© C Sears, 2015

Net Income for Tax Purposes

 Net Employment Income
 Net Business Income
 Net Property Income
 Capital Gains and Losses
 Other Income
 Other Deductions
 Current Year Losses – Capital or Non-Capital

 = Net Income For Tax Purposes

Differences so far
 Net Employment Income
 Can only be earned by individuals
 Taxed on the cash basis

 Net Business Income

Net Property Income

Capital Gains and Losses

 Can be reported by any taxable entity (corporation, trust,
individual)
 Taxed on the accrual basis (some exceptions)
Business vs. Property
 Property Income  Business Income
 Less effort to earn  Actively Earned
 Interest  “An adventure in the
 Dividends
nature of trade”
 Not employment
 Rental
income
 Royalties
Definition
 Difference from Business Income covered in great detail
in Session on business income.

 Return on invested capital where little or no effort is

required by the investor to produce the return.

 Doesn’t include capital gains, as these are included

elsewhere as income under the tax act.
Important Because
 CCA cannot be used to increase or create a loss on
property income.

 No requirement to prorate CCA on assets used to

produce property income for short year ends.

 Limited deductions for property income – No

convention expenses,
Restrictions
 Deductible only to the extent it is incurred to earn
business or property income.

 Capital gains do not qualify

 Employment Income does not qualify
 Cannot be interest for personal purchases
Typical Home Buying Transaction
 Ordinarily a
taxpayer will loan Bank
funds from a
bank to buy a
Bank loan House
home.
used to
 Personal purchase
Transaction home
 No deduction if
there is interest
Law Firm
paid
Singleton Case – Step 1
 Withdrew funds
from his law firm Bank
to purchase a
personal home.
 Personal House
Transaction
 No deduction if
there is interest Partnership
paid Law Firm Account used
$0 left to buy home
Singleton Case – Step 2
 THEN, received a
commercial loan Bank
and reinvested in
the law firm.
Bank loan House
 Interest on this
used to
debt, used to reinvest in
invest in Partnership
business
income earning
asset, is Law Firm
deductible.
Singleton - Result
 The “shuffle of cheques” created legal relationships.

 The interest paid by the taxpayer was on debt used to

earn income (by being contributed to the law firm)

 Therefore, the interest was deductible. (ie. Taxpayer

WIN!)

 No debt existed for the purchase of the home, therefore

the structure is the most tax advantageous (no lost
deduction for interest paid)
Ludco Case – Step 1 Interest
paid to
 Borrowed funds bank
to invest in an Investor Bank
offshore
company
Shares held
 $6,000,000 in
of Offshore
interest paid Dividends Co.
 $600,000 in paid up
dividends
received Offshore Co.
Ludco Case – Step 2 Sale of
Offshore
 Shares of Co.
Offshore Co. sold Investor Purchaser
to a purchaser
 $9,200,000
capital gain
Shares held
incurred.
of Offshore
 CRA’s position Co.
that purchase
was to earn Offshore Co.
gains, not
income.
Ludco - Result
 Earning business or property income doesn’t have to be the ONLY
purpose of the transaction.

 An investment can have multiple purposes.

 Therefore, the interest was deductible. (ie. Taxpayer WIN!)

 This case is further complicated by the size of income ($600,000) to

interest paid ($6 million). Although approved in this case, there is
some dispute over whether it would fall prey to the proposed
Reasonable Expectation of Profit Rules (REOP)
Interest
 What is interest?

 It must be accrued on a continuous basis (able to be

calculated at any point in time)

 It must be calculated based on a principal amount

 It must be compensation for the use of the principal

amount.
Direct or In-Direct Use
Requirement is that the funds borrowed must be used to
earn income from Business or Property.

