PRINCIPLES OF CANADIAN INCOME TAX LAW Fifth Edition PETER W. HOGG Professor Emeritus, Osgoode Hall Law School York University, Toronto Scholar in Residence Blake, Cassels & Graydon LLP, Toronto JOANNE E. MAGEE Associate Professor, Atkinson Faculty of Liberal and Professional Studies York University, Toronto and JINYAN LI Associate Professor, Osgoode Hall Law School, York University, Toronto THOMSON CARSWELL
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PRINCIPLES OF CANADIANINCOME TAX LAW
Fifth Edition
PETER W. HOGGProfessor Emeritus, Osgoode Hall Law School
York University, TorontoScholar in Residence
Blake, Cassels & Graydon LLP,Toronto
JOANNE E. MAGEEAssociate Professor, Atkinson Faculty
of Liberal and Professional StudiesYork University, Toronto
and
JINYAN LIAssociate Professor, Osgoode Hall Law School,
York University, Toronto
THOMSON
CARSWELL
CONTENTSPreface iiiSummary of Chapters vTable of Cases xxv
Chapter 1 lncome Tax Law and Policy
1.1 Role of the income tax 21.2 The Income Tax Act 4
(a) Primary source of tax law 4(b) Structure of the Act 4(c) Citing the Act 6(d) Statutory style 6
1.3 Interpreting the Act 7(a) Important skill 7(b) Statutory Interpretation 8
(i) What is it? 8(ii) Approaches 8(iii) Statutory language 9
(c) Meaning of words 10(i) Statutory definitions 10(ii) Ordinary, technical, or legal meaning 10(iii) Context 11
(d) Legislative purpose and intent 11(e) Interpretation tips 12
1.4 Other sources of tax law 13(a) Income tax application rules 13(b) Income tax regulations 13(c) Tax treaties 14(d) Tax cases 14
1.6 History 18(a) Confederation 18(b) Provincial income taxes 19(c) Federal income tax 19(d) Federal-provincial agreements 19(e) Tax reform of 1971 and the Carter Report 20
Chapter 6 Income from Business or Property: Profit
6.1 Statutory framework 1396.2 Concept of profit 140
(a) Net concept 140(b) Financial versus tax accounting 140(c) Question of law 145
6.3 Judicial interpretive framework 146(a) Canderel and the framework 146(b) "Accurate picture" of profit requirement 147
(i) The goal 147(ii) Measurement of "accurate picture" 149(iii) Onus of proof 150
(c) Freedom of choice of accounting methods within constraints 150(d) Financial accounting principles as interpretive aids 151
6.4 Methods of accounting 151(a) Cash method 151(b) Accrual method 152(c) Accounting for capital assets 154(d) Accounting for inventory 155
Chapter 7 Income from Business or Property: Inclusions
7.1 Separate sources 1587.2 "Business" and "property" defined 158
(a) Importance of characterization 158(b) Statutory definitions 159
XI
C O N T E N T S
(c) Common law lest: pursuit of profit 159
(i) Stewart and Walls 160
(ii) Intention to profit as opposed to reasonable expectation of profit . . . .161
(iii) Layperson's sense of "profit" 162(iv) Implications for tax shelter investments 162
(d) Personal endeavours distinguished 164(i) Importance of distinction 164
(ii) Hobbies 165(iii) Personal elements in rental properties 166(iv) Gambling 166
(e) Employment distinguished 167(f) Capital gains distinguished 167(g) Business distinguished from property 168
(i) Level of activity 168(ii) Differential tax treatments 169
7.3 Inclusions in Computing income from business '70(a) Income vs. capital receipt 17°(b) Timing-realization principle '71(c) Amounts received '72(d) Amounts receivable ' "
