2017 Federal Tax Proposal
The Department of Finance recently announced drastic proposed changes to the taxation of private corporations. Based on comments in the March 2017 Federal Budget, businesses and taxpayers were expecting to see some changes put forth, but few envisioned the sweeping proposals tabled on July 18, 2017. Some say that the proposals will somewhat level the playing field, while others argue that every private business in Canada will be affected and if adopted, could hurt job creation and Canada’s competitiveness on the global stage.
Here is an overview of what the
new, proposed federal tax laws could mean
for you as an owner or
shareholder of a private company.
The proposal focuses on three tax planning strategies commonly used by private corporations:
• Sprinkling Income Using Private Corporations
• Holding a Passive Investment Portfolio inside a Private Corporation
• Conversion of Dividends paid by a Private Corporation Into Capital Gains
Here is an overview of what the proposal could mean for you as an owner or shareholder of a private company.
A common technique employed by private corporations is to “sprinkle” income to family members by way of salary, wages or dividends. This strategy can result in tax savings by shifting income from an individual taxed at the highest marginal tax rate to family members subject to lower marginal tax rates.
Current tax rules exist to prevent the payment of unreasonable salaries or wages to family members who are not actively involved in the business. The Income Tax Act also has provisions to tax dividend distributions paid to minor children (under the age of 18) at the highest marginal personal income tax rate. This special tax is commonly referred to as the “kiddie tax”.
The proposed changes significantly expand the scope in which income sprinkling techniques can be taxed through:
• Broadening the definition of Tax on Split Income (“TOSI”) to “specified individuals” defined as spouses, minor and adult children, parents, siblings, aunts, uncles, nephews and nieces.
• Curtailing the Multiplication of the Lifetime Capital Gains Exemption (“LCGE”), and
• Taxation of Second Generation Income.
Compared to the previous regime, the net has been cast much more broadly under the new TOSI rules. The new measures are intended to more heavily tax additional types of income such as income from a partnership or trust originating from a business of a related person, income from private company debt, capital gains on private company shares, compound interest on property subject to TOSI, certain shareholder benefits, and dividends received on private company shares subject to the current kiddie tax rules.
Individuals between the ages of 18 to 24
must be actively engaged on a regular,
continuous and substantial basis
in the activities of the business.
TOSI rules will apply where the income received by the specified individual is deemed unreasonable in relation to his or her contribution to the company. Reasonableness is assessed by comparing the payments received by the specified individual to what would have been paid to an arm’s length person, taking into account the specific functions performed, assets contributed, risks assumed on the amounts received by the specified individual and all previous amounts paid or payable.
The reasonableness test can only be satisfied in situations where the company is engaged in an active business. If TOSI rules apply, income received by the specified individual is taxed at the highest marginal personal tax rate (currently 53.5% in Ontario).
So, what is reasonable in the circumstances? The answer is subjective and could produce widely differing results. It will be imperative to document the labour and capital contributions made by each specified individual in order to assess whether amounts paid are reasonable.
The proposed legislation provides some guidance in assessing the “reasonability” of amounts paid relative the individual’s age, labour and capital contributions. Individuals between the ages of 18 to 24 must be actively engaged on a regular, continuous and substantial basis in the activities of the business, and will only be entitled to receive a return on their investment equal to the prescribed rate under the Income Tax Act (currently at 1%). Individuals who are 25 or older must only be involved in the activities of the business, and assessing reasonableness of returns will be determined based on both the assets contributed to the business as well as risks assumed.
Multiplication of the Lifetime Capital Gains Exemption
A very common structure utilized by private corporations contains an operating company whereby the founder owns fixed value non-growth preferred shares, and a family trust owning common shares which typically increase in value over time. The beneficiaries of the family trust typically include the spouse and children.
Upon the sale of common shares, capital gains realized on the transaction are allocated to the beneficiaries of the trust (including minor beneficiaries under the age of 18). This enables the individuals to shelter the first $835,716 (2017 figure) of capital gains through the use of the LCGE, assuming the shares meet the criteria to qualify as Qualified Small Business Corporation (“QSBC”) shares.
Under the proposals commencing in 2018, the ability to multiply the LCGE will be significantly curtailed. Subject to transitional provisions, minor children under the age of 18 will no longer be eligible to claim the LCGE on a disposal of QSBC shares.
Moreover, any gains that accrue to an individual prior to attaining the age of 18 will no longer qualify for the LCGE.
Given that gains accruing after the child turns 18 may qualify for the LCGE, a valuation of the private company shares may be required at the time the child turns 18 in order to document the growth in value occurring after that time.
A trust can continue to allocate capital
gains to a minor beneficiary realized ...
transitional relief provisions
In addition, capital gains allocated by a family trust to a beneficiary will no longer be eligible for the LCGE commencing in 2018. Thereby eliminating the opportunity to access multiple unused LCGE’s of family members. Note that certain exceptions will apply to capital gains allocated by Alter Ego Trusts, Spousal Trusts and certain Employee Share Ownership Trusts. Further, anti-avoidance provisions will be put in place to restrict the ability to claim the LCGE when a trust distributes common shares of the operating company to a beneficiary prior to the sale of the shares.
A trust can continue to allocate capital gains to a minor beneficiary realized prior to December 31, 2017 or 2018 through certain transitional relief provisions in order to utilize the LCGE. However, relief is only provided on a sale of shares in arm’s length transactions.
