Canadian Tax Primer 15: Capital Gains Exemption and Shares of Active Business Corporations

As indicated in Tax Primer 14 (click here to read it), each Canadian-resident individual can claim up to $813,600 in tax-free capital gains on a sale of shares of an active business corporation.

The technical rules in the Income Tax Act actually refer to the sale of shares of a “small business corporation”.  Like too many tax terms, however, this technical term is misleading.  A corporation’s shares can qualify for the capital gains exemption even if the shares are worth $10 million.  So this tax primer will use the term “active business corporation”.

To be an active business corporation, a corporation must meet the following requirements.

1. It must be a taxable Canadian corporation.
2. It must be a privately-held corporation (not listed on a stock exchange).
3. It must not be controlled by any combination of non-residents and corporations that are listed on a stock exchange.
4. At the time in question, it must use substantially all its assets in carrying on an active business primarily in Canada.
5. During the preceding 24 months, it must have used at least 50% of its assets in carrying on an active business primarily in Canada. 

For example, the capital gains exemption will often apply in respect of a sale of shares of a family-held corporation that carries on an active business – provided that the corporation has been structured properly.

While this may seem bizarre, access to the capital gains exemption can be lost if the corporation is too successful.  For example, assume that you have a very successful family business corporation and you decide to leave profit inside the corporation to bolster the retained earnings figure on the balance sheet.  The corporation does not need this surplus cash for its operations, so the corporation invests the surplus income in mutual funds and GIC’s.  If the value of the investments grows too large (for example, if the mutual funds do too well), the corporation will have too many investment assets and its shares will no longer qualify for the capital gains exemption.  Substantially all the corporation’s assets will no longer consist of assets used in the active business because the investments will make up too large a proportion of the corporate value.

The Canada Revenue Agency treats “substantially all” as meaning 90%.  While this is not necessarily the correct legal position, it is generally best to keep the value of non-business assets below 10% of the value of all corporate assets.  As one invests in the hope that investments will grow significantly in value, this means that it is best to hold investments outside the active business corporation.

Many successful entrepreneurs get tripped up on this aspect of the rule.  Fortunately, this problem can easily be avoided through the use of a holding corporation to receive surplus cash from the active business corporation through the payment of tax-free intercorporate dividends.  The holding corporation can then invest the surplus cash.  If the business corporation unexpectedly needs access to cash for a business use, the holding corporation can simply lend funds back to the business corporation and can even secure that loan (as if the holding corporation were a bank).

As noted above, each individual resident in Canada can claim the capital gains exemption.  If you have an incorporated family business and hope to sell the shares some day in the future, it is important to structure the share ownership so as to make maximum use of the exemption.  This is best done far in advance of any sale, as value has to accrue on shares held for the benefit of other family members.

For example, assume that you and your spouse have two children.  Using the 2015 exemption level, this gives rise to four potential exemption claims.  Four times $813,600 is equal to $3,254,400.  However, the other family members must have an ownership interest in the shares for this level of exemption to apply.

One option is to have the shares held by a family trust.  If each member of the family is a beneficiary of the trust, the trust can sell the shares and allocate the capital gain out to the beneficiaries so that the beneficiaries can claim the capital gains exemption on their respective shares of the capital gain.  However, the trustee (usually, the entrepreneur) manages the shares while they are held inside the trust and so can decide when to sell the shares and can have the final say on the negotiation of any share sale terms.  As well, the trust can protect the shares from matrimonial claims if a child’s marriage breaks up (or if a common-law relationship turns sour).

In order for the trust to be able to allocate the gain out to the beneficiaries, the capital gain must accrue while the shares are held inside the trust.  If you are the sole shareholder of the corporation, there is no point in transferring the shares to the trust just before a sale.  At that point, the value will be in the shares held by you.  Transfer of that value to a trust will give rise to a capital gain that will be solely your gain.  There will be no time for the shares to increase in value inside the trust if the sale is completed one month after the trust acquires the shares.

Only individuals can claim the capital gains exemption.  Accordingly, the corporate structure must ensure that growth can accrue to individuals but that surplus cash can be transferred on a tax-deferred basis to a holding corporation.  These may seem like conflicting objectives, but proper structuring can achieve both goals.  In order to maximize use of the exemption, it is important to put this structure into place as soon as possible and in any event well in advance of a sale.

Sometimes, a buyer will insist on buying assets rather than shares.  In this situation, it is possible to get the best of both worlds by engaging in a hybrid sale in which the seller sells shares for part of the value and the corporation sells assets for the rest of the value.  In this regard, see our blog post from May 11, 2015 “Purchase of Sale of a Business:  having your cake and eating it, too” (click here to read it).

Even if it is not possible to sell shares of the corporation or to use the hybrid transaction technique, the capital gains exemption can still be of use.  If the corporation sells its assets, it will replace its business by cash and become an investment corporation.  At that point, the corporation’s shares will cease to qualify for the capital gains exemption.  Prior to the sale, it might be wise to lock in the exemption by triggering a sale of the corporate shares so as to increase the tax cost of those shares.  This can reduce the capital gains tax that will be payable in future on the death of a shareholder (see Tax Primer 8 which discusses the subject of deemed dispositions on death by clicking here).  This can make it easier for heirs to manage the tax burden that is triggered by a death.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 14: General Rules for the Capital Gains Exemption

Each individual resident in Canada can claim a lifetime capital gains exemption.  This means tax-free capital gains on the sale of qualifying assets.

Two separate limits apply.  An individual can claim up to $813,600 (in 2015) in exempt capital gains on the sale of shares of an active business corporation.  If the sale involves specified types of farming or fishing property, the exemption limit is $1 million per Canadian-resident individual.

Even though there are two separate limits, the limits are cumulative over one’s lifetime.  If you claim the exemption on one type of asset, that claim reduces your exemption room on the other type of asset.  For example, assume that you have previously claimed $300,000 in exempt capital gains on the sale of shares of an active business corporation.  This means that you have $513,600 of remaining exemption room if you sell more active business corporation shares (the $813,600 cumulative limit less the $300,000 previously claimed) or $700,000 of remaining exemption room if you sell qualified farming or fishing assets (the $1 million cumulative limit less the $300,000 previously claimed).  You cannot claim both $536,000 on the sale of shares plus $700,000 on the sale of farming or fishing assets.

Just to be clear, these exemption limits refer to the whole capital gain (not the half of the capital gain that is included in income).  Tax Primer 5 explains that only half of a capital gain is subject to income tax, but ignore that rule for this discussion.

The exemption limit for active business corporation shares is linked to the inflation rate, so new exemption room is added each year.  The exemption limit for farming and fishing assets is fixed at $1 million until the limit for active business corporation shares also reaches $1 million (as a result of inflation).  Once that point is reached, both exemption limits will thenceforth march into the future arm-in-arm, both linked to inflation.

