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CIFP - FINANCIAL PLANNING 2

M1C11V10 ITP 01/10

Income Tax Planning

The Canadian Institute of Financial Planning 3660 Hurontario, Suite 600 Mississauga, Ontario L5B 3C4 Tel: 1-866-635-5526 www.CIFP.ca

This printed text material is a facsimile of the online text. It is to be used in conjunction with the online course.

2010, Canadian Institute of Financial Planning All rights reserved. No part of this publication may be reproduced in any form without written permission from the Canadian Institute of Financial Planning.

Table of ContentsUnit 1: Introduction to Income Tax Planning.................................................... 1-1Lesson 1: Money Management .....................................................................................................1-2 Lesson 2: Understanding Credit ..................................................................................................1-29 Lesson 3: Income Tax Basics .........................................................................................................1-43 Lesson 4: Completing an Income Tax Return.............................................................................1-47 Lesson 5: More on Completing an Income Tax Return .............................................................1-54 Lesson 6: Integrating Income Tax Planning and Financial Planning ......................................1-59

Unit 2: Proprietorships and Partnerships ........................................................... 2-1Lesson 1: The Role of Businesses in Wealth Accumulation .....................................................2-2 Lesson 2: Partnerships ...................................................................................................................2-8 Lesson 3: Partnerships and Income Tax ......................................................................................2-16 Lesson 4: Limited Partnerships ....................................................................................................2-26 Lesson 5: Business Income ............................................................................................................2-35

Unit 3: Corporations ............................................................................................... 3-1Lesson 1: Defining a Corporation ................................................................................................3-2 Lesson 2: Types of Business Corporations ..................................................................................3-6 Lesson 3: Shares and Shareholders ..............................................................................................3-12 Lesson 4: Organizational Structure of a Corporation................................................................3-18 Lesson 5: Corporate Taxation 1 ....................................................................................................3-25 Lesson 6: Corporate Taxation 2 ....................................................................................................3-41 Lesson 7: Taxation of Shareholders .............................................................................................3-52 Lesson 8: Corporations as Wealth Accumulation Vehicles for the Owner/Manager ..........3-58

Unit 4: Income Tax Planning and Research ....................................................... 4-1Lesson 1: Residency and Installment Payments ........................................................................4-2 Lesson 2: Deadlines, Penalties, and Review ...............................................................................4-10 Lesson 3: Income Tax Planning and Research............................................................................4-21 Lesson 4: Miscellaneous Deductions ...........................................................................................4-28

Unit 5: Taxation of Employees and Alternative Minimum Tax .................... 5-1Lesson 1: Types of Employment Income and Taxable Benefits ...............................................5-2 Lesson 2: Fringe Benefits not Included in Income .....................................................................5-13 Lesson 3: Employee Stock Option Plans .....................................................................................5-23 Lesson 4: Alternative Minimum Tax ...........................................................................................5-30

Unit 6: Taxation of Property Income ................................................................... 6-1Lesson 1: Interest, Dividends, and Income Earned ...................................................................6-2 Lesson 2: Rental Income ................................................................................................................6-10 Lesson 3: Capital Cost Allowance ................................................................................................6-17 Lesson 4: Disposing of Depreciable Property.............................................................................6-26 Lesson 5: Other Deductions from Business and Property Income ..........................................6-36 Lesson 6: Income Attribution Rules.............................................................................................6-43

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Unit 7: Taxation of Capital Property ................................................................... 7-1Lesson 1: The Role of Property in Wealth Accumulation .........................................................7-2 Lesson 2: Calculating Capital Gains and Losses ........................................................................7-10 Lesson 3: Dispositions ...................................................................................................................7-21 Lesson 4: Losses ..............................................................................................................................7-33 Lesson 5: Special Situations ..........................................................................................................7-41 Lesson 6: Capital Gains Exemptions ...........................................................................................7-49

Unit 8: Making Use of Tax Advantages .............................................................. 8-1Lesson 1: Tax Advantages .............................................................................................................8-2 Lesson 2: Investment Benefits.......................................................................................................8-9 Lesson 3: Choosing the Right Tax Advantages ..........................................................................8-13

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Income Tax Planning

PreassessmentThis Preassessment is an optional tool to help you make efficient use of your time. It allows you to test yourself before you start the course. You can use it to identify content that you are already familiar with, and areas where you will need to focus more attention. You will answer 100 questions covering the general areas of study. After you answer all of the questions, you can click Submit to see your score. Your score will not be tracked; it is for your information. If you would like to do the Preassessment now, click the Preassessment link. If you do not want to do the Preassessment, click Course Overview on the table of contents to start the course.

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Income Tax Planning

Course OverviewWelcome to the Income Tax Planning course. This course will provide you with the knowledge and judgment to guide your clients in managing their business and investment assets. This requires an understanding of the economic issues, business activities, investment products, their tax implications, and numerous management strategies. After completing this course, you will be familiar with the following: various money management strategies and the different types of consumer credit the structure and taxation of various business forms, including proprietorships, partnerships, and corporations the deadlines for filing tax returns, the impact of filing late, and the major components of the federal and provincial tax legislation the taxation of employment income and benefits, including ways to increase an individuals compensation without necessarily increasing his or her taxable income the taxation of investment income, including property income (interest, dividends, and rent) and capital gains as well as the important deductions available for various income sources how economics affect the accumulation of wealth how an individual can make use of the different tax strategies available to maximize his or her wealth accumulation

To continue, click the Next button in the bottom, right corner of the screen.

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I FPUnit 1: Introduction to Income Tax Planning

Income Tax Planning

Unit 1: Introduction to Income Tax PlanningWelcome to Introduction to Income Tax Planning. In this unit, you will learn about money management strategies, the different types of consumer credit, and fundamental terminology associated with personal income taxation. You will also learn how to perform various tax calculations, as well as describe the implications of tax planning in financial planning. This unit takes approximately 4 hours to complete. You will learn about the following topics: Money Management Understanding Credit Income Tax Basics Completing an Income Tax Return More on Completing an Income Tax Return Integrating Income Tax Planning and Financial Planning

To start with the first lesson, click Money Management on the table of contents.

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Introduction to Income Tax Planning

Lesson 1: Money ManagementWelcome to Money Management. In this lesson, you will learn about the different perceptions that different people have about money, and how those perceptions affect their money management decisions. You will also learn about how you can use money wisely through cash flow management, budgeting, and the cautious use of credit. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: describe how people perceive money, and how those perceptions affect their management styles explain how various financial statements are used in the money management process identify typical money management strategies collect and analyze your clients money management information, including statement of lifestyle expenditures and statement of cash flow assist your client in identifying money management objectives

OverviewTechnically, money is a medium of exchange or a measure of value that you can use to pay for goods and services and to settle debts. Money in our society is, in its most basic sense, an economic necessity. You need money to purchase the things that you require for your survival and well being. However, money is also a motivator of human behaviour, and it means different things to different people. Depending on the person, money may symbolize power, security, freedom, self-respect, happiness or even love. The way that you perceive money significantly influences the way that you manage it. This influence can be either positive or negative, in that it may help or hinder your ability to meet your financial goals. The money management process is an essential component of any financial planning process. In fact, good money management mirrors the five-step financial planning process. Because the use of credit is so prevalent in our society, credit management is a critical component of sound money management. This lesson discusses the range of perceptions that people have about money, and how those perceptions affect their money management decisions. It also provides information on how you can use money wisely through cash flow management, budgeting and the cautious use of credit.

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Income Tax Planning

Personal Money PerceptionsEveryone has different values or perceptions about money and the role that it plays in their lives. Though most people have similar perspectives, some people have more extreme values and perspectives. Some examples of these extremes are: Value of money: To some people, money means security, and the need to save money controls most of their financial decisions. To others, money means freedom and a way to do whatever they please, right now, today, without any thought of what is needed for tomorrow. Risk tolerance: Some people are so afraid of risking their future financial security that they shun all but the most conservative of savings vehicles, or even worse, keep their cash hidden away at home. Others are quite flamboyant about their investments, and are tantalized and tempted by get-rich schemes that are almost certainly doomed to failure. Credit: Some people consider credit to be a natural extension of their personal bank account. They believe that they must be in a strong financial position as long as someone is willing to advance them credit. Others refuse to enter into any kind of credit arrangement, even when it is justified for a modest house purchase, or when borrowing money for investment purposes makes good sense.

