Year-end Tax Planning

YEAR-END TAX PLANNING

As the end of the year approaches, it is time again for our annual summary of various income tax issues and planning opportunities.

CLAIM YOUR PERSONAL TAX CREDITS

Although the types of personal tax credits remain largely unchanged for the 2002 taxation year , the federal credits now equal 16% of the applicable amounts (down from 17%), owing to the decrease in federal income tax rates. However, the applicable amounts have been indexed from last year to account for inflation. Thus, for example, the basic personal credit for the 2002 taxation year is 16% of $7,412 (for a total federal credit of $1,186), and the spouse and equivalent-to-spouse credits are 16% of $6,194 (total federal credit of $l,007). The federal tax credit for charitable donations is 16% on the first $200, and 29% on the excess.

Provincial tax credits tend to parallel the federal credits, although they do vary somewhat and the rates differ from the federal rates. The total credits available depend on your province of residence.

In addition to the basic, spousal and charitable gift credits, other personal credits include:

• Tuition and education credits
• Medical expense credit
• Disability credit
• Age 65 or over credit
• Pension income credit
• Infirm dependent credit
• Caregiver credit
• Student loan interest credit

For some of the credits, you are required to submit documentation or the appropriate tax form. For example, prescribed receipts are required for charitable donations, and receipts are required for the medical expense credit. For the education credit, you will require a prescribed certificate from the educational institution. In the case of the disability credit, you will require a certificate in prescribed form from a medical doctor or other appropriate health care professional.

RRSP CONTRIBUTIONS

Most taxpayers are aware of the obvious tax advantages to investing in registered retirement savings plans (RRSPs). Contributions to RRSPs are tax-deductible) and the income earned inside an RRSP grows tax-free until the funds are withdrawn. Accordingly, an RRSP remains one of the most effective and tax-efficient investments available.

The RRSP deduction limit for the 2002 taxation year is the lesser of $13,500 and 18% of your "earned income" for the year 2000. Earned income includes income from employment, income from business, net rental income from real property, certain types of royalty income, and spousal support payments that are included in your income. The contribution deadline for the 2002 taxation year is March 1, 2003.

If you are a member of a registered pension plan or deferred profit sharing plan, your RRSP deduction limit for 2002 will be reduced by the amount of your pension adjustment (PA) for the 2000 taxation year. The PA essentially reflects your employer's contributions or actuarial commitments to such plans in the year 2000.

Some basic RRSP strategies and planning issues are discussed below.

Spousal RRSPs
You are permitted to contribute to your spouse's RRSP (or common-law partner's RRSP) to the extent of your RRSP deduction limit for the 2002 year. The contribution will reduce the amount that you can contribute to your own RRSP.

A contribution to your spouse's RRSP can beneficial for a few reasons. First, if your spouse is younger than you are, the RRSP funds can accumulate on a tax-deferred basis for a longer period of time. Second, if you are over 69 years old (and therefore prohibited from contributing to your own RRSP), you can contribute to your spouse's RRSP until he or she reaches 69 (as long as you have sufficient RRSP deduction room).

Furthermore, there is the potential to split income, because the withdrawal of the funds from the RRSP will be included in your spouse's income rather than your income. This will be beneficial if your spouse is in a lower tax bracket when the funds are withdrawn.

Note, however, that the withdrawal will be included in your income (and not your spouse's income) if the withdrawal of any funds from your spouse's RRSP is made in the year in which you made your contribution or any of the two subsequent years.

RRSP carryforwards
You are allowed an additional deduction for RRSP contributions (in addition to the regular deduction limit) to the extent of your unused RRSP deduction room carried forward from prior years. Effectively, this means that if you did not contribute the maximum amount to your RRSP in previous years (going back to 1991), the unused deduction room can be carried forward and used in the 2002 year.

However, if you were in a low tax bracket in 2002 and expect to be in a high tax bracket in 2003, you might consider waiting and carrying forward the unused RRSP deduction room to the 2003 year. Since you will be in a higher tax bracket in that year , the tax deduction in 2003 will lead to a larger savings or refund of tax as compared to a deduction in 2002.

RRSP over-contributions
You are allowed to contribute $2000 above and beyond your regular RRSP deduction limit on a cumulative basis without a penalty. Although the $2,000 over-contribution will not be deductible from your income for the year, the amount will still earn tax-deferred income while in your RRSP. Thus, it often makes sense to deliberately make an over-contribution. Furthermore, the over-contribution will normally be deductible in a future taxation year , to the extent that you have RRSP deduction room available in that year.