Various rules affect a person’s ability to claim the capital gains exemption.  For example, access to the exemption may be restricted if you have a positive balance in your CNIL account.  The tax acronym CNIL is pronounced “senile”; however, we are told that it has nothing to do with the government’s opinion of the average taxpayer.  Instead, it stands for “Cumulative Net Investment Loss”.  A “Cumulative Net Investment Loss” arises if certain investment expenses deducted after 1987 exceed certain types of investment income reported after 1987.  You might have a “CNIL” problem if you have invested in certain types of tax shelters.

If you have previously incurred allowable business investment losses (referred to as ABIL’s in tax shorthand), you will have to pay tax on capital gains until you have “paid back” the tax relief provided by those losses.  Once that is done, you can start to apply your capital gains exemption against any remaining capital gains.

A capital gains exemption claim can also trigger federal minimum tax.  This is a timing consideration.  The government wants you to be successful, but not too successful in any one year.  If the exemption claim saves too much tax, you may have to defer part of the tax savings to a future taxation year.  Usually, however, this amounts to no more than a mild irritation in the long run.

Only Canadian-resident individuals can claim the capital gains exemption.  This can cause confusion in connection with the sale of active business corporation shares.  An individual has to sell shares of an active business corporation in order for the exemption to be available.  If the individual sells assets of an unincorporated business, however, the individual cannot claim the exemption.  So it may be necessary to incorporate the business before selling the business.

While it may be necessary for the business to be incorporated before an individual can claim the exemption, a corporation itself cannot claim the exemption.  So it is important to ensure that the business is incorporated but that individuals own the shares of the corporation that carries on the business.

While only Canadian-resident individuals can claim the capital gains exemption, each Canadian-resident individual can claim an exemption.  If you have an incorporated family business, therefore, you might want ownership of that business to be structured so that each family member can claim a capital gains exemption on a future sale of the shares of that incorporated business.  I will discuss this in more detail in Tax Primer 15.  Stay tuned!

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 13: The Family Home

For many Canadians, the family home is a major asset.

In tax parlance, the family home is called the “principal residence”.  In general, any increase in value on a principal residence is not subject to capital gains tax.  This rule applies whether the capital gain arises as a result of an actual or a deemed disposition.

As with any tax exemption, some rules have to be kept in mind.  In general, a family unit can have only one principal residence at a time.  A family unit consists of a mother, a father and their unmarried children under the age of 18.

If you and your spouse have a house and a cottage, only one of the properties can qualify as a principal residence.  You can choose which of the properties to claim as your principal residence.  In most cases, you will want to select the property with the largest increase in value.  However, the capital gain on the property you do not select as your principal residence will be subject to tax. 

The one-principal-residence-per-family restriction creates a significant tax disadvantage if you place title to your home in the joint names of yourself and your adult child (assuming that the child also owns a home).  In that case, the child will have two residences:  an interest in the child’s own home and a 1/2 interest in your home.  Only one of those properties will qualify as the principal residence of the child.  The likely result is that 1/2 of any increase in value on your home will become subject to capital gains tax at some point down the road.  If you had retained sole ownership of your home, the entire capital gain would be immune from tax up to the date of your death.

The above discussion assumes that the principal residence has always been used as a personal home.  A part of the capital gain may be subject to tax if the house has been used for other purposes.  For example, you may have rented the house to tenants at some point in the past.  In this case, a pro-rata portion of the increase in value may be subject to tax.  However, the rules on this point are fairly complex.

The principal residence exemption applies only for income tax purposes.  The value of the house may still be subject to probate taxes on death.  As well, various provinces impose transfer taxes on the transfer of real estate.  Whether a transfer tax applies on the transfer of a principal residence to a related person depends on the province in question.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 12: KiddieTax

No, the government has not decided to impose a tax on the number of children that you have.  In tax jargon, “kiddie tax” refers to a special tax on certain types of income “earned” by a child under the age of 18.  In general, that income is income that has been generated through the efforts of the child’s parent.  For example, the parent might have an incorporated business.  If a family trust holds shares of that corporation and receives dividends that are flowed through to a child who is under the age of 18, the dividend will be taxed as if the child paid tax at the top marginal rate of tax.

The kiddie tax applies only in respect of specific types of income.  The types of income include dividend income from private (i.e. family) corporations as well as business income derived from a business of providing goods or services to a business carried on by a relative.  In contrast, no kiddie tax applies to a dividend paid by a corporation that is listed on a stock exchange. 

The kiddie tax ceases to apply in the year that the child is 17 years old at the start of the year (i.e. the year the child turns 18).  Unless the child is a prodigy and goes to university at a young age, therefore, the kiddie tax will not apply to university-age children.  Therefore, it still makes sense to establish a family trust for the purpose of splitting family corporation income with university-age children.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 11: Childhood Attributions

Tax Primer 10 (click here to read it) discussed the income tax attribution rules as they apply between spouses.

Separate attribution rules apply in respect of children (including grandchildren and great-grandchildren) as well as nieces and nephews, but only during the time that they are under 18 years of age.  These “under-18” attribution rules apply only in respect of investment income (such as interest and dividends).  The rules do not apply in respect of capital gains.  For example, a grandparent might gift money to a non-discretionary trust established for the benefit of a grandchild who is under 18 years of age.  Any interest or dividend income earned by the trust will be taxed as if it had been earned by the grandparent.  However, no attribution will apply in respect of capital gains.  If the trust invests in a growth mutual fund and realizes capital gains, the trust will pay the tax on the capital gain at the child’s low rate of tax and not the grandparent’s higher rate.

Attribution rules in respect of under-18 year olds generally cease in the year that the child, grandchild, great-grandchild, niece or nephew turns 18.  Attribution can continue to apply, however, in respect of certain loan arrangements.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canada Revenue Agency Phone Scams

Scam artists, posing over the phone as Canada Revenue Agency officials, have been very active recently.  They are very skilled at preying on fears and can appear very convincing.  They may even have your social insurance number.

Typically, the scam artist starts off by advising that the CRA is about to start legal action for unpaid tax – that your bank accounts are being frozen and that someone is on the way to your home to arrest you.  This is a sure sign of a scam.  Any actual legal action has to go through proper administrative and court procedures.  If the CRA was actually starting collection action against you, you would have already received notice of an amount owing.

In our system, you do not get arrested for owing back taxes.  The CRA issues a notice of assessment and you have at least 90 days to dispute the amount in question.  Nobody swoops down out of the blue to arrest you.  Debtor’s prison was abolished a long time ago.

The caller will usually supply a phony name and a made-up badge number.  If you ask to speak to a supervisor, the caller will have an accomplice to play that role.  As noted, the caller may also have your social insurance number.  Because many Canadians supply their social insurance numbers freely on numerous forms, it is relatively easy for a scammer to know your correct social insurance number.  

