TAX LETTER for May 2004 INCOME ATTRIBUTION RULES SPLIT INCOME OF MINOR CHILDREN FEDERAL BUDGET HIGHLIGHTS AROUND THE COURTS

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1 BLAIN M. ARCHER, B.Sc., CA* PAUL M. FOURNIER, B.Sc., CA* RUSS J. WILSON, B.Sc., CA* KATRIN BRAUN, B.B.A., CA* KELLY A. RIEHL, B. Comm., CA* TAX LETTER for May 2004 INCOME ATTRIBUTION RULES SPLIT INCOME OF MINOR CHILDREN FEDERAL BUDGET HIGHLIGHTS AROUND THE COURTS INCOME ATTRIBUTION RULES Overview of the rules There are various income attribution rules under the Income Tax Act that can apply if you lend or transfer money or property to family members for inadequate consideration. If the rules apply, the income from the loaned or transferred property will generally be included in your income. The purpose of the rules is to avoid income splitting between high tax bracket family members and low tax bracket family members. For example, if you are in the highest tax bracket and your minor child has no income, it would obviously be beneficial from a tax perspective to have some investment income shifted to your child, who would be taxed at a lower rate than yourself. Unfortunately, the government does not generally take kindly to these types of income splitting arrangements. Under the income attribution rules, if you lend or transfer property which includes money to or for the benefit of your spouse or commonlaw partner, or a person who has since become your spouse or common-law partner (i.e. after the loan or transfer), any income or loss from the property will be deemed to be your income or loss. The attribution of the income or loss from the property can continue throughout the period that you are a resident of Canada. The attribution will cease if you are no longer married or in the common-law relationship, or if you are living separate and apart by reason of breakdown of the marriage or common-law relationship. Similar rules provide that any taxable capital gains or allowable capital losses from the loaned or transferred property to your spouse or common-law partner are attributed back to you. An income attribution rule also applies to your loans or transfers of property to non-arm s length children under the age of 18 (e.g. your children, grandchildren, great-grandchildren) and nieces and nephews under the age of 18. In these cases, the attribution will normally cease in the year in which the children turn 18. Note that there is no attribution rule for capital gains of children. Accordingly, you can loan or transfer property to your minor children and any capital gains realized from the property will be taxed to the children rather than yourself. If the above attribution rules apply, they apply both to the loaned or transferred property and to any substituted property. Thus, for example, if the loaned or transferred property is sold and replaced with another property, the income attribution rules can continue to apply to the other property. Furthermore, the attribution rules can apply to your loans or transfers of property to trusts in which your spouse or common-law partner or Page 1 of 7

2 non-arm s length minor children are beneficiaries, generally to the extent that income from the property or substituted property is distributed from the trust to those beneficiaries. Attribution can also apply to taxable capital gains from the property distributed from the trust to your spouse or common-law partner. The attribution rules do not apply to taxable capital gains of the trust distributed to your minor children. Special deeming rules deeming equals considered to be In addition to applying to direct loans and transfers to your spouse (or common-law partner) or minor children, the attribution rules can apply in other similar circumstances. For example, the rules can apply to so-called back-to-back loans or transfers of property. Therefore, if you loan or transfer money to a third party, and money is in turn loaned or transferred from the third party to your spouse or minor children, the rules can apply. Similarly, if you loan or transfer property to a third party on the condition than another property be loaned or transferred to your spouse or minor children, the rules can apply. If you guarantee a third party loan (for example, a bank loan) made to your spouse or minor child, you will be deemed to have made the loan for the purposes of the attribution rules. Accordingly, the attribution rules would generally apply. There is also a deeming rule that applies where you loan or transfer money to your spouse or minor children, if they use that money to pay down a loan that was previously used by them to acquire an income-earning property. In such case, the attribution rules can apply so that some or all of the income from the property can be attributed back to you (generally, depending on how much of the money is used to pay down the loan). Exceptions to the rules Notwithstanding that the attribution rules can apply to any loans or transfers of property to your spouse (or common-law partner) or minor children, there are various exceptions that apply. If you fall within one of the exceptions, the attribution rules will not apply. Under one of the main exceptions, the rules do not apply if the transfer of property was made for fair market value consideration. However, if such fair market value consideration included debt, the exception applies only if the interest on the debt is paid each year at the prescribed rate of interest under the Income Tax Act in effect at the time that the debt was incurred. Each year s interest must be paid during the year or by January 30 of the next year. The prescribed rate of interest is set quarterly, and currently stands at 3% per annum. In the case of a transfer to your spouse or common-law partner, the above exception applies only if you elect out of the tax-free rollover that normally applies to transfers of property between spouses and common-law partners. In such case, the transfer will normally take place at fair market value, meaning that you will have to realize any accrued capital gain on the property. Unfortunately, however, you will not be able to claim any accrued capital loss on a property, owing to the superficial loss rules found in the Income Tax Act. A similar exception also applies to fair market value loans. This exception applies if you charge the prescribed rate of interest at the time the loan is made, and each year s interest is paid during the year or by January 30 of the following year. Unfortunately, this exception, as with the debt exception described above, ceases to apply if even one year s interest is missed or is made late. Example Page 2 of 7

