Canada: Measures Announced To Stop Tax Planning Strategies Involving Private Corporations

On July 18, 2017, Federal Finance Minister Bill Morneau announced the launch of consultations on measures to address tax planning strategies involving the use of private corporations. The Government is targeting the following three issues identified in Federal Budget 2017:

  • Sprinkling income using private corporations, which shifts income from a high-income individual facing a higher personal income tax rate to family members who are subject to lower personal tax rates or who may not be taxable at all.
  • Converting an individual shareholder's income from a private corporation from salary or dividends into capital gains, which reduces income taxes by taking advantage of the lower tax rates on capital gains.
  • Holding a passive investment portfolio inside a private corporation, which may lead to higher investment returns than if the passive investment portfolio were held directly by an individual.

The proposed measures, as set out below and if enacted, may have a significant effect on the taxation of privately held corporations of all sizes and their shareholders.

Income Sprinkling and Access to Lifetime Capital Gains Exemption

Commencing in 2018, the Government proposes to extend the existing highest rate tax on split income (the "TOSI") for minors to certain adult individuals. Under current rules, taxpayers earning active business income have been able to divide this income among adult family members (who are often in lower tax brackets), resulting in significant annual overall tax savings. The new rules will require such adult family members to contribute, in labour or capital, to the business at a level commensurate with the income received, and introduces a reasonableness test for the purpose of determining whether the TOSI applies to adult individuals — a test which will be stricter for 18-24 year olds. Only a "reasonable" split income amount received by an adult individual would not be subject to the TOSI.

The Government also proposes to limit the multiplication of the lifetime capital gains exemption among family members who are not actively engaged in the business (again, measured based upon a reasonableness test), and to prevent gains accruing during periods while shares are held by minors, or in a family trust, from qualifying for the exemption. Proposed transition rules will permit access to the exemption for gains that accrue before the new rules take effect.

The proposals also introduce more stringent tax reporting requirements for trusts to ensure they are subject to rules that parallel those currently in place for corporations and partnerships.

Draft legislation was released for comment in conjunction with the consultation paper.

Converting Income into Capital Gains

As only one-half of a capital gain is included in income, the effective tax rate for capital gains is significantly lower than the rate applicable to other types of income. Currently, there is an anti-avoidance rule that prevents individual shareholders from converting salary or dividend income into capital gains in certain limited circumstances involving the transfer of shares between non-arm's length parties. The Government proposes to broaden the existing rule to ensure that more transactions between non-arm's length parties will give rise to dividends, rather than capital gains. The Government also proposes to introduce a separate "anti-stripping" anti-avoidance rule with a purpose test. These rules will apply to distributions on or after July 18, 2017.

The Government recognizes that restricting the ability to access capital gains treatment may hinder the transfer of a business from one generation to the next. Consultations will ask stakeholders to consider ways to accommodate such transfers while broadening the anti-avoidance rule.

Draft legislation was released for comment in conjunction with the consultation paper.

Holding Passive Investment Income Inside a Corporation

The Government has indicated that it views the ability to invest after-tax business income earned in a corporation (which is subject to significantly lower tax than income earned by an individual) as an unfair advantage available to private corporations. As such, it is seeking feedback from stakeholders on possible approaches to eliminate incentives to invest passively within a corporation that also meet the following objectives:

  • Preserving the intent of the lower tax rates on active business income earned by corporations, which is to encourage growth and job creation; and
  • Eliminating the tax-assisted financial advantages of investing passively through a private corporation, and ensuring that no new avenues for avoidance are introduced.

Next Steps

These proposals are far-reaching and will have a significant impact on most small businesses and private corporations. The Government is seeking input on all of the proposed measures and is accepting submissions on these proposals until October 2, 2017. We anticipate that, subject to the results of the consultations, formal legislation will be introduced before the end of the year in connection with the proposals relating to Income Sprinkling, the Lifetime Capital Gains Exemption, and Converting Income into Capital Gains.

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