Canada, tax, Executive TaxBreaks, Summer 2005 newsletter

Executive TaxBreaks, Summer 2005

The CRA “top ten” part III: The return of the taxman
Family discretionary trust: A practical tax planning tool
Rewarding executives of income trusts

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The CRA “top ten” part III: The return of the taxman
In the past two years, at the conclusion of personal tax season, we published an article enumerating the “top ten” items on tax returns that were most often questioned by the Canada Revenue Agency (CRA). This article has proven to be one of the more popular features of Executive TaxBreaks, and so we are pleased to present Part III: The return of the taxman. As in prior years, the information has been compiled using the results of an unscientific poll of our practitioners across Canada. We cannot predict with any certainty which filing positions or claims are likely to be scrutinized. However, based upon our experience with thousands of personal tax returns nationwide, the following items deserve a place in this year’s top ten:

Verification of capital gains and losses. Details in relation to capital gains and losses incurred are often sought by the CRA. It is very important to track cost base information accurately, particularly with respect to income trusts, which often provide a return of capital that erodes the cost base over time, and investments denominated in foreign currencies, where the foreign exchange gain or loss must be calculated in addition to the economic gain or loss. There are often significant discrepancies between the carrying cost reflected on the statements provided by a financial institution in respect of an investment account and the cost of the investments for tax purposes.
Allowable business investment losses (ABIL). This one is automatic. Losses claimed on investments in small business corporations are almost inevitably followed by a standard form letter from the CRA requesting additional information. The ABIL rules are very complicated and it is recommended that all the supporting material be made available at the time the loss is claimed.
Carrying charges. A perennial issue. Expenses incurred to earn investment income, such as interest and management fees, are generally deductible, but it is critical to retain supporting documentation and not to claim any amounts that relate to personal expenses. Increasingly, the CRA is requesting more detailed information and actively investigating the use of borrowed funds.
Foreign tax credits. This item is new to the list this year. Many Canadians earn foreign-source income, either from investing or through employment. Foreign tax credits can generally be claimed against Canadian tax owing to reflect the cost of taxes paid to other countries. The CRA has become much more active in questioning entitlement to claim foreign tax credits and reviewing the amounts claimed.
Province of residence. This topic was a new addition to the list last year, and has garnered even more attention over the last 12 months. The subject of interprovincial tax planning – whether at the individual, trust or corporate level – is growing in importance and the provinces are alert to the need to protect their revenue base. The reference in the May 2005 Ontario budget to increased scrutiny of interprovincial planning is simply the most recent example.
Large charitable donations or donations of property. Cash donations in excess of $25,000 are consistently reviewed, as are donations of property other than cash. There have been significant legislative changes in this area, and the tax authorities are focused on weeding out abusive structures that make inappropriate use of the tax relief provided to charitable donations.
Employment expenses. Eligibility to claim employment expenses is limited, and subject to stringent conditions contained in the Income Tax Act. Because most employees do not qualify to claim this deduction, those individuals that do make a claim should anticipate questions.
Child care expenses. Verification of costs incurred for child care is another common request by the tax authorities. We have noticed that many organizations provide receipts to parents for services that may not qualify for tax relief because their principal purpose is not the provision of child care. Examples of these services include athletic coaching, music lessons and tutoring. Confusion ensues because the receipts are frequently printed with the phrase “for tax purposes” and parents quite reasonably assume the amounts paid qualify for the child care deduction.
Mining and oil & gas investments. Request for flow-through amounts and investment tax credit confirmation is fairly standard. It is not uncommon for these items to be reported incorrectly for tax purposes, particularly when an individual is not familiar with the specialized tax rules governing resource investments.
Tuition/Education expenses. Support for tuition and education expenses is consistently requested, so make sure your student has the documentation!

Heather Evans, Toronto, with contributions from across Canada

Family discretionary trust: A practical tax planning tool
Setting up a family discretionary trust can allow income splitting within the same family. Plans must be carefully established, as several conditions must be met to reach the desired goals. Note that the following information applies only to inter vivos trusts, meaning those created by a person while he or she is alive.

What is a family discretionary trust?
A family discretionary trust is a trust created for the benefit of several members of the same family. One or several persons (called trustees) manage the trust’s assets to suit the best interests of the beneficiaries. A trust qualifies as a discretionary trust when the trustee has the authority, at his or her full discretion, to pay or use the trust’s income or capital to benefit one or more beneficiaries. A trustee may even, for a given year, decide to keep all of the income at the trust level. The discretionary authority of the trustee could also be partial, or effective for only a limited time. For example, a trust could be entirely discretionary for as long as Mr. X is alive, but upon his death it would become non-discretionary, and the interests of each beneficiary would then be calculated according to the trust deed.

