COMM 433 Income Tax For Finance Students PDF

COMM 433 Income Tax for Finance Students Unit # 1 – Introduction (Chapters 1-2) History of Income Tax in Canada Until the First World War, Canada did not impose tax on its citizens. In an effort to attract more immigrants, nei...

COMM 433 Income Tax for Finance Students Unit # 1 – Introduction (Chapters 1-2) History of Income Tax in Canada Until the First World War, Canada did not impose tax on its citizens. In an effort to attract more immigrants, neither individuals nor businesses were taxed on their incomes. The Business Profits War Tax Act of 1916 required all corporations with more than $50,000 in capital to file a yearly tax return. The Income War Tax Act of 1917 expanded the Business Profits War Tax Act to include the taxation of individuals earning more than $1,000 individually or $2,000 for a married couple. Less than 10% of Canadians had to pay income tax (even in 1934, only 2% of Canadians earned enough money to pay tax). Both of these acts were intended to be temporary. In 1948, the Income Tax Act replaced the Income War Tax Act and introduced ten different federal tax brackets (low of 15%, up to 84%). Even so, less than 20% of the population earned sufficient income to be required to pay income tax. Note too that the length of the Income Tax Act was approximately 20 pages, double the length of its predecessor but nowhere near the 3,000 pages of legislation we have today (not to mention the extra 2.000 pages of Income Tax Regulations). The first major revision took place starting in 1962 as a result of the Carter Commission, which did not get parliamentary approval until the 1971 budget address. It was enacted on January 1, 1972. Since that time, every federal budget has presented numerous amendments to the Act. By 2017, approximately 67% of all Canadians were paying income tax. Why Study Taxation? Tax impacts all Canadian businesses and individuals. It influences the economy since it shapes the way businesses and individuals earn income, spend and save. Since the impact of tax is different depending on the circumstances, tax impacts both the business and personal decisions made by Canadians every day. Further, as can be inferred from the above, Canadian tax law is not straightforward. Business decision makers need to be able to identify when taxation might impact operating, financing or investing decisions. Complicating matters is the fact that taxation mixes economic soundness with political expediency – tax laws can result from either in varying combinations. In other words, a tax law might make sense from an economic perspective but may not be politically acceptable, and vice versa. The objective of taxation is to fund the government’s expenditures. According to the 2022/23 Annual Financial Report of the Government of Canada (YE March 31), in 2022/23 the federal government spent $483.1 Billion. The bulk of this money is transferred directly to the provinces. However, the following is a partial indication of where the money ends up. Category ~$ Billions ~% National Defense, Crown Corporations, Other Direct Programs 129.4 23.6 Elderly Benefits 69.4 15.1 Child Care Benefits 24.6 7.5 Public Debt Charges 35.0 7.6 Employment Insurance 21.8 4.7 Transfers for health and other social programs 63.1 19.8 Other transfers 99.2 21.7 Other Expenses 40.6 8.4 Total 483.1 100.0 1 According to the same report, Canadian federal revenues were derived from the following sources (creating a deficit of $35.3 Billion): Source ~$ Billions ~% Personal Income Tax 207.9 46.4 Corporate Income Tax 93.9 21.0 Non-resident Income Tax 13.2 2.9 Goods and Services Tax (GST) 45.9 10.3 Other taxes and duties 18.3 4.1 EI Contributions 26.9 6.0 Non-tax revenues 33.6 7.5 Proceeds From Pollution Pricing 8.1 1.8 Total 447.8 100.0 Tax Policy Taxes provide the government with the revenues it needs to operate. In setting tax policy, governments must consider several factors. The first is to choose amongst the various forms of taxes: Head tax – flat tax on every individual over a certain age Income tax – tax on the income of a taxpayer Wealth tax – tax on the net worth of a taxpayer (could be called a capital tax) Consumption tax – tax on the consumption of either a specific, or any, commodity Value Added Tax (VAT) – tax on the value added to a product or service by the taxpayer User tax – tax on the use of a resource or service (e.g. bridge, highway, hospital) Transfer tax – tax imposed when specified property is transferred from one taxpayer to another (e.g. land transfer, business transfer, estate transfer) Tariff – tax or duty imposed on specific goods, usually imports, to make prices competitive with domestically produced goods Canada uses most of the above – income tax on all individuals and businesses, wealth tax on certain businesses, consumption tax (GST, gasoline/tobacco/alcohol taxes), user tax (licences, passports), transfer tax (real estate, business sales) and tariffs. Principles of Fair Tax Horizontal equity – people at the same economic level are treated the same, in terms of tax owing Vertical equity – people at higher economic level pay a greater share of tax (greater capacity to pay) Neutrality – tax treatment does not alter economic decision making (i.e. tax does not cause poor or less desirable economic decisions owing to differing tax treatment for alternatives being considered) Adequacy – tax system must meet the funding requirements of the