Insurance Journal – Page 17

Denied tax credit for interest on student loans

At issue

As many a parent will attest, it can be very costly to put a child through post-secondary schooling. If the family does not have immediate resources available, it is common to consider borrowing to finance the need.

Fortunately, the tax system provides support to qualified loans through a non-refundable tax credit based on the amount of interest paid in the course of retiring such loans. To qualify, section 118.62 of the Income Tax Act (ITA) requires that the loan must be made “under the Canada Student Loans Act, the Canada Student Financial Assistance Act or a law of a province governing the granting of financial assistance to students at the post-secondary school level.”

Unfortunately, it’s almost an annual ritual that a case is reported where a past student is denied entitlement to the tax credit because the particular loan does not meet this criterion.

Mueller v. R., 2013 TCC 3

Two sisters were unable to obtain student loans under the federal government’s student loan programs, as their parents’ income was too high. Instead, they secured loans from a bank under its “Student Line of Credit” program, promoted by the bank as being at rates lower than under the student loan program.

On filing their tax returns in the year following graduation, their interest claims related to loan retirement were denied.

The sisters’ mother represented them in their appeals, and testified that a bank employee had represented that the loans were tax deductible. No reference to this effect appears in the promotional literature, and no one from the bank was called to testify.

It was acknowledged that the loans were not of the listed types in ITA 118.62, which the judge found was “fatal to their claim.” Appeals denied.

Sandhu v. R., 2010 TCC 223

The taxpayer was represented by his father in this appeal from a denied tax credit claim based on repayment of a loan to a bank.

The father provided a letter from a bank representative dated a week prior to the hearing. It read in part: “Due to my busy schedule, I will not be able to appear personally on April 7, 2010. The student loan to Gurdarshan Sandhu was made under the Canada Student Loan program.”

The judge allowed no evidential weight to the letter as no details of the loan were provided. Indeed, there was no way to be certain whether the referenced loan was even the loan at issue in court. The judge went so far as to speculate whether the writer may have been confusing student loans with some internal lending program the bank makes available for professional graduate programs. Appeal denied

2001-0074215E Refinancing-Student Loans

A taxpayer proposed to obtain a mortgage against his residence to reduce the interest rate on his existing qualified student loan. The Canada Revenue Agency (CRA) stated that interest on the new loan would not qualify for claiming the tax credit under ITA 118.62.

2010-0376461I7E Credit for Interest on Student Loan

The CRA was asked its opinion on whether interest paid on a student loan assigned to a collections agency would still qualify for the tax credit claim. The writer opined that the likelihood is that being under a collections process alone would not be sufficient to lose the tax credit claim, but that a court judgment would definitely extinguish it.

Practice points

A ‘loan to a student’ is not necessarily a “student loan” for the purpose of claiming the tax credit on the interest. To qualify, the loan must be arranged under the Canada Student Loans Act, the Canada Student Financial Assistance Act or a corresponding law of a province.
If challenging a denial of interest, make sure the facts are satisfied (so you don’t waste your time), and that you have the original documentary evidence to prove it. Second and third degree-removed hearsay assertions will not suffice.
A debtor should carefully consider the lost tax credit on qualifying student loans before including those debts in a refinancing or consolidation, even if on the face of it the new interest rate appears lower.
A person facing collections action should understand the importance of keeping up payments on student loans in order to preserve the tax credit entitlement, as this will be lost if a judgment is entered.

Canadian dividend taxation – Rule changes are designed to restore balance

Viewed in isolation from other income sources, the preferred tax rates accorded to Canadian dividends can appear to be a gift from the government. Rest assured, though, that we are not simply being plied by our politicians. There is a logical method to the apparent madness of the process for calculating those tax bills.

Still, the inputs underlying that logic can sometimes fall out of balance. Such is the case with the treatment of so-called “ineligible” dividends from private corporations, as identified in the 2013 Federal Budget. As a result, adjustments will be coming in 2014 that will lead to a small increase in net dividend tax rates for small-business owners.

The integration model

With two types of taxpayers – individuals and corporations, each facing different levels of taxation – there is a risk of double taxation in our system. The model built into the system that reconciles this two-stage taxation is called “integration,” and it has two principal components:

Gross-up – The actual dividend received by a shareholder from a Canadian corporation is increased by an arithmetic factor designed to add back the taxes paid by the corporation. The resulting figure is the amount of taxable dividend that is used to calculate the individual’s initial tax liability
Dividend tax credit – Another arithmetic factor is then applied to reduce the individual tax liability by the amount of corporate tax paid

Past reforms – Eligible dividends

Until 2005, one set of factors for gross-up and tax credits applied to all Canadian-source dividends. Specifically, there was no distinction between original income that had been subject to the full general corporate rate versus income that had made use of the small-business deduction.

