Most of us have a familiar pattern when we visit our accountants this time of year: drop off paperwork, call to make an appointment, attend their office, ask how much our tax refund/taxes owing are, pay their bill and go home. Repeat annually. While we do pay our accountants to minimize our taxes, how many of us ask them about our investments or our investment strategy?

The point is not ask your accountant whether to invest in bonds or stocks or where they think the price of oil will go. Instead, the exercise is to determine how tax efficient or tax inefficient your investments are.  Fees, inflation and taxes are the trinity of factors reducing any investor’s return. There are products which address the first two factors- mainly low cost ETFs and real return bonds, but tax efficiency requires a much more individualized solution than purchasing a flow through shares or other tax friendly vehicles.

Since tax rates, income splitting, loss carry forward and loss carry back rules tend to vary from jurisdiction to jurisdiction, one cannot simply pull a tax friendly product  off the shelf (setting aside whether such a vehicle may eventually be subject to audit scrutiny if found to be too taxpayer friendly) and believe the solution has been found.  While a tax reduction product (for lack of a better term) may possibly reduce taxable income, is the reason why taxable income is higher than desired is because the taxpayer/investor has the wrong products in the wrong place?

In a nutshell, there are different tax treatments for interest/salary, dividend income and capital gains/capital losses. Taxation policy tends to favor the taxpayer investing in businesses. Hence, there is favorable tax treatment if the taxpayer sells stocks for a profit (whether publicly owned or privately owned). The return for our savings, in the form of interest income, is penalized with a higher tax rate (leading to a law of unintended consequences which I will address in a future post).  Since most investment advisors do not complete their client’s tax returns, the tax effect of products  can be glossed over in product selection.

Having spoken to some accountants about this topic, the general consensus seems to be that most taxpayers ignore the tax implications of their investments. Too many interest bearing products are in non-tax deferred accounts resulting in, after inflation and taxes, a de facto negative return. For taxpayers who are employees, and do not have the full range of deductions available as business owners, there is less tax planning flexibility to reduce such oversights and/or errors.

As a practical tip, after reviewing your taxes with your accountant, think about arranging a time to see your accountant after the tax season and show them your investment portfolio. The key is not to focus on whether they think you bought the right product but whether your over-arching strategy and tax implications of your product selection make sense given your income, life-stage and tax history.

Around this time every year, empty retail outlets all across the land are rented out by tax preparation businesses advertising “cheap tax preparation”, “get your tax refund now!” or “instant cash back on your taxes!” The concept itself is all well and good and, ever mindful of a household’s dollar, these types of businesses tend to attract customers but how accurate are these tax preparation businesses and what is the cost of an inaccurate income tax return?

In 2008, the U.S. Treasury Department randomly posed as taxpayers and had their income tax returns prepared by 28 different tax preparation businesses. They found that only 39% of the income tax returns were accurate and a third of all inaccurately prepared tax returns were due to intentional misconduct rather than a liberal interpretation of the law.

The sample size is small and it is unclear how the government determined what constituted an accurate return. However, it does highlight a problem. In many jurisdictions, tax preparation businesses are not regulated and are unlicensed and there is no minimum standard of competence. In contrast,  accountants are licensed and bound by  standards of professional conduct.

Even larger, more well established, tax preparation businesses have had their own high-profile problems. In 2006, H & R Block had to restate previous years’ earnings due partially due to income tax accounting errors. In other words, the tax preparers could not even prepare its own taxes correctly.

The issue with tax preparation houses is three-fold:  (i) you get what you pay for in life and may of these businesses work on a cheap, cheap, cheap model; (ii) it is difficult to track down many smaller tax preparation businesses if there is a problem which is not often detected until well after income taxes have been filed and tax preparation shops have moved on; and (iii) the liability to people who prepare income tax returns, for both tax preparation businesses and accountants, can be relatively modest.

The final point is often something most taxpayers do not understand. The taxpayer, regardless of whether it uses a tax preparation business, book-keeper, accountant, tax lawyer or family member, is ultimately responsible for any inaccurate or incorrect income tax returns. The liability of accountants who incorrectly file your taxes is equal to the interest and penalties that you otherwise would not have paid but for the inaccurate or incorrect return plus the fees for another accountant to rectify the return. The same applies to other non-accounting tax preparers keeping in mind that: (i) you may not be able to find them; or (ii) they may not have errors and omissions insurance to pay out a valid claim.

