Budget 2010–Online Notices

The Budget Plan noted that various federal statutes, including the Income Tax Act, the Excise Tax Act, and others, will be amended to allow for the electronic issuance of notices by the Canada Revenue Agency (CRA), which are currently provided to taxpayers by ordinary mail. Once implemented, these measures will allow the CRA to issue certain notices electronically, through existing secure online accounts (ie, My Account or My Business Account), where a taxpayer has specifically authorized electronic receipt. This electronic delivery service will be made available for notices of assessment and reassessment of Part I income tax, as well as notices of determination and re-determination in respect of the GST/HST credit and the Canada Child Tax Benefit. In addition, legislative authority will also be provided for the CRA to issue electronic notices for GST/HST, excise tax and duty, and the Air Travellers Security Charge. Notices under any of these regimes which are specifically required to be personally served, or to be served by registered or certified mail, will not be eligible for electronic transmittal. The electronic distribution of specified notices will commence at a time to be announced by the Minister of National Revenue.

Budget 2010–Capital Cost Allowance – Clean Energy Generation

The Budget also proposed some changes to assets in Classes 43.1 and 43.2. Class 43.2 provides CCA at a 50% declining balance rate for certain types of clean energy generation and conservation equipment. The Budget proposes to expand Class 43.2 for certain types of heat recovery equipment and distribution equipment of a district energy system acquired after March 4, 2010 that have not previously been used or acquired for use. Class 43.2 currently restricts heat recovery assets to those where the heat that is recovered is reused in the same type of process that generated it. This restriction is being removed. Classes 43.1 and 43.2 are also being expanded to include specified distribution equipment that is part of a district energy system used to provide district heating or cooling through the use of thermal energy provided primarily by a ground source heat pump system, an active solar system, heat recovery equipment, or a combination, as long as the generation equipment is included in Class 43.1 or 43.2.

Budget 2010–Capital Cost Allowance – Television Set-Top Boxes

The Budget proposed to increase the CCA rate for television set-top boxes that are used to decode digital television signals. Currently, satellite set-top boxes are Class 8 assets with a 20% CCA rate. Cable set-top boxes are Class 10 assets with a 30% CCA rate. Both satellite and cable set-top boxes that are acquired after March 4, 2010 and that have not previously been used or acquired for use will be eligible for a 40% CCA rate.

Budget 2010–Refunds of Non-Resident Withholding Tax

The Budget proposes a measure designed to assist non-residents to recoup taxes that have been withheld and remitted on their behalf to the Canada Revenue Agency (CRA). Where a person (“the Payor”) makes a payment to a non-resident in respect of services rendered in Canada or purchases “taxable Canadian property” (TCP) from a non-resident, the Payor is generally required to withhold and remit a portion of the payment to the CRA. The remitted amount is on account of the non-resident's potential Canadian tax liability in respect of the services performed or the TCP sold. In many instances, the non-resident may be exempt from Canadian taxation pursuant to an income tax treaty with Canada. In such cases, the non-resident can generally seek a refund of the amount withheld and remitted by filing an income tax return for the relevant year, within the prescribed time periods. The Minister's ability to make assessments against the Payor for failure to withhold and remit does not include a limitation period for the CRA to reassess for such failures. However, as mentioned above, the non-resident is constrained in the amount of time that a refund of overpayments can be requested, which may lead to difficulties where the CRA has assessed a Payor after the time period for requesting a refund has expired. The Budget proposes to remedy this situation by permitting a refund of an overpayment of tax under certain circumstances. To claim a refund, the non-resident must file a tax return no more than two years after the date of that assessment. This measure is effective for applications for refunds claimed in returns filed after March 4, 2010.

Budget 2010–U.S. Social Security Benefits

Currently, a Canadian resident receiving benefits under U.S. Social Security (including tier 1 railroad retirement benefits, but not including unemployment insurance) is entitled to deduct 15 percent of the amount of the benefit for purposes of calculating Canadian income tax. Prior to changes to the Canada-U.S. Treaty made effective in 1996, the deduction rate was 50 percent. The Budget essentially restores the 50 percent deduction rate on the total of all U.S. Social Security benefits received by a Canadian taxpayer, by allowing an additional 35 percent deduction for taxation years ending after 2009. A taxpayer will qualify for the additional 35 percent deduction if: (a) the taxpayer has been resident in Canada and has continuously, since before 1996, received U.S. Social Security benefits in each taxation year; or (b) the benefits are payable to the taxpayer in respect of a deceased spouse or common-law partner who qualifies under (a), and the taxpayer was resident in Canada and received such benefits in each taxation year from the time of death to the current taxation year.

