chap06

CHAPTER 6

Income from Property Problem 1 (Basic) [ITA: 12(1)( g ); ); IT-462] The Country Pie is a highly recognized baker of quality pies in Beamsville, Ontario. The current proprietor, Rudolph Strudel, started the business about 20 years ago with an initial purchase of equipment of $150,000 and built up the name of the the company by closely supervising the pie production process. Many have said that that it is this attention and his recipes that have made the business a success. Rudolph has decided to sell his business and move to the coast to get away from the pressures of running a business. An offer has been made for the assets of The Country Pie by Big Food Corporation Ltd. (“BFC”). There was a meeting of the minds as to the value of the fixed assets of The Country Pie. However, there was considerable dispute as to the value of The Country Pie name in generating pie sales after a purchase by BFC. Consequently, it is proposed that the full proceeds be determined in part by future sales. The BFC offer is for $50,000 cash; $60,000 to be paid on the basis of sales over the next three years with any balance of the $60,000 remaining at the end of the third year payable at that time; and 25% of gross sales in the next five years. As part of the agreement, Rudolph would provide consulting services to BFC as needed during the next three years. REQUIRED —

Discuss the income tax implications to Rudolph of the proposal from BFC.

183

184

Introduction to Federal Income Taxation in Canada: Fundamentals

Solution 1 (Basic) (A) As a fixed sum, the $50,000 cash payment is treated as proceeds of disposition for the assets of the business. [IT-462, par. 5(b)] (B) The $60,000 paid on the basis of sales over the next three years with any balance remaining at the end of the third year payable at that time is not subject to paragraph 12(1)( g ). ). Hence, the amount is also considered to be proceeds of disposition for the assets. It is not the amount of this receipt, but the timing of the instalments of the $60,000 that is dependent on production or use (i.e., sales). [IT-462, par. 8] (C) The receipt of 25% of the gross sales over the next five years is dependent on production or use and, hence, must be included in property income when received [par. 12(1)( g )]. )]. It is neither a capital receipt nor proceeds of disposition for goodwill. goodwill. (D) Fees earned for consulting services by Rudolph would be taxable as either employment income or business income from self-employment, depending on whether he is considered an employee or a self-employed individual in respect of the consulting services.

184


Solution 1 (Basic) (A) As a fixed sum, the $50,000 cash payment is treated as proceeds of disposition for the assets of the business. [IT-462, par. 5(b)] (B) The $60,000 paid on the basis of sales over the next three years with any balance remaining at the end of the third year payable at that time is not subject to paragraph 12(1)( g ). ). Hence, the amount is also considered to be proceeds of disposition for the assets. It is not the amount of this receipt, but the timing of the instalments of the $60,000 that is dependent on production or use (i.e., sales). [IT-462, par. 8] (C) The receipt of 25% of the gross sales over the next five years is dependent on production or use and, hence, must be included in property income when received [par. 12(1)( g )]. )]. It is neither a capital receipt nor proceeds of disposition for goodwill. goodwill. (D) Fees earned for consulting services by Rudolph would be taxable as either employment income or business income from self-employment, depending on whether he is considered an employee or a self-employed individual in respect of the consulting services.

Solutions to Chapter 6 Assignment Problems

185

Problem 2 (Basic) A taxable investment of $15,000 in bonds yields 8% per year before tax. The same investment can be acquired in a self-directed RRSP (tax sheltered). Assume that the yield is reinvested each year at the same 8% before tax. Further assume that the investment investment is held for 10 years, at which time the RRSP will be cashed in and taxes paid at 45%. REQUIRED —

Which investment approach provides the best cash return?

186


Solution 2 (Basic) To calculate the after-tax rate of return for the first investment alternative — the bond held outside of an RRSP — you must multiply the pre-tax rate of return by (1 − t). Therefore, the after-tax rate of return will be 4.4% (8% (1 − 0.45)), or $660. As the annual after-tax yield is reinvested at the same pre-tax 8%, the compounded yield is $8,073 (i.e., $15,000 (1.044)10 − $150,000). Inside the RRSP, the 8% interest compounds unhindered by tax, and in 10 years the RRSP amount grows to $17,384 (i.e., $15,000 (1.08)10 − $15,000); however, income taxes must be paid on withdrawal from the RRSP at 45% equalling $7,823 and yielding $9,561. The RRSP approach produces the b est after-tax yield, $9,561 versus $8,073 outside the RRSP.


