Finance Minister Bill Morneau released the much anticipated consultation paper proposing changes to how private corporations are used to gain tax advantages on July 18, 2017 entitled “Tax Planning Using Private Corporations”. The news release from the Department of Finance, with the caption “Minister Morneau Announces Next Steps in Improving Fairness in the Tax System by Closing Loopholes and Addressing Tax Planning Strategies” continues from the original announcement in March 2017 as part of the 2017 Federal Budget.
BDO Canada issued a 4 part series of blogs in late June in anticipation of the announcement in July and you can find the first in the series here. As expected, the proposed changes are far-reaching and will impact all Canadians who use private companies, including family businesses and incorporated professionals. Certain proposals were accompanied by draft legislation with effective dates, demonstrating the government is prepared to move ahead with these changes. A summary highlight document was published by BDO Canada on July 19, 2017 and a webinar entitled “Reining In Income Sprinkling: Reviewing the Proposed Changes” was delivered by BDO on July 20, 2017, during which leaders within BDO's Canadian tax practice examined the proposed reforms in more detail and can be viewed on demand.
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The proposals focus on three main areas that the federal government believes provide unfair tax results to Canadian taxpayers:
- Income splitting with family members to reduce the overall family tax burden. This is generally achieved by having income that would otherwise be earned by an individual who is taxed at high marginal personal tax rates taxed in the hands of family members who are taxed at lower marginal rates;
- Perceived tax advantages achieved through the accumulation of a passive investment portfolio owned by a private corporation; and
- Strategies that convert regular income or dividend income of a private corporation into capital gains, which are taxed at lower tax rates.
The government has commenced a 75-day consultation process during which it will accept submissions on these proposals.
In order to provide our clients with more information about the proposed changes, what follows is a detailed examination of the proposed measures contained in the consultation paper, as well as some suggestions of what business owners can do now to start mitigating the impact of these changes and how our trusted BDO advisors can help.
Income splitting
Income splitting describes a variety of tax-planning arrangements that allow for the redistribution of income among members of the same family. This occurs when revenue and income-earning assets are transferred out of the hands of the higher-income earning family members into the hands of the lower-income family members. This strategy reduces the overall family tax burden that would otherwise occur if that same income was paid to one family member.
It is the government's view that such arrangements are possible predominantly because the private ownership of a business permits its principals to more easily control or influence the legal form of ownership of the business and the circumstances in which profits are distributed. The government contends that this can provide unfair tax advantages to high-income Canadians.
In order to constrain these perceived tax advantages, the government is proposing a number of legislative measures to limit income splitting. These proposals would be effective for 2018 and later tax years and may severely limit the ability of business owners to split income with family members.
These measures fall into three general categories:
Extension of the tax on split income (TOSI) rules
There are existing rules in place that are meant to curtail income splitting. Specifically, the tax on split income (TOSI) rules were put in place to prevent the transfer of certain types of income from high-income earning individuals to their children under 18 by taxing such income in the minor's hands at the top federal personal tax rate. Under the current rules, split income generally includes dividends received from a private corporation as well as income from a partnership or trust derived from a business or rental activity of a related individual. At present, the TOSI rules do not apply to adults (i.e. individuals 18 and over), and are therefore commonly referred to as the kiddie tax rules. Furthermore, the existing rules do not apply to income derived from salaries and/or wages. Instead, other rules currently apply to limit the deductibility of wages and other fees paid by a corporation to a family member, where that amount is determined to be unreasonable as compared to what would be paid to an arm's length third party for the same services.
The consultation paper contains proposed measures that, if enacted, will extend the TOSI rules to apply to any Canadian resident individual, regardless of age, who receives split income, to the extent that the split income is determined to be unreasonable. In this regard, the proposed measures include an extension to the meaning of a specified individual which incorporates adults, establish a reasonableness test to determine what would be included in split income, and introduce the definition of a connected individual for the purpose of determining the split income of an adult received from a corporation.
Specified individuals – Under the current TOSI rules, only specified individuals are liable for this income tax. Currently, the definition of a specified individual is limited to an individual resident in Canada who is under the age of 18. Under the proposed measures, the definition of a specified individual would be expanded to include adults (age 18 and over) who receive split income. As such, there would be two categories of specified individuals: minor specified individuals and adult specified individuals.
