Navigating the tax traps 1. Chapter 12 problems 2.

1

Navigating the tax traps

2

Chapter 12 problems

3

Typical client question

4

Approach

• Look at each scenario and calculate the tax flow under each, first as a receipt assuming an individual, then as a corporation

• You can then compare the two and make a recommendation to your client

5

Received as individual

Interest income (8% of $200,000)$16,000

Grossed-up dividend (5% of $550,000 5/4) 34,375Taxable capital gain (10.5% of $550,000 1/2 28,875Incremental income and taxable income

$79,250Federal tax on taxable income of $109,250 (i.e., $79,250 incremental income +

$30,000 other income); $15,372 on the first $83,088 + 26% on the next $26,162) $22,174

Less: dividend tax credit (131/3% of $34,375) $4,583

other personal tax credits 2,100(6,683)

Basic federal tax$15,491

Provincial tax

$9,139 on first $83,088 + 15% on next $26,16213,063

less: personal tax credits(1,400)

dividend tax credit (6⅔% of $34,375)(2,292)

Total tax payable$24,862

6

Received through a corporationInvestment income received through a corporation: Tax @ 41% Tax @ 40%

(i) CorporationInterest income $16,000 $16,000Dividend income (5% of $550,000) 27,500 27,500Taxable capital gain 28,875 28,875Corporation income

$72,375 $72,375 72,375 72,375Less: inter-corporate dividends [sec. 112]

27,500 27,500Taxable income $44,875 $44,875Corporation tax under Part I @ 41% / @ 40%

$18,399 $17,950Part IV tax @ 33⅓% of $27,500 9,167 9,167Additional refundable tax (6⅔% ($16,000 +

$28,875) 2,992 2,992Total tax (30,558) (30,109)Corporation retention* (excluding non-taxable portion of capital

gain which can be distributed tax-free) $41,817 $42,266Potentially refundable tax:

Part I tax (26⅔% of ($16,000 + $28,875))$11,967 $11,967

Part IV tax 9,167 $21,134 9,167 21,134Potentially available for taxable dividend

$62,951 $63,400

7

The dividend at 41%

• Note that a dividend of $62,951 will result in a dividend refund of only $20,984 (i.e., $62,951 1/3), not the $21,134 that was added to the RDTOH for the year. This deficiency results from imperfections in the tax rates. A larger dividend of $63,402 (i.e., 3 $21,134) would have to be paid, using other sources of funds, to clear the RDTOH. Alternatively, the maximum dividend that can be paid in this case is $62,726, determined algebraically, as follows:

R = 1/3DD = N – T + R where:

= N – T + 1/3D R = dividend refund= (N – T) 3/2 D = dividend= ($72,375 – $30,558) 3/2 N = Division B net income= $62,726 T = total tax

R = $20,909

8

To shareholder

Grossed-up dividend from corporation ($62,951 5/4) / ($63,400 5/4)

$78,689 $79,250Federal tax on income from grossed-up dividend + $30,000; $15,372 on the first $83,088 + 26% on the remainder)

$22,028 $22,174Less: dividend tax credit (13⅓% of $78,689) /

(13⅓% of $79,250)

$10,492 $10,567other personal tax credits

2,100 (12,592) 2,100 (12,667)Basic federal tax

$9,436 $9,507Provincial tax

$9,139 on first $83,088 + 15% on remainder$12,979 13,063

less: personal tax credits(1,400) (1,400)

dividend tax credit (6⅔% of grossed-up dividend)(5,246) (5,283)

Total tax payable$15,769 $15,887

9

Tax comparison

Note how integration is perfect when the combined net corporate rate of tax is 20% (i.e., 40% + 62/3 – 262/3%).

Investment income received directly $24,862 $24,862

Investment income received through corporation:

Corporate tax $30,558 $30,109

Less: refund to corporation 21,134 $9,424 21,134 $8,975

Individual tax 15,769 15,887

Total tax $25,193 $24,862

Tax cost of using corporation $ 331 Nil(2)

10

Other points to look at:Other considerations:

Advantages of incorporating —

Estate planning considerations:

Possible income splitting by having his wife and children subscribe for the shares of the investment company if they have their own source of capital to buy the shares.