(i) Accrual method of accounting '73
(ü) Meaning of "receivable" ' 7 4
(iii) Säle of property ) 7 5
(iv) Services 1 7 6
(v) Professional businesses '777.4 Inclusions in Computing income from property '77
(a) Retum on Investment '77(b) Dividends 1 7 8
(c) Rent and royalties 178
(d) Interest ' 7 9
(i) Definition l 7 9
(ü) Special timing rules l 8 °(e) Blended payments l 8 2
(0 Discounts l 8 3
(i) Definition l 8 3
(ü) Position of creditor l 8 4
Chapter 8 Income from Business or Property: Deductions
81 Two fundamental questions '(a) Deductibility l 8 9
(b) Timing of deductions l 9 °8.2 Income tax logic and the ability to pay l 9 1
8.3 Income-eaming expenses l 9 "(a) Statutory rules '^2
(b) Purpose test l 9 3
(i) Income-earning vs. personal expenses
CONTENTS
8.4 Personal or dual-purpose expenses 194(a) "Personal or living expenses" defined 194(b) Dual-purpose expenses 195(c) Child care expenses 196(d) Food and beverages 197(e) Entertainment expenses 198(f) Commuting expenses 200(g) Housekeeping expenses 201(h) Home-office expenses 201
8.5 Public policy 203(a) The issue 203(b) Fines, penalties and illegal payments 203
(i) Common law approach 203(ii) Statutory prohibitions 206
(c) Damages and similar payments 207(d) Expenses of illegal businesses 208
8.6 "Reasonable" requirement 209(a) Rationale 209(b) Unreasonable amount attributable to personal elements 209(c) Unreasonable amount in non-arm's length payments 210
8.7 Timing 211(a) Capital vs. current expenditures 211(b) Current expenses 212
8.8 Inventory 224(a) What is inventory? 224(b) A matter of timing 224(c) Cost of goods sold 225(d) Valuation methods 226(e) Tracing inventories 228
8.9 Interest expense 229(a) What is interest? 229(b) Current or capital expenditure 230(c) Paragraph 20(I)(c) 231(d) "Purpose" lest 231
(i) "Any" not "the" purpose 233(ii) "Gross" not "net" income 234
CONTENTS
(iii) "Reasonable" expectation of gross income()(e) Tracing the use of borrowed money 236
(i) Money is fungible 236(ii) Current use ZJI
(iii) Direct use 238(f) Other costs of financing 240
8.10 The lay of the land on deductions 24-(a) General categorization of expenses 24-(b) Different purpose tests for interest and other expenses 242(c) Mismatch and tax arbitrage 243
Chapter 9 Income from Business or Property: Capital ExpendituresO/tQ
9.1 A timing issue -*°(a) Capital versus current expenditures 248(b) Tax deferral — the impact of capitalizing expenses 249
9.2 "Capital expenditure" defined 250(a) Common law tests 250
(i) Enduring benefit test "(ii) Recurring expenditures 25-(iii) Residual test in favour of the taxpayer 2M
(b) Acquisition of assets Z J
(c) Repair of tangible assets ~J
(d) Protection of intangible assets(e) Websites and domain names 2*(f) Corporate takeovers 258(g) Goodwill 259(h) Expenses with respect to a new business
9.3 Recovery of capital expenditures 261(a) Statutory guesswork(b) Accounting methods 26~
(i) Straight-Iine method 2
(ii) Declining-balance method9.4 Capital cost allowance (CCA) 2 6 4
(a) Overview 264(b) Depreciable property and CCA rates
(i) Meaning 2 6 5
(ii) Rate of CCA 2 6 6
(iii) Accelerated cost recovery(c) Undepreciated capital cost (UCC)
(i) Meaning 2 6 8
269(ii) Cumulative account
269(iii) Class concept
T70(d) Capital cost . . . . .
