Author Archives: gilmourknotts

Tax Question:

Why does a business valuation matter to your accountant or tax advisor?

Facts:

When you are buying or selling a business, the purchaser wants to know if they paid a fair price and the seller wants to know that they received a good price.  “Value” is the price in a perfect market. Price can be different from value. However, markets are rarely perfect and the price can be higher if there is a limit on supply or lower if there is an oversupply at the exact moment the transaction occurs.

Discussion:

The primary situation where valuation matters to your accountant or tax advisor is in corporate reorganizations or other tax transactions that change ownership.

A tax transaction is an event that can trigger tax. Common events include change of corporate ownership or other tax deferred reorganizations (see FAQ #46). A tax deferred reorganization is when a person reorganizes his corporate structure to get a better business or tax result, but to also manage tax costs when doing it. Examples include when an established business brings in new owners (especially family members) and wants to have zero tax cost on that transaction; or when a business spins out a business division to a new stand-alone corporation. When these transactions occur, Canada Revenue Agency (CRA) is watching and will want to collect tax on the transaction. The business owner does not want to pay tax in most circumstances because he did not receive any cash with which to pay those taxes. Fortunately there are sections of the income tax act, like Section 85 rollovers (see FAQ #52), that can be used to reduce the tax to zero or defer the tax until a real cash sale occurs.

A valuation on these events is relevant because CRA might not be collecting any tax today; however, there may be future or related party tax consequences. The valuation is used in internal calculations to ensure that no benefit has been passed between family members or related corporations and escaped taxation or to establish a cost base for future events. The value must be at fair market value (FMV) otherwise there are avoidance and penalty provisions that apply.

The valuation is providing an independent third party assessment that CRA are more likely to accept rather than a self assessment. This then provides a more concrete base for the FMV of the transaction and quantifies both the current and future tax cost. If a non-FMV is used in a transaction, CRA are more likely to challenge the transaction and if successful will not only assess tax but also penalties and interest.

Recommendation:

If you have questions concerning business valuations, please contact us at Gilmour Knotts Chartered Accountants for our help on this issue.

Tax Question:

What is a Rights and Things Return and when is it filed?

Facts:

A Rights and Things Return is a return which may be filed for a deceased person in addition to the regular date of death return. It would include items that were unpaid at the time of the death, such as interest on un-matured deposits, unpaid salary and unpaid dividends. A Rights and Things Return is always optional; however, is advisable if there are relatively large unpaid amounts of income at the time of death.

Discussion:

Conceptually, think of a rights and things return as the return that would have been filed had the deceased lived past their date of death.  It contains things that would have been normally experienced had the deceased continued to live.  In contrast, the date of death return only captures things that happened to complete before the date of death or were deemed to have occurred as at the date of death.

If the unpaid amounts are significant, filing a separate Rights and Things Return permits a doubling up of certain tax credits, such as the basic personal credit, the age credit, the spousal credit, the eligible dependant credit, the caregiver credit and the infirm dependents age 18 or older credit.

In addition, other tax credits can be split between the two returns, such as the disability amount for the deceased or their spouse, interest paid on student loans, tuition amounts for the deceased or transferred from a child, medical expenses and charitable donations. By splitting these tax credits between the two returns, a portion can be claimed on each return to match the credits to the income claimed. You also receive the advantage of the graduated tax rates on the income filed on both returns.

Overall, filing a Rights and Things Return can result in significant tax savings.

Recommendation:

If you would like help determining if it is beneficial to file a Rights and Things Return for your deceased loved one, please call Gilmour Knotts Chartered Accountants for our help with this issue.

Tax Question:

What happens for Canadian income tax purposes to my assets when I die?

Facts:

Upon death, your assets are distributed to your beneficiaries. Through a will, you can set how the assets are distributed, clearly identify your beneficiaries and plan to minimize taxes. If you die without a will, (intestate), the distribution of your assets is governed by legislation rather than by your wishes and you will lose the opportunity to make the distribution tax effective.

Discussion:

Some things to note regarding the distribution of assets are:

There are provisions that allow for tax free rollover of assets to spouses at death.

• Assets left to beneficiaries, other than a spouse, are transferred at fair market value. This means the estate would owe taxes on any capital gains resulting from the deemed disposition.
• Some assets, such as life insurance policies and investments such as RRSP’s can designate a beneficiary directly inside the plan itself and do not need to be dealt with inside a will.

Some non-tax issues to think about when drawing up a will are who to choose as an executor and who to appoint as guardian of your minor children.

An executor is the person in charge of distributing your estate. The executor ensures your assets are distributed according to the instructions you left in your will, files your last tax returns and disposes of any other property.

The guardian you appoint will raise your minor children in the event that you and your spouse both die. You will want to ensure that the guardian can responsibly use the money that you left your minor children to ensure their needs are met.

Recommendation:

If you would like to discuss how to plan to minimize taxes on the deemed disposition of your assets, please contact Gilmour Knotts Chartered Accountants for our help on this issue.

Tax Question:

When is a company expenditure considered an asset?

