On October 3, 2016, the Government announced an administrative change to Canada Revenue Agency’s reporting requirements for the sale of a principal residence.
“When you sell your principal residence or when you are considered to have sold it, usually you do not have to report the sale on your income tax and benefit return and you do not have to pay tax on any gain from the sale. This is the case if you are eligible for the full income tax exemption (principal residence exemption) because the property was your principal residence for every year you owned it.
Starting with the 2016 tax year, generally due by late April 2017, you will be required to report basic information (date of acquisition, proceeds of disposition and description of the property) on your income tax and benefit return when you sell your principal residence to claim the full principal residence exemption.”
On October 3, 2016 the Government introduced a new requirement to disclose the sale (or other disposition) of a principal residence on your personal tax return in the year that the property was disposed of. The disposition must be reported on page 2 of Schedule 3 of the return –
$8,000 (Max) Penalty For Failure To Report
According to the CRA website, if a taxpayer doesn’t report the sale and designation of the property as his or her principal residence, a penalty of up to $8,000 for failing to report the disposition may be applied :
“7. What should I do if I sold a property and want to claim the principal residence exemption but I forget to report the designation of principal residence on my income tax return for the year of sale?
For the sale of a principal residence in 2016 or later tax years, CRA will only allow the principal residence exemption if you report the sale and designation of principal residence in your income tax return. If you forget to make a designation of principal residence in the year of the sale, it is very important to ask the CRA to amend your income tax and benefit return for that year. Under proposed changes, the CRA will be able to
accept a late designation in certain circumstances, but a penalty may apply.
The penalty is the lesser of the following amounts:
1. $8,000; or
2. $100 for each complete month from the original due date to the date your request was made in a form satisfactory to the CRA.
More information on late designations is available on the CRA website under Late, amended, or revoked elections.
The CRA will focus efforts on communicating to taxpayers and the tax community the requirement to report the sale and designation of a principal residence in the income tax return. For dispositions occurring during this communication period, including those that occur in the 2016 taxation year (generally for which the designation would be required to be made in tax filings due by late April 2017) the penalty for latefiling a principal residence designation will only be assessed in the most excessive cases”
What About Deemed Dispositions on Change in Use?
By virtue of Paragraph 45(1)(a) of the Income Tax Act, if a person converts a residential property into a rental property (or the other way round), he or she is deemed to have disposed of the property at “fair market value” and re-acquired it at that same value. So if you move out of your principal residence and begin renting it out, you will need to report that disposition on Schedule 3 of your T1 return for the year.
The change in use rules have always been challenging for individuals filing their own returns. Since no actual purchase or sale has occurred, such transactions could easily be overlooked.
On January 16, 2017 the Alberta Government has introduced a new Alberta Investors Tax Credit, providing a tax credit for investments in private, early stage companies in Alberta (Dentons).
Under the terms of the legislation, the province provides tax credits of 30% calculated on the gross amount of the investment. For individuals the tax credit is refundable, so individual investors will get a tax refund if their Alberta tax liability is less than $30,000. For corporate investors, the tax credit is deducted from tax otherwise payable.
A quick read of the review by Dentons indicates that it was copied almost word for word from BC’s Small Business Venture Capital Act. It seems that both provinces cap the tax credits each year at about $30 million, so businesses need to register early to avoid disappointment.
In BC, if companies arrange for offerings that are eligible, they need to quickly file Share Purchase Reports to ensure that their investors receive the tax credit. So waiting until the end of the calendar year isn’t advisable.
I understand that your Minister of Science launched a review of innovation policy on June 13th of this year, and that you are now responsible for that review.
As a CPA and income tax practitioner my clients will be very much affected by changes to Canada’s existing policies designed to encourage innovation. I am a member of an ad hoc CATA “LinkedIn Group”. As such I am aware of lobbying efforts being made by CATA to your Ministry.
I feel that I must point out to you that CATA does not represent the vast majority of my clients and that while their lobbying efforts have some merit, you should not believe that they necessarily represent the best interests of the entire community.
They are presenting your Ministry with a complex suite of recommendations and seeking validation from members using online petitions. As you would expect, their petitions overly simplify the situation, making it much easier for busy executives to “just say yes”.