Simply put, the denied deduction or reassessment, if illegal, will fall back on the taxpayer itself and finger-pointing is generally not a valid defense to the tax authorities. It may make them sympathetic in terms of a payment schedule if the circumstances are extenuating. But, if the tax authority’s position is ultimately proven to be correct, the buck stops at the taxpayer.

Hiring the wrong people is only half of the equation on why a tax return may be incorrect. It is tempting for a taxpayer to instruct a tax preparation business or accountant to claim deductions which are not there or illegal (or to make illegal claims on an on-line tax preparation software).  After all, the thinking goes, if I am paying you money, you do what I tell you to do. Avoid this temptation.

Taxpayers who are employees have a relatively narrow band of tax deductions and tax credits. Don’t get creative outside of it since such creativity will stick out like a sore thumb. Income made by businesses have more deductions and a relatively lower threshold of deductibility. However,  the rules do tend to be complicated and beyond the scope of either retail based tax-preparation businesses, accountants who prepare mainly personal income tax returns or on-line tax preparation software once the business gets to a certain size (once you have a series of inter-related companies, it is best to hire an accountant since the range of deductions and the danger of denied deductions increases at the same time).

The moral of the story is always the same for all things personal finance related. Do not be tempted by people promising you secret deductions which will give you a great tax refund- there are no magic bullet solutions in life. Delegate and do not abdicate your responsibilities. Be educated about income taxes by visiting some tax resources but keep in mind it is general information and not specific advise. If in doubt, hire good talent. Good luck.

Congrats to Veselin who won a free copy of the QuickTax tax preparation software.

As many Canadian taxpayers know, the Home Renovation Tax Credit (HRTC) was a one year tax credit for eligible home renovation expenses incurred between January 27, 2009 to February 1, 2010. The 15% credit applies for eligible expenses between $1,000 to $10,000 (here is a full summary of the HRTC).

If you own a condo, the HRTC works on two levels: within the unit itself and on eligible expenses spent by the condo corporation. Since the condo corporation spent eligible expenses on behalf of the unit-holders/owners, the HRTC is passed down to each owner/taxpayer on a proportionate basis.

It is important to note that only owners are eligible and occupation of the condo is not necessary to be eligible for the HRTC.  The key is that the condo corporation spent money which, if it was within the condo unit itself, would be classified as an eligible expense.

The amount of the HRTC is determined by the share of your contribution to the total contribution of maintenance fee by all unit-holders/owners. For example, if a condo unit contributed to 1% of the total maintenance fees of the condo corporation, the taxpayers HRTC will be 1% of the eligible expenses.

It is possible to add up eligible expenses both within the unit and by the condo corporation to bump a taxpayer over the $1,000 threshold to claim the HRTC. For example, a taxpayer may have spent $900 on bathroom renovations inside the condo unit; given this is below the $1,000 minimum, this expense cannot be claimed under the HRTC. However, if the proportionate eligible expense incurred by the condo corporation and passed down to the unit-holder/owner is greater than $100, the taxpayer now qualifies for the HRTC.

To claim the HRTC, the condo corporation issues documentation which the taxpayer in the prescribed form. In other words, there is no need for the contractor to invoice each condo and ultimate responsibility for preparation of the HRTC receipt is the condo corporation.

Thus, it is important to ask your condo corporation when the documentation is available and to pick it up. Given the sheer amount of notices that go up in most condos, this may get lost in the shuffle so please do be aware of that condo owners are eligible for the HRTC on the condo corporation level as well. As always, please consult your accountant for specific accounting advice and questions.

There is justifiably a lot of attention paid to the effects of fees on investment returns particularly MER charged on mutual funds and ETFs. While in no way should it provide a defense to high-fee products, this focus, taken to a myopic level, can obscure the two largest external factors eroding your net worth.

Taxes and inflation.

There are already many wonderful summaries of the tax consequences of each type of investment. Suffice to say, the general rule is this: low risk, low upside investments (think high interest savings accounts, GICs, T-bills, Bonds) tend to attract higher taxes than higher risk, higher upside investments (stocks, real estate (on sale and not rental income), investments in private business) which tend to attract lower taxes. The government does this on purpose. As an industrial policy, it wants to encourage taxpayers to invest in innovation and risk.

