DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Loophole Repairs, Part Two

In Canadian Income Tax on August 16, 2011 at 3:14 pm

In this post, we continue our list of loophole repairs made by the federal government in recent months.

Loophole #3 – Flow-Through Share Donations

In an effort to encourage charitable giving, the law was changed a few years ago to allow a person to donate publicly traded stock to a registered charity without having to recognize and pay tax on any capital gain on the disposition of the stock.

In an effort to facilitate the funding for the exploration of natural resources, tax laws have for many years provided for the existence of “flow-through shares”. Essentially, a resource company issues shares to a taxpayer and then allocates, or “flows through” its exploration expenses, which can be fully deductible to the shareholder. This deduction has its consequences – it reduces the tax cost of the share so that a capital gain will apply if it is sold.

A loophole was created when tax planners found a way to combine the two incentives described above. A taxpayer purchases a flow-through share, receives the related resource deductions, then donates the share to a registered charity, claiming a donation credit, without having to recognize the gain on the disposition of the share. This strategy effectively reduced the cost of making a donation to near zero.

The Fix:

The 2011 federal budget proposes to eliminate the above loophole by restricting the capital gain exemption on donation of shares to the amount by which the value of the donated share exceeds the amount that was originally paid for it (as opposed to the reduced cost), thereby reinstating the tax on the gain attributed to the deductions allowed.

Loophole #4 – Interest on “Adjustable” Loan

Generally, a corporation or partnership records transactions on an accrual basis for tax purposes. When interest is payable on a loan, but remains unpaid at year-end, a deduction is available for “accrued interest” on the loan.

In the case of Collins, a partnership accrued interest on a loan where the principal could be reduced at the borrower’s option by making a final payment before a certain date. Interest, however, continued to accrue on the original principal amount until the option was exercised. The interest was never paid, but the accrued deductions were allowed.

The Fix:

The proposed legislation now provides that in cases where a taxpayer has a “right to reduce” an amount in respect of an expenditure, it cannot make a deduction in respect of that expenditure in excess of the reduced amount.

Loophole #5 – Arm’s Length Interest Payments

Historically, interest paid to non-residents of Canada are subject to withholding tax which can be as high as 25%. There are certain exemptions, one of which now applies to all interest paid to arm’s length parties.

In the case of Lehigh Cement Limited, a company was paying interest to a related foreign person, and was required to deduct withholding tax. In order to circumvent this requirement, the interest portion of the payments were sold to an arm’s length bank. Guarantees were given, and the bank was duly compensated for its trouble, and a loophole was created.

The Fix:

The government has now changed the wording of the withholding tax exemption. Rather that applying to interest paid to a non-arm’s length person, the withholding tax will now also apply to interest paid in respect of a debt owed to a non-arm’s length person.

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