Category: Domestic Tax

Managing increasing prescribed interest rates on loans

Posted on by Edixon

Authored by RSM Canada

With rampant inflation and growing interest rates, Canadians everywhere are bracing for a looming recession. The interest rates applicable for tax planning in Canada have been increasing as well, leaving many tax decisions that once made sense to now being much tougher to manage economically. Interest rates applicable for tax planning refer to the prescribed interest rates, which are computed quarterly and published online by the Canada Revenue Agency (CRA).

This article is the second article in the series with a focus on the impact of increasing prescribed interest rates on certain tax-planning loans. You can find the first article here, which discusses how increasing prescribed interest rates impacts income tax reassessments.

Employer-provided home purchase loans

Under certain employment circumstances, employees are able to take advantage of low-interest loans offered by their employers to purchase a dwelling. These housing loans have certain beneficial tax attributes, including that the loan itself would not be considered employment income. Rather, the employee would only have taxable income inclusion equal to the prescribed interest rate times the principal amount owing less any interest actually paid on the loan.

The prescribed interest rate on these types of loans is fixed at the rate at the time the loan was made. Therefore, if the loan was first made a few years ago, it would still be fixed at the prescribed interest rate of 1%. However, there is a mandatory 5-year “refresh” on home purchase loans, deeming a new loan to arise at that time. This means that any housing loans previously taking advantage of historically low prescribed interest rates may soon be up for a refresh at current prescribed interest rates.

As an example, assume there was an outstanding home purchase loan issued to an employee for $250,000 on January 1, 2018, requiring to be repaid by January 1, 2028. The loan did not require any interest to be paid and the employee was including $2,500 (1% prescribed interest rate times $250,000) in their taxable income each year since 2018. On January 1, 2023, there was a mandatory refresh of the loan, meaning it now carries the Q1 2023 prescribed interest rate of 4%. Assuming there has been no principal repayments yet, the inclusion to taxable income for 2023 has now increased to $10,000 (4% prescribed interest rate times $250,000). Depending on the employee’s marginal tax rates this could mean an increase of taxes owing of almost $4,000.

Taxpayers who may be affected by this mandatory refresh should start considering if it still makes financial sense to have the home purchase loan or if they should refinance.

Prescribed rate loans

A common way to avoid adverse tax implications on certain types of loans is to have the loan carry the prescribed interest rate. For example, individuals can generally borrow funds from a corporation they own for a short term at the prescribed interest rate and only need to include that interest in their taxable income. These type of financing options may have historically been effective, but given the recent increases to prescribed interest rates, this may no longer be a sound strategy.

Prescribed rate loans are also used in income splitting strategies for high-net-worth families by utilizing a family trust to hold income-earning securities. The trust then distributes the income earned to its beneficiaries, typically minors or a spouse, to attempt to split the investment income earnings across taxpayers with lower marginal tax rates. While this strategy can be thwarted under certain circumstances, one way to make sure the planning works as intended is to utilize a prescribed rate loan. Typically, this involves a high-income-earning family member to loan funds to the family trust at the prescribed interest rate.

In contrast with home purchase loans, there is no mandatory refresh of these loans. Instead, these loans remain outstanding indefinitely as long as the taxpayer continues to meet the relevant criteria. This means that taxpayers are incentivized to enter into these loans when the prescribed interest rate is as low as possible. The reason for this is because the interest paid on the loan is taxable to the creditor, typically the high-income-earning family member. As such, the higher the interest rate, the larger the income inclusion to an individual likely already at the highest marginal tax rate.

If taxpayers were interested in utilizing this type of planning right now, they have until March 30, 2023 to lock in the current prescribed interest rate of 4%. Despite the rate being relatively high, economically is still may make sense to take advantage of this planning. For example, assume that a high-income-earning family member paying tax at a marginal rate of 50% has $500,000 of excess cash they would otherwise have invested themselves in a security that yields 6% annually. They could consider a prescribed rate loan plan where they lend the $500,000 to a family trust at an interest rate of 4% which would then invest in a security that yields 6% annually.