Stopping or slowing the tax leakage in your net worth, comes down to answering two questions:

1. WHAT are you buying? Is it, based on the totality of your income streams, increasing the tax leakage or lessening it? For example, assume you are at or near the top of the personal income tax bracket and all of your income and investments are cash/cash equivalents (high interest savings account, money market funds, income trust distributions characterized as income). Would you invest surplus cash into another vehicle that is taxed as income, potentially pushing you into a higher tax bracket and keeping less and less of each dollar earned? The more tax efficient approach may be to invest in products that pay dividend income or are eligible for capital gains tax.
2. WHERE are you buying it? Tax inefficient products (see above on low risk, low upside investments) bought outside of tax deferral plans (RSP, TFSA, 401(k)) erodes net worth. (as a side note, as an accountant said to me, it is interesting that the TFSA should ideally be used for stock market speculation given the gain is entirly tax free but the average investor opts instead not to fully top up their RSP and divert funds to the TFSA to buy money market funds. Certainly food for thought).

The Millionaire Next Dollar observed that taxes paid constituted 12.9% of the average American household’s income but the millionaires they studied had a rate at a mere 6.7%. How? To paraphrase the authors, average households carry too much cash or near cash equivalents which are eroded by taxes while millionaires tend to be invested in appreciating assets which are not taxed until sale.

Finally, in Stocks for the Long Run, Jeremy Siegel noted that real returns after taxes for someone making $50k based on returns for the period of 1913-2006 were 4.4% (stocks), 0.5% (bonds), -0.6% t-bills, 0.4% (gold). In other words, the tax inefficiency of fixed income over stocks becomes glaring over time which does not/should not concern an elderly investor with shorter investing horizons but is quite damaging to the shell-shocked middle aged investor parked in cash in a non tax-deferral account.

Inflation, the erosion of a dollar over time, is an equal opportunity eroder of wealth. Over the short term, there are few vehicles which truly can combat inflation. Real return bonds (or TIPS) are effective but its utility is diminished if it is held in a non-tax deferred account since the tax leakage has de facto inflationary effects on return.

Over the long term, some argue certain types of stocks are ideal to fight inflation. However, as history proves, over the medium term, high inflation can defeat stock market returns. Consider the period of 1966-1981, the Consumer Price Index, a measure of inflation, ran at 7.0 and the real return on stocks (return after inflation) was -0.4%.

However, during the same period, the real return on fixed income was -4.2%. If you made $50,000 during that period, after tax return was -6.1 which is a triple indignation since one could have bought government debt via a t-bill or GIC, received a real return which was negative and then get taxed on that return; the government got your money twice and you lost money!

What does this all mean to you?

Where stock market returns are modest, tax leakage and inflation can and will turn modest paper gains into losses. A flight to safety in uncertain times is a prudent tactic to adopt but as a long term strategy, as the above slows, at the wrong age and for the long length of time, it can actually move your net worth backwards.

What should you do?

1. Speak to your accountant about tax leakages in your portfolio. Don’t ask her if buying Apple was smart. She is not qualified to answer that question. She is, however, qualified to say where ideally any stock you buy should go or what should go into tax deferral vehicles. Looking at your life structurally for tax leakages is an often over-looked benefit of a good accountant.
2. Be aware of the effect of inflation on your returns. A 8% paper gain may sound great but if inflation is at 4%, the real return is actually 4%.  Hard assets, stocks of companies that can pass on cost increases to customers, inflation-protection fixed income products in moderations are products which should be studied to see if they fit within your portfolio.

The point is not to structure one’s life solely to pay less taxes and combat inflation. However, they should be factors which need to be paid attention to by most investors.

Best of luck.

Now that it appears that the financial system will not sink into a black hole, many of us are waking up and realizing that the government is in a lot debt.  In essence, we nationalized the bank’s sins and we are going to have to pay for it. With a much older population than the last government deficit problems of the late 1980′s, this one may take a lot longer to get out of.

There are two large methods to fight deficits: raise taxes or cut programs. The former is always easier than the latter. Why? Because we want it all. We want our programs and are not willing to give them up.

