Morneau Proposals – Take Two

Morneau’s Tweet

As most readers are aware, the federal government’s small business July 18 tax proposals created an enormous backlash, with many groups and individuals, including yours truly making submissions to voice their concern. It appears the government heard the outcry as it has softened its stance to varying degrees on its new proposals. Here is a summary of how things now stand:

Income Sprinkling

The original proposals would extend the Tax on Split Income (“TOSI”) to dividends received by adults, unless they can show that the dividends are reasonable in light of their labour and/or capital contributions to the business.

The response by the tax and business communities focused mainly on the uncertainty of what might be considered “reasonable” and how this might translate into an acceptable dividend.

The finance minister has announced that it intends to move forward with the income sprinkling proposals. It intends to ensure that the rules will not impact businesses to the extent there are clear and meaningful contributions by family members. It will introduce reasonableness tests for adults in two categories – those aged 18-24 and those aged 25 and older. Adults will be asked to demonstrate their contribution to the business based on four basic principles:

  • Labour contributions
  • Capital or equity contributions
  • Financial risk, such as co-signing a loan, and/or
  • Past contributions of labour, capital or risks

While no new draft legislation has been released, the government states that the concerns surrounding uncertainty have been heard and they will simplify the proposed measures and reduce the compliance burden. Stay tuned to see what the specific legislation will contain.

Multiplication of the Capital Gains Exemption (“CGE”)

The original proposals would have disallowed the lifetime capital gains exemption on the sale of Qualified Small Business Shares and Qualified Farming Property as follows:

  • Elimination of CGE for minor children
  • Imposing TOSI reasonableness tests on availability of the CGE
  • Elimination of CGE for property held in a trust

After review, the government has backed off on all of the above proposals and will not be going forward with any of them.

Converting Income into Capital Gains

These proposals were designed to curtail what the government perceived as abusive “surplus stripping”.  It would have extended the rules in section 84.1, to any non-arm’s length sale of shares to a corporation. It would also have applied dividend treatment to any such sale, even where tax had already been paid on a previous capital gain on the same shares.

These proposals would have eliminated the “pipeline” strategy, widely used to limit the incidence of taxes on the death of an individual shareholder to a single capital gain in the hands of the deceased. It would have greatly increased the chances of gains on private company shares being taxed twice.

Thanks to the concerns expressed by the tax and business communities, the government has backed off completely on these proposals and will not be going forward with them.

This is great news for those who still have reservations about the legitimacy of implementing the Pipeline strategy on the death of a private company shareholder as the government specifically mentioned that it was responding to concerns about taxation on death.

Holding Passive Investments

The initial proposals addressed concerns that shareholders of private corporations are able to defer the ultimate taxation on their savings, thereby creating a larger pool of capital to be invested for retirement. This is an advantage that a shareholder of a private corporation enjoys compared to a person without a company and is to be eliminated.

After consulting with the public, the government, while not abandoning the proposals, has agreed to relax them.

First, any capital already in existence will not be affected by the new rules. They will not apply retroactively to existing retained earnings.

Second, there will be a base amount of $50,000 of passive income that a corporation may earn each year while still not having the rules apply. This is the equivalent of $1 million of capital invested at a 5% rate of return. Any income above that amount will not benefit from the tax deferral.

There is still no draft legislation to indicate exactly which mechanism will put in place. The new year should bring new announcements and more details in this important area.

Response to Tax Proposals – Part 2

Yesterday, I published Part 1 of my letter to Bill Morneau, addressing the general tone of the presentation of the federal government’s July 18 proposals to reform the taxation of private corporations. In today’s Tax Issue, Part 2 of my submission, dealing with the specific proposals themselves, and offering some suggestions for improvement, and in some cases, abandonment.

Part 2 – The Proposals – Suggestions for Improvement

Having aired my general concerns with the sweeping nature and tone of the Proposals, my experience as a tax professional leads me to acknowledge that there are, within the Proposals, certain areas that should, in all fairness be addressed. In this section I will review the four areas covered by the Proposals and offer my suggestions for improvement where warranted.