187

Problem 3 (Basic) [ITA: 12(1)(c), 12(1)( j), 74.1, 74.5, 82(1); IT-510, IT-511R] Mr. Wiser is contemplating investing in two different mutual funds. His investment options are set out below. Amount $2,000 $2,000

Mutual Fund International Income Fund Canadian Dividend Fund

Distribution Annual interest of 8.0% Annual dividend of 6.0%

Mr. Wiser contemplates holding both mutual funds for the same period of time — from purchase to December 31, 2012. Mr. Wiser is in the top federal income tax bracket (29%). Mr. Wiser’s provincial tax on income rate is 17%. Assume that the combined federal and provincial dividend tax credit is equal to the dividend gross-up. Assume that the Canadian Dividend Fund receives and distributes dividends from Canadian-resident public corporations. REQUIRED —

(A) Based on the above information, which mutual fund should Mr. Wiser prefer? (B) Can Mr. Wiser achieve any advantage by purchasing the above mutual fund in the name of his 8-yearold daughter who has no other source of income? (C) Mr. Wiser’s spouse has no source of income. Can Mr. Wiser achieve any advantage by lending $200,000 to his spouse and having her purchase a rental property earning $16,000 per year? The $200,000 loan would be evidenced by a promissory note repayable in 4 equal annual instalments on each of December 31, 2008 to 2011 and bearing interest at the prescribed rate of 3%.


188 Solution 3 (Basic) (A) Dividend Fund:

Dividend Income (6% of $2,000)...................................................................................... Add: gross-up of 45% of dividend.................................................................................... Grossed-up dividend subject to tax................................................................................... Federal and provincial tax on grossed-up dividend @ 46%............................................... Less: dividend tax credit................................................................................................... Net tax payable................................................................................................ ................. After-tax dividend ($120.00 – $26.04)............................................................................ .. Income Fund: Interest income (8% of $2,000)......................................................................................... Federal and provincial tax payable @ 46%....................................................................... After-tax interest ($160.00 – $73.60)................................................................................

$ 120.00 54.00 $ 174.00 $ 80.04 (54.00) $ 26.04 $ 93.96 $ 160.00 $ 73.60 $ 86.40

The difference between the two is $93.96 – $86.40 = $7.56. As a percentage of the $2,000 principal invested, this difference is marginal (less than 1% of the principal invested), so non-tax factors may affect the decision. (B) Putting the investment in the name of the daughter would be of no advantage in the holding period envisaged: — this would be considered as a transfer of the property subject to the income attribution rules [ssec. 74.1(2)]; — the effect would be to require that the investment income be included in the income of the father until the daughter reaches the age of 18 years; — since the holding period is expected to be until 2012, the daughter who is presently 8 years old will not reach 18 in the holding period. (C) Subsection 74.5(2) would except this loan with interest at the prescribed rate from attribution in subsection 74.1(1): — the wife must pay interest which will be income to him and will reduce or eliminate any income splitting benefit on a fixed-income security; — would be a good strategy if substantial capital gains were expected.


189

Problem 4 (Basic) [ITA: 18(2)–(3)] Furniture Focus Limited provides competitive prices to consumers by using a no-frills approach to displaying its product in large stores surrounded by ample parking. Furniture Focus Limited has excess land that is not currently used in its business. This vacant land is rented to the adjacent automobile dealer who stores new cars on it. For the year ended December 31, 2008, Furniture Focus Limited had the following operating expenses: Sales.............................................................................

$ 35,000,000

Cost of goods sold........................................................

(20,000,000)

Gross profit..................................................................

$ 15,000,000

Selling expenses...........................................................

(5,000,000)

General and administrative expenses...........................

(2,000,000) $

Other income............................................................... Net income...................................................................

8,000,000 50,000

$

8,050,000

The general and administrative expenses include $30,000 of interest and $5,000 of property taxes on the vacant land rented to the automobile dealer. There are no other expenses connected with this land. Other income includes $10,000 of rental income paid b y the automobile dealer. REQUIRED —

Determine the income tax consequences of the various payments related to the vacant land.

