CGA TX1 Module 1

fileF|Courses2010-11CGATX106coursem01introhtm[11102010 43357 PM]

Module 1 Introduction and concept of incomeOverview

The purpose of this module is to help you understand the Canadian tax system its objectives and itsstructure This understanding is essential to comprehending the tax rules you will study in subsequent modulesand how these rules affect taxpayers Policy considerations underlie the design and evolution of the taxsystem the governing principles of taxation and the specific rules An appreciation of the intent of specificrules and of the general scheme of the tax system helps users interpret and apply the legislation in particularinstances

This module reviews the framework of the Income Tax Act (ITA) and the principles that govern itsinterpretation It shows you how to make effective use of the ITA as a reference tool Since the ITA is the maininstrument in the study and practice of income tax law this knowledge will be beneficial throughout this courseand in practice afterwards

To complete this introduction to Canadian income tax law you will learn about administrative issues and ethicalissues related to tax work You will study the underlying principles of tax planning and certain tax planningtechniques You will learn that a tax plan is important in making business decisions and that it should bestructured to take into account the specific situation and goals of the taxpayer for which the plan is designed

Since taxpayers are eager to reduce their tax bill and sometimes may go too far you will study the differencebetween acceptable tax planning and abusive tax avoidance or tax evasion It must be remembered that anoverriding consideration for a CGA as a professional is the duty to act ethically with respect to clients theprofession and society as a whole

Following this important introductory material you will learn the basic steps for computing income undersection 3 of the ITA and Part I tax payable A computer illustration will show the relationship between theframework for the computation of income tax payable in the ITA and the T1 tax return that individuals mustfile each year

The study of specific provisions of the ITA will begin with the basic principles of the liability for tax Thematerial examines who is taxable in Canada under Part I followed by an analysis of the concept of income forthe purpose of Part I tax

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge thedepth of study required

Module 1

11 Income tax History objectives and legislative process12 Professional ethics13 Tax evasion avoidance and planning14 Administration and enforcement15 Structure and interpretation of the Income Tax Act16 Learning to use the ITA17 Steps in computing income tax18 Computer illustration 18-1 Completing a simple income tax and benefit return19 Liability for Part I tax110 Computation of income111 Steps in computing income

Course Schedule Course Modules Review and Practice Exam Preparation Resources

Learning objectives

11 Outline the role of income tax in Canadian finances and the tax policy principles underlying the Canadian taxsystem and explain the legislative process to amend the ITA (Levels 1 and 2)

12 Identify situations where ethical problems may occur and analyze ethical problems related to tax planningpreparation and advising (Level 1)

13 Distinguish between tax evasion tax avoidance and tax planning giving a broad outline of the generalanti-avoidance rule (Level 1)

14 Describe the procedures for filing tax returns assessments the payment of taxes and appealingassessments and demonstrate a general knowledge of the powers conferred on the Canada Revenue Agency(CRA) for administering and enforcing the ITA including the civil penalties applicable to third parties (Levels1 and 2)

15 Describe the structure of the ITA and interpret its provisions (Level 1)

16 Explain how to use the ITA mdash CCH 90th Edition (Level 1)

17 Describe the steps in the computation of Part I tax (Level 1)

18 Complete an income tax return using Cantax and comment on the relationship between the ITA and the T1income tax and benefit return (Level 1)

19 Determine who must pay income tax in Canada and on what income and determine if a person is resident inCanada (Level 1)

110 Describe the source concept and compute income for tax purposes for a taxpayer liable for Part I tax (Level1)

111 Calculate income (net income) according to section 3 of the ITA (Level 1)

Assignment reminder

Assignment 1 (see Module 5) is due at the end of week 5 (see the Course Schedule tab) You may wish totake a look at it now in order to familiarize yourself with the requirements and to prepare for any necessarywork in advance

Module summary

Print this module

fileF|Courses2010-11CGATX106coursem01t01htm[11102010 43357 PM]

11 Income tax History objectives and legislative process

Learning objective

Outline the role of income tax in Canadian finances and the tax policy principles underlying theCanadian tax system and explain the legislative process to amend the ITA (Levels 1 and 2)

Required reading

Text Chapter 1 Overview 1010 to 1045 1151 to 1195 1410 (Level 2 except as noted)Text 1040 to 1045 (Level 1)

LEVEL 2

History

The most significant of the post-1971 changes were introduced in 1988 These changes were primarilyintended to make the system more equitable and fair and included these provisions

a broadening of the tax base by increasing the inclusion rate of capital gains to two-thirds for1988 and 1989 and three-quarters thereafter The 2000 Federal Budgets changed the incomeinclusion rate for capital gains to two-thirds for capital gains realized after February 27 2000 andbefore October 18 2000 For dispositions of capital property after October 17 2000 the inclusionrate was changed to one-halfthe reduction of tax rate brackets from ten to three 17 26 and 29 (the 2000 FederalBudgets changed the three levels to four 16 22 26 and 29 in 2007 the first bracketwas reduced to 15)the conversion of many deductions allowed in the computation of taxable income such aspersonal and dependant exemptions to non-refundable tax credits so that these tax credits havethe same dollar value to taxpayers regardless of their level of incomethe introduction of a general anti-avoidance rule to stop abusive tax planning that went beyondthe spirit of the ITA without constituting tax evasion

On March 1 1994 a consolidated version of the ITA was proclaimed into force The revisions affected mainlythe structure of the individual sections For example a subdivision broken down into paragraphs before theconsolidation may now be expressed as a formula This simplifies the interpretation and application of affectedprovisions

LEVEL 1

Tax policy

The Tax Policy Branch of the Department of Finance is responsible for the development and evaluation offederal taxation policies and legislation However the actual collection of taxes and interpretation of tax law(compliance) are the responsibility of the Canada Revenue Agency (CRA) CRA is accountable to Parliamentthrough the Minister of National Revenue The Minister of National Revenue is responsible for compliance withCanadas tax and trade legislation More detailed information regarding the CRArsquos responsibilities can be foundat wwwcra-arcgcca ldquoInformation about CRArdquo

The ITA is the instrument that sets out the rules by which the government levies income tax It reflects the taxpolicy of the government The design and the evolution of the Canadian income tax system and thus of theITA are influenced not only by the need to raise revenue but also by other social and economic objectivesHowever these objectives often conflict with one another and choices between them must often be made

Read sections 1040 and 1045 of the text for a discussion of these objectives along with a discussion on taxreform guidelines

Revenue

While the objective of raising revenue is quite clear the way in which such revenues will be raised is influencedby other objectives The tax base (what is taxed) and the tax rates (the variables that determine the amount ofrevenue raised) will change depending on the weight given to the different objectives at a given time Oursociety is in constant evolution and so are the values of society The tax system also changes over time toreflect these changes in values

LEVEL 2

Legislative process to amend the ITA

There are special procedures for adopting fiscal legislation Sections 1021 to 1025 of the text provide a goodsummary of this process

Effective date

Amendments to the ITA may come into effect prior to the date of adoption of the amending legislationhowever amendments generally take effect on the date of the Budget or on the date on which they wereannounced to the public by the Minister of Finance and not on the date on which the bill is adopted A changemay even be made retroactive to a date prior to the tabling of the Budget or motion Generally this is onlydone when the changes are beneficial to taxpayers Therefore you must pay careful attention to the dates onwhich different amendments take effect For example Bill C-72 following the 1998 Budget introduced ameasure that was applicable to 1994 and subsequent years

A time lag between the date on which a measure is to take effect and the date on which it is adopted cancause problems especially when planning a transaction between the two dates The position of the taxpayer isuncertain since there is always a possibility that the measure will not be adopted Normally it is wise to takethe new measure into account when planning a transaction during this interval in order to avoid adverse taxconsequences if and when the new measure is ultimately adopted When deciding if a particular measureshould be taken into account you will have to make a judgment as to whether the measure is likely to beadopted

The Finance Canada website (httpwwwfingccaaccessleg-ehtml) is a good resource to review the progressof legislation It posts legislation released in draft format for consultation current legislation and historicallegislation from prior sessions in Parliament

12 Professional ethics

Learning objective

Identify situations where ethical problems may occur and analyze ethical problems related to taxplanning preparation and advising (Level 1)

Required reading

ERH Unit C3 Code of ethical principles and rules of conduct (Level 1) (provided electronicallywith the course modules)

LEVEL 1

Focus on ethics

Tax preparation is the area in which accountants are most often asked to act unethically Questionabledeductions forged amounts under-reporting and illegitimate personal or business deductions are commonareas where clients try to bend or break tax rules

Another matter that raises ethical issues is the dating of documents and the timing of transactions The ITA ismodified regularly and it is often important for a transaction to occur before or after a certain date to obtain aspecific tax benefit Tax practitioners have an ethical duty to avoid misleading or fraudulent advice or actions inrelation to dating and timing that could affect the client or third parties including the CRA For examplebackdating documents must be avoided not only because it is illegal and may lead to the assessment ofpenalties but also because it is unethical

