January 1, 2004 by Canadian Underwriter
With the soft “thump, thump” sound of my wiper blades as background, I drove slowly down the town’s snow-clogged main street, peering through a half-frozen windshield at the blizzard outside. Finally, I spotted the welcoming light of the small restaurant I was looking for, and pulled to a slithering stop. Holding on to my hat, I bent forward into the swirling mass of snowflakes, and clumped my way to the entrance. Seated at the circular table near the front window was my host, broker Al.
It was my mid-winter visit to Al, who had a successful and well-automated brokerage in a town of about 75,000 people, located an hour-and-a-half drive from the city where my company’s branch office was located. I had agreed to meet with him for coffee before we went to his office to talk business. He rose from the table as I hung my wet coat on the rack by the door.
“Greetings, Dave! Don’t we save some great weather for you to drive through, eh?” As we walked to the table I could see three other people sitting with mugs of coffee in front of them. Two were brokers I recognized, but the third person was a stranger. Al introduced me to his two broker friends, Tom and Earl. Then as I shook hands with the other man, Al said: “Dave, meet Mark. He’s a C.A. and he’s our local income tax specialist. He was sitting in here on his own when we came in, so we invited him to join our little coffee social.” He paused for a second then added with a small laugh, “We thought we’d buy him coffee and pick his brains for free tax advice.”
Mark smiled and raised his mug. “Nothing’s totally free, my friend. You can buy me another one of these.” His second coffee arrived, and I threw a quick question at him. “Mark, let me lead off with a dumb question that’s been at the back of my mind for ages. I think I must have the world’s greatest collection of old invoices and receipts. Just how long should I keep all the paper stuff that’s related to my income tax statement?”
Mark looked over at me. “That’s not so dumb at all, Dave. Lots of people either don’t keep tax records long enough, or they keep wads of information that goes back thirty years. The ‘number-one rule’ is to keep everything that’s relevant to your tax filing, and to keep it for seven years. By relevant, I mean ‘T-slips’, ‘RRSP contribution receipts’, purchase or lease agreements, medical and charitable donation receipts. And, of course, any supporting documentation that supports business expenses that you incurred – the sort of items that you were referring to a second ago. The ‘number-two rule’ is to hold on longer than seven years to anything that had or has some impact on your tax returns in later years. For instance, real estate transaction documents or investment purchase agreements. They have a longer active shelf life so far as income tax is concerned.”
It was Earl, the youngest in our group, who posed the next question. “Tell me, Mark, why does Canada Customs and Revenue Agency suddenly decide to do an audit of someone? Is it purely by chance? I mean, does your name just come out of a hat at random?”
Mark shook his head. “CCRA may do the odd random audit, but usually they decide on an audit because something jumps out at them from a tax return. Often it is something that has never been in your return before or perhaps something that they know has often led to adjustments to other people’s returns. They have learned through the audits of thousands of taxpayers the sorts of items that call out for review. Certain industries also seem to be among their favorite targets. Fortunately for you gentlemen, insurance brokering is not one of them.”
I could see Al’s head nodding. “So, you’re saying that in filing you need to be consistent. Is that the message?”
“Yes to a degree,” Mark answered slowly. “It sure doesn’t hurt. Filing on time is also important. I think the overall idea is to be one of a large herd of taxpayers rather than standing out as a stray. Strays get special attention.”
Tom had been quiet so far, but now he spoke up. “Mark, do you have any advice on how we should pay ourselves and the people in our businesses? To be the most tax efficient, I mean.”
Mark swirled the coffee in his mug for a second. “That depends on the answers to three questions. First, what is the tax position of your business? Second, what is your tax position personally? And third, what’s the tax position of any members of your family who may derive income from your business? You see, the general rule for small incorporated business used to be that the first $200,000 of profit was taxed at a preferred rate and any amount over that was taxed at significantly higher rates. That encouraged a lot of people to record bonuses to themselves, their family or their staff to bring their corporate profit down to $200,000.” He gave us a small smile. “Now that the preferred limit has been increasing lately, both provincially and federally, it’s no longer such an easy decision to call. We now have two or three other grades where we have to make a decision. You have to think, what will the tax rate be for the person getting that bonus, versus the tax savings the firm could realize by paying that bonus?”
Mark paused for a sip of his coffee, and Tom jumped in. “I think I’m with you so far, but I have a question about family members. Our firm is a limited company and my wife is listed as a director. It’s not an empty title because she worked in insurance before we married and when some of our CSRs go off on holiday, she fills in for them at the office. Question is, how much can I pay her as a director above and beyond her salary as a temp?”
“Good question,” Mark replied and looked around our table. “The general rule is this – you pay someone in your family the same amount you would pay another person who isn’t related to you to do the same work. In other words, decide what the range is for reasonable compensation for the director’s duties, and once you determine that, you can probably move toward the high end of that range.” Seeing our questioning looks at this last statement, Mark continued. “You want the number to be reasonable and defensible. Smaller amounts will likely not need to be defended as I’d say from experience that CCRA generally considers $10,000 and under pretty small. They’re unlikely to give you grief on that scale of a directors’ annual payment.” He paused and grinned. “Now, if your sister is a director, has virtually no duties, and you’re paying her $50,000 – then I’d say you’re probably going to have some problems defending that. Compensation, after all, should reflect the value of the work a person does.”
A waitress brought a fresh pot of hot coffee to our table, and after pouring, Al spoke up. “Can we move from people to machines for a minute? I’d like to replace a couple of items in my computer set-up, but not only is it pretty expensive, it also seems to become obsolete in a year! I know this isn’t strictly a tax question, but wouldn’t it be better for me to lease the stuff?”
