China tax reform update
Is the TFSA for you?
It’s time to start thinking about tax automation

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China tax reform update

In 2008, the Olympic Games are not the sole focus in China: it’s also the year in which a significant tax reform takes place. The Chinese tax system that we described in our April 2006 issue of TaxBreaks has undergone major changes.

Effective January 1, 2008, the new Enterprise Income Tax Law consolidates the law for domestic Chinese enterprises and the one for foreign enterprises and foreign-invested enterprises. This new law provides for a 25% rate that applies to both domestic and foreign-funded enterprises and, subject to transitional relief, enterprises that have enjoyed preferential treatment.

The new law is drafted in a very broad manner and the detailed implementation rules were officially issued on December 11, 2007. However, implementation details on some aspects are not covered in the implementation rules and it is expected there will be future circulars or further amendments; some of the rules issued in the past few months include the following:

Withholding tax on dividends
As was widely expected, the withholding tax rate on dividends has been set at a rate of 10%. Previously no withholding tax was levied on the payment of dividends. However, this withholding tax rate is reduced by several treaties to 5%.

The imposition of a dividend withholding tax may require the reorganization of holding structures to ensure holding companies are resident in an appropriate treaty jurisdiction to take advantage of the 5% reduced withholding rate.

Business agent
The presence of a business agent will result in a taxable presence in China. An agency relationship is deemed to exist where there is warehousing, shipping or receiving activity. 

The threshold for establishing a taxable presence may be raised by a tax treaty, and so existing supply chain arrangements should be reviewed and/or restructured if necessary to ensure an unintended taxable presence is not created in China.

New research and development tax incentives
A 15% incentive rate will apply to all enterprises, regardless of their location, engaged in designated “new high-tech” enterprises. The specific requirements to qualify to establish a high-tech enterprise are not fully defined. However, qualification will require ownership of intellectual property and a certain amount of research and development (R&D) activity within China. The detailed rules will be released at a later date.

Moreover, a super deduction equal to 150% of eligible R&D costs will be permitted. The definition of eligible costs and activities will also be released at a later date.

Transitional relief for former tax incentives
Effective January 1, 2008, tax holidays are eliminated. However, tax holiday periods that were approved prior to that date and that had not previously started are deemed to have begun January 1, 2008, and will expire December 31, 2012. A 100% exemption applies in years one and two and a 50% tax exemption in years three to five.

Enterprises that previously benefited from favourable tax rates (e.g., 15%) that no longer qualify for preferential rates will be subject to the general tax rate of 25% in 2012. Until then, their rates will gradually increase over the next years as follows:  2008 – 18%, 2009 – 20%, 2010 – 22%, 2011 – 24%.

General anti-avoidance rule
The general anti-avoidance rule (GAAR) will apply if the main purpose of a transaction is to reduce, avoid or defer tax payments. The rule is similar to Canada’s GAAR in that, to avoid its application, a transaction should have a valid business purpose. The implementation rules did not state whether the rule would apply retroactively or how the provision will be interpreted.

Transfer pricing
Transfer pricing rules will apply to all related party transactions (domestic and foreign). Documentation is required to be filed annually with the tax return reporting related party transactions containing information similar to Form T106 in Canada. Based on the draft implementation rules, transfer pricing documentation must also be submitted within thirty days of receiving a request from the tax authorities (although this can be extended by a further 45 days). A 5% penalty (in addition to interest) will apply to any tax resulting from a transfer pricing adjustment if documentation is not sufficient.

Companies interested in exporting their products to China to take advantage of the vast pool of consumers or in setting up a low-cost manufacturing centre, should take these new tax measures into account, as they may have a significant impact on the way the operations are structured.

Charles Evans, Kitchener
Jay Niederhoffer, Toronto

Is the TFSA for you?

A number of studies show that Canadian households are amassing record levels of debt. To reverse the trend and encourage saving, the federal government introduced the tax-free savings account (TFSA) in its February 26, 2008 budget.

In some ways, the TFSA mirrors the registered retirement savings plan (RRSP) and registered education savings plan (RESP). As with RRSPs, there is an annual contribution limit, but like RESPs, the contributions are not deductible. Unlike RRSPs, however, the contributions and income that accumulate in a TFSA are not taxable on withdrawal. A TFSA therefore lets you grow tax-free investment income (i.e., interest, dividends and capital gains) earned on the contributions made using already taxed income.

Contribution and withdrawal
Starting in 2009, individuals 18 years of age and older who are resident in Canada may contribute a maximum of $5,000 to a TFSA each year. This amount will be indexed as of 2010 and rounded to the nearest $500. Unused contribution room can be carried forward to future years. Accumulated amounts may be withdrawn from the TFSA as needed and at any time. The tax benefit will not be lost if an amount is withdrawn from a TFSA because the individual will gain contribution room equal to the withdrawal, making a TFSA much more flexible than an RRSP where the contribution room is lost.

Let’s look at an example of how it works (disregarding indexation). If you contribute $2,000 to a TFSA in 2009, your contribution room for 2010 will rise to $8,000 ($5,000 in 2010 and $5,000 minus $2,000 from 2009). A few years later, say in 2016, you withdraw $35,000 from the TFSA to buy a car. You can then contribute $35,000 to your TFSA because you gain back contribution room equal to the withdrawal without affecting your annual contribution room.

Other features
Generally speaking, a TFSA is administered in the same way as an RRSP: an account has to be opened with an authorized issuer, you must provide your social insurance number, and loan expenses and interest are non-deductible, etc.

There is no restriction on how withdrawals can be used. Withdrawals may be made for personal reasons, investment, or any other purpose.

As with RRSPs, the money must be invested in qualified investments and there will be penalties for contributions exceeding the annual limit.

Transfer
Individuals may contribute to their own TFSA with funds provided by their spouse without the spouse’s annual contribution room being affected. Moreover, the attribution rules will not apply to income earned on those contributions.

On death, the money held in a TFSA can be directly transferred to the surviving spouse’s TFSA, whether or not the spouse has contribution room and without reducing the spouse’s existing contribution room. The amounts accrued in the TFSA will thus continue to be tax exempt. On the breakdown of a marriage or common-law partnership, an amount can also be directly transferred to the ex-spouse’s TFSA. Although the transferor’s contribution room will not be reinstated, the transfer will not be counted against the transferee’s contribution room.

Should you contribute to a TFSA?
Because TFSA withdrawals are not included in income, they will not affect eligibility for income-tested benefits or credits such as Old Age Security benefits, the Guaranteed Income Supplement, the Canada Child Tax Benefit, Employment Insurance benefits, the Goods and Services Tax Credit and the Age Credit.

This means that even if contributing to a TFSA yields no immediate tax break, unlike an RRSP, the benefit arises when you withdraw money.

Also, because amounts accumulated in a TFSA are not taxable, it may be advantageous to invest in interest-generating investments taxed at the highest rate (maximum tax rate of 48%). On the other hand, investments giving rise to a capital gain (maximum tax rate of 24%) may have a potential for better returns, but the risk is higher.

Lastly, don’t forget about TFSA implementation and management fees. The materiality of these fees will be lower if you take a long-term rather than a short-term investment horizon.

We definitely recommend investing in a TFSA, but only after making the maximum contribution to an RRSP, which gives you an immediate tax break because it can be deducted from income. A TFSA should be considered as part of an individual’s overall saving strategy, a strategy that includes an RRSP, as well as an RESP if the individual has dependent children.

Yves Thivierge, Quebec
Julie Galibois, Quebec

It’s time to start thinking about tax automation

Five years ago, tax automation software was virtually non-existent – five years from now, it will be commonplace. For many companies, it may be time to start thinking about implementing one of the new software applications that can raise the efficiency and value of the tax department.

The majority of companies in Canada do tax provision work with basic spreadsheet software and manual data transfers. These kinds of systems have drawbacks that become clearer as companies grow in size and complexity. As the corporate structure grows larger and more intricate, the spreadsheets can become awkward to manipulate. For any size company, the risk of data entry errors or corrupt formulas is high. Further, spreadsheets are very limited when it comes to modeling or forecasting, and in meeting new regulatory requirements. If one line item changes on the provision worksheet, the same change has to be replicated for budgets and forecasting models. Maintaining a history of those changes is another challenge.

