Chap 11

CHAPTER 11

Computation of Taxable Income and Tax after General Reductions for Corporations Problem 1 [ITA: 3; 110.1–112] The following data summarizes the operations of Red Pocket Limited for the years of 2002 to 2005 ended September 30. 2002 2003 2004 2005 Income (loss) from business...... $ 54,000 $ 32,000 $ (75,000) $ 62,500 Dividend income — Taxable 42,500 22,500 18,000 10,500 Canadian corporations............ Taxable capital gains.................. 11,000 2,500 5,000 9,000 Allowable capital losses............. 2,000 4,500 3,500 — Allowable business investment 3,750 — — — loss.......................................... Charitable donations.................. 23,000 9,000 3,000 13,000 The corporation has a net capital loss balance of $13,500 which arose in 1998. — REQUIRED Compute the taxable income for Red Pocket Limited for the years indicated and show the amounts that are available for carryforward to 2006. (Deal with each item line-by-line across the years, rather than computing income one year at a time.)

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Introduction to Federal Income Taxation in Canada

230 Solution 1 Par. 3(a)

Income from business....................... Income from property.......................

Par. 3(b)

Taxable capital gains......................... Allowable capital losses....................

2002 54,000 42,500 $ 96,500 11,000 (2,000) $

2003 32,000 22,500 $ 54,500 2,500 (2,500)

2004

$

$ $

2005 62,500 10,500 $ 73,000 9,000 Nil

Nil 18,000 18,000 5,000 (3,500)

$

19,500 n/a (75,000) Nil — Nil

$

1

Par. 3(c) Par. 3(d)

ABIL................................................. Business loss..................................... Income from Division B.................... Inter-company dividends...................

Par. 3 (e) Sec. 112 Sec. 110.1

Par. 111(1)(b)

Charitable donations2: Carryover.................................... Current........................................ Net capital losses3..............................

Par. 111(1)(a) Non-capital losses4............................ Taxable income................................................................

$ 105,500 (3,750) n/a $ 101,750 (42,500) $ 59,250

$

54,500 n/a n/a $ 54,500 (22,500) $ 32,000

n/a (23,000) $ 36,250 (9,000) $ 27,250 (27,250) Nil

— (9,000) $ 23,000 — $ 23,000 (23,000) Nil

$

— — Nil (1,500) Nil — Nil

82,000 n/a n/a $ 82,000 (10,500) $ 71,500 (3,000) (13,000) $ 55,500 (500) $ 55,000 (24,750) $ 30,250

— NOTES TO SOLUTION (1) A maximum of $2,500 can be deducted in 2003. (2) Charitable donations: 2002: Lesser of: (a) 75% of $101,750 = $76,313 (b) $23,000 Carryforward: Nil 2003: Lesser of: (a) 75% of $54,500 = $40,875 (b) $9,000 Carryforward: Nil 2004: Lesser of: (a) 75% of Nil = Nil (b) $3,000 Carryforward: $3,000 2005: Lesser of: (a) 75% of $82,000 = $61,500 (b) $3,000 + $13,000 = $16,000 Carryforward: Nil (3) Net capital losses 1998 net capital loss converted to 2002 rates: $13,500 × 1/2/3/4........................................... Net capital loss deducted in 2002 to the extent of net taxable capital gains......................... 2003 net capital loss not utilized.......................................................................................... 2004 net capital loss deducted to the extent of net taxable capital gains.............................. 2005 remaining net capital loss deducted in 2005 to the extent of net taxable capital gains Available for carryforward...................................................................................................

$

9,000 (9,000) Nil $ 2,000 (1,500) $ 500 (500) Nil

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(4) Non-capital losses Par. 3(d) Loss from business in 2004........................................................... $ 75,000 Dividends deducted under sec. 112............................................... 18,000 Add: net capital loss deducted............................................................................................ Less: sec 3(c): par. 3(a) dividends................................................................. par. 3(b) taxable capital gain.................................................

$ 18,000 1,500

Losses utilized: 2002..................................................................................... $ 27,250 2003..................................................................................... 23,000 2005..................................................................................... 24,750 Closing balance..................................................................................................................

$ 93,000 1,500 $ 94,500 19,500 $ 75,000 75,000 Nil

Introduction to Federal Income Taxation in Canada

232 Problem 2

[ITA: 111(4), (5), (5.1); 249(4)] On November 1, 2005, Chris purchased all the issued shares of Transtek Inc. from an acquaintance, Tom. Transtek carries on a transmission repair business and has done so since its incorporation on January 1, 2004. In addition to the transmission repair business, Transtek rents out a small building it owns. Neither the transmission repair business nor the rental endeavour has been successful. When Chris purchased Transtek, his financial projections indicated that Transtek would have significant income within two years. Chris credited Transtek’s failure to Tom’s brash personality and laziness. Chris, on the other hand, has a strong work ethic and has many contacts in the automotive industry to refer work to him. The values of the capital assets owned by Transtek at the time of purchase by Chris are as follows: Repair shop Rental property Land Building Land Building F.M.V...................... $ 140,000 $ 230,000 $ 70,000 $ 120,000 Cost/A.C.B.............. 80,000 150,000 90,000 120,000 U.C.C...................... — 147,000 — 120,000 Chris selected June 30, 2006, as the first fiscal year-end for Transtek after his purchase. The following is a schedule of Transtek’s income (and losses) from its inception, January 1, 2004, through June 30, 2007. Period Jan. 1/2004–Dec. 31/2004.................... Jan. 1/2005–Oct. 31/2005.................... Nov. 1/2005–June 30/2006.................... July 1/2006–June 30/2007....................

Transmission repair business

Rental income (loss)

Capital Loss

$ (40,000)

$ (2,000)

$ (10,000)

(60,000)

(5,000)

—

(25,000)

6,000

—

54,000

11,000

—

— REQUIRED (A) Discuss the tax implications of the acquisition of Transtek Inc. on November 1, 2005, ignoring all possible elections/options. (B) Determine the tax consequences of the acquisition of Transtek Inc. under the assumption that: (i) the maximum amount of all elections/options is utilized; and (ii) the partial amount of all elections/options is utilized so that only enough income is generated to offset most or all of the losses which would otherwise expire on the acquisition of control.

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Solution 2 The data given in the problem statement can be summarized as follows:

Note that if no election is made, there is no income to offset the current business loss of $60,000 or the noncapital loss carryforward of $40,000. Therefore the non-capital loss available to carry forward from October 31, 2005 is $100,000 (i.e., $60,000 + $40,000). Note that the $2,000 of non-capital loss carryforward from a property loss expires. If the maximum election is made, the $3,000 of recapture offsets the business loss, leaving $57,000 (i.e., $60,000 – $3,000) of net business loss. The $70,000 of taxable capital gain offsets the $22,000 of expiring losses, leaving $48,000 (i.e., $70,000 – $22,000) to offset the remaining $57,000 of business loss. There is no remaining taxable capital gain to offset some of the $40,000 non-capital loss carryforward. As a result, the non-capital loss available for carry forward from October 31, 2005 is $40,000. If only a partial election is made, it should be enough to offset only $20,000 of the $22,000 of expiring losses. The other $2,000 of expiring loss is the property loss carryforward which can only be utilized if enough Division B income is elected, resulting in the elimination of the current business loss, as was the case with the maximum election. If a partial election of only $20,000 of taxable capital gain is made, the current business loss of $60,000 is not offset and, hence, is available to carry forward, along with the $40,000 of business non-capital losses, from October 31, 2005 for a total of $100,000. Part A (Ignoring all possible elections) An acquisition of control occurred when Chris acquired more than 50% of the voting shares of Transtek Inc. from an unrelated person, Tom. The taxation year of Transtek is deemed to end immediately before the acquisition of control, October 31, 2005 [ssec. 249(4)]. Tax returns are required to be filed for this short year (i.e., 10 months) and amounts, such as C.C.A. (if claimed), will have to be prorated. It is assumed that any accrued losses in inventory and accounts receivable have been recognized in calculating the business loss of $60,000.

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234

There are no accrued losses on the depreciable property. Therefore, there is no adjustment required [ssec. 111(5.1)]. There is a $20,000 accrued loss on the rental property land that must be recognized. The A.C.B. of the land is reduced from $90,000 to $70,000 [par. 111(4)(c)]. The $20,000 reduction is deemed to be a capital loss [par. 111(4)(d)]. The income (loss) for the taxation year ended October 31, 2005 is computed below. Par. 3(a) Par. 3(b)

Business income.......................................................................................................