Facts:

There are three criteria for recognizing an expenditure as an asset for accounting purposes. The expenditure must meet all three criteria to be considered an asset.   The tax treatment is similar but not identical to accounting treatment. Generally for tax all items are expensed unless they are capital in nature as defined by tax criteria.  This FAQ covers accounting not tax treatment. Tax and Accounting treatments can be different.

Discussion:

There are times in which we may want to delay an expense and recognize it as an asset for accounting purposes in order to match the expense with the revenues when they occur.  An example would be an intangible asset such as goodwill or a deferred development cost.  In order to recognize the amount as an asset, it must meet the following three criteria:

1. The company must control access to the asset. A good test of this is whether the company is able to sell the asset. You may be able sell a car or a piece of equipment. In contrast you may have exclusive rights or a membership which is non-transferrable and thus un saleable. If it is un salable because it is non-transferrable, it cannot be claimed as an asset.

2. The transaction must have already occurred. You cannot claim an item as an asset if you made an agreement to purchase the item in the future, even if you have paid a deposit. To claim the asset, the purchase must have already taken place.

3. There must be a future economic benefit associated with the expenditure. For example, equipment purchases may help a company manufacture more items which will increase cash flows. A vehicle will allow you to visit clients or potential clients which will also increase cash flows. If there is no future economic benefit, then it is not considered an asset.

Once you have determined that the expenditure is an asset, the asset is then depreciated over its useful life.

Recommendation:

Most expenditures are easily defined as assets or expenses, but sometimes the lines seem to blur.  If you are unsure about how an expenditure should be treated for accounting purposes, please contact Gilmour Knotts Chartered Accountants for help on this issue.

Tax Question:

How can I pay for my children’s university tuition with dividends and not lose the tuition credits?

Facts:

If your children are shareholders in your company, it may be beneficial to have them receive dividends and use those dividends to pay tuition. The reason dividends are used is that if we used salaries, we would find that they  must be “reasonable” for the work performed. This could limit the amount of salaries as the children are likely too busy at university to show up at your business and work. There is no reasonableness test for dividends; however, there is a technical tax challenge to using dividends instead of salaries. Dividends receive dividend tax credits and these tax credits can cause you or your children to lose the tuition credits as you cannot “double dip”. The result of losing the tuition tax credit is that you pay a hidden tax on the tuition. Any tax savings from using dividends is lost.

Discussion:

With the rising costs of tuition and living expenses, it is getting more and more expensive to send your children to university. If you own your own business, it is beneficial to pay your children wages through the company to cover the cost of school.

If the children are shareholders, this allows the company to pay them dividends at the discretion of the voting shareholders, which are usually the parents. Therefore, there is no cap on the dividends like there is for wages. The trick with paying dividends is when the children prepare their personal income tax returns. You want to be able to use all their dividend tax credits and be able to carry forward their unused tuition tax credits to another year or transfer them to the parent.

Dividends are grossed up for tax purposes, which increases the taxable income and then a credit is applied  to reduce the taxes. However, the dividend credit is applied after all the other credits are used. As a result, the tuition credit will be used first. Since the grossed up income from the dividend usually uses up all the tuition credit, there is none available to be carried forward to future years or transferred to a parent. The dividend credit is applied last and may not be needed since the tuition credit decreased the income to Nil. As the dividend credit cannot create  a refund and cannot be carried forward to future years, it is wasted.

Therefore, we suggest giving a large dividend in one year rather than a smaller dividend each year the child is in university. If one large dividend is issued to cover two or three years of tuition and living expenses, the credits are used to reduce the taxes owing in the one year that the dividends are issued. That means that in years two and three, the child will report no income and be able to carry forward or transfer their unused tuition credits.

The company’s cash flows will not be affected by the large dividends as the full amounts do not have to be paid. They can be put into the children’s shareholder loan accounts and drawn down over the two or three years as needed.

Recommendation:

This is an example of tweaking that is sometimes necessary to take a good concept like using dividends and make it actually work for you. If you have questions concerning how to pay your children’s tuition expenses using dividends from your company, please contact us at Gilmour Knotts Chartered Accountants for our help on this issue.

Tax Question:

What are tax treaties?

Facts:

Canada has tax agreements with many countries which are commonly known as tax treaties. A tax treaty is designed to avoid double taxation for corporations and individuals who would otherwise pay taxes on the same income in two countries.

As of March 2012, Canada has 89 tax treaties in force, 7 tax treaties and protocols signed but not yet in force and 11 tax treaties under negotiation.

Discussion:

Tax treaties generally cover a wide range of taxable items, including dividends, interests, royalties and capital gains. The provisions can vary highly across treaties between different countries. Although very few tax treaties are alike, most of them include the following:

1. Define which taxes are covered, who is resident and who is eligible for benefits.

2. Reduce the amount of tax withheld from interest, dividends and royalties paid by a resident of one country to the resident of the other country.

3. Limitation of taxes on business income of a resident of the other country to that income from a permanent establishment in the first country. If a business is a resident of one country and is considered to have a permanent establishment (i.e. a fixed place of business including an office, branch, etc.) in another country, then it is generally subject to tax in the other country.

4. Provide an exemption of certain types of organizations or individuals. This generally includes charities and pension trusts.

