in income. Employer Derived GST benefit is included in employment income except zero-rated and exempt goods. EMPLOYEE LOANS: Interest free or low interest loan is a taxable benefit as the difference between the prescribed interest rate (issued by the Bank of Canada every quarter) at the time the loan was made. 2% less than prescribed rate; input based on # of days/quarter: $20,000 x 90/365 x 4% = $197 add up for each quarter for the taxable benefit. Only the interest actually paid by either the employee or employer is deductible. Home purchase loans use a rate set by for each quarter the loan is outstanding as the lesser of: the prescribed rate for the quarter while the loan was outstanding OR the prescribed rate in effect at the time loan was made. A partial exemption for the imputed interest income inclusion is on the first $25,000 of a “home relocation loan.” Investment loans: has to be treasury shares that are un-issued (not previously issued). For computation, the benefit is included 3(A) and the carrying charge is deducted 3(C). Investment loans are included in income to raise the base income calculation for RRSP contributions (limited to 18% of total income) and childcare expenses. Housing loans: treated as a regular loan with a 5-year term (re-calculated after the end of each term). Based on a prescribed rate for interest, which remains constant unless it drops (it can only go down). Generally used for shareholders or small company employees – the taxable benefit is the difference in interest from a bank. AUTO BENEFITS: if the employer makes a car available for 365 days a year, the personal use of the car is a taxable benefit. Allowances: travelling expenses for employees who sell property or negotiate contracts - must be reasonable; “ordinary employees” must be reasonable for travelling expenses, but motor vehicle are not included and the recipient must travel away from the municipality of the employer’s establishment at which the employee normally worked. Specific inclusion of a standby charge for automobiles PLUS all operating costs (gas, oil, maintenance, insurance) paid by the employer for personal use. Any benefit related to personal parking will be included. Standby Charge - A standby charge represents a benefit conferred upon an employee through the availability of a company-owned or leased car for any use, whether for employer or personal. Since the employee does not have to spend tax-paid dollars on either purchasing or leasing a car, the benefit should be taxed. Employee is assessed for personal use whether he uses it personally or not. Can’t have the car both purchased and leased. STANDY BY CHARGE FORUMLA: A/B x (2% of (C x D) Employer owned OR 2/3 (E – F) x # of months – as per class instruction) Employer leased A = the lesser of personal use km during available time period (keep a log) OR 1,000 x (days available/30 – must be full month) B = 1,000 x (total days available/30) – to a maximum of 12,000 km (trying to determine the number of days available) C = original or capital cost of car, including GST and PST D = total days available when employer owned car/30 (number of full months as per class instruction) E = lease payments, including GST and PST, made by employer (but not insurance) F = insurance (because the insurance has to be paid regardless) A/B looks whether there is a reduction to the taxable income considered for personal use – when less than 12,000 km, you get a reduction on the taxable benefit. 2% is the time available to the employee. Standby charge is computed by the employer. Operating costs for personal use paid by an employer and not reimbursed by the employee give rise to a taxable benefit to the employee including gasoline, insurance and maintenance costs, but not parking costs. Any benefit to personal parking is included in income separately. Either 1/2 the standby charge or the 16 cents per kilometer method which ever is better for the employee. Excess of 16 cents per km is charged to employee as a benefit. OPERATING COSTS FORMULA: A – B, where A = 1/2 the standby charge (provided 50% business use) OR 16 cents per kilometer (whichever is the lower or more favorable rate for the employee) and B = whatever the employee has paid the employer for the operation of the car is deducted Employer paid Insurance Benefits are exempt. Disability payments received are employment income. Where an employee has paid any amount of these premiums, these amounts are deductible. STOCK OPTIONS - Company grants an option for a limited time period to buy its stock at reduced market value. Taxable benefit comes into play when you purchase the shares. Exercising a stock option will result in employment income if the price paid under the option is less than the FMV of the shares at the time of their purchase. The benefit equals the difference between the purchase price and FMV x the number of shares. Options must be received as a result of employment – rights or warrants by virtue of shareholdings alone would be excluded. The inclusion of that benefit occurs at the time the shares are disposed of, thereby deferring the inclusion of the benefit. The excess of the actually selling price over the FMV at the date the option is exercised will result in a capital gain at the appropriate inclusion rate. Taxable gains are taxed at 1/2 the rate of normal income. If it is shares of a Canadian controlled private corporation, you can defer the stock option benefit until the time the shares are sold. NOT INCLUDED: employer’s contributions to a registered retirement pension plan, group sickness or accident plan, private health service premiums, supplementary unemployment benefit plan, deferred profit sharing plan, group term life insurance, retirement compensation arrangement, employee benefit plan or trust; mental or physical counseling related to retirement or relocation and benefits under a salary deferral arrangement. Other Exceptions: Non-taxable gifts limited under $100; club membership must be principally for the employer’s advantage for exemption; Employer-reimbursed actual cash loss on the sale of a home from employer-instigated move not included. Spousal business trips if the spouse was engaged primarily in the business activities on behalf of the employer. Housing loss - One-half the amount in excess of $15,000 of an employer-paid amount is included in employment income for an eligible housing loss. An eligible housing loss is the taxpayer’s housing loss – the cost of the residence to the taxpayer minus the proceeds of disposition or FMV. 40 km minimum distance between new and old residences and work locations is imposed. Different forms of payments have different tax treatments – offered cafeteria packages. The employee has to trade off the level of after-tax compensation with other factors such as timing and risk – compute the expected value. Salary and wages are the most certain forms of compensation but a long-term disability package is not (it only has value if the employee suffers an accident). Of greater risk are bonuses that are tied to company performance and stock options. DEDUCTIONS: SALES/NEGOTIATING EMPLOYEE - The nature or type of expenses is not restricted, except for capital nature. Employee must pay his expenses as stipulated in the contract of employment and the employer does not reimburse the expenses (e.g. real estate agent or commission salesperson). The employee must ordinarily be required to travel away from the employer’s place of business. The remuneration must be dependent on value of sales or contracts (must be part commission in order to apply deductions) - a non-taxable allowance cannot be received. Un-reimbursed amounts included for meals and lodging while travelling away from home on the employer’s vehicles are allowed. No deductions for an office in the home. Only 50% of meals and entertainment can be deducted. If away from municipality where office is located more than 12 hours and 40km, personal meals are deductible. Can’t deduct capital cost allowance (e.g. car or mortgage) or club dues (only allowed under business income). Can’t deduct interest on the car loan. Can’t deduct more than total commission. Pension plans, union dues, professional membership fees are all deductible, as well as advertising, phones and reasonable car expenses (37 cents for the first 5,000 km and 31 cents for all kilometers over 5000). Deductions must be reasonable in the context (e.g. if the employer provides a car allowance and housing, it will accept deductions on top if they are reasonable – these are taxable benefits). Employee cannot deduct these expenses since the employer is. Allowed 16 cents per km for the car allowance – the excess is taxable to the employee and not eligible as a deduction to the employer. Use 8(1)H if expenses are not deductible under 8(1)F – no income ceiling on the amount that can be claimed (claim travel and vehicle expenses), but no promotion or meal deductions are allowed. Use either F or H. Allowed a car allowance or car expenses. HOME OFFICE: To be able to deduct for office in home, 60% of business activities must be performed at home and space must be used exclusively for earning income (e.g. used regularly for meeting clients). Deductions include maintenance expense for rental units and rent, repairs, supplies, telephone, utilities, home insurance, property tax for owned property. Ordinary employees exclude last 3, commission employees include them. Both exclude capital cost allowance and mortgage interest as a deduction. Cannot create a loss in current year with home office deductions – carried forward to future years. Others included for ordinary employees: legal expenses to re-coup previous remuneration, annual professional membership dues, office rent paid or salary paid to an assistant & CPP/EI, cost of supplies paid; work space in home - % of space, maintenance costs but not interest on capital loan CHAPTER 4 - BUSINESS INCOME Income from a business for a taxation year is the profit (income after the deduction of expenses currently incurred to produce it). Includes service, sales, professionals, restaurants and can come from anywhere. Types of businesses: proprietorships, partnerships, professionals, corporations. Specifically excludes an office or employment. Portrayal of income according to common law on “sound commercial principles”, including GAAP but is not required by legislation to be interpreted in conformity with GAAP. Taxes are based on income earned in a year. Income computed on accrual-basis – when customers are billed. Employment income computed on cash-basis – when income is received. Courts apply analogy of fruit-bearing trees to determine whether a transaction is capital or income. Did the taxpayer deliberating seek a profit of income rather than a capital gain? Intention must be inferred from taxpayer’s behavior and entire course of conduct. Circumstances which force the sale of property do not have the effect of retroactively converting a property held to produce income. Checklist of factors to determine reasonable expectation of profit – manner in which activity is operated, elements of personal pleasure, expertise of taxpayer or his advisors, history of income and loss, time and effort expended, financial status of taxpayer, amount of occasional profits, success of taxpayer in other activities, expected appreciation of asset, sale or discontinuance of activity Courts have developed a set of indicators – badges of trade – to determine the relation of transaction to taxpayer’s business – if similar, it is income. Activity normally associated with trade – if handled as a normal business transaction (e.g. quantities purchased, method of sale and promotion), it is considered income. Nature of assets involved – fixed assets if sold result in capital, circulating or working assets if sold result in income. Number and frequency of transactions by taxpayer in given period – large number = income, smaller = capital. Length and period of ownership of asset – longer ownership = inventory, shorter = capital asset. Supplemental work in connection with property to enhance value results in income on disposition. Circumstances that caused the disposition – an unsolicited offer. Corporate objects or partnership agreement Business income included in Sections 9 – 12 (Business Income, Inventory, Fiscal Year End & Taxation Year, Inclusions) Real Estate – feasibility of taxpayer’s intention, location