PERSONAL TAX PLANNING

by
John G. Patte, C.A.

Introduction

Tax planning should not be considered an end in itself - it is an integral part of your overall financial and business planning and should be considered in light of your personal goals. Many tax saving ideas may in fact move you further away from achieving your most important financial goals. Investments in risky tax shelter investments may save taxes but leave you with an investment of little value and a severe debt hangover. A poorly designed income-splitting scheme may save short-term taxes but distort your estate planning objectives.

Good tax planning then is more about achieving your personal financial and business goals than it is about reducing your tax load. Good tax planning begins with sound personal and business planning.

Tax planning should be a year-round activity, not one that you consider just at the end of the year or at the RRSP deadline or in April. By then, you may have missed opportunities. Asking your tax consultant how you can reduce your taxes after the income has been earned or after various transactions have been completed is like locking the barn door after the horses have escaped. A few of the "horses" may be recoverable - there are some options available on filing your tax return - but mostly, his role will be limited to merely helping you count how many "horses" have escaped.

With these comments in mind, let's look at a few ways that you may be able to reduce your taxes.

Employment Income

Opportunities for reducing taxes on employment income may be limited but here are some ideas that may be relevant to you:

1. Non-taxable employee benefits

Consider renegotiating your compensation to convert taxable income into useful non-taxable benefits

Cash compensation, bonuses and certain benefits may be necessary for our day-to-day lifestyle but they also increase our tax load. Some benefits though may reduce our need for cash income or improve our long term financial position without adding to our tax liability:

• employer contributions to pension plans, deferred profit sharing plans, group sickness and accident plans, private health plans;
  
• employee discounts, subsidized meals, distinctive uniforms and special clothing and protective footwear (including laundry costs), social/athletic club memberships mainly for the purpose of promoting the employer's business (which unfortunately would not be deductible to the employer);
  
• non-cash gifts and awards with a value less than $500 (including taxes) in the year;
  
• personal counseling for mental/physical health, re-employment and retirement;
  
• moving expense reimbursement (including in some cases mortgage interest subsidies).

2. Employee stock options

Employee ownership through stock options can provide tax and other benefits to both the business owner and the employee

Canadian-controlled private corporations - employers may reward arm's length employees by allowing them to acquire shares in the employer at discounted prices without any current income tax cost to the employee. The employer benefits by not incurring any current outlay of cash; and stock options could be used as part of a long-term succession plan to retain, motivating and prepare a valued employee for future purchase of the business.

For the employee, there may be considerable long-term benefits far exceeding the current value of the shares; the feeling that he will benefit beyond his cash income from helping to build the business; there is also of course the risk that the business may not be successful and the shares may be worthless.

A few comments concerning taxation and general business issues:

• 50% of the difference between the value of the shares when the employee acquired them and the option price that he paid will be taxable as employment income to the employee when he disposes of the shares if he does not dispose of them within two years after acquisition;
  
• any increase in value above the value at acquisition will be taxable as a capital gain, possibly eligible for the $500,000 capital gains deduction for shares of qualified small business corporations;
  
• a shareholders' agreement should be drafted to define the rights and obligation of the various shareholders;
  
• while there is no cash outlay to the employer, the employer receives no deduction for tax purposes for this benefit; and the primary shareholder may find he has less operating freedom once he admits a new minority shareholder.

  Other corporations - different rules face employees of non-CCPCs and employees of CCPCs who dispose of their option shares within two years:

• 50% of the difference between the value of the shares when the employee acquired them and the option price that he paid will be taxable as employment income to the employee in the year that he exercises the option as long as the option price is not less than the value of the shares when the option was granted and the employee dealt at arm's length;
  
• the taxable benefit may be deferred, if the employee so elects on a timely basis, to when the shares are sold or the employee dies or becomes a non-resident;
  
• for non-arm's length employees and for option prices below market value, 100% of the difference is taxable as employment income when the option is exercised.

3. Employee Automobiles

Consider reimbursement for employee use of the employee's automobile based on a reasonable per kilometre allowance

Reasonable allowance based on business distance traveled is not taxable. Any allowance or reimbursement (e.g., fixed monthly allowance) paid by the employer that is not based on business distance traveled is taxable and should be entered on the employee's T4 slip.

Employers can deduct a "per kilometre" allowance up to $0.41per km for the first 5,000 km and $0.35 per km thereafter. Higher allowances may in some cases still be considered reasonable and not taxable to the employee but they will not be fully tax-deductible to the employer.

4. Employee Automobiles

Consider deducting the cost of business use of the employee's automobile against employment income Maintain automobile log of your personal and business travel to support your deduction

If no reasonable per kilometre allowance is provided, or where the allowance is added to the employee's income, the employee may deduct actual costs of operating his automobile for employment purposes:

• employer must complete form T2200 Conditions of Employment;
  
• employee should maintain a log of employment use or risk disallowance of the expense;
  
• employee must maintain records of actual costs, including gas, repairs, car washes, insurance, licence, auto club membership, financing costs, lease costs, purchase costs;
  
• limitations exist on the amount of tax depreciation (capital cost allowance or CCA) and financing costs or lease costs that may be deducted.

5. Employer-provided Automobiles

Employer-provided vehicles offer substantial benefits to employees but carry a significant taxable benefit

There are two parts to the taxable benefit added to the employee's T4 for use of an employer-provided automobile:

• standby charge - 2% of the original cost of the vehicle per month that it is available for employee use, or 2/3 of the lease cost (plus GST), which may be reduced if employment use is more than 50% of total use and personal use is less than 1,667 km per month (i.e., 20,004 km/year);
  
• operating costs - benefit is calculated in one of two methods:
  • $0.17 per km driven for person use, less any reimbursement to the employer within 45 days after the end of the year;
    
  • 50% of the standby costs if the vehicle is used at least 50% for business and the employee notifies employer in writing by December 31, less any reimbursement to the employer within 45 days after the end of the year.

To reduce the taxable benefit, consider:

• maintaining automobile logs of your personal and business travel to support benefit calculation;
  
• purchasing an older employer-provided vehicle since the standby charge is computed on original cost no matter how old it is;
  
• notifying employer of intention to use the 50% of standby costs for operating benefits;
  
• reimbursing employer for 100% of personal-use operating expenses.
  

6. Loans To Employees

Employees may benefit from low-cost loans from the employer even with taxable benefit. Paying tax on the benefit may be less costly than paying the full interest costs

Now may be an ideal time to lock in a low interest rate benefit for a house purchase loan.

For low and no-interest loans, the taxable benefit is computed as the difference between interest computed at a rate prescribed quarterly by Canada Customs & Revenue Agency and the interest that the employee actually pays on the loan within 30 days of the end of the year.

The benefit related to a home purchase loan is calculated at the lower of current prescribed rate and the rate in effect at the time the loan was given, less the amount repaid by the employee within 30 days of the end of the year.

A deduction may be claimed for the amount of the taxable benefit for interest on a home relocation loan of up to $25,000 for up to five years. To qualify, the employee must have purchased a home in connection with a move in Canada that is at least 40 km closer to the employee's new place of employment as a consequence of a change in the location of employment.

The taxable benefit for no/low interest loans is considered to be interest paid in the year. If the loan were used to earn income from business or investment, the taxable benefit may be deducted as a carrying charge.

7. Employment Expenses

Deduct expenses incurred in connection with employment

Commission sales employees may deduct a variety of expenses related to the earning of their commission income, up to the amount of their commission income, when these expenses are not reimbursed by the employer. Meals and entertainment expenses are restricted to 50% of the cost (except when incurred at a lodge, camp or golf course - these may not be deductible at all based on recent tax cases).

Employees without commission income may deduct employment-related expenses on a more restrictive scale:

• office rent (but not mortgage interest and property taxes incurred instead of rent, or insurance); for employees working out of their homes, utilities and maintenance costs;
  
• salary of an assistant;
  
• cost of supplies consumed;
  
• automobile expenses, including CCA (CCA is restricted on vehicles costing more than $30,000 plus related PST and GST; restrictions also apply to interest and lease costs).