I have reproduced their most recent online questionnaire below:
I cannot in all conscience respond to this survey. It appears that my only option is to reply “Yes”. Any attempt at a “nuanced” response, will presumably be ignored, since they have already determined what their proposals are.
SO WHO IS CATA and WHO DO THEY REPRESENT?
The small, early stage companies that I typically represent are very seldom members. Large CPA firms are well represented. In fact, CATA’s key spokesperson is Dr. Russ Roberts, a former partner at Deloitte, LLP.
So while CATA’s views are certainly worthy of consideration, they do not represent my clients or their needs. I therefore urge you to tread carefully when conducting your review.
The US introduced a new “refundable” tax credit for startups. Commencing in 2017, companies will be able to apply up to $250,000 to offset payroll withholdings on behalf employees.
According to Miller & Chevalier, CPAs:
For purposes of the credit, a “qualified small business” is an employer with gross receipts of less than $5 million in the current taxable year and no more than five taxable years with gross receipts. Qualified small businesses may claim the R&D payroll tax credit in tax years beginning after December 31, 2015.
It appears that the applicable amount of the federal credit is capped at $250,000 per year – for a maximum of 5 years. The effective amount of the benefit federally appears to be about 10% of qualifying wages (“QREs”) – compared with 54.25% in Canada. If QREs exceed $1 million Canadian, the percent will start to decline. State incentives for R&D include job credits, R&D tax credits and a variety of investment credits.
Hopefully Canada’s Federal Government will take this into account in their review of supports for the knowledge-based industry ecosystem.
Old style politicians tend to prefer direct funding programs because they can trumpet their successes – in other words they provide photo opportunities. Since direct funding programs generally involve a selection process, that also provides opportunities for politicians to sell their influence.
That simply isn’t true for the SR&ED program, since tax information is confidential – and taxpayers have a right in law to funding if the meet the eligibility requirements.
In the current review of the effectiveness of different approaches to encouraging innovation, some key voices are speaking out against SR&ED and other so-called indirect programs. This began a number of years ago with the Jenkins Report and other conservative voices in academia and the business press. Too many of these pundits confused Adam Smith’s “invisible hand” with “the hand of God”.
While there clearly are issues with the way the administration of the SR&ED program has evolved, it is still a valuable program – particularly for early stage technology programs. Finding effective ways to fund growing businesses has always been difficult. According to an article published by fundable.com:
…less than 1% of startups are funded by angels or VCs. The article points out that startups are 3 times more likely to rely on crowdfunding than they are to attract arm’s-length investors…
So how well does equity crowdfunding work?
On April 5, 2012 President Barrack Obama of the United States signed the JOBS Act into law with a remarkable level of bipartisan support. The intent was to update the U.S. Federal Security laws and make it legal for entrepreneurs to use crowdfunding to raise a limited amount of early-stage equity-based financing. Congress gave the Security Exchange Commission 270 days to draft the rules necessary to implement the legislation.
However it wasn’t until May of 2016 that crowdfunding portals in the US were open to anyone other than “accredited investors”. A few months earlier – in February of 2016 – the BC Securities Commission introduced regulations that allowed startups to raise small amounts of money from BC-based Crowdfunding portals…
A quick review of the National Crowdfunding Association of Canada’s directory (see above) reveals just how much this resembles the wild west. Many of the BC portals have abandoned their websites, some portals have no listings – and the busiest I found showed a single active listing, along with many “future listings”.
One of the equity portals listed – seedups.ca – has already pivoted away from its origins as an equity crowdfunding portal:
“We have evolved to be better aligned with the needs of these companies and the investors wanting to back them by focusing our efforts on a lead investor, member network model. As a result of these changes, we are no longer operating as a crowdfunding portal.”
Given the current state of flux in this sector, it may be wisest for early stage companies to look at crowdfunding as a way to launch creative content (eg. video games or internet-based tv series) or new products using Kickstarter or Indiegogo…
The upfront compliance and regulatory costs associated with equity crowdfunding are very high. Admittedly it costs less than going public, however existing equity crowdfunding portals don’t appear to have much, if any traction. As a result those upfront costs will almost certainly be stranded.
In BC where I practice, small business (50 or fewer employees) accounts for 55% of private sector employment (Source: BC Stats – Small Business Profile 2016). If politicians want photo opportunities and political donations, it makes sense to focus on direct funding approaches. If they want the economy to work, they should support and enhance the SR&ED program.