and zoned use, extent to which intention was carried out, evidence of change in stated intention after the purchase, extent to which borrowed money was used to finance acquisition, factors which motivated the sale Securities – knowledge or experience in securities market, time spent studying securities, financing primarily by margin or other debt, advertising or making it known the taxpayer is willing to purchase securities Since the performance if a business contract usually results in income, damages received for non-performance are regarded as income. While damages received for a cancellation of agency agreement is usually income, if the agreement is of sufficient importance to the company’s business structure, the compensation paid on termination of contract can be capital. Damages for loss of property may be regarded as a receipt of capital if the property was fixed capital OR a receipt of income in the property was working capital such as inventory. Profits from carrying on an illegal business are taxable. Non-capital expenditures incurred to produce income are normally deductible, but deduction of specified illegal payments is prohibited. Proceeds from private betting or gambling are regarded as non-taxable, as long as the activity is not organized or of a business nature. Existence of system for management of risk may indicate a professional gambler. Government or any other subsidy may result in income receipt where it supplemented the taxpayer’s income and enabled him to operate at a profit OR to ensure a reasonable return on the capital invested. On the other hand, a capital receipt may result if the taxpayer was reimbursed in respect to a capital outlay OR to encourage an activity in public interest (e.g. unemployment). Forgiveness of debt – when debt obligation is incurred, principle is not income. Hence, no deduction is allowed on repayment (and is made with after-tax funds). When a debt is settled or forgiven for less than its principle, there is no tax – only when interest charged was deductible to the debtor. Inventory – valuation of each item in an inventory at the lower of cost or market is permitted, although a higher value would be more desirable to reduce a loss that might expire. Where the cost of inventory can be identified, actual laid down cost is used including duties, freight and insurance. Goods in process produced in manufacturing can include direct labor & overhead. Cost of Goods Sold: Beginning inventory PLUS purchases MINUS closing inventory Where individual items cannot be identified for costing, FIFO (first in, first out) must be applied for determining inventory cost – must match revenue to expenses. Market price is the prevailing current purchase price, realization value (i.e. the selling price which the goods will realize) and the replacement value (cost of reproducing the article into its present state of completion.) Value attributed to opening inventory must be the same as the closing inventory the year before – intended to prevent profits escaping tax and restrict the flexibility in inventory valuation method from 1 year to another Depreciation allocation of inventory – cost of closing inventory includes an allocation for depreciation, obsolescence or depletion write-offs, which must be added to income for the year. The depreciation included in the cost of closing inventory is not charged as an expense in the year, since it reduces the COGS. Since the same allocation will be included in the cost of opening inventory the next year, a deduction for the amount of the allocation added into the current year is made in the subsequent year. Artistic endeavor – allowed to elect nil as the value of year-end inventory for such a business (paintings, prints, drawings, etc.), but does not include the business of reproducing such works. Applies to supplies, works in progress and finished works and allows the artists to write off the costs involved in the year the work is produced, rather than when it is sold. Sole proprietorship – individuals who report business income, including professional income, must report that income on a calendar year basis. This requirement also applies to partnerships. INCLUSIONS – any amounts received for services rendered or goods to be delivered are included in income (different from GAAP which defers such income until the year in which earned). A reasonable reserve for unearned amounts can be taken. A complementary reserve (limited to 3 years) is available for property sold due to the uncertainty of collecting the amounts. All receipts for reimbursements (e.g. grants, subsidies) or inclusions in acquiring an asset or incurring deductible expenses can be included in business or property income unless the amount has already reduced the cost of the property or the amount of the expense. Warranties – Replacement values have to be treated as a liability if company extends a warranty – has to be a reasonable amount, based on history. Down Payments received are considered income – can take a reserve for the amount due. Reserves (deferred revenue) - Department of Finance allows you to take a reserve for A/R, but it is not a permanent deduction – you have to calculate the reserves every year and add last year’s reserve to establish current year reserve. Deferred remuneration (unpaid salary, wages) must be paid within 180 days of fiscal year end. If it’s not paid, it’s not an allowable expense and is added back into income. Section 20(1)N – gross profit/gross selling price x amounts due (A/R). If amounts are still due after 3 years, you can’t claim a reserve again. DEDUCTIONS – courts rely on ordinary commercial practices, including GAAP, to provide the basis of profit unless IT Act requires an alternate treatment. An expense or outlay must be made by the taxpayer for the purpose of gaining, producing or maintaining income and be expected to generate income related to the taxpayer’s business or property (although no income may have been generated). An outlay of a capital nature (bringing an asset into existence or for enduring benefit of trade) is attributable not to revenue but to capital. Bad debt can be deducted. Section 18 – Restrictions on Deductions (non-deductible amounts) and Section 20 – Deductions. If a deduction is not included in Section 20, look to Section 18. If not included in Section 18(1)A, it isn’t deductible. Prohibited Deductions – producing exempt income, reserves, payments on discounted bonds, payments on income bonds, dividends paid out, personal and living expenses (expenditure must be made with a reasonable expectation of profit), recreational and club dues (unless provided to the public in the course of business, golf course fees not deductible), political contributions, automobile expenses paid to an employee for use of his automobile (limit is 41 cents for first 5000 km and 35 cents thereafter), payments for income taxes, interest and penalties and prepaid expenses (deductible only in the taxation year to which the expenses relate), expenses of investing in sheltered plans, workspace in home (unless principle place of business and used to regularly meet clients), provincial taxes on payroll expenses unless in excess of $10,000 – allowance is the amount by which 6% of a corporation’s taxable income exceeds $10,000 (CPP and EI contributions can be included), limitation on accrued expenses (must constitute a genuine liability for the taxpayer), unpaid amounts (must be paid within two years of the end of thesttaxation yearrdin which it was declared; if unpaid, must be brought back into income on the 1 day of the 3 taxation year), unpaid remuneration (salaries, wages must be paid within 179 days of the end of the taxation year in which the expense was incurred), GST = input tax credit eliminates GST , hence GST should not be deductible, Permitted Deductions – write offs on capital expenditures (depreciating property; must be amortized equally to achieve better matching principle), interest paid or payable on funds borrowed to finance capital expenditures, expenses of issuing shares or borrowing money (for the purchase of capital property acquired to earn income), interest on fund borrowed to buy shares (since dividend income will be earned), premiums on life insurance used as collateral for a loan and paid on the lives of officers, employees or shareholders; limited to portion of premium that represents the net cost of pure insurance; denied is the deduction of any discount from the face value of a debt obligation (bond, debenture, note, mortgage, etc. – acceptable discount is 3% due to market fluctuations) and the actual cash outlay on redemption or open market purchase; reserves – deductions include doubtful debts, loan guarantees of a financial institution - % set by particular industry – last year’s added back into income and current year is computed; goods and services not rendered or deposits for returnable containers, warranties for a mounts paid or payable to an insurer, amounts not due until a later year under an installment sales contract; where debt has been established to have become bad debt, it can be written off as an expense if previously included as income; employers contribution to RPP, employers contribution to a profit sharing plan paid to a trustee, employer’s contribution to a deferred profit sharing plan (limited to 1/2 the money-purchase dollar limit per year or 18% of the employee’s compensation), cancellation of lease costs due to a lessee (treated as a prepaid expense for the lessor), landscaping of grounds around a building used to produce income from business, expenses of representation for obtaining a license, permit, franchise or trademark (may deduce 1/10th the amount over 10 consecutive years), expenses for investigation of site planned for use in an existing business, utilities connection service, disability-related modifications and equipment, convention expenses for 2 per year – meals only 50% of actual cost, articles of incorporation or amendment are eligible capital property, charitable donations, dividends paid (dividends received are included in income from property), appraisal made to maintain adequate insurance, legal costs of defending a customer’s suit, reasonable bonuses, losses in cash sustained by criminal action of employees or officers (not partner or senior officers), damages for failure to deliver goods Section 67 – limitations on meals & entertainment, lease costs, interest on automobiles. Section 20(1)C – interest is deductible on loans taken to earn income (but loan amounts are not taken into business income). If part of the loan is for personal use, the interest on the personal use portion is not deductible and must be added back into income. Sales/Negotiating Person’s Expenses revisited – unlike ordinary employees, sales persons can deduct expenses incurred to produce employment income, limited to the amount of commission income received in a year; passenger vehicle – capital cost allowance may be claimed at $30K after 2000 + GST & PST; interest on purchase loan are limited to $300 per 30/days; employer’s automobile expenses for employees have limited deductions; 8(1)f does not restrict automobile deductions to commission income; home office expenses – rent, CCA, property taxes, mortgage interest, heat, electricity, insurance, maintenance IF individual’s principal place of business and used for regular client meetings; limited to the income for the year for which the office is used; food, beverage and entertainment expenses limited to 50% of the amount paid both for regular visits and conventions Ceasing to carry on business – sales of A/R – to be able to reserve for doubtful or bad debts, they must have been included as income previously; where a taxpayer disposes of any part of a business or inventory it is deemed to have been sold in the normal course of carrying on business; any mounts that have been billed are required to be included in income of a professional; works in progress representing unbilled services are considered inventory Scientific Research and Experimental Development – deductions allowed for engineering, design or operations research, mathematical analysis or computer programming, data collection, testing and psychological research; not included is market research or sales promotion, quality control or routine testing, social services or humanities research, natural resource exploration, commercial development of