In either case, form T2200 Conditions of Employment must be completed by the employer and should be filed with paper returns.

8. GST Rebates

Employees claiming automobile expenses or other employment-related expenses may claim a rebate for the GST included in the cost claimed

To claim the rebate, the employee should:

• retain supporting receipts showing the supplier's GST registration number;
  
• know the employer's GST registration number; (employees of GST-exempt employers are not eligible for the GST rebate - e.g., insurance agents);
  
• claim the expenses in the year incurred including GST;
  
• include the amount of the GST rebate in the employee's income in the following year.

Business Owners and Professionals

9. Fiscal year end for unincorporated businesses

Since 1995, unincorporated businesses must use December 31 as the year end for tax purposes Except where they elect to use the alternative method

An exception to the December 31 rule may arise where the business elects to use an alternative method of computing income. Certain businesses, such as partnership with members other than individuals, are not eligible for the alternative method. Also, once the alternative method is revoked or the business becomes ineligible, the alternative method may not be used thereafter for that particular business.

The alternative method is available to new businesses that were not in place at the end of 1994.

• use the alternative method if there are non-tax reasons for using it (e.g., business cycle, financing reporting for banking purposes);
  
• use the alternative method to defer income for tax purposes if income is increasing;
  for new businesses in 2003 and you choose the alternative method, consider reporting some income in 2003 to reduce your 2004 tax liability;
  
• for new businesses in 2003 using the alternative method, the election must be filed by June 15, 2004.

For businesses that had non-calendar year ends before 1995, these rules resulted in more than 12 months of income being reported for tax purposes in 1995. To alleviate some of the tax cost, a reserve was allowed to
spread the additional income out over up to 10 years by claiming a special reserve. For each year since 1995, the business person was obliged to include in income a portion of the reserve. By the end of 2004, there will remain no further reserve.

10. Owner's remuneration

Benefit from flexibility - consider how much remuneration, in what form that remuneration should be paid and when the remuneration should be paid

Since 1972, the tax system for small business has attempted to "integrate" the tax of the corporation and that of the shareholders to nullify any advantage of incorporation. In theory, the tax payable by a sole proprietor on his business income should be equal to the total tax on the same business income earned through a corporation if the corporate tax and the personal tax on salary and dividends were added together. Surtaxes and variations in provincial tax rates mean that integration is generally less than perfect.

One of the main benefits of incorporation remains the owner's has control over the amount, timing and form of his remuneration. This control may allow the owner to optimize and reduce the overall tax load. Yet, for such a mundane issue, the relevant factors can be intimidating:

• income in the corporation is taxed at 18.62% up to $225,000; from $225,001 to $300,000 - 27.62% above $300,000 - 38.95% (36.95% for manufacturers);
  
• dividends are not deductible to the corporation; salaries and bonuses are deductible;
  
• bonuses should usually be accrued payable to active shareholders to reduce corporate income below the $225,000 threshhold, (or possibly $300,000 because of the reduced corporate tax rate up to $300,000; accrued bonuses must be paid within 179 days of the corporate year end to be deductible;
  
• dividends up to about $29,000 can be paid without any personal income tax if the recipient has no other income; individuals with deductions in excess of other income (e.g., RRSP, carrying charges, alimony, rental losses) may be able to take larger amounts of dividends before paying tax;
  
• retention of income in the corporation may result in a substantial tax deferral because of the lower corporate tax rate;
  
• corporations with investment income may have refundable taxes that can be refunded only with the payment of taxable dividends by the corporation at the rate of $1 of refund for each $3 of dividends;
  
• dividends will reduce cumulative net investment losses (CNIL) that may interfere with the claiming of the capital gains deduction on the sale of shares of a qualified small business corporation;
  
• US citizens may not benefit from the Canadian tax preference accorded dividends;
  
• earned income (income from employment, self-employment, net rental income, alimony) is needed if one wishes to make RRSP contributions - pay sufficient salary or bonuses to allow for the desired amount of RRSP contribution next year;
  
• similarly, employment or self-employment income is required to make CPP contributions, a factor that may be important to those within 10 years of retirement;
  
• salary is more effective in reducing alternative minimum tax (AMT) that may arise on tax-preference items (such as large capital gains) than dividends;
  
• dividends may be preferred to salary if the corporation has loss carry forwards or tax credits available to offset income or tax in the corporation;
  
• salaries will increase Employer Health Tax in the corporation if total salaries and wages exceed $400,000 for the calendar year;
  
• dividends paid out of the corporation's capital dividend account can be received free of any tax;
  
• repayment of amounts loaned to the corporation by the shareholder and reduction of share capital can be received by the shareholder as a tax-free return of capital;
  
• salaries can be paid to a lower income spouse and/or children who contribute their services to the business to make use of their lower tax rates and personal tax credits and reduce corporate tax; salaries should be reasonable in relation to the work performed by them;
  
• dividends must be paid proportionately to the share ownership of any particular class of shares;
  
• dividends on a junior class of shares may be restricted unless appropriate dividends are also paid on more senior share classes, which shares may be held by other shareholders;
  
• interest expense incurred in the corporation on funds borrowed to pay dividends may not be tax-deductible if the corporation is in a deficit; (paying dividends from corporation without sufficient surplus may result in other difficulties and should be reviewed with the corporate lawyer).

11. Other matters relevant to tax planning to business owners

Spousal partnership

An unincorporated business may be structured as a partnership between spouses to achieve tax reductions through income splitting

A spousal partnership is feasible if the both spouses either:

• contribute substantial time and skills to the business;
  
• invest property (including cash) in the business
  

Splitting of income in the partnership need not be equal but should be reasonable in the circumstances, preferably based on a written partnership agreement. It should be consistent from year to year, based on fixed percentages or on a formula, not arbitrarily - Canada Customs & Revenue Agency may reallocate partnership profits that have been allocated arbitrarily for tax advantage or may question the existence of the partnership.

Shareholder loans

Repay loans to shareholders before the end of the next fiscal year

The amount of any loan made to a shareholder in one year that is not repaid before the end of the following year must be added to the shareholder's income for tax purposes in the year that the loan was made. While there are some exception to these rules, the exceptions are severely restricted by the Income Tax Act. If an amount is included in the shareholder's income for one year, a deduction is allowed for the amount of any loan repaid. Repayments should not be part of a series of loans and repayments.

• shareholder loans and indebtedness should be repaid before the end of the fiscal year;
  
• where amounts have previously been included in income as a result of the shareholder loan rules, consider repaying all or a portion of the amount before the end of the calendar year.
  
  

Incorporate an unincorporated business

Consider incorporating your business

Professionals in particular should now consider the option of incorporation not previously available

Owners of unincorporated businesses should consider incorporating to take advantage of the tax planning opportunities, including control of personal income for tax purposes and tax deferral.

Incorporation may also allow a business owner to sell his business for a tax-exempt capital gain of up to $500,000 by claiming the capital gains deduction for shares of qualified small business corporations. Non-tax considerations (e.g., limited liability and isolation of non-business assets from business risks) may also enter into the decision to incorporate.

• When incorporating an existing business, consider filing a special income tax election to avoid unexpected taxation on accrued gains, including unbooked goodwill, small tools, inventory, recaptured depreciation and capital gains;
  
• consider filing a special income tax election to allow the corporation to claim as bad debts uncollected accounts receivable transferred to the corporation;
  
• consider whether a spouse should be added as a shareholder for income-splitting and estate planning purposes.
  

Shareholders' agreement

Draft a formal shareholders' agreement whenever there are two or more shareholders

A shareholders' agreement should be drafted for corporations where there are more than one shareholder, including those in which the only shareholders are family members, to protect their individual interests, minimize shareholder disputes and ensure that there is an orderly transition in the event of death, disability or retirement of a shareholder. The valuation of shareholders' interests and the funding of any payments to a shareholder or his estate on voluntary or involuntary withdrawal are important issues to be considered. Existing shareholders' agreements should be reviewed periodically to ensure that they remain consistent with the wishes and personal circumstances of the shareholders and that they remain valid in light of legislative changes.

