The Canada Revenue Agency: protecting Canadians from gifting tax shelter schemes

Ottawa ON, October 30, 2012 - The Canada Revenue Agency (CRA) is taking steps to better inform and protect taxpayers from gifting tax shelter schemes.

This is the time of year when promoters are heavily marketing their tax schemes to Canadians. For this reason, the CRA is reminding Canadians that if it seems too good to be true, it probably is. If a tax shelter promoter offers a tax receipt for a larger amount than the donation or payment, it is very likely not a valid donation.

Starting with the 2012 tax year, the CRA will put on hold the assessment of returns for individuals where a taxpayer is claiming a credit by participating in a gifting tax shelter scheme. This will avoid the issuance of invalid refunds and discourage participation in these abusive schemes. Assessments and refunds will not proceed until the completion of the audit of the tax shelter, which may take up to two years. All gifting tax shelter schemes are audited and the CRA has not found any that comply with Canadian tax laws. A taxpayer whose return is on hold will be able to have their return assessed if they remove the claim for the gifting tax shelter receipt in question.

The CRA has to date denied more than $5.5 billion in donation claims and reassessed over 167,000 taxpayers who participated in gifting tax shelter schemes. In addition, the CRA has revoked the charitable status of 44 charitable organizations that participated in these gifting tax shelter schemes. Since June 2000, the CRA has also assessed $63.5 million in third-party penalties against promoters and tax preparers.

The CRA urges Canadians who are considering entering into a tax shelter arrangement to obtain independent, professional advice before signing any documents. Independent advice means advice from a tax professional who is not connected to the tax shelter or to the promoter.

Corporate Directors on the Firing Line

The board of directors, which once seemed above the fray, is increasingly in the thick of it—fending off everything from bad publicity to nasty lawsuits.

By Philippa Maister - Corporate Counsel, July 9th 2012.

"The buck stops here."

It's a phrase immortalized by a sign on the desk of President Harry Truman, and it's often associated with the willingness of chief executives to accept responsibility for the performance of their companies. These days, however, the buck is often landing on the conference table where the board of directors sits. And the results aren't always pretty.

Consider recent events at Yahoo! Inc. In May the Sunnyvale, California–based Internet services company announced the resignation of CEO Scott Thompson, after just five months on the job. Third Point, a hedge fund that holds a substantial chunk of Yahoo's stock, had notified the board 10 days earlier that Thompson had misstated his academic credentials. He held a bachelor's degree in accounting, but had not completed a second in computer science, as he'd claimed—and as a simple Google search would have revealed, the fund's letter stated. Beyond the false credentials, Third Point said in a letter filed with the Securities and Exchange Commission that "shareholders must also question how the board of directors, specifically the search committee chaired by Ms. Patti Hart, could permit the company to hire a CEO with this discrepancy in the public record."

Third Point then turned its attention to Hart herself. The director, who chaired Yahoo's nominating and corporate governance committee, and was a member of its audit and finance committee, claimed to hold a degree in marketing and economics. Yet, Third Point noted, her degree was actually in business administration.

The hedge fund, which had been engaged in a no-holds-barred proxy fight to nominate its own slate of directors to Yahoo's board, won a complete coup. After Thompson left, Yahoo and Third Point agreed to a settlement. The company appointed three Third Point nominees to its board, while five Yahoo directors resigned immediately.

One of them was Hart. She said that her decision to resign was made at the request of the board of International Game Technology, where she is CEO. Embarrassingly, IGT's chairman, Philip Satre, was forced to issue a statement that his board "unanimously stands behind Patti as our CEO," and had found "no material inconsistencies in Patti Hart's academic credentials." (Hart did not respond to a request for comment.)

And all this occurred just a few months after Carol Bartz, Thompson's predecessor, told Fortune magazine, after she was fired, that Yahoo's directors were "doofuses."

Doofuses? Once upon a time, directors lived in a kinder, gentler world. They got paid for meeting a few times a year with their friends and listening to the company's officers tell them what to do. It was all very chummy and exclusive, and they didn't have to worry about nasty comments in the press—at least not about them. Or so it seemed.

These days, in a time of economic uncertainty and fraying public confidence in the integrity of business leaders, directors face challenges from myriad sources. Boards are expected to question management, play an active role in overseeing corporate strategy, have a role in risk oversight, and ensure that executive pay matches performance. The role of lead director has been created to provide leadership to other independent directors and counterbalance the weight of the CEO.
Increasingly, directors find themselves in the firing line. Activist shareholders have a greater voice in corporate decisions. Litigation seems to be a constant threat: Class action lawyers launch investigations into big mergers even before a plaintiff shows up. Regulators are stepping up enforcement. And generous incentives for whistle-blowers under Dodd-Frank are bringing tales of hidden misconduct to light.

In this environment, there's a risk that directors may be tempted to shirk tough decisions because they're looking over their shoulders at the potential fallout. Or they'll simply bail out.

continue reading this article at http://www.law.com/jsp/cc/PubArticleCC.jsp?id=1341133331503&thepage=2 

BDC Perspective: Subordinate financing - a lesser known financing alternative

You may have heard it called "mezzanine financing", "junior debt", "structured equity" or "quasi-equity financing" but as Anthony Esposti, Manager of Subordinate Financing at BDC explains, the myriad of names all share a common principal - subordinate financing is basically a hybrid of debt and equity financing.

"It shares some of the characteristics of debt financing because the borrower has the obligation to repay," emphasizes Esposti. On the other hand, subordinate financing also mimics equity financing because repayment is based on cash flow rather than depreciating company assets. "What's important to remember is that the word "subordinate" basically refers to the fact that the security of BDC, for example, ranks behind or is secondary to senior lenders." Ultimately, the risk is shared.
So what's the key advantage of this type of financing for a small or medium-sized business? "Subordinate financing provides the capital necessary for a business to fuel its growth or secure its continuity. Repayment is not based on diminishing asset value but more on cash flow potential." emphasizes Esposti.

Expected cost
Entrepreneurs can expect part of the cost to be in the form of fixed interest, which is a deductible expense. The remaining cost comes in the form of a variable component such as a royalty, bonus payments or options to purchase shares in the company at a discount. "It's a higher risk so naturally a investor is looking for a higher return," he says.

