ACC 522 – Chapter 10 Notes: Determination of Taxable Income and Taxes Payable

Determination of Taxable Income For individuals, the process of converting NI for tax purposes to TI focuses largely on two areas:

the utilization of losses and the lifetime capital gain deduction. The basic format and the comparative marginal rates of tax that are relevant to decision maker. Taxable Income (TI) = Net Income (NI) – Special Reductions

o NI consists of the aggregate of the five sources of income.o Special reductions are grouped together in Division C of the ITA. Several of these

reductions apply to individuals; the most important of these are the loss carry-over provisions and the lifetime capital gain deduction.

Third reduction relates to employment income derived from stock options. Study Exhibit 10-1 to see the taxable income formula for an individual

o The items in the formula must be included in the order in which they appear. In part 1 of the formula, (b) includes the item net taxable gains from listed personal property. It

requires that only net gains be included in the formula.o Losses from listed personal property can be offset only against gains from LPP.o A loss that cannot be used in a given year can be carried back 3 years or forward 7 years

for use against a listed personal property gain in those years. o Net taxable gain for the year is the amount by which the current year’s taxable gain

exceed the allowable losses from the current years plus those from a carry-over year. The special reductions portion of the formula deals with transactions of other years or modifies

the treatment of certain items in the net income portion.

Loss Carry-Overs Capital losses can be deducted only to the extent that capital gains were realized in the year. Losses from business, employment, and property, and ABIL, can be offset against all other

sources of income; they too may be restricted if the losses are greater than the combined total of other income sources.

Losses incurred in the particular year must be deducted first, as part of NI, before losses of other years can be applied.

Net Capital Losses Allowable capital losses incurred in a current year, if they cannot be utilized in arriving at NI, are

reclassified as net capital losses. These can be carried back 3 years and forward indefinitely. During this carry-over period, the net capital losses can be deducted only to the extent that the

taxpayer has realized net capital gains for that year. Can only be used to offset capital gains. However, upon the death of an individual, the unused losses may be utilized as a deduction

against any other type of income earned in the year of death or in the preceding year.

Non-Capital Losses Most other losses incurred in a year, if they cannot be used, are reclassified as non-capital losses. Employment losses, business losses, and property losses, as well as ABIL, if they cannot be used

because there is insufficient income in the year, discard their identity and become lumped together as non-capital losses.

Non-capital losses can be carried back 3 years and forward for 20 years and regardless of the type of income earned.

o One exception to the 20-year carry-forward limit. A non-capital loss that was created by an ABIL can be carried forward for only 10 years. If the loss is unused after the 10-year carry-forward period, that unused loss is reclassified as a net capital loss and can be carried forward indefinitely to be used against future capital gains.

Farm Losses and Restricted Farm Losses Farm losses concern taxpayers whose chief source of income is farming or fishing. Losses are

actually business losses and are created in the same way as the non-capital losses.o Can be carried back 3 years and forward 20 years.

Restricted farm losses are losses from farming where farming is not the primary source of the taxpayer. The annual deductible loss in this situation can be no more than $2,500 plus ½ of the next $12,500 ($8,750 annually).

o These unused losses can bee carried back 3 years and forward 20 years but can only be deducted to the extent that farming income was earned in those years.

Sample Calculation of Loss Carry-Overs Taxpayers who anticipate that their following year income will be much higher and therefore

subject to a higher rate of tax, may prefer to delay utilizing the non-capital loss until 20X2. It should be noted that the losses incurred in a given year must be used to the extent possible in

that year when determining NIFTP. Only unused loss carry-over can be utilized in other years.

Loss Utilization – Impact on Decision Making The sooner losses are utilized; the sooner cash flow will be increased as a result of reduced taxes. The taxpayer must utilize them against source of income within a specified time period.

Forms of Business Organization Organizational structure chosen to carry on an active business has an influence on loss utilization. In a proprietorship, losses can be offset against the owner’s other income sources in the year of

loss or carried over to other years, also against all other sources of income. In a corporation, a business suffers losses, the share value will decline, but such a loss can be

recognized only by the shareholder when the shares are sold or if the corporation becomes legally bankrupt or is insolvent.

