Personal Financial Planning Business 4099 CHAPTER 7 INCOME TAX PLANNING
Key Concepts • Progressive nature of personal taxation in Canada • social, economic and political objectives of the Income Tax Act • deferring income tax is beneficial to the taxpayer because of the time value of money K. Hartviksen 2
Tax Minimization Strategies • Tax avoidance vs.tax evasion • Tax Minimization Strategies • Income deferral • income splitting • income spreading • tax shelters K. Hartviksen 3
Income Deferral • RPP - registered pension plan (employer) • DPSPs - deferred profit-sharing plans (employer) • RRSPs - registered retirement savings plans • capital gains
Income Taxation and Tax Planning RESPs Business 4099 1 K. Hartviksen
Registered Education Savings Plans (RESPs) • Contributions to RSEPs are NOT tax deductible for the contributor. • There is a tax-deferral opportunity because the contributions accumulate tax-free within the plan. • On withdrawal, the payments will be taxable in the hands of the beneficiary, provided that the beneficiary is enrolled full-time in a qualifying educational program at a designated educational institution. • Presumably, the beneficiary will be in a lower tax bracket than the contributor at the time of withdrawal….hence, withdrawals from the plan would be taxed at a lower rate. 2 K. Hartviksen
The Canada Education Savings Grant (CESG) • The federal government will make contributions to private RESPs to financially assist parents and guardians save for their child’s education. • CESG is equal to 20% of the first $2,000 in annual RESP contributions per child. • That amounts to a maximum federal contribution of $400 annually per child to a lifetime limit of $7,200. • You can receive CESG grants up to December 31 of the year the beneficiary turns 17. 2 K. Hartviksen
RESP - Contribution Limits • Contribution Limits: • Maximum annual contribution per beneficiary = $4,000 • Maximum lifetime RESP contribution per beneficiary = $42,000 • Unlike RRSPs, if you contribute less than $4,000 in a particular year, you cannot catch up by contributing more than $4,000 in a later year. • A penalty tax of 1% per month is imposed on excess contributions. • Maximum period over which income generated in an RESP may be sheltered from tax is 26 years. • RESPs set up after February 20, 1990 may make payments only to individuals who are full-time students. 3 K. Hartviksen
RESPs - Use • Usually established by parents or grandparents to assist in the financing of a child (or grandchild’s) post-secondary education. • If the beneficiary (child) does not continue education beyond high school, the accrued income in the RESP remains in the plan or is paid to a designated educational institution……the capital contributed to the RESP can be refunded to the parent (or grandparent) free of tax. 4 K. Hartviksen
Canada Education Savings Grant (CESG) • Federal government will provide a direct grant to the RESP of 20% of the first $2,000 of annual contributions made to the RESP in a year. • The grant will be worth up to $400 per year for each year the beneficiary is under 18, to a maximum of $7,200 per beneficiary. • The grant amount will not be included in the annual and lifetime contribution limits for the beneficiary. • If the $2,000 maximum contribution is not made in a year, entitlement to the grant can be carried forward to a later year (within restrictions).
RESPs • There are two ways to invest in an RESP: • enroll in an existing group plan (two or three major ones which advertise heavily in baby magazines and pediatrician’s offices) or, • set up an individual (self-directed) plan, in which case you have control over the investment of funds as well as choosing the beneficiaries of the plan
Where Can you Open an RESP • Almost any financial institution • As well as other specialized organizations such as: Canadian Scholarship Trust (CST) 200-240 Duncan Mill Road Don Mills, Ontario M3B 3P1 CANADA 1 - 800 - 387-4622
Income Taxation and Tax Planning RRSPs Business 4099 K. Hartviksen 1 1 K. Hartviksen
Registered Retirement Savings Plan (RRSPs) • Introduced by the Federal Government in 1957. • Specifically designed as an incentive for Canadians who have ‘earned income’ to save during their working years for retirement. • Is an individual retirement savings plan which has been registered with Revenue Canada • normally permits deductible contributions to the RRSP and income earned in the plan is exempt from tax until payments are received from the plan. K. Hartviksen 2
RRSP Contribution Limits • 18% of the previous year’s earned income Dollar limits: • $14,500 for 2003 • $15,500 for 2004 • $16,500 for 2005 and • $18,000 for 2006 and there after indexed to inflation, however in February 2005 Budget announcement • $22,000 limit proposed for 2005.