Budget 2010–Employee Stock Options

Stock Option “Cash-Outs”

Generally, when stock options are issued by an employer to an arm's length employee, the taxation of the benefit derived by the employee from the options is subject to tax pursuant to various rules set out in the Income Tax Act (the “Stock Option Rules”). The Stock Option Rules are almost always a benefit to an employee participating in a stock option arrangement, since the effective rate of tax on the stock option benefit will be equivalent to capital gain rates. At the same time, the Act denies any deduction to the employer with respect to the stock option benefit provided to the employee. A CRA administrative position, however, has often been relied upon to create a “win-win “ scenario with respect to employee benefits derived by way of stock option arrangements in certain cases. The Budget proposes new rules to reverse this effect of this administrative position in circumstances where cash is received by the employee for the disposition of the employee's rights. This change applies with respect to a stock option issued after 4:00 p.m. on March 4, 2010.

Tax Deferral Election and Remittance Requirement

The February 27, 2000 Budget recognized that requiring immediate taxation of the benefit arising from certain options might create undesirable results in some cases. Upon exercise of the options, in many instances, employees would be forced to sell the underlying shares to pay the tax. Accordingly, a new set of rules was introduced to allow the deferral of the benefit, up to a set limit. Based on the statements made in the Budget, it appears that many taxpayers who took advantage of the deferral have suffered from a subsequent decline in value of the stock obtained by exercising the option. The problem that arises in this instance is that the loss in value of the stock is treated generally as a capital loss, which cannot be applied to offset the benefit. In many cases, it also appears that the value of the stock at the time of sale was not sufficient to satisfy the tax owing, and tax was not being paid in many situations. The Budget contains measures to deal with this problem, by eliminating the ability to defer the benefit for non-CCPC options, effective for employee stock options exercised after 4pm EST on March 4, 2010.

The Budget also clarifies the withholding obligations imposed on employers when stock options have been exercised and shares have been acquired.

Special Relief for Tax Deferral Elections

To address the problem of declining stock value after the exercise of options, the Budget provides a new way of looking at the net economic gain or loss of the employee. This new relief is only to be available with respect to securities sold before 2015 which were the subject of a deferral election. Where a taxpayer makes and files an election in prescribed form (the “Special Election“), special relief will ensure that the tax liability payable will not exceed the proceeds of disposition for the particular shares. The capital gain deemed to have been realized as a result of the Special Election will be disregarded for the purposes of various provisions of the Act relevant when claiming certain personal tax credits, computing the tax on Old Age Security Benefits, and computing the Working Income Tax Benefit.

Budget 2010–Charitable Expenditures

In order for a charity to retain its registered status, it must expend a specified amount of its funds on charitable activities or on gifts to qualified donees each year. The specified amount is the charity's disbursement quota, the rules of which were intended to discourage the accumulation of funds in excess of those needed by a charity to meet its charitable objectives. Generally, a charity's disbursement quota was equal to the sum of 80 percent of receipted donations for the previous year and 3.5 percent of all assets not used in charitable programs or administration in excess of $25,000. Charities are also subject to some restrictions on their ability to accumulate capital and some anti-avoidance rules in respect of delayed expenditures on charitable activities and gifts between non-arm's length charities. The Budget proposes to repeal the charitable expenditure rule, modify the capital accumulation rule, and expand the grounds on which the Minister may impose penalties on, or revoke the registration of, a charity.

Budget 2010–Scholarship Exemption and Education Tax Credit

The Budget provides that, where the scholarship exemption applies to a student in a part-time program, the exemption will apply only to an award to the extent it covers tuition fees and costs incurred for program-related materials. The budget papers indicate that this limit will not apply to students entitled to the disability tax credit or students who cannot enroll full-time owing to a mental or physical impairment.

Currently, scholarships, bursaries, and fellowships (“awards”) are excluded from income if received by students in respect of programs at post-secondary institutions, or in respect of programs at other institutions that are certified by the Minister of Human Resources and Skills Development as being institutions that furnish a person with skills for, or improve a person's skills in, an occupation. The Budget proposes that a post-secondary program that consists principally of research will not be a “qualifying education program”, and therefore not eligible for the scholarship exemption or the education tax credit, unless the program leads to a diploma from college or CEGEP, or a bachelor, masters or doctoral degree (or an equivalent degree). According to the budget papers, this means that post-doctoral fellowships will not be subject to the exemption and therefore will be taxable.

These proposals apply for the 2010 and subsequent taxation years.