Income Sprinkling

The sprinkling of dividends among family members and other shareholders is a legal right sanctioned by the Supreme Court of Canada in the decision of McLurg v. Canada. Since that time, incorporated business owners have often structured their affairs to multiply low marginal income tax rates by issuing shares to family members, often minor children, even new born babies. The ability to use minor children in this manner was eliminated in 2000 with the introduction of the tax on split income (“TOSI”).

The Proposals now seek to extend these TOSI rules even further, to spouses and adult children. They have introduced legislation that will create an inordinate amount of complexity and uncertainty into the system.

First of all, the sprinkling of income with a spouse should not be disallowed. Often, a business is a family endeavour and a spouse offers support in many ways. Further, there are many instances, such as pension income splitting, where the distribution of family income among spouses is specifically allowed. I would recommend that the proposals with regard to spouses be abandoned.

Secondly, the sprinkling of dividend income to adult children is beneficial generally only to the extent that the child is not otherwise employed. In other words, the real benefit accrues during the time the child is still in school and not earning a salary. If it offensive to sprinkle income with adult children, then I would suggest that the TOSI simply be extended to an age where the most benefit is being attained, i.e., to age 25. After that, the benefits are virtually non-existent, unless the child is, in fact, involved in the business full time.

On the other hand, if the government is intent on introducing another reasonableness test with respect to dividend income paid to children, then they should amend the TOSI rules for minor children as well, since even a 15-year-old child, for example, can work in the business in the summertime and after school.

The proposals with regard to Capital Contributions should be abandoned. The fact is anyone who starts a small business through incorporation will normally capitalize the company with a nominal amount of share capital. No dividend paid on a common share of a small business corporation would meet the proposed reasonableness test in this regard, and it simply introduces more complexity into the law.

Lifetime Capital Gains Exemption

I have been involved in the structuring of many corporations where minor children are issued shares for the purposes of multiplying the capital gains exemption. My feeling is that the parent is using for his or her own purpose, without consent, a benefit that belongs to the child that he or she may wish to access in the future. I therefore agree that the participation of minor children in the ownership of a small business corporation for the purpose of multiplying the capital gains exemption should be curtailed.

With respect to family members over the age of 18, my feeling is that if they are legally allowed to contract, they should be allowed to own shares of a corporation, and as such, make their own decisions as to whether or not to claim the capital gains exemption on the sale of their shares. For spouses and children over the age of 18, therefore, I disagree with any restrictions on the use of the capital gains exemption on qualifying shares. These proposals should be abandoned.

Holding Passive Investments

The deferral of income within the corporate structure has been a staple of small business since the 1930’s. It is correctly considered to be the “nest egg” that a business owner can rely upon for retirement. If we add up the pros and cons of small business owners vs. Rich CEO’s as I did earlier, this item is perhaps the biggest reward that a small business owner can look forward to at the end of his or her career. While the Rich CEO can enjoy a large severance package and a generous pension upon retirement, the small business owner can rely on the accumulated investments in a holding company. The income from these investments is taxed at the highest marginal rate, so there is currently no income tax advantage to earning investment income through a holding company.

The idea that the government would attack accumulated wealth within a small business corporation and undermine a lifetime of labour by its owner seems excessive and cruel.

In my view, these proposals should be abandoned.

Converting Income into Capital Gains

Currently, the rules in section 84.1 address the issue of surplus stripping. Furthermore, the avoidance transaction that the Proposals are trying to address in this area has essentially been settled in cases such as Macdonald v. Canada. The CRA has successfully applied the General Anti-Avoidance Rule to curtail abusive transactions in this regard. Due to the CRA’s success in the courts in attacking these transactions, I would not recommend them to any of my clients. I therefore see no need to introduce legislation that would not only target abusive transactions, but would also deny capital gains treatment in cases where bona fide share sales were made. The Proposals make no allowances for the possible transfer of a business from a parent to a child or a sale between siblings. In fact, the Quebec government has recently gone in the reverse direction, introducing legislation that facilitates business transfers to the next generation.

