Canadian taxes are levied on both personal and corporate income, but the government recog- nizes the potential for double taxation of income earned through a corporation and has designed a partially integrated system. We will explain what we mean by partially integrated as we develop our understanding of taxes. We begin by noting that the United States operates a classical system of double taxation, while Europe, by and large, operates a fully integrated system, which leaves Canada somewhere in the middle. How taxes are levied has important implications for corporate finance, so it is important to realize from the outset that the Canadian tax system differs in some fundamental ways from the U.S. system. As a result, cor- porate finance strategies that are based on the U.S. tax code are not directly applicable in Canada or Europe.
Learning Objective 3.5 Describe the Canadian tax system and explain the differences between how a corporation and an individual are taxed.
18 This is a typical definition for free cash flow; however, several variations exist.
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84 CHAPTER 3 Financial Statements
Corporate Taxes
As we saw in Chapter 2 , corporations are distinct legal entities and are taxed as such. We saw in this chapter that corporations file income tax returns with Canada Revenue Agency that are determined in much the same way as they prepare their income statement for investors.
However, we also noted that there are some differences. One main difference that we have discussed previously is that different methods are used to calculate amortization expense.
Another major difference is in the treatment of investment income and expenses. We will now elaborate on these two issues.
CCA is amortization for tax purposes, and the government has designed it to be as simple as possible. First, all assets are allocated to one of a number of CCA asset classes. Five of the major ones are listed in Table 3-3 . 19
TABLE 3-3 Major CCA Asset Classes
Asset Class Type of Assets CCA Rate
Class 1 Buildings 4%
Class 8 Office equipment 20%
Class 10 Computer hardware, system
software
30%
Class 43 Manufacturing equipment 30%
Class 45 Computers 45%
Class 8 is, in fact, a general catch-all category, so when in doubt use a 20 percent CCA rate!
The CCA rate is the rate that is applied to the undepreciated capital cost (UCC) of an asset class; the higher the rate, the faster the assets are depreciated. Notice that the general rates make sense in terms of the assets ’ economic lives. Computers may last a long time, but the rapid pace of technological progress means that you will generally replace them before they wear out. Their economic life is relatively short, and their CCA rate is high. In contrast, build- ings last much longer, so their CCA rate of 4 percent is much lower. The asset classes or pools have been designed so that CCA is applied to the balance of the pool at the end of the fiscal year. Rather than calculating CCA for each item separately, it is calculated for the pool as a whole. For most firms, unless they make a special election, their fiscal year is the same as the calendar year.
One minor adjustment associated with CCA is that because it is taken on the year-end balance, Canada Revenue Agency allows firms to apply only one-half of the CCA rate to net acquisitions of an asset class in the first year the assets are acquired. This is known as the half-year rule , which was implemented to reduce the incentive to purchase assets right at the end of the year and then claim a full year ’ s CCA on them. Remember, CCA is a non-cash expense, but it reduces taxable income and therefore reduces current taxes payable. As a result, firms generally want to charge as much CCA as possible.
For example, suppose a company buys a new computer for $5,000. The CCA would be 45 percent of $5,000, or $2,250. Using the half-year rule, only $1,125 can be deducted in the first year. After deducting CCA of $1,125, the balance that remains to be depreciated (i.e., the asso- ciated UCC) is $3,875, which equals the asset class ’ s UCC if it were the only asset in that class.
For the following year, if no further class 45 assets were acquired, the CCA would be 45 percent undepreciated capital cost
(UCC) the undepreciated cost of assets, calculated by asset class and written off on a declining balance basis
half-year rule the rule by which Canada Revenue Agency allows firms to apply only one-half of the CCA rate to net acquisitions of an asset class in the first year the assets are acquired
19 There is no category for land, since it is a non-depreciable asset.
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85 CHAPTER 3 3.5 The Canadian Tax System
of the UCC of $3,875, or $1,744. Notice that although 45 percent seems to be a high deprecia- tion rate, it is applied to the UCC, which declines each year, so the firm will actually be taking CCA on this computer forever, even though its economic life may be only three years.
Conversely, most of the asset ’ s value will be depreciated within three years, and virtually all of it will be depreciated after six years, as illustrated in Figure 3-7 . Notice that although CCA expenses technically go on forever, for practical purposes they end after six years or so for this asset class. By year 10, the UCC is only $18 and CCA deductions are only $8.10, which is trivial when compared to the original investment of $5,000.
One advantage of using CCA asset classes or pools is that individual assets are not amor- tized separately, unless they are the only asset in the pool. This makes it easy to account for sales of assets: the proceeds are subtracted from, instead of added to, the pool, and the half- year rule comes into play only when the net acquisitions figure for an asset class is positive (i.e., when purchases exceed sales for that asset class). Example 3-1 illustrates how to apply the CCA system.