Nil

Property income........................................................................................................

Nil

Net capital gains: Taxable capital gains......................................................................

Nil

Allowable capital loss: rental property ($20,000 × 1/2)..................

$ (10,000)

Par. 3(c) Par. 3(d)

Nil Nil

Business loss......................................................................................

$ (60,000)

Property loss.......................................................................................

(5,000)

$ (65,000)

Division B income....................................................................................................

Nil

The net capital losses (($10,000 × 1/2) + $10,000 = $15,000) expire immediately following the October 31, 2005 year-end [par. 111(4)(a)]. The non-capital loss balance at November 1, 2005 is computed as follows: Balance, Jan. 1, 2005................................................................................................................... $ 42,000 Loss for taxation year ended Oct. 31, 2005: from business.................................................................................................

$

from property.................................................................................................

5,000 $

Less Par. 3(c) amount determined above..............................................................

60,000 65,000 0

65,000

Balance, Oct. 31, 2005................................................................................................................

$ 107,000

Less: unutilized losses about to expire: non-capital property losses..........................................................

$ 2,000

current property loss....................................................................

5,000

Balance, Nov. 1, 2005.................................................................................................................

7,000 $ 100,000

Only the portion of the non-capital loss that may reasonably be regarded as a loss from carrying on a business ($40,000 + $60,000 = $100,000) is deductible after October 31, 2005. Thus, the rental losses ($2,000 + $5,000 = $7,000) expire immediately following the October 31, 2005 year-end [par. 111(5)(a)]. The $100,000 non-capital loss will be deductible only if the following condition is met — the transmission repair business is carried on for profit or with a reasonable expectation of profit throughout the taxation year in which the losses are to be claimed [spar. 111(5)(a)(i)]. The condition appears to be met for the June 30, 2006 and the June 30, 2007 taxation years. The transmission repair business was carried on throughout each of the years. It was carried on for profit for the taxation year ended June 30, 2007. Due to Chris’s work ethic and contacts in the industry, it is reasonable to assume that it was carried on with a reasonable expectation of profit for the taxation year ended June 30, 2006, despite the loss that was actually realized. The $100,000 non-capital loss is deductible only to the extent of income from the transmission repair business and income from a business selling similar products or providing similar services [spar. 111(5)(a)(ii)]. Thus, $54,000 of the non-capital loss incurred prior to November 1, 2005 is deductible for the June 30, 2007 taxation year. None of it is deductible for the June 30, 2006 taxation year due to the loss in that year. The remainder ($100,000 – $54,000 = $46,000) can be carried forward to 2008 subject to these same restrictions.

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235

These restrictions do not apply to the non-capital loss ($25,000 – $6,000 = $19,000) incurred in the taxation year ended June 30, 2006. Thus $11,000 of the 2006 non-capital loss is deductible in 2007, in addition to the $54,000 mentioned above. Part B (i) (Maximum election) Paragraph 111(4)(e) allows Transtek to elect to be deemed to have disposed of the repair shop land for proceeds of $140,000 (maximum) and the repair shop building for proceeds of $230,000 (maximum). If Transtek makes this election, the A.C.B. of the land on November 1, 2005 will be $140,000 and the A.C.B. of the building will be $230,000. The new undepreciated capital cost for the building will be limited by paragraph 13(7)(1) to $150,000 + 1/2 ($230,000 – 150,000) = $190,000. The income for the taxation year ended October 31, 2005 will be as follows: Par. 3(a): Business income........................................................................................................ Property income........................................................................................................ Par. 3(b): Net capital gains: Taxable capital gains: Repair shop land ($140,000 – $80,000) × 1/2................................. $ 30,000 40,000 Repair shop building ($230,000 – $150,000) × 1/2......................... $ 70,000 (10,000) Allowable capital loss ($20,000 × 1/2)................................................ Par. 3(c) Par. 3(d)

............................................................................................................ Business loss....................................................................................... Less: recapture — building ($147,000 – $150,000)...........................

Nil Nil

$

60,000

$

60,000

$ (60,000) 3,000 $ (57,000) Property loss....................................................................................... (5,000) Division B income....................................................................................................................... Division C deductions: Par. 111(1)(a) Net capital loss from 2004..................................................... $ (5,000) Par. 111(1)(b) Non-capital loss: Business.......................................................... $( Nil) Property........................................................... (Nil) (Nil) Taxable income........................................................................................................................... Non-capital loss balance, Nov. 1, 2005: Balance, Jan. 1, 2005............................................................... Added in taxation year ended Oct. 31/05 ($60K – $5K – $5K – $57K.................................................... Utilized in taxation year ended Oct. 31, 2005 or expired........ Remaining...............................................................................

Business $ 40,000

Property $ 2,000

7,000 (Nil) 47,000

Nil (2,000) Nil

$

(62,000) Nil

(5,000) Nil $

Total 42,000

$

7,000 (2,000) 47,000

The $47,000 remaining may reasonably be regarded as a loss from carrying on business and thus is deductible in a taxation year after October 31, 2005, subject to the restrictions discussed in Part A. By making the maximum elections possible, the non-capital loss balance of Transtek at November 1, 2005 has been significantly reduced. Part B (ii) (Minimum election to utilize expiring losses) The following losses will expire October 31, 2005, if not utilized: The 2004 net capital loss.............................................................................................. The Oct. 31, 2005 allowable capital loss...................................................................... The rental loss portion of the 2004 non-capital loss..................................................... The Oct. 31, 2005 rental loss........................................................................................

$

5,000 10,000 2,000 5,000 $ 22,000

It is impossible to utilize the rental loss portion of the 2004 non-capital loss of $2,000 without triggering sufficient income under paragraph 3(c) to utilize the entire October 31, 2005 business loss. This would not be beneficial. Therefore, only $20,000 of the expiring losses will be used.

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236

To utilize these losses in the taxation year ending October 31, 2005, a capital gain of 2 × $20,000 = $40,000 is needed. To avoid recapture, the election should be made on the land, not the building.* Thus, Transtek will elect under paragraph 111(4)(e) to be deemed to have disposed of the repair shop land for proceeds of $120,000, i.e., (2 × $20,000) + 80,000. The A.C.B. of the land at November 1, 2005 will be $120,000. * An alternative is considered below. The income for the taxation year ended October 31, 2005 will be as follows: Par. 3(a)

Business income........................................................................................................ Property income........................................................................................................ Par. 3(b) Net capital gains: Taxable capital gain: Repair shop land ($120,000 – $80,000) × 1/2..................................... $ 20,000 (10,000) Allowable capital loss ($20,000 × 1/2)................................................ Par. 3(c)....................................................................................................................................... Par. 3(d) Business loss....................................................................................... $ (60,000) Property loss....................................................................................... (5,000) Division B income.......................................................................................................................

Nil Nil

$ 10,000 $ 10,000 (65,000) Nil

Division C deductions: Par. 111(1)(a) Net capital loss from 2004............................................................................ Taxable income............................................................................................................................

$ (5,000) Nil

The net capital loss claimed has no effect on taxable income, but it will increase the non-capital loss balance. The non-capital loss balance at November 1, 2005 is computed as follows: Balance, Jan. 1, 2005................................................................................................................... Par. 3(d) Loss for taxation year ended Oct. 31, 2005: from business........................................................................................ $ 60,000 from property........................................................................................ 5,000 $ 65,000 Add: Net capital loss deducted.............................................................................. 5,000 $ 70,000 Less: Par. 3 (c) amount determined above............................................................ 10,000 Balance, Oct. 31, 2005................................................................................................................ Less: the unutilized non-capital property loss............................................................................. Balance, Nov. 1, 2005.................................................................................................................

$ 42,000

60,000 * $ 102,000 2,000 $ 100,000

* Exactly equal to the business loss above.