Reasonableness test – The distinction between adult and minor specified individuals will be relevant as the government is proposing to apply a reasonableness test to determine whether the new TOSI rules would apply to split income received by an adult specified individual. If income of an adult specified individual, that would otherwise have been considered split income, is determined to be reasonable within the meaning of the test it will be excluded from split income and thus not subject to TOSI. The reasonableness test is proposed to apply differently depending on the age of the adult specified individual. Specified individuals between the ages of 18 and 24 will be subject to more stringent tests for reasonableness than specified individuals 25 years old and over. The government believes that higher-income earning individuals with younger adult family members (i.e. between the ages of 18 and 24) are currently enjoying additional benefits when seeking to split income, since these younger adult family members tend to have lower income and therefore lower marginal tax rates.
In applying the reasonableness test to split income of an adult specified individual, several criteria will be considered. For labour contributions (e.g. salaries and wages), adult specified individuals between the ages of 18 and 24 must demonstrate that they are actively engaged on a regular, continuous and substantial basis in the activities of the business in order to meet the test for what is reasonable. For those 25 years of age and over, it will be sufficient to show that the specified individual was involved in the business. For capital contributions, the reasonableness test for specified individuals between the ages of 18 and 24 will be set at a legislatively prescribed maximum in respect of an allowable return on assets contributed by the individual in support of the business. It is expected that the prescribed rate will follow current prescribed rates for shareholder benefits. For specified individuals over the age of 24, the reasonableness test will consider the extent that the individual contributed assets, or assumed risk, in support of the business. Additionally, the proposed reasonableness test will consider all previous amounts paid or payable to the individual in respect of the business.
Connected individual – This new definition is being proposed as a means of determining whether an adult specified individual's income from a corporation (or trust or partnership in certain circumstances) is to be treated as split income. A connected individual would be an individual who exerts a certain measure of influence over the entity, as specifically defined under the proposed legislation. Where an adult specified individual receives split income from a connected individual, it would have to be determined whether a portion of that income is unreasonable (according to the factors set out in the reasonability test) for the purposes of applying the TOSI.
As mentioned, these proposed measures are intended to apply to 2018 and later taxation years. It is evident that these proposals, if enacted, will severely limit the ability of business owners to split income with family members through the payment of dividends on separate classes of shares held by those family members. They will also eliminate the ability of many professional service firms to split income with family members through the use of a service vehicle (a corporation or partnership owned by family members that provides certain services to the professional service firm for a fee).
Planning Consideration: Consideration should be given to maximizing income splitting with adult family members in 2017 as allowed under the existing rules, before the proposed rules become enacted. For example, it may be beneficial to maximize dividend payments to family members in 2017 as those payments may be subject to the TOSI in 2018. Please consult with our trusted BDO advisors to determine whether this is an effective plan for you and your family.
Constraining access to the lifetime capital gains exemption
A surprise in the document released by the federal government was the significant restrictions proposed for the use of the lifetime capital gains exemption (LCGE). The LCGE provides an exemption in computing taxable income in respect of capital gains realized by individuals on the disposition of qualified small business corporation shares and qualified farm or fishing property. The LCGE may be claimed by several members of a family in circumstances where those individuals are legal owners of the business.
The federal government contends that the current tax rules “do not appropriately constrain the multiplication of access to the lifetime capital gains exemption (LCGE)”. The government views that these individuals may not have effectively contributed to the business in respect of which the exemptions are being claimed and the government believes this should be stopped. The government is also concerned about the use of family trusts, primarily those that are discretionary, to allocate capital gains and income among family members.
In response to these concerns, the government is proposing three general measures to limit situations that currently allow for the multiplication of the LCGE.
Age limit – An age limit is being proposed so that individuals will no longer qualify for the LCGE in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual turns 18 years old.
Reasonableness test – The proposed measures include a reasonableness test such that the LCGE will generally not apply to the extent that the taxable capital gain arising from a disposition is included in an individual's split income.
Trusts – The proposed measures would ensure that, subject to certain exceptions, gains that accrued during the time that property was held by a trust will no longer be eligible for the LCGE. In this regard, an exception will be provided for capital gains that accrue on property held by a spousal or common-law partner trust or an alter ego trust, where the individual claiming the LCGE is the trust's principal beneficiary, as well as for certain employee share ownership trusts. Note that this measure would apply in situations where the trust realizes a capital gain and allocates it to a beneficiary, as well as to situations where the trust elects to transfer the property with an accrued gain to a beneficiary who realizes the gain at a later date on a disposition of the property.
These proposed rules will generally apply to dispositions occurring after 2017. However, it is important to note that transitional rules are being proposed for certain dispositions that occur in 2018, allowing an individual to elect to realize, on a day in 2018, a capital gain in respect of eligible property by way of a deemed disposition for proceeds up to the fair market value of the property.
