The Financial Advisor Guide to Taxation Self-Study Course # 5

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1 The Financial Advisor Guide to Taxation Self-Study Course # 5

2 OVERVIEW Upon completion of this course, you will be able to understand which income sources constitute earned income. You will study tax deductions and tax credits, and how they will affect your clients and prospects net income. We will look at how indexing can affect an individual s tax situation. You will be in a better position to tell the difference between being an employee of a company, and being self employed and at the same time know what deductions and write offs are available to your clients and prospects who are in a similar situation. The complex taxation of Life Insurance, Annuities, RRSP s, and Variable Contracts will be studied in a way that makes it simple to understand. You will have a working knowledge of Capital Gains, Capital Losses and the nuances of Canadian taxation. Where possible, we have updated the Taxation Rules & Regulations to reflect any changes for the 2015 and 2016 Tax years. INTRODUCTION Today, it is reasonable to believe that high taxes are here to stay. With the growing cost of government social services, high government indebtedness, and the high cost of infrastructure, we find ourselves being taxed at very high rates. To add to this, the taxation laws and regulations are forever changing. As an Advisor, Agent or Broker, you must develop a good working knowledge of the Canadian taxation system as it applies to the products and advice that you provide. Some of these purchases could include Life Insurance, Disability Insurance, RESPs, RRIFs, LIFs, Annuities or savings and investment contracts. Employee benefits or Corporate Retirement Plans can also attract some form of taxation. As their advisor, you are expected to know the general tax rules pertaining to each individual area. It is not necessary to get into the technical aspects of taxation with your clients or prospects, but knowing where to find the answers would be extremely beneficial to you as well as them. Remember that you are a part of their team that includes the Accountant (tax expert), and their Lawyer. 2

3 You may not have all the answers, but you must know who to refer them to. LOOKING AT INCOME TAX IN A GENERAL WAY Even though Federal income taxes were first introduced in 1917, the Income Tax Act has changed many times over the years. These changes are a direct result of changes in the government s views on monetary and fiscal policy. Of course, over the past few years the change in the global economy has had a direct impact on our taxes as well. The lion s share of the government s revenue comes from the taxes that you and your clients pay on a yearly basis. The Canadian Income Tax rules and regulations are one of great complexity and constantly shifting emphasis. Much of our planning process, whether it is Financial Planning or Estate Planning, centres on how to minimize tax for our clients and prospects without breaking the law. With this in mind, we still have to gain the greatest advantage in the investments and other products that we market to our clients and prospects. We must understand how Income Tax relates to their finances and investments as well as to the products we sell them. Even though we are not qualified to give tax advice, we must acquire a working knowledge of how it affects the market place we serve. Income tax must be paid on income received after allowable deductions have been taken into consideration. Individuals who are resident in Canada are liable for income tax on their worldwide income. Non-residents are liable on Canadian-source income (including income from employment in Canada and income from carrying on a business in Canada) and on capital gains derived from taxable Canadian property. Residence means the jurisdiction in which a person regularly, normally, and customarily lives. Indicators of residency include: ownership of a home in Canada, whether other members of the individual's family reside there, and membership in clubs and associations in Canada. Individuals present in Canada for periods totalling 183 days or more may be deemed resident. 3

4 The acquisition of permanent resident status for immigration purposes is a significant factor. Citizenship has little or no relevance to the question of residence for tax purposes. Individuals becoming residents are generally deemed to have acquired all property, other than taxable Canadian property, owned at that time at a cost equal to the current fair market value. Individuals ceasing to be resident are regarded as having disposed of their property, other than taxable Canadian property, at its current fair market value. Taxable Canadian property for this purpose is defined as including: Real property situated in Canada. Most capital property used in carrying on a business in Canada. Shares of a corporation (other than a public corporation) resident in Canada. Shares of a public corporation if, within the five years preceding disposal, the nonresident and persons with which the non-resident did not deal at arm's length owned at least 25% of any class of capital stock of the corporation. An interest in a partnership if, at any time during the twelve months preceding disposal of the interest, the fair market value of taxable Canadian property held by the partnership constituted 50% or more of the fair market value of all the partnership property. A capital interest in a trust (other than a unit trust) resident in Canada. A unit of a unit trust (other than a mutual fund trust) resident in Canada. A unit of a mutual fund trusts if, at any time during the five years immediately preceding the disposal, the non-resident and persons with whom the non-resident did not deal at arm's length owned at least 25% of the issued units of the trust. Property deemed to be taxable Canadian property. For example, the owner of the property may make an election to that effect when he or she ceases to be resident in Canada. Security has to be provided to Revenue Canada to cover taxes that would otherwise be payable. 4

