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Should You Incorporate Your Personal Service Activities?

In the past, individuals considering incorporating their personal services activities were given a warning that the corporation could be viewed as carrying on a personal services business, which would result in negative tax consequences. The income earned within the corporation would be taxed at the top corporate rate, deductions would be limited, and a higher overall tax rate would apply once the income was withdrawn by way of dividends from the corporation.

With corporate tax rates decreasing and lower personal tax rates applicable to eligible dividends, the strategy of incorporating personal services activities should be revisited.

What is a personal services business?

Subject to specific exceptions, the Income Tax Act describes a personal services business carried on by a corporation as a business of providing services where the incorporated employee, but for the existence of the corporation, would reasonably be regarded as an employee of the business to which the services are provided. Whether or not an individual would reasonably be regarded as an employee of the business to which the services are provided is a question of fact, and is based on such factors as the degree of control over the activities of the individual and the ownership of tools and equipment.

Tax consequences

There are two main tax consequences for corporations carrying on personal services businesses:

1. Personal services business is excluded from the definition of active business in the Income Tax Act. As such, income earned from carrying on a personal services business is not eligible for the small business deduction and is therefore taxed at the top corporate rate. Consequently, dividends paid by the corporation could be identified as eligible dividends, which are subject to an enhanced dividend tax credit.

2. The Income Tax Act limits deductible personal services business expenses to:

the salary, wages or other remuneration paid in the year to an incorporated employee of the corporation;
the cost to the corporation of any benefit or allowance provided to an incorporated employee in the year; and
any expenses incurred to negotiate contracts or collect amounts owing for services rendered.


Tax planning opportunities

Although a corporation carrying on a personal services business is not able to benefit from the small business deduction, there exists an opportunity to defer tax by retaining income in the corporation. That opportunity will increase further as corporate tax rates decrease over the next few years.
The actual amount of tax deferral depends upon the province in which the tax is paid. In Ontario and Alberta, for example, the 2010 deferral would be approximately 15% and 11% respectively.

Incorporating a personal services business may also provide income-splitting opportunities by providing a dividend stream through the ownership of shares by family members. It is important, however, to consider the various anti-avoidance provisions in the Income Tax Act.

Summary
As corporate tax rates continue to drop, the incorporation of your personal services activities should be considered in conjunction with your overall tax planning. Contact your Collins Barrow advisor to determine whether incorporating your personal services activities is appropriate for you.

 

 

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Tax-Free Savings Account Changes

On January 1, 2009, the very popular tax-free savings account (TSFA) became available to Canadians who are 18 years of age or older. The TFSA allows individuals to make non-deductible contributions of up to $5,000 per year, and any income or capital gains realized in the account are not taxable and may be withdrawn from the account at any time without tax. Furthermore, if the account holder makes a withdrawal from the plan, he or she may return the funds to the TFSA in a subsequent taxation year to "top it up."

In order to prevent abuses of the TFSA, the existing legislation contains provisions to penalize individuals who make contributions in excess of the $5,000 annual limit. The penalty is levied on the amount of the over contribution at the rate of 1% per month.

In addition, there are restrictions as to the type of investments that a TFSA can purchase. In general, these restrictions parallel the rules for registered retirement savings accounts, which limit investments to shares and debt of publicly traded corporations and mutual funds, as well as Guaranteed Investment Certificates and term deposits. The legislation also prohibits investments in entities in which the account holder has a significant interest (10% or more), or with which he or she does not deal at arm's length - generally referred to as "prohibited investments." An individual who owns a TFSA that acquires a non-qualified or a "prohibited investment" is currently subject to a penalty of 50% of the fair market value of the property. This penalty is refundable if the investment is disposed of by the end of the year following the year in which the investment was acquired, except where the individual knew or ought to have known that the investment was ineligible. Furthermore, income and capital gains realized on "prohibited investments" are subject to a tax of 150% of the tax that would be payable by the TFSA were it not for its special tax-free status. This tax is payable by the individual. (The 50% mark up is a proxy for provincial tax payable, since the provinces do not have similar provisions.) Finally, a TFSA that earns income or capital gains from non-qualified investments (other than "prohibited investments") is itself subject to tax on that income.

Notwithstanding these rather onerous penalties, some tax planners devised creative schemes to use TFSAs to generate income and capital gains that exceed the penalties. These schemes generally resulted in assets remaining in the TFSA in excess of the prescribed annual limits. These assets then continued to earn income on a tax-free basis within the account, and could also be withdrawn later without tax.

