Department of Accounting and Finance

UNIVERSITY OF MANITOBA97.06.23

9.305Taxation Accounting Final ExamA. Murdoch

Paper Number 88June 19, 1997 7:00 - 9:30 p.m.Page 1 of 6

1.There are two questions totalling 120 marks: 75 marks for the first, 45 for the second.

2.The examination books must be handed in when the exam is completed.

3.Hand calculators and an annotated copy of the Income Tax Act may be used but not shared. The Act may not have material pasted into it (e.g. post-it notes), have more than 25 tabs, nor have tabs with other than section numbers on them. There will be a penalty of 1% for each tab in excess of 25, and for each word on tabs or material pasted, stabled or otherwise attached to the Act. Flagrant violations will result in the Act being confiscated until the exam is handed in.

4.Do not cite sections or divisions of the Act unless specifically required in the question.

5.If you feel you require more information in a fact situation, outline the exact nature of the information and specify how it would affect your decision, but do not contradict fact or assume the abnormal.

6.If you are given financial statements, assume they are prepared in accordance with GAAP, unless clearly indicated to the contrary.

7."Compute" means determine the amount(s) required, showing individual amounts totalling to the amount(s) required. Where the Act refers to "the lesser of" some amounts, you need only compute that lesser amount.

“Compute in accordance with the Act” means determine the amounts required in the manner specified in the Act. Where the Act refers to “the lesser of” some amounts, each amount is to be computed.

"Discuss" means indicate quantitative and qualitative factors relevant to the question. Where the Act refers to "the lesser of" some amounts, you should show each of the amounts to demonstrate which is the lesser one.

For questions requiring you to "compute" an amount, marks are awarded for each amount needed to calculate the total; marks will be deducted for amounts included incorrectly in the computation.

8.Bonus marks will be awarded for intelligent tax planning ideas relevant to the question.

QUESTION 1 (75 MARKS)

Mr. Rich, a new client, has invested in rental properties, principal residences and other capital property with inheritance moneys and other liquid cash. He provides you with the following information with respect to his 1996 taxation year.

Mr. Rich is employed by Wealth Inc., a Canadian-controlled private corporation, and received the following income and benefits:

(1)Salary (net)...... $51,156

Payroll deductions:

Income taxes...... $15,100

CPP...... 893

UIC...... 1,151

Registered pension plan (defined benefit: current service)3,70020,844

$72,000

(2)Mr. Rich paid professional fees of $500 to the Professional Engineers of New Brunswick.

(3)Mr. Rich, who is engaged in negotiating contracts for his employer, received for the entire year a monthly allowance for traveling and car expenses of $550 and $650, respectively.

In September of 1996, Mr. Rich sold his car for $12,500 and purchased a new car costing $35,000, including PST of 8% and GST of 7%. Mr. Rich purchased his previous car in January 1993 for $25,000 plus PST and GST. The UCC at January 1, 1996 was $10,000. Mr. Rich’s kilometers for personal use were 6,250 out of a total kilometers of 25,000.

Mr. Rich’s employment contract requires him to use his own car and pay all of his expenses.

Traveling expenses:

Meals...... $3,500

Accommodation...... 4,500

Gas and oil...... 2,100

Insurance...... 800

Maintenance...... 500

License...... 85

$11,485

(4)Mr. Rich sold two lots of his stock options. He provides you with the following:

1st lot -450 shares sold on February 15, 1996 for $26.50 per share. These shares were purchased in February 1989 for $8 at which time the shares were valued at $10.50. The fair market value at the date of grant in 1988 was $7.

2nd lot -600 shares sold on December 5, 1996 for $25 per share. These shares were purchased on March 12, 1996 for $15 at which time the shares were valued at $21. The fair market value at the date of grant in 1995 was $17.

(5)Mr. Rich received an interest-free loan of $9,000 on March 12, 1996 to enable him to purchase shares of Wealth Inc. The loan was outstanding until the shares were sold on December 5th, at which time the loan was repaid.

In addition, during 1996 Mr. Rich received the following income from various sources including certain capital dispositions.

