Owner-Managers of businesses operating in Canada have some unique options available to them that may not be available to the average taxpayer who doesn’t have a Canadian company. This allows the business owner to structure their financial affairs using tools available through the business – but the availability is determined by the business structure itself.
Canadian Business Owners are well suited to the four elements of Real Wealth Management - Accumulation, Growth, Preservation and Transition of wealth; after costs, inflation and income taxes.
This article will provide you with an understanding of the four elements and how they can be maximized for the Owner-Manager of a business registered in Canada.
Accumulation – The business creates profits and therefore drives the accumulation of wealth for the business owner. The business structure is a key aspect in determining the ability of the individual to retain the wealth generated.
Growth – As profits accumulate, the business owner has a number of options available to accumulate and grow the wealth. This includes utilizing an RRSP, an IPP or retaining the cash corporately.
Preservation – The ability to income split and pay dividends to other family members (as shareholders) allows the owner-manager to preserve wealth. Utilizing tax preferred methods of distributing income in conjunction with the individual tax preferences available to family members can substantially reduce taxes.
Transition – Proper structuring allows for the eventual transition of the business to a family member or other third-party. There is also the potential to use the Capital Gains Exemption.
There are many different ways in which a business can be organized. Consider the following:
We will review the implications of using these various business structures, paying particular attention to the way in which the business income is taxed, both as it is earned and as the individual owner of the business is compensated.
It is estimated that there are close to three million small businesses in Canada. Small business owners operate enterprises of every type: professionals, commission salespersons, farmers, fishermen and revenue property owners. These business owners invest their time and money up front to reap the rewards of profit and equity in their enterprises later.
Small business ownership has its tax advantages and provides the potential to increase the return on personal time and effort over the long term. That’s because small business owners have numerous opportunities to do the following:
In order to enjoy the benefits of these opportunities, the small business owner must understand the Canadian tax rules relating to their particular structure. That includes an understanding of how business income is taxed in Canada, as well as the relationship between their business income and the amounts the business owner withdraws for personal expenditures.
Definition of Business Income
The Income Tax Act gives the word “business” the following definition: a “profession, calling, trade, manufacture or undertaking of any kind whatever, and except for the purposes of S. 18(2)(c) (limit on certain interest and property taxes) S. 54.2 (certain shares deemed to be capital property), S. 95(1) (definitions relating to foreign affiliates) and S. 110.6(14)(f), (certain shares issued after June 18, 1988), an adventure or concern in the nature of trade, but it does not include an office or employment.”
This definition is of only limited use in assessing whether or not a business is being carried on. The key issues that need to be addressed are:
o the time and capital devoted to the activity or undertaking;
o the intentions of the owner;
o the owner’s experience and ability with respect to the activity or undertaking pursued; and
o a written business plan with income projections and cash flows.
Reasonable Expectation of Profit
In Canada Revenue Agency Policy Statement P-176R, the CRA outlines its policy with respect to the concept of a reasonable expectation of profit: “Whether or not a taxpayer has a reasonable expectation of profit is an objective determination to be made from all the facts. The relevant factors to be considered in making such a determination will differ with the nature and extent of the activity or undertaking.”
The CRA’s approach is that where the revenue from an activity exceeds the expenses involved in generating that revenue, a profit results and the activity is deemed to have a reasonable expectation of profit. When the expenses exceed the revenue, the nature of the activity and the taxpayer’s approach to the activities (whether they are carried on as a business or as a hobby) does create a question whether the taxpayer’s intent is to earn “income” from business or property.
CRA’s view as to a “reasonable expectation of profit” (REOP) is not legislatively supported within the Income Tax Act. There is no requirement for a taxpayer to meet a REOP test to prove that the undertaking or activity qualifies as a business activity. However, on the practical side of this issue, if there is no profit, it becomes a question of fact whether a business exists and, hence, whether the loss is deductible.
The best method of ensuring that deductions and business losses are allowed by CRA is to keep meticulous records of business activities to show that each expense was reasonable and that each was incurred to earn business income.
As it is common for a start-up business to have more expenses than revenue, it is doubly important that the taxpayer keep good records for a start-up business. The question of whether the activity can be considered a “commercial activity” cannot be decided in the taxpayer’s favour unless records exist to show that the taxpayer was indeed involved in a business and not a hobby.
Just when does a passion or a hobby become a viable business with a view to the taxpayer carrying on the undertaking to earn income?
The nature of business start-ups is usually that the prospective entrepreneur must spend both time and money before reaping the rewards. The risk hopefully will justify the rewards, which often are several years away.
What counts is that it can be proved to a tax auditor that, especially in the lean start-up years, the start-up expenses claimed are incurred in a commercial enterprise, with the potential for viable sources of revenues, not a hobby pursued for personal pleasure.
The Income Tax Act recognizes five sources of income subject to tax: employment income, income from property, business income, capital gains and ‘other’ sources of income, which are specified in detail in the Act.