As a result, on October 16, 2009, the Minister of Finance announced new provisions to restrict perceived abuses of TFSAs. Specifically, the following additional penalties will be charged:

1. Income and capital gains earned on over contributions and on "prohibited investments" will be taxed in the individual's hands at the rate of 100% (i.e. the entire amount of the income).
2. The existing tax on income and capital gains from "prohibited investments" will be cancelled.
3. The tax payable by the TFSA on income and capital gains earned on non-qualified investments (other than "prohibited investments") will be extended to include income on that income, and so on, thus restricting tax-sheltering of this ancillary income in the future.
4. Withdrawals of amounts in respect of over contributions, prohibited investments, non-qualified investments, and income earned on those amounts will not constitute "distributions" for TFSA purposes and, as a result, will not create additional TFSA contribution room (i.e. they cannot be considered in the "top up" calculation).

Finally, it seems that some individuals engaged in "swap" transactions, whereby assets are purchased and sold between a TFSA and another account, such as a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF). When structured properly, these "swaps" allowed transfers of value from the RRSP/RRIF to the TFSA without paying the tax that would otherwise be payable on an RRSP/RRIF withdrawal. The new provisions will impose a penalty of 100% of the TFSA amounts reasonably attributable to these types of asset transfer transactions.

The new provisions will be applicable to all transactions after the date of the announcement. Draft legislation has not yet been introduced. Contact your Collins Barrow advisor to find out more about how these new TFSA rules will affect you.

 

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Voluntary Disclosure – Providing Tax Closure

If you have not filed all of your income tax, GST or other tax returns, or have filed them incorrectly by claiming ineligible expenses or failing to report all of the income you received, the following information may be of interest to you.

The Canada Revenue Agency (CRA) has a program that is designed to encourage taxpayers to come forward voluntarily to correct previous omissions in their dealings with the CRA. The program is called the Voluntary Disclosure Program (VDP). If the CRA accepts a disclosure under the VDP, the taxpayer will still have to pay the taxes and related interest charges, but will not incur the penalties or possible prosecution to which he or she would otherwise be subject.

The VDP received significant press recently when it was disclosed that former Prime Minister Brian Mulroney had used the program to report payments that he had received in a previous year and failed to report as income. Some of the features of the VDP from which Mr. Mulroney was reported to have benefited are no longer available, but the main purpose and benefit of the program remain.

To be accepted under the VDP, a valid disclosure must meet the following four conditions:

It must be voluntary, which means that the submission must be made before the CRA or any other authority has initiated contact with the taxpayer.
It must be complete and accurate. If full disclosure is not provided, the penalties may not be waived.
It must involve a penalty. A late filing penalty is the most common, but this could also include discretionary penalties for omissions or gross negligence.
It must include information that is at least one year past due.

A submission under the VDP must be made in writing and must be mailed or faxed to the CRA tax service office that has jurisdiction over the area in which the taxpayer resides. This can be done using Form RC199 or by a letter containing similar information as is required by Form RC199. The information to be submitted includes such things as name and address of the taxpayer, disclosure of the reason for the submission, and an explanation of how the four conditions for a valid disclosure (noted above) have been met. The date that the CRA receives the written submission becomes the effective date of disclosure. From this date forward, provided that the submission is determined to be a valid disclosure, the taxpayer is granted protection against penalties and possible prosecution regarding the issues identified in the disclosure. It is therefore important to make the submission as soon as possible; waiting could result in the CRA initiating contact, rendering the taxpayer ineligible for the program.

There may be circumstances in which the taxpayer cannot submit all of the information or documentation immediately. The CRA generally will provide additional time of up to 90 days after the effective date of disclosure in which to complete the submission. If the information is not provided within the required time period, the CRA may commence action and the submission would not be a valid disclosure, and penalties and possible prosecution may result.

The CRA will review the submission and determine if the four conditions have been met for a valid disclosure, and will then assess the tax and interest owing.

