Mod 5 Notes

Question 1

Property Income - Overview

Answer 1

• Property income generally includes interest income, dividends and rental income.
• Rental income could be classified and taxed as business income in some circumstances.
• The key distinction is property income is earned passively but business income is active.

Question 2

Method of reporting interest income

Answer 2

• Accrual method must be used. Taxpayers have to report interest income earned but not yet received.
• Individuals must accrue interest income on each of the anniversary of the debt instrument. Interest already received (cash method) and interest already earned but not yet received (receivable method) must be reported as well of course.
• Corporations must accrue interest income at fiscal yearend (similar to financial accounting).

Question 3

Special rules regarding deep discount

Answer 3

• Deep discounts can be used to convert interest income to capital gains for the investors while the interest expense remains fully deductible to the issuer.
• To prevent this from happening, if the discount is deemed to be a deep discount, the issuer can only deduct 50% of the interest expense.
• A deep discount is when (1) the obligation is issued at a discount greater than 3% or (2) the yield rate on the debt obligation exceeds the nominal rate by more than one-third.
• Discounts associated with T-bills and zero coupon bonds are always taxed as interest income.

Question 4

Dividends

Answer 4

• Dividends are paid out of after tax profits, therefore, a dividend gross-up/tax credit system is needed to avoid double taxation and to remove the effects of corporate taxes. Ideally, the amount of taxes should be paid whether the business is run through a corporation or as a sole proprietor.
• Dividends gross-up and dividend tax credit represent corporate taxes paid.
• Taxpayers are taxed at grossed up dividends to remove the effects of corporate taxes and they are entitled to claim dividend tax credit to compensate for taxes already paid at the corporate level.
• The gross-up and dividend tax credit system has not achieved perfect integration but close. For example, the gross-up rates assumes a certain combined federal and provincial corporate rate but the federal government cannot control the various provincial rates.
• There are two types of dividends for tax purposes, eligible and non-eligible dividends.
• Eligible dividends
  
  • attract a higher gross-up rate and a larger dividend tax credit.
  • They come from corporate profits taxed at a higher rate, therefore, generally public companies (with exceptions).
  • Gross-up rate: 38%
  • Federal tax credit: 6/11 of gross-up
  • Therefore, the assumed combined corporate rate is 27.5% (1/1.38)
• Non-eligible dividends:
  
  • attract a lower gross-up rate and a smaller dividend tax credit.
  • They come from corporate profits taxed at a lower rate.
  • Gross-up rate: 25%
  • Federal tax credit: 2/3 of gross-up
  • Therefore, the assumed combined corporate rate is 20% (1/1.25)
• Dividends received from non-resident corporations are not entitled to this preferential treatment. The tax treatment is same as interest income.

Question 5

Rental Income – special rules

Answer 5

• Rental properties with a cost over $50,000 must be placed in a separate CCA pool individually. Therefore, re-capture cannot be delayed by adding rental properties to a CCA pool.
• CCA cannot be claimed to create or increase a rental loss. Please note: if the rental income is taxed as business income rather than property income, this rule does not apply.

Question 6

Income Attribution

Answer 6

• Because of our progressive tax system, it is beneficial to a taxpayer to transfer property income and capital gains to a lower income spouse or a child.
• Between spouses, if the transfer is not transacted a market price, both property income and capital gains will be attributed back to the transfer. Please note that the transfer must elect out of the automatic spousal rollover.
• Spousal rollover allows spouses to transfer properties between them taxes deferred. It applies automatically and the end result is a transfer not conducted at market price.
• Between a parent and a minor child, if the transfer is not transacted a market price, both property income will be attributed back to the transfer.
• Income attribution can still apply in some circumstances outside the two scenarios described above if the only reason for the transfer is tax avoidance.

Question 7

Kiddie Tax

Answer 7

• Income attribution rules apply to property income only.
• Without Kiddie Tax, it is still possible to avoid tax by transferring business interests to a minor child.
• In a nutshell, Kiddie Tax taxes the business income in the hands of the minor child at the highest marginal rate negating all tax advantages of the transfer.

Question 8

Interest Expense Deductibility

Answer 8

• Interest expense is only deductible if incurred to generate property or business income.
• It can be difficult to determine how the proceeds have been used after several layers of transactions.