3520-8-updated 2012.doc

3520-8: Last updated on 10/08/12 1-13 1 Lecture 8: Income or Loss from a Business and Introduction to GST/HST 1.1 Coverage  Use the lecture notes for studying; for parts that you think you really need more info please search for the relevant materials in CTP ch. 6 and ch. 21  Self-study problem 6-8: ignore items 12 and 13 2 Business Income Compared to Employment Income, Property Income and Capital Gains  The rules for computing income or loss from business or property are contained in subdivision b of Division B of ITA 9 to 37  Before we can apply the rules in subdivision b we must decide if it is business income or employment income (subdivision a) or property income (also subdivision b) or capital gains (subdivision c)  Although “business” is defined in ITA 248(1) there have been many court cases on this  Business income is generally speaking income earned from selling goods or providing services. However providing the services of an employee is not business income (it is employment income). Employment income and the difference between an employee and a self-employed business person were discussed in lecture 2  Business income differs from property income in that property income is typically passive income earned from investing assets whereas business income actually involves selling goods or providing services to clients or customers. Property income was discussed in lecture 3  A capital gain on the sale of a capital asset is not business income. Business income occurs when a taxpayer sells inventory and inventory is not a capital property. The difference between inventory and capital property is covered in lecture 3  read CTP 6-12 3 Determining Business Income: ITA 9 to 37 (fiscal period ITA 249.1)  ITA 9: start with profit (generally GAAP net income)  ITA 10: deals with inventory. Inventory must be recorded at the lower of cost or fair market value  ITA 12: income inclusions  ITA 18: items you can't deduct  ITA 20: what you can deduct  ITA 37: deduction of most costs of scientific research and experimental development (SRED or R&D) carried on in Canada (except land and buildings, which are capitalized)  The deduction does not have to be taken in the year  The costs go into a pool and can be carried forward indefinitely  There is a related investment tax credit [email protected] 3520-8: Last updated on 10/08/12 2-13  ITA 249.1: deals with the fiscal period (individuals must generally use the calendar year, corporations can choose a non-calendar year end but must be consistent once they choose one) 3.1 Some other rules that apply for all purposes of the ITA are also applicable to the calculation of business income including: 3.1.1 The Reasonable Requirement  ITA 67 says that expenses in excess of a reasonable amount cannot be deducted  e.g. if a salary in excess of a reasonable amount is paid (e.g. to a family member), the excess amount is not deductible 3.1.2 The 50% meals and entertainment rule  ITA 67.1 says that you can only deduct 50% of meals and entertainment  This includes meals claimed as a traveling expense and business deductions for taking clients to the ballet, opera, plays, sporting events, etc.  Different rules apply to truck drivers (not discussed in this course) 3.1.2.1 There are a few exceptions to the 50% rule that mean that the outlay is 100% deductible, these include:  events generally available to all employees at a work location  e.g. Christmas party, not exceeding six per year  The 50% rule in ITA 67.1 would apply to the 7 and all subsequent such events  events to raise funds for registered charities  e.g. cost of a ticket to a charity dinner/fundraiser  where taxpayer was compensated by someone else for the meals  e.g. the accountant who bills the meals to a client can claim 100% of the cost as a deduction (as long as they include in income the amount billed to their client)  where meals and entertainment are provided as a part of normal course of business, etc (e.g. the cost of meals to a hotel, resort or airline) 3.1.3 Fines and Penalties  ITA 67.6 says there is no deduction allowed for fines and penalties levied by a country, province or municipality  e.g. parking tickets, government fines for pollution, etc 3.1.4 Car restrictions [email protected] 3520-8: Last updated on 10/08/12 3-13  There are various restrictions on the deduction of items related to automobiles, designed to restrict deductions on expensive cars (covered in ADMS 4561)  tax-free car allowances [ITA 18(1)(r), Reg. 7306]  CCA on passenger vehicles [ITA 