Earned Income • All income earned by an individual from Canadian sources except income from securities, investments, capital gains and income-averaging annuities. • Includes: • net Canadian salaries and wages (before deducting RPP and CPP contributions, but after deducting all other employment expenses) plus: • commissions, plus • net business and rental income from real property (including recaptured depreciation) plus • bonuses, plus • other sources of earned income: K. Hartviksen 3
“Other Sources” of earned income • “other sources” of earned income include: • alimony or separation allowance payments ordered by a court • royalties from a published work or an invention • supplemental unemployment benefits (but not EI benefits) • research grants (net of related expenses) • disability payments received under the CPP or QPP. K. Hartviksen 4
Special Trusteed Plans Eligible for RRSP Registration • The following are considered special trusteed plans and can be registered: • whole life insurance policies: • part of the premium paid for a whole life (permanent or non-term) insurance policy may be registered and eligible as a tax deduction. The portion of the premium eligible depends on the policy holder’s age when the policy is issued and the type of insurance plan purchased. On retirement the proceeds paid to the holder or beneficiary from the registered part of the policy are subject to income tax. • fixed-income funds and/or equity funds: • some fixed-income funds and/or equity funds available from investment dealers, trust companies, mutual funds and most banks can be registered. • self-directed RRSPs: • these plans can invest in most Canadian publically-traded securities including common stocks, preferred stocks, bonds, warrants, etc. K. Hartviksen 5
Checklist for RRSP Selection QUESTIONS FOR GUARANTEED PLANS: • What is the annual administration fee? This must be deducted when calculating a net yield. • What has been the pattern of such interest rates in recent years? • How often is interest calculated? • How often is interest credited? Semi-annually, quarterly, or monthly? • At what rate is interest reinvested - at the initial rate when the deposit was made, or , as is more frequently the case, at the current rate when the interest is credited. • How often is the interest rate adjusted and, in the case of a savings plan, is it related to some key interest rate such as the non-chequing savings rate, or say a term deposit rate? • Is there a registration or termination fee? What are the details? • Are there minimum initial and subsequent contribution limits? K. Hartviksen 6
Checklist for RRSP Selection QUESTIONS FOR INVESTMENT FUND PLANS: • What has been the performance record of the fund’s shares? • Is there an acquisition charge, or, as it is frequently called, a front-end or rear-end load? • Is there a termination fee? How much is it? • What are the investment management fees? Are there other charges? • How quickly is income reinvested? • What are the underlying investments? What risks are involved? • In the case of a mortgage fund, ask whether the fund consists of residential or commercial mortgages or both. Where are the properties located? What percentage of the fund is invested in mortgages versus short-term money? K. Hartviksen 7
Checklist for RRSP Selection QUESTIONS FOR SELF-DIRECTED PLANS: • What is the basic fee and will the size of your portfolio justify the minimum fee? • How many free transactions are allowed each year and what is the cost of each additional trade? (These charges are apart from brokerage commissions.) • Are annual fees based on the book value (cost to the plan) or market value of securities? Since the trust company has nothing to do with appreciation or depreciation of the portfolio, many advisers say fees should be based on book value. • Have you the time, knowledge of the tax rules and investment acumen to manage the portfolio better than managers of other types of plans? • What services or advice does the plan issuer provide? • Is there a charge for terminating a self-directed plan. If so, what is it? K. Hartviksen 8
Borrowing to Contribute to An RRSP • Interest is not tax deductible when you borrow for the purposes of making an RRSP contribution • However, your financial institution is usually willing to set the rate of interest at or close to the prime lending rate.
Income Splitting Strategies • Attributions rules • affects gift giving • income earned on the gift is attributed back to the original spouse…but income on the income is not • this can apply to grandparents gifts to grandchildren, parents gifts to children
Income Splitting Techniques • Spousal RRSPs • between other family members: • preferred shares in small business • higher income earner pay the family expenses • gifts to children • RESPs • estate freezes (realize capital gain, retain control, allow further growth to be taxed in the hands of offspring or others.)
Why Income Splitting? • The Canadian tax system uses progressive tax rates (the marginal tax increases as taxable income increases): • Tax payable on two $40,000 incomes will be significantly less than that on one $80,000 income
Income Tax Act • Contains a number of measures to prevent the most obvious kinds of income splitting strategies, however, some opportunities do exist. E.g.: • increase the lower-income spouse’s investment base • employ your spouse and children • transfer of business assets • spousal loans • reinvesting attributed income • transfers for fair market value • transferring capital property to children • spousal RRSP • your children’s employment income • assignment of CPP benefits
General Anti-Avoidance Rule • The Act provides a general anti-avoidance rule applicable to all transactions. • If you come up with a way of avoiding the attribution rules that is not caught by existing rules, but is a misuse or abuse of the Income Tax Act, it may be caught by GAAR.