270(i) Meaning
^71(ii) Apportionment "(iii) Timing of acquisition
(e) Proceeds of disposition
CONTENTS
(i) Meaning 273(ii) Timing 274
(f) Half year rule 275(g) Example of CCA computation 276(h) Retirement of depreciable property 277
(i) No more guesswork 277(ii) Recapture 279(iii) Terminal loss 280(iv) Review example 281
(i) Limitations on CCA deductions 283(i) Tax shelter losses 283(ii) Rental properties 283(iii) Leasing property 284
9.5 Eligible capital expenditures 285(a) Amortization of intangibles 285(b) "Eligible capital expenditure" defined 286(c) Deduction 287
Chapter 10 Capital Gabis
10.1 History 29010.2 Policy 291
(a) Should capital gains be taxable? 291(i) Equity 291(ii) Neutrality 292(iii) Certainty 292
(b) Should capital gains be taxed preferentially? 292(i) Partially taxable 293(ii) Lifetime exemption 294
10.3 Statutory framework 296(a) Inclusion in income 296(b) Taxable capital gains/allowable capital losses 296(c) Capital gains/capital losses 296(d) Gains/losses 297
10.4 Basic concepts 297(a) Capital property 297(b) Depreciable property 298(c) Disposition 298(d) Proceeds of disposition 299(e) Adjusted cost base 300
10.5 Computation of gain or loss 301(a) Proceeds due within the year 301(b) Proceeds due in a future year 301(c) Loss 305
10.6 Timing of realization 305(a) General rule 305(b) Timing of "disposition" 305(c) Policy implications 306
CONTENTS
30710.7 Special events and deemed dispositions
(a) Purpose
(c ) ° ' f t 3.0<d> T r u s t 310(e) Change of use(f) Departure from Canada
10.8 Capital losses(a) "Quarantined"(b) Stop-loss rules
(i) Superficial losses(ii) Personal-use property losses(iii) Listed personal property losses
10.9 Principal residence exemption(a) Tax expenditure(b) "Principal residence"
(d) Registered retirement savings plans (RRSPs) 364(i) Definition of RRSP 364(ii) Contributions based on earned income 364(iii) Withdrawals 366(iv) RRSP annuities 367(v) Registered retirement income funds (RRIFs) 368(vi) Tax consequences on death 368
(e) Contributions vs. direct transfers to RPPs, RRSPs and DPSPs 36912.5 Registered education savings plans (RESPs) 37012.6 Retiring allowances 372
(a) Meaning of "retiring allowance" 372(b) Tax treatment 375
12.7 Spousal and child support 376(a) Definitions 376(b) Deduction-inclusion System 377(c) Policy objectives 378
12.8 Workers' compensation and social assistance 38012.9 Moving expenses 381
(a) Deduclion 381(b) Policy objectives 382
12.10 Child care expenses 382(a) Deduction 382(b) Policy objectives 383
CONTENTS
Chapter 13 Income Splitting
13.1 Whose income? 38613.2 Income Splitting: why and how? 387
(a) Tax savings 387(i) Tax unit 387(ii) Rates and credits 388(iii) Characterization of income 389
(b) Techniques 38913.3 Taxation of the family 389
(a) Non-recognition of the family 389(b) Policy debate 390
(i) Equity between families 390(ii) Impact on household labour and employment 39-(iii) Equity between families and unattached individuals 393
(c) Limited recognition of the family 39413.4 Non-arm's length transfers 395
(c) Transfer to spouse or common-law partner — on death 403(d) Transfer to child 404
(e) Transfer to Corporation ^0513.6 Attribution rules 405
(a) Taxing the original owner 405(b) Transactions 4 0 6
(i) "Transfer" or "loan" 4 0 6
(ü) Indirect transfer 4 0 8
(iii) Anti-avoidance 4 0 8
(c) Attributable income 4 0 8
(i) Income from property or substituted property(ii) Income from business excluded(iii) Capital gains 4 I 0
(d) lntra-family transfers 4 "
(i) Spouse or common-law partner(ii) Related m'inor 4 1 2
