The Canadian Rational Investor
Brian Beamish FMA, FCSI
Canadian Tax Strategies
Evasion is illegal, avoidance is not.


Introduction


This is an introductory seminar on tax minimization strategies for Canadian workers and investors. This information is meant for basic understanding of the general concepts behind government encouraged tax shelters and by no means represents a thorough examination. My goal is to try and convey a few of the pieces of market wisdom, with regard to tax strategies, I have picked up over the past fifteen years. I strongly encourage feedback and hope to hear your questions, as all of these seminars are an ongoing work in progress.

What is a tax shelter
RRSP's
RRIF's
RESP's
Other Tax Shelters
One Example
The first part of the seminar is focused on defining three very popular government endorsed savings vehicles: RRSP, RRIF and RESP. The second section refers to other basic tax shelters including Working Opportunity Fund, flow-through shares and the Cdn. dividend tax credit. Lastly, we look at a typical Canadian taxpayer, his basic tax bill and his various options available to him to potentially reduce the bill by as much as 50 percent.

What is a tax shelter

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A tax shelter is defined in the Income Tax Act to be "any property for which a promoter represents that an investor may claim deductions or receive benefits which equal or exceed the amount invested within four years of its purchase" (Revenue Canada Web site). Revenue Canada is very particular when it comes to avoidance vs. evasion issues and tax shelters. Shelter's carry the most scrutiny and are constantly under review. Because we pay such high taxes in Canada, tax shelters have become a very big business. In fact, whole industries have grown to help Canadian taxpayers reduce their assessments. Shelters range anywhere from investments in the film and movie industry to prescription drugs for orphans in the Middle East. Since there are so many, one could not possibly give the industry full justice here. Needless to say, one should tread very lightly since the industry can be unregulated. Having said that, there are still many ways one can take advantage of programs the federal government endorses which can greatly reduce your tax burden. These include: registered retirement plans, registered educational plans, labour sponsored venture capital pools, flow-thru shares, dividend and mining/exploration tax credits.

People believe the greatest selling point about sheltered contributions is the tax break one realizes in the year of the contribution. In reality, it's the tax-free compounding that assets enjoy inside a sheltered plan that is the real value. Below is a comparison of a taxed portfolio (at top rate) and a sheltered portfolio over a five year period and assuming a 10% annual return.

Product
Sheltered
Non-Sheltered
After 1 year
1.10
1.05
After 2 years
1.21
1.1025
After 3 years
1.331
1.1576
After 4 years
1.4641
1.2155
After 5 years
1.61
1.2763
Totals
61%
27.63%



Registered Retirement Savings Plan (RRSP)

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Faced with staggering government outlays and under-funded defined benefit plans, the Canadian government now encourages citizens to actively save for their retirement. A registered retirement savings plan (RRSP) is a retirement plan that is registered with the Federal Government and that you or your spouse or common-law partner contributes to. Any income you earn in the RRSP is usually exempt from tax for the time the funds remain in the plan. However, you generally have to pay tax when you cash in or receive payments from the plan. You can withdraw from RRSPs to buy or build a home for yourself or for someone who is related to you and is disabled. See Home Buyers' Plan for details. You can withdraw from RRSPs to finance training or education for you or your spouse or common-law partner through the Lifelong Learning Plan too.


Your RRSP deduction limit is shown on your Notice of Assessment or Notice of Reassessment for the previous tax year. You can also see it online (Revenue Canada), you can call the automated Tax Information Phone Service (T.I.P.S.) at 1-800-267-6999, or you can call the individual income tax inquiries line at 1-800-959-8281.

If you are unable to use any part of the RRSP deduction limit, the amount is carried forward to the next year and added to the deduction limit for that year. Any part of your RRSP deduction limit that you do not use can be carried forward indefinitely. For those facing a large income tax assessment (and have not contributed in some years) maximizing your RRSP contribution can often offset those taxes owed.

You may want to set up a spousal or common-law partner RRSP. This type of plan can help ensure that retirement income is more evenly split between both of you. The benefit is greatest when a higher-income spouse or common-law partner contributes to an RRSP for a lower-income spouse or common-law partner. The contributor receives the short-term benefit of the tax deduction for the contributions, while the annuitant, who is likely to be in a lower tax bracket during retirement, receives the income and reports it on his or her tax return.

One can hold various types of assets within an RRSP. These include; common stock, bonds, mutual funds, call options, private placements and even home mortgages. For a complete list of eligible investments, visit Eligible RRSP Content.