Right now, if you're considering subordinate financing as an option, Esposti believes that talking to organizations such as BDC is important. "The industry is typically focused on larger transactions at $5 million and over. The Business Development Bank is a dominant player in the market for smaller transactions under $3,000,000," he says. "As Canada's small business bank, we truly understand the needs of SMEs."

Who's eligible?
Essentially, BDC would consider a small or medium sized business eligible if they have a sound management team, a record of profitability and an established line of credit. This means that start-ups are not considered for subordinate financing "We're looking for companies that have a proven track record and want to move to the next level."

However, he emphasizes that subordinate financing is not a formula-driven solution and can be customized to specific needs, depending on factors such as business seasonality, working capital requirements and the repayment structure. "The first step is to sit down with your lender, bring in your transaction and explain exactly what you're looking for. After that, a customized deal can be worked out," he says.

Typical investment scenarios
So what are the most typical scenarios when lenders consider subordinate financing as an option?

Management buy-outs/buy-ins
With an aging population, many 50+ business owners are looking for ways to exit their companies. Subordinate financing can provide the necessary funds for an existing management team to invest in the company. "Basically, we're helping entrepreneurs fill the financing gap in a transaction ," says Esposti.

CASE
Company X is an insurance adjuster in business since 1986, one of the fourth largest in Canada, showing $22 million in sales and very profitable. 14 senior managers in the company want to buyout owners who are 60+ and are looking to retire. The lender structured a deal that involved an equity injection by the new owners, a loan provided by the exiting owner and subordinate financing to round out the financing.

Mergers & Acquisitions
Mergers & Acquisitions naturally involve both fixed assets and more difficult-to-finance and intangible assets such as "goodwill." Subordinate financing can help companies purchase the goodwill while preserving their cash flow during a period where some uncertainty may exist.

CASE
An online research company has been in business since 1973 but has postponed its IPO due to market conditions. The company has expanded into the US and acquired businesses that will drive 25% growth over the next two years. The company has proven profitability, a strong management team and is a market leader with consistently retained earnings. The deal involves subordinate financing with payment at maturity, allowing the business to preserve cash flow.

Working capital for growth
Subordinate financing is often used to finance working capital for growth, which enables companies to increase revenues and profits. Entrepreneurs looking to invest money in market penetration, improve product R &D or finance additional headcount can take advantage of subordinate financing without compromising their regular cash flow used for daily operations.

CASE
A hardware company in business since 1981 has recently completed development of a proprietary technology. Financing was needed to help the company market this technology to existing clients and a broader market. This business needed to react to the market on a timely basis and to pre-build a one-month inventory of its products. The subordinate financing deal enabled this company to do just that.

Looking to buy a business: Know what you're buying...

Before purchasing a business, you need to be sure you understand exactly what you're buying. That can be difficult. Valuating a business is not a simple exercise or an exact science. It simply provides a theoretical figure that will give you an idea of a fair price to pay.

Perform due diligence
The first thing to do when considering purchasing a company is to assess its financial statements, legal status and assets, including inventory, equipment and accounts receivable. You should use the services of in-house and outside experts to do this.

You should also confirm the vendor's good faith and the soundness of the business. If most of its sales are generated by only a few customers, for instance, you will need to confirm that they intend to continue doing business with the firm once you have acquired it.

You must also take into account any changes you intend to make to the company after acquiring it. No matter how essential these changes may be, keep in mind that their cost may substantially reduce the return on the capital you have invested.

Evaluating assets
The vendor should supply you with a detailed list of what is up for sale. These assets may include land, buildings, equipment, inventory, the name of the business, its customer list and any contracts it has with employees and suppliers, as well as prepaid expenses and intellectual property.

When assessing the value of a company's equipment, make sure you have model numbers, dates of purchase and a record of how well the machinery is working, along with maintenance schedules and warranty details. When appraising inventory, check the age and condition of the stock. Are any of these items obsolete? If they're perishable, are they still well within their best-before date? When assessing accounts receivable, you'll need to determine how likely it is the amounts owing will be repaid. Are the receivables old? Are they collectible? Has adequate provision been made for bad debts? Are there any disputes involved?

Company liabilities
Depending on the nature of the assets, a company's loans or unpaid liabilities may become your responsibility as a buyer. A previous lender might even be in a position to seize the company's assets as repayment for an unpaid loan, leaving you with nothing. You need to know if the company has signed agreements that might lower the value of the assets or limit your freedom of action.

Determining fair market value (FMV)
There are a number of ways to determine an asset's fair market value. A specialist's appraisal may be needed for assets such as real estate, major equipment or specialized inventory. Likewise, a collection agency can help you evaluate the true value of accounts receivable, especially when assessing a company with many customer accounts.

Never rely only on the judgment of your accountant or the seller. It's always best to obtain an independent report from an expert specializing in business valuations. This is an unregulated field, but the Canadian Institute of Chartered Business Valuators provides guidelines and a code of ethics.

There are two main methods of valuating a business: one based on assets, the other on earnings and cash flow. An asset-based valuation can be based either on its book value - the company's assets minus its liabilities, as shown in financial statements - or its liquidation value: what a business could expect to fetch if it sold all its assets, paid down all debts including taxes, and then distributed the surplus to shareholders. An earnings-based valuation looks more closely at a company's current and projected future cash flow.

Although it's ideal to try to compare your potential acquisition with a similar transaction, in reality you will rarely be able to do this. In general, little information on such deals is publicly available, and the terms of any deal are often too closely tied to conditions in a particular economic sector to make them truly comparable.

Implications of buying shares
Anyone buying shares in a company takes a stake in the business, together with all of its assets and liabilities, whether they are recorded on the company books or not. A purchase agreement can include a provision that involves a buyer directly in the management of the company, or the purchaser can remain a silent partner. This latter option can smooth the transition between owners, lowering the price paid by the purchaser and allowing existing owners to show buyers how a business is run. The purchaser sometimes has the option of buying out the remaining shares and becoming sole owner later. Such a scenario is more likely if the target business is publicly traded and if the buyer has purchased enough shares to have some influence on how it is run. If a business is privately owned, the owners may prefer an outright sale.

There are always risks. Deals like these can sour if the buyer does not get along with the original owners or if the new and original owners have conflicting strategies. A purchaser may also unwittingly become responsible for liabilities such as unrecorded income tax reassessments, lawsuits and warranty claims that were not recorded in the financial statements. The new owner should also avoid being bound by the previous owner's depreciation schedules, which can be altered based on the purchase price.