government Flexibility – tax system must be flexible enough to meet changing economic or social conditions Certainty – taxpayers must know in advance the tax consequences of any transaction (in order to plan), the amount of tax and the deadline for payment of tax Simplicity – taxpayers must be able to understand the tax system and report their tax owing, without seeking outside advice Low cost – the cost of administering and collecting tax should be as low as possible 2  Competitive Globally – given the mobility of individual and corporate taxpayers, a tax system must be competitive globally or risk seeing more talented taxpayers leave for more tax advantageous countries The Canadian income tax system scores well in some areas (cost, vertical and horizontal equity, competitive corporate taxes) but is somewhat lacking in others (simplicity, certainty, competitive individual taxes). Canadian Legislative Overview The Income Tax Act (hereinafter “the Act”) is the primary piece of legislation that governs federal income taxation in Canada (each province has its own provincial act as well). The Act is split into Parts (18 in total – Part 1 is Income Tax), Divisions, Subdivisions and Sections, and is over 3,000 pages long. As an illustration of how complex it is, the table of contents is 31 pages long. The Canada Revenue Agency (CRA) is responsible for administering and enforcing the Act, and publishes several documents to aid taxpayers in interpreting the Act. The Income Tax Regulations are part of the law and handle various specific situations, definitions, etc. in carrying out the provisions of the Act. Examples include the meaning of employer, employee, pay period, etc. The Income Tax Application Rules (ITARs) are a set of rules that provide for the transition from the pre-1972 Act to the post-1972 Act, especially the introduction of capital gains taxes. International Tax Conventions are pieces of legislation that Canada has negotiated with other countries to govern cross border transactions, and to reduce the potential for double taxation or tax avoidance. Note that these rules supercede the rules in the Act. Information Circulars (denoted as IC#__) are CRA publications explaining administrative and procedural matters associated with the tax system such as a tax audit, electronic record keeping, acquiring an advance income tax ruling, etc. Interpretation Bulletins (denoted as IT#__) outline the CRA’s interpretation of specific sections of the tax law, such as determining residence status, valuing barter transactions, deductibility of losses, etc. Neither ICs nor ITs have the force of law. In Northwest Hydraulic Consultants vs. Her Majesty the Queen, Chief Justice Bowman explained that if a judge were to rely on either ICs or ITs they would be relying on one party’s interpretation of the law, which would not really make the court an independent arbitrator of the law. This raises the role of case law. Taxpayers file tax returns and the CRA accepts or rejects the taxpayer’s computation of tax owing. A taxpayer who disagrees with the CRA’s response will start with the filing of a Notice of Objection within 90 days and wait for the CRA to review the matter. In extended disputes, the matter will be resolved by the courts. The level of the courts involved in tax disputes are (from lowest to highest): the Tax Court of Canada (referred to in cases as T.C.C.), the Federal Court of Appeal (F.C.A.) and the Supreme Court of Canada (S.C.C.). In rendering decisions at each level, the court gives the facts of the case and its rationale for the decision, often referencing previous decisions and in some cases, even decisions that were made in other countries. Although the facts in any case are rarely exactly the same as a prior case, these decisions do set precedents for subsequent decisions. As such, taxpayers and their advisors must consult case law for guidance in interpreting the Act. Proof and Appeals Since Canada has a self-assessment system of reporting for tax purposes, in any dispute, it is the taxpayer who must prove that an assessment is incorrect, since it is assumed that the taxpayer has access to all of the records. 3 This highlights the importance of keeping good records for tax purposes. Also, the standard of proof is that of the balance of probabilities rather than the beyond all reasonable doubt used in criminal cases. As indicated above, a taxpayer who disagrees with the CRA’s Notice of Assessment has 90 days from the date of mailing of the assessment notice to file a Notice of Objection (must be in the CRA’s offices by the end of the 90th day). See: http://www.cra-arc.gc.ca/E/pbg/tf/t400a/t400a-12e.pdf for the form. A taxpayer who disagrees with the CRA’s response to the Notice of Objection has 90 days from the date of the decision to appeal to the Tax Court of Canada (T.C.C.). The taxpayer has the option of an informal or general procedure if the amount of tax owing is $25,000 or less, or the losses in question are $50,000 or less. Note that if the taxpayer chooses an informal procedure, they may not appeal any questions of fact to a senior court. Informal decisions are not used as precedents in subsequent cases. However, a taxpayer who loses an informal appeal cannot be asked to pay court costs as part of the settlement, whereas it can be part of the settlement in a general procedure. A taxpayer, or the CRA, who disagrees with a T.C.C. decision has 30 days to appeal to the