The scammer will provide very specific instructions for you to follow at your bank.  You will be told to drive to your bank – alone – and not to speak to anyone because time is of the essence, (remember, the arresting officer is on his way).  In Canada, however, you always have the right to speak to someone.  We do not live in a Franz Kafka novel.  Magna Carta has its 800^th anniversary this year.

The scam artists are very convincing if you allow fear and emotion to take over.  A scammer recently even caused doubts to arise in the mind of an individual who had recently retired from a senior position in a financial institution.  Fortunately, however, that retiree took the time to think about what was going on and hung up on the scammer.

Remember that you have the extreme good fortune to live in a free and democratic society – a society that is governed by the rule of law.  The Canada Revenue Agency – like any arm of the government – has to follow due process.  Anyone who threatens to swoop down on you out of the blue is a scam artist.  Simply hang up the phone.  If you have any concerns, look in the telephone directory and telephone someone at the real office of the Canada Revenue Agency to confirm that you have indeed paid your taxes.

For more information on these and other scams, visit the Canadian Anti-Fraud Centre at http://www.antifraudcentre-centreantifraude.ca/index-eng.htm (a legitimate website).

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 10: Making Attributions

As noted in Tax Primer 9 (click here if you haven’t read it yet), spouses can transfer assets to each other without triggering capital gains tax.  However, attribution rules can apply after the transfer.  The attribution rules tax future income and capital gains on the transferred asset as if no transfer had occurred.  If the attribution rules apply, income and capital gains realized by the recipient spouse after the date of the transfer are “attributed” back for income tax purposes to the transferring spouse.

For example, assume that you have very significant income and pay income tax at the top marginal rate.  In contrast, your spouse has very little or no income and either pays no income tax at all or pays income tax at a very low rate.  If you can decrease your income and increase your spouse’s income, you can have some of your high-rate income taxed at your spouse’s lower rate.  In order to accomplish this, you gift some mutual funds to your spouse (which you can do without triggering any capital gains tax).  However, the attribution rules will apply to those transferred mutual funds.

(a)        If the mutual fund distributes $100 in dividend income to your spouse, the dividend income will belong to your spouse.  However, you will have to pay the income tax on that dividend at your tax rate (as if you were still the owner of the mutual fund).

(b)        If your spouse sells the mutual fund and realizes a capital gain, the proceeds of sale will belong to your spouse.  However, you will have to pay the income tax on that capital gain at your tax rate (as if you were still the owner of the mutual fund).

In other words, income and capital gains realized after the date of transfer are all attributed back to you for income tax purposes – even though your spouse is the actual owner of the income and the capital gains.  The attribution rules override reality for income tax purposes.

These attribution provisions do not apply if the transferring spouse elects to transfer the asset at fair market value and pays tax on the capital gain that arises on the transfer to the low-income spouse.  In addition, the low-income spouse must actually pay fair market value for the asset.

Attribution rules apply in a similar fashion to loans made from a high-income spouse to a low-income spouse (unless a fair market value rate of interest is actually paid on the loan).  Assume that you lend $100 to your low-income spouse on an interest-free basis and your spouse invests the money.  You will have to pay income tax at your tax rate on any income or capital gain realized by your spouse in respect of that investment.

As suggested in Tax Primer 3 (click here if you haven’t read it yet), one can avoid these attribution rules by having the high-income spouse to lend funds to the low-income spouse at a fair market value interest rate.  The interest rate has to be at least equal to the Canada Revenue Agency prescribed rate of interest in effect at the time of the loan.  As of the June 15, 2015, this prescribed rate of interest is a mere 1%.  If the low-income spouse invests the loaned funds and earns a 4% return, the low-income spouse pays tax on a 3% return (after deducting the 1% interest paid to the high-income spouse).  While the high-income spouse pays tax on the 1% interest received, the high-income spouse avoids paying tax on the other 3%.

The loan has to be carefully documented and the low-income spouse has to actually pay the interest to the high-income spouse within 30 days of the end of each calendar year.  With proper structuring of the loan, the current 1% interest rate can be locked in for a considerable period of time (up to 20 or 25 years).  Over time, the low-income spouse can build up a significant investment portfolio.

Other ways around the attribution rules follow.  These are not as effective as the loan method but – for those who like technical details – illustrate how the attribution rules work.

The attribution rules do not apply on attributed income.  For example, assume that you gift units of a mutual fund to your low-income spouse.  After you make this gift, the mutual fund distributes a $100 dividend to your spouse.  As discussed above, you will have to pay income tax at your rate on that $100 dividend (as if you were still the owner of the mutual fund).  However, assume your spouse likes the investment game and re-invests that $100 dividend in shares of Bell Canada Enterprises.  If Bell Canada then pays a $5 dividend to your spouse, attribution will not apply to the $5 dividend.  Instead, your spouse will pay the income tax on the $5 dividend at your spouse’s tax rate.  Attribution does not apply to the $5 because your spouse bought the Bell Canada shares with “fresh” money rather than money that had been supplied by you. 

While the process is long and slow and requires some bookkeeping work, there is a long-term benefit to paying the tax on attributed income so that your spouse gets to invest the attributed income and build up an investment portfolio that will be taxed in your spouse’ hands.  The tortoise does sometimes win the race.  In order to benefit from income splitting, it is not necessary to make your spouse a millionaire.  It is sufficient to shift enough income so that your spouse uses up those lower tax brackets.  The benefits of income splitting disappear once your spouse’ income reaches the top marginal tax rate levels.

The exception for investments purchased with “fresh” income does not apply to investments purchased with substituted property.  For example, assume that you gifted an investment to your spouse and your spouse later sold the investment.  The proceeds of sale received by your spouse constitute “substituted property”.  In essence, the investment increased in value and was sold.  On the sale, the investment changed its form from an investment to cash.  That cash is not “fresh” money; it is just a different form of the property that you transferred to your spouse.  Even if your spouse re-invests the cash, income earned on the re-invested cash will still be subject to the attribution rules.

If you are the high-income earner and your spouse has some income, it is always possible to have your spouse build up an investment portfolio by having your spouse save all that income.  You would become the “spending spouse” and use your income to cover all the family expenses.  Meanwhile, your spouse would become the “saving spouse”, cover none of the family expenses and instead save and invest every cent of the spouse’ income.  The attribution rules would not apply because you would have made no transfer of any property to your spouse and you would have lent no money to your spouse.  Your spouse simply would have no obligation to cover any household or personal expenses, thereby keeping all his or her income and investing it.  Consequently, your spouse’s investment earnings would be taxed at your spouse’s tax rate.

If you are attempting to increase the investment assets of a low-income spouse, segregation of those assets in a separate account is critical.  You and your spouse need to be able to show that the attribution rules do not apply in respect of your spouse’ assets.  This could be difficult to prove if all your assets have been co-mingled in a single bank or investment account.  If everything is mixed together, it becomes virtually impossible to show that your spouse made investments with his or her own independent funds (rather than funds that are traceable to you).