Business valuation 101

How do I go about evaluating the asking price of an existing business?

No 2 valuations are the same, even for companies in the same industry. Unfortunately, there is no table of factors based on company size, profits and industry.

First, you will need to be clear on your definition of revenue versus profits. Revenue refers to gross sales before deducting any expenses, and net profits or net earnings represent what is left after deducting all the expenses of earning that revenue. When valuing a business as a going concern, one of the most important factors is calculating normalized net profits or net earnings.

There are 2 basic methods of valuing a business: breakup value and going concern value.

Breakup value is calculated by taking the current market value of all assets of the business, then deducting the liabilities and reasonable liquidation fees. The resulting value is what you would end up with if you sold off the assets and paid off all the liabilities. That is the value of the business on a "breakup" basis.

Going concern value is arrived at through a rather complicated process. This involves "normalizing" earnings, eliminating the impact of assets or revenue streams that do not form part of the core asset base or main revenue stream of the business. These assets and ancillary revenue streams are valued separately. Appropriate capitalization rates reflect reasonable levels of risk given the nature of the business.

The basic question to be answered in valuing a business is, "How much am I willing to pay someone for a business if in paying that amount, I will receive a stream of future income from that business of $X annually?"

In determining this value, review the historical earnings stream, adjusting for the financial impact of unusual events such as a one-time windfall profit or an unusually large non-recurring expense. Common adjustments may also be required to reflect such things as "normal" wages of the management, reflecting what the business would have to pay in wages if it had hired a manager at market rates.

Once you have determined what the "normalized" future earnings would likely be, based on historical data and trends, select an appropriate capitalization rate. Consider the level of risk associated with the business and the rates of return on other types of investments. To put this range into perspective, look up the current payout rate for Guaranteed Investment Contracts (GICs), which are risk-free and can be cashed in at any time. Compare that to venture capitalists who require annual compound rates of return in the 25% to 30% range, since they typically invest in high-risk, high-return businesses by way of unsecured equity investments. Somewhere between these 2 ranges is where most businesses fall.

Before making a commitment on this purchase, you should seek the advice of your accountant and a chartered business valuator (CBV).

General aspects to consider before acquiring a business

What are some of the most important aspects to look for in buying a business?

The guiding principles of acquisition are called synergies, value and equilibrium. Synergies must occur between the 2 companies that are merging or between the buyer and the company being acquired. Ideally the companies that are merging should have similar or complementary product or service lines, and their marketing and sales methods should be in harmony.

There are 3 areas where synergies should occur:

• Marketing and sales (new products and services, new clients or new markets should create more revenues)
• Operations (there should be volume discounts or better ways and means to create and deliver products and services, or both)
• Finance and administration (the merger or acquisition should improve cash flow and fuel additional business projects)

If there are no synergies, there should be no acquisition. Value, meanwhile, is the capacity to generate profits and cash flow. Profits and cash flow create value and support growth: profits generate equity that increases value, and cash flow builds working capital and strengthens the day-to-day operations.

A business that cannot create value should not be acquired.

Equilibrium is striking the right balance. With regard to synergies, the acquisition should be feasible operationally and financially. In other words, a very small company should not acquire a very large company, and a company that manufactures widgets should probably not acquire a company that manufactures clothing. Another kind of equilibrium is in the potential to create value: the investor should be able to add value to the company being acquired and vice versa.

An acquisition that is not in equilibrium with positive synergies and value should not be made.

Question & Answer: Acquiring a franchised business

QUESTION:

We're looking to acquire a franchised business. Any tips or due diligence processes that may vary from acquiring a non-franchised business?
ANSWER:

The due diligence is the same for any other comparable business; however, the following are some franchise-specific issues.

You will want to thoroughly review the franchise agreement, and you should also have it reviewed by a good business lawyer who specializes in franchises.

Before thinking about signing a franchising contract, you should be able to answer the following questions:
Does the franchisee have an exclusive territory?

• Is the franchise transferable? How long is left on the existing franchise agreement?
• Is the franchise renewable? For how long?
• Is it renewable at the franchisor's or the franchisee's option?
• What am I getting for the franchise fee? Accounting systems? Operating systems? Lower prices on supplies?
• What exactly am I buying? Am I buying the right to use the name? Is the building part of the deal, and do I own the real estate? Will I be paying rent?

Confirm that the current franchisee is in good standing with the franchisor, and talk to other franchisees within the group to ensure that there are no hidden issues with the franchisor.   Franchise law is complex and we recommend that you contact HazloLaw to seek proper advice before signing any documents.

Tax Tips: Addressing myths about CRA online filing

Did you know?

Many of the ideas floating around about filing online are actually not true.

There are so many great reasons to file your income tax and benefit return over the Internet–more than half of the returns that come in to the Canada Revenue Agency (CRA) arrive electronically. Canadians know how easy, simple, and fast it is to file online, plus they get their refunds faster.

Why are some returns still coming in on paper? Here's a common myth:

"If I file online, I am more likely to be audited."

Not true. When you file online, the CRA may request a copy of one or more of your receipts to support the claims on your return. This is a routine verification, not an audit. When the CRA flags a file for audit, the criteria are broad, complex, and not based on filing method.

Home owners – don't forget claim your tax credits

Did you know?

Home owners may benefit from certain non-refundable tax credits when filing their income tax and benefit return.

Important facts

First-time home buyer's tax credit: If you are a first-time home buyer, a person with a disability buying a home, or an individual buying a home on behalf of a related person with a disability, you may be able to claim a non-refundable tax credit of up to $750 when you buy a qualifying home.

• Non-refundable tax credits can only be used to reduce your federal income tax payable. If the total of your non-refundable tax credits is more than your federal income tax payable, you will not receive a refund for the difference.
• Other credits and deductions may be available to you. For more information, go to www.cra.gc.ca/myhome.

The CRA's online services make filing even easier

With the CRA's online services you can file your return, track your refund, and change your personal information. You can also sign up for direct deposit to receive your refund in your account at your Canadian financial institution – no more waiting for cheques to arrive in the mail. It's fast, easy, and secure. For more information, go to www.cra.gc.ca/getready.

