April 2019 Newsletter

General rules

A partnership is not considered a "person" or a "taxpayer" for most purposes of the Income Tax Act. As a result, a partnership does not file an income tax return or pay income tax.

Instead, the partners include their shares of the partnership’s income or loss for the year (specifically, their taxation year in which the partnership’s fiscal period ends). The percentages are usually determined under the partnership agreement.

In addition, the type of income (business income, income from property, etc.) generally flows through and is taxed as such to the partner. A partnership is therefore considered a flow-through entity (in contrast to a corporation, which is a taxpayer and pays tax on its income, and its after-tax income paid out as dividends to the shareholders is also subject to tax, with a dividend tax credit intended to offset the corporate tax).

The income (or loss) is included in the partner’s income regardless of whether it remains in the partnership or is withdrawn as a partnership “draw”. When the partner withdraws the income, there is no further income inclusion.

Most businesses must use an accrual method in computing their business income for income tax purposes. An exception is made for certain taxpayers such as farmers or fishers, who can use a cash method.

Under the accrual method, a taxpayer carrying on a business must include amounts receivable in a year, even if they are not received in the year. In general terms, an amount is receivable where the taxpayer has an unconditional right to the amount in the year even though it is not due until a future year.

In some cases, a business of selling property (inventory) may deduct a reserve in respect of an amount receivable. The reserve, under Income Tax Act paragraph 20(1)(n), is allowed only if part or all of the proceeds of the sale are not due for at least two years after the date of sale, or in the case of real estate if all or part of the proceeds are due after the year of the sale.

If you sell a property and have a capital gain, it must be reported for tax purposes even if some of the proceeds are due after the year of sale. One-half of the gain is included in income as a taxable capital gain.

However, similar to the situation discussed in the preceding section, a reserve is allowed by Income Tax Act subparagraph 40(1)(a)(iii) where some or all of the proceeds are due after the year of sale. In the case of capital gains, the reserve in a taxation year is the lesser of:

  • gain on sale x proceeds due after year / total proceeds on sale (conceptually, this is the portion of the gain that hasn't yet been received); and
  • The following fraction amount, depending on the year:

Year 1(year of sale): 4/5 of gain

Year 2: 3/5 of gain

Year 3: 2/5 of gain

Year 4: 1/5 of gain

Years 5 and future: No reserve

If you receive a loan from your employer with an interest rate below the “prescribed rate” of interest, you must normally include in your employment income an imputed interest benefit, under section 80.4 of the Income Tax Act.

The amount of the benefit to be included in your income for a taxation year is:

  • the prescribed rate of interest applied to the principal amount of the loan outstanding during the year, minus
  • any interest you pay on the loan in the year or by January 30 of the following year.

The prescribed rate of interest is set for each quarter of each year and is based on 90-day Federal treasury bill rates. For the first quarter of 2019, the rate was 2%. The amount of the benefit can therefore vary from quarter to quarter and year to year as the loan remains outstanding.

If you own a debt instrument such as a bond, you will of course include the interest income from the instrument in your income for tax purposes. But what happens if you sell the debt before the next interest payment date, with accrued interest that you do not receive?

For income tax purposes, you must include the amount of interest that accrued up to the date of the sale. Typically, this is not problematic since the purchaser of the debt should compensate you for that interest by way of an increased purchase price (i.e. more than the debt’s face value). However, since the purchaser will be required to include in income the full amount of interest to the next interest payment date, the purchaser can deduct the interest accrued to the time of purchase.

In the February 2019 Tax Letter, we discussed the debt forgiveness rules under section 80 of the Act. As discussed, when a debt used for income-earning purposes is forgiven or otherwise settled, certain tax attributes of the debtor are reduced, such as previous years' loss carryforwards and the tax costs of some properties. If some of the debt remains outstanding after the reduction of the tax attributes, one-half of the remaining amount is included in the debtor’s income.

In the February Letter, we also noted that a debtor corporation can normally claim a reserve, which effectively allows it to spread out the income inclusion over five years, with a 1/5th inclusion each year.

However, another reserve may apply, under section 61.3 of the Act, if the debtor corporation is insolvent, or more particularly, where the remaining debt exceeds two times the corporation’s net assets. (The net assets for this purpose are computed using a formula in the Act.)

Principal residence exemption denied for sale of “wood lot” adjacent to home

The principal residence exemption generally exempts part or all of the capital gain from the sale of your home, depending on how many years it was your "principal residence". In addition to your home, the land surrounding the building is included as your principal residence for this purpose if it can “reasonably be regarded as contributing to the use and enjoyment of the housing unit as a residence”. Typically, your driveway and front and back yards qualify as part of your "principal residence".

However, if the surrounding land exceeds one-half hectare (about 1.24 acres), the excess will be considered part of your principal residence only if you can establish that the excess was necessary to contribute to your use and enjoyment of the housing unit.

In the recent Makosz case, the taxpayer bought a house on some land, and subsequently bought more of the surrounding land. The total land she owned exceeded one-half hectare. One part of the land, described as a “wood lot”, contained trees which were cut down to provide wood. The taxpayer claimed that wood from the wood lot was necessary for heating her house, which had a wood heating system, an electrical system and a gas fireplace. She subsequently sold the wood lot at a gain and attempted to shelter the gain using the principal residence exemption.

The CRA denied the principal residence exemption. The CRA was of the view that the taxpayer had not established that the wood lot was necessary for her use and enjoyment of the house. Upon appeal to the Tax Court of Canada, the Court agreed. They determined that the lot was not necessary for her use and enjoyment since the wood could have been obtained elsewhere.