Chapter 7: Property Income – Financial Accounting Study Notes

Property Income

Definition and Classification

Property income refers to passive returns generated from investments that require little or no active effort. It is a key concept in financial accounting and tax reporting, especially for individuals and corporations.

• Property income includes Rents, Interest, Dividends, and Royalties (RIDR).

• If significant effort is required to generate these items, the income may be classified as active business income.

• Property income received incidentally by a corporation can be reclassified as business income.

Additional info: Property income is generally taxed differently from business income, with specific rules for deductions and credits.

Interest Expense

Deductibility of Interest

Interest expense is a common deduction in financial accounting, provided the loan is used to generate business or property income.

• Interest is deductible if the loan proceeds are used for business or property income purposes (ITA 20(1)(c)).

• Special rules apply to bonds, especially regarding discounts and premiums (see assigned readings).

Rental Income

Determination and Deductible Expenses

Rental income is a form of property income and is typically determined using the accrual method, though the cash basis may be used in limited circumstances.

• Accrual method is standard for rental income determination.

• If there are minimal receivables and outstanding expenses at year-end, the cash basis may be used.

• Deductible expenses include: utilities, repairs, maintenance, interest, insurance, property taxes, management fees, fees to rental agents, and Capital Cost Allowance (CCA).

Capital Cost Allowance (CCA)

CCA is a tax deduction for depreciation of property used to earn rental income.

• Buildings costing $50,000 or more must be placed in a separate CCA class.

• For individuals, the full calendar year is considered the fiscal year in the year of purchase (no proration for short fiscal years).

• CCA cannot be used to create or increase a property loss (applied on a combined basis for all properties).

• On disposal, any recapture or terminal loss is included in property income.

Interest Income

Corporations and Partnerships

Corporations and partnerships recognize interest income using the normal accrual method, consistent with GAAP except for bonds, which have special tax treatment.

• Interest income is recognized as it accrues (ITA 12(3)).

• Bonds may require special tax treatment.

Individuals

Individuals must record interest income for amounts received or receivable, less amounts previously recorded. The Modified Accrual Method is used.

• Interest is accrued on each anniversary date of an investment contract (ITA 12(4)).

• Anniversary date: One year after the day before the date of issue (e.g., April 1 issue date, anniversary is March 31).

• Compare accrued amount to cash received to determine income inclusion.

Interest Income from Bonds

Bonds generate interest income based on the coupon or stated rate, regardless of issuance at a discount or premium.

• If issued at a discount, the purchaser receives more cash at maturity than paid, treated as a capital gain.

• If issued at a premium, the purchaser receives less cash at maturity than paid, treated as a capital loss.

Accrued Interest on Debt Securities

Debt securities may be purchased between issue and interest payment dates, resulting in accrued interest.

• The seller must include accrued interest in income; the purchaser receives a deduction equal to the accrued interest.

Royalties

Definition and Tax Treatment

Royalties are payments based on production or use, typically recognized using the accrual method (ITA 12(1)(g)).

• If the original artist receives the income, it is likely classified as business income due to active work.

Dividends

Foreign Dividends – Individuals

Foreign dividends are included in income at the full amount before any withholding taxes (ITA 12(1)(k)).

Foreign Tax Credits

Canadian residents are taxed on 100% of their foreign income, but may face withholding taxes from other countries. Canada provides two tax credits to mitigate double taxation.

• Foreign business income tax credit: Equal to foreign taxes withheld.

• Foreign non-business income tax credit: Limited to the lesser of foreign taxes withheld, 15% of foreign non-business income, or any excess foreign income tax deductible from property income.

• Canada's treaties often limit withholding taxes to 15% or less.

Dividends from Canadian Corporations – Individuals

Dividends from taxable Canadian corporations receive special tax treatment to allow for integration (ITA 12(1)(j)).

• Perfect integration: After-tax cash is the same whether income is received directly or through a corporation paying dividends.

Example: Perfect Integration Illustration

PROPRIETORSHIP	CORPORATION
Business Income: 10,000	Business Income: 10,000
Personal taxes @ 30%: (3,000)	Corporate taxes @ 20%: (2,000)
	Personal taxes @ 30% on original income: (1,000)
After tax cash: 7,000	After tax cash: 7,000

Taxable Dividends – Individuals

To achieve integration, individuals must include an estimate of the corporation's income when receiving dividends, using a grossed up dividend.

• If the corporate tax rate is 20%, the gross up is 25%.

Example of Integration

Income through a Corporation	Taxable Income/Payable
Net income: 10,000	Net income: 10,000
Corporate taxes 20%: (2,000)	Corporate taxes 20%: (2,000)
After tax income: 8,000	After tax income: 8,000
Dividend received: 8,000	Dividend received: 8,000
Gross up 25%: 2,000	Gross up 25%: 2,000
Grossed up dividend: 10,000	Grossed up dividend: 10,000

Note: The gross up equals the corporate taxes, resulting in the grossed up dividend equaling the corporation's net income.

Dividend Tax Credit

The grossed up dividend is subject to personal taxes, but a dividend tax credit is provided to offset corporate taxes already paid.

• The credit consists of both federal and provincial components.

• Credits should approximate the amount of the gross up.

• Credits may be stated as a percentage of the actual dividend, the gross up, or the grossed up dividend.

Eligible and Non-Eligible Dividends

Canadian corporations are subject to either high (public) or low (private) tax rates, requiring two types of dividends for integration:

• Eligible dividends: High taxed corporate income (e.g., 27.54%)

• Non-eligible dividends: Low taxed corporate income (e.g., 13.04%)

• Gross up rates: 38% for eligible, 15% for non-eligible dividends

Example of Integration – Eligible Dividends

Income through Corporation	Taxable Income/Payable
Net income: 10,000	Net income: 10,000
Corporate taxes 27.54%: (2,754)	Corporate taxes 27.54%: (2,754)
After tax income: 7,246	After tax income: 7,246
Eligible dividend: 7,246	Eligible dividend: 7,246
Gross up 38%: 2,754	Gross up 38%: 2,754
Grossed up dividend: 10,000	Grossed up dividend: 10,000

Dividend Tax Credit Calculation

• Federal dividend tax credit for eligible dividends: $\frac{6}{11}$ of the gross up, 15.02% of the grossed up dividend, or 20.73% of the actual dividend.

• Provincial dividend tax credit for perfect integration: $\frac{5}{11}$ of the gross up.

• For non-eligible dividends: $\frac{9}{13}$ of the gross up, 9.0301% of the grossed up dividend, or 10.3846% of the actual dividend.

Stock Dividends

Stock dividends are treated like cash dividends for tax purposes, requiring shareholders to pay taxes even if no cash is received. The amount of the dividend is added to the Adjusted Cost Base (ACB) of shares.

Effective Tax Rates (Alberta, 2024)

Type	Effective Tax Rate
Interest	48%
Capital gains	24%
Non-eligible dividends	42.31%
Eligible dividends	34.31%

Shareholder Benefits

Tax Treatment

Personal benefits provided by a corporation to its shareholder are considered property income to the shareholder. The corporation cannot deduct these items, resulting in double taxation.