Home buyers' plan and lifelong learning plan
Under the home buyers' plan (HBP), individuals are allowed to use their RRSPs to finance the purchase of a home. The HBP is generally limited to buyers who have not owned a home in the past 5 years. The HBP allows you to withdraw up to $20,000 from your RRSP on a tax-free basis if your home is purchased by September 30 of the year following the year of withdrawal. Your spouse (or common-law partner) is also allowed to withdraw $20,000 from his or her RRSP for this purpose.

The HBP withdrawals must be repaid to your RRSPs within a 15-year period, without interest, beginning with the second year following the year of withdrawal. The minimum amount that must be repaid in each of the 15 years is one-fifteenth of the withdrawn amount. Any amount not repaid as required is included in your income and, becomes taxable.

Under the lifelong learning plan (LLP), you can withdraw funds from your RRSP if you or your spouse (or common-law partner) are going back to school on a full-time basis. Part-time studies can qualify in the case of disabled students. The maximum amount that can be withdrawn in any one year is $10,000. Withdrawals are allowed for up to four years, although the total amount that can be withdrawn over the four years is limited to$20,000. Both you and your spouse can withdraw from your RRSPs for your education.

The withdrawn amounts under the LLP must be repaid to the RRSP over a period not exceeding ten years, without interest. The repayment period usually begins with the second consecutive calendar year in which the student is no longer enrolled on a full-time basis, although in some cases repayment is required earlier.

CAPITAL GAINS SPLITTING WITH YOUR CHILDREN

There are various income attribution rules that apply when you transfer or tend income-earning property to your spouse or minor children. For example, if you transfer stocks and bonds to your spouse for no consideration, any dividends, capital gains or interest earned by your spouse on the investments will be included in your income.

Although similar attribution rules apply to property transferred to your minor children, the rules do not apply to capital gains. Furthermore, the recently enacted "kiddie tax" rules (which apply to certain types of investment income earned by minor children) do not apply to capital gains.

As a result, you can purchase investments for your children that trigger capital gains (e.g. common shares or equity mutual funds) without worrying about attribution on the future capital gains earned on the investments. Note that if you transfer your existing investments to your children, the transfer will take place at fair market value, which may give rise to a capital gain and if so half of that gain will be included in your income. Accordingly, you are best advised to transfer investments that have little or no accrued capital gain. In fact, if possible, you are best off transferring an investment with an accrued capital loss. The so-called "superficial loss" rules do not apply to property transferred to your children, so that the resulting capital loss on the transfer can be used to offset any capital gains you might otherwise have.

DEDUCTING YOUR INTEREST EXPENSES

Interest on borrowed money is deductible for income tax purposes if the borrowed money is used for the purpose of earning income from a business or property. Interest on personal borrowings is not deductible. It is important, therefore, to keep track of your interest payments and the use of your borrowed money. Suffice it to say that, to the extent possible, you should use your borrowings for investment purposes and use your cash or savings for personal purposes.

When paying off your loans, you should pay down any personal loans before your investment loans, again because the interest expense on the former is not deductible.

If you own investments such as stocks or mutual funds and you also carry some personal debt, it is possible to "convert" the nondeductible interest on your personal debt into deductible interest. For example, you could sell the investments, use the proceeds to pay off your personal debt, and then borrow money to repurchase the investments. The interest will then be deductible because the newly borrowed money is being used for the purpose of earning income from property. As discussed later in this letter, the Supreme Court of Canada recently gave its blessing to this type of tax planning.

Example
You currently own $50,000 worth of mutual funds. You have an existing $50,000 mortgage on your home, and none of the interest on the mortgage is deductible because your home is not used for income-earning purposes.

You sell the mutual funds for $50,000 and use the funds to pay down your mortgage. You then borrow $50,000 and repurchase the mutual funds (note that you could even re-mortgage your home for this purpose). The interest payable on the $50,000 new borrowing will now be tax-deductible.

Note that if the cost of the mutual funds is lower than their fair market value, the sale of the funds will trigger a capital gain. In such case, you will have to weigh the benefits of the potential interest deduction against the amount of the capital gains tax liability in order to determine whether the transaction makes sense from a financial perspective.

