The argument is that tax deductions and tax credits tend to erode the fairness of the tax system. Since the deductions and credits are targeted at certain sectors, they are not universal tax relief to all. Some also argue that the deductions and credits are claimed by the very people who do not need them as much. A recent Globe and Mail article found that the children’s fitness tax credit is disproportionately claimed by people making $50,000 and over a year even though they constitute a minority of Canadian taxpayers. Time Magazine found a similar pattern in who claimed the mortgage interest deduction.

Finally, academics for years have attempted to determine why governments continue to rack up deficits. The findings cast no politician in a friendly light. Studies have found that: (a) government rack up deficit in order to increase re-election chances (patently obviously); (b) conservative governments rack up deficits if they know they are going to lose in order to constrain their opponent’s policy choices; and (c) an incumbent who knows it will lose will run a deficit to limit the successor’s choices so the incumbent can win in the election afterw0rds (there are some interesting articles on this topic here and here). Undoubtedly, tax credits and tax deductions are often used as tools for wooing voters and increasing deficits as a result.

The most touted solution to the government deficit problem has been a flat tax. The theory being there is less tax leakage in a flat tax system and revenues are easier to predict.  The fear of the flat tax has always been that the rate will be set too low to fund programs (more of an issue in an aging society).  The other proposal is to limit the increase in government spending in the years before elections; any increase above the cost of living allowance would require a super majority of the legislature or a referendum of the voters (in a minority government situation, the government would treat each budget as its last).

Regardless of where-ever you fall on the tax credit and tax deduction divide, this is the system we have and it appears that not enough people are utilizing tax credits and tax deductions properly.

(Canadians can rely only upon a portion of the U.S. estate tax exemption as illustrated here; the tax rates listed are dated but the analysis continues to be correct).

However, what Uncle Sam giveth with one hand it taketh with the other.  Under the Small Business Jobs Act 2010, owners of real estate purchasing more than $600 worth of goods and services will be required to provide a Form 1099-MISC (which is like a T4A in Canada).  The issue is not providing the form per se. The issue is that a Canadian will need to apply for a Taxpayer Identification Number to file the form which means it will be classified as a “non-resident alien”  (in simple terms, a non-resident alien is not a U.S. citizen but has submitted to its taxing jurisdiction).

The most likely result is: (i) administrative burden of keeping paperwork; (ii) more professional fees in retaining accountants to file tax returns; and (iii) possible audit risk from the IRS (as a non-resident alien taxpayer, there is no one in Congress who wants to intervene on your behalf given the taxpayer is not a voter).

The second issue is an ongoing one. The exemption from the U.S. estate tax is calculated on the market value of the property of the deceased whereas in Canada only the gain on the deemed disposition at death is taxed; to phrase this another way, the Canadians tax you for being a shrewd investor; the American tax you for merely holding it. This is a crucial difference that most Canadians who do not have experience with American tax law do not initially grasp.

All of this is to say that Canadians holding U.S. assets (including stock listed on U.S. exchanges) are increasingly being caught in a jurisdiction badly in need of tax revenue and widening their scope to collect it. Professional advice is required for any Canadian in this situation.

While there is a time and place for certain types of tax savings products, the more fundamental issue is that most taxpayers do not claim tax deductions or tax credits which are readily available. For example, Time Magazine reported that more than 1/3 of all American taxpayers do not claim the mortgage-interest deduction. For a household making between $40,000- $75,000 a year, this is lost tax savings of approximately $542.00 a year; a not insignificant sum in penny pinching times.

The most overlooked tax deductions and tax credits tend to cluster around medical expenses and children/provision for dependents. For example, the following are some tax deductions or tax credits in connection with children and medical expenses available to Canadian taxpayers:

• Childcare expense
• Child disability credit
• Tuition fees and textbooks
• Moving expenses for eduction (greater than 40km)
• Children’s fitness tax credit
• Caregiver deduction (dependent must be over 18)
• Medical expense tax credit

This does not include the Canada Child Tax Benefit which is a monthly allowance for eligible taxpayers (but only if you sign up). Generally, the range of tax deductions and tax credits available to taxpayer receiving employment income is relatively less than the self-employed. But, as the above non-exhaustive example shows, the government is encouraging us to have kids by providing numerous tax incentives.

For American taxpayers, here is a link to most overlooked tax deductions.

The key to all these  tax deductions or tax credits is good book-keeping/record retention. Rather than running this post during tax season, it is timely to remember to keep your invoices and receipts related to children as they tend to pile up this time of year.

Tax shelter do have their time and place. They work on the same risk-reward principle as investing so it is important to remember the larger the potential tax deduction (or the larger the product falls outside any existing and endorsed tax plan), the greater the risk of audit and the costs associated therein.

However, the larger point remains that tax shelter should only be restored to if all possible deductions and credits are claimed.

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.

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.

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.

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.

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.

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.

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.