• in particular, shareholders' agreements funded by life insurance should be reviewed in light of changes to certain "stop-loss" rules that may increase tax on the death of a shareholder.

Investors

12. Investment fundamentals

Maximize after-tax real rate of return from investments in relationship to the associated risk

Since interest, dividends and capital gains are each taxed differently, taxation will affect the end return.

Inflation effects may confuse the issue. During periods of high inflation, nominal rates of return may appear relatively high. However, that high nominal return is subject to tax, reducing the bottom line. Meanwhile, inflation is eroding the investment, reducing purchasing power of the capital invested. Consider the following example:

	Low inflation	High inflation
Inflation rate	2%	8%
Nominal interest rate	6%	12%
Marginal tax rate	50%	50%
Investment	$1,000	$1,000
Interest earned in one year	$60.00	$120.00
Tax on interest	30.00	60.00
After-tax return	30.00	60.00
Add capital invested discounted for inflation	980.00	920.00
Total amount	$1,010.00	$ 980.00

In real after-tax terms, the return in the low inflation example is a positive 1% compared to a negative 2% return in the high inflation/high nominal rate of return example.

(We should be cautious how we interpret examples such as these. While the government publishes a consumer price index, the figures are of only general interest. Each of us, depending on our consuming habits, family situation, age and geography, has our own personal rate of inflation that may not relate to the published figures.)

13. Interest income

Report accruing interest income annually

Interest earned on investments acquired after 1989 must be reported for tax purposes annually on the anniversary date of the investment. Interest income receives no preferential tax treatment and is taxable at normal tax rates - the maximum tax rate in Ontario in 2003 is 46.41%.

• interest accrued but not received on investments purchased after January 1, 2003 can be deferred for tax purposes until 2004;

14. Dividend income

Benefit from preferential tax rate on dividends

Dividends from Canadian corporations receive preferential tax treatment in Canada. First, the actual amount of the dividend is "grossed up" by 25% - the taxable amount is 125% of the actual amount. Then, a non-refundable dividend tax credit approximately equal to the amount of the gross-up is allowed as a reduction of the tax payable. At the maximum marginal tax rate in Ontario, the effective tax rate on dividends is 31.34%. The net result of this preferential tax treatment to the investor is that the return on dividend-paying investments need be only 78% of the return on interest-bearing investments to yield the same amount after tax. Put another way, a 5% dividend yield is equivalent to a 6.4% interest rate.

• consider investing in high yield dividend-paying shares;
  
• but consider that dividend-paying shares may be more interest-sensitive - should interest rates increase, the market value of the shares may decrease more than interest-bearing investments; in fact, interest-bearing investments such as Canada Savings Bonds will suffer no decrease in market value since they may always be disposed of for their principal amount
  
• US citizens, taxable on their world income including Canadian-source dividends, do not receive the same preferential tax treatment in the US; the beneficial tax treatment in Canada may be lost as a result of paying higher US taxes on the dividends.

15. Capital gains and losses

Benefit from preferential tax rates on capital gains

 

Capital gains receive preferential tax treatment in Canada since only 50% of the amount of the gain is added to income for tax purposes.

Capital gains are calculated as the excess of the proceeds of disposition over the taxpayer's cost of tax purposes
(adjusted cost basis or ACB); if the ACB exceeds the proceeds, the taxpayer has a capital loss; capital gains and capital losses are netted in the year and 50% of the net amount is either the taxable capital gain or allowable capital loss for the year. Taxable capital gains are added to income; allowable capital losses may be carried over to other years as net capital losses and offset against taxable capital gains in the three previous year or in any subsequent year.

• consider carrying back net capital losses against taxable capital gains of the previous three years;
  
• but, if the capital gains deduction were used in the previous year to offset the taxable capital gain, it may be preferable to carry the net capital loss forward to be applied against future capital gains;
  
• consider realizing accrued losses before the end of the taxation year if there are realized gains in that year or any of the previous three years; allow sufficient time before the end of the year for the share sale to clear.

16. Capital gains reserves

Defer capital gains by claiming allowable reserves

A portion of a capital gain may be deferred for tax purposes if all or a portion of the proceeds is not due until after the end of the year. The reserve may spread the gain out over up to five years as long as at least 20% of the gain is taxable each year. For instance, assume that 10% of the proceeds were received in the year of sale and the remaining 90% was receivable as set out below for the next 4 years. The maximum reserves and gains subject to tax would be as follows:

	Proceeds	Cumulative	Maximum	Portion of gain
	received	proceeds received	reserve	taxed - cumulative
Year 1	10%	10%	80%	20%
Year 2	10%	20%	60%	40%
Year 3	60%	80%	20%	80%
Year 4	10%	90%	10%	90%
Year 5	10%	100%	0%	100%

• consider claiming maximum reserve to defer taxation of the capital gain;
  
• ensure that the cash received on sale and in each subsequent year will be sufficient to pay the tax as it arises. The illustration above illustrates the short-term tax problem that can arise: after Year 2, only 20% of the sale proceeds had been received but 40% of the gain was taxable. A large disparity between the proceeds and the taxation of the gain can cause cash flow difficulties.
  
• consider claiming less than the maximum reserve in years when income is low or there are tax credits or other deductions that would reduce the tax on the gain.

17. allowable business investment losses (ABIL)

Claim allowable business losses against other income

A business investment loss is a capital loss on the disposition of investment in a small business corporation, either in its shares or in debt owing by the corporation. A business investment loss may also arise on debt owing by a small business corporation that is established to be a bad debt and on the investment of shares of such a corporation where the corporation is bankrupt or insolvent. An ABIL is 50% of the business investment loss. This amount is reduced by previous claims for the capital gains deduction. Unlike a normal net capital loss, an ABIL may be deducted against other income in the year incurred. If the ABIL exceeds income from all other sources, the result is a non-capital loss that can be carried back three years or forward seven years to be applied against other income. If the loss can not be fully applied in the carry over period, it reverts to a normal net capital loss that may be carried forward indefinitely.

• claim an ABIL when it is realized or established as delay may result in loss of the deduction;
  
• beware of claiming an ABIL if you have previously claimed the capital gains deduction; beware of claiming the capital gains deduction if you have previously claimed an ABIL;
  
• document the investment as Canada Customs & Revenue Agency frequently requests additional information concerning the investment and the loss, possibly including copies of the financial statements of the corporation.

18. capital gains deduction on qualified small business corporation shares

Claim the capital gains deduction on the sale of shares of a qualified small business corporation

The capital gains deduction is still available for gains realized on shares of a qualified small business

corporation. The maximum exemption is $500,000 less the capital gains deduction previously claimed. If there is a cumulative net investment loss (CNIL), only the taxable capital gain in excess of the CNIL will qualify for the capital gains deduction.

Very briefly, shares of a qualified small business corporation must meet the following criteria:

• the shares must have been owned continuously by the taxpayer or a related person for the immediately preceding 24 months;
  
• during the previous 24 months, at least 50% of the corporation's assets, and at the time of disposition, "all or substantially all" (at least 90%) of the corporation's assets must have been used principally in an active business; the computation is done at fair market value and would include unbooked goodwill.

In planning for the sale of a qualified small business corporation and the related capital gains deduction, consider the following:

• does the corporation qualify for the capital gains deduction? Consider whether there may be excessive non-active business assets and, if so, consider "purifying" the corporation by removing those assets by transferring them to another corporation; (caution: "purification" immediately before a share sale in contemplation of the sale may be considered a "surplus strip" and may be treated as capital gain. "Purification" transactions should be carried out without an actual sale in sight.)
  