 Remember Singleton – The use of the loan on which the

interest is paid is the important one. Economically was to
purchase a home, directly was to invest in law firm.
Direct or In-Direct Use
Direct Use is the general use, with Two Exceptions

 Exception 1: FILLING THE HOLE

Interest on loans made to Pay Dividends, Redeem Shares, or
Return Capital can be deductible where:

The loan takes the place of capital already invested in

the company
 Return of capital limited to paid up capital of
shares.
 Redemptions and dividends limited to retained
earnings left in the company
Filling the Hole – ROC Step 1
 Step 1 :
Shareholder
Individual invests
$10,000 of his
own money in a $10,000 invested in
company. shares
100 shares for $10,000
PUC
Invested capital
is $10,000
Corporation
Filling the Hole – ROC Step 2
 Step 2 :
Shareholder
Corporation
borrows $10,000 100 shares
from the bank $10,000 of PUC with $0
and repays the returned to PUC
Shareholder shareholder

Invested capital
remaining is $0
Bank Corporation
Loan to
Corporation pays Corp
interest to bank with
Interest
 Filling the Hole – ROC Result
 Direct use of the money was to return capital to the shareholder.

 In-direct use of money was to replace money the shareholder

invested to earn income from business or property.

 Hence why it is called the “Fill the hole” concept. Based on

replacing money, that was originally used for purposes that would
cause interest to be deductible.
Filling the Hole – Dividend Step 1
 Step 1 :

Shareholder
Corporation
earns $10,000
after tax and
never pays a Shares held by
shareholder
dividend.

Retained
Earnings of Corporation
company is $10,000 RE
$10,000
Filling the Hole – Dividend Step 2
 Step 2 :
Corporation
borrows $10,000 Shareholder
from the bank
and pays a Shares
dividend to the $10,000 of owned by
shareholder Dividends paid SH
to Shareholder
Retained
Earnings is $0
Bank Corporation
$0 RE Left
Corporation pays Loan to
interest to bank Corp
with
Interest
 Filling the Hole – Dividend Result
 Direct use of the money was to pay a dividend to the shareholder.

 In-direct use of money was to replace money the shareholder

invested to earn income from business or property.
 shareholder “invested” the retained earnings of the corporation, by not
distributing them previously.
 By leaving them within the corporation the shareholder made the
choice to invest them.

 Hence why it is called the “Fill the hole” concept. Based on

replacing money, that was originally used for purposes that would
cause interest to be deductible.
Interest Free Loans
Interest paid on loans used to make interest free loans are
not deductible

 Exception 1: INTEREST FREE LOANS

Interest on money borrowed to make interest free loans can
be deductible if income is expected to be earned another
way than by interest because that loan was made

Example:
 Interest free loan to a corporate subsidiary, who
then pays dividends to the lender.
Interest Free Loans Interest
 Borrowed funds to paid to
invest in a bank
Investor Bank
subsidiary
 Loan to sub allows
them to earn Interest free
income, which loan made to
they distribute as Dividends Subsidiary
dividends paid up

 Investor has Subsidiary

earned dividend
income (property)
from the loan
Linking to Current Use
The current use of the borrowed funds must be to earn income.

 Step 1: An individual borrows $100,000 to buy shares of a

corporation that pays dividends.

 Interest on the loan is deductible.

 Step 2: The individual sells the shares of the corporation for

$100,000 and uses those funds to buy a yacht. The loan is still
outstanding

 The interest on the loan is no longer deductible. The current use

of funds is to buy a yacht
Linking to Current Use
The current use of the borrowed funds must be to earn income.

 Step 1: An individual borrows $100,000 to buy shares of a

corporation that pays dividends.

 Interest on the loan is deductible.

 Step 2: The individual sells the shares of the corporation for

$100,000 and uses those funds to invest in a copyright that earns
royalties. The loan is still outstanding

 The interest on the loan remains deductible. The new use is to

earn royalties, which is property income.
Linking to Current Use
What happens if sold for more or less than the purchase price?

 Step 1: An individual borrows $100,000 to buy shares of a corporation

that pays dividends.

