Most Canadians regard paying taxes as a task that falls somewhere between a chore and an obsession. It’s akin to fuelling up your car. No matter how diligent you are about keeping an eye on pump prices, you’re convinced that there’s an even cheaper per litre price somewhere close by.
Perhaps that’s one reason why the Panama Papers–the massive data leak detailing how the world’s uber-wealthy use off-shore accounts to shelter billions of dollars from the tax man—is striking a nerve.
The idea of avoiding taxes is appealing to just about every Canadian, regardless of their income bracket. In part, because we as Canadians pay a lot of taxes. On average, a working Canadian (single or family income) earns just over $79,000, but paid $33,272 in total taxes, as of 2014. To put this in perspective, that same Canadian paid just $28,887 on food, clothing and shelter combined. So unlike the world’s wealthy who sock their money into off-shore accounts, the average Canadian spends 42.1% of their income on taxes and only 36.6% on basic necessities.
It should come as no surprise, then, that wealthier Canadians have a long history of finding ways to avoid paying tax. Six years ago, the consumer advocacy group, Canadians for Tax Fairness, released data that showed how firms and individuals were sheltering as much as $170 billion in offshore tax havens in 10 locations across the globe. Executive director Dennis Howlett stated, at the time, that the “$170 billion figure almost certainly under-represents the problem.”
So, what is a tax haven?
To help provide context, the Organization of Economic Cooperation and Development (OECD), a Paris-based group of 30 developed countries, uses three key attributes for identifying whether a country is a tax haven:
No. 1. There is no or only nominal tax. While a tax structure can vary from country to country, the one common characteristic of a tax haven is that it charges little or no taxes to non-residents who park their money or assets in that jurisdiction.
No. 2. The jurisdiction protects personal financial information. Tax havens will zealously protect personal financial information—going as far as to pass formal laws or enact administrative practices that will prevent scrutiny by foreign tax authorities.
No. 3. Lack of transparency. No scrutiny also means little or no transparency and that can mean sudden legislative changes because of behind-closed-doors secret rulings.
Canadians, be wary of these tax strategies
Of course, most of us don’t even come close to the net worth required to take advantage of off-shore tax havens, like the ones uncovered in the Panama Papers leak, but that doesn’t mean you can’t get nailed for tax evasion.
Over the last decade, at least a handful of tax evasion strategies have come under the Canada Revenue Agency scrutiny. These strategies include (but aren’t limited to):
No. 1. Dubious charitable donations. Five years ago, the CRA began to crackdown with audits on every gifting tax shelter available to Canadians. That’s because at that time, approximately 170,000 taxpayers were allegedly dodging tax by claiming as much as $5 billion in dubious donations to not-so-legitimate charitable organizations.
While there’s not a lot, if any, of these schemes around anymore, the key to not getting caught up in this type of tax evasion scheme is to apply the too-good-to-be-true rule: If you invest $100 and get a charitable donation receipt of $130 then consider that too good to be true. That’s because no legitimate charity will claim you donated more than you did nor will they issue a tax receipt for an inflated donation.
No. 2. Business income, not investment gains. Have you opted to skip the stocks to invest in real estate? Don’t immediately assume that the profits from the sale of those investment properties will immediately qualify for the principal residence or even the preferential capital gains tax treatment.
About five years ago, the CRA began to crack down on real estate profits. For example, the CRA forced a taxpayer to fork out $11,400 in penalties, in addition to tens of thousands in back taxes, for trying to claim tax exemption on seven homes—that she’d bought and renovated in six years. The CRA denied her the principal residence exemption on all seven of the homes—making all profit fully taxable. Worse, the CRA ruled that the profit was actually business income, not capital gains, because the house-flipping was actually a business and not an investment.
No. 3. Tax-free trusts. Up until a decade ago, smart investors could get juicy tax-free returns of 8% to 12% by investing in income trusts. But in October 2006, the government suddenly announced that income trusts would be taxed and the value of these trusts plunged overnight. But that doesn’t mean you still can’t take advantage of income trusts. Even with the income trust tax, some trusts are still yielding 7%.
If you decide to include income trusts in your retirement portfolio, Dan Hallett, vice-president at HighView Asset Management in Oakville, Ont., suggests that you keep them outside your RRSP. That way you can apply the dividend tax credit to the income they provide. If income trusts are held inside your RRSP, the income you get is taxed at the regular income tax rate when it is withdrawn.