Hence it is important that you are fully aware of both your legal and ethical responsibilities when you provideadvice on tax matters or engage in tax preparation or planning

The CGA-Canada Code of Ethical Principles and Rules of Conduct (CEPROC) outlines broad values and principlesthat must be regarded as a minimum level of acceptable conduct It is important for you to review it regularlyso as to maintain an acceptable level of professional behaviour Even though professional codes of ethics arenot part of the law courts often refer to them in civil cases concerning the liability of professionals A CGAmust also adhere to the CEPROC to avoid disciplinary measures for professional misconduct

The legal responsibility of CGAs under the case law applicable to professionals is to exercise reasonable careand competence in what they do They are not expected to be infallible but they must not be negligentTherefore a CGA who fails to file a particular tax form on a timely basis could be held liable for the resultingdamage to the client that is interest and penalties for late filing since it is expected that a reasonablycompetent professional would have filed the form on time Also a CGA who gives tax advice is expected to beup-to-date on the tax laws and to take the appropriate measures to remain so

13 Tax evasion avoidance and planning

Learning objective

Distinguish between tax evasion tax avoidance and tax planning giving a broad outline of thegeneral anti-avoidance rule (Level 1)

Required reading

Text 1360 13500 to 13595 (Level 1)ERH Unit A5 Moral principles (Level 1)ERH Unit C1 The marks of a profession (Level 1)ITA 239(1) 245 (Level 1)

Note When a paragraph in the text pertains to the ITA the relevant ITA section is noted in the margin

Optional reading

IC 88-2 and Supplement 1

Note The IT IC and Technical News are located on the CRA website wwwcra-arcgcca Fromthe CRA website home page click Forms and publications then click either Publications listedby publication number or Document type to locate the desired document Alternatively youcan use the Search feature (located on the CRA website home page) which requires you toenter the publication number

LEVEL 1

It has always been recognized that taxpayers may organize their affairs in such a way as to pay as little tax aspossible However the transactions carried out by taxpayers must not constitute tax evasion or abusive taxavoidance As a tax advisor an accountant must apply a code of ethics and understand when the line must bedrawn To do so the accountant must recognize the conflict between the interest of the client and societysinterest

In the context of legitimate tax planning the legal and ethical duties of a CGA are mainly towards the clientwho relies on the advice given and who may suffer economic losses as a consequence of trusting bad advice

Since tax evasion is an unlawful activity for both legal and ethical reasons a CGA must not engage in adviseon or participate in tax evasion A CGA who participates in agrees to or participates in tax evasion is liableunder subsection 239(1) of the ITA to a minimum of 50 of the amount sought to be evaded and up to amaximum of 200 of that amount The CGA is also liable to imprisonment for a term not exceeding two years

Accountants have an obligation to refuse to participate in illegal or unethical actions on behalf of their clientsIf a client wants to take a position that is contrary to the law the CGA should resign from the engagement ifthe client cannot be convinced to change his position

A tax avoidance transaction is one that is undertaken solely or mainly to derive a tax benefit using theprovisions of the ITA A CGA can suggest a tax plan that uses the provisions of the ITA and will not fall intothe three-part GAAR test A CGA should not suggest a tax plan to clients that from any reasonableperspective could be considered abusive tax avoidance (that is where GAAR will apply) In addition to theethical violations the CGA could face third party civil penalties under section 1632 this is discussed in the nexttopic

When a CGA is not sure if the scheme constitutes abusive tax avoidance the client should be informed of thisuncertainty because a CGA has ethical responsibilities to his or her client that include the full disclosure of therisk involved in the transaction While not an agent of the CRA a CGA also has a moral obligation to societyindirectly through properly advising clients of the intent of legislation and the requirement to follow thatlegislation

A CGA is also required under the law to act in the best interest of the client mdash this is often referred to as thefiduciary duty This fiduciary duty is composed of several elements that may be summarized as follows

the duty to avoid and disclose conflicts of intereststhe duty to disclose any material informationthe duty to avoid personal gainthe duty to act with good faiththe duty to advise in the best interest of the client carefully honestly and in good faiththe duty to observe the clients instructionsthe duty to maintain confidentiality

A CGA who breaches this fiduciary duty is liable for the damage resulting from the breach

In a Supreme Court of Canada case Hodgkinson v Simms [1994] DTC 377 an accountant was held liable forthe losses incurred by a client that had invested in multiple unit residential building (MURB) tax shelters on theadvice of the accountant The accountant had failed to disclose that he was acting for the developers in thestructuring of each of the MURB projects The client had looked to the accountant as an independent advisorand may not have invested in the MURB had he known the true nature and extent of the accountantsrelationship with the developers

Consider another case1 in which an accountants advice reduced a clients tax liability by $15000 This advicewas given on the basis of the generally accepted interpretation of a specific provision of the ITA Shortlythereafter a Tax Court of Canada case dealing with this provision of the ITA rendered an entirely differentinterpretation of the provision which may render the accountants advice incorrect The CGA should advise theclient and inform him of the options available to him under the circumstances

Every case is judged based on a unique statement of facts While one Tax Court decision will seldom changetax interpretations dramatically those that do are usually publicized broadly Tax practitioners must staycurrent with the legislation and court cases to properly advise clients If the accountant recognizes favourableor unfavourable interpretations for clients with tax planning in progress there is an ethical responsibility toinform clients of the interpretations

If the client asks you to prepare the tax forms on the basis of the original position you should tell the clientthat on the basis of the Tax Court case the CRA is likely to disallow the clients tax claims unless the ruling isreversed by a higher court If the Supreme Court made the tax ruling you should tell the client that there is nopossibility of further appeals Hence the accountant should insist that the tax forms be filed in accordance withthe Supreme Court ruling

Ethical behaviour goes beyond what is legally acceptable However the legal boundaries of the fiduciary dutyare a good starting point when one has to determine how to act in a given situation Remember that theseduties must be considered along with the other duties a CGA has namely to society and the profession

Activity 13-1 - Ethics quiz

In this quiz you apply your knowledge of professional ethical standards

1 Floyd W Windal Ethics and the Accountant Text and Cases (Englewood Cliffs NJ Prentice Hall Inc1991) page 83 Case 3 18

14 Administration and enforcement

Learning objective

Describe the procedures for filing tax returns assessments the payment of taxes and appealingassessments and demonstrate a general knowledge of the powers conferred on the CanadaRevenue Agency (CRA) for administering and enforcing the ITA including the civil penaltiesapplicable to third parties (Levels 1 and 2)

Required reading

Text 14010 to 1401530 (Level 1)Text 1300 to 1350 14020 to 1403530 14050 to 14220 (Level 2)ITA 150(1) 150(11)(b) (Level 1)ITA 162(1) 163(1) 163(2) 1632 165(1) 165(3) (Level 2)IC 01-1 (Level 2)

Optional reading

ITA 152(1) 152(2) 152(31) 152(4) to (42) 152(5) 153(1) to (12) 157(1) 157(21) 158161 to 180 (except as noted above) 220 222 to 244REG 4300 5800IC 78-10R4

LEVEL 1

The role of the CRA is the enforcement and collection of taxes due by taxpayers The ITA sets out a systemwith respect to filing of tax returns assessments payment of taxes audits objections and appeals that allowthe collection of taxes in an efficient and fair manner The CRA is given broad powers to administer thissystem

You must not overlook the administrative aspects of the ITA if you wish to avoid unpleasant surprises such asthe assessment of interest or penalties and the loss of the right of appeal

LEVEL 2

Penalties and offences

Read the text readings from Chapter 14 for a complete discussion on filing deadlines penalties (including civilpenalties for misrepresentation by third parties) assessments and appeals With respect to penalties takespecial note of the late filing penalty This penalty can be reduced or eliminated with some planning as outlinedin the following example

Charles Henle is the president of Columbus Trading Inc and has no personal business income On April 28of the current year he realizes that he has not yet prepared his tax return for the prior year and will beunable to do so before the April 30 filing deadline Realistically Charles can file his income tax return by May21 He estimates that he has $15000 in unpaid taxes for the year in addition to the instalments that he haspaid In reality his unpaid taxes amount to $16100 What are Charles tax consequences

Tax consequences

1 If Charles does nothing before May 1Penalty under subsection 162(1) 5 times $16100 $805

2 If Charles pays $15000 to the CRA on or before April 30 Penalty under subsection

162(1)5 times ($16100 - $15000) $ 55

When reading Information Circular 01-1 Third Party Civil Penalties pay particular attention to the area onprinciples in the introduction and consider these in light of your earlier readings on tax policy Also noteparagraphs 61 to 64 where the CRA comments on the accounting bodys code of ethics and rules ofprofessional conduct These comments integrate tax accounting and ethical considerations