As an adult, your own approach to money has likely been influenced by your parents, family members, cultural background, and your financial experiences. For example, if the lack of money was a frequent cause of bitter parental disputes when you were growing up, you may have come to believe that building your savings and financial security is a priority. On the other hand, if money never seemed to be a problem when you were growing up and your parents never discussed the issue in front of you, you might have developed a more carefree attitude towards money management. Caroline, a 35-year-old lawyer, is the only child of a successful professional couple. She works 60-hour weeks and has an income of $150,000 per year. She owns a beautiful home in an exclusive part of town, drives a BMW and belongs to the best clubs. However, she has a huge mortgage on her house and she leases her BMW. She has $250 in the bank, a $23,000 outstanding balance on her credit card and lives from paycheque to paycheque. In contrast, David is a 50-year-old engineer. He was born and raised along with his six siblings in rural Ontario, and he was always taught the value of saving. David is the president of an engineering company, and he also works very hard to earn $150,000 per year. He owns a comfortable home in a good part of town and drives a four year old Chevrolet. He has fully paid for both his house and car. He does not believe in credit cards and pays for everything in cash unless travelling on company business. David has always contributed the maximum to his RRSP and has invested other savings in blue chip stocks. As a result, he has built a portfolio worth $850,000. A fundamental underlying element of the money management process is understanding your own perceptions about money so that you can work to overcome any biases that may be hindering the achievement of your financial objectives.

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Financial Planning ProcessAs seen in other courses, the financial planning process consists of 6 basic steps.

Money Management and the Financial Planning ProcessMoney management is an essential component of any financial planning process. You need to have income to be able to sustain your lifestyle. Effective money management will help ensure that you will have some money left over, after paying for basic necessities and taxes to implement your long-term financial strategies. The money management process is similar to the 6-step financial process. However, in this lesson we will discuss the money management process from your perspective and eliminate the establishment of the client-planner relationship. The 5-steps of the money management process are as follows:

Although it is similar to the financial planning process, the focus of the money management process is narrower. It deals with the management of cash over the relatively short term (days, months or a few years) and it includes debt and credit management. It does not deal with many of the broader and longer term issues covered by a comprehensive financial plan, such as insurance, estate planning, the appreciation of capital assets or the tax implications of owning a second property. As with the financial planning process, the steps in the money management process are somewhat flexible and they occasionally overlap. Step 1 and Step 2 (setting objectives and data collection) are particularly inter-related. Each of these steps as it applies to money management is discussed further in the following sections.

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Income Tax Planning

Step 1: Defining Your Money Management ObjectivesAn objective is a financial state or position that you want to achieve. Well-defined objectives are critical to the success of any money management plan. They provide your plan with a sense of purpose, and a benchmark against which you can measure your progress.

When you develop a personal financial plan, your objectives tend to be long range and all encompassing. They may include building financial security, financing a larger home, minimizing life risks, planning for retirement or distributing your estate. When you develop a money management plan, your objectives are likely to be specifically oriented towards cash, and focused on a shorter time frame. Some examples of money management objectives include: paying off an outstanding credit card debt avoiding bank overdraft and NSF (non-sufficient funds) charges by improving the management of your income and expenses establishing an emergency fund or saving $1,000 over the next six months to pay for a vacation

Some money management objectives may relate directly to strategies in your broader financial plan, such as having sufficient money available each month to contribute towards your retirement. Two of Robert and Joanne Smiths financial objectives are for Robert to contribute $3,430 to a spousal RRSP and for Joanne to contribute $2,578 to her own RRSP. One of the Smiths money management objectives could therefore be to set aside sufficient cash each month to implement these strategies. Money management objectives must be realistic in view of your level of income and expenses. The objective of having $1,000 left over each month to put towards your savings when your annual household income before tax is $27,000 and you have two children and a mortgage is not realistic. However, objectives should also require some moderate effort on your part to be worthwhile. As with the broader financial planning process, it is imperative that you and your spouse or common-law partner agree on your money management objectives. Through discussion and compromise, you must both identify and establish priorities for your objectives, and agree to commit yourselves to your cash management plan.

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Step 2: Collecting and Analyzing InformationIn order to determine if your objectives are realistic, you must have a good understanding of your current income and expenses. This exercise can also help you determine if you have any chronic money management problems, such as excessive use of credit cards or a consistently overdrawn bank account.

A number of common financial statements are useful in both the financial planning process and the money management process. These include the following: statement of net worth balance sheet statement of lifestyle expenditures statement of cash flow

Each statement is described in more detail on the following pages.

Statement of Net WorthNet worth is the best single measurement of your financial condition and resources at a specific point in time.

By preparing a statement of net worth - also referred to as a statement of financial position- every year, you will be able to see the financial growth or decline that you have achieved. A statement of net worth includes a summary of your liquid assets, investment assets and personal assets, along with any related debt obligations, as shown in the example for Robert and Joanne Smith in the following table.

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Income Tax Planning Note: It is accepted industry practice that negative numbers in tables are indicated by parenthesis. For example, the short-term obligations: (6,200) in the table below. Sample Statement of Net Worth For Robert and Joanne Smith as at December 31st

The table also shows an equity ratio for each set of assets. An equity ratio is the ratio of net assets (assets liabilities) to total assets.

The equity ratio for your liquid assets and short-term debts provides a measurement of your ability to pay short-term obligations as they come due. Your equity ratio for your investment assets indicates the extent to which you are leveraging your investments. If you can earn a higher rate of return on the funds that you borrowed than the cost of borrowing the funds, you are earning money with other peoples money. Your equity ratio for your personal assets is a measure of the extent to which you have borrowed to finance these purchases. The interest on these debts is usually not tax deductible. Robert and Joanne have personal assets worth $208,000, with outstanding loans of $106,000, the equity ratio for their personal assets is 49%, calculated as ((personal assets outstanding loans) personal assets) or (($208,000 - $106,000) $208,000).

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Introduction to Income Tax Planning In addition to providing an overall measure of your financial health, your statement of net worth documents the amount of cash or other liquid assets that are available to be managed.

Balance SheetThe balance sheet is similar to a statement of net worth, although the information is presented in more detail and is organized somewhat differently, as shown in the example, below. Like the statement of net worth, your balance sheet provides an overview of your financial situation at a single point in time. The balance sheet is of limited use as a financial planning tool because it does not readily show how various strategies could affect your financial situation. However, it is useful in the money management process because it provides a clear picture of your assets and liabilities, including short-term debt obligations that are of particular concern in money management. The following table includes the Smiths balance sheet for two consecutive years, which shows how they have repositioned their assets and liabilities over that time. For example, they have: made significant contributions to their RRSPs sold their cottage sold the rental property and used part of the proceeds to eliminate the mortgage on their house purchased another rental property with part of the purchase price provided by a mortgage loan increased the balance on their credit cards

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Income Tax Planning Balance Sheet Robert and Joanne Smith as at December 31stLast Year ASSETS Liquid Assets Cash Short-term investments Other liquid investments $ 5,300 4,200 1,265 10,765 Investment and Business Assets RRSP Robert RRSP Joanne Registered Pension Plan Canada Savings Bonds Common shares Rental property Mutual funds Other investments 28,720 500 14,500 10,000 4,500 95,000 32,000 0 185,220 Personal Assets Residence Furnishings Vehicles two cars Cottage Other personal assets 125,000 17,000 21,000 35,000 10,000 208,000 137,500 17,000 21,000 0 10,000 185,500 36,300 6,860 17,140 0 5,000 99,750 36,000 21,000 222,050 $ 3,392 0 2,776 6,168 This Year

Total Assets

$ 403,985

$ 413,718

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Tax Deduction for Interest ExpenseInterest on a loan is deductible from taxable income if and only if the proceeds of the loan are used to produce business or investment income. In the case of Robert and Joanne Smith, their residence was not an income producing investment and therefore, the interest on the mortgage on their residence was not tax deductible. Similarly, had they simply taken out a loan secured by a mortgage on their previous rental property and used the proceeds to pay off the mortgage loan on their residence, the interest on this new loan would not be deductible because the proceeds were not directly used for investment purposes. The interest on their new mortgage loan however, is tax deductible because the proceeds were used to purchase a new investment property.

