Tax developments

By Brenda Crockett
Illustration: Geneviève Côté

A practical overview of recent changes from charitable donations to tax credits for caregivers’ expenses to trusts

Over the past year, some interesting and important developments have arisen in the area of personal and trust taxation. Some of these changes, which have been announced in press releases, draft technical amendments and the federal budget, have an effect on a number of areas such as charitable giving, non-compete payments, disability and medical deductions and credits, the fairness provisions and trust affiliation rules.

Charitable donations
In a December 5, 2003 press release, the Department of Finance added to its arsenal of restrictions to render various charitable arrangements ineffective. The new provisions, detailed in the Feb. 27, 2004 Technical amendments, can limit the amount of a donor’s eligible gift for the purposes of the charitable donation tax credit to the lesser of the fair market value of the donated property and the donor’s adjusted cost base. This limitation will apply if the donor acquired the donated property less than three years before the date of the gift, or if the donor intended to make the gift at the time of acquiring the property.

Relief is afforded if the donation is made as a consequence of the donor’s death, or the donated property is inventory, real property, ecological property, certain cultural gifts or a gift of publicly traded securities eligible for the 25% capital gain inclusion rate. If, by way of a series of transactions, the donor intentionally increases the property’s cost (by realizing the gain), avoidance provisions effectively prohibit an increase in the cost for these purposes.

An example of a typical arrangement now prevented is where a taxpayer, through a promoter, purchases goods at a price below fair market value, donates the goods to a registered charity, and receives a donation receipt for the full fair market value. Since the goods are not capital property or inventory to the taxpayer, the gain is not taxable, and a donation credit windfall results.

Interestingly, these limitations can also apply where a taxpayer donates private corporation shares to a registered charity. For example, the eligible gift will be less than fair market value if the donor undergoes a tax-deferred exchange of the shares (i.e., Section 85 or Section 86) in the three years prior to the donation, or at any time prior, if completed in order to facilitate the donation.

This limitation applies to gifts made as of 6 p.m. (EST) on December 5, 2003.

Restrictive covenants
In response to recent judicial developments, the February 27, 2004 Technical Amendments contain provisions, originally announced in an October 7, 2003 press release, which ensure that payments under non-compete agreements and other similar arrangements — referred to as restrictive covenants — are taxable.

There are four alternate ways in which amounts received or receivable by a taxpayer (or by a person with whom the taxpayer does not deal at arm’s length) out of a restrictive covenant may be treated:

• As employment income if in respect of an office or employment. These amounts are taxed in the year of receipt. Furthermore, any amounts that are receivable will be included in income in the year that they become outstanding for more than 36 months. They are deductible to the pur-chaser as wages.
• As a reduction in the formula for cumulative eligible capital, if in respect of the disposition of eligible capital property of a business, and if the taxpayer and the purchaser file a joint election. These amounts are eligible capital property to the purchaser.
• As proceeds of disposition, if it relates to a disposition of an interest in a partnership or a share of a corporation that carries on a business, and if the taxpayer and the purchaser file a joint election. These amounts are added to the cost of the property acquired by the purchaser.
• If none of the above applies, the amounts received or receivable are taxable as other income. The proposed amendments do not recognize any deduction or outlay on the purchaser’s part in these circumstances.

A number of other new provisions incidental to these restrictive covenant rules — for example, amounts that are bad debts, payments to non-residents — have also been introduced.
These amendments apply to amounts received or receivable after October 7, 2003, other than amounts received before 2005 under a written agreement entered into by the taxpayer and an arm’s-length party on or before October 7, 2003.

New deduction for disability expenses
A positive development for persons with disabilities comes in the form of a proposal in the 2004 federal budget to replace the current attendant care deduction with a deduction for disability supports expenses incurred for purposes of employment or education. Not only does the scope of expenses eligible as disability supports include much more than just attendant care expenses — for example, teletypewriters and voice recognition software are now deductible — the two-thirds income limitation has been removed as well.

The new deduction applies for 2004 and subsequent taxation years. Expenses claimed for a disability supports deduction are precluded from also being eligible for a medical expense tax credit.

Improved tax credits for medical expenses
The current rules severely limit the tax credit that can be claimed for medical expenses paid on behalf of a dependent other than a spouse or common-law partner.  However, under the 2004 federal budget proposals, commencing in 2004, medical expenses paid for a minor child, regardless of the child’s income, can be pooled with the taxpayer’s and the taxpayer’s spouse or common-law partner’s medical expenses on the taxpayer’s tax return.  Where medical expenses are paid for another dependent relative, the taxpayer will be entitled to a tax credit based on the amount by which the expenses exceed 3% of the dependent’s net income, to a maximum of $5,000.

Extended carry-forward period
The carry-forward period for non-capital losses and unused foreign tax credits has been extended from seven years to 10 as a result of the 2004 federal budget. This applies to losses and credits that arise in taxation years that end after March 22, 2004.

Additional limits on fairness applications
As part of what is commonly called the Fairness Provisions, individuals (except trusts) and testamentary trusts can apply to have the minister:

• reassess prior tax returns in order to receive a refund or reduce tax payable, not-withstanding that the normal reassessment period has passed,
• waive or cancel penalties and interest assessed, and
• for prescribed elections, accept late, or permit amended or revoked elections.

The above relieving provisions are pres-ently available in respect of 1985 and all subsequent taxation years. Since, as more years pass, this has the potential of becoming an administrative nightmare, the 2004 federal budget proposes to limit such requests to taxation years that end in any of the 10 preceding calendar years.
This change is effective for all applications made after 2004, giving taxpayers the balance of 2004 to make any requests in respect of years prior to 1995.

Trusts and affiliated persons
Under the 2004 federal budget proposals, the rules for determining whether a person is affiliated with a trust, or whether two trusts are affiliated with each other, have changed entirely. Affiliation is a key element in the application of the superficial loss and suspended loss provisions of the Income Tax Act, making a review of the affiliated person rules a critical part of any planning involving the realization and utilization of capital losses, for example, subsection 164(6) loss carry-backs.

The current practice of looking at the trustee’s relationships in determining whether a trust is affiliated has been specifically eliminated under the proposed rules. Instead, a person will now be affiliated with a trust if the person, or someone affiliated with that person, is a majority interest beneficiary of the trust. A majority interest beneficiary is generally entitled to a majority of the trust income or capital, and in the context of a discretionary beneficiary, discretion will be regarded as having been fully exercised, or not exercised, as the case may be, in respect of each person who is a potential beneficiary of the discretion.

Two trusts will now be affiliated if a person who has contributed property to one trust is affiliated with a person who contributed property to the other trust, both contributions were made on a non-arm’s-length basis for inadequate consideration, and if, generally speaking, majority interest beneficiaries and/or members of a majority interest group of beneficiaries are affiliated. The concept of majority interest group of beneficiaries resembles that of the existing “majority interest group of partners.”

These changes apply for determinations made after March 22, 2004.

In general, most of these changes can be regarded as positive, either on account of the objective sought or the clarification gained. And while the descriptions here are neither comprehensive nor complete, they should provide a practical overview.