Disadvantages of incorporating —

Initial prepayment of tax:

Tax on corporate income

$30,558

$

30,109Tax on individual’s $30,000 of existing income [$7,500 – ($2,100 + $1,400)]

4,000 4,000

$34,558

$

34,109Less: tax on total income received directly

24,862 24,994Prepayment through corporation

$9,696

$

9,115 Administrative costs of a corporation;

Corporate losses not available to shareholder to offset personal income.

7,500 on $30,000 @ 25% (combined federal and provincial).

11

Problem 15 – what are the issues?

• High Income Limited• Investment income• Scarf retail business• Should she incorporate?

– Show numbers

12

High Income Limited

• The ultimate effect of incorporating the investment portfolio is a small tax cost (relative to earning the income directly) on both the interest income and the capital gain, and no cost or benefit relating to either receipt of dividends.

• (Calculations follow)

13

High Income Limited

• Additionally, income earned by High Income Limited from GIC interest, portfolio dividends, and capital gains would need to be paid out to the shareholder in the year to avoid a prepayment on taxes on this income. The tax liability on the dividends received from the connected corporation Stage can be deferred by leaving the dividends in High Income Limited. This indicates that if they intend to keep the money for reinvestment in the company, there is a prepayment of taxes on all of the sources of income excepting the Stage dividends. Further, from a tax perspective, there is no benefit to earn income from those sources

14

High Income Limited

• If incorporated, High Income Limited (HIL) would be considered to be carrying on a “specified investment business” (SIB) under the definition of that term in subsection 125(7) of the Act. This means that the investment income earned by the company would not be considered active business income (ABI) and would, therefore, be ineligible for the small business deduction normally allowed to Canadian-controlled private corporations (CCPC) on their first $500,000 of ABI

15

Incorporation issues

• GIC Interest & Capital Gains• When received by a corporation, ½ of the capital gain would be put

into a capital dividend account and would not be subject to tax. Capital dividends could then be issued tax-free after filing the proper election.

• The taxable portion of the capital gain and the GIC interest would then be pooled together as “aggregate investment income” (AII). They would both be initially taxed at 48⅔% (38% basic federal rate less the 10% federal abatement plus the 6⅔ additional refundable tax plus the assumed 14% provincial rate). Of this, 26⅔% is a refundable portion that goes into the Refundable Dividend Tax on Hand account to be refunded when dividends are paid out.

• Upon paying this income in the form of dividends, the corporation is refunded a portion of the taxes at a rate of 26⅔% of the income, resulting in an ultimate corporate tax rate of 22% (48⅔% - 26⅔%) on this income.

16


• There is a small tax prepayment (no deferral benefit) because earning this type of income directly is taxed at 46%, while it would be taxed at 48⅔% if earned by a corporation.

• The refundable tax mechanism ensures that the total tax paid by the corporation on the income and shareholder on the dividends will be similar in amount as the tax that they would pay earning the investment income personally.

• Since the investment income is ultimately taxed at 22% (higher than 20% needed for perfect integration), there will be a small tax cost in using the corporation to earn investment income.

• Dividends paid out of the investment income of CCPCs are not considered “eligible dividends” and are subject to the 25% gross up to arrive at the total amount taxable at the marginal tax rate. A federal and provincial dividend tax credit (approximately the amount of tax paid at the corporate level) will apply to reduce the personal taxes payable.

17


• Portfolio investment in public corporation shares• The $10,000 dividend received from the publicly traded company is

subject to Part IV tax at 33⅓%. This tax takes away the advantage of tax deferral. Earning this income through the holding company results in a tax prepayment of $1,109.33.

• The Part IV will be added to the Refundable Dividend Tax on Hand (RDTOH) and refunded at $1 for each $3 of taxable dividends paid to Susan.

• This dividend received from the publicly traded company is considered to be an “eligible dividend” for tax purposes and will be added to the General Rate Income Pool (GRIP) of the corporation. When they receive dividends from this account, they must include in your income a 44% gross up to arrive at the taxable amount and you are eligible to deduct a dividend tax credit. The effective tax rate on dividends from GRIP is about 22.24% in the top combined federal and provincial personal tax bracket.