Business Owners: Why you MUST have a Holding Company (Holdco)

Today, I would like to share an excellent article written by Tim Cesnick, clearly explaining the advantages of Holding Companies.  At HazloLaw, we advise clients on a daily basis about the necessity of putting in place this type of structure and we also suggest to add a Family Trust to your current structure.  Please email us at info@hazlolaw.com is you have any questions.
HOLDING COMPANY
This summer when you're standing around the barbecue with your business-owner neighbours, impress them with your knowledge of tax planning.

I can tell you from experience that you'll bore them to tears with the conversation, but they'll thank you later when the tax savings start rolling in. Specifically, share with them that holding companies can help them to defer tax. Here are the highlights.

THE RULES

If you happen to own a corporation that carries on an active business, give some thought to setting up your affairs to allow for a deferral of tax.

How? By establishing a holding company to own the shares of your active business corporation (ABC).

You see, if you own the shares of your ABC directly, then any payment of dividends from that corporation to you will be taxable in your hands personally in the year you receive those dividends.

If, on the other hand, you have a personal holding company that owns your shares in your ABC, you can pay a dividend to your holding company that will, in most cases, be tax free to your holding company.

It's subsection 112(1) of our tax law that allows, in most cases, your holding company to claim a deduction for taxable dividends received from your ABC. And, as long as your holding company and ABC are "connected" under our tax law (which will be the case in the vast majority of situations), you'll avoid another tax called the Part Four tax.

By passing some of those earnings from your ABC to your holding company, you'll defer tax, which is essentially the difference between the tax paid by your ABC on its profits, and the amount of tax you would have paid had the profits been paid out immediately to you as a bonus.

The tax deferred is approximately 30 per cent of the taxable income in most provinces for someone in the highest tax bracket.

THE STRATEGIES

What strategies should you be thinking about?

Multiple shareholders: If you're one of multiple shareholders in your ABC, setting up a personal holding company for each shareholder can provide flexibility to each of you.

Think of each holding company as a tap to control the payment of dividends to each of you personally.

Your ABC can pay dividends to each of the holding companies on a tax-free basis, and then each holding company can pay dividends to its shareholders based on his or her personal cash requirements.

Splitting income: Your holding company can be owned by more than one person in the family.

Your spouse, for example, could own some shares. This will allow you to sprinkle dividends to your spouse or others in the family so that the tax burden on those dividends can be shared.

It's not always advisable to issue shares in the holding company directly to your children (and if they're minors, this isn't possible), and so a family trust can be utilized, which brings me to the next strategy.

Establish a trust: I really like this structure. The shares of your ABC can be held by a family trust.

The beneficiaries of the trust will include you, your spouse, your children (regardless of their age), and your holding company.

Now, any dividends paid by your ABC to the trust can be distributed out to your holding company as a beneficiary of the trust, and you'll achieve the same tax-free payment to the holding company as you would achieve if the holding company owned the shares in the ABC directly, provided the two companies are "connected."

The advantages, however, include: The ability to sprinkle dividends to family members or the holding company as beneficiaries of the trust, at your discretion; the ability to multiply the lifetime capital gains exemption on a sale of the shares of your ABC (assuming the shares qualify for the exemption); creditor protection over the property of the trust, including the shares of the ABC, among other benefits.

Protection from creditors: Any excess profits of your ABC can be paid to your holding company as dividends, and can be lent back to your operating business on a secured basis, if the cash is needed for the business. This will protect those excess profits from other creditors of the business.

Retirement nest egg: The accumulation of assets inside your holding company can become the type of retirement nest egg or "pension" that you will need to look after yourself during retirement.

Top 10 ways to reduce your tax bill

Did you know?

There are a number of ways to reduce the amount of tax you owe and keep more money in your pocket at tax time. The Canada Revenue Agency (CRA) website can help you learn more about the various credits and deductions that you may be entitled to and that can save you money when you file your 2011 income tax and benefit return.

Important facts

For individuals:

1. Plan ahead - Go on CRA's website and Register for My Account, gather your receipts and NETFILE access code, and sign up for direct deposit before April 30. Submitting your income tax and benefit return before the tax-filing deadline means you can avoid having to pay late-filing penalties.

2. Families - Save those receipts! All the activities you have been paying for throughout the year (piano, karate, tutoring, hockey, and more) may save you money at tax time.

3. Tax-free savings account - A tax-free savings account (TFSA) is one great way to save money since you don't pay tax on any income you earn from investments in your TFSA.

4. Registered retirement savings plan - Any income that you earn in a registered retirement savings plan (RRSP) is exempt from tax, as long as the funds stay in the plan. RRSPs help you save for your retirement and give you a break at tax time too.

5. Public transit tax credit - If you or someone in your family is a regular user of public transit, then you may be able to claim a non-refundable tax credit based on the cost of eligible transit passes.

6. Pension income splitting - If you receive income from a pension, you can split up to 50% of eligible pension income with your spouse or common-law partner to reduce the taxes that you pay.

7. Students - Are you still in school? Students can claim the tuition, education, and textbook amounts. Have you graduated recently? You may be eligible to claim the interest that you paid on your student loans.

8. Child care expenses - If you have children, you may be able to claim child care expenses that you or your spouse or common-law partner paid so that either of you could work, do research, or go to school.

9. Home buyer's tax credit - If you're a first-time home buyer you may be eligible to claim $5,000 on the purchase of your new home, which can save you up to $750.

For people who are self-employed:

10. Hiring an apprentice - Did your business employ an apprentice? A salary paid to an employee registered in a prescribed trade in the first two years of his or her apprenticeship contract qualifies for a non-refundable tax credit for the employer.

Tax Tip: Lean more about potential tax savings for tradespersons

Did you know?

As a tradesperson, you may be eligible for certain deductions.

Important facts

If you were a tradesperson in 2011, you may be able to claim a deduction for the cost of eligible tools (to a maximum of $500). For more information, go to www.cra.gc.ca/trades.

You can claim certain expenses you paid to earn employment income as a deduction, but only if your employment contract required you to pay for your own expenses, and either you did not receive an allowance for them or the allowance you received is included in your income. For more information, go to www.cra.gc.ca/employmentexpenses.

If you had expenses that included GST/HST in the course of your employment duties, and you deducted these expenses from your employment income, you may be able to claim a rebate of part or all of the GST/HST you paid on these expenses.