 Interest on the loan is deductible.

 Step 2: The individual sells the shares of the corporation for $60,000
(less) and uses $20,000 to invest in a new car and $40,000 to invest in
another corporation.

 The interest on the loan is prorated. 2/3 will be deductible, 1/3 will
not be.
 This is the ratio of the current use of the funds ($40,000 income
earning/$60,000 total proceeds = 2/3 deductible)
Linking to Current Use
What happens if sold for more or less than the purchase price?

 Step 1: An individual borrows $100,000 to buy shares of a corporation that

pays dividends.

 Interest on the loan is deductible.

 Step 2: The individual sells the shares of the corporation for $120,000
(More) and uses $20,000 to invest in a new car and $100,000 to invest in
another corporation.

 Option 1 – the interest on the loan is allocated 100% to the most beneficial
use ($100,000 of loan allocated to $100,000 investment)
 Option 2 – the interest is prorated based on the % of the proceeds is used to
earn income
 $20,000 / $120,000 = 16.67% of the interest will be non-deductible.
Disappearing Source Rules
If loan proceeds disappear, borrower isn’t penalized.

 Step 1: An individual borrows $100,000 to buy shares of a corporation

that pays dividends.

 Interest on the loan is deductible.

 Step 2: The individual sells the shares of the corporation for $60,000
and uses those funds to repay the loan. $40,000 of the loan is
outstanding

 The interest on the loan is still deductible.

 The asset’s decline in value shouldn’t unfairly penalize the taxpayer
Common vs. Preferred Shares
 Preferred shares typically have set dividend rates (ex. 5% per year)

 Purpose of earning income is easy to observe. Dividends received

regularly

 Common shares do not ordinarily have a mandatory dividend on them.

They are “participating” in that they can share in the growth of the
company by receiving dividends when and if there is income in the
company.

 Purpose of earning income is still present, if it could be expected that

dividends will be paid.
 Not there if explicitly state in their terms that no dividends will be paid.
Interest
 Taxed when earned by
corporations and trusts
(Accrual method)

 Taxed on the anniversary

date for individuals or
when cash is received if
earlier.
Bond Cash Flow
This is a $10,000 5% bond

Date Cash Flow Income

Feb 1, 2024 ($10,000) Issued -
Dec 31, 2024 Year end -
Feb 1, 2025 $0 $500 Accrued

March 15, 2025 $700 $200 (Cash is

taxable, less accrued amount already reported

Dec 31, 2025 Year End -

Feb 1, 2026 $0 $300 2nd year
accrual (2 years x $500 per year, less excess cash already reported)
 Example:
Definition $100,000 Revenue
($20,000) Supplies Expense
-----------
 Dividends are payments of
$80,000 Net Income
corporate earnings to
shareholders. (12,400) Tax on Net Income
------------
 Paid out of after tax $67,600 After Tax Income
retained earnings
$30,000 Opening RE
$67,600 Current Year Income
 Not deductible to the
(40,000) Dividends Paid
corporation
-----------
$57,600 Ending RE
Concept of Integration
 Theory that regardless of how a specific type of income is
earned, the same overall tax should be levied.

 Ie. earned through corporation, partnership, sole-proprietor,

etc.

 Eligible and Non-Eligible Dividends help create this

“integration”

 Will be covered more thoroughly in ECON3205 when

discussing corporate taxation.
Integration X+Y=Z

Proprietor Employee Shareholder

Tax = Z Tax = X

Tax = Z Corporation Corporation

Tax = $0 Tax = Y

Income Income Income

Source Source Source
Dividends – Non-Eligible
 Non-Eligible Example
 Grossed up 1.15 x Actual $1,000 non-eligible dividend.
 Credit 13.55% of Actual
 Applies to dividends from $1,150 Taxable Dividend
small corporations who pay included in income ($1k x
the low rate of tax. 1.15)