3 You lent $10,000 to your spouse several years ago, and your spouse used the money to purchase an income-producing property. You charged the prescribed rate of interest on the loan, and your spouse paid the interest on time every year until the 2003 year, when she was two days late with the interest payment (i.e. she paid it on February 1, 2004). Unfortunately, the fair market loan exception ceases to apply for 2003, so that the attribution rules will apply and the income from that property will be taxed in your hands for 2003 unless you fall within another exception. As noted earlier, the attribution rules cease to apply if you are no longer married or in the common-law relationship. In the case of transfers and loans to children, the rules stop in the year in which they turn 18. The rules also stop applying if you become non-resident for income tax purposes, or if you die (a small comfort). The income attribution rules do not apply to income earned on income previously subject to the rules. Thus, for example, if the rules applied to you in respect of investment income received by your spouse, any further income that your spouse earns by investing that income will not be subject to attribution. The income attribution rules also do not apply to business income. Therefore, for example, you can make a loan or transfer to your spouse to be used in his or her business, and any resulting business income will not be subject to attribution. The attribution rules do not apply to split income of your minor children, which is discussed in the next section of this letter. Unfortunately, split income is taxed to your children at the highest marginal rate of tax, so that any benefit of income splitting in regards to this type of income is lost in any event. Joint and several liability If the income attribution rules apply in respect of property you loaned or transferred, the transferee (e.g. your spouse or minor child) will be jointly and severally liable for the income tax you owe on the income or taxable capital gains attributed to you. Therefore, if you cannot come up with the money to pay your taxes on such income or gains, the CRA can pursue the transferee for such taxes. SPLIT INCOME OF MINOR CHILDREN Overview of the tax on split income Until recently, there were at least two ways of avoiding the income attribution rules described above, which the government felt were contrary to the underlying tax policy. For example, family-owned corporations could be structured in a manner in which minor children received dividend income on shares in the corporation either directly or through a trust or partnership, without attracting attribution. Accordingly, it was fairly easy to dividend-split with minor children. Another structure that effectively avoided the attribution rules was a management services partnership or trust that provided services to a professional practice or other business in which a parent of the children was involved. The children would be passive members of the partnership or beneficiaries of the trust. The income earned by the partnership or trust could be flowed out to the children without being subject to the attribution rules. As noted, the government felt that such structures were contrary to the underlying tax policy, and it therefore enacted a tax on split income of minor children, applicable to 2000 and subsequent taxation years. This is known as the kiddie tax. The tax on split income is imposed at the highest marginal rate of tax. Not surprisingly, split income is defined to catch the types of income described above that were not subject to the existing attribution Page 3 of 7

