INVESTMENT INCOME PLANNING

Transcription

1 INVESTMENT INCOME PLANNING COURSE 5: BORROWING TO INVEST WITH INSURANCE 2011 The Knowledge Bureau. All rights reserved. This entire work print, audio and online is licensed to AGF for use with permission. It is copyright protected and may not be reproduced by users in any manner, or stored on any system, without prior permission. For details on reproduction policy see: Disclaimer: Much care has been taken to produce accurate subject matter and to trace ownership of copyrighted matter in the material; however, the publisher will welcome any information that enables it to rectify any reference or credit, for subsequent editions. The material provided in this publication is provided for general informational purposes only. Laws, regulations, policy and procedures regarding this subject are continuously changing and the information and examples are intended as general guidelines only. This publication is therefore presented with the understanding that neither the publisher, authors nor AGF can be held liable for any actions taken as a result of the material presented. It is therefore recommended that professional advice be obtained before acting on any of the information herein. Users of the information in this module are responsible for their own actions and outcomes. AGF, Knowledge Bureau, its authors, lecturers and publishers expressly disclaim any and all liability in respect of any consequences.

2 Course Content Instructions for use: Step 1: Watch the Online Lecture View the audio-visual presentation for this course by logging in online. The online lecture will open in a new window (or tab). It may take up a minute for the presentation to load, depending on your connection speed, so please be patient. Step 2: Read the Knowledge E Journal Review the online E-Journal for this course. Step 3: Take the CE Quiz Take the CE Quiz online. A mark of 60% is required to pass the course. A make-up Quiz is available for this course, if required. On successful completion of the course: Print your certificates Knowledge Bureau CE Certificate Alberta Insurance Council Certificate Insurance Council of Manitoba Continuing Education Certificate Chambre de la sécurité financière Attendance Certificate Need help? Click the HELP button available online. 5.2

3 YOUR INSTRUCTOR WALTER HARDER Knowledge Bureau Faculty Member Walter Harder is a graduate of the University of British Columbia where he holds an honours degree in Physics. Walter started his career as a high school teacher, teaching math, physics, biology and chemistry as well as science, but once he discovered the world of income tax, he left high school teaching to join one of Canada s largest income tax firms, H & R Block. Walter was soon conducting management training for managers across the country. He moved on to managing the creation of the internal communications and income tax courses for the company. In the 80s he spearheaded the computerization of the income tax preparation function. In 1995, Walter joined CANTAX to stabilize its software development after strategic moves to development in Quebec were ill received. In the following years, he introduced many new features in the product, including a variety of tax planning calculators, which helped it to maintain its reputation as the most popular income tax preparation product in Canada. Walter also created the TaxBase software, designed to help income tax professionals manage their businesses more effectively. In this capacity, Walter toured Canada each fall presenting an update on income tax and software features to professional customers coast to coast, and so is well known to professional tax practitioners nationally. Each year he also worked with The Jacks Institute as their lead training software developer including the creation of their leading edge InstaGrader feature. He is currently President of Walter Harder and Associates, specializing in tax research, and business building tool development. Walter has been selected to lead tax research and web tools development for The Knowledge Bureau. The Knowledge Bureau is a national designated educational institute focused on excellence in financial education for financial advisors and their clients. Reminder: Listen to the online lecture from the instructor before reviewing the Knowledge E-Journal. 5.3

4 COURSE 5 BORROWING TO INVEST WITH INSURANCE Online Lecture Knowledge Journal Reading Time CE Quiz 30 minutes 30 minutes 10 minutes Great Transitions Require Stewardship for Real Wealth Management. The Knowledge Bureau KEY CONCEPTS AND ISSUES - WHAT YOU WILL LEARN: Generally the cost of insurance related to earning income from business or property is deductible by the taxpayer. However there are exceptions to the rules. In this Course the participant will learn more about interest deductibility and the deductibility of insurance. NEW SKILLS TO BE MASTERED: When interest is deductible When the cost of insurance is deductible Interest on loans to buy life insurance policies and annuity contracts Interest on Policy Loans Unreasonable interest charges Interest on disappearing sources Capitalizing interest costs LEARNING ACTIVITIES: To test the learning process, the student will answer THREE multiple-choice questions and contemplate the role of the advisor and insurance solutions, as required. 5.4

