What’s Your Tax Issue? Mortgage Refinancing

The Tax Issue:

Our rental property is coming up for mortgage renewal.  Can we take equity out of the rental to pay down on our principal residence?  Obviously then, the mortgage on the rental has increased and the interest is being written off.  Can we do this?

The Answer:

Well, since this is the second time this week I’ve been asked the same question, here’s the answer: NO!

Perhaps I should elaborate.

Under Canadian tax law, interest on borrowed money is deductible only under certain specific conditions. For the sake of bandwidth, I will only mention the most important:

The borrowed money must be used for the purpose of earning income from a business or property.

The emphasis on the word used is intentional. The Supreme Court of Canada, many years ago, laid down the rule that it is the use of the borrowed funds that we look to to determine whether this condition is met. To be more specific, it the direct use made of the borrowed funds. This is a technicality that has both helped and hindered the CRA over the years.

In your case, for example, even though you have dutifully paid down the mortgage on the rental property and now own equity in it, refinancing it is simply borrowing money, using your equity in the rental property as collateral. It is not the collateral that is important, but the direct use of the borrowed funds. Therefore, if you use the borrowed money, as you intend, to pay down you personal mortgage, this will be viewed as money borrowed for personal use, and the interest would not be deductible.

One often recommended strategy, taking advantage of the “direct use” rule, would be to use funds that you currently have invested in savings, such as stocks and bonds to pay down your personal mortgage. Then, refinance the rental property, and use the borrowed funds to repurchase your income-earning investments.

Alternatively, if you remortgaged your rental property and purchased a second rental property, or invested in some other income-earning vehicle, then the interest would be deductible.

What’s Your Tax Issue? Credit Card Rewards

Questions3The Tax Issue

What is the policy for using a personal rewards credit card to pay business expenses? Do I get taxed if I use the points I earned for business only. Will this raise red flags with CRA if I start spending 50k/month on this personal card?

The Answer

Believe it or not, the CRA has put so much thought to this question and changed their policy so often, I don’t blame anyone, including me for needing a quick refresher, so I’m glad you brought this up.

Basically, the CRA’s position is rooted in section 6 of the Income Tax Act, which essentially taxes an employee on the value of any employment-related benefit received in any manner whatever.

Regarding your question, the CRA’s general position has historically been as follows:

Where an employee accumulates points while incurring employment-related expenses which are reimbursed or paid for by the employer, the employee will be in receipt of a taxable benefit if the points are redeemed by the employee for personal travel or to obtain other personal benefits.

It is the employer’s responsibility to quantify the value of the benefits received by the employee, and include that amount on the employee’s T4 slip each year.

However, in 2009, the CRA modified its position, recognizing that it would be difficult for employers to quantify the benefit where the credit card was a personal one controlled by the employee. So, unless it’s a company credit card, the employer is off the hook. But the employee is not.

Well, not entirely. The CRA does acknowledge that it would be difficult for an employee to track personal expenses vs. business expenses on his personal credit card, so their position is that no taxable benefit will arise on points earned on a personal credit card. However, there are conditions.

No taxable benefit will arise on points redeemed from the use of a personal credit card, as long as:

  • the points are not converted to cash
  • the plan or arrangement is not indicative of an alternate form of remuneration, or
  • the plan or arrangement is not for tax avoidance purposes

The CRA provides an example of an employee who is allowed by her employer to pay for business expenses whenever possible through her personal credit card, for which she is reimbursed. In order to maximize her points, she uses her personal credit card to pay for various employer business expenses, including travel expenses of other employees.

The CRA would view this arrangement as being indicative of an alternate form of remuneration and would therefore not allow their administrative concession. The employee would have to calculate the value of the benefit and add that amount to her taxable employment income.

So, to finally answer your question, if you use your personal credit card mostly for normal personal use, and for your own normal business expenses for which you are reimbursed, the CRA would likely not charge you with a taxable benefit; however, if you suddenly start putting $50K/month of your employer’s business expenses on your personal credit card, I would say that it appears this might be a plan to increase your remuneration as outlined in the above example. And yes, the CRA might come knocking on your door.

Taxpayers Behaving Badly – Part 2

In the case of CIBC v R., the CRA disallowed a deduction for expenses solely on the basis that the taxpayer’s conduct was morally reprehensible. The tax court agreed, and The Federal Court of Appeal was asked to rule on this question.

 The issue in this case was the deductibility of $3 billion in payments made by the CIBC to settle litigation in the U.S. relating to the bankruptcy of Enron Corporation. The CIBC was named as a co-defendant in the case, and the settlement was paid to avoid being jointly and severally liable with Enron for its part in the dissemination of misleading financial information.

