Tax Exam
Chapter 7: Income from property
Income from property defined
– Generally defined as the return on invested capital where little or no time, labour, or attention has been
expended by the investor in producing the return
1. The return of dividend income on the investment in capital shares of public and private
corporations
2. The return of interest income on investments in bank deposits, loans, mortgages, bonds,
and debentures
3. The return of rental income on the ownership of real estate or other tangible property
4. The royalty income on the ownership of properties, such as patents and mineral rights
– Not include gain or loss resulted from sale on property = CG/CL
– Disposal = NOT property income
– Rental property sold = CG/CL, but CCA deducted to determine property income earned from rents=
recapture → property income and terminal loss→ property loss
– To qualify as property income, interest must be earned in a relatively passive way, w/o the commitment
of significant time, labour and attention by the owner
•Interest income earned by a small/large financial institution ≠ property income, it is business
income b/c taxpayer must expend significant effort in order to generate that income
•Income = business income and not property income wont change the income calculated with
some exceptions
General rules for determining property income
– Property income = net property income (rev-Exp)
– Expenses incurred to earn property income can be deducted for tax purposes provided that
•They are incurred for the purpose of earning income that is taxable
•They are not an expenditure of a capital nature, an expenditure on the account of capital, or
depreciation and amortization
•They are not a reserve
•They are not a personal or living expense
•They are reasonable under the circumstances
– Property income and the taxation year
•Taxation year for individual= calendar year, corporation= fiscal year
– The deduction of interest expense
•Interest expense incurred on a loan used to acquire an investment = on account of capital →
exception to the general rule
•Interest on loans used to purchase investments, such as bonds, bank certificates, share of
corporations and real estate, is deductible against the interest, dividends and rental income
earned
•When individuals are in the position to acquire both personal and investment assets, they
should apply these principles in order to maximize their after-tax CF:
oPersonal assets should, to the extent possible, be acquired with excess cash. Such
assets- cars, a house, a cottage, and the like-can then be used as collateral to obtain
loans for investment purposes
oWhen individuals have personal and investment loans, excess cash should first be used
to repay personal loans that are incurring non-deductible interest. It is important that
separate loans be arranged for personal use and investment use
The unique features of property income
– Interest income
•Interest income = compensation received for the use of borrowed funds
•Recognition of income
oDifferent types of debt obligations require the pmt of interest to the creditor at different
times
oHow to tax on interest? Timing difference
oThe timing of income recognition for tax purposes is important b/c it affects the net after-
tax CF and, by extension, the yield on a particular investment
oAll corporations (private/public) must recognize income according to the normal rules for
profit determination and do so on an accrual basis
Corporations must include interest as income as it is earned on a daily basis
oIndividuals, unlike corporations, have at their disposal, within a certain time limitation, 3
methods for recognizing interest income:
Receivable method
Cash method
Anniversary day accrual method
oEx. One can use cash method for investment A and annual accrual method for
investment B
oReceivable method = interest is included in income only when the amount is legally due
and payable
Ex. Corporate bond paid semi-annually on june 15 n dec 15. If end of taxation
year = dec 31 and dec 15 interest is not received, it must still be included in the
year’s income b/c its legally due and receivable
oCash method= interest income is taken into income for tax purposes only if it has been
received by the individual in the year
oAnniversary day accrual method= requires interest income be recognized for every 12
month period from the date the investment was made
When an investment requires that interest be paid after a long period of time (≥ 1
year)
Means that interest income recognition can be deferred for only a limited period
NOTE: individuals cant use the normal accrual method for accruing interest on a
daily basis, as can corporation and partnerships
Ex. Interest payable at the end of 2 years
Under special annual accrual method, interest must be recognized every
12 months from Feb 1,2011 until the end of the term of the loan
Feb 1,2011- Dec 31,2011 = NIL
Feb 1,2011- Jan 31,2012 = 12% x 100 000
Feb 1, 2012- Jan 31, 2013 = 12% x [100 000 + (12% x 100 000)]
•Foreign Interest
oInterest earned on investment in a foreign country is recognized in terms of Canadian
dollars
oWhen foreign taxes are withheld from the payment, the full amount of interest, before the
amount is withheld, must be included in property income (Canadian tax on this foreign
income can be reduced thru foreign tax credit)
oTreat foreign tax as expense against property income = element of double taxation
•Life insurance policies
oCertain life insurance policies include both a savings component and a life insurance
component (whole life insurance)
oOthers are designed solely to provide life insurance protection (term life insurance)
oLife insurance policy includes a savings element that accumulates interest returns
Must be reported annually, when exempted = combination of life insurance and
savings can amount to a significant long term tax deferral
•Deductions from interest income
ob/c property income = “profit therefrom”, interest income calculated on a net basis (rev-
Exp)
oExpenses incurred to earn income are:
Interest exp on loans used to acquire interest bearing investments
Investment counselling fees
Costs incurred to obtain a loan (legal fees, mortgage appraisal fees, and
registration fees: amortized over 5 years at the rate of 1/5 per year)
Fees paid to managers of investment portfolios
Fees paid to a financial institution for holding securities (cost of a safety deposit
box is NOT a deductible)
Acc fees for record keeping and determination of income from property
Reserves/complete deductions for interest income that has been accrued but is
not collectible b/c debtor’s inability to pay
– Dividend Income