The submission can be made on a "named" or on a "no-name" basis. A no-name submission is made by a representative of the taxpayer with the taxpayer's identity withheld initially. In such cases, the taxpayer may be undecided as to whether to proceed with the disclosure. Informal, non-binding discussions are undertaken with a VDP officer to provide the taxpayer with a better understanding of the possible tax consequences of his or her situation and the relief available under the VDP. The taxpayer will then have to decide either to come forth on a named basis or not to proceed with the submission, in which case he or she would remain at risk of the CRA discovering the omission and applying the related penalties and possible prosecution. If the taxpayer decides to come forth on a named basis, his or her identity must be provided to the CRA within 90 days of the effective date of disclosure or the file will be closed.

The tax system has become extremely complex and it is not uncommon for taxpayers to make inadvertent errors or to miss filing an information return. The returns required for reporting foreign assets, subcontractor payments made in the construction industry, and non-profit information returns are common examples. When filed late, these forms carry penalties of up to $2,500 per year, but if filed under the VDP the penalties can be waived.

If you become aware of an omission in your dealings with the CRA, contact your Collins Barrow representative to determine if the Voluntary Disclosure Program can help you avoid the possible penalties.

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Estate Planning: The Finer Points - Direct Bequests or Transfers to Your Spouse

Most estate plans provide that all property is to be left to the surviving spouse on the death of the first spouse. Although well intended, this may not produce the best tax result. At times, it is better to structure things differently for the surviving spouse and the entire family.

A little background knowledge of the Income Tax Act is necessary. The funds held at death in all RRSPs and RRIFs are taxable in the year of death as income. This does not apply to funds that are transferred to a surviving spouse. These plans can be "rolled over" to the surviving spouse. Capital assets, such as mutual funds, stocks, bonds, and real estate that is not the principal residence, may be subject to capital gains tax if the fair market value of the assets at death is greater than their adjusted cost base. Valuable personal property, like jewelry, art, china, silverware, coins and stamps, is also subject to similar rules and can be rolled over without tax consequence to the surviving spouse.

Despite these obvious tax benefits, there are other options to leaving assets to a surviving spouse that might provide better tax results.

Spouse or common law partner trust

The Income Tax Act provides that all capital assets can be transferred to a spouse or common law partner trust created by a will. This may also occur on a rollover basis, without immediate tax consequences. The spouse must be entitled to all of the income of the trust during his or her lifetime, and be the sole beneficiary of the capital of the trust during his or her lifetime. A spousal or common law partner trust created by a will that satisfies these conditions will benefit from a separate graduated tax rate, saving up to about $10,000 to $12,000 in ongoing investment income. Rather than being taxed at high marginal rates (and perhaps resulting as well in a claw-back of Old Age Security) in the surviving spouse's hands, the income may be taxed at the lower marginal rate of the spouse or common law partner trust.

Proper drafting of the trust documents must address a host of related issues, including:

Loans and transactions by the trust with persons other than the spouse or common law partner, during lifetime, must be on reasonable commercial terms, otherwise it may be argued that the trust is not solely for the benefit of the spouse or partner.
the assets must vest indefeasibly in the trust within 36 months of the death. This requirement can impact on shareholder agreements.
The disposition of the remainder of the trust on the death of the surviving spouse must be addressed, and it may be advisable to include a limited power of appointment in favor of the surviving spouse. The CRA has expressed some concern that where a person is sole trustee, with absolute discretion, and is the sole beneficiary for a period of time, there may be a legal question as to whether or not a trust exists.(see doc 2007-0256521E5).


Family Trusts

If there are insurance proceeds or cash on death, it may be best to leave these to a broader trust for the possible benefit of the whole family. Although such a trust is not a spousal trust, it can also benefit from a separate graduated tax rate if set up and funded on death. This may provide an additional set of marginal rates, and additional flexibility. It may be best to leave discretion to the estate trustee to allocate assets to the spouse or partner trust and to the family trust after death, as specific assets will change over time. It is necessary to provide for the distribution of the Family Trust on the death of the surviving spouse, and perhaps to leave a limited power of appointment to the surviving spouse to permit flexibility.

RRSPs and RRIFs to children

RRSPs and RRIFs can be rolled over not only to surviving spouses or common law partners, but also to dependant children or grandchildren (dependants with physical or mental impairment are subject to special rules). For example, a surviving spouse or partner with young children and employment income may be a candidate for this treatment. If the surviving spouse wishes to access the RRSP funds, he or she will be taxed fully at his or her marginal rate. However, if the RRSPs are rolled over to dependant children who have no other income, no tax will be paid on about $10,000 per child per year.
Since there can be a lot of tax payable on death, it is important to structure clients' affairs properly. Accountants and tax lawyers should work together to ensure that proper, complete estate tax planning advice is given.


