Less is More When it Comes to the CRA

I am often asked by my readers in the comments section of my blog, if they should send in documents such as appraisals, invoices and interest expense statements to the Canada Revenue Agency ("CRA") to support a tax deduction, tax credit or cost base adjustment. They also ask should they write to the CRA and explain their situation. The answer in almost all situations is a resounding NO. I address this below.

As readers of my blog are aware, I answer almost all the questions I am asked. I attempt to answer the less complicated questions (although they are often couched in case I was not with provided all the facts) and I provide guidance in response to other questions. Unfortunately, I am not able to provide answers in the areas of corporate or personal income tax planning, because of (a) time constraints (b) without knowing all the facts and circumstances; I cannot attempt to properly answer a question with these limitations.

I however, do greatly appreciate my reader's comments, as they provide tangible evidence I have engaged them. A bonus for me is that the questions actually provide me with ideas and topics for future blog posts. The comments provide feedback on which posts have wide appeal or are at least controversial topics. For example: my post on Is Your Corporation a Personal Service Business? has 76 comments, my post on The Income Tax Implications of Purchasing a Rental Property has 65 comments and my post on CRA Audit – Will I Be Selected? has 50 comments. For certain other posts, like Is it Morbid or Realistic to Plan for an Inheritance, I just enjoy reading the comments I receive.

Anyways, back to the matter at hand. With E-filing, there are few hard documents the CRA requires to be filed initially. That is not to say the CRA will not follow up with an information request for copies of actual receipts to evidence expenses claimed such as child care and credits such as donations. For those that still paper file (starting in 2012, all accounting firms must now EFILE all returns), the receipts you submit essentially include any T-slips, RRSP contribution receipts, medical receipts and donations.

That is all you should provide the CRA. If you have back up support for stock transactions, real estate transactions, interest expense or what have you, you should not provide these documents to the CRA unless you are requested to do so. In many cases, even if the item is contentious, the reality is that it will not necessarily be selected for an audit follow up. So why ever volunteer such information?

In addition, people for some inexplicable reason have an urgent need to explain their actions to the CRA. I have had several cases where a new client who has engaged me to assist in a tax matter proudly shows me the 3 page letter full of reasons and excuses they sent to the CRA.

I would suggest that in most cases, these letters are browsed through by the CRA. Where your letter is read in detail, I would submit the CRA representative is only looking for facts contained therein and they have little or no interest in your story and excuses (save your story for an actual auditor assigned to your case or a fairness application) unless you are providing them their dose of daily entertainment. What in fact you have done in many cases is provide the CRA an audit trail for an item probably not even on their radar.

My advice is simple. Do not ever provide anything voluntarily, be it a document or a mea culpa letter. If you have an issue or need to correct something, engage an accountant, who will know how to finesse the item without providing more than is required. Remember, less is always more with the CRA.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Legislative Update on Personal Service Businesses and Limited Liability Professional Partnerships

On Wednesday, Jim Flaherty, Minister of Finance, tabled a Notice of Ways and Means Motion to implement outstanding technical tax amendments. Included in the amendments are changes to the taxation of Personal Service Businesses (“PSB's”) and professional limited liability partnerships.

PSB's

My blog of January 24, 2012, “Is Your Corporation a Personal Service Business?” generated significant interest amongst many “incorporated employees”. I keep getting asked about the status of the legislation, so today; I thought I would provide an update. The Notice of Ways and Means has introduced an amendment for PSB’s which essentially means that the general rate reduction of 13% currently available to PSB’s will be removed. The Federal tax rate will thus increase to 28% from the current 15%. For Ontario, you will tack on an additional 11.50%, bringing the corporate income tax rate to 39.50%. If you have filed previously as a PSB, your rate would have been 26.50%. If you have filed as a non-PSB with income eligible for the small business deduction, your rate would have been 15.5%.

Clearly this amendment is punitive. The amendment states that it applies to taxation years that begin after October 31, 2011. Thus, this legislation is now as good as passed, so if you have not already considered this legislation in planning, you should do so for any year-end that began after Oct 31, 2011.

