DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Loophole Repairs, Part One

In Canadian Income Tax on August 9, 2011 at 10:23 am

Years ago, when I was first introduced to a tax practitioner, I was compelled to ask him for a list of loopholes I could use in preparing my tax returns so I would pay little or no taxes. After all, that’s what they did, right?

I later learned, of course, that you can avoid paying some taxes all of the time, you can avoid paying all taxes some of the time, but you can’t avoid paying all taxes all of the time. (I think Bob Dylan said that).

Which brings me to the subject of this two-part post – you guessed it – tax loopholes. Rather, the federal government’s recent assault on some tax planning strategies that it has finally seen enough of.

Loophole #1 – Tax Deferral Using Partnerships

Once upon a time a self-employed person starting up a new business could defer income tax by simply choosing an off-calendar fiscal period. While individuals report their taxes every calendar year, the income they reported from a business was based on the earnings for the fiscal period ending in the calendar year. For example, an attorney with a fiscal year end of January 31, 1991 would not have to pay taxes on income for that year until April of 1992, even though 11 months of that income was earned in 1990.

In 1995 the rules were changed to force any individual or partnership with individuals as partners to report their income on a calendar year basis.

That change, however, did not apply to corporations. Nor did it apply to partnerships, all the members of which are corporations. Therefore, a common tax planning tool for a company would be to enter into a partnership with another corporation. The partnership could establish a year-end that was different from the company’s fiscal year, thereby deferring tax on income earned through a partnership.

The Fix:

The 2011 federal budget proposes to eliminate the deferral for corporations earning income through a partnership where the company has a significant interest in the partnership. Partnership year-ends will now have to coincide with the fiscal period of the corporation.

Loophole #2 – Kiddie Capital Gains

In the early 1990’s, family trusts were all the rage. Income splitting with your children was possible by placing shares of a company in a trust. The beneficiaries of the trust could be your children, and dividends paid to the trust were allocated to the beneficiaries. Children with no other sources of income could earn up to $30,000 of dividends without paying any tax!

In 1995, the government eliminated this benefit by introducing the “kiddie tax”. Essentially, now, any dividends paid to a minor child will be taxed at the highest tax rates for individuals.

The above rule, however, does not apply to capital gains. Therefore, a trust could, for example, sell a portion of its shares to a related person and allocate the capital gain to a minor child, thereby skirting around the kiddie tax.

The Fix:

Proposals in the 2011 federal budget take aim at the above loophole by extending the kiddie tax to any capital gain earned by a minor child on a sale to a non-arm’s length party where a dividend on the share would have been subject to the tax. The capital gain will be treated as a dividend, and will not be eligible for the capital gains exemption.

In our next post, more loophole repairs!!

  1. […] the CRA was asked about the new partnership year-end rules and joint ventures. As we reported in an earlier post, new rules were introduced in the 2011 budget that will essentially eliminate any tax deferral to a […]

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