Budget 2010–Provincial Payments into RESPs and RDSPs

The federal and provincial governments provide financial assistance to Canadian families who wish to save for their children's education through Registered Education Savings Plans (“RESPs”) or who wish to save for the long-term financial security of their severely disabled children through Registered Disability Savings Plans (“RDSPs”). The federal government also provides certain grant and bonds, such as the Canada Education Savings Grant and the Canada Learning Bond in relation to RESPs, and the Canada Disability Savings Grant and Canada Disability Savings Bond with respect to RDSPs. Currently, only provincial payments made into RESPs and RDSPs through provincial programs that are administered by the federal government receive the same treatment as federal grants and bonds paid into RESPS and RDSPs; accordingly, such provincial payments do not exhaust a beneficiary's RESP or RDSP contribution room and they do not attract or reduce federal grants and bonds. The Budget clarifies that all payments made into an RESP or into an RDSP through a program administered by a province or under a program funded, directly or indirectly, by a province but administered by a third party will be treated in the same manner as federal grants and bonds paid into RESPs and RDSPs. The changes relating to provincial programs administered by a province will apply for the 2007 and subsequent taxation years. Those changes relating to programs that are funded directly or indirectly by a province, but which are administered by a third party, will apply for the 2009 and subsequent taxation years.

Budget 2010–Rollover of RRSP Proceeds to an RDSP

Currently, a deceased individual's Registered Retirement Savings Plan (RRSP) or Registered Retirement Income Fund (RRIF) proceeds may be rolled over to the RRSP or RRIF of a financially dependent infirm child or grandchild. The Budget proposes to extend this special tax treatment to allow a deceased individual's RRSP or RRIF proceeds to be rolled over to the Registered Disability Savings Plan (RDSP) of a financially dependent infirm child or grandchild. This change applies with respect to deaths that occur after March 3, 2010, to contributions made to an RDSP of an individual, provided that certain conditions set out in the Budget are met. Transitional rules also apply.

Budget 2010–Medical Expense Tax Credit - Purely Cosmetic Procedures

The Budget proposes to exclude from the list of expenses eligible for the Medical Expense Tax Credit, expenses incurred after March 4, 2010 for purely cosmetic purposes, including related services and other expenses (such as travel). This includes surgical and non-surgical procedures aimed solely at enhancing one’s appearance such as liposuction, hair replacement procedures, botulinum toxin injections, and teeth whitening. Cosmetic procedures (including those noted above) will continue to qualify for this credit if they are required for medical or reconstructive purposes. Such situations include surgery with respect to a deformity relating to a congenital abnormality, a personal injury stemming from an accident or trauma, or from a disfiguring disease.

The Budget also proposes to clarify that purely cosmetic procedures are subject to GST/HST.

Budget 2010–Universal Child Care Benefit for Single Parents

The Universal Child Care Benefit (UCCB) provides families with $100 a month for each child under the age of six. In the case of a single-parent family, UCCB amounts are generally included in the single parent’s income. The Budget announced that, for 2010 and subsequent taxation years, a single parent will have the option to include the total UCCB amount received (with respect to all of his or her children) in his or her income, or in the income for the dependant for whom an Eligible Dependant Credit is claimed. This measure is intended to remedy situations in which a single-parent family pays more tax on the same UCCB than a two-parent family with the same income, where the UCCB is included in the income of the lower-income spouse or common-law partner. Single parents unable to claim this credit will have the option of including the total UCCB amount in the income of one of the children for whom the UCCB is paid.

Budget 2010–Benefits Entitlement - Shared Custody

Currently, child benefits paid under the Goods and Services Tax/Harmonized Sales Tax Credit (GST/HST credit), the Canada Child Tax Benefit, and the Universal Child Care Benefit, may not be claimed by more than one eligible individual. To improve the allocation of child benefits between parents sharing custody of a child, the 2010 Budget announced that, for benefits payable beginning July 2011, two eligible individuals will be entitled to receive the GST/HST credit and the Canada Child Tax Benefit and Universal Child Care Benefit amounts, with respect to a child. The recipients must be eligible to receive amounts under the Canada Revenue Agency's existing shared eligibility policy, which applies where a child lives more or less equally with two individuals who live separately. Corresponding amendments will be made to the Universal Child Care Benefit Act.

Transition planning for entrepreneurs and family businesses.

Transitioning family wealth from one generation to the next is a process of education, planning and communication. Please contact us if you would like to receive this quarterly newsletter via e-mail or you would like some assistance in this area of practice.

