An Overview of Taxation in Canada: Corporate Taxable Income - PricewaterhouseCoopers LLP
The computation of taxable income for Canadian tax purposes begins with net income as reported by a corporation in its unconsolidated financial statements. This is generally calculated in accordance with Canadian generally accepted accounting principles. The calculation is then modified by specific rules of the Income Tax Act. It should be noted that the calculation of a corporation's taxable income must be prepared for each company as a separate entity. Consolidated tax reporting by a related group of corporations is not permitted.
Where a non-resident corporation carries on business in Canada through a branch, the corporation must calculate its Canadian-source taxable income as if the branch were a separate company.
The remainder of this article and the following article will briefly highlight some of the more frequently encountered adjustments that must be made to financial statement net income to obtain taxable income.
Capital Gains: Gains (losses) realised on the disposition of capital property (generally, property that is not inventory) are regarded as capital gains (losses). Only three-quarters of such gains realised by a corporation are included in its Canadian taxable income. A capital gain is computed as the excess of proceeds over cost, less expenses related to the disposition. Cost is the actual cost paid or, in certain circumstances, the fair market value of property at December 31, 1971 (the date capital gains became taxable in Canada). Capital losses are reduced to three-quarters of the loss otherwise calculated and can only be used to offset capital gains. Capital losses can be ordinarily carried forward indefinitely and carried back for three taxation years.
No statutory distinction is made between a short-term and a long-term capital gain. If a gain is a capital gain, only 75% is included in taxable income subject to tax at the ordinary federal and provincial tax rates.
Capital Cost Allowance (Tax Depreciation): Accounting depreciation is not deductible. However, the Canadian tax system permits the deduction of the cost of fixed assets (capital cost allowance) as defined by specific tax regulations, generally using a declining balance method, at rates from 4% to 100%, depending on the classification of the asset.
For each classification or class of assets, capital cost allowance is calculated on the balance in the class at year-end. Any amount up to the maximum prescribed amount for each class can be deducted. New acquisitions are added to the class when they are available for use, and only half of their cost is recognised for a capital cost allowance deduction in the first year. Disposals of assets are removed from the class at the lower of their cost or proceeds. If this results in a negative balance in the class and no assets remain, the resulting negative amount is added to income as "recaptured depreciation". If a positive balance remains when no assets remain in a particular class, the amount is deducted as a "terminal loss".
Deducting capital cost allowance is discretionary. A taxpayer may choose not to deduct the maximum available capital cost allowance in a year in which the corporation is otherwise in a net loss position. (Loss carryforwards have a limited life and undepreciated capital cost amounts can be carried forward indefinitely.)
Canada encourages investment in certain industry sectors by accelerating the capital cost rates. For example, manufacturing and processing equipment has a 30% rate; some computer software has a 100% rate. Small tools, dies, jigs and moulds can also be deducted at 100%.
In particular circumstances, the deduction of capital cost allowance may be subject to restrictions. Some of these restrictions can apply when a taxpayer carries on more than one business. In such a case, assets that would otherwise be included in the same classification must be segregated into separate classes, one for each business. When the tax year is less than twelve months, capital cost allowance claims must be prorated on the basis that the number of days in the tax year is 365.
Scientific Research and Experimental Development: A corporation that carries on business in Canada may deduct capital expenditures made in Canada and current expenditures made either within or outside Canada, for scientific research and experimental development related to the taxpayer's business. Guidelines as to what is scientific research and qualifying expenditures are contained in the Income Tax Act and Regulations. The entire amount of the expenditures for work carried on in Canada may be deducted in the tax year during which the qualifying expenditure was made or, if the taxpayer so chooses, it may deduct only part of the expenditure and carry forward the excess indefinitely to be deducted in future years. Current expenditures for work carried on outside Canada must be claimed in the year incurred. Restrictions can apply to undeducted amounts following a change of control. Generally, building costs or building rental expenses are not eligible for the 100% deduction unless they relate to a prescribed special-purpose building. When a taxpayer disposes of capital property, the cost which has been written off under these provisions, such costs, or a portion not exceeding the write-offs, are included in income subject to tax.
In addition, certain scientific research expenditures can earn federal investment tax credits.
Some provincial governments have legislated tax incentives to encourage scientific research and experimental development expenditures in their own provinces.
Inventories: For income tax purposes, inventory is generally valued at the lower of cost or fair market value. Valuation is determined by the "first-in, first-out" method, and most other established costing methods. "Last-in, first out" is not permitted. The method chosen must be consistently applied from one year to the next.
Interest: Interest on money borrowed to earn business income is deductible only when it is payable under a legal obligation and the interest expense must be deducted in computing income for the year in which it was paid or became payable.
A portion of the interest expense in respect of debts owing to specified non-residents is not deductible where a 3:1 debt/equity ratio is exceeded. The term "specified non-residents" includes a non-resident owning 25% or more of the shares of a corporation (a specified non-resident shareholder) as well as any non-resident not dealing at arm's-length with a specified non-resident shareholder. These rules are commonly known as the thin capitalisation rules.
There may also be restrictions on the deductibility of interest for funds borrowed to acquire land and for interest costs incurred during the construction, renovation, or alteration of a building. The tax rules also provide that certain bonuses and early repayment fees, as well as interest rate reduction payments, be amortised over the term of the related debt.
Intangibles: Amounts paid for goodwill, incorporation expenses, customer lists, certain legal fees, and other intangibles are included in an "eligible capital expenditure" pool to the extent of 75% of their cost. This tax pool can be deducted at the rate of 7% of the declining balance per annum. These deductions may be recaptured and included in income on a disposition of similar intangibles.
Reserves: No deduction is allowed for general profit reserves or contingent liabilities unless expressly permitted by the tax legislation. Some of the reserves provided for by the Income Tax Act include:
- a reasonable amount for doubtful debts that have been included in computing income for the year, or a preceding year;
- a reserve for amounts included in computing income on account of goods not yet delivered or services not yet rendered;
- a reserve for certain amounts not payable until a year later for inventory sold during the year; and
- a capital gains reserve when disposal proceeds are not payable until after the end of the tax year (subject to specified limitations).
- The decision to claim a qualified reserve is at the discretion of the taxpayer. However, a reserve claimed in on year must be added to taxable income for the following year.
Tax Losses: Operating losses (known as non-capital losses) incurred in a taxation year may be carried back for deduction from income earned in the prior three taxation years and forward for deduction in the following seven taxation years. Losses arising from the sale of capital property may reduce taxable capital gains realised in the prior three years and in any future year, but cannot be used to reduce operating income. When control of a corporation is acquired, undeducted capital losses expire and the deduction of operating losses becomes restricted. Pre-control change non-capital losses are deductible from income earned in the post-control change period and vice-versa, provided the same or a similar business that generated the loss is continued in the post-control period.
The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.
While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a PricewaterhouseCoopers LLP professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your PricewaterhouseCoopers LLP advisor, or:
David W. Steele PricewaterhouseCoopers LLP 145 King Street West Toronto, Ontario M5H 1V8 Canada
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