Canada, tax, TaxBreaks, February 2006 newsletter

TaxBreaks, February 2006
06-1

What’s new in your 2005 tax returns?
Will the tax proposals announced before January 23 take effect?
Contribute to your RRSP for 2005
How to Reduce the Tax You Pay – New edition

Download the full PDF version of this newsletter below.

What’s new in your 2005 tax returns?

The time of year has arrived when you start to receive information slips and compile other documents required to file your 2005 income tax returns. We would like to draw your attention to certain changes made in 2005, as well as to other noteworthy tax matters.

Filing tax returns
To benefit from the Canada Child Tax Benefit, the Québec child assistance payment and similar programs offered in most other Canadian provinces, both spouses must file an income tax return, even if one spouse receives no income. The same goes for taxpayers wishing to claim the federal GST/HST tax credit or the Québec QST tax credit. If you are a student and want to carry forward tuition fees that you were not able to claim in 2005 because you did not have an income or because your income was not high enough, you should also file a tax return; you should file Schedule 11 with your federal return and Schedule M with your Québec return so that the tax authorities can track these amounts.

Indexation and other changes
In the November 14, 2005, Economic and Fiscal Update, Canada’s Minister of Finance proposed to: (1) roll back the lowest personal income tax rate from 16% to 15%; (2) roll back the non-refundable credit and minimum tax rates from 16% to 15% and (3) increase the basic personal amount by $500 (to $8,648) and the amount for a spouse or common-law partner, as well as the amount for a qualified dependant, by $425 (to $7,344), all retroactive to January 1, 2005. These changes were not reflected in the paper versions of federal income tax returns sent to taxpayers. The changes have now been made to both the guide and forms and a mini-kit has been mailed to taxpayers over the last few weeks. Make sure to calculate your tax using the revised Schedule 1 in order to benefit immediately from these changes.

You will also notice a slight increase in tax brackets and personal credits in 2005 at the federal level and in Québec. The same goes for Newfoundland and Labrador, New Brunswick, Ontario, Saskatchewan, Alberta, British Columbia and the three territories. Tax brackets and personal credits applicable to Nova Scotia, Prince Edward Island and Manitoba remain unchanged.

In the 2005 budget, Canada’s Minister of Finance increased the eligible amount for medical expenses for other dependants from $5,000 to $10,000 (line 331). This measure also applies to all provinces and territories except Québec, where it does not exist as such.

A new non-refundable credit to claim an amount for certain adoption fees, up to a maximum of $10,000, was also introduced at the federal level in 2005. Newfoundland, Ontario and Alberta also implemented this credit. Note that in Québec, the adoption credit has existed since 1994 and that in 2005 the maximum amount is $6,000, to which a 30% credit rate is applicable.

In 2005, Ontario taxpayers must pay the full Ontario health premium created by the Minister of Finance in 2004. The premium is calculated according to taxable income, and the $900 annual maximum is reached when taxable income exceeds $200,600.

Mutual funds and income trusts
If your non-RRSP portfolio contains mutual fund or income trust units, pay particular attention when calculating the cost of these units, i.e., their adjusted cost base (ACB). To avoid double taxation, the ACB of such units must be increased by the amount of periodic income distributed in the form of additional units. Furthermore, the amounts you periodically receive from income trusts often include the payment of a capital sum, which must be deducted from the ACB. By taking these adjustments into account, you can correctly calculate your capital gains or losses when you sell these investments.

Foreign mutual funds and other foreign investments
If you hold investments in foreign mutual funds or interests in other foreign investments, you must determine if the new rules concerning foreign investment entities (FIEs) apply. These rules have been applicable since 2003, although their final version, published on October 30, 2003, and to which certain technical changes were made on July 18, 2005, has not yet been adopted. These rules were created to put an end to the particular benefits enjoyed by Canadians holding foreign mutual funds which were not available to those holding Canadian mutual funds.

FIE rules are complex and cannot be summarized in a few sentences. For more information, please refer to issues 04-1 and 05-4 of our Executive TaxBreaks newsletter, which is available on our Web site. We would advise you to consult a tax expert to find out whether your interests in foreign mutual funds or other foreign investments are FIEs and if they are subject to the new rules, and also to establish the amount to be added to your income.

