DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Posts Tagged ‘Losses’

Earl Jones Victims Get A Raw Deal From CRA

In Canadian Income Tax, Losses on March 3, 2010 at 11:50 am

The latest news that the victims of Earl Jones are now about to suffer even further at the hands of the CRA comes as no surprise to me. Back in August, in the very first issue of The Tax Issue, I speculated on the possibility that these taxpayers might be in for a bit of a shock around tax time. Lo and behold, I was right.

You see, the investors are caught in an unfortunate Catch-22 situation. They made an investment which was supposed to earn them income – a hefty return on their money. Theoretically, these “phantom earnings” were reinvested, although we now know they were used to support the Earl Jones pyramid.

In the real world, investment income such as dividends that are reinvested are still reported on a T5 slip and investors must pay tax on them, even though they don’t see the actual cash. What happens to it? Well, the reinvested earnings get added to the capital cost (ACB) of the investment.

So, here comes the Catch-22. Either the victims pay tax on their phantom earnings, add it to their ACB and claim a capital loss on their invested capital, as I suggested in my August article, or they go with the theory that this was a  fraud from the start, in which case there was never any investment income. In this case, because the investment generated no income, the capital that was lost cannot be taken as a capital loss. However, would the CRA accept that the income was never earned, and allow the victims to claim refunds for 2009 and previous years?  I imagine that will be the topic of the discussions coming up this week.

In a 1991 statement, the CRA concluded that an investor who suffers a loss due to fraud may be entitled to claim a capital loss if certain criteria are met. This makes me think that this is the position the CRA will take here. However, a capital loss may not be of much use to these victims. Capital losses can only be deducted against capital gains, not regular income. While they may be carried forward forever, it may be a while, if ever, before these taxpayers are in a position to generate capital gains and actually benefit from these tax losses.

Contrast this Canadian quagmire with the U.S. victims of fraudsters such as Bernard Madoff. On March 17, 2009, the IRS released a clear and generous tax relief package for these taxpayers. They are allowing the victims of fraud to claim the total of their capital and their reinvested phantom income as “theft losses”, which are fully deductible and may be carried back and forward against all other types of income, thereby generating tax refunds.

Update: In an announcement on March 3, 2010, the Quebec Minister of Revenue has stated that Quebec will, in fact, be granting relief to the victims of the Earl Jones and similar frauds. This relief mirrors somewhat the package offered by the IRS. The victims will be allowed to deduct all phantom income not received from their investment in their 2009 returns. Should this deduction create a loss, it will be considered as a “non-capital loss”, and will be therefore available to be carried back to any of the 3 prior tax years and forward 20 years. No statement was made concerning the loss of capital invested.

Deducting Business Losses? Make Sure You’re In Business!

In Canadian Income Tax, Losses on December 10, 2009 at 12:36 pm

It is said that everyone has at least one great song inside of them. Thinking of going into the music business? Got that CD in the works? Got a few good songs to record? Those costs can add up. Studio time, CD packaging, travel expenses, etc. Would you like to deduct your expenses for tax purposes? Consider the case of Singh Binning.

The recent case of Binning v. The Queen (2009 DTC 1311) highlights the logical notion that in order to deduct business losses, you must have an actual business.

More specifically, the law has always been predicated on the idea that, to deduct losses, there must be a business and a reasonable expectation of profit.

In Binning’s case, he was employed full time as a supervisor in a lumber mill in Ontario, but managed the less-than-bourgeoning music career of his brother back in India. He financed the production of an album and two music videos in New Delhi, paying close to $100,000 which he reported as business losses over five years from 2001 to 2005. A good chunk of these expenses were for travel, and there were ostensibly no revenues to speak of during that period.

Financing a music star in India - There has to be some semblance of a business

The Supreme Court of Canada, in the case of Stewart v. The Queen (2002 DTC 6983) set out a twofold test to determine the deductibility of business losses, as follows:

Where the activity contains no personal element and is clearly commercial, no further inquiry is necessary. Where the activity could be classified as a personal pursuit, then it must be determined whether or not the activity is being carried on in a sufficiently commercial manner to constitute a source of income…

The Tax Court in Binning summarized this case as follows

…there is an absence of the businesslike conduct that one would expect if this were a profit-seeking venture. There is no plan. There is no evidence of efforts to try to make sure the business becomes profitable or to ensure that royalties are in fact being received. All of this is incompatible with there being a source of income…

Binning’s tax losses were denied.

So if you’re a parent of a child who wants to make it in the entertainment industry, instead of deflating his ego by telling him he lacks the talent, you can try discouraging him by presenting a dissertation on the law on tax losses. That should bring him to his senses!

Non-Resident Investors In Canadian Real Estate

In Canadian Income Tax, Non-residents on September 29, 2009 at 5:20 pm

Maybe it’s the global warming thing, but Canada has suddenly become a very popular destination for non-residents (“NR”) investing in real estate. What are the tax rules for non-resident investors, and what investment vehicle should be used?