Unlike employment income, capital gains and other sources of income, business income and income from property start with the concept of profit, which is itself not defined. Thus, the determination of business income starts with the measurement of an economic concept – the profit the business has produced. There are, however, a great many specific rules that can modify the measure of economic income that the business starts with.
Businesses are required to account for revenue using a modified form of accrual accounting. Specifically, in determining business income a taxpayer must include in income both amounts receivable (earned but not received) and amounts received but not earned.
Where an amount received but not earned is included in business income, a reserve may be available to offset the inclusion.
An exception is granted to farmers and fishers, who may elect to account for revenue using the cash method.
A business may manufacture or purchase items in one year that are not sold until a subsequent year. If the business were to include in income all sales made in the year and deduct all purchases or manufacturing costs in that year, the net income from operations would not properly reflect the actual income from operations in the year. If more items are manufactured or purchased than sold, some of the expenditures relate to increases in inventory rather than cost of earning the reported revenue.
For this reason, businesses that have an inventory must calculate the cost of goods sold.
Unlike deductions relating to employment income, the Income Tax Act is silent on what specific deductions can be claimed in computing business income. As the starting point in computing business income is the determination of profit, reasonable expenditures are legitimate, provided that they have an income-earning purpose and are not personal in nature.
This general principle is often overridden, however, by specific limitations that apply to either categories of expenditure or expenditures of a defined nature.
In addition, there are general override rules for claiming deductions relating to a business that are covered in the Income Tax Act, as follows:
Thus, unless specifically restricted or prohibited (see below), any expense that is reasonable in the circumstances and incurred for the purpose of producing business income is deductible.
Certain expenses are specifically disallowed by the Income Tax Act in Canada.
Capital Outlays: An expenditure to acquire an asset which has an extended useful life is not deductible. Similarly, fees that relate to that acquisition (e.g. legal fees) are part of the cost of the asset and not deductible when paid.
Pre-paid Expenses: Expenditures which are for a period that is not part of the current fiscal year may not be deducted in the year paid but must be allocated to the year to which they apply. For example, property insurance premiums paid in the year are only deductible to the extent that the coverage they pay for relates to the current fiscal year.
Personal Expenses: Expenditures that are wholly for the personal use of the owner are not deductible at all. Those that have a personal-use component are restricted (see below).
Fines and Penalties: Prior to March 2004 in Canada many fines and penalties were deductible if they were incurred for the purpose of earning income for the company. After March 2004 fines and penalties imposed by law may not be deducted.
Certain expenses are deductible but the amount that can be claimed by the Canadian taxpayer is limited in one way or another. Here are some of them.
Passenger Vehicles: The capital cost allowance (CCA) deductible for the cost of certain vehicles called ‘passenger vehicles’ is limited to a maximum amount per year. Also interest paid on a loan to acquire the vehicle, the cost of leasing the vehicle, and the amount used to calculate the portion of the vehicle’s cost for CCA purposes is also restricted.
Meals and Entertainment: In almost every case involving the purchase of meals or outlays for entertainment, the amount that may be deducted (if the outlay is made in order to earn business income) is limited to 50% of the actual cost.
Convention Expenses: Self-employed taxpayers may claim the cost of attending up to two conventions per year. Any costs of meals associated with convention are limited as described above. In addition, the convention expenses are only deductible if the convention is related to the taxpayer’s business and is held in a location that may reasonably be regarded as consistent with the territorial scope of the organization.
Home Workspace Expenses: If a business operates out of the taxpayer’s home then a portion of the costs of operating the home may be deductible (see Mixed-use Expenses). However, the deduction for home workspace expenses is limited to the net business income for the year. Home workspace expenses may not be deducted to create or increase a business loss.
Expenditures that have both a business component and a personal component are referred to as mixed-use expenses. The general rule is that the expense must be allocated in a reasonable manner into a business-use component and a personal-use component.
Home Workspace Expenses: A portion of the cost of operating the taxpayer’s home may be deductible if a portion of the home is used to operate a business. The expenses are generally prorated according to the square footage of the home that is used for business purposes. In some cases a pro-ration based on time used may be more appropriate.
Owner-operated Vehicles: When a taxpayer uses his or her own vehicle for both business and personally, the cost of operating the vehicle must be allocated to each use, generally using the number of kilometers driven for each purpose.
When an expenditure results in the acquisition of an asset that has an extended useful life, the full amount of the expenditure must be amortized over a period of time rather than deducted in the year that the expenditure is made.
Tangible assets which have a fixed life and depreciate in value over that life are called ‘depreciable assets’. Each year the taxpayer may take a deduction under the capital cost allowance system to account for the decrease in value of the asset over the fiscal year.
Outlays to acquire most intangible assets which have an extended useful life are called eligible capital expenditures. Like depreciable assets, the taxpayer may take a deduction each year for a portion of the capital cost of the asset.
Some tangible capital assets, such as land, livestock or other living things, are not depreciable assets and there is no deduction allowed for the cost of acquiring the asset either at the time of acquisition or in subsequent years.