Keep all receipts and documentation to support the claims made on your return.

The deadline for filing your individual income tax and benefit return is midnight on April 30, 2012. However, if you or your spouse or common-law partner carried on a business in 2011, you have until June 15, 2012, to file your return. You must pay any balance owing for 2011 on or before April 30, 2012, regardless of your filing due date. In addition to these deductions, other credits, deductions, and benefits may be available to you. For more information, go to www.cra.gc.ca/trades.

Business Owners: The cold hard logic behind freezing your assets or Estate Freeze 101

The cold hard logic behind freezing your assets - written by Tim Cesnick and published in the Globe and Mail.

Paul is a close friend of mine. We don’t see each other often enough, but we got together for lunch this week. “Tim, I’m freezing my assets,” Paul said. For a minute, I was wondering if Paul was making a commentary on the sub-zero temperatures we’ve been experiencing. But that wasn’t it. Paul was actually freezing his assets. And I’m not talking about the fact that he left his lawn furniture and lawn mower out in the backyard this year to face the elements rather than putting those things away for the winter (he says he got busy and forgot).

 

No. Paul has decided to implement a tax manoeuvre called an “estate freeze.” Although it’s possible to “freeze” most assets, this is most commonly done by those who own shares in a private company and want to accomplish a few things. Let me explain.

The concept
Completing an estate freeze involves identifying certain assets – perhaps private company shares – and freezing those assets at their current value. When this is done, the future growth in value of those assets won’t accrue to you (the person completing the freeze), but will belong to others who you have chosen to receive that future growth. There are a number of benefits to this idea, but most notably you’ll pass the tax bill on that future growth to others. That is, you will have “capped” your tax liability on the assets frozen at today’s value.

The example

Paul owns the shares of a corporation that holds rental properties that he’s been accumulating over the years. The value of these properties is about $5-million today (net of any mortgages). He expects these properties to continue to grow in value in the future. Paul doesn’t need the income from these properties to support his lifestyle.

When Paul passes away, there’s going to be a tax bill owing on the shares of his corporation. After all, the shares are worth $5-million today (since the properties owned by the corporation are worth $5-million), but his adjusted cost base of his shares is nominal, at $100. In this case, Paul will owe about $1,160,227 in taxes upon death (he lives in Ontario and is in the highest tax bracket).
As the value of the properties grows, so will Paul’s expected tax bill on death. Paul decided to cap this tax liability by completing an estate freeze. How? Paul is going to exchange his common shares that he owns in his corporation for new preferred shares that are fixed, or frozen, in value (this exchange can take place without tax at the time of the exchange). These shares won’t appreciate in value as the properties grow in the future. Paul is going to issue new common shares in the corporation to his children. The future growth of the company will accrue to these common shares.
In actual fact, Paul isn’t going to issue the new common shares to his kids directly (although he could), but has decided to issue those shares to a family trust of which the kids are beneficiaries. This will allow Paul to continue to control those shares (as trustee of the trust) for the time being. He can distribute those shares out of the trust to the kids in the future if he chooses (this distribution can generally be done on a tax-free basis). But there are real benefits to having the trust in place to hold the shares today, including the ability to split income with the beneficiaries of the trust.

The nuances

Now, there’s more than one way to accomplish an estate freeze. Exchanging shares in an existing corporation for new frozen shares, as Paul is planning, is one method. It’s also possible in most cases to take assets that are currently outside of a corporation and transfer those assets to a corporation and take back, in exchange, shares in the corporation that are frozen in value. It may also be possible to place assets directly in a trust (without use of a corporation) so that the future growth will accrue to the beneficiaries, but this method may trigger a tax bill when transferring the assets to the trust if those assets have appreciated in value (in which case a corporation is likely the better route).
Freezing your assets won’t eliminate the tax bill that has accrued to date on those assets, but will stop the bleeding by passing the future growth to others who will likely pay the tax on that growth at a much later date than you. More on this topic next week.

Tim Cestnick is president and CEO of WaterStreet Family Wealth Counsel and author of 101 Tax Secrets for Canadians.

Holding Company (Holdco): What Is It and How Does it Work?

Below is a great article written by Rolland Vaive, CA, TEP, CPA www.taxadvice.ca - An excellent accountant based in Ottawa and specializing in complicated tax matters.

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Speak to any tax accountant for more than a minute and they'll surely be talking about holding companies, or HoldCo's for short.

A holding company is not a term which is defined in the Income Tax Act. It is a term which is used to define a corporation which holds assets, most often income generating investment assets. It does not typically carry on any active business operations.

A HoldCo can arise for a variety of reasons. In the early 1990's, the personal marginal tax rate in Ontario was slightly higher than 53%, while the corporate rate of tax was considerably lower than that. High income individuals who had significant investment assets could realize a tax deferral by transferring their investment assets to a HoldCo, particularly in situations where they did not need the income which was being generated by the investments. This breakdown between the corporate rate of tax and the personal rate of tax lead to many HoldCo's being formed.

HoldCo's may also come about as an effective means of creditor proofing profitable operating companies, as a result of Canadian estate planning, or as a means of avoiding U.S. estate tax and Ontario probate fees.

Regardless of their origins, the investment income generating HoldCo is taxed in an unusual manner, which I will attempt to explain.

The underlying concept of HoldCo taxation is called "integration". In general terms, integration means that an individual should pay the same amount of tax on investment income if they earned it personally or if they earned it through a corporation and withdrew the after-tax income in the form of dividends. When we look at some real numbers, you will see that this in fact generally holds true. However, it is possible to exploit some breakdowns in integration, at which time it may become quite beneficial to earn your investment income through a HoldCo.

Let's look at the theory. We often hear about how corporations are taxed at low tax rates. In situations where a private company is earning income from active business operations carried on in Canada, that is quite true. In these situations, the rate of tax would be a flat tax rate of 18.620% if the company was resident in Ontario. The other provinces have similarly low rates of tax on "active business income". The low rate of tax does not apply to investment income, which is what the HoldCo would be generating.

For an Ontario resident private company generating investment income, the combined Federal and Provincial rate of tax would be a flat 49.7867% on all forms of investment income, other than dividends from other Canadian corporations. Bear in mind that only 1/2 of capital gains are included in income, so the effective corporate rate of tax on capital gains would be 24.8934%.