Exercise: Money Management

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Income Tax Planning

Statement of Lifestyle ExpendituresYour statement of lifestyle expenditures shows how much money you pay to sustain your current lifestyle. It also includes the interest charges that are associated with financing major capital purchases, such as a house or a car. However, it does not include income taxes or any capital transactions that increase or decrease your personal, business or investment assets. The following table provides the Smiths statement of lifestyle expenditures for two consecutive years. One of the major changes of note here is that, since they shifted their mortgage obligations from their home to their rental property, the interest expense no longer shows up on their statement of lifestyle expenditures. Also, in response to recommendations from their financial planner, they have increased their life and disability insurance coverage. Statement of Lifestyle Expenditures Robert and Joanne Smith for the Year Ending December 31st Last Year This Year

Mortgage (interest only) Property taxes Insurance Utilities Maintenance Garden Upkeep Housing Costs

$ 8,460 1,900 700 2,300 1,600 500 $15,460

$0 1,995 735 2,415 1,600 500 $ 7,245

Food Household expenses Telephone Personal care Clothing Other Food, Household, etc.

4,600 700 900 1,200 4,300 500 $12,200

4,830 735 900 1,260 4,500 500 $12,725

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Last Year Car payments (interest only) Insurance Gasoline Maintenance Public Transportation Transportation 1,400 700 2,100 1,200 500 $ 5,900

This Year 1,100 770 2,200 1,200 550 $ 5,820

Entertainment Eating out Gifts Fees, Accounting, etc. Holidays Other Discretionary

1,500 1,200 1,400 1,700 1,200 5,300 $12,300

1,500 1,200 1,400 1,800 1,200 0 $ 7,100

Medical expenses Life and disability insurance Payroll deductions (sundry) Bank Charges (including overdraft & NSF charges) Credit Card Interest Other Miscellaneous

600 300 1,800 240 580 1,320 $ 4,840

650 1,000 2,000 270 630 1,600 $ 6,150

Basic Lifestyle Expenditures

$ 50,700

$ 39,040

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Income Tax Planning

Statement of Cash FlowYour statement of cash flow is perhaps the most important piece of information for money management purposes. It describes all money flows over a period of time, including all sources of income, taxes, lifestyle expenditures, investments, the interest expenses associated with those investments, mortgage, and loan principal repayments and money received from the sale of assets. It shows whether you have any cash left over at the end of the reporting period, and is a useful place to start when preparing a budget. The following table is the Smiths Statement of Cash Flow for two consecutive years. In addition to showing how their cash flow has been reallocated over the two years, it demonstrates that they have actually reduced their income tax by over $400, despite an increase in total income of over $4,500. This can largely be attributed to their RRSP contributions and the fact they shifted their mortgage obligation from their personal residence (where the interest expense is not tax deductible) to their rental property, (where the interest expense offsets rental income). Statement of Cash Flow Robert and Joanne Smith for the Year Ending December 31st Last Year This Year

Cash from Sources of Income Employment and self-employed income Pension income Dividends, interest, and rents $ 72,000 0 12,015 84,015 Cash Outlays for Expenses Income taxes Lifestyle expenditures Interest expense for investments Other cash outlays for expenses Unaccounted for difference in cash (17,520) (50,700) (5,160) 0 430 (72,950) (17,104) (39,040) (11,640) 0 44 (67,740) $ 76,500 0 12,045 88,545

Cash flow from income and expenses

11,065

20,805

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Cash Flow from Net Investment Assets RRSP Robert RRSP Joanne Registered Pension Plan Canada Savings Bonds Common shares Rental property Mutual Funds Other investments Investment Loans (2,420) (500) (1,080) 0 0 0 0 0 (500) (4,500) Cash Flow from Net Personal Assets Residence Furnishings Vehicles - two cars Cottage Other personal assets Loans to purchase personal assets 0 0 00 0 (500) (3,500) (4,000) 35,000 0 (96,200) (61,200) 0 0 (4,250) (5,818) (1,134) 10,000 0 0 0 (20,000) 54,000 32,798

Total Cash from All Activities

$ 2,565 $ (7,597)

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Income Tax Planning

How Much Information and How Often?The amount of information that you compile (6 months worth or 3 years worth?) and the level of detail will depend on the quality of your records, the complexity of your situation, and the time and money you are willing to commit to the task. For example, in simple cash management cases, it may be sufficient to prepare a statement of cash flow on an annual basis. However, in situations where your income or your expenses may fluctuate significantly from month to month or season to season, or when you will be preparing a detailed budget, you may wish to document your cash flow on a monthly or quarterly basis. If you have trouble managing credit or discretionary spending, you may want to provide a very detailed breakdown of your expenditures.

Step 3: Identifying Money Management StrategiesThe more Canadians earn, the more they tend to spend. Regardless of their income, many people tend to shy away from the financial planning process because they feel that they barely have enough money to meet their immediate needs, let alone extra money for investment or savings purposes. As a result, money management is a critical first step for many people undertaking the financial planning process. By adopting some of the money management strategies discussed in the next few pages, you may find that you do have discretionary cash to meet your financial objectives.

Pay yourself first Experience has shown that if you do not plan to save first, you will likely not save at all. Planning to save what is left over does not seem to work because there is rarely anything remaining after expenses. Therefore, one of the simplest and most successful money management strategies is to pay yourself first, which involves earmarking a portion of your income for savings before any expenses are paid. To reduce the temptation to spend, arrange to have the savings deducted directly from your pay or arrange to have the money transferred automatically from your chequing account to an investment account. This is called a preauthorized chequing arrangement or PAC. A PAC can also be used to purchase mutual funds.

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Introduction to Income Tax Planning Account for your expenditures Many people have only a vague idea of how they spend their money. When you collect the information on your expenses and cash flow, you may be surprised to learn how much you spend on incidentals like take-out food at lunchtime or magazines. Pay particular attention to those items that you tend to lump in the miscellaneous category. You may want to reconsider whether these miscellaneous expenditures are necessary to maintain your lifestyle.

Limit Available CashA large balance in your wallet or everyday bank account may be money that is "burning a hole in your pocket". Reduce the temptation to spend this money by transferring it to a savings vehicle, leaving only the cash necessary to cover your planned expenditures easily accessible. Do not be too strict on yourself While the strategies discussed to this point are effective and important, take care not to go overboard and deny yourself any discretionary expenses or make yourself accountable for every penny spent. A miscellaneous component is a realistic and essential part of any money management system, provided it is held to a reasonable and justifiable percentage of total expenditures. As in dieting, overly strict denial will doom your best intentions. Use credit wisely Credit has become a part of our everyday life as we can use it in one form or another to purchase just about every type of good or service available. While there is no doubt that credit is a convenient way to pay for transactions, when it is misused the buy now and pay later approach can lead to real problems. Credit can derail your financial plans by: seducing you into buying things that you really do not need subjecting you to hefty interest charges reducing the amount of cash available for implementing financial planning strategies

If you use a credit card for a lot of small purchases or you buy major items on an installment basis, you should be sure that the required minimum payments are within your cash flow capacity. Ideally, you should be able to pay off all credit card balances when you receive your monthly statement. Credit experts recommend that maximum monthly credit payments should be kept to 20% of the after-tax income less any mortgage payments.