4 rules. In general terms, the split income of a minor child includes: 1. taxable dividends received on a share of a corporation, other than a share listed on a prescribed stock exchange or a share of a mutual fund corporation; 2. an amount included in the child s income under the shareholder benefit or shareholder loan rules of the Act, except benefits and loans in respect of shares of a corporation that are listed on a prescribed stock exchange; and 3. income from a trust or partnership if the source of the income is the provision of property or services by the trust or partnership to or in support of: (a) a business carried on by a person related to the child; (b) a professional corporation in which a person related to the child is a shareholder; or (c) a corporation in which a person related to the child is a specified shareholder. For these purposes, a specified shareholder generally means a person who owns, directly or indirectly, 10% or more of the shares of any class in the corporation. The tax on split income can apply in a taxation year if the child is under 18 years of age at the end of the year, was resident in Canada throughout the year, and had a parent who was resident in Canada at any time during the year. Amounts that are subject to the split income tax are not subject to the income attribution rules described earlier. them were transferred from the parent to the minor child for no consideration so that care must be exercised in order to ensure that those rules do not apply. Split income does not include income from employment or personal services carried on by the child. Thus, if your minor child earns income by providing services to your business, either as a sole proprietor or as an employee of the business, the income will not be split income. Furthermore, split income will not include your child s other employment income or self-employment income. Capital gains realized by your minor children are not split income and are not subject to the attribution rules. An excluded amount is not included in the minor child s split income. In general terms, an excluded amount is income from a property acquired by the child as a consequence of the death of the child s parent. Thus, income from property that your minor child inherits in the event of your death will be exempt from the split income tax. An excluded amount also means income from property in a particular year if the property was inherited from anyone else (i.e. other than a parent), if the child is eligible for the disability tax credit in the year or is enrolled as a full-time student at a post-secondary educational institution during the year. Joint and several liability for parents Exceptions As noted above, the tax on split income does not apply to dividends received on shares of corporations listed on prescribed stock exchanges, mutual fund corporations, and dividends received through mutual fund trusts. However, such amounts may be subject to the attribution rules described earlier for example, if the shares or the money to buy If your child is subject to the tax on split income in a taxation year, you will normally be jointly and severally liable to pay the tax with your child (there are some very limited circumstances under which you would not be so liable). Therefore, if your child cannot come up with the money to pay the tax, the government can assess you for the tax. Page 4 of 7

5 FEDERAL BUDGET HIGHLIGHTS This year s federal budget was released on March 23, Although not overly eventful, the budget did propose some significant tax measures. Some of those measures are summarized below. New disability supports deduction The budget proposes to replace the attendant care deduction with a broader disability supports deduction, which will recognize attendant care as well as other disability support expenses incurred for education or employment purposes. The current 2/3 rds income limitation that applies to the attendant care deduction (generally speaking, the deduction is limited to 2/3 rds of certain forms of income) will not apply to the disability supports deduction, which applies to the 2004 year and subsequent years. Amendment to refundable medical expense supplement (RMES) As a result of the above proposal, the value of the RMES will be equal to 25 per cent of allowable expenses claimed under the medical expense tax credit plus the new disability supports deduction, up to a maximum limit of $562 for 2004, and indexed for future years. Caregiver medical expense credit Subject to certain thresholds, taxpayers paying medical or expenses on behalf of a spouse, common-law partner or other dependent relative may claim those expenses under the medical expense tax credit (METC). The amount of claimable expenses is reduced if the other dependant s income exceeds the basic personal amount ($8,012 for 2004). The budget proposes a couple of changes in this regard. First, medical expenses paid on behalf of minor children will be pooled with the medical expenses of the taxpayer and those paid on behalf of his or her spouse or common-law partner, and will not be affected by the income of the minor child. Second, for medical expenses paid on behalf of any other dependent relative, taxpayers will be able to claim medical expenses paid on behalf of such a dependant only to the extent that they exceed the lesser of 3 per cent of the dependant s net income and $1,813 (this latter amount is the threshold for the METC that would have applied if the dependant had claimed the expenses). The maximum amount of medical expenses that can be claimed on behalf of dependent relatives other than minor children will be $5,000. Education tax credit Under current law, the education tax credit cannot be claimed by students who pursue post-secondary education that is related to their current employment. The budget removes this restriction, as long as the costs of education are not reimbursed by the student s employer. Increase in small business deduction limit In the 2004 taxation year, the small business deduction allowed in respect of active business income earned by a Canadiancontrolled private corporation applies to the first $250,000 of such income. Last year s budget proposed to increase this monetary income limit by $25,000 in each of 2005 and This year s budget accelerates the increase in the income limit, so that it will increase by $50,000, to a total of $300,000, for 2005 and subsequent taxation years. 10-year carry-forward period for non-capital losses Under the Income Tax Act, non-capital losses can be carried forward 7 years and back 3 years to offset income in those years. The budget extends the carry forward-period to 10 years, beginning with taxation years that end after March 22, Page 5 of 7