Take heart, you can still save on taxes
Still, for those actively trying to prepare their T1s for the tax deadline of May 2, there are legitimate ways to pay less tax.
Here are a few suggestions:
No. 1. Income splitting. While the new Liberal Budget 2016 has eliminated income splitting for couples with children under the age of 18, that doesn’t mean you can’t save taxes through income splitting.
If one spouse is a high-income earner you could consider setting up a family trust that names the other spouse (and any children under age 18) as beneficiaries. Then loan the trust a sum of money, say from your investment portfolio, and charge the trust a low-interest rate, say of 1%. That way, the income from the trust portfolio is taxed in the hands of your spouse and kids, at a much lower tax rate. (Just make sure you keep the loaned money in the trust for at least three years.)
No. 2. Spousal retirement plans. Another option is to set up spousal RRSPs and TFSAs. The spouse with the higher income contributes to them and when the spouse with the lower income withdraws the money, it’s taxed at a lower marginal rate.
No. 3. Shelter your biggest asset with an exemption. The payment of capital gains tax applies to all property, however the Canada Revenue Agency offers an exemption that shelters any capital appreciation on your principal residence from being taxed. Suppose you owned a property that you used as a vacation home for 14 years, but then sold your principal residence and lived in it as your principal residence for the next 14. From a tax perspective, you owe tax on any price appreciation in the first 14 years you owned the property. However, for the remaining 14 years—when you lived in the property as your principal residence—any appreciation in value is exempt from capital gains tax.
No. 4. Use legit tax shelters. Of all the ways to thwart the tax man, the easiest and most effective way is to use two legit tax shelters: the RRSP and TFSA.
The RRSP lets you defer paying taxes on a portion of your yearly income (the amount you contribute to your RRSP) and give you a tax rebate in the year you make the contribution. These contributions then grow, tax-free, so you don’t have to pay income, dividend, interest or capital gains tax regardless of how much your investments earn in your RRSP. When you finally withdraw the money, you’ll have to pay tax, but for most Canadians they’ll end up paying less tax because their income in retirement is less than during their working years, putting them in a lower marginal tax bracket.
TFSAs are similar to RRSPs in that contributions put into these accounts grow tax-free. Unlike the RRSP, TFSA contributions earn no up-front tax refund, but the government doesn’t get a dime of your money when funds are withdrawn.
No. 5. Harvest tax losses. Another way affluent investors can smooth out their tax hit is to use their losses and gains in the stock market strategically. When investors harvest an investment loss—by selling the tanking stock—they can apply that loss against gains in that same tax year as well as any gains in subsequent tax years, so they end up paying less tax overall. To learn more, read our article on the Secrets of the rich.
No. 6. Use life insurance. If you die at a ripe old age, you’re not likely to have dependents who are still relying on your income but that doesn’t mean your family won’t face big expenses when you die. For example, if you own rental property, you can’t pass it to your children tax-free; your estate will be on the hook for capital gains taxes, whether or not your heirs sell the real estate. The same applies to investment portfolio, RRSPs and RRIFs.
Truth is, once you and your partner have died, the final tax bill on your estate can also be enormous. That’s because once both of you die, the RRSP and RRIF investments are fully taxable in the year of death. Depending on your province, that means up to 53% of your nest egg will go to the government instead of your children, grandchildren or charity.
As part of a comprehensive estate plan, you might consider a permanent life policy with a death benefit designed to offset all or part of your final expenses, including the final tax bill. The premiums can be very high if you don’t get the coverage until late in life, but the payout is guaranteed. If you know you won’t need the cash while you’re alive, it may be the best way to keep your wealth in the family. For more see our article on using life insurance to thwart the final tax bill.
Finally, for those of us that fall on the chore side of the tax paying equation, take heart. You don’t have to do a lot to shave the amount of tax you pay on your investment returns. For a great primer on what to keep in a tax sheltered investment, such as an RRSP or TFSA, and what to leave in unregistered (not tax sheltered) accounts, see our previously published article, Asset Location: Everything in its place.
Sources: Associated Press, Investopedia, MoneySense, Rob Gerlsbeck