I could see Mark shaking his head his head slowly. “Actually, Al, leasing is almost always more expensive than buying. For one thing, there’s more accounting to do on a monthly basis. That costs money, and the people who are leasing the equipment to you aren’t going to eat that accounting cost. They pass it on to you through higher lease payments.” He opened up his hands in front of him. “And don’t forget, the same bogey of rapid obsolescence affects the leasing company as well as the company that sells the same piece of computer equipment. They aren’t going to eat that rapid depreciation. They’re going to pass that cost of doing business on to you and their monthly or annual financing costs will reflect this fact. You’ll still wind up paying for the obsolescence factor, plus you’ll be paying for all that accounting work to keep track of the system you lease from them. The interest charges factored into many equipment leases are also often considerably higher than lending rates.”
We all nodded silently at the simple logic of Mark’s explanation, but I could see that he wasn’t finished with his thou
ght. “Timing is another thing worth remembering,” he said slowly, “from a deduction standpoint. Let’s say you’re going to buy a piece of computer equipment in the next two or three months and you’re near the end of your fiscal year. Buy it before the fiscal year ends, rather than delay the purchase to your next fiscal period, because you’ll get the depreciation allowance a full year earlier.” He let that sink in for a moment, then added: “On the other hand, make sure you need the equipment. I always advise my clients to go easy on office space, improvements and equipment because ultimately it impacts on your bottom-line. When you keep firm control of your overheads, you’ll be in a much better position to flourish in the good times and survive a downturn in your business or in the economy.”
Tom quickly jumped in with another question. “How about allowable expenses? How do I know what’s deductible and what is not?”
That brought a quick smile to our guest’s face. “The general rule is that anything that helps your business earn income is normally deductible. Then you have to look at specific rules regarding specific items. As an example, right now, income tax law dictates that you’re only allowed to deduct half the cost of meals and drinks that you incur to help your business earn income. Remember now, be reasonable.” Mark held up a cautionary finger. “There are some items that seem to be related to your business that CCRA is very unlikely to accept. Clothing is an example. Suits, shirts and shoes can be darned expensive, but take my word for it: CCRA’s not going to accept the cost of these things as something that earns you income even if you only wear them for business. They will look at an item and focus on any personal use in relation to it. If they determine that the item is personal, it will not be allowed as a deduction.”
I grinned at him. “I was afraid of that. No sense of humor at the income tax department.”
Mark smiled back at me. “I hate to disappoint you all, but dealing as I do with Canada Customs people on a daily basis, I find they’re usually pretty reasonable folks – if you’re sensible and reasonable with them.”
The brief silence that followed was broken by Earl. “How about the cars we all drive, Mark. Better to buy or lease?”
Mark leaned back in his chair. “Again similar to equipment, leasing generally is a more expensive option. And nowadays, a lot of vehicles are available to buy at zero percent interest. That’s pretty hard to beat. In general, I have to say that by the end of the fourth or fifth year, the deductions that you would receive are about even either way. If you buy, timing is a factor in the first year because you get the same deduction whether you buy January 1, or December 31.” He took a sip of his coffee. “From a tax standpoint, you get half the normal capital asset depreciation rate, and the normal rate for vehicles is 30% on the declining balance. And don’t forget, there’s a deduction limit of $30,000 plus sales taxes, on whatever vehicle you purchase. A similar limit is in place for leases.”
“I understood there’s a slight tax advantage to leasing,” I said. “Am I wrong?”
Mark shrugged his shoulders. “Again I think it is all about timing. There can be a short-term timing advantage in the first year through leasing, but it usually starts reversing itself in the second and third years and by the fifth year, it’s a wash. If you get your new vehicle late in your fiscal year, you may actually get a larger deduction in the first year by purchasing the vehicle. If you can get yourself a really good deal either way – buying or leasing – then take it. If you don’t drive the car that much, it’s not going to depreciate as much, so maybe buying would be the best option because you’re going to have some tangible value remaining in the car. If you drive a lot, and are hard on the car, then probably leasing is the route for you.” He paused in thought. “Of course, the other factor that has changed recently is the so-called ‘standby charge’. That’s the term Canada Customs uses for the taxable benefit you receive by having a company-owned or leased vehicle available to you for your personal use. The rule used to be that you had to drive more than 90% of the time on company business in order to quality for a reduced benefit. But after losing a court case a few years ago, CCRA will now allow you to reduce the standby charge if more than 50% of your driving is for the company. This is important because as that taxable benefit goes down, the personal tax that you pay on the benefit goes down as well.”
“Fair enough,” Tom responded. “But tell me, have they changed the maximum allowable lease charge?” That brought a quick shake of the head from Mark. “No, it’s still set at $800 per month,” Mark answered, “and again you can add the federal and provincial sales taxes on the $800.”
As he finished, I saw Mark glance quickly at his watch. “Must leave you now,” he said cheerfully. “I have to go and visit with my friends at the tax department.” He stood up, then paused as another thought occurred to him. “As good insurance people, I’m sure you all know that the commissions that you earn on those insurance policies and investments that you sell to yourself are deductible?” He stood up, shook hands all round, and pushed his way out of the restaurant’s front door into the blowing snow outside.
Al turned to me with a smile. “Hope you learned something from all that, Dave. Don’t I put on good morning coffee sessions for you?”
“You certainly do, my friend,” I answered. “But now we face another kind of ‘taxing situation’. We have to go outside and decide whose car to dig out first – yours or mine.”
AXIOM wishes to thank Mike Holloway, C.A., for his help in preparing this article.