If a corporation ceases operations, the shareholder would recognize the business losses when the shares were disposed off. However, this loss would be a capital loss, of which only ½ would be available for use against other capital gains.

If the share loss qualified as an ABIL, ½ of the loss would be available for carry-over against other sources of income.

In summary, when an individual chooses a corporate structure over a proprietorship or partnership, the risk of not being able to use a loss for tax purposes is increased.

Preserving Tax Losses Actual expenses should be deferred for tax purposes, when possible, and that accrued gains

should be realized sooner than later.Reducing Expenses

If the expenses are not claimed in a particular year, they can be deduced in a subsequent year. By not claiming CCA, the UCC of the asset’s class would remain at a higher amount; the CCA

deduction would thus be preserved for future years. It is not necessary to claim a reserve for A/R that may be uncollectible. If the receivables still

remain doubtful in future years, they can be deducted at that tie, after the loss carry-overs have been utilized.

Creating Income Gains can be realized for tax purposes by triggering a disposition. Sale of capital property can create capital gains and/or recapture of CCA, which can be used to

offset the losses carried over.o Because the property has been sold and reacquired, its cost base for tax purposes is

increased by the gain.

Business suffering in losses can create taxable income by leasing out assets with lease-and-buyback agreements.

The Capital Gain Deduction The deduction applies only to gains realized on three specific types of property – qualified small

business corporation share, qualified farm property, and qualified property used in a family fishing business.

All individuals who are resident in Canada are permitted to reduce their TI by the net capital gains realized on these properties over their lifetime to a maximum of $750,000. As only ½ of capital gains are included for tax purposes, the maximum deduction is $375,000 of net taxable capital gains.

A qualified small business corporation must be a small business corporation at the time the shares are sold. Two further requirements are to be met: shares must not have been owned by another non-related person in the past 24-months, and during that same period, more than 50% of the FMV of the assets of the corporation must have been used in an active business.

Ability to claim the capital gain deduction is limited by two items – capital losses incurred (ABIL), and accumulated investment losses, which are referred to as the cumulative net investment loss.

The capital gain deduction is to provide a deduction only to the extent that lifetime capital gains exceed capital losses.

The cumulative net investment loss (CNIL) is more difficult to understand. It is based on the premise that an investment in capital property normally results in two types of returns – the annual net income (loss) from rents, dividends, or interest (property income), and the change in the value of the investment itself (capital gain or loss).

Under the CNIL provisions, a capital gain deduction cannot be claimed to the extent that the accumulated annual investment returns (from all types of property) from 1988 to the year in question are in a negative portion.

o If property expenses exceed property incomes on a cumulative basis, the capital gain deduction is reduced by that amount.

o The CNIL does not eliminate or reduce an individual’s total available capital gain exemption; it simply delays it use until a later year.

Read Situation & Analysis on Pg. 376

Calculation of Tax for Individuals Federal tax is expressed in terms of a tax rate applied to the individual’s taxable income. Taxes for individuals are expressed as a percentage of the taxpayer’s taxable income. Non-residents do not pay provincial taxes but instead pay an additional tax (48%) that is a

percentage of the federal basic tax. Federal tax rates are seasonable. Provincial tax rate vary considerably from province to province

and are subject to regular changes based on provincial budget demands.

Overall Tax Calculation Read Exhibit 10-3 for how to determine federal and provincial tax for an individual Federal tax is reduced by tax credits, which have been divided into two categories. The first

category of tax credits recues the primary federal tax to an amount referred to as the basic federal tax.

Federal Tax Federal tax is determined by applying progressively higher tax rates to higher levels of annual

income. Each rate of tax is applied separately to the portion of the individual’s income that falls within the

applicable range.

