As evidenced by massive stock market losses in the autumn of 2008, a sharp rebound this past spring, high unemployment, rock-bottom interest rates, economic volatility and an uncertain outlook for the future, these are unsettling times for Canadian investors.
But, as always, sound financial planning fundamentals \u2014 such as setting goals, assessing risk and determining the proper asset allocation \u2014 offer a safe harbour. An essential element of financial planning is tax planning, which can help you minimize clients\u2019 tax liabilities while maintaining the flexibility to alter goals and financial plans in the future.
\u201cStep back first and do an overview of your situation; ask yourself if you\u2019re still on track,\u201d says Prashant Patel, vice president of high net-worth planning services with Royal Bank of Canada\u2019s wealth-management services division in Toronto. Once you\u2019ve drilled down a bit deeper and determined whether there have been any changes to your risk tolerance, asset allocation and other financial planning considerations, he adds, there may be specific tax strategies that could be useful.
Tax experts appear to agree that volatile times such as these present opportunities for investors to make use of some tried-and-true tax strategies. Here is a closer look at some of those strategies:
> Prescribed Rate Loans. <\/b> Normally, the attribution rules governing transfers of money between spouses or other family members prevent a higher-income family member, whose income would be taxed at a high rate, from obtaining a tax advantage by transferring money to a lower-income family member, whose income would be taxed at a lower rate.
However, family members can split the income by making loans to other family members at the prescribed rate that the government sets without triggering the attribution rules.
The Canada Revenue Agency<\/b>\u2019s prescribed rate for loans between family members has been at an all-time low of 1% since April, and it will remain unchanged until at least the end of the year. The rate, which is reset quarterly, can\u2019t be any lower than 1% by law.
\u201cNo one could ever have imagined the rate would get this low,\u201d says Teresa Gombita, an executive director and industry leader of the private client services group with Toronto-based Ernst & Young LLP<\/b>. \u201cThis represents a great opportunity to set up a loan with a family member.\u201d
In a prescribed-loan strategy, a family member with a high income gives a loan to his or her spouse, child or grandchild who earns a lower income and is in a lower tax bracket. The family member receiving the loan must pay interest on the loan, at the prescribed rate, before the first 30 days of the following year.
Any income or gains on an investment made by the family member receiving the loan \u2014 and by using the borrowed funds \u2014 is taxable in the hands of that family member, presumably at a lower rate than the family member who lent the money, thereby lowering the overall tax liability for the family as a whole.
The family member who made the loan must declare the interest received on the loan as income, while the family member who received the loan can claim the interest paid as a deduction on his or her income \u2014 if the money loaned was invested.
The rate on any loan between family members can stay fixed at the prescribed rate at the time the loan was made, and the interest rate doesn\u2019t need to rise or fall along with the prescribed rate the government sets in future quarters. Also, the term of the loan can be payable on demand and, therefore, can continue until the monies are demanded. The attribution rules should not apply as long as the interest keeps getting paid.
It\u2019s vital that a loan between family members be documented properly, so that it can hold up to scrutiny from the CRA, tax experts say. It is also vital that all the rules governing the use of such loans be followed and that the strategy be executed properly.
For instance, it\u2019s important that the interest be paid annually and at the proper rate, and that the money for the interest payment come from the family member who borrowed the money. If the CRA can prove that the money to pay the interest on the loan \u2014 or to make the payment on the loan itself \u2014 came from the family member who made the loan, the attribution rules may be applied to the loan.
@page_break@> Tax-Loss Selling. <\/b> After the market meltdown of a year ago, tax-loss selling was a major theme for the 2008 taxation year, as most investors found themselves holding at least a few equities in their portfolio worth less than what they had originally paid for them. Even with the market run-up that has taken place so far this year, experts believe the tax-loss strategy will be useful to many investors again this year.
As Patel says: \u201cThere are still [unrealized] tax losses floating around.\u201d
Selling stocks that are worth less than their original cost is a great way to realize at least one positive from a negative situation. That\u2019s because capital losses can be matched against capital gains realized in the current year, with the net effect being no taxes owed on the amount of capital gains to which the losses can be matched.
If no capital gains were realized in the current year, tax losses can be carried back for up to three taxation years and matched against capital gains in those years. Tax losses can also be carried forward indefinitely until they are used to match against capital gains in a future taxation year.