13(7)(g), Reg. 7307]  interest payments on car loans [ITA 67.2, Reg. 7307]  car lease payments [ITA 67.3, Reg. 7307] 4 Business Income and Accounting Financial Statements  When you prepare a tax return reporting business income, you generally start with the accounting (financial statement) net income  The next step is to make adjustments (you add back certain items and deduct others) to convert the accounting net income to the tax net income (called Division B net income or net income for tax purposes)  This applies when you are computing business income for an individual or a corporation  ITA 9 says that to compute business income, you start with "Profit" and adjust as the ITA requires  Corporate tax returns (T2s) reporting business income must contain: a reconciliation (Schedule 1) between financial statement (accounting) income and net income for tax purposes; and must include the financial statements of the business prepared using the CRA's standardized financial statement format, the "General Index of Financial Information" (GIFI) = a standard way of categorizing financial statements  The adjustments required to reconcile financial statement income to business income for tax purposes are mostly add backs – there are very few deductions  There is case law on whether a taxpayer has to follow GAAP (generally accepted accounting principles) when the ITA is silent  The Supreme Court of Canada has said no in Canderel Ltd. v. Canada, [1998] 1 SCR 147  Taxpayer has to provide an “accurate picture of profit” that does not necessarily have to be in accordance with GAAP  An example is the treatment of tenant inducements paid by a landlord (fully deductible for tax but amortized over the lease term for accounting purposes)  Finally, profits of an illegal business are taxable and damages are taxable if they replace amounts that would have been income 4.1 Add back and deduct items in adjustments  Note: if an item is deducted in the computation of accounting net income and not deductible for tax purposes then you “add it back” to accounting net income (in order to determine net income for tax purposes)  read 6-69 for ITA 18(1)(a) [email protected] 3520-8: Last updated on 10/08/12 4-13  any amounts that are not incurred to earn income (and that have been deducted in accounting net income) would have to be added back under ITA 18(1)(a), personal expenses are also specifically denied under ITA 18(1)(h)  read 6-73 for ITA 18(1)(b)  see CTP Figure 6-3  Depreciation and amortization  Depreciation or amortization (the two words mean the same thing) are a way of deducting the cost of a capital asset over a number of years  The method used by an accountant and the method used in the Regulations of the ITA are quite often different (sometimes they will be the same)  So the accounting amortization or depreciation expense is added back (because ITA 18(1)(b) requires amounts on account of capital to be added back) and the tax number (CCA or CECA) is deducted  There are other timing differences between accounting and tax but this is the main one  CCA and CECA will be covered in lecture 8  Permanent differences such as meals and entertainment  For obvious tax policy reasons (i.e. there is a personal benefit relating to meals and entertainment), the government has decided that only 50% of meals and entertainment is tax deductible [ITA 67.1] The U.S. tax system has the same rule  So it is important to find out how much (if any) of the business person’s advertising and promotion account is meals and entertainment  If the financial statements reported capital gains and losses, it’s important to add back the accounting loss (deduct the accounting gain) and compute the net taxable capital gain (i.e. 50% capital gain net of 50% of capital losses) 4.2 Example of an Unincorporated Business: business of a doctor or accountant  There are sales or revenues (from services provided to patients or clients) and these amounts must be included whether the doctor or accountant receives the cash immediately or at a later date (from the client or OHIP)  The typical expenses of a doctor or accountant (or dentist or consultant or any other individual providing a service business) might be salaries and benefits to employees (e.g. receptionist, etc.), office rent and expenses (e.g. rent and utilities, paper and other supplies, professional fees, conferences, etc), advertising and promotion (e.g. ads, flyers, cost of taking clients out), depreciation or amortization on equipment (e.g. computers, etc.) and interest on borrowed money