5 COURSE 5 BORROWING TO INVEST WITH INSURANCE When interest is deductible The general rule applied by the Income Tax Act is that taxpayers must pay tax on their income from business or property. In calculating income from a business, the taxpayer may deduct any reasonable expenses incurred to earn that income. Because the number of such expenses is large and varies from one business to another, the Income Tax Act does not list all of the allowable expenses, but only specifies that the expenses must be reasonable and must have been incurred to produce income from the business. Under those guidelines then, reasonable interest incurred to earn business income is deductible. Examples: the cost of mortgage interest on the acquisition of a piece of real estate used by the business to earn income the interest on a line of credit used by the business to provide working capital for the day-to-day operation of the business. In calculating income from property (i.e. passive rather than active income), taxpayers may deduct, as a carrying charge, the cost of interest paid in order to acquire the asset that earns the income. Examples: the mortgage interest on the acquisition of a rental property the interest paid to a broker on a margin account used to purchase stocks. Unfortunately, capital gains are not considered to be income from property so the intention to earn capital gains on the sale of stock does not make the interest paid on a loan to buy the stock deductible. However, in the case of borrowing to purchase stocks, CRA has stipulated that interest is deductible if there is the possibility that the stocks might pay dividends. Thus, whether the stock actually pays dividends or not, the interest paid on money borrowed to purchase the stocks is deductible, unless the stock has a published policy that it will not pay dividends. Under certain circumstances interest may not be deductible in the year paid but might have to be capitalized. See Capitalization of Interest later in this course. 5.5

6 When the cost of insurance is deductible Most expenses not related to the earning of business income are not deductible, unless specifically mentioned as deductible in the Income Tax Act. For individuals, the cost of insurance generally falls into that category. One exception is the cost of private health insurance which may be claimed as a medical expense. Where insurance premiums are paid in order to earn income from a business or property, then those premiums will generally be deductible. Examples: Fire insurance premiums on a rental property Errors and Omissions insurance premiums for a self-employed consultant Liability insurance premiums for a business Group insurance premiums paid by an employer for employees if the premiums are a taxable benefit to the employees Private health insurance premiums for the proprietor and employees of a business so long as more than half of the employees are covered by the plan Life insurance premiums are generally not deductible, even if paid through a business. There is one exception to this general rule. If the business is paying for life insurance on the life of an employee, the premiums for this life insurance policy are only deductible as a business expense if the insurance was a requirement to obtain financing. Interest on loans to buy life insurance policies and annuity contracts Just as life insurance premiums themselves are generally not deductible, the cost of borrowing to buy life insurance policies is not deductible. Exceptions to this rule are: a policy that is or is issued pursuant to an RPP, an RRSP, an income-averaging annuity contract, or a DPSP segregated fund Investments in segregated funds are considered to be investments to earn income from property and are therefore deductible as a carrying charge. Likewise, interest on loans to buy annuity contracts is deductible to the extent that the income from the annuity is included in income. 5.6

7 Example: Loan to Purchase Annuity Contract A taxpayer paid $2,000 interest in 2011 on a loan to purchase an annuity contract and only $1500 of the income paid out of the annuity was taxable to the taxpayer in Only $1500 of the interest on the loan will be deductible. Interest on Policy Loans When a taxpayer borrows against an insurance policy (policy loan), the interest paid is deductible under the same general rules as outlined earlier if the loan proceeds are used to earn income from a business or property, then the interest paid is deductible, otherwise it is not. Where only a portion of the proceeds are used to earn income, then the pro-rata portion of the interest paid on the loan is deductible. Example: Policy Loan Interest John borrows $100,000 against the cash surrender value of his life insurance policy. He uses $50,000 to pay off consumer debt and invests $50,000 in shares. In 2011, his policy loan interest is $2,500. As he used 50% of the loan proceeds for investment purposes, he may deduct 50% x $2,500 = $1,250 as a carrying charge in In order to deduct policy loan interest, both the insurer and the taxpayer must complete Form T2210 Verification of Policy Loan Interest by the Insurer. Interest paid on a policy loan may either be deducted or added to the adjusted cost base of the policy, but not both. Example: Policy Loan Interest John (previous example) can add the remaining $1,250 to the ACB of the policy as he did not deduct it. Unreasonable interest charges As stated earlier, a taxpayer may claim any reasonable expense incurred to earn income from a business. Thus reasonable interest charges may be deducted. Likewise, only reasonable carrying charges paid may be deducted against income from property. Interest charges in excess of reasonable amounts may not be deducted. 5.7

