Canadian-owned businesses are frequently carried on in private corporations owned by a controlling shareholder who is an owner-manager. This structure has recently come under scrutiny by the federal government that announced with the March federal budget that it has been studying the way private corporations are used to save taxes. At that time, the government identified three main strategies that are currently being used by owners of private corporations to take advantage of preferential tax rates. One of these strategies is using private companies to defer tax.
According to Deborah Graystone, partner and Private Client Service Practice leader, the Canadian corporate tax system for private corporations that are controlled by Canadian residents is designed around the concept that at certain levels of income, a Canadian resident individual will be tax-neutral whether that income is earned in a corporation or earned personally.
The rules can be clarified by looking at two scenarios. Grant and Alisha are both in business for themselves and are Canadian resident individuals carrying on business in Canada. Grant incorporated his business in a Canadian company, Grantco, and he is the sole shareholder, while Alisha runs her business as a sole proprietorship.
Both businesses earned an income of $300,000 last year, net of expenses. We will assume a corporate tax rate on this income of 25%, a personal tax rate on dividends paid from Grantco of 20%, and a personal tax rate on ordinary income (i.e. income that is not a dividend or a capital gain) of 40%. These tax rates are for illustration only and are representative of the current Canadian rates.
Grantco would have paid tax of $75,000 on the $300,000 of income in the company, leaving $225,000 to be paid out by way of dividend. When the dividend is received by Grant, he will pay $45,000 in personal taxes, leaving him with $180,000 after tax. Alicia would have paid tax of $120,000 on the same net income of $300,000, leaving her with $180,000 after tax.
In the situation where Grantco pays the corporate after-tax profits as a dividend to Grant, Alicia and Grant have the same after-tax income. However, if Grant does not need the profits from his company for personal use currently, then Grant pays significantly less tax now than Alicia does by earning his business income in the company. However, when Grant needs funds for personal use, and his company pays a dividend to him, he will pay the tax at that time. In the meantime, there is a deferral of the tax that he will ultimately pay.
In this illustration, the difference between personal and corporate tax rates is 15%. However, the small business deduction can reduce corporate tax to between 10.5% and 18.5%, at current rates, depending on the province, instead of the 25% used in the illustration. In many provinces, the personal tax rate rises to 50% or more. These two factors can combine to create an actual deferral of tax of up to 40% in some provinces.
It is “this ability to defer the payment of tax that the government is concerned with”, says Graystone. Even though the two-tiered tax system creates the deferral, the trend by the federal and the provincial governments over the past few years has been to lower corporate tax rates, while increasing personal tax rates, thus increasing this tax deferral for incorporated businesses. Keep in mind that the risks of a business owner differ from taxpayers who are employees, and that the risks of a business to its owner is one of the main reasons that drives incorporation and not just the tax advantages.
Graystone also notes that the above tax deferral analysis is only true for active business income earned by a private company. The same tax deferral advantage is generally not available for most investment income earned in a company due to the complex refundable tax rules, which subject the income to a high rate of tax in the company. The rate approximates the combined personal and corporate tax on the income and eliminates any tax deferral opportunity. In order to prevent double taxation, the company receives a refund of a portion of the corporate tax paid when it pays out a taxable dividend to individual shareholders, who would then pay personal tax on the dividend income.
The government mentioned in the federal budget papers that one of the three tax planning strategies that they were concerned about was “building a passive investment portfolio inside a private corporation by taking advantage of generally lower corporate tax rates”. The ability to build a passive investment portfolio only comes when the profits of the owner-managed business are not required by the owner-manager to cover personal expenses as the company must make payments to the owner-manager by way of salary or dividends in order to provide personal funds to the owner-manager.
We will need to wait to see what steps that the government might propose, if any, to address the gap between corporate and personal tax rates, which is creating the incentive for owner-managers to defer tax.
As announced by Minister Morneau at a recent Board of Trade speech in Toronto, we expect the government to release a consultation paper in the coming days or weeks proposing changes to the way private corporations are taxed as a way of dealing with these three tax savings strategies. Following the release of this paper, we will be hosting a webinar with Dave Walsh, Tax Service line leader for Canada along with a number of our partners in order to review and discuss the impact on private corporation owners. Our BDO Canada Tax advisors will remain dedicated to providing you with updates and information as it is released.
Update - July 18, 2017
Finance Minister Bill Morneau released the much anticipated consultation paper on July 18 proposing changes to how private corporations are used to gain tax advantages. The Canadian Department of Finance promised a consultation paper, however, Canadian taxpayers received proposals with effective dates and draft legislation on income splitting and conversion of capital gains. The federal government is asking for further consultation around holding passive investments inside a private corporation.
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The information in this publication is current as of June 26, 2017.
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