Taxation

1
Chapter 6

• Taxation

34
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2
Personal Income Tax

• You can access many resources from Canada Revenue
  Agencys web site (including downloadable forms
  in PDF format) at
• http//www.cra-arc.gc.ca/menu-e.html

3
Personal Income Taxation

• Income Tax Act
• self-assessment
• progressive
• marginal vs. average tax rates
• tax brackets
• tax credits vs. deductions
• Taxation of Investment Income
• interest
• dividends
• capital gains and losses

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4
1997 Rates of Income Tax

• FEDERAL TAX RATES
• Taxable Income Tax Rate
• 0 - 29,590 17
• 29,500 - 59,180 26
• 59,180 29
• ONTARIO PERSONAL TAX RATE
• 48 OF FEDERAL

5
Income Taxation (Feb, 2000)

• Paul Martins budget of February 28, 2000
  introduced fundamental changes to our income tax
  system.
• 66.67of realized Capital gains will now be taxed
  rather than at 75
• Federal tax brackets have been increased and are
  now fully indexed
• increase of personal exemption to at least 8,000
• Taxable Income Pre 2000 budget rates July 1, 2000
• 0 - 29,590 (35,000) 17 17
• 29,591- 59,180 (35,001 - 70,000) 26 24
• 59,180 ( 70,000 ) 29 29
• In 1999 Ontario tax rate was 39.5 of federal tax

6
Income Taxation (Fall, 2000)

• Paul Martins pre-election mini budget in the
  fall of 2000 set forth a series of election
  promises from the Liberals.
• 50 of realized Capital gains will now be taxed
  rather than at 66.67
• Federal tax brackets have been increased and are
  now fully indexed and an additional tax bracket
  above 100,000 was added.
• increase of personal exemption to at least 8,000
• Taxable Income Federal Rates 2000 Provincial
  Rates TOTAL
• 0 - 30,004 17 6.37 23.37
• 30,005 - 60,009 25 9.62 34.62
• 60,010 29 11.16 40.16
• In 2000 Ontario disentangled its tax rates from
  the federal rates.

7
Individual Marginal Tax Rates 2001
FEDERAL Taxable Income Tax on
Rate on Excess Base Amount 30,754 or less
-- 16 30,755 - 61,509
4,921 22 61,510 - 100,000 11,687 26 100,0
01 or more 21,694 29 ONTARIO Taxable
Income Tax on Rate on
Excess Base Amount 0 -
30,814 0 6.16 30,815 61,629 1,898 9.22 gt
61,630 4,739 11.16
8
Individual Marginal Tax Rates 2004
FEDERAL Taxable Income Tax on
Rate on Excess Base Amount 35,000 or less
-- 16 35,001 - 70,000
5,600 22 70,001 - 113,804 13,300 26 113,8
05 or more 24,689 29 ONTARIO Taxable
Income Tax on Rate on
Excess Base Amount 0
33,375 0 6.05 33,376 66,752 2,019 9.15 gt
66,752 5,073 11.16
9
Marginal versus Average Tax Rates
10
Taxes

• Key issues
• What is an average tax rate? When should it be
  used?
• What is a marginal tax rate? When should it be
  used?
• Why do we pay attention to marginal tax rates?

11
When Might You Use an Average Tax Rate?

• In this course we will use this when forecasting
  after-tax income available sometime in the
  future, when you are given gross income
  forecastsand must make some assumptions about
  taxes

12
When Might You Use a Marginal Tax Rate?

• Whenever you are evaluating an incremental
  decision
• For example
• When evaluating an investment decision to
  determine the net after-tax rate of return.
• For example if you want to find the marginal
  after-tax rate of return on interest income of
  10

13
Marginal Tax Rate

• That rate of tax you will pay on the next dollar
  of income.
• This is the rate you should use when making
  investment decisionsbecause investments lead to
  you receiving incremental investment income
  (dividends, interest or capital gains)
• It is the after-tax returns you will expect from
  your investment that are relevant for investment
  decision-making.

14
Taxation of Investment Income

• Investment income includes
• interest
• dividends
• capital gains
• interest is taxed at the persons marginal tax
  rate
• dividends are grossed up by 25 and included in
  income, then the taxpayer is allowed a dividend
  tax credit equal to 16.67 of the cash dividend
• 50 of a realized capital gain is subject to tax
  at the taxpayers marginal tax rate
• an allowable capital loss is 50 of the capital
  loss and may be used to offset taxable capital
  gains (carry back and carry forward provisions do
  apply.)