Personal Federal Tax Credits A tax credit is a specific reduction of the tax otherwise payable and has a value equal to its stated

amount. Tax credits benefit all individuals equally, whereas tax deductions provide a greater benefit to those in higher tax brackets.

A tax deduction reduces taxable income; the related amount of tax saving is based on the marginal tax bracket of the individual for that particular year.

The credits below are normally established as 15% (lowest federal tax bracket) multiplied by a designated amount.

Basic All individuals receive a basic credit of $1,623, which is equivalent to $10,822 of taxable income. Income below $10,822 is not subject to federal tax.

Spouse or Equivalent to Spouse Individuals supporting a spouse receive an additional credit of $1,623, which is equivalent to

taxable income of $10,822. The credit is reduced by 15% of the spouse’s net income. The spouse support is not available when support payments are being made to a spouse who is

separated and living apart.Child

A credit of $329 (15% of $2,191) for each child under age 18 at the end of the year can be claimed by either parent when the child resides with the parents throughout the year.

Any unused credit can be transferred to the other parent. Infirm Dependents

A credit of $960 (15% of $6,402) is available for supporting a related person who is at least 18 years of age and is dependent by reason of physical or mental infirmity.

The credit is reduced by 15% of the dependent’s net income in excess of $6,420.Caregiver

In-home care for a parent or grandparent who is 65 years of age and above or for a dependent relative who is inform are entitled to a $660 tax credit against federal tax (15% of $4,402).

Credit is reduced by 15% of the dependent’s net income in excess of $15,033. The credit is completely eliminated when the dependent’s income exceeds $19,345.

Family Caregiver Amounts on which credits for family members are increased $2,000 where dependent are infirm. The $2,000 is added to each of the following amounts: (1) spouse or equivalent, (2) child under

18, and (3) caregiver amount. Tax credit is 15% of the increased amounts.Age Amounts

Individuals who are 65 years of age or older can claim an additional credit of $1,008, which is equivalent to taxable income of $6,720 (15% of $6,720).

The limit of $6,720 is reduced by 15% of the taxpayer’s net income in excess of $33,884. Credit is completely eliminated when net income reaches $78,684. If the age credit is unused it

can be transferred to a spouse.Pension

Individuals can claim a credit of 15% of the firs $2,000 of qualified pension income received in a year.

Employee Credit Individuals who are employed can claim a credit of 15% of $1,095 ($165) in 2012.

Adoption Expenses A credit of 15% for eligible adoption expenses on completed adoption of an eligible child, up to a

maximum of $11,440.Public Transit Pass

Credit of 15% of the cost of monthly public transit passes for unlimited travel on local buses, streetcars, subways, commuter trains or buses, and local ferries.

Credit is available for transit passes for the taxpayer, a spouse and child under age 19 at the end of the year.

Children’s Fitness Credit Credit is a maximum of $75 (15% of the fees paid in 2012 (max. $500) that relate to the cost of

registering a child, under age 16 at the beginning of the year, in a program of physical activity.Children’s Arts Tax Credit

The art is a maximum of $75 (15% of the fees paid in 2012 – max of $500) that relate to the cost of registering a child, under the age of 16 at the beginning of the year in an eligible program of artistic, cultural, recreational or development activities.

First-Time Home Buyer’s Credit Individual’s who acquire a qualifying home for the first time can claim a credit of 15% on up to

$5,000 for a maximum credit of $750. Individuals cannot have owned a home in the past 4 years.

Volunteering Firefighters Perform a minimum of 200 hours of volunteer hours of firefighting services to a fire department

can claim a tax credit of $450 (15% of $3,000).Charitable Donations

Gifts to charities receive a credit of 15% on the first $200 of contributions and 29% on the remainder. Annual donations cannot exceed 75% of the individual’s net income for the year.

Donation in excess of the limit can be carried forward for five for subsequent taxation year.Medical Expenses

Tax credit for medical expenses is 15% of the qualified medical expenses that exceed either 3% of the taxpayer’s income for the year, or $2,109, whichever is less.