Planning Consideration: There may be a window of opportunity to make the election referred to above such that realized capital gains would be eligible for the LCGE under the existing tax rules. Please consult with our trusted BDO advisors to determine if there is an opportunity and benefit to elect and create a deemed disposition of eligible property in 2018 so that the taxable gain can be reduced by the LCGE. Similarly, if the shares of a business are held in a discretionary family trust, it is critical that you contact us in order to help you determine whether you might benefit from making this election in 2018.
Supporting measures to improve the integrity of the tax system in the context of income sprinkling
Additional measures have also been proposed in an effort to ensure that trusts are subject to information reporting rules that are consistent with the existing rules for corporations and partnerships. The proposed measures will assist in improving the administration of the income tax rules to address income sprinkling and would apply for 2018 and subsequent taxation years.
Holding passive investments inside a private corporation
The concept of integration in the Canadian tax rules ensures that an owner-manager carrying on a business in a corporation pays essentially the same amount of tax on that business income as they would pay if they had earned that income personally. The business income earned is taxable in the corporation and the dividend distributed to the owner-manager is taxable to the individual.
The current system allows for a tax deferral of the individual tax payable if the shareholder leaves the funds in the corporation. The government believes that this tax deferral results in a significant tax advantage to owners of private corporations. For example, assuming a small business tax rate of 15% applies, an individual earning active business income of $100 in their private corporation would have $85 after-tax to invest passively if those funds are retained in the corporation. In contrast, if an individual earned the same $100 as salary, assuming they are subject to a high personal tax rate of 50%, they would have $50 after-tax to invest personally. The government believes that the additional $35 of capital available to corporate owners to invest in passive investments when using a corporation results in a significant advantage that grows over time.
The existing rules also apply additional refundable taxes on passive income earned in a corporation, which are then generally refunded on the payment of dividends to shareholders. However, the rules do not differentiate between the source of capital used to fund the passive investment. If the funds invested are from retained earnings that have been taxed at the corporate tax rate on active business income, the government believes this additional capital is an advantage and they want to close this gap. It is important to note that passive investments can be held by any type of business and the income earned on these types of investments can take many forms, including interest, dividends, rental income, or capital gains.
The government has not yet introduced draft legislation to deal with how to bridge the divide caused by lower corporate tax rates as compared to higher personal tax rates. They are seeking feedback with respect to a new system of taxation for investment income in a private corporation. It is intended that any changes made would apply on a prospective basis.
A key element of the suggested new system of taxation of passive investment income is identifying the source of funds in the private company that is being used to generate the income, and determining the tax rate that applied when earning that source of funds. To accomplish this, income would generally be divided into three pools based on the tax rate that had applied to that income. Under this suggested system, the source of the funds would then determine the rate at which the investment income earned by such funds would be taxed.
Another key element of the suggested new system is removing the refundability of passive investment income taxes where earnings used to fund passive investments were taxed at low corporate tax rates. In general, if the invested funds come from a low-tax rate pool, then a non-refundable tax would be imposed to even-out the overall tax when compared to earning the same investment income personally. The non-refundable tax would in essence claw-back the advantage of starting with a larger investment base in a corporation as compared to investing after-tax personal capital.
The government indicates in the consultation paper that the implementation of the suggested system could be made in two general ways — with the use of either an apportionment method or an elective method. Generally, the apportionment method would entail tracking the source of income used to acquire investments, as well as the income that the investment generates. The government recognizes that this method would be very complex in practice and outlines a possible method for consideration.
Alternatively, the elective method would subject private corporations to a default tax treatment, unless an election is made. Either the default tax treatment or elective treatment would then determine how the passive income will be taxed without the need for detailed tracking. Specifically, under the default tax treatment, passive income would be subject to non-refundable taxes (at rates equivalent to the top marginal tax rate). Then, dividends distributed to the shareholder would be taxed as non-eligible dividends. This method assumes that the passive income is funded by income taxed at the small business rate and that shareholder contributions were not used to fund passive investments. For corporations that are subject to the general tax rate on all or most of their income, an election could be made to have additional non-refundable taxes apply on passive income and treat dividends paid out from passive income as eligible dividends, which provide a higher dividend tax credit to the shareholder. However, it is important to note that this election would remove the corporation's access to the small business rate.
In respect of capital gains, the paper confirms that the 50% inclusion rate will continue to apply, and that such income will continue to be subject to passive investment income taxes. However, it is contemplated that the suggested new system would eliminate the ability for corporations to add the non-taxable portion of capital gains to the capital dividend account, where the source of capital of the investment is income taxed at corporate tax rates. This would reduce the amounts that can be distributed tax-free to shareholders through the capital dividend account rules.