material, products or processes); expenditures including capital made in a year are deductible – those not deducted are placed in a pool and may be deducted in the future; expenditures can include R & D related to the business directly undertaken by taxpayer, payments to an approved association, university, research institute, non-profit corporations resident in Canada and direct costs of personnel who directly perform research part of the time; as further incentive to invest in R & D, an investment tax credit lowers the cost of R & D GST impact on business activity – if an entity is carrying on business for income tax purposes, it is also considered to be carrying on business for GST purposes; a business includes an adventure or concern in the nature of trade, a profession, calling, trade, manufacture of any kind, but not an office or employment; expectation of profit is not necessary (e.g. charities, hospitals); supply of property through lease, license is also considered a business; exclusions from definition of commercial activity is any part of a business making an exempt supply or a business consisting solely of individuals without a reasonable expectation of profit; the value on which the GST is imposed is not affected by the discount or penalty; GST is payable at the time the supply is paid – with partial payments, GST must be included with each payment; when an employer provides a taxable benefit for the employee’s operating costs for an employer-owned automobile, the value is determined by the per km method or 50% of the standby charge – in either case, the registrant employer is required to remit GST equal to a prescribed percentage of 5% of the benefit (less than the 7% to recognize that the benefit includes exempt supplies such as insurance and license fees) Input Tax Credits – available to registrants for GST paid on goods and services that are purchased for use in commercial activity; purchases can be partially intended for commercial activity (70%, with a credit equal to 70%); Restrictions: club membership, home office expenses which is neither the taxpayer’s principal place of business or used for regular client meetings, personal or living expenses; expenses must be reasonable when claiming an ITC; automobile allowance for an employee not claiming the allowance is eligible for an ITC GST adjustments – where a supplier has overcharged GST, the amount is adjustable; price reductions allow the reduction of GST charged (except cash discounts for prompt payment); GST charged but not collected on bad debt; where lease costs exceed the maximum amount deductible, a portion of the ITC will be recaptured; at the end of the registrant’s fiscal year, there will be a recapture of 50% of the total ITC for food, beverage and entertainment expenses PREPAID EXPENSES – includes insurance, rent. Assets must be added back into income and deducted in the current year. FARMING INCOME (part time) – there must be an expectation of profit, therefor losses are restricted and can only be applied to farm income. Maximum loss is $8,750 OR $2,500 + (1/2 loss – 2,500/12,500?). For example, $60,000 farming loss in a year – deduction is $2,500 + 6,250 = 51,250 carried forward for 10 years or carried back for 3 years. PASSENER VEHICLE LOANS – deduction is lesser of interest paid or payable. FORUMLA: A/30X B where A is the prescribed amount and B is the number of days interest is payable. (e.g. lesser of $4800 actually paid OR prescribed amount of $300 – 300/30 x 365 = $3650 is what is deductible) Have to add back the difference of what was deductible for accounting purposes and what is deductible for tax purposes CHAPTER 5 - DEPRECIABLE CAPITAL PROPERTY AND ELIGIBLE CAPITAL PROPERTY CAPITAL COST ALLOWANCE - Only applies to non-depreciable property (inventory, receivables, land, investments, personal use property and LPP) – cannot have a capital loss on depreciable property (buildings, cars, fixtures, furniture, which use the straight-line depreciation method) or eligible capital property (goodwill, customer lists). Class ends when you sell the asset. Example: Class 8 Asset – rate of 20% CCA. 1999: $200,000 x 20% = $40,000 CCA (maximum deduction for the year) and balance of UCC = $160,000 (Undepreciated Capital Cost) for the following year. 2000: $160,000 x 20% = $32,000 CCA and balance of UCC = $128,000. Have to allocate between land (non- depreciable) and building (depreciable). Vehicles have a maximum of $ 30,000 UCC 50% RULE – only 50% of the net addition to the same class (combination of all additions and dispositions) is taxable in the year of acquisition. Example: 2000 UCC = $60,000 with additions of $40,000 and dispositions of $10,000 in the same class. Net addition is $30,000 and is only 50% taxable ($15,000). Therefor the amount subject to CCA is $60,000 + 15,000 = $75,000 x 20% CCA rate = $15,000. Closing UCC = $75,000 – $15,000 CCA + $15,000 not subject to CCA (must be added back for closing UCC total) = $75,000. Exceptions to the 50% rule are certain class 12 property and class 14 property. Also does not apply to a negative net acquisition (amount must be positive) OR straight line depreciation. ADJUSTED COST BASE – includes all associated costs in purchasing the asset (i.e. legal & accounting fees, commissions on sales, etc.) RECAPTURE – If an asset within a particular CCA class is sold for more than the outstanding UCC balance (i.e. a profit is made), 100% of the difference is added back into income – usually 50% as income and 50% as a capital gain (with only 1/2 the amount subject to tax). TERMINAL LOSS – If an asset within a particular CCA class is sold for less than the outstanding UCC balance (i.e. a loss is incurred), 100% of the loss can be applied to any sort of income. No capital loss on depreciable property. IDENTICAL PROPERTIES – Used for a group of identical properties acquired over time at different capital costs (e.g. stocks in a particular corporation) – must be averaged out and calculated upon disposition. First, calculate the total paid for the shares divided by number of shares for the ACB. Secondly, multiple the Proceeds of Disposition by the number of shares, then subtract (the number of shares multiplied by the averaged ACB). If this is a capital loss, 50% can be deducted. If this is a capital gain, 50% is included in income. LEASEHOLD IMPROVEMENTS - Used to adhere to the matching principle. Lesser of: 1/5 of capital cost OR capital cost/lease + 1 renewal option. Cannot be greater than 40 years. CAPITAL GAIN RESERVE – To provide a break to companies where money is owing to them for a capital gain with the tax on the capital gain payable. Recalculated each year for a maximum of 5 years @ 20% each year, with the reserve added back from previous year and current year reserve deducted. First, calculate the maximum reserve - Receivable amount/proceeds x capital gains. 900,000 owing/1,000,000 net sale x 600,000 capital gain = $540,000 (being paid at $100,000 per year) Second, calculate the allowable reserve for current year – 20% x (4-0) x capital gain 20% x (4-0) x 600,000 = $480,000 - therefore capital gain – reserve = taxable capital gain (600,000 – 480,000 = 120,000, with $60,000 being taxable) NEXT YEAR: 800,000 owing/1,000,000 net sale x 600,000 = $480,000 maximum reserve 20% x (4-1) x 600,000 = $360,000 - therefore capital gain – reserve = taxable capital gain (480,000 – 360,000 = 120,000, with $ 60,000 being taxable) Repeat for the next 3 years. SUPERFICIAL LOSS – To close loophole and prevent a lower ACB. Loss on sale of similar assets (e.g. stocks) must be added back to the new ACB of the second purchase. CHAPTER 6 - INCOME FROM PROPERTY regarded as return on invested capital when little or no time, labor or attention is expended in producing the return – dividends, interest, rental income and royalties; income from property is the “profit therefrom for the year”. Income or loss from property does not include capital gains or losses – this is important when considering the deductibility of an expenditure which depends on producing income from property. Any amount received that is dependent on the use of or production from property is taxed as income. Interest is defined as “the return or consideration or compensation for the use or retention of a sum of money, belonging to or owed to another. To forestall taxpayers from converting amounts from interest to capital, CCRA deems these amounts to be interest and requires them to be brought into income at specified intervals. The primary method for computing interest on a “debt obligation” is the annual accrual method, also defined as an investment contract – bank accounts, term deposits, guaranteed investment certificates, Canada Savings Bonds, mortgages, corporate bonds and loans. Received interest must be included in income to the extent is has not been included previously by the accrual method. It is not possible to defer the recognition of compounding interest by using the cash method to report that interest only when it is received. Long-term investment contracts before 1989, use the expiration date to bring accrued interest (receivables) into income. After 1992, use the annual anniversary date or the end of the year to bring into income. Individuals can use the anniversary date, corporations must use their fiscal year end. If transferred to a spouse mid-year, Partner A must report the income in the year up to the transfer date. Individuals holding interest in an investment contract must include in income any interest that has accrued on the anniversary of the contract not previously included in income other than salary deferral, various types of income-based debt, government sponsored debt for small business. Interest on a scholarship trust fund is not taxable to a parent or grandparent who establishes the fund under a registered education savings plan. The interest is considered to be the income of the recipient child. Bonds - Interest from bonds sold or otherwise transferred accrued to the date or transfer must be brought into the income. This is not a capital gain Loans – if a loan is made at a discount, but repayable at par, where a payment can reasonably be regarded as being part interest payment and part capital payment, that part can be regarded as interest to be included in the income of the recipient. If a property is sold at FMV, no interest component has to be assumed. However, interest income applies to the sale of property if the contractual price in total exceeds the FMV of the property. Dividends – taxable dividends received in the year from Canadian corporations must be included in income and where that taxpayer is an individual, a further amount of 1/4 the dividends must also be added to income. Thus the individual pays tax on 5/4 of an actual dividend received. This is designed to place the individual shareholder in approximately the same income position that the corporation was in before it paid corporate tax on its income – what the corporation approximately needs to generate to pay the dividend from after-tax income. A taxpayer may elect to include the dividends of a spouse in his income following the same rules for personal dividends. Section 121 provides a dividend tax credit equal to 2/3 of the dividend gross-up to reduce the tax paid on dividends – this approximates the tax the corporation has paid on the shareholder’s behalf. The result is the elimination of double taxation, but applies to individual taxpayers only (not corporate shareholders). For Dividends, return on capital is different from interest. Sources can be stocks, Canadian or foreign sources. Capital dividends arise from non-taxable sources (capital gains are only 50% taxable, which reduces the cost of the shares). Foreign source dividends will have tax withheld at their source, which is a tax credit on the Canadian tax return. All dividends are grossed up to 125% their value for tax purposes due to integration and recognize the after-tax value the corporation has paid out on the dividend. However, individuals receive a tax credit of 22% on dividends received to counter-act gross up. Because corporations don’t get a deduction for dividends paid, they aren’t an expense to earn income. Corporations are not taxed on the dividends they issue – deductible and go into a pool to pay out. Shareholder benefits – Section 15(1) prevents the distribution of accumulated surplus (other than taxable dividends) to shareholders