If the taxpayer loaned the funds on January 1, 2023, the following tax results would occur for the 2023 taxation year:

High-income-earning family member

Family trust

Revenues

Interest income on loan: $20,000
($500,000 x 4%)

Security yield: $30,000
($500,000 x 6%)

Expenses

–

Interest expense on loan: $20,000
($500,000 x 4%)

Net income

$20,000

$10,000

Approximate tax owing @ 50%

$10,000

–

Absent this planning, the high-income-earning family member would have earned $30,000 on the security themselves and pay an approximate tax of $15,000. The planning has effectively saved approximately $5,000 of taxes annually ($30,000 * 50% vs $20,000 * 50%).

The take-away

Tax planning involving loans is not static, it requires constant attention and reevaluation of effectiveness regularly. Even if a plan made sense a certain time ago, changes in economic circumstances can change that drastically.

This article was written by Daniel Mahne and originally appeared on 2023-03-24. Reprinted with permission from RSM Canada LLP.
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The information contained herein is general in nature and based on authorities that are subject to change. RSM Canada LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM Canada LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

UNREPORTED REAL ESTATE DISPOSITIONS: Multiple Issues

Posted on by Edixon

A September 12, 2022, Tax Court of Canada case reviewed the gain on a residential property purchased in 2007 and disposed of in 2011. The property was substantially rebuilt during the ownership period. The proceeds, cost, and gain were all determined by CRA as the sale was unreported. These amounts were largely unchallenged by the taxpayer and accepted by the Court. The Court noted that the taxpayer’s tumultuous relations with her ex-husband, whom she divorced in 2014, resulted in “an off-again/on-again cohabitation” during much of the relevant period.

Although the taxpayer argued that the property was her principal residence, CRA denied it, assessing the gain as an adventure in the nature of trade and, therefore, fully taxable. CRA also assessed outside the normal reassessment period of three years and applied gross negligence penalties.

Capital property or adventure in the nature of trade?

The Court accepted that the taxpayer lived at this property from time to time during the ownership period, a personal use inconsistent with a business venture of acquiring, improving, and selling the property for a profit. In addition, the taxpayer was a teacher not connected to the real estate sector. Her marital difficulties demonstrated a plausible reason for acquiring this larger residence for personal use as a residence in which to start a family. There was no suggestion that the reconstruction was undertaken for purposes other than for personal use. The nature of the property, length of ownership, lack of prior or subsequent activity in real estate, and her personal circumstances all led to the conclusion that the property was acquired for personal use and not resale, so it was a capital property.

Principal residence?

The property was used as an intermittent refuge and was never occupied with regularity. In the absence of evidence such as a change of address, domestic expenses beyond mandatory utilities, or other permanent hallmarks, the Court could not conclude that the property was ordinarily inhabited, preventing it from being the taxpayer’s principal residence. As such, the taxpayer could not claim the principal residence exemption on the disposition.

Statute-barred?

The Court acknowledged that a fully exempt principal residence sale was not required to be disclosed in the taxpayer’s 2011 personal tax return. However, the taxpayer provided no details to show a reasonable basis for believing the gains were fully exempt. Without such evidence, she could not support her defense that the failure to report the gain was based on a reasoned and thoughtful assessment of her filing position rather than a result of carelessness or neglect, as CRA asserted. As she could not disprove CRA’s assertions, the return could be assessed outside the normal reassessment period.

Note that all principal residence sales were required to be disclosed in an individual’s tax return starting in 2016. If not reported, the individual could not claim the principal residence exemption on the disposition of the property and would be liable for the tax on the gain on disposition. As the taxpayer’s disposition was in 2011, this issue was not addressed in the Court case

Gross negligence?

The Court noted that CRA’s gross negligence penalty assessment (50% of the understated tax) was linked to three factors: the conclusion that the property was held in the course of an adventure in the nature of trade; the assertion that the taxpayer never lived in the property; and the magnitude of unreported income. All three of these assertions were incorrect. The taxpayer’s belief that she could navigate the tax laws related to personally held real property was incorrect; however, it was not tantamount to a deliberate act demonstrating indifference to compliance with the law. The gross negligence penalties were therefore reversed.