While it may not have been apparent to the individual shareholder/taxpayer, the effect was an element of double taxation. To address the issue, beginning in 2006, dividends from large corporations became “eligible” for an enhanced gross-up and associated tax credit. Both of these were adjusted to align with the series of reductions in the general corporate rate from 2010 through 2012.

For 2013, the federal gross-up is 38% and the dividend tax credit is 6/11 (approximately 55%) of the grossed-up amount. Provinces use the federal gross-up, but apply their own tax credit rate that aligns with their respective corporate tax rates. These would be the rates applicable for an investor earning Canadian dividend income in an investment portfolio. There are no pending changes to these factors.

Current reforms – Ineligible dividends

Ineligible dividends are those that arise out of corporate income that has benefited from the small-business deduction. The term “ineligible” is not actually a defined term, but is simply used to distinguish from the eligible dividend treatment described above. Again, the procedure is the same, but the factors are different.

When eligible treatment was introduced in 2006, the existing factors were left unchanged and have remained so right up to the present. In fact, those factors overcompensate individuals who receive dividends from a corporation that has used the small-business rate on active business income.

Accordingly, the government will change the factors applicable to ineligible dividends beginning in 2014. As with eligible dividends, provinces will continue to employ the federal gross-up factor and make appropriate adjustments to their respective tax credit rates. The accompanying table summarizes the changes for the calculation of federal tax, with dollar examples at top federal income-bracket level.

* The credit is calculated as a fraction of the grossed-up amount.

Restricted farm losses – Chief income source rule reinstated

At issue

Like any other endeavour, farming can sometimes be a profitable undertaking, and at other times a losing proposition. Should losses arise in a year, the ability to deduct them depends on whether there had been an intention to undertake a commercial activity, and what other income sources the taxpayer may have had:

Where a farming business is the chief source of income, losses can be applied against other income sources, including 3 year carryback and 20 year carryforward.
At the other extreme where there is no expectation of profit – so-called ‘hobby farming’ – losses are not deductible, despite that any net income is fully taxable.
In between, where the “chief source of income … is neither farming nor a combination of farming and some source of income” [Income Tax Act s.31(1)], the ‘restricted farm loss’ rules apply.

It is this in-between category that is often a bone of contention between taxpayers and the Canada Revenue Agency (CRA). A formula is used to cap the amount of losses that may be claimed in a given year to $8,750. As with the chief income source, these losses may be carried back 3 years and forward 20 years, but can only be used against farming income.

A taxpayer win over the CRA at the Supreme Court of Canada (SCC) in 2012 drew the government’s attention, with a double-edged response making its way into the 2013 Federal Budget.

Moldowan v. The Queen, [1978] 1 S.C.R. 480

This SCC decision sets forth the three classes of farming taxpayers summarized above. On the facts, the Court found that Mr. Moldowan’s farming business was subordinate to his other sources of income, and therefore the farm loss deduction limitations applied.

This case has been considered and followed in dozens of subsequent cases.

Gunn v. Canada, 2006 FCA 281

In the approximate three decades that elapsed since Moldowan, there had been much criticism of the judgment. It required farming to be the chief source of income in both the first and second classifications, despite that nothing in the relevant ITA sections appears to require that.

In the Gunn decision, the Federal Court of Appeal sought to give effect to the word “combination” in the second classification, and declined to follow Moldowan.

Canada v. Craig, 2012 SCC 43

In Craig, both the trial and appeal courts followed the FCA in Gunn, effectively purporting to overrule Moldowan. The SCC in the present case remarked that the lower courts should have merely given reasons why they found Moldowan problematic, but otherwise followed it. Still, the matter now stood before the SCC.

The judges then proceeded to review the troubled history of Moldowan, and the concurrent development in legislative interpretation at the SCC. There is a delicate balance between the values of correctness and certainty when the top court considers overruling one of its own decisions, but in the end that is what it did.

The revised view of “combination” is to look at a variety of factors including capital invested, time spent, farming history and future intentions. If a taxpayer places significant emphasis on both farming and non-farming income, the combination suffices to be the chief source of income whether or not the farming income is greater.

Mr. Craig was entitled to his approximate $425,000+ losses for the two years in question.

Federal Budget – March 21, 2013

The Budget document briefly recaps the preceding history culminating in Craig, then proposes to restore the interpretation in Moldowan. Assuming passage of the Budget, for taxation years ending after March 21, 2013, “a taxpayer’s other sources of income must be subordinate to farming in order for farming losses to be fully deductible against income from those other sources.”

Concurrently, and in recognition that the deduction limits have not changed for 25 years, the formula will be amended to effectively double the annual deduction limit to $17,500.

Practice points

Certainty is an important part of legal and tax planning. Unfortunately for part-time farmers, it is now the certainty of being caught by the restricted farm loss rules where farming is not the chief source of income.
For those taxpayers with more modest farming losses than the six figure amounts in these high-profile cases, the doubling of the deduction limit is the good news in this development.