5 PERSONAL INCOME TAX RATES Both the federal and provincial governments levy personal income tax. Provincial income tax is in most provinces is calculated as a percentage of federal income tax payable and is collected by the federal government on behalf of the province. For provincial income tax purposes, business income is apportioned between the provinces when individuals carry on business through permanent establishments in more than one province. Other income, however, is generally considered to have been earned in the province in which the individual resides at the end of the tax year, regardless of where it has actually been earned. Federal Income Tax Rates Canadian federal income tax is calculated based on taxable income, and then nonrefundable tax credits are deducted to determine the net amount payable. For 2016, every taxpayer can earn taxable income of $11,474 before paying any federal tax. The basic personal tax credit is calculated by multiplying the lowest tax rate by the basic personal amount. The 2016 tax credit is 15% x $ 11,474 = $1, The Department of Finance announced in November 2007 that the lowest federal tax rate would be reduced to 15%, and certain tax credits would be revised to compensate for the lower tax rates. The revised rates are being used on 2016 personal income tax returns provided by Canada Revenue Agency (CRA). The tables below have been revised to include the 15% tax rate and the basic personal exemption amount increase Federal Marginal Tax Rates 2016 Taxable Income Marginal Tax Rates Other Income Capital Gains Eligible Dividends Non-eligible Dividends First $45, % 7.50% -0.03% 5.24% $45,282 - $90, % 10.25% 7.56% 11.67% $90,563 - $140, % 13.00% 15.15% 18.11% $140,388 - $200, % 14.50% 19.29% 21.62% Over $200, % 16.50% 24.81% 26.30% 5

6 Federal personal income tax breakdown Statistics Canada recently published a study titled Federal Personal Income Tax: Slicing the Pie, which examines the breakdown of federal personal income taxes paid by high and low income earners in Canada. The data was merged with data from The Fraser Institute s Canadian Tax Simulator to produce the following information. A. Share of federal personal income tax paid Income group % of federal personal income taxes paid % with lowest incomes 6.7% 8.5% 40% with intermediate incomes 47.3% 43.4% 10% with highest incomes 46.0% 48.1% All Canadian tax filers 100.0% 100.0% B. Effective federal personal income tax rates Income Group Federal tax as % of income % with lowest incomes 4.30% 4.97% 40% with intermediate incomes 11.75% 9.83% 10% with highest incomes 17.79% 16.95% All Canadian tax filers 12.25% 11.00% C. Share of total income Income group % of total income % with lowest incomes 19.0% 21.7% 40% with intermediate incomes 49.3% 47.4% 10% with highest incomes 31.7% 30.9% All Canadian tax filers 100.0% 100.0% Provincial/Territorial tax rates for 2016 Under the current tax on income method, tax for all provinces (except Quebec) and territories is calculated the same way as federal tax. 6

7 Form 428 is used to calculate this provincial or territorial tax. Provincial or territorial specific non-refundable tax credits are also calculated on Form 428. Canadian federal and provincial/territorial income taxes are calculated separately, although on the same tax return, except for Quebec. The rates are combined here so that taxpayers can see the total tax rate being paid, including any provincial surtax. The combined tax rates in these tables are marginal tax rates, including any provincial surtax. Other income would include any income from employment, self-employment, interest from Canadian or foreign sources, foreign dividend income, etc. After the income tax amounts are calculated, non-refundable tax credits are deducted from the tax payable. Non-refundable tax credits include the basic personal amount, which is available to every taxpayer. A list of most of the non-refundable tax credits can be seen in the tables of federal, provincial and territorial non-refundable personal tax credits. Top Combined Federal/Provincial Tax Rates 2016 Province Provincial/Territorial Top Personal Rate Combined Top Marginal Rate Other Capital Eligible Income Gains Dividend Alberta 15.00% 48.00% 24.00% 31.71% British Columbia Manitoba New Brunswick Newfoundland & Labrador Nova Scotia Ontario PEI Quebec Saskatchewan NWT Nunavut Yukon

8 Combined rates reflect the following provincial surtaxes: Alberta no provincial surtaxes. British Columbia no provincial surtaxes. Manitoba no provincial surtaxes. New Brunswick no provincial surtaxes. Newfoundland no provincial surtaxes. Nova Scotia no provincial surtaxes. Ontario 20 per cent applies when Ontario tax exceeds $4,484; 36% applies when Ontario tax exceeds $5,739. PEI 10 per cent applies when PEI tax payable exceeds $12,500. Quebec no provincial surtaxes. Saskatchewan no provincial surtaxes. Northwest Territories no territorial surtaxes. Nunavut no territorial surtaxes. Yukon no territorial surtaxes. Note: All Canadian provinces and territories, except Quebec, have adopted a "tax on income" (TONI) system of calculating provincial personal income tax. Quebec continues to administer its own provincial taxes, as it has since How Does Indexing Affect Our Taxes? Inflation, a general rise in prices over time, creates problems for income taxation because it affects people s purchasing power their ability to buy goods and services. If people s income and the general level of prices both increase at the same rate over time, then people s real income the amount their income will buy remains the same. In other words, if your income doubled, but at the same time all prices doubled because of inflation, you would be no better or worse off. However, unless special actions are taken, under the existing progressive bracket rate schedule, the proportion of your income taken by taxes would increase. Increases in income due to inflation can push people into higher tax brackets, a phenomenon known as bracket creep. 8