A portion of the tax that HoldCo pays each year on its' investment income goes into a notional pool called the RDTOH pool. This is an acronym for "refundable dividend tax on hand". Of the 49% rate of tax that is paid by the corporation, 26.67% will go into the RDTOH pool each year and is tracked on the corporation's Federal tax return. If HoldCo pays a taxable dividend to its' shareholders in a particular year, it gets back part of its RDTOH pool. More specifically, the company will get back $1 for every $3 of dividends that it pays. This RDTOH recovery is called a dividend refund, and would be a direct reduction of the corporation's tax liability for the year. If the corporation pays a large dividend to a shareholder, the dividend refund would also be large and may result in the company actually getting money back from the Canada Revenue Agency. In short, the HoldCo will pay a large tax liability on its investment income up front, but it can get a large portion of it back at a later date if it pays out dividends. The dividend refund is an attempt to compensate for the fact that the dividend will attract tax in the hands of the shareholder. Without this mechanism, the 48% rate of tax on investment income combined with the tax paid by the shareholder on the dividend that they receive would result in an onerous rate of tax.

It is possible that a second notional tax pool may arise in HoldCo if it is generating capital gains on its' investment assets. You will recall that only 1/2 of capital gains are included in income. The other 1/2 portion of the capital gain which is not included in income will get added to the capital dividend account, or "CDA", of HoldCo. The CDA balance is something which needs to get tracked by the company on a regular basis, since it does not appear anywhere on the company's financial statements or tax returns. The CDA is important because it is possible for HoldCo to pay a dividend to a shareholder and elect to pay it out of the CDA balance, making the dividend tax-free to the shareholder. If a company realizes a capital gain of $10,000 , only $5,000 will be included in taxable income, with the remaining $5,000 being added to the company's CDA balance. The company could then pay a $5,000 dividend to the shareholder. By electing to do so out of the CDA balance, the shareholder would not be taxed on the dividend.

Lets look at this in conjunction with the RDTOH balance. If the company pas a dividend to a shareholder out of the CDA balance, it is tax free to the shareholder, but it is not going to generate a dividend refund to HoldCo. HoldCo only gets a dividend refund if the dividend is a taxable dividend to the shareholder.

Armed with this theory, we can look at a live example of how this would work. Lets consider the example of an Ontario resident individual who is holding shares that have an adjusted cost base (i.e. tax cost) of $1,000. These shares have experienced a dramatic increase in value, and are now worth $100,000. The individual is going to sell these shares and would like to know if there is any advantage to doing so through a HoldCo. The individual is in the highest marginal tax rate (currently 31.310 % on Canadian source dividends and 46.410 % on everything else). The individual wants the after tax money, so they would withdraw everything from the HoldCo once the shares are sold. If they were to go the HoldCo route, they would elect to transfer their shares to HoldCo at their $1,000 tax cost prior to the sale (to transfer them at fair market value would defeat the purpose), and would have the capital gain realized within HoldCo. In the process of transferring the shares to HoldCo, they could arrange to have HoldCo issue a note payable to them equal to their original $1,000 tax cost.

Integration tells us that selling the shares through a HoldCo should give us the same result as selling the shares personally. If the individual wants to get the money out of the HoldCo following the sale of the shares, they would elect to take part of the proceeds from the share sale out of HoldCo as a non-taxable repayment of their $1,000 note and as a non-taxable payment our of the CDA balance. The remaining cash would be withdrawn from the company as a taxable dividend, leading to a dividend refund in HoldCo.

As this example illustrates, there is no advantage to using the HoldCo to sell the shares even without considering the professional fees associated with the HoldCo. So why do it?

Well, there may be some good reasons for doing it. Firstly, the example assumes that the individual withdraws all of the cash from HoldCo in the year of the share sale, and at a time when they are in the highest marginal tax rate. If the cash from the sale was left in the corporation and withdrawn as a dividend a year or two later when the individual was not in the highest marginal tax rate, then the results may be quite good. The HoldCo would get the dividend refund at a rate of $1 for every $3 of dividends in that later year when the dividend is paid, and the shareholder may not incur a significant tax liability on the dividend that he or she receives.

Alternatively, it may be possible to transfer the shares to HoldCo well before a sale is to happen. In this way, future growth in the value of the shares could be shifted to other family members. When the shares are sold, the growth in value since the time of the transfer could be paid as a dividend to these other family members. If these family members are in a low marginal tax rate, they would not incur much tax on the dividend, and the results could be quite good when compared to the alternative where the shares continue to be held by the individual and sold by him or her personally.

There are a host of issues to be considered before embarking on such an exercise, including the corporate attribution rules and the tax on split income to name but a few.

As always, seek professional advice before undertaking any steps and do not hesitate to contact me should you have any questions.

The 21-Year Rule is Taxing on Family Trusts

Family trusts are popular estate and succession planning vehicles for good reason: they can be versatile and effective tools to help manage family wealth and taxes.

But many Canadian family trusts are now well into their second decade and need attention to avoid significant—even devastating—tax bills triggered by the Income Tax Act’s “21-year rule.” “This rule,” says Angela Ross, associate partner, tax services, PwC, “states in general that any family trust, whether it is created during someone’s lifetime or on the death of a person, has to treat itself as having disposed of its property every 21 years.”

In Canada, when someone dies, they are seen as having disposed of their property (except property left to their spouse) at fair market value and their estate pays taxes on any gains realized on that property. Any property then acquired by their child will again be deemed disposed on the death of that child. Were it not for the “21-year rule,” a family trust could hold property for multiple generations without ever incurring tax on the death of a generation.

So every 21 years in a family trust’s “life,” the CRA looks at the property in a trust as if it were the property of someone who had just died. “When the 21 years are up, if the trust holds property on that date, it is deemed to have disposed of the property at its current market value and has to pay taxes on it. Say the trust owns property that had an original cost of $10 but its value on the 21-year anniversary is $100. That trust will be deemed to have realized a $90 capital gain.” As we enter 2011, many Canadian family trusts are approaching the 21st anniversary of their creation and families need to be aware that in most cases, with proper, advanced planning, steps can be taken to defer the tax.