As illustration of this problem, the State of California is dead broke. But in a recent survey of Californians 67% supported spending cuts over tax increases to solve the state’s deficit. However, a majority of those surveyed also opposed program cuts to 10 of 12 program areas under the state’s jurisdiction. The only programs those surveyed had no issues cutting were parks and prisons (I suspect in the next breath those surveyed cited crime as a concern too and want government to adopt a more law and order agenda).

What does this tell us? When push comes to shove, the environmental agenda takes a back seat to money.  Equally as important, as tax-payers, we are an extremely passive-aggressive lot. Say cut a program and everyone says “yeah!”. The government tells you that they are cutting YOUR program and suddenly it is a sacred cow (call it the NIMP syndrome- not in my program).

Our city experienced this recently. The city cannot balance its budget- it requires the Province to give it a grant- and there was much grumbling about property tax increases. But when the city attempted to close public pools 1 more day of the week or institute higher user fees to save money, the back-lash was quick and severe and the city backed down quickly. Our city is fundamentally mismanaged but, in one of the few times I will defend the administration, how can it solve its fiscal issue if every program cannot be cut (let’s overlook the fact municipal election turnout is 40% maximum)?

This is why, sadly, tax increases are always easier. Programs have stake-holders who can form a lethal and concentrated voting blocks. For example, try cutting back welfare to seasonal fisherman and you’ll lose an entire region of votes.  The benefit is widely unreasonable and should be scaled back but that’s not the point. Fisherman vote en masse for anyone who will maintain this benefit. Politicians are, foremost, self-preservationist and will not dare mentioning cutting this program.

Raising taxes, on the other hand, hits everyone equally and there are always scapegoats (blame the previous government, the U.S., the Russians, the Chinese, the oil industry, welfare bums, the socialists, special interest groups etc.). Every once in a while, a poorly designed tax can topple a government but, as a whole, the entire electorate is a poor lobby group- too big, too divergent, too scattered and increasingly indifferent to really mobilize.

What can you do? The cynic in me says prepare for the inevitable tax increase. The democrat in me (small d democrat) believes its time to clearly articulate what we want as an electorate. Do we want good programs with accompanying high taxes or do we want to be self-sufficient individuals with low taxes? We can’t have good programs with low taxes.  It is all pixie dust politicians sell you to vote for them. In this era of frugality, it is something we should cut back on buying as well.

If you ask me what one item a household should increase its expenditure on in the upcoming year, my answer would be to think seriously about paying for a good tax accountant. A tax accountant is different than an accountant that helps you file your taxes. On a very general basis, a tax accountant structures your affairs in a tax efficient basis before you file your taxes while a “regular” accountant minimizes the damage afterwords (in other words, a tax accountant deals with strategy and a “regular” accountant deals more with tactics). Why?

Our taxes are going up. The only question is by how much.

There are three large factors why this is occurring:

1. It is simple demographics. Even without the credit crisis, the number of people claiming government benefits (old-age, health-care etc.) will soon outnumber the number of people contributing to the pool. In other words, outputs will soon exceed inputs and you can raise taxes, lower taxes to stimulate the economy (which, if you are unemployed or underemployed, means little) or cut services to solve the issue. The 3rd option often encounters stiff resistance, the 2nd option is most likely not feasible right now which leaves us with raising taxes.
2. Governments running massive deficits. We spend much of our time on North American issues but we may want to look across the ocean for a harbinger of things to come. England’s real estate bubble burst earlier, its government has taken large ownership stakes in 2 of the largest 6 banks and its official unemployment rate stands at 7.1%. Like the U.S., the English government has to enter into a large deficit to keep the economy afloat. How is it paying for this? In April, it announced it was increasing its top personal income tax rate from 40% to 50% (to add insult to injury, the VAT, a consumption tax, is going back up from 15% to 17.5% in 2010)
3. The pension time-bomb has exploded. Related to point #1, as Michael James on Money wrote: ” If there are only 20 cookies on a plate and ten people are owed three cookies each, something has to give.”  Pensions may prove to be more problematic than health care. There are ways, politically repugnant to some, to reduce government expenditure in health care. For pension short-falls, you can’t manipulate market returns in a defined pension plan. If the GM pension bailout is a precedent, this means the taxpayer funds private pension short-falls for financially insolvent companies (next up, Air Canada). It gets worse. The Treasury Board of Canada estimates that the taxpayer is funding 72% of the service costs of defined benefit pension plans for federal civil servants (if you are in the U.S., read this article on public pension short-fall and try to keep your lunch down at the same time). How do we pay for both gold plated public and private pensions? Yep, more taxes.