A tax practitioner must also consider ethical issues when preparing tax forms and opinions based onunreasonable facts or assumptions or when asked to prepare a tax opinion that is limited in scope and may bemisleading to third parties such as investors in tax shelters or the CRA

Appeals

If a taxpayer does not agree with an assessment or reassessment issued by the CRA he may object to theassessment under the terms and conditions set out in sections 165 to 180 (Sections 165 to 180 are optionalreadings (except for subsections 165(1) and 165(3)) and are not examinable)

Read text 1320 to 1340 regarding appeals The CRA has 90 days to reply to a Notice of Objection If a reply isnot received within that time taxpayers have the right to proceed directly to the Tax Court of Canada An appeal to the Supreme Court of Canada must be made within 60 days from the date of judgment of theFederal Court of Appeal

When taxpayers appeal to the Tax Court of Canada they have the burden of proof that the factual findings ofthe CRA are wrong When an appeal is to a higher level court the burden of proof depends on who hasappealed the lower courts decision which could be either the taxpayer or the CRA

15 Structure and interpretation of the Income Tax Act

Learning objective

Describe the structure of the ITA (CCH 90th Edition) and interpret its provisions (Level 1)

Required reading

Text 1110 to 1145 (Level 1)ITA Sectional List (Level 1)

LEVEL 1

The Income Tax Act and related documents

In addition to the ITA the federal tax law has its source in the Income Tax Application Rules 1971 (ITAR)which consist of transitional rules needed to pass from the pre-1972 Act to the Act implementing the 1971 taxreform At present only a few of these rules are still relevant A rule that is still significant concerns thevaluation of property held on December 31 1971 for the purpose of computing capital gains on thedisposition of such property

The different documents that are the source of Canadian taxation are located in the ITA Check the GeneralTable of Contents for the complete list or you can check the section reference at the bottom of each page(CCH mdash 90th Edition)

Structure of the ITA

Consult the Sectional List in the ITA Observe the titles of the different divisions and subdivisions in Part I Youwill notice that the ITA follows a plan the sections dealing with a particular subject are grouped together inthe same division or subdivision This fact is very useful as it can save you time For example if you are facedwith a question concerning income from employment you do not have to look through the entire ITA You canlimit your search to subdivision a of Division B entitled Income or loss from an office or employment whichcomprises sections 5 to 8 If you are looking for a given deduction in computing income from employmentyour search can be confined to section 8 Similarly if you are trying to determine how to compute tax payableaccording to Part I you will consult divisions E and E1 or sections 117 to 12755

Tax under Part I commonly referred to as Part I tax is the main subject of this course In later modules youwill examine taxes under Parts I3 III IV X1 and XIII Part XVII which contains the definitions of variousterms used in the ITA is especially important for interpretation Each of these parts is a separate taxingprovision applicable in differing situations In addition to the Sectional List you can use the index to search forspecific study topics

Regulations

The Regulations are also divided into Parts and each Part deals with a different subject New Parts are addedin chronological order therefore there is no logical order to the different Parts For a listing of the subjectsdealt with in the Regulations consult the table of contents of the ITA

Nomenclature

To understand the ITA you need to have a solid grasp of the nomenclature The nomenclature reflects thestructure of each section of the ITA just as the parts divisions and subdivisions reflect the structure of the

ITA as a whole

A section may include a number of subsections in turn each subsection may include a number of paragraphsand paragraphs may include subparagraphs [20(1)(l)(ii)] and subparagraphs may include clauses[20(1)(l)(ii)(D)] and clauses may contain subclauses [20(1)(l)(ii)(D)(II)] However a section may have nosubsections as is the case with section 30 There are exceptions for example refer to section 3 which doesnot have any subsections but is divided into paragraphs subparagraphs and clauses This is also the case withsection 60

Provisions listing definitions are structured so that the definitions are listed in alphabetical order This can beseen in section 54 and subsection 248(1)

Subsection 2(3) begins with the phrase Where a person who is not taxable under subsection (1)hellip Sinceno figure precedes the (1) the reference is to subsection (1) of the same section namely section 2 At theend of subsection 2(3) it is stated that taxable income is to be computed in accordance with Division D Thisstatement refers to Division D of Part I which is entitled Taxable Income Earned in Canada by Non-Residentsand comprises sections 115 and 116 according to the Sectional List

Look at paragraph 8(1)(f) Subparagraph (vi) makes reference to paragraph 18(1)(l) Here section 18 ismentioned since the paragraph in question is not in the section you are currently reading In contrastsubparagraph 8(1)(f)(v) makes reference to paragraph (j) This designates paragraph (j) of subsection 8(1)

Exhibit 15-1 outlines the terminology and the numbering used in the structure of the ITA and the individualsections

Exhibit 15-1 Terminology and numbering used in the ITA

Terminology Numbering Part I Upper case Roman numeralDivision A Upper case letterSubdivision a Lower case letterSection 1 NumberSubsection (1) Number with parenthesesParagraph (a) Lower case letter with parenthesesSubparagraph (i) Lower case Roman numeral with

parenthesesClause (A) Upper case letter with parenthesesSubclause (II) Upper case Roman numeral with

parenthesesSubsubclause 1 Number with full stop

Interpretation

Knowledge of the structure of the ITA and the nomenclature is not sufficient to interpret its differentprovisions The ITA is a legal document written in legal language that is not always readily understandableThe complex wording is essential to ensure that any benefits apply only to those individuals for whom they areintended and that the wording does not permit more than was intended

It was originally recognized that in constructing the ITA a literal interpretation must be adhered to unless thewords taken in their ordinary sense could lead to an absurdity or an inconsistency with some other provision ofthe ITA However the role of the ITA has evolved to become a means to attain selected policy objectives Forthis reason the Supreme Court of Canada confirmed in Stubart Investments Limited v The Queen [1984]DTC 6305 that in the construction of the taxation statutes the law is not confined to a literal interpretationThe rule today which was confirmed by the Supreme Court of Canada in CorporationNotre Dame-du-Bon-Secours v Communauteacute Urbaine de Queacutebec [1995] DTC 5017 is to read the words in a

substantive sense taking into account the context in order to find a construction that is workable and inharmony with the evident purpose of the ITA But as confirmed by another Supreme Court of Canadadecision Friesen v The Queen [1995] DTC 5551 object and purpose can only play a role in interpreting theITA when the plain meaning of the provision admits some doubt or ambiguity The concept of a literalinterpretation of the legislation versus its substantive spirit and intent continues to be an issue

In addition to this construction rule whenever a specific provision of the ITA conflicts with a general provisionthe specific provision prevails For example a general rule under the ITA allows the deduction of expensesincurred to earn business income Under section 67 expenses are only deductible if they are reasonable in thecircumstances However under section 671 only 50 of such expenses are deductible where the expensesrelate to the consumption of food or beverages or the enjoyment of entertainment Since section 671 is morespecific than the general rule it prevails when dealing with expenses mentioned in section 671

Interpretation rules contained in acts and regulations

Acts other than the ITA

The ITA is subject to the Interpretation Act RSC 1985 c I 21 Section 11 of this Act states that the text ofany federal Act including the ITA must be given a fair large and liberal interpretation to ensure theattainment of its objectives It is often under this interpretation rule that the courts try to determine thelegislative intention in order to interpret a fiscal measure

It is well established that words must be given their plain and ordinary meanings unless they are defined in thestatute The ITA contains many definitions that may be considered interpretation rules because they specify themeaning to give to certain words Section 248 contains a great number of definitions that apply to the entireITA Accordingly subsection 1 of section 248 begins with the words In this Act The definitions are listed inalphabetical order and sometimes may refer you to another section of the ITA

Definitions may be given elsewhere in the ITA in which case they generally have a more limited applicationFor example see the definitions in section 54 These definitions have limited application as stipulated at thebeginning of the section In this subdivision This phrase refers to subdivision c which deals with taxablecapital gains and allowable capital losses See also subsection 19(5) which states that the definitions applyIn this section that is in section 19

Interpretation guide

When you research a provision proceed in the following manner

1 Determine which words are defined in the ITA2 Give the other ordinary and technical words their ordinary dictionary or technical meaning within

the given context as the case may be3 Determine the meaning of the provision by reading it in light of steps 1 and 24 Consult government interpretations and case law to determine whether the CRA or the courts

have already given their interpretation on the subject

Activity 15-1 mdash Keywords in the ITA

In this activity you learn the particular meaning of keywords used in the ITA

16 Learning to use the ITA

Learning objective

Explain how to use the ITA mdash CCH 90th Edition (Level 1)

Required reading

ITA Sectional List Topical Index (Level 1)

LEVEL 1

The ITA consists of a number of documents and is organized in such a way that it is possible to locate sectionsrelevant to a given subject by referring to the Sectional List The sections of the ITA are structured accordingto a model that has a specific nomenclature or terminology

Throughout the ITA there are definitions of terms that help to interpret a given provision In addition thereare keywords that frequently recur in the ITA the use and meanings of which are essential to understandingthe ITA

