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TAX
Hard Times Tax
Bad debts, mortgage foreclosures and corporate losses are all by-products of an economic recession. The Income Tax Act is rife with rules and regulations dealing with the tax treatment of such items. Most of these rules, however, are designed to ensure that taxpayers receive only those tax advantages which are due them. Consequently, a goodly part of a tax practitioner’s mandate is to exploit those rules and regulations to there fullest. This article will outline some of the tax issues that arise in hard times and the basic strategies that result.
Corporate Loss Utilization The use of corporate losses is the object of the most creative, the most outlandish and the most complicated of tax planning. There are very substantial gains to be derived by manipulating losses to shelter the income of current, future or past periods.
A private corporation may carry non-capital losses back three years and forward seven years (three years and ten years for farm losses). The proper filing of corporate income tax returns becomes critical, as a late-filed return will preclude the company from carrying a loss back to the oldest of the three years. These loss carry backs can produce significant results. For example, a Canadian controlled private corporation in Ontario carrying a loss of $10,000 back to 2000 will recover approximately $2,000 of tax at the active business rate.
In some circumstances, it becomes advantageous to accelerate expenses to increase corporate losses. A company that has paid tax in previous years may wish to accrue bonuses to its owner/manager to create or increase a loss carry back. If the owner/manager pays personal tax on the bonus at the lowest marginal rate, this strategy extracts tax paid monies from the company at a very low cost.
Many corporations have paid little or no tax in the past three years. The company may, therefore, wish to reduce the current year’s tax loss. One method of doing this is by changing the method of remunerating the shareholder/manager. The shareholder can be taken off salary and paid dividends on his shareholdings. An individual with no dependants and no other income can receive approximately $24,000 a year in dividends and pay no personal income tax. This eliminates source deductions and Employer’s Health Tax thereby improving cash flow substantially. The shareholder will, however, forego the current year’s Canada Pension Plan contribution and the following year’s R.R.S.P. contribution.
A group of corporations under common control may find itself with losses in some companies and profits in others. Often this imbalance can be corrected using intercompany charges such as rent, management fees or other services. CCRA will allow a fair degree of latitude in the setting of these charges provided they are reasonable and incurred for the purpose of earning income from business or property. Intercorporate product pricing can be adjusted to reallocate profits as can intercorporate financing arrangements. Profit generating assets or assets with accrued (unrealized) gains can be transferred (rolled) to loss companies on a tax-deferred basis. The profits earned or gain realized on the disposition of the asset will then be sheltered by the losses of the acquiring corporation.
Bad Debts Many companies find themselves in the unenviable position of having delinquent accounts receivable. The Income Tax Act will allow the company to deduct a reserve for such bad debts provided that the amount was included in income at some point, and that all reasonable steps have been taken to recover the debt. Customers sometimes offer assets other than cash to pay off their accounts. Any difference between the amount of the receivable and the value of the asset received can be expensed as a bad debt. Keep in mind that Provincial Sales Tax and Goods and Services Tax remitted on accounts that become uncollectible can be recovered.
Foreclosures and Repossession Everyone is familiar with the fact that secured creditors generally have the power to seize a debtor’s assets in the event of default. The tax implications of such transactions are complex.
Generally, the creditor (lender) upon seizing the property has a cost equal to the outstanding principle amount of debt. The debtor (borrower) has proceeds of disposition of the property equal to the same outstanding principle. Any interest forgiven will be included in the debtor’s income to the extent that it was expensed in the current or prior years. If the creditor seizes the property, sells to a third party and receives more than enough to extinguish the debt, he will presumably pass the extra proceeds on to the debtor. This amount then becomes additional proceeds of disposition and may result in further recapture on depreciable property or a reduction of a capital loss.
A debtor should be aware that a seized property with a high rate of capital cost allowance could result in a tax liability in that the deemed proceeds may be higher than the undepreciated capital cost.
Expenses paid by the creditor relating to the property (taxes, utilities, repairs, or interest on a third party mortgage) will also be included in the debtor’s proceeds of disposition if the total debt is extinguished on seizure.
A conveyance of land under a mortgage foreclosure will result in the imposition of Ontario land transfer taxes to the mortgagor, the value of the lands being the lesser of fair market value and the sum of the principal owing plus various other costs and consideration. There are countless other provisions in the Income Tax Act that deal with the symptoms of hard economic times. A public accountant must have a good knowledge of these provisions and the tax planning opportunities they create.
It is often in the worst of times that accountants are of the most economic benefit to their client.
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