A Primer in Tax Jargon...

Below is an excellent article written by Rollie Vaive, C.A. based in Ottawa, Ontario - its a must read:

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Given enough time and a dose of patience, a good tax practitioner should be able to explain virtually any concept to you in plain English, and distill the issue down to a level where it can be understood. Tax is complex, but once all of the nuts and bolts provisions of the Income Tax Act are analyzed, most people should be able to understand the issues before them so that they can make an informed decision about their affairs.

When explaining tax ideas and concepts, even the best tax practitioners sometimes slip up and resort to using obscure tax terminology. If you’ve ever been in the same room with two tax practitioners, you’ll know what I mean. The conversation is littered with acronyms and buzzwords that will leave you scratching your head.

We thought that it would be a good idea to explain some of these acronyms and buzzwords so that you can slide them into the conversation next time you’re talking to a tax advisor.

ABIL: Pronounced "Able". This is an acronym for Allowable Business Investment Loss, which is a definition contained in the Income Tax Act. An ABIL is a capital loss that is incurred on very specific types of assets, namely shares or debt of a small business corporation. Whereas a normal capital loss is of limited use because it can only be deducted against capital gains, an ABIL can be used to offset any type of income. If you invest in shares of a small business corporation, and you incur a loss on that investment (either because you sold it for less than you paid for it, or the company went out of business), you can use that loss to offset employment income, business income, or any other type of income. Like all capital gains and losses, an ABIL is subject to a 1/2 inclusion rate when determining how much of a deduction can be claimed against your other sources of income. If you invest $1,000 in a small business corporation, and the corporation goes bankrupt, your ABIL is 1/2 x $1,000, or $500.

ACB: This is an acronym for Adjusted Cost Base, which is a definition contained in the Income Tax Act. In short, ACB is the "tax cost" of a non-depreciable asset for income tax purposes. A non-depreciable asset is any asset whose physical state is not subject to wear and tear. Examples of non-depreciable assets would include shares of companies, bonds, mutual fund units, interests in a partnership, and land to name just a few.

ACB is important, since it will determine how much of a capital gain or a loss that you realize on the disposition of an asset. When determining the tax consequences of a disposition, we calculate the proceeds of disposition and compare it to the ACB of the asset which was disposed of.

Determining the ACB of an asset can be very simple or very difficult. The starting point is usually the amount that you pay for an asset. If you were unfortunate enough to buy 100 Nortel shares when they were trading at $100, each Nortel share that you hold has an ACB of $100. If you acquire additional Nortel shares on the open market, the ACB is averaged over all of the Nortel shares that you hold. If you buy another 100 Nortel shares at $3 each, you now hold 200 shares for which you’ve paid a total of $10,300. Your new ACB would be $51.50 per share.

CCA: This is an acronym for Capital Cost Allowance. CCA is defined in the Income Tax Act, and is essentially the depreciation deduction that you can claim in a particular year to reduce your income for tax purposes. It is the technical term for tax depreciation.

The Regulations to the Income Tax Act contain detailed rules on how to claim CCA. The Regulations break assets into different categories, called CCA classes, and state the maximum rate that you can depreciate the asset each year. A fax machine or a photocopier, for example, are placed in Class 8 and can be depreciated at up to 20% per year subject to a number of complex rules which are beyond the scope of this forum. Computers are considered Class 10 assets and are depreciated at a rate of 30% per year subject to the same complexities . CCA is optional, and you can choose not to claim depreciation in a particular year. While most often we do claim maximum CCA (because we want to reduce our income and taxes to the maximum extent possible), there are many instances where we may decide not to claim the maximum CCA. We have the flexibility to make this decision each year.

CCPC: This is an acronym for Canadian Controlled Private Corporation. This term is defined in the Income Tax Act, and is one of the few tax terms which can be relatively well understood by the plain English meaning of the expression.

A CCPC is a corporation which is private (i.e. it does not have shares or debt that are listed on a stock exchange, and is not controlled by a public corporation). The corporation must also be controlled by Canadian resident shareholders. For this purpose, control is generally meant to mean possession of a majority of the votes to elect the Board of Directors. Other concepts do come into the concept of control, so it is clearly not as simple as it seems.

Whether or not a company is considered a CCPC is extremely important. CCPC's and shareholders who own shares of a CCPC are given a multitude of beneficial tax "breaks". CCPC's pay a low rate of tax on active business income and qualify for enriched R&D tax credits to name just two. Shareholders who own shares of a CCPC may be in a position to realize the $500,000 enhanced capital gains deduction on the sale of their shares, or may qualify for ABIL treatment if they lose money on their investment.