Only the portion of the non-capital loss that may reasonably be regarded as a loss from carrying on a business ($40,000 + $60,000 = $100,000) is deductible after October 31, 2005. It is subject to the restrictions discussed in Part A. Summary: The three alternatives presented above are summarized as follows for comparative purposes: Taxable Income for the Deemed Taxation Year Ended October 31, 2005: No election Par. 3(a) Income from non-capital sources (≥ 0)....................... Par. 3(b) Net taxable capital gains (≥ 0): Deemed taxable capital gains (elective): land..................................................... Nil building.............................................. Nil Accrued allowable capital loss (automatic): rental land........................................... $ (10,000) Par. 3(c) Par. 3(a) + par. 3(b).....................................................

Maximum election Nil

Nil $

Nil Nil

30,000 40,000

(10,000)

Partial election Nil $ 20,000 Nil

$ 60,000 $ 60,000

(10,000)

$ 10,000 $ 10,000

Solutions to Chapter 11 Assignment Problems Par. 3(d) Losses from non-capital sources and ABILs: Loss from business operations.................... Recapture (elective): building..................... Loss from property......................................

$ (60,000) Nil (5,000)

237

(65,000)

Division B income...................................................................... Optional net capital loss deducted........................ Nil Non-capital loss deducted: From property.............................................. Nil From business.............................................. Nil

Nil

Taxable income..........................................................................

Nil

$ (60,000) 3,000 (5,000)

(62,000)

(65,000)

Nil (5,000)

Nil

$(60,000) Nil (5,000)

Nil Nil

Nil (5,000)

(Nil)

Nil Nil

Nil

Nil

Nil

Non-Capital Losses Available for Carryforward at Deemed Taxation Year Ended Oct. 31, 2005: No election Balance from Jan. 1, 2005.......................................................... $ 42,000 Non-capital loss — Oct. 31, 2005: Par. 3(d) losses — see above........................ $ 65,000 Add: net capital losses deducted................... Nil Less: par. 3(c) income — see above.............

$ 65,000 Nil

65,000

Maximum election $ 42,000 $ 62,000 5,000 $ 67,000 60,000

$ 107,000 Less: losses utilized at Oct. 31, 2005..................... losses not utilized but expired: Current property loss............................ Carryforward property loss..................

Nil

Partial election $ 42,000 $ 65,000 5,000

7,000

$ 70,000 10,000

$ 49,000 Nil Nil 2,000

60,000 $ 102,000

Nil

$ 5,000 2,000

7,000

Available for carryforward from Nov. 1, 2005..........................

$ 100,000

$ 47,000

$ 100,000

Net Capital Losses available for Carryforward..........................

Nil

Nil

Nil

2,000

Nil 2,000

2,000

The results of the above comparison of the three alternatives are further summarized as follows: Alternatives (A) (B)(i) (B)(ii) Taxable income................................................................. Nil Nil Nil Net capital loss deducted................................................... Nil $ 5,000 $ 5,000 Non-capital loss balance, Nov. 1, 2005............................. $ 100,000 47,000 100,000 A.C.B. of repair shop land................................................. 80,000 140,000 120,000 A.C.B. of repair shop building.......................................... 150,000 230,000 150,000 U.C.C. of repair shop building.......................................... 147,000 190,000 147,000 * * $147,000 + $3,000 + 1/2 × ($230,000 – $150,000)

Alternative B (ii) is better if the non-capital loss can be offset by income generated in the next seven years. The resultant lower A.C.B. of the land and building under this option is only relevant on a disposition. The lower U.C.C. on the building only represents an opportunity loss of C.C.A. at a 4% declining balance rate. Consider the alternative of electing deemed proceeds of disposition of $190,000 (i.e., (2 × $20,000) + $150,000) on the repair shop building. Income under paragraph 3(b) would be the same as for Part B (ii). However, the business loss under paragraph 3(d) would be only $57,000 (i.e., $60,000 – $3,000 recapture), since recapture would be triggered. This would reduce the non-capital loss balance at November 1, 2005 by $3,000 to $97,000. However, the UCC of the repair shop building could be increased from $147,000 to $170,000 (i.e., + $3,000 of recapture + $20,000 of taxable capital gain). The increased CCA base would begin to shelter income from tax, in this case, in the year ended June 30, 2006, when the corporation earns a profit. If, for example, the corporation uses a discount rate of 10% and faces a tax rate of 20%, the present value of the tax shield on the incremental UCC base of $23,000 (i.e., $170,000 – $147,000) is: $23,000 × .04 × .20 = $1,314 .04 + .10 The value of the extra $3,000 in the non-capital loss balance in the same year and at the same assumed tax rate of 20% is $600 (i.e., 20% of $3,000).

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Introduction to Federal Income Taxation in Canada

Problem 3 [ITA: 111(4), (5), (5.1); 249(4)] In 2002, a chain of bakeries, called Buscat Ltd., commenced operation. The industry is highly competitive and because of Mr. Buscat’s lack of marketing skills, the corporation incurred losses in the first three taxation years of operations as follows: Taxation year-end Dec. 31, 2002.................................................. Dec. 31, 2003.................................................. Dec. 31, 2004..................................................

Non-capital losses $ 60,000 45,000 25,000

Capital losses $ 12,000 8,000 4,000

On July 1, 2005, Mr. Buscat decided to sell 75% of his common shares to Mr. Bran, owner of Buns Plus Ltd. Mr. Bran has been in the business of supplying bread dough, pastry dough and bun bags for ten years and has been very successful. Buns Plus Ltd. has two divisions: a bakery and a coffee shop, which it intends to transfer to Buscat Ltd. The following income tax data relates to Buscat Limited’s operations from January 1, 2005 to June 30, 2005: (a) Business loss (before inventory valuation).. $ 10,000 (b) Allowable capital loss................................. 2,000 (c) Property loss................................................ 5,500 (d) Assets at June 30, 2005: Inventory............................. Land.................................... Building.............................. Bakery equipment...............

Cost/A.C.B. $ 85,000 155,000 65,000 100,000

U.C.C. — — $ 45,000 86,000

F.M.V. $ 65,000 195,000 75,000 70,000

During the later part of the 2005 calendar year, the bakery/coffee shop of Buns Plus Ltd. was transferred to Buscat Ltd. For the six-month period ending on December 31, 2005, Buscat Limited had net income of $90,000 from all its businesses. The net income earned was as follows: Buscat bakery..................................................... $ (55,000) Buns Plus bakery................................................ 130,000 Coffee shop........................................................ 15,000 $ 90,000 In the 2006 taxation year, Buscat Ltd. expects to earn $250,000, of which $65,000 will be from the original Buscat bakery business and $20,000 from the coffee shop business. — REQUIRED Prepare an analysis of the income tax implications of the acquisition of shares. In your analysis, consider the two election options from which an election choice is most likely to be made.

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239

Solution 3 The data given in the problem statement can be summarized as follows:

The two election options to consider are the maximum election and the partial election. If the maximum election is made, the $20,000 of recapture offsets the business loss, leaving $26,000 (i.e., $46,000 – $20,000) of net business loss. The $25,000 of taxable capital gain offsets the $19,500 of expiring losses, leaving $5,500 (i.e., $25,000 – $19,500) to offset the remaining $26,000 of business loss, leaving $20,500 of that business loss. As a result, the non-capital loss available for carry forward from June 30, 2005 is $150,500 (i.e., $20,500 + $130,000). If only a partial election is made to offset the $19,500 of expiring losses, the current business loss of $46,000 is not offset and, hence, is available to carry forward, along with the $130,000 of non-capital losses, from June 30, 2005 for a total of $176,000. If the election is made on the land, the ACB of the land can be increased without a tax cost. Note that if no election is made there is no income to offset the current business loss of $46,000 or the noncapital loss carryforward of $130,000. Therefore, the non-capital loss available to carry forward from June 30, 2005 is $176,000 (i.e., $46,000 + $130,000), which is the same as in the partial election, but there is no increase in any cost value.. Deemed Year-end Buscat Ltd. is deemed to have a taxation year ending June 30, 2005, immediately before the acquisition of control by Buns Plus Ltd. on July 1, 2005 [ssec. 249(4)]. Tax returns will have to be filed for this short taxation year (i.e., 6 months) and amounts such as C.C.A. will have to be prorated. In addition, the short taxation year will cause the counting of a carryforward year for the non-capital losses from 2002, 2003 and 2004.

