Canada, tax, TaxBreaks, October 2006

Contribute to your RRSP
Take advantage of the reduced tax rate on eligible dividends
Claim the $500,000 capital gains deduction
Stagger taxes of certain capital gains
Defer the tax on certain stock option benefits
Use your capital losses
Offset taxable income with an allowable business investment loss
Donate
Repay shareholder loans
Declare a bonus
Check whether interest on your loans is deductible
Make certain disbursements before the end of the year
Make your December instalment
Keep your transit passes!

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Fall is always a good time to take stock of your tax status. Several weeks remain before the end of the year, so now is the time to review your 2006 transactions and make any necessary adjustments. No matter what your situation — whether you work, are retired, operate a business directly or through a corporation, or hold shares in a public company that pays dividends — your tax planning and efforts to reduce your fiscal burden should be ongoing. Here are fourteen ways, among others, to save on taxes for 2006.

1. Contribute to your RRSP

If you haven’t yet contributed to your RRSP for 2006, don’t wait until the end of February 2007 — contribute now. The earlier you do, within the allowable limits, the more quickly your retirement funds will grow, sheltered from tax.

2006 contribution. Your maximum contribution for 2006 is 18% of income earned in 2005, principally from employment or a business, up to a maximum of $18,000 (compared to $16,500 in 2005). The maximum RRSP contribution for 2006 applies to earned income of $100,000 in 2005. If you participate in a pension plan, you should keep the pension adjustment in mind — and the pension adjustment reversal, if applicable. To find out the exact amount that you can contribute, look at the “RRSP Deduction Limit Statement for 2006” section of your federal assessment notice for 2005.

Think ahead to 2007. The RRSP limit will increase in 2007, to $19,000. If you have your own corporation, have no other source of earned income, and are able to do so, pay yourself a salary of at least $105,556 before 2006 ends to ensure that you can contribute the maximum amount to your RRSP in 2007.

Unused RRSP contribution room. If you contributed less than the maximum allowable amount to your RRSP in a previous year, and if you can afford it, take advantage of that unused room by contributing enough to eliminate it. Don’t wait too long to use up unused room, as doing so will give you less time to reap the benefits of compound interest, and you will have less in your RRSP when you retire. Remember that your investment horizon may be for 10, 20 or even 40 years, depending on how old you are now and at what age you think you will need funds from your RRSP.

Be careful of overcontributions. The law allows you to contribute up to $2,000 over the authorized maximum. Do not exceed this limit, because the penalty of 1% per month on overcontributions can add up fast, and the administrative formalities to recover excess contributions are relatively complex.

If you turn(ed) 69 in 2006. If you turn(ed) 69 in 2006, you must terminate your RRSP no later than December 31, 2006. It is extremely important not to wait until the last minute to plan for the maturity date of your RRSP. There are many options available: transferring your RRSP to a Registered Retirement Income Fund (RRIF), receiving an annuity, receiving a lump sum, or choosing a combination of these options. If you fail to elect the form in which you wish to receive your retirement income before December 31, the full market value of your RRSP will be added to your taxable income in 2006. Discuss the options with your tax advisor.

Is your spouse younger than you? If your spouse is younger than you and you anticipate that his or her retirement income will be less than yours, consider creating a spousal RRSP. You can then continue contributing to the spousal plan until your spouse turns 69, provided that you yourself have unused contribution room.

2. Take advantage of the reduced tax rate on eligible dividends

On June 29, 2006, draft federal legislation was released containing proposals to reduce the tax rate on certain dividends received after 2005 by individuals and trusts. Assuming this legislation is adopted:

In general, the effective personal tax rate on “eligible dividends” (explained below) will be reduced. Before these changes, the combined top marginal rate that individuals were paying on taxable dividends received from Canadian corporations ranged from 24% to 37%, depending on the taxpayer’s province of residence. Assuming the provinces make similar modifications to their respective regimes, the proposed changes will reduce the tax rate significantly on eligible dividends. At this time, only five provinces have announced the harmonization of their legislation with federal law. The reductions in rates are: 6.66% in Quebec, 8.96% in Ontario, 11.25% in Manitoba, 9.53% in Alberta, and 13.11% in British Columbia.