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Shareholder Loans

Under the shareholder loan provisions of the Income Tax Act, a shareholder of a corporation who become indebted to the corporation or to any related corporation is required to include the amount of the debt in income, unless the debt falls within one of the exceptions discussed below.

The provisions can also apply to a person who does not deal at arm's length with the shareholder, if such person becomes indebted to the corporation. Thus, for example, if the shareholder's spouse receives a loan from the corporation, the amount of the loan will be included in the spouse's income, unless one of the exceptions applies.

The amount include in the shareholder's income (or the non-arm's length person's income) is treated as ordinary income and not as dividend. Accordingly, the amount is not eligible for the dividend tax credit. Furthermore, the corporation will not be allowed a corresponding deduction, so that there will normally be double taxation.

Fortunately, there are some exceptions to the shareholder loan provisions. Where an exception applies, the loan or debt is not included in the shareholder's income. The major exceptions are described below.

Exceptions where shareholder loan rules not applicable

Loans made for specified purposes

A loan from a corporation is not included in an individual's income if:

1. The individual is an employee of the lender corporation but not a specified employee. In general terms, a specified employee is an employee who owns 10% or more of the shares of any class in the lender corporation or in a related corporation;
2. the individual is an employee of the lender corporation or is the spouse or common-law partner of the employee, and the loan is used to acquire a home;
3. the individual is an employee and the loan is used to purchase newly issued shares of the employer corporation or of a related corporation; or
4. the individual is an employee and the loan is used to acquire a motor vehicle to be used in the performance of the employee's duties of office or employment.

In order for any of these exceptions to apply there are two additional requirements.

First, it must be reasonable to conclude that the employee (or the employee's spouse or common-law partner, as the case may be) received the loan because of the employee's employment and not because of any person's shareholdings.

Second, at the time the loan was made, bona fide arrangements must have been made for repayment of the loan within a reasonable time.

Loans made in ordinary course of corporation's business

The shareholder loan provisions do not apply if the loan or debt arises in the ordinary course of the corporation's business and bona fide arrangements are made, at the time the loan or debt arises, for repayment within a reasonable time.

The ACCRA take the view that trade debts that arise in the ordinary course of a business from the sale of goods by the corporation to the shareholder, on the same terms for payment as sales to other customers of the corporation, will fall within this exception.

If the corporation is in the business of lending money, the CCRA takes the view that a shareholder who receives a loan from the corporation will fall within this exception if the terms and conditions attached to the loan are the same as for another person who does not own, or is not related to someone who owns, shares in the corporation.

Repayment of loan by the end of the corporation's next taxation year

A shareholder loan is not included in income if it is repaid within one year after the end of the corporation's taxation year in which the loan was made. Accordingly, in some circumstance, the loan will not have to be repaid for almost two years under this exception. For example, if a corporation's taxation year-end is December 31 and a shareholder loan was mad on January 1, 2003, the shareholder will have until December 31, 2004 to repay the loan under this exception.

This exception does not apply if it is reasonable to conclude that the the repayment of the loan was part of a series of loans and repayments. For example, you likely will not be successful if you try to use this exception two or three times in a row, by borrowing an amount, repaying the amount in the next year, re-borrowing the same amount, and so on.

However, repayments of shareholder loans that result form the payment or crediting of dividends, salaries, or bonuses from the corporation to the shareholder are not normally considered to be part of a series of loans or other transactions and repayments.

Deduction when loan repaid

If the shareholder repays part or all or a loan that was previously included in income under the shareholder loan provisions, the amount of the repayment is deductible. However, the deduction is allowed only if it is clear that the repayment of the loan was not part of a series of loans and repayments.
Deemed interest benefits for low-interest loans

If a shareholder loan is not included in the shareholder's income because of one of the exceptions, the shareholder may nonetheless be taxed on a deemed interest benefit if the loan bears a less than adequate rate of interest.

This "deemed interest benefit" rule provides that the shareholder/debtor must include in income the amount, if any, by which 1) the interest computed on the loan using the prescribed rate of interest in effect during the year, exceeds 2) the total interest paid on the loan during the year or within 30 days after the end of the year.

Note that the shareholder loan provisions and the deemed interest benefit provisions cannot apply at the same time. In other words, you can be taxed under one of the provisions but not both.

 

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