DONATING PUBLICLY-TRADED SECURITIES TO CHARITIES

If you donate publicly-traded securities to a charity, such as shares listed on a prescribed stock exchange or units in a mutual fund, only one-quarter of any resulting capital gain is included in income (instead of the regular one-half inclusion rate for other capital gains). Thus, for example, a resident in Ontario in the highest tax bracket making such a donation will be taxed on the resulting capital gain at the rate of only 11.6%. This can result in a significant savings in tax, owing to the combination of the lower capital gains rate and the fact that annual donations in excess of $200 earn the charitable credit at the top 29% federal rate plus the applicable provincial rate.

The special rule was introduced as an incentive to encourage charitable donations, and it was originally meant to expire on December 31, 2002. However, the federal government recently announced that it will remove the deadline and make the rule permanent. Furthermore, the government indicated that it will continue to work with the charitable sector to determine whether there is an appropriate and cost-effective basis for broadening the rule even further.

HOME OFFICE EXPENSES

If you run a business out of your home, you are allowed to deduct certain home office expenses if the office is either your principal place of business, or if it is used exclusively for business purposes and on a regular and continuous basis for meeting clients, customers or patients of the business. The home office expenses are deductible only to the extent of your business income otherwise determined, meaning that they cannot be used to create a loss. However, the home office expenses in excess of income otherwise determined can be carried forward and used to offset business income in future years.

Eligible home office expenses include the prorated portion of expenses such as rent or interest on your mortgage, capital cost allowance, property insurance, property taxes, and heating, utility and maintenance costs. The expenses should be prorated based on the business versus non-business use of your home. This is normally done on a square footage or square metres basis (e.g. for a 200 square foot office in a 2000 square foot home, you could claim 1/10th of the total expenses).

If you are an employee working out of your home, similar rules apply to your home office expenses, although the types of expenses that qualify for a deduction are more restricted. You are allowed to deduct certain expenses if your home office is the place where you principally perform the duties of your employment, or if it is used exclusively for employment purposes and on a regular and continuous basis for meeting customers. A deduction will not be allowed unless you are required to pay the expenses under the contract of your employment. Additionally, you must file the prescribed Form T2200, signed by your employer, with your tax return for the year.

BE CAREFUL WITH TAX SHELTERS

Taxpayers are often tempted, particularly at the end of the year, to invest in tax shelters that promise large tax write-offs. Many shelters are promoted and advertised as guaranteeing immediate tax deductions that exceed the amount of the taxpayer's investment. In most cases, the expected return over the first few years of the investment stems largely from the expected income tax saving or refund.

As we noted in last month's Tax Letter, the CCRA has warned taxpayers to be careful about investing in these types of tax shelters. The CCRA has been aggressive in its audits and reassessments of tax shelters, and it has several statutory weapons at its disposal in this regard. This is not to say that all tax shelters are "bad", only that great care must be taken in distinguishing the legitimate ones from the not-so-legitimate ones.

It is also important to remember that the fact that a tax shelter is registered with the CCRA does not mean that it has been "approved" in any way by the CCRA. Registration is required under the Income Tax Act, and if anything, it only serves to put the CCRA on notice that the tax shelter is being marketed. When you file a return claiming tax shelter deductions, you have to report the shelter's registration number, which makes it easy to audit.

EMPLOYEE GIFTS

The CCRA recently announced a change to its policy on non-cash gifts and awards received by employees from their employers. Previously, the CCRA allowed a tax-free gift of up to $100 per employee per year. Under the new CCRA policy, an employee is allowed two non-cash gifts or awards per year with a total cost of $500 or less. These amounts will be tax-free to employees, and they will be deductible for employers. The new CCRA policy is effective as of January 1, 2002, so that it will apply if you lived gifts from your employer during this calendar year.

Note that if the value of the gifts or awards received in the year is over $500, the entire amount will be taxable to the employee, and not just the portion over $500.

The CCRA policy is meant to apply to gifts and awards for things such as an employee's longevity or safety records, birthdays, weddings, Christmas, and other similar events. The CCRA stated that the policy does not apply to cash or near-cash gifts, or other amounts that are "disguised" salary or remuneration.

EMPLOYEE CHRISTMAS PARTIES

As the year comes to an end and the holiday season draws near, many of us will be attending Christmas parties and other social functions at work. In this regard, the CCRA recently stated that its policy on Christmas parties and other employer-provided social events remains unchanged. Under this policy (set out in interpretation Bulletin IT-470R), a party that is generally available to all employees will be nontaxable to the employees if the cost is reasonable in the circumstances. As a guideline, events costing up to $100 per person will be considered to be nontaxable. However, parties costing more than that amount may result in a taxable benefit.

