Historical Backgrounder on Investment Taxation

4:12 PM |

Investment Accounting for Tax Purposes

Taxpayers must report all investment activity on personal, corporate and trust tax returns.

Challenges given the range of investment opportunities available include:

· Obtaining complete historical records and documentation

· Complexity of transactions

· Tax treatment

· Accounting treatment, timing, allocations, methods

There are many risks inherent in tax preparation when investments are involved:

· Accurate calculation of the adjusted cost base

· Accurate calculate of capital gains and losses and utilization of carry forward/back

· Reconciliation of the change in ACB each year to the T slips and other transactions that should be reported as income or expenses

· Calculation of comprehensive income net of tax for mark to market investments

· Giving of advice

· Monitoring source of cash (Proceeds of Crime, Money Laundering and Terrorist Financing (FINTRAC)

· Classification of investments as capital or current assets, for example land held as inventory

Comprehensive Income

Accountants also account for investments for financial reporting purposes and calculate tax consequences in order to report under the new Comprehensive Income reporting requirements

October 1, 2006, it became mandatory for Reviews and Audits of reporting entities for interim and annual reports (including non profits) to provide Comprehensive Income statements and to record certain assets as fair market value.

How does one keep track of ACB, FMV and the tax consequences and prepare working papers for this new reporting requirement?

October 1, 2007, non reporting entities were to begin to comply for both interim and annual financial statements but that has been postponed (check the current status).

The workshop I'm presenting in January 2013 hosted by the Institute of Professional Bookkeepers of Canada (www.ipbc.ca) will provide practical solutions to meet the challenges and mitigate the risks of accounting for investments for tax purposes.

Significant dates to remember regarding investment taxation:

n 1917 Income Tax Act

n 1927 CRA founded

n 1966 CPP program commencement

n 1971, Valuation Day, inception of Capital Gains

n 1972 EI

n 1988, Cumulative Investment Income Limit (CNIL) calculations commenced

n 1991 GST

n 1993 Child Tax Benefit

n 1994, the last year $100,000 Capital Gains Lifetime Exemption claim, cost basis may have been adjusted if election filed

n 2004 CGE flow through pool eliminated after 10 years, ACB adjustment for un-utilized remainder of pool

Benefits of accounting for your portfolio and conferring with a qualified accountant

n Legal fees can be significantly reduced for asset listing required when probating the estate of a deceased person

n Portfolio calculations will be beneficial for life cash flow and growth planning

n Portfolio calculations are beneficial for estate planning

n Investment analysis combined with a knowledge of taxation may reduce tax during lifetime, at death and for the estate

n Analysis of earnings and growth may lead to better choices, reduced risk of missing out on changes in the market

n Net worth and portfolio analysis lead to planning opportunities for:

q Net worth maximization

q Income tax minimization

These are just a few of the 27 reasons for keeping track of your ACB. You’ll find all 27 reasons on my blog (just type 27 reasons in the search this blog box)

What four steps would you take to account for investment?

Step One – Verify Opening Balances

At the heart of accounting for investments is tracking the adjusted cost base (ACB) of your client’s investments.

The ideal situation is to request clients with active investment portfolios provide their documents frequently throughout the year.

One way to handle this is to request a duplicate statement and additional reports from investments such as flow through investments are sent direct from the broker/banker/insurance advisor every month.

Record the bulk of the year’s investment transactions prior to tax season. This affords more time to verify complex items with third parties such as brokers and bankers.

Warnings before embarking on investment accounting:

Premature greying can occur when calculations of flow through investments are undertaken in the middle of April.

Sudden death can precipitate the requirement to calculate all investment transactions since 1971 in order to determine that appropriate actions were taken by the taxpayer in years past that would not block a Clearance Certificate (or if not caught until later, and if fraud can be proven) would require payment of taxes, penalties and interest by the beneficiaries.

First Time Clients

The first time a client with assets and investments asks you to prepare a personal tax return, determine the opening ACBs and capital loss carry forwards (LCFs).

Both ACBs and LCFs are ongoing, necessitating an accurate starting point.

To accomplish this, the client’s entire investment and tax history must be obtained.

Obtain information both from the client and corresponding verification that was the client has recorded was accepted and recorded by CRA.

Document all investments, registered and unregistered, assets of all kinds including principal residence, cottages, boats, cars, RV’s, timeshares and don’t forget insurance products, especially Segregated Funds. Oh yes, include any associated debt because you will need to ensure that attribution rules are not a problem.