Technology companies – in fact most small businesses – often have difficulty taking advantage of the recently enriched lifetime capital gains deduction. When first introduced the capital gains deduction was targeted the first $500,000 of capital gains on family farms and qualified small business corporation shares (“QSBCs”). Since then the lifetime capital gains limit has been increased to $806,800 for QSBCs and $1 million for family farms.
However it is always difficult for sellers to sell shares. Buyers prefer to buy assets for 2 reasons:
- The cost of shares is not deductible by the buyer against income – while most assets are at least partially deductible
- Shares of small business corporations are much more complex beasts to acquire and may include undisclosed liabilities or other “surprises” that buyers are understandably nervous about acquiring
Buyers and their legal representatives will typically discount the purchase price if the vendor insists on selling shares. In some cases buyers simply won’t consider acquiring shares.
Many small, private corporations have at least a few skeletons in their closets. Closely-held companies often operate a little too close to the line and sophisticated buyers will often engage professionals to uncover at least some of these.
As a former senior manager with PwC LLP in Vancouver I was seconded to a due diligence team looking at the potential acquisition of a technology company. As it happened, the target company was one of a number of companies owned by the same entrepreneur. The entrepreneur had separate accounting firms handling each of his companies.
The problem was that he never informed his accountants of the existence of the other companies. Each year he filed for refundable SR&ED tax credits with one of his companies. Presumably his accountants were unaware of the existence of these other companies, since they were not disclosed on the tax returns as “associated” corporations.
Because of the amount of taxable income of the associated group, the corporation would not have been entitled to high-rate refundable tax credits. Thus any purchaser could be on the hook for undisclosed tax liabilities – and penalties – in the millions of dollars.
Of course it isn’t only undisclosed tax liabilities that could surface after an acquisition. There could be problems with employees, former employees, customers or suppliers. With small corporations eligible for the lifetime capital gains exemption, financial statements are often merely compiled with little or no assurance from the public accountants drafting the statements.
For that reason most accounting and legal professionals will advise buyers of QSBCs to purchase assets – or to discount the purchase price and conduct significant due diligence before determining that price.
CAPITAL DIVIDENDS AS AN ALTERNATIVE STRATEGY
Technology entrepreneurs looking to sell their companies should understand that the value of their companies is most often determined by the value of their IP.
Eligible capital property of a business is intangible capital property, such as goodwill and other “nothings”, the cost of which neither qualifies for capital cost allowance nor is fully deductible as a current expense in the year of its acquisition.
Selling intellectual property developed by a technology company results in a gain on disposition of eligible capital property. These types of gains are similar to capital gains – in that only 1/2 of the gain is taxable. The remaining un-taxed half can be distributed tax-free to shareholders via an amount paid out of the capital dividend account (“CDA”).
So rather than selling shares – typically at a discount – the entrepreneur keeps the company and sells the IP within the company. So the sale price is higher, the sale is only partially taxable and may even be shielded by non-capital losses, SR&ED ITCs or SR&ED expenditure pools within the company. When the proceeds are distributed, the company can elect to pay dividends from the CDA account.
While this works well for technology companies that have IP, it can also work for any corporation selling goodwill as well. Of course buyers will typically attempt to structure their purchase so that proceeds are allocated more to tangible assets which can be depreciated more quickly.