Essentially, while necessary, the money sent to keep the economy afloat has a tab and the tab will be called soon. The only way to avoid increased taxes is if the taxpayer collectively says “let’s cut services across the board now” which is a remote possibility and ignores the fact that, even after such cuts, there are long term obligations governments must continue to fund.

On a personal basis, what can you do?

As a practical manner, arrange an appointment with a tax accountant now (while they are on their down season) to review your personal affairs or to obtain a 2nd opinion. There may be deductions which have been missed (remember you can file amendments to your taxes) or ways to be more tax efficient. For example, business income is generally more tax efficient than employment income and dividend income more tax efficient than interest income. The key is not to completely re-arrange your life for the sole purpose of paying less tax but to be as tax efficient as possible to prepare for the coming tax increases.

I will try to devote more time to this issue but, in the meantime, Canadian Tax Resource is a good place to start. Good luck.

It is tax return season again and the question always arises whether you should file your own tax return or hire an accountant to prepare your taxes? There are no absolute answers just contextual ones so think about the following this tax season.

There is always a cost of preparing taxes. Whether this cost is hiring an accountant to prepare your taxes, buying tax preparation software or the plain old traditional way of filing your taxes yourself, preparing your tax return takes time and money. Michael James conducted an experiment of how long it would take to prepare an  on-line tax returns; with the use of QuickTax, it took him 6 hours. Thus, it is inaccurate to say that preparing your own tax returns is done at no cost.

Assuming that one agrees that preparing tax returns costs something, the question then becomes one of opportunity cost?  In other words, is it more efficient for you to file your own tax returns if, in lieu of preparing your taxes, you were engaged in some other more economically efficient activity? For example, a lawyer friend of mine has always hired an accountant to prepare their tax returns. This makes perfect sense in this context. If their tax return costs $200-$400 and their hourly billable rate is $400/hour (plus), assuming we all clock in around 6 hours to prepare our taxes, my friend is weighing the cost of $200-$400 to pay someone to prepare a tax return versus potentially earning $2,400 in legal fees. This is a bit of an extreme example but what can you do with that extra 6 hours otherwise used to prepare your tax return?

The other factor to consider is efficiency and your own skill set. Can you find all the deductions that apply to you or is an accountant’s ability to find hidden deductions equal to or greater than their cost? This factor has been significantly reduced by on-line tax preparation software (and here is a thorough review of online tax preparation software) and, frankly, for most people who earn employment income only, tax preparation software is a very cost-effective manner to file tax returns.

If you typically hire third parties to file tax returns because filing tax returns becomes a question of skill, but you have a limited budget, then consider the following.  I tend not to like the tax preparation businesses that set up in malls and plazas during tax season. They are cheaper alternatives than accountants BUT, if they filed your tax return improperly, who can you complain to? I also worry about the obvious question of the skill level of people preparing your tax returns.

Professionals, although most people do not think of them as such, run their own businesses too. If cost is a barrier to hiring an accountant, some ways to reduce your costs are to speak to your accountant like a business person. For example, my tax returns are relatively cheap for someone making business income and all the paperwork that comes with it. However, I have also referred to my accountant numerous clients; given that accounting clients are “sticky”, this is a recurring source of income for him and, as a result, my tax returns are prepared much cheaper than they should be.

In other words, negotiate fees with your accountant by doing most of the book-keeping work or asking them for a deal if you refer clients to them.

There is no right answer on who should file your tax returns. The above are some factors to consider. As a side-note, for those self-employed, my experience has always been to find a good book-keeper before a good accountant; a good book-keeper can spot cash flow trends as they are unfolding and advise you to make adjustments. A good accountant may see you 1-2 times a year and the damage may have been done. Good luck.

I am on business travel this week so I may not be responding to comments that frequently. Thanks for your understanding.

As previously reported by Michael James and Canadian Capitalist, QuickTax is offering this year “Audit Defence Services” for $39.99. The company is part of a growing trend in the tax, book-keeping and accounting fields to offer this option to traditonal tax prepartion and filing services.  What exactly is the nature of this service and is it for you? As a precusor to my post, here is a quick review of what happens when you are audited (again with a Canadian perspective) and here is the full Audit Defence Membership Agreement provided by QuickTax (albeit under a separate legal entity known as “Canada TaxResources, Inc.” which is a subsidiary of an American company which appears to be providing the same audit defence plans).