Segregation of accounts merely means that the low-income spouse puts all his or her independently-earned income into a separate account.  This does not mean that the spouses cannot have joint accounts.  Joint accounts are often convenient, as they allow either spouse to access funds in the account.  For example, the high-income spouse could deposit his or her income into a joint bank account in respect of which each spouse was an authorized signatory for the purpose of withdrawing funds.  It does not matter which spouse can access the funds in the account, as long as it is possible to clearly identify the source of the funds that went into the account.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 9: Transfers Between Spouses

In general, the deemed disposition rules (click here to learn more about deemed dispositions) do not apply to transfers between spouses.

Assume that you bought shares of a major Canadian bank in 1972 for $100.  Since 1972, those shares have increased in value to $1,000.  You can transfer the shares to your spouse without triggering any capital gains tax.  In this case, your spouse would step into your shoes as far as ultimate tax liability is concerned.  The spouse would be considered to have paid $100 for the shares.  If the spouse later sells the shares for $1,500, the capital gain will be equal to $1,400 (a combination of the increase in value during the time that you owned the shares and the increase in value during the time that your spouse owned the shares).

The above rule is sometimes referred to as the “spousal rollover” rule because the transferred asset “rolls over” to the spouse without any immediate income tax consequences.  The term has nothing to do with other spousal activities and can be used in polite company.

An asset transfer between spouses can be effected on a tax-free basis in the sense that no income tax is payable at the time of the transfer.  However, it is important to remember that this is just a tax deferral.  No tax saving results – just a postponement of the tax liability to a point further down the road.

A similar “spousal rollover” rule applies on death.  If you die and your spouse survives you, you can leave all your property to your spouse without triggering a deemed disposition of that property.  Your spouse then steps into your shoes:  capital gains tax will apply when your spouse sells or gifts the property or on the death of your spouse (whichever occurs earliest).  That capital gains tax will include tax on any increase in value that occurred while you owned the property.  Again, this is merely a deferral of tax and not a saving of tax because the surviving spouse will eventually die.

Actually, it is possible to defer capital gains tax indefinitely if the surviving spouse always remarries a much younger individual and leaves property to that much younger spouse, who then remarries on the death of the older spouse and so on ad infinitum.  However, this strategy has never actually fit into anyone’s long-term estate plan.  The children might have objections.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 8: Deemed Dispositions

As noted in Tax Primer 7, Tax is triggered by specific events (such as the sale of an asset).  Some events, while seemingly innocuous in real life, can trigger a deemed disposition of an asset – a disposition that occurs without an actual sale of the asset.

A deemed disposition is a bit of income tax make-believe.  In certain circumstances, income tax legislation will deem you to have sold assets for fair market value proceeds (even though you did not in fact sell the asset and even though you have not actually received any money).

The most common deemed disposition events are gifts and death.  Giving up Canadian residence can also result in a deemed disposition of assets, but that will be discussed in a separate article.

Gifts

You may have heard that Canada does not have a gift tax.  Technically, that is a true statement.  What Canada has, however, is a deemed disposition of a gifted asset.  For example, assume that you own a painting by A.J. Casson, one of the Group of Seven painters.  Assume that you paid $10,000 for the painting and that it is now worth $100,000.  If you decide to give it to your son for his 40^th birthday, the Income Tax Act will deem you to have sold the painting for $100,000.  You will have a capital gain of $90,000 and will have to pay the government for the privilege of being generous to your son.  In other words, the gift to your son also results in a forced “gift” to the government.

This is technically not a gift tax because the tax applies only to the gain and not to the entire value of the gift.  In the case of an asset with a very low cost and a very significant gain, however, this distinction has no substantive difference.  A tax is a tax is a tax.

Of course, a gift of Canadian cash will not attract any tax.  If you have $100 in Canadian cash, you have already paid tax when you earned that cash.  Accordingly, you can gift the $100 in Canadian cash to your son without having to pay tax.  The deemed disposition rules trigger tax only in respect of assets that have increased in value.  The tax applies to the increase in value since the date on which the asset was acquired.  If the asset was acquired before 1972, the Income Tax Act taxes only the increase in value since 1972.

Death

Nothing is surer than death and taxes.  In Canada, death and taxes go together.

On death, the deceased is deemed to dispose of all assets for fair market value.  An exception applies in respect of assets transferred to a surviving spouse of the deceased, but this merely defers the deemed disposition to the death of the surviving spouse.

The deemed disposition on death may well produce very significant capital gains tax.  For example, assume that you decide that your 40-year-old son is too young to have a Casson painting and you decide to keep the painting until your death.  In your will, you bequeath the painting to your son.  On your death, you will be deemed to have disposed of the painting for its fair market value (measured at the time of your death).  If the painting has increased in value to $200,000 by the time of your death, you will now have a deemed capital gain of $190,000.  As well, you may have a capital gain on other assets that you own at the date of your death.

While the Canada Revenue Agency would not be able to come after you personally for the taxes – there is no taxation beyond death (yet) – the executor of your estate would have to pay this tax bill before distributing assets to your heirs.  Taxes are a major cause of estate shrinkage.  The heirs receive only what is left after the payment of taxes.

Technically, Canada does not have an estate tax.  However, the deemed disposition on death provisions are a form of estate tax in everything but name.

It is usually advisable to take steps to manage the amount of tax that will arise on death so that you heirs are not forced to sell valuable investment assets in order to pay tax.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 7: Depreciation of Rental Buildings

Tax is triggered by specific events.  For example, the sale of an investment or other asset will often trigger tax.

Assume that you buy some shares for $100 and later sell the shares for $500.  You will have a $400 profit on the sale.  If you make a business of buying and selling shares, the $400 increase in value will be taxed as ordinary income.  If you bought the shares as an investment, the $400 increase in value will be taxed as a capital gain.  As discussed in Tax Primer 6, whether you are in the business of buying and selling shares or merely an investor is a question of fact.

The comments in this chapter will assume that you are an investor.

If you are an investor, you will realize a capital gain when you sell an investment that has increased in value.  The sale of certain types of investments, however, may result in the taxation of both a capital gain and ordinary income.  For example, assume that you purchase a building for $1 million and rent it to tenants.  Income tax law allows you to depreciate the cost of the building (but not any associated land) over specific periods of time (a bit each year).  You claim this depreciation expense (in tax jargon, capital cost allowance) as a deduction against rental income, thereby reducing the tax payable on the rental income.  For the purposes of this example, assume that you have claimed $400,000 in total depreciation on the building over your years of ownership.  Eventually, you get tired of being a landlord and decide to sell the building.  If you sell the building for $1.4 million, you will pay tax on two different amounts.  As you probably expect, you will have a capital gain of $400,000 (the $1.4 million sale price less the $1 million cost).  However, you will also have ordinary income of $400,000 (equal to the past depreciation claims).  Since the building did not in fact go down in value, you have to “recapture” the depreciation deductions that you claimed in the past.