Pay Off Debts QuicklyDebt payments can put a significant dent in your cash flow, reducing the amount of money that you have available for implementing other financial strategies. Paying off debts therefore, can free up your cash flow. As important as cash flow management may be however, the most important reason for paying off your debts is because it may be the best financial investment that you can make. You can use your savings to pay down your debt or you can invest this money.

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Income Tax Planning

The following are factors to consider in determining the better choice: the rate of return that you can earn on your investment and the income taxes on your investment income the interest rates that you pay on the debt and the income tax implications of paying down debt

Investing the MoneyIf you invest the money, you will earn interest, dividends, rents, and/or capital gains and must pay tax on the income. Assume Roberts marginal tax rate is 40%, and he has an extra $1,000 of cash. He might choose to purchase a Canada Savings Bond and maybe earn 3% or $30 in interest in the first year. The following are the specific calculations for the after-tax investment return: the interest on the Canada Savings Bond is $30, calculated as (the interest rate times the principal) or (3% $1,000) the tax on the interest income is $12, calculated as (the marginal tax rate x the interest income) or (40% $30) the after-tax income is $18, calculated as (the interest income - the taxes) or ($30 - $12) the after-tax return is 1.8%, calculated as (the after-tax income the principal) or ($18 $1,000)

The formula for deriving the after-tax income (ATI) from before-tax income (BTI) based upon the marginal tax rate (MTR) is:

These formulas express the investment returns as dollars. However, there are situations where it is useful to refer to investment returns as percentages, calculated as the investment returns in dollars divided by the principal or amount invested in dollars.

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Introduction to Income Tax Planning The formula for after-tax investment return (ATR) is:

Paying Down the DebtYou cannot deduct the interest expense for consumer purchases from your taxable income, so you have to pay the interest expense in after-tax dollars that are remaining after income taxes have been paid. If you pay down the debt, you will not have to pay interest. You will not have to pay income taxes on the interest that you saved. Now assume Robert also has an outstanding credit card balance of $1,000, and his card carries an interest charge of 18%. If he carried that $1,000 for one year, he would pay $180 in interest, using after-tax dollars. In fact, he would have to earn $300 to have the $180 left over to pay the interest. Therefore, if he used his spare $1,000 to pay off the credit card, he would save $300 in interest expense in one year, which is the same as a return on his investment of 30%. the interest on the loan is $180, calculated as (the interest rate x the principal) or (18% $1,000) the interest on the loan is in after-tax dollars. Using formula (3), the amount of before-tax income required to pay the interest of $180, is $300, calculated as BTI = (ATI (1 MTR)) or ($180 (1 40%)) the 18% interest rate is an after-tax rate. The before-tax rate is the rate of return you would need before-tax to have 18% left after-tax. Using formula (7), the equivalent before-tax rate of return is 30%, calculated as BTR = (ATR (1 MTR)) (18% (1 40%))

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Income Tax Planning Choosing The primary consideration in deciding whether to invest or pay down debt is the after-tax return on the investment compared to the interest rate on the debt. So, Robert can earn 1.8% after-tax on his CSBs or save 18% after-tax by paying down the debt. Alternatively, you can consider the before-tax return on the investment compared to how much Robert would have to earn to pay the tax and then the debt. This is called the equivalent before-tax return. Robert can earn 3% before-tax on his CSBs, but will have to earn 30% before-tax to have 18% left to pay his debt.

Exercise: Paying Down Debt

Avoid Unnecessary Bank ChargesIf you do not keep a close eye on your bank balance, you may run the risk of bouncing cheques, that is, writing cheques where there are insufficient funds in your account to cover the cheque. Not only can this hurt your reputation with creditors, it can be costly when the merchants turn to you to cover the NSF (non-sufficient funds) administration charges, which can run between $10 to $20 per incident. If you bounce checks frequently, or if you have an erratic cash flow pattern (e.g., you only get paid once per month, but your mortgage is paid every other week), you may benefit from overdraft protection offered by your bank. With overdraft protection, your bank will cover cheques and debits from your account, up to a prearranged credit limit. You may pay high daily interest on the credit extended by your bank, and administration fees, but you will not face NSF charges. Overdraft protection is only intended to cover brief periods (a few days) of negative cash balances. You should not rely on overdraft protection, as a source of long-term credit, because the interest charges will quickly accumulate and the interest rate charged is often quite high.

Establish an Emergency FundThere are countless events that are almost impossible to plan for and that can seriously derail the best-formed cash management plan. These unexpected events can be moderately inconvenient, like a major car repair, to the potentially disastrous, like the death or disability of an income earner. Some of the problems can be moderated by life or disability insurance or unemployment benefits, but even in these cases there will be a financial impact.

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Introduction to Income Tax Planning Some form of emergency fund is critical to every cash management plan. The size of the emergency fund that is right for you will vary on your circumstances. You might want to consider questions such as: How secure is your job? If you lost your job, how difficult would it be for you to find a new one? What would happen to your cash flow if you or your spouse became disabled? What is the condition of your car, your furnace and your major appliances? Could you handle unexpected travel expenses?

You should also consider saving to meet anticipated decreases in income or increases in your expenses, such as the addition of a new family member, children starting postsecondary education, or your own retirement. Many financial planners recommend that you set aside enough money in an emergency fund to cover four to six months worth of living expenses. If your family has an after-tax income of $24,000 and you are barely meeting your day-to-day expenses, setting aside $8,000 to $12,000 may seem next to impossible. However, you may be able to structure your assets so that you can get at them in an emergency, reducing the need for such a large stockpile of cash. For example, you might have mutual funds that you could sell, or RRSPs that you could draw on during periods of long unemployment, when your taxable income is reduced. Once you pass through the financial crisis, be sure to restore your assets to their previous levels. Withdrawing funds from RRSPs should be a last resort. You are limited in how much you can contribute in the first place and withdrawing funds does not restore your contribution room. So you can never really put these RRSP funds back, although you can make contributions based on future years income. Credit, in the form of overdraft protection, should not be used as a substitute for an emergency fund. Not only will you be obligated to repay any money that you borrowed with interest, you may get yourself into serious financial difficulty if your emergency lasts longer than you expected. A personal line of credit is considered to be an effective strategy to obtain funds in an emergency for those with stable incomes. Otherwise, the appropriate strategy is an appropriate amount invested in some form (such as Canada Savings Bonds, treasury bills or a money market fund) that can be readily converted to cash.

Income Tax StrategiesIncome and taxes usually go hand-in-hand, but there are ways that you can improve your cash flow and your overall financial situation through proper planning and some creative paperwork: Interest income is taxable. However, you can minimize the amount of tax paid on this income by registering investments that generate interest income in the name of the spouse with the lower income. The most desirable type of debt is when the interest cost is tax deductible. Interest on money borrowed for business or investment purposes may be deducted from your taxable income.

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Income Tax Planning Robert and Joanne Smith reduced their taxable income by switching the bulk of their mortgage obligations from their principal residence to their rental property (refer to Robert and Joanne's statement of cash flow). Although they still make similar total mortgage payments each month, the interest portion of the mortgage payment on their rental property is an expense that they can deduct from their rental income. It can make good financial sense to borrow money to contribute to an RRSP, provided that you arrange a short-term loan at an attractive interest rate and that you use the tax refund generated by the contribution and other savings to repay the loan as soon as possible.

Step 4: Implementation, Budgeting and Cash ManagementCash management refers to the routine, day-to-day administration of your cash resources. This administration may include a number of activities, such as: preparing and following a budget setting up automatic payment of your bills automatically or manually repositioning cash from one account to another

Your cash management plan may range from very simplistic to very complex, depending on the variability of your cash flow, your spending habits and your own "money personality".