 In disallowing the settlement amount as a tax deduction, the CRA argued:

 The misconduct of [CIBC and its affiliates] was so egregious and repulsive that any consequential settlement payments […] cannot be justified as being incurred for the purpose of gaining or producing income from a business or property …. The [CIBC affiliates] knowingly aided and abetted Enron to violate the United States’ federal securities laws and falsify its financial statements. The misconduct of [the CIBC affiliates] in enabling Enron to perpetrate its frauds, known to [CIBC], or the misconduct of [CIBC] itself, was so extreme, and the consequences so dire, that it could not be part of the business of a bank.

 If you know your tax history, you will recognize the CRA’s words as stemming from the comments made by the Supreme Court of Canada in the case of 65302 British Columbia Ltd. v. R. In that case, the taxpayer deducted quota penalties it was charged for the over-production of eggs. The quotas were intentionally exceeded in order to maintain a major customer. The court in that case allowed the deduction, but also stated, with regard to penalties in general that:

 It is conceivable that a breach could be so egregious or repulsive that the fine subsequently imposed could not be justified as being incurred for the purpose of producing income.

 In the end, Finance enacted a provision which generally disallows the deduction of any government penalties. But, the CIBC case did not involve penalties, and there is no specific provision of the Income Tax Act that would disallow a settlement payment based solely on the moral conduct of the taxpayer. Indeed, it is a well known fact that income from all sources, including criminal activities is taxable in Canada.

 So, in the end, the Court of Appeal overturned the decision of the Tax Court and did not disallow the deduction solely on the basis of the taxpayer’s conduct. The case will, however, resurface when the time comes to judge whether the deduction should be allowed on its merits as a business expense.

Harassment, Conflict and Litigation – Part Three

In the final instalment of this series on what creates the most HCL with the CRA in our SAS (“harassment, conflict and litigation” with the “Canada Revenue Agency” in our “self-assessment system”), we cover the granddaddy of disputable expenses – automobile costs. Any tax auditor worth his salt will zero right in on auto expenses like my tee shots to water. Why? Because everybody loves to drive and everybody loves to deduct car expenses. The problem is that the rules in this area are so onerous and complex, few taxpayers under investigation ever come out of it with no HC or L. It’s the record-keeping burden that gets most people into the HCL zone. So heed the following, and minimize your grief.

First, let’s summarize the basic rules for deductibility. As with any expense, the costs deducted must be in connection with your business. So how do we identify the business portion of the cost of something we regularly and continuously use for both personal and business purposes?

Kilometres.

Anyone who uses a car for business should keep track of the total amount of kilometres driven during the year, and a detailed account of which of those kilometres were driven in the performance of their business or employment functions.

Keep receipts and a detailed account of all your auto expenses, such as gas, repairs and maintenance, insurance, licence, registration, car loan interest and leasing costs. If you own your car, you may be able to claim depreciation (CCA).

Now you’re almost there, but you should be aware of certain limits that apply. If you lease your vehicle, deductible payments are restricted to $800 per month (or less, based on a formula, if the value of the car exceeds $30,000).

If you’ve borrowed to purchased your car, loan interest is limited to a maximum of $300 per month. For CCA purposes, there is a maximum on the capital cost of $30,000.

Finally, if you receive a non-taxable per-kilometre allowance from your employer, then you are not entitled to claim any auto expenses personally.

These rules are fairly detailed and objective, so where does the HCL come in? Problems normally arise in two areas – record-keeping, and what constitutes business mileage.

Most people by nature do not keep records as meticulously as the CRA would love to see. If you are audited, and need to justify the amount of kilometres you drove in a year for business purposes, the best evidence you could have would be a logbook where you keep track of where you drove, the number of kilometers, and the business purpose. Compare that to the total kilometres driven for the year, and you have pretty well justified your calculation. In most cases, however, a logbook does not exist, and the taxpayer is left to plead, cajole, regale and negotiate with mostly unsympathetic auditors to have them accept his ad-hoc percentage of business use.

In Quebec, the law requires that you keep a logbook if you drive a company car. Employees must provide their employer with a logbook within ten days after the end of the year, or face a fine of $200.

The second issue of concern is that sometimes it is not clear whether a trip qualifies as business use. Some taxpayers are unaware that travel from home to the place of work does not constitute business travel. However, here’s a tip: if you start out at home, make a stop for business purposes, say at a client’s premises, then proceed from there to your office, then the entire trip would qualify.

What about the case where home is the regular head office and work is carried out at remote sites, such as in the case of a self-employed contractor? If you can establish that your home is your center of operations, then all travel to a work site should be considered for business.

In this series of posts, we touched on some of the most common areas where taxpayers find themselves in hot water with the CRA. Our SAS requires good record-keeping and knowledge of the law. Hopefully, these articles have helped you with the SAS and your HCL level should go down from here.

