In July 2017 the government has proposed significant changes that will affect how many privately owned corporations are to be taxed in Canada. Although the changes were introduced by the way of a discussion paper; there is much consensus that many of these changes will be enacted in October 2017.
The Department of Finance has outlined a series of proposed measures to shut down some of the current tax planning strategies available to owners of such private corporations.
In short, the proposed measures are aimed at:
- disallowing income sprinkling with family members
- preventing investment income from being earned within private corporations by taxing them at punitive rates, and
- disallowing owners of private corporations to reduce their overall tax cost by converting income into capital gains (most commonly seen at retirement).
Income sprinkling is the practice of distributing income that would be taxed at the highest personal rates if earned by owners directly, to family members that are subject to lower personal tax rates. Previously, there were rules regarding the taxation of split income that applied to minors.
Now, these rules may extend to other adults as well, particularly those of ages between 18-24 years old. This would however also depend on the level of involvement of the recipient with respect to their contribution to the business’ capital or labour, frequency of income allocations, and if there was any risk acquired by the recipient.
Any unreasonable/unjustifiable amounts would be subject to the highest marginal personal tax rate. This measure is proposed to take effect for the 2018 and following tax years and is particularly worrisome as it will eliminate the ability of small business owners that own corporations to income split with those not involved in the day to day operations of the business.
Furthermore, there would also be new measures brought in to prevent business owners from splitting the capital gain with family members upon the sale of a business.
In order to reduce the tax on a capital gain arising from the sale of their company, current tax planning strategies often use trusts and/or other structures to multiply the number of lifetime capital gains exemptions available to family members.
The proposed measures would limit the use of the exemption to only shelter the portion of the capital gain related to the period that begins with the taxation year in which the said family members turn 18 until the date of disposition. It would also not be available for capital gains related to periods where a trust held the shares and gains that are included in an individual’s split income.
Earning Investment Income
Many small business owners often look to accumulate wealth within their corporations by holding passive investment portfolios therein. This is due to the corporate income tax rates being generally lower than the personal tax rates.
This creates an incentive often referred to as a tax deferral to keep money within their corporations allowing them to use pre-tax dollars to invest allowing them to build their investment portfolios much quicker than outside of their corporation.
The proposed measures would look to affect private corporations by increasing the way such passive investments are to be taxed – thus removing the incentive to keep money within the corporation. The proposed approach would remove the inclusion of the non-taxable portion of capital gains in the capital dividend account for those gains related to an investment acquired using active business income.
There will be further consideration made regarding whether additions to the capital dividend account should be preserved in certain limited situations. The new rules would be applied going forward and would certainly have an impact on how tax professionals and financial advisors advise their clients on maintaining their investments.
Converting Corporate Income into Capital Gain
Generally, lower tax rates would apply if an owner of a private corporation received a distribution as a capital gain instead of a salary or dividend income. In 2017, the highest marginal tax rates applicable to an Ontario resident are:
- Regular income (including salary): 53.53%
- Non-eligible dividends: 45.30%
- Eligible dividends: 39.34%
- Capital gains: 26.76%
Surplus stripping is the act of extracting a corporation’s net assets in the form of a capital gain instead of a dividend. This generally includes a sale of the individual’s shares to a non-arm’s length corporation.
The proposed measures would reduce the cost base of an individual’s shares by an amount equal to all capital gains realized on previous dispositions of shares by the individual and any non-arm’s length individuals. Right now, a cost basis reduction would only occur if the capital gains exemption was previously claimed on the share.
In the case of situations where it’s reasonable to consider that one of the purposes of a transaction was to provide an individual with non-share consideration in a manner that caused a “significant disappearance” of the corporation’s assets, the non-share consideration will be treated as a taxable dividend.
These rules would apply to share dispositions and amounts that were received or became receivable on/after July 18, 2017.
Questions? Schedule a call to discuss your tax situation
The proposed legislation will have a critical impact on the taxation of private corporations and their owners, possibly even leading to double taxation. It is important that owners of private corporations revisit their current business strategies in terms of tax and financial planning by evaluating the effects of the proposed measures.
Although we are hoping that not all of the proposed changes become enacted; we are keeping abreast of this discussion papers and will inform you what actually gets approved in the fall. Until then, please do not hesitate to contact us with any further questions.