Canadian Private Corporations Upset
On July 18, 2017, Canada’s Minister of Finance, William Morneau, released the consultation paper “Tax Planning Using Private Corporations” and corresponding draft legislation. The paper is a follow-up to the 2017 Federal Budget, which identified tax-planning strategies that owners of private corporations are utilizing to gain what the government views as unfair tax advantages.
The paper proposes measures to address the following four tax planning strategies commonly used by owners of Canadian private corporations:
- sprinkling income using private corporations;
- accessibility to life time capital gains exemptions;
- holding a passive portfolio within a private corporation; and
- converting a private corporation’s regular income into capital gains.
The proposals, if enacted, will significantly change the tax planning landscape for private corporation owners, many of whom are professionals and small business owners.
The Ministry of Finance is accepting submissions on these proposals until October 2, 2017. Many of the proposed tax measures are expected to be implemented on January 1, 2018.
The measures proposed are as follows:
1. Sprinkling Income Using Private Corporations
Income sprinkling (also known as income splitting) is regularly used as a strategy have income that would otherwise have been taxed as income of a high-income individual taxed as income of a lower-income individual, typically a family member of the high-income individual.
There are some limits currently in place to limit income sprinkling – the Income Tax Act presently includes rules to curtail the use of this planning, including a rule that applies a special “tax on split income” (TOSI or “kiddie tax”) to make sprinkling of certain income to minor hildren less advantageous.
The proposed measures would extend the TOSI rules from children under the age of 18 to adults receiving split income. A “reasonableness” standard would be introduced which considers labour and capital contributions, and, for adults over the age of 18, only the amount that is considered to be “unreasonable” in the circumstances would be subject to the TOSI.
This reasonableness test would apply differently based on the age of the adult and is more restrictive for adults age 18-24, a group with whom income sprinkling is most often used. For adults age 18 to 24, the TOSI would also apply to “compound income” – income derived from an investment of split income, whether or not it meets the reasonableness test. These measures would apply for the 2018 and later taxation years.
2. Accessibility to life time capital gains exemption
The current tax rules allow you to multiply the life time capital gains exemption (“the LCGE”) available if your family members also own shares in the corporation, either directly or through a family trust.
The government proposes to disallow the use of the LCGE in respect of capital gains that are realized or accrue before an individual turns 18. The LCGE would also not apply to the extent that a taxable capital gains from the disposition of property is included in an individual’s split income. Finally, with the exception of joint partner trusts, alter ego trusts and certain employee share ownership trusts, gains that accrued during the time that property was held by a trust would no longer be eligible for the LCGE. The proposed measures would apply to dispositions after 2017, although transitional provisions have been proposed as well.
3. Holding a Passive Portfolio Inside a Private Corporation
Corporate income is taxed at lower rates than personal income, to give businesses more money to invest in order to grow their business. When private corporations earn income beyond what is needed to re-invest and grow the business, business owners are able to hold passive assets inside the corporation to utilize the preferential corporate tax rate. This planning has been widely utilized by professionals as a form of retirement planning.
The government seeksto neutralize this ability while preserving the intent of the lower tax rates on active business income, which is to encourage growth and job creation. They have not yet proposed draft legislation, but are considering several options involving the refundable tax provisions to achieve this objective.
4. Converting a Private Corporation’s Regular Income into Capital Gains
An individual can reduce their income tax rate by converting their private corporation’s surplus into capital gains and taking advantage of the lower tax rates on capital gains versus the individual’s personal income tax rate. This can be done by paying out some portion of the surplus to a non-arm’s length corporation (for example, to another corporation owned by the individual) and having the non-arm’s length corporation use that surplus to pay the individual, instead of the individual paying themselves directly from the first corporation.
The Income Tax Act currently has an anti-avoidance rule to ensure that a corporate distribution is properly taxed as a taxable dividend when an individual sells shares of a corporation to a non-arm’s length corporation. However, the application of this anti-avoidance rule has not always been effective.
The proposed measures would extend the current rules to cases where the shareholder’s adjusted cost base is increased in a taxable non-arm’s length transaction. There would also be a separate anti-stripping rule added to counter tax planning that circumvents the specific provisions meant to prevent the conversion of a private corporation’s surplus into lower-taxed capital gains. The rule would treat non-share consideration as a taxable dividend in a non-arm’s length transactions where it is reasonable to consider that one of the purposes of the transaction was to pay an individual shareholder/vendor non-share consideration that is otherwise treated as a capital gain. Both measures are proposed to apply to transactions that occur on, or after the date of the release of the consultation paper.