Harassment, Conflict and Litigation – Part Two

This series of articles deals with a topic that often gets taxpayers into conflict with the taxman, what a client of mine described as “harassment, conflict and litigation”, which I have shortened to the easy-to-spell HCL. In our self-assessment system (SAS) of tax reporting, we are required to be aware of the rules, and honestly provide the CRA with correct information about our taxes. Most often, tax auditors like to zero in on those deductions that are most easily “miscalculated” by us SAS-ers. That’s because of the strict rules surrounding them, and their potential personal component. I am speaking, of course of meals and entertainment, and automobile expenses (MENTA). This article will discuss the rules surrounding meals and entertainment expenses.

Taking a client out for a meal is a long-standing and acceptable business practice. Traditionally, business-related meals have been deductible in our system. However, there is a 50% restriction on the deduction, in recognition of the fact that there is at least one person (you) enjoying a personal benefit from the arrangement. (In Quebec, there is a further restriction based on a percentage of gross sales.)

What constitutes a business meal to a taxpayer may not always pass muster with the CRA, and here’s where the HCL comes in. For example, there are some tax auditors who simply make the assumption that any meal consumed on the weekend is non-business related and automatically disallowed. Evidence that a meal is business related should include a copy of the restaurant bill, the name of the guest and the business reason for the meal. The burden is on the taxpayer to prove his case on a balance of probabilities.

There are similar rules for entertainment expenses. Sports and theatre tickets are good examples. If you purchase season tickets to a sporting event, for example, you must show the business purpose for the purchase by keeping track of who uses them and their business relationship to you.

Golf is pretty popular in the business world, and the CRA has always known this. That’s why there is a special rule for golf and other such club dues and fees. It’s a simple one: they are not deductible.

But what about business meals at a golf club? Back in 1997, the CRA came up with a policy that meals consumed at the club in conjunction with a game of golf were not deductible. So, as long as you weren’t playing golf, you could go there for a meal. If you played, you had to go somewhere else afterwards to enjoy a nice tax deduction with your meal. The CRA has since seen the silliness of this policy and now allows business meals at a golf club to be deductible (subject to the 50% restriction). Club dues and green fees, however are still off limits.

The meals and entertainment rules have been great fodder for HCL for many years. In one case, the CRA applied the 50% restriction to an investment advisor who routinely gave donuts to his clients to thank them for referring business. The Tax Court of Canada held that donuts did not constitute a “meal”, and allowed the deduction in full. Personally, I can’t imagine the staggering number of Timbits it would take to justify the cost of going to court over this issue, but at least the judge was able to show he was familiar with the basic food groups 🙂 .

In another case, a food critic, whose sole job it is to eat meals at restaurants was told by the CRA that the 50% restriction applied to her. This illustrates that there are no exceptions to the 50% rule (except, of course the exceptions, which include employee parties and charitable events – but I digress).

In our next article, more HCL with automobile expenses.

Harassment, Conflict and Litigation – Part One

I took a client to lunch the other day and he made an interesting observation. He thinks the income tax system in this country is based on harassment, conflict and litigation (what I will hereafter refer to with your permission as the HCL of Canadian tax). I felt obliged to point out to him that although HCL is a dominant feature, the actual basis of our tax mechanism is quite the opposite. In fact it relies at its core on the “self assessment system” of taxes by the taxpayer himself (Let’s call it the SAS). If a taxpayer practices accurate and honest SAS, then he will completely avoid the HCL. Well, that’s what our government (the CRA) tells us anyway, and I guess that would be true, at least in a perfect world (APW). Of course we don’t live in APW, and in our constant efforts to SAS, we might inadvertently cross the line, receive a friendly visit from the CRA and get into some stressful HCL.

The next three articles will deal with what I believe to be among the most common causes of HCL in our system: meals and entertainment, and automobile expenses (MENTA). When MENTA are related to the process of earning taxable income they may be deducted from income for tax purposes. Therefore, I should have been allowed to write-off the cost of that lunch as well as the gas and other car expenses for my trip downtown, right? True, but what about the personal element to my expenses? Arguably, I had to eat anyhow, and what about my little side trip to Golf Town on the way back to the office?

Now you’ve got the picture, right? These business expenses will invariably contain some personal element and it is this problem that not only causes a great deal of HCL, they have led to constantly changing sets of rules developed and refined over the years that are so difficult to understand and comply with, that only The Tax Issue could be relied upon to explain them to you, kind reader.

Before we get into the actual details of what can be deducted, let’s talk about who can take these deductions. For the purposes of our discussion, let’s divide the world into two types of taxpayers: those who are employed and those who are in business. If you are in business, then you generally have no restrictions on what you can deduct as an expense as long as it relates to your earning of income. All you have to do is follow the specific rules relating to the MENTA as we will discuss later.

