Tax Planning Using Private Companies
Brent Hamilton - Nov 09, 2022
As noted in our 2017 Federal Budget summary, the federal government indicated that it would review the use of certain tax planning strategies involving private corporations that it perceives unfairly reduce personal taxes of high-income earners through a variety of tax reduction strategies unavailable to other Canadians. On July 18, 2017, the government followed up on its review of private corporation taxation by releasing a consultation paper which sets out the nature of its concerns and proposed policy responses, which was open for consultation until October 2, 2017
The following measures proposed in the consultation paper are very wide-ranging in their potential impact to private corporations. They affect many common tax planning strategies employed by family businesses and professional corporations, and seek to limit many of the current tax benefits of incorporation.
The Government is concerned with the widespread use of incomesplitting strategies involving private companies, particularly where individuals enriched are not actively involved in the business.
Active business income earned by a Canadian-controlled private corporation is generally taxed at the small business corporate income tax rate, which is significantly lower than the highest personal income tax rate. As a result, to the extent a small business owner or incorporated professional retains a portion of their business earnings within the corporation, they are able to defer paying significant income tax until a later date when the funds are withdrawn, thereby providing additional funds that could be invested by the corporation to generate investment income.
Because of this deferral advantage available to many incorporated business owners that is not available to individuals, the government is concerned with the ability of high-income Canadians to invest more (after-tax) funds within their private corporation in ‘passive’ investments (versus reinvesting in the business) than what would be available after-tax if the business income was earned personally. The government is of the view that fairness and neutrality require that private corporations not be used as a personal savings vehicle for the purpose of gaining a tax advantage. As such, it is seeking to ensure that passive investments held within privately-controlled corporations be taxed at an equivalent rate to those held outside such corporations.
Accordingly, the government is proposing fundamental changes to the current tax system of “integration” which aims to ensure that an individual is indifferent between earning income through a corporation or directly. It has therefore introduced several approaches for review and consultation to establish what it perceives as greater fairness in the tax treatment of passive investment income of a private corporation, so that the benefits of the corporate income tax rates are directed towards investments focused on growing the business, rather than conferring a personal investment advantage to the corporate owner.
The government is also concerned with the use of certain complex tax strategies by higher-income individuals to reduce their income taxes by converting dividends (and salary) that would otherwise be received from private corporations into lower-taxed capital gains. Although there is an anti-avoidance rule that deals with transactions among related parties aimed at converting dividends and salary into lower-taxed capital gains, this rule is often being circumvented. Accordingly, the government has proposed amendments to this rule to address such tax planning practices. Specifically, effective as of July 18, 2017 – the date of the consultation paper – the government proposes that: