Understanding your clients

1
Understanding your clients tax requirements

• Perry Truster, FCA,TEP
• Truster Zweig LLP
• Chartered Accountants

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The impact of tax rates

• Selected Ont.2003 personal tax rates
• Tax Ordinary
  Capital
• bracket income Dividends gains
• 0 22.05 4.48 11.03
• 32,435 31.15 15.86 15.58
• 64,368 36.98 21.86 18.49
• 104,648 46.41 31.34 23.21

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The impact of tax rates

• Obviously the after-tax return on dividends and
  capital gains is greater than on ordinary income.
  Therefore lesser amounts of these can be realized
  while earning the same after-tax returns.
• Interest Dividends
  Gains
• Amount 1,000 780
  698
• Max tax 464 244
  162
• Net 536 536
  536

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Public income trusts

• Investments in publicly traded income trusts
  should yield greater after-tax returns than
  investments in publicly traded corporations.
• The corporation will incur tax on its income. The
  shareholder receiving a dividend will incur tax
  as well. The total of the corporate and personal
  taxes can exceed 56 to a top bracket Ontarian.

5
Public income trusts

• This rate substantially exceeds the maximum
  personal tax rate in Ontario of 46.41 in 2003.
• The trust would be liable for tax at he highest
  personal rate. However, if the trust distributes
  all of its income, annually, it will have no
  income subject to tax. Rather, the unitholders
  are taxed on the income.

6
Public income trusts

• If the unitholder is a deferred plan such as a
  RRSP, the result is more dramatic in that there
  is no tax at all until funds are withdrawn from
  the RRSP.
• The trust can distribute cash flow sheltered from
  tax by, say, capital cost allowance. Such
  distributions are considered to be returns of
  capital and reduce the adjusted cost base of the
  units.

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Public income trusts

• Only if the ACB goes negative by virtue of such
  reduction will the return of capital be taxed
  immediately.
• Otherwise, the ACB reduction will result in a
  larger capital gain or reduced capital loss on
  the eventual disposition of the unit.n

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Interest deductibility

• When interest is deductible for tax purposes is
  widely misunderstood.
• For example, the Income Tax Act has, since 1972,
  contained a provision (subsection 9(3)) that
  negates the deduction of interest which is
  incurred to realize capital gains.

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Interest deductibility

• In theory, therefore, interest incurred on funds
  borrowed to acquire traditionally non-dividend
  paying stocks could be disallowed.
• However, this has not been the governments
  administrative policy.
• Recently, the government has lost a number of
  high profile tax cases in which the courts have
  been very liberal in allowing interest deductions
  and have refused to apply the REOP test where
  there is no personal element present .

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Interest deductibility

• The governments response has been to introduce
  draft legislation which, if passed in its present
  form, will commencing in 2005, introduce a REOP
  test into the law.
• In broad terms, draft section 3.1 will disallow
  losses unless, in the year, the taxpayer can
  reasonably be expected to realize a cumulative
  profit over the holding period, including future
  years.

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Interest deductibility

• The draft legislation also provides that, for
  this purpose, profits are to be determined
  without considering capital gains or losses.
• In the context of investments in the market, this
  could mean that interest will be disallowed where
  it is incurred to fund the purchase of stocks
  which do not pay dividends or other investments
  which do not distribute income.
• The government would use hindsight.

12
Interest deductibility

• Investors may have to report gains on the
  disposition of investments as ordinary income in
  order to preserve their interest deductions if
  the legislation is passed in its present form.

13
Corporate owned life insurance

• For purposes of determining the FMV of corporate
  shares that are deemed to have been disposed of
  by an individual on his/her death, the FMV of an
  insurance policy on the life of the individual
  (or on an individual not at arms length with the
  shareholder) is deemed to be its CSV immediately
  before the individuals death.