CDA: This is an acronym for Capital Dividend Account, which is defined in the Income Tax Act. The CDA is a concept which applies only to corporations. It is an account balance which can be used to pay tax-free dividends to a shareholder.

When an individual realizes a capital gain, only 1/2 of the capital gain is included in income, and the other 1/2 of the capital gain is never subject to tax. Similarly, when an individual realizes a capital loss, only 1/2 of the loss can be used by the individual to offset capital gains. When a corporation realizes a capital gain or loss, the same concept applies, and only 1/2 of the capital gain or loss is included in the corporation's taxable income or is eligible to be used to offset capital gains. That 1/2 portion of the capital gain which is not included in the corporation's income is added to the corporation's Capital Dividend Account. The 1/2 portion of the capital loss is deducted from the corporation's Capital Dividend Account. The corporation's Capital Dividend Account is therefore the sum of all of the non-taxable portions of capital gains that the corporation has realized, and is reduced by all of the non-included capital losses that the company has realized. The 1/2 inclusion rate applied to capital transactions has changed over the years. Depending on the year that the transaction would have occurred, the inclusion rate may have been 2/3rds (i.e. 1/3 of the capital gain or loss is included in the calculation of the CDA), or 3/4ths (i.e. 1/4 of the capital gain or loss is included in the calculation of the CDA). The Capital Dividend Account is also increased if the corporation has received life insurance proceeds, or if it has received a capital dividend from another corporation.

The Capital Dividend Account is not shown on a company's balance sheet, and it will not appear anywhere on the company's tax returns. It is a balance which must be calculated by looking to the company's past tax returns. Once the CDA is calculated, and assuming the balance is positive, a dividend can be paid to a shareholder and declared to be paid from the CDA. This dividend would be received tax-free by a Canadian resident shareholder. The payment of a capital dividend must be done in a specific manner, and requires an election form to be filed with the Canada Customs and Revenue Agency.

CNIL: Pronounced "Senile". This is an acronym for Cumulative Net Investment Loss, which is defined in the Income Tax Act. CNIL is a concept which applies only to individuals.

When an individual realizes a capital gain on shares of a qualified small business corporation, that gain may qualify for the $500,000 enhanced capital gains deduction. There are a number of tests which must be met before this can happen. Not only do the shares that are sold have to meet the very strict definition of qualified small business corporation, the individual must not have a CNIL balance.

The CNIL balance is the sum of an individual's investment expenses claimed from 1988 onward and is reduced by the sum of an individual's investment income from 1988 onward. Investment expenses include deductions claimed for interest expenses and investment counsel fees, rental losses, and limited partnership losses. Investment income includes interest income, dividend income, limited partnership income and net rental income.

The CNIL balance is important because an individual who has a CNIL balance will see their ability to use the $500,000 enhanced capital gains deduction reduced by the amount of their CNIL balance, even if they realize a capital gain which would otherwise qualify for the enhanced capital gains deduction.

Because the CNIL is a cumulative balance, it is possible that an individual may have a CNIL balance in one year, only to find it eliminated in a subsequent year if they generate investment income in that subsequent year.

Crystallization: This is a tax expression which is not defined in the Income Tax Act. A crystallization refers to a series of tax transactions which result in an individual triggering a gain or a loss on an asset.

In its most common form, crystallization refers to a series of transactions which are designed to utilize an individual's enhanced capital gains deduction. When an individual sells shares of a qualified small business corporation, the capital gain may qualify for the $750,000 capital gains deduction. The end result of this could be a significant reduction, or altogether elimination of tax on the sale of the shares. It is a very, very powerful tax incentive. However, there are many tests that need to be met in order for the gain to qualify for the enhanced capital gains deduction. An individual may hold shares of a corporation which have increased in value, and for which the gain may qualify for the enhanced capital gains deduction if they were to be sold today. However, the individual may not be in a position to sell those shares today, and there may be some real concerns that the gain will not qualify for the enhanced capital gains deduction when they are sold at a later date. In this case, it may be a good idea to "crystallize the capital gains deduction". The individual would undertake a series of steps which would trigger a gain on the shares in question, without actually giving up ownership of the shares. The gain which is triggered would be reported on the individual's personal tax return, and would be offset by the enhanced capital gains deduction. The series of transactions would increase the tax cost of the shares in question by the crystallized amount. When the shares are actually sold at a later date, the gain will not qualify for the enhanced capital gains deduction, but the amount of tax paid at that later date will be substantially reduced or eliminated because the tax cost of the shares would have already been increased as a result of the crystallization.

