Tax Planning Using Private Corporations — The Government Speaks

July 2017

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Finance Minister Bill Morneau has released the much anticipated consultation paper proposing changes to how private corporations are used to gain tax advantages. The release of the proposed changes was originally announced as part of the 2017 Federal Budget and BDO Canada issued a 4 part series of blogs in late June in anticipation of the announcement in July. 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 moving ahead with these changes.

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.

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Following is a summary of what the consultation paper contains.

Income splitting

Income sprinkling

There are rules in place to curtail income splitting with certain minors (known as the tax on split income or “kiddie tax” rules). These rules prevent the transfer of income from high income earning individuals to their children under the age of 18 by taxing split income, such as dividends from private companies, as well as income from a partnership or trust derived from a business or rental activity of a related individual, at the top marginal personal tax rates.

The government is proposing to apply the tax on split income to any Canadian resident individual, regardless of age, who receives split income to the extent that the split income is determined to be unreasonable. An amount would be considered unreasonable to the extent that it exceeds what an arm’s length party would have paid. 

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.

Multiplication of the Capital Gains Exemption

A surprise in the document released yesterday 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 the family in circumstances where those individuals are legal owners of the business.

The policy paper proposes to significantly restrict the circumstances in which the LCGE may be claimed including:

  • Individuals will no longer qualify for the LCGE in respect of capital gains that accrue before that individual reaches 18 years of age.
  • The LCGE will generally not apply to the extent that the taxable capital gain arising from the disposition is included in the individual’s split income.
  • Subject to certain exceptions, gains that accrue in a trust will no longer be eligible for the LCGE.

These proposals have significant impact to many Canadian private company shareholders.

These proposed rules will generally apply to dispositions occurring after 2017; however transitional rules are being proposed for certain dispositions that occur in 2018.

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.

The government is seeking feedback with respect to suggested solutions outlined in the paper to deal with the taxation of investment income in a private corporation in order to eliminate this perceived advantage. The suggested methods would require taxpayers to identify the source of funds in the company that are being used to generate investment income, with the tax rate applied to this income being different depending on the source of funds. Additional non-refundable taxes on investment income would be used to eliminate the tax deferral advantage that accumulating investments in a corporation currently offers.

The paper is clear that the changes the government is considering should not apply to companies that reinvest the after-tax profits in the active business operations.

Converting income into capital gains

The third area addressed in the consultation paper deals with 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.

It is proposed that both of these measures will be effective as of the release date of July 18, 2017. This type of planning can no longer be implemented if these measures are enacted.

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 is asking for further consultation around holding passive investments inside a private corporation.

Individuals and businesses impacted by any of the three proposed areas of change should begin planning revised strategies as soon as possible. Please contact one of our trusted BDO advisors for assistance with this planning.

We will be releasing a more detailed Tax Alert with further analysis on these proposed changes.

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

Access the government consultation paper documents and proposed legislation.

Learn more about BDO's Canadian Tax Services.


The information in this publication is current as of July 18, 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.