18


• Investment in 40% common shares of Stage• The holding company does not pay tax on the dividends received from Stage

because dividends are exempt from Part I tax and there is no Part IV tax since the two corporations are connected.

• Since this dividend comes out of the after-tax earnings of Stage, which has been taxed at 16% (all income earned by Stage is subject to the small business deduction), this dividend will come out of the Low Rate Income Pool (LRIP). It is not an “eligible dividend” and is therefore subject to the 25% gross-up when received personally and a dividend tax credit can be claimed. 32.5% effective tax rate on dividends from LRIP.

• Since the holding company does not pay tax on dividends received from a connected corporation for which the connected corporation did not receive a dividend refund, the tax liability can be deferred indefinitely while the dividends are left in the holding company. For this reason, it is advisable to receive this source of income through High Income Limited. High Income Limited will not be able to claim the capital gains deduction when it sells the Stage shares in the future. If Stage is expected to increase in value significantly then shares should not be held in High Income Limited.

19

The scarf business

• If the scarf business were to be incorporated, the corporation would be a Canadian-controlled private corporation earning active business income.

• The effective total federal and provincial tax rate after claiming the small business deduction would be 16%. Compared to the 46% total personal tax rate (your current personal tax rate), there is a tax saving of $5,400 as well as a deferral of $60,000 in tax payable.

• If incorporated, the scarf retail business would be considered to be a CCPC eligible for a small business rate of 16% on the first $500,000 of active business income (38% basic federal rate less the 10% federal abatement less the 17% federal small business deduction plus the assumed 5% net provincial rate after provincial small business deduction). Since the business would not meet the definition of a specified investment business or a personal services business [ssec. 125(7)] all $200,000 of taxable income would be considered to be from an “active business”.

• When paid out, the $168,000 in non-eligible dividends would be grossed up by 25% to arrive at the taxable amount. The federal and provincial dividend tax credits which combined are equal to the amount of the gross-up are then deducted to arrive at the taxes payable.

20

Tax to be paidGIC

Interest Dividends Capital GainsPublic

company Stage TaxableNon-

taxableHigh Income Limited Income 5,000 10,000 20,000 10,000 10,0001

Tax @ 48⅔% on investment income [Part I] (2,433) - - (4,866) Tax @ 33⅓% on portfolio dividends [Part IV] - (3,333) - -

2,567 6,667 20,000 5,134

Refund on payment of dividend: @ 26⅔% of investment income 1,333 - 2,666 @ 33⅓% of portfolio dividends - 3,333 - - Available for payment of dividend 3,900 10,000 20,000 7,800

Susan (assumes 46% combined rate) Dividend received 3,900 10,000 20,000 7,800 Gross-up (41% on eligible dividends 25% on other-than-eligible dividends) 975 4,100 5,000 1,950 Income for taxes 4,875 14,100 25,000 9,750

Tax @ 46% 2,243 6,486 11,500 4,485 Less: eligible dividend tax credit

(assume 13/23 Fed & 10/23 Prov) - (4,100) - - non-eligible dividend tax credit (⅔) (assume ⅔ Fed & ⅓ Prov) (975) - (5,000) (1,950) Net tax paid 1,268 2,386 6,500 2,535

21

Tax summary

High Income Limited (net after refund) 1,100 - - 2,200

Susan 1,268 2,386 6,500 2,535

Total 2,368 2,386 6,500 4,735

Tax paid on equivalent amount of income if received directly by Susan (a) 2,300 2,3862 6,500 4,600

Cost /(Benefit) of incorporation 68 - - 135

Tax paid by High Income Limited before paying dividend (b) 2,433 3,333 - 4,867

Deferral / (prepayment) of tax through High Income Limited (a)-(b) (133) (947) 6,500 (267)

22

Tax consequences of incorporating the scarf retail business

Corporation

Income from active business $200,000

Corporate tax (@ 16%) (32,000)

Available for dividend $168,000

Susan

Dividend $168,000

Add: gross up (25%) 42,000

Income subject to tax 210,000

Personal tax before credit (@ 46%) 96,600

Dividend tax credit (assume equal to gross up) (42,000)

Net tax 54,600

Add: tax paid by corporation 32,000 (A)

Total tax 86,600

Tax on income if unincorporated $ 92,000 (B)