190


Solution 4 (Basic) The interest and property taxes on vacant land can only be deducted to the extent of income from the land in excess of all other expenses [ssecs. 18(2) and (3)]. None of the exceptions in subsection 18(2) is met by the facts of this case. (a) The land is not used in the course of the taxpayer’s business. (b) The land is not held primarily for the purpose of gaining or producing income therefrom. (c) Leasing, rental, sale or development of land is not the taxpayer corporation’s principal business. Any remaining non-deductible amounts can be added to the cost base of the land held as a capital property [par. 53(1)(h)]. Thus, $10,000 is included as income and $10,000 of interest and property taxes may be deducted in the current year. While the remaining $25,000 of interest and property taxes is not deductible, it can be added to the cost base of the land.


191

Problem 5 (Advanced) [ITA: 20(1)(a); ITR: 1100(11), 1101(1ac), Sch. II] Sara Shimizu is the owner of two rental properties, 509 Brunswick Avenue and 356 Spadina Road. These properties were purchased six years ago for $525,000 and $600,000, respectively. In 2008, 509 Brunswick Avenue was sold for $550,000. A reasonable allocation of this amount is considered to be 75% to the building and 25% to the land. The following income and expenses were incurred in renting out the two properties in 2008: Rental......................................................................... $ 60,000 Interest on mortgage.................................................. (40,000) Operating costs.......................................................... (15,000) Promotion costs for sale of property.......................... (5,000) Net income................................................................. 0

There are no meal or entertainment expenses included in the $5,000 of sales promotion costs. At December 31, 2007, the undepreciated capital cost of 509 Brunswick Avenue was $383,500 and that of 356 Spadina Road was $400,000. REQUIRED —

Determine the income from property for income tax purposes assuming Sara wishes to report the least amount possible for tax purposes in 2008.

192


Solution 5 (Advanced) Income or loss from rental property: Rental revenue...................................................................................................................................... $ 60,000 Deduct/Add: Interest on mortgage..................................................................................................................... (40,000) Operating costs............................................................................................................................. (15,000) Promotion cost for sale of property (expense of disposition, not current expense)........................ Nil Recaptured CCA on 509 Brunswick Ave. (Schedule 1)................................................................ 10,250 Subtotal................................................................................................................................................ 15,250 CCA on 356 Spadina Road (Schedule 1).............................................................................................. (15,250) Net income from property.......................................................................................................... .......... Nil Schedule 1 509 Brunswick (1) 356 Spadina(1) Class 1: 4% Class 1: 4% Total UCC, December 31, 2007.................................................... $383,500 $400,000 Disposition in 2008 (lesser of cost and proceeds)................. (393,750)(2) — Balance................................................................................ $(10,250) $400,000 Recaptured CCA in 2008..................................................... 10,250 — $10,250 Nil $400,000 CCA for 2008 at 4% (limited).............................................. Nil (15,250 )(3) $15,250 UCC, December 31, 2008.................................................... Nil $384,750

NOTES TO SOLUTION —

(1) Regulation 1101(1ac) requires that rental buildings with a cost over $50,000 be placed into separate CCA classes. (2) Sale of 509 Brunswick Ave.: Building Proceeds of disposition (75% of ($550,000 – $5,000))................................................................. $ 408,750 Cost base (75% of $525,000)........................................................................................................ $ 393,750

(3) The inclusion of recaptured CCA in income from property allows for more CCA to be deducted without creating a loss on rental property. In most circumstances, a loss on rental property cannot be created or increased by claiming CCA [ITR 1110(11)]. In this situation, the full $16,000 (4% × $400,000) of CCA was restricted to $15,250 so as not to create a loss.


193

Problem 6 (Basic) Capital cost allowance, recapture, and terminal loss all form part of the net income calculation for rental properties. There are two special rules that apply only to rental properties that serve to limit the treatment of capital cost allowance. One of the special rules stipulates that each rental property having a cost of $50,000 or more must be held in a separate capital cost allowance class. REQUIRED —

Determine the second special rule.

194


Solution 6 (Basic) Since the rule relates to capital cost allowance, Regulations Part XI, Capital Cost Allowances, would be a starting point. More specifically, ITR 1101(1 ac) deals with the separate classes rule related to rental properties having a cost of at least $50,000. The other special rule is ITR 1100(11), which states that capital cost allowance on rental properties can only be deducted to the extent that it does not create or increase a net loss from all rental properties combined. Note that Interpretation Bulletin IT-195R4, Rental Property — Capital Cost Allowance Restrictions, provides further details.


