Tax Midterm
Chapter 1: Taxation- Its role in decision making
Taxation and the financial decision process
– Taxation is a controllable cost
•Tax cost = cost of doing business
•Analyzed to determine which actions or activities have a greater/lesser impact on the resulting
tax cost
•Each alternative= different impact on the amount of tax and the timing of the payment of tax
•Even if marketing decision = direct effect on the long term tax cost of the firm → thus on profits
and value
•Tax= important on any decision making
•Tax costs are relevant when alternative strategies are being considered
– Cash flow (CF) exists only on an after-tax basis
•All CF= after tax
•NPV compared and ranked
•Shows the actual value of the individual/corporation
•Analysis can’t be of value unless the real tax impact is included
•Alternative action to minimize the tax impact
•After tax = % of interest x (1 – Tax rate)
o5% dividend on the equity of a “public corporation” = not deductible to the business →
after tax = 5% (real cost)
oNet value to individual investor subject to 45% tax rate = 3.6% (after applying dividend
tax credit)
The fundamental income tax structure and its complexity
Taxpayers
– Individuals
– Corporations
– Trusts
Business & investment
structures
– Proprietorship
– Corporation
– Partnership
– Limited partnership
– Joint venture
– Income trusts
Types of income
– Employment
– Business
– Property
– Capital gain
– Others
Tax jurisdictions
– Provincial
– Federal
– Foreign
– Important = interaction among these major variables
– When variables change = alternative tax structures are created
– Equity capital is serviced by DIVIDENDS
•Not deductible by the payer
•Constitute: property income taxed in a certain way to the investor
– Debt capital is serviced by INTEREST PAYMENTS
•Deductible by the payer
•Constitute: property income to recipient
– Taxed differently on the receipt of dividends or interest
– Decision to benefit to both the corporations and its supplier of capital
– Employment income= different tax rules
– Corporate tax rate ≠ individual tax rates
– Alternatives for compensating staff
•View to reducing the after tax costs of employee benefits while increasing the after tax income
to employees
Chapter 2: Fundamentals of tax planning
What is tax planning?
– Tax planning = the legitimate arranging of one’s financial activities in a manner that reduces or defers
the related tax cost
•General anti- avoidance rule (GAAR)
– Tax evasion
•CRA definition= it is the commission or omission of an act with the intent to deceive
oFailing to report revenue, claiming the deduction of a false expense or both
oAlso knowingly omitting material facts from the tax records
•Overstating or understating
•Against the tax law
– Tax avoidance
•Involves transactions which, while legal in themselves, are planned and carried out mainly to
avoid, reduce or defer tax payable under the law
•Ex. Commonly owned corporations can be permitted with flexible loss utilization
oBut unrelated corporations becomes related for the sole purpose of exchanging loss =
not acceptable
Related Corporations Unrelated Corporations
Take advantage of the rules
and DID NOT run counter to
the spirit of the system
To be related to circumvent the
intended rules and went
AGAINST the spirit of the
system
•CRA thinks tax avoidance = abusive
oThen its denied the resulting benefits
•Can’t get punished
Types of tax planning
– Objective = reduce/defer (or both) the tax cost of financial transactions
– Shifting income from 1 time period to another
•Recognizing income for tax purposes
•Change of FUTURE TAX RATES
oMay be >, <, = as the current tax rate
•Tax saving ≥ related financing cost = a wealth enhancement for tax payers
•When making the judgement, determine:
oFuture tax rates or income level that will cause those tax rates or both
oDiscretionary opportunities within the tax systems
oTime value of money
•General rule: if future tax rates will likely be ≤ or = than the current tax rate
oOne should seek to delay income recognition
•When expecting ≥ than current tax rate
oDecision to delay the income recognition is made due to the potential use of those funds
in the shorter term
•Capital gain: only ½ of the gain will be taxable
•Shows delaying the recognition of income for tax purposes permits the annual return =s to
accrue and compound without annual tax cost
oLonger the delay= greater the advantage
– Transferring income to another entity or alternative taxpayer
•Only individuals can enjoy the benefits of accumulating wealth
•Shifting income to another entity may reduce/significantly delay the amount of tax otherwise
payable
•Anticipate possible future events
•CF map is altered but eventually leads one back to the original source
•Transferring income from 1 entity to another may have beneficial results in 1 area but negative
results if certain future events should occur
•Individual → corporation + individual
– Converting the nature of income from 1 type to another
•He had the choice to pay dividend or not
oIf he didn’t pay the dividend, he would’ve converted dividend income (=property income)
into a capital gain
•Preferred tax treatment
oAdvantage= converting dividends (property income) into CG but not always!