When depreciating a building for income tax purposes, remember that the income tax saved through the depreciation claims will have to be repaid to the government at some future date.  Think of that tax “saving” as a form of interest-free loan.  It makes sense to invest the tax savings to earn more income.  If you use the tax savings for personal consumption (such as a vacation), remember that the tax savings might have to be repaid some day.  The tax savings is not really a savings – just a deferral.

If the asset actually depreciates in value over time at a rate that is at least equal to the depreciation claimed for income tax purposes, no recapture will arise on sale of the asset.  This is the case with most cars, for example.

When you claim depreciation for income tax purposes, the depreciation is called capital cost allowance.  The cost that has not yet been depreciated is called the undepreciated (as in not yet depreciated) capital cost of the asset.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 6: Intentional Capital Gains

In the Canadian Tax Primer 5 article, we pointed out that a lower tax rate applies to a capital gain as compared to ordinary income.  But what is a capital gain?

It is sometimes difficult to distinguish between a capital gain and ordinary income.  Much of the distinction has to do with the purpose behind the acquisition of the asset.  Characterization depends on specific facts, as illustrated by the following simplified examples.

Assume that you find that perfect piece of real estate and buy it for $100,000.  You plan to build your dream cottage on it, but not right away.  You are just starting a business and want the business to be established before you take on the cost of building the cottage.  As it turns out, the business takes more and more of your time and you realize that you do not have the time to make the trek to a far-off cottage.  After 15 years, you decide to sell the property for $500,000 and you use the cash to install a much more accessible swimming pool in the backyard of your home.  In this case, the $400,000 increase in value should be taxed as a capital gain.

Assume that you purchase the same piece of real estate because you anticipate that you will be able sell the property for a tidy profit once the area becomes a cottage haven.  You have to wait for 15 years, but events turn out as you anticipate.  The cottage building frenzy finally starts and you sell the real estate for $500,000.  In this case, the $400,000 increase in value should be taxed as ordinary income.

The only difference between these two examples is your intention when you buy the real estate.  In the first example, you buy the real estate for the purpose of building a cottage on it but you never actually build the cottage.  In the second example, you buy the real estate for the purpose of reselling it.

The same question arises with publicly-traded investments.  If you buy a share of Bell Canada and hold those shares for a year or so, sale proceeds will usually be treated as a capital gain – even though making a profit on resale gain is usually one of the purposes in buying shares.  This has to do with the nature of investments, as everyone hopes that the investments will grow in value over time.  But not all sales of Bell Canada shares will give rise to a capital gain.  If you are a day trader who buys and sells shares on a daily basis, your profit will likely be treated as ordinary business income.  Unlike the ordinary investor, a day trader is in the business of buying and selling shares.

While you may know what your intention was in purchasing an asset, it may be difficult to prove that intention to the Canada Revenue Agency (the “CRA”) if that should become necessary.  The CRA will determine your intention on the basis of external manifestations of that intention, the nature of the property involved and the amount of time you held the property.  No one factor will be determinative – characterization will depend on the combined impression created by all the relevant factors.

If the CRA reassesses a capital gain and treats the gain as ordinary income, the onus of proof will be on you to establish otherwise.  Keep any evidence that may be relevant to establishing your intention.  For instance, in the cottage example discussed earlier, keep any building sketches that you may have made for the cottage you never ended up building.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 5: Different Tax Rates on Different Types of Income

Besides varying by province (see the Canadian Tax Primer 2 article), Canadian tax rates vary by the type of income earned.  The 2015 rates referred to below are for an individual resident in British Columbia and paying income tax at the top marginal rate (has over $150,000 of taxable income).  If the individual has a lower level of income, she will have correspondingly lower tax rates.

The highest rate (about 46%) applies to employment income, business income, interest income and dividends received from non-Canadian corporations.

A lower rate applies to dividends received from taxable Canadian corporations.  This is not an example of government generosity, however, or an example of the government encouraging investment.  The shareholder is merely paying part of the tax on the income.  In order to pay the dividend, the corporation had to earn income and likely had to pay income tax on that income.  Payment of a dividend is not a deductible expense for the corporation, so the dividend has to be paid out of the corporation’s after-tax income.

(a)        If the corporation pays the dividend out of active business income that has been taxed inside the corporation at the (lower) active business rate, tax on the dividend is about 36% of the dividend.  The shareholder will pay this tax.

(b)        If the dividend is paid out of corporate income that has taxed at the (higher) general corporate tax rate, tax on the dividend is about 29% of the dividend.  The shareholder will pay this tax.

When the corporate and personal taxes are combined, the overall tax should (in theory) be about the same as an individual would have paid if the individual had earned the income directly (rather than through a corporation).  This integration of the corporate and personal tax rates never works out perfectly in real life, but that is the overall goal of the system.

The lowest tax rate (about 23%) applies to capital gains.  For example, assume that you buy a long-term investment for $100 and sell the investment down the road for $500.  In this case, you would have a capital gain of $400 and would pay tax of about $92 (23% of $400).  This is a simplified way of expressing the rate.  As a technical matter, you bring only half of that $400 gain into income and you pay tax at the normal 46% rate on that $200 income inclusion.  But for our purposes, 46% of half is the same as 23% of the whole.

The 23% tax rate on capital gains is only part of the story, however.  The capital gain will have arisen over a period of time.  During that time, inflation will have eroded the purchasing power of a dollar.  In order to determine whether a $1 capital gain actually increases your purchasing power on an after-tax basis, you need to take inflation into account.  The Canadian tax system does not attempt to adjust for inflation other than by taxing capital gains at a lower rate.  This is a rough form of adjustment and might over- or under-compensate for inflation, depending on the period of time involved.

For example, assume that you purchased an investment in 1985 for $100 and sold that investment for $201.92 in 2015.  On paper, you have doubled your money and have made a capital gain of $101.92.  In fact, however, your purchasing power has merely stood still over the 30 years in question.  The increase in value is attributable solely to inflation:  see the Bank of Canada inflation calculator at http://www.bankofcanada.ca/rates/related/inflation-calculator/?page_moved=1.  Even though you have made no real economic gain, you would still be obligated to pay capital gains tax on the inflation-induced capital gain.  After payment of the tax, you would have lost on the investment – because your purchasing power would have declined by the amount of the tax.  In order to have an actual after-tax economic gain, you need a rate of return that is equal to inflation plus the tax payable on the capital gain.

