My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. My posts are blunt, opinionated and even have a twist of humour/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, April 17, 2023

The Importance of Tracking Your Adjusted Cost Base from an Inheritance

From an income tax perspective (I am obviously ignoring the emotional issues) receiving an inheritance provides two tax related benefits. The receipt of the inheritance is typically tax-free and you may also receive a “bump” (increase) in the adjusted cost base (“ACB”) of any capital property inherited.

However, over the years, I have seen cases where people pay unnecessary income tax and/or have disputes with the CRA because they (1) forget or are not aware of the cost base bump (2) have misplaced documentation or never obtained documentation (3) have switched accountants (or the original work was prepared by their parent’s accountants and is no longer accessible).

Today, I want to remind those of you who have inherited capital property, to ensure you have in place the documents (easily accessible) to support the ACB of any inherited property when you sell the property in the future.

Taxation on Death

I think to provide context for my comments, I first need to explain how the Income Tax Act works when someone passes away.

In Canada, where you receive cash or a cash like inheritance, there are no income tax implications. Where you inherit capital property, such as stocks and real estate, you will have no immediate income tax implications, plus you will inherit the “bumped-up” cost base of the capital property to the deceased.

By “bumped-up” I mean the following. When a person passes away there is a deemed disposition of the deceased persons capital property at the fair market value ("FMV") of the property right before the person's death (this is typically the last spouse or common-law partner to die, as the income tax allows a tax-free transfer of property to a surviving spouse or common-law partner).

For example; say your mother passed away in 2015 and she owned 1,000 shares of Royal Bank (ignoring stock splits) that were worth $80 a share at her passing, that had been purchased for $12,000 in 2001. (Note: The Royal Bank shares could have been transferred to your mother as a tax-free spousal transfer from your father on his passing or the shares could have been purchased directly by your mother, it is the same tax result).

Your mother’s estate would have filed a final (terminal) income tax return reporting a deemed capital gain of $68,000 (FMV at death of $80,000-$12,000 original cost). This deemed capital gain is known as a deemed disposition on death and occurs despite the fact the Royal Bank shares were not sold. This is because your mother was the last surviving spouse and owned the shares at her date of death. Your mother’s deemed disposition FMV of $80,000 becomes the new cost base of your inherited shares. So, if you sell the Royal Bank shares in the future, the gain would be equal to your sales proceeds less your bumped-up cost base of $80,000. 

The same thing would occur if your father/mom owned real estate. The fair market value at your mothers passing would become your new ACB, although there would be an allocation between land and building. The rules relating to the inheritance real estate can get tricky for a non-arm’s length decedent. You should speak to your accountant to get an accurate understanding of your cost base and allocation between land and building.

While I use parents in the above example, the same result occurs if you inherited the capital property from a relative or friend etc.

A totally separate but interrelated ACB tax issue, is the 1994 Capital Gains Election. In 1994, the $100,000 capital gains exemption was phased out. However, individuals were eligible to make an election on their 1994 personal tax return to bump the value of their capital properties by up to $100,000. Where you inherit capital property, if possible, before the accountant files the terminal return of the deceased, you should ask them if they have the 1994 election on file, or if not, see if you can find the deceased's 1994 return to determine if an election was made in 1994. If the election was made, it will likely have no impact on your inherited ACB, but it may reduce the tax on the terminal tax return of your parent or relative etc.

Supporting Your "Bumped- Up" Adjusted Cost Base

Now that I have provided the income tax context, I can discuss the importance of documentation, as without the documentation, you will not know the inherited cost base of your capital property.

The key documents you hopefully already have on hand or can dig up from a box in storage are:

1. The terminal income tax return of your last surviving parent. This return will reflect the deemed disposition of any capital property held on your parent’s passing on Schedule 3 -Dispositions of Capital Gains (or Losses). The proceeds of disposition on this form will form the new ACB of the inherited property to you. Using my prior example, Schedule 3 would reflect proceeds of disposition of $80,000 for the 1000 RBC shares held on death and the $80,000 would become your new ACB.