Tax cost/(savings) of incorporation $(5,400)

Tax deferral/(prepayment) available through incorporation ((B) – (A)) $ 60,000

23

Chapter 13

Planning use of corporation and shareholder-manager remuneration

24

Dog vs cat

25

Objectives for today

• Understand the more common elements in the remuneration of a shareholder-manager and the considerations needed to make a choice

• Salary vs dividend tradeoff including taxfree amounts

• Reasons for a holding company• Why we have GAAR• How to maintain eligibility of shares for

capital gains exemption

26

Employment remuneration

• Consideration of cash needs– Immediate and future needs

• Need to optimize mix– What is optimum level in order to meet

various deductions available?

27

Comparison

Dividend later

Bonus Now A B

Corporate income

1,000 1,000 1,000

Bonus 1,000 0 0

Taxable income Nil 1,000 1,000

Tax @ 16/32.5% 0 -160 -325

Funds for dividend

Nil 840 675

Income 1,000 840 675

DGU 25%/45% 0 210 304

Taxable income 1,000 1,050 979

Combined tax 46%

460 483 450

DTC 25/45 0 -210 -304

Net tax 460 273 146

Cash available 540 567 529

Tax deferral 460-160 300 135 460-325

Tax cost 27 -11

28

Other considerations

• Individuals tax bracket• Deductions and CF available to

shareholder• Province of residence of corporation

29

Salaries and bonuses

• General guideline – should fully utilize deductions and credits

• Reduce ABI to SBD threshold• Salaries and bonuses need to be reasonable

– Reasonableness of bonus in relation to profit and services rendered

– Payment for real and identifiable service– Some justification for expecting a bonus over

regular salary– A legal obligation to pay the bonus

30

Shareholder benefits and loans

• Shareholder benefits– Home purchase loan– Vehicle purchase loan– Share purchase loan

31

Exceptions

• A loan made to a shareholder who is also an employee but not a specified employee

• A loan made to a shareholder who is also an employee to:– Buy a house– Buy shares– Buy a car to use in performance of duties

• A loan fully repaid within one year is excluded from income inclusion and/or interest benefit calculations

32

Example

• Smartmoney Mfg Ltd built a 21-room house for its principal shareholder-officer on a country property owned by him. The company expensed the costs as promotion expenses on the basis that he would use the property to entertain distributors of the company’s products to ensure continuing outlets for the company’s products.

• What are the tax consequences?

33

Considerations

• Is there a benefit to the shareholder?• What is the value?

34

Solution

• Value of house plus GST included in income of shareholder– Company does not own the property– Company expensed the cost on its books– Shareholder has received a benefit

• Normally deductible but company must own the property

35

Another problem

• Mr Edwards owns all of the outstanding shares of Edwards Inc which manages over 20 large apartment buildings.

• One spring the company paid for repairs to his cottage ($8,500 plus GST)

• Because of his busy schedule, he forgot to tell the controller to send him a bill

36

Considerations

• Is forgetfulness an excuse?• He owns the company – does this matter?• What would CRA do in this case?

37

Solution

• Shareholder benefit in the amount of $8,500 plus GST because the company paid for it.

• Company would probably be denied the deduction and be forced to pay tax on it – the expense was not incurred to earn income

• Double taxation issue – Mr Edwards pays tax on money he never received, and the company pays tax on money they spent

38

Shareholder loan flowchartIs the loan to a shareholder or

connected person?

No implications

Is the loan to a corporation resident

in Canada?

Loan principal not included in income

Does the loan meet one of the

exceptions?

Was the loan repaid within one year from the end of the fiscal

period

Loan principal taken into income in the year loan made

Income deduction in year of repayment

Deemed interest benefit

Employment or shareholding

39

example

• Mr I.M Portly owns all the O/S shares or Run for Your Life Limited and he is the president. On July 1, 2008 the company made a loan to him of $19,500 to buy a car at FMV. All other employees are eligible to receive this loan. Car is required for his duties. Loan is repayable in two equal instalments starting July 2009 with no interest.

• Is there a taxable benefit?• Can the company’s position be affected by this

loan?

40

considerations

• Just him or all employees?• Interest rate?• Set terms of repayment?• Why is it needed?