A crystallization may also refer to transactions which are designed to trigger capital losses on shares. If you have sold shares at a gain in the current year, and you continue to hold other shares which have decreased in value, you may want to sell those loss shares to trigger capital losses which will reduce or offset the gains. This would be an example of "crystallizing losses".

PUC: Pronounced "Puck". This is an acronym for Paid Up Capital. PUC is more of a legal concept, and although it is defined in the Income Tax Act, it is not well defined.

PUC is essentially the amount that was paid into a corporation as consideration for shares of the company. PUC is calculated on an averaged basis, and is calculated separately for each class of shares issued by a corporation. In it's simplest form, if I subscribe for 100 common shares of a company and pay $100 to the company for those shares, I will hold shares whose PUC is $1 per share. PUC is only calculated based on what is paid to the company for those shares. Continuing my example, if I sell 50 of those 100 common shares for $1,000 to someone else, the shares will still have a PUC of $1 per share since there would not have been any new money paid into the corporation as a result of my sale. If a new investor later subscribes for 100 additional common shares, and pays $5,000 into the company for those shares, the PUC of my shares will be affected. The company would have had issued a total of 200 shares for total consideration of $5,100. My 50 common shares would now have PUC of $25.50 per share.

PUC is important because it represents an amount that can be returned to a shareholder without incurring any tax. A company can pass a resolution and make a payment to a shareholder which represents a return of their PUC. When this happens, the shareholder will generally not pay any tax on the return of PUC. Similarly, when a company redeems its own shares (i.e. buys them back from a shareholder), the shareholder will only be taxable on the portion of the redemption proceeds that exceed the PUC of the shares which are redeemed.

RDTOH: An all-time favourite expression. It is an acronym for Refundable Dividend Tax On Hand, which is defined in the Income Tax Act. RDTOH is an expression that relates to corporations.

A corporation generally pays a low rate of tax on active business income. Investment income, on the other hand, is subject to a considerably higher rate of tax. Depending on the province in which the corporation operates and the year end of the corporation, this tax rate may be in the 50% range. When the company is a CCPC, it pays a high rate of tax on its investment income, but a portion of it is added to the RDTOH account. The refundable portion of tax is 26 2/3% , although the actual calculation is a bit more complex than that. Consider the example of an Ontario resident corporation which generates $1,000 of interest income. The corporation will pay a combined Federal and provincial tax rate of approximately 48%, but $266.67 will be added to the corporation's RDTOH balance. If the corporation pays a taxable dividend to its shareholders, the company will be refunded $1 out of its RDTOH balance for every $3 of dividends that it pays. This may actually provide the company with a Federal tax refund.

Consider the following example. A company has accumulated an RDTOH balance of $2,313 over its' existence. During the current year, the company pays a taxable dividend of $12,000. Because the company has an RDTOH balance, it is entitled to a dividend refund. The dividend refund is calculated on a 1:3 ratio. The $12,000 dividend paid by the company could result in a dividend refund of $4,000, but the dividend refund cannot be higher than the RDTOH balance itself. In this case, the $12,000 dividend would result in a dividend refund of $2,313 to the company. The dividend refund is only generated by taxable dividends. If the $12,000 dividend was paid by the company as a non-taxable dividend out of the CDA balance, it would not recover a dividend refund from its RDTOH balance.

Rollover: Rollover is a tax expression, and is not defined in the Income Tax Act. A rollover is any transaction which takes place on a tax-deferred basis.

Here are a few examples.

When an individual dies, all of their assets are disposed of at their fair market value for tax purposes, leading to a potentially significant tax liability. If the deceased's assets pass to their spouse on death, there is no fair market value deemed disposition. Instead, the assets pass to the surviving spouse at their tax cost, and no tax consequences result at death. The tax consequences are deferred and will only occur when the surviving spouse dies. This would be an example of a spousal rollover at death.

There are certain provisions of the Income Tax Act which allow assets to be transferred at their tax cost. Let's say that you personally own shares of a public company that you bought for $100, but which were now trading at $250. Section 85 of the Income Tax Act would allow you to transfer these shares to a Canadian corporation at their tax cost, allowing the shares to be disposed of without triggering a capital gain in your hands. The corporation would inherit your $100 ACB, and it would be the corporation which would realize the capital gain if the shares are sold for $250. This is an example of what we call a Section 85 rollover. Section 85 rollovers are relatively common, and are a powerful tool for reorganizing corporations and corporate structures without immediately triggering any tax.