Simplified Cash Management PlanA simplified cash management plan involves setting aside a certain portion of your income to help meet your objectives before you pay for current living expenses. This is useful in cases where you have good intentions to save each month, but there is rarely anything left to save. The simplified cash management approach works because it forces you to save for your goals first, applying the principle of "out of sight, out of mind". This approach may work for you if you are truly motivated and just need that extra push to help you save, rather than spend. If you have problems handling credit or controlling your spending habits, or if you have complex or irregular cash flow patterns, a comprehensive approach (discussed later) may be more appropriate. Before you develop your cash management plan, you must have completed Steps 1 through 3 of the money management process. You must have a good understanding of your current lifestyle expenditures, your income and other cash flow patterns, and you must have identified some money management objectives that are realistic in light of your financial situation. Finally, you must have selected some strategies for reaching your objectives.

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Introduction to Income Tax Planning James and Jody have a combined take-home pay of about $4,000 per month, and would like to set up an emergency fund of at least $10,000 (their objective Step 1). Although they never have any problems meeting their mortgage and car loan payments or paying off their credit cards on time, etc., they never seemed to save any money. After reviewing their past spending patterns, they found that they tended to make a lot of impulse purchases, such as specialty tools, kitchen gadgets and extravagant dinners, whenever their bank balance was over $1,000 (data collection and analysis Step 2). They decided that they could afford to divert $400 of their monthly income towards an emergency fund without seriously affecting their lifestyle (their strategy Step 3). Jodys employer offered a direct payment plan that directed money from her regular paycheque to a separate account (implementation-cash flow management Step 4). Within one year, James and Jody were pleased to find that they had saved almost $5,000 (monitoring Step 5).

A Workable Cash Management PlanThe graph below illustrates a slightly more complex cash flow plan that works for many people. The plan is as follows: 1. Initially, direct all of your income into a collection account. Ideally, this should be an interest bearing account, such as a money market mutual fund. 2. Transfer a fixed amount of money from the collection account to an investment account to fund your objectives. This transfer should be done monthly, (or more or less often, depending on the timing of your cash inflows). 3. Transfer a fixed amount from the collection account to your chequing account each month. This is the money you can use to meet your normal monthly expenses. You should not spend more than this amount by using credit cards. If there are significant timing differences between large cash inflows and outflows (you might get paid every two weeks, but pay your mortgage monthly), you may wish to divert some of your monthly allocation to an intermediate savings account to ensure that you do not spend it before the payment is due. 4. You can use any amount remaining in your collection account as your emergency fund. However, you should review the balance in this account semi-annually and transfer any excess from the emergency account into your investment account.

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If, after working with your simplified plan for a while, you find that you do not have enough money to meet your lifestyle expenditures, you may have to adjust your distribution of income or consider whether you need to have a more comprehensive cash flow management plan.

Comprehensive Cash Management PlanIf a simplified cash flow plan does not give you enough structure to help you reach your objectives, or if you have erratic cash flow patterns, you may wish to develop a more comprehensive cash flow management plan. As with the simplified cash flow plan, the development of a comprehensive cash flow plan requires that you first complete Steps 1 through 3 of the money management process. In gathering and analyzing your historical cash flow information, you may uncover spending patterns that you were not aware of, such as excessive use of credit, frequent NSF charges or a large amount of money spent on take-out food. This in turn may lead to the identification of some general money management strategies, such as paying off your debt or taking control of your discretionary expenses. Once you have a clear picture of your existing cash flow, your next step is to project that cash flow pattern into the future in a way that reflects your new objectives and money management strategies. In order to do this, you will have to make some assumptions about: your future income the rate of return on your investments your expected cash outflow non-recurring expenses the money you can set aside for savings or debt reduction

This cash flow projection then becomes your budget for the coming year. A budget is simply a plan for how you are going to allocate your money. The success of the budget depends largely on your willingness to stick to it.

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BudgetThe level of detail in your budget will depend once again on your own circumstances and money personality. Some people can manage with annual or quarterly budgets, while others need monthly or even weekly breakdowns. Some people manage well with a simplified budget, with expenses broken down into broad categories (for example, housing, household expenses, food, transportation, clothing, miscellaneous, and so on). Other people need to account for every dollar spent. In this case, the categories should be broken down into subcategories (for example, food could be subdivided into home-prepared meals, work lunches, takeout and dining out; utilities could be subdivided into heat, electricity and telephone, and so on). Although it is natural to have some miscellaneous expenditures, do not let this category account for the bulk of your budget. The trick with any budget is to make it simple to develop, follow and maintain. Budgets that require hours of paperwork each week are doomed to failure. Several personal computer packages are available that can help you track your past expenditures and then use this information to develop and monitor a budget. These packages have the added advantage of being able to illustrate graphically where your money went, and how your actual expenditures compared to your budget. They also allow you to run various what-if scenarios that are particularly useful when developing new strategies. This is a budget for your lifestyle expenditures. It is an important part of your cash flow, but only part of it. The following table provides the Smith's monthly budget for January of next year. Robert and Joanne Smith Monthly Budget January of Next Year Housing costs Mortgage interest Property taxes Insurance Utilities Maintenance Garden upkeep Total Housing costs Food, household etc. Food Household expenses Telephone Personal care Clothing Other Total Food, household $ 0.00 166.25 61.25 201.25 133.33 41.66 603.74

402.50 61.25 75.00 105.00 375.00 41.66 1,060.41

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Transportation Car payments (interest only) Insurance Gasoline Maintenance Public transportation Total Transportation Discretionary Entertainment Eating out Gifts Fees, accounting, etc. Holidays Other Total Discretionary Miscellaneous Medical expenses Life and disability insurance Payroll deductions Bank charges Credit card interest Other Total Miscellaneous

91.67 64.17 183.33 100.00 45.83 485.00

125.00 100.00 116.67 150.00 100.00 0.00 591.67

54.17 83.33 166.67 22.50 52.50 133.33 512.50

Total Expense

$3,253.32

Exercise: Cash Management Plan

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Step 5: Monitoring Your ResultsMonitoring your progress is vital to the success of any money management plan. You need to know if your strategies are actually helping you achieve your objectives, and if they are not, why the strategies are not working. If you are implementing a simplified cash flow management plan, monitoring may simply consist of reviewing the annual increase in your investment account. If you have met your savings goals, you do not need to take any action beyond increasing the amount to be saved next year by an amount equal to inflation. If you have not been able to meet your savings goals, you should reconsider whether your original objectives were realistic, or whether you need to switch to a more comprehensive cash management approach to gain control of your expenditures.

If you are implementing a comprehensive cash flow management plan, you will have to be more diligent about comparing your actual expenditures to your budgeted amounts on a monthly or quarterly basis. You should break your credit card bill down according to expenditure category. If you notice regular discrepancies between your budgeted and actual expenses in any category, either your projected amounts were incorrect or you need to take greater care in your spending. In either case, you must take action if you want to achieve your objectives. Robert and Joanne also used their computer package to monitor their actual expenditures in comparison with their budget. The output is shown in the following table. Robert and Joanne Smith Monthly Budget Comparison Actual Versus Budget January of Next Year

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ReflectionTake a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.

ReviewYou have completed Money Management. In this lesson, you have learned how to do the following: describe how people perceive money differently, and how those perceptions affect their money management styles explain how various financial statements are used in the money management process identify typical money management strategies collect and analyze clients money management information, including statement of lifestyle expenditures and statement of cash flow assist client in identifying money management objectives

If you are ready to move to the next lesson, click Understanding Credit on the table of contents.

AssessmentNow that you have completed Money Management, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.

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Lesson 2: Understanding CreditWelcome to Understanding Credit. In this lesson, you will learn about the general lending criteria, the different types of consumer credit, and the uses of refinancing, debt consolidation, insolvency, and bankruptcy. This lesson takes 1 hour to complete. At the end of this lesson, you will be able to do the following: explain the general lending criteria (collateral, capacity, character, credit history) and their impact on financial planning describe and compare the different types of consumer credit explain and describe the uses of refinancing, debt consolidation, insolvency, and bankruptcy

Understanding CreditIn our society, entering into debt should be considered a necessary evil. That is not to say that it should never be done. Often it is more convenient and safer to use credit cards than cash, and sometimes the high cost of a capital asset, like a car, may make a cash purchase unrealistic. However, once you decide to enter into debt, you should give priority to minimizing the cost of borrowing. This section examines the types of credit available, how to obtain them, avoid abusing them, and how to get out of trouble if the use of credit has got the best of you. There are two main credit systems available to consumers: revolving credit and consumer loans.