Changing Lanes Spring 2011 When Business Owners Put the Cart Before the Horse	Changing Lanes Winter 2011 Managing the Seven Dwarfs
Changing Lanes Fall 2010 Please Pass the Potatoes	Changing Lanes Summer 2010 The Day Before Thanksgivin
Changing Lanes Spring 2010 Consider Both Sides of the Coin	Changing Lanes Winter 2010 Beware the Golden Handcuff
Changing Lanes Fall 2009 Know Where You Are Going	Changing Lanes Summer 2009 Keep your vehicle roadworthy
Changing Lanes Spring 2009 Find out what how to avoid collisions on the Family Business Highway.	Changing Lanes Winter 2009 Find out what to do when your family and business overlap! Also, identify the core strengths to take your business into the next generation
Changing Lanes Fall 2008 How do you go beyond dreams and move into the action stages? This issue explains how we build the confidence to move forward in our transition planning.	Changing Lanes Summer 2008 Building the Foundation - This issue we delve further into The Seven Complexities of business families, to address the challenges to ensuring the continuity of your business when you are no longer at the helm
Changing Lanes Spring 2008 A Vision or a Dream? This issue we continue the examination of The Seven Complexities with a look at how to address the challenges arising from Complexity #4 -- No clear vision or direction, only dreams.	Changing Lanes Winter 2008 Managing Change is the Key to Success! - This issue focuses on the steps around managing conflict, developing prevention strategies and developing an issue resolution process
Changing Lanes Fall 2007 Why Formalize the Business? This issues focus is the seven complexities of working in family business and how to recogize them.	Changing Lanes Summer 2007 Not Interested in Retiring? This issue focuses on the importance of transitioning values and social capital from generation to generation.
Changing Lanes Spring 2007 How do you go beyond dreams and move into the action stages? This issue explains how we build the confidence to move forward in our transition planning.	Changing Lanes Winter 2007 Ensure you have a Choice! Prepare for the internal sale of your business and build your integrated transition plan.
Changing Lanes Summer 2006 My Dad can't let go! Does this sound familiar? This issue explores how to effectively transition the authority in the business.

 

Two quarterly newsletters have been added—one about personal issues, and one about corporate issues.

Two quarterly newsletters have been added—one about personal issues, and one about corporate issues. They can be accessed below.

Corporate:

Issue #19 Corporate

Personal:

Issue #19 Personal

A number of circumstances and developments have come together over the past few years to make working from a home office—once almost unheard of—a common fact of business life. First and foremost, of course, is the technology (particularly communications technology) which enables the home-based worker to have access to all of the information and services available to his or her in-office counterpart. Given the right technology, it’s nearly as easy for an employee working from home to send and receive e-mails through the employer’s communications network and access the people, information, and services needed to do his or her job in the same way as it would be if he or she was at the office.

A number of circumstances and developments have come together over the past few years to make working from a home office—once almost unheard of—a common fact of business life. First and foremost, of course, is the technology (particularly communications technology) which enables the home-based worker to have access to all of the information and services available to his or her in-office counterpart. Given the right technology, it’s nearly as easy for an employee working from home to send and receive e-mails through the employer’s communications network and access the people, information, and services needed to do his or her job in the same way as it would be if he or she was at the office.

While technology has made it possible to work from home on a regular basis, other developments have made the daily commute to the office, and the maintenance of large offices in major urban centres less and less appealing. The ever increasing price of gasoline has made the cost of that daily commute prohibitively expensive in some cases. As well, there is an increased awareness of the environmental cost of having most major highways clogged each morning and evening with hundreds of thousands of cars sitting in traffic gridlock. And finally, the cost of renting office space in most major Canadian cities means that most employers are at least willing to consider the cost savings which might be realized from work-at-home or telecommuting arrangements for their employees.

Along with the greater availability of work-at-home arrangements for employees, there has been a significant increase in the number of self-employed Canadians. And while not all of the self-employed work from home, it’s fairly common for those venturing into the world of self-employment for the first time to save costs by operating their business, at least initially, out of a home office.

One of the things which makes a telecommuting or work-at-home arrangement attractive, aside from avoiding the daily commute, is the tax deductions which can be claimed. While those benefits, especially for employees, are not necessarily as generous as is popularly believed, it is the case that working from home can make costs which would be incurred in any event deductible for tax purposes.

As is usually the case in tax matters, the rules differ for employed taxpayers and for the self-employed, as the latter enjoy a greater degree of latitude in the deductions which may be claimed. That said, both the employed and the self-employed must meet the same basic two-part test in order to be eligible to deduct home office expenses, and that test is as follows:

• the home office must be the place at which the taxpayer principally (defined by the Canada Revenue Agency as more than 50% of the time) performs the duties of employment or must be the taxpayer’s principal place of business: or

• the home office must be both used exclusively for the purpose of earning income from employment or from the business and must be used on a regular and continuing basis for meeting customers or clients of the employer or the business.

