In the 2017 Federal Budget, the Liberal Government vowed to tighten tax rules that allow some Canadians to utilize private corporations to unduly reduce the payment of income taxes. This is in keeping with the Liberal Government's theme of robbing the rich to give to the middle class and making the tax system a more "fair and efficient tax system for Canadians." See the author's earlier posts on previous measures to tax the rich. On July 18, 2017, the Government released draft legislation and a consultation paper regarding its proposed measures to curb the use of three tax practices which utilize private corporations to gain "unfair tax advantages."
1. Income Sprinkling (Including Restrictions on the Use of the Lifetime Capital Gains Exemption)
This involves diverting income from high-income individuals to family members with lower personal tax rates (or those who pay no tax) through the use of a private corporation. The Government is concerned that high-income business owners are splitting their income with low-income earners, regardless of whether such low-income earners are involved in the business.
The Government's proposals seek to expand the tax on split income rules to add a "reasonableness test" for relatives who draw revenue from a corporation, with a particular emphasis on adult children. A family member receiving salary or dividends will now be tested on three areas in relation to a business: (i) the labour contributions of the individual, (ii) the assets contributed or risks assumed by the individual, and (iii) the previous returns/salary paid to the individual. This proposed measure is designed to prevent private corporations from shifting or "sprinkling" income to adult relatives who are not active in the business.
In addition, planning involving the lifetime capital gains exemption (LCGE) is also being restricted, to limit the availability of the LCGE to those low-income earners discussed above and to prohibit the multiplication of the LCGE through the use of family trusts.
2. Passive Investment Income
Canada's corporate income tax rate is the second lowest in the G7 which is designed to encourage business investment and economic growth. However, because of Canada's high personal tax rate, there is an incentive for high-income earners to seek to utilize the low corporate tax rate for passive investment, while deferring tax at the high personal rate. A tax advantage is achieved (without a corresponding economic policy advantage) for an individual who holds money in a private corporation and uses it for investment. At a lower tax rate, there is more money left over for passive investment as compared to employees who can only invest amounts left over after being taxed at the high personal rate. In order to restrict this strategy, the Government will tighten the rules on retaining passive investments in a private corporation.
3. Conversion of Income to Capital Gains
This tax planning strategy has been a focus of the Government since the Liberals were elected in 2015. There have been tax changes in several areas that have focused on restricting the ability of taxpayers to convert income (taxed at a high rate) to capital gains (taxed at half such rate). Some private corporations have been undertaking tax planning which converts dividends (and salary) that would otherwise be paid to high-income earners into lower-taxed capital gains. There are anti-avoidance rules in the tax legislation which are designed to prohibit this, but the Government notes that these rules are being circumvented. The Government's proposed legislation seeks to tighten the rules and address such circumvention.
The Government is seeking public consultation on its tax proposals until October 2, 2017 which may result in additional changes. The majority of the proposals are not expected to come into effect until 2018, except for the anti-avoidance provisions dealing with capital gains which are intended to apply as of July 18, 2017.
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