The year you turn 69 is the last year that you can contribute to RRSPs (you can contribute to a spousal or common-law partner RRSP if your spouse or common-law partner is 69 or younger on December 31 of the year you make the contribution). What can you do with your RRSPs? By the end of the year you turn 69, you have to choose one of the following options for your RRSPs: withdraw them; transfer them to a RRIF; use them to purchase an annuity for life; or use them to purchase an annuity spread over a number of years. When you withdraw funds from your RRSPs, your RRSP issuer will withhold some tax. Your RRSP issuer will not withhold tax on amounts that are transferred directly to a RRIF or that are used to purchase an annuity.


Registered Retirement Income Fund (RRIF)

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Once an investor reaches retirement age assets held within an RRSP must be transferred out. This can lead to a large tax bill if taken out all at once. To limit the tax implication the federal government created a registered product to take the place of the RRSP in retirement. The Registered Retirement Income Fund (RRIF) is meant to allow investors to continue to grow their savings tax free while ensuring a timely disposition of those assets. You have to be paid a minimum amount from your RRIF each year after the year you set it up. You will receive a T4RIF slip showing the amount of RRIF payments you received. You have to include payments you receive from a RRIF on your return, even though the minimum amount you get each year does not need to have income tax withheld from it.

Like the RRSP, many different types of assets can be held within an RRIF. These include (but are not limited to) Common stock, Bonds, Mutual Funds, call options, private placements, and some mortgages.

To calculate the minimum annual withdrawl required by Revenue Canada multiply the fair market value of the property (other than certain types of annuities) held in connection with the fund at the beginning of the year by a prescribed factor, and adding the result to the total, if any, of all amounts representing either: a periodic payment received by the trust in the year under an annuity, the fair market value of which is not included in the calculation of the minimum amount; or an estimate of a periodic payment the trust would have received under such an annuity held at the start of the year, if the trust had not disposed of the right to the payment during the year. The prescribed factor can correspond to the age of the first annuitant under the fund or, if the first annuitant so elects before receiving any payments under the fund, to the age of the annuitant's spouse or common-law partner at that time. Visit Revenue Canada or Section 7308 of the Income Tax Regulations describes the prescribed factor.

The prescribed factor for a qualifying RRIF is the factor in the following table that corresponds to the age in whole years (in the table referred to as "X") of the individual at the beginning of the year, or the age the individual would have been at the beginning of the year if the individual had been alive then.

Age Factor
under 79 1/(90-Age)
79 .0853
80 .0875
81 .0899
82 .0927
83 .0958
84 .0993
85 .1033
86 .1079


Registered Education Savings Plans (RESP)

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In an effort to both help and encourage parents to save for their children's education, the federal government introduced a plan that shelters capital gains on assets specifically set aside for education costs. An education savings plan (ESP) is a savings vehicle generally used by parents to save for their children's post-secondary education. More precisely, it is a contract between an individual (the subscriber) and a person or organization (the promoter). The subscriber makes contributions that accumulate tax-free earnings. In return the promoter agrees to use the accumulated funds to pay or to cause to be paid educational assistance payments to one or more beneficiaries designated by the subscriber. A registered education savings plan (RESP) is an ESP that has been registered with Canada Customs and Revenue Agency.

3 Types of Plans

Non-family plans: These plans can only have one beneficiary. There are no restrictions on who can be a beneficiary under these plans. This means that anyone can be the beneficiary of a non-family plan. The subscriber is free to decide when and how much he wants to contribute. The subscriber can also decide to take a break in contributions at any time.

Family plans: These plans can have one or more beneficiaries. However, each beneficiary must be connected by blood or adoption to each living subscriber under the plan or have been connected to a deceased original subscriber. The subscriber is free to decide when and how much he wants to contribute. The subscriber can also decide to take a break in contributions at any time.

Group plans: These plans are usually offered by non-taxable entities like foundations. These plans are administered on an age group concept i.e. all contracts for beneficiaries who are 9 years old are administered together. Contributions to a Group plan are calculated by the Foundation's actuary. The amount and frequency of these contributions stay the same as long as the beneficiary has not attained 18 years old.


Other Tax Shelters

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Working Opportunity Fund Western Canada's largest venture capital fund is available for sale to all residents of British Columbia.

WOF was incorporated in 1992 and raised $7 million from 2,000 individual British Columbians in its first year of operations. Since then it has raised more than $300 million from over 50,000 BC residents and has grown to approximately $500 million in assets.

In January 2000, GrowthWorks Capital introduced Working Opportunity Fund Growth Shares, a second class of shares with greater equity exposure in its investment portfolio. This revolutionary new product is the first of its kind in Canada.Investors in WOF receive 30% tax credits on their investment that can be used to reduce income tax payable.