FIGURE 3-7 CCA Expenses through Time
CCA
UCC CCA
6,000 5,000 4,000 ($) 3,000 2,000 1,000
Year 0
1 2 3 4 5 6 7 8 9 10
A company purchases equipment for $650,000. The equipment is in asset class 38, which has a CCA rate of 30 percent (declining balance method). Assume this is the only asset in this class. Calculate the CCA associated with this asset class for the year of acquisition and for the subsequent two years.
Solution
For year 1, apply the half-year rule, which states that only one-half of the CCA rate is applied in year 1. Therefore, we can calculate CCA in year 1 as
CCA year( 1) ($650 000, ) ( . ) ( / )0 3 1 2 $97 500 ,
Because the full CCA rate is applied to the UCC of the asset class in all years subsequent to the fi rst year, we can calculate the CCA in years 2 and 3 as follows:
UCC beginning of year( 2) UCC beginning of year( 1) CCA year( 1) $6500 000, $97 500, $552 500, CCA year( 2) (UCC) (CCA rate) ($552 500, ) ( . )0 3 $165 750 ,
UCC beginning of year( 3) UCC beginning of year( 2) CCA year( 2) $5522 500, $165 750, $386 750, CCA year ( 3) (UCC) (CCA rate) ($386 750, ) ( . )0 3 $116 025 ,
EXAMPLE 3-1 Calculating CCA
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Other issues arise with respect to depreciable assets when they are sold. First, if the selling price is greater than the original capital cost, a capital gain arises, which is taxable. However, the converse is not true; when a depreciable capital asset is sold below its original purchase price, this does not generate a tax deductible capital loss , because this is expected (i.e., it is a depreciable asset and, as such, is expected to depreciate in value below its original cost). In fact, capital losses are generated only when a non-depreciable asset (such as land or financial assets) is sold at a price less than its original cost.
Aside from capital gains, additional tax consequences may arise in the form of CCA recapture or terminal losses . These may arise if the CCA asset class is terminated by selling the asset, which would occur only if there were no other assets included in that asset class for the firm. Under this scenario, the firm would have to pay additional taxes on “excess” CCA charged against the asset (or assets) if the salvage value is greater than the ending UCC for the asset (or asset class). The amount by which the salvage value exceeds the UCC is referred to as CCA recapture and is fully taxable. 20 However, if the salvage value is less than the ending UCC, the amount by which the UCC exceeds the salvage value is referred to as a terminal loss, which is fully tax deductible. 21 Finally, CCA recapture may occur even if an asset class is not termi- nated, if an asset (or assets) is (are) sold for a price that exceeds the remaining UCC for that asset class. Example 3-2 illustrates capital gains and CCA recapture, and Example 3-3 illus- trates terminal losses.
capital gain a taxable gain realized when an asset is sold at a price greater than its original cost
capital loss a tax-deductible loss generated when a non-depreciable asset is sold at a price lower than its original cost
CCA recapture a tax on the amount by which the salvage value (sale price) of an asset exceeds the undepreciated capital cost; occurs only if the asset class is terminated or if an asset is sold for a price that exceeds the remaining UCC for that asset class
terminal loss a tax deduction equal to the amount by which the undepreciated capital cost exceeds the salvage value (sale price); occurs only if the asset class is terminated
20 In other words, it is viewed as if the firm charged too much CCA (amortization), because the asset is sold for more than its depreciated book value for tax purposes (UCC). Therefore, the firm must pay back the amount of taxes it saved by charging too much CCA.
21 In other words, the firm did not charge enough CCA, because the asset was sold below its book value for tax purposes (UCC).
Therefore, the firm is permitted to amortize the asset to its selling price and deduct this charge for tax purposes.
Assume that, during year 3, the company from Example 3-1 sells for $700,000 the equipment it purchased for
$650,000. Estimate the tax consequences of this transaction, again assuming that this is the only asset in this class.
Solution
First, check for capital gains, which do occur in this example:
Capital gains Selling price Original cost $700 000, $650 000, $550 000,
Next, determine whether a CCA recapture or terminal loss results. The CCA recapture (terminal loss) will equal the excess (defi cit) amount of CCA that the fi rm charged, which can be determined as the difference between the lower of the selling price and the original cost, and the beginning UCC in year 3 (which was determined in Example 3-1 ):
CCA recapture terminal loss( ) Lower of selling price and the originaal cost UCC
$650 000, $386 750, $263 250,
This number is positive, so it represents a CCA recapture of $263,250. The fi rm must claim this taxable amount on its income tax return.
EXAMPLE 3-2 Capital Gains and CCA Recapture
Ignore Example 3-2 and now assume that, during year 3, the company from Example 3-1 sells for $200,000 the equip- ment it purchased for $650,000. Estimate the tax consequences of this transaction, again assuming that this is the only asset in this class.