As a result, tax provision work tends to involve a great deal of time-consuming checking by senior tax professionals – often under extremely tight deadlines.

Automating software has become the norm in many other areas of finance, but differences between tax jurisdictions have posed a challenge that delayed the development of appropriate software. However, in the last two or three years, the drive to develop software to automate and streamline the tax provision process has accelerated.

More complex regulatory requirements, and the subsequent need to share more detailed tax information across an organization, are among the key drivers behind the stronger push to automation. In addition, the tax department’s ability to add value in the decision-making process is being recognized. However, to have time for that, the tax directors must move beyond a compliance-only role; tax provision software helps by improving efficiency.

Companies in the United States and Europe have been the first to switch to automated, technology-enabled systems. The growth of such applications abroad is attributed to the greater number of large companies, for whom the problems inherent in spreadsheet systems tend to be bigger and arise sooner. In Canada, we’ve been able to wait and then take advantage of others’ experiences in the area of tax automation.

The primary benefit from moving to a technology-enabled tax provision process is the reduction in non-productive work, which frees up the time of tax professionals for more valuable, strategic projects. It also improves financial reporting controls, because checking for errors and inconsistencies is far easier. The software also facilitates comparisons and assessments of potential changes.

An automated tax provision process does still require a considerable amount of data entry; however, interfaces and security measures mean it’s possible for more junior staff to complete these kinds of tasks.

The software applications that are currently available offer varying degrees of user-friendliness and differ in the number and type of reports that can be produced, but they are very similar in their essentials. TaxStream and CORPTAX, both from the United States, are the leaders in the market, and are expanding the applicability of their products globally. Longview is the leading Canadian provider.

Choosing the right software provider requires considerable time from the tax group, but is necessary to get the software that works best for your company. Based on experience gained working with colleagues in the United States and Europe, our TMC group recommends assessing applications based on usability, controls and security features, reporting functionality, and data collection and calculation functionality.

The first step in any implementation plan should be developing a clear understanding of your current processes and needs, as well as possible future needs. This will enable you to define the solution that best serves you and your company. Most of all, it is important to realize that this is not just about loading a new software application – automating your tax provisioning can involve fundamental changes to the way a tax department operates.

Moving to an automated tax provision process is a significant investment in time and money, but one that offers clear and valuable benefits. To be useful, tax automation software needs to do all the things that spreadsheets do, but better and more efficiently. The application should also provide better planning abilities and be suitable for use in very tight timelines. Companies that have already done such implementations have no doubt seen the promised benefits, since none of them have announced a return to the old spreadsheet approach.

The time to start thinking about tax automation is coming – how soon may depend on the size and structural complexity of your company. You can benefit from the new method immediately. Our professionals will be delighted to help you.

Harold Chmara, Toronto

Set for April 30th?

You may feel as if the deadline to file your tax returns has arrived faster than spring this year but the fact is that the countdown to April 30th is on!

If you have a balance owing, your must file your tax returns no later than April 30, 2008. Otherwise, you will be charged compound daily interest, at an annual rate of 8% (9% in Quebec), starting May 1, 2008, on any unpaid amounts owing. If you carried on a business in 2007, you have until June 15, 2008 to file your returns. However, if you have a balance owing, you still have to pay it by April 30. Note that the right to file on June 15 is extended to the spouse or common-law partner of the self-employed individual.

Moreover, if you owe tax for 2007, and do not file your return on time, you will be charged a late-filing penalty both at federal and Quebec levels; this penalty is 5% of your balance owing, plus 1% of your balance owing for each full month that your returns are late (to a maximum of 12 months).

If you file your tax returns online or file by mail but without including some supporting documents, make sure you keep all tax records you don’t send in case you are contacted by tax authorities. Some specific items, such as medical or moving expenses, are more frequently queried than others by tax authorities.

Do you file your tax returns yourself, or do you simply want to get a better understanding of your tax returns? Then the 2008 issue of our book How to reduce the tax you pay is a must-have (published by Key Porter and available in bookstores). This indispensable guide written by our tax professionals will provide you with valuable tips that will enable you to minimize your tax burden and avoid costly mistakes.

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