Solution Manual for Canadian Income Taxation 25th Edition by William Buckwold, Joan Kitunen, Matthew Roman

Solution Manual for Canadian Income Taxation 25th Edition by William Buckwold, Joan Kitunen, Matthew Roman CHAPTER 1 TAXATION― ITS ROLE IN BUSINESS DECISION MAKING Review Questions 1. If income tax is imposed after profits have been determined, why is taxation relevant to business decision making? 2. Most business decisions involve the evaluation of alternative courses of action. For example, a marketing manager may be responsible for choosing a strategy for establishing sales in new geographical territories. Briefly explain how the tax factor can be an integral part of this decision. 3. What are the fundamental variables of the income tax system that decision-makers should be familiar with so that they can apply tax issues to their areas of responsibility? 4. What is an ―after-tax‖ approach to decision making? Copyright © 2022 McGraw-Hill Education Ltd. 1 Solutions to Review Questions R1-1 Once profit is determined, the Income Tax Act determines the amount of income tax that results. However, at all levels of management, alternative courses of action are evaluated. In many cases, the choice of one alternative over the other may affect both the amount and the timing of future taxes on income generated from that activity. Therefore, the person making those decisions has a direct input into future after-tax cash flow. Obviously, decisions that reduce or postpone the payment of tax affect the ultimate return on investment and, in turn, the value of the enterprise. Including the tax variable as a part of the formal decision process will ultimately lead to improved after-tax cash flow. R1-2 Expansion can be achieved in new geographic areas through direct selling, or by establishing a formal presence in the new territory with a branch office or a separate corporation. The new territories may also cross provincial or international boundaries. Provincial income tax rates vary amongst the provinces. The amount of income that is subject to tax in the new province will be different for each of the three alternatives mentioned above. For example, with direct selling, none of the income is taxed in the new province, but with a separate corporation, all of the income is taxed in the new province. Because the tax cost is different in each case, taxation is a relevant part of the decision and must be included in any cost-benefit analysis that compares the three alternatives [Reg. 400-402.1]. R1-3 A basic understanding of the following variables will significantly strengthen a decision maker's ability to apply tax issues to their area of responsibility. Types of Income - Employment, Business, Property, Capital gains Taxable Entities - Individuals, Corporations, Trusts Alternative Business - Corporation, Proprietorship, Partnership, Limited Structures partnership, Joint arrangement, Income trust Tax Jurisdictions - Federal, Provincial, Foreign R1-4 All cash flow decisions, whether related to revenues, expenses, asset acquisitions or divestitures, or debt and equity restructuring, will impact the amount and timing of the tax cost. Therefore, cash flow exists only on an after tax basis, and, the tax impacts whether or not the ultimate result of the decision is successful. An after-tax approach to decision-making requires each decision-maker to think "after-tax" for every decision at the time the decision is being made, and, to consider alternative courses of action to minimize the tax cost, in the same way that decisions are made regarding other types of costs. Failure to apply an after-tax approach at the time that decisions are made may provide inaccurate information for evaluation, and, result in a permanently inefficient tax structure. Copyright © 2022 McGraw-Hill Education Ltd. 2 CHAPTER 2 FUNDAMENTALS OF TAX PLANNING Review Questions 1. ―Tax planning and tax avoidance mean the same thing.‖ Is this statement true? Explain. 2. What distinguishes tax evasion from tax avoidance and tax planning? 3. Does Canada Revenue Agency deal with all tax avoidance activities in the same way? Explain. 4. The purpose of tax planning is to reduce or defer the tax costs associated with financial transactions. What are the general types of tax planning activities? Briefly explain how each of them may reduce or defer the tax cost. 5. ―It is always better to pay tax later rather than sooner.‖ Is this statement true? Explain. 6. When corporate tax rates are 13% and tax rates for individuals are 40%, is it always better for the individual to transfer their business to a corporation? 7. ―As long as all of the income tax rules are known, a tax plan can be developed with certainty.‖ Is this statement true? Explain. 8. What basic skills are required to develop a good tax plan? 9. An entrepreneur is developing a new business venture and is planning to raise equity capital from individual investors. Their adviser indicates that the venture could be structured as a corporation (i.e., shares are issued to the investors) or as a limited partnership (i.e., partnership units are sold). Both structures provide limited liability for the investors. Should the entrepreneur consider the tax positions of the individual investors? Explain. Without dealing with specific tax rules, what general tax factors should an investor consider before making an investment? 