2. It is possible a parent who pre-deceased their spouse left property directly to you. If that is the case, you would need their terminal tax return to review their schedule 3.

3.  Tax reorganization memos from your parent’s accountants if they undertook any post-mortem tax planning for your parent(s) private corporations. Depending upon the reorganization, there could be ACB increases, although in many cases, the key planning is creating tax-free promissory notes.

An interesting capital asset is the principal residence (“PR”) of your parents or anyone else you inherited property from. If the house was inherited and not sold immediately (say you kept the PR as a rental property), then the FMV of the PR on the death of your parent becomes important. However, prior to 2016, when the sale of a PR had to start being reported on Schedule 3 (and from 2017 onwards when it had to be reported on Schedule T2091) administratively the CRA did not require you to report the sale of your PR if it had always been your PE and the sale was exempt from tax as your PR. 

Thus, you may need to obtain a real estate valuation for the value of the PR at the deceased's passing, since there may be no record of the FMV on death.

If you have inherited capital property from your parent’s or any other person, hopefully you already have the documentation discussed above in place. If not, it would be a very useful project to try and obtain the documents before you decide to sell the asset and are forced to scramble to find information that can be twenty or thirty years old.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

Monday, April 3, 2023

The 2023 Federal Budget

Before I started reading through the federal budget report tabled on March 28th by Deputy Prime Minister and Minister of Finance, Chrystia Freeland, I expected there would be significant personal and corporate tax changes. But this budget is about “clean and green” technology refundable investment tax credits for business owners, changes to the alternative minimum tax (“AMT”) to make it harder for high-income earners to avoid paying income tax, tightening up the rules on intergenerational transfers of businesses and some other smaller changes.  There are no changes to the general personal tax rates or the general corporate tax rate.

Today, most of my comments will relate to how the budget affects high-net-worth ("HNW") individuals and small business owners.

Personal Tax Measures

Alternative Minimum Tax 

In the 2022 budget report, there is a section titled “A Fair Tax System”. Within the section, the report stated “some high-income Canadians still pay relatively little in personal income tax as a share of their income—28 per cent of filers with gross income above $400,000 pay an average federal PIT rate of 15 per cent or less, which is less than some middle-class Canadians pay. These Canadians make significant use of deductions and tax credits, and typically find ways to have large amounts of their income taxed at lower rates”.

This budget follows through on the above “fairness initiative” and proposes to limit the deductions and credits used by high-income Canadians by amending the AMT to "better target" high-income individuals.

Prior to my retirement from public accounting, I worked over 35 years with multi-National firms, mid-sized firms and a smaller firm. I only rarely observed my HNW filers paying tax at a 15% or less rate. My experience in the majority of cases was the opposite. HNW individuals less than thrilled, over how much tax that had to pay, most of it at a 54% tax rate. But I will accept the CRA's statistics as accurate and assume my sample size was not representative.

The AMT was created in 1986, to ensure high income Canadians paid at least a minimum rate of income tax. Conceptually, the AMT prevents high income earners from paying little to no tax by comparing their tax liability as calculated on their "regular" tax return to an alternative method, in which AMT is charged at 15% with adjustments for certain amount less a $40,000 exemption. If the AMT is higher than the regular tax, the taxpayer must pay the higher AMT result.

It should be noted that many of the reasons a taxpayer may pay a low rate of income tax in the first place is due to incentives provided by the Income Tax Act for donations, reduced capital gains rates, the sale of Qualifying Small Business Corporations etc. Thus, as I discuss below, the increase in AMT comes about in part because you will be required to add back a higher percentages of some of the incentives the government provides for charitable organizations etc. on your income tax return, which is counter to public policy in some cases.