195

Problem 7 (Advanced) [ITA: 18, 20] It is early January 2008 and the president of BDC Distributing Limited, a client of your firm, called recently to discuss the tax implications regarding the construction of a new building. BDC has been growing rapidly and needs new warehouse space. They have b een unable to locate any suitable space in the existing buildings in town and, therefore, have decided that their only option is to build their own building. They have identified the site and have estimated the costs of the project. These projected costs (and dates of completion) are as follows: The land that has been identified will be purchased on February 15, 2008, for $405,000. There is no significant site preparation required so construction of the building can commence immediately. The cost of the building is estimated to be $1,348,000 plus the costs noted below. It is anticipated that BDC will be able to occupy the building on October 31, 2008. BDC currently has an architect finalizing the drawings for the building. The architect fees, which will all be paid in 2008, will amount to $7,200. There will also be fees of $2,100 for an engineer to examine the drawings. BDC has arranged for the financing required for the project. The project will be financed with a mortgage of $875,000 and $1,000,000 of preferred shares issued on January 15, 2008. Interest on the mortgage is payable semi-annually on July 15 and January 15 at a rate of 8% per annum. The preferred shares pay dividends of 5% per annum, payable semi-annually on July 15 and January 15. There will be a number of costs incurred in order to issue the debt and shares. These costs are legal and accounting fees of $18,450, commissions of $58,300 and registration fees of $1,800 for amending the articles of incorporation to allow the issuance of the preferred shares. The balance of the costs related to the building are summarized below: Building insurance from April 15, 2008 @ $450 per month.............................................. $ 3,825 Property taxes from February 15, 2008 @ $770 per month................................................ 8,085 Soil testing to determine location of footings for building................................................. 1,825 Relocation expenses........................................................................................................... 34,100 Utilities service connections estimated to be completed on May 20, 2008......................... 3,800 Mortgage insurance premium from March 1, 2008 of $325 per month.............................. 3,250 Maintenance from October 31, 2008.................................................................................. 2,500 Utilities from October 31, 2008......................................................................................... 6,300 Landscaping....................................................................................................................... 15,500

REQUIRED —

Advise the corporation of the impact of the proposed transactions on their December 31, 2008 income tax return. Ignore the leap-year effects.

196


Solution 7 (Advanced) The 2008 year can be broken into three different time periods: pre-construction (January to February 14, 45 days); construction (February 15 to October 30, 258 days); post construction (October 31 to December 31, 62 days). The following amounts must be capitalized to the bu ilding [ssec. 18(3.1)]:(1) Cost.................................................................................................................................................... $ 1,348,000 Architectural fees................................................................................................................................ 7,200 Engineering fees................................................................................................................................. 2,100 2,925 Building insurance during construction (61/2 mos. × $450)................................................................ 6,545 Property taxes during construction (81/2 mos. × $770)....................................................................... Soil testing.......................................................................................................................................... 1,825 Utilities service connections............................................................................................................... 3,800 2,600 Mortgage insurance during construction (8 mos. × $325).................................................................. 258 49,479 Interest accrued on mortgage during construction ( /365 days × 8% of $875,000)............................. Total cost......................................................................................................................................... ... $ 1,424,474 The following amounts are deductible in computing BDC’s income for 2008: $ 42,734 CCA on building @ 6% of $1,424,474 × 1/2....................................................................................... 900 Building insurance after construction (2 mos. × $450)....................................................................... 1,540 Property taxes after construction (2 mos. × $770).............................................................................. 650 Mortgage insurance after construction (2 mos. × $325)..................................................................... Relocation expenses............................................................................................................................ 34,100 Maintenance from October 31, 2008................................................................................................... 2,500 Utilities from October 31, 2008.......................................................................................................... 6,300 Landscaping [par. 20(1)(aa)].............................................................................................................. 15,500 Interest accrued on mortgage one month before and two months after construction 17,836 (93/365 days × 8% of $875,000).................................................................................................... 15,350 Issue costs [par. 20(1)(e)] (1/5 × ($18,450 + $58,300))(2)..................................................................... 3 95 CECA on articles of amendment ( /4 × $1,800 × 7%)........................................................................ Total deductible costs................................................................................................................. ........ $ 137,505


(1) Subsection 20(29) does not apply to allow the deduction of all or some part of the “soft costs” in this case because the building is not being rented to tenants. (2) The issue costs are considered to be long-term financing costs that are not attributable to the period of construction.