Transitional provisions are also proposed to enable adult taxpayers to crystallize their LCGE on eligible property by electing to dispose their private company shares at an amount between cost and fair market value. The adjusted cost base of the shares would be increased by the elected amount with any resulting gain offset with the LCGE. This election may be filed at any time in 2018.
Overall, the new TOSI rules are quite complex and will come into effect on January 1, 2018. Opportunities to sprinkle income to adult family members will be considerably restricted. Existing corporate structures that allow for payment of dividends to adult family members should be reviewed with your tax advisor as the new proposed tax rules may result in higher overall tax liabilities to dividends paid to non-active family members. While opportunities to multiply the LCGE will be restricted, you may consider taking advantage of certain transitional provisions afforded to minor children and adults in 2018.
Holding a Passive Investment Portfolio inside a Private Corporation
Integration, a fundamental principle in the Canadian income tax system states that the taxes paid on corporate earnings plus the personal taxes paid on dividend distributions should equal the personal taxes paid on that same income if earned directly by a self-employed individual.
In their proposal, Finance has advanced their position that the use of private corporations has facilitated the accumulation of personal savings for shareholders by deferring corporate taxes over an indefinite period of time. Effectively, an individual using his or her private corporation to carry on an active business has more capital to invest (or savings to accumulate) than an employee.
This position results from the fact that corporate earnings taxed at the small business rate (15% in Ontario) is considerably lower than the highest marginal personal tax rate that approximates 50%. Some argue that this tax deferral is necessary as it compensates the incorporated individual for the financial and business risks assumed, and allows them to accumulate funds that can be reinvested into the business or held as a rainy day fund for economic downturns.
The Apportionment Method requires the
corporation’s taxable income be
tracked in three separate pools:
Finance’s consultation paper discusses several alternative approaches to handle the issue noted above; namely the Apportionment Method, the Elective Method, and an election for Corporations Focused on Passive Investments.
The Apportionment Method requires the corporation’s taxable income be tracked in three separate pools: the Small Business Rate (“SBD”) Pool (15% in Ontario); the General Rate Pool (26.5% in Ontario); and the Shareholder Contribution Pool which tracks investment contributions made by the shareholders.
The passive investment income earned in the current year would be allocated to each of these pools. A corporation would then designate which pool the dividends were paid from.
Dividends from the SBD pool would be taxed personally as non-eligible dividends (approximately 45% in Ontario), dividends paid by out of the General Rate Pool would be personally taxed as eligible dividends (approximately 40% in Ontario), and distributions paid by out of the Shareholder Contribution Pool would be returned to the shareholder tax free.
The Elective Method provides two treatment options, both of which eliminate tracking taxable income by separate pools.
The Default Treatment proposes to treat all dividends paid as non-eligible dividends. Under the Elective Treatment, a private corporation can elect to tax all active business income at the general corporate rate of 26.5%, resulting in dividends being paid to individuals taxed as eligible dividends. Both the Default and Elective Treatments eliminate the payment of tax-free dividends through the Capital Dividend Account and the concept of refundable taxes at the corporate level.
Under both the Apportionment Method and Elective Method, a further election for private corporations that focus on passive investments is possible. The corporation could file an additional election to tax income under the current refundable tax system which attracts a tax that approximates the highest marginal personal tax rate. Additional refundable taxes may also apply to inter corporate dividends received. It is unclear whether the tax free portion of capital gains could be paid out to shareholders on a tax free basis under this new system.
According to the Department of Finance the new rules on passive investments will only apply on a go-forward basis and are intended to have limited impact on existing passive investments accumulated by private corporations to-date.
Conversion of Dividends paid by a Private Corporation into Capital Gains
Finance is concerned that taxpayers are triggering capital gains to distribute after-tax earnings from private corporations that would otherwise have been taxed as dividends at much higher dividend personal tax rates (i.e. 26.7% for capital gains vs. 45.3% for non-eligible dividends in Ontario). In other words, taxpayers were undertaking transactions to enable the distribution of corporate surplus at a much lower capital gains tax rate whereby one spouse sell shares to the other spouse for a promissory note and triggering a capital gain on the transfer. The purchasing spouse would transfer the newly-acquired shares to another private corporation and extract corporate funds tax free in order to repay the promissory note.
These are significant changes that will
surely affect many
owners of private corporations.
Finance proposes to expand the existing anti-avoidance provisions found in the Income Tax Act to apply to non-arm’s length sale of shares to curtail these type of transactions. However, if enacted in their current form, the proposed changes will inherently increase the tax payable on certain post-mortem planning strategies. These strategies have historically enabled the use of non-arm’s length transactions by Estates to mitigate double taxation issues that arise on the death of a shareholder. This could have a significant impact on the overall tax burden for existing estate plans drafted under the rules of the previous regime.
Recommendations for Canadian Businesses
These are significant changes that will surely affect many owners of private corporations. We will be following the progress of this consultation closely, including continuing to assess the impact on tax planning for these owners. In the meantime, your tax adviser can help you assess the impact of any potential changes to you and your family.
Carlo Ciaramitaro, CPA, CA is the Partner-In-Charge of the KPMG in Waterloo office’s Canadian tax practice. He provides privately-held companies advice with respect to Canadian tax challenges, including compensation planning, tax efficient structures, and acquisitions and divestitures. Carlo is the former National Practice Leader of KPMG’s R&D Incentives Practice. Jeff Howald, CPA, CA is a Partner in the Canadian tax practice and based in the KPMG Waterloo office. He brings almost 15 years of corporate and personal tax experience in public accounting, advising owner manager clients on tax compliance and advisory matters to support the growth of their business.