The Ying and the Yang for Small Business Owners, Investors, and Trusts

There was good news and bad news for small business corporations and investors in this budget. Here are the details of those provisions and other tax news for farmers and investors.

Capital Gain Exemption. The $750,000 lifetime capital gains election available on the disposition of qualified farm property, qualified fishing properties and qualified small business corporation shares will be increased by $50,000 to $800,000 in 2014 and indexed thereafter starting in 2015. 

Other Than Eligible Dividends.  Beginning with tax year 2014, the gross-up of other than eligible dividends (small business dividends) will be reduced from 25% to 18% and the Dividend Tax Credit for other than eligible dividends reduced from 2/3 of the gross-up to 13/18 of the gross-up.

Example: $1,000 dividends are taken in income for a taxpayer who is taxed at 40%

*2013: Income is $1,000 x 125%.  Tax is $500, credit is $166.66 so net tax is $333.33 or 33.3%

*2014: Income is $1,000 x 118%.  Tax is $472, credit is $130.00 so net tax is $342 to 34.2%

The actual dollar increases will vary, depending on the client’s Marginal Tax Rates and province of residence.

RPP Contribution Errors.  Where an RPP contribution made after 2013, that has already been deducted by a taxpayer, is refunded to the taxpaeyr due to a reasonable error, the taxpayer must include that refund in income.

Restricted Farm Losses.  The current $8,750 maximum deduction for losses where farming is not the taxpayer’s chief source of income will be increased to $17,500 ($2,500 + 50% of the next $30,000) for taxation years ending after Budget Day.

Safety Deposit Boxes.  Beginning with tax year 2014, the cost of renting a safety deposit box from a financial institution will no longer be deductible.

Leveraged Insured Annuities.   A leveraged insured annuity is an investment purchased with borrowed funds which includes a life annuity plus a death benefit.  The annuity payments are taxable income and the interest paid on the borrowed funds are carrying charges.  The death benefit is received tax-free.

For investments in such contracts where the borrowing occurs after Budget Day, the following changes will be made:

1. Income paid under the annuity will be subject to taxation on an accrual basis
2. No deduction will be allowed for interest paid on the loan or premiums paid on the policy
3. Where the beneficiary is a corporation, the death benefit will not be added to the capital dividend account of the corporation
4. The fair market value of the annuity contract assigned to the vendor in connection with the investment will be deemed to be the total of the premiums paid under the contract.

10/8 Arrangements.  In a typical 10/8 arrangement, the taxpayer invests in a life insurance policy, borrows an equal amount to invest in an income-producing asset in order for the interest payments to be tax deductible.   The insurance policy or an investment account under the insurance policy is typically used as collateral for the loan. The arrangement is named after a typical arrangement where the borrower pays 10% interest on the loan and earns 8% on the investment. 

For taxation years ending on or after Budget Day, the following  changes will be in effect:

1. Interest paid or payable on the borrowed funds will not be deductible
2. Premiums paid on the policy will not be deductible
3. If the beneficiary is a corporation, then the proceeds of the insurance policy will not be added to the capital dividend account of the corporation

To facilitate termination of existing 10/8 arrangements, the budget proposes to alleviate the income tax consequences of withdrawal from such arrangement if the withdrawal is made between Budget Day and the end of 2013.

Labour-Sponsored Funds Tax Credits. The 15% federal Labour-Sponsored Fund Tax Credit will be phased out beginning in tax year 2015.  The rate for 2015 will be 10% (to a maximum of $500).  For 2016 the rate will be 5% (to a maximum of $250).  The credit will not be available after 2016.

Deemed Dispositions. Where a taxpayer enters into a transaction or set of transactions which have the effect of eliminating the taxpayer’s risk of loss and opportunity for gain or profit in respect of the property, that taxpayer will have been deemed to have disposed of the property for its fair market value and to have re-acquired it for a cost of NIL.

Normal Reassessment Period for Tax Shelters. Beginning with taxation year 2014, where a tax shelter investment has been made and the information return for the tax shelter or reportable transaction is not made on time,  the normal three-year reassessment period for a participant in such a tax shelter or reportable transaction will begin when the required information return is received by CRA rather than when the return for the participant is originally assessed.

Mineral Exploration Tax Credit for Flow-Through Shares.  The mineral exploration tax credit has been extended for another year so that investments up to March 31, 2014 in flow-through shares will be eligible for the mineral exploration tax credit for exploration up the end of 2015.

Derivatives: Character Conversion Transactions.  For derivative forward agreements entered into or extended after Budget Day, if the agreement is not determined by the capital property being purchased or sold under the agreement, the agreement will be taxed independently of the disposition of the capital property.  The agreement would result in an income inclusion (or deduction) equal to the excess of the fair market value of the property delivered when the agreement is settled over the amount paid for the capital property.  Any income included as a result of the derivative forward agreement will be added to the ACB of the property acquired.  Effectively, the excess that the buyer pays over the FMV of the property will be treated as ordinary income and not as a capital gain.

Example:

Tom and Jerry enter into an agreement where Tom will buy a property from Jerry on January 1, 2015 for an amount that is equal to the value of 10,000 shares in a certain ETF.  The FMV of the property is currently $100,000 and Jerry’s ACB is $90,000.  Assume the value of the ETF is $120,000 on January 1, 2015 and the agreement is settled.  The FMV at the property at that time is $110,000.

*Without the new rules, the result will be a disposition for $120,000, ACB of $90,000 so Jerry will report a capital gain of $30,000.

*With the new rules, the settlement of the agreement will result in Jerry reporting  $120,000 -$110,000 = $10,000 as ordinary income.  The ACB of the property will be increased by this $15,000 so he will also report a capital gain of $120,000 – ($90,000 + $10,000) = $20,000.

Trust Loss Trading.  Rules will be put into place to ensure that a person will not be able to acquire interest in a trust that has unused losses in order for that person to take advantage of the trust’s unused losses.

Non-Resident Trusts.  Where a Canadian resident owner transfers property to a non-resident trust but maintains effective ownership of the property after the transfer, will be treated as a loan or transfer of a restricted property which will result in the deemed residence rules being applied to the trust.  This will apply to all transfers made after Budget Day.

Testamentary Trusts.  The government has announced its intention to consult on possible measures to eliminate the tax benefits of taxing testamentary trusts (and grandfathered inter vivos trusts).  These trusts currently pay taxes at the graduated rates applicable to individual rather than the 29% rate paid by inter vivos trusts.

Next time:  Details of GST and CCA News for Business Owners