Canada: Update: Tax Planning For Private Corporations And Shareholders

The Times They Are A-Changin'

The title to Bob Dylan's 1964 song is an appropriate way to describe the impact of newly released proposed tax rules.  On July 18, 2017 the Government released draft legislation that will have a significant impact on tax planning for private corporations and their shareholders.

The draft proposals invite public consultations by October 2, 2017 and, due to the nature of the proposals, will undoubtedly result in significant feedback and (possibly) some amendment.  However, whatever the result of the consultations, the Government has made their intentions clear and all private businesses should be prepared for significant changes.  The Crowe MacKay tax team has summarized the changes below.

Income Splitting

Income splitting refers to the transfer of income between family members to effect a lower overall tax rate.  A commonly employed method of income splitting is having non-active family members own shares of a corporation (directly or indirectly) that carries on a business that is run by an active (in the business) family member.  The corporation pays a low rate of corporate tax on its business income (for example 15% on the first $500,000 of active business income) leaving behind $0.85 of every $1.00 earned to be paid as dividends to family members in low tax brackets.  The result being a reduced tax rate compared to if the income was earned directly by the active family member.

In 1999 the concept of tax on split income ("TOSI") was introduced whereby family members under the age of 18 are currently taxed at the highest marginal rate on dividends received from a family corporation.  This essentially curbed the practice of splitting income with minors but still allowed for income splitting with adult children which was beneficial to the extent parents were still funding them (e.g. while in post secondary education).

The proposed rules extend TOSI to all related individuals regardless of age starting in 2018.  This includes spouses, adult children and other family members.  This means that any dividends paid to an individual from a corporation that carries on a business in which a related individual is active, could be subject to tax at the highest marginal rates.  The most significant impact of this change will be restricting dividends paid to a spouse who is not active in the business.

Income will not be subject to TOSI to the extent the amounts are considered "reasonable".  The reasonability test applies different parameters for related individuals aged 18 to 24 and related individuals aged 25 and over (note all amounts paid to individuals under 18 remain subject to TOSI).  How the reasonability parameters will be applied remains to be seen but it is clear that the days of paying discretionary dividends to family members are soon to be over.

Lifetime Capital Gains Exemption ("LCGE")

The LCGE is a cornerstone of the Canadian tax system for owners of private corporations allowing for a tax-free capital gain on the sale of shares (up to $835,000 for 2017).  The proposed amendments to the LCGE rules result from the same perceived abuses as addressed in the income splitting changes.  Effective in 2018 the changes can be summarized as follows:

  • gains realized, or accrued, in the hands of an individual while under the age of 18 are not eligible for the LCGE
  • gains on property held by trusts are not eligible for the LCGE

    • spousal trusts, alter ego trusts and certain employee share ownership trusts (where employee is arm's length) are excluded
    • applies regardless of whether the trust disposes of property and allocates gain to a beneficiary or rolls the property to a beneficiary who then disposes of it
  • gains on shares of a corporation that would be subject to TOSI are not eligible for the LCGE

    • this excludes "reasonable" gains which is determined based on the same tests as for reasonability of amounts paid to which TOSI may apply

These changes will be significant to many family owned businesses as holding shares of a private corporation through a family trust could increase the overall tax burden upon sale of the business.  The changes severely restrict the use of family trusts as part of the ownership structure.

The proposals do provide some relief in the form of an election that can be filed for 2018 to allow accrued gains to be realized on shares otherwise eligible for the LCGE.  An individual (including a trust) would be eligible to make the election to trigger a capital gain and claim the LCGE to the extent the shares otherwise qualify.  However, an individual under the age of 18 cannot elect on shares of a private corporation nor can a trust to the extent the resulting gain is to be allocated to a beneficiary under the age of 18.

Passive Investment Income Inside a Corporation

The Government is also concerned about the deferral of tax that is achieved by having income taxed inside a private corporation at low business income tax rates and invested to generate passive investment income.  No draft legislation has been released on this matter but the Government is asking for feedback regarding a couple of proposed options:

  • the 1972 Approach
  • Deferred Taxation

The 1972 Approach would introduce an additional refundable tax on preferentially-taxed business income when the income is retained and used to fund passive investments.  For example, assuming the combined Federal and provincial small business tax rate is 15%, the new additional refundable tax would be 35% bringing the total rate to 50%.  If the passive investment assets were sold and used to purchase active business assets the 35% would be refunded.  It would also be refunded if the passive investment assets were sold and the proceeds distributed as dividends.

The Deferred Taxation approach would not result in a change in corporate tax rates but would not provide a refund of otherwise refundable taxes on passive investment income when earnings used to purchase the passive investment assets were taxed at lower corporate tax rates on business income. The Government is also considering changing the tax treatment of dividends received by shareholders of private corporations based on whether the corporation used its retained business income to purchase passive investment assets.

It remains to be seen which approach is followed.  But, regardless of which  is chosen, the tax deferral provided by retaining business income in private corporations looks to be disappearing.

Conversion of Income into Capital Gains

The current personal tax rate environment has spawned planning that results in the taxation of corporate surplus at capital gains rates instead of dividend rates.  Draft legislation has been released that expands upon existing rules that are designed to curb this type of planning and essentially the new rules operate to convert capital gains triggered on a disposition of shares to a related party to dividends which are subject to higher personal tax rates.

The most significant immediate impact of these changes is the shutting down of post-mortem pipeline planning.  It should be noted that these changes are effective immediately.

More details on the changes will become available as tax practitioners have the opportunity to digest the full scope of the changes.  It is clear though that tax planning for private corporations and their shareholders will look very different beyond 2017.

'Come senators, congressmen
Please heed the call
Don't stand in the doorway
Don't block up the hall
For he that gets hurt
Will be he who has stalled
There's a battle outside
And it is ragin'.
It'll soon shake your windows
And rattle your walls
For the times they are a-changin'.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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