Non-Resident Investors

A NR investor is subject to withholding taxes under Part XIII of the Act. Generally, 25% of gross rents must be remitted to the CRA each month. An election under section 216 may be made. Under this election, the NR files a tax return and is eligible for the same deductions as Canadian residents including capital cost allowance. However, it does not entitle the NR to loss carryovers from prior years.

A survey of the tax rules would be advised prior to investing in Canadian real estate

A survey of the tax rules would be advised prior to investing in Canadian real estate

If form NR6 is filed, the NR undertakes to file a return within 6 months from the end of the year, and the tax withheld is reduced to 25% of the estimated income after deductions. Where no undertaking is filed, the tax withheld is 25% of the gross rent, but the deadline for filing a return is extended to 2 years.

Under certain circumstances a NR paying interest to another NR may also be subject to withholding taxes on the interest payments.

A NR corporation would be subject to further withholding requirements known as branch tax. This tax is intended to equal dividend withholding tax on profits repatriated out of Canada by the NR corporation. The branch tax rates are similar to withholding rates for dividends, subject to treaty reductions. NR corporations are also subject to tax on capital in certain provinces. Finally, an NR corporation may be subject to “thin capitalization” rules that restrict interest deductions.

A NR trust pays no branch tax or tax on capital. Losses of a trust , however, cannot be flowed out to beneficiaries.

Using a  Canadian Investment Vehicle

The two major choices for a Canadian investment vehicle is the Canadian resident trust or the Canadian corporation.

A Canadian corporation is subject to the full rates of tax on investment income. Unless it qualifies as a Canadian controlled private corporation, no part of the taxes payable will be refundable upon the payment of dividends. Dividend payments will be subject to withholding taxes of 25%, unless reduced by treaty. Further, in certain provinces, a Corporation is subject to tax on capital. Thin capitalization rules apply as well. These factors make this vehicle an unpopular choice for most NR investors.

A Canadian trust is not subject to tax on capital. Nor would the payments to beneficiaries of after-tax income be subject to any withholding taxes. Thus, the trust would be subject to tax only once, at the highest marginal tax rates for individuals. This rate could vary, depending on the province of residence of the trust.

Dispositions of Real Estate by Non-Residents

As taxable Canadian property, a gain on the disposition of real estate by a non-resident is generally subject to Canadian tax at Canadian rates for capital gains and recaptured capital cost allowance.

Withholding taxes must be remitted, and may be based on the gain on sale only where a withholding tax certificate is obtained under section 116 of the Act. If no certificate is requested by the due date (either before the sale, or within 10 days following the sale), then the purchaser is required to withhold based on the gross purchase price. The withholding rate is 25%. An additional 12% applies for the province of Quebec, which has its own certificate request procedure under Article 1097.

One common problem that arises when a NR disposes of Canadian real estate is that a 116 certificate will only be issued if all the withholding requirements have been met in the past. That is, if no returns were filed under section 216, then the CRA will require remittance of 25% of gross rents for the previous years plus interest. If the 2 year deadline has passed, the CRA will normally not accept late-filed 216 returns.

What’s Your Tax Issue?

In Canadian Income Tax, Losses on September 25, 2009 at 12:41 pm

The Tax Issue:

I loaned some money to my son’s company and now he can’t pay me back. Is there a tax deduction I can claim?

The Answer:

Unfortunately, I get this question quite frequently after it’s too late –  a loan has already been made and gone bad. Often, a loan is made from a parent to a child’s company with no interest charged. Under the rules of the Income Tax Act, any loss on a loan made for no consideration is not deductible for tax purposes. So if you are thinking of helping out a family member, don’t be so generous as to deny yourself a tax deduction of you don’t get paid back. Always check with a professional before making a business loan.

If interest was charged, or if you are also a shareholder of the company to which you loaned the funds, 50% of the loss is considered  an allowable  capital loss. Such a loss may be claimed only against taxable capital gains. Unused losses can be carried back three years and forward indefinitely.

Under certain circumstances, the allowable capital loss may qualify as an allowable business investment loss, in which case it is deductible against any income for the year. The company would have to meet certain tests in order to establish that it meets the definition of a small business corporation. Essentially, this is a corporation that uses all or substantially all of its assets in an active business carried on in Canada.

Before any loss can be claimed, the debt must be established to be uncollectible. According to the CRA you must have exhausted all legal means of collecting the debt and/or the company is insolvent. The courts have taken a more lenient view and require only that the debt be uncollectible in the eyes of the creditor, without the need to exhaust all legal means of collection. If a debt is established to have gone bad in a year, then you must make an election in your income tax return to establish it as a bad debt and claim whatever loss you are entitled to based on the above criteria.