Rules that prevent Income Splitting • Indirect payments: • a payment or transfer made “pursuant to the direction of, or with the concurrence of” a taxpayer to some other person is to be included in the taxpayer’s income to the extent it would have been if paid to the taxpayer… for example, if you direct your employer to pay some part of your salary to your child’s account, that income will still be taxed in your hands.
Rules that prevent Income Splitting • Attribution Rules: • these rules attribute income from property back to the person who transferred or loaned the property. • Example: let’s say you transfer or loan a bond portfolio to your spouse…the income from that portfolio will taxed in your hands • exception: if you transfer for fair market value consideration and report the resulting gain, the rule will not apply.
Income Splitting Opportunities • Increasing the lower-income spouse’s investment base: • the higher-income spouse should pay household expenses…leaving the lower income spouse more disposable income for investing for future income. • Pay your spouse’s tax bills with your own funds • simply make sure that the cheque paying your spouses’ taxes is drawn on your own account. Since the amount you pay goes directly to the government and is not invested by your spouse, there is no property from which income can be attributed. The result is that any funds your spouse would otherwise use to pay income taxes can be invested with the income being attributed back to you.
Income Splitting Opportunities • Pay the interest on your spouse’s investment loans: • if your spouse has taken out an investment loan from a third party, consider paying the interest. • There will be no attributed provided you do not pay any principal on account of the spousal loan (Since the amount you pay is not actually invested by your spouse, there is no property from which income can be attributed.) • this technique will also preserve your spouse’s assets and thereby increase his or her investment income.
Income Spreading • Use RRSPs to smooth high to low income years (ie. Going back to school, taking a sabbatical, etc.) • small business owners - fiscal year end for incorporated business…discretion over dividend payouts...
Tax Shelters • Capital gains - don’t realize them • principle residence rules • farm property • choose investments that allow you to receive dividends or capital gains rather than interest
Specialized Tax Shelters • Limited partnerships • films and television productions: • ‘at risk’ rules of limited partnerships • tax benefits for pre-1996 film shelter investments depend on whether the particular production is certified or not (certification means that the production meets a number of Canadian content rules) • certified productions entitle you to a deduction for CCA of 30% on the balance sheet of your investment each year…that is on a $1,000 investment you can deduct $300 in the first year. • Flow-through shares
Other Tax Shelters • Real estate investments… • mortgage interest expense, property taxes and maintenance costs can all be written off • CCA for buildings is normally 4% per year, but cannot be used to create or increase a loss used against other income. (no CCA on land) • Labour-sponsored venture capital corporations • an investment in a LSVCC of up to $3,500 entitles you to a special federal tax credit of 15% of your investment. You may get a further 15% or 20% credit against your provincial tax depending on the province.
Tax Shelters K. Hartviksen 1 1
Tax Shelters • Have been curtailed in recent years by changes in tax law and administrative practice. • A taxpayer should be in a high tax bracket and have satisfied basic consumption needs before considering a tax shelter. The risks are high and proper accounting and legal advice is essential before a commitment is made. • INVESTORS SHOULD BE SATISFIED THAT TAX SHELTERS WILL YIELD RETURNS COMMENSURATE WITH THE ASSOCIATED RISKS. (Remember, tax relief is accorded to such investments to encourage investment which might not otherwise be forthcoming.) K. Hartviksen 2 2
Essential Features • With most tax shelters, the investor can claim capital cost allowance and/or other expenses on certain types of investments for the purpose of sheltering income and deferring income tax. 3
Decision Factors • The main factors to consider when making such investments are: • CCA rate for tax purposes • the amount of downpayment and subsequent payments • the individual’s tax bracket for the current year and future years • the probability of receiving sufficient income from the tax shelter investment to recover the original cost and provide a profit. 4
Current Tax Shelters • Oil and gas ventures • mining exploration investments • Canadian film and video productions • residential or commercial real estate • mutual fund fee partnerships • limited partnership constraints • whole and universal life insurance • farming • provincial venture capital programs 5
Oil and Gas Ventures • Oil and gas ventures through partnerships or “flow-through” shares have become less attractive as tax shelters due to several factors including the introduction of the Alternative Minimum Tax (AMT), the elimination of the capital gains exemption and the impact of “cumulative net investment losses.” • However, oil and gas investments continue to be offered to investors. 6