•Dividends= returns provided on the investment in shares of a corporation; they reflect the
distribution of a portion of the corporation’s profits to the shareholders
•Dividend income can be received by both corporations and individuals
•Corporate earnings are taxed in the hands of the shareholder, either as dividends (property
income) or as CG, depending on whether or not the corporate profits are distributed
•Dividends received by corporations
oDividends paid by 1 corporation to another is included in NITP when they are received
oNITP – (special deductions: dividends from Canadian corporations) = Taxable income
oDividends paid by Crop 1 is not taxable to the shareholder: Corp 2
oDividends received by Canadian corp from a foreign corp are excluded from taxable
income if the foreign corp = foreign affiliate
Foreign affiliate of a Canadian corp if owner’s equity % in the foreign corp is not
less than 10%
•Dividends received by individuals
oDividends earned by an individual on investments in taxable Canadian corporate
shares= in individual’s NITP
oDividends received from Canadian private crop= grossed up to include 118% or 138% of
the dividends depending on the source of the corp’s income
118%= non-eligible dividends
138%= eligible dividends
oGrossed up b/c they reflect the corporate taxes already paid by the corp on its income
Grossed up dividends= pre-tax income earned by the corp that has been
distributed as dividends
oIndividual shareholders use their own tax on the same corporate earnings (grossed up)
by applying the individual tax rate to income = at this point corporate earnings is taxed
twice
oIndividual tax on the grossed up dividend is then reduced by the corporate tax that has
been already paid on the income
This is “Dividend tax credit” = more/less equal to the gross-up b/c it reflects the
corporate taxes that have been paid
oEliminates double taxation
oWhen corporate tax is greater= dividend tax credit is not sufficient and some double
taxation occurs
oIndividuals receiving dividends from foreign corp= not subjected to gross-up and
dividend tax credit
Actual amt of dividends from foreign corp (b4 withholding taxes) is included in
income in the year received
•Stock dividends
oForced reinvestment of dividend returns in the capital shares of the corp
oAny gains/loss on their disposition= determined according to the normal capital gain
treatment
– Rental Income
•Compensation received for allowing another party to use one’s tangible property
•Derived from the ownership of real estate (land and building)
•Recognition of income
oRental revenue = included in NITP on the accrual basis when earned, rather than when
received
oIf received in advance = revenue recognition can be delayed and included in a particulatr
year to which the advance pmt applies
•Deductions from rental income
oInterest exp incurred on loans used to acquire the rental property or the fund repairs and
improvements
oCosts incurred to obtain loan financing, such as mortgage fees, legal fees, and appraisal
fees (amortized over 5 yrs, 1/5 of the cost/year)
oInsurance exp
oProperty taxes
oRepairs to the property of a non-capital nature
oMaintenance costs (cleaning, lawn care, and snow and garbage removal)
oUtility costs (heat, power, water)
oLandscaping costs around a building even though such costs may be of a capital nature
oCCA on the building, other related tangible assets (furniture and equipment)
oSalaries and wages paid to employees who supervise and/or maintain the property
oProperty management fees paid to an independent property management organization
oAcc costs for record-keeping and income determination
oCosts incurred to collet rent
oAdvertising
Gross lease= tenant pay only a specific rent
Net lease= tenant pay basic rent + costs associated with the running of the
property with the exception of financing costs
Total exp ↑ than rent rev = property loss
Property loss from rentals can be offset against all other sources of income
•Special rules for CCA
oCCA, terminal loss and recapture= net income calculation for rental properties
oSpecial rules only applies to rental properties
CCA on rental properties can be deducted only to the extent that it doesn’t create
or increase a net loss from all rental properties combined
Each rental building having a cost of $50 000 or more must be held in a separate
CCA class (different from normal requirements that assets of a similar class be
pooled)
oIf CCA is over combined rental income = NIL
oIf rental income= loss before CCA, no CCA can be claimed in that year
– Royalty income
•Normally treated as property income from an investment when they are received for the use of
owned property such as trademark, copyright, patent, or other similar intangible properties when
the taxpayer acquired these properties by a purchase, gift or inheritance
oEx. Purchase copyright= royalties received from licensing the copyright to others=
property income
•Maybe classified as business income
oEx. Author writes a book or musician writes a music score and receives royalties for
licensing copyright= business income
Impact on investment decisions
– CF and return on investment
•Interest-bearing securities
oReturn of interest is fully taxed when earned or, for individuals, at least every 12 months
from the date the investment is made
•Investments in corporate shares
oPresent combined annual yield in the form of both dividends payments and a growth in
value of the shares
oDividends= taxed when received, however for individuals, the dividend tax credit reduces
the effective tax rate (45% to 24% [net personal tax/net earnings available for dividends])
oGrowth in value of shares= ½ of CG and the gain is taxed when the investment is sold,
rather than when the growth in value occurs (45%/2= 22.5%)
•Real estate investments
oYield both rental income (fully taxable annually when earned) and capital growth (taxed
as a CG when the property is sold)
– Business organization structure
•Corp A (no land or buildings) rents from Corp B (that has only land and building)
•B/c land and buildings are held by corp B= rental income, classified as rental properties
•Each building in Corp B= in separate CCA pool
oResulting tax recapture will diminish cash available to finance the new acquisition (↑
financing cost)
oIf buildings held by corp A= buildings will be in the same pool, no recapture would occur
on the disposal and new acquisition
– Corporate financing
•Tax treatment of property income has an impact on the cost of corporate financing
– Splitting property income among family members: attribution rules
•Anti-avoidance provisions of the ITA
•Why not simply invest a family’s savings in the name of the family member with the lowest tax
rate?
