Income from Property Inclusions: Interest, Dividends, and Production-Based Income

1. Chapter 6 Income from Property

2. InclusionsSec. 12 • Interest income from savings, deposits, loans, bonds, and debentures; • Dividends from shares; and • Income based on the production or use of property.

3. Interest Income • Reporting • Corporations, partnerships, and trusts • Accrual method of accounting • Individuals • Annual accrual based on the anniversary date of an investment contract • Annual accrual does not apply if individual receives interest prior to anniversary date (under general rule)

4. Interest Income • Purchasing a corporate bond at discount • Investor’s Position • Is interest income equal to amount actual received or based on effective interest rate? • Issuer’s Position • “Deep” discount versus “shallow” discount • If a deep discount, only 50% of discount can be deducted as if it were an interest expense

5. Interest Income • Treasury Bills • Discount included as interest income • Zero-coupon bonds • Interest is paid as part of redemption proceeds at maturity • Difference between the cost of bond and the maturity value represents the present value of the accumulated interest income (compounded on annual basis for Type 1 bonds)

6. Interest Income • Purchasing an accrued interest bond • Interest income is divided as: • Transferor must include interest accrued up to the date of the transfer. Amount included in income is excluded from the proceeds of the debt obligation. • Transferee must include interest from the date of the transfer.

7. Payments Based on Production or Use • Must be included as property income • Purpose of rule: To prevent taxpayers from characterizing property income as capital gains which have a lower tax rate

8. Dividends • All dividends are income • Including dividend-in-kind • “Taxable dividends” are dividends from resident corporations • “Dividends” are dividends from non-resident corporations

9. Dividends from Corporations Resident in Canada (Figure 6-1)

10. Canadian Dividend Taxation System • Issue: • Double taxation • Income taxed first at the corporate level and then in the hands of shareholders as dividends. • To eliminate double taxation: • Gross-up of dividend received and calculation of tax on that base, and • A dividend tax credit for income tax paid by corporation.

11. Canadian Dividend Taxation SystemDividends from Corporations Resident in Canada

12. March 21, 2013 Proposals • Dividend gross-up and dividend credit be changed for dividends from: • Active business income of a CCPC that is taxed at the lower corporate tax rate • Investment income of a CCPC

13. Dividends Received from Non-Resident Corporations • Dividends still taxable but dividend gross-up rules do not apply • Entitled to foreign tax credit if income tax withheld from source

14. Income Attribution “Income attribution” allocates income earned on property that was transferred to a non-arm’s length individual back to original owner. Purpose: Prevent taxpayers from splitting income with family members who earn less income and pay tax at a lower rate.

17. Income Attribution Avoiding Income Attributions Subsection 74.5(1) • FMV Transfer • Interest charged at prescribed rate • Spousal Election Subsection 74.5(3) • Marital Breakdown

18. Income Attribution • Anti-avoidance rules relating to attribution • Repayment of existing indebtedness • Back-to-back loans • Loan guarantees • Artificial transactions • Compensation • Corporation

19. Income Attribution • Does not apply to: • Second generation income from property • Loans or transfers to non-arm’s length individuals who are 18 years of age or older

20. Kiddie Tax • Income attribution rules do not apply to income from a business transferred to a minor • “Kiddie Tax” applies to dividends from a private Canadian or foreign corporation • Taxed at top marginal rate of an individual • Can only claim dividend tax credit or foreign tax credit

21. Kiddie Tax • Income subject to Kiddie Tax: • Taxable dividends and taxable capital gains derived from private Canadian or foreign corporations and that are received directly or indirectly through a trust or partnership • Shareholder benefits included in the minor’s income under section 15 • Partnership or trust income derived from the provision of goods and services to a business that is carried on by • A person related to the minor; • A corporation which has a “specified shareholder” who is related to the minor; or • A professional corporation which has a shareholder related to the minor.

22. Kiddie Tax • Exceptions: • Income from a corporation or partnership paid to individuals over 18 years of age; • Taxable dividends from public corporation; • Reasonable remuneration to minors; • Capital gains on disposition of shares of private Canadian or foreign corporation; • Income from property inherited from a parent; • Minors who have no parent resident in Canada; or • Income from property inherited from someone other than a parent.

23. Kiddie Tax • Where taxable capital gains are derived from a disposition of shares to a non-arm’s length person and if taxable dividends on such shares would have been subject to the tax on split income. • An amount equal to two times these taxable capital gains will be deemed to be dividends and subject to ‘‘Kiddie Tax’’ at the top marginal rate.

24. Deductions • Carrying Charges on Land • Limitation on deduction – Vacant land • Only deductible to the extent of the net income on the land • Carrying charges not deducted are added to cost base of land • Applies only to property developers whose business is the sale or development of land, or to land that is held, but not used, in a business.

25. Deductions • “Soft Costs” Relating to Construction or Buildings or Ownership of Land • Includes interest expenses, legal and accounting fees, mortgage fees, insurance, and property taxes • During construction, costs must be added to the cost or building or land • Does not include CCA, landscaping expenses, or disability-related modifications

26. Deductions • Rental Properties • Separate classes – rental property costing over $50,000 • Losses from rental property • CCA can only be deducted to the extent that it does not create or increase a net loss from all of a taxpayer’s rental properties combined.

27. Deductions • Interest Deduction • Can deduct interest if it: • is paid or payable in the year; • arises from a legal obligation; • is payable on borrowed money that is used for the purpose of earning income from business or property; and • is reasonable in amount.

28. Deductions • Interest deduction limitations: • Deduction of interest imposed under the Act is denied; • Deduction of interest on funds borrowed to buy vacant land is limited; • Interest that is part of “soft costs” must be capitalized; • Deduction of interest paid to certain non-residents is limited; and • Deduction of interest on funds borrowed to make a contribution to tax sheltered retirement savings fund (e.g., RRSPs) is denied.

29. Deductions • Interest Deduction • Loss of the source of income • Election to capitalize interest

30. Personal Loan Planning and Interest Deductibility • Strategy: • Buy personal assets with your own funds (as interest not deductible on borrowed funds used to purchase personal assets) • Use these assets as collateral to borrow to invest in assets that earn property income (since interest will be deductible)

31. Other Deductions • Carrying charges • Investment counsel fees • Legal and accounting fees • Foreign non-business income tax • Taxpayer allowed a tax credit up to 15% of foreign income from property • Foreign taxes paid in excess of 15% can be a deduction against property income

32. GST/HST and Property Income • Interest and dividends exempt from GST/HST • “Soft Costs” • GST/HST applies to sales and rentals of real property unless the supply is specifically exempt under Part I of Schedule V (e.g., sales of used residential housing and long-term residential rents) • Input tax credits can be claimed if property and services are purchased for use in commercial activities