In Canada, only individuals, corporations and trusts are subject to tax. No other entity is taxable. Coupling this with the various ways in which a business enterprise can be organized (as discussed in the introduction), we have the following matrix.
A corporation is a separate entity both at law and for income tax purposes. Income from a business carried by a corporation is computed at the corporate level and is taxed at that level – the corporation itself pays tax. A corporation affords its shareholders (owners) the protection of limited liability. Furthermore, a corporation may pay tax at a lower rate than the shareholders would have had they earned the income directly.
Income that flows through a corporation is ultimately subject to tax twice – when it is initially earned by the corporation and again when the after-tax income is distributed to the shareholders as a dividend.
A corporation can reduce its income subject to tax by paying a tax deductible salary/bonus to an employee/shareholder thereby reducing its income subject to tax and increasing the employment income of the recipient. In certain circumstances, however, technical rules and administrative policies may affect the corporation’s ability to deduct such payments.
The taxation of income within a corporation and the subsequent distribution of its tax paid retained earnings to shareholders, as compared to earning such income personally, is called “corporate integration”.
A proprietor is an individual who carries on unincorporated business. The proprietor computes his or her business income using the normal rules and adds that amount to his or her income from other sources. Business income is therefore included in both the net and taxable income of the proprietor and it is the proprietor’s taxable income which is subject to tax.
A proprietor can split income with a family member by paying that family member a salary from the proprietorship. The salary must be reasonable in light of the services provided, in order to meet the general limitation that denies a deduction if an outlay is not reasonable in the circumstances.
A partnership is not a separate entity at law but a commercial relationship between the partners.
For income tax purposes, a partnership is treated as though it were a person but only for the purposes of computing net income. That net income is allocated for income tax purposes to the partners, added to their incomes from other sources and taxed in the normal manner.
A partnership cannot pay a salary to a partner. It can, however, pay and deduct a reasonable salary to a family member of a partner.
A joint venture is neither a person at law or for income tax purposes. Each joint venturer calculates its share of joint venture income independently.
A trust is not a separate entity at law but a relationship between the settlor of the trust, the trustees and the beneficiaries.
For income tax purposes, a trust is a taxpayer and is generally taxed at graduated rates as though it were an individual, except that a trust cannot claim personal credits. Effective January 1, 2016 new tax rules will apply to testamentary trusts.
A trust is allowed a deduction for income paid or payable to its beneficiaries, so that the trustees can generally choose whether tax is to be imposed at the trust level or if the income is to be reported by and taxed in the hands of the beneficiaries.
A major handicap is that a trust that is established during the life of the settlor does not get the benefit of graduated tax rates but pays tax at the top rate applicable to individuals.
Trusts are not generally used to carry on a business, although they can be.
Income that is earned by a corporation registered in Canada is subject to tax twice: once in the corporation, and again when it is distributed to the shareholders by way of dividends. However, our tax system provides for a dividend gross-up and tax credit mechanism with the theoretical intention of “integrating” the overall tax result to eliminate any “double tax” impact. Tax rates vary province to province and also between individual taxpayers. Hence, situations occur where there will be both “under” and “over” integration.
When a proprietor earns business income, that income is simply added to his or her income from other sources and taxed at his or her marginal rate.
A partner in a partnership that carries on a business takes into income each year his or her share of that income and pays tax on it at his or her marginal rate.
There is no scope for business income planning around compensation issues for such taxpayers. Cash flow planning is still important, as the proprietor or partner must balance his or her personal cash flow requirements with those of the business. It may also be possible to split some income with family members by paying them reasonable salaries from the proprietorship or partnership.
A shareholder in a corporation that carries on a business has substantially more alternatives and options for deferring tax and income-splitting, albeit with added complexity and tax compliance requirements. Compensation for an incorporated business owner, should consider the following:
A taxpayer’s income from business is the profit therefrom. Profit is not a defined term and starts with economic profit. There are, however, constraints imposed under the Income Tax Act in Canada on what can be deducted in computing business income for income tax purposes.
There are several ways in which a Canadian business can be carried on.
Tax planning complexity arises where the business is carried on through a Canadian corporation. This complexity arises because such income is ultimately subject to tax twice. Furthermore, the way in which the income is taxed in the corporation and the way in which the corporation can distribute the income create additional scope for planning. Canadian Corporate tax integration is the key concept to understand.
Remuneration planning in a Canadian Corporation involves a number of factors, quite different and distinct from an unincorporated business owner. It is important to understand the factors that should be considered in structuring compensation for an incorporated owner manager of a Canadian company.
We can assist you with arranging your corporate taxation and financial affairs and determining the best solutions for your Small Business in White Rock, Langley or Surrey, BC. Here at Green Quarter Consulting - Accounting and Bookkeeping Services for Small Businesses in White Rock South Surrey, Langley and Surrey BC, we navigate Small Business Owners with analyzing transactions, sources of income and your tax risks and how they relate to your business strategy.