Inflation has to be taken into account in respect of any form of income – such as interest and dividends – if you are looking at returns over an extended period of time.  As indicated, interest is taxed as ordinary income and so is subject to a larger tax bite as well as the usual erosion of purchasing power through inflation.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 4: Sharing Income with University-Age Children

If you operate an incorporated business, you have lots of options to split income with other family members (including children who have turned 18).

You can have the corporation hire family members, but any salary paid to the family member cannot be higher than the salary that you would have paid to a non-family member for doing the same type of work.  If your child is away at university most of the year, you must reduce the amount of salary that you pay to the child accordingly.

A better option may be to have the corporation pay dividends to your child.  Dividends are a return on investment.  Your child can receive dividends even if she or he is hitting the university texts hard and doesn't work for the corporation at all.

Many parents are reluctant to have a child own shares directly in the business corporation.  This is where a trust can be useful.  If a properly-structured trust is established, the parents can be the trustees and manage the trust assets.  If the trust assets include shares of the corporation, the parents can control the shares as well as the dividends paid on the shares.  If the student achieves targeted grades, for example, the trust can pass dividends through to the child to assist with tuition and other expenses.  If the target grades are not achieved, however, the child has no right to receive anything from the trust.  If the parents are also beneficiaries of the trust, the parents can distribute the shares to themselves on the termination of the trust.  There is no risk of feeding a sense of entitlement.

Introducing a trust as a shareholder will usually require a corporate reorganization.  The trust itself must be established in a very specific manner in order to take advantage of the income splitting advantages.  If the parents want to be trustees, a parent would not usually establish the trust.  This is usually the role of the grandparent or some other close family friend.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 3: Graduated Rates for Individuals

Canada uses a graduated rate system for individuals.  This means that the rate of tax increases as the overall level of taxable income increases.  For example, assume that you reside in British Columbia and that you have $75,000 of total taxable income.  Tax applies at a 20% rate on the first $37,869 of this taxable income, at a 23% rate on the next $6,800 of taxable income and at 30% on the rest.  So your effective tax rate is a combination of these various rates on the different portions of your income.

Because of the graduated rate system, it is much better to have two spouses each earning $75,000 in taxable income rather than a single spouse earning $150,000 (two times $75,000) in taxable income.

Various rules in the Income Tax Act make it difficult (but not impossible) to split income between spouses.  If a high-income spouse simply gifts money to a low-income spouse and the low-income spouse invests the gifted money, income earned by the low-income spouse on the gifted money will still be taxed at the rate of the high-income spouse.  However, there are ways around this rule.

In 2014, the federal government introduced a family tax cut credit.  This allows a couple with a child under the age of 18 to transfer up to $50,000 of taxable income from a high-income spouse to a low-income spouse.  However, the maximum tax benefit from such a transfer is limited to $2,000 in any one year.

In many cases, it is better for the high-income spouse to lend funds to the low-income spouse with interest.  The interest rate has to be at least equal to the Canada Revenue Agency prescribed rate of interest at the time of the loan.  As of the second quarter of 2015, this prescribed rate of interest is only 1%.  If the low-income spouse invests the loaned funds and earns a 4% return, the low-income spouse pays tax on a 3% return (after deducting the 1% interest paid to the high-income spouse).  While the high-income spouse pays tax on the 1% interest received, the high-income spouse avoids paying tax on the other 3%.

The loan has to be carefully documented and the low-income spouse has to actually pay the interest to the high-income spouse within 30 days of the end of each calendar year.  With proper structuring of the loan, the current 1% interest rate can be locked in for a considerable period of time (up to 20 or 25 years).  Over time, the low-income spouse can build up a significant investment portfolio so that the couple can split income even after the children have reached the age of 18 and the family tax cut credit is no longer available.  Furthermore, the amount of annual income tax that can be saved with the loan method is not limited to $2,000.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 2: General Rules for Individuals

Canadian income tax is usually triggered by a specific event:  the earning of income.  Triggering events come in many different forms.  For an employee, the receipt of a paycheque triggers tax on the salary included in the paycheque.  For an investor, the sale of an investment will often trigger tax on any increase in value of the investment.

Income tax is calculated as a percentage of taxable income.  The applicable percentage depends on various factors, including the province (or territory) in which the individual resides or carries on business.

Canada is a federation consisting of a federal government (serving the whole nation), ten provincial and three territorial governments.  Each level of government imposes an income tax.  In order to determine the total amount of tax that you have to pay, you have to combine the federal income tax with the applicable provincial/territorial income tax.  As a result, the combined rate of income tax varies by province. 

For non-business income earned by an individual, the taxing province is the province of residence on the last date of the calendar year.  For business income, it is the province in which the business income is earned.  So an individual who resides in British Columbia will usually pay tax to the federal government and to the British Columbia government.  If the individual resides in Field, BC and is employed across the border at the Chateau Lake Louise, the individual will still pay income tax to BC rather than to Alberta.  If the individual decides to become an entrepreneur and starts his own unincorporated business selling ice cream to tourists walking around Lake Louise, however, he will have to pay Alberta provincial income tax on his Alberta business income (but will not pay BC provincial tax on that business income).

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Canadian Tax Primer 1: Where do you Reside?

Canada imposes income tax on the basis of residence.  A Canadian resident pays Canadian income tax on all income arising anywhere in the world (including interest earned on a bank account in the Cayman Islands).  In contrast, a non-resident of Canada pays Canadian income tax only on specific types of Canadian-source income.

Unlike the United States, Canada does not impose income tax on the basis of citizenship.  So to escape Canadian income tax, you need not turn in your passport.  You merely have to leave Canada, cut off all your ties to Canada and start to reside elsewhere.  However, the termination of Canadian residence may trigger significant Canadian tax liability on deemed capital gains that have accrued up to the date of departure.

In determining your place of residence, you have to look at all the connections that you have in your daily life, from the big ones to the small ones.  Do you have your home in Canada?  Do you use a Canadian driver’s licence?  Do you subscribe to Canadian magazines and periodicals?  Do you rely on Canadian health care funding?

There is considerable confusion about a 183-day test that applies when determining residence status.  This test applies only to individuals who are clearly non-residents.  A non-resident becomes a deemed resident of Canada by being physically present in Canada for more than 182 days in any one calendar year.  The test does not work in reverse, however.  If you are in fact a resident of Canada, you do not escape Canadian tax by spending more than half the year at a vacation resort outside of Canada.  If only life were that simple (and if only one were wealthy enough to spend over half the year on vacation)!

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Purchase or Sale of a Business: having your cake and eating too

Canadian-resident individuals can receive up to $800,000 in tax-free capital gains on the sale of qualifying shares of an active business corporation.  Alas! Most buyers prefer to buy amortizable assets rather than non-amortizable shares.  But why be locked into an "either/or" approach?  With good planning, you can combine both approaches and enjoy the best of both worlds.