Revolving CreditRevolving credit is credit that you can use from time to time to buy goods and services. Revolving credit can take the form of: a credit card issued by a financial institution, such as VISA, or by a retailer, such as Sears a standing charge account (for example, with a grocery store or a taxi company) a line of credit with a financial institution

In each case, the revolving credit lender will set an upper limit on the total amount that you may borrow. In exchange for the credit privilege, you agree to pay an interest charge on

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Introduction to Income Tax Planning the outstanding balance each month, and you may also be required to pay a service fee and stipulated principal payments. Most credit cards will give you an initial credit limit of about $500. The lending institution will usually increase that limit as you develop a credit history. Lines of credit usually start at $10,000 and are often more difficult to arrange. Some types of revolving credit (like some lines of credit) may require security, while credit cards and store accounts are usually unsecured. In the case of a line of credit, you will receive a better interest rate if you are able to provide security. Revolving credit is popular because of its convenience and flexibility. Once you have established your account, you can use it when you need it and forget about it when you do not. However, this constant availability can be seductive. Because revolving credit can often be used as a substitute for cash, you may quickly find that you are overspending. Furthermore, if you are not required to pay the outstanding balance in full each month, you run the danger of accumulating a large outstanding balance, on which you will pay a relatively high rate of interest. You are usually required to repay revolving credit loans according to a minimum percentage of the outstanding balance, and you are free to pay off the full amount at any time you wish. The rate of interest may be variable (some lines of credit), fixed (credit cards and some loans) or fixed for short-term periods, in which case the rate is adjusted periodically.

Consumer LoansConsumer loans (also often referred to as direct or fixed credit) are usually arranged for a specific purpose (e.g., a car loan repayable over four years). They are available through financial institutions such as banks, trust companies, credit unions and small loan companies. The lending institution may or may not require security (or collateral) for these loans, as discussed later. When you arrange a consumer loan, the lender usually allows you some choice in terms of a payback period (term) that best suits your circumstances. The lender then arranges a schedule of monthly payments that combines repayment of the principal with interest charges on the outstanding balance. Depending on your loan agreement, the interest rate may be fixed for the duration of the loan, or may vary as the lenders rates rise and fall. Direct or fixed credit may be easier to control but, depending on your arrangement with your lender, it could lock you into making substantial monthly payments, sometimes at a rate of interest that is considerably higher than the current rate. If you are self-employed and your income fluctuates from month to month, you may not want to tie yourself down to a large fixed repayment obligation. In some cases, the payback terms may be inflexible, requiring you to pay a hefty penalty if you want to repay the loan in full before maturity. Other consumer loans, such as car loans, may be fully open, meaning that you may pay off the outstanding balance in full at any time without penalty.

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SecurityCredit is typically classified as either secured or unsecured. A secured loan is one that provides the lender with the right to seize or sell specified assets, or collateral, in the event that you default on your loan agreement. Lenders prefer collateral that is liquid. Liquidity refers to the ease with which assets or collateral can be converted into cash. Depending on your credit rating, age, job security, health, etc., your lender may require different types of security in granting a loan. Collateral for a secured loan usually takes one of two forms. Most commonly, you may be required to sign a chattel mortgage. This document will transfer the ownership of the collateral assets to the lender if you default on your debt. However, you will keep possession of the goods as long as you maintain the loan in good standing. One of the most common types of secured loans is a car loan, where your car is the collateral and you are required to assign a chattel mortgage to the lender. If you do not make the installment payments on your car loan, the lender may repossess the car and use the proceeds from its sale to satisfy the debt. A lien is similar to a chattel mortgage, but it is used where the goods or services are immovable. If you purchase a new furnace for your home and have it installed, it is for all practical purposes now a part of your home and impossible to repossess. So, a lien is registered against your home as security for payment and you cannot sell your home unless the loan is repaid and the lien discharged. In cases where you have a poor or unestablished credit history, or where you have insufficient collateral to secure the loan, the lender may require that your loan be guaranteed by a guarantor, a third party who agrees to repay any outstanding balance on the loan if you fail to do so. Alternatively, the lender may be satisfied if the loan is co-signed by a co-signer, who is equally responsible for the debt with the principal debtor, whether or not the principal debtor defaults on the loan. Frank and Ellen are living in a common-law relationship. They borrowed $10,000 from a bank to purchase a car. They signed the loan as co-signers. If the payments are not made, the lender can pursue either Frank or Ellen to obtain repayment of the entire loan. Frank and Ellen are equally responsible for the entire amount, not just a share of it. Initially, the bank was reluctant to lend them the money. Franks father guaranteed the loan. If the payments are not made, the bank can pursue the father to repay the loan if they have determined that neither Frank nor Ellen can repay it. Frank and his father are equally responsible for the loan. His father is responsible if Frank and Ellen default. You may agree to a wage assignment, which allows the lender to collect up to 20% of your gross wages directly from your employer, with the proceeds to be used for the purpose of paying your debt. Unsecured loans are loans made by a creditor based on your credit history, reputation and integrity to ensure payment. A debt incurred through the use of a credit card is often an unsecured loan. Another example is an unsecured promissory note, which is a written loan agreement signed by the borrower and specifying the name of the borrower, amount of the loan, interest rate, and terms of repayment. The lender may require nothing more than your signature to advance the requested funds. Usually, unsecured loans are only available to the lowest risk borrowers.

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Interest ChargesThe rule here is borrower beware. Different lenders, particularly those issuing credit cards, calculate their interest charges in different ways. However, regulations do require lenders to provide full disclosure of the interest rate charged, including a description of how the interest costs are calculated. You have to read the small print on the contract. Debit cards The debit card is a method of payment, but not a form of credit. Instead of extending credit, the debit card is used to withdraw funds from the purchasers bank account. The debit card is physically similar to a credit card, but the user enters his Personal Identification Number (PIN) into a terminal to authorize the withdrawal from his bank account.

Credit CardsThere is a significant difference in how bank credit cards (for example, VISA and MasterCard) and retail store cards (for example, Sears or Canadian Tire) calculate their interest charges. Apart from user fees and grace period considerations, how and when interest rates are applied to outstanding balances are very important. Most credit cards offer a grace period of 15 to 21 days after the statement date. During the grace period, you will not be charged any interest provided you make payment in full by the end of the grace period. If you do not make payment within the grace period, or if you make only a partial payment, a bank credit card will typically charge interest on the full amount of the purchase from either the date of purchase or the date of posting. Interest charges are computed on a daily basis and partial payments are applied to the oldest outstanding debt first. Retail store cards typically only charge interest on the difference remaining on the balance effective after any partial payment has been credited. Compounding methods may also vary among different credit card issues. Bank cards tend to charge straight interest (for example, compounded annually, but calculated daily), while retail cards usually compound their interest monthly. Credit card issuers are required to provide you with a clear statement of how their interest charges are calculated. Consequently, balances carried over periods of several months and reflecting many purchases can result in wide differences in actual interest costs, even though the interest rates quoted by both lenders may seem to be similar when taken at face value. Sample disclosure statement This is a sample of a disclosure statement provided by a company operating in the four western provinces and Newfoundland & Labrador (the rates may no longer be valid, but the nature of the disclosure is still appropriate). A charge will be added to your account each month based on the previous months balance to the nearest dollar, as indicated in the table below. If 75% or more of the previous months balance is paid during the current month, no cost of credit will be added. If 50% or more of the previous balance is paid, the payment is first deducted before the cost of credit is calculated. The annual rate is 21.0% per annum on the monthly balance.