10. What is a tax avoidance transaction? 11. ―If a transaction (or a series of transactions) that results in a tax benefit was not undertaken primarily for bona fide business, investment, or family purposes, the general anti-avoidance rule will apply and eliminate the tax benefit.‖ Is this statement true? Explain. Solutions to Review Questions R2-1 There is a distinction between tax planning and tax avoidance. Tax planning is the process of arranging financial transactions in a manner that reduces or defers the tax cost and that arrangement is provided for in the Income Tax Act or is not specifically prohibited. In other words, the arrangement is chosen from a reasonably clear set of options within the Act. In contrast, tax avoidance involves a transaction or series of transactions, the main purpose of which is to avoid or reduce the tax otherwise payable. While each transaction in the process may be legal by itself, the series of transactions cause a result not intended by the tax system. R2-2 Both tax planning and tax avoidance activities clearly present the full facts of each transaction, allowing them to be scrutinized by CRA. In comparison, tax evasion involves knowingly excluding or altering the facts with the intention to deceive. Failing to report an amount of revenue known to exist or deducting a false expense are examples of tax evasion. R2-3 CRA does not deal with all tax avoidance transactions in the same way. In general, CRA attempts to divide tax avoidance transactions between those that are an abuse of the tax system and those that are not. When an action is abusive, CRA will attempt to deny the resulting benefits by applying one of the anti-avoidance rules in the Income Tax Act. R2-4 There are three general types of tax planning activities: • Shifting income from one time-period to another. • Transferring income to another entity. • Converting the nature of income from one type to another. Shifting income to another time-period can be a benefit if it results in a lower rate of tax applying to the income. Even if a lower rate of tax is not achieved, a benefit may be gained from delaying the payment of tax to a future time-period. Shifting income to an alternate taxpayer (for example, from an individual to a corporation) may beneficially alter the amount and timing of the tax. There are several types of income within the tax system such as employment income, business income, capital gains and so on. Each type of income is governed by a different set of rules. For some types of income, the timing, the amount of income recognized, and the effective tax rate is different from other types. By converting one type of income to another, a benefit may be gained if the timing of income recognition, the amount recognized, and/or the effective tax rate is favorable. R2-5 The statement is not true. Paying tax later may be an advantage because it delays the tax cost and frees up cash for other purposes. However, the delay may result in a higher rate of tax in the future year compared to the current year. In such circumstances, there is a trade-off between the timing of the tax and the amount of tax payable. R2-6 There is not always an advantage to transfer income to a corporation when the corporate tax rate is lower than that of the individual shareholder. While an immediate lower tax rate results, remember that the corporation may be required to distribute some or all of its after-tax income to the shareholder, which causes a second level of tax. Whether or not an advantage is achieved depends on the amount of that second level of tax and when it occurs. Other factors may also be relevant such as the tax treatment of a possible business failure or sale. R2-7 The statement is not true. Knowing the tax rules is, of course, a major element in the tax planning process, but it does not guarantee the expected outcome. Planning means that certain steps are taken now in preparation for certain activities that may occur in the future. However, those anticipated activities might not occur and the desired tax result may not be achieved. Tax planning also requires that one must anticipate and speculate on possible future scenarios and relate them to the current tax planning steps. Those scenarios are never certain. R2-8 To develop a good tax plan, one must be able to: • Understand the fundamentals of the income tax system. • Anticipate the complete cycle of transactions. • Develop optional methods of achieving the desired business result and analyze each of their tax implications. • Speculate on possible future scenarios and assess their likelihood. • Measure the time value of money. • Place the tax issue in perspective by applying common sense and sound business judgement. • Understand the tax position of other parties involved in the transaction. R2-9 Yes, the entrepreneur should consider the tax position of the potential investors. They will be taking a risk in accepting the investment. If the entrepreneur knows the tax effect on the investors, of each alternative organization structure, the entrepreneur can choose the one that provides investors the most favorable tax treatment (i.e., one that reduces their after-tax loss if the investment fails, or increases their after-tax income if it succeeds). Before making the investment, the investor should determine the tax impact on: • income earned by the venture, • income distributed to the investor, • losses