If you worked for a small Canadian controlled private corporation (CCPC) and were offered shares in that corporation there may be tax consequences if the shares are redeemed by the corporation.

Small corporations, like large corporations, will often allow key employees to purchase shares of the corporation to allow key employees to share in the profits of the company.  As profits are earned, they are distributed to all shareholders based on their shareholdings. These distributionsare normally taxes as dividends in the shareholders hands. 

Sales Of Shares Are Often Restricted

The stocks of small corporations cannot be sold on stock exchanges and shareholders agreements often restrict to whom the shares may be sold to (normally other existing shareholders).  As a result, if funds are required by the shareholder or if the shareholder terminates employment with the corporation, and qualified buyer is not available, then the corporation may redeem the shares at a specified price.

On the face of it sounds like you are saved if you can’t find a qualified buyer.  But the tax treatment of a share-redemption may be very different than a sale of shares to another person.

Situation

John was an employee of Investco Ltd. and was invited to purchase shares in the corporation as a reward for good service.  The shareholders agreement  restricts the re-sale of the shares issued to other qualified employees of Investco.  As an alternative, Investco will redeem the shares at their fair market value using a prescribed valuation formula.

John purchased 1,500 shares in 2004 for $100 each.  The paid up capital (PUC) of these shares was also $10 each.

In 2008, John left the corporation and the fair market value of the shares had grown to $400 each.  John’s marginal tax rate is 45% on normal income, 22.5% on capital gains, 33.33% on ineligible dividends and has never claimed any capital gains or losses in the past. 

At the time, Investco was a CCPC and a qualified small business corporation. The company does not have a GRIP balance and therefore all dividends would be considered ineligible.

Scenario A – Sale of Shares to a Third Party

If a qualified shareholder was available to purchase the shares, and assuming that shareholder is not related to John and Investco, the tax consequences of the sale are as follows:

John will realize a capital gain of 1,500 shares x ($400- $100) = $450,000.  Since Investco is a qualified small business corporation and the capital gain is less than the $750,000 lifetime capital gains exemption, there are no tax consequences.

Scenario B – Investco Redeems The Shares for $400 Each

If John cannot find a buyer and Investco redeems the shares, then the Income Tax Act looks at the transaction differently:

• The redemption at $400 per share results in a deemed dividend of 1,500 x ($400 – $10) = $585,000.  The marginal tax on the ineligible dividend would be $195,000.
• The redemption also results in taxable capital loss of $67,500 that may qualify is an allowable business investment loss (ABIL) and could be deductible against other income.  If the loss were an ABIL, the tax savings realized would be $15,200.
• The total tax, assuming the ABIL may be fully claimed would be $179,800.

Clearly an arms-length sale of the share shares is a better result as it would avoid the deemed dividend.

Ask A Question Or Share Your Thoughts

Ask a question or leave a comment on this article in the comment box below.

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It’s been a very busy summer! The Canadian Tax Resource Blog has seen an ever increasing number of visitor, particularly after the TFSA penalty fiasco!

I’ve also been working on developing the strategy and business plan for my consulting practice. So far, I have identified my customer base and have determined there is a demand for my services (Statistics Canada and Industry Canada are very good sources of information!).

Consulting Services

Here is a list of consulting services I will deliver:

• Incorporation Services – I can help evaluate whether you need a corporation and discuss the advantages and disadvantages. I can also create your corporation for you and help you roll assets into your corporation.
• Start-Up Assistance – This involves name registrations, business licenses search and registration, create the bookkeeping systems, or simply provide information and help as required.
• Business Plans & Business Planning – With over 18 years of experience in business and finance, I have created and help create strategic plans, operational plans, and marketing plans. I can either evaluate a clients business plans or help the create one.
• Performance Measurement – Many businesses large and small need some form of help to identify what to measure and how often. Typically, profit is the key metric, but in reality it can only tell you how you did … it is not predictive!
• Business Evaluation – What are the key risks facing your business right now and how can you manage them? Business evaluation looks at the internal and external factors affecting your business or industry and looks for way to come out on top.
• Exit Strategies – Many people are looking to retire from their business but are not sure if they should sell it, save it, give it to their family, or where to start.

A work process is an important element and one I have put a lot of time and effort into. A work process helps guide my clients and myself through a structured system. At each point in the process we both know where we are.