Oil and Gas Ventures ... • Some of the tax and financial incentives include: • Canadian exploration expenses (net of any assistance) are fully deductible in the year incurred. • Development expenses may be written off on a 30% declining-balance basis, with some development expenses fully deductible. New provisions that became law in May, 1994 allow a company to renounce up to $2 million of Canadian development expenses to individual flow-through shareholders as exploration expenses. This allows costs deductible at 30% to the company to be deducted at a 100% rate by the individual investor. • The purchase price of Canadian oil and gas properties may be amortized on a 10% declining-balance basis….. 7
Oil and Gas Ventures ... • Some of the tax and financial incentives include: • certain “grass roots” oil and gas exploration expenses incurred within 60 days of year-end may be treated as if incurred on the last day of the previous calendar year and the tax benefits claimed accordingly by flow-through shareholders. • One-half the write-offs claimed by individual investors enter into the calculation of “cumulative net investment losses” for purposes of the enhanced capital gains exemptions. • Investors in partnership or joint ventures that pay oil and gas crown royalties to Alberta are eligible to claim a refundable Alberta Royalty Tax Credit. British Columbia, Alberta and Saskatchewan also have crown royalty tax rebates which reduce tax otherwise payable to these provinces. 8
Mining Exploration Investments • Like oil and gas ventures, mining exploration and development expenses attributed to an investor are deductible against income from all sources at the prescribed 100% and 30% rates respectively. • Investors in mineral exploration activities may also benefit from provincial incentives such as the grants available under the Ontario Mineral Exploration Program. • Investors can no longer earn a depletion allowance, but any unclaimed depletion earned before 1990 should not be forgotten. It is still deductible to the extent of 25% of current resource profits. 9
Canadian Film and Video Productions • Changes in the 1995 Federal Budget replaced the existing incentive CCA system for tax shelters with a refundable tax credit system for eligible films acquired after 1995. • The credit, which is available in respect of films produced and owned by qualifying corporations, will be at a rate of 25% of eligible salaries and wages incurred in the production, not to exceed 12% of the cost of the production. The credit will reduce the capital cost of the related film. 10
Residential or Commercial Real Estate • Ca often prove a worthwhile choice, especially when capital appreciation and a rental income flow are combined with tax benefits. • CCA may be claimed on the cost of buildings, but cannot normally be used to create or increase a loss for application against other sources of income. • Mortgage interest, property taxes, and repair and maintenance costs can usually all be deducted. 11
Mutual Fund Fee Partnerships • These tax shelters involve the syndication of mutual fund fees using a limited partnership. • The taxpayer invests in a limit partnership that will earn income from future administration and redemption fees of a mutual fund. • The current sales commissions on the sale of fund units are paid by the partnership using the money invested by the taxpayer. • Revenue Canada allows these expenses to be deducted at the rate of 33.3% per year. • For the investor, these deductions claimed as partnership tax losses can shelter other sources of income. Thus a tax deferral is achieved, provided the future fee income at the least equals the previous losses. 12
Limited Partnership Contracts • For a number of years, a limited partner’s tax deductions and credits that can be claimed have generally been restricted to an amount actually invested and “at risk” in the partnership. • However, in some cases it would be possible for a limited partner to claim tax deductible losses and receive cash distributions that exceed the amount invested. Where such distributions result in a negative adjusted cost base of a partnership interest for a limited or “specified” passive partner, the amount will be taxed as a capital gain. The latter rules apply to partnership fiscal periods ending after February 22, 1994. 13
Whole & Universal Life Insurance • The acquisition of Whole or Universal life insurance policies will give rise to the accumulation of investment income earned by the insurer at a very low tax cost to the company. • Upon death, the entire proceeds from the policy are free of tax. • The returns from virtually tax-free accumulation after the deduction of insurance costs, compared to taxable accumulations, can, over a long period, be quite remarkable. • While professional advice may be required, those with capital to invest would be well advised not to overlook this investment vehicle (and eventual source of capital). 14
Farming • The urban farm investor must demonstrate to Revenue Canada that there is some prospect that the farm will earn a profit. • Farming losses are disallowed by Revenue Canada when there is no expectation of a farming profit and the farm is solely for personal use. • Gains on the disposition of “Qualified Farm Property” are eligible for a lifetime capital gains exemption of $500,000. • Qualified Farm Property includes real property used by the taxpayer or family members for farming in Canada/shares of a family farm corporation and an interest in family farm partnerships or trusts/eligible capital property such as farm quotas may also qualify. 15