Furthermore, these proposals will subject estates to double and in some cases triple taxation. Upon the death of an individual, there is a deemed disposition of shares at fair market value. The estate pays capital gains tax. When the company then liquidates its assets for distribution, there is a second tax that must be paid on the accrued increase in the value of investments within the company. Finally, upon distribution of the corporate assets to the heirs, a third dividend tax is levied. This is clearly unfair.

There is only one mechanism currently in place within the law that directly relieves this burden. Subsection 164(6) allows for an election to be made to offset the capital gains tax on death, but only where the company is dissolved within one year from the date of death. The administration of an estate can run much longer than one year. The government has acknowledged this with its newest laws regarding Graduated Rate Estates (“GRE”), which have a life of 36 months.

The Proposals will eliminate the ability of estates to implement what is commonly referred to as the “Pipeline” plan, which involves capitalising the cost base of shares that were taxed on death. In my opinion, the Pipeline is not an unfair advantage. The capital gain triggered on the death of an individual is clearly not a voluntary tax outcome. It is an automatic tax triggered by virtue of the law. The government seems not to be satisfied with this tax, and by denying the ability to plan to limit their taxes to this involuntary event, wishes to force a second and more onerous tax on the estate. Again this seems cruel and unfair.

My recommendation is that the anti-avoidance provision contained in the Proposals be abandoned and that the “Pipeline” transaction be expressly sanctioned by the CRA.

Failing this, at the very least, the election under subsection 164(6) should be made available to an estate for as long as it remains a GRE. Further, the designation currently allowed in certain circumstances under paragraph 88(1)(d) should be extended to corporations that have been liquidated in favour of a GRE. This would limit the tax burden on an estate to one incidence of tax, albeit the result of a forced transaction yielding a higher tax burden.

The Morneau Massacre of 2017

loopholes

If you’ve just returned from vacation and wondering what’s new in the tax world, you’d better sit down and take a pill. On July 18, finance minister Bill Morneau rolled out the federal government’s proposals designed to “close loopholes and deal with tax planning strategies that involve the use of private corporations”. In short, Finance is proposing to tax an axe to many of the tax strategies that have been available to small business owners and professionals up until now.

The proposals are complex, comprehensive and wide-ranging, covering the following main areas of tax planning:

  • Income sprinkling
  • Multiplication of the capital gains exemption
  • Converting a private corporation’s regular income into capital gains
  • Holding investments inside a private corporation

Income Sprinkling

This strategy involves the splitting of income to take advantage of lower marginal tax rates available to family members. Many rules have been put in place over the years to curtail this practice. Most notably, the tax on split income (TOSI), or “kiddie tax” applies the highest marginal tax rates to certain dividends paid to minor children.

With the new proposals, the TOSI will no longer be limited to minor children. Complex new rules will apply the TOSI to dividends paid to adult individuals unless such dividends are reasonable in light of that individual’s labour contributions and/or capital contributions to the corporation.

The TOSI will also be expanded to apply to capital gains on property, the income from which was subject to the TOSI. Further, it will also apply (for individuals under age 25) to “compound income” that was previously subject to attribution rules or the TOSI.

These proposals are scheduled to apply to for the 2018 and later years.

Multiplication of the capital gains exemption

A capital gains exemption (CGE) of up to $800,000 (indexed) is currently available to any individual on the sale of qualifying shares of a private company. Issuing shares to family members, either directly or through a trust, is a common way to multiply this tax benefit.

The finance minister has proposed a three-pronged approach that will eliminate the multiplication of the CGE:

Age limit: The CGE will no longer be available to individuals where the gain occurs in any year before the individual reaches the age of 18 years.