The trick is for the seller to sell enough shares to use the capital gains exemption without giving the buyer control of the corporation.  The buyer then buys the business assets from the corporation.  The corporation then buys back the shares owned by the buyer.  This leaves the seller with tax-free cash from the sale of the shares and gives the buyer amortizable asset costs that can generate future tax deductions.  The seller also never gives up full control of the corporation, which now has proceeds from the sale of the assets.

Proper proportions have to be maintained when deciding how much value to allocate to the share sale.  Additionally, the corporation will likely have to create special-purpose shares.  By thinking flexibly and with proper planning, both buyer and seller can have the best of both worlds.  At the closing, buyer and seller can have their cake and eat it too!

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Active Business Income Consultation

It’s nice to be asked for your opinion.

The federal government is asking for comments about the criteria used to distinguish between active business income and investment income earned by corporations.

The distinction is important.  The first $500,000 of annual income from an active business qualifies for a special low corporate tax rate.  Income in excess of that threshold is taxed at a higher rate (but one that is still below the rate that applies to investment income).  The lower rate provides the corporation with more after-tax income that can be invested back into the business operations or passed up to a special purpose holding entity for other investment uses.  In contrast, investment income is taxed at full rates with a partial refund of some of that tax when the corporation pays a taxable dividend (the refund is approximately equal to the tax that the dividend recipient will pay).

If the principal purpose of a business is to derive income from property (such as rental income from the use of real estate), the income generated by the business is considered investment income unless the business employs more than five full-time employees throughout the year.

Concern has been expressed about how this distinction applies in the case of self-storage facilities and campgrounds.  While not specifically mentioned in the budget materials, this issue also applies in the case of many roadside motels and mobile home parks.  Usually, smaller-scale operations of these types do not employ more than five full-time employees throughout the year.  For example, campgrounds and roadside motels are often seasonal operations.  However, the business is more akin to a business that requires active management than a passive form of investment.

The government has invited interested persons to submit comments no later than August 31, 2015.  Comments should be sent to by email to business-entreprise@fin.gc.ca.

If you send in a submission, please indicate whether you consent to having the submission posted on the Department of Finance website.  If you consent, indicate the name (your name or the name of your organization) that should be identified on the website as having made the submission.  Submissions should be provided electronically in PDF format or in plain text.  The Department will not post submissions that do not clearly indicate consent to posting.

I suggest that you clearly consent to having the submission posted on the Department of Finance website.  If your submission is posted, there is a better chance that others might support your ideas.  Your submissions will have the chance to go tax-world viral.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Reporting Ownership of Foreign Assets

When filing income tax returns, Canadians have to indicate whether they own foreign assets that had an aggregate cost of more than $100,000 (measured in Canadian currency) at any time during the taxation year.  If they do, details of the foreign assets must be provided on Form T1135.  This is the case even if the foreign assets are held inside a Canadian brokerage account and even if the foreign assets did not produce any income that year.  Specific exceptions apply for specific types of foreign assets, such as a foreign vacation home that is used only for personal purposes (in other words, that is not rented out to others at any point in the year).

This is a complicated filing requirement that has caught many Canadians who were unaware of the breadth of the reporting requirement.  After all, the question arises on an income tax return, not a wealth tax return.

The Canada Revenue Agency (the CRA) revised Form T1135 in 2013.  The revised form requires much more detailed information about foreign assets, increasing even further the compliance burden.  In some cases, the cost of compliance is out of all proportion to the value of the foreign assets.

The 2015 Budget proposes to simplify the foreign asset reporting system for taxation years that begin after 2014.  These new rules will not apply for 2014 returns but will apply for returns that cover the 2015 taxation year.

The simplification will retain the CAD $100,000 aggregate cost threshold.  If the total cost of reportable foreign assets is less than CAD $250,000 throughout the year, the taxpayer will be able to report these assets under a more simplified system.  Details of the simplified system have not yet been released.

It does not look as if the proposed streamlining will eliminate the need to report foreign investments that are held in a Canadian brokerage account and in respect of which the broker issues information slips reporting the income received.  That type of streamlining would require a statutory amendment rather than just changes to Form T1135.

If you have failed to report all foreign assets in the past, you may be able to avoid penalties by voluntarily disclosing the failure to the CRA.  In order to avoid penalties, you must approach the CRA before the CRA approaches you.  Generally, voluntary disclosures (also called tax amnesties by some advisers) are initiated on a no-names basis through a law firm so that you do not have to disclose your name until you have an idea of what the CRA will require in order to correct the past omission.

If you need advice about the voluntary disclosure program or believe that you may need to make a disclosure, please contact Layli Antinuk at 250-360-2110.  Any conversations will be protected by lawyer-client privilege.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

2015 Budget: Source Deductions and Non-Resident Employers

If a non-resident employee performs duties of employment in Canada, the employer must deduct and remit source deductions made on account of income tax.  This is the case even if the employee’s salary is expected to be exempt from Canadian taxation by virtue of a tax treaty between Canada and the non-resident employee’s home country.  If the employment income is exempt from Canadian tax under a treaty, the employee pays tax on the income in the employee’s home jurisdiction but must file a tax return in Canada in order to claim a refund of the source deductions withheld from his or her paycheque.

This source deduction requirement applies whether the non-resident employee works in Canada for a foreign employer or a Canadian employer.

To avoid the source deduction requirement, the non-resident employee (not the employer) must apply to the Canada Revenue Agency (the CRA) for a waiver from the source deduction requirement.  If granted, the waiver applies on an employee-by-employee basis and applies for only a specific period of time.  This makes for an inefficient system.

In an attempt to address this administrative issue, the 2015 budget proposes a statutory exception to the normal source deduction requirement for salary paid by qualifying non-resident employers to qualifying non-resident employees.  The statutory exception will apply for salary paid after 2015.
 

A non-resident employee will qualify for the exemption from source deduction requirements if the employee

• is exempt from Canadian income tax under a tax treaty between Canada and the home country of the employee; and
• is not physically in Canada for more than 89 days in any 12-month period that includes the time of the salary payment.

A qualifying non-resident employer must be resident in a country with which Canada has a tax treaty. If the employer is a partnership, at least 90% of the partnership’s income for the fiscal period that includes the time of the salary payment must be allocated to persons that are resident in a treaty country.  In either case, the employer must not carry on business through a Canadian permanent establishment and must be certified by the CRA.
 

This new statutory exception will not cover all cases in which the employment income is likely to be exempt from Canadian income tax.  Most of Canada’s tax treaties provide an exemption for Canadian employment income earned by a non-resident if the employee is present in Canada for no more than 183 days.  As noted, the employee must be present in Canada for no more than 89 days in order to obtain the source deduction exemption.  As a result, at least some non-resident employees will still have to apply for the waiver.
 

The source deduction exception does not apply if the employer is resident in Canada.  This likely means that foreign employees on very short-term Canadian assignments (less than 90 days) will remain employed by a foreign employer.  Only foreign employees who are likely to be in Canada for 90 days or more will end up being seconded to a Canadian affiliate of the foreign employer.