41

solution

• Normally yes, but there is an exception because:– For use in performance of duties– Loan was received because of employment not

because he was a shareholder– Repayment arrangements– Reasonable time to repay

• Interest benefit calculated at prescribed rate• Foregone interest is not a deduction for the

company• Interest deductible if company took loan out

42

Fringe benefits

• Private health insurance• Group accident insurance• Retirement benefits• Retiring allowance• Income splitting

43

Tax-free dividends for 2011

25% 41%

Taxable dividend 36,223 72,308

Gross-up (25/41) 9,056 29,646

Taxable income 45,279 101,954

Tax 11,656 32,246

Less deductions -2,600 -2,600

Less DTC -9,056 -29,646

Total tax 0 0

Net cash retained 36,223 72,308

44

Data

• Company earns $120,000 of ABI• Shareholder has no other income and has

federal personal tax credits of $2,000 and provincial personal tax credits of $1,290

45

Salary vs dividends

Salary Dividend

Pretax corp income 120,000 120,000

Salary -120,000 0

Taxable income 0 120,000

Corp tax @16% 0 -19,200

Available for dividend 0 100,800

Personal tax paid 36,145 13,405

Corporate tax 0 19,200

Total paid 36,145 32,605

Difference 3,540

Savings as % of salary 3.0%

Savings as % of tax on salary

9.8%

46

Salary vs dividend?

47

Approach

• Need to use excel to do some modelling using rates

48

How much to pay?

• If a salary of $47,200 is paid to maximize her CPP contribution then, based on the assumption given, her RRSP contribution will be $8,496. In order for her to retain $40,000 after tax she will need to pay a dividend of $10,778.

Tax on Income CashSalary $47,200 $47,200

RRSP contribution (8,496) (8,496)

Dividend 10,778 10,778

Gross-up 2,695$52,177

Federal tax $(8,612)DTC 1,797Credits 2,100CPP credit 324Provincial tax (5,442)DTC 898Credits 1,400CPP credit 216Total tax paid $(7,319) (7,319)

CPP paid (2,163)

$40,000

49

Holding companies

• Extension of integration• Compensation issues• Deferral of tax• Implementing an estate freeze

50

Small business corporation

• A Small Business Corporation is a corporation which was at any particular time:– A CCPC, and– All or substantially all (90%+) of FMV of assets

were• Used principally in an active business carried on by

– The particular corporation or– A related corporation

• Share or debt that was connected • A combination of the above

51

QSBC?

52

Purification needed?

53

Qualified small business share

• At any time:– A share that meets the following:

• SBC test– Owned by individual– Spouse– Partnership related to individual

• Holding period test– 24 month owned by individual or related person

• Basic asset test– 50% of assets used in active business operations

54

What is active?

FMV %

Active business assets Nil Nil

Shares of Cyber Corp $1,450,000 94.0 %

Term deposits 100,000 6.0 %

$1,550,000 100.0%

The FMV of the assets of K Ltd. is as follows:

Active business assets: FMV %Cash $ 4,500Accounts receivable 780,000Inventory 920,000Prepaid expenses 1,000Fixed assets 150,000Goodwill 200,000

$2,055,500 74.6 %Other: marketable securities 700,000 25.4 %Total $2,755,500 100.0 %

The FMV of the assets of Cyber Corp. is as follows:

55

Tests to be met for K

• (1) SBC Test• At the time of sale, K Ltd. must be a small business corporation (SBC). A SBC is defined as a CCPC having all

or substantially all (i.e., at least 90%) of the FMV of its assets either used principally in an active business carried on primarily in Canada, or shares or debt of a connected SBC, or a combination of the two [ssec. 248(1)].

• K Ltd. is a CCPC since all the shares are owned by Karen who is a resident of Canada.• Cyber Corp. is connected to K Ltd., because K Ltd. controls Cyber Corp. But Cyber Corp. is not a SBC as it

does not meet the 90% test, i.e., 74.6%.• Thus, K Ltd. does not meet the SBC test.• (2) Holding Period Test• Throughout the 24 months preceding the sale, the shares cannot be owned by anyone other than Karen or a

person related to Karen. Karen has owned the shares of K Ltd. since 1994. Thus, this test is met.• (3) Basic Asset Test• In order to meet this test, K Ltd. needs to have more than 50% of the FMV of its assets used in an active

business carried on primarily in Canada for the 24 months preceding the sale. K Ltd. does not have any of its assets used in an active business, but it does have shares of a connected corporation. Therefore, the modified asset test must be used.