Reasonableness test: In essence, this rule will deny the CGE on any gain on the sale of shares if the gain from those shares is subject to the TOSI measures described above.

Trusts: With exceptions for spouse or alter ego trusts the GCE will no longer be available on any gain on a share that is held by a family trust.

These proposals will apply to dispositions after 2017. However, there will be transitional rules that will allow an elected deemed disposition at any time in 2018. The fair market value of the shares would have to be determined, and the qualification criteria for the CGE will be treated as being satisfied if they are met at any time in the preceding 12 months.

Converting a private corporation’s regular income into capital gains

Normally, a distribution of a corporation’s retained earnings is considered a dividend and taxed as such. The top rate on dividends is approximately 44%. Strategies have been used with varying degrees of success to arrange for dividends to be transmogrified into capital gains, which are taxed at 25%. This involves the utilization of the high cost base on shares that have been acquired through a non-arm’s length transaction that had previously triggered a capital gain. Current rules are in place to curtail such “surplus stripping” in limited circumstances. Section 84.1 effectively forces a return to dividend treatment where the capital gains exemption was claimed on the previous capital gain.

The government proposes to extend these rules to any situation where a non-arm’s length transaction involved even a fully taxable capital gain. This proposal is meant to address what has become known as the “pipeline” transaction.

The pipeline has been used extensively in recent years as a post-mortem planning tool to avoid double-taxation where the capital is deemed to occur on the death of a corporate shareholder. Unless the current proposals are altered, the pipeline strategy will no longer be available to an estate.

These proposals will take effect for all dispositions that occur after July 18, 2017. There will be no room for transitional planning.

Holding investments inside a private corporation

One of the long-standing advantages of incorporation is the tax deferral that comes with lower rates on business income. Once the retained income has accumulated over time, the company will have a larger amount available for investment. This has been a great contributor to the retirement of many small business owners. However, it is an advantage that salaried persons or those who don’t incorporate cannot access. Accordingly, the government proposes to eliminate it.

Of all the proposals announced, this is the only one that is not fully developed with draft legislation. The Minister has included some suggested strategies to deal with the issue, each one complex in its own right, and generally altering the system of integration currently in place by eliminating the effect of the corporate tax deferral for future passive investment.

The Minister acknowledges that there currently exists a significant amount of capital invested within private corporations, and it is not his intent to affect these holdings. Any new rules will have effect on a going-forward basis.

These proposals are subject to a consultation period which will end on October 2, 2017. Interested parties should write to the Minister of Finance with any concerns before that date. I suspect that it will be an interesting and eventful autumn for the tax community.

The End of the Tax Mulligan

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What happens when a transaction is undertaken that is planned to be tax-free, but due to an unforeseen error in the execution of the plan, it is subsequently discovered that tax is payable? Until recently, if all else failed, one option was to apply to the courts to allow for “rectification”. That is, since the parties to the transaction originally based their actions on the assumption that the plan was tax-effective, ask the courts to allow them to “redo” the deal correctly to restore its original tax-free intent.

Rectification is essentially not a tax concept. It generally applies where parties to a transaction discover that the legal documents that apply do not accurately represent the agreement or intent of the parties at the time. When both parties agree, the courts are inclined to grant relief and allow for a retroactive correction of the legal documents.

Back in 2000, in the case of Juliar, rectification was granted in a tax context to correct what was essentially an error on the part of the tax planners. Simply put, Mr. and Mrs. Juliar transferred shares to a holding company on the assumption that the shares had a high adjusted cost base (ACB) and no rollover provision was made. When it was subsequently discovered that the ACB was indeed low, they applied to the court for rectification, asking to convert a taxable sale to a rollover under section 85 of the Income Tax Act. The court agreed.

Since then, the case of Juliar has been cited often in cases where mistakes in legalities have created undesired tax results. However, in the recent decisions of Jean Coutu and Fairmont, the Supreme Court has overturned Juliar and has put an end to the idea that rectification can be used as a tool to correct errors in tax planning and its execution.