Note that the proposals do not provide relief in regard to interest and penalties on unpaid taxes for taxpayers who have held FIEs since 2003. Taxpayers who ultimately amend their 2003 to 2005 returns will have to rely on the discretion of the Canada Revenue Agency (CRA) to waive interest. Previously, the CRA had indicated informally that taxpayers would not be assessed interest and late-filing penalties on the amount owed under the new rules, provided that they file amended returns shortly after the legislation is enacted and request that the interest and penalty be waived (presumably under the “fairness” package). We understand that the CRA has indicated recently that it is reviewing this issue and intends to address it when the proposals are tabled in Parliament.

Net capital losses
First you need to determine if your total losses upon disposing of investments and other property in 2005 exceed your capital gains. If they do not, you will have realized a lower net capital gain because of such losses, and half the net gain is taxable. If, on the other hand, the total amount of your losses is greater than your gains, the tax laws provide an alternative: you can either use the loss in future periods against future capital gains, or, if you have declared a net capital gain in one of the three previous years (2002, 2003, or 2004), you can carry it back.

Carrying net capital losses from 2005 back to previous years can be a good move, because you will immediately recover income tax that you have already paid. Elections to carry back losses must be made using the appropriate forms (T1A for federal tax and TP-1012.A for Québec) and not by filing a modified return. The federal T1A form can be joined to your income tax return or sent under separate cover, but the Québec TP-1012.A form must be sent under separate cover. If your income tax returns are filed electronically, you must send a printed version of these forms to the appropriate tax authorities.

Amount for persons with disabilities
If you are claiming the disability tax credit for the first time, you must have Form T2201 filled out by a physician or another authorized person and file it with tax authorities. This form must be received and examined by tax authorities before your income tax return is assessed. If you have already filed this form for a previous taxation year, you do not have to file it again. The fact that you receive a disability benefit under the Canada Pension Plan or the Québec Pension Plan does not necessarily make you eligible to claim the disability tax credit. The equivalent of the disability tax credit in Québec is the amount for a severe or prolonged mental or physical impairment. The required form is TP-752.0.14.

A disabled person can claim a deduction for products and services, including attendant care expenses, as well as other expenses that the individual incurs for products and services that help him or her to earn income despite the handicap. The required form to use at the federal level is T929, while TP-358.0.1 is the required form in Québec.

Stock options
If, in a previous year, you elected to defer a benefit related to the exercise of stock options, and you still held these shares as at December 31, 2005, do not forget to fill out and attach form T1212 to your federal income tax return. This form advises the tax authorities that you are still holding these shares and that the measures deferring the tax on this benefit are still in force. This form has no equivalent under Québec legislation.

The deduction for stock options was not modified in 2005. The deduction for stock options at the federal level is still 50% of the benefit. In Québec, the deduction is 25% of the benefit.

Transfer of dividends between spouses
At the federal level, you may choose to add to your income all of the taxable dividends of taxable Canadian corporations that your spouse received, or is deemed to have received, if doing so increases your claim for the spouse or common-law partner amount. You would normally elect this choice if your amount for your spouse or common-law partner was reduced by the fact that your spouse received dividends but is not subject to tax. The dividends that you chose to include in your income are excluded from your spouse’s income. Using this option can maximize the tax credit for dividends and the amount for your spouse or common-law partner and thereby reduce the federal taxes payable. In Québec, because your spouse can transfer to you his or her portion of non-refundable tax credits that did not serve to reduce his or her own taxes, the option of including the dividends received by your spouse in your income is not available.

Disappearance of the exempt capital gains balance
The federal budget of February 22, 2004, abolished the $100,000 exemption that could, until that time, apply to the capital gains that a taxpayer could realize upon the disposal of most of his or her assets. If, for the 1994 tax year, you made an election (federal form T664) concerning a “flow-through entity” (e.g., a mutual fund trust or a partnership), this asset was assumed to have been disposed of at its fair market value, and the realized gain was recorded in an account named “exempt capital gains balance”. At December 31, 2004, your unused exempt capital gains balance was added to the cost base of the interest that you still held in the entity. If you disposed of this interest in 2005, take into account the increase in the cost base when calculating the capital gain or loss arising from the disposition. Similar rules also exist with respect to eligible capital property (e.g., goodwill) with the “exempt gains balance”.

Elimination of the simplified tax system (Québec)
Québec introduced the simplified tax system (which was never really simple) in 1998 to benefit individuals who received few social benefits. Originally, this tax system stipulated that a flat amount would replace a set of deductions and tax credits, but with the changes made to it over the years, it became increasingly similar to the general tax system, and was therefore eliminated. However, to maintain the advantages of the flat amount, a complementary amount at least equal to the flat amount ($2,965 in 2005) has been granted in order to calculate non-refundable tax credits.