15
Calculating a Marginal Tax Rate(Interest Income)
16
Calculating a Marginal Tax Rate(Capital Gain
Income)
17
Calculating a Marginal Tax Rate(Capital Gain
Income, Interest and Dividend)
18
Average Tax Rate

• Equals Net Taxes Payable/Taxable Income
• will always be much lower than your marginal tax
  rate because the first few dollars of taxable
  income are not taxedthe first 30,000 is taxed
  at the lowest federal rateand so on...

19
Total Marginal and Average Tax Rates
2001(excluding surtaxes)
20
Tax Deduction

• Is amount that you are allowed to deduct from
  income in the process of calculating your taxable
  income.

21
Tax Credit

• Is a direct reduction of tax otherwise payable.

22
Non-Taxable Income

• Some amounts you receive are not taxed.
  Nevertheless, you have to include them on your
  return because they may affect other deductions
  or credits which you may be entitled to receive.
  These amounts are Workers' Compensation payments,
  Social Assistance payments, and Net Federal
  Supplements. On line 144, enter your Workers'
  Compensation payments, which are shown in box 10
  of your T5007 slip. On line 145, enter your
  Social Assistance payments, which appear in box
  11 of your T5007 slip or the federal part of your
  Relevé 5 slip if you were a resident of Quebec.
  If you lived with your spouse or common-law
  partner at the time either of you received the
  social assistance payments, the one of you with
  the higher net income has to report these
  payments. On line 146, enter the amount of Net
  Federal Supplements which appear in box 21 of
  your T4A(OAS) slip.
• You claim a deduction on line 250 which equals
  the total of the amounts you entered on lines
  144, 145 and 146, unless your income on line 234
  is more than 55,309 and you reported Net Federal
  Supplements. If this situation applies to you,
  contact us to find out how much you can deduct on
  line 250 by calling the general enquiries service
  at 1-800-959-8281.

23
Non-Taxable Income

• You do not have to report any of the following
  amounts on your return since these amounts are
  not taxable, and they do not affect any credits
  or deductions you can claim on your return. Do
  not report
• the goods and services tax/harmonized sales tax
  credit
• Canada Child Tax Benefit payments and related
  provincial benefits
• lottery winnings
• most amounts received because of disability or
  death that resulted from war service
• most amounts received from a life insurance
  policy following someone's death or
• an inheritance.
• However, you do have to report any income you
  earn from investing these non-taxable amounts.

24
Scholarship and Other Income

• 130-03 - Reporting a scholarship, fellowship,
  bursary, or artist's grant
• Scholarship income includes any amount you
  receive in the form of a scholarship, fellowship,
  bursary, artist project grant, or prize for
  achievement in your field of study. Add up all
  the scholarship income you received, and if the
  total is 500 or less, do not report it on your
  return. If the total is more than 500 and you
  did not receive it for your enrolment in a
  program for which you can claim the education
  amount for 2001, subtract a 500 tax-free amount,
  and report the remainder on your return. If you
  are an artist, and you receive an artist project
  grant, you can reduce the amount you report by
  either the related expenses, or the 500 tax-free
  amount, whichever amount is more beneficial to
  you. If you claim the expenses, make a list of
  them and attach the list to your return. If you
  receive a research grant, please refer to line
  104 in the General guide. The pamphlet called,
  "Students and Income Tax" may be of interest to
  you. You can also pick up or order this pamphlet
  from your tax services office.
• However, if you received an amount "other than an
  artist's project grant" for your enrollment in a
  program for which you can claim the education
  amount for 2001, report only the amount that
  exceeds 3,000.

25
Support Payments

• 128 - Support payments received
• If you receive support payments, often called
  alimony or maintenance, you will need to know if
  you have to include these amounts in your income.
  Report the total amount of support payments you
  received on line 156 and the taxable support
  payments on line 128 of your return. These
  payments qualify as earned income for RRSP
  purposes. For the purposes of the Income Tax Act,
  the term spouse applies only to a person to whom
  you are legally married. You also have to report
  amounts you received from a common-law partner.
  The definition of a common-law partner is given
  in message 303, and in your guide. You may not
  have to include in your income, child support
  payments received in 2001, if certain conditions
  are met.

