Canada: Tax Proposals Target Tax Planning Using Private Corporations

On July 18, 2017, Canada's Minister of Finance released a consultation paper and draft legislative proposals that target the use of private corporations to sprinkle income among family members, hold passive investments and strip surplus by converting corporate surplus into capital gains. In the government's view, such tax planning strategies provide tax advantages that unfairly help the wealthiest Canadians. The proposals, if enacted, will affect both small and large private corporations and their shareholders.


I. INCOME SPRINKLING USING PRIVATE CORPORATIONS

Income sprinkling, also known as income splitting or shifting, generally occurs when income that would otherwise be realized by a high-tax-rate individual is realized by family members who are in a lower tax bracket. Income sprinkling is often achieved through a private corporation and, until now, has been viewed as perfectly legal and acceptable tax planning. For instance, the high-income individual, in his or her capacity as controlling shareholder of the private corporation, may cause the corporation to distribute a portion of the corporation's after-tax income to family members, most frequently through a family trust or discretionary-dividend shares. This strategy makes it possible to achieve a lower aggregate effective tax rate for the family, including by accessing unused tax credits or multiplying the use of the lifetime capital gains exemption.

The Income Tax Act (Canada) already contains rules preventing income sprinkling in certain circumstances, including the so-called attribution rules and the kiddie tax rules (tax on split income). The government is proposing to tighten some of these rules, particularly those regarding the tax on split income and the lifetime capital gains exemption.

Generally, under the proposals, the tax on split income would be modified so that it applies after 2017 to any Canadian resident individual, whether a minor or an adult, who earns split income from a private corporation (or partnership or trust) in which a connected individual has an interest. Specifically, the tax on split income would be modified by:

  • subjecting adult individuals' split income to a reasonableness test that takes into account the individual's labour and capital contributions to the corporation as well as previous dividends and remuneration received from the corporation (the test would be stricter for individuals aged 18 to 24);
  • introducing the concept of "connected individuals"—i.e. Canadian residents who are connected to a private corporation, either because they exercise control over it or participate in 10% or more of its equity value, because the property they transferred to the corporation represents 10% or more of the corporation's property value, or because they participate in the performance of the services constituting the corporation's business; and
  • expanding the definition of "split income" to include—in addition to certain dividend, partnership and trust income—compound split income (i.e. income on previously-taxed split income).

Also, measures are proposed to address the multiplication of claims to the lifetime capital gains exemption of an individual on the disposition of eligible shares of a private corporation, which is approximately $835,000 for 2017. Specifically, the following capital gains would no longer qualify: (i) capital gains realized or that accrue while the individual is a minor, (ii) capital gains included in the individual's split income, and (iii) capital gains accrued while the shares are held by a trust.

However, the transitional rules would allow individuals to elect to realize a capital gain on qualified shares in 2018 by way of a deemed disposition at fair market value and to claim the lifetime capital gains exemption in respect of that capital gain.

II. HOLDING PASSIVE INVESTMENTS THROUGH PRIVATE CORPORATIONS

According to the government, a tax-deferral advantage is achieved when surplus funds are retained in a corporation for passive investment purposes instead of being distributed to the shareholders, through taxable dividends, salary or otherwise, for the shareholders to invest personally. Because the corporate tax rates on active income are lower than the marginal personal tax rate, when surplus funds are left in a private corporation, the tax that would have been payable upon distribution of the surplus to the shareholders can be deferred, resulting in the corporation having more capital to invest.

The government does not propose any specific measures and is instead seeking consultation on the appropriate means of eliminating this tax-deferral advantage. The alternatives considered by the government include the elimination of the current refund of some of the corporate tax on passive investment income, the implementation of an additional refundable tax on corporate surplus that is not reinvested in the corporation's business or in other eligible investments, and the elimination of the increase in the capital dividend account for the non-taxable portion of capital gains derived from passive investments. According to the government, a transition period will be provided before any such proposal becomes effective.

III. SURPLUS STRIPPING

The surplus of a private corporation is generally distributed through salary or dividends, which are then included in the personal taxable income of the recipient. However, as only one-half of a capital gain is taxable, capital gains are effectively taxed at a lower rate. Therefore, to access corporate surplus, some individuals have engaged in transactions that trigger capital gains for themselves or in the corporation and make it possible to pay tax-free capital dividends. These techniques are called "surplus stripping."

Various provisions of the Income Tax Act (Canada) restrict surplus stripping. The government proposes measures to further restrict surplus stripping and, specifically, transactions used to sidestep current anti-surplus stripping provisions.

In general, the new anti-surplus stripping measures would apply to non-arm's length transactions entered into on or after July 18, 2017 where one of the purposes of the transaction is for the corporation to distribute non-share consideration (e.g. cash) to a shareholder in a manner that would result in a capital gain and cause a significant reduction of the corporation's assets. In such cases, the non-share consideration would be treated as a taxable dividend.

IV. COMMENTS

Certain aspects of the proposals represent a significant shift in tax policy and are likely to have a broad financial impact on private corporations and their shareholders. The proposed elimination of the so-called tax-deferral advantage for passive corporate investments is particularly far-reaching and will have unexpected consequences for profitable private corporations.

For instance, corporate surplus may be accumulated in order to start a new active division or business or to provide funding in low seasons of a cyclical business. In addition, entrepreneurs and family members involved in their businesses generally do not benefit from pension plans, employment insurance, parental benefits and other social benefits available to employees, and they have risked their capital, not to mention invested considerable time, in setting up the business. They also may not have accrued significant Canada or provincial pension plan entitlements, as a portion of their income may be earned through dividends, rather than salary. Such a dramatic change would place private businesses on a different footing from public corporations and foreign-owned corporations, which can retain after-tax corporate surplus and thus defer shareholder-level income tax—including withholding tax, in the case of foreign-owned corporations. The retained surplus may be used to fund current or future expansion, debt repayment, share buy-backs or dividends, pension plans, future retirement bonuses, or other post-retirement income, as well as any number of things that may not, strictly speaking, represent an immediate, or even future, reinvestment in the current business.

The government is inviting comments and ideas regarding the announced measures by October 2, 2017.


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