Source: http://www.ormack.com/dec31st.html
Timestamp: 2018-09-21 20:26:46
Document Index: 230316791

Matched Legal Cases: ['art 1', 'art 2', 'art 2', 'art 2', 'art 2', 'art 2']

Eliminating The Deferral Of Tax On Business Income-Part 1
The December 31st Year-End Change
For taxation years beginning after 1994, individuals who report business income, including professional income, will be required to report that business income on a calendar year basis under a proposal of the February 27, 1995 Federal Budget. This proposal will eliminate the deferral of taxes for all sole proprietorships, professional corporations and partnerships in which at least one member is an individual, a professional corporation, or another affected partnership, by eliminating the use of an off-calendar fiscal year. These businesses would be required to change their fiscal year-end to December 31st, effective in the taxation year 1995. These original proposals were outlined before Finance Minister Paul Martin and his government had consulted with the taxpayers affected. Outlined below are the original proposed changes that should become law this fall.
The Department of Finance has subsequently announced changes to this original proposal so we encourage you to read Part 2 of this topic. See the Index Of Current Topics. Included in Part 2 are updated proposals which were a direct result of consultation with the taxpayers and their elected representatives. Also included in Part 2 are the effects of a change in year-end on GST and its reporting.
Currently, an owner of an unincorporated business, or a member of a partnership, must include in his or her personal income for a calendar year income for the fiscal period of a business ending in that calendar year. A taxpayer then, can choose a year-end other than the calendar year and thereby obtain a deferral of income. The largest and most common tax deferral was obtained by choosing a January 31st fiscal year-end. This would achieve a deferral of the income earned in the period February 1st to December 31st of each taxation year, to the following taxation year.
For example, in the 1995 taxation year, a self-employed business person with a January 31st year-end, would report as income, the profit for the twelve months ended January 31, 1995. This actually comprises eleven months of 1994 and one month of 1995. However, since the fiscal year ended in calendar 1995, that is the taxation year in which to report the income. The effect is to delay paying taxes on income earned in the balance of 1995 until April 30, 1997, the due date of 1996 income tax returns. The total effect of this deferral however, is lessened somewhat by the requirement to pay quarterly instalments of income tax.
The proposed new rules will require that all unincorporated businesses have two year-ends in the taxation year 1995. One ending at the normal fiscal year-end of the business and another ending on December 31, 1995. To keep with our January 31st example, this would require that the self-employed business person take into income, 23 months of net profit in one taxation year. Of course, the burden of such a change would be so great to some taxpayers that the government introduced transitional provisions in the form of a ten year reserve designed to lessen the impact of this change.
Effectively, the transitional provisions provide for a phase in period of up to ten years for the profit related to the additional "year-end" of December 31, 1995. This means our self-employed taxpayer in the example above will determine the profit for the period February 1, 1995 to December 31, 1995, based on financial statements prepared for that period, for purposes of the phase-in. This additional taxable income will be taxed over a period of ten years: 5% in the first year, 10% in the next eight years, and 15% in the tenth year, through a reserve system. The additional taxable income will be taxed at the individual's marginal tax rate for the particular year.
Assume a self-employed taxpayer has a January 31, 1995 fiscal year-end. This means the taxpayer will report 23 months of income in the taxation year 1995 as follows:
(a)  Income for the fiscal year ended January 31, 1995, 12 months.
(b)  Income for the deemed year-end of December 31, 1995, 11 months.
If we assume that the profit for (a) is $150,000 and the profit for (b) is $125,000, then the income for the total 23 month period is $275,000. Because of the transitional rules however, the taxpayer will pay tax based on the following calculations:
Income for the year ended January 31, 1995 --- $150,000
Additional income to report due to December 31, 1995 year-end --- $125,000
Subtract:  Reserve for the year --- $(118,750) --- {$125,000 x 95%}
Equals:  Total taxable income for 1995 --- $156,250
This example is very simplified. There are several other factors and considerations that must be reviewed which are beyond the scope of this article.
Future Taxation Years
In future years, the taxpayer will be required to add into income the prior year's reserve taken. Then, a new reserve amount will be calculated based on that year's specified percentage. This has the effect of increasing taxable income each year until the entire reserve amount originally calculated in 1995 has been taken into income. In our above example, in the 1996 taxation year, the taxpayer will calculate his or her 1996 taxable income as follows:
Income for the year ended December 31, 1996 --- $150,000
Add:  1995 Reserve Amount --- $118,750
Subtract:  1996 Reserve Amount --- $(106,250) --- {$125,000 x 85%}
Equals:  Total taxable income for 1995 --- $162,500
Notice that the taxpayer begins with income for the period ended December 31, 1996, due to the required change in year-end. Also, the specified percentage for calculating the reserve amount has dropped from 95% to 85%.
There are tax planning considerations here as the claiming of the maximum reserve amount each year is optional. Therefore, in periods of low taxable income, the taxpayer may wish to claim less than the maximum reserve, thereby increasing taxable income, to take advantage of low marginal tax rates. This benefit must be compared with the fact that the taxpayer is effectively prepaying the tax on this income. Further planning ideas and pitfalls associated with this topic are outlined in Part 2.
There are other changes which will affect the unincorporated business owner. To alleviate some of the pressure and workload involved in preparing financial statements at December 31st, the due date for filing of income tax returns for unincorporated business owners has been extended to June 15th from April 30th. This will become effective for the 1995 taxation year, which means tax returns must be filed by June 15, 1996. However, all taxes remain due and payable by April 30, 1996, or interest charges will result. If the tax return is filed later than June 15, 1996, late-filing penalties will result.
It is inevitable that owners of unincorporated businesses and their tax advisors will be busier than normal in preparing 1995 taxes. You should be preparing now by ensuring that all your information is up-to-date and accurate. The financial statements for your original fiscal year should be prepared well in advance of traditional periods. The information for the period ended December 31, 1995, should be available as soon as possible so that your accountant can have an early start in estimating the tax effect of these new changes.
These tax changes are some of the most significant and far reaching in recent years. Please consult your financial advisor or a representative of Ormsby & Mackan for further information and planning tips before taking any action.
Take me to Part 2 of this topic.