Engage Me!

If you or anyone you know are looking these or similar services, please feel free to contact me to discuss what you need and what I can offer.

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So you’re tired of living with short summers and are thinking of moving to the U.S. Perhaps you are U.S. citizen who worked in Canada for a number of years and are returning. In either case, you may be wondering if you should leave your RRSP in Canada or take it with you.

Can I Roll My RRSP Over To A U.S. IRA?

No. There are no provisions in the U.S. that allow a rollover of RRSP to an equivalent Individual Retirement Account (IRA).

If you want to take the RRSP with you to the U.S. you would have to collapse your RRSP and the full value would be included in your income in the year of the withdrawal. This could result in a substantial tax hit. 

What Should I Do With My RRSPs When I Move?

Avoid withdrawing the funds from your RRSP. Instead, leave the RRSP in Canada where the investments can grow free of Canadian tax. When you become a resident of the U.S. for tax purposes, any withdrawals from the RRSP will be taxed under non-resident rules and will be subject to the 25% withholding tax. If you decide take periodic (rather than lump sum) withdrawals, the withholding tax would be reduced to 15%.

Once you are a resident of the U.S. any withdrawals from your RRSP will be subject to U.S. taxes. However, in the U.S., you are permitted to withdraw the cost base of your RRSPs tax-free. The cost base is determined to be the original cost base on the date you became a resident of the U.S. For example,

Assume you purchased investments in your RRSP 10 years ago, paid $10,000, and made no other investments since, the cost base on the date you became a resident of the U.S. would be $10,000.

If you sell all of your investments inside your RRSP account and reinvest them before leaving for the U.S. you will have increased your cost base. In the above example, if the market value of the investments was $50,000 and you sold and reinvested this amount, your new cost base would be $50,000. There are no Canadian tax consequences and you have increased the amount you can withdraw tax-free when you are in the U.S.

It is important to note that you should engage the services of a professional to help you give up your Canadian residency properly to ensure you are not subject to full Canadian taxes on your withdrawals.

Questions About Moving RRSP’s To The U.S.

Have you moved to the U.S. are think about it. Please share your experience with others by leaving a comment.

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Following is a copy of an e-mail sent to Jim Flaherty and Keith Ashfield today about the TFSA penalties many are facing right now.

Subject: Request To Address TFSA Overcontribution Penalties

Dear Mr. Flaherty & Mr. Ahsfield,

As you may be aware, a number of Canadian’s are receiving requests for payment from the CRA in response to over-contributions made to TFSA’s.

If you read the comments of many the visitors to my website, http://blog.taxresource.ca/tfsa-over-contributions/, you will see that in many cases the over contributions were unintentional errors resulting from a general misunderstanding of the workings of the account. Similar comments and experiences can be viewed at the popular http://forums.redflagdeals.com/my-tfsa-balance-200-cra-wants-me-pay-interest-5700-wtf-899497/

The TFSA has proven to be a popular savings vehicle for Canadians. However, the $5,000 contribution limit has resulted in confusion. Many Canadians viewed the account as a regular savings account and were unaware that withdrawals would not be added back to the limit until the following year. In one case, a reader to my website indicated that he had over contributed to the tune of $40,000 while another had $70,000. In these cases it appears the taxpayer effectively contributed $5,000 to a TFSA, withdrew it and deposited the same amount to another TFSA and repeated the process in search several times, unaware of the ability to transfer between TFSA’s and avoid an over contribution.

I have directed many taxpayers to contact the Canada Revenue Agency to ask for leniency or request that the penalties be waived. Based on some of the responses I have received back, indicate that there seems to be an inconsistent application the Taxpayer Relief Provisions with respect to TFSA penalties.

I would ask that the Government of Canada direct the Canada Revenue Agency to waive all TFSA overcontribution penalties in those cases where an honest mistake or error has resulted in the overontribution. In addition, I would also suggest that a public education initiative be undertaken to help Canadians and financial institutions understand the TFSA.

I would like to extend an invitation to both of you to respond directly through The Canadian Tax Resource Blog either in the form of a letter or a media release. Such a response would provide you the opportunity to interact and address the concerns of Canadians on this specific matter. Finally, the substantive content of this letter will be posted on the site later today.

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The first step in creating a business plan is to develop, what I like to call, a proof of concept. This is an evaluation of your business idea and to find out where any gaps exist. It will help you begin the market research phase and determine whether your idea will make money.

