On July 18, 2017, the federal Department of Finance released legislative proposals and a consultation paper dealing with tax planning affecting private corporations. The goal is to close loopholes that allow wealthy Canadians to avoid higher tax rates, largely by targeting people who incorporate themselves and then draw income from their businesses while paying lower corporate taxes. The Department of Finance believes about 50,000 families in Canada do this, a practice the government calls income sprinkling.
These proposals, if enacted, will potentially affect most Canadian business owners who carry on their businesses through private corporations, significantly increase the complexity of the tax rules applicable to private corporations and reverse many long-standing tax policies that have encouraged business growth.
The Government of Canada is consulting Canadians on three tax practices that they allege “are being used to gain unfair tax advantages”:
The proposals will eliminate most common income splitting strategies used by small businesses. Currently, the rules allow a spouse and children over the age of 18 to be shareholders of a private corporation (known as adult shareholders) and receive dividends from the corporation. Such dividends are then taxed in the hands of the shareholder at his or her personal graduated income tax rate.
The proposed legislation significantly expands the scope of the tax on split income, which is currently known as the “kiddie tax,” to dividends and other amounts received from a corporation by adult shareholders.
Currently, the kiddie tax applies to the “split income” of a child under the age of 18, to the amount of the child’s unearned income (such as certain dividends on private company shares, trust allocations or partnership income) and capital gains realized on dispositions to non-arm’s-length persons. The kiddie tax rate is the marginal tax rate (the highest rate applied to the last dollar earned).
The proposals extend the “tax on split income” (TOSI) to any Canadian resident who receives income from a related business if the income received is unreasonable in the circumstances having regard to the labour and capital contributed by the individual to the business.
Accordingly, income earned by persons aged 18 to 24 will be subject to a higher degree of scrutiny to establish that the income is reasonable. Moreover, under the proposals, dividends and other amounts received by a family member of the principal of the business may be subject to a reasonableness test.
The reasonableness test will require the family member to show that the amount of the dividend is reasonable given his or her labour contributions to the activities of the business, his or her assets contributed or risks assumed in respect of the business and his or her previous returns and remuneration paid to him or her. If the reasonableness test is not met, the dividend or amounts received by the family member from the business will be taxed at the highest personal income tax rate.
The proposals extend the tax on split income to income from certain indebtedness to capital gains if the income on the disposed property would have been subject to the tax on split income, and to any income realized by minors and certain adults under the age of 25 that is derived from after-tax earnings that were subject to the tax on split income or the attribution rules in the Income Tax Act.
If the proposals are enacted, the TOSI will apply to dividends and other amounts received in 2018.
Measures are also proposed to address other “income sprinkling” issues, including the multiplication of claims to the lifetime capital gains exemption.
Lifetime capital gains exemption
A common tax planning strategy under the current rules is to have a family trust (with family members, including minors, as beneficiaries) hold the common shares of an active business in Canada. On a future sale of the shares of the corporation to a third party purchaser, the capital gains would be realized by the family trust and the gains would be allocated to one or more beneficiaries of the trust. If the beneficiary has not claimed his or her lifetime capital gains exemption (in 2017, the exemption is $835,714), he or she may claim such exemption to shelter all or a part of the gains allocated to him or her.
The new rules include no lifetime capital gains exemption in respect of capital gains from a disposition after 2017 (subject to the transitional rules) for minors (individuals under the age of 18), for gains while the corporation was held by a trust and where income relating to the gain period was caught by income splitting explained above.
These proposals would also restrict the ability to claim the lifetime capital gains exemption to many family business owners who have undertaken typical estate planning transactions and introduce substantial uncertainty relating to the valuation of property where only part of the ownership period is during the denial period.
The proposals refer to a special election in the 2018 taxation year to allow individuals to crystallize their unutilized capital gains exemption.
If the proposals are enacted, the rules will apply to dispositions after 2017.
The change also includes an expansion of Section 84.1 of the Income Tax Act to reduce the ability to strip value out of corporations as capital gains rather than dividends.
The government is concerned that individuals who carry on business through a corporation can leave their business income in the corporation to make passive investments, thereby providing a tax deferral advantage to these individuals.
Holding a passive investment portfolio inside a private corporation may be financially advantageous for owners of private corporations compared to other investors. This is mainly due to the fact that the small business rate or the general corporate rate, which are generally much lower than personal rates, facilitate the accumulation of earnings that can be invested in a passive portfolio. As a result, if the after-tax business income is retained in the corporation, a larger sum is available to invest.
The government released proposed changes to target those who gain tax relief through passive investment income, which enables corporate owners and employees to make one-time investments from $100,000 of pre-tax income and retain them for 10 years.
Several proposals are being considered to discourage passive investments in corporations. The proposals consider both an apportionment method and an elective method to determine the source of the income. A further election is envisioned for corporations focused on passive investments to maintain the current system. An exception would be made where the investments are funded by income contributed to the corporation by a shareholder from income taxed at the personal rate.
There will be a 75-day public consultation period to allow stakeholders to examine and weigh in on the three sets of proposals. The deadline for submissions will be October 2, 2017. More on how to submit and access to consultation paper can be found here.