A self-employed taxpayer who meets these criteria is entitled to claim (on Form T2124(E) (Statement of Business Activities)) expenses such as property taxes, rent, or mortgage interest (but not mortgage principal amounts), insurance, utilities costs etc. However, such expenses are not deductible in their entirety: rather, the taxpayer must apportion the expenses based on the percentage of the total space which is used as a home office. For example, a self-employed taxpayer whose home office takes up 15% of available floor space and who incurs $2000 each year in qualifying expenses would be entitled to deduct $300 ($2,000 times 15%) in home office expenses for that year. There is one further caveat, in that the amount of home office expenses claimed in a year cannot be greater than the amount of income from the business. It’s not, in other words, possible to run a business which produces $5,000 in income for the year and to then claim $10,000 in home office expenses relating to that business. However, where home office expenses exceed business income in any given year, the excess expenses can be carried over and claimed in a subsequent year in which there is sufficient business income to offset those expenses.

Employed taxpayers who meet the two-part test set out above must meet a further condition before being eligible to claim home office expenses, as follows:

• the employer must provide the employee with a Form T2200, which indicates that the employee is required by his or her contract of employment to provide and pay for the expenses related to the home office;
• the employee must not have been reimbursed by the employer for such expenses; and
• the expenses must have been used directly in the employee’s work at home.

Once the T2200 has been issued, and the other conditions are met, an employee who is a tenant can claim a proportionate part of his or her rent. An employee who owns his or her own home can claim a proportionate percentage of utilities and maintenance costs. An employee is not, however, entitled to claim any portion of mortgage interest, property taxes, or home insurance costs paid, and cannot claim capital cost allowance.

As is the case with self-employed taxpayers, an employee’s deduction for home office expenses cannot be greater than the income from employment income for the year to which the expenses relate. And, once again, carryover to a subsequent taxation year is allowed.

One of the tax benefits which is commonly supposed to exist for the home office workers is the right to claim depreciation (or capital cost allowance (CCA), in tax parlance) on one’s home for tax purposes. For employees, however, such a claim is simply not allowed. And, while the self-employed may be entitled to claim CCA on a home, making such a claim can create a short-term benefit with long-term costs. Making a CCA claim on one’s home is likely to erode the principal residence exemption from capital gains tax which is claimable when a home is sold, and that exemption is almost always more valuable, in monetary and tax terms, than any CCA claim which might have been made.

Being able to claim home office expenses doesn’t result in the huge tax benefits that some popular tax myths claim. However, it can and does permit qualifying taxpayers to claim a portion of home ownership (or rental) expenses which would have been incurred in any case while also avoiding the dreaded daily commute, making it a win-win scenario.

As if dealing with bills from the recent holiday season and trying to come up with the funds for an RRSP contribution weren’t enough, February is also the month in which millions of Canadian taxpayers receive an Instalment Reminder from the Canada Revenue Agency (CRA). For many of those taxpayers, who have received many such notices in the past, the reminder and the tax instalment process are familiar, although not necessarily welcome. For those who are receiving one for the first time, however, both the reminder itself and figuring out how to deal with it can be baffling.

As if dealing with bills from the recent holiday season and trying to come up with the funds for an RRSP contribution weren’t enough, February is also the month in which millions of Canadian taxpayers receive an Instalment Reminder from the Canada Revenue Agency (CRA). For many of those taxpayers, who have received many such notices in the past, the reminder and the tax instalment process are familiar, although not necessarily welcome. For those who are receiving one for the first time, however, both the reminder itself and figuring out how to deal with it can be baffling.

Most Canadians, certainly those who are employed, have income tax deducted “at source”, meaning that their employer deducts an amount for income tax from their paycheques and remits it to the CRA on their behalf. However, for those who are self-employed or, frequently, those who are retired, no such deduction is automatically made from their income, and the issuance of an Instalment Reminder by the CRA may be the result.

The receipt of such a Reminder may be particularly puzzling to the newly retired, who have been accustomed to having tax deducted at source from their paycheques throughout their entire working life. However, no matter what the source of one’s income or the reason that tax has not been deducted at source, the options available to a taxpayer who receives such a reminder are the same.

Canadian federal tax rules provide that a taxpayer may be required to pay income tax by instalments where the amount of tax owing on filing is more than $3,000 in the current year (2012) and either of the two previous years (2010 or 2011). Essentially, the requirement to pay by instalments will be triggered where the amount of tax withheld from the taxpayer’s income is at least $3,000 less than their total tax liability for the current and either of the two previous years. Such instalment payments of tax are due on March 15, June 15, September 15, and December 15 of each year.

An Instalment Reminder issued by the CRA in February 2012 will specify two amounts, one to be paid by March 15 and the other due by June 15. Those amounts represent the CRA’s best estimate, based on the taxpayer’s return filed for the 2010 taxation year, of the net tax will which be payable by the taxpayer for 2012. The taxpayer then has the following three options.

