On July 18, 2017, the Department of Finance released a consultation paper, along with explanatory notes and draft legislation, proposing a number of tax changes that were aimed at private corporations. The changes were intended to remove the perceived unfair tax advantages available to owners of private corporations. Finance provided a consultation period and requested comments on their proposals by October 2, 2017. Following a review of the submissions received during the consultation period, Finance announced a number of changes to the original proposals, some of which they will not proceed with.
In light of these proposed changes, if you are involved, either directly or indirectly, in a private corporation, you will want to review the current corporate structure and any tax planning strategies you have implemented that relate to the private corporation. To help you prepare for the conversation with your tax and legal advisor, this article provides an overview of the proposals, the subsequently announced changes, the possible impact of the proposals, and some planning considerations.
Proposals not being implemented
Lifetime capital gains exemption. The government has decided to not move forward with the proposals that were intended to constrain the ability to claim the lifetime capital gains exemption (LCGE). The proposals would have limited access to the LCGE by denying the exemption to individuals under the age of 18 or where was held by a trust, for example. Concerns were raised that the measures had unintended consequences on intergenerational transfers of family businesses.
Converting regular income into capital gains. The government has also decided to not move forward with the proposals that addressed converting regular income into capital gains. These proposals would have prevented certain advanced tax planning strategies that involved shareholders extracting surplus cas from a private corporation at lower tax rates. During the consultation period, concerns were raised that these measures were too broadly worded and had unintended consequences such as disallowing the "pipeline strategy" which is commonly used to avoid double taxation on the death of a shareholder.
Proposals being implemented
Small business tax rate decrease. Currently the small business deduction reduces the federal corporate income tax rate to 10.5% on the first $500,000 of active business income earned by a Canadian Controlled Private Corporation (CCPC). On October 16, 2017, the government announced that it intends to decrease this rate to 10%, effective January 1, 2018 and to 9% effective January 1, 2019.
In conjunction with the proposed reduction in the small business tax rate, the government has announced that it will adjust the gross-up factor and dividend tax credit applicable to "non-eligible" dividends in order to maintain integration of corporate and personal taxes.
The effect of this measure will allow corporation to retain more funds for reinvestment. However, the overall impact on the corporate and personal integrated tax rate, when the corporation's income is flowed out to its shareholders, is likely very small.
Income splitting using private corporations. There are currently "tax on split income" (TOSI) rules, commonly referred to as "kiddie tax" rules, which limit splitting certain types of income with minor children. The TOSI rules currently apply to many types of income received from a private corporation, such as dividends, but they do not apply to salaries or bonuses. Where TOSI applies, the income is subject to tax at the highest marginal rate and the minor child loses the ability to claim personal tax credits, such as the basic personal tax credit, on the split income.
The proposals announced on July 18, 2017 would expand the types of income on which TOSI applies. The proposals would expand the application of the current TOSI rules to include other family members (such as spouses, adult children, aunts, uncles, nieces, and nephews) resident in Canada, regardless of their age, who receive split income. For individuals age 18 or older, a reasonableness test will be applied an only the amount considered to be unreasonable would be subject to TOSI. The basis for reasonableness would be what an arm's length party would have agreed to pay the individual, considering labour and capital contributions, the risk assumed, as well as previous returns and remuneration paid to the individual. The reasonableness test will be more restrictive to those age 18-24 as opposed to those age 25 and older.
On October 16, 2017, the government announced that it intends to move forward with these measures while ensuring that the rules will not impact businesses to the extent there are "clear and meaningful contributions" by spouses, children and other family members. They intend to better target and simplify the proposed measures as well as reduce the compliance burden associated with establishing the contributions of spouses and family members.
The government intends to release revised draft legislation later this fall outlining the proposed changes, which will be effective beginning January 1, 2018.
Income splitting planning considerations. If you currently use your private corporation to split income with family members, you may be affected by these rules. If you use a family trust that allocates dividends received from a private corporation out to your spouse or children, you may be affected by these rules. If you or your family made loans to your private corporation and received interest in return, you may be affected by these rules. These are just some situations in which these new rules could impact you or your family.
We recommend that you review your business structure, remuneration, financing, and succession strategy with your tax and legal advisors to ensure you understand how the changes could affect your specific situation. Below we have provided a non-exhaustive list of some general items you can discuss with your advisors, but it is important to note that the suggested planning considerations assume that the draft legislation will be passed as is. As previously mentioned, the government intends to revise the draft legislation.
