Few surprises ahead in 2004 tax season

(December 30, 2003) With the tax year drawing to a close, Canadians can look ahead to a fairly routine filing season, as there are few changes to the tax regime for 2004.

“The good news is that the whole tax system will be indexed again, in accordance with inflation,” says Jamie Golombek, vice president of taxation and estate planning at AIM Trimark. “The brackets were stagnant for years and years, simply because while they were supposed to be indexed to inflation, that only applied if inflation was over 3%.”

The federal government announced an indexation rate of 3.3% for the year just before Christmas. The rate affects not only the tax brackets, but also raises the dollar values for tax credits, such as the basic exemption and spousal, age and disability credits.

“What happened in the old days was that if you received only an inflationary increase in your salary — so your real salary was the same in real dollars — you’d end up paying more tax because it could push you into a higher tax bracket. Now that it’s been corrected, as long as your salary stays adjusted to inflation, you’ll stay in the same bracket.”

Also new in 2004, cuts to Employment Insurance premiums will not be negated by increased contributions to the Canada Pension Plan.

“It’s great news that the CPP rates are not increasing. Any benefit that we’ve been getting from a reduction in EI was being more than offset by increases in CPP premiums,” says Golombek. “Finally, Canadians will be able to benefit truly from a reduction in payroll tax, given that the EI rates will fall, yet the CPP rates are not increasing this year.”

There is one figure that Golombek thinks investors should pay close attention to, however. CCRA has capped the prescribed interest rate for spousal loans at 3% for the first quarter of 2004. A spousal loan can be locked in for 10 years, for example, at that rate.

A spousal loan allows a lower income spousal to borrow money from higher income spouse for investment purposes. The borrower invests the funds and pays the interest to their spouse, who declares the interest received as income. The borrower can deduct the interest payments from their taxes and claim the amount they receive from their investment.

“That’s a very legally effective way of doing income splitting between spouses,” Golombek points out.

With the interest rate capped at 3%, it should not be difficult to claim a reasonable expectation of profit (REOP) on an investment. This could become more of an issue next year, as new rules announced October 31 on interest deductibility are slated to come into effect for January 1, 2005.

Under the new rules, investments must offer a “reasonable expectation” of profit, which will favour income investments, but dissuade equity investments because profits from stocks usually come in the form of capital gains. Capital gains are taxed at a lower rate than interest earnings, so it is in the government’s interest for the investor to hold income investments.

“Essentially, if you’re borrowing money to invest in common shares or mutual funds and you don’t have a reasonable expectation of income, as opposed to capital gains, then you can’t deduct the loss that would be created by deducting interest expense,” says Golombek.

Mutual funds remain the investment of choice for many Canadians, but disallowing interest deductibility could put a damper on them.

“We are very concerned with this and the potential effect on capital markets,” he says. “As the law is drafted right now, it is pretty clear there is going to be a major problem. This is something we are working on right now at IFIC, to try to convince the government that this is not good legislation.”

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