On July 18, 2017, the Department of Finance (Finance) released a consultation policy paper that, if implemented, would significantly impact owners of Canadian private corporations and their families. The paper calls for input on the proposed measures by October 2, 2017.
In the 63-page paper titled “Tax Planning Using Private Corporations,” Finance proposes measures to address “unfair” tax advantages to private corporations. In this report, we provide an overview of the following measures and their potential impact on owners of private Canadian corporations:
- Limiting income sprinkling using private corporations
- Restricting access to the lifetime capital gains exemption
- Increasing taxes on passive investment portfolios inside a corporation
- Eliminating conversion of a private corporation’s income into capital gains
LIMITING INCOME SPRINKLING USING PRIVATE CORPORATIONS
“Income sprinkling” refers to splitting income with adult family members who are subject to lower personal tax rates. This strategy is often accomplished by distributing private company dividends directly to family member shareholders or indirectly through a family trust. There are currently “tax on split income” (TOSI) rules to prevent income splitting with minor children by taxing all such income at the top marginal rate. These, commonly referred to as “kiddie tax” rules, have been in place since 1999.
Finance proposes to extend the TOSI rules to adult family members, subject to a new “reasonableness” test that considers the level of the family members’ involvement in the business based on such factors as contributions of labour and capital. If the degree of involvement isn’t deemed reasonable, the top tax rate will apply. Stricter reasonableness requirements are proposed for family members aged 18-24 “because the tax benefits of income sprinkling are higher, on average, when adult children of high-income filers are younger and have lower income.”
Finance also proposes to expand the application of the TOSI rules to include capital gains from the sale of private company shares.
This measure will likely have the broadest impact on small business owners and incorporated professionals. If you currently pay dividends to your spouse or adult children from an active business in which they are not involved, you will likely lose any advantage from income sprinkling and face a higher family tax burden in the future.
The proposed legislation, if enacted, would be effective starting in 2018.
RESTRICTING ACCESS TO THE LIFETIME CAPITAL GAINS EXEMPTION
Canadian residents have a lifetime capital gains exemption (LCGE) available to shelter capital gains of up to $835,716 (2017) on the disposition of “qualified small business corporation” shares and capital gains of up to $1,000,000 on the disposition of qualified farm and fishing property.
Finance proposes to prevent multiplying the LCGE across family members by denying the exemption:
- on gains that accrue before the individual turns 18;
- on gains that accrue on shares while held in a trust (except alter ego, spousal and certain employee share ownership trusts); and
- if the individual is subject to the TOSI rules outlined above.
Business owners who have put structures such as family trusts in place in contemplation of selling the shares of their operating business one day and sprinkling the LCGE across multiple family members will need to revisit their share structure and potential tax exposure.
The proposed legislation, if enacted, would be effective starting in 2018. However, a transitional rule has been proposed whereby business owners can elect to crystalize a capital gain and claim the exemption by the end of 2018.
INCREASING TAXES ON PASSIVE INVESTMENT PORTFOLIOS INSIDE A CORPORATION
Canadian-controlled private corporations (CCPCs) pay tax at a reduced rate on the first $500,000 of active business income. In BC, for example, the combined federal and provincial small business rate for 2017 is 12.62%. Business owners and incorporated professionals then pay tax on the salary or dividends (typically “non-eligible”) at their personal marginal rate. Salaries are deductible to the corporation; dividends are not.
Consistent with the “theory of integration,” there is currently virtually no tax rate advantage between the aggregate amount of corporate and personal tax paid in this scenario versus the tax paid by a non-incorporated salaried employee. In fact, there is a small tax rate disadvantage for earning active business income through a corporation in most provinces and a larger tax rate disadvantage for earning investment income and capital gains in a corporation.
However, in cases where excess funds are available (after paying tax at the small business rate of 12.62%) to be invested within the corporation and where the business owner defers taking dividends until a future year, there is a significant deferral advantage ranging from 35% (BC) to 40%.
The government has stated the deferral advantage to be “unfair” to unincorporated individuals. The government is targeting passive investments (i.e., stock portfolios), not reinvestment in active businesses.
Although Finance has not released draft legislation on this topic, the consultation paper outlines two broad approaches it is considering and invites public input on policy and implementation. Both approaches are complex but, in a nutshell, target staple mechanisms of the Canadian tax system for private corporations.
Proposed measures include:
- Eliminating refundable taxes on passive investment income
- Where the source capital of an investment is income taxed at corporate income tax rates:
- Denying access to the lower “eligible dividend” tax rates on distribution of corporate earnings; and
- Denying the addition of the non-taxable portion of capital gains (currently 50%) on passive investments to the capital dividend account (CDA).
If you are able to retain after-tax funds from active business income and invest them in a corporate investment portfolio, you will likely see the tax deferral advantage reduced or eliminated, resulting in higher taxes and less funds to invest going forward.
Once enacted, any new rules are meant to have limited impact on existing passive investments. It is not yet clear how Finance plans to tax income and accrued capital gains on those investments.
Unknown. New rules, per Finance, would only apply after the release of draft legislation on a go-forward basis.
ELIMINATING CONVERSION OF A PRIVATE CORPORATION’S INCOME INTO CAPITAL GAINS
Capital gains are taxed at half the rate of regular income. For BC residents, capital gains are taxed at 17.10% and 7.45% less than non-eligible and eligible dividends, respectively. One strategy that allows private company shareholders to exploit this difference by extracting retained earnings as capital gains rather than dividends is currently available in some circumstances.
Finance proposes an amendment to the anti-surplus stripping of the Income Tax Act to eliminate these transactions.
This change is not expected to have as wide an impact as the other proposed changes. However, it would reduce options for avoiding double-taxation caused by owning private corporation shares with unrealized gains upon death.
The proposed legislation, if enacted, would be effective for transactions on or after July 18, 2017.
If you own a private corporation, consult your tax advisor well before December 2017 to assess how these proposals may impact you. Do not rush into any transactions or structural changes, and make sure to update tax balances (e.g., CDA, GRIP, RDTOH) for corporate investment income earned and capital gains/losses realized since your last corporate year-end.
With the above information, revisit any previous planning and discuss with your tax advisor whether it makes sense for you to take any of the following steps:
- Take advantage of income splitting in 2017.
- Crystalize any unrealized capital gains/losses in 2017.
- Distribute any available capital (tax-free), eligible and/or non-eligible dividends in 2017.
- Provide feedback to the Department of Finance before October 2, 2017, and share your concerns with your Member of Parliament.
Please contact your Odlum Brown Investment Advisor or Portfolio Manager with any questions or for assistance gathering relevant year-to-date information based on your corporate year-end.