Don't forget to include principal residences where a portion of the residence was utilized as a home office or a corporate office (commercial tenancy rules apply here and GST/HST applies from $1 rent).

Verify that the changes in their holdings each year were reported correctly on the tax returns. Often capital gains or losses are not reported at all or calculated incorrectly. This may necessitate a discussion with the client about a voluntary disclosure or it may require a deemed assumption of a disposition and resultant adjusted cost base without the benefit of a claim for the gain or loss if only the current year is adjusted.

Source – False Statements in Prior Years – IC01-1 Voluntary Disclosures P.67

Below is a checklist ofitems the accountant will need to calculate the ACB and capital LCF and verify that income and expenses were claimed in prior years:

· Tax schedules and returns

btain applicable prior years’ tax returns, keeping the following significant dates in mind

1971 includes valuation day
1988 was CNIL commencement
1994 was the last year for the Capital Gains $100,000 lifetime exemption claim
2004 end of flow through pools from 1994

· Statements from:

o Brokers transaction reports by month for all previous years since inception of each account or computer generated cash transaction reports which denote all transactions including cash dividends, reinvested dividends, buy, sell, split, etc.

o Bank accounts by month to verify source and transfer of funds

o Wills or Estate documentation to verify inheritances and contracts that survive the will

o Documentation to establish source of funds for other capital transactions or windfalls

o Registered (RSP, RIF, RDSP, RESP, TFSA) accounts for all previous years since inception

· Documentation of special transactions not reported on statements

· Calculations for special transactions

· Contracts for purchases and sales of assets not recorded on the broker statements

· Reports from third parties

· Insurance contracts

o Tax consequences and insurance? yes, Seg Funds, dividends…etc.

Comparison to Canada Revenue Agency (CRA) records available in My Account

To obtain CRA records, have the client sign a T1013 form or an RC 59 for a corporate or trust client. These forms allow CRA to communicate directly with the accountant about the client’s tax matters and allow the accountant to access the records available on the CRA My Account system.

Request older returns in writing. It may take weeks/months to receive printout’s of older tax returns for all prior tax years, and may no longer be available back to 1988. If you request copies of those and older returns, it may take months for them to send someone to hunt them down in storage.

It’s better to request the online printouts where available, not the copies unless it’s absolutely essential that you see what was actually filed.

Often everything needed except returns more than 3 or 4 years old are available on My Account is available at the CRA website: www.cra-arc.gc.ca

Step 2 – Record the Current Year’s Activity

Accuracy of the current year’s opening ACB and capital LCF for the new client, and reporting of capital and income transactions for prior years must be verified first.

Only then is it possible to account for current year transactions. Adjusted cost base is calculated using weighted average cost. Calculations should be done in chronological order in order to determine new average costs.

It’s important to remember this caveat does not always hold true. Sometimes the broker will date the receipt of a return of capital after the shares have been sold. The ACB of those shares should be reduced by the return of capital first before the shares were sold. Sometimes it’s necessary to amend the dating of transactions in order to effectively deal with situations like this one. Every year there are a few transactions that must be adjusted to sort them logically in order to end up with the right result.

Gather Data

Current year’s investment activity will likely include these main transaction types:

1) Income, such as interest or dividends

2) Capital, such as capital gains or losses, reinvested dividends

3) Purchases

4) Sales

5) Other, such as investment tax credits, stock splits, spin-offs

6) Return of capital (decreases ACB)

7) Income allocated to increase ACB

8) Cash transactions in the account

Differences between what is recorded in the accounts and what the T-slips record may require reconciliation and investigation or explanation. Often the company whose shares are held will have an explanation for their particular transaction in the shareholder information section of their website. Look there first, then call the broker/agent if you can’t find what you need. Usually the client will not have understood that the explanation they received was necessary for you to calculate their taxes and have relegated it to the shredder or the recycle bin.

Income should be reported on required T-slips which should be reconciled against the transactions recorded on account. Capital transactions may have a variety of sources.

