The Canadian Taxation System

The Canadian Taxation System

• Minimizing taxes is important in financial planning, but not the primary goal.
• Legitimate tax avoidance includes using deductions, converting expenses, postponing income, splitting income with family, and selecting investments with better after-tax yields.

The Income Tax System

• Canada taxes the world income of its residents, as well as the Canadian source income of non-residents.
• Companies incorporated in Canada under federal or provincial law are usually considered residents of Canada.
• Foreign companies managed and controlled in Canada are considered residents and are subject to Canadian taxes.
• Quebec administers its own income tax on individuals and corporations.
• Alberta administers their own income tax on corporations.

Taxation Year

• All taxpayers must calculate their income and tax on a yearly basis.
• Individuals use the calendar year, while corporations may choose any fiscal year, provided it is consistent year over year.
• No corporate taxation year may be longer than 53 weeks.
• Professional & personal service corporations must use a December year-end.

Calculation of Income Tax

• Calculation involves 5 steps.
• Calculating all income sources from employment, business, or investments
• Making allowable deductions to arrive at taxable income
• Calculating the gross or basic tax payable
• Claiming various tax credits, if any
• Calculating the net tax payable
• After determining total income, prescribed deductions and exemptions may be made to calculate taxable income.
• For individuals, deductions and exemptions may include registered pension plan and RRSP contributions, childcare expenses, and certain net capital and non-capital losses.

Types of Income

• There are 4 general types of income: employment, business, property, and capital gains & losses.
• Income from employment and business is included.
• Business income arises from profits earned from producing/selling goods or rendering services.
• To encourage CCPCs to expand, some companies get a Small Business Deduction, reducing the overall tax rate.

Types of Income (Continued)

• Income from property is another form of income.
• Property owners rarely do more than simply own the income-producing property.
• Individuals can deduct reasonable expenses like property taxes, repairs, maintenance, and financing costs, like interest paid on a margin loan.
• Only net income is subject to tax.
• Capital gains and losses are taxable for both corporations and individuals.
• A capital gain (loss) results when capital property is disposed of at a sale price greater (lower) than its cost.
• Costs of disposition are included in determining a capital gain or loss.

Calculating Income Tax Payable

• Federal income tax rates for 2018 include:
• Up to $46,605 taxed at 15%.
• $46,605 - $93,208 taxed at 20.5%.
• $93,209 - $144,489 taxed at 26%.
• $144,490 - $205,842 taxed at 29%.
• $205,842 + taxed at 33%.
• Given an investor’s marginal tax rate, the tax consequences of certain investment decisions can be estimated.
• Advisors can minimize taxes and select securities for the portfolio that offer a higher after-tax yield.

Payment of Income Tax

• Employers must withhold income tax from salaries/wages and remit it on their employees’ behalf.
• Some individuals and all corporations pay taxes by instalments.
• Individuals getting over 25% of their income from non-withheld sources must pay quarterly instalments on March 15, June 15, September 15, and December 15, if federal taxes payable are over $1,000.
• Instalments are based on either the tax reported for the preceding year, the tax reported for the second preceding year, or an estimate of the tax for the current year, whichever is least.
• Adjustments for over/underpayment are made at the year-end through the annual tax return, and interest is charged on deficient instalments.
• Corporations must pay federal and provincial tax instalments at each month end.

Tax on Dividends

• Individual taxpayers receive preferential tax treatment on dividends from taxable Canadian corporations.
• The taxpayer must gross-up the dividend amount by 25%.
• Then, the taxpayer can claim a tax credit of 13.33% of the taxable dividend amount.
• In all Canadian provinces except Quebec, the provincial tax is calculated using the provincial tax rate to the basic federal tax on the dividend income after deducting the federal dividend tax credit.
• Quebec collects its own provincial taxes levied as a percentage of taxable income on an ascending graduated scale, unlike other provinces.
• Stock dividends and dividends reinvested in shares are treated like cash dividends.

Minimizing Taxable Income on After-Tax Yield of Investments

• Dividends from taxable Canadian corporations (excluding foreign corporations) are taxed less than interest but more than capital gains.
• A shift from interest-bearing investments to dividend-paying Canadian stocks may reduce taxes and improve after-tax yield.
• The dividend income is $1,000, taxable income is $1,380 grossed up by 38%.
• The federal tax at 29% is $400.20.
• The federal tax owed is $192.92* , after the dividend tax credit of ($1,380 x 15.02%) $207.28 , Provincial tax must be added; it is calculated on the taxable income.
• The capital gain is $1,000, taxable income is $500 (50% of $1,000).
• The federal tax is $145.00.
• Dividends from foreign corporations mean that:
• Individuals who get dividends from non-Canadian sources usually receive a net amount, as taxes are typically deducted at the source.
• Investors may be allowed a deduction from the Canadian income tax otherwise payable.
• The allowable credit is essentially the lesser of the foreign tax paid and the Canadian tax payable on the foreign income, subject to certain adjustments.