Solution
First, check for capital gains, which do not occur in this example, because the selling price of $200,000 is less than the original cost of $650,000.
Next, determine whether a CCA recapture or terminal loss results:
CCA recapture terminal loss( ) Lower of selling price and the originaal cost UCC
$200 000, $386 750, $186 750, The number is negative, so it represents a terminal loss of $186,750.
EXAMPLE 3-3 Terminal Loss
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87 CHAPTER 3 3.5 The Canadian Tax System
Firms often make temporary investments while waiting to pay bills. These assets generate investment income. Similarly, CP has both debt and common shares outstanding, so it paid interest on its debt and dividends on its common shares. How investment income and expenses are treated for tax purposes is very important in finance. The basic rule is that inter- est is fully taxable when earned and fully deductible when paid. Usually, firms combine these two items into one “net interest” amount that is taxable.
Unlike interest, dividends are not tax deductible when paid; they are paid out of after-tax income. In return, when a Canadian corporation receives dividends from another Canadian corporation, they are not taxable, because they are paid out of the after-tax income of the issu- ing corporation. Otherwise, dividends flowing through multiple companies would attract tax at every stage, thereby increasing the effective tax rate. This represents another difference between accounting income and income for tax purposes. In particular, for accounting pur- poses, any dividends received are added to income. All else being constant, the different tax treatment of interest and dividends means that companies prefer to pay interest (issue debt) and receive dividend income. We will return to this preference when we discuss corporate financing issues in Chapter 21 . In terms of taxable income, it means that firms with significant dividend income and high CCA deductions will appear to pay lower rates of tax on their finan- cial statements.
The basic tax rates for Canadian corporate income for 2013–15 consisted of a federal and a provincial rate, and are provided in Table 3-4 . The basic rate of federal corporate income tax was 15 percent for active businesses in 2015—that is, for non-investment income—with a 4-percent reduction to 11 percent for small businesses earning less than $500,000. 22 Provincial taxes run from 0 percent for small businesses in Manitoba, for an overall rate of 11 percent, to 16 percent for larger businesses in Nova Scotia and Prince Edward Island, for an overall rate of 31 percent. Operating losses can also be important for corporations, since they can be used to reduce taxable income. If a company has a loss, it can carry it back three years to restate prior tax returns and get a refund on taxes that have been “overpaid.” Alternatively, the operat- ing loss can be stored and carried forward for 10 years to reduce future taxes payable.
operating loss loss generated when a firm ’ s tax deductions are greater than its taxable income; losses can be carried back three years to get a refund on taxes paid or carried forward for 10 years to reduce future taxes payable
TABLE 3-4 Corporate Income Tax Rates 2013, 2014, 2015 (%)
2015 2014 2013
Federal General 15 15 18
Small business CCPC 11 11 11
Alberta General 10 10 10
Small business CCPC 3 3 3
British Columbia General 11 11 10.5
Small business CCPC 2.5 2.5 2.5
Manitoba General 12 12 12
Small business CCPC 0 0 1/0
New Brunswick General 12 12 11
Small business CCPC 4 4.5 5
Newfoundland and Labrador General 14 14 14
Small business CCPC 3 4 4
(continued)
22 Note that this is the federal limit. At the time of writing, provincial limits were $500,000 in every province or territory except Manitoba, where it was set at $425,000, and Nova Scotia, where it was $350,000.
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88 CHAPTER 3 Financial Statements
2015 2014 2013
Northwest Territories General 11.5 11.5 11.5
Small business CCPC 4 4 4
Nova Scotia General 16 16 16
Small business CCPC 3 3 5
Nunavut General 12 12 12
Small business CCPC 4 4 4
Ontario General 11.5 11.5 12
Small business CCPC 4.5 4.5 4.5
Prince Edward Island General 16 16 16
Small business CCPC 4.5 4.5 1
Quebec General 11.9 11.9 11.9
Small business CCPC 8 8 8
Saskatchewan General 12 12 12
Small business CCPC 2 2 4.5
Yukon General 15 15 15
Small business CCPC 3 4 4
CCPC: Canadian-controlled private corporation
Source: Data from Canada Revenue Agency website, www.cra-arc.gc.ca, and provincial and territorial websites.
TABLE 3-4 Corporate Income Tax Rates 2013, 2014, 2015 (%) (continued )
Personal Tax
Canada operates a progressive personal tax system in which the rates increase with income.
For 2015, the basic federal income tax rates were the following:
• 15 percent on the first $44,701 of taxable income
• 22 percent on the next $44,700 of taxable income
• 26 percent on the next $49,185 of taxable income
• 29 percent on income above $138,586
In addition, each province operates a separate provincial tax system. It used to be that provincial taxes were a simple multiple of federal taxes, so that Ontario, for example, would add 52 percent (at its peak) of federal taxes. However, things have changed over the past 10 years, and most provinces have developed a parallel progressive tax system.