used in the business  Assume: CCA is $6,000, Meals & entertainment expenses included in the promotional expenses are $4,000  A financial statement might look like the following:  Sales or revenues $110,000  Expenses [email protected] 3520-8: Last updated on 10/08/12 5-13  Salaries and benefits to employees $30,000  Office expenses 10,000  Advertising and promotion 6,000  Depreciation or amortization 5,000 (51,000)  Income $59,000  The reconciliation would be  Income per financial statements $59,000  Add 50% of meals and entertainment $ 2,000  Add depreciation or amortization 5,000  Deduct CCA (6,000)  Income for tax purposes $60,000 5 No adjustment is needed if an item is treated the same way for both accounting and tax 5.1 Interest on bank loan used to purchase an investment (e.g., common shares, factory, etc.) or used to finance business operations (e.g., working capital etc.) [ITA 20(1)(c)]  is deductible for accounting and for tax purposes  but interest paid on late-paid income taxes is not deductible [ITA 18(1)(t)] 5.2 Costs incurred to dispute an income tax assessment [ITA 60(o)]  are deductible for accounting and for tax purposes 5.3 Most expenses such as salaries and benefits for employees, rent, supplies, etc.  are deductible for accounting and for tax purposes 5.4 Prepaid expenses (e.g., prepaid rent, insurance or advertising) [ITA 18(9)]  these are amounts paid in advance and are not deducted until the applicable period they relate to has occurred. Same treatment for accounting and for tax purposes 5.5 Bad debt allowances and write offs of accounts receivable  As long as the allowance is reasonable and is based on a review of the accounts receivable, it is deductible, even though it is an estimate [ITA 20(1)(l)]. Actual write-offs of bad debts are also deductible [ITA 20(1)(p)] 5.6 Landscaping deducted for accounting purposes [email protected] 3520-8: Last updated on 10/08/12 6-13  Landscaping paid in the year is deductible for tax purposes under ITA 20(1)(aa)  Sometimes landscaping is capitalized and amortized for accounting purposes and in this case we do make an adjustment by adding back the amortization and deducting the full amount paid in the year  Accountants may or may not deduct the item depending on what it is  e.g. flowers vs. stone retaining walls 5.7 Capital items  Many items that are capitalized for accounting purposes are treated the same for tax Examples are:  Costs of investments plus outlays or expenses (commissions, legal fees) paid on the purchase of an investment (shares, factory, land, etc.)  A good accountant would not deduct them and would instead add them to the cost of the investment  ITA 18(1)(b) also requires the amount to be capitalized  Appraisals  If the appraisal relates to the purchase of property, it becomes part of the cost of the asset under ITA 18(1)(b)  again, a good accountant would treat it this way as well, so it will generally not be deducted for accounting purposes  If the appraisal is incurred for the purpose of gaining or producing income (e.g., to get insurance), the cost is deductible for accounting and tax purposes  Add back cost of articles of incorporation under ITA 18(1)(b)  CECA deduction is available (discussed in lecture 8) 5.8 Site investigation costs (e.g. costs of investigating land prior to purchase)  Site investigation costs paid in the year are deductible for tax purposes under ITA 20(1)(dd)  Sometimes site investigation is capitalized for accounting purposes and in this case the adjustment is to add back any amortization and deduct the full amount when paid 5.9 Utilities service connection  Utilities service connection costs paid in the year are deductible for tax purposes under ITA 20(1)(ee)  Sometimes it will be capitalized and in this case the adjustment is to add back any amortization and deduct the full amount when paid 5.10 Convention Expenses  Taxpayers earning business income can deduct the cost of attending up to 2 conventions (related to the business) per year [ITA 20(10)]. If a portion of the cost of the convention is for food, [email protected] 3520-8: Last updated on 10/08/12 7-13 beverages and/or entertainment then this portion is only ½ deductible (i.e., the usual 50% deduction for meals and entertainment applies). If the cost of food, beverages, and/or entertainment is included in the convention cost and unknown then the cost will be deemed to be $50 per day [ITA 67.1(3)] 6 Add back amounts deducted for accounting purposes (that are not deductible for tax purposes)  These add backs are ne