In this topic you will explore features of the CCH edition that will help you make effective use of the ITA andparticularly help you find your way through the ITA You should have your ITA handy to locate each of theitems referred to in this topic

The ITA print or electronic version

Included in your course material are both an electronic version of the ITA and a print version The legislation ineach is the same The electronic version includes a help function to assist you in finding information and usingthe electronic version You are allowed to use the print version of the ITA when you write the TXI examinationConsult your regional CGA office or your student guide or handbook about what you can and cannot do toprepare your ITA for the exam While you will probably use the electronic version of the ITA for your coursereadings ensure you can find the same information in the printed copy because that is the only one you canuse in the exam For more information on using the electronic version of the ITA refer to FolioViews 43Quick Reference Card in the navigation pane

Quick indicators and locators

To help you find a specific section in the ITA a section number is shown at the bottom of each page On theleft-hand page the number refers to the first section dealt with on that page on the right-hand page it refersto the last section dealt with on that page

Centred at the top of each page of the ITA are indicators of where you are in the Act on the left-hand pagethe Part of the ITA and on the right-hand page mdash only if you are in Part I mdash the division of Part I In theRegulations the page heading on the left indicates that you are in the Regulations and the page heading onthe right tells you which Part of the Regulations you are in

Topical Index

At the back of the ITA is a comprehensive Topical Index indicating the relevant sections alphabeticallySometimes you will need to work through varying combinations of the subject to find what you are looking forAt the front of the ITA is the Sectional List The sectional list follows the sequence of income types taxableincome and tax payable and so on Your level of familiarity with the different concepts as the course

progresses will decide which is better for you to use

Text in boxes

You may disregard pending amendments to the ITA and Regulations that appear in a box immediatelyfollowing the affected provision since they are not examinable However in practice the boxed text is usefulfor practitioners and interested taxpayers as an aid to awareness of pending legislation

History and other information at the end of sections

After each section or subsection under the heading History you will find a history of the provision stating theamendments made to it since the Fifth Supplement version of the ITA was proclaimed into force onMarch 1 1994 and their effective dates This information is useful for determining whether the provision isapplicable to the case in question particularly when dealing with income tax returns or assessments for prioryears It is also helpful when studying past exams A check of the history section may let you know why acertain item was treated differently from one exam to the next An example would be subsection 82(1) Therules on the dividend gross-up changed dramatically in the 2006 tax year If you did not know the rules hadchanged comparing a 2005 exam to the 2006 exam may be confusing

Example

1 What information is given in the History of subsection 4(4) on limitations respecting inclusionsand deductions

2 Have there been many changes to subsection 146(5) amount of RRSP premiums (contributions)deductible

3 Sometimes there is other information following the History heading Look at the end ofsubsection 85(1) What information do you find

Solution

Activity 16-1 mdash Whatrsquos in the Income Tax Act

In this activity you learn about how information is organized in the ITA

fileF|Courses2010-11CGATX106coursem01t06solhtm[11102010 43401 PM]

Solution

1 This subsection was repealed in 1996 for taxation years that end after July 19 1995 TheHistory then states how subsection 4(4) read before its repeal It continues by giving a previousamendment

2 This subsection has been amended repeatedly The last time was in 1999

3 The following information is included after the history section related sections regulationsinterpretation bulletins information circulars advance tax rulings forms income tax technicalnews tax topics tax profile newsletter Canadian Tax Foundation Canadian Petroleum TaxJournal Tax Window files and cases

17 Steps in computing income tax

Learning objective

Describe the steps in the computation of Part I tax (Level 1)

LEVEL 1

You will now begin studying the rules pertaining to the taxation of income found in the ITA paying particularattention to Part I tax There are four steps to computing the income tax payable by an individual orcorporation under Part I These steps are identified in the ITA in Divisions A B C and E of Part I Consult theSectional List to identify these four steps then read the following descriptions They provide you with anoverview of how to compute the income tax payable by individuals and corporations

Step 1 Determining liability for Part I tax

This step consists of determining whether a person is liable for Part I tax The word person as defined insubsection 248(1) includes an individual trust or a corporation

The rules regarding liability for taxes are set out in Division A of Part I [see subsection 2(1)]

Step 2 Computation of income

Once it is established that a person is liable for Part I tax the second step is to compute that persons incomeas provided for in Division B of Part I The ITA does not define income However section 3 gives the generalrule for computing a persons income for tax purposes

The specific rules applicable to the different sources of income included in the calculation of income undersection 3 are numerous and sometimes complex

On tax forms the term net income is used to designate income as calculated under section 3 While theterm net income does not appear in the ITA it is commonly used in practice both by practitioners and by theCRA It appears on the T1 tax form and in the T1 software program that you are using in this course Netincome serves to distinguish income for tax purposes pursuant to section 3 from its various components asidentified by their source (that is employment income business income property income and income fromother sources)

Step 3 Computation of taxable income

Once you have determined a taxpayers income the next step is to compute taxable income which iscalculated by adding or deducting from income certain amounts provided for under Division C of Part I [seesubsection 2(2)]

Step 4 Computation of tax payable

Computing tax payable consists of applying the appropriate rate provided for by the ITA to taxable incomethen deducting certain tax credits and in some cases adding surtaxes

Division E of Part I specifies the steps for computing tax payable In the case of an individual it is sometimesnecessary to compute minimum tax Division E1 deals with this topic

18 Computer illustration 18-1 Completing a simple incometax and benefit return

Learning objective

Complete an income tax return using Cantax and comment on the relationship between the ITAand the T1 income tax and benefit return (Level 1)

LEVEL 1

This computer illustration demonstrates how to calculate a taxpayers income and deductions according to ITAprovisions to arrive at federal tax payable Although the T1 software program will also calculate provincial taxpayable you will ignore provincial tax in this course because of the wide range of possible variations requiredby different provinces

This illustration is designed to show you how a T1 income tax and benefit return for an individual follows thefour basic steps as outlined in Topic 17

Description

Paul Merlin was a resident of Canada during the entire year of 2009 On December 31 2009 he resided inBritish Columbia His social insurance number is 999-999-998 He is divorced and was born on January 81953 Paul filed an income tax return for the previous year He is a Canadian citizen and would like toauthorize the CRA to provide his personal information to Elections Canada As well Paul did not own more than$100000 in foreign property at any time in 2009 His address and telephone number are

100 First AvenueVancouver BCV6G 1K1Phone (604) 555-5555

In 2009 Paul was employed as a shipping clerk by ABC Ltd in Vancouver Following are the relevant tax datafor Paul for the taxation year 2009

Employment income $ 30000Registered Retirement Savings Plan contributions (financial institution Mega Bank) June 6 2009 (receipt 11245) 1500 December 22 2009 (receipt 11246) 5002007 Non-capital loss carryover 1000Income tax withheld none2009 RRSP deduction limit from 2008 Notice of Assessment 4500

To keep this illustration simple several details of a typical income tax return are omitted

Required

Use Cantax to compute Paul Merlinrsquos income tax payable for the 2009 taxation year Print the followingfour pages that form the body of the T1 tax return

T1-2T1-3T1-4

Solution

fileF|Courses2010-11CGATX106coursem01t08cihtm[11102010 43403 PM]

Computer illustration 18-1 Suggested solution

Start-up steps

1 Start Cantax as described in Use software in the course under the How To tab2 On the Cantax welcome screen click New Return Cantax displays a blank T1mdashINFORMATION

window for you to enter personal information about the taxpayer

Moving around Cantax

The left column of your screen displays an index of all the forms available in Cantax organized in folders

There are a few different ways to open forms within Cantax Two of these ways are provided here for yourreference Choose whatever method is easiest for you

1 On the left side of the window is an index of the ten sections of Cantax You can make the left-hand side of the screen as wide or narrow as you wish by dragging the vertical divider If youclick on the + sign in any of the sections the forms for that section will be displayed Double-clicking on the form name will open the form

2 Another way to open forms is to select Goto then Form from the menu options and then typethe form number Pressing F4 at any time will also open the Goto menu Type in the form nameor use the arrow key to select the form You can also use Goto then Line from the menu optionsto jump to a specific line number on the T1 return

On the screen directly underneath the toolbar you will notice the tabs for the different formsthat are open If you click any of these tabs the specific form will be brought to the frontwindow

You can close most open forms by pressing the esc key when that form is open From the Gotomenu you will see other methods of moving between forms in Cantax Some useful keystrokecommands are

F2 OverrideF4 Go toF6 Expand or open a form from a line with magnifying glassF8 Tax SummaryCTRL-F2 Go to a specific line numberCTRL-J Go to the T1 JacketESC Close the screenSHIFT-F2 Recalculate the tax returnSHIFT-F3 Save

Identification

Complete this section carefully To determine the individuals liability for tax you must enter the necessaryinformation concerning Paul Merlins residence during 2009

