Firstly, this is my list not yours. It is very subjective and is a reflection of my many years of experience of being a tax specialist and building a “tax only” advisory practice. Most of the practitioners that are clients and friends of our firm know their tax limitations. However, there are other practitioners whose work we often trip across that do not know their limitations. The simple fact is that tax is tough. I would venture to say that it is one of the most challenging professions in existence. Unfortunately, there is no tax specialist designation in Canada to help the public identify professionals who have credible knowledge and experience in tax. I’m hopeful that will change soon.
With the above in mind, here are the top five mistakes we often see.
1. Taxable benefit issues not considered
The Canadian Income Tax Act (the ”Act”) is littered with benefit provisions. For example, section 6 of the Act deals with employment benefits. The section is purposefully drafted broadly to capture many types of benefits into the employee’s taxable income. Section 15 is another example and applies to many types of benefits received by a shareholder of a corporation. Again, section 15 is purposefully drafted very broadly but also has specific provisions so as to capture certain types of benefits into the shareholder’s taxable income. We find in many cases that an inexperienced practitioner may not have considered taxable benefit exposure when reporting on a taxpayer’s situation.
For example, consider the situation of Mr. Apple who is the shareholder of a Canadian – controlled private corporation, “Opco”. Mr. Apple’s acquaintances, and perhaps his advisor, have told him that he should purchase his personal use vacation property through Opco since he “will save a lot of tax”. Wrong. While the specific facts would need to be reviewed in order to give proper advice, it is highly likely that Opco has conferred a taxable benefit on Mr. Apple by virtue of section 15 of the Act as a result of the purchase and personal use of the vacation property. In some cases, such a taxable benefit can lead to ultimate double taxation. I’ve written and lectured about this many times. Accordingly, be very aware of situations that can cause taxable benefits to arise.
2. Taxation of prepaid amounts
One of the fundamental accounting principles that is taught to accounting students early on in their studies is the ”matching principle”. Overly simplified, it stands for the proposition that expenditures must be matched to the derivation of the related income. For example, if Opco pays $10,000 on January 1, 2012 for an insurance policy that will expire on December 31, 2013, the matching principle will generally cause accountants to not expense the full $10,000 in Opco’s 2012 fiscal year (assuming a calendar year end for Opco) but will instead amortize the cost over the period of benefit being 24 months. Accordingly, the prepaid portion of the insurance contact will be capitalized and reflected as an asset on the balance sheet of Opco.
The same logic applies for amounts received by Opco. For example, let’s assume that Opco provides consulting services and charges one of its customers a lump sum amount of $24,000 on January 1, 2012 for services that it will provide over the next 24 months. Let’s further assume that Opco has received the $24,000 on January 1, 2012. Using the matching principle, most accountants would record the $24,000 as a deferred liability on the balance sheet of Opco as of January 1, 2012 and amortize such amount to revenue over the next 24 months.
For Canadian tax purposes, the receipt of the $24,000 on January 1, 2012 is likely immediately taxable under paragraph 12(1)(a) of the Act irrespective of the fact that it may not have yet been earned for accounting purposes. There are certain reserves under section 20 of the Act that may be available to defer such unearned amounts until the time that it is earned but the facts and circumstances would need to be reviewed as the eligibility for the section 20 reserves are very specific and narrow.
Bottom line… review amounts received in advance and be aware that more than likely section 12 of the Act will apply to capture such amounts into taxable income irrespective of the accounting treatment.
3. Salaries paid to family members
Canada’s system of personal taxation is one which taxes income at progressive tax rates. Canada’s system is also one where each taxpayer must report and pay tax on their own income separately. Unlike the US, there is no ability to jointly file returns and combine income in certain cases. Accordingly, Canada’s system will often cause taxpayers and their advisors to look for clever ways to income split amongst family members so as to use multiple progressive tax rates and reduce the overall family tax burden.
One strategy that is used by certain practitioners when advising their entrepreneurial clients is to pay salaries to family members so the business can claim a deduction against its business income and the recipient family member can use their lower progressive tax rates. In some cases, we see significant salaries being paid to very young children. Simple… but does it work? This particular strategy is one of the many tax myths that exist in practice. We often hear from people that they’ve heard that salaries of say $7,000 to $10,000 to kids are acceptable since the Canada Revenue Agency (“CRA”) has said so. Or that their buddy has been using such a strategy for years and the CRA has never challenged it so it must be fine.
