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Chapter 9

Income From Property

© 2007, Clarence Byrd Inc. 1


Income From Property
► The
General
Concept
 Little Or No Effort
Required
 Some Different
Rules
 Includes Interest,
Rent, Dividends,
And Royalties
 Does Not Include
Capital Gains
© 2007, Clarence Byrd Inc. 2
Interest As A Deduction
► Concepts

 All Deductible

 None Deductible

 Canadian
Approach

© 2007, Clarence Byrd Inc. 3


Interest As A Deduction
► Proposed Legislation

 Loans To Employees And


Shareholders
 Acquisition Of Preferred
Shares
 Loans To Related
Enterprises
 Distributions To Equity
Interests
© 2007, Clarence Byrd Inc. 4
What Is Interest?
► Must Accrue On A
Continuous Basis
► Must Be Calculated
On A Principal Sum
► Must Be
Compensation For
The Use Of That
Principal Sum

© 2007, Clarence Byrd Inc. 5


Interest As A Deduction
► Non-Deductible
Amounts

 RRSP Loans

 Personal Property
Loans

 Late Income Tax


Payments
© 2007, Clarence Byrd Inc. 6
Direct Or Indirect Use
► TheDirect Use Must
Be Considered
 The Queen vs.
Singleton
 Direct Use To Invest
Capital In
Partnership
 Indirect Use to
Finance Home
 Economic Reality
Cannot Override
Direct Use
© 2007, Clarence Byrd Inc. 7
Exceptions To Direct Use
► Filling The Hole
 New Debt Replaces
Other Forms Of
Capital

© 2007, Clarence Byrd Inc. 8


Exceptions To Direct Use
► Interest-Free Loans
 Loans To
Subsidiaries To
Produce Income
 Loans To Employees

© 2007, Clarence Byrd Inc. 9


Linking To Current Use

► TheCurrent Use Of
The Borrowed
Money Establishes
Deductibility

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Disappearing Source Rules
► An Investment Financed
With Debt Is Sold For
Proceeds That Are Less
Than The Debt
► Insufficient Proceeds To Pay
Off All Of Debt
► ITA 20.1 Deems The
Remaining Debt To Be
Producing Income And
Interest Is Therefore
Deductible © 2007, Clarence Byrd Inc. 11
Investments In Common
Shares
► Dividend income is
often less than
interest on
borrowings
► IT-533 – CRA will
consider most
interest on share
borrowings to be
deductible

© 2007, Clarence Byrd Inc. 12


Discount – Issuer
► Deductible Interest Based On Coupon
(Stated) Rate
► Excess Of Amounts Paid To Retire
Bonds Over Proceeds Received From
Sale Is A Fully Deductible Business
Loss At Maturity, if:
 Bonds Issued For Not Less Than 97% Of
Maturity Value
 Effective Yield Not More Than 4/3 Of Stated
Rate © 2007, Clarence Byrd Inc. 13
Premium - Issuer
► Money Lenders
 Premium Taken Into Income Immediately
► Other Taxpayers
 Premium Is A Non-Taxable Receipt
► Deliberate Creation Of A Premium
 Interest Paid Will Be Reduced To A
“Reasonable” Amount Over The Life Of
The Debt

© 2007, Clarence Byrd Inc. 14


Interest As An Inclusion
► Corporations

 ITA 12(3) Requires Full Accrual

 Generally The Same As GAAP

© 2007, Clarence Byrd Inc. 15


Interest As An Inclusion
► Individuals
 ITA 12(1)(c) Allows Use Of
Cash Basis, Receivable Basis,
Or Full Accrual

► Accrual Rules - ITA 12(4)


 Interest must be accrued on
each anniversary date of debt

© 2007, Clarence Byrd Inc. 16


Discount And Premium
Example: Bonds with a maturity value of $1,000,000 are issued at a
price of $980,000. Interest at 10 percent of maturity value is paid
annually and bonds mature in 20 years.

Interest Expense $101,000


Bonds Payable - Discount $ 1,000
Cash 100,000

Cash $100,000
Bond Investment 1,000
Revenue $101,000

Tax Expense And Revenue


© 2007, Clarence Byrd Inc. 17
At Maturity
Investor: The extra $20,000 received is a capital gain (taxable
amount equals $10,000).

