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CHAPTER 2:
Fundamentals of Tax Planning
Copyright 2016 McGraw-Hill Ryerson, Limited. All rights reserved.
1 CHAPTER TWO Fundamentals of Tax Planning I. What Is Tax Planning? II. Types of Tax Planning. III. Skills Required for Tax Planning. IV. Restrictions to Tax Planning.
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I. What is Tax Planning?
Tax Planning: legitimate arranging of financial activities that reduces or defers tax costs. within the object and spirit of the law. Tax Evasion: Very clear - an act with the intent to deceive. includes knowingly failing to report revenue, or claiming the deduction of a false expense, or both.
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I. What is Tax Planning?
Tax avoidance: Circumvents the law to avoid tax, Transactions that do not reflect the real facts, May be regarded as abuse.
Often, difficult to distinguish between legitimate tax planning and
abusive tax avoidance.
When CRA perceives tax avoidance transactions to be abusive, it
will attempt to deny the resulting benefits.
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II. Types of Tax Planning
The objective of tax planning is to reduce or defer the
tax cost. All tax planning opportunities into one of three categories: 1. Shifting income from one time period to another. 2. Transferring income to another entity or alternative taxpayer. 3. Converting the nature of income from one type to another.
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A. Shifting income from one time period to another (continued) Future tax rates may be greater than, less than, or the same as current tax rates.
Current tax rate Current tax rate
Lower than higher than Future tax rate Future tax rate
Tax savings to recognize Tax cost to recognize
Income now vs. later Income now vs. later
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Shifting Income Example
The following is tax information for ABC corp.
Tax rate on Income < $500,000 15%
Tax rate on Income > $500,000 25% 20X1 income after reserve = $150,000 $20,000 Reserve can be delayed to 20X2 20X2 income is estimated to be $550,000
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Shifting Income Solution
Increase in tax in 20X1
if no reserve is taken ($20,000 x 15%) $ 3,000
Decrease in tax in 20X2
if reserve is taken in 20X2 ($20,000 x 25%) $ 5,000
Ultimate tax savings $2,000!
No consideration given to the reduced cash flows relating to the prepayment of tax.
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A. Shifting income from one time period to another (continued) In making a decision to shift income, must determine: Future tax rates. Future income levels. Discretionary opportunities within the tax act (i.e. reserves). Time value of money.
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B. Transferring Income to Another Entity
Individuals can accumulate wealth by using different
entities: Corporations, proprietorship, partnerships etc.
The tax treatment varies with the entity chosen.
Ultimately, the wealth leads back to the individual or
family members.
Shifting income to a different structure
may reduce or delay tax payable.
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B. Transferring Income to Another Entity (continued) For example: An individual may run a business through a corporation or as a sole-proprietor. Individual needs $39,000 after-tax Corporate tax rates 15% on first $500,000 25% on excess Personal tax rates: First $45,000 24% Next $45,000 32% Next $49,000 40% Income over $139,000 45%
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B. Transferring Income to Another Entity (continued) Unincorporated Incorporated
Business $100,000 Bus. Profits $100,000
Profits Less Salary ($52,100)
Taxes ($29,200) Corporate ( $7,200)
Taxes Personal ($39,000) Expenses
After-tax $31,800 $ 40,700
Cash Flows
Incorporation provides an extra $8,900 available for expansion
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B. Transferring Income to Another Entity (continued) Other factors to consider: Requirement for cash distributions from corporation. Corporate Income earned greater than $500,000. Business Losses incurred in corporation. Business failure, Sale of business, etc. Shareholder dies or leaves the country
Must anticipate Possible Future Events.
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C. Converting Income from One Type to Another Four basic types of income:
1. Employment (Chapter 4) 2. Business (Chapter 5) 3. Property (Chapter 7) 4. Capital gains (Chapter 8)
Amount of taxable income & the timing depends greatly on the type of income.
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C. Converting Income from One Type to Another Can alter the amount of tax and its timing by adjusting a financial transaction to generate a different type of income. It is not always simple to convert one type of income to another. converting income may also involve shifting that income from one entity to another.
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III. Skills Required for Tax Planning
Anticipation envision the complete cycle.
Flexibility seek out alternative methods. Speculation anticipate tax effects. Application of compound interest. Perspective common sense must prevail. Global approach consider all sides.
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IV. Restrictions to Tax Planning
Tax planning is divided between acceptable and
unacceptable activities.
The Act specifically prohibits a number of activities.
anti-avoidance rules
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IV. Restrictions to Tax Planning
Specific Rules: Transaction between related taxpayers are subject to specific anti-avoidance rules non-arms length rules (ITA 69) prohibited to direct payment to related parties. Etc. General Rules: General anti-avoidance rule (GAAR) supplement the more specific rules.
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IV. Restrictions to Tax Planning
GAAR stipulates: When a person is involved in an avoidance transaction, the tax will be adjusted to deny the benefit.
Not an avoidance transaction if,
Its primary objective is other than to obtain a tax benefit. Undertaken primarily for bona fide business, investment or family purposes.
Establishes a business purpose or economic reality
test Helps distinguish between unacceptable and acceptable planning activities.
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IV. Restrictions to Tax Planning
For a tax plan to be rejected it must:
Fail the business purpose test and,
Must be extreme - that it is not within the spirit of the tax system.
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