“A trust can generally transfer its assets to Canadian resident beneficiaries on a tax-deferred basis prior to the 21-year anniversary, meaning it can transfer its assets to beneficiaries without triggering the tax on the gain,” says Ross. “So if the trust owns property with a cost of $10, and at 20 years, its fair market value is $100, the trust can transfer the entire asset to its Canadian resident beneficiaries at its $10 price. The trust disposition would reflect $10 of proceeds and not the $90 gain. The taxes on the $90 capital gain can be deferred until that beneficiary sells or dies.” Ross advises family trusts to begin planning for the transfer at least a year in advance of the 21-year anniversary—although in more complex cases two or more years will be needed.

Some important points to keep in mind include: With the exception of Canadian real estate held in a trust, the general rule is you can’t transfer the trust’s assets at cost to beneficiaries who are not Canadian residents. But even if you have non-Canadian resident beneficiaries, depending on the terms of the trust and situation, it may be possible to do some planning to get the assets out for the benefit of that non-resident. It can be very complicated, so start early.

If timed properly and you have the right tax scenario, you can transfer the trust’s assets to grandchildren rather than your children and thus defer the taxes for another generation. In the case of a family trust owning a business that is transferring shares to children or grandchildren, it’s prudent to have a shareholders’ agreement in place before the children or grandchildren receive the shares.

Even if your family trust is nowhere near 21 years old, having it reviewed carefully by an expert now can be a smart move. “There are a few provisions in the Tax Act that could prevent you from doing the rollout before 21 years,” says Ross.

“Most important is 75(2)—the revocable trust provision. It applies if the trust received property from any person who is a capital beneficiary of the trust or is a person who decides when the trust property is disposed of or to whom it eventually goes. It’s a brutal provision that may prevent the rollout of any assets to beneficiaries before 21 years and it’s one people need to be aware of.” Although there’s nothing that can be done to change it, with enough time, it’s possible to develop strategies to fund the eventual tax liability. “The sooner you know you have this issue, the better,” says Ross. “Alternative planning may be possible.

You could implement a reorganization at say 10 years to stop the growth in a bad trust and potentially start the growth in a good trust and minimize the tax hit that’s going to happen at 21 years.”

written and published by Ms. Angela M. Ross from PriceWaterHouseCooper(PWC)

How a trust can lighten the burden of raising a family

Today, we would like to share a great article written by Tim Cesnick and published in the Globe & Mail.

At HazloLaw, we often advise clients to consider the implementation of a Family Trust.

How a Trust can lighten the burden of raising a family

My friend Allan gave me a call this week.  “Tim, I just got an e-mail letting me know about my high-school reunion in the fall,” he said. “Sounds like fun, Al,” I replied. “Tim, I graduated 25 years ago, and I feel like I’ve been wasting time. The reunion is coming up fast. I only have four months to make something of myself. Got any ideas?” Then it hit me. “Al, why don’t you set up a family trust?” I suggested. “It really doesn’t matter how successful you’ve actually been – most successful people have a family trust. ” “Tim, I like it! So, when people at the reunion ask what I’m doing today, I can just tell them the truth – I play video games – but mostly I watch over my family trust. Wow, that sounds great. Uh, Tim, what am I going to do with this family trust once it’s set up?” I then shared with Allan a primer on how a trust can save a family significant tax dollars.

Here are the highlights.

A trust is actually a legal relationship between the settlor (the person who transfers the assets to be held in trust), the trustee (the person(s) who holds the assets that were transferred), and the beneficiary (the person(s) for whom the assets are being held). Now, from a tax perspective think of a trust as a vehicle to hold certain assets you choose to place in the trust. The trust is treated as a separate individual for tax purposes, and any income earned by the trust will be subject to tax. The trust can pay the tax, or the trustees may choose to distribute the income to the beneficiaries, in which case the trust claims a deduction for the amount distributed and the beneficiaries face the tax on that income instead (the beneficiaries will receive a T3 slip showing the amount of income they must report). So, it’s possible to sprinkle income to various family members (beneficiaries) who might pay tax at lower rates than you might face.

You should know that there are two types of trusts: An inter vivos trust, which is a trust you might establish during your lifetime, and a testamentary trust, which is established by your will after your death. I’m talking today about inter vivos trusts. These trusts are taxed at the highest possible marginal tax rate – which is not a good thing, obviously.

So, you’ll generally want to distribute the income of the trust to beneficiaries to face tax in their hands at lower rates.

Trust example.

Consider my friend Allan. He has children and regularly pays for many things for them. What if Allan could pay for these things using dollars that have been taxed in the kids hands rather than his own? The tax savings could be huge.

To make this possible, Allan is going to lend money to a family trust that will be established. Now, there’s no hard and fast rule around how much he should advance to the trust. In my view, it should be at least $500,000 over time in order to gain sufficient benefit.

If Allan lent, say, $500,000 to his family trust, the trust could invest those dollars.  Let’s assume the trust earns 5 per cent annually on those funds. This would result in $25,000 of income annually. If this income were taxed in Allan’s hands, he’d pay $11,600 in taxes (in the highest tax bracket in Ontario this year). In this case, however, the trustee of the family trust – Allan in this case – can distribute the $25,000 of income to Allan’s three kids.

The result? Each of his kids reports one-third of the income ($8,333 each) and pays little or no tax since these kids have little or no other income and they each have a basic personal tax credit that will shelter the first $10,527 of income from tax in 2011.

Here’s the problem: Allan doesn’t really want to distribute cash to each of his kids directly. No problem. Allan can simply use the income in the trust to pay for expenses related to the kids. He could, for example, pay for their tuition, sports, travel, and other costs. The taxman will generally consider these amounts to have been distributed to the kids even when paid directly to third parties, provided the costs are clearly for the benefit of the kids.

Small business owners should beware the taxman's test

written by Tim Cesnick and published in the Globe and Mail.

Small business owners should beware the taxman's test

I was at a local hockey arena last weekend when I ran into an old friend who I hadn’t seen in a while. “Jack, I haven’t seen you for a couple of years! I heard that you’ve started a new business. Is that right?” I asked. “That’s right,” Jack replied. “This time it’s a non-profit corporation,” he continued. “I didn’t intend it that way, but it is.” As it turns out, Jack is going to save big tax dollars because of his business losses. Many taxpayers have done the same thing in the past. Self-employment can be a great tax shelter, but you should understand the taxman’s – and the court’s – view of this. A recent court decision serves as a good reminder about the guidelines to follow. The tax shelter If you operate a business as a proprietorship (rather than incorporating the business), any losses you report from the business can be applied to offset other income you might be reporting on your personal tax return. Quite often, the losses stem from costs you’re incurring anyway.