• does the taxpayer have a CNIL? If so, consider paying dividends to eliminate it;
  
• consider "crystallizing" the capital gains deduction for shares of the qualified small business corporation by selling them to a related holding company or by exchanging the shares for other shares using a special income tax election;
  
• will the capital gain trigger AMT? If so, consider paying additional salary or realizing other income to reduce the AMT;
  
• consider transferring an unincorporated business to a corporation so that the sale will qualify for the capital gains deduction; in that case, the 24 month holding period does not usually apply.

19. capital gains deduction on qualified farm property

Claim the capital gains deduction on the sale of qualified farm property

Qualified farm property consists of real property used in the business of farming in Canada, shares of a family
farm corporation, an interest in a family farm partnership, eligible capital property. Complex holding period and other rules apply in determining whether such property qualifies for the capital gains deduction. The maximum exemption is $500,000 less the capital gains deduction previously claimed.

• farm property may be transferred from parent to child at any value between cost and fair market value;
  
• consider transferring the farm property at a value that will make full use of the remaining capital gains deduction so that the child will have a higher cost base for future dispositions.

20. Gain on disposition of principal residence

Make optimal use of the principal residence exemption on the sale of your principal residence

The gain on sale of a principal residence is exempt from tax. A principal residence is generally any accommodation owned by the taxpayer and ordinarily inhabited by the taxpayer, his spouse or child, provided that the taxpayer designates the property as his principal residence.

Prior to 1982, it was possible for both spouses to each designate a different property in any particular taxation year. After 1981, however, only one property may be designated by any family unit.

• for each principal residence owned before 1982, consider there is benefit in separate ownership and whether the value at December 31, 1981 should be established
  
• a seasonal residence such as a cottage may qualify a principal residence; however, if the cottage is designated as the principal residence for a particular year, the city house can not also be designated for that same year.

21. Interest expense

Deduct interest expense incurred to earn investment income

Convert loans incurred for personal purposes to tax deductible loans

Interest on funds borrowed to purchase income-earning investments is deductible on either a "paid" or "payable" basis as long as that basis is followed consistently. If the "paid" basis is used then only the interest actually paid in the year is deductible.

It may be possible to re-arrange one's affairs to turn non-deductible interest into tax-deductible interest by using personal cash or selling investments to pay off personal loans and borrowing to re-purchase investments.

Any excess cash should be applied against non-deductible loans in preference to tax-deductible loans.

Limitation on the deduction of interest expense may arise if at the time the investment was purchased the interest rate exceeded the maximum possible yield on the investment. For preferred shares, the interest expense will generally be deductible if the interest rate does not exceed the grossed up amount of the preferred dividend. For instance, if the interest rate is 6% and the actual dividend rate is 4% - gross up to 5% - part of the interest expense may be disallowed.

Interest expense related to an investment that has been disposed of at a loss will continue to be tax-deductible if the proceeds of sale are applied to reduce the loan to the extent possible or the proceeds are used to purchase some other income-earning investment.
Interest on funds borrowed for personal purposes, such as to purchase a home or cottage, is not tax-deductible. However, if you borrow with the home or cottage as security and use the funds to invest, the interest on the loan should be deductible. It is not the security that determines the deductibility, but the use of the funds borrowed.

Interest expense related to investment in an RRSP is not generally tax-deductible, except for pre-1982 RRSP loans for this purpose.

While tax-deductible when incurred, the interest expense is added to the cumulative net investment loss (CNIL) balance and may effectively be "clawed back" by reducing the availability of the capital gains deduction.

Interest expense is technically only deductible when the funds are used to purchase income-earning investments. However, interest incurred on funds borrowed by a shareholder of a closely-held corporation to loan on an interest-free basis to his corporation is generally allowed as tax-deductible. The corporation must use the funds to acquire income-earning properties and business assets. The basis for this policy is that income earned in the corporation is available for the payment of dividends to the shareholder. (A similar connection does not apply where one spouse borrows funds to re-loan to a corporation owned by the other spouse.)

22. Investment holding companies

Consider the possible benefits of an investment holding company

Prior to 1995, significant tax deferrals were available by earning investment income through an investment holding company. However, the deferral was effectively eliminated in 1995 when an additional refundable tax was introduced on investment income. All the same, there may be benefits from using an investment holding company:

• probate fee planning;
  
• sheltering of assets from US estate taxes;
  
• creating earned income for RRSP purposes by paying director's fees;
  
• reduction of personal income to reduce personal tax, eliminate OAS "clawback" and preserve GST and Ontario tax credits.

  23. Transfer of investments to RRSP - eligible investments may be transferred to one's RRSP either as a contribution in kind, the fair market value of which will be considered the taxpayer's RRSP contribution, or as a sale for cash or other property in the RRSP. A capital gain or capital loss will generally arise on the transfer based on the fair market value at the time of transfer. A capital gain is taxable in the same way as any other capital gain. Any capital loss is denied.
  
  24. Venture capital investments - Ontario investors may invest up to $5,000 in labour-sponsored venture capital corporations (LSVCC). The investor receives an Ontario and a federal tax credit equal to 15% of the investment for each (i.e., 30% in total). The investment may be transferred to the taxpayer's RRSP, compounding the tax saving. Alternatively, the investment may be made outside the RRSP to recover the tax credits. If the taxpayer has cash in his RRSP, that cash can be used to invest in a LSVCC and the taxpayer will receive the same tax credit. Sale of the investment within eight years will cause the taxpayer to repay the tax credits received.
  
  25. Tax shelter investments - while a properly structured tax shelter may have the desired impact of reducing income taxes, they may not be appropriate investments for many investors. The taxpayer should look beyond the immediate tax saving to determine whether the investment makes economic sense when overall after-tax return and risk are considered.
  
  Tax shelter investments can take many forms, including flow-through shares, film production limited partnerships, limited partnership commission arrangements.

  To evaluate a tax shelter, consider the following:

  • financial risk;
    
  • rate of return;
    
  • liquidity;
    
  • reasonableness of underlying assumptions in cash flow and profitability analyses;
    
  • tax deferral confirmation, based on an advanced tax ruling from Canada Customs & Revenue Agency;
    
  • history of promoters or developers;
    
  • administrative costs.

Alternative minimum tax (AMT) may substantially reduce the income tax benefits that an investor hopes to obtain from a tax shelter investment. While a tax shelter may reduce regular taxable income and tax calculated on regular taxable income, tax shelter losses and related carrying charges (as well as RRSP deductions and the non-taxable portion of capital gains) are not deductible for AMT purposes. The adjusted AMT taxable income is then computed by deducting a special $40,000 AMT deduction. A flat 17% (federal only) rate is applied to the resulting AMT taxable income to calculate the AMT. If the AMT is greater than the regular tax, the taxpayer pays the higher AMT tax, including the surtaxes and provincial tax on this base.

Should AMT arise, the excess of the AMT over the regular tax in that year may be carried forward for up to seven years and applied to reduce regular tax to the extent that the regular tax in that year exceeds the AMT. Therefore, AMT may not be a permanent tax.

Family Tax Planning

26. Home Buyers' Plan

First time home buyers may use RRSP savings toward their home investment

The Home Buyers' Plan has been extended indefinitely but has been restricted to first-time home buyers. The plan allows eligible taxpayers to withdraw funds from their RRSPs, up to $20,000, to assist with the financing of their home purchase. To be considered a first-time home buyer, neither the taxpayer nor his spouse must have owned a home or lived in it as their principal place of residence in any of the immediately preceding five years.

• a home must be purchased by October 1 of the year following the withdrawal of the funds;
  
• no tax will be withheld from the funds withdrawn from the plan;
  
• caution: RRSP contributions within 90 days of the withdrawal will not be deductible;
  
• any amount withdrawn must be repaid to the RRSP over a period not exceeding 15 years, commencing in the second calendar year following withdrawal; the repayment may be made in the year or within 60 days of the end of the year; Canada Customs & Revenue Agency send affected taxpayers an annual notice of the amount of the minimum repayment necessary;
  
• any shortfall in the repayment for a particular year must be added to income in that year;

27. Charitable donations

Claim charitable donations in the year that the donation is made

Donations to registered charities entitle the donor to a federal tax credit of 16% of the amount of the donation up to $200; above $200 in the year, the tax credit is 29%. The combined federal and Ontario tax credits are approximately 25% up to $200 and 46% thereafter. The maximum amount of charitable donations in any year is generally 75% of the taxpayer's net income. Excess donations may be carried forward for up to five years.