Taxpayers with net income above $70,300 can deduct all medical expenses above $2,109. The tax credit for medical expenses paid for other dependents (over 18) is 15% of the qualified

expenses that exceed either 3% of the dependent’s NI for they year, or $2,109, whichever is less.Disability

Severe and prolonged mental/physical impairment can claim an additional credit of $1,132, which is equivalent to TI of $7,546. An additional credit of $660 is available for a person under 18.

Education Amount, Tuition Fees, and Textbook Amount Claim a credit of 15% of tuition fees paid. Full-time students have an additional credit equal to

15% of $465 for each month of full-time attendance.o Amounts to $70/month.

Part-time education credit of 15% of $140 or $21 or available for each month of attendance. The unused portion is transferable (within limits) to spouse, parent, or grandparent. Alternatively, a student may keep the unused credit and carry it forward indefinitely until such

time as he/she has sufficient income to use the credit. Maximum credit that may be transferred to a spouse or parent is $750 annually less any credit

used to reduce the student’s tax to zero.Interest on Student Loans

Deduct 15% of the interest portion of student loan payments. Can be claimed in the year it is earned or in any of the following five years.

CPP and EI Taxpayers can claim a tax credit of 15% of their maximum allowable CPP and EI contributions in

any year.

Dividend Tax Credit Two dividend tax credit calculations. Determining which one to use depends on the type of

dividend received by an individual.

Dividends designated as eligible receive a dividend tax credit of 6/11 of the 38% gross-up, which is 15% (15.019%) of the taxable amount. Eligible dividends refer to: (1) taxable dividends from Canadian public corporations, (2) taxable dividends from Canadian private corporation that are not Canadian controlled, (3) taxable dividends from CCPC at the high corporate tax rate.

Non-eligible dividends receive a dividend tax credit of 2/3 of the 25% gross-up which is 1313

% of

the taxable amount.

Other Federal Tax Credits Canadian taxpayers can reduce their Canadian taxes through the foreign tax credit. The credit for foreign investment income is further limited to 15% of the foreign income earned;

however, any unused amount can be used as a deduction from income, rather than a credit. Unused foreign tax credits can be carried back 3 years and forward 10 years. Tax credit for federal political contributions is based on a graduated scale. The annual credit is

75% of the first $400, 50% of the next $350, and 3313

% of contributions over $750.

o However, total annual political contributions credit cannot exceed $650.

Provincial Taxes Individuals subject to tax in a particular provincial jurisdiction if they resided in that province on

the last day of the calendar year. An exception to this rule requires that an individual who resides in a particular province but carries on business from permanent establishments in other provinces must allocate business income to those provinces.

If all sales had been made to a province from another province, then there would be no allocation to the first province, and all the business activity would be allocated to the host area.

Special Adjustments to the Tax Calculation There are two basic areas where the normal tax calculations may be adjusted to a higher amount:

(1) alternative minimum tax; and (2) the special tax on old-age security benefits.

The Alternative Minimum Tax (AMT) AMT rules are designed to impose a minimum level of tax on individuals when the normal

amount of tax has been reduced as a result of certain tax preference items being included in income.

Any additional minimum tax paid in one year can be carried forward for up to seven years to reduce the normal tax of a future year to the extent that the minimum tax rules do not apply.

AMT only applies to individuals.

Special Tax on Old Age Security Benefits Special tax is equal to 15% of NI in excess of $69,562, up to a maximum of the Old Age Security

Payments.

Final Returns on Deceased TaxpayersTaxable Income and Net Capital Losses

In the year of death, capital losses that are unused can be deducted from any source of income in the year of death or the previous year.

The amount available for this application is the unused net capital losses at the date of death minus any capital gain deductions claimed in prior years.

Tax Returns and the Use of Tax Credits In the year of death, representatives must file a final tax return and include all income accrued. All non-refundable tax credits can be claimed in full regardless of the date of death.

Income that qualifies as a right or thing may be included in the final tax return of a deceased taxpayer or optionally included in a separate rights and things return.