26
Definition of Support

• Support payments are certain amounts you receive
  from your spouse or common-law partner or former
  spouse or common-law partner when the two of you
  are living separate and apart because of a
  breakdown in the relationship.  It also includes
  amounts received from a person who is not your
  spouse or common-law partner, or former spouse or
  common-law partner,  but is the natural parent of
  your child, and you are living apart from each
  other.

27
Basic Requirements that make support payments
taxable

• Before your support payments are taxable, you
  have to meet certain basic requirements as
  follows
• the payments were made under a court order, or a
  written agreement
• you and your spouse or common-law partner, former
  spouse or common-law partner, or the person
  required to make the payments, were living
  separate and apart because of a breakdown in the
  relationship
• you and your spouse or common-law partner, former
  spouse or common-law partner, or the person
  required to make the payments, were living apart
  when the payments were made
• the payments were for your maintenance, the
  maintenance of your children, or both
• the payments were an allowance payable on a
  periodic basis and
• the payments were made to you or to someone else
  on your behalf.

28
Reporting Interest Income before 1990

• The 3 methods of reporting interest you earned
  from investments made before 1990 are
• the annual accrual method, in which you report
  the interest in the year you earn it regardless
  of when you are entitled to receive it or when it
  is paid
• the receivable method, in which you report the
  interest in the earlier of either the year you
  are entitled to receive it, or every third year
  since you made the investment and
• the cash method, in which you report the interest
  in the earlier of either the year it is paid to
  you, or every third year since you made the
  investment.  You should include a note with your
  return stating which investments you have chosen
  to report annually.
• You can change from the cash or receivable
  methods to the annual accrual method, but once
  you start using the annual accrual method for an
  investment, you cannot change to any other method
  for that investment. If you have been reporting
  interest using the cash method or the receivable
  method, you cannot go back and change your method
  to the annual accrual method on returns from
  previous years.  For all Canada Savings Bonds,
  report the interest shown on the T5 slip you
  receive each year.

29
Example of Tax Deduction use in determining
Taxable Income

• Income From employment 50,000
• Net Business Income 10,000
• TOTAL INCOME 60,000
• Less Deductions
• RPP 4,000
• RRSP 10,000
• NET INCOME 46,000
• Less Other Deductions
• Limited partnership losses (past) 1,000
• TAXABLE INCOME 45,000

30
Taxable Income

• Is the base upon which your personal tax
  liability is determined.
• Eg. In the lowest tax bracket
• Federal Taxes taxable income 17
• 10,000 .17
• 1,700

31
Tax Credits

• Examples of Tax Credits
• non-refundable tax credits (17 of basic personal
  amount, age amount, spousal amount,
  CPPcontributions, EI contributions, pension
  amount, tuition and education deductions, medical
  expensesetc.)
• Dividend Tax Credit
• Federal political contribution tax credit
• Labour-sponsored funds tax credit

32
Provincial Tax Rates

• See Table 6.3, page 113
• Note the divergent provincial tax approaches
• Five tax brackets in B.C. no surtaxes
• Flat provincial tax of 10 in Alberta
• Significantly higher tax rates in all brackets in
  Atlantic Canada together with surtaxes

33
Problem 6 - 2

• EAR on the Quarterly Dividend of 0.25
• (1.01)4 - 1 4.06 p.a.
• EAR on Canada Bonds
• (1.027)2 - 1 5.47 p.a.

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34
Problem 6 - 1

• T1 Return Line
  number Federal Ontario
• Employment income 101
  80,098.00 80,098.00
• Taxable dividends Can 120
  276.14 276.14
• Interest, other invest 121
  486.67 486.67
• Taxable Capital Gains 127
  1,520.00 1,413.60
• Other income (royalties) 130
  400.00 400.00
• Total income 150
  82,780.81 82,674.41
• 200
  82,780.81
• Reg. Pension Plan Cont 207
  4,000.00
• Union, Prof dues 212
  125.00
• Alimony 220
  6,000.00
• Carrying charges 221
  25.00
• 233
  10,150.00
• Net income before adjust 234
  72,630.81 72,524.41
• Taxable income 260
  72,630.81 72,524.41

35
Problem 6 1

• Non-refundable tax credits
• Basic personal amount 300
  7,231.00
• Equivalent to spouse 305
  6,140.00
• Canada Pension Plan 308
  806.00
• UIC Premiums 312
  1,245.24
• 335
  15,422.24
• X 17 338
  2,621.78
• Donations 340 750.00
• 346 200.00_at_17
  34.00
• 348 550.00_at_29
  159.50
• Non-refund tax credits 350
  2,815.28