9 In effect, inflation can increase people s tax liability without any change in tax law. Amounts subject to indexing include the various personal credits, the tax brackets for individuals and the thresholds for repaying government allowances, such as the Old Age Security. OAS Tax Figures (2016) Threshold at which the middle tax rate begins to apply. Threshold at which the top tax rate begins to apply. Threshold (Claw back) where Old Age Security commences to be repaid. Threshold where Old Age Security is eliminated completely $45,282 $200,000 $73,756 $119, Federal Personal Tax Credit Amounts Basic personal amount $11,474 Age amount (maximum) $7,125 Amount for eligible dependant $11,474 (maximum) Spouse or common-law partner $11,474 amount (maximum) Amount for infirm dependent over $6,788 age 18 (maximum) Pension Income (maximum) $2,000 Disability amount (maximum) $8,001 DETERMINING IF YOU ARE AN EMPLOYEE OR SELF-EMPLOYED? Business Relationship or Employer-Employee Relationship? Before you advise your clients and prospects in areas of taxation, you should determine which category of employment status they fall into. It helps to know whether they are an employee or self-employed. This gray area has for some time been under scrutiny in our business. Most of us are commission salespeople. There is no gray area when you deal with your clients or prospects, they are either an employee, or self-employed. 9

10 It is important to know this information before making your financial recommendations. There may be some tax advantages that would be beneficial to be one way over another. When it comes to taxation of income, the government has criteria that they will look at to see what type of income you have. Canada Revenue Agency (CRA) will usually look at four key areas: 1. Control As a rule, in an employer-employee relationship, the employer will control the way that work is done and what methods are used. Specific jobs are assigned, as well as the way in which the job is to be done. If an employer does not directly control the employees, but still maintains the right to do so, control will still exist. The Employer may control: Work hours. Quality of the work to be done. Any reports submitted to the employer. Any client lists and territories covered. Any training and development. If a business relationship exists, the employer will not usually have any control over the employee s workday. The employee is left on their own to decide how and what work will be done. 2. Ownership of Tools The amount for tools invested, Values of equipment and tools, Rental and maintenance of equipment and any tools. 10

11 In an employer-employee relationship, the employer will usually supply any equipment necessary for the employee to do their work. Costs such as any repairs, rentals, and transportation are also usually at the expense of the employer. In a business relationship, tools and equipment are supplied by themselves. If an employee purchases any tools or equipment necessary to do their job, it is at their own expense because they are self-employed perhaps contracted individuals. 3. Chance of Profit or Risk of Loss Does the employee / worker have any chance of making a profit? What are any risks leading to losses from bad debts, damage to equipment or materials or any delivery delays? Who covers the operating costs? In an employer-employee relationship, the employer alone would assume any risk of loss. An employee is entitled to receive his full salary or wages regardless of how much a company earns or loses. In a business relationship, self-employed individuals could profit or have a loss. They cover any operating costs alone. 4. Integration This area looks at the possibility of looking at the first three areas and not being able to determine what your status is. As a rule of thumb, a business relationship will exist if the worker can integrate his or her own activities with the employer s activities. This would mean that the worker is acting on his or her own behalf. They are not dependent on the payer s business and he is in business for himself. If on the other hand, the worker can integrate their activities to any commercial activities of the payer, there is a good chance that an employer-employee relationship will exist. This means that the worker is connected with the payer s business and dependent on the employer s business. 11

12 In order for an employer-employee relationship to exist, the employer must: Register with Canada Revenue Agency to acquire a Business Number (BN). Withhold income tax, CPP or QPP contributions, and Employment Insurance (EI) premiums. Remit the withheld as well as any required employer s share of contributions to Canada Revenue Agency on an ongoing basis. Report the employee s income and deductions on the appropriate returns. Give the employee T4 slips by the end of February of the following year. Register with Workmen s Compensation. In order to have a business relationship, when the self-employed worker s income exceeds $500 or any income tax has been deducted, the payer (employer) must: Report any self-employed individuals income and tax deductions to the Revenue Canada Agency (CRA). Provide the self-employed with a copy of their T4A by the end of February of the following year. Questions That Should Be Answered to Determine Employee or Self-Employed Status Who is responsible for planning the work to be done? Who decides how and how much the worker is to be paid? Who decides on any periods? Who decides how the work is to be done? Who decides on the hours of work? Who decides on the location? Who assigns the individual tasks? Who supervises the tasks? Who sets the standards to be met? Payer Worker N/A Quality? Volume? Time frame? Who decides whether work must be redone? 12