Issuer: The extra $20,000 paid is a deduction.


ITA 20(1)(f) - Fully deductible if:
- Issue price not less than 97 percent of face value, and
- Effective yield does not exceed 4/3 of stated yield.

Otherwise: An allowable capital loss (1/2 deductible)

© 2007, Clarence Byrd Inc. 18


Prescribed Debt Obligations
► ITR 7000(1)(a) - Zero Coupon Bonds
►Use Effective Rate
► ITR 7000(1)(b) - Stripped Bonds
►Use Effective Rate
► ITR
7000(1)(c) - Rate Increases Over
Time
►Use Effective Rate Based On Maximum
► ITR 7000(1)(d) - Contingent Rate
►Maximum Payable For The Year
© 2007, Clarence Byrd Inc. 19
Example
Example: Purchase debt obligation for $1,000. At maturity
after five years it pays $1,762 (effective yield = 12 Percent).

Year 1: [(12%)($1,000)] = $120


Year 2: [(12%)($1,120)] = $134
Year 3: [(12%)($1,254)] = $150
Year 4: [(12%)($1,404)] = $169
Year 5: [(12%)($1,573)] = $189 + $1,573 = $1,762

© 2007, Clarence Byrd Inc. 20


Indexed Debt Obligations

► Interest And Principal


Determined By
Changes In The
Purchasing Power Of
Money

► Indexed Amount Must


Be Included In Income
Even If Not Received By
The Investor

© 2007, Clarence Byrd Inc. 21


Accrued Interest
► On October 1, 2007
buy $100,000 bond
with interest payable at
10 percent on
December 31, 2007.
Price = $107,500
 $7,500 will be included in
the income of the
transferor
 $7,500 can be deducted
by the transferee - ITA
20(14)

© 2007, Clarence Byrd Inc. 22


Accrual Rules Example
► Example: Five year,
$100,000 bond is issued
on January 1, 2005. Pays
annual interest of 10
percent only at maturity.
 No cash flow until maturity
 Would have to record
interest on each January 1,
regardless of when bond
purchased.

© 2007, Clarence Byrd Inc. 23


Payments Based On
Production Or Use
► Rents
► Royalties
 Can Be Earned
Income For RRSP
Purposes Only If
Writer, Composer,
Inventor, Etc.

© 2007, Clarence Byrd Inc. 24


Rental Income
► General Rules
 Rents Included On
An Accrual Basis
 Deductions
►Interest
►Taxes
►Maintenance
►Management Fees
►CCA (Restricted)

© 2007, Clarence Byrd Inc. 25


Rental Income Example
An individual acquires a rental property at a cost of
$120,000 (ignore land cost). It is rented for $1,200 per
month and has a $90,000, 9 percent mortgage. Condo fees
are $150 per month and property taxes are $3,000 per year.

Rents $14,400
Taxes ($3,000)
Interest ( 8,100)
Condo Fees ( 1,800) ( 12,900)
Net Before CCA $ 1,500
CCA [(4%)($120,000)(1/2)] ( 2,400)
Net Rental Income Nil
© 2007, Clarence Byrd Inc. 26
Special Rules
► SeparateClass For
Each Rental
Property With A
Cost Greater Than
$50,000

► CCA Cannot Be
Used To Increase Or
Create A Rental
Loss
© 2007, Clarence Byrd Inc. 27
Cash Dividends - Integration

I get the same after tax


amount by either route!!!