while the corporation is a going concern. Shareholder loans – normally when funds are borrowed, the principal amount of the debt is not considered to be income and the amount of the debt repaid is not deductible. Incurring and repaying debt is a capital transaction. Section 15(2) prevents a shareholder from borrowing funds from a corporation instead of receiving taxable salary, interest or dividends and never repaying them. Loan or other indebtedness to shareholders (other than corporate shareholders) or to person’s not at arm’s length to the shareholder are required to be include in income of the borrower for the year in which the loan was made. The capacity in which the individual receives the loan, either a shareholder or an employee, is not relevant. There are two exceptions: indebtedness between non-resident persons AND debt that arises in the ordinary course of the lender’s business as long as bona fide arrangements are made at the time the loan is taken for repayment within a reasonable time. Section 15 (2.4) provides exceptions for 4 types of shareholder loans for which the principal amount can be excluded from income: a loan made by the corporation to a shareholder who is an employee AND a loan to a shareholding employee for a home for his occupation, previously un-issued shares of the corporation purchased directly from the corporation or a motor vehicle to be used in the performance of his duties. This is based on 2 conditions: the loan arises because of employment, not shareholdings, and bona fide arrangements must be made at the time of the loan for repayment in reasonable time. Excluded from income is a loan fully repaid within one year of the end of the taxation year in which it was made if the repayment is not part of a series or loans and repayments. Where an amount has been included in income for the preceding year, the taxpayer is permitted to deduct any repayment of the loan from his income in the year of repayment if it wasn’t part of a series of loans and repayments. This only allows a deduction for the decrease in the loan account unless the decrease is temporary. Where the principal amount of the loan is not included in income because it meets one of the exclusion conditions, the Act requires that any person who received a loan or other debt by virtue of individual employment or intended employment, shareholdings in a corporation or the shareholding of a person who does not deal at arm’s length must include in his or her income an amount in respect of an interest benefit on low-interest or interest-free loans. If the loan is a “home purchase or relocation loan”, the imputed interest benefit is calculated for each quarter to the lesser of: the prescribed rate in effect at the time the loan was received and the prescribed rate (changed on a quarterly basis) in effect during the quarter. A new loan will be deemed to be received every 5 years, which has the effect of changing the rate of imputed interest at least every five years. If the company borrows the funds to lend to the employee, it is able to deduct the interest it paid as part of reasonable remuneration Chart on Shareholder loans page 309 Progressive income tax rates applied to individuals provide an incentive to split income, particularly among family members. The highest rate of federal income tax for income in excess of $100,000 in 2001 is 29%. The lowest rate for income up to $30,754 is 16%. If income-producing property can be acquired by family members in lower tax brackets, income tax can be saved. Rules exist to attribute income from property (but not income from business) to an individual who may have transferred or loaned property to split income. Attribution of income or loss from property will occur where an individual transfers or loans property to a spouse or common-law partner (who cohabits in a conjugal relationship for a continuous period of at least one year, including same-sex partners). Attribution of income or loss from property (but usually not capital gains or losses) will also occur on a transfer or loan to a minor (under age 18) who is non-arm’s length, which continues until the minor turns 18. Applies to direct or indirect transfers or loans to OR for the benefit of the person. Attributions still considers the income or loss of the transferor during his lifetime as long as he or she is resident in Canada. Attribution deems related persons not to deal at arm’s length with each other. Chart page 306 describes related individuals. The word transfer is considered to include a sale, whether or not at FMV, and a gift. The Act requires specific conditions be fulfilled before the taxpayer will be exempted from the attribution rules: First - if the property is sold for its fair-market value, these rules do not apply. All gifts of income-earning property are subject to attribution which are less than the FMV of the property transferred. Second - if the transferor takes back a debt, then interest that is at least equal to the prescribed or arm’s length rate must be charged. The interest must be paid within 30 days of the end of each and every year in which the debt was outstanding or attribution will occur. Where a transfer or loan takes place at FMV, the benefits of income splitting are reduced or eliminated. The FMV consideration will help avoid attribution of income from property and more importantly, capital gains on a transfer to a spouse or common law partner. Avoiding the attribution of capital gains may provide a significant benefit. Third – accrued income on depreciable capital property and other capital property is automatically deferred on the transfer to such a property to a spouse or CL partner. However, to avoid attribution, the deferral must be waived by the transferor spouse. Hence, a disposition will occur at the FMV, triggering a capital gain or loss. Summary of avoiding income attribution on transferred property: FMV consideration must be received by the vendor, if part of the consideration is debt, then interest must be charged at the prescribed rate and paid by Jan. 30 and if the transfer is to a spouse or CL partner, the transferor must elect out of the rollover. Anti-avoidance rules – prevent the refinancing of an old loan by the substitution of a commercial rate loan that would result in attribution – provided to prevent “back to back” loans or transfers. Loan guarantees are also not allowed – a commercial rate of interest must be charged and paid. “Artificial transactions” or “reverse attribution plans” are covered under a general anti-avoidance rule. An individual can remunerate a spouse or related minor for services provided in a taxpayer’s business provided conditions are met and the amount paid must be deductible in determining the business income and is included in the recipient’s income. Income attribution rules do not apply to income arising from child tax benefits transferred or loaned to the child. Income attribution applies only to the transfer of property that results in income or loss from property rather than income or loss from business. This includes substituted property, but does not include income earned on attributed income, often referred to as “second- generation” income. Income from property resulting from a low or no interest loan to another non-arm’s length individual will be attributed back to the lender in situations. Applies only to loan, but not to sales or gifts. Loans that bear a commercial or arm’s length rate of interest are exempt from the attribution if the interest is paid within 30 days of the end of the year in which it was charged. Chart on Attribution of Income from Property page 310 Tax on split income – attribution rules do not apply to business income transferred to a minor, but a special income-splitting tax on certain income of minors has been introduced which applies to the following types of income earned by those under 18: taxable dividends from private corporation shares (not listed on a stock exchange) received through a trust; shareholder benefits included in minor’s income; partnership or trust income from a business carried on by a person related to a minor, a corporation with a shareholder related to the minor, professional corporation with a shareholder related to the minor. This income will be subject to tax at the top marginal rate, not eligible for any deductions or credits (except dividend tax credit and foreign tax credits), not eligible for an offsetting deduction equal to the specified income and not subject to the attribution rules. The income splitting tax does not apply to: dividends from shares listed on a stock exchange, minors who have no resident parent in Canada, income from inherited property, income from inherited property if the minor is in full-time attendance at a post-secondary institution or who is eligible for the disability tax credit DEDUCTIONS: carrying charges (interest and property taxes) which is vacant and not used to produce income is limited unless held primarily for the purpose of producing income. Interest and property taxes can be deducted only to the extent that gross revenues exceed all other expenses. If the land is regarded as a capital asset, the non-deductible part of the interest and property tax can be added to the cost base of the land for computation of capital gains. Corporations whose principal business is the leasing, rental or sale (or development for) are permitted to deduct carrying charges on vacant land in excess of net income. The limit of this deduction is the “base level deduction”, limited to an amount of interest computed at the 8% prescribed rate. Soft Costs – expenses attributable to the period of construction, renovation or alternation of a building must be capitalized to the building rather than deducted on a current basis (interest, legal and accounting fees, insurance and property tax). CCA and landscaping are exempted from this treatment. Also exempted are disability-related modifications to buildings. Soft costs can be deducted to the extent of the taxpayer’s rental income. Rental Properties – CCA are computed on the balance at the end of the year in a pool of similar assets. Dispositions throughout the year reduce the balance in the pool, which may end up negative. Such a negative balance, to the extent that it is offset by purchase of same- class assets, will not result in recapture. The exception is each rental building purchased after 1971 that costs $50,000 or more must be placed in a separate CCA class, which results in immediate recapture when the building is sold. CCA may be deducted to a maximum amount obtained by applying the prescribed rate for a class to the undepreciated capital cost in the class at the end of the year. If these amounts, when added to other business expenses exceed business revenues a loss is created which can be offset against other sources of income. CCA on rental property is not deductible on non- rental income, excluding furniture and fixtures. The taxpayer cannot shelter other sources of income by offsetting a loss created by CCA on a rental building against other sources of income unless the taxpayer is a corporation whose principal business is property rental or leasing. Rental income can be business income – therefor the business income rules apply. If deemed a property income, you cannot create a loss with CAA. Expenses can be deducted. Depreciated-based or similar tax shelters such as residential buildings, films, yachts, hotels, recreational vehicles and nursing homes have been available in the past, used as a tool of fiscal policy to encourage investment by providing a fast write-off. The ability to shelter other income with the losses created by CCA has been eliminated or reduced. Assets sold as tax shelters are high-risk investments with a small chance of profit. The main advantage of a sheltered asset has been a tax deferral (valuable to those in higher tax brackets). All investments shelter the cost of the investment from taxation. The advantage of the faster write-off cannot provide a profit for an investment that does not return both its cost and its after-tax carrying charges. Interest – Reasonable interest paid or payable is deductive if the borrowings were used to produce income or to acquire property to produce income. The first level of compound interest is allowed if the original amount borrowed meets the test for deductibility. Where a benefit is included in the income of a taxpayer, the amount of the benefit will be regarded as an interest expense. Section 18 (3.1) capitalizes interest as part of “soft costs” pertaining to real property ownership. 