incurred by the venture, • the loss of the investment if the venture fails, and • the gain on the investment when it is eventually sold. R2-10 A tax avoidance transaction is a term used within the general anti-avoidance rule (GAAR) of the Income Tax Act. An avoidance transaction is a transaction or series of transactions that results in a tax benefit and was not undertaken primarily for bona fide business, investment or family purposes [ITA 245]. R2-11 The statement is not true. In order for the tax benefit to be denied under the general anti- avoidance rule (GAAR), the transaction, in addition to not being primarily for bona fide business, investment or family purposes, must be considered to be a misuse or abuse of the income tax system as a whole. What constitutes a misuse or abuse is not always clear. However, certain avoidance transactions are permitted and others are not [ITA 245(3), IC 88-2]. Key Concept Questions QUESTION ONE The Income Tax Act contains a general anti-avoidance rule (GAAR) in section 245. Consider each of the following situations and determine whether the GAAR will likely apply. 1. Christine Jensen transferred her consulting business to a corporation primarily to obtain the benefit of the low corporate tax rate. 2. Paul Devi owns 100% of the shares of P Ltd. He provides services to P Ltd. In the current year he received no remuneration for his services because the payment of a salary to Paul would increase the amount of the loss that P Ltd. will incur in the year. 3. A Canadian-controlled private corporation pays its shareholder/manager a bonus that will reduce the corporation’s income to the amount eligible for the low tax rate. The bonus is not in excess of a reasonable amount. 4. A profitable Canadian corporation has a wholly owned Canadian subsidiary that is sustaining losses and needs additional capital to carry on its business. The subsidiary could borrow the funds from its bank but could not obtain any tax saving in the current year by deducting the interest expense due to its loss situation. Therefore, the parent corporation borrows the funds from its bank and subscribes for additional common shares of the subsidiary. The parent corporation reduces its taxable income by deducting the interest expense. The subsidiary uses the funds to earn income from its business. CPA Competency 6.1.1 GAAR. Income tax reference: ITA 245(1),(2),(3),(4); IC 88-2. QUESTION TWO John Ivanov has owned all of the shares of Corporation A and Corporation B since their inception. In the current year, John had Corporation A transfer, on a tax-deferred basis, property used in its business to Corporation B. The reason for the transfer is to enable Corporation B to apply the income earned on the transferred assets against its non-capital losses. Will the general anti-avoidance rule (GAAR) apply to disallow the tax benefit? CPA Competency 6.1.1 GAAR. Income tax reference: ITA 245(1),(2),(3),(4); IC 88-2. Solutions to Key Concept Questions KC 2-1 [ITA: 245(2) – GAAR] The GAAR provision in ITA 245(2) is to be used when specific anti-avoidance provisions do not suffice. For the GAAR to apply, the following four conditions must be met: 1) A tax benefit results from a transaction or part of a series of transactions [ITA 245(1) – ―tax benefit‖ definition], 2) The transaction is an avoidance transaction, in that, it was not undertaken primarily for bona fide purposes other than to obtain the tax benefit [ITA 245(3) – ―Avoidance transaction‖ definition], 3) No other provision of the Act stops the taxpayer from achieving the intended tax advantage, and 4) The transaction is an abusive transaction, in that, it can reasonably be concluded that the tax benefit would result in a misuse or abuse of the Act, read as a whole [ITA 245(4)]. For the transactions described in the four situations: • A tax benefit results in each case, • The transactions have been undertaken primarily to obtain a tax benefit and are, for that reason, avoidance transactions, and • The transactions are not subject to any other anti-avoidance rule in the Act. Therefore, the issue to be determined is whether the tax benefit would result in a misuse or abuse of the Act, read as a whole. Situation 1: There is nothing in the Act that prohibits Christine from incorporating her business. The incorporation is consistent with the Act read as a whole and, therefore, the GAAR would not apply. Situation 2: There is no provision in the Act requiring a salary be paid to Paul and the failure to pay a salary is, therefore, not contrary to the scheme of the Act read as a whole. The GAAR would not apply to deem a salary to be paid by P Ltd. or received by Paul. Situation 3: The Act recognizes the deductibility of reasonable business expenses, which include bonuses. The payment of the bonus is not an abusive transaction and, therefore, the GAAR should not apply to the payment. Situation 4: The borrowing by the parent corporation is for the purpose of gaining or producing income as required by paragraph 20(1)(c) of the Act. The GAAR should, therefore, not apply. In fact, CRA has indicated, in comfort letters, that where one corporation (A Ltd.) borrows from a financial institution to invest in shares of another corporation (B Ltd.) and B Ltd. re-loans the funds back to A Ltd. and charges interest at a reasonable rate, thus, shifting income from A Ltd. to B Ltd., the transactions