First, the taxpayer can pay the amounts specified on the Reminder, by the respective due dates of March 15 and June 15. A taxpayer who does so can be certain that he or she will not face any interest or penalty charges, even if the amount paid turns out to be less than the taxes actually payable for the 2012 tax year. (If the instalments paid turn out to be more than the taxpayer’s net tax liability for 2012, he or she will of course receive a refund on filing.)

Second, the taxpayer can make instalment payments based on the amount of tax which was owed for the 2011 tax year. Where a taxpayer’s income has not changed between 2011 and 2012 and his or her available deductions and credits remain the same, the likelihood is that total tax liability for 2012 will be slightly less than it was in 2011, owing to the indexation of tax brackets and personal tax credit amounts.

Third, the taxpayer can estimate the amount of tax which he or she will owe for 2012 and can pay instalments based on that estimate. Where a taxpayer’s income will decrease from 2011 to 2012 and there will consequently be a reduction in tax payable, this option may be worth considering.

A taxpayer who elects to follow the second or third options outlined above will not face any interest or penalty charges where there is no tax payable when the return for the 2012 tax year is filed in the spring of 2013. However, should instalments paid be late or insufficient, the CRA can impose interest charges, at rates which are higher than current commercial rates. (The rate charged for the first quarter of 2012—until March 31, 2012—is 5%.) As well, where interest charges are levied, such interest is compounded daily, meaning that on each successive day, interest is levied on the previous day’s interest. It’s also possible for the CRA to impose penalties, but this is done only where the amount of instalment interest charged for the year is more than $1,000.

Most Canadian taxpayers are understandably disinclined to pay their taxes any sooner than absolutely necessary. However, ignoring an Instalment Reminder is never in the taxpayer’s best interests. Those who don’t wish to have to involve themselves in the intricacies of tax calculations can simply pay the amounts specified in the reminder. The more technical-minded (or those who want to ensure that they are paying no more than absolutely required, and are willing to take the risk of having to pay interest on any shortfall) can avail themselves of the second or third options outlined above.

It’s that time of year again, when advertisements about the wisdom of contributing to your registered retirement savings plan (RRSP) fills the airwaves and Web sites. And, since the introduction of tax-free savings accounts (TFSAs) in 2009, February is now also the month in which Canadians wrestle with the question of whether to put any available funds into an RRSP before the contribution deadline of February 29, 2012, or whether to deposit those funds instead in a TFSA.

It’s that time of year again, when advertisements about the wisdom of contributing to your registered retirement savings plan (RRSP) fills the airwaves and Web sites. And, since the introduction of tax-free savings accounts (TFSAs) in 2009, February is now also the month in which Canadians wrestle with the question of whether to put any available funds into an RRSP before the contribution deadline of February 29, 2012, or whether to deposit those funds instead in a TFSA.

It’s important to be clear, at the outset, that it’s not an either/or choice. Taxpayers can (and probably should) utilize both the RRSP and TFSA options in planning their financial affairs. Realistically, however, for most taxpayers the limitation is one of resources and cash flow, and it’s often not possible to fund contributions to both an RRSP and a TFSA in the same year, let alone in the same month. That said, what are the considerations which apply in determining which savings/investment vehicle is preferable for 2012?

There are some similarities between TFSAs and RRSPs. Both allow savings to grow and compound free of current tax, and for both, contributions not made in a year can be carried forward and made in any subsequent year. As well, the types of investments which can be made with RRSP or TFSA contributions are, for all intents and purposes, the same, meaning that one’s choice of investment (i.e., guaranteed investment certificates (GICs), mutual funds, bonds, etc.) should be irrelevant to the choice of RRSP vs. TFSA. However, the differences between the two savings vehicles are at least as significant as their similarities.

Perhaps most important to taxpayers, contributions made to an RRSP are deductible from income, resulting in a lower tax bill for the year of contribution and, for many taxpayers, a tax refund. Contributions to a TFSA are, on the other hand, made with after-tax funds, meaning that tax will already have been paid on the income used to make that contribution. Many taxpayers, when presented with an option which will reduce current year taxes, find that the most attractive choice. However, over the long-term, the tax consequences of choosing an RRSP over a TFSA can erode that benefit. When funds contributed (along with investment income earned on those funds) are withdrawn from a TFSA or an RRSP, the tax consequences are very different. Funds withdrawn from an RRSP (or a registered retirement income fund (RRIF) into which the RRSP has been converted) are fully taxable, without exception, at whatever tax rate applies to the taxpayer at the time of withdrawal. TFSA funds (including accumulated investment income) are withdrawn from the plan free of tax, regardless of when the withdrawal is made or the purpose to which the funds are put. And for taxpayers who are receiving Old Age Security benefits (or any other means-tested benefits) from the federal government, it is important to note that RRSP or RRIF funds withdrawn will be included in income for the purpose of determining eligibility for such benefits, while TFSA funds will not. Finally, while RRSP contributions for 2011 must be made by February 29, 2012, there is no similar deadline for TFSA contributions—they can be made at any time during the calendar year. Finally, when funds are withdrawn from a TFSA, the plan holder can “top up” the TFSA in any subsequent year by the amount of that withdrawal. Funds withdrawn from an RRSP cannot be re-contributed, unless the withdrawal was made as part of government-sanctioned withdrawal plans, like the Home Buyers’ Plan or the Lifelong Learning Plan.