Corporation

© 2007, Clarence Byrd Inc. 28


Gross Up Tax Credit Procedures
(Non-Eligible Dividends)
Corporation Earnings $100,000
Taxes At 20 Percent ( 20,000)
Available For Dividends $ 80,000

Dividends Paid $ 80,000


Gross Up (25%) 20,000
Taxable Dividends $100,000

Tax At 45 Percent (29% + 16%) $ 45,000


Dividend Tax Credit (2/3 + 1/3) ( 20,000)
Total Taxes Payable $25,000

Cash Retained ($80,000 - $25,000) $55,000


Direct Receipt ($100,000)(1 - .45) $55,000
© 2007, Clarence Byrd Inc. 29
Gross Up And Tax Credit Procedures
Eligible Dividends
Corporation Earnings $100,000
Taxes At 31.03 Percent ( 31,035)
Available For Dividends $ 68,965

Dividends Paid $ 68,965


Gross Up (45%) 31,035
Taxable Dividends $100,000

Tax At 45 Percent (29% + 16%) $ 45,000


Dividend Tax Credit (11/18 + 7/18) ( 31,035)
Total Taxes Payable $13,965

Cash Retained ($68,965- $13,965) $55,000


Direct Receipt ($100,000)(1 - .45) $55,000
© 2007, Clarence Byrd Inc. 30
Stock Dividends
► Treated Exactly Like
Cash Dividends For
Tax Purposes
► Treatment
Discourages Use
► Amount Of Dividend
Added To Adjusted
Cost Base Of Shares

© 2007, Clarence Byrd Inc. 31


Capital Dividends
► Paid from non-
taxable portion of
capital gains.
 Received Tax Free
 Does Not Reduce
ACB
► Will
be covered in
Chapter 16

© 2007, Clarence Byrd Inc. 32


Mutual Fund Dividends
► MutualFunds Distribute
Earnings
 Retain their character
(Capital Gains, Dividends,
Interest, Etc.)

© 2007, Clarence Byrd Inc. 33


Mutual Fund Dividends
► MutualFunds Distribute
Earnings
 Subject to tax
 Even if reinvested
 Reinvestment amount added
to ACB

© 2007, Clarence Byrd Inc. 34


Income Trusts
► How do they work (current
rules)
 Distribute 100% of free cash
flows
 No tax at trust level
 Distributions retain character and
include amounts that are a
return of capital

© 2007, Clarence Byrd Inc. 35


Income Trusts
► Change in 2011
 There will be tax on distributions
 Distributions will be eligible
dividends with gross up and
credit
 Not a big deal for resident
individuals

© 2007, Clarence Byrd Inc. 36


Income Trusts
► Adjusted Cost Base

 Starts with cost

 Amounts reinvested are


added

 Return of capital is deducted

© 2007, Clarence Byrd Inc. 37


Foreign Source Income
► Non-Business Income
 Include 100 percent in net
income
 Will receive a credit against
tax payable for amounts
withheld
 Credit maximum is 15
percent
 Excess a deduction
 No Carry Over
© 2007, Clarence Byrd Inc. 38
Foreign Source Income

► Business Income
 Include 100 Percent In Net
Income
 Will Receive Credit Against
Canadian Tax Payable For
Foreign Taxes Withheld (No
Limit)
 Carry Over Of Unused
Amounts (Back 3, Forward 7)

© 2007, Clarence Byrd Inc. 39


Foreign Source Income
(Example)
► Earn $1,000, receive $850
► $1,000 in income
► Taxes @ 40% equal $400
► Credit of $150 leaves $250
► Total $150 + $250 = $400 (same as if
received in Canada)

© 2007, Clarence Byrd Inc. 40


Shareholder Benefits
► Benefits Other Than Loans - ITA 15(1)

© 2007, Clarence Byrd Inc. 41


Shareholder Benefits
► Loans - ITA 15(2)
 General Requirements
► Principal Amount Must Be
Added To Shareholder’s
Income
► No Imputed Interest Under
ITA 80.4(2)
► Can Be Deducted Under ITA
20(1)(j) When It Is Repaid

© 2007, Clarence Byrd Inc. 42


Shareholder Loans
► Exceptions
 Corporation In Lending
Business: ITA 15(2.3)
 Loan Repaid Prior To
Second Balance Sheet
Date
 Not Specified Shareholder
 If not in income – imputed
interest under ITA 80.4(2)

© 2007, Clarence Byrd Inc. 43


Shareholder Loans
► Exceptions
 Loans To
Shareholder/Employees: ITA
15(2.4)
► To Acquire Personal Residence
► To Acquire Shares Of The
Company
► To Acquire An Automobile To
Be Used In Employment Duties

© 2007, Clarence Byrd Inc. 44