Chapter Objectives

Be able to: Explain sources of Canadian tax law. Identify the two primary entities that are subject to tax. Explain how residency is determined for the two primary entities. Explain how non-residents are taxed in Canada. Explain how residency can affect business structures and decisions. Explain the process for determining income for tax purposes. Identify the taxation year for the two primary entities. Identify the five possible types of income. Apply the aggregating formula in determining net income for tax purposes. Identify the allowable deductions from net income for tax purposes in

determining taxable income.

Sources of Canadian Tax Law

The three sources of income tax law in Canada are:Statute lawCommon lawInternational tax conventions

Statute law is the Income Tax Act Common law is the jurisprudence from court cases settled. International tax conventions are reciprocal tax treaties with foreign entities

to define jurisdictional authority and to avoid double taxation. When these international treaties are in conflict with the ITA, the international treaty will take precedence.

The CCRA’s interpretation of complex sections of the ITA are included in Interpretation Bulletins and Information Circulars. Although these publications are not law, they do reflect current assessment policy and should be referred to during tax planning.

Liability for Tax - Entities

The two primary types of taxable entities are individuals and corporations. Trusts are also taxable entities but they have limited application to business and investment structures.

Although there are other forms of business organizations (such as proprietorships, partnerships, limited partnerships and joint ventures), profits from these organizations are allocated to the participating owners, who are the two primary types of taxable entities, and then taxed.

Given that corporations are ultimately owned by individuals, the individual is the ultimate recipient of profits and cash flows. This means that the separate taxation of the two entities in only temporary.

Liability for Tax - Residents

Canadian residents, regardless of whether they are individuals or corporations, are subject to tax on their world income.

Since non-residents are subject to tax only on certain types of income, residency may be an important factor in determining how an entity is taxed.

An individual will be considered a Canadian resident if a continuing state of relationship is maintained with Canada.

A company incorporated in Canada will always be a resident of Canada.

A company incorporated in a foreign jurisdiction will be considered a Canadian resident if it can be established that the central management and control is exercised from within Canada.

Liability for Tax - Non-Residents

International transactions can be placed in one of two broad categories.

The first one is transactions that are started and completed in the foreign host country. Income is determined on a net basis. Maintaining a permanent establishment is usually a factor. An example would be when a foreign entity sells product from a Canadian branch office.

The second one is transactions that originate in one country but are concluded in a second country. Income is determined on revenue only. This is usually in the form of a withholding tax. An example would be when a foreign entity receives dividends from a Canadian company.

Knowledge of these concepts is also useful for Canadian residents since most foreign jurisdictions will tax non-residents in the same manner.

Decision Making and the Residence Issue

The knowledge that the two primary entities are taxable on world income only if they are Canadian residents provides an insight into which international transactions are taxable in Canada.

In addition, knowledge of the Canadian framework for taxing non-residents carrying on business in Canada can be reversed and applied to Canadian activities in foreign jurisdictions, thereby permitting a general appreciation of the foreign taxes that affect such activities.

Under different business structures, cash flows along many different paths and at various speeds before it finally comes to rest with the ultimate investor. When applying the tax factor, the key is to identify the point along the path where taxes will be incurred. Cash flow is taxed only as it enters one of the two primary entities. Type of income and rate of tax should also be considered when applying the tax factor.

Determination of Income

Income must be determined on the basis of a taxation year. Net income (revenues less expenses) must be included from five

general categories. Each category has its own fundamental principles. The net income from the five categories are aggregated in accordance

with a strict formula. The sum of which is called Net Income for Tax Purposes.

Net Income for Tax Purposes is then reduced by a limited number of specific items which vary between the two primary entities. The net result is called Taxable Income.

Taxable Income is the base to which the rate of tax is applied.

The Taxation Year

A corporation’s taxation year is its fiscal year and can only be changed with the concurrence of the CCRA.

An individual’s taxation year is the year ended December 31. Although the concept of taxation years is a simple one, it can have a

significant impact on the timing of cash flows and, thus, the incidence of tax.

As a result, the choice of year end for each of the entities within a business structure should always be carefully considered.

Types of Income

The five categories are: Employment income - salary, wages, benefits and so on. Business income - enterprises carried out with the intention to profit. Property income - return that is earned on invested capital. Capital gains - profit realized on the sale of assets that were acquired

for the purpose of generating monetary returns or personal enjoyment over a long period of time.

Other income and deductions - includes and is limited to items specified in the ITA.

Determination of Net Income for Tax Purposes

Net Income for Tax Purposes is determined by using an aggregating formula with four segments. Although it is not complex, it does require strict adherence.

It is applicable to both of the primary entities, individuals and corporations.

Segment A includes positive net incomes from employment, business, property and other.

Segment B includes the amount that taxable capital gains exceed allowable capital losses.

Segment C includes other deductions. Segment D includes negative net incomes from employment, business

and property. It also includes allowable business investment losses.

Determination of Taxable Income

Taxable income is determined by reducing Net Income for Tax Purposes by certain specified deductions.

The list of specified deductions, however, does vary between the two primary entities.

Specified deductions for individuals include unused losses of other years, employee stock options and capital gain deduction.

Specified deductions for corporations include unused losses of other years, charitable donations, dividends from other Canadian corporations and dividends from foreign affiliates.