(A)Mr. Rich owns two rental properties:

Wealthier St.Richmount St.

Cost of land...... $70,000$100,000

Cost of building...... $55,000$80,000

UCC - January 1, 1996, Class 3...... $39,000$65,000

Rental revenue in 1996...... $18,000$7,600

Expenses:

Taxes (property)...... $2,100$1,800

Other expenses...... 4,3006,100

Mortgage interest...... 3,600Nil

$10,000$7,900

The Richmount St. rental property was sold in November for $250,000, including $140,000 for the land, before a commission of $9,000. Mr. Rich took back a $100,000 first mortgage on the property for 5 years. Mr. Rich will receive a capital repayment each year, excluding the first year, of $20,000.

Mr. Rich purchased the Wealthier St. rental property by placing a mortgage on his home. His monthly payments are $450 per month, of which $300 per month represents interest.

(B) Mr. Rich gifted his wife, who is a full-time homemaker, $10,000 in June, 1996 to allow her to invest in the stock market. Mrs. Rich decided to be a cautious investor for the first while; as a result, she invested the $10,000 in Treasury Bills which paid $600 interest from June to December of 1996.

(C) In addition, Mr. Rich decided to provide his younger brother, who is 22, with a non-interest bearing loan of $5,000 to allow him to complete his Masters in Marine Biology. Mr. Rich’s brother paid his tuition fees with the funds.

(D) Mr. Rich gifted $8,500 to each of his twin children, Dolly and Camp, aged 15. Both children placed their moneys in high interest-bearing savings accounts each receiving interest of $1,050 in 1996.

(E) Mr. Rich received dividends from the following investments:

Foreign Co. - a foreign corporation (net of $66 withholding tax)...... $300

Wealth Inc. - a taxable Canadian corporation...... 800

(F) In 1993, Mr. Rich loaned $120,000 to his brother-in-law’s company which was a small business corporation. The loan paid interest at commercial rates, but no interest was received in 1996 because the company went into receivership. As an unsecured creditor, Mr. Rich received 10 cents on the dollar ($12,000) in 1996 in full payment of this loan.

(G) Mr. Rich owns two mutual funds, Dumark Mutual Fund and Paget Mutual Fund. He received a T3 slip from Dumark Mutual Fund indicating the following income amounts allocated to his account and reinvested in 1996:

Capital gains...... $1,200

Actual amount of dividends...... 400

Taxable amount of dividends...... 500

Mr. Rich had invested $20,000 in the Dumark Fund in 1995. This resulted in the purchase of 1,640.824 units of the fund. In 1995, income of $46.31 was allocated to his account and reinvested. The reinvestment resulted in the purchase of 3.845 units at the market value of $12.044 per unit. The 1996 income allocation resulted, on reinvestment of the $1,600, in the purchase of 119.358 units at the market value of $13.405 per unit. Late in 1996, after the income allocation, Mr. Rich sold 1,000 units for a total of $12,912.

He also received a T5 slip from Paget Mutual Fund indicating that he had received a $280 capital gains dividend during 1996.

(H) Mr. Rich sold a $100,000 Government of Canada bond for $115,327. This bond paid interest semi-annually at an interest rate which was much higher than current interest rates. The proceeds received of $115,327 included accrued interest of $5,327. Mr. Rich had purchased the bonds when they were originally issued for $98,000.

REQUIRED

(A) Compute Mr. Rich’s 1996 income for tax purposes in accordance with Section 3 of the Act.

(B) Compute Mr. Rich’s income tax payable for 1996.