British Columbia’s Small Business Venture Capital Act provides a 30% tax credit to eligible investors in corporations involved in a “prescribed business activity” within BC. For individuals the tax credit is fully refundable and isn’t considered taxable under paragraph 12(1)(x) of the Income Tax Act:
SUBSECTION 12)(1) – INCOME INCLUSIONS
(x) Inducement, reimbursement, etc. — any particular
amount (other than a prescribed amount) received by the tax –
payer in the year, in the course of earning in come from a busi –
ness or property, from
(i) a person or partnership (in this paragraph referred to as the
“payer”) who pays the particular amount
(A) in the course of earning in come from a business or prop –
(B) in order to achieve a benefit or advantage for the payer or
for persons with whom the payer does not deal at arm’s
(C) in circumstances where it is reasonable to conclude that
the payer would not have paid the amount but for the receipt
by the payer of amounts from a payer, government, munici –
pality or public authority described in this sub paragraph or
in sub paragraph (ii), or
(ii) a government, municipality or other public authority,
where the particular amount can reasonably be considered to
have been received
(iii) as an inducement, whether as a grant, subsidy, forgivable
loan, deduction from tax, allowance or any other form of in –
(iv) as a refund, reimbursement, contribution or allowance or
as assistance, whether as a grant, subsidy, forgivable loan, de –
duction from tax, allowance or any other form of assistance, in
(A) an amount included in, or deducted as, the cost of prop –
(B) an outlay or expense,
to the extent that the particular amount
(v) was not otherwise included in computing the taxpayer’s in –
come, or deducted in computing, for the purposes of this Act,
any balance of undeducted outlays, expenses or other
amounts, for the year or a preceding taxation year,
(v.1) is not an amount received by the tax payer in respect of a
restrictive covenant, as de fined by sub sec tion 56.4(1), that was
in cluded, under subsection 56.4(2), in computing the income
of a person related to the taxpayer,
(vi) except as provided by subsection 127(11.1), (11.5) or
(11.6), does not reduce, for the purpose of an assessment made
or that may be made under this Act, the cost or capital cost of
the property or the amount of the outlay or expense, as the case
(vii) does not reduce, under subsection (2.2) or 13(7.4) or
paragraph 53(2)(s), the cost or capital cost of the property or
the amount of the outlay or expense, as the case may be, and
(viii) may not reasonably be considered to be a payment made
in respect of the acquisition by the payer or the public author –
ity of an interest in the taxpayer, an interest in, or for civil law a
right in, the taxpayer’s business or an interest in, or for civil
law a real right in, the taxpayer’s property;
The key wording here is:
(other than a prescribed amount)
VCC tax credits are prescribed by Regulation 7300 of the Income Tax Act to be “prescribed amounts” for the purposes of paragraph 12(1)(x). Not only do recipients not have to include the tax credit in income, they don’t have to reduce the Adjusted Cost Base of the underlying shares after receiving the tax credit (Regulation 6700)
This is a good deal for investors – to extent that investments in such companies can ever be considered “good” for investors. It also means that friends and family can invest in eligible shares and obtain a full deduction for the share when transferring to a self-directed RRSP.
Whether you are an individual looking for a broader range of tax deductions than employees are ordinarily entitled to, or an employer looking for a more flexible working arrangement with your “employees”, you need to understand the rules around employment.
The employer-employee relationships is dealt with by a number of different legislative regimes. These include:
- The Income Tax Act (Canada)
- The Canada Pension Plan
- The Employment Insurance Act
- The BC Employment Standards Act
It is important to understand that simply wanting to qualify for enhanced tax deductions as an independent contractor isn’t enough. Similarly employers can’t avoid the obligations of an employer merely by stating that a person providing services is self-employed.
Tax authorities – as well as other regulators – will look to the specifics of the relationship itself and make their own determination. This is true whether or not both parties intended to avoid the characterization of the relationship as an employment contract.
If you wish to establish a relationship that isn’t an employer-employee relationship, you should understand the position of the CRA with respect to this issue.
The CRA publication:
Employee or Self-Employed?
explains how this issue is perceived by both the CRA and the courts.
It is possible for the employer and the employee/contractor to contract out of the employee relationship, but it must be done thoughtfully and should be in writing. Regardless of whether or not the contract is in writing, the terms must clearly avoid the appearance of a “master-servant relationship”, or the courts (and the CRA) will look through the contract and assess accordingly.
If an employer pressures an employee to agree to a position as an independent contractor, the government may side with the employee if the self-employed contractor seeks employment insurance and severance when he or she is dismissed.
In a situation like this the employer could be required to pay severance and be subject to an assessment for a shortfall in CPP and EI withholdings.
The website TaxTips.ca has a decent explanation of many of the issues: TaxTips.ca
If an “employee” forms a corporation to provide services to his or her employer, the corporation may be considered as a Personal Services Business – which would have significant implications. These are potentially more onerous than what an individual would face if he is deemed to be an employee without the complication of a corporation.
The case of Walter Pielasa and his wife, Susan (758997 Alberta Ltd. v. The Queen – 2004 TCC 755) illustrates some of the problems that an “incorporated employee” can face if his corporation is found to be a personal services business.