197

Problem 8 (Advanced) [ETA: 123(1); Schedule V, Parts VI and VII] Reconsider the facts of Problem 7. Assume that GST was paid, where applicable, in addition to the amounts shown. REQUIRED —

Calculate the GST consequences of the transactions presented.

198


Solution 8 (Advanced) To the extent that property and services are purchased for use in commercial activities, input tax credits in respect of the GST paid on those purchases may be claimed. The expenditures are given the following GST treatment. Expenditure GST treatment Amount ITC @ 6% Land..................................................................... taxable $ 405,000 $ 24,300 Building................................................................ taxable 1,348,000 80,880 Architect and engineer fees.................................. taxable 9,300 558 Building insurance................................................ exempt: financial service [ETA: ssec. 123(1)] — — Landscaping costs................................................. taxable 15,500 930 Maintenance......................................................... taxable (unless salaries or wa ges) 2,500 150 Utilities................................................................. taxable 6,300 378 Mortgage insurance premium............................... exempt: financial service [ETA: ssec. 123(1)] — — Relocation expenses............................................. taxable 34,100 2,046 Property taxes....................................................... exempt [Sched. V, Part VI, 21] — — Soil testing............................................................ taxable 1,825 110 Utilities service connections................................. taxable 3,800 228 Interest on mortgage............................................. exempt: financial service [Sched. V, Part VII] — — Dividends on preferred shares.............................. exempt: financial service [ETA: ssec. 123(1)] — — Discount on bonds................................................ exempt: financial service [ETA: ssec. 123(1)] — — Legal and accounting fees.................................... taxable 18,450 1,107 Commissions........................................................ exempt: financial service [ETA: ssec. 123(1)] — — Articles of amendment.......................................... exempt: financial service [ETA: ssec. 123(1)] — — Total ITC....................................................................................................................................... ... $ 110,687

Note that the ITC in respect of capital expenditures can be claimed for the period in which the tax is p aid or becomes payable. As a result, there is no requirement for amortization. Since an ITC represents a recovery of the cost of GST, the amount of GST paid, if any, does not become part of the capital cost of a capital asset such as the building in this case. Similarly, the GST paid is not deductible as an expense because it is recovered through an ITC.


199

Problem 9 (Basic) Tim Markus, Vice President of Phone Lines, earned $92,000 in salary last year. In addition to his salary, he also received low-interest loans from his employer. Tim's interest rate on these loans is 3% and he owed $160,000 throughout last year. Tim used the loan to purchase a rental property (see Schedule 1). Assume a prescribed interest rate of 8% for the entire year. Five years ago, Tim invested in some common shares of a foreign corporation. He receives $18,000 in dividends (net of $2,000 withholding tax) annually from this corporation. Last year, he also received taxable eligible dividends of $30,000 from his investment in a Canadian public company which is resident in Canada. Tim also owns $100,000 worth of 10% bonds. Schedule 1: Rental revenue Maintenance expenses Utilities on rental units CCA—half-year rule

REQUIRED —

Compute Tim's income for tax purposes for last year.

$26,000 5,500 8,200 3,200


200 Solution 9 (Basic)

Net Income for Tax Purposes Employment income: Salary Deemed interest benefit (Note 1) Income from Employment Property Income: Rental revenues Maintenance expense Utilities expense Interest expense (Note 2) CCA (Note 3) Net rental income Foreign dividends received Add: Withholding tax Gross foreign dividends Interest income Taxable dividend received Add: Gross up at 45% Taxable amount of dividend Net income from property Net income for tax purposes

$92,000 8,000 $100,000 26,000 ( 5,500) ( 8,200) (12,800) ( 0) (500) $18,000 2,000 20,000 10,000 30,000 13,500 43,500 73,000 $173,000

Notes:

1.

Subsection 80.4(1) deems an interest benefit of ($160,000) (8% − 3%).

2.

Section 80.5 and paragraph 20(1)(c) allows interest expense of the actual paid amount at 3% ($4,800) and the deemed interest benefit included in employment income ($8,000).

3.

CCA allowed = zero (cannot create/increase a loss with CCA on the rental property).