You might, for example, use your car in your business and claim depreciation (known as “capital cost allowance” – or CCA) on your car. You’re paying for a car anyway, so why not make it deductible? It’s not uncommon to experience losses in the early years of a business. The story Brian Sumner is a gentleman who decided to start a business several years ago. Although he had a full-time job as an economist, he owned a vacation property in Victoria Beach, Man. (primarily a summer recreational area), spent weekends and vacations there, and felt there was a demand in that area for excavation services.

So, Mr. Sumner registered a business called Sumner Mechanical. He turned his garage into a maintenance shop and bought a back-hoe, tractor and skid-steer loader. Mr. Sumner reported losses on his tax returns in 2004, 2005 and 2006, and the Canada Revenue Agency disallowed losses amounting to $26,857, $29,648, and $32,710 for those years respectively. Most of the losses were created by claiming CCA on the equipment he had purchased. Mr. Sumner took CRA to court over the issue, and he lost his case. His story serves as a reminder as to what you need to do if you hope to have a small business (full- or part-time) to open the door to tax deductions. The lessons This type of battle with the taxman is nothing new. Yet, in the last few years, the courts have spelled out the principles that should be followed by taxpayers – and the CRA – when determining whether losses from an activity should be allowed.

In particular, it was the Supreme Court of Canada in the Stewart decision (2002 SCC 46) that set out the principles to consider. The Supreme Court recognized that Canadian tax law will allow deductions where a source of business or property income exists. The question in every case, including Mr. Sumner’s case, is whether a source of income existed. Canada’s top court established that if an endeavour is clearly commercial in nature, with no personal element to it, then a source of income exists. This is not to say that the endeavour must produce a profit in any particular year. Where an endeavour is commercial in nature, then there is no room for the CRA to disallow losses on the basis that there is no reasonable expectation of profit. Where the endeavour could be classified as being personal in nature, or having a personal element to it, then it must be determined whether or not the activity is being carried on in a sufficiently commercial manner to constitute a source of income. If so, then deductions and losses may be allowed.

A problem arises where the endeavour has a personal element to it and is not carried on in a sufficiently commercial manner. In this case, a source of income is not considered to exist, and losses won’t generally be tolerated by the taxman or the courts. When deciding whether an endeavour is sufficiently commercial in nature, the taxman will look at many factors, including: the profit and loss experience in past years, your training in the activity being carried on, your intended course of action, and the capability of the endeavour to show a profit. Mr. Sumner failed the commerciality test. Since he used his equipment more for his own personal property maintenance, advertised his business only seasonally, earned very little revenue, had little experience or training and lacked certain licences to operate some of his equipment on public roads, the courts ruled against him.

Business Owners: Tax savings should be top of your resolution list

Happy New Year 2012 to everyone who is readying this blog. Today, I would like to share an excellent article from Tim Cesnick and published in The Globe & Mail. &&&&&&&&&& Tax savings should be top of your resolution list Once again it’s time for my annual New Year’s resolution. That’s right, a single resolution. This year, I’m getting into shape again. I’m going to start by eating slowly in 2012. It’s not about slowing my metabolism. It’s about my kids. They eat so much that if I slow down my pace of eating, there won’t be anything left by the time I’ve finished my salad. That’ll do it. What about you? If you’re still thinking about your New Year’s resolutions, consider adding tax savings to the list. If you make just one change to your affairs annually to save tax, you’ll do yourself a world of good in a short time. Consider one of these ideas: 1. Create self-employment earnings. Self-employment is still one of the greatest tax shelters available. Why? Deductions. Operating a part-time business from home is all you need to do. This can open the door to deducting a portion of those things you’re paying for anyway, such as mortgage interest, rent, property taxes, home insurance, home repairs, utilities, vehicle repairs, gas, auto insurance, interest on a car loan or lease payments, computer costs and more. 2. Pay family members a salary. If you have self-employment earnings you can move income into the hands of a family member who is in a lower tax bracket by paying wages or a salary for work performed. If you’re an employee, speak to your employer about requiring you to hire your own assistant for your work. Our tax law will allow an employee to deduct salary or wages paid to an assistant provided your employer required you to pay for one. Hiring your spouse or a child who is in a lower tax bracket will keep the money in the family and will save tax dollars. 3. Make your interest deductible. If you’re paying interest costs that are not deductible, and have some cash or investments on hand, consider doing a “debt swap” to create a deduction for your interest. You can do this by taking some of your cash, or selling some investments to create the cash, and using the cash to fully or partially pay down your non-deductible debt. You can then re-borrow to replace those investments or that cash. As long as the new debt is used for an income-producing purpose you should be entitled to deduct your interest costs. 4. Extract cash from your company tax-free. If you own a corporation, consider paying yourself capital dividends, repaying shareholder loans owing to you, and returning “paid up capital” to yourself to access the cash in your company tax-effectively. Also, consider claiming a refund of “refundable dividend tax on hand” (RDTOH) by paying yourself taxable dividends. All of this may sound like a foreign language, but a visit to a tax pro, perhaps your friendly chartered accountant, will help. 5. Consider a leave of absence or sabbatical. You can defer tax by setting aside some money in a deferred salary leave plan (DSLP). You can then take a leave of absence or sabbatical in a later year and collect your deferred salary at that time. Speak to your employer about setting up a DSLP. A DSLP must be in writing and meet certain criteria, such as: No more than one-third of your salary can be set aside for the leave, your leave must be at least six consecutive months, the leave must begin no later than six years after the salary deferral begins, and following the leave you must return to work for a period at least as long as the leave. There are other details that must be looked after as well, so your employer will need to seek advice on this. 6. Create pension income for the credit. If you have eligible pension income you’ll be entitled to claim the pension tax credit. If you and your spouse each claim the credit, this could fully or partially shelter the tax on $4,000 ($2,000 each) of pension income. It’s not going to make you wealthy, but it’s all part of building up tax savings year after year. You can create eligible pension income by, for example, converting part of your registered retirement savings plan to a registered retirement income fund to create $2,000 of RRIF income annually. You can also provide your spouse with eligible pension income by reporting up to half of certain pension income in his or her hands.