Last year’s tax traps

This year’s federal budget just came out, but the industry’s still reeling from Budget 2013. Make sure you understand its nuances before you help clients with their 2013 taxes.

01 New T1135

The industry’s abuzz over the new Foreign Income Verification Statement, best known as the T1135.

Last November, Barbara Amsden, director of special projects at the Investment Industry Association of Canada (IIAC), sent CRA a letter detailing concerns your clients will face.

Amsden notes there’s been no change to the criteria that determine who has to file a T1135. But, the new information CRA wants presents difficulties. In fact, “it will be almost impossible,” says Amsden, for clients to get the information on time. “Even taxpayers who were completing, or whose tax professionals were tracking, an exhaustive listing of securities before completing the T1135 will not have some of the information they need,” Amsden says.

★★★★★ highest risk ★ lowest risk

Here’s what IIAC has flagged for the 2013 tax year. ★★★★★

Issue #1: Highest Cost

Old form: Asked for cost within a range of values (e.g., more than $700,000; more than $1 million).

New form: Requires highest cost for each foreign property held.

Problems:

• Clients can’t usually access the daily value of each security.
• Clients can hold identical assets at different brokers. Clients will have to find out the value from each dealer, compare values for each security per day, and then report the highest amount (see “Highest value,” bottom of page).
• Dealers don’t have the information. Keeping it on a daily, per-client basis is a data storage burden.

Issue #2: Geography

★★★★ Old form: Required region where foreign property is located.

New form: Requires the country on a security-by-security basis.

Problems:

1. Clients may not be able to identify the country code without extensive searches. And, even if they could, CRA needs to clarify how to treat the following:

• Supranational organizations’ securities: These include those issued by the World Bank and European Investment Bank.
• Dual-listed securities: Some stocks can be bought on both the NYSE and the TSX, for instance. Clients would not know whether this affects the threshold.
• Securities whose ownership changes hands: Tim Hortons, for example, went from Canadian to American ownership, then back again. A typical taxpayer likely wouldn’t know this because the place of incorporation isn’t displayed on monthly statements.
• Securities of Royal Dutch Shell: “A” shares are listed on the London and Netherlands exchanges; “B” shares are only available in London or via an NYSE ADR, with income that may be paid in British pounds or U.S. dollars, for later conversion into Canadian dollars.

Issue #3: Net income

★★★ Old form: Required total income (including taxable capital gains) from the foreign property.

New form: Requires net income from a foreign property on a security-by-security basis.

Problems:

• The majority of dealer T5-slip and XML reporting is in aggregate form.
• Issuers can make income adjustments after their filing deadline of March 7, 2014. And 25% of limited partnership units alone are refiled.

02 10/8s and Leveraged Insured Annuities (LIAs)

Budget 2013 also looked at two complex insurance strategies, 10/8 arrangements and Leveraged Insured Annuities (LIAs), on the grounds that they created unintended tax benefits.

10/8s

“We accepted that Finance wanted to get rid of [10/8s] and did not object,” says Kevin Wark, president of the Conference for Advanced Life Underwriting (CALU). “But we wanted…to ensure that the legislation didn’t target other planning arrangements involving leverage, and provided sufficient time for affected policyholders to effectively transition out.”

Fortunately, both wishes were fulfilled. “There was not a lot of collateral damage—a number of other planning strategies involving leverage can continue.”

Wark says these are the options for clients who held 10/8s:

1. Repay the 10/8 loan

Repaying the loan terminates the investment account backing the loan. This can be done with external funds or through a withdrawal from the policy.

Wark says clients who wind up 10/8s with the latter method may get a T5 from the insurance company. But, the legislation provides for an offsetting deduction. “Initially, that deduction was only available to the end of 2013. We asked that it be extended until the end of March of this year [and] Finance agreed.”

2. Compliant loan from insurance company

Several insurance companies with programs affected by the new legislation are offering new loan arrangements to avoid the application of the 10/8 legislation. These offerings have reduced tax benefits.

3. Borrow from another institution

This would mean the loan should not be linked to the insurance structure, so it wouldn’t be caught by the new rule.

“The other financial institution may have different terms and conditions that may require [the client] to offer more security,” notes Wark.

LIAs

Unlike 10/8s, holders of LIAs benefit from grandfathering: arrangements in place prior to Budget Day can continue indefinitely—with all associated tax benefits.

“If you don’t increase the amount of the borrowing after the Budget date, you could refinance or extend the loan and it would be grandfathered indefinitely,” adds Wark. But those who didn’t set up an LIA prior to Budget 2013 are out of luck.

Wark adds that some worried the new rules would negatively impact back-to-back arrangements. “They don’t,” he says. “As long as there’s no loan structure attached to it that meets the definition of an LIA policy, [clients] can still benefit from these structures.”

03 Testamentary trusts

Budget 2013 also floats changes to testamentary trusts. And while the legislative hammer hasn’t yet come down, most expect it won’t be long.

Finance’s main concern is these trusts give beneficiaries access to more than one set of graduated rates, a perk not typically enjoyed by beneficiaries of standard inter vivos trusts or those getting the same amount of income directly.

Stella Gasparro, a partner at MNP LLP, says these trusts can still be useful after the tax advantages are legislated away. Say your client doesn’t like her daughter-in-law, worrying she’ll divorce her son. A testamentary trust would protect the son’s inheritance because it separates it from his and his wife’s family assets.

Once the government does away with the tax advantages of testamentary trusts, clients will have three main options, Gasparro says.

Option #1: Gift the money to the children while the client is still alive.

Option #2: Client isn’t worried about probate tax: Leave the funds to the children through the will. “Probate tax isn’t that bad,” says Gasparro. “It’s only when you start getting into larger estates—about $5 million—that you should look at the trust option, because of set-up and administration costs.”

Option #3: Probate is a concern: Transfer the assets into an alter ego or joint-partner trust.

“Alter ego and joint-partner trusts are essentially the same,” Gasparro notes. “Alter ego is for an individual and joint-partner is when you do it as a couple.”

04 Character conversion funds

Character conversion mutual funds use derivative contracts to convert interest income into capital gains, giving investors the safety of fixed income with the tax benefits of stocks. Budget 2013 pulled the plug on these products. Initially, the government said contracts had to be wound up within 180 days of March 21, 2013.

But some offerings had agreements expiring after the deadline; others have rolling contracts that renew every 30 days, explains Carol Bezaire, VP of tax and estate planning at Mackenzie Investments. So the government backtracked, issuing new requirements in July.

Short-term contracts (less than 180 days) with rolling renewals can continue until December 31, 2014. Contracts expiring after 2014 can run their course, but the last day for character conversion is March 22, 2018.

Clients can still enjoy the tax benefits, but in most cases they can’t add to positions. Also, funds can’t take new investors. Fund companies can discontinue affected offerings. Another option is to reorganize them as fixed-income investments.

But it’s not all bad. The contract adds 75 to 100 basis points to unitholder fees. “When the fund’s reorganized,” notes Bezaire, “savings are passed on to investors.”

Highest value

Determining highest value is difficult because it can’t be discerned on a security-by-security basis, says Barbara Amsden, director of special projects at IIAC. This is because:

› It’s not reflected on monthly account statements.

› There are no pre-existing report queries calculating highest cost in a year per security, per taxpayer.

› Firms with millions of clients and over 100,000 securities would need extensive manual workarounds. Automation upgrades would require about 12 weeks to develop and test, which at this point would mean missing CRA’s April 30 deadline.

CRA is listening, and they’re working with IIAC to find a mutually workable solution.