IMPLICATIONS TO A CORPORATION OF CLASSIFICATION AS A ‘PERSONAL SERVICES BUSINESS’
LIMITS TO ALLOWABLE DEDUCTIONS
Paragraph 18(1)(p) of the Income Tax Act restricts the deduction of expenses of a personal services business of a corporation to the following allowable deductions:
The above amounts are only deductible by a personal services business if they would be deductible by a business other than a personal services business.
LOSS OF THE SMALL BUSINESS DEDUCTION
While these outcomes would significant for any incorporated employee and could be devastating to employers, there are other potentially significant disadvantages in those cases where the employer is successful in structuring contracts to meet the definition of ‘independent contractor’. I’ll discuss these in a future post.
Prochuk v The Queen (2014 DTC 1050)
Day Trading Within Tax-Sheltered Investments
The Prochuk case involved an individual who was denied a business loss from what turned out to be a fraudulent investment scheme. While normally individuals purchasing investments in securities would expect to qualify only for capital treatment. One exception to this would be the situation of a person in the business of trading in securities – in this example day trading.
Mr. Prochuk was engaged in successful day trading activities within his RRSP. The fraudulent investment was held outside his RRSP. Based upon his day trading activity within the RRSP, Mr. Prochuk attempted to argue that he was in the business of trading in securities.
Instead the court found that RRSP – a trust – was a separate entity from Mr. Prochuk personally. The nature of his trading activities had to viewed within each entity separately. Since the investment in the fraudulent investment scheme was an isolated transaction, it bore the characteristics of a capital transaction.
The determination of whether a gain or loss is on account of business or of capital is one of the most common types of issues to be litigated. Clearly this is because each case must be determined on its own merits, based upon the specific facts involved and secondly, because the tax consequences of the determination will be significantly different.
I can’t help but think that this taxpayer’s aggressive approach to tax planning in earlier years strengthened the Tax Department’s resolve to find against him.
This case also had the unintended consequence of focusing the CRA on the issue of day trading within tax-sheltered entities – like RRSPs and and TFSAs. Mr. Prochuk’s case may result in the CRA looking through the protection of his RRSP to tax profits within the plan.
 In 2005, Mr. Prochuk invested $250,000 in a foreign exchange currency fund with the Sabourin and Sun Group of Companies (“SSGC”).
 According to the parties, the SSGC investment fund turned out to be a fraudulent investment scheme.
 As a result, Mr. Prochuk claimed a business loss of $186,250 for his 2007 taxation year, namely the difference between the $250,000 he invested and the $63,750, he received from SSGC.
 The respondent’s position is that Mr. Prochuk is not entitled to claim a business loss since he was not in the business of trading and the SSGC investment was not an adventure or concern in the nature of trade. She submitted that the loss incurred by Mr. Prochuk was a capital loss.
 Mr. Prochuk is a civil engineer. Until 1985, he worked for BC Hydro. In 1985, BC Hydro decided to postpone the development of major hydro projects and, as a consequence, Mr. Prochuk was laid off. He was given severance pay that he rolled into his registered retirement savings plan (“RRSP”).
 Mr. Prochuk always had an interest in the financial field. After he left BC Hydro, he took financial courses to satisfy licensing requirements and started working for investment companies.
 From 1986 to approximately 1999, he worked in the financial field. In 1986, he worked for Evergreen Futures, and later for Mustard Seed Capital and then Yaletown Futures Group. Mr. Prochuk stated that working for these companies gave him great exposure to the financial field. However, for one reason or another, he was not successful at it, and since he was doing well with his RRSP investments, he decided to stop working for others and to take care of his own finances. He stated that from 1987 to 1999, he managed to increase the capital in his RRSP by a factor of eight.
 Mr. Prochuk stated that starting in 2000, he made his livelihood from gains made with his RRSP. The evidence showed that he withdrew $250,000 from his RRSP in the 2005 taxation year, $100,000 in each of the 2006, 2007, 2008, 2009 taxation years, and $95,000 and $70,000 in the taxation years 2010 and 2011 respectively.
With the return to the old regime in British Columbia, businesses are now forced to comply with the complexity of 2 separate consumption taxes (i.e. PST and GST). What prompted this discussion were the challenges faced by one of our clients – a software developer – in complying with the new regime.
