Discover how to navigate the Canadian tax system and keep more of your hard-earned money.
As a newcomer to Canada, you've already conquered the challenges of moving to a new country and establishing yourself professionally. Now it's time to master another essential skill: making the Canadian tax system work for you. In my previous blog, we discussed wealth planning, and we talked about building financial security. Today, let's dive into tax planning – and yes, it can be enjoyable once you realize the Income Tax Act provides perfectly legal ways to minimize your tax burden!
We often joke about the fear that the "tax man" instills – that mysterious government figure who seems determined to claim a chunk of everything you earn. But here's a secret: when you learn the rules, this seemingly intimidating character becomes more like a strict but fair referee with a rulebook you can study. You'll still pay taxes, but wouldn't you rather pay what's necessary instead of overpaying due to lack of knowledge?
Filing Returns: Even When You Don't Have To
Tax season may be annoying for some, but I urge you to still file your taxes annually even if your income is below the basic personal amount (BPA) exemption threshold ($16,129). Here is one advantage of filing a tax return, particularly if you have a child earning an income.
Filing your taxes even with a low income makes you eligible to begin accumulating RRSP room. RRSP room arises from your previous year of earnings, based on the lesser of 18% of earned income or the annual max amount, currently at $32,490. The long-term benefit of this is that as your income improves in future years, you’d have the advantage of accumulating a larger RRSP room that could be used to bring down the taxes you owe during your high-earning years.
The Magic of Income Splitting for Couples
In Canada, taxes are based on individual earnings rather than on household income. Due to this interpretation and Canada’s progressive tax system (the higher your income, the more taxes you pay), it is more beneficial if you are a couple and each earns $100,000 rather than one of you earning $200,000. Here is what it looks like in practice.
If you are in a different tax bracket, reporting some income from the high-income earner under the lower-income earner may be advantageous. However, you must ensure you do not trigger undue taxes due to “attribution rules.” This rule prevents the higher-income spouse from transferring or loaning some of their income to the lower-income spouse. Such a maneuver will cause the transferred income to be attributed back to the higher-income spouse, resulting in no tax savings.
There are two simple strategies the Income Tax Act allows couples to split their income. The first is through a different RRSP (Registered Retirement Savings Plan) account, Spousal RRSP, and the other via TFSAs (Tax-Free Savings Account). With the spousal RRSP, if during planning discussions you foresee that one of you will earn less in retirement, you may want to have the higher earner make RRSP contributions to the spousal RRSP account of the low earner. The benefits:
- This strategy allows the lower earner to withdraw retirement funds at a lower tax bracket, reducing household taxable income.
- More importantly, this strategy allows the high-income spouse to reduce their taxable income today through deductions from the contributions while allowing for tax-deferred growth of retirement funds.
You can also use TFSA to split your income. Sometimes, you may want to contribute to your spouse’s TFSA via a gift if they are in a lower tax bracket. This will ensure they do not compromise their retirement access to income-tested government pension programs such as OAS (Old Age Security) or GIS (Guaranteed Income Supplement). However, remember that withdrawals of the gifted funds from TFSA must be used to cover living expenses; otherwise, you can be subject to the attribution rules discussed above.
Business Owner Decisions: To Incorporate or Not?
As an Immigrant business owner in Canada, you have access to some interesting tax planning strategies. However, one of the critical decisions is whether it makes sense to incorporate or not. Incorporation brings many tax advantages and benefits, such as the option to be paid in salary dividends or both. I’ll expand on this topic in the next blog.
The Losses Trap
If your business is still in the early stages and you are reporting losses in the first few years, those losses are trapped in your corporation. So, waiting until you start generating profits might make more sense. This is because a corporation is a separate legal entity, so any incurred losses cannot be claimed by its shareholder and thus trapped within the corporation. On the other hand, if you were unincorporated, the losses can be used against other income earned by you. Granted, there are different reasons for incorporating, even if you have losses, such as creditor protection or limited liability.
Incorporating is more beneficial once you are profitable, especially if you don’t need all your profits to reinvest in the business or fund your lifestyle. The tax benefit of retained profits/earnings in a corporation is that you defer paying taxes on personal income until you redeem it in the form of salary or dividends. You will pay taxes on corporate profits, but the corporate tax rate is relatively low (currently 12.2% in Ontario) on the first $500,000 of active business income earned by a Canadian Controlled Private Corporation (CCPC) due to the Small Business Deduction (SBD) limit.
The Golden Ticket: Lifetime Capital Gains Exemption
In Canada, there is one generous tax strategy that many business newcomers are unaware of, which could make or break their bank whenever they exit the business. However, without planning in advance, you risk forfeiting this valuable exemption. As of today, if you sold Qualified Small Business Corporation Shares (QSBCS), you can shelter up to $1.25M in capital gains generated from the disposition of those shares. This exemption isn’t automatic and comes with a list of eligibility requirements. The “tax man” won't let you off that easy. If you have QSBCS and plan on selling them within the next 5 years, there are a few criteria you need to pass to maximize the exemption.
The first test is that your business must be a CCPC. If you sell via your holding company or passive business, it will not qualify, and the CCPC must be an active business or operating company (OpCo). A passive business collects rental, interest or dividend income. Your business must manufacture or offer services within Canada, and at the time of sale, 90% of the fair market value of the assets being sold must have been used in active business in the year of the sale. Additionally, 50% of the assets must be used to produce active business income in the preceding 24 months. As you can see, there are some strict targets to meet. Otherwise, you can kiss that exemption goodbye or delay the sale of your business. I'm not sure if that is a great idea if you already have buyers lined up.
Advanced Strategies: Purification and Multiplication
To address the issue of maintaining the appropriate asset levels, you must consider purifying your business occasionally. To do so, you’d make a holding company (HoldCo) the beneficiary of a trust, who is also a shareholder of your active corporation. This allows purification as a means of transferring out passive assets from your active corporation, such as dividends, to the trust. Since the HoldCo is the trust beneficiary, the dividends are reported under HoldCo.
Another fantastic strategy to consider is the multiplication of LCGE. Multiplication becomes highly advantageous for businesses with more than one shareholder since each shareholder benefits from the full LCGE limit. But what if you are the sole shareholder? There is a way to multiply the benefit to your immediate family through a family trust since it's inappropriate to make your spouse or children direct shareholders of your OpCo if they are not actively involved in the business. Nonetheless, it is acceptable to make your spouse and children beneficiaries of a “Family Trust” that is a shareholder of your OpCo.
A Final Word of Caution
As with all tax planning discussions, always consult your tax professional to ensure these strategies apply to you and comply with the Income Tax Act. Tax planning is a collaborative effort that involves your Financial Planner, CPA, and lawyers. More importantly, don't delay this planning! You’ll end up disappointed and regretting it. It's not something you want to face after all the sacrifices you've made to start a business, especially in a new country.
Remember, the "tax man" isn't your enemy – but he does expect you to follow the rules. With proper planning, those same rules can help you build and preserve your wealth as you continue your Canadian success story.
