Taxation in Canada, Part 1

Taxation in Canada

 

Taxable entities:

Income taxes are imposed on Individuals, Corporations, and Trusts.

Other entities such as proprietorships, partnerships, and joint ventures, are not taxable entities as defined by the Income Tax Act. However, individual owners of these entities are obliged to pay tax on their income from all sources including the above.

 

Criteria for tax liability:

Residency is the primary criteria for tax liability in Canada.

Canadian residents, whether individuals or corporations, are subject to tax on their world income.

 

Criteria to identify residency:

Residency factors for individuals may include:

1. regularity and length of visits to Canada

2. business or employment ties in Canada

3. residential ties or the motives for being present or absent

4. ownership of a dwelling in Canada while away, and its accessibility

5. residence of spouse, children, and other dependents

6. origin and background of the individual

7. the general mode and routine of the individual’s life

8. memberships to social clubs, banking privileges, car registration

 

Residency factors for Corporations may include:

(a) Corporations incorporated in Canada are considered residents of Canada

(b) A company incorporated in a foreign jurisdiction may be resident in Canada if the central management and control over the major policy affairs of the entity’s business is exercised within Canada. This may includes:

• Where the Board of Directors meets to make decisions regarding operations

• Where the books and records are located

• Where the registered office is located

• Where the major business contracts are signed

 

Types of residency:

1. Full-time residents are subject to tax on their worldwide or global income throughout the entire calendar year.

 

1. Deemed full-time residents

An individual is deemed to be a resident of Canada for the entire year, and therefore subject to the same tax rules as a full-time resident, if the individual:

1.  

   • Sojourns (lives temporarily) in Canada 183 days (24 hour period) or more in a calendar year

   • Is a member of Canadian forces

   • Performs services outside Canada under an international assistance program of the Canadian International Development Agency (CIDA), if the individual was resident in Canada at any time during the three months prior to the day the services commenced

   • Is an officer or servant of Canada or a province if, immediately prior to the appointment, the individual was resident in Canada

 

3. Part-year residents

A part-year resident is a person who enters or leaves Canada part-way through the year on a permanent basis. Immigrants are examples of part-year residency. This person is considered to be a resident for tax purposes during the period of permanent residence only. Part-year residents are subject to tax on worldwide income earned while considered resident in Canada.

 

4. Non-residents

Non-residents are subject to Part I tax only on income from Canadian sources. This includes income from employment, business, investment and sale of a capital property.

A non -resident may also be liable for 25% withholding tax on other types of income from Canadian sources, such as: interest, dividends, pension income, and so on. This tax is deducted at source.

 

 

Sources of income for tax purposes:

1. Net income from an office or employment

2. Net income from a business

3. Net income from property

4. Capital gain

5. Other sources of income, such as:

   1. pension

   2. employment insurance

   3. registered pension plan

   4. registered retirement savings plan

   5. deferred profit sharing plan

   6. alimony or maintenance

   7. separation allowance

   8. various forms of social assistance

 

Note: Windfall gains, such as an inheritance, a gift, or gambling winnings are excluded from the concept of income. While these amounts represent receipts of monies, the amounts represent transfers of wealth that have once been taxed.

 

 

 

The tax rate structure:

After arriving at taxable income, a tax rate is applied to determine the preliminary taxes payable. The rates differ between corporations and individuals:

• Individual rates are progressive; and

• Corporations are subject to tax at a flat rate depending on the type of corporation

 

Employee versus independent contractor:

For tax purposes the distinction between an employee and an independent contractor is important for the following reasons:

 

• The deductibility of expenses is considerably more restricted for employees. Self-employed individuals may take more deductions.

• Employers must remit income tax, EI payments, and CPP payments to the CRA for employees only.

• Ineligibility for EI benefits, holidays, employer-paid or other non-cash benefits

• Potential liability issues that arise for independent contractors

• Inability to collect severance pay

• Lack of job security and increased economic risk

 

Employment income:

Employment income is determined on cash basis and consists of the amounts received by the taxpayer in the year. Also, a benefit conferred on an employee is taxable when it confers an economic advantage to the employee and is determined at the fair market value of the benefit.

The bonus not paid to employee within 180 days of the corporation’s year end is not deductible to the corporation.

 

Business income:

Determining whether a taxpayer is carrying on a business is a question of fact. The courts have developed and applied numerous tests to assist in defining this source of income. Generally, the principal tests used by the courts include:

 

• whether the taxpayer dealt with the property he/she acquired in the same way as a dealer in such property ordinarily would deal with it;

• whether the nature and quantity of the property was such that it could not produce income or personal enjoyment for its owner and the only purpose of acquisition was to sell the property; and

• whether the taxpayer’s intention of purchasing the property indicated a trading motivation to sell the property for a profit, rather than as an investment only.

 

 

 

 

Business Income vs. Employment Income:

Income from an office or employment is not business income as it is excluded from the definition of “business”.

Taxpayers are often motivated to report their income as a source of business income rather than employment income as there are fewer restrictions on deductions that can be claimed in computing business income.