18(4) limits deductible interest paid to certain non- resident shareholders. 18(9) prohibits the deduction of prepaid interest. 18(11) prohibits the deduction of interest on funds borrowed to make a contribution to sheltered or tax-assisted RRPs. Borrowed money must be used for the purpose of earning income. Where a loss of the source of income occurs, borrowed money ceases to be used for an income-producing purpose but the interest on such borrowed money continues to be deductible. Employer loans – if the employer borrows funds to make a low- or no-interest loan to an employee, the interest is deductible. If borrowed for a shareholder, the interest is deductible only to the extent of the amount included in the borrower’s income. Taxpayers may borrow money to acquire shares bearing a fixed dividend that is lower than the rate of interest on borrowings – no net income will be generated from the shares. The interest deduction would be limited to the amount of the grossed-up dividends included in the shareholder’s income. Interest not deductible in a particular year may be added to interest on borrowings for the next year to be deducted subject to the same limit of taxable dividend income. Shareholders may be required to borrow income and incur interest expense to make low- or no-interest loans to his business or to acquire shares with little or dividend entitlement in his corporation. Since there is no reasonable expectation of profit, interest deduction is denied. For the interest to be deductible, two conditions must be met: the corporation receiving them must use the funds for the purpose of earning Canadian-source non-exempt income. Second, the corporation cannot be in a financial position to borrow the funds on its own terms. Interest deductible under these rules is limited to interest on the amount borrowed up to the equity. Section 21 permits certain borrowing costs and interest to be treated as non-deductible expenses and added to the cost of depreciable property in respect of which the expenses were incurred. Personal loan planning and interest deductibility – reasonable expenditures incurred for the purpose of producing income from property are deductible from that income. No income need actually be earned in order to deduct interest paid. In the case of preferred shares held by an individual, interest is deductible to the extent of the grossed-up dividend income. If the preferred shares can be freely converted into common shares, interest expense on borrowed funds for the preferred shares will be fully deductible regardless of the dividend rate. Interest on funds borrowed to purchase personal property is not deductible because it is not used to produce income, as well as interest on funds borrowed to invest in commodities. Loan planning suggests the taxpayer borrow funds to produce income to make the interest tax deductible. Care must be taken in maintaining the connection between the interest paid and the use of the funds – must be traced to an income producing purpose. Differences between business and property income: BUSINESS INCOME INCLUSIONS: write-off of eligible capital property, reserves, specific expenses of representation, site investigation and utilities connection, convention expenses, short-year proration for CCA. PROPERTY INCOME INCLUSIONS: restriction of CCA for rental properties, attribution rules, foreign taxes on property income in excess of 15% deductible GST and property income – interest and dividends are exempt from GST, financial services rendered to Canadian Residents are exempt from GST (e.g. the receipt of interest, dividends or other financial instrument (i.e. debt security, equity security (share of capital stock in a corporation), insurance policy, etc.) GST and Shareholder benefits – certain benefits may be subject to GST (same rules apply as employee benefits). Where a shareholder receives a benefit from a corporation that is required to be included in income, the corporation is deemed to have made a taxable supply to the shareholder and to have collected GST – the shareholder is required to include the corporation-paid GST in income as a taxable benefit. No income inclusion of GST is required on exempt or zero-rated benefits or if the benefit is monetary in nature, such as an allowance. GST and soft costs – applies to sales and rentals of real property unless exempt (i.e. used residential housing and long-term residential rents). GST applies to real estate developers and builders in producing a taxable supply. Input tax credits may be claimed on the purchases for use in that commercial activity. Soft costs such as interest, insurance and property taxes are exempt to GST. Substantial renovations of homes for resale are treated in the same manner as the builder of new homes. GST is charged on the sale and the builder is able to claim input tax credits on purchases of property and services. Not included in the GST are the costs of acquiring the property, interest and other financial services and costs of other purchases where GST has been previously paid. CHAPTER 7 - CAPITAL GAINS prior to 1972, capital gains were not taxed under the Act – out of concern for equity among taxpayers, a complete set of rules for taxing capital gains was introduced. The Act does not define a capital gain – the provisions merely set up technical computations to be made once it has been determined whether a transaction is an income receipt or a capital receipt. The result is the confusing and each situation must be judged in relation to facts surrounding the particular transaction. The indicator is the taxpayer’s primary intention – did the taxpayer intend to make a business or trading profit on the transaction. Secondary intention is also considered in respect of, but not limited to, real estate transactions. The factors, often referred to badges of trade, used to establish intention include: the relationship of the transaction of the taxpayer’s regular business, the nature of the activity or organization associated with trade, the nature of the assets involved, the number and frequencies of transactions, the length of ownership, any supplemental work in connection with the property, if the transaction was completed as the stated objectives of an incorporation or partnership. Capital gains treatment requires a disposition – any transaction entitling a taxpayer to proceeds of disposition. “Proceeds” is a broader term that “selling price” because it includes deemed proceeds. Section 54 defines the “adjusted base cost” which encompasses more that the traditional accounting “laid-down cost”. There are over 40 specific adjustments to establish a notional cost based on fair market value. Selling costs are not included in the adjusted cost base, and hence, may in themselves give rise to a capital loss. There are 2 major exemptions to capital gains: principle residence (permanently exempted from tax) and reserves for amounts not due in the year (tax deferral). A taxable capital gain (allowable capital loss) is the portion of the capital gain (loss) taken into income – inclusion rate is 1/2 after October 17, 2000. Business investment losses (BILs) are capital losses which occur on the disposition of either shares or debt of a small business corporation, defined as a Canadian controlled private corporation where all or substantially all of its FMV assets are used to carry on an active business in Canada or shares or debt of connected small business corporations. While BILs are still capital losses, only fractionally deductible, they are given special treatment as an incentive for investment – uses the same inclusion rate as capital losses (i.e. 1/2 after October 17, 2000). Until February 22, 1994, there was a general lifetime deduction for taxable capital gains of $75,000 for individuals, other than trusts. This was eliminated, but taxpayers could elect to realize taxable capital gains accrued to that date. There continues to be a capital gains deduction for up for $250,000 (after October 17, 2000) of taxable capital gains on qualifying shares of a small business corporation and certain farming property. A taxpayer can elect that the disposition of “Canadian Securities” only will always be a capital receipt, which will remain forever in force, excluding “dealers in securities.” The treatment of commodity transactions, including futures, is similar to securities. A general anti-avoidance rule in respect of capital gains was designed to prevent a corporation from converting a capital gain into a dividend which would normally avoid income tax when the parties involved are corporations. A gain on the disposition of property is determined as: the proceeds of disposition minus the adjusted cost base and expenses of disposition. A negative amount does not result in a loss for depreciable capital property since the total decline in value should have been accounted for through the CCA system. Proceeds of disposition will be the value of the consideration received or receivable. Where a deemed disposition occurs, it will be the FMV of the property at the time of disposition. The adjusted cost base is usually defined as its cost plus or minus the adjustments found in Section 53 including the invoice cost, relevant provincial taxes, excise and custom taxes, insurance, freight and perhaps some start-up costs. Where the person is a GST registrant and eligible for an input tax credit, the GST should be excluded from the adjusted cost base. Cost for accounting purposes is modified by Section 52 – e.g. the cost of property received as a dividend in kind is the FMV of the property received. A stock option benefit is excluded from the application of the general rule. The second exception is in respect of depreciable property. In order to preserve the integrity of the CCA system, the adjusted cost base of depreciable property cannot be allowed to fluctuate. Certain exemptions, such as the exempt portion relating to a principal residence and amounts not yet due could be deducted in order to arrive at the capital gain. A capital gain reserve for dispositions, where all or part of the proceeds are payable after the end of the year, is the lesser of a reasonable amount and an amount that brings 20% of the gain into income in the year of disposition and each of the immediately following four years. FORMULA for the reserve – page 348 Certain farm property, shares in a family farm corporation or partnership have a 10 year reserve period. Adjustments to the Cost Base – the laid-down cost of capital assets may be subjected to certain adjustments which are not recognized for accounting purposes. These adjustments reflect amounts that would otherwise be treated as capital gains or losses or amounts of ordinary income, but instead have been deferred. The result is for the purpose of measuring a future capital gain or loss. Non-deductible interest and prohibited property taxes on unproductive land can be added to the adjusted cost base of the land. A stock option benefit included in income can be added to the cost based of the shares acquired on the basis that the amount of the benefit represents a tax-paid cost of the shares. Grants subsidies and other government assistance may be deducted from the cost base of non-depreciable capital property. A negative adjusted cost base could result at any time if the sum of the amounts deducted is greater than the cost of the property plus the sum of amounts added to it. Such a negative amount is deemed to be an immediate capital gain at the time that an adjustment causes the adjusted cost base to become negative. The adjusted cost base is brought to 0 and future adjustments are made from that 0 base. Principal Residence Exemption – Generally there are no capital gains subject to tax on principal residences, but there may be a gain if it can be exempted by designating the home as the taxpayer’s residence only for certain specific years. A principal residence is virtually any housing unit or right to such unit owned by the taxpayer himself or jointly and ordinarily inhabited by the taxpayer, his spouse or his child at any time in the year. It must be designated as such upon disposal. Only one residence can be designated for a given year. The taxpayer must be resident in Canada