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Income Tax Planning For example:

Cost of Credit means Cost of Borrowing or Credit Charges as defined in the Statement of Information regarding cost of credit as required by The Consumer Protection Act (BC), The Credit and Loan Agreements Act (Alta.), The Cost of Credit Disclosure Act, 1967 (Sask.), The Consumer Protection Act, 1969 (Newfoundland) and The Consumer Protection Act (Man.).

Installment LoansYou are usually required to repay a consumer installment loan in fixed monthly payments, which consist of a blend of principal and interest. You negotiate a repayment, or amortization period, over which the payments will be spread. Most consumer installment loans are amortized over a 1- to 5-year period. Your monthly payment will be calculated using an amortization schedule, which is a table that shows how much of each blended payment is interest and how much is principal, along with the principal outstanding after each payment. An example of an amortization schedule for a consumer car loan of $10,000 over five years at 12% is provided in the table. Installment loans are front-end loaded with interest, which means that the payments in the early period of your loan consist mostly of interest. Towards the end of the loan, the payments are largely principal. The following table illustrates this effect. By choosing to make a principal repayment early in your loan repayment schedule, you effectively bypass some of the heavy interest payments.

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As shown in the table above, the payments are fixed over the amortization period. However, the interest component of each monthly payment is roughly equivalent to the outstanding balance multiplied by 1/12th of the annual interest rate. The remainder of each payment is applied against the principal. In the early stages of loan repayment, a significant component of the payment consists of interest. However, as the outstanding balance is reduced, the proportion of principal in each payment rises steadily. The interest rates on installment loans may be fixed or variable, or may be adjusted periodically. When the rate changes, a new amortization schedule is used, reflecting the remaining outstanding balance, the remaining amortization period and the new interest rate.

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Exercise: Credit

Obtaining CreditLenders will usually look for four main criteria, referred to as the 4Cs, when assessing your credit application:

Your Credit RatingYour credit rating is a historical record or file maintained by a local credit bureau that documents your credit history (usually over the past seven years). It allows a lender to assess your history of repaying loans and provides the lender with an indication of your repayment behavior in the future. The various credit bureaus share information, so a lender can usually just make a single inquiry and retrieve your credit history. Your credit file consists of a series of ratings provided by the lenders of previously- or currently-held loans and credit cards. If you always pay at least the minimum required payments on a loan or credit card, that particular loan will receive a rating of one. Each time you miss a payment, the rate declines until it reaches nine, which is the poorest rating. Your credit file only includes facts about payment patterns, and never includes opinions. It also does not include information about utility bill payments, bank accounts, student loans, bounced cheques or specific credit card purchases. While your credit file may include information from civil court proceedings, including bankruptcies or orders to pay, it does not include criminal court proceedings. Along with the information discussed above, your credit file will include a listing of everyone who has requested the file in the past. You are entitled to see your credit file as maintained by your local credit bureau. You should check your own credit file every year or so, or at least six months prior to any major loan application, to make sure that it doesnt include erroneous information. If there are errors, you can usually work with the credit bureau or the original lender to correct them. Even if information is correct, you will usually be permitted to add an explanation about why the problem occurred.

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Your Capacity to Repay the DebtConsumer lending institutions use a number of measures to evaluate a borrowers capacity to repay debt. The total debt service ratio is very effective as it considers all debt obligations and fixed housing costs, and then compares these amounts to the gross income (before-tax income) of the family unit. We will use Total Debt Service Ratio (TDSR) for this purpose in this course and we will use the following definition (your financial institution may use a different one): The TDSR compares the amount of your mortgage and consumer debt payments to your income. The higher the TDSR, the more difficult it becomes to make your payments. The maximum acceptable TDSR according to the Credit Union Institute is 40% for most loans. Financial institutions generally set a maximum TDSR of 35% to 42%. For a homeowner, the formula for TDSR is:

For a renter, the formula for TDSR is:

Let's look at a TDSR calculation for Ben and Sarah Straw, a married couple, who are considering the purchase of a new van. They need a bank loan of $22,000 to finance the purchase. The interest rate would be 8% compounded monthly and the payments would be $537.08 per month at the end of each month for four years. The Straws have other consumer loan payments of $380.00 per month. They own their own home. Their annual costs for property taxes are $3,200, heating costs are $3,600, and mortgage principal and interest costs are $14,800. Their annual income before tax is $90,000. If the Straws purchase the van, their TDSR will be 36.23%, calculated as ((payment of principal and interest on mortgage + property taxes + heating costs + 50% of condominium fees + payments on other personal loans) gross income) or ((($14,800 + $3,200 + $3,600 + $0) + (($537.08 + $380.00) 12)) $90,000). The TDSR is within 35% to 42% of their gross income, so Ben and Sarah will likely qualify for the loan based upon TDSR limits.

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Income Tax Planning Some credit advisors suggest that you limit your consumer debt payments, excluding mortgage payments to 20% of your take-home pay. The TDSR may be a better measurement because it considers all debt.

Collateral and Your CharacterCollateral available for security As discussed earlier, some forms of credit are unsecured, such as debts incurred through the use of a credit card. However, most other lenders will insist on some form of collateral to secure loans. Because unsecured loans carry a higher risk of loss for the lender, the interest rate for those debts will usually be substantially higher than for a secured loan. In the case of secured loans, you may be able to negotiate a more favourable interest rate if you are able to provide more than the minimum collateral required by the lender. Your character In an industry based on facts and numbers, it is easy to come to believe that the individual does not matter. However, a wise lender takes into account a person's character. Your character is defined here as your moral quality or integrity, not your eccentricity. It is worth taking the time to develop a good working relationship with your banker, especially if your cash flow is in a constant state of flux. Also, be warned that it does not pay to embellish your credit application. If the lender discovers your deliberate misstatement, the lender will likely deny your application regardless of your credit rating, collateral, or capacity to pay. Furthermore, this indiscretion could haunt you from lender to lender, as your credit rating file will clearly show that the previous lender has requested a copy of your credit history. A cautious lender will wonder why other lenders have requested your history and have not advanced credit to you, and may contact the previous lenders for an explanation.

Exercise: Credit Rating

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Signs of TroubleSome people rely too heavily on their misguided belief that if the lender is willing to advance credit, they must be able to afford it. Still others are simply unable to keep track of how their debt load is accumulating. You should be aware that you might have a credit problem if any of the following factors apply to you:

Getting Out of TroubleIf you do find that you have a credit problem, do not automatically despair. Most lenders realize that they stand a better chance of recovering their money if they work with you. Rather than just ignoring the problem by deferring payment on overdue bills, you should voluntarily approach your lender and explain your situation. In many cases, you may be able to renegotiate terms with your lender (this is where your good working relationship pays off). Some credit card companies will renegotiate their repayment schedules before referring you to a credit counsellor, a financial advisor who specializes in credit problems. A credit counsellor will help you find a source of money that you can use for debt repayment after your living expenses have been met. For example, she may suggest that you cut back

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Income Tax Planning on the amount you spend on clothes, rent, recreation, alcohol, or convenience foods. She may also suggest that you sell your car and switch to public transport. If you are too far in debt to recover simply by changing your lifestyle expenditures, a credit counsellor will help you consider other strategies for getting out of debt. You might be able to consolidate your debts by arranging a loan at a reasonable payment term and using the proceeds to pay off your various creditors or arrange with your creditors a repayment schedule that assures that you can handle the payments.

Insolvency and BankruptcySome people may be unable to climb their way out of debt even with the help of a credit counsellor and by eliminating all but the bare necessities. These people will learn about the Federal Bankruptcy and Insolvency Act of 1992. According to this Act, you are insolvent if, you are not declared bankrupt, your obligations to your creditors exceed $1,000 and you: are unable to meet your obligations as they typically come due have ceased paying your debt obligations have debts due and accruing which, in combination, exceed the reliable value of your assets

You are declared bankrupt if you are insolvent and you voluntarily declare yourself as bankrupt or if your creditors are successful in lodging a receiving order against you that forces you into bankruptcy. In both cases, your assets will be sold and the proceeds will be distributed to your creditors in an equitable manner. If a creditor has security on a specific asset, that creditor will be entitled to repayment from the proceeds of sale from that specific asset. If a creditor has no such security, his loan will be unsecured and he will be entitled to a proportionate share of the assets left after all the secured creditors have been satisfied.