- Consider paying dividends or increasing the amount of dividends you pay to adult family members in 2017 since the proposed rules will only apply starting in 2018.
- Consider what type of document you can uses to evidence reasonableness. For example, keep timesheets to document hours worked.
- Analyze your current business practices with regards to paying salaries and dividends and consider paying salaries instead of dividends since it is easier to establish a reasonable amount of salary. Be mindful of the additional cost of paying salaries in teh form of payroll taxes, CPP/QPP, EI, and other payroll expenses such as provincial workers' compensation and health taxes.
- Consider whether a share reorganization is required so that each shareholder holds a different class of shares to enable dividends to be declared and paid in different amounts on each class to reflect what is reasonable for that shareholder.
- In reviewing your business structure, if you determine that your corporation has no purpose other than to split income with family members, you may want to consider whether it needs to remain in place or whether it should be dissolved.
- Consider other income splitting strategies such as prescribed rate loan to your spouse or children directly or indirectly through a family trust.
Holding passive investments inside a private corporation. Currently there is a perceived tax deferral advantage for business owners who retain after-tax income in their corporation. This is because corporate business income is generally taxed at a lower rates than income earned personally, which can result in incorporated business owners having more after-tax money to invest. The government intends to introduce tax changes that will make the value of the after-tax portfolio of a business owner investing within a corporation equal to that of someone investing in their personal account who is taxed at the top marginal tax rate.
On October 18, 2017, the government announced that they are moving forward with the measures to limit the deferral benefits of holding passive investments within private corporations. However, there will be no tax increase on $50,000 of passive income earned annually. This $50,000 threshold is intended to provide flexibility for business owners to hold savings for business contingencies or future investments such as the purchase of equipment, hiring staff or business expansion, as well as savings that can be used for personal benefits such as sick leave, parental leave, or retirement. Further, the government pointed out that only 3% of CCPCs with taxable passive income were above the $50,000 threshold in 2015 so that the majority of businesses will not be affected by these tax proposals.
The government reiterated that these measures will not apply to existing passive investments inside a private corporation as well as the future income earned on those investments. It seems as though this will require some sort of tracking mechanism of grandfathered and non-grandfathered investments. They state that these measures will only apply on a go-forward basis, however there is uncertainty as to the effective date of these rules.
As of now, there is uncertainty as to how the $50,000 threshold will apply. We do not know if the threshold will increase each year to account for the accumulation of investment income. We do not know if the threshold applies only if the investment portfolio is derived from income subject to the small business tax rate. We do not know how the threshold will apply if you own multiple corporations. There are also questions as to whether withdrawals from the investment portfolio will be considered to be made from past investments, which are grandfathered, or those investments which are not grandfathered. The government announced that draft legislation will be released at the 2018 federal budget. There will hopefully be more clarity on these rules once the draft legislation is released.
Passive income planning considerations. The proposed changes will generally affect business owners who are using some of their corporate surplus for passive investments. It is likely pre-mature to consider removing passive assets from your corporation or winding up your corporation before these proposals are better understood. Any type of asset transfer or sale could create a prepayment of taxes. At this point, it would be prudent to review the level and the types of passive investments held within your corporation and consider if these investments serve a business purpose.
If the reason for keeping excess funds in your corporation is to save for retirement, you can consider retirement vehicles that are set-up within the corporation, such as an Individual Pension Plan (IPP) or Retirement Compensation Arrangement (RCA). These retirement vehicles allow you to use surplus corporate assets while deferring tax and they should not be affected by the proposed changes.
In addition, you may want to consider the benefits of re-allocating some of the excess funds in your corporation to a tax-exempt life insurance policy.
Conclusion
There is still great uncertainty as to how some of these wide-reaching proposed measures will apply. If you are involved either directly or indirectly in a private corporation, we strongly recommend that you reach out to your tax and legal advisors to determine how the proposed legislation could impact you and your future plans.
Although the consultation period has ended, Finance has stated that they will continue to solicit and listen to input on the proposed measures.
This article may contain several strategies, not all of which will apply to your particular financial circumstances. The information in this article is not intended to provide legal or tax advice. To ensure that your own circumstances have been properly considered and that action is taken based on the latest information available, you should obtain professional advice from a qualified tax and/or legal advisor before acting on any of the information in this article.
Sourced from: The Navigator. INVESTMENT, TAX AND LIFESTYLE PERSPECTIVES FROM RBC WEALTH MANAGEMENT SERVICES
October 2017
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