Chapter 8: Gains/Losses on the disposition of capital property- CG
CG/CL defined
– Property= classified as capital property
•It must have been acquired and used for the purpose of providing the owner with a long-term or
enduring benefit
•Note: doesn’t say that the property must be held for a long time or that it must provide a benefit=
instead it is enough that the intended purpose of the acquisition was to achieve benefits over a
long period of time
•Based on the intended purpose of the property acquisition rather than on the actual results
achieved
– Capital vs. Business income
•Depends on the intended purpose of acquisition
•Property acquired for resale= inventory= business income/loss
•Property acquired for providing owner w/ a long term or enduring benefit= CG/CL
– Intention
•Period of ownership
oLong-time= claims capital property but period of ownership by itself doesn’t provide
compelling evidence of intention
•Nature of the transaction
oEx. Purchase vacation land w/ intention of building a summer cottage but then sold the
raw land for a profit after a brief ownership period= may be considered CG
•Number and frequency of transactions
oHistorical pattern of frequent buying and selling = business income even tho held for
respectable period and reasonable rental profit were achieved
•Relation of transaction to taxpayer’s business
oSimilar to the owner’s business
oEx. Individual makes a living by selling real estate properties, that property = business
•2 areas with respect to intention that require special mention
oChange of ownership’s intended purpose from 1 period to another
Gain/loss be allocated b/w capital and business income in accordance w/ the
property’s value at the time the purpose changed
Ex. Land: capital property- resale = CG set at the difference b/w property’s MV at
the time of change and the original cost
Any further gain= business income
Both gains are recognized only at the time of the actual sale
oCertain properties: marketable securities often acquired for the dual purpose of providing
annual benefits as well as a profit on sale
Permits taxpayers (other than security dealers) to remove themselves from the
common-law rules of intention and simply elect to have all sales of Canadian
securities treated as capital transactions (Canadian securities= capital stocks)
– Categories of capital property
•Personal-use property (PUP)
oPUP= owned by the taxpayer that is used primarily for the personal use or enjoyment of
the taxpayer, or persons related to the taxpayer, and that doesn’t generate financial
returns
oCar, boat, land, house, cottage, furniture, piano= PUP and subjected to CG treatment
•Listed personal property (LPP)
oLPP= items that are for personal use but also have some element of investment value
oprint, etching, drawing, painting, sculpture (or other similar work of art), jewellery, rare
folio, rare manuscript, rare book, stamp, coin
•Financial property (FL)
oFP= all capital properties that was acquired to generate a benefit thru a financial reward
oShares, bonds, loans, land, buildings, equipment, patents, licenses, franchises, and
vehicles
oFew capital properties are exclude= properties that qualify as eligible capital properties
Determining CG/CL: General Rules
– General calculation
•
•Only ½ of the above CG is included in NITP= taxable CG, ½ of CL= allowable CL
– Disposition and proceeds of disposition
•CG/CL recognized only when a disposition of the property occurs
•If investment of a public corporation shares increases in value = no CG
•If investment of a public corporation shares decreases in value = no CL
•Bond compounds interest annually but pays nothing for 10 yrs= investor who purchased it must
recognize accrued interest annually
•Disposition occurs when
oProperty is sold
oProperty is involuntary eliminated by theft, destruction, or expropriation
oShare, bond, debenture, note or similar property is cancelled, redeemed, or settled
oA share owned by a taxpayer is converted by amalgamation or merger
•Proceeds of disposition