6 CCA for computer equipment and data network infrastructure equipment The budget increased the capital cost allowance (CCA) rate for computer equipment acquired after March 22, 2004 to 45 percent from the current 30 percent rate. The budget also increased the CCA rate for data network infrastructure equipment acquired after March 22, 2004 to 30 percent from the current 20 percent rate. This equipment will be included in a separate class for CCA purposes. Deduction of fines and penalties By virtue of a 1999 Supreme Court of Canada decision, many fines and penalties are deductible in computing income from a property or business. The budget has responded to this decision, and a new rule will be enacted to deny the deduction of any fine or penalty imposed by law, including that imposed by a government or governmental agency, a regulatory agency, a court or other tribunal, or any other person with statutory authority to levy fines or penalties. However, the new rule will not deny the deduction of penalties for interest payments accrued under the GST legislation or under the Excise Tax Act. Income trusts Despite the pre-budget speculation that the government might drastically change the existing rules relating to income trusts, the budget only proposed to restrict the ownership of units in such trusts by pension funds. Generally speaking, pension funds will be required to limit their holdings in income trusts to 1 percent of all of their assets, and will be restricted from owing more than 5 percent of the units in any one income trust. General anti-avoidance rule (GAAR) The government utilizes GAAR to combat tax avoidance transactions. The budget proposes to clarify that GAAR applies not only to a misuse or abuse of the Income Tax Act, but also to a misuse or abuse of the provisions of the Income Tax Regulations, the Income Tax Application Rules, and to any misuse or abuse of an income tax treaty. Canada learning bond The budget proposes greater education assistance for low-income families in the form of the Canada Learning Bond (CLB). The CLB will provide up to $2,000 of education savings by age 16 for children in families entitled to the National Child Benefit (NCB) supplement. Starting in 2004, an initial $500 CLB will be provided at birth for children in families that are entitled to the NCB supplement. Subsequently, these children will qualify for up to 15 additional $100 CLB payments, until the age of 15, for each year in which the families are entitled to the NCB supplement. AROUND THE COURTS On-line program qualified for education credit but not tuition credit In the recent Cleveland case, the taxpayer was allowed to claim the education tax credit in respect of his enrolment in an online program with a US university. However, he was not allowed to claim the tuition tax credit. The taxpayer was enrolled at Capella University, which is based in Minnesota, in an online Masters of Science program. The courses were provided through online course rooms, , telephone, and virtual libraries. The taxpayer participated in the courses from his home in Saskatchewan. The taxpayer claimed both the education and tuition credits while enrolled in the on-line program. The CRA denied both credits. Page 6 of 7

7 In denying the tuition credit, the CRA argued that the taxpayer was not in full-time attendance at the university, which is generally a requirement for the tuition credit as it applies to non-resident universities. With respect to the education credit, the CRA argued that Capella University did not qualify as a designated educational institution and that the program was not a specified educational program, both being requirements for the education tax credit. The taxpayer appealed to the Tax Court of Canada. In denying the tuition credit, the Tax Court held that, in order to be in full-time attendance at the university, the taxpayer was required to be physically present at the university. Since he was only enrolled on-line and did not attend physically on campus, he did not fulfill the attendance requirement. However, the Tax Court allowed the education tax credit. The Court found that the taxpayer was enrolled in a designated educational institution in a specified educational program since he spent 12 hours or more per month on courses in the program and the program lasted at least 13 weeks (these requirements are fund in the definitions of those terms in the Income Tax Act). * * * This letter summarizes recent tax developments and tax planning opportunities; however, we recommend that you consult with us before embarking on any of the suggestions contained in this letter, which are appropriate to your own specific requirements. Page 7 of 7