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Solutions to the Strategy Questions! - Post #12 - FPSC Level 1 Examination - December 2017

Posted by John Gobeil on

In our last Post, we provided the solutions to two questions on income tax planning and looked further into income tax-planning strategies.

In this Post, we will look at the solutions to the questions involving the recommendation of income tax-planning strategies.

Income Tax Planning

The competencies involving the recommendation of income tax-planning strategies are:

  • 3.113 Formulates tax planning strategies
  • 3.114 Evaluates advantages and disadvantages of each tax planning strategy
  • 3.115 Utilizes the optimal strategies to make tax planning recommendations
  • 3.116 Prioritizes action steps to assist the client in implementing tax planning recommendations

Question 1

Branson and his wife own a very large home on 1,000 acres located within the city boundaries of Vancouver. The property is worth $150 million and their adjusted cost base is $138 million. Branson expects that the property will increase in value by $120 million over the next five years. Branson could develop the property. Branson and his wife have never used the lifetime capital gains exemption. He wants to avoid income tax on the expected appreciation of the property.

Branson and his wife should:

(A) transfer their interests in the property to tax-free savings accounts.
(B) plan to use principal residence exemption.
(C) transfer part of the property to a Canadian controlled-private corporation.
(D) transfer their interests in the property to alter ego trusts.

In Branson’s situation, there is no opportunity to avoid income tax on the expected appreciation. The correct answer is none of the above. Do you know why?

Branson wants to avoid income tax on the expected appreciation of the property. He might be able to avoid some income tax using the lifetime capital gains exemption. However, for 2017, the maximum shelter is $835,716 of capital gains.

Question 2

Marco and his wife own a home on 50 acres located within the city boundaries of Langley. The property is worth $800,000 and their adjusted cost base is $450,000. Marco expects that the property will increase in value by $100,000 over the next five years.

Marco and his wife have never used the lifetime capital gains exemption. He wants to avoid income tax on the expected appreciation of the property. About 45 of the acres are zoned highway commercial.

Marco and his wife should:

(A) transfer their interests in the property to tax-free savings accounts.
(B) plan to use principal residence exemption.
(C) transfer part of the property to a Canadian controlled-private corporation.
(D) transfer their interests in the property to alter ego trusts.

(Choice A) A tax-free savings account (TFSA) is a flexible, general-purpose savings vehicle that allows residents of Canada to contribute each year and to withdraw funds at any time in the future to be used for any purpose (ITA 146.2). As of January 1, 2017, the cumulative contribution room to TFSAs is $52,000. The Income Tax Act imposes a special tax on excess TFSA contributions (ITA 207.02).

The property is worth $800,000. The 45 of the acres zoned highway commercial would exceed their TFSA contribution room.

So, Marco and his wife cannot transfer a significant portion of their interests in the property to tax-free savings accounts.

(Choice B) The principal residence exemption is a deduction that is permitted from a capital gain on a principal residence that is designated for a particular year of ownership.

Where the total area of the land upon which a housing unit is situated exceeds one-half hectare, the excess land is deemed not to have contributed to the use and enjoyment of the housing unit as a residence and thus will not qualify as part of a principal residence, except to the extent that the taxpayer establishes that it was necessary for such use and enjoyment. The excess land must clearly be necessary for the housing unit to fulfill its function as a residence and not simply be desirable (ITA 54(e) and Interpretation Bulletin IT-120, Principal Residence).

They would probably not be able to establish that the 45 of the acres zoned highway commercial was necessary for such use and enjoyment.

There is no opportunity to avoid income tax on the expected appreciation of the property.

So, Marco and his wife cannot to use principal residence exemption to avoid tax on the 45 of the acres zoned highway commercial.

(Choice D) An alter ego trust is an inter vivos trust where the trust deed specifies that:

  • the settlor of the trust must be entitled to receive all of the income that the trust earns prior to her death;
  • the settlor must be at least 65 years of age at the time that he creates the trust; and
  • the only individual who has any access to the trust capital during the settlor's lifetime is the settlor (ITA 104(4) (ii.1) and (iv)); ITA 248(1)).

An individual can transfer capital property to an alter ego trust without the transfer being considered a disposition for tax purposes. As an inter vivos trust, any income attributed to an alter ego trust is taxed at the top, combined federal and provincial marginal rate. The trustee would allocate the trust's taxable income between the settlor and the trust to minimize income taxes and the clawback of social security benefits.

Even if they were 65 years of age and could establish alter ego trusts, any property income and capital gains would be attributed to them or taxed at the top marginal rates. There is no opportunity to avoid income tax on the expected appreciation of the property.