Eligible dividends. The rules for eligible dividends differ, depending on the status of the corporation. For example, a Canadian-controlled private corporation (CCPC) may pay eligible dividends to the extent that they come from the taxable income that is not eligible for the small businesses deduction (excluding investment income). Such income will accumulate in the general rate income pool (GRIP), representing the balance that may be paid out as eligible dividends. Dividends not paid from the GRIP will be considered ordinary and their tax rate would not be reduced under the proposed changes. For public corporations and other non-CCPCs resident in Canada, the new rules generally allow eligible dividends to be paid out of net income, unless the corporation has a balance in its low rate income pool (LRIP) at the end of a taxation year. The LRIP, in short, represents the accumulation of net income that has benefited from the small business tax rate and therefore may not be paid out as eligible dividends.

Determining dividends. Based on the draft legislation, corporations that pay eligible dividends will have to designate them as such and must inform their shareholders of the designation in writing.

Impact of the draft legislation. Individuals with stock portfolios in public corporations need not take any action. Public corporations will have to notify them in writing, within 90 days following the adoption of the legislation, whether or not the dividends they paid after 2005 are eligible dividends. These individuals' information slips and tax returns will have to show the information needed to apply the appropriate tax treatment to eligible dividends. Furthermore, CCPCs with income greater than the small business deduction will have to decide whether it’s better for them to pay out eligible dividends to their owner-manager instead of “bonusing down” to the small business tax rate. Further, in other situations, the CCPC could choose, under the draft legislation, to forego the small business deduction so that it may pay eligible dividends. It may also be necessary to review the structuring of investment holding companies and portfolio investments to ensure their tax efficiency is optimal.

3. Claim the $500,000 capital gains deduction

Small business corporation shares, qualified farm property, and, for 2006 at the federal level and since December 11, 2002, in Quebec, qualified fishing property (including, for qualified agricultural and fishing properties, shares of a corporation and partnership interests) qualify for the lifetime capital gains deduction of $500,000. Claiming this deduction often requires a good dose of planning and help from your tax advisor. If you are thinking about selling the assets that qualify for this deduction before the end of the year, consult your tax advisor as soon as possible.

If you have already claimed the $100,000 personal capital gains deduction (abolished in 1994), you are entitled to a maximum deduction of only $400,000. If you plan to use this deduction in 2006, check with your tax advisor to find out whether you have realized an allowable business investment loss (ABIL) in prior years or have cumulative net investment losses (CNILs) as at December 31, 2006, as these will have to be taken into account, and it is possible that you will not be able to claim the full deduction.

4. Stagger taxes of certain capital gains

If you dispose of property on which you realize a capital gain, you can stagger the payments of this gain over up to five years if you allow the buyer to stagger the payment of the proceeds from the sale over a five year period as well. The term is increased to 10 years for the transfer of farm or fishing property, shares from a family farm or fishing corporation, or from a small business corporation when this transfer is carried out in favour of a child, a grandchild or a great-grandchild living in Canada.

5. Defer the tax on certain stock option benefits

If you exercised stock options in 2006 on publicly traded shares and expect to keep these shares until at least December 31, 2006, you can defer the benefit related to exercising options worth $100,000, as this amount is based on the fair value of the shares at the time the stock options were granted. To defer the benefit, you have to notify your employer before January 16, 2007, so this information can be included in your T4 (Relevé 1 in Quebec) for 2006. Your tax advisor can help you to determine whether the deferral is beneficial and, if so, how to optimize it.

6. Use your capital losses

Under the tax rules governing capital losses, you can use your 2006 capital losses to decrease the current year’s taxes if you have realized at least an equal amount in capital gains. Many taxpayers also sell their investment losses before the end of the year once they have realized significant gains earlier in the year. But be careful! If, within the 30 days prior to or following the sale of an asset that resulted in a capital loss, you purchase an identical asset, the superficial loss rules prevent you from claiming a capital loss on an asset you clearly intended to continue holding. This rule also applies if your spouse or a company under your control purchases the identical asset.

7. Offset taxable income with an allowable business investment loss

Whereas capital losses can be used only to reduce capital gains, an ABIL can be used to reduce your overall income. Therefore, if you are a shareholder or creditor of a financially unstable private corporation, consider selling your shares or debt to an unrelated person before December 31 to realize an ABIL for 2006. Remember, however, that if you have already claimed a capital gains deduction in the past, the amount of the ABIL is reduced by the claimed amount. Furthermore, pay particular attention to the documentation related to this loss, as the tax authorities could require you to produce it during the assessment process.