8 Example: Unreasonable Interest The taxpayer borrowed $200,000 with a stated interest rate of 20%. The taxpayer could have borrowed from another lender for 6% but chose not to do so as a result of some fairly strict covenants. Interest of $38,000 is paid in The taxpayer will be entitled to deduct $11,400 as an interest expense despite having paid $38,000 in interest. (6% / 20% x $38,000) Interest on disappearing sources The general rule is that interest paid on money borrowed to purchase an income-earning asset is only deductible so long as that asset continues to be used to earn income. Once the asset is sold, the interest on the loan is no longer deductible. An exception is made when the value of the asset decreases and the taxpayer disposes of the asset and the proceeds of disposition are used to reduce the loan balance. Interest on the remaining balance may still be deducted even though the income-earning asset is no longer owned. Where the proceeds are not used to decrease the outstanding loan balance, only the interest on the balance in excess of the proceeds may be deducted. Example: Disappearing Asset Mary borrowed $50,000 to purchase 1000 shares of BP at $50 per share. After the Gulf oil spill in 2010, the value of the BP shares plummeted and she sold the shares for $30 per share. She paid down the loan with the proceeds but the balance remained at $20,000. Interest on the loan for 2010 was $2,000. In spite of the fact that Mary no longer owns any of the shares, she can deduct the full amount of the interest paid on the loan in She may also continue to deduct the full amount of interest paid on the loan in future years until the loan is repaid. Capitalizing interest costs Sometimes, especially at the start-up of a business, the taxpayer s income is not sufficient to benefit from the allowed deduction for interest costs to acquire depreciable business assets. In this case, the taxpayer has the option to add the interest to the cost base of the assets rather than claiming a deduction for the interest and claim those interest costs as capital cost allowance (depreciation for tax purposes) in later years. The election to capitalize interest may be made on all or any part of the interest paid and may be made applicable to the year the election is made plus any of the three taxation years preceding the election. 5.8

9 It should also be noted that interest paid that is related to the construction or renovation of a building prior to completion of the construction or renovation must be added to the cost base of the property and may not be deducted during the construction or renovation period. Also interest on undeveloped land may not be deducted but must be added to the cost base of the land. Example: Election to Capitalize Interest Anthony opened a new restaurant in He borrowed $300,000 to renovate a local building which he already owned and another $100,000 for furniture and equipment for the restaurant. The restaurant opened in December. Aside from any claims for interest, the net loss from operations was $20,000. The interest on the $300,000 loan during the period of renovations is not deductible, but is added to the cost base of the building. The interest on the renovation loan after renovations were complete and the interest on the loan to purchase furniture and equipment are deductible, but with the business already having a loss from operations, there would be no tax benefit to claiming the expense. Anthony may elect to add the interest that would otherwise be deductible to the cost base of the building, furniture and equipment in In future years, when income is sufficient to absorb the expense, that capitalized interest may be deducted as capital cost allowance. 5.9

10 IN SUMMARY: KEY CONCEPTS Interest (including policy loan interest) is deductible if it is reasonable and paid to earn income from business or property. Insurance premiums are deductible if paid to earn income from business or property. Life insurance premiums are not deductible by an individual and generally not deductible by a business unless the insurance is required in order to secure financing. Policy loan interest that is not deducted may be added to the cost base of the policy. When the value of an asset decreases, interest on the loan to purchase the asset may still be deductible after the asset is disposed of. In some cases, interest paid may be added to the ACB of an asset rather than being deducted. 5.10

11 NEXT STEPS This completes the written portion of your course material. Please return to your online course and take the CE Quiz for your certification and accreditation. 5.11

12 Evaluate this course and Receive $10 Off your purchase of any of these books: 5.12