AROUND THE COURTS

Supreme Court of Canada rules on interest deductibility (twice)
The Supreme Court of Canada recently released its decisions in two important cases dealing with the deduction of interest for income tax purposes. Both decisions carry significant and beneficial tax ramifications for investors. The applicable income tax provision in each case was paragraph 20(1)(c) of the Income Tax Act, which allows a deduction or interest on borrowed money used for the purpose of earning income from a business or property.

Singleton case
In the Singleton case, the taxpayer was a lawyer who withdrew funds from the capital account at his law firm, used the funds to purchase a home, and on the same day borrowed money from a bank to refinance his capital account. The taxpayer deducted the interest on the borrowing on the grounds that it was used for the purpose of earning income from a business, namely, from his law practice. The CCRA disagreed and reassessed the taxpayer on the grounds that the transactions effectively resulted in the taxpayer using the borrowed money for the purpose of purchasing the home, rather than for the purpose of earning income. Accordingly, the CCRA denied the interest deduction.

The taxpayer won the case at the Federal Court of Appeal level, and the Supreme Court of Canada upheld the decision in favour of the taxpayer. The Supreme Court concluded that as a matter of law, the taxpayer used the borrowed money to refinance the capital account in the law firm which was a direct and eligible use within the meaning of paragraph 20(1)(c) (that is, a use for the purpose of earning business income). The characterization of this use was altered by the fact that the taxpayer had used the money previously withdrawn from his capital account at the law firm to purchase the house. Nor was the characterization of the use altered by the fact that the transactions occurred all on the same day. As a result, the interest on the borrowing was fully deductible.

The Supreme Court's decision in Singleton is welcome, and it reinforces the Court's tendency to look to the legal form and effects of transactions as opposed to the so-called "economic realities" of transactions. The decision opens the door for basic tax planning strategies similar to those outlined earlier in this letter. For example, it is possible for taxpayers to cash-in existing investments to pay down personal debt, borrow to repurchase the investments, and claim an interest deduction on the new borrowing.

Ludco case
In the other important decision (Ludco), the taxpayers were Canadian residence who purchased common shares in two companies located in an offshore tax haven for $7.5 million. The taxpayers borrowed money to purchase the shares and paid $6 million of interest expense on the borrowing, which they deducted for Canadian income tax purposes. Over the years in question, the shares generated dividend income of $600,000 that was subject to tax in Canada. When the shares were ultimately redeemed, the taxpayers realized a capital gain of $9.2 million. The CCRA disallowed the deduction of the $6 million interest expense on the grounds that the shares were not acquired for the purpose of earning income from property (the dividends), but rather for the "real" purpose of obtaining a capital gain (capital gains are not considered income from property).

Although the Ludco case was somewhat unusual, in that it involved some deliberate tax deferral through the use of offshore companies, the arguments raised by the CCRA caused some concern in the community. The positions put forth by the CCRA in the case appeared to conflict with its general administrative position that interest incurred on borrowed money used to purchase common shares is normally deductible.

Fortunately, the Supreme Court held in favour of the taxpayers and allowed the interest deduction. The Court held that the borrowed money was used for dual purposes, namely to earn dividend income and to achieve capital gains. According to the Court, as long as one of the purposes was to earn income from property (the dividends), the interest was fully deductible. The Court held that it was not necessary that the dual purposes somehow be ranked in order of their importance to determine the taxpayer's "real' or "bona fide" purpose in using the borrowed money.

The Court also held that the borrowed money only had to be used for the purpose of earning an amount of gross income, and not net income. In other words, it was not necessary for the taxpayer to show that the dividend income generated from the shares would exceed the interest expense incurred on the borrowing.

Based on the Ludco decision, interest expense incurred on borrowings used to purchase common shares, equity mutual funds and similar capital gains investments should continue to be fully deductible, as long as there is a reasonable expectation that at some amount of income will be generated from the investment (e.g. some future dividends on shares). Note, however, that the Supreme Court warned that if the income generated from the investment is merely 'window dressing', or if the investment is part of a "sham", the interest deduction will not be allowed.

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This letter summarizes recent tax developments and tax planning opportunities however, we recommend that you consult with us before embarking on any of the suggestions contained in this letter, which are appropriate to your own specific requirements.