Capital Dividends

• Private corporations may elect to pay a dividend from its capital dividend account.
• The capital dividend account represents the non-taxable portion of net capital gains realized by the corporation since 1971.
• The dividend is not included in the investor's income when received and doesn't affect the adjusted cost base of the shares on which it was paid.

Tax on Interest

• Taxpayers must report interest income (CSBs, GICs, and Bonds) on an annual accrual basis for investment contracts acquired after 1989, regardless of when it's paid.

Tax-Deductible Items Related to Investment Income

• Tax rules allow individuals to deduct certain carrying charges.
• Interest paid on funds borrowed to earn investment income is tax deductible unless the funds are for a rental property under construction or vacant while being renovated.
• Investment counselling fees(excluding commissions paid to registered investment counsellors) are deductible.
• Counselling fees for RRSP/RRIF are non-deductible.
• Fees paid for investment administration or safe custody are deductible.
• Administration and trustee fees for self-directed RRSPS & RRIFs are NOT deductible.
• Accounting fees paid for recording investment income are deductible.

Tax Deductible Items Continued

• A taxpayer can deduct interest paid on funds borrowed to purchase securities if:
• The taxpayer is legally obligated to pay the interest
• The purpose of borrowing is to earn income
• The income from purchased securities isn't tax exempt
• The interest is deductible, whether it's an arm’s length transaction or not.
• If interest paid to borrow funds exceeds the interest earned on a debt security, the difference isn't deductible.
• However, carrying charges are fully deductible for convertible debentures, as they can convert to common shares, potentially paying unlimited dividends.
• A portion of preferred share carrying costs with a fixed dividend rate may be disallowed if costs exceed the grossed-up dividend amount.
• Carrying charges on common shares are generally tax-deductible, even for non-dividend paying growth securities, because earnings and dividends may rise later.
• Carrying cost deductibility hinges on the investment's income potential.

Capital Gains and Losses

• A capital gain arises from selling a capital property for more than its cost.
• CCRA typically views share dispositions as capital in nature.
• If a taxpayer's actions indicate they're trading securities to realize a speculative profit, an exception occurs.
• In this case, CCRA may tax gains as ordinary income (and losses are fully deductible).
• Factors CCRA reviews to assess speculative trading.
• Short periods of ownership
• History of extensive buying & selling of shares or quick turnover of shares
• Special knowledge of or experience in securities markets
• Substantial investment of time spent studying the market and investigating potential purchases
• Financing share purchases on margin or some other form of debt
• The nature of the shares like speculative and non-dividend type.
• CCRA views a "dealer or trader" in securities as someone promoting or underwriting shares or acting as a dealer to the public.
• Employees of corporations engaged in these activities are generally not considered dealers.
• However, employees engaging in insider trading to realize quick gains are considered "traders" of those shares.
• The adjusted cost base (ACB) of shares sold is generally the purchase price plus commission expense.

Valuing Identical Shares

• Investors often own the same class of shares bought at different prices.
• The method used to value identical shares is the average cost method.
• Per share, average cost is calculated by adding all stock cost bases and dividing by the number of shares held.

Cost of Shares

• When an investor exercises the conversion right attached to a security, the conversion isn't deemed a disposition of property, so no capital gain or loss occurs
• The new shares' ACB is that of the original convertible securities.
• Cost of Dual Securities Acquired through Purchase of Units occurs when
• Units of securities ( 2 or more securities offered as a package) are sold at a unit price
• Since each security can be sold separately by the purchaser, a cost base for each security must be determined to calculate a capital gain (or loss) when either security is sold
• The owner of a unit calculates the cost base of each component by assigning the cost of the unit on a proportionate basis using the market values at the date of acquisition
• Example with ABC Company selling a new issue of units includes the equation calculation for each type

Warrants and Rights

• Investors acquire warrants and rights in 3 ways:
• Through direct purchase in the market
• By owning shares on which a rights offering is made
• By purchasing a unit of securities (bond with warrants attached)
• The method warrants and rights are acquired matters because there is different tax treatment for shares acquired when the warrants or rights are exercised
• Direct Purchase has a tax treatment is that discussed under convertible securities
• Rights Received from Direct Ownership must have the cost base of the original shares purchased adjusted
• Warrants and rights are not always Exercised, but an investor may :
• Sell them in the open market or allow them to expire.
• The capital loss would equal the purchase cost plus commission if the warrants and rights were directly purchased
• If Warrants and rights were zero cost, there isn't a loss or gain.
• If costs are zero and then sold in the open market, their cost is considered to be zero and all the profits earned are taxed as capital gains.