for tax purposes. FORMULA page 350. Personal use property – Where a property is used primarily for personal use, subject to tax, losses on such property may not be deducted – they are considered to be a personal or living expense. For the purpose of calculating the capital gain, the taxpayer’s cost is deemed to be the greater of the adjusted cost base of the property and $1000. Similarly, the taxpayer’s proceeds of disposition are deemed to be the great of actual proceeds and $1000. Losses arising from debts, which are PUP and are uncollectible will be recognized to the extent the gain was previously recognized on the disposition of the PUP in return for the debt. Listed personal property is a special sub-set – art, jewelry, rare books, stamps or coins. All the same rules for PUP apply to listed PUP, except that capital losses arising on the disposition of LPP can be utilized, but only to the extent of LPP capital gains. Losses can be carried back 3 years and forward 7 years, but once again to be applied only against LPP gains. Net gain is defined as LPP capital gains minus LPP capital losses in the year and LPP capital losses arising from the 7 preceding years or the 3 years immediately following. Does not include antiques. Pooling of Identical Assets purchased after 1971 – there are many methods for arriving at a cost base for identical assets for accounting purposes, but for tax purposes there is only one method – “floating weighted-average method”. For stock transactions, the FWAC is calculated by dividing the aggregate costs of the identical properties by the number of such identical properties. For bonds, debentures, etc. the FWAC is calculated by dividing the aggregate of the cost of the identical properties by the quotient obtained when the principal amounts of the identical properties are divided by the principal amount of the property disposed of. Mutual funds allocate their income to their investors, such that the income is taxable to the investor. As a result, investors must include in their income for tax purposes the amount of net investment income such as interest and dividends and net taxable capital gains paid or payable to them in the year. Reinvested income amounts, whether actually distributed, can be added to the adjusted cost base of the investor’s units in the fund. The adjusted amount for capital gains would be the full capital gain rather than the taxable capital gain. For dividends, the adjusted amount would be the actual dividend, not the grossed-up dividend. When an investor redeems or disposes of units in a mutual fund, a capital gain or loss is realized. The calculation of the capital gain or loss follows the normal formula of proceeds of disposition minus the sum of the investor’s ACB and selling costs. This capital gain or loss is separate from the taxable capital gains allocated from the income of the fund which are made annually and taxed as paid or declared payable. Disposition of shares acquired under a stock option - there is a special provision which applies when a taxpayer disposes of a security that is identical to other securities owned by the taxpayer. Certain conditions must be met: the stock must have been acquired under an employee stock option agreement, the disposition must occur no later than 30 days after the taxpayer acquires the particular security, there must be no other acquisitions or dispositions of identical securities in the intervening period (but this does not preclude the taxpayer from acquiring other identical securities at the same time as the disposition in respect of which the designation is being made), the taxpayer must make the designation in the return of income that is filed for the year in which the disposition occurs, the taxpayer must not have designated the particular security in connection with the disposition of any other security. The stock option employment benefit is exempt if the employee disposes of the security to a qualifying charity within 30 days after its acquisition. The ABD of each such security and thus the capital gain or loss on the disposition of the security is determined without regard to the ACB of any other securities owned by the taxpayer. ACB of Shares – March 16, 2001 Notice of Ways and Means provides for an addition to the ACB of a security acquired by a taxpayer under an employee option agreement. The amount added is the amount of the employment benefit received in connection with the acquisition of the security, generally equal to the excess of the FMV at the time. An option by a Canadian- controlled private corporation to an arm’s length person (non-employee) applies to defer recognition of the benefit to the year in which the taxpayer disposes of the security. For employee option securities acquired after February 27, 2000, the employment benefit is included in the ACB of the security from the time of acquisition, even if the recognition of the employment benefit is deferred for tax purposes until the taxpayer disposes of the security. Identical properties – the cost of identical properties acquired by a taxpayer must be averaged over all such properties, which results in each of the properties have the same ACB and ensures that the capital gain or loss on the disposition of any one of the properties can be determined without having to identify a particular property as the one disposed of. Some securities are exempt after February 27, 2000 as follows: securities under an employee option agreement for which a deferral is provided and securities acquired in exchange for such securities, securities acquired under an option agreement where designated by the taxpayer as identical properties and subject of a disposition of identical properties within 30 days and employer shares received as part of a lump sum payment on withdrawing from a deferred profit sharing plan. Each security that applies (subject to section 47(3)) has its own unique ACB. Cost of Certain Properties – cost of property is usually incurred with after-tax funds therefor cost is recovered tax free on a disposition because it represents an amount that was already paid. Normally the cost of capital or the capital cost of depreciable property is the laid down cost for accounting purposes. For taxation purposes, where a taxpayer has acquired a property and an amount in respect of its value (a benefit) is included in income, that amount is added to the cost of the property (except for a stock option benefit already included in employment income). The cost of property in respect of (non-cash) dividends in kind and lottery prizes is the FMV. Note that the prize itself is not subject to an income inclusion. Prior to 1977, a stock dividend was treated in the same manner as any other dividend. For 1977 to 1985, stock dividends for public companies were not deemed to be dividends and there was no income inclusion and the cost base of the stock received was deemed to be nil. This treatment resulted in a larger eventual capital gain. Therefor public companies could offer shareholders different classes of shares paying either ordinary dividends subject to the gross up and tax credits OR dividends which results in future capital gains treatment. Adjustments to the Cost Base – the ACB of depreciable property is its capital cost and for all other capital property the cost is adjusted in accordance with Section 53. A number of adjustments already examined include: employment income through a stock option, addition for land interest and property taxes previously denied, reduction for reasonable costs of surveying or valuing property for acquisition or disposition, reduction for government assistance for capital or depreciable capital property, reduction for the amount of accrued interest paid for the purchase of a bond and deducted from interest earned during the holding period of the bond. Other adjustments include: dividends where the paid-up capital of a corporation is increased by more than the increase in the FMV of the net assets of the corporation and an addition for the “superficial loss” associated with the trading of securities (e.g. securities with an accrued capital loss at the end of the year which are sold to trigger the loss to offset a capital gain previously realized in the year AND then re-purchased – if the taxpayer is denied the superficial loss at the time of disposition, he is permitted to add the superficial loss to the ACB of the substituted property). Three conditions exist to establish a superficial loss: the taxpayer or an “affiliated person” (spouse or corporation controlled by the taxpayer or spouse) must dispose of the property, identical property must be acquired 30 days before and after the disposition AND the taxpayer or affiliate must still own some of the property (after the point of time in condition B). Computational Rules – Section 3(a) includes the aggregate of all income from each non- capital source: property, business, office and employment and the amount from each source must be a positive amount. 3(b) deals with taxable capital gains and allowable capital losses and is composed of the excess of: all taxable capital gains (excluding LPPs) PLUS LPP taxable net gains MINUS allowable capital losses EXCEPT FOR LPP losses and allowable business investment losses (ABILs). 3(c) adds together 3 (A) and (B), while (E) subtracts such deductions as moving expenses, alimony, RRSP. (D) also subtracts losses deducted from office, employment, business and property (non-capital sources). Normally allowable capital losses can only be claimed against taxable capital gains. ABILs have no such restriction and can be deducted along with other losses from non-capital sources – results in a more rapid deduction as an investment incentive. As a capital loss, ABILs are still only 1/2 deductible. Allowable Business Investment Losses – includes capital losses arising from the disposition of shares and debts of a small business corporation (Canadian-controlled private corporation where all or substantially all of the FMV assets were used principally in an active business carried on primarily in Canada. ABILs are really a sub-set of capital losses and determined by the same inclusion rate as allowable capital losses – prior to 1988 - 1/2, 1988 & 1989 – 2/3, 1990 to Feb. 27, 2000 – 3/4, Feb 28 to Oct 17, 200 – 2/3, after Oct 17, 2000 – 1/2. An individual cannot obtain a benefit of the capital gains deduction on capital gains that are not offset by capital losses in the form of ABILs at the same time he received a benefit from ABILs which offset non-capital sources of income. 1/2 (after Oct 17, 2000) of the disallowed BIL reverts to an allowable capital loss for the year realized, which offsets taxable capital gains which may not be available for the capital gains deduction. Any portion the of the ABIL added to the non-capital losses for th year are subject to the non-capital loss carryover rules – if not used by the end of the 7 carryforward year, it becomes a net capital loss, restricted by the net capital loss carryover rules. CHART FOR TREATMENT OF A BIL PAGE 367. CHAPTER 8 – CAPITAL GAINS, FINER POINTS Foreign Exchange Gains and Losses – taxpayers must determine whether the foreign exchange gain or loss arose from income or a capital receipt, using common law rules discussed in Chapters 4 and 7. For income, the full gain or loss will be included in business or property income. For capital receipts, the net capital gain or loss is determined in the normal manner. For individuals, exemption of $200 is permitted. A currency gain or loss must be distinct and separate from another transaction that may have given rise to the currency transaction. Sale of an article must be computed in Canadian dollars to arrive at the gain or loss. Subsequent conversion of foreign funds would give rise to the currency gain or loss. Part Disposition – Section 43 requires that a reasonable portion of the total ACB of the property be allocated to the partial disposition to determine the capital gain or loss – cost allocated to the part sold should be in the ratio of the total value of the property. Exchanges of Property – permits the deferral of some or all of the capital gain on property which is disposed of and subsequently replaced. 