are permissible and will not be challenged. KC 2-2 [ITA: 245(2) – GAAR] The GAAR provision in ITA 245(2) is used when specific anti-avoidance provisions do not suffice. For the GAAR to apply, the following four conditions must exist: 1) A tax benefit results from a transaction or part of a series of transactions, 2) The transaction is an avoidance transaction, in that, it was not undertaken primarily for bona fide purposes other than to obtain the tax benefit, 3) No other provision of the Act stops the taxpayer from achieving the intended tax advantage, and 4) The transaction is an abusive transaction, in that, it can reasonably be concluded that the tax benefit would result in a misuse or abuse of the Act, read as a whole. In the case of John and his two corporations: • The transaction does result in a tax benefit as using the losses will reduce tax, • It appears that the transaction was undertaken primarily for the tax benefit, and • There is no provision in the Income Tax Act prohibiting the transfer of the property on a tax-deferred basis to a related corporation nor the deduction of the losses by Corporation B, So, the question that remains is whether the transaction is an abusive transaction. Since the Act contains specific provisions permitting the transfer of losses between related corporations, the transfer in question is consistent with the scheme of the Act and, therefore, is not an abusive transaction. Thus, the GAAR should not apply. However, had the transfer of a property been undertaken to avoid a specific rule, such as a rule designed to preclude the deduction of losses after the acquisition of control of a corporation by an arm's length person, such a transfer would be a misuse of the provisions of the Act and be subject to the GAAR [IC88-2]. Where the GAAR applies, the tax benefit that results from an avoidance transaction is denied. In order to determine the amount of the tax benefit that is denied, the provision indicates that the tax consequences of the transaction to a person will be determined as is reasonable in the circumstances. CHAPTER 3 LIABILITY FOR TAX, INCOME DETERMINATION, AND ADMINISTRATION OF THE INCOME TAX SYSTEM Review Questions 1. Which of the following entities are subject to income tax? (a) proprietorship (b) individual (c) joint venture (d) trust (e) limited partnership (f) corporation (g) partnership 2. Describe how the income earned by any of the non-taxable entities listed in Question 1 is included in the Canadian tax system. 3. How and when does income earned by a corporation affect the tax position of an individual who is a shareholder? 4. In describing who is liable for tax in Canada, the Income Tax Act simply states, ―An income tax shall be paid, as required by this Act, on the taxable income for each taxation year of every person resident in Canada at any time in the year.‖ Accepting that ―person‖ includes an individual and a corporation, briefly discuss the meaning and ramifications of this statement. 5. In what circumstances are non-residents subject to Canadian income tax? 6. Can a Canadian resident be subject to tax in Canada as well as in a foreign country on the same earned income? If yes, explain how. Also, what mechanism is available to minimize double taxation? 7. Explain the difference between net income for tax purposes and taxable income for the taxable entities. 8. Explain what is meant by the statutory scheme, and describe the scheme’s relevance to the Canadian income tax system. 9. For tax purposes, would you prefer that a financial loss be a capital loss or a business loss? Explain. 10. Explain the difference between income from property and a gain on the sale of capital property. 11. You may have heard that ―corporations are entitled to more deductions for tax purposes than individuals.‖ Based on your reading of Chapter 3, is this statement true? Explain. 12. If an individual earns a living as a lawyer, what possible categories of income, for tax purposes, may the person generate? Describe the circumstances for each possible classification. 13. What types of income for tax purposes may result when a profit is achieved on the sale of property (e.g., land)? 14. Individual A, a Canadian resident, owns and operates a profitable small farm in North Dakota, U.S. They also have a large amount of money earning interest in an American bank. Individual B, also a Canadian resident, owns 100% of the shares of an American corporation that operates a profitable small farm in North Dakota. The corporation also has a large amount of money earning interest in an American bank. Describe and compare the tax positions of these two individuals who conduct the same activities but use different organizational structures. 15. Jane Quinn owned an apple orchard for 20 years. During that time, she had cultivated a unique brand of apple that was popular with health food fans. Toward the end of the 2022 growing season, Jane became seriously ill and put the orchard up for sale. Jane’s neighbour agreed to purchase the entire orchard for $250,000. It upset Jane to have to sell at that time of year because the year’s crop was of high quality and in three weeks would have been ripe for picking. What types of property might have been included in the total purchase price of $250,000? For tax purposes, what types of income might have been generated from the sale of the orchard? Explain your answer.