$136 Dividend Tax Credit

($1,000 actual dividend x
13.55%)
Dividends – Non-Eligible
Calculate Tax Assuming $50,000
in salary as well as this $1,000
non-eligible dividend.
Example
$1,000 non-eligible dividend.
$51,150 Taxable Income
$13,142 Tax on income (10,363 +
$1,150 Taxable Dividend
((51,150-43,000)x.341))
included in income ($10k x
$15,000 Personal Credit 1.15)
(3,615) Reduces Tax ($15k x .241)
(136) Dividend Tax Credit $136 Dividend Tax Credit
(3,751) Total Credits ($1,000 actual dividend x
13.55%)
$9,391 Net Tax (13142 – 3751)
Dividends - Eligible
 Eligible Example
 Grossed up 1.38 x Actual $1,000 eligible dividend.
 Credit 40.05% of Actual
 Applies to dividends from $1,380 Taxable Dividend
big corporations who pay a included in income ($1k x
high rate of tax 1.38)

$553 Dividend Tax Credit

($1,000 actual dividend x
40.05%)
Dividends – Eligible
Calculate Tax Assuming $50,000
in salary as well as this $1,000
eligible dividend.
Example
$1,000 eligible dividend.
$51,380 Taxable Income
$13,221 Tax on income (10,363 +
$1,380 Taxable Dividend
((51,380-43,000)x.341))
included in income ($10k x
$15,000 Personal Credit 1.38)
(3,615) Reduces Tax ($15k x .241)
(553) Dividend Tax Credit $553 Dividend Tax Credit
(4,168) Total Credits ($1,000 actual dividend x
40.05%)
$9,053 Net Tax (13221 – 4168)
Dividend Example A
Murray received a dividend on his shares of TD Bank of
$25,000. He wants to know how much tax he will pay.

Type:

Gross up:

Credit:

Tax Calculation:
 Dividend Example A
Murray received a dividend on his shares of TD Bank of
$25,000. He wants to know how much tax he will pay.

Type: From large public corp - Eligible

$25,000 x 1.38 = $34,500 Taxable

Taxable Income:
$25,000 x 40.05% = $10,013
Credit: reduction of income tax
$34,500 x 24.1% (first bracket) = $8,315 Tax
Tax Calc: $15,000 (personal credit) x 24.1% = $3,615 + $10,013
Can’t be negative DTC = $13,628 Reduction of Tax
tax owing $8,315 - $13,628 = $- Net Tax Owing (non-refundable)
Dividend Example B
Murray received a dividend on his shares of Murray Co., which
he owns, of $25,000. Murray Co. makes $250,000 in taxable
income per year. He wants to know how much tax he will
pay.

Type:

Gross up:

Credit:

Tax Calculation:
Dividend Example B
Murray received a dividend on his shares of Murray Co., which
he owns, of $25,000. Murray Co. makes $250,000 in taxable
income per year. He wants to know how much tax he will
pay.

From small corp & under $500,000 – Non-eligible

Type:

$25,000 x 1.15 = $31,150 Taxable

Taxable Income:
$25,000 x 13.55% = $3,388
Credit: reduction of income tax
$31,150 x 24.1% (first bracket) = $7,507 Tax
Tax Calc: $15,000 (personal credit) x 24.1% = $3,615 + $3,388
DTC = $7,003 Reduction of Tax
$7,507 - $7,003 = $504 Net Tax Owing
Dividends Cont’d
 Capital Dividends
 Non-taxable
 Must be paid from a
company’s “Capital
Dividend Account”.
 Will be covered in
corporate tax.

Obtained Oct 22, 2013 from:

[Link]
dividends/
Dividends Cont’d
 Example
 B Co. issues a stock dividend
 Stock Dividends to its shareholder of 1,000
Class B preferred shares.
 A distribution of corporate
stock to an individual.
 The shares have a PUC of $20
 Actual dividend is the
and a FMV of $1 million
“paid up capital” amount of
the stock.
 Actual Dividend is $20. FMV
 Can have a set FMV or be a has no impact until shares are
common share with sold or redeemed.
floating value.
 Eligible or non-eligible
treatment applied to the $20
Royalties
 Defined as: Payments based on production or use

 Calculated using the accrual method – royalties earned but

not received during the year must be included in income.