13 Who covers the cost? Who is responsible for training? Who covers the related costs? Who decides on the territory to be covered? Who decides on periodic activity reporting? Who decides if the work is to be done by the worker himself? Who hires helpers? Who supplies the heavy equipment or covers it rental cost? Who supplies the specialized equipment or covers cost? Who covers equipment maintenance costs? Who supplies the large tools or covers their rental costs? Who supplies the specialized tools or covers their rental cost? Who supplies the small tools? Who covers tool maintenance costs? Who supplies the materials? Who has invested in the equipment and tools? Who covers the costs of damage to equipment or materials? Who covers the costs of liability insurance? Who covers the office expense? Who covers the rental costs? Who covers delivery and shipping costs? Who covers costs related to bad debts? Who assumes responsibility for ensuring that guarantees relating to materials are honoured? Who guarantees the quality of work? Who covers the costs incurred by the worker in carrying out the work? Who covers the costs of the worker s benefits (vacation, sick leave, life insurance premiums, etc.)? Contract Employees The employment environment has changed over the past years. Many of the jobs filled by employees are now contracted out. These positions are filled temporarily and sometimes long term by contract employees. This is looked at, as a way for the companies to save operating costs, as they do not have to provide pensions, health benefits etc. These employees work as independent contractors and offer skills and knowledge as their employable edge. They sometimes work sequentially for different employers at once. Either way the transition from paid employee to self-employed contractor can be a rocky experience. 13

14 THREE MAIN SOURCES OF EMPLOYMENT INCOME Employment income is the main source of revenue for many people, but there are a few different forms. The main three are: 1. Direct Compensation 2. Commission Agreements 3. Income for Service 1. Direct Compensation Wages and Salary Employee gross income such as: salaries, wages, commissions, directors fees, and all other remuneration received by an officer or employee is included in income for the purpose of taxation. Canadian residents are taxable on worldwide income whether the income is remitted to Canada. Salaries and Wages If your clients or prospects fall into the employee category, they will receive a T4 slip from their employer(s) for income that they received during the year. Commissions Total commissions are reported in box 42 on all T4 slips. If your clients or prospects are self-employed salespeople, they should read the tax guide entitled Business and Professional Income. This helps to determine how to report income and account for expenses. Payments may be regulated by: Provincial Employment Standard Collective Union Agreement Individual Employment Contract 14

15 In cases such as this, an Employer Employee relationship will be established. 2. Commission Agreements These agreements may be varied and complex, but most of them will be dependent on the sale of a product that generates revenue for the employer. They may be related to dollar value or volume of sales. The Commission could be a fixed dollar for each sale or a percentage of revenue. This arrangement does not establish an employer/employee relationship and in fact, the individual may be an independent contractor. 3. Income for Service Food and personal care services may generate tips, gratuities and bonuses. If you are involved in marketing or other services you may receive performance bonuses, all of which form taxable income. Alternate Forms of Income Indirect compensation can be received in the form of benefits paid by your employer on your behalf or to your credit. Not all benefits result in a taxable benefit to the employee. CANADA/QUEBEC PENSION PLAN For 2016, employees and employers must each pay 4.95 % of employees contributory earnings. Contributory earnings are those between a certain floor (years basic exemption) and ceiling (years maximum pensionable earnings) and are subject to change yearly. Self-employed persons must pay 9.9% of earnings on the same basis. The 2016 CPP/QPP information at a Glance Year s maximum pensionable earnings (YMPE) (ceiling) $54,900 Year s basic exemption (YBE) (floor) $3, Year s maximum contributory earnings (YMPE YBE) $51,400 Maximum required contribution in 2016 Employee and employer each pays 4.95% of contributory $2, earnings Self-employed pays 9.9% of contributory earnings $5,

16 CPP/QPP in a Nutshell Both employer and employee contribute equally. Contributions are a mandatory percentage of income, deducted at source. Employers contributions are not a taxable benefit. Employee receives a tax credit of approximately 15% of their premium paid. Self-employed individuals pay 100% of premium. Self-employed individuals can now deduct one-half of their contributions, and use the balance as a tax credit. EMPLOYMENT INSURANCE (EI) PREMIUM RATES Who has to pay EI premiums? Employers are responsible for deducting the EI premiums from all employees, regardless of age. The employer pays a premium of 1.4 times the employee premium. Self-employed people do not pay EI premiums, and do not qualify to receive EI benefits. EI premiums are not payable in some employment situations, such as when the employee controls more than 40% of the corporation's voting shares, when the employee and the employer do not have an arm's length relationship (depending on other circumstances), or some other cases. For employees, the 2016 premium rate is $1.88 per $100 of insurable earnings. The rate paid by employers is $2.63 per $100 of insurable earnings. EI Contribution amounts for selected years Canada rates maximum insurable earnings $50,800 $41,100 $39,000 employee rate 1.88% 1.73% 1.95% employee maximum $ $ $ employer maximum $1, $ $1,

17 Québec rates maximum insurable earnings $50,800 $41,100 $39,000 employee rate 1.52% 1.39% 1.53% employer rate 2.13% 1.95% Please note that Québec started providing their own parental benefits beginning January 1, 2006, so their EI rates are lower. Who is eligible to collect? To be entitled to Employment Insurance (EI) benefits you must show that: you have been without work and without pay for at least 7 consecutive days; and in the last 52 weeks or since your last claim, this period is called the qualifying period, you have worked for the required number of insurable hours. The hours are based on where you live and the unemployment rate in your economic region at the time of filing your claim for benefits. How much does the individual receive? The basic benefit rate is 55% of your average insured earnings up to a maximum amount of $537 per week. Your EI payment is a taxable income, meaning federal and provincial or territorial - if it applies - taxes will be deducted. You could receive a higher benefit rate if you are in a low-income family (net income up to a maximum of $25,921 per year) with children and you or your spouse receives the Canada Child Tax Benefit (CCTB). You are then entitled to the Family Supplement. EMPLOYER HEALTH TAX (EHT) In Ontario and Manitoba, the employer is assessed a payroll tax to cover the costs of Medicare. This is not considered a taxable benefit and must be paid by the employer. In other provinces, the employer may pay all or part of the contribution and this is considered a taxable benefit. 17