(e) Transfer to trust or Corporation 4
(i) Trust 4 l 2
CONTENTS
(ii) Corporation 41313.7 Income diversion 414
(a) Rationale 414(b) Indirect payment 415(c) Transfer of rights to income 417(d) Interest free or low interest loans 417
13.8 Tax on minors 418(a) Rationale 418(b) The "kiddie" tax 418
13.9 Evaluation 420
Chapter 14 Taxable Income and Tax for Individuais14.1 Tax payable 42414.2 Net income 425
(a) Foundation of the tax base 425(b) "Net" of current year losses 425(c) Loss from an income source 425(d) Allowable capital losses 426(e) Allowable business investment losses 427
14.3 Losses 428(a) What is a "loss"? 428(b) Does source matter? 428(c) When do losses occur? 428(d) Whose losses? 429
14.4 Limitations on deductions for losses 430(a) Personal losses 430(b) Capital losses 430(c) Farm losses 430(d) Tax shelter losses 432
(i) Characteristics of tax shelters 432(ii) Techniques of tax shelters 433(iii) Judicial response 434(iv) Legislative response 435
(e) Stop-loss rules 43614.5 Taxable income 43714.6 Loss carryovers 437
(a) Non-capital losses 437(b) Net capital losses 439(c) Allowable business investment losses 439(d) Farm losses and restricted farm losses 440(e) Change of corporate control 440
14.7 Tax policy 442(a) Objectives 442
(i) Ability to pay 442(ii) Economic efficiency and neutrality 442(iii) Stimulation of certain economic and social activilies 443(iv) Technical deductions 444
CONTENTS
444(b) "Slaging" the deduction
445(c) Utility of "net income concept
t • 44S
(d) Conversion of deductions to credits446
14.8 Tax rates for individuals446
(a) Rate structure446(i) Federal rates - 447(ii) Provincial rates448
(b) Marginal and average rates(c) Progressive, regressive or flat rates
449(i) Definition 450(ii) Justification for progressive rates 4^2(iii) Arguments for Hat rates 4 ^(iv) Flattening the rates "
(d) Indexing for inflation(i) Effect of Inflation(ii) lndexation rules
Chapter 15 Corporations and Shareholders15.1 Introduction
464(a) Scope of chapter(b) Incorporation
465(c) Public and private corporations(d) Canadian-controlled private corporations(e) Corporate distributions
46915.2 Integration of Corporation and shareholder taxes
469(a) Double taxation of corporate income(b) Carter Commission's proposals
472(c) Tax reform of 1971
4/3(d) Subsequent reforms „,
47615.3 Shellering income in a Corporation
476(a) Carter Commission's proposals
477(b) Tax reform of 1971
47 s(c) Tax reform of 1988(d) Reforms in the 1994 and 1995 budgets
(e) Rate reductions in 200015.4 Taxation of shareholders
480(a) Integration and imputation(b) Gross-up and credit procedure
4ö-*(c) Effect of gross-up and credit
48415.5 Taxation of corporations
484(a) Taxable income
CONTENTS
(i) General rule 484(ii) Intercorporate dividends 485(iii) Charitable donations 486
(b) Tax rates 486(i) Federal lax 486(ii) General rate reduction 486(iii) Corporate surtax 487(iv) Large corporations tax 487(v) Provincial abatement 488(vi) Provincial taxes 488(vü) Standard corporate rate 489
(c) Investment income of Canadian-controlled private corporations 490(i) Canadian-controlled private corporations 490(ii) Policy 490(iii) Refundable dividend tax on hand account 491(iv) Dividends 492(v) Capital gains 493
(d) Active business income of Canadian-controlled private corporations 493(i) Small business deduction 493(ii) Active business income 494(iii) Investment income compared 495(iv) Limits on the small business deduction 495
(e) Manufacturing and processing credit 496(f) Conclusion 497