8. Donate

If you have not already done so, now is an ideal time to review your donation plans for 2006 and benefit from the charitable donations tax credits. The federal credit is equal to 15.25% of the first $200 of charitable donations paid in the year and 29% for any donation in excess of $200 (12.73% and 24.22% respectively for Quebec residents). For tax purposes in the territories and provinces other than Quebec, the credit varies from 4% to 11% for the first $200 and from 11.16% to 18.02% for amounts exceeding $200. For Quebec tax purposes, the credit is equal to 20% of the first $200 (this amount was previously $2,000) and 24% of the excess.

Another very interesting tax strategy, for both you and the charity, is to donate publicly traded company shares from your portfolio, especially if these shares include a significant unrealized gain. Since 2006, no taxes are payable on capital gains that you make by donating listed shares to a charitable organization (other than a private foundation). Under these circumstances, the charity receives a larger amount than it would have received if you were to sell the shares and donate the proceeds after paying taxes on the gain.

If you are thinking about making a charitable gift before the end of the year and exercising stock options acquired during the same period, then donating these shares to a charity can also be a very effective tax-saving strategy, since you could deduct the entire benefit you received. This easing measure only applies in respect of shares acquired that were donated in the year and in the 30 days after the option was exercised. Under such circumstances, it seems preferable to exercise the options and donate the shares rather than to sell them once the options are exercised and donate the proceeds less the taxes related to the benefit.

9. Repay shareholder loans

If you took a loan from your corporation in 2005, repay it before the end of 2006. If you delay, the full amount of the loan will be added to your income for 2005. An exception is available if the loan was made to an employee-shareholder for purchasing a residence, securities issued by the employer, or a car for work purposes. However, other restrictions apply to these types of loans.

10. Declare a bonus

The small business tax deduction (SBD) is available to CCPCs with incomes of less than $300,000 federally in 2006 (this amount will increase to $400,000 in 2007 and varies as concerns provincial and territorial taxes). If the active business income derived from your company exceeds the $300,000 threshold, it was common to suggest that the corporation pay out a bonus to bring its income below the threshold. In light of the changes made to the federal and Quebec corporate tax rates in 2006 and those that were announced for future years, as well as the changes made to dividend tax rates (see the “eligible dividends” section above), it remains important to make the necessary calculations to ensure that this planning is always on target with your situation and generates the best tax savings possible. Talk to your tax advisor. If you opt for this solution, your company will be able to claim the tax deduction as long as the bonus is paid within 180 days of your corporation’s fiscal year-end.

11. Check whether interest on your loans is deductible

To be able to deduct loan interest when computing your income, the loans must have been contracted for the purpose of earning income from a business or property. If you are currently paying interest that is not deductible (for example, on a home mortgage loan, on a loan to contribute to your RRSP, or to acquire an interest in a life insurance policy), ask your tax advisor if you could reorganize your business affairs to make the interest deductible. Recent legal precedents and the administrative positions of the Canada Revenue Agency regarding interest deductibility should prompt taxpayers to at least review their current situation.

If you are a taxpayer living in Quebec, you will also have to consider the rule which limits the deduction of financing costs related to “passive” investments to the amount of investment income generated from these investments. If your 2004 or 2005 financing costs were limited by the application of this rule and you were unable to defer the amount exceeding the limit in prior years, check whether you can increase your investment income in 2006 to absorb both your financing costs from 2006 and your excess financing costs from previous years. As the capital gains are part of the investment income for purposes of this rule, you may be able to realize additional capital gains for this purpose, if circumstances permit.

12. Make certain disbursements before the end of the year

Some deductions and credits can only be claimed if the amount was disbursed before the end of 2006. This is the case for charitable donations, child support (if deductible), childcare expenses, interest on loans for investment purposes, tuition fees, and union and professional dues.

13. Make your December instalment

If you are required to pay your income taxes in instalments and estimate that your 2006 income will be significantly less than it was in 2005, decrease the amount, if you have not already done so, of your December 15, 2006, instalment. However, be careful when making this estimate: if your actual income in 2006 is higher than expected, you could be required to pay interest that is not tax deductible.

14. Keep your transit passes!

The 2006 federal budget proposed to authorize individuals to claim a non-refundable tax credit for monthly or longer-duration public transit passes purchased after June 30, 2006. The credit for a tax year will be calculated based on the lowest individual income tax rate for the year. While waiting for the Canada Revenue Agency to publish additional information on how to claim the tax credit, keep your transit passes, receipts or other proofs of payment. Quebec will not adopt this measure, having opted to offer different incentive measures to employers in its May 2006 budget.

Jean-Luc Beauregard, Montreal
Marina Panourgias, Toronto

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