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Corporate owned life insurance

• For purposes of the small business capital gains
  exemption
• - the FMV of corporate owned life insurance
  is deemed to be equal to its CSV at any time
  before the death of a shareholder whose life is
  insured, and
• - after death, the FMV of the life
  insurance proceeds to a corporation is

15
Corporate owned life insurance

• deemed not to exceed the CSV immediately
  before death if the proceeds are used, within 24
  months after death (or upon written request, a
  longer period, if reasonable) to redeem, acquire
  or cancel the deceaseds shares.

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Corporate owned life insurance

• The portion of life insurance proceeds that
  increases a corporations capital dividend
  account is the amount in excess of the policys
  ACB.
• Therefore, consideration should be given to
  having the corporation acquire a policy that
  returns premiums.

17
Corporate owned life insurance

• When a deceaseds estate acquires shares upon
  his/her death, in the absence of the
  spousal/common-law partner rollover, the estates
  tax value of the shares is deemed to be equal to
  their FMV immediately before the deceaseds
  demise.
• If the estate tenders the shares for redemption,
  the estate is deemed to have realized a dividend
  equal

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Corporate owned life insurance

• to the excess of its proceeds over the paid-up
  capital (generally nominal) of the shares.
• At the same time, the estate is deemed to have
  incurred a capital loss equal to the paid-up
  capital of the shares less their high tax value.
• Such capital loss can be utilized on the
  deceaseds terminal return to offset any

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Corporate owned life insurance

• capital gains reflected thereon, generally the
  gain resulting from the deemed disposition of the
  shares immediately before death.
• However, if the deemed dividend is elected to be
  a capital dividend, rules introduced on April 26,
  1995 are problematic in this regard.

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Corporate owned life insurance

• Unless the pre April 26, 1995 rules are
  grandfathered, the capital loss incurred by the
  estate on the redemption, will be reduced by 50
  of the capital dividend received by the estate if
  the loss is utilized on the deceaseds terminal
  return.

21
Corporate owned life insurance

• This problem can be eliminated if the deceased
  bequeaths the shares to a spouse or commonlaw
  partner.
• The automatic rollover would be availed of on the
  transfer to the spouse or common-law partner.
• The shareholder should not, prior to death, enter
  into an agreement requiring that the

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Corporate owned life insurance

• spouse or common-law partner to sell to the
  surviving shareholder(s) as this would negate the
  rollover on death.
• Instead, prior to death, the shareholders would
  enter into put/call arrangements
• -the surviving spouse or common-law partner
  would have the right to tender the inherited
  shares for redemption and to

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Corporate owned life insurance

• receive capital dividend treatment, to the
  extent possible, on the resultant deemed
  dividend.
• -the surviving shareholder(s) would be
  given a call option to force the surviving spouse
  or common-law partner to sell, if the shares were
  not tendered.

24
Corporate owned life insurance

• In most cases, the surviving spouse or common-law
  partner, having inherited the low ACB of the
  deceased, will not incur a capital loss that
  would otherwise be reduced by 50.

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Miscellaneous tax planning ideas

• Consider transferring investments to a
  corporation and drawing a salary from the
  corporation to create earned income for RRSP
  purposes.
• Consider transferring investments to a
  corporation to reduce or eliminate the OAS
  clawback (which commenced at a taxable income
  level of 57,879 in 2003).

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Miscellaneous tax planning ideas

• CPP benefits transferred to a spouse or
  common-law partner are not subject to the
  attribution rules.
• Capital gains earned by a minor are not subject
  to the attribution or kiddie tax rules.
• Income on income is not attributed.
• Business income is not attributed.

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Miscellaneous tax planning ideas

• An individual who is older than 69 can contribute
  to the RRSP of a spouse or common-law partner who
  is 69 or younger.
• It may be possible to establish a trust which is
  resident in a lower taxed jurisdiction within
  Canada, such as Alberta, to earn income which
  would otherwise be taxable in a more highly taxed
  jurisdiction.

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Miscellaneous tax planning ideas

• Consider having a will create multiple
  testamentary trusts rather than making direct
  bequests.