Voluntary BankruptcyIf you are insolvent and you do not owe more than $75,000 (excluding your mortgage on your principal residence), you may make a formal consumer proposal to your creditors requesting that they reduce your debt or extend the schedule for repayment of your debts. You must prepare this proposal with the assistance of a trustee or administrator who is licensed under the Bankruptcy and Insolvency Act. This trustee will be responsible for investigating your financial affairs and providing counselling. If, after receiving the proposal, your creditors do not request a meeting, they are assumed to have accepted your proposal. Once it is accepted, and provided you follow the proposal, you will be protected from further action by creditors, including having your apartment or home lease terminated by your landlord, or having your utilities shut off. If your proposal is not successful, or if you are unable to develop a feasible proposal, you may choose to declare yourself as bankrupt by making an assignment. This means that you file a petition with an official receiver as designated under the Act, accompanied by a sworn statement describing your property and your debts and creditors. The official receiver will then appoint a trustee and assign your property to that person for management. The trustee will be responsible for administering your estate. From that point on, you cease to have any right to dispose of, or deal with, your property.

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Introduction to Income Tax Planning During the last recession, many people assumed a cavalier attitude towards personal debt and thought that declaring personal bankruptcy was an easy way of getting around their financial obligations. These people often didnt realize that all their assets, including art collections, antiques, family heirlooms, and so on, would be liquidated in an attempt to satisfy their creditors.

Forced into BankruptcyIn some cases, a creditor or a group of creditors may file a petition with your local court to have you declared bankrupt. They may do this if you owe them more than $1,000 and if you have committed an act of bankruptcy in the past six months. Some examples of an act of bankruptcy include: assigning your assets to a trustee, in a manner that is not satisfactory to your creditors fraudulently transferring your assets to a third party in anticipation of bankruptcy, with the intention of withholding those assets from distribution to your creditors paying off one creditor in preference to the outstanding claims of other creditors (referred to as fraudulent preference) failing to give up goods that are to be seized from you under an execution order trying to depart secretly and suddenly, with the intention of defrauding your creditors failing to meet your liabilities as they come due

Note: You do not have to be insolvent before your creditors can petition to have you declared bankrupt. Committing an act of bankruptcy is sufficient grounds for such a petition. Bankruptcy proceedings are penal in nature. The petitioning creditors must meet the burden of proof before a court. You may oppose the petition by disputing the existence of the debt or the alleged act of bankruptcy. Even if the creditors are successful in proving their case, the court has the discretion of refusing the petition if they feel that you may be able to meet your obligations in a reasonable period if you are given a fair chance. If your creditors are successful with their petition, the court will make a receiving order, which effectively vests your property to a trustee appointed by the court. This trustee will be responsible for liquidating your assets and distributing the proceeds to your creditors in an equitable manner.

Protecting Yourself from CreditorsIf you plan well enough in advance, there are ways to protect your personal assets from creditors, particularly if you are in business. Incorporating a business A common way to protect assets from creditors is to incorporate your business. A corporations liabilities are its own, and liability does not extend to its shareholders simply because they are shareholders. However, this strategy is not perfect: it is typical for many small business owners to give personal guarantees in order to obtain credit, which provides creditors with a claim against personal assets in the event of bankruptcy. Also, directors

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Income Tax Planning may be held personally liable for certain business expenses, including unpaid income taxes, wages, and vacation pay. Incorporation also may not protect an individual from professional negligence lawsuits. Family members hold title to assets Another tactic is to have other members of your family hold title to your property. However, this must be arranged long before you risk insolvency or bankruptcy. The Bankruptcy and Insolvency Act allows a bankruptcy trustee to recover any assets that you may have "gratuitously" transferred to someone else up to a year before bankruptcy. This period could be extended up to five years before bankruptcy if the trustee can show that you transferred the property with the intent to defraud your creditors or that you knew you would be unable to pay your debts if you no longer possessed the property. Other protection strategies Other protection tactics include the following: purchasing life insurance products that include an annuity or RRSP component, with your spouse, your common-law partner, your child, your grandchild, or your parent named as a beneficiary setting up individual registered pension plans (RPPs), instead of investing in RRSPs because RPPs cannot be seized by creditors

Bankruptcy DischargeA discharge under the Bankruptcy and Insolvency Act usually cancels the unpaid portion of any debts remaining after they have been reduced by proceeds from the liquidation of your estate. In other words, it gives you a fresh start. A discharge is an official act of court. The court may refuse to grant a discharge for a number of different reasons, including cases when: your assets were insufficient to pay your unsecured creditors at least 50% of your debt you have not kept adequate records you continued to do business after knowing that you were insolvent you caused the bankruptcy by rash speculation or extravagant living

If you are bankrupt and you have not yet obtained a discharge, you will be liable to a fine or imprisonment if you: obtain credit of more than $500, unless it is to supply the necessities of life for you or your family recommence your business without letting your suppliers know that you are an undischarged bankrupt

In order to obtain a discharge, you may be required to complete a process of counselling with a financial counsellor.

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Exercise: Insolvency and Bankruptcy

ReflectionTake a moment to reflect on this lesson and identify three main points. It could be information you can apply when serving a client, or it could be something that surprised you, or something you feel you should review. You may want to add these points to your study notes, so that you can review them at any time. If you would like to add them to your study notes, click Take Notes now.

ReviewYou have completed Understanding Credit. In this lesson, you have learned how to do the following: explain the general lending criteria (collateral, capacity, character, credit history) and their impact on financial planning describe and compare the different types of consumer credit explain and describe the use of refinancing, debt consolidation, insolvency, and bankruptcy

If you are ready to move to the next lesson, click Income Tax Basics on the table of contents.

AssessmentNow that you have completed Understanding Credit, you are ready to assess your knowledge. You will be asked a series of 3 questions. When you have finished answering the questions, click Submit to see your score. When you are ready to start, click the Go to Assessment link.

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Income Tax Planning

Lesson 3: Income Tax BasicsWelcome to Income Tax Basics. In this lesson, you will learn about fundamental terminology associated with personal income taxation. This lesson takes 15 minutes to complete. At the end of this lesson, you will be able to do the following: explain fundamental terminology associated with personal income taxation

Economic DevelopmentThe Canadian Government first collected income tax in 1917 as a temporary measure to help finance Canadas costs in World War I. The federal and provincial governments collect taxes on personal income to provide revenue to cover the cost of the services provided by the government. Revenue from taxes on personal incomes has long been the main source of income for the Canadian federal and provincial governments. Direct taxes from individuals represent about 46% of the federal governments revenue, and 33% of the provinces revenues. The Canadian government uses the income tax system to encourage investment in high-risk ventures or specific industries that have the potential to stimulate the countrys economy. When the housing industry was in a slump, the tax rules were changed to allow people to borrow from their RRSPs to buy a house. Sometimes tax rules intended to stimulate the economy have undesirable consequences. The result is often a change in the rules. Until 1994, Canadians had a lifetime capital gains exemption of $100,000. During the 1980s economic boom in Canada, this exemption encouraged investors to speculate in real estate. The result was escalating real estate prices. The federal government responded in March, 1992 by excluding capital gains from real estate investments from the $100,000 life-time capital gains exemption. Tax rules are sometimes changed in response to conditions in one part of the country and not others. The real estate boom in Ontario, for example, was not experienced in Atlantic Canada. Nevertheless, Atlantic Canada taxpayers were subject to the change in rules that excluded real estate from the lifetime capital gains exemption.

Tax ConceptsThere are five important concepts to understand about taxes: average tax rates marginal tax rates tax deductions tax credits refundable tax credits

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Average Tax RatesThe average tax rate is calculated as:

A

tax

Documents

income tax return

income tax basics

business income

limited partnerships

corporate taxation

online text

taxation of shar

types of business corporations