The court in Fairmont stated:

“…rectification is not equity’s version of a mulligan. Courts rectify instruments which do not correctly record agreements. Courts do not “rectify” agreements where their faithful recording in an instrument has led to an undesirable or otherwise unexpected outcome.”

Juliar was expressly overturned on the basis that the decision resulted in “impermissible retroactive tax planning”.

There is a famous decision (Shell Canada) that stands for the idea that a taxpayer is taxed on the way it arranges its affairs, rather than how it could have arranged its affairs. This concept is often referred to when a legal transaction is executed poorly, resulting in unintended tax consequences. These new decisions are in line with this concept, and they take away a weapon of last resort for taxpayers and their advisors.

2017 Federal Budget Summary

Under the Auspices of the Order of Chartered Professional Accountants of Canada, I am pleased to provide a summary of 2017 Federal budget summary/ 2017 Résumé du budget fédéral. I will also place a link on the Tax Links Page, and it will remain there, along with past federal and Quebec budget summaries for future reference.

Sold your House? Make Sure You Report It!

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If you have sold your home recently, you should take note of the new reporting rules announced by the CRA regarding the principal residence exemption (“PRE”).

The PRE applies on a pro-rata basis based on the number of years you are claiming the house as your principal residence. Form T2091 is technically required to report and claim the PRE on the sale. If you were claiming the exemption for the full period of ownership, then the gain on the sale is fully exempt from tax. The CRA’s policy until now has been that no reporting was required in such a case.

However, for 2016 and future years, this administrative policy has changed. Form T2091 is still not required if the full exemption is claimed, However, the sale must be reported on Schedule 3 of your tax return for the year. You will need to report a description of the property,  the year of acquisition and  the proceeds of disposition. Failure to report the sale will result in the denial of the PRE. However, you may go back and amend your return to report the sale and claim the exemption, subject to possible penalties of $100 per month to a maximum of $8,000.

For Quebec tax reporting, there has never been any administrative policy regarding a fully exempt sale of a principal residence and form TP-274 continues to be required.

Changes for Trusts

If your principal residence is owned by a trust, new rules will apply to you. I outlined the current rules in a previous post.

Under the new rules, only certain specialized trusts are now eligible to claim the PRE. They are alter-ego trusts, certain spousal or common law partner trusts, certain protective trusts or certain qualified disability trusts.

Starting in 2017, any trust that owns a home and does not fit within any of the categories above, will no longer be eligible for the PRE on the sale of the home. Therefore, if the house is sold before the end of 2016, the PRE can still be claimed.

For 2017 and later years, a home that was owned by a trust that no longer qualifies for the PRE will be allowed to calculate the exemption based on transitional rules that would require a valuation of the property as at the end of 2016. The PRE will be available for the “notional” gain up to the end of 2016, while the future growth in value will be subject to capital gains tax.

Anyone who currently lives in a home owned by a personal trust should consult their tax advisor.

Changes for Non-Residents

New rules will also apply to anyone who was a non-resident at the time they purchased a residential property in Canada. Under the current rules, the pro-rata formula that is used to calculate the PRE allows for an extra year (the plus 1 rule) in calculating the exemption. This generally allows for the fact that in a year where someone sells their home, they may own two properties, both of which should qualify for the exemption.

For a non-resident, the plus 1 rule allowed them to claim a portion of their gain as exempt, even though they never qualified since they were non-residents of Canada. Accordingly, for all sales on or after October 3, 2016, the Plus 1 rule will no longer be available to any taxpayer who was a non-resident of Canada in during the year in which he or she acquired the property. There are no transitional rules to this provision.

2016 Federal Budget Summary

Under the Auspices of the Order of Chartered Professional Accountants of Canada, I am pleased to provide a summary of 2016 Federal budget summary / 2016 Résumé du budget fédéral. I will also place a link on the Tax Links Page, and it will remain there, along with future federal and Quebec budget summaries for future reference.