Assets that can be held in a trust can be of different types (for example, an investment portfolio, shares in a private company, rental properties, a principal residence, etc.). Assets can be given to the trust or acquired by it.

Tax rules to consider
Before creating a family discretionary trust aimed at income splitting, one must consider certain tax rules on asset transfers, as well as potentially applicable attribution rules that could restrict income splitting possibilities for the family. From a tax point of view, the transfer of assets by one person to a family discretionary trust gives rise to a disposition of assets at their fair market value for the donor. Furthermore, the attribution rules – which were created to prevent income splitting between spouses and between family members and their descendants or their minor nephews and nieces – could apply after the donation and deem the income to have been earned by the donor, thereby preventing any income splitting. Note that capital gains earned by a minor are not subject to the attribution rules.

In addition, certain types of income received by minors, such as taxable dividends from private companies, are taxable at the highest marginal rate, regardless of whether the attribution rules apply.

To be exempt from the attribution rules, the trust must be set up from the outset of a company’s start-up operations, regardless of the nature of the company (active or investment business). The trust should acquire the assets directly, as opposed to receiving them from a third party.

Once a structure to circumvent the attribution rules has been put in place, it is then possible to split income by allocating income to beneficiaries who are subject to lower tax rates. As such, the amounts paid and allocated will be deducted from the income earned by the trust and will be taxable in the hands of the beneficiaries. All income kept in the trust will be subject to the maximum marginal tax rate applicable to individuals.

Tax planning
Despite the existence of these rules, it is possible to set up advantageous plans to split income within the same family. Aside from allocating a trust’s capital gains to minor children and all types of income to adult children (by allocating, for example, income generated by the trust’s assets to an adult child to pay university tuition), other plans can reduce a family’s tax burden.

When no trust was created at the outset of a company’s operations, it is often possible, when implementing an estate freeze, to integrate one by having it subscribe independently for common shares of the company that operates the family business. The trust could then split the dividends received from the company with the spouse and children (subject to the company qualifying as a “small business corporation”).

In addition, given the low current prescribed rates, it could be advantageous, in tax terms, for a parent to make a loan to a trust at the prescribed rate (3% for the third quarter of 2005); the trust would, in turn, invest the loan in an investment that might generate a higher return than the interest paid. The income generated by the investments could then be allocated to the spouse and minor children without contravening the attribution rules.

Finally, a discretionary trust could constitute a vehicle to hold rental properties. In addition to the trust not being subjected to capital tax, if the rental property is acquired from a third party, the rental income generated by the property could be allocated to the spouse and minor children without contravening the attribution rules.

All in all, a family discretionary trust can bring you many advantages. Our professionals would be happy to assist you in setting up a structure that meets all your objectives.

Cindy Harvey, Montreal
Sophie Bélanger, Montreal
Danielle Lacasse, Montreal

Rewarding executives of income trusts
There has been a wave of change in executive compensation in the past few years. Now, the employers are facing a new challenge – how best to reward executives and trustees of income or royalty trusts.

The popularity of the trust structure has resulted in the conversion of a number of companies to income trusts. This, in turn, has given rise to opportunities and obstacles as the new trusts try to replicate compensation plans sponsored by the previous corporate employer or introduce new plans to attract top executive talent.

Many compensation arrangements currently recognized for income tax purposes pre-suppose the existence of a corporate employer. This can make it challenging for income trusts to provide comparable compensation plans. In addition, the status of a trustee as an officer or employee of the trust is unclear under the Canadian Income Tax Act (the Act). Consequently, extra care should be taken when extending to trustees compensation plans designed for employees.

Deferred bonus plans, Unit option plans, Deferred stock unit plans and Executive loans are compensation plans that deserve consideration.

Deferred bonus plans
Under a deferred bonus plan, payment of a bonus is deferred until the executive satisfies certain vesting criteria, such as remaining in employment for a specified period of time. The amount that would otherwise be paid as a bonus is invested, notionally or through the use of a special purpose trust that acquires the employer’s shares, for the duration of the vesting period. Once the vesting criteria are satisfied, the bonus, plus any appreciation from the investment in the employer’s shares, is paid to the executive. To avoid certain adverse tax consequences, the bonus typically vests and is paid out within three years following the year in which the services giving rise to the bonus were rendered. The employer, in general, is entitled to a deduction when the bonus is paid to the employee.