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Introduction to Federal Income Taxation in Canada

Loss from Non-capital Sources Losses from non-capital sources for the deemed taxation year ended June 30, 2005, before any elections and options are computed as follows: Loss from business....................................................................................................... $ 10,000 Add: Inventory loss [ssec. 10(1)] ($85,000 – $65,000).............................................. 20,000 Bakery equipment — Deemed CCA ($86,000 – $70,000)................................ 16,000 Total business losses..................................................................................................... $ 46,000 Add: Property loss (will expire unless utilized by June 30, 2005).............................. 5,500 Total losses from non-capital sources........................................................................... $ 51,500 Maximum Election Division B income and taxable income Par. 3(a) Income from non-capital sources................................................................................ Par. 3(b) Net taxable capital gains:............................................................................................ Election on land [($195,000 – $155,000) × 1/2].................................................. Election on building [($75,000 – $65,000) × 1/2]................................................ Less: Allowable capital loss................................................................................ Par. 3(c) Sum of par. 3(a) plus par. 3(b) less any Subdivision e deductions (nil)...................... Par. 3(d) Property loss........................................................................................... $ 5,500 Business losses....................................................................................... 46,000 $ 51,500 Less: Building recapture......................................................................... 20,000 Sec. 3 income................................................................................................................................ Division C deductions: Net capital losses: 2002..................................................................................... $ 6,000 2003..................................................................................... 4,000 2004..................................................................................... 2,000 Taxable income.............................................................................................................................

Nil $ 20,000 5,000 $ 25,000 2,000 $ 23,000

31,500 Nil

$ 12,000 Nil

Non-capital losses available for carryforward after acquisition of control: Balance — July 1, 2005 2002 non-C.L..................................................................................................... 2003 non-C.L..................................................................................................... 2004 non-C.L..................................................................................................... Non-C.L. from deemed taxation year before acquisition of control: Total par. 3(d) loss (see above calculation)....................................................... Add: Net capital loss deducted..........................................................................

$ 60,000 45,000 25,000

$ 130,000

$ 31,500 12,000 $ 43,500 Less: Par. 3(c) income above............................................................................. 23,000 Total non-capital losses.................................................................................................................

20,500 $ 150,500

The $150,500 loss carryforward balance must “reasonably be regarded as its loss from carrying on a business.” 2002, 2003 and 2004 loss carryforwards from a business as stated in the question............... $ 130,000 June 30, 2004 business loss net of recapture..................................................... $ 26,000 Less portion of this loss used against par. 3(c) income*................................... 5,500 20,500 $ 150,500 * Par. 3(c) income........................................................................................................ Less: Property losses....................................................................... $ 5,500 Net capital losses restored as business losses....................... 12,000

$ 23,000 17,500 $

5,500

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241

The non-capital losses will expire as follows, assuming that Buscat Ltd.’s fiscal year-end after the acquisition of control returns to December 31. 2002 non-C.L. — on December 31, 2008 2003 non-C.L. — on December 31, 2009 2004 non-C.L. — on December 31, 2013 2005 deemed taxation year — on December 31, 2014 The adjusted cost base/capital cost of the properties which were deemed to be sold at their fair market values would be: Capital U.C.C. Adjusted cost cost base Bakery equipment................................................................... $ 100,000 $ 70,000 $ 100,000 Land........................................................................................ n/a n/a 195,000 Building*................................................................................ 70,000 70,000 75,000 * $65,000 + 1/2 ($75,000 – $65,000).

In order for these non-capital losses to be deductible in subsequent fiscal periods, two conditions in subparagraph 111(5)(a)(i) must be met: (a) the bakery business which generated the loss must be carried on throughout the taxation year in which the non-capital loss is deducted; and (b) the bakery business must be carried on for profit or with a reasonable expectation of profit. It would appear that both conditions will be met, since the Buscat business is being carried on and Buns Plus expects that the Buscat bakery business will earn a profit of $65,000 in 2006. If the conditions of subparagraph 111(5)(a)(i) are met, then the non-capital losses may be deducted from income of the bakery business that generated the loss plus the income from the sale of similar products or services. If it can be assumed that the bakery business, transferred to Buscat Ltd., sells similar products and/or services as the Buscat bakery business, then the maximum $90,000 of non-capital losses can be deducted on December 31, 2005 as follows: Lesser of: (a) Net income for year...................................................................................................... $ 90,000 (b) Income from: the loss business............................................................... Nil the sale of similar products.............................................. $ 130,000 $ 130,000 The remaining $60,500 ($150,500 – $90,000) of non-capital losses can be carried forward to 2006 subject to the deductibility tests discussed above. Partial election The minimum amount to be elected upon under paragraph 111(4)(e) (i.e., proceeds of disposition) should be an amount equal to 2 times the sum of: (a) the allowable capital loss of $2,000 which is about to expire, (b) the net capital losses of $12,000 which would otherwise expire, and (c) the property loss of $5,500 which otherwise expires plus the adjusted cost base of the property to be elected upon. If the land was chosen as the asset to trigger all of the taxable capital gain, then the deemed proceeds would be determined as: [2 × ($2,000 + $5,500 + $12,000) + $155,000] or $194,000 The resulting taxable income computation would be: Par. 3(a) Par. 3(b)

Par. 3(c)

Non-capital sources of income Net taxable capital gain: Land, 1/2 ($194,000 – $155,000)......................................................... $ 19,500 Allowable capital loss......................................................................... (2,000) Sum of par. 3(a) plus par. 3(b) less any Subdivision e deductions (nil)....................

Nil $ 17,500 $ 17,500

Introduction to Federal Income Taxation in Canada

242 Par. 3(d)

Property loss....................................................................................... Business loss.......................................................................................

$

5,500 46,000 $ 51,500 Less: Building recapture..................................................................... Nil Sec. 3 income.............................................................................................................................. Division C Net capital loss............................................................................................................................ Taxable income........................................................................................................................... Non-capital losses available for carryforward after the acquisition of control: Balance, July 1, 2005................................................................................................................... Non-capital losses from the deemed taxation year ended June 30, 2004.............. $ 51,500 Add: Net capital losses deducted above................................................................ 12,000 $ 63,500 Less: Par. 3(c) income above................................................................................ 17,500 Total non-capital losses...............................................................................................................

51,500 Nil $ 12,000 Nil $ 130,000

46,000 * $ 176,000

* Exactly equal to the business loss above.

Summary The two alternatives presented above are summarized as follows for comparative purposes: Taxable Income for the Deemed Taxation Year Ended June 30, 2005: Maximum Partial election election Par. 3(a) Income from non-capital sources (≥ 0)................................ Nil Nil Par. 3(b) Net taxable capital gains (≥ 0): Deemed taxable capital gains (elective): land.................................................... $ 20,000 $ 19,500 building.............................................. 5,000 Nil Allowable capital loss............................... (2,000) $ 23,000 (2,000) $ 17,500 Par. 3(c) Par. 3(a) + par. 3(b)............................................................. $ 23,000 $ 17,500 Par. 3(d) Losses from non-capital sources and ABILs: Loss from business.................................... $ (46,000) $ (46,000) Recapture (elective): building................... 20,000 Nil Loss from property.................................... (5,500) (31,500) (5,500) (51,500) Division B income............................................................................... Nil Nil Optional net capital loss deducted........................................................ (12,000) (12,000) Non-capital loss deducted.................................................................... Nil Nil Taxable income.................................................................................... Nil Nil Non-Capital Losses available for Carryforward at Deemed Taxation Year ended June 30, 2005: Maximum election Partial election Balance, Jan. 1, 2005............................................................................ $ 130,000 $ 130,000 Non-capital loss — June. 30, 2005: Par. 3(d) losses — see above.................................... $ 31,500 $ 51,500 Add: net capital losses deducted............................... 12,000 12,000 $ 43,500 $ 63,500 Less: par. 3(c) income — see above......................... 23,000 20,500 17,500 46,000 $ 150,500 $ 176,000 Less: losses utilized at June 30, 2005............................. Nil Nil losses not utilized but expired............................... Nil Nil Nil Nil Available for carryforward from June. 30, 2005.................................. $ 150,500 $ 176,000 Net Capital Losses available for Carryforward................................... Nil Nil

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The results of the above comparison of the two alternatives are further summarized as follows: Alternatives Taxable income......................................................................... Net capital loss deducted.......................................................... Total non-capital losses available for carryforward.................. A.C.B. of land........................................................................... U.C.C. of building..................................................................... A.C.B. of building.....................................................................