• (4) Modified Asset Test• This test requires that K Ltd. and Cyber Corp. both meet the 50% test throughout the 24 months preceding the

sale and that either K Ltd. or Cyber Corp. meet the 90% test throughout the 24 months preceding the sale.• On reviewing Cyber Corp., it can be seen that more than 50% of its assets are used principally in an active

business carried on primarily in Canada, i.e., 74.6% of its assets are used in this way.• On reviewing K Ltd., it can be seen that at least 90% of the FMV of its assets are shares of a connected

corporation, Cyber Corp., meeting the 50% test, i.e., 94%.• Thus, this test is met.

56

Failed the test

• K Ltd. meets both the holding period test and the modified asset test, but fails the SBC test. Therefore, the shares of K Ltd. are not QSBC shares and thus Karen will not qualify for the capital gains deduction.

57

What could be done?

• In order for K Ltd. to become a SBC, Cyber Corp. must be a SBC. The following alternative could be considered as a way to have Cyber Corp. become a SBC immediately before the sale of the shares.

• Approximately $471,600* of the marketable securities could be sold on the open market and the cash used to reduce the liabilities. However, the sale of the marketable securities would result in a capital gain which would be subject to full corporate tax net of refundable tax if dividends are paid prior to the sale of shares.

• Be careful not to become too precise when doing this calculation. Remember, the fair market value of the assets, especially goodwill, is subject to challenge. If your fair market values are too high, then you will not have sold enough securities to meet the 90% test.

58

What to do…

* Total assets including $2,055,500 of active business assets ($2,055,500 ÷ .90)

$2,283,889

Less: active business assets 2,055,500

Maximum value of marketable securities $ 228,389

Current marketable securities $ 700,000

Maximum marketable securities (228,389)

Sell marketable securities $ 471,611

59

Kiddie tax

• A special income tax computed at the top rate is levied on specified income of a minor– Dividends derived from unlisted shares of any

corporation– Income from trust or partnership which

derives income from the business of providing property or services to a business carried on by a relative of the minor or a corporation in which the relative is a specified shareholder

60

Exceptions

• Minor has no parent resident in Canada• Inheritance from parent• Full time attendance at post-secondary

institution• Eligible for disability tax credit

61

GAAR

• New section 245 of the Act is a general anti-avoidance rule which is intended to prevent abusive tax avoidance transactions or arrangements but at the same time is not intended to interfere with legitimate commercial and family transactions.

62

GAAR framework

• (a) Does any other provision of the Act or other rule of law apply to stop the taxpayer from achieving the intended advantage?

• (b) Does the transaction result, directly or indirectly, in a tax benefit, as defined in ssec. 245(1), i.e., a reduction, avoidance or deferral of tax or an increase in a refund?

• (c) Is the transaction part of a series of transactions which would result, directly or indirectly, in a tax benefit?

• (d) Can the transaction reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the benefit?

• (e) Can it reasonably be considered that the transaction would result, directly or indirectly, in a misuse of the provisions of the Act or an abuse having regard to the provisions of the Act read as a whole?

63

GAAR

64

Using the framework

• (1) The contribution and the withdrawal are specifically permitted under the Act.

• (2) A deferral of tax will be achieved with the contribution and, depending upon the marginal tax rate in the year of withdrawal, there may be a tax saving.

• (3) Since each transaction hinges on the other, these transactions could be considered a series. However, since the answer to (b) was yes, then (d) can be addressed directly after (b).

• (4) It may be possible to argue that the contribution was made for bona fide reasons, but an unanticipated need for cash necessitated the withdrawal. This argument is not likely to be successful when the withdrawal follows the contribution within a short period of time or when the same transactions are repeated over a period of years.

• (5) Each transaction is specifically permitted under the Act.

(1)

(a)Does any other provision of the Act or other rule of law apply to stop the taxpayer from achieving the intended advantage?