For donations made in the year of death and the immediately preceding year the donation limit is 100% of net income. Donations made in the taxpayer's will are considered to have been made in the year of death.

For donations "in kind" - a gift of property rather than cash - the property is generally considered to have been disposed of at its fair market value, with whatever income or capital gains consequences that may entail, and to have been donated at the same value. However, a taxpayer may elect to report the disposal and the donation at any value between the adjusted cost base and fair market value. Also, the amount of the donation is not limited to 75% of the taxpayer's net income. Gifts of business property (e.g., inventory or capital assets such as a computer) are treated as if the property were disposed of at donation amount and therefore may increase business income.

• donations must be supported by an official tax receipt from the charitable organization; unofficial receipts and cancelled cheques do not constitute official receipts;
  
• "contributions" made in connection with fund-raising activities such as a circus held by charitable organizations are generally not charitable donations for tax purposes; nor is the excess paid over market value for goods or services purchased from a charitable organization;
  
• charitable organizations, however, may issue charitable donation receipts in connection with charitable events such as a fund-raising dinner for the excess paid by the attendee over the organizer's cost;
  
• donations from both spouses should usually be claimed in the return of one of them if doing so will result in the total amount exceeding $200; this applies to donations made by payroll deduction and reported on the T4 slip;
  
• donations are only creditable if they are actually paid in the year or in the previous five years.
  Unpaid pledges are not creditable. Donations purposely or inadvertently not claimed in the year that the donation was actually made may be claimed in a subsequent year within the five year carryover period.
  
• gifts to the Crown (Canada or a province) qualify for tax credit but are not limited by 75% of net income; gifts to hospitals and universities do not automatically fall under such rules but may sometimes be structured as gifts to the Crown;
  
• special rules apply to gifts of objects certified as Canadian Cultural Property by the Canadian Cultural Property Export Review Board and gifted to a designated institution or public body: capital gains on disposition are not taxable and the 75% of net income restriction does not apply;
  
• special rules also apply to gifts of ecologically sensitive land: while the taxpayer is able to claim a tax credit based on the donation at its fair market value (as certified by the Minister of the Environment), the taxable capital gain is only 25% of the total capital gain instead of the normal 50%.

28. Political donations

Claim political donations in the year that the donation is made

Tax credits are available for both federal and Ontario political contributions. An official receipt must be filed with the taxpayer's return for the year. As with charitable donations, each spouse is considered an agent for the other allowing the family unit to optimize the tax credit between them. Because of the way that the tax credit is calculated, it may not be advantageous to aggregate political donations entirely in the return of one spouse - it may be preferable to split the donations equally between spouses.

The federal tax credit is computed as 75% of the first $200, plus 50% of the next $550, plus
33 1/3% of contributions over $550, up to a maximum credit of $500; the maximum credit is reached with contributions totaling $1,075; for 2004, the credit is scheduled to increase to 75% of the first $400, 50% of the next $750 and 33 1/3% of donations over $1,150 to a maximum credit of $650.

The Ontario tax credit is computed as 75% of the first $300, plus 50% of the next $700, plus
33 1/3% of contributions over $700, up to a maximum credit of $1,000; the maximum credit is reached with contributions totaling $2,275.

29. Alimony and maintenance

Deduct periodic spousal support payments made under a written separation agreement or court order

Child support payments are no longer deductible or taxable for agreements after April 30, 1997

For 1996 and prior years, alimony and maintenance payments are taxable to the recipient and deductible to the payor, as long as certain conditions are met:

• payments are made on a periodic basis to the taxpayer's spouse or former spouse;
  
• for the maintenance of the recipient, children of the recipient or the recipient and children of the recipient;
  
• the couple are living separate and apart because of a breakdown in the marriage;
  
• payments are made pursuant to a written separation agreement or court order.

Certain third party payments made under the separation agreement may be deductible (and taxable).

Payments made before an agreement is signed or a court order obtained are only deductible (and taxable) if the agreement is signed or court order obtained before the end of the following year and the agreement or order so specifies by referring to subsection 60.1(3) of the Income Tax Act.

For child support payments under agreements or court orders made after April 30, 1997 including amendments to existing agreements, the payments will not be deductible by the payor (or taxable to the recipient). Agreements entered into before May 1, 1997 are not affected unless both spouses apply to Canada Customs & Revenue Agency to have the new rules apply to payments after April 30, 1997. Alimony payments for the support of the spouse or former spouse are similarly not affected by this change.

30. Child care expenses

Claim child care expenses paid in the year

Child care expenses are deductible only by the lower-income spouse unless that spouse is infirmed, confined to an institution or in full-time attendance at a designated educational institution. The amount is also limited to 2/3rd of the taxpayer's earned income (income from employment or self-employment). The maximum deduction is the total of $7,000 for each child under seven or infirm, and $4,000 for each child between seven and fifteen.

Payments to the child's parent or to any related person under age 18 are not eligible. Nor are babysitting costs while the parents go to dinner and the movies.

The maximum amount claimable for a boarding school and residential camps such as sports camps is limited to 1/40th of the maximum annual amount for that child - i.e., for a child over 7 years old, the maximum claim is $100 per week of attendance.

Receipts should be obtained from the caregiver indicating the date of the service, the caregiver's name and social insurance number and the amount paid.

31. Child tax benefit

Consider segregating and investing the child tax benefit in the child's name

The child tax benefit is a refundable, non-taxable benefit based on the number of children under age 18 and the recipient's family income. The credit is reduced as income increases at the rate of 2.5% of family net income above $33,487 (5% for families with two or more children).

The maximum benefit is $1,169 per child. For families with three or more children, there is a $82 supplement added for the third and each additional child. For children under seven, there is an annual supplement of $232, but this supplement is reduced by 25% of any child care expenses claimed.

If the child tax credit payments are co-mingled with the other funds of the parents, any income earned on the investment of those funds will generally be taxable to the parent recipient (usually the mother). However, if the funds are segregated and separately invested for the child, the investment income will be taxable to the child and not to the parent.

32. Income splitting

Minimize family tax costs by splitting income and capital gains with lower income family members

Our so-called "progressive" tax rate structure means that, as your income increases, so does your marginal tax rate. Also, certain benefits and tax credits are "clawed back" - e.g., Old Age Security benefits, age tax credits. Significant tax savings can be realized by re-directing income and capital gains that would otherwise be taxable to a high income family member to a family member with lower income. In addition, lower-income family members may have unused tax credits available to shelter additional income.

There are obstacles to re-directing one's income. The income attribution rules are intended to minimize opportunities for income splitting. The attribution rules state that:

• they apply when cash or property is transferred by gift or loan either directly or through a trust to a spouse or child under the age of 18; attribution also applies to the income earned on loans to non-arm's length persons such as a child over the age of 18 unless the loan is interest-bearing at a rate equal to or greater than the prescribed rate;
  
• the income earned from the property or investment is taxable to the transferor;
  
• especially onerous rules apply where a corporation is used for income-splitting purposes;
  
• special "kiddy tax" rules apply on income earned by a minor from dividends paid on unlisted shares and income from a partnership or trust derived from providing services or goods to business carried on by a person related to the minor, or a corporation of which the related person is a shareholder.