18 Ontario Employer Health Tax - Two Key Issues (for illustration purposes) Ontario-based employers are all too familiar with the multitude of payroll taxes they must pay, including the provincial Employer Health Tax ("EHT"). Employers are required to pay EHT calculated at 1.95% of remuneration paid to employees who: Report for work at an employer's permanent establishment ("PE") in Ontario and Who do not report for work at a PE in Ontario but are paid from or through the employer's PE in Ontario. Ontario-based employers with workers on contract and non-ontario employees should be aware of the following two issues: 1. Whether an employer-employee relationship exists with their workers on contract (which would tax these payments for EHT purposes); and 2. Whether their non-ontario employees report for work at a PE (which would exempt their remuneration from EHT). Non-Ontario Employees It is often a question of fact whether employees residing outside of Ontario report for work at a PE. For example, a salesperson's home office may be a PE of the employer if certain factors apply, such as the salesperson conducts business in the office, the employment contract requires that the salesperson provide an office, the office is set aside exclusively as an office of the business, etc. If enough factors apply, employees who are not residents of Ontario could be considered employees who report to work at a PE outside of Ontario, in which case the remuneration of these employees would not be included as part of taxable remuneration and therefore, would not be subject to EHT. 18

19 To summarize, if your corporate clients and prospects employ self-employed contractors or have employees working outside of Ontario, there are risks of being assessed EHT on payments to these individuals. The Health and Post-Secondary Education Tax Levy in Manitoba The Health and Post-Secondary Education Tax Levy, known as the Payroll Tax, is a tax imposed on remuneration that is paid to employees. The Payroll Tax is paid by employers with a permanent establishment in Manitoba. Employers with total remuneration in a year of $1.25 million or less are exempted. Associated groups (associated corporations/certain corporate partnerships) must share the $1.25 million exemption based on the total of their combined yearly payroll. Total Yearly Payroll Tax Rate $1.25 Million or Less Exempt Between $1.25 Million and $2.5 Million 4.3% on the Amount in Excess of $1.25 Million Over $2.5 Million 2.15% of the Total Payroll (The $1.25 Million is not a Deduction) PROFIT SHARING AND STOCK OPTIONS PLANS Employee Profit Sharing Plan (EPSP) These types of plans are also registered under section 144(1) of the Income Tax Act. The employer s contributions are not subject to any limits. They are deductible to the employer with immediate taxation to the employee. An EPSP is an arrangement whereby an amount is paid to a trustee (or trustees) to be held for the benefit of some or all of your employees. Although such plans are often used to share profits with key employees, you can also establish one of these plans exclusively for your benefit and the benefit of your family members who are employed in the business. 19

20 What are the tax implications of EPSP? The company accrues a payment to the EPSP trust which is fully deductible by the company if paid within certain timeliness. The EPSP trust is exempt from tax and is not required to file a return. However, there are certain nominal compliance requirements that must be managed. Each year, the amount allocated to a particular employee is included in the respective employee's taxable income for the year. No source deductions are required with respect to the amount allocated to the employee. When would an EPSP be beneficial? If the employer can answer 'yes' to the following questions, an EPSP may be beneficial to them: Do they routinely follow a policy of "bonusing-down" to the small business limit (currently $300,000 federally)? Are they expecting a large one-time increase in income (possible due to a sale of a division or business resulting in significant recapture or gain on the sale of goodwill)? Do regulatory requirements or their current business structure prevent them from effectively income splitting with other family members? Under certain circumstances, an EPSP can be used as an alternative to traditional remuneration strategies to effectively defer tax and facilitate income splitting. What about EPSP tax deferral? An EPSP can potentially provide an initial tax deferral of one year beyond that which can be achieved through a bonus accrual. This deferral aspect works best for corporations with a fiscal year ending after September 3rd (generally, September 30th, October 31st, November 30th and December 31st.) For example, consider a situation where a company's pre-tax income is expected to be approximately $2,000,000 and the company's year-end is September