What is Audit Defence Service?

As the name implies, a representative of the entity that sold you the service will designate a representative to assist you in an income tax audit in the tax years that you bought the service for. In other words, if you bought the service for the 2008 tax year only, the service does not apply to an audit for the 2007 tax year. As my previous post indicated, an audit may simply be triggered by some clerical error on your part (for example,you forgot to include a T5 slip)- which would most likely not get you out of the reassessment phase- or it could mean a full blown review of particular tax years. But, in a non-criminal audit, the service is triggered no matter how serious the scope of the audit subject to the exclusions below.

It usually takes 2-3 years for the government to inform you an audit has began unless a reassessment is due to errors of a clerical nature. Thus, the service may not be used for some years.

What do I get?

QuickTax/Canada TaxResources Inc.’s services include “…defend[ing] you through the completion of any income tax audit for the tax year return identified on the membership certificate…” which includes correspondence with CRA, negotiations up to Tax Court, settlement discussions and collection assistance if additional taxes are due.

Please note that this service is not a substitute for a lawyer at Tax Court. In fact, this is an exclusion of the service.

In the member’s obligation section, there’s an interesting term that you are asked to comply with the audit procedure and strategy recommended by the service provider. If you are unable to make this commitment, the service provider can terminate its service. In other words, if you get a 2nd opinion on the matter and it is contradictory to the strategy being executed and you end up disagreeing with QuickTax/Canada TaxResources Inc., you can be fired. Thus, you better trust that your service provider knows what they are doing.

What don’t I get?

The service is not for corporate, partnership, trust or estate tax returns. Essentially, it is a product only for individuals. It also will not assist you in book-keeping, amending your return or instances where civil or criminal fraud is alleged. It will also not assist you if you filed your taxes late, are a tax protester or under investigation of the Criminal Investigations Program of CRA. The service will not apply to GST and payroll audits. In other words, it is a service to assist in issues arising out of the simplest of tax returns.

One other important exclusion- the plan does not provide assistance for collection where the plan did not defend the audit. In other words, you filed taxes and you owe money but you did not pay it. In this case, the Audit Defence Plan will not help you cut a deal on payment terms. The issue arises not from claiming the wrong deduction but non-payment.

Given that many taxpayers may be in this situation in the upcoming year, this is an important exclusion to note. Audit Defence plans are not debt consolidation services. They will not help you negotiate a better deal to pay if you have past tax debt that CRA is beginning to turn their mind to collecting.

What else should I know?

If you have serious tax issues (non payment for many years, overly aggressive deductions, complicated individual tax planning), an Audit Defence Service is not for you. You simply have too complicated of a file to fall under a $40.00 service.

The service is also not provided by a lawyer or law firm which means your information is NOT subject to legal privilege and confidentiality. Again, if your matter is of a serious nature, you should hire a lawyer so that the information can be afforded proper legal protection.

One practical consideration to note- $40.00 is not a lot of money. It is a helpful service but how extensive will the services be for $40.00? Will the negotiations be quick and dirty to minimize any additional expenses incurred by the service provider? You get what you pay for in life. If you think you may be a little off-side on some tax issues then it is a good piece of mind service. But how do you really know if you are a little or a lot off-side?

Also remember that the service does not help you review your book-keeping, organize your records or other clerical tasks. You still have to do some heavy lifting and this may include hiring an accountant to review your returns if you filed them yourself.

Is it for me?

If your first language is not English or French (since, at the time of writing, the service was not in multiple languages), you are a plain vanilla taxpayer (basically, you have employment income and some investment income and nothing fancy in the way of inclusions or deductions) and your tax issues are relatively minor, it is a pretty decent program for its cost. But anything past Audit review 101 would most likely take it out of its sweet spot and one most likely should hire a professional to assist.

As a value play, the question becomes what provides greater piece of mind: (a) buying QuickTax and the Audit Defence Plan; or (b) using that money towards hiring an accounting to help file your taxes (I understand that option (b) would likely cost you more)?