1 Complete the INFO screen by entering the following information

Personal information

Social Insurance Number 999-999-998

Title (Mr Mrs etc) MrFirst name and initials PaulLast name MerlinBirth date 19530108Disability amountFirst year of claim NoYour language of correspondence EnglishDisplay colour for this taxpayer PrimaryHas the taxpayers name changed in 2009 or is this the first tax return No

Depending on your Windows date default you might need to enter Pauls birthdate in adifferent format

Present Address

Care of Apt No Street No Street Name 100 First AvenuePO Box City VancouverProvince British Columbia (use

drop-down menu)Postal code V6G 1K1Country (other than Canada) State Zip Code Telephone (Home) (604) 555-5555 (Work) Cell phone Fax number Pager number Email address Province or Territory of residence on December 31 2009 BCProvince or Territory of the current residence (if differentfrom the one in mailing address)

Province or Territory of self-employment (or of employmentif non-resident)

Country of residence on December 31 2009 ifnon-resident

Marital Status

On December 31 2009 you were Divorced

Spouse information

Paul is not married so most of this section will be leftblank The two items following are the exceptionsProcess spousal returns together NoSame address as spouse NoDelete any address and telephone number informationwhich may have duplicated in the spouse information area

Special returns and changes in 2009

No entries are required in this section

Elections Canada

Is the taxpayer a Canadian citizen YesAnswer the following question only if the taxpayer is aCanadian citizen As a Canadian citizen does thetaxpayer authorize the Canada Revenue Agency to give hisor her name address date of birth and citizenship toElections Canada for the National Register of Electors

Foreign Property Reporting

In 2009 did the taxpayer own more than $100000 offoreign property

Alternative address authorization (paper return only)

Does the taxpayer consent to you using an alternativeaddress authorization ndash T1132

Since Paul is not authorizing an alternative address orfiling an estate return the next two sections can be leftblank

Federal credits

Working Income Tax Benefit NoWas the taxpayer confined to a prison or similar institutionfor a period of 90 days or more in 2009

Client Letter

Print letter for noneTaxpayerrsquos and Spousersquos full name Leave uncheckedSalutation for client letter Default text will be

deleted when noneselected above

Optional client letter paragraph Leave blank

2 After completing this section choose File Save As and save the file as TX1M1P1 replacing TX1with your initials

Computation of net income (Steps 1 and 2)

This section requires you to enter information to calculate Pauls net income for 2009 Paul only had incomefrom his employment at ABC Ltd

1 At the Index select T4 Employment income from T4 slips in the Income from informationslips folder by double-clicking the item Enter the following information about Pauls employmentincome in Column 1

Payer (reference only) ABC LtdTotal earnings (box 14) 30000

2 Since Paul contributed to an RRSP during the year this deduction needs to be entered in hisreturn Go to the Index and scroll down to the Calculation of net and taxable income folderOpen the folder and double-click RRSP Allowable 2009 RRSP deduction to open the form

3 Under 2009 RRSP Deduction Limit enter the amount of 4500 from Pauls 2008 Notice of

(Re)Assessment This is the maximum amount Paul is allowed to contribute to an RRSP in 2009

Move to the RRSP Receipts section In the first row enter the first of Pauls contributions forthe year

Receipt 11245Institution Mega BankContribution date 20090606Contribution amount 1500

Accept the default of No for the Spousal Plan then press Enter

In the second row enter Pauls second contribution for the year 500 on 20091222 receipt11246 also deposited with Mega Bank

Scroll down to the RRSP Contributions section and note that the $2000 total contribution hasbeen brought forward from the itemized schedule that you just completed Note that Cantax hasalready calculated his RRSP deduction limit for 2010 based on the information entered

4 Choose Goto Form Scroll down to Summary select it and click Open to open the 2009 TaxSummary (This could also be accomplished by pressing F8) Pauls total income for 2009 is$30000 His net income which is affected by his RRSP contribution is $28000 and has beencalculated for you by Cantax It is a good idea to save your file at this point

Computation of taxable income (Step 3)

Step 3 is the computation of taxable income To calculate Pauls taxable income you need to account for thenon-capital loss carryover from 2007

1 At the Index in the Identification folder double click the Summary of carry forwards folderDouble-click CARRYFW-1 Summary of carry forwards mdash Page 1

2 In the third section titled Other Non-capital Losses move the cursor to line 2007 in the From2008 column Enter the non-capital loss of 1000 then press enter This loss is now identifiedas being available mdash it has not yet been deducted on Pauls tax return Confirm this by clickingthe Summary tab and viewing the Tax Summary that you opened earlier Scroll down to Paulstaxable income and note that it is still $28000

3 You need to tell Cantax to use the loss in 2009 Go to the Index and scroll down to theCalculation of net and taxable income folder Double click LOSSES Losses of other years toopen the form Note that the loss amount you just entered is listed in the Non-capital Lossescolumn as a Loss available for use In the Non-capital Losses column move the cursor to the lineLoss to be applied in 2009 and enter 1000

4 Review the Tax Summary again and note that Pauls taxable income is now $27000 reflectingthe loss from a prior year that you just claimed for him

Computation of tax payable (Step 4)

Once all the relevant information is entered Cantax automatically completes step 4 by calculating the taxpayable Any applicable deductions should be entered In order to keep this illustration simple you do not needto consider additional deductions in Pauls return

1 With the Tax Summary still displayed on-screen (if it is not click the Summary tab) check thatthe total payable is $319121

2 Save the return

Printing the income tax and benefit return

1 From the pull-down menu select Print then Return to display the Diagnostic menu whichhighlights any diagnostic messages (that is items to double-check or items that should beincluded with this tax return) Ignore these warnings and click Print to display the Index of PrintSchedules This displays the pages and schedules that Cantax automatically selects for printingbased on the information that has been entered For this illustration you will concentrate on themain body of the T1 tax return and not the supporting schedules Therefore you need to firstclear the default selections by clicking the Select button and choosing Clear All Cantax clears allthe page selections

2 Select Regular for Print order and then click the box in column A for T1-1 T1-2 T1-3 and T1-4

3 Click OK to print the selected pages

Reviewing the printouts

You have now seen the four steps of computing income tax payable illustrated using Cantax To keep theillustration simple we have limited the type of income and deductions As you work through the course thecomputer illustrations will cover the various incomes and deductions in more depth

The body of the tax return printed for Paul Merlin appears in Exhibit 18-1 This exhibit contains the four mainpages of every income tax and benefit return that is submitted to the CRA In most cases there are additionalsupporting schedules and receipts that are also included as you will see in future illustrations

Exhibit 18-1

of the return outlines all the personal information that you entered This information is automaticallycarried forward each year by Cantax so it does not have to be entered every time you do the same personsreturn Note that if you are married or live common-law your spouses SIN and name appear on your taxreturn

calculates total income Your income from all sources is summarized on lines 101 to 147 with the totalappearing on line 150 Pauls total income is $30000

calculates net and taxable income All allowable deductions from income are summarized on lines 207to 232 and subtracted from line 150 to arrive at net income ($28000 for Paul Merlin line 236) Lines 244 to256 summarize any allowable deductions to arrive at taxable income (line 260) The amount on line 260 is thenused to calculate taxes payable

is the final page that summarizes the bottom line It shows the total taxes payable less any incometaxes already deducted (usually from a T4 slip) and credits to result in a balance owing or refund Paul owes$319121 (line 485) The page provides a place for your signature and the name and address of any personthat has received compensation for preparing your return

Also note that your name and SIN appear at the top of every printed page These computer forms areapproved by the CRA and can be submitted on white paper as printed

Again these four pages are the core pages of the income tax and benefit return Any total from the supportingschedules that provide the detailed calculations will appear on one of these four pages

Verifying the income tax and benefit return

1 To check your results against the suggested solution click File Close and Yes to close thereturn Choose File Open to display the Open menu

2 Move the cursor to the file named TX1M1P1S select it and then click Open to open this file

3 Choose Goto Form and select Summary or print the tax return from the suggested solutionusing the steps described previously in the section Printing the income tax and benefit returnand compare it with your solution Resolve any differences

4 Choose File Close Yes to close the file

5 Choose File and Exit This will return you to Windows

Relationship between the ITA and the T1 income tax and benefit return

The four pages which form the body of the T1 tax return correspond to Divisions B C and E of Part I of theITA In particular Division B which provides rules for the computation of income corresponds to the netincome amount calculated on line 236 of page 3 (although the term net income does not appear in the ITA)Next Division C which provides rules for the computation of taxable income corresponds to line 260 ofpage 3 Finally Division E which specifies the steps for computing tax payable corresponds to the total taxpayable on line 435 of page 4

Summary

In this computer illustration you learned some of the steps required to use a T1 income tax and benefit returnprogram You also followed the four basic steps required to determine income tax payable At this point youshould not be concerned with the detailed computation of employment income allowable RRSP contributionsloss carryovers and non-refundable tax credits You learn more about these topics in subsequent modules