Example: Jim purchases the right to a Post Malone song

which earns $30,000 in the year after the date of his
purchase. $5,000 of that amount was not received until the
next year. How much must Jim include in income?
Royalties
 Defined as: Payments based on production or use

 Calculated using the accrual method – royalties earned but

not received during the year must be included in income.

Example: Jim purchases the right to a Musician’s song which

earns $30,000 in the year after the date of his purchase.
$5,000 of that amount was not received until the next year.
How much must Jim include in income?
Jim must include $30,000 in income; the amount earned.
Rental Property
 Calculated using the accrual method – can use cash
method if net income would be effectively the same. It is
rare for this method to be used.

 CCA can be claimed on rental properties.

 Remember that each rental property costing more than
$50,000 receives it’s own CCA “pool”.
 CCA cannot be used to create or increase a rental loss
that is property.
Rental Property - Example
Example:
Jerry has rental income of $40,000 in 2024. He calculates
that his rental expenses are $36,000. His opening UCC
balance on his rental building is $200,000 (4%). Calculate
the maximum CCA Jerry can take.
Rental Property - Example
Example:
Jerry has rental income of $40,000 in 2024. He calculates
that his rental expenses other than CCA are $36,000. His
opening UCC balance on his rental building is $200,000
(4%). Calculate the maximum CCA Jerry can take.

$200,000 Opening UCC x 4% = $8,000 maximum CCA claim.

However, net income is currently $4,000 before CCA ($40,000

income - $36,000 expenses). Cannot use CCA to create or increase
a loss.

Therefore, max CCA claimable is $4,000. Enough to bring income

to zero.
Rental Property - Example
Example:
Jerry has rental income of $40,000 in 2024. He calculates
that his rental expenses other than CCA are $36,000. His
opening UCC balance on his rental building is $50,000
(4%). Calculate the maximum CCA Jerry can take.
Rental Property - Example
Example:
Jerry has rental income of $40,000 in 2024. He calculates
that his rental expenses other than CCA are $36,000. His
opening UCC balance on his rental building is $50,000
(4%). Calculate the maximum CCA Jerry can take.
$50,000 Opening UCC x 4% = $2,000 maximum CCA claim.

Jerry’s net income is currently $4,000 before CCA ($40,000 income

- $36,000 expenses). Cannot use CCA to create or increase a loss.

Therefore, max CCA claimable is $2,000. Net income after CCA is

$2,000 ($4,000 before CCA less $2,000 CCA = $2,000). Not
negative, so no reason to adjust CCA claimed.
Rental Property
If in home:
 Rental Income Current expenses are pro-rata
 Less: based on space used.
 Utilities
 Repairs Always remember to separate
out the current and capital
 Maintenance expenses.
 Interest
 Insurance All expense deductible. This
 Property Taxes isn’t employment income,
which limits what can be
 CCA if not in your home deducted.
Mutual Funds  A “trust” where you pool
your money with many
other investors to buy a
pool of investments

 Income of the pool gets

flows out to you as:
 Dividends
 Capital Gains
 Interest,
 Foreign Income
Teco Rodrigues/For the Toronto Star
 Return of Capital (ROC)
Foreign Source Income
 Taxed as regular income regardless of type (US interest,
dividends, etc.)
 Taxes withheld by foreign authorities (like the IRS) is used
as a tax credit to reduce Canadian taxes paid.

 Example:
John received US dividends of $15,000. $1,000 in US taxes was
withheld from the dividends so he received $14,000 in cash.

John includes $15,000 in his taxable income. His total taxes

owing will be reduced by $1,000.