Even if not required to make source deductions, a qualifying non-resident employer will continue to be responsible to file information slips with the CRA reporting all income paid to non-resident employees.

2015 Budget: Good News for Charities with Endowment Funds

Some charities (such as charitable foundations) have endowment funds that are invested to produce income that can then be used for charitable purposes.  The 2015 Budget provides a greater range of investment possibilities for those funds by making it easier to invest in limited partnerships.

Traditionally, partnerships were closely-knit groups of individuals who carried on business together.  For many years now, the partnership concept has morphed into much more complicated business structures in order to take advantage of tax rules that apply to partnerships.  Many partnership units are traded on stock exchanges in the same way that corporate shares are traded.  Even so, each partner is considered to be carrying on the partnership business.  Usually, partnerships that are traded on stock exchanges are limited partnerships so that investors are not fully liable for the debts of the partnerships and are therefore more like shareholders of a corporation.

Income tax rules restrict the types of businesses that a charity can carry on.  As even a limited partner of a partnership is considered to be a participant in the partnership business, this limits the types of limited partnership investments that a charity can make.

Effective for investments made after April 21, 2015, a charity will not be considered to be carrying on a business solely because the charity invests in a limited partnership interest as long as

• the charity – together with all non-arm’s length entities – holds no more than 20 per cent of all interests in the limited partnership; and
• the charity deals at arm’s length with each general partner of the limited partnership.

These rules will also apply to registered Canadian amateur athletic associations.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

2015 Budget Refinements for Gifts to Foreign Charities

With so many Canadians anxious to help with earthquake relief in Nepal, I hesitate to deal with the following very technical 2015 budget change for fear that confusion might result.

A very technical change announced in the 2015 federal budget will adjust the rules that apply for gifts to selected foreign charities.  However, this has nothing to do with donations to help those in Nepal.  Donations for earthquake relief can be made to the Red Cross and various other Canadian charities that have international arms providing disaster relief.  There is no need to give a gift to a foreign charity.  This budget change has nothing to do with disaster relief in Nepal.

Under current rules, Canadians can deduct a gift made to a foreign charitable organization if the foreign charitable organization has received a gift from the federal government within the past two years and is registered by the Canada Revenue Agency (CRA).  For example, Canadians can deduct gifts made before November 7, 2015 to the US-based Clinton Foundation (see http://www.cra-arc.gc.ca/chrts-gvng/qlfd-dns/qd-lstngs/gftsfrmhrmjsty-lst-eng.html).  The time limit for making the donation is the second anniversary of the gift from the Canadian government.

The current rules allow for registration only if the foreign charity is a “charitable organization” – one that carries on its own charitable works.  Canadian tax law distinguishes a charitable organization from a charitable foundation.  Under Canadian tax nomenclature, a foundation exists primarily to fund charitable works carried on by charitable organizations.

The 2015 budget will extend the current rules to foreign charities in general so that foreign charitable foundations can also be registered in Canada if the Canadian government makes a donation to the foreign foundation.  This is a very technical change that will affect only a small number of selected foreign charities.

This budget change will cause some to ask how Canadians can make tax-deductible gifts to the Clinton Foundation if foreign charitable foundations are not covered by the current rules.  The answer is one of tax nomenclature.  The Clinton Foundation (despite its name) carries on charitable works in partnership with other charities and would be classified in Canada as a charitable organization.  The “Foundation” moniker was presumably chosen for reasons other than Canadian tax classifications.

As noted, most Canadian charities have international operations.  As a result, there is no need to donate to a foreign charity to assist with international aid relief.  Various Canadian charities are providing much-needed relief in the earthquake-ravaged areas of Nepal.  In order to assist in that effort, simply donate to one of those many Canadian charities.  I repeat that this budget change has nothing to do with earthquake relief efforts.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Good News for Giving Back to the Community

The 2015 Budget contains an important change affecting charitable donations made in 2017 and subsequent taxation years.

For much of the past, the charitable donation system assumed cash donations and actually discouraged Canadians from donating property to charity.  If property had an accrued gain, part of the charitable donation receipt had to be used to avoid tax on the capital gain that resulted from the making of the donation.

Recent changes have made it easier for Canadians to donate property by eliminating the capital gain for specific types of donated property.  For example, assume that I donate $100 worth of shares that are listed on a stock exchange (such as shares of Bell Canada Enterprises).  Even if the shares have a nominal cost, the donation will not result in any capital gains tax.  As a result, I will be able to apply the full $100 donation receipt against my other income.  This makes sense, as I will have actually given $100 away.

The 2015 Budget will extend this enhanced treatment to cash donations that are sourced from sales of real estate and from sales of private corporation shares (shares that are not listed on a stock exchange).  However, these new rules will come into effect only in respect of sales that occur after the end of 2016.

The new rules will not apply if the real estate or the shares are donated to the charity.  Instead, the donor sells the real estate or the shares and donates cash from the sale proceeds within 30 days of the sale.  No capital gain arises on the part of the sale proceeds donated to the charity.  This means that the charitable donation deduction can be applied to reduce capital gains tax on the portion of the sale proceeds that is not donated to the charity.

To use a very simple example, assume that I sell real estate (not my principal residence) for $3 million and would have a capital gain of $3 million on that sale.  If I donate $1 million (one-third of the sale proceeds) to a charity within 30 days of the sale, I pay tax on a capital gain equal to only $2 million (2/3^rd of the sale proceeds).  As only 50% of a capital gain is included in income, I have an income inclusion of only $1 million.  Any tax arising on that $1 million income inclusion will be completely offset by the charitable donation of $1 million.  As a result, I give $1 million to the charity and retain $2 million out of the sale price of $3 million.  Without the charitable donation, I would have paid about $690,000 in tax and retained about $2.31 million of the sales proceeds.  So the charitable donation would have cost me only $310,000.

The tax relief applies only to the capital gain.  A sale of rental real estate will often give rise to taxation of depreciation taken in previous years if the building has not actually declined in value.  Tax will still apply in respect of previous depreciation claims that have to be brought back into income on the sale.

As noted, the donation to the charity must occur within 30 days of the sale.  Furthermore, the sale must be to a purchaser who deals at arm’s length with both the donor and the charity.  Anti-avoidance rules will apply to prevent abuse of the new rules.  For example, anti-avoidance rules apply if the donor or another family member re-acquires any of the sold property within five years of the sale.

While I have used the colloquial term “charity”, the new rules will apply in respect of a donation to any “qualified donee”.  Besides registered charities, that term includes registered Canadian amateur athletic associations.

As with any charitable donation, the tax system provides tax relief to assist with the donation.  However, the donor is still making a donation and has to want to give back to the community.  The new rules will make it easier to give back starting in 2017.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.