Despite the attribution rules, it is still possible to split income with lower-income family members:

• sale of property for fair market value and loans under commercially available terms and rates do not attract attribution; for a sale between spouses, a special election must be filed to avoid attribution (otherwise the property will automatically transfer at the vendor's adjusted cost base);
  
• gifts to adult children do not attract attribution;
  
• by policy, Canada Customs & Revenue Agency does not apply attributions to the investment of the child tax benefit if the investment is segregated for the child;
  
• corporate attribution generally will not apply under estate planning arrangements where the
  objectives are other than income splitting;
  
• no attribution applies on capital gains realized on property transferred to children or related persons other than a spouse; (caution: the transfer of property to a related person is treated as a sale at fair market value and may trigger a capital gain to the transferor);
  
• CPP benefits may be split without attribution;
  
• retirement income from a spousal RRSP do not attribute back to the contributing spouse (although withdrawals made from an RRSP or amounts withdrawn from a RRIF in excess of the minimum amount will be added back to the income of the contributing spouse if the withdrawal occurs with three years of the contribution);
  
• income earned on the reinvestment of attributed income does not attribute: for instance, if Spouse A gifts $1,000 to Spouse B and B invests the money to earn, say, $100 income on the investment, that $100 will be taxable to A; however, if B then invests the $100 income and earns $10 on that investment, that $10 is taxable to B, not to A; over time, the non-attributed income can accumulate to significant amounts;
  
• arranging the family financial affairs to allow the lower income spouse to accumulate investment assets can also result in significant benefits over time; for instance, high income Spouse A could pay for the personal expenses of the family - groceries, mortgage payments, possibly B's personal tax liability, etc., and low income Spouse B could invest his or her income; the investment income earned would be taxable to B, the lower income spouse.

In a business, salary can be paid to lower income family members for services provided to the business. The key is to make sure that the salary is reasonable relative to the value of the services provided. If the salary is reasonable, it will be deductible against the business income and taxable to the lower income person. Excessive salaries will be disallowed by Canada Customs & Revenue Agency. Note that there are other effects of paying a salary: the recipient will generate RRSP contribution room; payroll taxes will apply including CPP, EI, WSIB and possibly EHT, although it may be possible to have the EI premiums waived on salary paid to a spouse.

33. Registered Education Savings Plans

Contribute to RESP for minor children to fund future higher education costs - the earlier the better

Taxation of investment income earned on savings and the attribution rules provide obstacles to saving for the education of children. However, RESPs offer parents and grandparents an opportunity to save without paying tax currently on the accumulating income earned on funds earmarked for the child's education.

A RESP is a special investment fund or trust, organized by a promoter or trustee and registered with Canada Customs & Revenue Agency for the purpose of allowing the accumulation of funds for higher education. The parent or grandparent agrees to make payments to the promoter and the promoter agrees to make educational assistance payments to a specified child beneficiary when the child attends a post-secondary educational institution. The contributions are not tax deductible but the income is not taxed until it is withdrawn by the student and then it is taxable to the student.

The maximum contributions for each beneficiary is $4,000 per year to a lifetime maximum of $42,000. The plan can not last longer than 25 years and no contributions can be made after 21 years.

The risk with RESPs is that the child may not continue on to post-secondary education. In that case, the contributions will be returned but the accumulated may not be. The return of the contributions will not be taxable to the contributor. However, if the plan has been in place for at least 10 years and the child is at least 21 years of age, the accumulated income can be paid to the contributor. Subject to the normal RRSP contribution limits, the RESP contributor may chose to transfer the income to his or his spouse's RRSP up to a maximum of $50,000. Any amount in excess of the amount transferred to the RRSP is taxable at 20%.

In addition to the contributions and the accumulating income earned, the federal government makes contributions to the RESP, referred to as Canada Education Savings Grant (CESG). The maximum CESG is 20% of the parent's contribution or $400 in any year for beneficiaries under 18 years of age, to a lifetime limit of $7,200.

Retirement Planning

34. Registered pension plans (RPP)

Maximize your RPP contributions and deduct contributions

Registered pension plans are an important source of retirement income for many Canadians. Some of the tax rules have been set out below.

There are two basic types of pension plans:

• Defined benefit plans - the amount of the employee's pension is defined by a formula in the plan; the formula normally involves the employee's pensionable earnings and the number of years of service with the employer or a related employer. The employee's contribution are usually also defined by a formula - as a percentage of earnings; based on actuarial evaluations, the employer's contributions will usually vary depending on investment returns - where investment returns are poor, the employer's contributions will have to increase to fill the gap; where the investment returns are better then projected, employer contributions may be reduced. The benefit to the employee is that he should always have the security of knowing what his pension will be. The concern for the employer is that he may not know what it will ultimately cost to fund that pension.
  
• Defined contribution plans (or money-purchase plans) - these are similar to RRSPs in that the ultimate amount of the employee's pension is unknown. His pension will be whatever the funds in the plan will buy as an annuity when he retires, which will depend on the contributions and the return on investment. However, both the employer and the employee know what their cost will be as their contributions are defined in the plan. Those contributions are used to earn an investment return. The amount accumulates until retirement and the pension annuity is purchased.

Employer contributions to an RPP are deductible to the employer and are not taxable to the employee. Similarly, contributions made by the employee are deductible against the employee's personal income in the year. Investment income is allowed to accumulate tax free. Amounts paid out of the pension plan to the employee are fully taxable when received. Under circumstances such as termination or early retirement, the employee's accumulated credit in an RPP may be transferred free of any tax to another RPP or to a locked-in RRSP.

For services after 1989, employees can deduct all contributions made to a defined benefit plan. For services before 1990, employees can deduct contributions to a defined benefit plan up to $3,500 per year for each past service year of service provided before 1990 in which they were not a contributor to any RPP. For pre-1990 years when the employee was a contributor to a RPP, the $3,500 per year limit is reduced by any contributions deducted in the current year. Any undeducted contributions may be carried forward and deducted when there is sufficient room within this limitation.

For defined contribution/money purchase plans, the maximum combined employer/employee contribution for 2003 was $14,500, increasing to $15,500 for 2004.

The amount of the employee's contribution is reported on the employee's T4 slip. Also reported on the T4 slip is a "pension adjustment". For money purchase plans, the pension adjustment is simply the total combined amount of the employer's and the employee's contributions. For defined benefit plans, the PA is computed based on a formula intended to estimate the cost of funding the accruing retirement pension. In both cases, the PA must be taken into account in determining the employee's maximum RRSP contribution for the following year.

35. Deferred profit sharing plans (DPSP)

Consider DPSPs to motivate, reward and retain key employees

DPSPs may be useful, particularly to smaller employers, as a means of motivating, rewarding and retaining key employees. Employees, including owner-managers and their families, owning over 10% of any class of share of the employer corporation are not eligible for membership. Subject to specified limit equal to 50% of the money purchase limit for RPPs ($6,250 for 2003), employer contributions must be computed by reference to company profits. Employee can not make contributions.

Amounts received by the employee out of a DPSP are fully taxable. DPSP proceeds can be used to purchase an annuity similar to a money purchase pension plan, in which case only the annuity payments are taxable when received. Lump-sum payments out of a DPSP may be transferred tax-free to another DPSP, RPP or RRSP only if transferred directly between trustees of the plans.

36. Registered retirement savings plans (RRSP)

Maximize your RRSP contributions and deduct contributions

RRSPs are the primary tax shelter of ordinary Canadians. The billions of dollars that have been accumulated in RRSPs represent a huge capital pool for investment in the Canadian economy. For thousand of Canadians, particularly small business owners and their employees, RRSPs represent the only tax-assisted means of saving for retirement available to them. Despite their popularity and the massive amount of information available, there remains considerable ignorance and misunderstanding about RRSPs, how they work and how they are intended to benefit taxpayers.

Types of plans - virtually every Canadian financial institution offers RRSPs. Most institutions in fact may offer several types of plans. The consumer's choice is mind-boggling. Compounding the problem is the fact that most taxpayers leave the decision to the last moment when there is little time to consider their options. Still, there are only three basic types of plan available:

• Deposit accounts - the most common type is merely a deposit with a financial institution, usually a trust company or bank. Deposit accounts are interest-bearing suitable to investors particularly concerned about security of capital. The investment is usually insured by the Canada Deposit Insurance Corporation within limits. There are usually no separate fees charged by the financial institution as they use the funds to earn a return higher than the amount paid to the depositor.
  