19 Liability for Part I tax

Learning objective

Determine who must pay income tax in Canada and on what income and determine if a person isresident in Canada (Level 1)

Required reading

Text 2000 to 2050 2090 to 2260 (Level 1)ITA 2 149 250(1) 250(4) (Level 1)ITA Definition 248(1) person (Level 1)IT 221R3 (Level 1)

LEVEL 1

Canada like many countries imposes taxes on persons or properties that have a link with the countryTherefore the question is what criteria should be used to determine the liability for tax Different criteria maybe considered such as citizenship domicile source of income or residence

Citizenship one criterion used by the United States presents enforcement challenges as citizens may move outof the taxing jurisdiction making it difficult for ensuring compliance Domicile is also a difficult criterion to applybecause the concept of domicile is not well-defined and is subject to an element of intention to staypermanently in one place which is difficult to prove The source of income criterion would allow wealthytaxpayers to arrange to earn their income in jurisdictions that have low tax rates which would contravene theequity objective of the system Residence allows the taxing jurisdiction to impose tax on a large group ofpersons that have strong social and economic ties with it The problem with the residence criterion is that it isnot always easy to establish the residence of a person because as you will see it is not a precise concept Itrelies on a number of factors that must be weighed to make a determination

Canada has chosen to use the residence criterion as the primary basis for the liability for tax Non-residents aresubject to tax in Canada using the source of income criterion

A second question that must be addressed when determining who is to pay tax is what entities will be requiredto pay tax In Canada individuals corporations and trusts are liable to pay tax

Residence of an individual

As a summary review the Example Problem in section 2120 of the text Exhibit 2-2 provides an excellentframework for analyzing a residence fact situation to determine if Part I tax applies to an individual

Residence of a corporation

As outlined in the text determining the residence of a corporation is somewhat easier than determining theresidence of an individual To complete your study of this issue read subsection 250(4)

110 Computation of income

Learning objective

Describe the source concept and compute income for tax purposes for a taxpayer liable for Part Itax (Level 1)

Required reading

Text 1210 to 1260 (Level 1)ITA 4(1)(a) 4(2) 9(3) 248(28) (Level 1)ITA Definitions 249(1) taxation year 2491(1) fiscal period (Level 1)

LEVEL 1

The next step in the computation of income tax is to determine what is taxed or the tax base Defining netincome for tax purposes is therefore very important The concept encompasses the whole incomemeasurement process which includes additions deductions and exemptions and the period for thecomputation Sections 3 and 4 of the ITA provide the general framework for the computation of income for thepurposes of Part I They are fundamental to the understanding of the ITA as a whole and are an introductionto the specific rules concerning the different sources of income that will be studied in the following modules

The following comments emphasize and complete the discussion in the text

Computation period

A person is required to compute his income and pay Part I tax on this income on a yearly basis according tohis taxation year The taxation year of an individual is the calendar year (January 1 to December 31) and thetaxation year of a corporation is a fiscal period [subsections 249(1) and 2491(1)] However when theindividual has business income he may elect to have business income computed for a fiscal period differentthan the calendar year as long as this period does not exceed 12 months This last possibility is called thealternative fiscal period method

A corporation will compute and pay Part I tax on its income for the period corresponding to its fiscal period

Computing income Rules specific to each source

The computation of income by source is required because the different sources of income are subject todifferent tax treatments Deductions allowed against one source of income may not be allowed in thecomputation of income from another source as outlined in section 4 This is also true where at first it appearseach source of income is from the same source For example Tom has a full-time job as a salesperson oncommission and a second job as a painter which he does in his spare time Each of these jobs constitutesemployment income and each job is a separate source of employment income that must be calculatedindependently of the other In Module 2 you will learn that an employee who is a salesperson on commissionwill be able to claim deductions that are not available to an employee who is not on commission

Capital gains are not considered as income from a source as they are not included in paragraph 3(a) nor arethey mentioned in subsection 4(1) Furthermore capital gains are excluded from income from property bysubsection 9(3) Under the source theory developed in England in the nineteenth century income from asource is the yield from a productive source It is the fruit from a tree Capital gains arise from the increase inthe value of the tree itself accordingly they are not income from a source Capital gains are covered in detailin Module 6

Under the source theory gains that are not related to a source are not taxable However the ITA has specificprovisions to include in income amounts that would not be taxable under the source theory For example theITA specifically provides for the taxation of pension benefits and capital gains Yet the source theory is stillrelied on to exempt some payments from tax In Fries v MNR [1990] DTC 6662 the Supreme Court ofCanada decided that strike pay was not taxable because it was not income from a source and no provision ofthe ITA specifically provided for its inclusion in income The theory was also discussed by the Supreme Court ofCanada in Schwartz v MNR [1996] DTC 6103 but the case was disposed of on another basis

Income from each source must be computed in accordance with the rules applicable to that source These rulesare contained in Division B of the ITA as follows

bull Subdivision a (sections 5 to 8) income or loss from an office oremployment

bull Subdivision b (sections 9 to 37) income or loss from a business orproperty

bull Subdivision d (sections 56 to 59) other sources of income

Note that the Sectional List at the front of your paper version of the ITA includes Subdivision a income or lossfrom an office or employment and Subdivision b income or loss from a business or property Thesesubdivisions are further broken down into Basic Rules Inclusions and Deductions

Keep in mind that income for tax purposes is not necessarily equivalent to accounting income In most casesaccounting income must be adjusted according to the specific and current provisions of the ITA Alsoremember that income or loss from a source in accordance with section 4 means the income from that sourceafter deducting all allowable expenditures Therefore income referred to in paragraph 3(a) is net income fromthat source

Example

Amir Hussein has the following income and allowable deductions for 2010

Income

Employment with Fun Inc Salary [subsection 5(1)] $ 70000 Automobile standby charge [paragraph 6(1)(e)] 2000Dividends (taxable amount) [paragraph 12(1)(j)] 1500Sales revenue from a business [subdivision b] 32000Amount withdrawn from a registered retirement savings plan(RRSP) [paragraph 56(1)(h)] 8000

Deductions

Interest expense to earn income from taxable dividends[paragraph 20(1)(c)] $ 650Union dues [paragraph 8(1)(i)] 250Alimony payments for the support of a former spouse [paragraph60(b)] 5200Deductible expenses related to the business [subdivision b] 40000

Required

Compute income by source for Amir

Solution

Double inclusion or double deduction

Subsection 248(28) generally provides that the ITA is not to be interpreted in such a way as to lead to doubletaxation of income of a taxpayer or to allow a deduction to be claimed more than once by a taxpayer Thisprovision does not apply where it is clear that double inclusion or double deduction was the intention of thelegislators

Solution

1 Computation of income from employment mdash Fun IncAll income and deductions listed in subdivision a [sections 5 to 8]relating to the particular employment Salary $ 70000 Automobile standby charge 2000 72000 Union dues (250)Employment income $ 71750

2 Computation of income (loss) from a businessAll income and deductions listed in subdivision b [sections 9 to 37]relating to the particular business Sales $ 32000 Deductible expenses (40000)Business loss $ (8000)

3 Computation of income from property

All income and deductions listed in subdivision b [sections 9 to 37]relating to the property Dividends (taxable amount) $ 1500 Interest expense (650)Property income $ 850

4 Computation of other sources of income

Income under subdivision d [sections 56 to 59] RRSP withdrawal $ 8000

5 The alimony payments are deductible under paragraph 60(b) a subdivision e deduction They willbe deducted separately when computing income under section 3

111 Steps in computing income

Learning objective

Calculate income (net income) according to section 3 of the ITA (Level 1)

Required reading

ITA 3 (Level 1)

Optional reading

ITA 31 (proposed) 81

LEVEL 1

Once the taxpayer has established his income by source according to the ITA his net income can be computedunder section 3 There are four steps to the computation These steps are not reflected on the income tax andbenefit return that taxpayers are required to fill out but they are part of the programming of the Cantaxsoftware you will be using It is also the way the CRA combines various lines from the T1 return when the CRAprocesses it

You will need to determine the amount of deductions permitted for the year under sub-division e and todetermine losses to be carried over This concept is very important When you are studying for your exam youwill see the words in good format in exams from previous years This means section 3 format In some partsof the ITA you will also see references to points within section 3 income By formatting your answer properlyyou can reuse amounts previously calculated and avoid having to do them over again

Here is a synopsis of the provisions of section 3

3(a) Include here only income (not losses) from different sources The incomefrom each source to be included here is the income net of any deductionsapplicable to each source calculated independently of all other sources aspermitted by the ITA

3(b) This paragraph deals with capital gains and losses Capital gains whiletaxable are subject to a different tax treatment than other types ofincome They are not considered income from a source [see subsection9(3)] which is why they are not included in paragraph 3(a) The result ofthe computation under paragraph 3(b) cannot be a negative amount Ifallowable capital losses exceed taxable capital gains in the year the excessmay not be deducted from other sources of income

