We're sure many of you are aware of the federal government's proposed tax changes released July 18, 2017, commonly referred to as the proposals.
Regardless of how these changes have been communicated, the proposals will have a significant impact on tax planning for all business owners, including farmers and other agribusinesses. This includes higher tax costs for family businesses, as well as more complexity and higher costs for tax compliance, retirement, succession, and estate planning.
It's important to understand how these changes will affect your business, since the Department of Finance has only given Canadians until October 2, 2017, to provide feedback on the proposals.
Background
When the 2017 federal budget was released in March, the government signaled its intention to address specific tax planning strategies involving the use of private corporations and announced it would release a discussion paper on this topic in the following months.
On July 18, 2017, the Department of Finance released the proposals, which not only included a consultation paper, but draft legislation and explanatory notes.
Specifically targeted by the proposals are the following strategies:
- Income splitting or sprinkling: The process of redirecting taxable income among family members so that the family unit pays the least amount of income tax. This includes allowing more than one family member to access the Lifetime Capital Gains Exemption (LCGE). The LCGE represents the ability to shelter up to $1,000,000 of capital gains from income tax when certain types of farm properties are sold.
- Tax deferral: The ability to delay triggering personal income tax on the after-tax income earned and retained by a corporation.
- Surplus stripping: Converting what would otherwise be a taxable dividend from a company to a capital gain, which are currently taxed at lower rates.
The rationale for introducing the proposals is that the above strategies represent “tax loopholes” that are used by “wealthy Canadians”, and is therefore unfair to non-business owners who cannot take advantage of these strategies.
Do the proposals affect my business?
Although Finance Minister Bill Morneau has suggested the proposals will only affect wealthy Canadians and the concerns of small business owners and industry groups are the result of “misinformation” in Canadian media, small businesses will be unquestionably impacted by the proposals.
If you own shares of a private farming corporation, have an interest in a farming partnership, or own farmland then the proposals will impact you and your farming business.
Although the proposals affect farmers in different ways, we are going to focus on some of the most significant areas for farmers—income splitting and access to the LCGE.
Income splitting
What is income splitting?
As noted above, income splitting (also referred to as income sprinkling) is the process of redirecting taxable income between family members to lower the tax burden for the family.
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Who is affected?
The proposals will affect income splitting between any and all family members.
What is changed?
Specifically addressed under the proposals are dividends from private corporations, income allocated from partnerships or trusts, as well as gains arising from the sale of shares of a private corporation or the sale of an interest in a partnership.
Salaries and wages paid to family members are not caught under the proposals, as there are already rules dealing with income splitting using salaries and wages.
How income splitting is affected?
The general concept is that income splitting with family members will be limited to a “reasonable” amount.
The reasonable amount will be based on the family member's labour contributions to the business, capital contributions to the business, risks assumed in respect of the business, and will account for previous remuneration paid to that family member for past efforts.
If the family member is under the age of 25, the proposals contain further restrictions on what can be considered reasonable.
If more than a reasonable amount is paid to a family member, the difference will be taxed at the highest marginal tax rate for the province of residence. Therefore the costs of making mistakes will be substantial.
Scenario 1: Incorporated business
Jack and Diane carry on a farming business through a corporation, and own shares in that corporation. Their two adult children, Bob and Sue, are also shareholders of the corporation.
Bob and Sue acquired their shares of the corporation for $1 each following an “estate freeze” by Jack and Diane. Bob is not actively involved in the farming business, while Sue is.
Although Bob is not involved in the business, part of Jack and Diane's estate plan involves paying dividends to Bob from the company, as Jack and Diane have no other significant assets outside the farm company.
Under the proposals, dividends paid to Bob would likely not be considered reasonable and therefore attract tax at the highest marginal tax rate for the province of residence. This represents a significant tax cost to Bob and effectively reduces his inheritance.
Scenario 2: Partnership
Paul and Beth are married and carry on a farming business through an informal partnership. They are equal partners and share the income of the partnership on a 50/50 basis. They both contributed equally to the partnership when it was formed.
In 2018, they had a child and they both agreed that Beth would spend more time raising the child than operating the partnership.
Under the proposals, if 50 percent of the partnership income in 2018 is allocated to Beth, some or all of that allocation could be viewed as “unreasonable” given her labour contributions for that year were not as significant as Paul's. The unreasonable amount would attract tax at the highest marginal tax rate for the province of residence. This represents a significant tax cost to Paul and Beth for what should be a simple farm partnership structure.