Advisors should also have a discussion with clients who hold stocks worth less than their original cost about whether selling those equities would make sense, Patel says, both from an investment and tax-efficiency perspective.
And clients who do sell stocks must ensure they don\u2019t run afoul of the \u201csuperficial loss\u201d rule, which prevents investors from claiming a capital loss on the sale of a stock if they or an affiliated person (such as a spouse or controlled corporation) buy the same stock within 30 days before or after selling it, or if the affiliated person owns the same stock after the 30-day period. Even though this rule is well known, it remains a common pitfall.
\u201cIt happens all the time,\u201d says Sharon Patterson, director of wealth services, tax planning with BMO Harris Private Banking<\/b> in Toronto, \u201cparticularly if the investment advisor and the accountant aren\u2019t communicating with each other.\u201d
> Transferring A Capital Loss To A Spouse. <\/b>Although couples might want to transfer securities from one spouse to another in situations in which one spouse has a potential capital loss on the sale of the securities and the other spouse has a capital gain that can be offset with that loss, the attribution rules prevent spouses from simply transferring securities from one to the other.
A way to accomplish the transfer without triggering the attribution rules is for Spouse A to sell the securities to Spouse B at fair market value. Spouse B would hold them for at least 30 days, thus purposely triggering the superficial loss rule. This means that Spouse A cannot claim the losses on the original sale to Spouse B, but this denied loss is added to Spouse B\u2019s cost, so Spouse B is now in a loss position. Spouse B then sells the security on the market and claims the capital loss.
> Business Tax Credits. <\/b> There are a number of federal and provincial tax credits that small-business owners regularly fail to use, either because they aren\u2019t aware they exist or because they forget to make use of them, says Paul Woolford, a tax partner with KPMG Enterprise at KPMG LLP<\/b> in Toronto. An example is the 10% federal non-refundable apprenticeship job creation tax credit available to businesses on the salaries and wages of apprentices. The maximum credit available is $2,000.
Business owners should consult with tax professionals to ensure they\u2019re making use of all available tax credits.
> Adjusting Tax Payment Instalments. <\/b>Self-employed individuals and business owners should review their tax instalments, which may have been set up when the economy was stronger. If their annual income has decreased, the instalments \u2014 the monthly or quarterly payment of taxes to the CRA \u2014 may be reset lower.
> Cash Damming. <\/b> It\u2019s always a good, sound financial planning to pay down non-tax-deductible debt before paying down tax-deductible debt, Patel says. Beyond that, there are a number of strategies, with differing levels of complexity, that can be used to attempt to swap non-tax-deductible debt for tax-deductible debt. One of these is \u201ccash damming,\u201d which may allow the owner of an unincorporated business to swap personal debt for business debt.
Normally, business owners will pay for expenses incurred in the operation of a business with the revenue generated from that business. In the cash-damming strategy, the business owner pays business expenses through a business line of a credit instead. The business revenue that would have otherwise gone to pay for those expenses can now be used toward paying down a non-tax-deductible personal expense, such as a mortgage. The interest on the business line of credit is tax-deductible.
In order for this strategy to work \u2014 that is, to withstand scrutiny from the CRA \u2014 it\u2019s vital that the business owner set up three bank accounts: one for depositing business income and paying off personal debts; a second bank account for paying business expenses; and a line of credit. Meticulous execution and documentation of the strategy is also important.
> Individual Pension Plans. <\/b> These are employer-sponsored defined-benefit plans for employees that are meant to boost retirement savings and increase tax-sheltered contributions and investment growth.
IPPs may be ideal for small-business owners, executives and incorporated professionals who are in middle age or older with annual T4 income of more than $100,000. These plans also offer creditor protection \u2014 a particular benefit during times of economic uncertainty.
Businesses may choose to establish an IPP for an employee as an employment benefit. Individuals may set up an IPP by choosing to incorporate him- or herself and become both shareholder and employee of that corporation.
There are several advantages to having an IPP, including higher contribution levels than an RRSP has and the possibility of making lump-sum contributions for previous years of employment.
On the other hand, funds in an IPP are locked in until retirement in most provinces; and the costs of setting up an IPP are higher than RRSP fees. However, IPP fees are fully tax-deductible for the company sponsoring the plan.\tIE<\/b>
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