Trust employers face unique considerations when sponsoring such plans:

Typically, income trusts attempt to maximize the after-tax funds that may be distributed to investors. As noted above, the employer cannot claim a deduction until the amounts are included in the executive’s income. In some situations, the deferral of the deduction may adversely affect a trust’s ability to meet a desired mix of income and return of capital for distributions to current unit holders.
Any appreciation on the bonus resulting from the notional or actual investment in the trust units is taxable as employment income to the executive, as is any portion of the distributions that represents a return of capital on these units.

In addition, when converting from a corporate to a trust structure, existing deferred bonus plans should be reviewed and a number of structural matters should be considered. For example:

It may be necessary to modify the control provisions to ensure that they do not accelerate the vesting arrangements.
The employer should not contribute units to the trust to meet funding requirements. Rather, cash should be contributed and the units purchased from independent third parties to avoid jeopardizing the deductibility of the contribution.

Evaluating the effectiveness of a deferred bonus plan from both the employer’s and employee’s perspectives requires an up-front model of the after-tax cash flows for the income trust and the employee. The effect of the deferred deduction on investor cash flow and taxation of distributions as employment income must be balanced against the human resource objectives for employee retention and delivery of a target level of compensation.

Unit option plans
Under the Act, options granted by an employer to an employee to acquire units of the income trust are generally subject to the same tax rules as employee stock options. As in the case of stock options, if certain requirements are met, only 50% (75% in Quebec) of the benefit realized on exercise is subject to tax.

However unit option plans have had mixed success. The value of the trust units is often in the income distribution stream. As a result, the underlying units may not increase significantly in value. As unit options are typically issued with an exercise price equal to the fair market value of the units at the time of grant, a static unit value will undermine the incentive aspect of these plans.

Some employers have tried to compensate by reducing the exercise price, either as income distributions are made under the old units, or in response to the satisfaction of certain investment criteria. Unfortunately, unless the reduction in the exercise price does not exceed a corresponding decline in the fair market value of the underlying units, this reduction will cause employees to forfeit their entitlement to the deduction (50% of the benefit realized upon exercise at the federal level and 25% in Quebec) that could otherwise be utilized upon exercise of the option to reduce their personal taxation.

Deferred stock unit plans
Deferred stock unit (DSU) plans are also commonly referred to as “phantom stock plans”, as no shares are actually issued to the employees. Rather, employees are issued notional shares in lieu of a bonus or other current income. Amounts are payable under the plan only following an employee's death, termination of employment, or retirement (whichever event occurs first). At that time, employees exchange their DSUs for a cash payment equal to the market value of an equivalent number of the employer’s shares.

The Act imposes certain conditions on a DSU plan. Failure of the plan to meet these conditions will result in the executive’s being subject to current tax on the value of the benefit accruing under the plan. One such condition is that the amount payable under the plan must be based on the fair market value of a class of shares of the corporate employer or a related corporation. The Act does not permit the value of a DSU to be tracked to a “unit” as opposed to a share. Thus, the implementation of such plans requires additional consideration and planning.

Executive loans
Many corporate employers have share ownership guidelines under which executives are encouraged to invest in the company. To facilitate such investment, the employer may loan to executives the funds needed to purchase the shares on the open market. If no interest is charged on the loan, or the rate is less than a prescribed rate set under the Act, the executive will be taxed on the interest benefit. However, this benefit should be treated as interest paid for investment purposes. As a result, the executive may be able to claim an offsetting deduction on the basis that the loan was used to acquire a capital asset, namely his or her employer’s shares.

However, this position may not be applicable to executives of income trusts who use low- or no-interest loans to invest in units of their employer. The Canada Revenue Agency recently indicated in a technical interpretation that a portion of the interest on a loan used by a unit holder to acquire units in a real estate investment trust (REIT) was not deductible to the extent that the unit holder received a capital distribution from the REIT and used such distribution for personal use. Thus, consideration must be given to reinvesting the capital distribution to maintain deductibility of the interest benefit.

It should also be noted that the restrictions in the Act concerning loans to shareholders are not applicable to loans made to unit holders.

Issues to review
As income trusts continue to grow in popularity, the need for effective compensation programs will also increase. However, existing corporate programs often will not provide satisfactory solutions without significant modification to accommodate the different structures of the income trust, the needs of investors and the implication of certain very detailed tax requirements set out in the Act. The successful design and implementation of such programs involves reviewing numerous issues. Advice from a range of professionals should be sought.

Susan Madu, Calgary
Anne Montgomery, Toronto

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