ADMN 3710 taxation ch 2

Chapter 2: Fundamentals of Tax Planning

1. Overview of Tax Planning

• Tax Planning: The process of organizing financial activities to minimize tax liability.

• Key Components:

  • What Is Tax Planning?: Understanding the tax implications of financial decisions.

  • Types of Tax Planning:: Different strategies available for effective tax management.

  • Skills Required for Tax Planning: Essential skills needed to navigate tax scenarios.

  • Restrictions to Tax Planning: Limitations set by tax laws and regulations.

2. Shifting Income from One Time Period to Another

• Key Considerations:

  • Limited opportunities in discretionary alternatives for shifting income.

  • Possibility to manage the recognition of income via reserves.

  • Assessing future tax rates is crucial in the decision-making process.

2.1 Future Tax Rate Considerations

• Future tax rates may vary:

  • Greater than current.

  • Less than current.

  • Equal to current.

• When current rates are lower than future rates, postponing income recognition can yield tax savings.

• Conversely, when future rates are lower, there may be a cost associated with deferring income recognition.

• Finance costs associated with early tax payments must also be considered.

2.2 Example: ABC Corp

• Tax Rates:

  • Income < $500,000: 13%

  • Income > $500,000: 27%

• Year 1 Income:

  • After reserve: $150,000

  • Reserve of $20,000 can be delayed to Year 2.

• Year 2 estimated income: $550,000

• Calculating Tax Savings:

  • Shifting the reserve can lead to tax implications:

    • Increased tax in Year 1: $20,000 x 13% = $2,600.

    • Decreased tax in Year 2: $20,000 x 27% = $5,400.

    • Total Tax Reduction: $2,800.

3. Financing Costs of Prepaying Tax

• Prepaying $2,600 tax incurs a financing cost, increasing overall cost.

• Additional costs from tax prepayment: $936 (financing cost).

• After tax saving from purchasing costs: $253 (deductible).

• Net Cost After Tax: $683, leading to overall savings of $2,117 (after accounting for financing costs).

4. Informed Decision Making in Income Shifting

• Critical factors when deciding to shift income:

  • Anticipating future tax rates.

  • Evaluating discretionary opportunities in tax legislation (e.g., reserves).

  • Considering the time value of money.

5. Transferring Income to Another Entity

• Different entity structures can accumulate wealth differently:

  • Types: Corporations, proprietorships, partnerships, trusts, etc.

  • Each structure has varying tax treatments that can impact tax liabilities.

  • Ultimately, income shifts back to individuals or family members.

5.1 Examples of Income Structure

• Business Example:

  • Individual needing $40,000 after-tax has options between corporate and sole-proprietor setups:

    • Corporate rates: 13% on first $500,000; 27% on excess.

    • Personal rates vary significantly with income brackets (up to 50%).

  • Choosing incorporation can provide additional funds for expansion.

6. Conclusion on Income Structure

• Understanding the implications of profit structures and corporate vs. individual taxation is critical for effective tax planning.

• Factors impacting decisions: Future cash requirements, corporate profit levels, business risks (failure/sale), and personal circumstances (shareholder changes).

7. Converting Income from One Type to Another

• Four types of income:

  • Employment

  • Business

  • Property

  • Capital gains

• Changing the type of income can alter tax amount and timing:

  • Requires thorough understanding of financial transactions and their implications.

  • Sometimes necessitates shifting money between entities or altering expenditure types.

8. Skills Required for Effective Tax Planning

• Anticipation: Viewing the complete cycle of decisions and consequences.

• Flexibility: Searching for alternative tax strategies.

• Speculation: Understanding potential tax implications of decisions.

• Compound Interest: Application of financial principles for savings.

• Perspective: Maintaining a common-sense approach to financial management.

• Global Approach: Evaluating tax implications from multiple angles.

9. Restrictions on Tax Planning

• Tax planning involves both acceptable and unacceptable activities.

• Restrictive Measures:

  • Income Tax Act: Prohibits certain actions to prevent tax avoidance.

  • Anti-Avoidance Rules: Focused on transactions between related parties versus independent entities.

9.1 General Anti-Avoidance Rule (GAAR)

• GAAR applies when:

  • An avoidance transaction is present

  • A tax benefit is received

  • A misuse or abuse of tax law occurs.

• Transactions failing the business purposes test and extreme in nature may be rejected for avoidance.

10. Conclusion on Tax Planning

• Effective tax planning involves a conscious effort to minimize tax liabilities while considering the surrounding flexibility offered by the tax system.

• It requires prudent decision-making consistent with sound business practices.