21 The company is planning on declaring a bonus to the owner-manager to reduce its taxable income to $300,000. An EPSP could be established so that the amount that would otherwise be paid as a bonus to the owner-manager is paid to the EPSP. Although the company can claim the amount as a deduction for its fiscal year ended in 2016, the amount does not have to be paid to the EPSP until January 28, The EPSP will then allocate the amount to the beneficiaries of the plan in 2017 as determined by the trustees. If the timing of the transactions is appropriately managed, the approximately $750,000 in source deductions that would otherwise have to have been remitted to the CRA on the bonus can be deferred for approximately 12 months. This amount can continue to be invested for an extra year, generating additional after-tax income. Employee Stock Option Plans What is a stock option? A stock option allows the employee to purchase a certain number of shares at a specified price ( the option price ) for a specified period of time. Often there is a holding period during which the employee cannot exercise the option. Once this holding period is over, the option is considered vested and the employee can exercise the option any time thereafter until the expiry date, if any. Stock options are an important way of motivating employees, especially in the hightechnology industry where many start-up companies have grown rapidly into multinational businesses. Because Canada is a relatively high-tax jurisdiction in close geographic proximity to the world s dominant high-technology player (the U.S.), the effective use of employee stock options is particularly critical to Canadian high-tech companies seeking to attract and retain the services of key employees. Some firms offer these stock option plans. The dividends earned can boost retirement income or the stock can be sold at retirement and used to provide additional income from the capital. 21

22 When an individual is granted a stock option by virtue of his or her employment, there are no immediate income tax consequences. At the time the option is exercised, however, the excess of the fair market value of the stock over the option price is fully taxable as an employment benefit, subject to the two exceptions noted below. For purposes of calculating capital gains (or losses) on a subsequent disposition of the shares, the tax cost of the shares acquired will be the fair market value at the time of exercise. The decision to exercise stock options is motivated primarily by investment criteria. However, it should be noted that growth in the stock value subsequent to exercise would be taxed on a future sale as a capital gain. If the shares are qualifying small business corporation shares, the gain can be reduced using the enhanced capital gains. Tax Rules on Employee Stock Option Plans Taxation of stock options from Canadian public companies While there are no tax consequences when such stock options are granted, at the time the employee exercises the option they trigger an option benefit. This benefit is equal to the difference between the market value of the stock and the option price. This benefit must be included in the employee s income from employment in the year in which the option is exercised. The employee can claim a tax deduction equal to one-half of the option benefit if the shares are common shares and the exercise price, at the time the options were granted, was equal to the fair market value of the shares. Taxation of stock options from Canadian controlled private corporations Employees of CCPCs do not need to include the option benefit in income until the year in which the employee disposes the shares. As with non-ccpc shares, the option benefit may be reduced by one-half as long as the exercise price at the time the options were granted was equal to the fair market value of the shares. If it does not meet these criteria, an employee may be able to access another one-half deduction as long as the shares have been held for at least two years at the date of sale. 22

23 Deferring the Option Benefit The 2000 Federal budget introduced a deferral of the option benefit for non-ccpcs until the employee sells the shares, or is deemed to have disposed of the shares on death or on becoming a non-resident of Canada. This deferral applies to options exercised after February 27, 2000, regardless of when the options were issued. The amount that may be deferred is limited to the benefit arising on $100,000 worth of stock options vested in a particular year. While the $100,000 amount is based on the fair market value of the shares at the time the option is granted, the actual benefit that can be deferred can be much greater. General Comments on Employee Stock Options & Canada Revenue Agency A few points are relevant to federal income taxation of employee stock options: Where employers do not withhold from employees salaries any amounts relating to stock option benefits, it is important for employees to be aware of how much will be added to their income for tax purposes from the stock option benefit, and they should set aside an appropriate amount of cash to fund the tax on this amount (whether from the sale of the acquired shares or from other sources). Whenever the employee exercises stock options at a time when she owns other shares of the employer, she cannot assume that it is possible to immediately sell the newly acquired shares without realizing a capital gain. This is because the ITA averages the tax cost of all identical shares held by a person at one time. As such, if an employee buys 10 shares at $2/share, and later exercise options to acquire another 10 identical shares at a strike price of $8/share while still holding the first 10 shares, she cannot sell the 10 newly acquired shares for no gain. Instead, the ITA deems each of the 20 shares to have a $5 tax cost, such that an immediate sale of 10 shares will produce a $30 capital gain. When an employee claims a very large amount in a year under one of the one-third deductions for employee stock option benefits described above, the possibility of triggering alternative minimum tax levied under the ITA must be considered. 23

24 While the ITA rules dealing with the taxation of employee stock options are not simple, they do offer significant tax advantages for many employees, especially when the appropriate planning takes place to ensure that the optimum benefits arise. The stock option rules in the ITA represent one of very few tax advantages in the ITA available to employees. Highlights of Stock Option Shares Payments received are considered taxable income. Capital gains or losses flow through to the employee. If the purchase price of the share is below market value, the difference between the purchase price and the fair market value of the share is a taxable benefit. INCOME FROM BUSINESS OR PROPERTY Self-employed individuals have the right to control a number of factors in their work environment. They hiring and firing of staff, the wages or salary to be paid and the place and manner in which work must be done are all at their control. They cover any other costs for any tools or other overhead expenses. The risk of self-employment and the mere fact of not having any guarantees of steady income are major factors to consider when determining whether an individual will work for himself or herself or for someone else. Self-employed individuals have full control over the success of their business venture. Other Areas that Can Provide Income Business Income Income to consider can consist of Salary versus Capital Dividends, Bonuses etc. Partnership Income Partnership income could come from the actual partnership business arrangement or a Spousal Business Partnership. It could be possible for the proprietor of a business that is not incorporated to have their spouse as a partner who is willing to share in the company s profits or losses. 24