201

Problem 10 (Basic) Trent Zalinski recently retired as a football player with the Saskatchewan Roughriders. In the current year, he received his salary of $150,000 from the team and is eligible for a CFL pension in 15 years. He and his wife Mary have settled in Weyburn, Saskatchewan, where he runs a small sporting goods store as a proprietorship. He has provided you with the following additional information. (a) His net income from the store for the fiscal year ended December 31 was $35,000. Next year he is hoping to double that. Mary works in the store about 35 hours a week and is paid $6.00 per hour. This is already included as an expense in determining the $35,000. (b) Trent's other current-year receipts are: fees received from endorsement of a brand of football equipment, $30,000; eligible dividends from Canadian public corporations, $7,200; dividends from foreign public corporations, (net of $750 withholding tax) $6,750; interest from Canadian bank, $3,000. (c) Trent also had the following expenses: safety deposit box fees, $50; cycling trip to Cypress Hills Provincial Park with family, $2,200; interest on bank loan to acquire public company shares, $4,000. (d) In May of the previous year, Trent purchased a five-year GIC in Mary's name. The interest rate was 6%, and it was for $10,000. None of the interest is receivable until maturity in five years. REQUIRED —

(a) Determine Trent's net income for tax purposes. (b) Do you have any basic tax planning advice for Trent?


202

Solution 10 (Basic) (a) Net income from employment, team salary Net income from proprietorship business Net income from endorsements (business income) Net income from property: Dividends from Canadian corporation Add 45% gross-up Taxable amount Dividends from foreign corporation Interest from Canadian bank One-year anniversary interest accrual on GIC (attributed to Trent) Expenses: SDBox Interest on loan Net income from property Net income

$ 50 4,000

$150,000 35,000 30,000 $ 7,200 3,240 $ 10,440 7,500 3,000 600 $21,540 ( 4,050) 17,490 $232,490

(b) Basic Tax Planning •

Consider using a deferred-income fund, such as an RRSP, for the GICs. •

Investigate whether the investment in the foreign corporation might not be better invested in a Canadian corporation because of the dividend tax credit. •

Pay higher, yet reasonable, compensation to Mary. •

Mary has a salary in her own right; consider investing it rather than spending it on family personal needs. This will result in the investment income being taxed in her hands. •

Consider incorporating the sporting goods store. •

Consider setting up a tax-free savings account in 2009.


203

Problem 11 (Basic) The following are independent situations: (a) Tony Lee gave $50,000 to his wife, Shannon, for the acquisition of shares of a Canadian company on the Toronto Stock Exchange. During the year, an eligible dividend of $5,000 cash was paid on the shares owned by Mrs. Lee. (b) At the beginning of the year in which her daughter Carey turned 18 in December, Ellen gifted $25,000 directly to Carey. Carey invested the $25,000 in an income-bearing investment that paid her interest of $2,500 during the year. In addition to the $2,500, Carey also earned another $7,500 in interest income from monies received from her mother previously. REQUIRED —

What are the tax consequences for the above situations?

204


Solution 11 (Basic) (a) Mr. Lee must include the dividend in his income, since the attribution rules will apply. The amount to be included in Mr. Lee’s income is $7,250 ($5,000 × 45% gross-up). He will also be eligible for the dividend tax credit. (b) As Carey turned 18 in the year, subsection 74.1(2) will not apply to attribute any of the income back to Ellen.


205

Problem 12 (Advanced) [ITA: Subdivision b] John Investor has provided you with the following information related to his various investment holdings as of December 31, 2008. Interest earned on joint bank account with his spouse (spouse contributes equally)......................................................................... $ 2,000 Interest earned on his investment account (not joint) with his 800 investment broker............................................................................ Interest earned on 2007 personal income tax assessment....................... 450 Interest on short-term investments: $20,000 term deposit taken out November 30, 2008 (interest at maturity in six months) Accrued interest from December 1–December 31, 2008........................ 85 $200,000 GIC purchased November 1, 2007 (interest payable at maturity on October 31, 2010) Accrued interest from November 1, 2007–October 31, 2008................. 16,000 Accrued interest from January 1, 2008–December 31, 2008.................. 16,214 Government of Canada Treasury Bills purchased for $9,009 on January 1, 2008 Amount received on maturity on December 31, 2008............................ 10,000 Cash dividends received from investment in common shares of Canadian-resident public corporations............................................. 24,000 Cash dividends received from common shares in U.S. corporations (net of $3,000 of foreign withholding taxes; all in $CDN).............. 17,000 Rental details from operation of two separate rental properties: Property 1 Property 2 Gross rental revenue.................................... $ 30,000 $ 46,000 Utilities........................................................ 5,000 8,000 Property taxes.............................................. 2,400 3,500 Repairs........................................................ 1,500 4,800 Mortgage interest......................................... 20,000 32,000 Opening UCC.............................................. $ 368,209 $ 520,225 Interest expenses paid during 2008: Interest on bank line of credit used for investing in shares described above.......................................................................................... $ 50,000 Interest on loan to acquire an automobile for his daughter for her 18th birthday.............................................................................. 3,200 Interest on a parcel of vacant land (purchased in 2003, the land does not generate any income)................................................... 10,000