To begin with small businesses must understand that accounting software isn’t expert software. Too often there is an expectation that commercial accounting software will provide professional expertise and guide inexperienced users into automatically recording transactions – including sales taxes – correctly.
In fact, from a marketing perspective Canadian customers are not a terribly important source of revenue to an international firm like Xero Limited. Xero is more focused on Australia, New Zealand (local markets), the UK, India and the US (large markets). As a result the software provides adequate generic tools to support various tax jurisdictions, but little or no ‘localization’ for secondary markets like Canada.
No matter how well accounting software has been localized to handle the mechanics of sales tax calculations for a particular jurisdiction, it simply isn’t realistic to expect the software to provide any expertise with respect to understanding what transactions are taxable or at what rates taxes need to be calculated. In fact such determinations are difficult for tax professionals, who invariably need a great deal of context before making decisions.
Handling GST in Xero
The Goods and Services Tax in Canada is a ‘value-added’ tax (aka “VAT”). That means businesses only pay tax on the value they add in taking products and services to the ultimate consumer. It is the ultimate consumer – at the end of the process – who pays the full amount of tax on the good. In the simple case of a consumer good – like a pair of shoes. The end user buys the shoes and pays GST on the full cost of the shoes.
The manufacturer buys raw materials and pays tax on the materials. It then ‘adds value’ by putting the raw materials through a manufacturing process and sells the shoes – usually to a retailer. The manufacturer charges GST on the sale price to the retailer. The difference between the GST collected on the sale price and the GST paid on the cost of the raw materials is remitted to the Canada Revenue Agency (the “CRA”).
Similarly the retailer collects GST from the consumer and gets a rebate from the CRA of the GST paid to the manufacturer. In the end, the final consumer pays the full amount of GST.
This type of value-added tax is commonplace in many countries (other than the US). Xero is familiar with handling value-added taxes and does a good job of handling Canada’s GST. All of the GST collected on sales and paid on purchases is collected in the Sales Tax Payable account.
Handling PST in Xero
Companies that charge PST to customers must remit the PST collected to the their provincial tax authority. However they don’t get any credit for PST paid on purchases. Instead PST paid is treated simply as a part of the cost of the good or service that was purchased.
This approach to sales taxes results in business paying tax on certain of their inputs. Typically raw materials and goods for resale are exempted from PST. However companies must still pay PST on overheads like telephone bills, tools and utilities. The PST paid is generally expected to form a part of the cost of any taxable good or service. Instead of being claimed as reduction or offset of PST collected, the PST ends up on the income statement as an expense.
Unfortunately Xero doesn’t handle this very elegantly.
This means that when entering PST on expenses, it should actually be entered as a second expense line (i.e. currently 7% of the taxable purchase) and should be allocated to the same account as the purchased item:
Supplies expense $100
Supplies expense …..7
Sales tax payable ……5
So we have 2 supplies expense lines. The first is subject to GST (input tax credits) at the current rate. The 2nd line represents the PST paid on the supply.
In this way the GST reports correctly as an input tax credit. The PST reports as an expense. Unfortunately the balance in the Sales Tax Payable account combines both GST and PST. So PST should NOT be set up as a sales tax.
Ideally there would be 2 separate Sales Tax Payable accounts (i.e. GST and PST), however it can be made to work as shown above. Of course other workarounds are possible – but they are workarounds, and could easily be misunderstood by bookkeeping staff.
Depending on where your business is located, GST rates can vary from 5% to 13% of all taxable supplies that your company purchases. For startups that expect to be in a loss position for a year or 2 after incorporation, that can mean a significant amount of cash donated to the federal government as a kind of ‘voluntary tax’ .
The problem is that registration isn’t automatic when you incorporate a company. In fact, until you’ve earned $30,00 in revenue you’re not required to register.
For many early stage companies they may spend 2 or 3 years burning through their equity to build a new product or service. If they don’t explicitly register for GST, they won’t be able to recover the 5% (or more) of expenditures paid to contractors and to purchase other services and supplies. In fact we recently completed 3 years of filings for a BC-based company that spent some $300K in developing new technology. Because they weren’t registered – at least not until we became involved – they lost almost $25K in recoverable GST.