ACTION ITEM: Ensure to report all dispositions of real property, whether it is eligible for the principal residence exemption or not, on your personal tax return.

SAUNA AND HYDROTHERAPY POOL: Medical Expense Tax Credit

Posted on by Edixon

In a December 4, 2018 Technical Interpretation, CRA was asked whether the costs of installing a steam shower (sauna) and hydrotherapy pool could be eligible for the medical expense tax credit (METC). The use of these devices was recommended as treatment to maintain strength and mobility.

CRA noted that, for renovations to be eligible, they must:

  1. enable the patient to gain access to the dwelling or be mobile and functional within it;
  2. not typically be expected to increase the value of the dwelling; and
  3. not normally be undertaken by individuals with normal physical development or who do not have a severe and prolonged mobility impairment.

While the expenses contemplated may meet criteria (a), CRA opined they would likely fail criteria (b) and (c) and, therefore, not be eligible for the METC. However, eligibility remains a question of fact, with the onus on the taxpayer to demonstrate that all requirements were met.

Also, CRA noted that a renovation cost incurred for the main purpose of enabling a qualifying individual to gain access to the dwelling or be mobile and functional within it (the same as criteria (a) for the METC) could be eligible for the home accessibility tax credit (HATC). The HATC is a non-refundable credit that provides tax relief on up to $10,000 annually of renovations to a home to enhance mobility or reduce risk of harm for a qualifying individual (those 65 years of age or older at the end of the taxation year or eligible for the disability tax credit). The HATC requirements do not exclude costs failing criteria (b) or (c) above.

ACTION ITEM: There are several renovations that can be eligible for one or both of these credits. Receipts, invoices and/or other supporting documents should clearly identify the health benefits and purpose.

Contact one of our Taxation team members for more tax tips and advice.

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WITNESSES FOR LEGAL DOCUMENTS: Choose them Wisely

Posted on by Edixon

A June 17, 2022, Ontario Superior Court of Justice case considered whether a will had been appropriately witnessed. In 2020, the owner of an insurance agency was diagnosed with terminal cancer and drafted a final will and testament. As it was the height of the COVID-19 pandemic, she chose two of her employees to meet her outside of the agency to sign the document as witnesses. She left everything to two children and nothing to the third. She died later that year.

Subsequent to her death, one of the beneficiaries wound up the agency and provided severance to the employees. One of the employee witnesses was not happy with the 14 weeks of severance pay offered and refused to affirm that she had witnessed the will signing until the dispute over her severance was completed. The Court also noted that she was quickly rehired by another insurance agent, the deceased’s child who had not received anything from the will. Later, the witness argued that she was not physically close enough to confirm that she had actually witnessed the document being signed.

The circumstances indicated that the witness was present at the signing, was close enough to see what was happening, and as a clerk in an insurance agency, would not have originally signed the will inappropriately. The Court found that the witness was lying about not having witnessed the signing with the likely motivation of increasing her severance.

While the will was eventually determined to be valid, this case reiterates the importance of carefully selecting individuals to witness signing important documents, such as a will.

ACTION ITEM: When selecting an individual to witness the signing of a legal document, consider whether they would be available and willing to properly verify their signature in the future, if required.

EMPLOYEE GIFTS AND PARKING: Updated CRA
Policies

Posted on by Edixon

CRA updated several administrative policies in respect of employment benefits, effective January 1, 2022. Two of the key changes relate to employee gifts and parking. These updates were released in late 2022.