Here are 10 things to consider when developing your business idea or proof of concept:

1. What Is your product or service? This one seems rather simple, but I have seen projects undertaken where the deliverable was never clearly defined. The leadership had an idea of what activities would be done, but had no clear direction of what service would be received.
2. Who will your customers be? Knowing your customer will help you create your business around them. This website for example was established to provide tax and financial planning guidance to individuals and small business owners. By defining the customer helps focus my articles to that specific audience.
3. Will your customers buy your product or service? A business idea can only be successful if people are willing to pay for the product or service. Once you know who your customers will be, determine if they can or are willing to purchase your product or service. If they are not, you may need to seek alternative ways to make money.
4. Who are your competitors? This goes beyond just stating who they are. Figure what they do and what they don’t do and then evaluate whether you can fill in the gap.
5. Can you compete in the market? Why will people buy from your competitors or from you? Is your product better quality or lower price? Anticipate your competitions response to you entering the market.
6. How will your distribute your product or service? Will you open up a retail establishment and sell to the general public or will you have another company distribute your product for you? You may need to modify your idea to a better delivery channel.
7. How will you promote your business? A business without clients is not a business! How will you get the word out? Some forms of promotion work better for some business. Consider your promotional activities, their cost, and how effective they will be.
8. Are there any regulations or licenses required? Are you allowed to sell your product or service in your location? Do you require special permits or licenses to set up shop? Your local community may have a business center or other sources to help you navigate you through the process.
9. Do you need to protect your product or service? Great products and services have patents, copyrights or trademarks to protect the developer/owner from others creating the same thing and outselling you. If your idea is unique and you feel there is a demand, then consider protecting yourself.

10.  How will your finance your business? What resources to do need (equipment) and how will you acquire them? Some businesses can be formed using nothing more than a home computer while others require buildings and equipment. Where will the money come from?  

Share Your Thoughts On Starting a Business?

Are you considering a new business? How are you developing your idea and conducting the market research? Share your thoughts on this topic with others.

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I am always amazed at how many accountants there are in the business world.

The other day, I was in a meeting with a VP at the company I work for and he mentioned in passing that he was a CA. I have worked with him for several years at the company and never put two-and-two together. In fact, of the 12 key divisions, 5 of the VP are accountants and many other accountant hold key positions in non-accounting areas.

I have been toying with the idea of going into public practice for a number of years, but have been held back by the company and industry I work in. And while I am not involved in sales and do not interact with clients very often in my current role, I am restricted from running an accounting practice by industry regulations.

At this point you are probably asking yourself “where is the Tax Guy going with this?”

Well according to an authoritative source inside the company, I may be restricted from running an accounting practice but I am certainly not restricted from operating a consulting business! As long as I’m not engaged in financial services related activities, preparing financial statements or tax returns, I can keep my job and work part-time as a consultant.

I’m starting a consulting business.

Time To Re-Apply Other Skills

I have been in the financial services industry for over 15 years and have spent the last 10 in a brokerage firm. Most of that time has been in the corporate accounting department, where I had a variety of responsibilities. Much of what I learned and applied was, what I like to call, non-financial accounting: Business planning, developing performance measures, assessing business risk, and managing business continuity.

Sharing The Business Start-Up Process

Over the next several months, I will be starting the business start- process. I will be refining the mission of my consulting practice, preparing a business plan, marketing plan, operating plan, and implementation plans. I’ll need to make decisions on business structure, insurance, as well as licensing. I will be reporting my progress along the way and looking for input from other business owners.

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The foreign tax credit for non-business income is a non-refundable tax credit and is available if you have income from foreign investments that have been subject to foreign withholding taxes.

There are actually two different foreign tax credits in Canada: The foreign non-business tax credit and foreign tax credit on business income. This article only addresses the foreign tax credit on non-business income.

The Foreign Tax Credit Is Not Simple

Although the basic concept of the foreign tax credit is to eliminate double taxation, the calculation of the credit is not straight forward and has limits on how much may be claimed as a credit. Further complicating the matter is the fact that the excess amount you cannot claim as a credit may be claimed as a deduction (which may mean re-calculating your total tax return again!).

Further complicating matters is the fact that the foreign tax credit must be calculated for each country unless the total foreign taxes are less than $200.