No(1)

(b)Does the transaction result, directly or indirectly, in a tax benefit, as defined in ssec. 245(1), i.e., a reduction, avoidance or deferral of tax or an increase in a refund? Yes(2)

(c) Is the transaction part of a series of transactions which would result, directly or indirectly, in a tax benefit? Yes(3)

(d)Can the transaction reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the benefit? No(4)

(e)Can it reasonably be considered that the transaction would result, directly or indirectly, in a misuse of the provisions of the Act or an abuse having regard to the provisions of the Act read as a whole?

Yes(5)

65

Using the framework

• (6) A gift to a spouse that does not result in the funds producing income from property is not subject to the attribution rules

• (7) The fact that second generation income generated by the loan is not taxed to the husband reduces his tax.

• (8) The cash gift to pay the taxes resulted in the wife having more cash to reinvest which would create more second-generation income. However, since the answer to (b) was yes, then (d) can be addressed directly after (b).

• (9) It may be possible to argue that the loan was primarily for a bona fide business, investment or family purpose, as indicated in paragraph 4 of Information Circular 88-2.

•(10) IT-511R suggests, in paragraph 6, that compound interest, i.e., income on attributed income or “second-generation” income is not subject to income attribution. The CRA, thereby, suggests that this transaction is not a misuse or abuse of provisions of the Act. As a result, the GAAR should not apply.

(2)


No(6)





No(10)

66

Using the framework

• (11) Section 74.4 only applies to transfers to a corporation by an individual.

• (12) There may be no tax benefit from this transaction. The loan capital was paid from earnings of Wells Ltd. that had been taxed. That capital will earn income in Stieb Ltd. that will be taxed at the corporate rate applicable to the type of income generated. On the other hand, it might be possible to argue that the surplus in Wells Ltd. would otherwise have been distributed to Mrs. Hogart in the form of dividends which would have been taxed. Then, if she loaned the funds to Stieb Ltd., the corporate attribution rules would have applied.

(3)


No(11)

(b)Does the transaction result, directly or indirectly, in a tax benefit, as defined in ssec. 245(1), i.e., a reduction, avoidance or deferral of tax or an increase in a refund? Maybe(12)

(c) Is the transaction part of a series of transactions which would result, directly or indirectly, in a tax benefit? Maybe

(d)Can the transaction reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the benefit? Maybe


Maybe

67

Using the framework

• (13) As long as the sale of the investments was at fair market value, then the Act has no prohibition on this transaction. The borrowing to purchase investments is specifically contemplated in paragraph 20(1)(c).

• (14) What was non-deductible interest is now technically tax-deductible.

• (15) See (13), above.• (16) Having borrowed to

purchase the house rather than to finance the investments initially, the re-structuring of the debt could be regarded as a transaction to obtain the tax benefit of interest deductibility.

• (17) There may be a misuse of provisions or an abuse of the Act read as a whole.

(4)


No(13)





No(17)

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Using the framework

• (18) Subsection 56(4.1) only deals with individuals.

• (19) Case similar to situation (3). See Note (12). In this case, if the statement that the loan was made to avoid subsection 56(4.1) is taken literally, then there may be a misuse or an abuse in answer to (e).

(5)


No(18)

(b)Does the transaction result, directly or indirectly, in a tax benefit, as defined in ssec. 245(1), i.e., a reduction, avoidance or deferral of tax or an increase in a refund? Maybe(19)

(c) Is the transaction part of a series of transactions which would result, directly or indirectly, in a tax benefit? Maybe

(d)Can the transaction reasonably be considered to have been undertaken or arranged primarily for bona fide purposes other than to obtain the benefit? Maybe


Maybe

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Bonus vs dividends

• Reconsider use of bonus, EPSP• In Ontario, 46.4% on bonus or ESPS• Ontario corporate tax rate is 40.79% reducing to

33.67% in 2012 on nonM&P ABI over $400,000• Dividend after tax income of Opco to a holding

company and pay eligible dividends when Ontario eligible dividend rate is 22.38% (2010)

• Approximately 10.3% more funds to invest if retain nonM&P income in company and you avoid the employer health tax on the bonus