36
Problem 6 1

• Refund or balance owing
• Taxable income 260
  72,630.81
• Federal tax 406
  13,709.23
• Federal pol contribute 409 150.00
• Credit 410 100.00
• 416
  100.00
• Fed tax before surtax 417
  13,609.23
• Fed individual surtax 419
  0
• Net federal tax 420
  13,609.23
• Ontario tax 428
  5,894.36
• Income tax deducted 437
  19,000.00
• Total credits 482
  19,000.00
• Balance owing 485
  503.59

37
Problem 6 - 2 ...

• A) Given tf 17, tp 38.5, tsf 0.0, tsp
  0
• Dividend taxation and after tax return
• tc (dividend) (1.25 (.17) - .1667)(1.03)
  .56 7.28
• kt(dividend) .0406 (1 - .073) 3.76
• Bond taxation and after tax return
• tc(bond) .17((1.03) .56) 27.03
• kt(bond) .0547 (1 - .2703) 3.99
• Therefore, Mr. Poor is better off with the Canada
  Bond.

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Problem 6 - 2 ...

• B. Given tf 29, tp 56, tsf 8.0, tsp
  33
• Dividend taxation and after tax return
• tc (dividend) (1.25 (.29) - .1667)(1.08)
  (1.33) .56 35.7
• kt(dividend) .0406 (1 - .357) 2.61
• Bond taxation and after tax return
• tc(bond) .29((1.08) (1.33) (.56)) 52.9
• kt(bond) .0547 (1 - .529) 2.58
• Therefore, Mrs. Wealthy is better off with
  preferred shares.

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39
Problem 6 - 3

• Jason Barnes
• T1 Return Line
  number Amount
• Employment income 101
  72,000.00
• Taxable dividends Can 120
  39,000.00
• Interest, other invest 121
  180.60
• Rental income gross 18,500 126 net
  lt512.10gt1
• Total income 150
  110,668.502
• 200
  110,668.50
• Pension adjustment 206
  5,250.00
• Reg. Pension Plan Cont 207
  2,500.00
• RRSP 208
  7,710.003
• Carrying charges 221
  2,852.00
• 233
  13,062.00
• Net income before adjust 234
  97,606.50
• Taxable income 260
  97,606.50

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40
Problem 6 3

• Jason Barnes
• T1 Return Line
  number Amount
• Non-refundable tax credits
• Basic personal amount 300
  7,231.00
• Canada Pension Plan 308
  806.00
• UIC Premiums 312
  1,245.24
• Tuition fees, ed ded transf. 324
  3,140.004
• 335
  12,422.24
• X 17 338
  2,111.78
• Donations 340 1360.00
• 346 200.00 _at_17
  34.00
• 348 1160.00 _at_29
  376.40
• Non-refund tax credits 350
  2,522.18
• Refund or balance owing
• Taxable income 260
  97,606.50
• Federal tax 406
  16,083.40
• Fed tax before surtax 417
  16,083.40
• Fed individual surtax 419
  54.17

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41
Problem 6 3

• Jason Barnes
• T1 Return Line
  number Amount
• Schedule 1
• Taxable income 97,606.50
• on first 60,009 tax
  12,901.00
• on remaining 37,597.50 29
  10,902.28
• Total federal income tax
  23,804.28
• Subtract
• non-refund tax credits 501
  2,522.18
• dividend tax credit 502
  5,198.70
• Total credits
  7,720.88
• Basic federal tax 506
  16,083.40
• Federal tax 406
  16,083.40
• Federal individual surtax
• Basic federal tax 16,083.40
• Amount A 16,083.40 minus 15,000 X 5
  54.17

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42
Problem 6 3

• Jason Barnes
• T1 Return Line
  number Amount
• Schedule 4
• Taxable amount of dividends from taxable Canadian
  corps.
• Mutual funds 1.25 X 1200 (case says "paid")
  1,500.00
• Nutshell 1.25 X 30,000
  37,500.00
• 
  39,000.00
• Note dividend tax credit .1333 X 39000
  5,198.70
• Interest and other investment income
• Joint bank accounts .5 X 361.20
  180.60
• Carrying charges Safe deposit box
  100.00
• Interest expense
  2,752.00
• Total carrying charges and interest
  2,852.00