Federal Court of Appeal (F.C.A.). This is normally the final destination for most cases, and certainly for questions of fact alone. However, there is an appeal provision to the Supreme Court of Canada. Typically, the S.C.C. only agrees to hear cases of legal interpretation, and rarely hears more than 2 or 3 cases per year. Filing Tax Returns and Paying Taxes Corporations must file a tax return every year regardless of whether or not they earned taxable income. The tax return is due six months after their fiscal year-end (note that the Act specifies that a fiscal year may contain no more than 53 weeks). Since most corporations have a December 31st year-end, most tax returns are due June 30th of the following year. As for the payment of taxes, corporations are generally required to make monthly instalments toward their balance owing, with the final balance due no later than two months following their fiscal year-end (for corporations qualified as small business final balance due date is three months).(NOTE: The only exception monthly installment requirement is when the income tax payable for the current year, or the income tax payable in the first preceding year, are $3,000 or less). The monthly instalments are due on the last day of every month and can be calculated as any of the following options: i. 1/12 of the estimated tax that will be owing in the current fiscal year, or ii. 1/12 of the actual tax paid for the immediately preceding fiscal year, or iii. Two instalments of 1/12 of the tax paid in the second preceding year, followed by 10 instalments of 1/10 of the amount by which the tax paid in the immediately preceding year, exceeds the sum of the first two instalments Example: A corporation that paid $48,000 in tax in 2010, $84,000 in tax in 2011 and estimates its 2012 tax bill to be $96,000 has the choice of the following for its 2012 instalments: i. $8,000 per month, or ii. $7,000 per month, or iii. 2 payments of $4,000 followed by 10 payments of $7,600 (1/10 * (84,000 – 2*4,000)) The total cash paid in Alternative 3 is the same as the cash paid in Alternative 2 but there is a slight benefit in that the first two payments are much lower. 4 Interest is imposed on any unpaid balances or overdue instalments. The rate is computed by reference to a government prescribed Base Rate, set every quarter. The Base Rate is set based on the effective yield on three month Government of Canada treasury bills, during the first month of the preceding quarter. The rate is usually announced a few weeks prior to the start of any quarter. It is currently at 5%. The rate charged on overdue taxes is the Base Rate + 4%, or currently, 9%. The rate credited to corporate taxpayers on overpaid amounts is the Base Rate (for individuals, the rate paid is the Base Rate + 2%). There is a late filing penalty imposed as follows: a) For first time offenders, the penalty is 5% of the tax that was unpaid at the filing date + 1% for each complete month the amount remained outstanding up to a maximum of 12 months (in addition to interest charged) b) For repeat offenders (i.e. have filed late in any of the three preceding years), the penalty is 10% of the tax that was unpaid at the filing date + 2% for each complete month the amount remained outstanding up to a maximum of 20 months (in addition to interest charged) There is usually no penalty on late instalments unless the amounts are large. In these cases the penalty can become fairly harsh. Also note that interest paid with respect to taxes owing is not tax deductible, meaning the after-tax interest cost will end up being much higher than a corporation would pay to a traditional lender (e.g. vs. the rate that would be paid on a conventional bank line of credit). A taxpayer that fails to report income must pay a penalty of 10% of the income, if there had been a failure to report in the previous 3 years. For taxpayers that under-report income either knowingly or due to gross negligence, the penalty is 50% of the increased tax liability (minimum $100). The Act also allows for the imposition of a fine of $1,000 to $25,000 or both the fine and imprisonment for up to 12 months for failure to file a return (i.e. instead of the penalties outlined above). For tax evasion, there is a fine between 50% and 200% of the tax sought to be evaded, or both the fine and imprisonment for up to two years if convicted of: Making a false statement on a return Destroying books and records* Falsifying books and records Willfully attempting to evade tax Conspiring to commit any of the above Note that for tax evasion, the Attorney General can elect to prosecute by indictment and therefore is able to impose fines of 100% to 200% of the tax evaded and imprisonment for up to 5 years. * There is a requirement set forth in the Act for all taxpayers to maintain adequate books and records, without a definition of adequate. In an Information Circular however, the CRA stipulates that this would include as a minimum invoices, receipts, contracts, bank statements and cancelled cheques (or electronic images of them). The books and records must be kept at the taxpayer’s place of business for a period of six years from the end of the taxation year to which they relate. Budgetary Process Insofar as amendments to the Income Tax Act, the federal Department of Finance receives public submissions and sources all proposals for change. The Minister of Finance will discuss such proposals with the Prime Minister