Chapter 16 Parlnerships
16.1 Introduction 49916.2 Definition of partnership 49916.3 Taxation of partnership 50116.4 Partnership interest 50216.5 Rollovers for the formation and dissolution of Canadian partnerships 504
Chapler 17 Trusts
17.1 Introduction 50817.2 Nature of trusts 508
(a) Definition of trust 508(b) Inrer vivos vs. testamentary trusts 508(c) Personal vs. commercial trusts 510(d) Discretionary vs. non-discretionary trusts 510(e) Spousal trusts 511(f) Alter ego and Joint spousal trusts 512
17.3 Special features of taxation 512(a) Legislative scheme 512(b) Taxed as an individual 513(c) Rates 514(d) Conduit treatmenl of trusts 515
17.4 Creation of trust 515(a) Methods of creation 515
CONTENTS
(b) Transfer of property 515(i) General 5 1 5
(ii) Transfer of property on death 516(c) Rollovers 5 1 6
C I O
17.5 Income taxed to the trust •""(a) Computation and designation of trust's income 518(b) Deemed disposition of trust property 519
17.6 Income taxed to the beneficiary -1
(a) Income paid or payable in the year 5-0(b) Preferred beneficiary election •(c) Special rules for capital gains J "(d) Flow-through character of income J
C73
(e) Tax-free payments to beneficiaries -17.7 Income taxed to the settlor -"-̂
(a) Anti-avoidance concems(b) Trusts for spouses or related minors 524(c) Trusts with reserved power of revocalion or control 525
17.8 Termination of trust 5 2 6
17.9 Tax planning with trusts 5 3°(a) Reasons for creating trusts(b) Planning a trust 5 3°
c<n(c) Income Splitting J
(d) Estate freeze 5 3 2
Chapter 18 Tax Administration and Ethics18.1 Filing of tax returns 5 3 5
18.2 Payment of tax 5 3 6
(a) Withholding at source(b) Instalmems 5
18.3 Assessment 5 3 8
538(a) Notice of assessment(b) Examination(c) Audit 5 3 9
18.9 Legal ethics 550(a) Role of tax lawyers 550(b) Rules of Professional conduct 551(c) Compliance 551(d) Litigation 552(e) Tax planning 552
Chapter 19 Statutory Interpretation
19.1 Statutory law 555(a) The Act is just another Statute 556(b) Policy objectives 556(c) Legislative scheme 557(d) Complexity 558
19.2 Statutory interpretation 559(a) Meaning of words 559(b) Characterization of facts 559(c) Judicial approach to statutory interpretation 560
19.3 Strict interpretation 561(a) Literal meaning 561(b) Outdated presumptions about tax law 561
19.4 Modem approach 562(a) The Stubart decision 562(b) Relevance of "object and spirit" 564(c) Piain meaning 566(d) Summary 569
19.5 Role of judges 569
Chapter 20 Tax Avoidance
20.1 Tax avoidance 572(a) Tax evasion distinguished 572(b) "Bad" avoidance distinguished 572(c) Moral and tax policy implications 574
20.2 Judicial doctrines 575(a) The Duke of Westminster case 575(b) Literal interpretation 577(c) Form over substance 578(d) Sham 580(e) Business purpose 581
20.3 Statutory anti-avoidance rules 58320.4 General anti-avoidance rule (GAAR) 585
(a) General nature of section 245 585(i) Measure of last resort 586(ii) Minister's discretion and role of the courts 586(iii) No down-side risk for taxpayers 587
(b) Application of section 245 588(c) Tax benefil" 589(d) "Transaction" or "series of transactions" 592(e) Primary purpose 594
(f) Misuse or abuse 599(i) Identifying "bad" avoidance 599(ii) Determination of "policy" 599(iii) Relevance of tax policy 600(iv) "Clear and unambiguous policy" policy test 601(v) Transactions resulting in misuse or abuse 602(vi) Non-abusive transactions 604
(g) Assessment of GAAR jurisprudence 607(i) Long live the Duke 607(ii) Continuing relevance of judicial and specific anti-avoidance rules . . .