Impact
These proposals will make income splitting with “non-active” family members extremely difficult, if not impossible. Many existing farm business structures involve ownership by a non-active family member, and that family member may have accumulated a significant amount of value in the business. Under the proposals, it may not be possible for that family member to extract their equity in the business without incurring a significant tax cost.
The proposals will also make income splitting with active family members more complicated and costly, especially considering the cost of “getting it wrong.” There is a lot of subjectivity involved as to what is reasonable—reasonability will be viewed differently between the business owner, the family member involved, professional advisors such as BDO, and the Canada Revenue Agency (CRA).
How will a farm business determine what is reasonable compensation, both for the current year as well as cumulative efforts over past years? How will reasonability be supported, and what kind of documentation will the CRA require to support reasonability? Without specific guidelines as to how reasonability is to be determined, future disputes with the CRA are foreseeable and business owners may have to resort to going to tax court.
Finally, business owners may not be able to transition their business to non-active members of the next generation, like their children, without setting up these non-active members for significant tax costs on their share of future income of the family business.
Planning
If the proposals become law, 2017 may be the last year to achieve effective income splitting with family members, especially for non-active family members. Therefore, you may want to consider maximizing compensation for your family in 2017.
Restrictions on LCGE access
What is the LCGE
As noted above, the LCGE represents the ability to shelter up to $1,000,000 of capital gains from income tax when certain types of farm properties are sold. Access to the LCGE is extremely important for farmers who are considering their retirement, succession, or estate plans, since it can result in significant income tax savings.
How is access to the LCGE affected?
The proposals will prevent an individual from accessing their full LCGE if:
- The gain is not reasonable in light of the individual's contributions to the value of the underlying property being sold (using the same criteria discussed above for income splitting.
- NOTE: This reasonability restriction will only apply if the property being sold is a share of a private corporation or an interest in a partnership. It will not apply to a sale of individually-owned farmland.
- The individual selling the property is under the age of 18.
- Any part of the gain being triggered accrued while the individual was under the age of 18.
- NOTE: It will only be the gain that accrued while the individual was under the age of 18 that will not be eligible for that individual's LCGE.
- Any part of the gain being triggered accrued while a trust held the property, subject to some very limited exceptions which will not be applicable in most cases.
- NOTE: It will only be the gain that accrued while the property was held by a trust that will not be eligible for that individual's LCGE.
Scenario 3: LCGE
John wants to transfer a farm he owns to his grandchild, Mark. The farmland is worth approximately $1,000,000. John acquired the farm 20 years ago —the year Mark was born—for $100,000. The farm was worth approximately $800,000 2 years ago—the year Mark turned 18.
John has already used his LCGE and does not want any consideration for the farm. He wants to gift the farm to Mark and avoid triggering tax.
John is able to transfer the farm to Mark without triggering tax, using the intergenerational rollover rules.
Under the proposals, if Mark decides to sell the farm down the road, he will not be able to shelter $700,000 of the resulting capital gain using his LCGE, because that is the portion of the gain that accrued on the farm before he turned 18. This represents a significant tax cost to Mark. Absent the proposals, this gain could be sheltered.
Impact
Many family farm businesses involve property that has been transferred through generations. In many situations, individuals will own property with gains that accrued before the individual turned 18. For future succession planning, it will be necessary to determine what portion of any gain on property accrued while the intended recipient (e.g. child or grandchild) was under the age of 18. Multiple appraisals and/or business valuations could be required to calculate this gain, which will result in increased costs whenever property is sold or transferred to the next generation. In some cases, it may be extremely difficult to determine value if information is not available for earlier periods.
Many family farm business utilize a family trust structure. It will be costly to determine what portion of the gain on any farm property accrued while it was held by a trust.
Family trusts are not only used for income splitting and LCGE purposes. Many family trusts are established to facilitate the succession or estate plan for a family farm. For example, a trust structure is very useful if the current owner wants to reward the next generation for their efforts in the farm business, but the next generation is not yet ready to assume control or ownership of the business. A farm business owner will have to decide if the non-tax benefits of using a trust outweigh the possibility of losing access to their LCGE. The proposals might also force a business owner to accelerate their succession or estate plans if the family trust was a key component of that plan.
Planning
Current business structures and farm property owned directly by individuals will have to be reviewed to see if LCGE access will be prevented under the proposals. If there is a problem with future LCGE access, the special election for 2018 (see below) should be considered.