So, Marco and his wife cannot avoid any income tax by transferring their interests in the property to alter ego trusts.

(Choice C is correct.) With a Section 85 rollover, Marco and his wife could transfer the 45 of the acres zoned highway commercial to a Canadian controlled-private corporation.

The lifetime capital gains exemption (LCGE) is a provision that, for 2017, allows a taxpayer to avoid income tax on up to $835,716 of capital gains realized on the disposition of qualified small business corporation shares (ITA 110.6). A qualified small business corporation is a Canadian-controlled private corporation of which all or substantially all (i.e., 90%) of its assets are used in an active business carried on in Canada.

They could not rollover land inventory and the capital gains exemption requires the corporation to produce active business income, so they would have to use the land to produce active business income (ITA 110.6).

However, none of the other alternatives offers an opportunity to avoid income tax on the expected appreciation.

So, Marco and his wife should transfer part of the property to a Canadian controlled-private corporation and use the land to produce active business income.  

Question 3

Mark and Jessica are in their mid 50’s and have been married for 30 years. Last year, Mark earned $92,000 and Jessica earned $40,000. Neither has established a TFSA. Each has over $40,000 of RRSP contribution room. Mark has $5,000 for investment purposes.

Mark should:

(A) give $5,000 to Jessica to contribute to a TFSA.
(B) give $5,000 to Jessica to contribute to her RRSP.
(C) give $5,000 to Jessica to invest in a non-registered GIC.
(D) contribute $5,000 to a spousal RRSP.

(Choice B) Jessica has over $40,000 of RRSP contribution room. Jessica could take a deduction for an RRSP contribution of $5,000 and could contribute a greater amount such that the after-tax cost would be $5,000.

However, an RRSP contribution:

  • would not provide avoidance on income tax on the investment income;
  • would provide deferral on the funds contributed and the income and capital appreciation; and
  • might provide an element of conversion to a lower tax rate during retirement.

The contribution would use up RRSP contribution room that would not be restored when funds are withdrawn.

So, Mark could give $5,000 to Jessica to contribute to her RRSP.

(Choice C) Where a taxpayer has transferred or lent property either, directly or indirectly, by means of a trust or by any other means, whatever, to or for the benefit of the taxpayer's spouse/common-law partner any property income or property loss from that property is attributed to the taxpayer (ITA 74.1).

Mark would have to report any interest on a non-registered GIC purchased by Jessica with the funds from Mark. There would be no tax advantage.

So, Mark could give $5,000 to Jessica to invest in a non-registered GIC.

(Choice D) Mark has over $40,000 of RRSP contribution room. You may contribute to an RRSP in your spouse/common-law partner's name, making your spouse/common-law partner the annuitant or beneficiary, while you deduct the RRSP contribution on your own tax return.

Mark could take a deduction for an RRSP contribution of $5,000 to a spousal RRSP and could contribute a greater amount such that the after-tax cost of $5,000.

However, the contribution would not provide avoidance on income tax on the investment income.

The contribution would use up RRSP contribution room that would not be restored when funds are withdrawn.

So, Mark could contribute $5,000 to a spousal RRSP.

(Choice A is correct.) The Income Tax Act provides an exception from the spousal income attribution rules for a transfer of property by an individual to the individual's spouse or common-law partner where the transferred property is contributed to a TFSA of which the spouse or common-law partner is the holder (ITA 74.5(12)).

A gift of $5,000 to Jessica that she contributes to a TFSA would:

  • result in avoidance of income tax on any property income and capital gains;
  • avoid attribution to Mark of any property income and capital gains;
  • restore her TFSA contribution room for any withdrawals; and
  • be readily available to provide funding for any purpose at any time.

So, Mark should give $5,000 to Jessica to contribute to a TFSA.

Question 4

Michael has only a few months left to live. He has hired you to review his estate plan. Michael has a spouse, Monica, who is 57 years of age and has a net income of $65,000.

Michael has a physically disabled daughter, Jacqueline, who is 28 years of age and has a net income of $12,000 per year. Michael has a granddaughter, Elizabeth, who is 12 years of age, has lived with them since the death of her parents and has net income of $7,000 per year.

Michael has $450,000 in an RRSP and other investment assets of $1.5 million. After his death, Michael expects the RRSP funds to earn 8%.

What should Michael do?

(A) Michael should leave his RRSP to Monica.
(B) Michael should leave his RRSP to Jacqueline.
(C) Michael should leave his RRSP to Elizabeth.
(D) Michael should leave his RRSP to Jacqueline and Elizabeth.