3(c) Some deductions permitted by the ITA do not relate to any particularsource of income They are listed in subdivision e [sections 60 to 668]Paragraph 3(c) allows the taxpayerrsquos income to be reduced by the amountof these deductions but only up to the amount of income computed byadding together the results obtained in paragraphs 3(a) and 3(b) Anyamount by which the deductions under paragraph 3(c) exceed the total ofthe amounts established in paragraphs 3(a) and 3(b) is lost meaning thatit cannot be claimed for the purpose of reducing income from other yearsSimply put paragraphs 3(a) + 3(b) minus 3(c) cannot be a negative amount

3(d) From the results obtained in paragraph 3(c) it is necessary to deduct thelosses from the various sources of income [income from the differentsources is accounted for in paragraph 3(a)] or any allowable business

investment loss (ABIL) At this point you need to know that an ABIL is aportion of the capital loss on shares or debts of a small businesscorporation that is treated in some respects as a business loss That is whyit is deducted from the capital losses in paragraph 3(b) and consideredalong with business losses in paragraph 3(d) The pending amendment forparagraph 3(d) clarifies losses must be from a source

Paragraphs 3(e) and (f) are not steps in computing net income These paragraphs specify that the amountcalculated under paragraph 3(d) constitutes the net income of a taxpayer and that if this amount is negativethe net income is deemed to be zero

The following example illustrates the operation of section 3 and the importance of establishing income bysource

Example

Michel Deprez personally carries on two separate businesses For the 2010 taxation year his income anddeductions are as follows

Interest $ 6000 Income from business A (Sales $100000 expenses $70000) $ 30000 Loss from business B (Sales $80000 expenses $93000) $(13000) Deduction under subdivision (e) $ 27000

By establishing his income by source Michel has a $4000 non-capital loss which he can use to reduce hispast or future income according to the rules applicable to this type of loss

If the income from the two sources is not differentiated the $4000 amount could never be claimed as itcannot be identified and traced back to a source Thus when income is established by source in computing netincome according to section 3 maximum benefit is derived from the loss carryover rules

Activity 111-1 mdash Calculating section 3 income

In this activity you calculate an individualrsquos net income using the rules under section 3 of the ITA For moreopportunities to practice select Start over at the top of the activity to generate new numbers

fileF|Courses2010-11CGATX106coursem01summaryhtm[11102010 43406 PM]

Module 1 summary

Introduction and concept of income

Module 1 is an introduction to the Income Tax Act (ITA) It reviews the reason for its existence and theprinciples that govern its interpretation It then focuses on the ITA structure and explains how to search forand interpret its provisions The module concludes with the study of two basic concepts first who must paytax in Canada second what is the concept of income for purposes of the ITA

The most desirable characteristics of an income tax arehorizontal equityvertical equityneutralityflexibilitycertaintyfeasibility and efficiency

The most important guidelines for evaluating tax policy areequityfairnesssimplicity and compliancebalancestabilityeconomic growthinternational competitiveness

Since the ITA is used not only to collect taxes but also to implement social economic andmonetary policies it is amended regularly which explains its complexity

Accountants are often faced with ethical questions when preparing tax returns or providing taxadvice

Tax advisers and preparers should be aware of third party civil penalties under the ITA (section1632 mdash Third Party Civil Penalties and IC 01-1)

The administration of the ITA is Canada Revenue Agencys (CRA) responsibility CRA has specificlegislated enforcement and administrative responsibilities

The Canadian tax system is based on self-assessment Taxpayers must file T1 income tax andbenefit returns on specified dates Since the Canadian tax system is self-assessing the burden ofproof rests with the taxpayer with respect to the assertions made by the taxpayer in their incometax return

Taxes are deducted at source on employment income Taxpayers must generally make instalmentpayments on other sources of income

The interpretation of the ITA is easier if you understand its structure and the importance of thedefinitions contained in the ITA Your competency to read and interpret the ITA isimportant

There are four steps in computing Part I taxdetermining the liability (ie whether Part I tax applies)computing incomecomputing taxable income

computing tax payable

The concept of residency is important in determining under what Part of the ITA (if any) apersons income is taxed Residency determines if a persons worldwide income or only thepersons income earned in Canada is taxable in Canada

There are three concepts of residencyresidentdeemed residentnon-resident

Courts have determined the general rules to determine whether a person is a resident of Canada(see IT-221R3)

A person who is resident in Canada is liable for Part I tax on his world income

A deemed resident means that an individual is deemed to be a resident of Canada for the entireyear in the cases listed in subsection 250(1) which includes the sojourning rule

If the individual sojourns in Canada for 183 days or more in a year he is deemed to be a residentof Canada for the entire year

An individual who is not a resident or deemed resident is a non-resident

A non-resident person may be liable for Part I tax only ifhe was employed in Canadahe carried on a business in Canada orhe disposed of a taxable Canadian property [subsection 2(3)]

Section 3 of the ITA is the fundamental section for the computation of income In order tocompute income under section 3 you need to

understand the source concept in section 4compute each source of income separately as defined in section 4allocate amounts using the format of section 3

ITA Section 3

Paragraph 3(a) Sources of income (all positives)+ Paragraph 3(b) Net capital taxable gains- Paragraph 3(c) Subdivision e deductions- Paragraph 3(d) Losses from employment property or business= Net income (cannot be less than 0)

Paragraph 3(a)

The total ofOffice incomeEmployment incomeBusiness incomeProperty incomeOther income

Example mdash Source Concept Employment Income

Use only those items (incomeloss deductions) from that source (section 4)Basic rules section 5Add benefits under sections 6 and 7

Deductions under section 8= Employment income

Paragraph 3(b)

Taxable Capital GainPlus Taxable Net Gain from listed personal property (LPP) Less Allowable Capital Loss (not including ABIL)= Amount cannot be less than 0

Paragraph 3(c)

Subdivision e deductionsNot applicable against any one sourceExamples include

Child care expensesMoving expensesRRSP contributions

Paragraph 3(d)

The total ofLoss from Office or EmploymentLoss from BusinessLoss from PropertyOther lossesABIL

Proposed section 31 (optional reading) will have a significant impact on the deductibility of lossesfrom business and property in the future

You should know how to demonstrate the relationship between income under section 3 and netincome on the T1 tax return

The CANTAX software often does the calculations for you

Know what the software is doing and why

fileF|Courses2010-11CGATX106coursem01selftesthtm[11102010 43407 PM]

Module 1 Self-test

Question 1

The Canadian tax system provides for progressive tax rates for the taxation of individuals Some peopleadvocate a flat rate system that is a one rate system Considering the underlying objectives of a tax systemdiscuss how the introduction of a flat rate system could affect the Canadian tax system

Solution

Question 2

Jerry Hampton received a Notice of Reassessment from the CRA for the 2005 taxation year The notice wassent on September 27 2009 and indicated that additional tax was due It was issued when the CRAdiscovered during an audit for the 2005 taxation year that the original assessment for 2005 was incorrect Theoriginal assessment was mailed on September 8 2006 Discuss whether Jerry is required to pay the additionaltax resulting from the reassessment

Solution

Question 3

Yolanda Ma is a wealthy businesswoman who lives in a country with which Canada has no tax convention In2010 Yolanda sojourned 264 days in Canada to set up a Canadian branch of her business Yolanda thinks shemust pay Canadian income taxes on her business income earned in Canada She seeks advice from Ali Jonsena CGA who advertises as a tax specialist

Ali knows Yolanda does not want to be taxed in Canada on her worldwide income He is also aware of thedeemed resident rule in the cases of individuals who sojourn in Canada for 183 days or more in a taxation yearAfter a lengthy discussion with Yolanda Ali is satisfied that it would be very difficult for the tax authorities toprove that Yolanda was present in Canada for more than 183 days in 2010

Ali advises Yolanda that she need only report her business income earned in Canada on her 2009 Canadianincome tax return since she is considered a non-resident of Canada

Comment on the ethical issues raised in this case

Solution

Question 4

State whether the following statement is true or false and provide the reasons for your answer

The words used in the ITA should always be given their usual meaning

Solution

Question 5

Which of the following isare from a source

a Gross salaryb Business income calculated under the ITA

c Taxable capital gaind RRSP withdrawals receivede Allowable business investment lossf Payments to an RRSP