(a) 0 $ 12,000 150,500 195,000 70,000 75,000

(b) 0 $ 12,000 176,000 194,000 45,000 65,000

Difference 0 0 $ 25,500 (1,000) (25,000) (10,000)

Alternative (b) is better if the additional $25,500 of non-capital loss can be offset by income generated in the next 10 years. The resultant lower A.C.B. of the land under this option is only relevant on a disposition. The lower U.C.C. on the building only represents a loss of C.C.A. at a 4% declining balance rate. On the other hand, if an additional $25,500 of income cannot be generated in the next seven years (i.e., business losses continue), Alternative (a) is better.

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Problem 4 [ITA: 9–20; 38–55; 110.1–112] The controller of Video Madness Inc. has prepared the accounting income statement for the year ended April 30, 2005: VIDEO MADNESS INC. INCOME STATEMENT FOR THE YEAR ENDED APRIL 30, 2005 Sales.................................................................. Cost of sales...................................................... $ 523,000 Administrative expenses................................... 185,000 Operating income.............................................. Other income and expenses.............................. Provision for income taxes................................ Net income........................................................

$ 995,000 708,000 $ 287,000 55,000 $ 342,000 102,000 $ 240,000

Other Information (1) Included in the calculation of “Administrative expenses”: (a) Interest on late income tax payments............................. (b) Depreciation and amortization (maximum capital cost allowance of $149,500).................................................. (c) Club dues for the local Country Club............................. (d) Federal political contributions........................................ (e) Donations to registered charities.................................... (f) Property tax with respect to vacant land not being used in the course of the business........................................... (g) Life insurance premium with respect to the president (the company is the beneficiary; not required for financing)....................................................................... (2) Included in the calculation of “Other income and expenses”: (a) Landscaping of ground around new premise................. (b) Fees paid with respect to the investigation of a suitable site for the company’s manufacturing plant................... (c) Dividends received from taxable Canadian corporation of $42,800 and foreign corporation dividends received (not from a foreign affiliate) of $5,500 (Cdn.)............... (d) Gain from the sale of another piece of land, used in the business, sold for $200,000 in March (purchased for $73,800)......................................................................... (e) Loss on sale of investments held as capital property purchased for $85,000 and sold for $75,000.................. (3) Loss carryforwards from 2004 are: (a) Non-capital losses.......................................................... (b) Net capital losses (realized in 1999)..............................

$

435 104,900 1,750 2,500 22,500 3,000 1,950 4,800 5,500 48,300 126,200 10,000 73,800 75,000

— REQUIRED Prepare a schedule reconciling the accounting net income to income for tax purposes and taxable income. Indicate the appropriate statutory reference for your inclusions or exclusions.

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245

Solution 4 Net income before income taxes.................................................................................................. Add: Loss on the sale of investment [ssec. 9(3)]................................................. $ 10,000 Depreciation and amortization [par. 18(1)(b)]........................................... 104,900 Interest on income tax payments [par. 18(1)(t)]......................................... 435 Club dues [par. 18(1)(l)]............................................................................ 1,750 Political contributions [par. 18(1)(n)]........................................................ 2,500 Charitable donations [par. 18(1)(a)]........................................................... 22,500 Property tax on vacant land [ssec. 18(2)]................................................... 3,000 Life insurance premium [pars. 18(1)(a), (b), (c)]....................................... 1,950 Subtotal...................................................................................................... Deduct: Capital cost allowance [par. 20(1)(a)].................................................... $ 149,500 Gain on sale of land [ssec. 9(3)]............................................................. 126,200 Add: Taxable capital gain on business land [sec. 38]: 1/2 × ($200,000 – $73,800)................................................................................................. Allowable capital loss on investments [sec. 38]: 1/2 × ($75,000 – $85,000):................................................................................................ Net income under Division B................................................................................ Less Division C deductions: Charitable donations [sec. 110.1]................................................................... Dividends [sec. 112]...................................................................................... Non-capital loss [par. 111(1)(b)]................................................................... Net capital loss [par. 111(1)(a)]: $75,000 × 4/3 × 1/2..................................... Taxable income..................................................................................................... The following items were correctly included on the accounting income statement: (a) Landscaping costs [par. 20(1)(aa)]; (b) Site investigation fees [par. 20(1)(dd)]; (c) Dividends from taxable Canadian corporations [par. 12(1)(j)]; and (d) Dividends from foreign corporations [par. 12(1)(k)].

$

147,035 $ 489,035 275,700 $ 213,335

63,100 (5,000)

$

$ 342,000

22,500 42,800 73,800 50,000

58,100 $ 271,435

189,100 $ 82,335

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Introduction to Federal Income Taxation in Canada

Problem 5 [ITA: 124; ITR: 400] The taxpayer, whose head office was in Manitoba, manufactured and sold various fans. Local sales agencies were maintained in Ontario and in Quebec. At the Ontario agency, two qualified representatives handled business under the company name. They were authorized to sign quotations. Contracts could be made, terms of payment arranged and credit given without reference to the head office in Winnipeg. The company name was displayed for public visibility, was used on calling cards, and was listed in the telephone directory. The Ontario agency, occupying one-half of a building with warehouse facilities, maintained an inventory worth about $6,000. Orders for standard-sized fans were filled from stock-in-trade. Orders for large fans were filled from the head office in Winnipeg. The Quebec agency was substantially similar to that in Ontario. — REQUIRED Determine whether or not the company has a “permanent establishment” in the provinces of Ontario and Quebec. In reaching a conclusion, compare this situation with the case of M.N.R. v. Sunbeam discussed in this chapter.

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Solution 5 [Reference: Chicago Blower (Canada) Ltd. v. M.N.R., (T.A.B.) 66 DTC 471] (A) Facts fall within Regulation 400(2)(b) (i) the company carried on business in each province through an agent, — the agent was established in a particular place, clearly identified to the public, — occupied building with various warehouse facilities, — the agent had general authority to contract, — the agent had a stock of merchandise from which he filled orders, — the exception to this was on orders for larger fans, — thus, the condition was met at least in part, (ii) therefore, the company does have a “permanent establishment” in the provinces indicated. (B) This conclusion differs from that in the Sunbeam case which can be distinguished on its facts, (i) in the Sunbeam case, the taxpayer’s representatives in Quebec did not have authority to make contracts on the company’s behalf, (ii) there was no telephone listing in the company’s name and that name did not appear on any business signs.

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Introduction to Federal Income Taxation in Canada

Problem 6 [ITA: Part I.3] Larger Than Life Inc., a public corporation in the service industry, had the following balance sheet as at December 31, 2005: Cash.......................................................................................... Accounts receivable (net) ........................................................ Inventory .................................................................................. Investment in Canadian subsidiary .......................................... Unsecured demand loan to Mr. Filth E. Rich ........................... Future income taxes (debit) ..................................................... Total assets ............................................................................... Accounts payable ..................................................................... Bank indebtedness (due on demand) ........................................ Mortgage due to Mrs. Low N. Shark ....................................... Common shares ........................................................................ Retained earnings ..................................................................... Total liabilities and equity .......................................................

($ 000’s) 40,000 50,000 60,000 120,000 60,000 20,000 350,000 55,000 75,000 35,000 65,000 120,000 350,000

The investment has been accounted for using the equity basis with the carrying value being computed as follows: Original cost of shares.............................................................. Accumulated share of subsidiary’s earnings............................. Accumulated dividends received.............................................. Carrying value..........................................................................

$ 110,000 20,000 (10,000) $ 120,000

Larger Than Life’s taxable income for its taxation year ended December 31, 2005, was $9,000,000 with 82% of its income being earned in a province. Larger Than Life grew significantly during 2005. In 2004, the corporation was not even subject to Part I.3 tax and its taxable income was only $800,000 (all earned in the province of Ontario). The corporation had no taxable income in the prior six years. — REQUIRED Determine Larger Than Life’s Part I.3 tax liability for its 2005 tax year. Assume that Larger Than Life is allocated $40,000,000 of the capital deduction in its related group of corporations.