As a marketing point, the audit defence service would probably gain a lot of traction if they had service representatives that spoke a wide variety of languages and it was advertised as such (not sure if they do or not; the feature is not advertised heavily). Taxpayers who’s language is not English/French could probably benefit merely from having someone explain what is happening in a dialect they understand.

Starting this year, Canadians can set up a “Tax Free Savings Account” (TFSA); more details on the TFSA can be found in other blogs). The TFSA is one of the better tax structures invented by government- short of the relatively modest contribution maximum of $5,000/year and lack of credit-proofing, it is pretty much a well thought-out structure. However, as a much larger question related to structures like TFSA’s, how important are tax considerations when you invest?

Some people absolutely dread paying any taxes. Other invest without thinking of the tax consequences but what should lead what? Should tax considerations lead the product to invest in or should you invest regardless of the tax consquences? The answer, as usual, is that it depends.

Firstly, let’s start with the primer on taxation and investing. I always start with Million Dollar Journey’s posts on investing and taxes. Please note that this is a general over-view and tax rates vary from jurisdiction to jurisdiction so please do your own research.

My guiding principle on this topic is always the following quote from the book The Millionaire Next Door: “To build wealth, minimize your realized (taxable) income and maximize your unrealized income (wealth/capital) appreciation without a cash flow.” However, I would argue that one should avoid making investment decisions based on some slavish devotion to tax considerations alone and that there are degrees of sensitivities to tax implication which need to be taken into account, but not as a determining consideration, when making an investment decision.

For example, if you made a relatively modest income and had a modest risk tolerance, you wouldn’t avoid putting your money into a high interest savings account simply because you pay more on interest income than capital gains or dividends. Conversely, if you were in the high tax bracket, you wouldn’t invest in all stocks simply to avoid paying taxes on interest income in a savings account. That is just bad asset allocation.

The point being that tax considerations alone should not drive the decision on what to invest in. But you have to layer onto this some degree of sensitivity. I illustrate on a non-exhaustive basis some situations where tax implications should be taken into account when making a decision on what to invest in:

1. People on fixed incomes: Without future earnings to off-set taxes which may be paid on investment income, individuals in this situation should be sensitive to tax implications of all investment decisions they make. Or, people approaching the clawback thresholds on government benefits, may have to assess whether potential taxable income from an investment will affect their benefits plan.
2. People in the highest tax brackets (generally $125,000 in Canada and $358,000 in the U.S. without accounting for the AMT): At tax rates approaching 50% in some cases (when you add federal/provincial/state and municipal taxes), there should be a greater sensitivity to what one is investing in. In this situation, the maxim quoted above truly makes senses- minimize taxable income and maximize non-taxable appreciation.
3. Self-Employed: Although able to claim legitimate business expenses against business income to minimize taxes, I include this class of persons based on experience; not enough reserves are ever held aside to pay for taxes of the owner manager (mitigated if the owner manager pays source deductions on pay day as opposed to just paying oneself a draw and paying the year’s taxes when the tax return is submitted). Receiving income from investment tends only to worsen this issue.
4. People approaching the next income tax brackets. Taxable income from an investment may push one into a higher bracket. The jump in tax brackets can be as much as 5-7% depending on what tax bracket you are in and are going to (best to speak to an accountant about this or do some research on the web).

In the above situations, the tax considerations of the investment should be a factor. For example, if someone was in the top tax bracket and had a choice between an income trust paying interest income and a dividend paying stock, the return on investment after taxes should be analyzed carefully since, at that tax-rate, it is important to put greater weight on after-tax return.

Although I do not disagree with the Millionaire Next Door, the statement above makes the most sense if you are an upperly mobile individual with a heavy tax burden. One must always remember that tax is one of many considerations to make in investing and not the determining one.

I am never sure if there is some devilish intent in the tax-collectors in Canada and the U.S. having the name “revenue” in their department. If nothing else, it shows you what the true role of these departments are- they are the revenue makers for the government. As general tax revenues decrease in down-times, guess what the revenue departments are doing?

Yes, finding ways to maximize revenue by combing through our tax returns and denying deductions. Basically, expect a lot more questions in the future about your tax returns if you have been an aggressive deducter of expenses. If you are being asked questions, or go into a full blown audit, are there things you need to know? Of course.