Both categories require data to be supplied by your client, including the following:

· T-slips that report interest income, dividends or other income or investment related expenses include:

o T3 Statement of Trust Income Allocations & Designations

o T5 Statement of Investment Income

o T101 Statement of Resource Expense

o T600 Ownership Certificate

o T5008 Statement of Securities Transactions (doesn't include deemed dispositions and this can be very dangerous if you assume this report is complete, it's not)

o T5013 Statement of Partnership Income

o Foreign income slips

· RSP & RIF Data

Dependent on where these are held, obtain statements and the following

T-slips from broker or bank

o T4RSP Statement of RSP Income

o T4RIF Statement of Income from a RIF

o RSP and RIF withdrawal slips / Transfer documents

· Broker’s statements and transaction slips for non-RSP and non-RIF investments

o Annual broker account summaries of purchases and sales

o Mutual fund statements for each fund held in a broker’s account

o Mutual fund annual reports

· Contracts from third parties for purchase and sale of investments, changes in the status or valuation of investments

· Provincial and federal tax credits for investments

· Deal sheets and original documentation for complete real estate deals plus closing statements of adjustment (including any side deals)

· Commission confirmation from real estate brokers

· Appraisals for change in use for real estate

· Documentation of debt acquired and payments to verify payment of principal and interest deductability

· NEW! RDSP’s and TFSA’s are trusts, just like RSP’s and RIF’s and the same rules apply. It’s necessary to ensure there aren’t identical properties involved between related parties.

Ownership of Investments

Ownership of investments for individuals can take a multitude of forms. The following is just a sampling for the accountant to keep in mind.

· Co-owners (real estate)

· Tenants in common (real estate)

· Direct ownership such as in

small business shares, qualified farm property, share certificates, real estate, depreciable property, bonds, debentures, promissory notes, mortgage foreclosures, conditional sales, repossessions, personal-use property, listed personal property, life insurance and annuities, segregated fund insurance contract which holds mutual funds

Ownership held in trust in accounts like RSP’s, RIF’s RESP’s, RDSP’s, TFSA's and non-RSP broker or bank accounts

Ownership held through third parties such as trusts or corporations

NOTE: Absolutely imperative!

No matter what form of ownership, ensure that the name on the documentation is the same name as the taxpayer/trust/corporation/etc. recording the transactions for that property on their tax returns.

And just because there's joint ownership doesn't mean that the income and capital gains/losses are shared jointly. Attribution rules require that income attributes back to the original owner of the asset. If that's an inheritance, income earned on the income may be attributed, but the original capital, and it's capacity to produce income will result in the income attributing back to the original holder. That's why it's important to consider co-mingling of funds before the calculations overwhelm you every year at tax time!

Data Entry

Each asset, debt, bank or broker account should have a separate account in a ledger to record the transactions since the inception.

Each account for all related family members must be recorded in order to check for stop or superficial losses.

Record all transactions including:

Transfers of cash/shares/units between accounts, taxpayers, to or from registered or non registered accounts
RSP , RIF, RESP, RDSP, RPP,TFSA etc... contributions and withdrawals
Purchases net of commission
Proceeds net of commission
Interest income
Expenses including margin interest, interest on debt, property taxes, accounting and legal fees
Deferral of property taxes
Cash dividends, reinvested dividends, ETF (exchange traded fund) distributions (no cash/no units), Flow through income (ACB adjustment)
Capital gains distributions
Employee stock options (exercised, expired, granted, vesting)
Return of capital
Stock splits
Short selling/cover short sell
Puts and calls
Switches (between mutual fund shares of corporation can elect tax free transfer)
Swaps

Held by Brokers

To ensure that all transactions have been included, the accountant should make certain that the wide variety of information possible from a client’s broker is complete. Examples of this would be:

· Mutual funds

o T3s report income distributions. They do not report capital gains and losses on the disposition of units of the mutual fund. These must be calculated in the same manner as for non-registered fund shares through the use of annual tracking of purchase and sales transactions.

o It is important to identify segregated funds as the units for these funds are included on the T3 slip and you would be double counting if you accounted for the disposition again.

o Switches between mutual fund corporations are identified because losses can be delayed under S.51 Convertible property

· Shares

o Capital gains and losses must be calculated through annual tracking of purchase and sales transactions. Also, remember to watch out for stop loss rules. (30 days before and after)

· Bonds

o Various types may require calculation of capital gains and losses

· Treasury Bills

o Requires correct timing of recognition of income

· Segregated Funds

o T3s for these include capital gains and losses

o Insurance contract that pays out to a beneficiary outside of probate and estate

o Estate may be left holding the tax liability while beneficiary has the capital

o Guaranteed amount of % of principal may require an insurance injection but that does not make it a non taxable investment, as the insurance that bumps the proceeds on settlement is likely treated as capital gain rather than insurance proceeds (not clearly defined and insurance companies are taking the conservative approach)