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43
Problem 6 3

• Jason Barnes
• Line number Amount
• Ontario Income Tax
• Basic Federal Tax 16,083.40 (A)
• Basic Ontario Tax 38.5 of (A)
  6,192.11
• Add Ontario Surtax
• (B) 4468 minus 3562 X 20 181.20
• (B) 6,192.11 minus 4468 X 56 965.50
• 
  1,146.70
• Ontario income tax
  7,338.81

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44
Problem 6 3

• Betty Barnes
• T1 Return Line number Amount
• Employment income 101
  4,500.00
• Taxable dividends Can 120
  10,000.00
• Interest, other invest 121
  1,330.60
• Rental income gross 18,500 126 net
  lt512.09gt1
• Total income 150
  15,318.512
• 200
  15,318.51
• Pension adjustment 206
• Reg. Pension Plan Cont 207
• RRSP 208
  3
• Child care expenses 214
  4,000.006
• Carrying charges 221
  
• 233
  4,000.00
• Net income before adjust 234
  11,318.51

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45
Problem 6 3

• 2 Jason might benefit from an election to report
  capital gains on the mutual funds accrued gain
  to Feb. 23, 1994 to the extent that he has room
  under the (former) lifetime exemption of
  100,000. This election can be filed late (with
  a penalty). This is an advanced point not
  covered in the text, but we mention it here for
  completeness. Gains on the Nutshell shares are
  probably still eligible under the family business
  exemption.
• 3 RRSP limit .18 X 72,000
  12,960
• (which is less than absolute limit)
• - PA
  5,250
• 
  7,710
• He can claim 7,710 in respect of 1996. The
  solution assumes that the remaining 290 is
  claimed for 1997, since contributions in Jan. and
  Feb. can used for the previous year or the
  calendar year. However, students could assume
  that he had contribution room unused in previous
  years and claim the 290 also in 1996, provided
  they made the assumption explicitly. The entire
  solution would change, and tax payable would
  decrease by 290 X the marginal rate.
• An important point here is to split future income
  by contributing to a spousal RRSP. See Chapters
  7 and 16 also. Students should probably notice
  this opportunity even before reading Chapter 7,
  since it is so common, but the instructor could
  use it as an introduction to Chapter 7. If this
  question is assigned after both tax chapters are
  covered, then this it is reasonable to expect
  them to notice it.

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46
Problem 6 3

• 4 Supporting parent may claim tuition fees and
  education deduction if student does not need them
  to reduce tax to zero. Education deduction is 8
  months X 80 640. Tuition fees are 2500, for a
  total of 3140.
• 5 Jason should be paying quarterly installments
  if his income continues at this level otherwise
  he will be paying non-deductible interest to
  Revenue Canada. We did not describe installment
  payments in detail in the chapter so we would
  not require students to recognize this point.
• 6 Lower income spouse must claim child care
  expenses.
• 7 Even part-time workers must pay this so we
  calculated the amount that Nutshell must have
  deducted from her pay.
• 8 Part-time workers with less than 24 hours per
  week do not ordinarily pay UI, nor qualify for
  UIC.
• 9 Since she has more credits than she needs to
  reduce her tax to zero, she should look for some
  way to increase her taxable income. This point
  anticipates Chapter 7, since income splitting is
  the likely method. Nutshell should appoint her
  as a director and pay directors' fees.
  Alternatively, Nutshell could lower Jason's
  salary and increase dividends.

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47
Problem 6 - 4

• A. PV 950
• FV 1000
• n 10
• PMT 25
• I 3.089 per 6 months
• YTM 2(3.089) 6.178
• EAR (1.03089)2 - 1 6.273

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48
Problem 6 4

• (b.) The coupon is taxed at 44. The after-tax
  coupon is .56 (25) 14.
• The capital gain of 1000 - 950 50 is 50
  taxed.
• 50(.5)(.44) 16.50
• The after-tax receipt is 1000 - 16.50 983.50
• PV 950
• FV 983.50
• n 10
• PMT 14
• i 1.800 per 6 months
• EAR (1.0180)2 - 1 3.632

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49
Problem 6 - 4...

• (c.) The investor must be able to reinvest the
  coupons at exactly the same rate for the
  remaining term of the bond. Thus, all future
  interest rates and taxes are held constant.
  While this is not generally going to happen, it
  is a more reasonable assumption than zero
  reinvestment rate, which is what the YTM
  calculation assumes for the first 6 months of
  each odd-numbered coupon.

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50
Problem 6 - 7

• Tc .29(1.5) .435
• after-tax return (1 - .435)(.05) 2.83

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