QUESTION 2 (45 MARKS)

Wealth Inc. is a Canadian-controlled private corporation whose fiscal period coincides with the calendar year. For the year ended December 31, 1996, the company’s taxable income was calculated as follows:

Income from manufacturing net of C.C.A. but before rent expense...... $221,000

Rent expense - manufacturing equipment...... (30,000)

Dividends from taxable corporations:

(a) dividend payment from wholly-owned subsidiary triggering a dividend

refund of $2,750 to the wholly-owned subsidiary...... 11,000

(b) portfolio dividends, triggering dividend

refunds of $3,750 to the payers...... 20,000

Taxable capital gain...... $29,000

Allowable capital losses...... 12,00017,000

Royalties...... 9,000

Recapture of C.C.A. on disposal of sales equipment...... 54,000

Income from rental of an apartment building (no full-time employees

and tenants provide virtually all of their own services)...... 14,000

Foreign non-business income (i.e., interest income)(before foreign tax

withheld of $2,147)...... 23,000

Foreign business income (before foreign tax paid of $2,400)...... 6,000

Interest charged on accounts receivable...... 5,000

Net income for tax purposes...... $350,000

Less:net capital losses carried over...... $7,000

non-capital losses carried over...... 10,000

donations...... 26,000

dividends from taxable Canadian corporations...... 31,00074,000

Taxable income...... $276,000

At December 31, 1995 there was a nil balance in the refundable dividend tax on hand accounts. The company paid $78,000 in dividends during 1996 to individual shareholders.

The company has a permanent establishment in New Brunswick and in the United States. Its gross revenue net of dividends, its salaries and wages, and its gross capital are attributed to its permanent establishments as follows:

GrossSalariesGross

revenue& wagescapital

New Brunswick

Sales...... * 85,000 *

Manufacturing...... 1,716,000155,000420,000

Rental of apartment ...... 60,00014,000144,000

Subtotal ...... 1,776,000$238,000$564,000

United States (sales) ...... 220,00016,000 3,600

Totals...... $1,996,000$254,000$567,600

*Gross revenue of $1,716,000 is attributable to sales and manufacturing. The manufacturing building and equipment costing $420,000 is also used 10% for finished goods inventory, 10% by the shipping department and 5% by the accounting and sales departments.

In the United States a salesman worked out of his home in which he kept a small stock of merchandise from which he filled orders.

REQUIRED

(A) Compute the federal Part I tax and provincial tax payable by the company for 1996.

(B) Compute the refundable dividend tax on hand balance as at December 31, 1996 and the dividend refund for 1996.

Comments - question 1

1.Most of you incorrectly recognized a recapture on the car Mr. Rich sold. ITA 13(2) (see chapter 5 notes) indicates that recapture does not apply to class 10.1 cars. Others incorrectly put both cars in the same CCA class. Still others tried to use the 13(4) replacement property rules, even though there is no involuntary disposition.

2.The question requires you to calculate income “in accordance with section 3 of the Act”. ITA 3 requires you to distinguish capital items (subsection 3(b)) from income items. ITA 3(a) requires you to calculate income from each source. This requires that you calculate income from each property source separately, appropriately matching expenses with revenues. E.g., the CCA on the Wealthier property needs to be deducted against its $18,000 revenue, not shown as a miscellaneous deduction in calculating property income in general or even rental income in general. Similarly the recapture should be included in the income from the Richmount property, and the interest expense (since the interest loan was received to invest in Wealth Inc.’s common shares) should be deducted against the Wealth Inc. dividends. Marks were deducted for failure to follow this requirement of the Act.

3.Several of you forgot that each rental building costing more than $50,000 goes in a separate CCA class. Several also allocated the total gain on the building between recapture and capital gain incorrectly.

4.Many did not recognize the loss on the loan to Mr. Rich’s brother as an ABIL, fully deductible in 3(d).

5.Since it appears that Mr. Rich is a resident of New Brunswick, you need to use the 64% tax rate that applies to that province. Also remember that provincial tax is 64% times basic federal tax. It seems unlikely that he is a resident of Manitoba (contrary to what some of you assumed) given that he pays his professional fees to New Brunswick, and he purchased a car in 1996 paying 8% PST.

Comment - question 2

Generally this question was well done. Most of you missed some minor points. Almost all of you correctly calculated the provincial abatement. However, some rounded the percentages off more than is probably appropriate.

Marks

2students obtained 90 marks, awardedA+

478 - 89A

770 - 77B+

766 - 69B

260 - 65C+

250 - 59C

145 - 49D