•Ex. Land= capital or expensed (leased payments)
oFactors: rate of growth, discount rate, tax rate @ end of leased term (etc.) or business
closed?
•Important but uncertain
Skills required for tax planning
– Anticipation= envision return of the investment as well as end of the business
– Flexibility= alternative methods, Ex. Land = leased/purchased
– Speculation= anticipate tax effects
– TVM= time value of money (compound interest)
– Perspective= understand transactions/tax factors
– Global approach= understand tax implications for the seller
– CASH FLOW FACTORS: amount of money inflow, outflow and timing
Restrictions to tax planning
– Specific anti-avoidance rules
•Transfers property to “non-arm’s length” party, price cannot be ≤ FMV
•Canadian tax payer sells property/services to “non-arm’s length” foreign party for amount ≤
reasonable price in open market, the reasonable price is imposed for tax purposes
•Taxpayer still includes directed anticipated taxable receipt to another person, in his income
•A taxpayer cant transfer a right to income to a related party
•When property is transferred to a spouse, the future income from that property is included in the
income of the original owner or tax purposes (prevents them from shifting income to family
members who may be subjected to lower tax rates
•The ability to recognize certain losses may be restricted or delayed when an entity undergoes
restructuring
– The general anti-avoidance rule (GAAR)
•Requires that when a person is involved in an “avoidance transaction”, tax will be adjusted to
deny the benefit that would have resulted from the transaction or from the series of transactions
oQuestion 1: what is an avoidance transaction?
oQuestion 2: what is the nature of the benefit referred to in the rule?
•Tax benefit= a reduction, avoidance or deferral of tax or an increase in the refund of tax
•For a tax plan to be rejected, it must fail the business purpose test and must be extreme to the
extent that it is not within the “spirit” of the tax system as a whole
Chapter 3: Liability for tax, income determination, and administration of the income tax system
Sources of Canadian tax law
– Statute Law
•Canadian federal income tax system is made in the legal statute called Income tax act
– Common law
•Court cases on disputes regarding the application and interpretation on income tax act
– International tax conventions (treaties)
•Canadian taxpayers invest, carry on business or are employed in foreign jurisdictions impacts
income tax act
oRationalize and define the jurisdiction authority on transactions of an international nature
oAvoid the incidence of double taxation resulting from applicable provisions of tax
legislation in 2 or more jurisdictions
Liability for Tax
– Entities
•Individuals
oOnly ultimate recipient of profits and CF
o(A) individual operating a business as a proprietorship
•Proprietorship= non- taxable entity
•All income earned is taxed to the individual
•Corporations
oArtificial person having the same legal rights and responsibilities as an individual
oAffairs are separated from the affairs of the owner(s)-shareholder(s)
oProfits/losses is to the corporation but the individual shareholders can receive dividends
and/or disposing of their shares
o(B) individual as a shareholder of a corporation
•Corporation= taxpayer subject to tax on its business income
•Individual= taxpayer if receives dividends or sells their shares
•Trusts
oHave limited application to business and investment structures (N/A)
– Resident Individuals and Corporations
•Individuals
oTo be a resident of Canada, an individual must maintain a “continuing state of
relationship” with the country
•Corporations
oAll corporations incorporated in Canada = residents of Canada and are subject to world
income
oIncorporated under the federal or provincial jurisdiction = Canadian resident, regardless
of where the controlling shareholders reside- in Canada or in any foreign jurisdiction
oForeign Corporation to be considered a Canadian resident? possible
•Canadian resident if it can establish that the “central management and control”
over the major policy affairs of the entity’s business is exercised from within
Canada
•Dual jurisdictions
oBoth individual and corporation= resident of Canada but it doesn’t mean there is no
foreign jurisdiction from claiming the right to tax the same activity and income generated
within their boundaries
oRate of tax paid on foreign income by the Canadian entity will always equal the tax rate