 

Business Income vs. Property Income:

Over a taxation period, income or losses generally arise from holding or using property. Whether this income is from property or from a business, is not always easily determined. The basic test is whether the income earned is active or passive income. If the income requires little or no activity by the taxpayer (or his/her employees), the income is usually considered passive and is income from property. Examples would include dividends on shares, interest on bank savings, and similar investments such as bonds, royalties, and rental income. It does not result from the same degree of time and effort as does business income, which may be descrided as active income. The passive versus active test has proven to not always be easy to apply or administer as there is always the question of the degree of required activity. Consequently, the Income Tax Act contains specific directives fro many cases.

 

Business Income vs. Capital Gain:

The distinction between income from a business and a capital gain has always been significant because of the preferential tax treatment on capital gains (currently one half of a capital gain is taxable). Today, the sale of a property will give rise to either

 

• business income (loss); or

• capital gain (loss)

 

The gain on disposition of an asset is considered business income if it results from the sale of property that is inventory. A gain from the sale of property is considered capital gain if the result is from the sale of capital property.

 

Criteria for determining whether a profit (loss) constitutes business income (loss) or a capital gain (loss):

 

1. The Number and Frequency of the Transactions

An individual who habitually undertakes an activity capable of producing a profit is probably carrying on a business; even if the activity is separate from his/her ordinary occupation.

 

2. Nature of Transaction

Even if the activity is not habitual, it may still be classified as business income if it can be shown that the taxpayer is engaged in an adventure or concern in the nature of trade. The courts consider the purpose of the purchase, the quantity purchased, the method of sale, and reason for the sale.

 

3. Taxpayer’s Intent

If the taxpayer’s intent in purchasing the property was to trade the property for profit, the gain may be viewed as business income.

 

Allowed Business Expenses:

In calculating net income from a business, the Income Tax Act does not specifically list all of the deductible expenses. In practice, if an expense is not specifically addressed in the Act, it is usually deductible for tax purposes if the expense is:

 

• deductible using generally accepted accounting principles;

• not a capital expenditure;

• incurred to earn taxable income;

• not a personal expense or expenditure; and

• reasonable in the circumstances

 

If the amount in question is material, taxpayers generally consult tax professionals to assist them in interpreting the law and the administrative treatment.

 

Deductible for Accounting Purposes but not for Tax Purposes:

Many deductions for accounting purposes, such as the write-down of property to fair market value and deductions for amortization, are disallowed for tax purposes. It is possible that some expense properly taken for accounting purposes do not fit into Canadian tax system at all.
Paragraph 18(1)(a) of the Income Tax Act requires that an expense taken for tax purposes must be for the purpose of gaining or producing income from the business or property, while paragraph 18(1) (e) disallows a provision for reserves on account of a contingent liability (example: estimated future environmental clean-up cost).

 

Disallowed Expenses:

 

a. Exempt Income

a deduction is allowed only to the extent that the related income earned is taxable. Any expense incurred to earn income that is exempt from Part I tax are not deductible in the calculation of business income for tax purposes.

 

b. Reserves and Contingent Liabilities

• Reserves for doubtful debts in excess of the reasonable amount

• Reserve for goods and services to be delivered after year end

• Reserves for deposits on returnable containers

• Manufacturer’s warranty reserve

• Reserves for unpaid amounts

• Reserves for contingent liabilities and sinking funds

 

 

 

c. Personal Living Expenses

 

d. Food, Beverage, and Entertainment

The deduction is limited to the lesser of:

• 50% of the amount paid or payable; or

• a reasonable amount

 

e. Recreational Facilities and Club Dues

 

f. Home Office

A home office must be either the taxpayer’s principal place of business or used exclusively for the purpose of earning income from business and used on a regular and continuous basis for meeting clients, customers, and/or patients of the taxpayer.

Home office expenses may not exceed the income from the business to create a business loss. However, any disallowed home office expenses that would not otherwise be deductible may be carried forward and offset against a future year’s business income.

The CRA accepts the following ongoing home expenses:

• rent

• mortgage interest

• property tax and insurance

• heat, light, water, telephone

• cleaning and maintenance

• yard maintenance

• minor repairs and supplies

 

Note: The portion of the home used for business may also be depreciated for tax purposes, but if capital cost allowance is claimed, a portion of the home becomes a business asset ineligible for the principal residence exemption.

 

g. Illegal Payments and Fines

Paragraph 18(1)(t) prohibits any deduction for federal income taxes, interests, and penalties imposed under the Act. However, there is no restriction on deducting interest paid on late municipal property tax or legal and accounting expenses incurred to object to a tax assessment or reassessment.

 

h. Automobile Expenses

The deduction of automobile allowance to employees is revised annually.

The interest expense incurred on money borrowed for a passenger vehicle is limited to $10 per day multiplied by the number of days interest was paid or payable.

There is a formula for calculating the maximum leasing cost, but it cannot exceed $800 per month ignoring GST/PST.

 

i. Interest and Taxes on Properties

The Act prevents creating or increasing a business loss where the land is not being used to earn or produce business income in the year. However, it is allowed to include these expenses in the capital cost of the property.

 

j. Advertising Expense

Advertising expenses in foreign media are not deductible when the advertising is primarily directed at the Canadian market.

 

k. Interest and Financing Expenses

To prevent the inappropriate expensing of interest, the Act requires that certain conditions must be satisfied before interest qualifies as a deduction:

 

• there must be a legal obligation to pay the interest

• the borrowed funds must be used for the purpose of earning income that is not exempt; and

• the amount must be reasonable (e.g. should not be greater than the market rate of borrowing).