REQUIRED —

Prepare a calculation of John’s property income. Comment on the income tax implications of items not included in your calculations.

206


Solution 12 (Advanced) Joint bank account (his portion)(1)............................................................................................... $ 1,000 Interest on broker account.......................................................................................................... 800 Interest on income tax assessment.............................................................................................. 450 Interest on short-term investments(2)........................................................................................... Nil (3) Interest on GIC ........................................................................................................................ 16,000 Interest of Government of Canada T-Bills(4)............................................................................... 991 34,800 Dividends from common shares of taxable Canadian corporations ($24,000 × 1.45)(5).............. Dividends from common shares in U.S. corporation (gross amount)(6)....................................... 20,000 (7) Rental loss ................................................................................................................................ (1,200) Interest on bank line of credit(8)................................................................................................... (50,000) Income from property................................................................................................................. $ 22,841


(1) If both John and his spouse contribute capital equally to the bank account, the attribution rules do not apply [sec. 74.1]. (2) Interest is not taxable for 2008 on the term deposit because there is no anniversary date in 2008. The interest will all be taxable when paid in 2009 [ssecs. 12(4), 12(11)]. (3) Interest on an investment contract (the GIC) must be accrued on the anniversary day, which is defined as the day that is one year after the day before the date of issue. The date of issue was November 1, 2007. The day before that day is October 31, 2007. Therefore, the first anniversary day is October 31, 2008 [ssec. 12(11)]. (4) The difference between the face amount and the amount paid ($10,000 – $9,009) is deemed to be interest [ssec. 16(1)]. (5) A dividend tax credit [par. 12(1)( j); ssec. 82(1)] (as discussed in Chapter 10) will be available in the calculation of tax. (6) A foreign tax credit (as discussed in Chapter 10) will be available in the calculation of tax. (7) The calculation of the rental loss is based on the aggregate of the two properties: Property 1

Gross rental revenue........................................................................................

$

30,000

Property 2

$

46,000

Utilities...........................................................................................................

(5,000)

(8,000)

Property taxes..................................................................................................

(2,400)

(3,500)

Repairs............................................................................................................

(1,500)

(4,800)

Mortgage interest............................................................................................

(20,000)

(32,000)

Income/(Loss) before CCA.............................................................................

1,100

(2,300)

Less: CCA — property 1 ($368,209 * .04 = $14,728)...................................

Nil

Nil

CCA — property 2 ($520,225 * .04 = $20,809)...................................

Nil

Nil

Net income/(loss)...................................................................................... ......

$

1,100

$

(2,300)

The aggregate rental loss before CCA is $1,100 - 2,300 = ($1,200). Since there is an aggregate loss from all rental sources, there is no CCA claim allowed for fiscal 2008. (8) This interest is paid in respect of common shares and thus is incurred for the purpose of earning income. The interest paid on the loan to acquire the automobile is for the purchase of personal use property and thus does not meet the requirements in paragraph 20(1)( c). The interest on the vacant land is not deductible by virtue of subsection 18(2).


207

Problem 13 (Basic) Your client, Ashley, has come to you for some advice on computing her n et income from property. (a) In February, Ashley sold all her investments and paid off her personal residence mortgage. On March 1, she borrowed $90,000 to reacquire many of the same investments she previously held. Many of the common shares purchased do not carry dividend rights. Her spouse has insisted that 50% of the investments be placed in his name. (b) On April 15, Ashley purchased a government bond that pays annual interest of 7%. When the bond was purchased, Ashley paid accrued interest of $262.50 to the previous owner of the bonds. (c) On June 1, Ashley borrowed $450,000 to purchase the vacant land next to her apartment block. The land is used as a parking lot and she collected monthly revenues of $2,500. She plans improvements that will double her income from the lot. Ashley's only expenses were $45,500 for interest and p roperty taxes. REQUIRED —

Discuss the income tax implications of each item above.