5. Provide procedures for enforcement of the treaty and how to resolve disputes.

In addition to avoiding double taxation, countries often enter to into tax treaties in an effort to reduce tax evasion and promote cross-border business and trading.

Recommendation:

If you have questions concerning withholding taxes, please contact us at Gilmour Knotts Chartered Accountants for our help on this issue.

Tax Question:

What is a section 51 corporate reorganization?

Facts:

Income splitting is one of the most tax effective tools that a corporate structure permits. However, many corporations are not set up for the most tax efficient distribution of income. Often, this is because little attention is given to the current or future relationship or income earning activities of the shareholders.

Discussion:

Often, a husband and wife will set up a corporation on a 50:50 ownership basis with both shareholders having the same class of shares. Then, a few years later, one of the spouses reduces his or her involvement in the business and seeks employment outside the corporation. This shareholder is now getting employment income from a third party in addition to a 50:50 share of the income from the corporation. The 50:50 share structure is no longer efficient because the spouse with the third party income will often be in a higher tax bracket due to the added employment income.

Having two spouses in separate tax brackets is not tax efficient as it means one spouse is paying more taxes on income that could be earned by the other spouse at a lower tax rate. A solution to this problem is to convert the current shares into different classes of shares so that different dividends can be paid to each shareholders.

Shareholders owning the same class of shares can only take dividends in proportion to their shareholdings. However, shareholders with different classes of shares can take different amounts of dividends, which are independent of the amounts of dividends issued to the other shareholders.

As with most reorganizations, a share swap constitutes a disposition of shares, which would result in a capital gain and a tax bill. Section 51 allows a shareholder to swap shares of one class with shares of another class in the same corporation without it being viewed as a sale, providing that the shareholder is not getting any additional benefit as a result of the swap. In other words, as long as they have the same rights to income, voting, and any other entitlements before and after the share swap, it will not attract a tax liability.

Recommendation:

If you have questions concerning reorganizations, please contact us at Gilmour Knotts Chartered Accountants for our help on this issue.

Tax Question:

What is the difference between an employee and a subcontractor?

Facts:

Many corporations are changing how they interact with workers to avoid employment rights issues and reduce labour costs. To do this, they are subcontracting works that used to be performed by employees.

Discussion:

Canada Revenue Agency (CRA) have a two stage process for determining the working relationship. First, they examine the intent. How did the two parties intend to define their relationship? Contracting parties are free to establish a relationship as they see fit. The easiest means of establishing intent is to draft an agreement that clearly states the type of the relationship.

If the intent is not clear, then CRA will examine the relationship based on a number of elements listed below:

Control – How much freedom does the worker have to perform their duties. The more control the worker has in setting their own deadlines, hours and methods, the less likely he or she is an employee.

Provision of tools – who provides the tools to perform the job. For example, computers, software, hammers and wrenches. The more tools an individual supplies, the less likely he or she is an employee.

Degree of financial risk – the likelihood a worker will have to cover costs personally whether he or she works or not. The more risk a worker has, the less he or she is an employee.

Opportunity for profit – can the worker pick and choose those contracts that will maximize a profit.  An employee is usually directed on what he or she works on, and irrespective of how well he or she does, a guaranteed salary is paid. If a subcontractor identifies efficiencies that save costs, he or she will reap the benefits.

Responsibility for investment and management – does the worker have to personally put up money to perform the work. Employees usually have no capital outlays and are paid no matter the results.

It is important to get the classification correct as misclassifying an employee as a subcontractor can result in penalties on failure to submit withholding taxes to CRA.

Recommendation:

If you have questions concerning employee vs. subcontractor classification, please contact us at Gilmour Knotts Chartered Accountants for our help on this issue.

Tax Question:

What is a section 85.1 rollover?

Tax Question:

What is a sister corporation?

Facts:

Sister corporations are corporations that are owned by the same shareholder or group of shareholders.

Discussion:

Corporations can be owned by a single shareholder or a group of shareholders. If two or more corporations have the same shareholders, then they are classified as sister companies. The two corporations do not have shareholdings in each other. But they are owned by the same individual or group of individuals.

Sister corporations are usually set up to hold different businesses or assets so that they are not all in one company.  For instance, the operations of a business are held in one corporation and the building it operates in is held in another sister corporation. This makes it easier down the road to sell the business operations but retain the ownership of the building. It is also common to have different businesses held in sister corporations. For instance, if a company manufactures widgets and also contracts out the use of or rents the widgets, one corporation will hold the manufacturing operations and a sister corporation will hold the contracting or rental operations.

Having many sister corporations does not increase your small business deduction as this must be split between all associated corporations. Please see FAQ #18 for information on the Small Business Deduction Limit and how it is split between associated corporations.

Sister corporations are also still required to charge sales taxes (HST/GST/PST) on the sale of goods or services between the corporations even though they are associated. The overall tax implications are Nil as one company collects the tax and the other company claims the input tax credit. However, it does affect each corporation’s cash flows.

Recommendation:

If you have questions concerning whether or not you have or need a sister company, please contact us at Gilmour Knotts Chartered Accountants for our help on this issue.