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249

Solution 6 Capital Capital stock [par. 181.2(3)(a)]............................................................................... Retained earnings [par. 181.2(3)(a)]....................................................................... Bank debt [par. 181.2(3)(c)].................................................................................... Mortgage payable [par. 181.2(3)(d)]....................................................................... Future income taxes (debit) [par. 181.2(3)(h)]........................................................ Total capital.................................................................................................................... Investment allowance2 Investment in subsidiary [par. 181.2(4)(a)]............................................................. Taxable capital ($265,000,000 – $110,000,000)............................................................ Taxable capital employed in Canada (82% of $155,000,000)........................................ Capital deduction (as allocated in related group)........................................................... Amount subject to Part I.3 tax........................................................................................ Part I.3 tax @ 0.175%.................................................................................................... 2005 surtax (4% of 28% of $9,000,000)......................................................................... 2005 Canadian surtax payable (82% of $100,800)......................................................... 2005 Part I.3 tax liability — (A) minus (B).................................................................... 2004 surtax (4% × 28% × 100% × $800,000)............................................................. Part I.3 tax payable ($69,769 – $8,960) ([sec. 181.1(4)]................................................

$

65,000,000 110,000,000 75,000,000 35,000,000 (20,000,000) $ 265,000,000

1

$ 110,000,000 1 $ 155,000,000 $ 127,100,000 40,000,000 $ 87,100,000 $ 152,425 (A) $ 100,800 $ 82,656 (B) $ 69,769 $ 8,960 $

60,8093

— NOTES TO SOLUTION (1) Subsection 181(3) requires that the equity method not be used in determining amounts to be included in capital and the investment allowance. Therefore, $10,000,000 has been subtracted from both the carrying value of the investment and retained earnings in order to remove the effect of the equity method of accounting. (2) The demand loan receivable does not qualify for the investment allowance since it is neither owing from a corporation [par. 181.2(4)(b)] nor a bond, debenture, note, mortgage, hypothec, or similar obligation of another corporation [par. 181.2(4)(c)]. (3) This amount can be offset by Canadian surtax payable in the following three years. No further unused surtax credits exist from the preceding seven years.

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Problem 7 [ITA: 125.1] One of your manufacturing clients, Mano-Pac Limited, a public company, provides you with the following information in order to calculate their manufacturing and processing profit deduction: (a) Salary expenses are represented by: Accounting staff........................................................... $ 200,000 Quality control staff..................................................... 150,000 Plant staff..................................................................... 800,000 Plant supervisors and maintenance............................... 90,000 Distribution staff (responsible for distribution of finished products)................................................. 65,000 Receiving department staff (responsible for receiving and storing raw materials).................................... 45,000 Clerk responsible for purchasing raw materials........... 35,000 $ 1,385,000 (b) Fixed assets of Mano-Pac Ltd.: Data processing equipment........................................... $ 50,000 Manufacturing equipment............................................ 900,000 Office equipment.......................................................... 100,000 Vending machines etc. in employee cafeteria.............. 10,000 $ 1,060,000 (c) Taxable income is comprised of: Manufacturing income................................................. $ 375,000 Investment income....................................................... 65,000 Division B income....................................................... $ 440,000 Less: charitable donations............................................ 15,000 Taxable income............................................................ $ 425,000 — REQUIRED Calculate the manufacturing and processing profit deduction Mano-Pac Ltd. can claim.

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251

Solution 7 Calculation of manufacturing and processing profits deduction from tax: 7% of lesser of: (a) Canadian manufacturing and processing profits.................................................. (b) Taxable income................................................................................................... 7% of $374,970 = $26,248

$ 374,970 1 $ 425,000

— NOTE TO SOLUTION (1) Calculation of Canadian manufacturing and processing profits: MP = = =

MC + ML × ADJUBI C+L $105,882 + $1,385,000 × $375,000 $106,000 + $1,385,000 $374,970

(a) ADJUBI (Adjusted Business Income): Division B income...................................................................................................... Less: Investment income............................................................................................. (b) C (Cost of Capital): 10% of gross capital cost of assets ($1,060,000) =..................................................... (c) MC (Cost of Manufacturing and Processing Capital): 10% of manufacturing assets ($900,000).................................................................... 100/85 of total (100/85 × $90,000) =......................................................................... Lesser of: (i) cost of capital (C).................................................................................. (ii) cost of manufacturing and processing capital (MC)............................. (d) L (Cost of Labour): Total salary expenses.................................................................................................. (e) ML (Cost of Manufacturing and Processing Labour): Portion of total salary expenses used in qualified activities: Total salary expenses........................................................................................... Less*: Accounting......................................................................... $ 200,000 Distribution........................................................................ 65,000 Raw materials clerk........................................................... 35,000 100/75 of $1,085,000........................................................................................... Lesser of: (i) cost of labour (1)................................................................................... (ii) cost of manufacturing and processing labour (ML).............................. * Regulation 5202: definition of qualified activities.

$ $

440,000 65,000 375,000

$

106,000

$ $

90,000 105,882

$ $

106,000 105,882

$ 1,385,000

$ 1,385,000

$ $ $ $

(300,000) 1,085,000 1,446,667 1,385,000 1,446,667

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Introduction to Federal Income Taxation in Canada

Problem 8 [ITA: 123; 124; 126] Barltrop Limited is a Canadian public company involved in the software consulting business. Its controller provided you with the following information related to its 2005 taxation year ended December 31: Income under Division B from consulting business including $100,000 earned in U.S. operations (before deducting $16,000 U.S. tax paid)....................................................... Canadian investment royalty income........................................ U.K. non-foreign affiliate income (before $3,000 tax withheld)............................................................................ Taxable dividend received from non-connected Canadian corporations....................................................................... Taxable capital gains................................................................ Charitable donations................................................................. Unused foreign tax credit in respect of U.S.............................. Net capital losses carried forward arising in 1999....................

$ 264,000 10,000 20,000 5,000 6,000 100,000 3,000 12,000

Barltrop Limited has permanent establishments in the U.S., B.C. and Alberta. Its gross revenues and salaries and wages data have been allocated as follows:

Gross revenues..................... Salaries and wages................

British Columbia $ 3,000,000 500,000

Alberta $ 3,000,000 300,000

U.S. $ 4,000,000 200,000

Assume that the British Columbia corporation tax rate is 13.5% and the Alberta rate is 11.5%. Also, assume that taxable income for Alberta is computed on the same basis as federal taxable income. Gross revenues exclude income from property not used in connection with the principal business operation of the corporation. — REQUIRED Compute the total tax payable by the company for the 2005 taxation year, including provincial tax. Show all calculations.

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253

Solution 8 Income under Division B from consulting business.................................................................... Canadian investment royalty income........................................................................................... U.K. non-foreign affiliate income............................................................................................... Taxable dividend received from non-connected Canadian corporations..................................... Taxable capital gains................................................................................................................... Income under Division B............................................................................................................. Deduct: Charitable donations (not exceeding 75% × $305,000 = $228,750).................................... Canadian dividends received................................................................................................ 1999 net capital loss ($12,000 × 1/2 / 3/4; limited to taxable capital gains of $6,000)........... Taxable income........................................................................................................................... Basic federal tax at 38% of $194,000.......................................................................................... Deduct: Abatement from federal tax (see Schedule 1)................................................................ Net............................................................................................................................................... Add: Federal surtax @ 4% of 28% × $194,000.......................................................................... Deduct: Non-business foreign tax credit (see Schedule 2)................................................................. Business foreign tax credit (see Schedule 3)........................................................................ Tax reduction (7% of $194,000)........................................................................................... Part I tax payable (federal).......................................................................................................... Provincial tax: British Columbia 13.5% of $77,600..................................................................................... Alberta rate 11.5% of $58,200............................................................................................. Total tax.......................................................................................................................................

$ 264,000 10,000 20,000 5,000 6,000 $ 305,000 (100,000) (5,000) (6,000) $ 194,000 $ 73,720 (13,580) $ 60,140 2,173 (3,000) (19,000) (13,580) $ 26,733

$

10,476 6,693 43,902

Schedule 1: Abatement from federal tax B.C. Gross revenues...................................... % gr. revenues (1)................................. Salaries and wages................................ % S&W (2)............................................ (1) + (2) ................................................ 2

Alberta

$3,000K 30% $500K 50%

$3,000K 30% $300K 30%

Total Cdn. $6,000K 60% $800K 80%

40%

30%

70%

U.S.