Gifts, awards, and long-service awards

Under CRA’s existing gifts and awards administrative policy, the first $500 of annual gifts and awards provided to arm’s length employees is non-taxable. This policy does not apply to cash or near-cash gifts. Historically, CRA had considered all gift cards to be cash or near-cash gifts and, therefore, a taxable benefit. However, CRA will now accept certain gift cards to be non-cash and eligible to be a non-taxable benefit provided all of the following requirements are met:

  • the gift card comes with money already on it which the terms clearly state cannot be converted to cash;
  • the use of the gift card is limited to purchases from a single retailer or a group of retailers identified on the card;
  • the employer maintains a log to record all of the following details:
  • name of the employee;
  • date the gift card was provided;
  • reason for providing the gift card to the employee (e.g. gift, award, social event);
  • type and amount of gift card; and
  • name of retailer(s) at which the gift card can be used.
Parking

Generally, employer-provided parking is a taxable benefit to employees unless a particular exception applies, such as where there is scramble parking. As a COVID-19 relieving measure, CRA stated that where there was a closure of the place of employment (including situations where employees were given the option to work from home full-time) due to COVID-19 between March 15, 2020, and December 31, 2022, no taxable benefit arose in respect of employer-provided parking in this period. When the employee returns to their regular place of employment to perform their duties, including returning on a part-time basis, the policy no longer applies, meaning that the parking benefit becomes taxable (unless another exception applies).

CRA also discussed many other policies related to parking benefits, such as the exception for scramble parking such that no taxable benefit arises. This policy requires that parking spaces are not assigned and are available to all employees who want to park. Not more than two parking spaces can be available for every three employees who want to park. CRA indicated that this ratio would be based on the average number of parking spaces and employees, calculated at least annually, with a recalculation if there is a significant change.

ACTION ITEM: Consider whether these updates will affect the taxability of current benefits offered.

CANADA DENTAL BENEFIT: Support for those
with Young Children

Posted on by Edixon

The Canada dental benefit, announced in September 2022, provides up-front tax-free payments to cover dental expenses for children under age 12 without dental coverage. The program began December 1, 2022, with expenses retroactive to October 1, 2022, being covered.

The program is available for two periods: December 1, 2022, to June 30, 2023, and July 1, 2023, to June 30, 2024. While the program expires in mid-2024, the government has stated that it is committed to fully implementing a dental program for all households with income under $90,000 by 2025.

Services that dentists, denturists, or dental hygienists are lawfully able to provide, including oral surgery and diagnostic, preventative, endodontic, periodontal, prosthodontic, and orthodontic services, are eligible for the benefit.

Amounts

The amount of payments that are provided annually (per period) per child under age 12 are based on adjusted family net income (AFNI) as follows:

  • $650/child if AFNI is under $70,000;
  • $390/child if AFNI is between $70,000 and $79,999; and
  • $260/child if AFNI is between $80,000 and $89,999.

AFNI for the benefit’s purpose is the same as for the Canada child benefit, with the annual income period ending on December 31, 2021, for the first period and December 31, 2022, for the second period.

Shared-custody parents at the beginning of the relevant period are each eligible for 50% of the benefit, based on whether they incur or will incur eligible expenses in the period and their respective AFNI.

The benefit does not reduce other federal income-tested benefits (for example, the Canada workers benefit, the Canada child benefit, and the GST credit).

Eligibility

To qualify, parents need to attest that the following conditions are met:

  • their child does not have access to private dental care coverage (for example, through a parent’s employer or coverage that is paid for personally); and
  • the child has received, or is intended to receive, dental care services during the relevant period.

Parents also need to provide documentation to verify that out-of-pocket expenses occurred (e.g. show receipts) if required by CRA.

To qualify, the child must be under 12 on December 1, 2022, for the first period and under 12 on July 1, 2023, for the second period.

Application

The application portal for the benefit is available online through CRA’s My Account. Those unable to apply online can call 1-800-715-8836 to complete their application with an agent. In addition to an individual’s standard identifying information and the above-noted attestation, parents need to provide CRA with the name, address, and telephone number of their and their spouse or common-law partner’s employer. They also need to provide information about the dental service provider from which they received or intend to receive services for their child.

ACTION ITEM: Eligible individuals must apply for this benefit on their own as accountants and representatives cannot apply on the client’s behalf.