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Solution 13 (Basic) (a) Under paragraph 20(1)(c) of the Act, interest expense can be deducted on debt incurred to earn income. In this instance, Ashley has sold her investments to pay down her mortgage. She then remortgaged the house and reacquired her investments. While the CRA might challenge this under GAAR, it appears Ashley has met the conditions required for the interest deduction. Placing 50% of the investments in her spouse’s name is an ineffective way of splitting income with her husband. Subsections 74.1(1) and 74.2(1) will attribute any income, loss, or capital gain on the split properties back to Ashley. (b) The accrued interest amount of $262.50 Ashley paid on acquiring the bond will be deductible in the current taxation year [ssec. 20(14)]. This is because Ashley, as the registered bondholder, will receive all the interest due on the bond from the bond issuer. Only the difference represents her real investment income. (c) Under subsection 18(2) of the Act, Ashley is only eligible to deduct interest expenses and property taxes up to the amount of income received from that vacant land. In this case, she will only be able to deduct $17,500 (seven months × $2,500/month). As this is vacant land used to earn income and not a personal-use property, she will add the non-deductible carrying charges to the adjusted cost base of her capital property, resulting in an adjusted cost base for the land of $478,000 ($450,000 + $45,500 − $17,500).


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Problem 14 (Basic) Nadi borrowed $140,000 at an 8.5% annual interest rate from a local financial institution to finance the following investments. Cost Common shares of a public corporation paying no dividends Gold bullion (treated as capital property) Corporate bond (yield is 9% per annum) Preferred shares (7% annual dividend) purchased in RRSP Common shares (5% annual dividend) in spouse's name Paintings from well-known galleries Guaranteed Investment Certificate paying interest at 9% per annum Total cost

$20,000 25,000 20,000 10,000 30,000 15,000 20,000 $140,000

REQUIRED —

Assuming that the investments were held for the full calendar year, determine the deductibility of interest expense for each investment.

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Solution 14 (Basic) Interest expenses are deductible if there is a reasonable expectation of earning income from property. Investment Common shares Gold bullion Corporate bond Preferred shares (RRSP) Common shares Paintings GICs Total

Not deductible

Deductible $20,0001

$25,0002 20,0003 4

10,000

30,0005 6

15,000

20,0005 $ 50,000

$90,000

Deductible interest = $90,000 × 8.5% = $7,650 NOTES TO SOLUTION —

(1) As there is often an expectation of dividend income on common shares, the interest is deductible. (2) As capital treatment has been chosen for gains/losses on the gold bullion, the interest is not deductible. (3) The corporate bond is income-producing and the associated interest would be deductible.

(4) The preferred shares were purchased in an RRSP; deduction of interest is disallowed. (5) The associated interest on the common shares and GICs would be deductible, as there is the expectation of earning property income. (6) The paintings from well-known galleries would be considered an investment for earning future capital gains and, therefore, the associated interest would not be deductible.


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Problem 15 (Basic) [ITA: 18(1), 20(1)( c), [20(1)( qq)]; IT-533] Funds are borrowed by an individual from a financial institution at an 11% per annum interest rate to purchase the following unrelated investments: (a) gold coins on which gains or losses will be treated as capital gains or losses; (b) an RRSP portfolio of investments yielding 12.5% in interest; (c) a five-year GIC paying interest at 8% per annum; (d) common shares of a Canadian-resident public corporation paying no dividends; (e) preferred shares of a Canadian-resident public corporation paying 7% dividends; (f) preferred shares of a U.S. corporation paying 9% dividends; (g) $100,000 of assets used in an unincorporated business which generated net income of $9,750 before drawings of $18,000 for the year; (h) lottery tickets which yielded $75,000 in winnings which were reinvested in short-term securities yielding 13%; and (i) common shares of a Canadian-resident public corporation paying dividends of 6%; later in the year the shares were sold at a small gain to repay a 14% second mortgage on a principal residence. REQUIRED —

Determine the deductibility of the interest expense in each of the unrelated cases.

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