Professional Limited Liability Partnerships

The CRA takes the position that the income earned during the fiscal year is not added to a partner's adjusted cost base (“ACB”) until the first day of the following year. However, any partner draws reduce the ACB in the current year. Thus, if you draw $10,000 and make $40,000, your ACB in the current year is negative $10,000, even though you are truly net $30,000. Where you are a limited liability partner, you have a deemed disposition when you have a negative ACB. For example, in the case above, you would have to report a $10,000 capital gain.

This provision was intended to deal with limited partners such as those in a tax shelter. However, it has caught full-shield limited liability partnerships for various professionals. However, the Notice of Ways and Means has introduced an amendment for professional partnerships that will allow the income earned in the current year to be considered in the ACB calculation, such that the negative ACB issue should be alleviated.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.

Is Your Corporation a Personal Service Business?

One of the first blogs I wrote was "I am a Contractor Unless CRA Says Otherwise" (Note: the link is being temperamental, so if you want to read that blog, either google it or it is listed as a favourite post on the right hand side-bar). In that blog I discussed the various criteria the CRA and the courts use to determine whether a person is an employee or a contractor. I then further discussed the income tax withholding issues that arise when the CRA attempts to re-characterize a contractor as an employee. Finally, I touched upon the concept of a personal service business (“PSB”) and the risk of incorporating if you are a contractor. In today’s post, I will expand on the PSB discussion.

For CFL fans of my vintage, the PSB rules came about because of the despised Ralph Sazio (despised if you were a Toronto Argonaut fan). Mr. Sazio, a member of the CFL Hall of Fame who led the Hamilton Tiger-Cats to three Grey Cup championships, decided he would incorporate a company to provide his services to the Tiger Cats to benefit from the low corporate tax rate. The CRA took Sazio to court, but Mr. Sazio won his case prompting the CRA to implement the PSB rules.

The PSB rules have reared their ugly head recently because of a CRA crackdown on IT consultants as discussed in this Ottawa Business Journal article by Peter Kovessy titled Taxman cracks down on IT consultants.

In addition, on October 31, 2011 the CRA released draft legislation that imposes further punitive rules on PSB's by removing the general rate deduction previously allowed. These new rules will become effective for taxation years beginning after October 31, 2011 and are discussed below.

The PSB rules deal with incorporated employees. Essentially, when a corporation has been interposed between what one would normally consider an employee-employer relationship, the employee becomes an "incorporated employee". As I have discussed in many prior blogs, incorporation is advantageous because it provides the following: access to the small business deduction and the related low income tax rate, a possible deferral of income tax, limited liability, and potential access to the $750,000 capital gains exemption on qualifying small business corporation shares.

In reviewing the PSB rules, you essentially need to ask yourself if you would reasonably be regarded as an employee or officer of the person or partnership to whom you are providing the services, but for the existence of your corporation . If you only have one or two clients and your corporation does not employ more than 5 full-time employees, and you do not meet the criteria I discuss in my contractor blog, you risk being characterized as a PSB.

So what are the income tax consequences of being considered a PSB once the new legislation is passed?

The corporation will be prevented from claiming the small business deduction, both federally and provincially, and as noted above, you will no longer even get the general rate reduction. In Ontario that means the corporation will be subject to income tax at a rate of 39.25% (in 2012). For comparative purposes, the current small business income tax rate is 15.5%. As a consequence, when taking money out of a PSB by way of dividends, the ultimate combined personal and corporate tax rate will approach 58% in Ontario, a very punitive amount which is 12% greater than a high-rate employed taxpayer would pay.

When determining the taxable income from a PSB, the only eligible deduction for the corporation will be any salary and benefits paid to the incorporated employee (yes, that means no other expenses such as travel, office supplies and auto are allowed). If the incorporated employee is a salesperson receiving commissions, expenses paid by the corporation that would have been allowed as a deduction to the individual personally as a commissioned salesperson will be allowed.

If you are concerned that your corporation may be a PSB, a conservative approach would be to pay yourself salary rather than using a dividend remuneration strategy. You may also want to avoid income splitting with family members who are not shareholders, however, your other business deductions are still at risk of being disallowed.

The proposed PSB rules are very punitive. If you may be an “incorporated employee” you should review your situation in detail with your accountant.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.