25 Qualifications for the spouse The spouse must have contributed a specified amount of time, or be able to provide a special skill or some form of training to the business; and to invest some form of property in the business. The partnership income should be reasonable under the circumstances. There should also be a written agreement in place as well. Farm Income Farming is considered a very specialized industry in Canada. It can take in a wide range of functions such as: tilling the soil, livestock raising or showing, tree farming, beekeeping etc. There are many different types of income tax provisions for this profession that should be considered when dealing with your clients or prospects. Loans to shareholders A loan made to an employee who is also a shareholder, or related to one, is generally considered being by virtue of the shareholding, rather than employment. Previously, the full loan amount had to be included in the individual s income, unless it was repaid within 12 months of that corporation s current fiscal year end. Furthermore, the loan could not be part of a series of loans and repayments. In recent years, however, the CRA has shifted its focus; running loan accounts no longer automatically constitute a series of shareholder loans and repayments. A revised position, assessing whether taxable benefits exist, places more emphasis on the use of funds rather than income receipt. The imposition of taxable benefits is now based on prescribed interest rates, as applied to the loan principal. Loan repayments are applied to outstanding balances on a first in, first out basis. 25

26 If bona-fide arrangements were made when the loan originated for repayment within a reasonable period of time, the loan may not be considered income if it occurred in the ordinary course of the lender s business or was made to enable individuals to: Acquire a dwelling for their own use; or Purchase an automobile for use in the course of employment; or Purchase fully paid shares from the corporation or a related corporation (provided such shares are held by the individuals for their own benefit). Some other Business or Property income areas to consider: Income from trusts and estates. Shareholders benefits. Income portion of a payment or arrangement. Traditional Income from Other Sources Payments from an RRSP, RPP, DPSP or interest portion of an unregistered annuity. Payments from CPP and OAS. Retiring allowance & Employer death benefit in excess of $10,000. Payment from EI benefits. Alimony or maintenance payments. To the above income, the following is added: Supplementary unemployment plans. Taxable gain from disposal of life insurance. Accrued interest annuity or non-exempt life insurance policy. Flow through gains in a variable contract. Adult training allowances under the National Training Act, except personal/living expenses. Scholarships, fellowships or bursaries in excess of $ per year beginning in Net research grants. 26 Indirect payments made for the benefit of the taxpayer.

27 CAPITAL GAINS AND LOSSES Some quick facts about the capital gains exemption in Canada Share sales qualify for the exemption if and only if they are of a Small Business Corporation, which is defined in the Tax Act as being a Canadian-Controlled Private Corporation with generally 90% of its assets involved in active business. The shares must have been owned by you or a relative for a 24-month period prior to the sale and for that same period at least 50% of the assets must have been used in active business in Canada. Steps should be taken to purify the corporation to take advantage of the exemption. This normally means removing investments held by the corporation, as these are assets not used in its active business and could thus violate the 50% and 90% rules above. Unincorporated businesses - sole proprietorships or partnerships - are not eligible to use the exemption, which is a prime benefit to incorporation. There are ways to roll business assets into a newly formed corporation not resulting in tax. You can crystallize the exemption at a time when the corporation qualifies, which involves transferring the shares to a holding corporation and electing to recognize a gain. In case the government decides to eliminate or change the exemption, you ve already taken advantage and are protected. As with any general tax information, your client s situation could be unique. You should definitely seek out a Chartered Accountant to review your personal situation and prepare a plan tailored to you. Some new strategies for business owners Not long ago, the top rate of tax on dividend income was lower than the top rate of tax on capital gains. This difference led to the development of planning strategies to take advantage of this fact. However, for a taxpayer in the top tax bracket, capital gains are now taxed more favourably than dividends. Planning will now focus on taking advantage of this tax difference. For example, a common strategy in the past was to transfer part of an operating company s surplus into another company prior to selling the operating company s shares. 27

28 This reduced part of the current capital gain on the sale of the shares and converted it into a future dividend. While this strategy might still be beneficial, a cost benefit analysis should be performed to determine if this is the most advantageous approach in light of the change in capital gains rates. So if you are thinking of selling your shares or otherwise doing some estate or succession planning, a visit to your tax specialist is in order. The change in the capital gains inclusion rate is also significant where you own shares of a Canadian-controlled private corporation (CCPC) on death. Several planning strategies in the past were based on the fact that it was preferable to have the share value taxed as a dividend rather than a capital gain. New strategies are evolving to deal with the fact that capital gains treatment is now more beneficial. In addition, if you have done an estate freeze in the past, or otherwise transferred assets to your company on a tax-deferred basis, there could be a double taxation problem on death that will have to be addressed. If your clients own shares in a CCPC, they should contact their tax adviser to see if their present strategy is the most beneficial to them. On the downside, the change in the inclusion rate has affected the computation of the Alternative Minimum Tax (AMT). This is a refundable tax that you might have to pay if you sell shares in your CCPC, or crystallize your capital gain and claim on offsetting capital gains deduction. Depending on your other income, you will now generally be subject to more AMT in the year the gain is triggered. Planning may be available to eliminate this tax or lessen its impact. Investors need to rethink strategies too You don t have to own shares in a CCPC to be affected by the change in the inclusion rate. Now is the time to review your investment portfolio to determine if it is still tax efficient. Capital gains, dividends and interest are all taxed differently. With respect to RRSP strategies, it has often been said that you should hold high tax investments such as bonds and debentures inside your RRSP and low-tax investments such as growth stocks - outside your plan. 28

