Tax Planning Using Private Companies
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.
a) Extension of the “kiddie tax” (Tax on Split Income)
New proposals released as draft tax legislation in the consultation paper include an extension of this existing tax on split income for minors (i.e., kiddie tax) to also apply to adults (of any age) in certain circumstances after 2017, as follows:
• Dividends and other amounts received from a business by an adult family member of the principal of the business, may be subject to a reasonableness test which will be stricter for those aged 18 to 24.
• The reasonableness test will be based on the contributions made (e.g., labour and capital) by the family member to the business, taking into account previous returns/remuneration, in light of the appropriate compensation that would be provided to an arm’slength person for similar contributions.
• To the extent the amount is not reasonable, the top tax rate will apply to the dividend income, regardless of the individual’s actual marginal tax rate.
Other changes proposed are intended to improve the existing kiddie tax rules and support these additional measures, including expanding these rules to encompass reinvested “compound” income on affected distributions received by individuals under age 25, and gains from dispositions after 2017 of certain property, the income from which is considered “split income.”
b) Restrictions on the multiplication of the lifetime Capital Gains Exemption (CGE)
In conjunction with the government’s intent to limit the tax benefits of family members not actively involved in the business, another specific concern of the government is the use of family trusts to “multiply” access to the CGE limits (currently $835,716 for 2017) to other family members to reduce capital gains tax.
Three general measures are proposed to address CGE multiplication, as follows:
• First, individuals would no longer qualify for the CGE in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual attains the age of 18 years.
• Second, the CGE would generally not apply to the extent that a taxable capital gain from the disposition of property is included in an individual’s split income (as part of the expanded kiddie tax provisions previously discussed).
• Third, subject to certain exceptions, gains that accrued during the time that property was held by a trust would no longer be eligible for the CGE.
These proposed measures would apply to dispositions after 2017. However, special transitional rules are also proposed.
2. Passive investment income
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.
Specifically, it is the government’s intention that the proposed approach would:
• eliminate the tax deferral advantage on passive income earned by private corporations;
• preserve the intent of the lower corporate taxes to support growth and jobs;
• ensure that private corporation owners do not have access to tax preferred savings options not available to others
• make the system neutral on a go-forward basis; and
• limit, to the extent possible, the complexity of these new rules
At this stage, no draft legislation has been introduced, instead the government announced that it will be seeking the feedback of stakeholders on the design considerations associated with each of the possible approaches introduced. The government intends to release a detailed proposal following these consultations, and indicated that it will provide time before any proposal becomes effective.
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:
3. Converting income into capital gains
• This anti-avoidance section be amended to prevent individual taxpayers from using non-arm’s length transactions that ‘stepup’ the cost base of shares of a corporation in order to avoid its application on a subsequent transaction.
• The Income Tax Act be amended to add a separate “anti-stripping” rule to counter tax planning that circumvents the specific provisions of the tax law meant to prevent the conversion of a private corporation’s surplus into tax-exempt, or lower-taxed, capital gains.