and Cabinet prior to presenting a “Notice of Ways and Motion to amend the Income Tax Act” to the 5 House of Commons. Once approved a bill is introduced, it is read in the House of Commons, then reviewed by the Standing Committee on Finance and Economic Affairs, then read in the House of Commons and the Senate before receiving Royal Assent by the Governor General. Tax Planning vs. Tax Avoidance vs. Tax Evasion Clearly all taxpayers want to pay as little tax as possible. In assessing whether a taxpayer has reduced their tax bill through legal or illegal means, the courts generally look at whether the taxpayer’s actions clearly violate the law, were done for bona fide business reasons and/or whether the reduction in taxes owing reflect the object and spirit of the law. Tax Planning occurs when the taxpayer organizes their affairs in a way that is perfectly legal, makes sense from a business purpose and is within the object and spirit of the law. Tax evasion occurs when a taxpayer knowingly avoids taxes by failing to report income, or falsely reporting deductions, etc. This is illegal, is a criminal offence and is punishable by fines, penalties, payment of taxes owing plus interest, and a possible prison sentence. In between these two extremes is Tax Avoidance. In this case, the taxpayer has legally circumvented the law by arranging their affairs in a way that reduces or eliminates taxes owing through transactions that do not reflect the business reality. The end result violates the spirit and intent of the Act. In these cases, the CRA will usually challenge the scheme through any means possible. The Act does contain a general anti-avoidance rule (referred to as GAAR) in which the government can ignore transactions or arrangements that it finds abusive. If the CRA is successful in challenging the scheme, the taxpayer must pay the taxes owing as if the transactions were ignored, plus interest and often plus penalties. COMMENT ON USE OF GAAR Form vs. Substance Case law has provided precedents in the interpretation of the Act and a taxpayer’s actions. Where it is consistent with the wording and objective of the law, substance will prevail over form. In other words, the CRA looks at the business reality or substance of the transaction. When parties to a transaction clearly intend that the legal rights and obligations are different from what the act and documents appear to create, the courts can declare the transaction to be a sham, and disregard the form of the transaction in favour of the substance. Calculation of Income In calculating income, the Act uses an aggregation approach. There are four basic types of income and each are calculated separately. Specific rules are used to calculate each of income from employment (only applicable to individuals), income from business and income from property separately (losses can be used to offset income from these sources) and then added to capital gains (less capital losses but capital losses cannot be used to offset income from non-capital sources), to arrive at total income for tax purposes. There are further adjustments made in Sections 110-114 depending on the individual’s or corporation’s circumstances (RRSPs, charitable donations, tax loss carryovers, etc.) to arrive at taxable income. The Act does not define income. Although GAAP (Generally Accepted Accounting Principles) are to be referenced, the courts have stated that the objectives of an accountant are not the same as the objectives of the tax act. One is to present a conservative view of profitability vs. the other’s objective of raising public revenues in a fair and equitable manner (Symes vs. The Queen). The wording of the Act suggests that principles of commercial trading ought to be relied on more heavily. At the end of the day, the rules in the Act result in income for tax purposes being different from income for financial accounting purposes, and in some cases, dramatically different. 6 Note that the Act distinguishes between amounts received on account of income from amounts received on account of capital (sale of the tree vs. sale of the fruit). The difference in terms of the impact on taxes owing is significant (in general, 50% of a capital gain is included in taxable income vs. 100% of income gains). Not surprisingly, this has produced a substantial number of court cases. In general, a capital asset is one that produces income, either from holding it or using it. Constructive Receipt This principal states that when a taxpayer has beneficially received an amount or it has become receivable, even though it has not been actually received, the amount is included in income and tax is payable. For example, accounts receivable are included in income. Note that there can be no restriction on the taxpayer’s access to it. For example, the part of accounts receivable relating to sales tax is not to be included in income since that amount must eventually be submitted to government. GST/HST Overview The Goods and Services Tax (GST) was created January 1, 1991to replace the federal sales tax. Five provinces (Ontario and the four Maritime provinces) combine the GST with their provincial sales tax to create the Harmonized Sales Tax (HST). The CRA administers the GST/HST. Most businesses pay GST on their purchases and then use those purchases to create a product for sale. They then collect GST from their customers, calculated on the final sales price. Since GST is only intended to be