29 Although maximizing your RRSP contribution is still beneficial, if you have sufficient funds to have both registered and unregistered investments, there may now be more of an incentive than ever to hold growth equity investments outside of a registered plan. Tax planning is a complex process that must be related to individual circumstances. Calculations for Capital Gains Capital gains or losses can arise due to sale, gift or death. Proceeds are actual sale price if achieved by arm s length transaction, or at fair market value. If property is stolen, destroyed, damaged or expropriated, then proceeds of disposition are used. Capital Gain or Loss = Proceeds (ACB + disposition costs) Net capital losses can be deducted from net taxable gain. Any excess loss can be taken back three years and carried forward until loss is exhausted. Any net capital loss un-deducted at death can be applied against all other taxable income in the year of death and previous year. Valuation Day Calculations Canadian Shares December 22, 1971 Capital Property December 31, 1971 There are two methods of valuation: Tax free zone method: The taxable gain is calculated by establishing the values of: Actual cost of the property on Valuation Day Fair market value as of December 1971 is deducted from the Net proceeds of disposition. 29

30 Whichever calculation results in the smallest gain is used. This avoids tax on any pre 1971 gains above the purchase cost. Valuation Day Method Uses two reference points: Value as of December 1971, Net proceeds at disposal. The same method must be used for all capital property dispositions. Exemption from Tax on Capital Gains Death benefit of life insurance policies. Bequests between spouses passing at death, outright or to spouse trust (Life Income). Inter vivos gifts between spouses (can be treated as a deemed disposition if elected. Principal residence Housing unit owner lives in (includes up to ½ hectare of land). No capital gain applies on property lived in by the taxpayer, spouse (or former spouse) or child designated and ordinarily inhabited by them. Personal Use Property No capital gains on proceeds of less than $1,000. No losses can be deducted. Capital Gains Deduction Capital gains from dispositions of qualified farm property and small-business corporation (SBC) shares may be eligible for a deduction of up to $813,600 in increasing to $1,000,000 with inflation over time - which, at a 50 per cent inclusion rate represents up to a $500,000 taxable amount. 30

31 Lottery Prizes and Windfalls All lottery winnings are received tax-free, but are taxed at disposal. Cost basis the fair market value at receipt. An individual s ability to claim the capital gains deduction may be reduced by past claims for capital-gains deductions, allowable business investment losses (ABIL) or a cumulative net investment loss (CNIL). Cumulative Net Investment Loss A taxpayer s cumulative net-investment loss (CNIL) at the end of a year is defined as the amount by which the total of investment expenses incurred after 1987 exceeds the total of their investment income for those years. The cumulative gains limit for purposes of the capital-gains deduction will be reduced by the amount of an individual s CNIL balance at the end of a taxation year. Attribution Rules Income earned from property transferred to a spouse or a minor, will be taxed at the taxpayer s rate except when: Spouse is paid a salary by taxpayer for services supplied. Transferred because of an agreement (Separation or Divorce). Taxpayer received property of equal value from spouse. Lifetime Capital Gains Exemption (LCGE) Under certain circumstances, small business owners, farmers, and fishers may be eligible for a lifetime capital gains exemption on the first $813,600 (increasing to $1,000,000) of capital gain realized on the disposition of qualifying capital property. 31

32 DEDUCTIONS AND TAX CREDITS The Income Tax Act requires that the federal non-refundable tax credits be claimed in the following order: personal tax credits (i.e., basic personal tax credit, spousal and spousal equivalent tax credits, and dependant/caregiver tax credits); age credit for an individual who has attained the age of 65; credit for employee contributions to the CPP and employee premiums for EI; credit for an individual who is in receipt of certain pension income; credit for severe and prolonged mental or physical impairment of: (i) an individual; or (ii) a dependant credit for unused tuition and education tax credits; tuition credit for fees of a student enrolled at a designated educational institution; the tax credit for a student enrolled in a qualifying education program at a designated educational institution (i.e., enabled through the payment of child-care or attendantcare expenses); credit in respect of unused tax credits for tuition or education that are transferred to the student s parent or grandparent; credit in respect of unused tax credits for tuition, education, age, pension and mental or physical impairment of an individual that are transferred from the individual to the individual s spouse; credit for medical expenses; credit for charitable donations; credit for interest on student loans; and What expenses can be written off against business income? In general, expenses incurred in order to earn business or property income are tax deductible. Many of your expenditures will be fully deductible in the year in which they are made. There are exceptions and limitations. 32