Total

$4,000K 40% $200K 20%

$10,000K 100% $1,000K 100%

30%

100%

Abatement: 10% of 70% of $194,000 = $13,580 Allocation of income to: B.C. 40% × $194,000 = $77,600 Alberta 30% × $194,000 = $58,200 Schedule 2: Non-business foreign tax credit (U.K. income) Lesser of: (i) tax paid

$ 3,000

income from U.K. tax otherwise payable after (ii) income less dividends and × abatement plus surtax minus net capital loss carryover general tax reduction $20,000 $305,000 − $5,000 − $6,000

× ($60,140 + $2,173 – $13,580)

$20,000 $294,000

× $48,733 =.....................................................................

Lesser amount is $3,000.

$ 3,315

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Schedule 3: Business foreign tax credit (U.S. income) Least of: (i) tax paid ($16,000 + $3,000).............................................................................................. tax otherwise payable income from U.S. (ii) income less dividends and × plus surtax minus general tax reduction net capital loss carryover

$ 19,000

$100,000 $305,000 − $5,000 − $6,000

× ($73,720 + $2,173 – $13,580)

$100,000 $294,000

× $62,313 =.....................................................................

$ 21,195

(iii) tax otherwise payable before any reduction or credits plus surtax less non-business tax credit ($73,720 + $2,173 – $13,580 – $3,000).................................................................. Lesser amount is $19,000.

$ 59,313

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255

Problem 9 [ITA: 12(1)(t); 37; 127(5)–(11); ITR:2900] Infotech is a public company in its first year of business in the information technology industry. It operates out of a plant in Ottawa, Ontario. In 2005, it incurred $2,200,000 of scientific research and experimental development expenditures (SR&ED) which qualify for deduction under subsection 37(1) of the Act. The breakdown of these expenses is as follows: Current SR&ED expenditures [par. 37(1)(a)]............................... Capital SR&ED expenditures [spar. 37(1)(b)(i)] • new equipment.............................................. $ 300,000 200,000 • used equipment.............................................

$ 1,700,000

Total SR&ED expenditures...........................................................

$ 2,200,000

500,000

Infotech’s federal income tax rate after abatement is 22.12%. Its taxable income before deducting the $2,200,000 claim under section 37 is $3,200,000. — REQUIRED (A) Compute the maximum investment tax credit available to Infotech in 2005. (B) Compute the company’s net federal Part I tax payable after the investment tax credit, assuming a maximum section 37 deduction is claimed. (C) What is the amount, if any, of the investment tax credit carryover? (D) Compute the company’s deduction or income inclusion in the following year if no further SR&ED expenditures are made.

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256 Solution 9

(A) The maximum investment tax credit is 20% × [$1,700,000 + $300,000] = $400,000 Note that the used equipment is not a qualified expenditure for the purposes of sec. 127(9) because it is not new property [Reg. 2902(2)(iii)]. (B) Taxable income before sec. 37 deduction................................................................. $ 3,200,000 Sec. 37 deduction...................................................................................................... (2,200,000) Taxable income......................................................................................................... $ 1,000,000 Net tax 22.12%.......................................................................................................... $ 221,200 Investment tax credit................................................................................................. (221,200) Net federal tax payable under Part I.......................................................................... Nil (C) The remaining investment tax credit of $178,800 (ie., $400,000 – $221,200) may be carried back three and forward ten years. (D) Sec. 37 SR&ED expenditures in first year................................................................ $ 2,200,000 Sec. 37 deduction in first year................................................................................... (2,200,000) Balance at the beginning of the second year............................................................. Nil Less: ITC claim for first year.................................................................................... (221,200) Recapture in second year [sec. 12(1)(t)].................................................................... 221,200 Balance after recapture.............................................................................................. Nil If no further SR&ED expenditures are made in the following year, the income inclusion would be $221,200 [sec. 12(1)(t)].

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Problem 10 [ITA: 123; 124; 125.1; 126; 127(5)] Up, Up and Away Limited is a public corporation that manufactures hot air balloons in the province of New Brunswick. For the year ended September 30, 2005, its accounting income statement was as follows: Sales...................................................................................... Cost of sales and other expenses including C.C.A................ Operating profit..................................................................... Other net income................................................................... Net income before taxes........................................................ Provision for taxes................................................................ Net income............................................................................

$ 1,225,000 (725,000) $ 500,000 198,500 $ 698,500 (200,725) $ 497,775

Selected Additional Information (1) Other income includes: Dividends from taxable Canadian corporation.................... $ 85,000 Canadian interest income..................................................... 52,500 Foreign interest income, net of withholding taxes of 61,000 $10,000................................................................................ (2) Up, Up and Away Limited has a non-capital loss carryforward of $255,545. (3) Up, Up and Away Limited purchased qualified equipment costing $250,000 which is eligible for the investment tax credit. (4) The M&P profits calculation under Regulation 5200 yielded $435,000. (5) Donations to registered charities were $9,755 (deducted from accounting income). — REQUIRED Calculate the total taxes payable for 2005 using a 13% provincial rate of tax. (For the calculation of the foreign tax credit, assume that there is no general tax reduction. Then, calculate the general tax reduction to show that this assumption is accurate.)

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258 Solution 10

Income under Division B: Operating profits.......................................................................................................................... Dividends from taxable Canadian corporations........................................................................... Canadian investment income (i.e., interest income).................................................................... Foreign investment income ($61,000 + $10,000)........................................................................ Add: donations.......................................................................................................................... Division B income....................................................................................................................... Less: Division C deductions: Taxable dividends deductible under sec. 112.......................................................... $ 85,000 Donations (max. 75% of $718,255 = $538,691)..................................................... 9,755 Non-capital losses................................................................................................... 255,545 Taxable income................................................................................................................................... Federal tax (38% of $367,955)............................................................................................................ Federal abatement (10% of $367,955)................................................................................................ Federal tax after abatement................................................................................................................. Add: surtax (4% of $103,027).............................................................................................................

$ 500,000 85,000 52,500 71,000 $ 708,500 9,755 $ 718,255

$ $ $ $

Less: M & P profits deduction(1)................................................................................... $ 25,757 Foreign non-business tax credit(2)........................................................................ 10,000 Tax rate reduction(3)............................................................................................. Nil Federal tax before investment tax credit.............................................................................................. Investment tax credit (10% of $250,000)............................................................................................ Part I federal tax payable..................................................................................................................... New Brunswick tax @ 13% of $367,955............................................................................................ Total tax liability................................................................................................................................. — NOTES TO SOLUTION (1) Manufacturing and processing profits deduction Lesser of: (i) M. & P. profits....................................................................................................... (ii) Taxable income..................................................................................................... 7% of $367,955 =.................................................................................................. (2) Foreign non-business tax credit Lesser of: (i) Amount paid.......................................................................................................... (ii)

$71,000 × $107,148 ........................................................................... $718,255 − $85,000

(3) Tax reduction Taxable income.................................................................................................................. Less: 100/7 M&P profits deduction (100/7 × $25,757)..................................................... Net......................................................................................................................................

350,300 367,955 139,823 (36,796) 103,027 4,121 107,148

35,757 $ 71,391 (25,000) $ 46,391 47,834 $ 94,225

$ 435,000 $ 367,955 $ 25,757

$

10,000

$

12,013

$ 367,955 367,955 Nil

Therefore, there is no tax rate reduction, since all taxable income is eligible for the M&P profits deduction.