Individuals will have to consider whether they should be triggering a gain on property that is being transferred to the next generation, if the next generation is going to have issues accessing their LCGE.
In some cases, it might make sense to accelerate an existing succession/estate plan, to allow for access to the LCGE using the special election for 2018.
Special election in 2018
What is it?
There is a mechanism in the proposals which will allow for a one-time election in 2018 to trigger a gain on certain types of property, including farmland and shares of farm corporations.
The intent of this election is to give taxpayers an opportunity to access their LCGE under the old rules, if LCGE access would otherwise be prevented under the proposals as discussed above.
It is important to note that this would be a paper gain only, with the idea that it could possibly save tax down the road when the underlying property is sold.
The election is not available to minors for shares of farm corporations, but it will be available to a minor for farmland or an interest in a farm partnership.
Problems
While the one-time election does present opportunities, there are some challenges:
- Triggering the gain and claiming the LCGE may still result in tax being payable, such as Alternative Minimum Tax (AMT). Therefore, individuals taking advantage of this election might have an actual tax cost, without corresponding cash flow to pay it (this election is a paper gain after all). AMT could be as high as $50,000 or more, depending on the gain being triggered and the province of residence. Although AMT can be recovered over a seven-year period, it requires careful planning and sufficient taxable income to do so. The special election could result in a permanent tax cost.
- Triggering the gain could have a negative impact on other income-tested benefits, e.g. Canada Child Benefit, Old Age Security, and the Guaranteed Income Supplement. Consideration will also have to be given to other sources of funding and loans that are tied to income reported in tax returns (e.g. post-secondary funding).
- An individual may have more than one property that qualifies for the election, which will make it more difficult to determine whether the election should be made and on which property, with the view of saving tax in the future when the property is actually sold.
- There are certain holding period issues if farm property is transferred from one generation to the next on a full or partial tax-deferred basis, and the recipient sells that same property within three years. Transferring farm property to the next generation on a tax-deferred basis (known as the intergenerational rollover rules) is extremely common with farm retirement and succession plans. There are concerns that the election would cause problems if the individual triggering the gain received the property within the past three years using the intergenerational rollover rules for farm property.
Other measures in the proposals
The proposals contain other measures that can also negatively affect your farming business.
For example, the proposals want to eliminate the deferral benefit for private corporations acquiring passive investments using active business income. In other words, corporations that use their after-tax business profits to invest in properties like GIC's and mutual funds. This can affect incorporated farmers who are nearing retirement and planned on using the equity in their corporation to fund their retirement.
The proposals have also made it more difficult to sell shares of a family farming corporation to the next generation. Under current tax rules family members who sell shares of their family farming corporation will be at a disadvantage from an income tax point of view when those shares are sold to another family member vs. selling those shares to an unrelated party. As a silver lining the government has indicated they are considering measures to put family transfers of shares on equal footing as share sales outside the family, although legislation has not been put forward.
Conclusion
There are many issues associated with the proposals that impact your family farm business regardless of the government's comments in the media.
Whether or not you agree with the policy rationale behind the proposals, the legislation is complicated and will result in higher compliance costs for all business owners, especially farmers. The manner in which the proposals were released and the timeframe for providing feedback may not be adequate in light of the impact the changes will have on business.
What can I do?
Concerned? Many Canadians are. Industry groups and tax experts have been vocal about the proposals in the media. While the changes put forth by the Department of Finance have yet to be finalized, it does not appear that the government is changing course.
All Canadians affected by these and other proposed changes are strongly encouraged to share their opinion on these measures by writing to their members of parliament, providing feedback to their advisors, and communicating with relevant professional organizations.
We recommend you contact your professional tax advisor to discuss how the proposals will affect your specific situation.
What is BDO doing?
BDO has a number of initiatives underway in connection with the proposals.
On behalf of our clients, we submitted our concerns on the proposals directly to the Department of Finance. We have helped other organizations understand how the proposals will affect their members, as well as assisted those organizations with their submissions to the government.
Local offices across Canada have been hosting information seminars on these topics, and more are planned throughout the fall.
We are also reaching out to our clients, the general public, and other tax professionals through blog posts, webinars, and other industry presentations to increase awareness of what the proposals mean and how they will affect Canadian businesses.
For more information, please contact Kurt Oelschlagel, Agriculture Tax Leader or Mark Verwey, National Agriculture Industry Leader.
Learn more about our Canadian Tax Services.