Table 3-5 provides the 2015 federal and provincial marginal tax rates. In looking at the tax rates, remember that these rates are marginal rates, which means they are the rates on the next dollar of income. For example, the top federal rate of 29 percent is applied to every dollar of income above $138,586. Someone earning over $150,000 in Nova Scotia would pay this federal rate of 29 percent, plus a provincial rate of 21 percent—effectively, the governments are equal partners for these individuals. Remember too that interest income is taxed as ordi- nary income: the marginal tax rate for investment income differs depending on whether the individual earns interest from debt, dividends from common shares, or capital gains from increases in security prices.
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89 CHAPTER 3 3.5 The Canadian Tax System
(continued) TABLE 3-5 Provincial/Territorial Personal Income Tax Rates, 2015
Provincial / Territorial Tax Rates (Combined Chart) Provinces/Territories Rate(s)
Federal 15% on the first $44,701 of taxable income, +
22% on the next $44,700 of taxable income, + 26% on the next $49,185 of taxable income, + 29% of taxable income over $138,586.
Alberta 10% of taxable income
British Columbia 5.06% on the first $37,869 of taxable income, + 7.7% on the next $37,871, +
10.5% on the next $11,218, + 12.29% on the next $18,634, + 14.7% on the next $45,458, + 16.8% on the amount over $151,050.
Manitoba 10.8% on the first $31,000 of taxable income, + 12.75% on the next $36,000, +
17.4% on the amount over $67,000.
Newfoundland and Labrador 7.7% on the first $35,008 of taxable income, + 12.5% on the next $35,007, +
13.3% on the amount over $70,015.
New Brunswick 9.68% on the first $39,973 of taxable income, + 14.82% on the next $39,973, +
16.52% on the next $50,029, + 17.84% on the amount over $129,975.
Northwest Territories 5.9% on the first $40,484 of taxable income, + 8.6% on the next $40,487, +
12.2% on the next $50,670, + 14.05% on the amount over $131,641.
Nova Scotia 8.79% on the first $29,590 of taxable income, + 14.95% on the next $29,590, +
16.67% on the next $33,820 + 17.5% on the next $57,000, + 21% on the amount over $150,000.
Nunavut 4% on the first $42,622 of taxable income, +
7% on the next $42,621, + 9% on the next $53,343, +
11.5% on the amount over $138,586.
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Both cash and stock dividends received by individuals from Canadian corporations are taxable using the dividend tax credit system, which provides for tax savings associated with dividend income. For “eligible” dividends (which essentially applies to those received from Canadian companies), the system works in the following manner. First, the amount of the dividend is “grossed up” (currently by 38 percent) to obtain the full taxable amount of divi- dend income included in taxable income. Then a federal dividend tax credit (currently 15.0198 percent) is applied to reduce the taxes owing. The appropriate provincial tax credit (which varies by province) is also applied. We will discuss how this interacts with corporate taxation later in the textbook (in chapters 21 and 22), when we consider how a firm should be financed. However, note for now that the tax rate on dividend income is always lower than that on interest income. Under recent rules, the dividend tax rates will be 20 to 25 percent lower than the marginal rates, depending on an investor ’ s tax category and on the provincial rules.
The final source of investment income is capital gains. These are currently taxed on the basis that 50 percent of the capital gain (i.e., the taxable capital gain) is included as ordinary income. As a result, the effective rate is simply half that of ordinary income. If an individual incurs a capital loss, it can only be used to offset capital gains income, but not ordinary income.
That being said, if there is an excess of capital losses, it can be carried back three years, to reduce any taxes paid on previous capital gains, or carried forward indefinitely. Of course, tax rates and tax rules are constantly changing, and we suggest that you check the newest tax rules.
TABLE 3-5 Provincial/Territorial Personal Income Tax Rates, 2015 (continued ) Provincial / Territorial Tax Rates (Combined Chart) Provinces/Territories Rate(s)
Ontario 5.05% on the first $40,922 of taxable income, + 9.15% on the next $40,925, +
11.16% on the next $68,153, + 12.16% on the next $70,000, + 13.16% on the amount over $220,000.
Prince Edward Island 9.8% on the first $31,984 of taxable income, + 13.8% on the next $31,985, +
16.7% on the amount over $63,969.
Quebec 16% on the first $41,495 of taxable income, +
20% on the next $41,490, + 24% on the next $17,985, +
25.75% on the amount over $100,970.
Saskatchewan 11% on the first $44,028 of taxable income, + 13% on the next $81,767, +
15% on the amount over $125,795.
Yukon 7.04% on the first $44,701 of taxable income, +
9.68% on the next $44,700, + 11.44% on the next $49,185, + 12.76% on the amount over $138,586.
Source: Data from Canada Revenue Agency website, www.cra-arc.gc.ca.
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