2 types of disposition which qualify for this deferral: involuntary (lost, stolen, destroyed or taken by expropriation or bankruptcy) and voluntary (former business property (defined as land and buildings) that usually occurs on relocation of a business). In the year of disposition, a taxpayer may choose to recognize the usual capital gain (proceeds minus ACB and selling costs) OR elect to report the capital gain as the lessor of the actual gain and the excess of proceeds for the old property over the cost of replacement. This must occur in the following taxation year for voluntary disposition and within 2 taxation years for involuntary disposition. Voluntary disposition of old property occurs only when the proceeds are receivable. With involuntary disposition, the proceeds are receivable as the earliest of: date agreed to the full amount of compensation OR date compensation is determined by a court or tribunal OR two years from the date or loss, destruction or taking where a claim or suit has not been taken to court. The election does not apply immediately where the taxpayer does not purchase the replacement property in the same year the proceeds become receivable. In the year when the proceeds become receivable, the disposition is handled normally by reporting the gain. ACB for the replacement property under the above election will be reduced by the deferred capital gain – the essence of a rollover. Hence the tax on that gain will be deferred since conceptually there would be no funds from the old property to pay the taxes. A future capital gain will arise on the ultimate disposal of the new property. Section 44(6) permits the proceeds on the dispositions of former business property to be reallocated between 2 components so less capital gain would be triggered. This recognizes that FMV of the total property, where land and building and not priced separately. Summary of Replacement property page 404. Proceeds on Disposition of Building – If land is sold clear of buildings which are demolished, none of the disposition proceeds are allocated to the building and the taxpayer could deduct a terminal loss on the business. Where the land is sold in the same taxation year as the building, the building proceeds may be great that the FMV which will reduce or eliminate the potential terminal loss. Where the land is not sold in the same taxation year, 3/4 of the apparent terminal loss on the building will be deductible allowing a capital loss on the sale of the building instead of an ordinary loss. The deductible amount is considered a business loss. Property with more that One Use – when a taxpayer changes the use of property, it is deemed to have been sold at FMV and to have reacquired the same property immediately thereafter which becomes the new ACB. Where a property has a dual use, its cost must be apportioned between the uses on a percentage basis, which is used on the disposition of the property. Change in use does not include a transfer of property from one income-producing use to another. For personal-use property only, the capital gain may be deferred until the taxpayer decides to dispose of the asset, is deemed to dispose of the asset or decides to rescind the election (applies where the property was originally personal use). The election will remain in force even when he changes back to personal use unless rescinded. Election is not available where the property was first used to produce income. In theory, there should be no difference in the total taxable capital gain, only a timing difference in the payment of the tax. Factors to be considered: does taxpayer have any capital losses which he wishes to trigger, will the taxpayer move into a higher or lower tax bracket? Principal Residence – 45(2) where principal residence is changed from personal use to income-producing use. Taxpayer can designate this home as principal residence for up to 4 years. CCA cannot be claimed against any income from that property. 54 provides for a similar 4-year maximum designation where property is converted from income-producing to personal. Exemption formula page 409. Where the change in use is secondary, CCRA deems that no change has taken place – the residence can still be principal, but not CCA can be claimed. 54(1) aids taxpayers and spouses who are transferred by employment – no 4 year limitation. Single ownership situations – enables transfer of wholly-owned principal resident from one spouse to another, with complete or partial relief on the capital gain taxation. Does not apply to an inter-spousal transfer that was previously jointly owned. Transferee spouse is deemed to have owned the property since the transferor spouse originally acquired it. Where 2 residences are owned by one spouse, transfer only provides partial relief since only one residence can be principal. Joint ownership situations – each spouse has unrestricted right to designate either residence as his principal residence, but legislation permits only one residence exemption per family, Leaving and Entering Canada – where a taxpayer ceases to be a resident of Canada, it is deemed that all of that person’s capital property is disposed of at FMV. Exemptions include: Canadian property that is not very movable used in a business carried on permanently in Canada AND Canadian property that is not very liquid (i.e. employment-related stock options). The taxpayer will continue to be liable on the tax on the disposition of such properties, but as a non-resident. Taxpayer can elect not to have this exemption so that capital gains (losses) are triggered to offset other capital losses (gains). Also exempted in the property of a business carried on in Canada (i.e. capital property, eligible property, eligible capital property and inventory which will be taxable as business income) AND the right to receive certain payments such as pension, retirement benefits, RRSPs, RRPs, DPSPs and RESPs where the taxpayer will be liable for withholding tax. Capital losses, except LPP, are restricted to the taxable capital gains actually triggered. Tax on departure does not apply if he resided in Canada for 60 months or less during the preceding 10 years before departure. Also exempt is an inheritance or bequest after residence in Canada is over. To set the cost of property for a person entering Canada, the taxpayer is taxed only on gains subsequent to his entry. When the taxpayer becomes a Canadian resident, he is deemed to have acquired all his property at FMV (other than taxable Canadian property and inventory/capital property of a business carried on in Canada). Options – Two basic types of options: to buy a property (call option) OR to sell a property (put) option. When an option (to buy) is granted, there is a disposition with an ACB of nil by the issuer. The result is a capital gain to the issuer in the amount of the proceeds of the option. The grantee (holder) has acquired a capital property with an ACB equal to the amount paid for the option. There are two exceptions: when an option in respect of a principal residence is granted, there is no disposition. There is no inclusion for the issuer, no tax effect and the grantee is denied a loss on expiration since it is personal use property. The other exception is for an option granted by a corporation to another person to buy its securities. The corporation has no disposition at the time the option is granted. If the option expires, the corporation is deemed to have disposed of a capital property with an ACB of nil. Proceeds are deemed equal to the amount received for granting the option. As a result, when this type of option expires, a capital gain is realized. When an option to buy is exercised, the granting and exercise is deemed not to be a disposition. On the exercise, the vendor must include the consideration received for the option in the disposition proceeds in the year it is sold. The purchaser must add the cost of the option held to the cost of the property. If an option to sell property is exercised, the grantor is the purchaser of the property on exercise and will have been paid an amount by the vendor of the underlying property. The granting and exercise is deemed not to be a disposition. The vendor who paid for the right to sell must deduct the amount paid for the option from the disposition proceeds. The purchaser must deduct the amount received for the put option from the cost of the property acquired. Basic rules for Taxation of Options as Capital Property page 419. Debts Established to be Bad Debts – where a debt taken back from a purchase of capital property is established to have become bad debt ca elect to have disposed of the debt and reacquired it immediately at a cost equal to nil. This results in a capital loss to offset any part of the gain on disposition of the property represented in the debt. Deemed disposition of shares of an insolvent corporation occurs to realize the capital gain if the corporation doesn’t carry on business in the year, the FMV of the shares in nil and it is reasonable to expect that the corporation will be dissolved. There is no provision for an “allowance for doubtful debts” in computing capital gains. 40(1)A provides a reserve for the uncollected gain portion of the proceeds, payable after the end of the year. Bad debt resulting from disposition of personal use property is different. Convertible Properties – where a taxpayer acquires shares from a corporation on the conversion of a convertible security, the exchange is deemed not to have been a disposition of property. The cost to the taxpayer of the shares received is deemed to be the ACB to him of the convertible property immediately before the exchange. Capital Gains Deferral – permits an individual to defer capital gains in respect of small business investments. To obtain the deferral, the proceeds from the sale of one small business investment must be used to acquire another. Considerations include: a deferral less than the maximum amount available by designating a lesser amount of replacement shares AND the permitted deferral is the amount of a capital gain from the disposition that can be deferred, which reduces the gain of the individual. Part of the capital gain that can be attributed to the ACB of disposed shares cannot exceed the $2 million investment limit. To qualify: disposition of common shares of capital stock of a corporation where each such share was: an eligible small business corporation share of the individual, was a common share of capital stock of an active business corporation throughout the time owned AND was owned by the individual throughout the 185 day period that ended immediately before the disposition. The active business has to be carried on primarily in Canada for at least 730 days during the ownership period; must be a Canadian-controlled private corporation with substantially all the FMV assets used principally in the active business; shares or debt issued by other eligible related small business corporations OR a combination of those 2 assets. Shares Deemed to be Capital Property – where a person substantially disposes of assets used in an active business to a corporation, the shares received in consideration are capital property of that person, which permits the transfer of business assets to a corporation in exchange for shares which are sold and treated as a capital gain or loss. Must be an on-going business that is transferred, not just a trading asset. Arm’s Length Transfers and the Attribution Rules – rules are designed to prevent tax avoidance in transactions between persons not dealing at arm’s length. A taxpayer and an intervivos or testamentary trust cannot deal at arm’s length if the taxpayer is an income or capital beneficiary of the trust. All unrelated persons do not deal with each other at arm’s length unless otherwise demonstrated – burden is placed on the taxpayer to prove the facts. Who does not deal at arm’s length: related persons, a beneficiary and the intervivos or testamentary trust, a question of fact. Related persons in terms of individuals and corporations are defined as those connected by blood, marriage or adoption. Non arm’s length relationships require control of more than 50% of the voting shares. A person is deemed related to himself in cases where he owns shares in two or more corporations. With a non-arm’s length transfer of anything tangible or intangible, the transferor is deemed to receive proceeds equal to the FMV at time of transfer. This rule includes gifts for no proceeds. On the other hand, the transferee is deemed to have acquired property at FMV even if he paid more than FMV or if received as a