The minority of working taxpayers who are members of registered pension plans will likely find the TFSA option particularly attractive. The maximum amount which can be contributed to an RRSP for the 2011 tax year is calculated as 18% of earned income for 2010, to a maximum contribution of $22,450. However, that maximum contribution is reduced, for members of RPPs, by the amount of benefits accrued during the year under the pension plan. Where the RPP is a particularly generous one, RRSP contribution room may be minimal, and a TFSA contribution the logical alternative.

In a similar way, for taxpayers over the age of 71, the RRSP v. TFSA question is simply irrelevant. Taxpayers over that age are not eligible to make contributions to an RRSP, making TFSAs the only tax-free savings vehicle to which they can make contributions. The benefit is greatest for older taxpayers whose required RRIF withdrawals are greater than their current needs. While such RRIF withdrawals must be included in income and taxed in the year of withdrawal, transferring the funds to a TFSA will allow them to continue compounding free of tax and no additional tax will be payable when and if the funds are withdrawn. And, unlike RRIF or RRSP withdrawals, monies withdrawn from a TFSA will not affect the planholder’s eligibility for Old Age Security benefits or for the federal age credit.

For younger taxpayers, where the savings goal is short-term (e.g., a down payment on a home or paying for next year’s vacation), the TFSA is clearly the better choice. While choosing to save through an RRSP will provide a deduction on that year’s return and probably a tax refund, tax will still have to be paid when the funds are withdrawn from the RRSP a year or two later. And, more significantly from a long-term point of view, using an RRSP in this way will eventually erode one’s ability to save for retirement, as RRSP contributions which are withdrawn from the plan cannot be replaced. While the amounts involved may seem small, the loss of compounding on even a small amount over 25 or 30 years can make a significant dent in one’s ability to save for retirement.

Taxpayers who are expecting their income to rise significantly within a few years (e.g., students in post-secondary or professional education or training programs) can save some tax by contributing to a TFSA while they are in school and their income (and therefore their tax rate) is low, and then withdrawing the funds tax-free once they’re working, when their tax rate will be higher. At that time, the withdrawn funds can be used to make an RRSP contribution, which will be deducted against income which would be taxed at the much higher rate, generating a tax savings. And, if a need for the funds should arise in the meantime, a tax-free TFSA withdrawal can always be made.

Financial planners and tax advisers are accustomed to being asked by clients at this time of year whether it makes more sense to pay down the mortgage (or other debt) or to contribute to an RRSP. That question has become more complicated now that the TFSA option has been added to the mix. There is, however, a solution which allows you to do both. Assuming a marginal tax rate of 45%, an RRSP contribution of $10,000 will generate a tax refund of $4,500. Contribute that $10,000 (or as much as you can) to your RRSP and, when the resulting tax refund lands in your bank account, move it to a TFSA or use it to pay down the mortgage or other debt, or split it between the two.

The Canada Revenue Agency has dedicated sections of its Web site to addressing the need of taxpayers for information about TFSAs and RRSPs, and those sections can be found at http://www.cra-arc.gc.ca/tx/tfsa-celi/menu-eng.html and http://www.cra-arc.gc.ca/tx/ndvdls/tpcs/rrsp-reer/menu-eng.html, respectively.

It’s almost impossible not to have heard that the amount of debt carried by Canadian households is at an all-time high—reaching, on average, just over 150% of household income. Carrying so much debt can be relatively painless when interest rates are at historic lows, but it’s clear that rates cannot and will not remain at such levels indefinitely.

It’s almost impossible not to have heard that the amount of debt carried by Canadian households is at an all-time high—reaching, on average, just over 150% of household income. Carrying so much debt can be relatively painless when interest rates are at historic lows, but it’s clear that rates cannot and will not remain at such levels indefinitely.

Whether it’s because of the warnings issued by financial professionals and government officials, or just the sight of ever-increasing balances on the monthly credit card or line of credit statements, it seems that Canadians are starting to recognize that their debt loads have to be reduced. And—right on cue—a number of debt reduction companies have begun advertising their services, promising to do just that.