• Professionally managed accounts - financial institutions offer funds that pool investments from many investors and that are managed on behalf of investors by professional money managers. Such funds invest in a wide variety of investments, including interest bearing investments (money market funds, bond funds, mortgage funds) and equities, subject to rules concerning Canadian content. "Balanced" funds and "asset allocation" funds include a combination of interest-bearing and equity investments. Some institutions operate several different funds, each with its own objectives and investment criteria, and usually allow investors to switch between funds at no cost. Security of capital and investment returns may vary widely depending on the underlying investments. Neither the capital investment nor the return on investment are guaranteed or secured, and past history is not guaranty of future returns. There may or may not be administrative fees charged for these funds, although there usually are no fees as the financial institution charges a separate management fee directly against the fund.
  
• Self-directed plans - self-directed plans are attractive to investors who want more control over their investments. The investor agrees with a financial institution - bank, trust company, investment dealer - to act as trustee for his RRSP and to perform the necessary administrative functions required. The investor is left to decide on the investments held in the plan, within the regulations set down for eligible investments, such as interest-bearing investments, mutual funds, equities, including foreign investments within limits (usually 30%, although foreign content may reach as high as 50% in certain circumstances). It is even possible to invest in an non-arm's length mortgage, including a mortgage on one's own home, as long as specific rules are complied with (including the purchase of mortgage insurance). Financial institutions usually charge an administrative fee which amount may usually be paid out of funds in the plan or from personal funds outside of the plan. The administrative fee is not tax deductible.

RRSPs have become so commonplace that many Canadians have come to underrate the long-term benefits of tax sheltering their earned and investment income to increase their retirement income. Taxpayers benefit from RRSPs in several ways:

• Immediate impact - immediate tax sheltering of employment and self-employment income;
  
• Intermediate impact - investment income earned in the RRSP is not taxed currently but is allowed to accumulate;
  
• Long-term impact - while withdrawals are fully taxed, planning may allow the funds withdrawn to be taxed at substantiallylower tax rates than when the funds were earned - say, in the hand of a lower income spouse (by using a spousal plan) or withdrawing when other income is reduced and marginal tax rates are lower.

Contribution limits - the amount of the contribution that may be deducted is based on the following formula:

• Add - unused RRSP contribution room carried forward from the prior year
  
• Add - RRSP deduction limit, equal to the lesser of
  $14,500 (for 2003) and 18% of earned income for the prior year.
  
• Deduct - pension adjustment (PA - see box on T4 slip) and past service
  pension adjustment for the year.
  (A past service pension adjustment may arise where a RPP has been amended
  to improve benefits accruing with respect to prior years.)

Canada Customs & Revenue Agency details its computation of the 2003 RRSP contribution limit for taxpayers on the 2002 Notice of Assessment.

The maximum contribution limits for future years is scheduled to increase, but you still must have sufficient earned income. (See below for details of how to determine your earned income.) The maximum limits and the required earned income are set out in the following table:

Year	Maximum limit	Minimum earned income
2003	$14,500	$80,556
2004	$15,500	$86,111
2005	$16,500	$91,667
2006	$18,000	$100,000
2007 and beyond	Subject to indexing	(Max. limit) / 18%

Spousal RRSP contributions - RRSPs offer taxpayers an opportunity for legalized income splitting of retirement income. Regular RRSP contributions within the limits described above may be made to the taxpayer's own plan, to a plan under which the taxpayer's spouse is the beneficiary ("annuitant") or to some combination of the taxpayer's and the spouse's plans. The taxpayer's contributions to a spousal RRSP have no effect on the spouse's contribution limit. The spouse may make contributions to the spouse's own plan, either the same plan to which the taxpayer made the spousal contribution or to another plan. Because of the anti-avoidance rules discussed below, it may be preferable for the spouse to make contributions to a separate plan to which the taxpayer has not made any contribution.

To prevent taxpayers from using spousal RRSPs as a short-term income splitting mechanism, the Income Tax Act includes rules that require amounts withdrawn from a spousal RRSP to be included in the contributor's income rather than the spouse's if the contributor had made a contribution in the year of withdrawal or either of the previous two years. This anti-avoidance rule does not apply to amounts received under a regular RRSP annuity or to amounts received from a RRIF that do not exceed the minimum amount required to be withdrawn under the RRIF.

As with other areas of the Income Tax Act, "spouse" includes a common-law spouse. A taxpayer can make deductible contributions to the RRSP of a common-law spouse.

Unused contribution room - if the taxpayer contributes less than the maximum amount allowed, the excess is carried forward to the following year and added to the deduction limit for that year. Starting in 1996, the carry forward period became unlimited.

Undeducted contributions - it may also happen that the taxpayer contributes more than his allowable limit. Similarly, the taxpayer may make a contribution but decide not to deduct it for the year even though it is within the allowable limits (for instance, where income is particularly low for one year but expected to increase in the next year). Undeducted RRSP contributions can be carried forward indefinitely and deducted in future years.

Over-contributions - contributions in excess of the deductible limit should be avoided by most taxpayers. If the over-contribution exceeds $2,000, the excess is subject to a penalty of 1% per month until the excess is removed by filing a special form (T3012A).

• With this cautionary note in mind, some taxpayers may wish to over-contribute within this $2,000 limit to tax-shelter additional investment income
  
• Special transitional rules apply to taxpayers who had over-contributed to their RRSPs prior to February 27, 1995 to allow them to phase out their over-contribution without penalty.

Earned income - the calculation of earned income is the starting point in the determination of the annual RRSP contribution limit. Earned income consists of the following amounts:

Add:

• Salary, wages, employment benefits;
  
• Net business income from a proprietorship or partnership in which the taxpayer was actively engaged;
  
• Net rental income;
  
• Alimony and maintenance receipts included in income;
  
• CPP disability pension (but not regular CPP benefits);
  
• Supplementary unemployment insurance benefits (but not EI benefits);

Deduct:

• Employment expenses and union dues;
  
• Net business losses from a proprietorship or partnership in which the taxpayer was actively engaged;
  
• Net rental losses;
  
• Alimony and maintenance payments deducted from income.

Notably absent from the earned income calculation are pension, DPSP, RRSP, RRIF and OAS benefits, investment income such as interest and dividends, business income or loss from a limited partnership, death benefits and retiring allowances (i.e., severance payments). Of particular interest to business owners when considering the form of their remuneration is that taking income as dividends will not generate RRSP contribution room - they must take salary for this purpose.

Retiring allowances - "retiring allowance" is the term used in the Income Tax Act to describe special payments that may be paid to an employee or former employee on retirement or in respect of a loss of employment, including amounts that may be received as damages. A retiring allowance may be paid to the employee or, after the employee's death, to a relation or dependent or the deceased's legal representative.

Not included in the definition of retiring allowance but included in the special rules for RRSPs are amount received out of "retirement compensation arrangement" (RCA). In simple terms, a RCA is a plan or arrangement under which an employer makes payments to a custodian or trustee on behalf of an employee to fund the employee's retirement, but does not include a RPP, DPSP or RRSP.

Amounts received as a retiring allowance or as benefits out of a RCA are taxable in the year received.

Within specified limits, taxpayers are allowed to transfer amounts received as retiring allowances or RCA benefits to their RRSP. The maximum amount is the sum of:

• $2,000 for each calendar year (including part of a calendar year) prior to
  1996 that the taxpayer was employed by that employer;
  
• $1,500 for each year prior to 1989 for which included above for which
  employer contributions to a RPP or DPSP have not vested in the employee.

For example, assume that an employee was employed by his employer for 20 years prior to 1996, including two years during which he was not a member of the pension plan. The employee's maximum RRSP contribution under these rules would be $43,000:

20 years @ $2,000 per year or $40,000
plus 2 years @$1,500 per ;year or $3,000.