The government is seeking ideas that would yield the best approach to maintain tax fairness without undue complexity. Also note that the paper is clear that the changes the government is considering should not apply to companies that reinvest their after-tax profits in their active business operations.
Converting income into capital gains
The consultation paper also has proposals that will impact the manner in which shareholders of private corporations extract funds from their corporations. A significant tax benefit can be obtained by individual shareholders with higher incomes when planning is undertaken to convert corporate surplus that would normally be taxable as dividends or salary into lower-taxed capital gains. This is often referred to as surplus stripping.
In an effort to prevent such planning, the government is proposing two measures to prevent the surplus income of a private corporation from being converted to a capital gain and stripped from the corporation. The first is the expansion of an existing anti-avoidance rule to include situations where the cost base of shares transferred to a non-arm's length corporation is increased in a taxable transaction, and that allows for this cost base to be extracted. The second is the proposal of a new anti-avoidance rule aimed specifically at surplus stripping.
Anti-avoidance rule expanded – The first measure targets the anti-avoidance rule under section 84.1 of the Income Tax Act. This rule may apply when an individual sells shares of a Canadian corporation to a non-arm's length corporation and the two corporations are connected immediately after the sale. Currently, this rule prevents surplus stripping to the extent that the cost of an individual's share represents capital gains realized by the individual (or a non-arm's length individual) on which the LCGE is claimed (or that represents pre-1972 surplus that arose before the capital gains tax applied). When the rule applies, non-share consideration may be treated as a dividend, rather than as a capital gain. However, the rule is limited in application, and surplus stripping transactions have been planned to ensure this current anti-avoidance rule does not apply.
It is proposed that the anti-avoidance rule be extended to apply to situations where the cost base of shares is increased in taxable non-arm's length transactions. The purpose of this proposal is to ensure that a taxpayer cannot extract corporate surplus on a subsequent sale to a non-arm's length company to the extent that the cost base of the shares is a result of previously realized non-arm's length capital gains. It is noted that in some cases a capital gain will be realized on the initial sale of shares as well as a deemed dividend on the subsequent non-arm's length sale of those shares, resulting in double taxation. This is a very punitive outcome for such planning and as such it will serve as a significant deterrent.
New anti-stripping rule – The second measure is the proposal of a new separate anti-avoidance rule. This proposed rule will apply to prevent the distribution of corporate surplus to an individual shareholder resident in Canada on a tax-reduced or tax-free basis in a non-arm's length transaction, where that surplus would otherwise be distributed as a taxable dividend. This rule will apply where it can reasonably be considered that one of the purposes of the transaction (or series of transactions) is to cause a significant reduction or disappearance of assets of the private corporation in a manner that the tax on the amounts received is less than what the individual would have paid if the corporation had paid them a taxable dividend immediately before the transaction. In such a case, the individual will be treated as having received a taxable dividend.
Planning Consideration: Draft legislation has been released for these anti-surplus stripping measures, and, if enacted, both are to be effective July 18, 2017, closing down targeted planning immediately. As a result, any planning currently being considered that will result in surplus being taxed as a capital gain should be reviewed to determine if it will be impacted by the proposals. These changes also put into question the use of pipeline transactions in post-mortem planning which have provided access to capital gains rates on death. This means that consideration will need to be given to this type of planning as well. Our trusted BDO advisors can assist you in navigating the complexities of these proposals with respect to your planning.
The government also indicated it would consider whether there are features of the current income tax system that have an inappropriate and adverse impact on genuine business transactions involving family members. A concern has been raised that the application of current anti-avoidance rules can be an issue in certain cases on the transfer of a business from one generation to another within a family because the LCGE would not be available. The government has requested feedback from stakeholders on how the tax rules could better accommodate genuine intergenerational business transfers while protecting against potential abuses that could arise with certain planning.
Summary
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 asked for further consultation around holding passive investments inside a private corporation and requested public input on the proposals by October 2, 2017.
BDO submitted feedback to the government on these targeted and complex changes on behalf of our clients, with their best interests in mind. We welcome your views on the proposals that have been released. Please contact one of our trusted BDO advisors to help determine the impact of the proposals on your private corporation tax planning.
View all of BDO's related content in our Private Corporation Tax Changes Round-up resource.
Dave Walsh
Canadian Tax Service Line Leader
Rachel Gervais
GTA Tax Service Line Leader
Peter Routly
Central Canada Tax Service Line Leader
Daryl Maduke
Western Canada Tax Service Line Leader
Shelley Smith
Eastern Canada Tax Service Line Leader
Learn more about BDO's Canadian Tax Services.
The information in this publication is current as of July 28, 2017.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.