Death of Testamentary Trust Rules

Turkey-Estate-Plan

The favourable tax rules enjoyed by estates and testamentary trusts until now are almost dead.  Major changes that were introduced in the 2014 federal budget are about to come into effect on January 1, 2016. Don’t be caught off guard.

Estate vs. Testamentary Trust

Until now, most of us have viewed a testamentary trust in basically the same way we would an estate. They both essentially were included in the definition of a “Testamentary Trust”, meaning a trust arising as a consequence of the death of an individual. As such, they were treated in similar fashion under the law, both benefiting from graduated tax rates and both able to have an off-calendar fiscal period for tax purposes.

But now, we must make a distinction between an estate and a testamentary trust.

A testamentary trust is generally a trust that is created by the will of the deceased person. Assets from the deceased’s estate are transferred to the trust for the benefit of named beneficiaries. These assets are then administered by designated trustees. Such a trust could go on for an indefinite period of time, depending on the terms of the trust.

On the other hand an estate is essentially the bundle of assets owned by an individual at the time of death, which is to be distributed by the liquidator to the beneficiaries pursuant to the will within a relatively short period of time. The CRA likes to refer to the “executor’s year”, implying that it should take a year or so to clear the estate and distribute the assets. In many cases it may take longer.

Elimination of Benefits to Testamentary Trusts

Now that we have our terms of reference, the first thing to note is that beginning in 2016, most testamentary trusts will no longer benefit from graduated tax rates, and they will have to switch to calendar taxation years. The only exception will be for “Qualified Disability Trusts”, which essentially is a testamentary trust with a beneficiary that qualifies for the disability tax credit.

There are no grandfathering rules. All existing testamentary trusts will have to cut off their taxation years on December 31, 2015. This could result in many trusts having two tax years in 2015. You should note that the due date for the first of these calendar taxation years will be March 30, 2016.

Furthermore, beginning in 2016, these trusts will:

  • be subject to the highest marginal tax rates
  • will have to make quarterly tax instalments
  • will lose the $40,000 alternative minimum tax exemption
  • will lose the ability to object to an assessment within one year (i.e. the 90 day deadline will apply)
  • will lose the ability to transfer investment tax credits to its beneficiaries
  • will lose the right to apply for a refund after the normal reassessment period
  • may become subject to part XII.2 tax on certain types of income where non-resident beneficiaries exist

Graduated Rate Estates

On the other hand, estates may continue to benefit from graduated rates and off-calendar fiscal years, under certain conditions. Estates that meet the requirements will be known as “Graduated Rate Estates” (“GRE”).

A GRE will qualify only under the following conditions:

  • no more than 36 months have passed since the death of the individual
  • the estate otherwise meets the definition of a “Testamentary Trust” under the law
  • the estate designates itself as a GRE in its tax return for the first taxation year ending after 2015
  • the deceased individual’s social insurance number is provided in the tax return
  • no other estate is designated as the GRE with respect to that individual.

Once 36 months has expired, the estate will no longer be a GRE and will become subject to the less favourable rules described above.

Charitable Donations by a GRE

Currently, a charitable gift made by an estate that was designated by the will of an individual is deemed to have been made by the deceased, and is not deductible within the estate.

Beginning in 2016, a GRE will benefit from new and more flexible rules regarding the claiming of charitable donations. If the estate is a GRE, then such donations may be claimed by:

  • the deceased in the year of death or the preceding year
  • the estate in the year in which the donation is made, or
  • the estate in an earlier taxation year or subsequent 5 years.

Other Changes

Other more complex changes regarding testamentary trusts are coming into effect as well, but a detailed description of these is beyond the scope of this short summary. Briefly, the election to pay tax within a trust, notwithstanding that income is paid to beneficiaries, will be virtually eliminated, unless certain conditions apply.