Disposition of Debt Securities

• Debt securities include bonds, debentures, bills, notes, mortgages, hypothec and similar obligations
• provincial Savings Bond and CSBs cannot generate a capital gain or loss because such bonds don't fluctuate in value and either are redeemed at par or mature.
• Accrued interest is not included in the capital gains calculation
• Instead, interest at the date of sale is income to the vendor and can be deducted from interest subsequently received by the purchaser.

Capital Losses

• Determined similar to capital gains and deducted from capital gains.
• Two important additional factors:
• When a security becomes worthless, the holder must fill out a form from CCRA declaring the security worthless, so a capital loss can be realized for tax purposes
• this doesn't apply to instruments with an expiry date, like warrants, rights, or options -One exception to the rule occurs when a security becomes worthless but is due to bankruptcy ( or insolvency) of the underlying company

Superficial Losses

• Superficial losses are not tax deductible as a capital loss
• Superficial loss is when security sold at a loss are repurchased within 30 days before or after the sale and are still held at the end of 30 days after the sale.
• The superficial loss rules apply not only to trades but also to trades by:
• The investor’s spouse or common-law spouse
• Corporations controlled by the investor
• Superficial losses are non-deductible for tax purposes, eventually receives the tax benefit after the investment is sold
• The count of the superficial losses is added to the cost of the repurchased shares, decreasing the ultimate capital gain
• Emigration (leaving Canada)
• Transfer of capital Losses does not apply to losses which result from:
• Emigration (leaving Canada)
• Death of a taxpayer
• Expiry of an option
• Deemed disposition of securities by trust
• Disposition of securities to a controlled corporation"

Tax loss selling Factors

• A hold or sell security should depend on the investor expectations for that security
• Taxes may also be a consideration in some circumstances
• Timing of subsequent repurchase must be carefully planned because of the the tax implications.
• settlement date (3 business days after the transaction date) is when ownership transfer happens.
• Keep the settlement/transaction date in mind near the year end.

Tax Deferral Plans

• A way to encourage Canadians to save for retirement by enabling them to reduce taxes
• Taxes are paid when its deferred from income and the rate is lower
• Registered Pension Plans (RPPs) has 2 types and are a trust
  • Money Purchase Plans also known as Defined Contribution Plans determine amount, and the benefits when dependency depends on it. -Combined contributions can't exceed 18% of the employee's current year · nor can it exceed $26,500 (2018)
  • Defined Benefit Plans has predetermined benefits ·Combined contributions are deductible up to amount recommended by a qualifed actuary so that they're adequately funded ·Designed current limits give an employee a max of 2% of pre-retirement earnings per year of service and approximately $103.055.40

RPP Employee Contributions

• The employee benefits based on this depend:

  -9% of employee compensation for a year -$600 plus 70% of PA for the year

Registered Retirement Savings Plans (RRSPs)

• Most popular vehicles for people to defer tax and save
• Income earned is not taxable until it is taken
• Single vendor is most suitable for an investor -The holder buys into GICs, segregated pooled funds, or mutual funds -Held in trust by an issuer from bank,insurance,credit union,or trust -Must must meed the requirements and conditions by the CCRA
• Self directed -Can by assets like securities -Managed by a fee from a financial company -Allows the investor to make decisions -While there are content rules, the content can by wide:

RRSP Contribution

• No limit to # of RRSPs
• annual tax is deducted from the two below: -18% of previous years earnings -RRSP cash limit was 26,320 and in 2019 expected to rise to 26,500 -Deduct PA& PSPA from year -Can add undeducted room at the end of the year period -Must made the year to be deducted by that year Earning income for the purposes is below: ---Total employment or union -Net rental or self income -From Work -Alimony -Funds from benefits -Penalites for contributions 1 - 1% of contributions is accessed more than 2000