The fact is salaries paid from a business to family members must be reasonable in the circumstances in order to be deductible and to comply with section 67 of the Act. Any non-reasonable amount will not be deductible to the business but is still taxable in the recipient’s hands (which results in double taxation). The facts and circumstances will dictate what is reasonable but let’s be serious. As a real example, I have 4 kids ranging from the age of 6 to 15. I love them to death but would it be reasonable to pay my 12 year old $10,000 from my business for ”administrative duties” or “licking stamps” (common examples that we often hear)? Not a chance. Or at the very minimum, highly debatable and not likely.
Further, the salaries must have been incurred to earn income from the business in order to comply with section 18 of the Act. Was the payment of the $10,000 to my 12 year old incurred to earn income from my business? Debatable but not likely. Accordingly, be wary of the many tax myths in this area and be mindful of the sections 67 and 18 risks.
4. Corporate surplus stripping
The use of a corporation to carry on a business is a traditional and often sound strategy. As most readers know, a corporation is a separate legal person. While the corporate vehicle can offer many tax advantages, it also has its downsides or challenges for the private business. One of the most challenging issues is how does a shareholder remove after tax corporate surplus (or what accountants often refer to as retained earnings) in a tax efficient manner? The most traditional way is by way of taxable dividends which are the subject to personal taxation in the individual shareholder’s hands.
However, some practitioners want to be clever and find ways to remove corporate surplus to the individual shareholders in a more tax efficient manner. One strategy that we often see involves the use of the $750,000 capital gains deduction (”CGD”) applicable to qualified small business corporation shares. Let’s consider the case of Mr. Apple again who owns shares of Opco. Let’s assume that the shares of Opco have a fair market value of $500,000 and that all the detailed conditions which need to apply for Mr. Apple to use his available CGD apply. Mr. Apple wants to access Opco’s surplus tax free. Accordingly, Mr. Apple’s advisor develops the following plan:
- Mr. Apple sells his shares of Opco to a new holding company (“Holdco”) that his wife wholly owns for $500,000.
- As payment for the shares, Holdco will issue a promissory note to Mr. Apple in the amount of $500,000.
- Given the above sale, Mr. Apple will realize a capital gain of $500,000 (assuming that his adjusted cost base of his Opco shares was nominal) but he will offset such gains with his available CGD.
- Opco then pays dividends over time (whenever it has surplus cash) to Holdco. Since the shares of Opco are wholly owned by Holdco, Holdco will be “connected” with Opco and will generally receive such dividends on a tax free basis.
- Holdco will then use the cash to repay the promissory note to Mr. Apple thus resulting in him receiving such cash tax free.
Sounds pretty good right? Well, if it were only that easy. Unfortunately, the above plan simply doesn’t work. Section 84.1 of the Act will cause Mr. Apple’s capital gain described in step c above to be recharacterized as a taxable dividend. This will result in Mr. Apple not being able to claim the CGD and cause him to pay tax at personal dividend rates. Not good. Section 84.1 is one of the most common reasons why advisors are sued in tax matters.
Similar to section 84.1, there are other anti-surplus stripping rules within the Act. Practitioners need to be aware of such anti-avoidance rules and ensure that their plans are not caught by them.
5. US tax issues not considered
The US is one of the only countries in the world that imposes taxation on a citizenship basis. Simply put, if you are a US citizen (or if you are substantially present in the US or are a green card holder) then the US will tax you on your worldwide income (unless you renounce your citizenship which is a separate topic that can come with significant tax complications). Identifying who is a US citizen is not always an easy exercise and is very much a matter that is reserved for US immigration lawyers.
We have written often on US tax matters but for brevity, US citizens resident in Canada often have significant reporting requirements, may have unanticipated US tax liabilities and have exposure to the US transfer tax regime (including the US estate tax depending on the size of the US citizen’s estate upon death).
Know your client. Are you sure they are not US persons? Are you doubly sure? Have you or your client sought US legal advice to confirm? Be careful.