The budget proposes for years beginning after 2023, to increase the AMT rate from 15% to 20.5% (plus the provincial component) and to increase the exemption from $40,000 to approximately $173,000 by 2024. The AMT base will be broadened by increasing the capital gains rate for AMT purposes only (the general capital gains inclusion rate of 50% was not changed) from 80% to 100%, by including 100% of stock option benefits, 30% of capital gains on the donation of marketable securities (again, this is only for AMT purposes, not regular income tax purposes where the donation of marketable securities eliminates any taxable gain associated with the stock donated) and will broaden the base by disallowing for AMT purposes, 50% of deductions such as child care, moving expenses, employment expenses (other than to earn commission income), interest and carrying charges, non-capital loss carryovers amongst others.

It is important to note that AMT can be carried forward seven years and thus, with proper planning and the right economic circumstances, the AMT can often be recovered over time to the extent a person’s regular income tax exceeds the AMT in a given year.

If you may have a significant tax event in 2024, whether a large income inclusion, a capital gain or a large donation or deduction, you will want to speak to your accountant. They can review your income tax situation to determine if you should accelerate any of these times to 2023 or whether you pay sufficient regular tax, such that if you wait until 2024 there will be no AMT impact or if you pay the AMT, you will recover it in future years.
General Anti-Avoidance Rule (“GAAR”)

The GAAR was introduced in 1988. The intent of the legislation was to prevent abusive tax avoidance transactions or arrangements, while not altering or interfering with legitimate commercial transactions. From the government’s perspective, they felt the GAAR was not achieving their objectives, so they stated they wanted to “modernize and strengthen” the rule. This rule applies to both personal and corporate tax planning.

The proposals will provide stricter rules and lower thresholds for an avoidance transaction. The proposals also include a penalty equal to 25% of the tax benefit, that can be avoided if the transaction is disclosed to the CRA. The government will hold consultations until May 31, 2023, after which they will release the legislation with an effective date.

Other Measures

There are various other personal tax provisions in the budget, including a small increase in RESP educational assistance withdrawals for the first 13 weeks on full or part-time enrollment, fees and premiums related to Retirement Compensation Arrangements and Registered Retirement Disability Savings Plans (extends the ability of a parent, spouse or common law partner to open an RDSP for an adult whose capacity to enter into a RDSP contract is in doubt by three years and broadens the definition of a qualifying family member) that you should discuss with your advisor if they relate to your circumstances.

Corporate Tax Measures

Clean and Green Equipment

The government has proposed a refundable investment tax credit (“RITC”) for clean hydrogen equipment, clean technology equipment (including geothermal equipment), clean technology manufacturing and processing equipment, carbon capture utilization and storage and consultations on RITC’s for certain clean electricity systems and equipment. 

If your business plans to purchase such equipment, I suggest you set-up a meeting with your accountant to discuss and understand the proposed requirements, effective dates and credits (15-40% depending on equipment and various factors) and to review the tax and environmental benefits for your corporation of purchasing such equipment.

From a business take-up perspective, some economic pundits feel the use of subsidies instead of RITC would result in a more effective Clean and Green strategy, but hopefully the RITC’s will prove to be a large enough incentive.

Intergenerational Business Transfers

This is very tax oriented rule, and you will need to consult your tax advisor. In general terms, the government wanted to facilitate intergenerational business transfers within families where a certain technical section of the Income Tax Act (84.1) was restrictive. However, the government felt the original provisions allowed unintended consequences such as parents still controlling the business and children not having sufficient active involvement in the business. Thus, they have proposed to tighten the rules for such transfers, effective January 1, 2024.

The exclusions have been tightened such that taxpayers can now rely on only one of two transfer options:

1. An immediate three-year test based on arm-length sale standards or

2. A five-to-ten-year test based on estate freeze characteristics (see this prior post on estate freezes).

As this provision is very complex, you will need to discuss any potential business transfer to your children with your tax advisor.

Employee Ownership Trusts (“EOTs”)

The budget proposes new rules (effective January 1, 2024) to facilitate the use of EOTs to acquire and hold shares of a business. EOTs are intended to assist private business owners in transitioning their businesses to their employees on a potentialy more efficient tax and financing basis.

If you are considering selling your business to your employees, speak to your advisor about whether an EOT may be a viable selling option for you in the future.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.