The amount of the retiring allowance may be transferred directly from the employer to the RRSP trustee or it may be contributed by the employee during the year or within 60 of the end of the year in which the amount was included in income. If the amount is transferred directly by the employer, no tax need be withheld at source. However, tax will be withheld on payments that are not made directly to the RRSP. To have the amount transferred directly to his RRSP, the employee should complete and provide to his employer Canada Customs & Revenue Agency form TD2.

The special RRSP contribution does not affect the taxpayer's regular RRSP contribution room computed on his earned income - this special contribution is in addition to the regular contribution. Unlike the regular contribution, however, any unused portion of the maximum deduction may not be carried forward. Nor may the contribution be made to a spousal plan.

To deduct a RRSP contribution under these special rules, the taxpayer must so designate in his tax return for the year by filing form T2097 with his return.

Caution: while the special RRSP contribution for retiring allowances are deductible for the regular tax calculation, it is not deductible for alternative minimum tax (AMT) purposes. A large RRSP contribution may therefore not have the immediate tax saving impact desired, although the excess AMT may be recovered in future years.

Other lump-sum transfers - lump-sum amounts from a RPP or DPSP may be transferred directly to a taxpayer's locked-in RRSP. Locked-in RRSPs fall under provincial and/or federal legislation that restricts withdrawal before normal retirement age. Amounts may be withdrawn in due course as an annuity or a life income annuity (LIF) similar to a RRIF.

On death, an amount in the deceased's RRSP may be transferred to the surviving spouse's RRSP without incurring tax. More precisely, the surviving spouse must include the amount in income and claim a deduction for the amount of the transfer to the survivor's RRSP. This contribution is tax-deductible for both the regular tax and the AMT calculation.

On breakdown of a marriage or common-law relationship, an amount can be transferred without tax consequences between the RRSP (or RRIF) of one spouse to that of the other spouse as long as:

• the spouses are living apart;
  
• the transfer is made pursuant to a written separation agreement or order of a competent tribunal;
  
• the recipient spouse is within the age limit to have an RRSP;
  
• the transfer is made directly between plans.

A transfer from one RRSP of a taxpayer to another plan of the same taxpayer may be carried out without tax consequences as long as the transfer is made directly between plans. If the taxpayer has access to the funds for his own use, the rollover provisions will not apply: the "transfer" will be taxable as a withdrawal and the contribution will only be allowed within the normal RRSP contribution limits with the possibility that a large amount could trigger a penalty for over-contribution.

Withdrawals from RRSPs - amounts received from a RRSP, either before or after maturity, are fully taxable to the annuitant (or to the annuitant's spouse if the plan is a spousal plan and the withdrawal is made with in the year of contribution or the two years following the year of contribution).

Partial or complete withdrawals before maturity are subject to withholding of tax at source as follows:

• up to $5,000, 10%;
  
• between $5,000 and $15,000, 20%;
  
• over $15,000, 30%.

The income and tax withheld are reported for the year on a form T4RSP. The tax withheld at source is creditable against the actual tax reported by the taxpayer in the year. You should be aware that the tax withheld is generally less than the actual tax on the RRSP withdrawal: the withholding tax rate is generally less than the actual marginal tax rate applicable to the income. Consequently, there is usually an additional tax liability in the year of a RRSP withdrawal that the taxpayer should be prepared for.

Maturity must occur by the end of the year that the annuitant turns 69. On maturity, taxpayers have several options:

• withdraw the accumulated funds, subject to withholding and taxation as described above;
  
• purchase an annuity to provide retirement income over a fixed term to age 90 in a regular flow of equal monthly payments; if the annuitant's spouse is younger, the annuity may continue until the spouse turns 90, if the annuitant so elects;
  
• purchase a life annuity to provide retirement income over the rest of the annuitant's life, or over the annuitant's and the spouse's lifetime if the joint life option is chosen, in a regular flow of equal monthly payments; a guaranteed pay-out period may be provided;
  
• transfer the funds to a registered retirement income fund(RRIF), and receive payments from the RRIF of at least a minimum amount; amounts in excess of the minimum amount may be withdrawn from time to time.

The cost of a life annuity is based on an actuarial calculation that takes into account the market rate of interest and the age and health of the annuitant. Including a joint life option and/or a guaranteed pay-out option has the impact of reducing the amount of the annuity that could be paid from a fixed amount of funds because the pay-out period tends to be longer. While building in these options may be prudent in many cases, there may be alternatives if retirement is properly planned at an early stage. For instance, the purchase of an insurance policy on the life of the annuitant may be preferable to choosing a joint survivor option on the RRSP maturity. (For instance, if the spouse should die before the annuitant, the annuitant would be locked in to a reduced annuity for the remainder of his life even though the joint feature would never be called upon.) However, cost and insurability may make this option impractical or impossible unless the insurance policy is purchased long before retirement.

The minimum RRIF amount is based on the annuitant's age at the beginning of the year. For those under 71 at the beginning of the year, the minimum amount is calculated by dividing the fair market value of the RRIF at the beginning of the year by the excess of 90 over the annuitant's age at the beginning of the year. For those age 71 and older, the minimum RRIF amount depends on whether the RRIF was purchased before 1993. For pre-1993 RRIFs, the minimum RRIF amount continues to follow the same formula as used before age 71. For post-1992 RRIFs, and for pre-1993 RRIFs after age 78, the minimum amount is set by regulation. The change in the formula allows for an extended pay-out period beyond age 90 that was formerly not possible. At the annuitant's option, the computation may be based on the age of annuitant's spouse.

RRSP planning - the following is a summary of some of the planning points available with RRSPs:

• maximize RRSP contributions particularly if you are years away from retirement; at 8%, $100 contributed today is worth $466 contributed 20 years from now; regardless of the carryforward provisions, those who fail to contribute early will never completely catch up;
  
• consider making spousal RRSP contributions, including contributions to a plan for a common-law spouse, for legalized retirement income splitting; ideally, the income of both spouses should be equal on retirement to minimize family tax;
  
• when funds are limited, maximize the RRSP contributions of the higher income spouse before making any contributions by the lower income spouse to maximize the tax benefit; the contributions may be to a spousal plan for the benefit of the lower income spouse;
  
• when faced with the choice of whether to contribute to a RRSP or to pay down the home mortgage, consider doing both by contributing to the RRSP and using the tax savings to pay down the home mortgage;
  
• make contributions early in the year rather than at the last minute to increase income tax sheltering and increase retirement income;
  
• when funds are limited, make contributions at the last minute to avoid non-deductible financing costs; consider borrowing to contribute, as a rule of thumb, only if the loan can be repaid within the next ten to twelve months;
  
• pay administrative fees outside the RRSP, even though they are non-deductible, to maximize tax sheltered retirement funds;
  
• contribute a retiring allowance within allowable limits to a RRSP even if it may be necessary to draw on the funds later;
  
• track undeducted RRSP contributions carefully to avoid penalties on excessive over-contributions;
  
• plan for next year's RRSP contribution this year by insuring that you have sufficient earned income to make the contribution that you wish;
  
• consider the RRSP maturity options well in advance to avoid missing out on opportunities;
  
• attempt to withdraw funds from RRSPs only when income - and marginal tax rates - are very low to minimize tax on the withdrawal; plan for any additional tax due on withdrawal in excess of the amount withheld at source;
  
• avoid withdrawing funds from an RRSP or RRIF any sooner than necessary to maximize the benefits of tax sheltering.

Conclusion

I hope that my comments will prove useful to you in your personal financial and tax planning. As I mentioned at the beginning, tax planning should be taken in context, as an integral part of your planning to reach your personal and financial goals. When we see how much we pay in taxes of one type or another, it is too easy to look on tax in isolation, and on tax saving as an end in itself. Hopefully, the information and ideas presented here will help you achieve broader and more important goals.

Caution
Many of the thoughts expressed here have been described in somewhat simplified terms. The actual rules can be very complex. You should also be aware that tax rules have an annoying habit of changing. Last year's great tax planning idea may be this year's tax trap. Please call me if you wish to pursue any of these ideas so that we can review together your particular circumstances.