• Ensure sufficient salary for maximum RRSP

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Bonus vs dividends

• Consider impact on SRED – qualify for full refundable ITC if income of corp is less than $400,000

• ITC is reduced dollar for dollar over SB limit• AMT – alternative minimum tax – a minimum

tax if your expected tax is not paid• If owner/manager has AMT, pay salary or

bonus to use up credit• Impact on corporate instalments

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Bonus vs dividends

• No EI or CPP if pay a dividend• No EHT in Ontario if pay a dividend• Paying salary reduces retained earnings

and possibly capital taxes

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Advantages of holdco

• Assume CCPC• Pay dividends from opco to holdco will

move GRIP balance (this is the eligible dividends balance)

• Opco has losses in subsequent year – GRIP in holdco is not affected if transferred

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Disadvantage of holdco

• Assume CDN traded securities which pay taxable dividends

• If personal ownership, tax rate is 24.64% on dividends

• If in holdco, tax rate is 33 /3% (Part IV tax)

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EPSP

• Deferral of tax on bonus is 180 days• Deferral of tax on EPSP is up to 13

months• Can be for owner and manager only• No limit on contributions• No withholding other than EHT• Doesn’t reduce RRSP or RPP• No investment restrictions

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Example

• September 2008 year end• Pay $1 million bonus – tax is pad in March

2009• EPSP tax is paid in April 2010

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Should she incorporate?

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Proprietorship

(A) — Income earned directly

Personal tax

Business income $150,000

Tax 1st $127,021 $26,880

Balance 22,979 @ 29%

6,664 $33,544

Less: federal personal tax credits (2,100)

31,444

Provincial tax (17% of ($150,000 – 127,021) + $15,776) 19,682

Less: Provincial personal tax credits (1,400)

Total personal tax $49,726

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Through a corporation

Income earned through corporationCorporate tax

Business income before salary $150,000Salary (50,000)Taxable income 100,000Federal tax @ 11% (38% – 10% – 17%) $100,000 (11,000)Provincial tax (5% $100,000) (5,000)After-tax retained earnings $84,000

Personal tax

Salary received $50,000Tax 1st $40,970 $6,146Balance 9,030 @ 22% 1,987 $8,133Less: Federal personal tax credits (2,100)

6,033Provincial tax (12% of ($50,000 – $40,940) + $4,097) 5,181Less: Provincial personal tax credit (1,400)Total personal tax $9,814

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Deferral benefit

(B)Tax deferral on $84,000 in after-tax retained earnings

$50,000 salary + $84,000 dividend 1.25 $155,000

Tax 1st $127,021 $26,880

Balance 27,979 @ 29% 8,114 $34,994

Less: Personal tax credits (2,100)

DTC (131/3% of $84,000 1.25) (14,000)

18,894

Provincial tax (17% of ($155,000 – $127,021) + $15,776) 20,532

Less: Provincial personal credit (1,400)

Provincial dividend tax credit (6 2/3% of $84,000 1.25) (7,000)

Total tax 31,026

Less tax paid on $50,000 salary (above) (9,814)

Amount of personal tax deferred until payment of dividend $21,212

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Tax savings

Personal tax paid now on $150,000 $49,726

Tax paid now if incorporated

Corporate tax $16,000

Personal tax on $50,000 salary 9,814

25,814

Tax paid later on dividend 21,212

$47,026

Tax saving from incorporation ($49,726 – $47,026) $2,700

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Notes

• Note that if Nancy received the dividend today, she would pay $2,700 less than if she earned the income directly (or received a $150,000 salary from her company).

• This is because the combined federal and provincial corporate tax rate is 16%.

• There is perfect integration of personal and corporate taxes, i.e., no tax savings or cost, when the combined federal provincial corporate tax rate is 20%.

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Scholarship program

• Scholarship program for children of key employees– Cannot be related to shareholders

• No taxable benefit to employee• No tax to child (56(3))• Deductible by company

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Wrapup

• Lots of options available• Consider all factors before making

decision

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Next week

• Problem 9 for discussion• Read chapter 15• Assignment 1: problem 6 & problem 11

Navigating the tax traps 1. Chapter 12 problems 2.

Documents

Transcript of Navigating the tax traps 1. Chapter 12 problems 2.