Solution

Question 6

a Discuss how reviewing tax cases to aid in the interpretation of tax laws can assist accountants inthe preparation of tax returns

b You are looking for a second opinion The CRA has recently disallowed a deduction for trainingexpenses that you believe were incurred to earn income Would a lawyer or accountant be betterequipped to advise

c In the formation of tax policy what distinguishes horizontal equity from vertical equity

d Discuss the income tax liability for each of the following stating any assumptions

i a sole proprietorshipii a non-resident corporation conducting business in Canadaiii a resident corporation with a subsidiary incorporated in Hong Kongiv a partnership between two individualsv a partnership between two corporations

e Tax evasion is considered a criminal offence Provide three examples of tax evasion

f If a taxpayer disagrees with the CRArsquos assessment of taxable income and federal taxes payablediscuss the course(s) of action available to the taxpayer Should all disagreements go to court

g What are the different sources of tax legislation Should taxpayers rely on CRA interpretationbulletins and advanced rulings as legally binding documents

h Khourarsquos client showed her a tax slip from BMO for $1500 interest but the client told her not toinclude it as income in his tax return Khoura gave the slip back to her client and completed herclientrsquos personal income tax return without reporting the interest Has Khoura committed acriminal offence What penalties could apply

i During 2010 an individual earned a salary interest income and a gain on the sale of land Whatsources of income did the individual earn Would your answer change if you found out theindividual was an active trader in real estate

Solution

fileF|Courses2010-11CGATX106coursem01selftestsol1htm[11102010 43407 PM]

Self-test 1 solution 1

In terms of revenues the flat rate system may not affect the total revenues levied by the government if thetax rate and the tax base to which it applies are chosen with care In such a system high-income earnerswould pay less than they otherwise would under a non-flat system and low-income earners would pay morethan they otherwise would under a non-flat system

Horizontal equity would be improved because all taxpayers earning the same economic earnings would pay thesame rate However a flat rate system would affect vertical equity since high-income taxpayers would nolonger pay their proportionate share of taxes although they have the ability to pay more

In terms of neutrality if the tax base is broad enough so that it does not discriminate between the differentsources of income and provides little or no incentives the flat rate system could be much closer to neutralthan the present system Also the complexity of the system should be reduced

With a flat tax system the use of the ITA as a tool to promote particular behaviour and economic growthwould be limited For example people may not save for their retirement if they did not get a tax deduction forputting money aside in an RRSP

The reassessment for 2005 was issued after the three-year time limit allowed by the CRA [under paragraph152(4)(b)] Jerry does not have to pay the additional tax because the reassessment is invalid

There are many ethical issues in this case here are some of them

Under CGA-Canadarsquos Code of Ethical Principles and Rules of Conduct (CEPROC) Ali may not beallowed to advertise as a specialist

Ali knowingly gave erroneous advice to Yolanda He did not disclose to her the actual residencyrule and that she may have problems with the Canadian tax authorities in the future As a taxadvisor Ali could be assessed civil penalties under section 1632 The civil penalties apply to thirdparties and tax advisors such as accountants and lawyers who advise or participate in a false taxfiling of others

Ali could also be charged with tax evasion if it could be demonstrated that the terms ofsubsection 239(1) had been met

Alirsquos attitude may also discredit the profession and it certainly affects the CRA and ultimately thepeople of Canada as third parties

Ali is a party to deceptive information and taking part in an unlawful activity

There could likely be repercussions from Alirsquos professional association if the client files a complaint(for example disciplinary measures and possible loss of membership)

False Ordinary words should be given their plain and obvious meaning and technical words such as legalterminology (ITA definitions excluded) should use their legal definition One should always determine if termsused in the ITA are defined in the ITA Definitions are found mainly in subsection 248(1) but are also locatedin other sections of the ITA The context in which the words are used and the intention of the provision to beinterpreted may be examined by the courts to assist in determining meaning

Gross salary Included in income from employment under paragraph 3(a) Employment income is from asource so the gross salary is part of the source calculation

Business income calculated under the ITA Income from a source per section 4

Taxable capital gain Not under section 4 or included under paragraph 3(a) not income from a source

RRSP withdrawals received Other income under paragraph 3(a) therefore income from a source

Allowable business investment loss Not under section 4 or included under paragraph 3(a) not incomefrom a source

Payments to an RRSP Payments to an RRSP are a deduction under paragraph 3(c) not income from asource

a The interpretation of tax laws can assist accountants in the preparation of tax returns Tax casesand court decisions provide insight into how the courts as mediators interpret the Income TaxAct They provide guidance as to whether the taxpayer should follow a strict literal interpretationor the doctrines of business purpose and substance over form The knowledge of legalinterpretations helps accountants to better evaluate alternative tax treatments and acquire abetter understanding of the tax system

b Both accountants and lawyers undergo extensive training to provide interpretations of tax lawHowever the process of appealing a CRA ruling extends beyond simple interpretation of theIncome Tax Act At the first stage of an appeal the pre-court stage extensive calculationsvaluations and knowledge of GAAP are required The expertise of a qualified tax accountant isusually sought to ascertain whether amounts were properly calculated and forms properly filed Itis then up to either a tax accountant or lawyer to determine whether or not they feel the taxpayershould proceed further with the appeal If it is eventually decided that litigation is warranted theservices of a tax lawyer may be obtained to assist in matters of research and to present the casebefore the courts

c Horizontal equity is concerned with the equal treatment of people in the same or similarsituations or positions For example two people who each have an income of $30000 per yearshould be equally taxed all else being equal Therefore it is concerned with the equitabletreatment of individuals at a certain level of income

Vertical equity concerns itself with equitable wealth redistribution Most people agree that high-income earners should pay more taxes than low-income earners since they are in a betterposition to do so without having a large impact on their current lifestyle Therefore it deals withthe degree of equality between individuals at various levels of income

d i The income earned by the business is included in the personal tax return of theowner and taxed at the ownerrsquos personal rate

ii Corporate taxes are paid on the income earned through Canadian operationsiii The subsidiary is an independent entity and does not carry on its business in

Canada Assuming central management does not reside in Canada then thesubsidiary is considered a non-resident and not liable for Canadian tax

iv Each individual taxpayer would include their share of the partnership income intheir own personal tax return

v Each corporation would include its share of the partnership income in its owncorporate tax return

e Examples of tax evasion include deliberately failing to report income such as self-employedearnings or tips claiming non-existent expenses misrepresenting a companyrsquos assets claimingitems not related to earning income such as personal expenses or claiming ineligible tax credits

f If a taxpayer disagrees with their assessment there is a sequence of appropriate actions that canbe taken First a Notice of Objection can be filed Under section 165 a taxpayer has the right toobject to an assessment made by the CRA Any taxpayer can do so by filing a Notice of Objectionwithin one year after the filing due date for the taxation year or within 90 days after the day ofmailing of the notice of assessment whichever is later The Notice of Objection must set out thereasons for the objection and all relevant facts A taxpayer may only file objections related to theissue that gave rise to the assessment

After a taxpayer has filed the objection the Minister is required to reconsider CRArsquos assessment

and reply to the taxpayer If the taxpayer receives no response from the CRA within 90 days or itis within 90 days from the date of mailing of the reassessment the taxpayer may appeal to theTax Court of Canada With the informal procedure the appeal may be submitted in writing andthe taxpayer may represent themselves However the taxpayer would not be able to appealfurther If the general procedure is used and the taxpayer is still not satisfied with the resultsthe taxpayer then can appeal to the Federal Court of Appeal within 30 days of the Tax Court ofCanadarsquos decision The final step is to seek leave for appeal to the Supreme Court of Canadawithin 60 days of the Federal Courtrsquos decision This right is limited to certain cases

Not all disagreements ultimately go to court If the reassessment is not in favour of the taxpayerthe taxpayer may wish to take it to court as outlined above If the taxpayer wishes to pursue it incourt it is important to get legal advice Legal precedent may indicate that it is not likely that thetaxpayer will win their case and that it may not be advisable to take the action any further

g There are three sources of income tax legislation

Statute law mdash Provincial and federal income tax actsCommon law mdash Court decisionsInternational tax conventions mdash Treaties between countries

Interpretation Bulletins and Advanced Rulings are not legally binding Rather the bulletins andrulings describe how the CRA interprets and applies the existing laws to the situation Thesedocuments are not immediately updated with a change in laws so there is a danger of thembeing out of date

Court decisions are legally binding and an integral part of income tax legislation

h Khoura has committed a criminal act by deliberately falsifying or knowingly participating in thefalsification of her clientrsquos income If convicted she is liable for a fine pursuant to subsection239(1) of between 50 and 200 of the tax evaded and a possible prison term of up to twoyears She is concurrently liable for a civil penalty under either subsection 1632(2) or (4) of atleast $1000

i A salary is sourced as employment income interest income is sourced as property income andthe gain on the sale of land is generally considered a capital gain All dispositions of capitalproperty are considered a capital disposition if the intent of the taxpayer was to earn incomefrom holding property The gain on the sale of the land could be treated as business income ifthe taxpayerrsquos intention was to profit from the disposition If this is the case the land would beconsidered inventory Subsection 248(1) defines business as including an adventure or concernin the nature of trade

As an active trader in real estate the taxpayer may be considered to be carrying on a businessHowever if the individual owned the land with no intention of reselling for a profit the gain onthe sale is considered a capital gain Fifty percent of this gain is considered a taxable capital gainunder paragraph 3(b)

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