The Working Opportunity Fund is a unique investment vehicle that gives investors the opportunity to receive tax credits and to participate in the success of some of the most entrepreneurial BC companies in the high growth sectors of the economy. W.O.F. invests equity capital in small to medium sized businesses in BC's emerging industries.


Venture Capital Corporations (VCC's) In responce to the very popular Working Opportunity Fund, the new Liberal Government in Victoria introduced Venture Capital Corporations as an alternative to WOF. Our provincial venture capital programs encourage investments in B.C. businesses by providing B.C. investors with a 30 percent refundable tax credit. The investment is made through a holding company called a Venture Capital Corporation (VCC) or a Community Venture Capital Corporation (CVCC). The VCC or CVCC raises investment capital from B.C. residents and then invests these funds in qualifying small businesses.

Examples of VCC's include Pender Capital's Life sciences and Growth funds that directly invest in smaller BC based companies withing their respective fields.


Flow Through Shares Flow-through Shares are 100% tax-deductible investments in Canadian mining companies - for example, if you have a taxable income of $100,000 and you invest $10,000 in Flow-Through Shares, you reduce your taxable income to $90,000 (for both federal and provincial taxes). In addition, investors get a 15% federal tax credit that further reduces your taxes.

There are also provincial tax credits. For example, if the company is working in BC and you are a resident of BC, you also get a 20% provincial tax credit. As a result, an investment of $10,000 in super flow-through shares has a net cost of $3,830 provided the investor is in the highest individual tax bracket.

There are many sites on the web to help investors specifically with Flow-Thru Investments. Just click on this link to take you to one such site.


Cdn. Dividend Tax Credit While income from employment and interest income are simply taxed at your marginal tax rate, dividend income from taxable Canadian corporations is given a preferential tax treatment that can save you money.

Dividends represent your share of a company’s after-tax profits. Since income tax has already been paid by the corporation, it would be unfair to tax them again in your hands. They aren’t completely tax-free, but using the dividend tax credit does save you money.

Here’s an example. You receive an annual dividend from Gigantic Company Ltd. of $1,000. To calculate the dividend tax credit, you “gross up” this amount by 25%, so the $1,000 income is now $1,250. This amount is taxed at your marginal tax rate. If we use a 26% tax rate for this example, then the federal tax on this income amounts to $325.00.

Now, you calculate the tax credit to apply to this amount. In this case, you would claim a credit of $166.63, which is 13.33% on the grossed-up amount of $1,250. The total calculation looks like this:

Dividend received: $1,000
Grossed-up amount $1,250
Federal tax at 26% $325
Dividend Tax Credit
13.33% x grossed up amount $166.63
Net federal tax (federal tax minus the dividend tax credit) $158.37

Provincial taxes would be added to the Federal tax owing and would also receive a dividend tax credit.

Excerpts taken directly from CSI web site.


One Example

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Here is one example of how a Canadian earning an annual salary & interest income can reduce their federal tax bill.

$50,000 annual income (made up of $40,000 in earned and $10,000 interest income)

At 26% = roughly $11,200 in federal taxes

Two strategies 1. maximize RRSP contributions & 2. reallocate interest earning assets.

1. Maximize RRSP contribution (either individual or spousal)
RRSP contribution of $10,000 = credit of $2,600
$5,000 purchase of WOF = $1,300 credit
$5,000 purchase of Flow Thru-Shares = $1,300 credit
RRSP credits & purchase credits = $5,200 credits

2. Reallocation of interest income assets
reduction from $2,600 owed to $1,583.70 in divident tax credits of $1,063.30

Total Credits $6,263.30
New Federal taxes owed = $4,936.70 or more than 50 percent reduction

In the above example the taxpayer makes a $10,000 RRSP contribution (either to their own or to a spousal plan) and receives a $2,600 tax credit for that contribution. With that contribution the taxpayer buys $5,000 of Working Opportunity Fund inside the RRSP and receives a $1,300 tax credit for that purchase. Additionally, the taxpayer buys $5,000 of Flow-Thru Shares inside the RRSP and receives a $1,300 tax credit for that purchase. The total credits received are $2,600 + $1,300 + $1,300 = $5,200.

In the above example the taxpayer shifts interest paying assets from either bonds or debentures to Canadian blue-chip common stocks that pay dividends. Because bond and debenture interest receives no special treatment and is taxed at your personal rate (in this example 26%) there are potential tax savings by moving assets to dividend paying stocks. $2,600 in federal taxes would be owed on bond interest income of $10,000. But, because of the dividend tax credit, only $1,583.70 would be owed in federal taxes on $10,000 in dividend income (refer to Other Tax Shelters above for a detailed explanation).

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