charged once, when the business remits GST to the government, it deducts any GST paid on products or services used to create the final product (referred to as input credits). Supplies of goods or services are either considered taxable supplies (includes some that are zero rated such as prescription drugs, medical devices, groceries, supplies of agricultural and fishing products, and exported goods and services) or exempt supplies. Suppliers of exempt supplies are not required to collect GST. These include donated goods and services sold by non-profit institutions, financial services, rental of residential property, most health care services and the supply of fine metals (gold, silver, platinum). Note that suppliers of exempt supplies may have to pay GST on purchases but cannot claim input credits. Supplies include the sale or rental of goods, the provision of services, any transfer of real property, copyrights, patents, barter and exchange transactions, as well as gifts. Note that to be a taxable supply it must be made as part of a commercial activity. Examples include sale of new housing, sales and rentals of commercial property, candy and soft drinks, clothing, footwear, taxis, hotels, barbers and hairstylists, car sales, car rental and car repairs. Liability for Tax In assessing who must pay tax, countries generally choose between citizenship (the U.S. basis), residency and domicile. In Canada, any person resident in Canada must pay tax on their worldwide income, i.e. all income earned during the year in any country. Note that a person is defined to include individuals, corporations and trusts. Residency is not a term defined in the Act so understandably there have been numerous court cases on the issue and the CRA has published the criteria they use in determining residence. In assessing residency for individuals (included here for interest – the course is focussed on corporations), the criteria that the CRA considers include: Significant residential ties (most important): dwelling place, spouse and dependants (i.e. location of each) 7 Secondary residential ties: personal property in, social ties to or economic ties to Canada; landed immigrant status or work permit, hospital or medical coverage from Canada, seasonal dwelling place, Canadian passport, member of Canadian union or profession Other ties: Canadian mailing address, safety deposit box or post office box, stationery or business cards with Canadian address Nature of absence from Canada: evidence of intention to permanently sever ties to Canada, regularity and length of visits to Canada, residence ties to another country Normally, an individual is either a resident or non-resident. However, in the year an individual becomes, or ceases to be, a Canadian resident, they will be a part-time resident – resident for part of the year and non- resident for the other part. Note that a non-resident must pay Canadian tax as well but only on their taxable income earned in Canada. This will be income from employment, from a business and from the disposition of any property. A part time resident pays tax on their worldwide income for the part of the year they were resident, and tax on their Canadian income for the part of the year they were non-resident. Assessing residency for corporations is usually straightforward. Any corporation incorporated in Canada after April 26, 1965 is deemed to be a resident of Canada. For corporations incorporated before that date, they are resident if they carried on business in Canada after that date or if common law principles indicate they are a Canadian resident. Corporations resident in Canada must pay tax on their worldwide income. Common law principles include: location of central management and control (the mind and management), and location of books and records. The courts have found that the mind and management occurs where the highest corporate decisions are made, which could be different from the day to day decisions. Generally speaking, the location of the board of directors’ meetings is often the most important factor. Carrying on business in Canada is determined by: the existence of a permanent establishment (with appropriate signage), keeping inventory in Canada, maintaining employees in Canada (vs. independent contractors) and maintaining bank accounts and records in Canada. Carrying on a business implies a continuous activity. A non-resident corporation who solicits orders from Canada could be found to be carrying on a business in Canada. If the offering for sale is handled through an agent or employee, who is able to conclude contracts in the name of the non-resident, they are carrying on business in Canada. If however, the offering for sale is handled through an independent contractor, then they are not carrying on business in Canada. Carrying on a business includes: producing, growing, mining, creating, manufacturing, fabricating, improving, packing, preserving, or constructing, in whole or in part, anything in Canada; disposing of real property in whole or in part, and soliciting orders through an employee (whether or not the transaction is completed in Canada). Note that a tax treaty can override the foregoing. The Canada-U.S. tax treaty stipulates that a U.S. business is not subject to Canadian tax on its business profits unless it has a permanent establishment in Canada, and then, it is only subject to tax on the business income associated with that permanent establishment. 8