· Others:

o Guaranteed Investment Certificates

o Term Deposits

o Unit Trusts

o Real Estate Investments Trusts (REIT)

o Resource Investments

o Limited Partnerships

o Working Opportunity Funds (WOF)

o Employee Stock Options

o Exchange Trade Funds (ETFs)

Timing

Fall or winter check ups for clients with asset sales are suggested. Suggest clients check before a sale to ascertain tax consequences. Of importance is that the accounting period to consider is more than the calendar or fiscal year. Consider one month prior and one month after the year end for stop loss rules and as current as March of the current year for reconciliation of RSP contribution purposes.

Reconciliation

Each asset, debt or account is reconciled to substantiate the calculation of changes in adjusted cost base. Verification to source documents is required for:

Income from all sources such as income slips, contracts or other documents
Expense claims
Sources of cash (Proceeds of Crime, Money laundering …)

Each security or other type of holding is updated to Fair Market Value in order to provide reconciliation to the broker statement which is reported at Fair Market Value and to provide the client with a means of making decisions about minimizing tax consequences on dispositions and acquisitions in the future.

Special Considerations

There are many special considerations when reporting on assets no matter how they are held or by whom. Let’s consider the following:

Swaps (RRSP to non-RRSP or vice versa) - losses are superficial
Switches (election to delay gains or losses on units in the same group of mutual fund corporate shares (not trusts as S. 51 only applies to corporations)
Transfers to other family members, non-family members at FMV or not
Transfers between spouses
Return of capital
Stock splits
Flow through shares
Foreign currency translation
Foreign income and asset reporting in US $ for Americans living in Canada
Allowable Business Investment Losses
Cumulative Net Investment Losses
Capital losses – ability to carry back and forward forever
Date of death returns– valuation and income prior to and after death
Treatment of accounting fees - capital cost vs. expenses (See IT-99R5 P 14)
Trust rules
Charitable donations
Personal use property
Partial and full change in use rules for Rental Properties
Deemed dispositions and dividends
Reserves on sale of mortgaged property
Non-resident rules
Attribution of income
Capital gains for example (iShares) where there are no new units and no new cash distributions but ACB is affected – sort of like a negative Return of Capital – (record a dividend with .0001 shares and then remove the shares (will affect ACB by pennies)
Losses may also be stopped under S. 112 when certain dividends received. See CRA IT-328R3 Losses on shares on which dividends have been received http://www.cra-arc.gc.ca/E/pub/tp/it328r3/README.html

ACB Bumps

Adjusting the cost base for reinvested dividends bumps up the cost base. The cost of the new units is added to the cost base, changing the average cost of each unit. No money, more units, change in average cost to include more units at a different cost than the original units.

Adjusting the cost base for iShares or ETF’s or Closed End Funds may involve a bump of a different kind. This is a distribution of income you must record on your tax return, without any money being paid out. Units or shares are consolidated back into the original units or shares. Result is an increase in the cost base. You own the same number of units, but the cost now includes the income you just added to your income on your tax return. Later, when you sell, the gain, which is the difference between Proceeds and Adjusted Cost Base is less because the ACB is higher. Consequences of a distribution, no money, no more units, income on which you may pay tax now, and later when you sell, pay less tax. All fine in theory as long as you actually pay tax.

ACB Grinds

Adjusting the cost base for return of capital grinds down the cost base because the cost of the units is reduced. Part of the funds used to purchase the units you hold has been returned to you. You could say it’s a discount on the price, dolled out each year. The result is your average cost per unit increases as you hold the same number of units for fewer dollars. Yesterday, I had 100 units at $100 cost. Today, I have 100 units at $90 cost because I received a $10 return of capital. My ACB is now $1.11 per unit.

Step 3 – Providing Reports

The accountant should generate reports summarizing investment activity to be included on the client’s personal, corporate and trust returns. The client should also be provided with these reports and have the reports explained. Some or all of the following reports may be applicable:

Adjusted Cost Base of each investment compared to Fair Market Value, for both the current and prior years

Summary Investment Income report which reconciles to the change in ACB and the change in FMV (with inclusion of the Unrealized gains and losses) with reports in detail for:

Capital gains and losses by investment, sorted by date to check stop loss rules.