Change to eligible medical expenses (Québec)
Expenses incurred by Québec taxpayers after April 21, 2005, for medical and dental services provided for purely aesthetic purposes are no longer considered eligible expenses. As a general rule, this includes medical and dental services to which GST and QST have been added. Furthermore, expenses incurred after April 21, 2005, for eyeglass frames are limited to $200.

Adjustment of investment expenses (Québec)
Since March 31, 2004, the deduction for investment expenses incurred to earn investment income cannot exceed the income from these investments. You must complete Schedule N, “Adjustment of Investment Expenses” if, in 2005, you incurred investment expenses such as: a loss by a partnership in which you were a specified member; the expenses incurred to earn investment income; or a resource deduction. If your investment expenses exceed your investment income, you must record the calculated adjustment amount on line 260 of your income tax return. Losses incurred from the rental of property are not considered investment expenses as defined by this measure. Another adjustment must be performed, on line 276 of your return, if you claimed a net capital loss from other years or a loss related to a partnership in which you were a limited partner. This measure applies to all taxpayers who file tax returns in Québec. Furthermore, the amounts recorded on lines 260 or 276, depending on the circumstance, could be used to reduce your investment income of the previous three years, or of subsequent years. To reduce your net investment income of previous years, complete form TP-1012.B and file it separately from your return.

Québec designated trust
If you resided in Québec on December 31, 2005, and were a beneficiary of a designated trust, you must complete form TP-663, Information Return to Be Completed by the Beneficiary of a Designated Trust, and check Box 22 of your Québec income tax return. The expression “designated trust” means any trust resident in Canada but outside Québec.

Under federal legislation, if in 2005 the trustee elected to have the income and taxable capital gains taxed in the hands of the trust, and you are the “designated beneficiary”, then in addition to completing form TP-663, you must include your share of this income when calculating your income for Québec tax purposes. Otherwise you may be eligible for a tax credit as a beneficiary of a designated trust (line 411 of Schedule E).

A “designated beneficiary” of a trust means a beneficiary who has a share of $5,000 or more of the income interests or 10% or more of either the capital interests, or of the income interests, of a designated trust.

The purpose of this measure is to counter certain tax planning measures implemented in the past few years by Québec taxpayers wanting to benefit from more advantageous tax rates offered in other Canadian provinces, notably Alberta. By requiring designated beneficiaries to include their share of the trust income in their 2005 income tax returns and granting them a non-refundable income tax credit, the Québec government forces these taxpayers to pay the difference between the Québec taxation rate and that of the other province on the income elected by the trustee.

Taxpayers who fail to include this information in the forms, or the amounts in their income tax returns, face severe penalties. You should consult your tax advisor if you are affected by this measure.

Jean-Luc Beauregard, Montréal

Will the tax proposals announced before January 23 take effect?

We don’t know yet if the new minority Conservative government, elected last January 23, will decide to follow up on the tax proposals announced by the Liberal government in November 2005 in its Economic and Fiscal Update. However, the Conservative Party has already indicated that it would support some of them, including the following:

The reduction of the general corporate income tax rate, which now stands at 21%, to 19% as of January 1, 2010.
The elimination of the corporate surtax as of January 1, 2008.
The elimination of the federal large corporation tax on January 1, 2006, instead of January 1, 2008.

The Conservative government also proposed to reduce the Goods and Services Tax (GST) from 7% to 6%, and eventually to 5%. Furthermore, the personal income tax reduction on dividends announced on November 23, 2005, would be retained. This reduction would take the form of an enhanced dividend gross-up and tax credit.

It remains to be seen if these proposals will be included in the budget that will likely be tabled in April

Contribute to your RRSP for 2005

It is not too late! You still have time to contribute to your RRSP for the year 2005; you have until March 1, 2006 to do so. In fact, contributions made in the first 60 days of the year can be deducted from your income of the previous year.

How to Reduce the Tax You Pay – New edition

Do you want to save taxes for 2005 and implement effective tax planning throughout 2006? If so, you should obtain a copy of the 18th edition of How to Reduce the Tax You Pay, written by members of our firm. With over 380,000 copies in print, this popular annual book, published by Key Porter Books Limited, is now available in or through bookstores across Canada for $19.95 a copy.

About TaxBreaks
A bi-monthly newsletter on corporate and personal tax.

Subscribe
View archives