(Choice A) Monica, who is 57 years of age, has a net income of $65,000. Michael has other investment assets of $1,500,000. 

The spouse/common-law partner of a deceased annuitant may rollover the amount of the deceased's RRSP or RRIF to an RRSP or RRIF or to an issuer to purchase a registered annuity (ITA 60(l)).

So, Monica could rollover any amount of Michael's RRSP left to her to her RRSP.

(Choice B) Michael has a physically disabled daughter, Jacqueline, who is 28 years of age and has a net income of $12,000 per year.

A financially dependent child/grandchild with a severe physical or mental disability must have net income for the year before the annuitant's death less than the personal amount and the disability amount. The financially dependent, disabled child/grandchild may rollover the amount to the child's RRSP or RRIF or to an issuer to purchase a registered annuity (ITA 60(l)). The child/grandchild could also report some, or all, of the amount as taxable income for the year of receipt.

Jacqueline is a financially dependent, disabled child/grandchild of Michael.

So, Jacqueline could rollover Michael's RRSP to an RRSP and could report some, or all, of the amount as taxable income for the year of receipt.

(Choice C) Michael has a granddaughter, Elizabeth, whose net income of $7,000 is less than the personal amount.

A financially dependent, non-infirm child/grandchild's net income for the year before the annuitant's death must be below the basic personal amount for the year (ITA 60(l)). A financially dependent, non-infirm child/grandchild can rollover an RRSP to a registered term certain annuity, but not an RRSP. The child/grandchild could also report some, or all, of the amount as taxable income for the year of receipt.

Elizabeth is financially dependent, non-infirm child/grandchild of Michael.

Elizabeth could rollover an RRSP to a registered annuity with a term of 6 years, calculated as:

  • (the greater of (0 and (18 years - the age in whole years of the child/grandchild))); or
  • (the greater of (0 and (18 - 12))).

So, Elizabeth could rollover an RRSP to a registered annuity with a term of 6 years and could report some, or all, of the amount as taxable income for the year of receipt.

(Choice D is correct.) Michael has other investment assets of $1,500,000. He could leave these assets to his spouse and he could defer paying income tax on any capital appreciation until she disposed of the assets. Monica also has a net income of $65,000. Michael also has $450,000 in an RRSP.

If he left the RRSP to Monica, she could defer income tax until she withdrew the funds. However, it is unlikely that she could avoid paying income tax on the funds.

He could leave the funds to his child and grandchild. To the extent that they had an amount of taxable income less than the personal amounts, including the disability amount for Jacqueline, they could avoid any income tax. The children would likely pay tax at a lower rate on any excess than Monica would.

In any case, as the mother/grandmother of the children, Monica would be in control of the funds and she would be using them to support her family. Michael's investment assets of $1,500,000 would also be available to provide for Monica and the children's needs.

So, Michael should leave his RRSP to Jacqueline and Elizabeth.

When you are faced with a strategy question, keep in mind that considering the alternatives requires a lot of thought and therefore time.                                 

Results of Candidates

A number of candidates who failed the last exam have sent us copies of their results. All of them had higher marks in analysis, than in collection or strategy. Analysis is essentially the kind of capability that you need to pass the qualifying courses to get to the CFP Examinations. Strategy seems to go well beyond the qualifying courses.

Collection would seem to be a precursor to analysis, but we do not understand how one could do worse on collection, than on analysis. One more of the mysteries of life!

Income Tax Planning

We received a call from a lady who had taken a 5-day course from another organization. She was panicked because they had gone through so much detail on income tax and she was unable to cope with it all.

The Exam that you are writing does not require you to prepare complex income tax returns from memory. You will not have to calculate someone’s Working Income Tax Benefit or their deduction for camp expenses as child care expenses for someone who is in prison. That is not what this exam is about.

You will have to prove that you understand how the principal residence exemption works, how the TFSA works, and how important planning stuff works.

You will not find any questions that require you to know some complex and obscure tax calculation, the income tax brackets for 1997, or the disability amount for 2003. If you are out of your depth, everyone else will be. Pick C and move quickly to the next question.

Effectiveness of our study aids

We always appreciate feedback on the effectiveness of our study aids. Together, we can continue to have the best study aids available.

Regards,

John Gobeil, BSc, CFP®
David Gobeil, CPA, CA, CFP®

Certified Financial Planner® and CFP® are certification marks owned outside the U.S. by the Financial Planning Standards Board Ltd. The Financial Planners Standards Council is the marks licensing authority for the CFP marks in Canada, through agreement with FPSB.


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