Solutions to Chapter 11 Assignment Problems

259

Problem 11 [ITA: 123; 124; 125.1; 126; 127(5)] Tecniquip Limited is a public corporation whose head office is located in Toronto, Ontario. The activities of the corporation are carried on through permanent establishments in the provinces of Ontario and Alberta, and in the United States. The following is an allocation of selected items for the fiscal year ended December 31, 2005. Ontario Alberta U.S. Total ($ 000) ($ 000) ($ 000) ($ 000) Sales............................................. $ 6,000 $ 400 $ 4,600 $ 11,000 Salaries: Production employees............. $ 900 $ 300 $ 1,000 $ 2,200 Payroll benefits for production employees......... 10 0 0 10 Office employees.................... 320 170 410 900 Purchasing agents................... 120 90 180 390 Raw material receiving & storing employees... 200 220 280 700 Finished goods warehouse employees........................... 500 0 0 500 Plant maintenance staff........... 80 20 60 160 Finished product inspectors.... 110 60 130 300 Sales staff............................... 300 100 300 700 $ 2,540 $ 960 $ 2,360 $ 5,860 Assets owned (capital cost): Office buildings...................... $ 300 $ 0 $ 250 $ 550 Office equipment.................... 90 0 70 160 Equipment used in SR&ED.... 250 0 0 250 Manufacturing plants.............. 1,750 40 900 2,690 Warehouses for finished goods................................... 800 40 1,220 2,060 Land........................................ 1,000 10 600 1,610 $ 4,190 $ 90 $ 3,040 $ 7,320 Assets leased (annual rental cost): Production machinery............. $ 540 $ 10 $ 80 $ 630 Automobiles for sales staff..... 2 0 2 4 $ 542 $ 10 $ 82 $ 634 For the year ended December 31, 2005, Tecniquip Limited obtained the following results: Income from manufacturing operations in Ontario..................... Income from manufacturing operations in Alberta..................... Income from manufacturing operations in the United States (before $200,000 Cdn. of US taxes paid)................................ Canadian-source interest income (investment)........................... Foreign-source investment income (before $3,000 in foreign tax withheld)............................................................................ Taxable capital gain.................................................................... Taxable dividends from taxable Canadian corporations............. Net income under Division B......................................................

$ 1,000,000 240,000 800,000 $ 2,040,000 12,000 20,000 10,000 15,000 $ 2,097,000

260

Introduction to Federal Income Taxation in Canada

In computing income from manufacturing, the corporation claimed a deduction of $150,000 under subsection 37(1) of the Act for scientific research and experimental development (SR&ED). $100,000 of the deduction related to expenditures of a current nature and $50,000 was the cost of equipment purchased during the year for use by it in scientific research and experimental development carried on in Canada. During the year, the corporation made charitable donations totalling $50,000 and claimed non-capital losses of $60,000 and the net capital losses carried forward from 1999 of $9,000. — REQUIRED Compute the federal Part I tax payable and provincial tax at 12% for Ontario and 11.5% for Alberta, assuming that taxable income allocated to those provinces is the appropriate provincial tax base. Show all calculations, whether or not necessary to your final answer. (For the calculation of the manufacturing and processing profits deduction, assume that the foreign tax credit is equal to the foreign tax paid. However, show the full calculation of the foreign tax credits, including the effect of the general tax reduction.)

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261

Solution 11 Net income under Division B.................................................................................................... Division C deductions: Dividends from taxable Canadian corporations.................................. Charitable donations (max. 75% × $2,097,000)................................ Net capital losses ($9,000 × 1/2 / 3/4)................................................... Non-capital losses............................................................................... Taxable income......................................................................................................................... Tax @ 38%................................................................................................................................ Federal abatement1..................................................................................................................... Surtax2....................................................................................................................................... Non-business foreign tax deductions3........................................................................................ Business foreign tax deductions4............................................................................................... Manufacturing and processing profits deduction5...................................................................... Tax reduction6............................................................................................................................ Federal tax before investment tax credit.................................................................................... Investment tax credit7................................................................................................................ Federal Part I tax payable.......................................................................................................... Provincial tax payable: Ontario @ 12% × $963,340............................................................... Alberta @ 11.5% × $196,600............................................................

$ 2,097,000 (15,000) (50,000) (6,000) (60,000) $ 1,966,000 $ 747,080 (115,994) $ 631,086 22,019 $ 653,105 (3,000) (200,000) (67,529) (70,091) $ 312,485 (30,000) $ 282,485 $ 115,601 22,609 $

138,210

— NOTES TO SOLUTION (1) Federal abatement:

Ontario........... Alberta........... U.S................. Total...............

Gross revenue Amount % $ 6,000,000 54.6% 400,000 3.6 $ 6,400,000 58.2 4,600,000 41.8 $ 11,000,000 100.0%

Salaries & wages Amount % $ 2,540,000 43.3% 960,000 16.4 $ 3,500,000 59.7 2,360,000 40.3 $ 5,860,000 100.0%

Allocation of taxable income to each province: Ontario................................................................................. Alberta.................................................................................

Average percentage /2 (54.6% + 43.3%) = 49.0% 1 /2 (3.6% + 16.4%) = 10.0% 1 /2 (58.2% + 59.7%) = 59.0% 1

49% × $1,966,000 = 10% × $1,966,000 =

Taxable income earned in a province or territory................

$

963,340 196,600

$ 1,159,940

Abatement is 10% × $1,159,940 = $115,994. (2) Surtax: (28% × $1,966,000) × 4% = $22,019 (3) Non-business foreign tax deduction: lesser of: (a) tax paid foreign non - business income (b) Div. B income - par.111(1)(b) - sec.112

$

3,000

$

5,617

tax otherwise payable × (basic – abatement + surtax – general reduction)

$20,000 × ($653,105 − $70,091) .............................................. $2,097,000 − $6,000 − $15,000

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262

(4) Business foreign tax deduction: least of: (a) tax paid........................................................................................................................ tax otherwise payable foreign non - business income (b) × (basic + surtax Div. B income - par.111(1)(b) - sec.112 – general reduction) $800,000 × ($747,080 + $22,019 − $70,091) .................................... $2,097,000 − $6,000 − $15,000

$

200,000

$

269,367

(c) tax otherwise payable minus non-business foreign tax deduction ($747,080 + $22,019 – $70,091 – $3,000)......................................................................................

$

696,008

(5) Manufacturing and processing profits deduction: 7% of the lesser of: (i) Canadian manufacturing and processing profits..........................................

$

964,697

(ii) Taxable income – (3 × ssec. 126(2)) ($1,966,000 – (3 × $200,000)).....................................................................

$ 1,366,000

7% × $964,697 = $67,529 MP = =

MC + ML × ADJUBI C+L $879,000 + $2,520,000 × $1,240,000 $879,000 + $3,490,000

= $964,697 Adjusted business income (ADJUBI): Income from an active business carried on in Canada ($1,000,000 + $240,000) = $1,240,000 Cost of capital (C): 10% × capital cost of depreciable property owned that is used to earn business income in Canada: Ontario — ($4,190,000 – $1,000,000)................................................................. Alberta — ($90,000 – $10,000)...........................................................................

$ 3,190,000 80,000 $ 3,270,000 × 10% $ 327,000

plus the rental cost for the year of such assets that are leased instead of purchased: ($542,000 + $10,000) $ Cost of manufacturing and processing capital (MC): Portion of cost of capital used in qualified M&P activities: Cost of manufacturing plants in Ontario and Alberta ($1,750,000 + $40,000)........... Cost of equipment used in SR&ED.............................................................................

Plus the rental cost of the production machinery ($540,000 + $10,000)..................... /85 × $754,000 = $887,059 Cannot exceed the cost of capital, $879,000. 100

552,000 879,000

$ 1,790,000 250,000 $ 2,040,000 × 10% $ 204,000 550,000 $ 754,000

Solutions to Chapter 11 Assignment Problems Cost of Labour (L): Salaries and wages related to carrying on business in Canada: Ontario salaries, net of payroll benefits...................................................................... Alberta salaries, net of payroll benefits....................................................................... Cost of manufacturing and processing labour (ML): Portion of cost of labour used in qualified M&P activities: Production employees ($900,000 + $300,000).................................................... Raw material receiving & storing ($200,000 + $220,000).................................. Plant maintenance staff ($80,000 + $20,000)...................................................... Finished product inspectors ($110,000 + $60,000).............................................

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$ 2,530,000 960,000 $ 3,490,000

$ 1,200,000 420,000 100,000 170,000 $ 1,890,000

/75 × $1,890,000 = $2,520,000 Cannot exceed the cost of labour, $3,490,000. 100

(6) Tax reduction Taxable income Less: 100/7 M&P profits deduction (100/7 × $67,529)..................................................... Net...................................................................................................................................... 7% of $1,001,300...............................................................................................................

$ 1,966,000 964,700 $ 1,001,300 $ 70,091

(7) Investment tax credit: 20% × $150,000 = $30,000 Since all $150,000 of the expenditure was deducted in 2005, all $30,000 of the ITC claimed in 2005 will be included in income in 2006 [par. 12(1)(t)].