Farmers need advice for wind-down of income stabilization program

(February 23, 2004) To most Canadian farmers, the idea of reaping what they have sown in March will seem a little early. But as the federal government prepares to roll out the new Agricultural Policy Framework, it is looking to put an old program out to pasture.

Starting March 31, farmers have to begin the process of winding down their Net Income Stabilization Account (NISA) plans. They have the option of closing the plan out completely, or gradually winding it down over five years.

“There will be new clients out there and this is a great way to step in and start with something — there’s a lot of prospecting that can be done here,” says Sandy Cardy, vice-president of tax and estate advisory services at Mackenzie Financial Services. “If [advisors] have existing farm clients, [they should] talk to them about this. Just be comfortable enough to know what the issues are and be sure to get them to see a proper accountant.”

The NISA plan was a federal program aimed at smoothing out the peaks and troughs of a farmer’s income. The system consisted of two accounts, designated as Fund 1 and Fund 2.

Fund 1 was a bank account opened by the farmer, into which they could deposit funds in a higher income year. There was no tax deduction on these funds, so they could be withdrawn later without incurring an additional tax burden.

Fund 2 was an account held by the federal government, into which the government would make matching contributions, up to 3% of the farmer’s eligible net sales. On top of that, the government paid an annual interest rate bonus of 3%, over and above the 90-day T-bill rates, on the monthly average balance in Fund 2. Since the cash in Fund 2 was essentially “free money,” it was taxable when withdrawn.

When a farm’s gross margin fell below the average for the preceding five years, the farmer could make a withdrawal from their NISA plan, on the condition that they tap the Fund 2 reserves first, thus incurring a taxable gain. Once Fund 2 was depleted, the farmer could tap into Fund 1 and withdraw tax-prepaid funds.

Since the Fund 1 monies are tax-prepaid, they present no problem. The cash in Fund 2, however, is the government contribution and is taxable. Unfortunately for the farmer, these funds are taxed as “other investment income” rather than “farm income.”

The total value of Fund 2 monies has swollen to over $4 billion and with the government preparing to roll out a new program — called the Canadian Agricultural Income Stabilization (CAIS) program — the feds are looking to clear that cash off their books.

To some farmers, the five-year plan might sound like the better option, but often the client might be better advised to take the one-time hit.

“There’s an opportunity cost,” says Cardy. “They’ll pay more tax if they take it all in one lump sum now, however, if they’re going to invest this money it’s better to take the lump sum and stick it in an investment that generates a rate of return and you’ll more than offset the whatever extra tax you may pay upfront.”

She points out that the money in the Fund 2 account is currently not earning the farmer anything at all, so the sooner it is taken out, the sooner it can be put to work.

“There’s a lot of opportunity for tax planning,” says Cardy. “It’s not all about just taking this money out and investing it, it’s more about making sure that we provide good advice to our clients and there’s a lot on these farmers’ plates.”

One strategy might include foregoing tax benefits the farmer is accustomed to receiving.

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“Some farmers are lower in income and they may be eligible for the child tax benefit,” she says. “The problem with taking NISA out is that it is classed as ‘other investment income’ and it will erode their child tax benefit.”

Taking the lump sum out at once may lose some of their tax benefits for that one year, but the next year they should be eligible again. Taking the NISA funds out over five years may disqualify them for every one of those years.

Another strategy is to maximize their RRSP contributions. Cardy says participants would often neglect their RRSPs in favour of topping up their NISA plans and may have large amounts of unused room in their registered plans.

“If they have large carry-forwards, there’s a great opportunity to take those Fund 2 balances and swing it into an RSP. There’s no withholding tax on Fund 2, so if there’s some RSP room, obviously we want to try to get some of it in there.”

These strategies focus on the proprietorship model for the farm. But farms may also be structured as small business corporations, which offer a different set of options. Since farms are usually incorporated only if they are already prosperous, this structure might not need to cash out as quickly.

But Cardy says there are reasons for a corporation take it all in one payment as well.

“It rolls into a corporation tax-free and anyone who has a small business corporation gets a small business deduction on the first $250,000 of income this year,” she says. “The Fund 2 NISA balance is considered active business income if you roll it into a corporation.”

Using Ontario as an example, she points out that the difference between corporate tax rates and personal tax rates can be as much as 26%, assuming the highest marginal tax rate of 46%.

“I would see how much room is left in that small business deduction and make sure we fill it up as much as we can with NISA. If there’s spillage, I might leave the spillage until next year.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(02/23/04)

Steven Lamb