Side Note About Tax Software

Be aware that if you have income from foreign investments, your income tax software may not properly calculate the foreign tax credit for you. If you have to calculate separate foreign tax credit for each country, you will no longer be allowed to file on-line and you will have to mail in your tax return.

Do you have a tax question unrelated to this article? Consider our CTR Answers.

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Non-resident withholding taxes generate a lot of questions and misunderstandings among investors. Knowing how withholding taxes work and when they apply will help you figure out the best way to invest in foreign stocks.

What Is A Non-Resident Withholding Tax?

Withholding taxes may be applied to interest, dividends or other income you receive from foreign investments. The withholding tax is not applied by Canada but is applied by a foreign country.

Lets say you own shares of Bayer AG. The dividends are subject to a 15% non-resident withholding tax. This 15% tax is paid to the government of Germany because Bayer AG is a German company.

The Foreign Tax Credit

If you hold your foreign investments outside of an RRSP, RRIF or TFSA (collectively called non-registered accounts), you may be able recover all or part of the foreign tax withheld by way of the foreign tax credit.

If you hold foreign investments inside registered accounts, you cannot claim the foreign tax credit. Continue reading!

How Do Withholding Taxes Affect RRSP’s & RRIF’s?

Under the Canada-U.S. Income Tax Treaty, there is no withholding tax applied to interest or dividends received on investments inside of an RRSP or RRIF (see below for the TFSA). If you have non-U.S. investments inside of your RRSP or RRIF, withholding taxes may be applied at varying rates. These withholding taxes are not recoverable and the foreign tax credit cannot be claimed!

How Do Withholding Taxes Affect The TFSA?

Dividends from U.S. companies received inside the TFSA are subject to U.S. withholding tax and are not recoverable nor is the foreign tax credit available. Interest, on the other hand, is not subject to withholding (whether it is received in your TFSA or outside of your TFSA).

Foreign Investments (Non-U.S.) may still be subject to withholding taxes depending on the country of origin.

Arrange Your investments To Maximize Returns?

Interest and foreign dividend income is fully taxed at your marginal tax rate. Generally, you should hold your interest generating investments and U.S. stocks inside of your RRSP or RRIF as these would be fully exempt.

Other foreign investments may be held inside of your RRSP, RRIF or TFSA if the withholding tax that would be applied is less than your marginal tax rate. For example, you would still be better off holding a foreign stock subject to a 15% withholding tax inside of your registered account if your marginal tax rate is 20%. Here is why:

• A $100 dividend received outside of your registered account would be effectively taxed at 20% and you would have $80 left over, after tax.
• If the same $100 was received in your registered account, you would have $85.

Summary

Knowing when and how withholding taxes will be applied and the rate that will be applied will help you determine the best type of account to hold your foreign investments.

Do you have a tax question unrelated to this article? Consider our CTR Answers.

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I am happy to announce the launch of The Canadian Tax Resource Answers site this past weekend.

Since the launch of the Canadian Tax Resource Blog back in January of 2008 I have received literally thousands of individual questions from around the world and have had many visitors pose questions directly on posts. I thought it would be a great idea to have a single location where you can ask a question and have it answered either by myself or other professionals (or knowledgeable individuals).

More Than Just Tax

Canadian Tax Resource is more than just tax. My intent has always been to cover variety of topics including business issues, retirement planning, mortgage, and other personal finance matters. The new personal finance Answers site is an extension of my original intent.

Over time I hope CTR Answers takes on a life of its own! I hope you find it helpful.

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It has been a busy couple of weeks on Canadian Tax Resource. I have been evaluating and posting a backlog of articles as well as working on improving the speed at which the site loads.

I am happy to announce that I have been able to cut the time it takes pages from Canadian Tax Resource by a full 2/3rds (from about 9 seconds to about 3!). This increase in performance should make your experience moving through the site much better.

Other improvements to CTR include:

• The new 2010 Income Tax Calculator
• A new subscribe box
• A Follow Us on FaceBook Button
• An Improved Google Search bar
• The addition of a QuickBooks product page

Special Thanks To Those Who Mentioned CTR on Twitter or via their bolgs:

• @nataliejoan
• @CanadianFinance – Tom at the Canadian Finance Blog
• @BlackStilt
• @josealbis
• @LLBrougham

Have a great long weekend!

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