This requires the reporting of one month prior and one month after each year end.

Dividends and interest listed by T-slips

RSP contributions:

March 1-Dec 31 of current year and

first 60 days of the following year

RSP withdrawals for the calendar year

Carrying Charges

Statement of Changes in Assets by account and by investment

General Ledger or Item transaction reports

What Software could you use?

There are several software programs available to assist with the tracking of investments.

1) Quicken XG

One of the most common and inexpensive programs to use is Quicken. It has been on the market for over 20 years. The user must understand capital asset accounting. Data entry, reconciliation between Cost and FMV, plus a full set of working paper reports can all be generated using this program

2) Write-Up

This program allows creation of a general ledger, data entry of investments including broker transactions, as well as generation of reports in detail or summary formats. It is fully exportable to most common formats, including CaseWare and Excel

3) Microsoft Money

Both the deluxe and premium versions of Microsoft Money 2004 include portfolio tracking and account integration capabilities

4) Excel

The most basic of methods to track investments is using a spreadsheet program such as Excel, although it does have its disadvantages if there is significant volume and complex transactions are involved

5) Profile PA

Intuit attempted to create software for investment accounting in 2005. It lacked the ability to do ACB adjustments or comparative reporting. It had a great layout and potential if Intuit spent more time and money developing it. It was possible to export reports to Excel to manipulate reports. In 2006, the project was shelved (I"m still in mourning, can you tell?)

6) QuickBooks Premier

Is it possible to use the Inventory module to account for investments? Maybe if you are extremely creative or the units are easy to account for. It does do average costing after all…

Step 4 – Maintaining Records

Set up a separate file folder for each account, asset and each associated debt with all contracts, statements, and other documents since inception, with the most recent statement on top. There could be multiple file folders if there are RSP, RIF and non-RRSP accounts with the same broker. Keep the same file going for a few years unless it’s too fat.

Set up a mutual fund statement folder for each mutual fund. There could be multiple mutual fund accounts on one broker statement for RSP, RIF and non-RSP funds. It is too confusing to put the mutual fund statements in with the broker statements. Have a file folder for each non-broker asset or debt.

Minimizing Risk

To minimize risk in the reporting of investment transactions during preparation of a personal tax return, the accountant should:

Understand the Income Tax Act, and interpretations, as the calculation of capital asset transactions can be complex. Know when to ask for help.

Understand that Brokers make mistakes in calculation of income and adjusted cost base is often stated when in fact it is not calculated correctly as there is no way for the broker to perform the calculation as they do not know whether the client elected to claim something different and has no history if there is a transfer from another broker.

Understand that clients do not know what documentation you require

Know the clients and have considered sufficient information per Code of Ethics R306

Know that accountants have a professional obligation to care, which has now been legislated in Third Party Civil Penalties legislation (IC 01-01 Para 26). As professionals, we ought to have known.

Know that The Proceeds of Crime (Money Laundering) and Terrorist Financing legislation makes it abundantly clear that we must be aware of the source of funds for investments

Know that CICA Handbook now requires FMV reporting and calculation of estimated tax consequences of disposition of assets on both annual and interim financial statements effective in October 2006 for public and non profit, October 2007 for private.

Maximizing Value

Accountants can provide value added services to their clients with the information gleaned from tracking investments. For instance, legal fees can be significantly reduced for asset listing required for probate purposes. Also, net worth and portfolio analysis leads to planning opportunities for net worth maximization and tax minimization.

Summary

Risks and challenges abound for the accountant dealing with their clients’ investments. The key to minimizing risk is using software that allows for calculation and reconciliation, as well as maintaining adequate records of transactions in case of audit.

REFERENCE MATERIALS

The following publications are available by visiting Canada Revenue Agency website at www.cra.gc.ca

Capital Gains Guide T4037

http://www.cra-arc.gc.ca/E/pub/tg/t4037/README.html

Rental Income Guide T4036

http://www.cra-arc.gc.ca/E/pub/tg/t4036/README.html

Preparing Returns for Deceased Persons T4011

http://www.cra-arc.gc.ca/E/pub/tg/t4011/README.html

T3 Trust Guide T4013

http://www.cra-arc.gc.ca/E/pub/tg/t4013/README.html

T4037 lists these forms with direct links on the last page of the publication:

Forms