gift, bequest or inheritance. Therefor a gift would be the best transfer since the FMV applies to both parties. Exhibit 8.2 page 425. Attribution Rules – Capital gains and losses are similarly attributed back (as with transfers and loans), but only to the transferor spouse or common-law partner. Minors do not result in attribution to the transferor. A series of anti-avoidance provisions apply attribution to transactions such as: back-to-back loans and transfers to third parties, repayment of loan through additional loans and transfers, loan guarantees for all or part of the principal and/or interest, artificial transactions which use the attribution rules to the taxpayer’s advantage. Definition of common-law partner is two persons, regardless of sex, who co-habit in a conjugal relationship continuously for at least 12 months. Attribution of capital gains has the effect of deferring any accrued gains on transfers between spouses or CL partners. The deferral occurs because the property is deemed transferred at proceeds exactly equal to the ACB immediately prior. When the transferee spouse disposes of the property, the gain or loss will be attributed back to the transferor spouse as long as the relationship exists. Taxpayers can elect not to have 73(1) apply and the normal non-arm’s length rules apply – property is disposed of at FMV and there would be no capital gains attribution on subsequent dispositions. Recapture – two rules apply to prevent the avoidance of recapture: the capital cost is the same for both the transferee and transferor AND the difference between the capital cost and deemed capital cost is treated as a CCA taken by the transferee. Summary Avoiding Income Attribution on Transferred Property – page 427 Death of a Taxpayer – capital gains may be triggered upon death depending on the status of the beneficiaries and the type of assets transferred. Death is the final chance to tax unrealized gains. Assets are deemed to have been disposed at FMV at the time of death at the taxpayer’s ACB and the surviving spouse assumes that cost base. Hence, no capital gain or recapture will be triggered unless the estate elects to do so. Depreciable property received by a beneficiary is also deemed to be disposed of at FMV – any resulting capital gain or recapture is included in the deceased final return. If FMV is less than original cost, the UCC is the FMV. CHAPTER 9 – OTHER SOURCES OF INCOME AND DEDUCTIONS: Sources: pensions (government or private), retiring allowance, death benefits, alimony/support payments, employment insurance, scholarships, research grants. Pension Benefits – includes income superannuation, CPP, retiring allowances, death benefits (with an exemption of a maximum of $10,000 for death benefits). Spouses or CL partners can split equally their CPP by 50%, prorated by the length of time living together in relation to the contributory period. Non-contributor must be at least 60 years old at time of election. Death benefits are for recognition of long service. Taxable under 56(1)A, but the first $10,000 is non-taxable. If paid out to both spouse and children, the spouse will receive the exemption and taxes on the remainder are paid equally between the children. Retiring Allowances – all payments on termination of employment are taxable except an employee benefit plan, a retirement compensation or salary deferral arrangement. Excludes pension and death benefits, but specifically includes payments for retirement from office or employment in recognition of long service OR loss of office including court-awarded damages. Best to roll into an RRSP to avoid taxation – eligible to include $2000 per year in the RRSP before 1996, $1500 prior to 1999 and 0 after 1999. This is on top of the regular allowable RRSP contribution of 18% of gross income. Support Payments – support income inclusions and deductions are mirror images of each other – the amount is not deductible if not included as income to the recipient. Custodial parent is required to include child support payments in income. Child support is not deductible. Any amount not identified in the agreement as solely for the support of the recipient will be considered an amount payable for child support. Spousal support – deductible if: payments are made as allowances on a periodic basis, made for the maintenance of the recipient, recipient has discretionary use of the funds, payments are made to spouse of CL partner due to breakdown of relationship or paid by a natural parent of a child the recipient and payments are made pursuant to a written agreement. Amount is limited to that which the recipient has discretionary use, even if paid directly but earmarked for mortgage payments, property taxes, utilities, medical expenses, etc. Three conditions must be met for an amount to be regarded as an allowance: amount must be limited and predetermined, must be paid to discharge a certain type of expense, receipt must be able to dispose of the amount completely. Payments include the acquisition of tangible property (unless medical or education expenses), as well as acquisition , improvement or maintenance of a self-contained domestic establishment. Legal fees incurred to enforce pre-existing rights to support payments are deductible, but establishing rights is considered a non-deductible capital outlay or personal living expenses. Support payments are mirror images - $6000/year is taxable income to the recipient and $6000/year is deductible. After 1997, support does not have to be reported (revenue neutral) and therefor there is no inclusion or deduction. Annuity Payments – full amount is included in income Deferred Income Plans – included in income: RRSP, Home Buyer’s Plan, Lifelong Learning Plan, Deferred Profit Sharing Plan, Registered Education Savings Plan, Registered Retirement Income Fund Education Assistance Payments – included in income: scholarships ($500 exemption), fellowships, bursaries, prizes, ($3000 exemption for all 3) project grants, research grants. Excluded are: amounts from RESP, in the course of business and in respect of employment and prescribed prizes for public recognition. If scholarship is received by virtue of employment, it is considered employment income and 100% taxable. If received for business research, it is considered business income and is 100% taxable. For other sources (e.g. an arts grant), anything in excess of $3000 is taxable OR claim 100% of income and reasonable expenses. Also included: amounts received as legal costs from a tax assessment, amounts received as a result of decisions under the Employment Insurance Act or CPP. These receipts are included if the expenses are deductible. Social assistance payments are included and Workers’ Compensation is included. Excluded are legal expenses relating to a property settlement arising from a marriage or CL relationship. Indirect payments: anti-avoidance provisions invoke the principal of constructive receipt by including to the taxpayer: income diverted at his discretion for the benefit of the taxpayer, any rights to income transferred to someone with whom he was not dealing at arm’s length and income earned on non-arm length loans which do not yield a commercial rate of interest Amount not included in computing income: amounts exempted by federal statues or foreign tax agreements, payments related to war services, war pensions of a country which has a reciprocal agreement, compensation by Germany for war victims, income and capital gains from personal injury for individuals under 21, social assistance payments based on a needs test, payments out of a profit sharing plan, expense allowance of elected municipal officers and members of provincial legislature and allowances of part-time employment travel expenses. DEDUCTIONS: permitted are amounts not attributed to a particular source of income (e.g. tuition fees, alimony), capital portions of annuity payments (Formula page 459) RRSPs are not covered in this course (page 460 to 478) Overpayments – amounts which have already been included in income, but which the taxpayer was not entitled (pension, unemployment and education assistance. Also deductible are legal and accounting expenses incurred in an objection or appeal. Legal expenses paid to collect or establish a right to a retiring allowance or pension benefits are deductible – limited to the amount of the benefits at issue, where the excess can be carried forward 7 years. Moving expenses – For an eligible relocation, deductible expenses include: reasonable travelling costs in moving family members to a new residence, transporting or storing household effects, cost of meals not exceeding 15 days ($11 per meal), lease cancellation costs, selling costs of old residence, cost of legal services, transfer or registration taxes of new residence where old residence is being sold, costs associated with a vacant old residence to a maximum of $5000, cost of revising legal documents and drivers licenses to reflect the new address and utility connections. Vehicle expenses for ownership and operation are a flat rate per km based on the province (Ontario is 40.5 cents). Selling costs of old residence may be deducted for capital gains purposes. Eligible relocation includes taxpayers that move to a new business or employment location in Canada (employment instigated) and students who move to attend a post-secondary institution full time inside or outside of Canada. Must move 40 km. Maximum moving expenses which can be claimed is the income earned at new location – the rest is carried forward to the following year. Expenses can only be claimed on the old residence – not the new residence. Child Care Expenses – deduction permitted in the same year the taxpayer incurs these expenses in the process of earning income, restricted to the parent with the lower income except where that individual is a FT or PT student, infirm or incapable of caring for children for at least 2 weeks, confined to a prison for a prison for at least 2 weeks, living apart from the higher-income taxpayer for at least 90 days due to marital breakdown. Restrictions include: child must be under 16, child care expenses cannot be made to related individuals, maximum amount claimable for boarding school is $175 per week for each child under the age of 7 or $100 per week for a disabled child. Earned income is defined specifically as employees, carrying on a business, research grants or attending a educational institution to upgrade work skills and knowledge. Expenses must be substantiated by receipts bearing the SIN of the person performing the service. Lower income spouse is restricted to a deduction of the least of: the amount paid by the taxpayer or supporting person, $4000 for each eligible child age 7 or older, $7000 for each under age 7 and $10,000 for disabled children OR 2/3 the earned income of the taxpayer minus the amount deducted by the higher-income spouse. Higher-income spouse is restricted to a deduction the lesser of: the lesser amount of the lower-income earning parent AND the sum of $250 for each disabled child, $175 for each child under age 7 and $100 for other eligible children. Parent as a full time student is defined as program not less than 3 consecutive weeks that requires not less than 10 hours per week on courses or work. Deduction for FT student is $175 per week of attendance per child under age 7 or $100 per disabled child over age 6 and under 16. Child must reside with the taxpayer to be claimed. Where there are two supporting persons, the lower-income person uses the deduction UNLESS in a designated educational institute (of at least 3 weeks in duration, requiring 10 credit hours/week) or carrying on research from a grant. Attendant Care Expenses – individual with severe and prolonged mental or physical impairment made deduct expenses paid to an unrelated attendant, who is at least 18, to enable the taxpayer to work as an employee, carry on a business, carry on research or attend a designated educational institution. Deduction is limited to the lessor of: the amount paid to the attendant AND 2/3 the sum of the total of employment income inclusions or taxable portion of scholarships or research grants AND income from business where the taxpayer is a student for the lessor of $15,000, $375 x no. of weeks in school and the amount by which the individual’s total income exceeds the individual’s earned income.
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