Tax Planning Using Private Corporations – An Update
On July 18, 2017, the Minister of Finance released a consultation document announcing the government’s intention to limit certain tax planning transactions undertaken by shareholders of private corporations. During the consultation period, which ended on October 2, 2017, various stakeholders provided comments on the proposed changes. During the week of October 16 – 20, 2017, the government provided additional information on how it will proceed with the changes. This article will summarize where we currently stand on the three main issues: income sprinkling, passive investments and surplus stripping.
Income sprinkling is the transfer of income from a person in a high tax bracket to a family member in a lower tax bracket (usually a spouse or adult child). When done correctly, the family’s overall tax burden can be reduced. Income splitting was typically achieved where a spouse and/or adult child received dividends from a private corporation. Corporate structures with family trusts could achieve similar results.
Similarly, these types of structures could also be used to multiply access to the Lifetime Capital Gains Exemption, which can shelter a capital gain on the disposition of qualifying shares up to $835,716 (indexed to inflation). Having multiple family members access this exemption on the sale of a company to a third party could yield substantial tax savings.
July 18 – Proposal
Through numerous and complex changes to the Income Tax Act, the government proposed to legislate a “reasonableness” test on the amount of dividends received by a spouse or adult child (or any other family member). No reasonableness test previously existed for dividends. The “reasonableness” test looks at factors such as labour performed, capital contributed, risks assumed and compensation otherwise received (via payroll). If the amount of the dividend paid to a family member is not “reasonable” or comparable to what a third party would have been willing to pay (based on the factors), the unreasonable portion of the dividend is taxed at the highest marginal tax rate. Therefore, private companies that were income sprinkling with dividends to a spouse and/or adult children that had little to no activity in the business would lose any benefit of income sprinkling. These changes are proposed to take effect on January 1, 2018.
Regarding the multiplication of Lifetime Capital Gains Exemption (LCGE), the government proposed that any gain accrued while the property was held within certain trusts (such as a family trust) would be ineligible for the LCGE. Additionally, gains realized by family members would be subject to the same reasonableness tests outlined above.
October 16 – Update
An unexpected corporate tax rate cut was announced. For businesses in Ontario the combined rate on income eligible for the small business deduction will be 14.5% starting on January 1, 2018 and 13.5% for 2019 and beyond. The current rate is 15%.
The government will be making changes to simplify their proposals for income sprinkling. However, based on the information released it appears they will still be attempting to legislate a “reasonableness” test. Later in the fall, the government will release revised draft legislation for the provisions which will be effective on January 1, 2018.
Due to unintended consequences such as the inter-generational transfer of a business, the government will not proceed with measures aimed at multiplying the capital gains exemption.
The owner of a private corporation that is generating excess cash flow can benefit from a tax deferral not available to an employee. If the owner of a private corporation already has enough income with which to live, the excess corporate income (which has only been taxed at a modest corporate rate of 15% and/or 26.5%) can be invested in passive investments. An employee does not have the ability to defer tax on an unlimited amount of income. Despite the fact that the corporation will pay a high tax rate on its investment income and that the owner will eventually have to pay themselves dividends, the government still feels this deferral advantage is unfair.
July 18 – Proposal
No legislation on how the government plans to curb this deferral was provided. Several possible methods were explained in theoretical detail. All methods were admittedly complex and none perfect. The government wants to encourage investment into the business but discourage investment into passive assets. Some of the methods explained in the consultation document involved extremely high tax rates on investment income earned by a private corporation.
October 18, 2017
The government confirmed that all past investments and the income earned will be protected (i.e. grandfathered into the new regime). There will be a $50,000 threshold on passive income earned in a year which will allow the accumulation of a modest portfolio of passive investments within a corporation before the new punitive regime kicks in.
The government will release draft legislation to limit the deferral opportunities as part of Budget 2018. The draft legislation will include provisions to ensure these rules only apply on a go-forward basis.
Currently only 50% of a capital gain is included in the taxable income of an individual. While dividend tax rates are lower than ordinary income, they are not as low as the effective rate on a capital gain. Therefore, the owner of a private corporation would rather structure payments from the company as capital gains rather than dividends. There are various ways to accomplish such a feat which usually involve a complex series of transactions. The conversion of dividend income into a capital gain using such a series of transactions is called “surplus stripping”.
July 18 – Proposal
The government announced two measures which were to take effect on July 18, 2017. First, they proposed to amend a pre-existing anti-avoidance section of the Income Tax Act. The amendment would make it virtually impossible to access the Adjusted Cost Base of shares and receive a distribution from a corporation in a tax favorable manner. Therefore, transactions aimed at deliberately triggering 50% taxable capital gains, building Adjusted Cost Base and stripping it from the corporation would be caught and deemed to be dividends.
Second, a very broad new rule was proposed that would deem certain receipts from a corporation to be dividends. This new section could apply if one of the purposes of a series of transactions was to effect a “disappearance” of corporate assets in a manner where the tax was less than if a dividend would have been paid.
October 19 – Update
The government will not be moving forward with measures relating to the conversion of income into capital gains. The government said that unintended consequences such as taxation upon death and challenges with intergenerational transfers of businesses could arise.