Typically, debt reduction companies promise to work or negotiate with an individual’s creditors in order to have the amount of outstanding debt reduced—a service for which the debtor will of course pay a fee. The claims made by some such companies can seem like a lifeline to debt-burdened families. For those dealing with calls from irate creditors and struggling to make minimum monthly payments on outstanding debts, the prospect of having those debts reduced by up to 70% is very compelling. When a promise to restore a good credit rating by removing past credit mistakes from the debtor’s credit history is added to the sales pitch, it can seem almost too good to be true. And that, in fact, is the title of a recent consumer alert issued by the Financial Consumer Agency of Canada (FCAC): “Debt Reduction Companies: Beware of “Too Good to be True” Offers. That alert is available on the Agency’s Web site at http://www.fcac-acfc.gc.ca/eng/resources/consumerAlerts/alerts_posting-eng.asp?postingId=393.

The alert issued by the FCAC examines some of the claims made by many debt reduction companies, and compares these claims to the reality of the situation. The first unrealistic claim is often the one made about the percentage by which an individual’s debt can be reduced. The FCAC notes that no creditor is required to negotiate with or speak to a debt reduction company, even if the debtor has paid a fee to have such a company negotiate on its behalf. And, even if the creditor is willing to deal with the debt reduction company, it is in no way obliged to reduce debt by any amount. In other words, it’s perfectly possible for the debtor to pay a fee but get nothing for it.

Another claim sometimes made by debt reduction companies is that they will protect the debtor’s credit rating or even “clean up” that rating by having information on past defaults or late payments eliminated. The reality is that, unless the information contained in a person’s credit rating is demonstrably inaccurate, there is no way to have it removed from the credit report. Listings of past transactions, like late payments or defaults, do eventually disappear from a credit report, but that happens after a specific period of time has elapsed, not because the removal of such information is requested or demanded by a third party. The FCAC alert also reviews claims made that working with a debt reduction agency won’t have any negative effect on the individual’s credit rating or score. It warns that some such companies delay making payments to creditors for a few months in the hope of getting better results from negotiations to reduce the debt amount and that, where that happens, those late payments are likely to be reported to the credit reporting agencies, further damaging the individual’s credit rating. In some cases, debt reduction companies encourage debtors to stop all direct contact with creditors, or even to sign a power of attorney, giving the company authority to make agreements by which the debtor will be bound, even if he or she had no knowledge of them at the time.

Perhaps the most egregious claim made by debt reduction companies is the strong impression given that they are approved by the Canadian government or even that they are operating as part of a federal government program. Neither is true. Neither the federal nor the provincial or territorial governments operate debt reduction companies, and there are no government sponsored programs offering this type of debt reduction. While it is the case a debt reduction company will usually need to be registered and/or licensed by its provincial or territorial government in order to operate as a business, that is simply an administrative requirement which applies to all companies operating in a particular province or territory. Licensing or registration does not in any way mean that the provincial or federal government has approved of or endorsed the company or its way of doing business, and any claims to the contrary are simply false.

Sometimes, debtors avail themselves of the services of debt reduction companies because they are under the incorrect impression that there is no other choice open to them to deal with their debts. There are, in fact, several options. Where a debtor intends to and is able to discharge existing debts, he or she could obtain a debt consolidation loan from a financial institution. The rate of interest charged on such a loan will almost certainly be lower than that being levied on outstanding credit card or payday loan company debts, and the debtor will be able to make a single payment instead of juggling the demands of multiple creditors. Where it’s not possible to obtain such a loan, or the debtor doesn’t feel able to manage the debt repayment process alone, the best course of action is to obtain the services of a reputable credit counseling agency, which can set up a debt management program for the debtor. As part of that program, the agency will contact the individual’s creditors to arrange a manageable payment plan which might include a reduction in interest rates charged. Once a program is in place, the individual makes payments to the credit counseling agency which, in turn, forwards payments to the individual’s creditors as agreed. As well, credit counseling agencies work with clients to help with budgeting and financial management skills, with the goal of avoiding a recurrence of the individual’s financial problems. Reputable credit counseling agencies exist in both the private and the not-for-profit sectors, and information on the latter can be found on the Credit Counselling Canada Web site at http://www.creditcounsellingcanada.ca/Home.aspx.

In many ways, getting out of debt has a lot in common with that perennial New Year’s resolution of many Canadians—losing some weight and getting in shape. With both, it’s human nature to want to believe that there is an easy, painless way of accomplishing the goal without a need to change existing habits, and so it’s easy to fall for persuasive sales pitches that claim to have a quick fix for the problem. In both cases, however, the reality is the opposite—results can only be obtained through some effort, but where that effort is made and existing habits altered, successful long-term results are possible.