First, let me be clear. Tax avoidance and tax evasion are two different concepts. Tax avoidance is using LEGAL means to reduce your taxes. Tax evasion is breaking the law. No one, especially me, supports tax evasion and this post is not a means to evade taxes. It is used as an informational piece to give you some sense of the process. This is a process piece not a substantive piece. As usual, this is not advice but information only. Please seek qualified professional help if you are subject of an audit.

Why am I being audited?

This is usually the first question asked. Generally, one of two things has happens: (i) someone ratted on you; (ii) your tax return had something extremely unusual in it. For example, your deductions are unusually large or your taxable income shows a blip from previous returns which is not easily explainable. If you are in a small business, large petty cash entries are usually a red flag (and justifiably so) or the business shows a loss year over year for a long period of time.

People spend a lot of time and energy wondering why this happened or who ratted on them. You know what? It is what it is. You are on the radar and you might as well spend your energy on productive efforts and not trying to track down your enemies (because the tax department will not tell you why the investigation began).

What is the general process?

This is for Canada only:

1. Tax return is vetted through pre-assessment screening.
2. CRA may ask a taxpayer for additional information such as receipts.
3. At the end of pre-assessment, if CRA has picked up something, it issues a Notice of Re-assessment indicating there are adjustments in the taxpayer’s return and what they are. There is a right of appeal.
4. CRA also has the power, as a follow-up to a Notice of Re-Assessment to audit the taxpayer by written notice requesting more information. This is a full-blown audit.
5. Upon receipt and review of information, CRA can either: (i) indicate no changes will be made to the taxpayer’s Notice of Re-Assessment or (ii) send a Proposal to Reassess which indicates that CRA are proposing to reassess the taxpayer for X dollars plus interest and penalities (its the interest and penalities that get a taxpayer).
6. If a taxpayer receive a Proposal to Reassess, there is a 90 day window to file a Notice of Objection which is an appeal to CRA’s position.
7. A Notice of Objection is considered by the Appeals Office of CRA and that decision can be further appealed to the Tax Court of Canada. In practicality, most audit cases are settled between when a Notice of Objection is filed and going to the Tax Court.

If a taxpayer missed something in its tax return (a chartiable receipt is missing or the math is wrong), the process typically stops at #3 with a Notice of Re-assessment indicating what the tax return should have been since this is more of a clerical issue than a substantive issue.

Who do I go to?

A qualified lawyer who has dealing with the tax collection departments. Why? Lawyers have duties of confidentiality to their clients. This means they cannot reveal any information a client says or writes to a lawyer unless compelled by the Court or under special circumstances. The reasoning for this is to ensure that the client gives full disclosure to a lawyer without fear that the information can be used against him. This concept is known as client-solicitor privilege.

An accountant has no such privilege. In other words, the tax-collectors can use your accountant’s information obtained during the course of responding to audit questions against you. Yes, your own accountant may have to testify against you.

A lawyer can hire an accountant to assist in responding to the audit and, in doing so, cover the accountant’s work under privilege.

When do I go?

Depends on the seriousness of the questioning in part #2 of the process. Most lawyers provide free consultations. If the questions in #2 are of a pretty serious nature (i.e. more than, please provide your receipt for money you made in an income trust you forgot to include in your last tax return), then see a lawyer on a free consultation to understand your rights.

Should I appeal?

Some audit processes (depending on jurisdiction) give you a right of appeal in which you can go to some special committee Ask your professional whether you should exercise it or not.

The primarily right of appeal is not to stop the clock on penalities and interest but on enforcement proceedings since doing nothing is an admission you agree with the audit’s findings (which you may or may not agree with) and enforcement of tax revenue begins. Invoking the right of appeal is sometimes used to extend the time for the parties to discuss the audit as well (government is not exactly known for a quick turn-around on things). Thus, it depends on circumstances.

What can a lawyer do?

If the taxpayer does owe money, usually negotiate reasonable payment terms (the horse-trading usually involves waiving interest and penalities for some immediate payment and a reasonable payment plan). If the taxpayer has a case, settled on mutually satisfactory terms. If the government has clearly missed the mark and is belligerant in its position, argue the case in front of the appeals bodies.

How long will it take?

Months and sometimes years depending on the complexity of the case. If the taxpayer has no case and there was no malice in the underpayment, it still take months to negotiate.

Again, this post is meant to give you some sense of the process involved on an informational basis. The substance of an audit depends from case to case so please do consult a professional but please do take the process seriously. Best of luck.