Finally, for testamentary life interest trusts, such as spousal trusts, upon the death of the beneficiary, a year-end will occur, and any gains or income triggered upon death will be deemed to have been paid to the beneficiary’s estate, making it liable for the taxes on death. This may create a mismatch between the liability for taxes and the ownership of the assets in cases where trust capital is to be paid out to persons who are not beneficiaries of the deceased beneficiary’s estate. A common circumstance where this issue could become a problem is in a case such as a second marriage where children from the first marriage are to receive the capital of a spousal trust upon the death of the beneficiary spouse.

 

2015 Federal Budget Summary

Under the Auspices of the Order of Chartered Professional Accountants of Canada, I am pleased to provide a summary of 2015 Federal budget summary  / 2015 Résumé du budget fédéral. I will also place a link on the Tax Links Page, and it will remain there, along with future federal and Quebec budget summaries for future reference.

Allocating Input Tax Credits

 

These days, with all the complexities of the GST/HST rules regarding what is taxable and what isn’t, many businesses and professionals may find themselves providing a mix of supplies; that is, sales are taxable or exempt, depending on the rules (for example, a pharmacist who sells taxable items as well as exempt prescription drugs). This begs the question: to what extent can a business or professional claim input tax credits (“ITC’s”) with respect to the GST/HST paid on its expenses?

With the notable exception of financial institutions, which have their own set of specific rules, in general, a business may claim ITC’s based on the amount of its expenditures consumed in pursuit of its commercial activities.

 

General Rule for Claiming ITC’s:

The starting point is the general rule which requires ITC’s to be calculated based on the following formula:

A x B

Where

A is the GST/HST paid or payable on the purchase of a property or service, and

B is a percentage, which represents the extent to which the person acquired the property or service in the course of the commercial activities of the person.

Based on the above, it is therefore necessary to determine what is meant by the term “commercial activity”. The law defines a commercial activity as a business carried on by a person, except to the extent to which the business involves the making of exempt supplies by the person.

Therefore, to the extent that the business activities do not involve the making of exempt supplies, they constitute commercial activities.

 

 

Allocation of Expenditures for ITC Purposes:

There is no requirement to apportion expenditures based on revenues or any other measurement. The only criterion set out in the law is that the apportionment must be reasonable and consistent.

The CRA provides guidance as to how to allocate ITC’s between commercial and non-commercial activities. In its GST Memorandum 8.3, it states that the methods used should link the property or service on which the input tax was paid to commercial and other activities. It suggests that directly allocating expenses to a commercial activity is most desirable. For example, where an expenditure relates exclusively to a taxable (or zero-rated) sale, then a full ITC should be claimed on this amount. The CRA suggests that expenditures be categorized between two groups, as follows:

1. single-use property and services used wholly in a particular activity; and
2. multiple-use property and services used in more than one kind of activity;

In the case of single-use property and services, it is clear that either a full ITC will be claimed (commercial activity) or no ITC will be claimed (exempt activity).

Note that a property or service consumed substantially all (i.e.90%) for a single purpose (either commercial or non-commercial) it will be deemed to be used 100% for that purpose and so will be considered a single-use property.

For multiple-use property or services, the recommended method is an “input” based method. This means that the allocation should be made based on usage. For example, if a self-employed contractor is providing services to both the taxable and exempt activities, then an allocation based on time spent may be reasonable. Rent may be allocated base on square footage used in either activity.

The CRA goes on to state that allocation based on “output”, i.e. revenues, should be made with caution to ensure such a method fairly represents the ratio of inputs used in each activity.

The issue of “reasonable allocation” was addressed by the Federal Court of Appeal in the case of Ville de Magog v. the Queen. The point made in this case was that the law requires only that the allocation method be reasonable and consistent. If the government performs an audit, and, as they did in this case, disagrees with the method for allocating expenses, they cannot change the allocation used by the taxpayer, as long as the taxpayer’s method was reasonable. In other words, the government was not allowed to change the method used on the basis that their method was “more reasonable” than the taxpayer’s method.