One more general note about business (and forgive the digression) – the calculation of deductible expenses is generally the same, whether the business is run by an individual (sole proprietor), partnership or corporation. So please don’t ask again.

Employees are not so lucky. In fact, they are treated in an opposite fashion. In general, they are allowed no deductions from income unless specifically provided for them under the law. In the case of MENTA, luckily, such provisions do exist, but there are certain conditions.

The most common MENTA deductions allowed to employees are automobile expenses. In order to claim auto expenses, employees must meet strict conditions. They must have a contract (verbal or written) with their employer providing that they are required, as part of their employment duties to travel, and that they must bear the cost of their auto expenses. As evidence, they must have their employer complete and sign a prescribed form stating the terms of their employment and whether auto expenses are reimbursed either directly or through an allowance.

Generally, you cannot deduct meals and entertainment costs if you are an employee. The only exception to this rule is if you earn commissions. A commissioned employee is generally treated similar to a person earning income from a business. That is, there is a general rule allowing the deduction of expenses relating to the earning of that income. The only restriction is that the deductions are limited to the amount of commission earned in the year.

Next time, we’ll be discussing the deduction of meals and entertainment expenses and the HCL that goes along with it!

What’s Your Tax Issue? Invoices Required

The Tax Issue:

I am going through an audit by Revenu Quebec. I have given the auditor my credit card statements as backup for certain expense claims, and he insists that he will disallow any deduction unless I can produce the actual invoice. Am I legally required to provide an invoice to support a tax deduction?

The Answer:

This is a question I get on a regular basis. The answer is no, but…..

First, let’s clarify the ground rules . We are talking here about general business expenses, and not items such as child care or tuition fees which specifically require tax receipts.

Also, we are discussing income tax deductions, not claims for GST/QST/HST inputs tax credits, which do legally require documentation showing the taxes charged and the supplier’s registration numbers.

OK, now let’s talk about tax deductions. There is nothing in the law that obliges you to produce an invoice to back up an expense claimed for income tax purposes. However, the law does place the burden of proof on you to show , on a balance of probabilities, that you have spent the amount and that it qualifies for a tax deduction.

The Quebec auditor has given you his position that he will not allow a deduction unless it is supported with an invoice. That is his right to do, and it is probably the policy of his department. The Minister can assess you based on any assumption he wishes. Here, he is assuming that no expense is deductible without an invoice.

Now, the burden falls on you to provide some other form of proof to support your claim. This is a difficult task without an invoice (which is why the auditor wants one).

Can the proof consist of verbal testimony? Yes, but it rarely works with auditors because they don’t generally have the discretion to go against their audit procedures.

You have a number of chances to state your case. There is usually some form of representation you can make to the auditor and/or the supervisor prior to an assessment. After that, you can object to the assessment at the appeals level. Finally, there are the courts, where you might wind up if the government sticks to its guns on the issue.

So, you can go ahead and let the auditor know that an invoice is not technically required, but then you must provide him (or ultimately, the judge) with sufficient proof to destroy his assumptions.

The iPhone – Is There An App for CRA?

This bit of news comes at a very opportune time for me personally as I teeter on the precipice of purchasing my very own iPhone (or Blackberry, or Zune, or iPod Touch – don’t ask!).

The CRA was asked whether an Apple iPhone is considered depreciable property falling into the same class as general purpose computers.

The iPhone: Yes! It's a computer!

Schedule II of the Income Tax Regulations lists the various classes of depreciable capital property and the applicable rates of CCA. “General-purpose electronic data processing equipment” (i.e., laptops and computers) acquired after March 18, 2007, is included in Class 50 (55% CCA rate) and if it is acquired after January 29, 2009 and before February 2011, subject to certain other conditions, it is included in Class 52 (100% CCA rate).

“General-purpose electronic data processing equipment” is defined as electronic equipment that requires an internally stored computer program that (i) is executed by the equipment, (ii) can be altered by the user, (iii) instructs the equipment that to perform certain functions, and (iv) depends on the data processed to determine the sequence of its execution.

In the CRA’s view, an Apple iPhone would qualify as general-purpose electronic data processing equipment.

Of course, the CRA took the time to caution that only the portion of the cost of the iPhone that is used for the purpose of gaining and producing income would qualify for CCA. This means I have to keep track of all the time I will spend playing PacMan, listening to Lady Ga Ga, taking videos of natural disasters as they occur, Googling myself, chatting with my wife, my kids, my mom and my bookie, then add up this time, divide by the total time I use the iPhone and multiply the result by the total cost of the iPhone and add that amount to the appropriate CCA class (and apply the half-year rule) – and I must do it all on the day I buy the iPhone! Hopefully, there’s an App for that!