Canada: Proposed Changes To Business Income Tax Rules: A Gamechanger For Private Business Owners

Last Updated: August 4 2017
Article by McInnes Cooper

On July 18, 2017, Canada's Minister of Finance released proposed changes to the Income Tax Act (Canada) that, if implemented, will mark one of the most significant reforms to Canada's tax system for business income in decades – and will significantly impact tax planning for all business owners. The proposed changes target three key areas the government perceives as abusive:

  • "Income sprinkling". The practice of splitting income within families to minimize the overall income tax payable.
  • Capital gains stripping. The conversion of after-tax corporate earnings into capital gains (i.e. capital gains stripping) resulting in a reduced rate of applicable tax.
  • Tax deferral. The holding of an investment portfolio inside a private corporation that, due to overall lower corporate tax rates as compared to personal tax rates, currently results in a financial advantage for owners of private corporations engaged in active business (i.e. passive investments).

The federal government has released a consultation paper on Tax Planning Using Private Corporations and is soliciting comments on the proposed changes and the detailed draft legislation proposed addressing income sprinkling and capital gains stripping. The proposed legislation is subject to change until the consultation phase closes on October 2, 2017. The government has not yet released draft legislation on passive investments in private corporations. Business owners are well-advised to start now (and well in advance of December 31, 2017) to determine how the new rules will impact their business structure, the planning steps they should take and opportunities for restructuring: if the proposals proceed, some will take effect as early as January 2018 – and some retroactively to July 18, 2017.

Here are the key changes the federal government proposes to the tax rules around planning using private corporations, and the business owners who will be most impacted by them.

PROPOSED ANTI-INCOME SPRINKLING MEASURES

The proposed legislation seeks to prevent income sprinkling by extending the current rules that tax "split income" at the highest marginal tax rate and by imposing new restrictions on the use of the Lifetime Capital Gains Exemption (LCGE). If enacted, the proposed income sprinkling measures will have effect as of January 1, 2018. The proposed changes to the income sprinkling rules are broad-reaching and will impact many common private business structures, including:

  • Structures involving family trusts that receive distributions from a business carried on (or controlled or influenced) by one or more principal family members.
  • Private corporations in which more than one family member owns shares and receives dividends or other forms of income.
  • Businesses involving multiple principals or related partners.
  • Any structure in which shares in a private corporation that have accrued or are accruing value are held by a family trust or by more than one family member.

Three of the key proposed changes to prevent income sprinkling are:

Kiddie Tax (or TOSI) Extension. The proposal is to extend the "Kiddie Tax" rules (or tax on split income, or "TOSI", taxed at the highest marginal rate) to additional types of income and to split income earned by related adults. The current "split income" rules tax income derived from a private corporation, partnership, or trust that is paid to a minor at the highest marginal tax rate (i.e. the "Kiddie Tax" or TOSI). The proposed rules would generally extend the TOSI to certain adult recipients of split income derived from a business of a related individual who resides in Canada, whether that business is carried on through a private corporation, partnership or trust. The proposed rules would also extend the types of income the rules capture. "Split income" currently includes dividend income, shareholder benefits from private corporations and certain distributions from trusts and partnerships. The expanded rules would also include income from certain debt arrangements, and certain capital gains. There are also proposed rules that would deem income on property that is the proceeds from income previously subject to the TOSI rules (i.e. compound income) in the hands of individuals under 25 to be "split income". The proposals affect income received by a spouse, adult child, or any other related party.

Reasonableness Test. The government also proposes a new "reasonableness" test to determine whether interest, dividends or capital gains received by an adult will be considered "split income" and therefore taxed at the highest marginal tax rate. Generally, the new rules propose to exclude from "split income" income that would be "reasonable" if the business operating entity and the family member in receipt of the amount were dealing at arm's length. The proposed "reasonableness" test considers factors such as contributions of work and assets, the assumption of risk, and other amounts paid by the business entity to the family member. If a distribution is considered unreasonable, the unreasonable portion will be taxed at the highest marginal rate. The reasonableness test for those aged 18 to 24 is more stringent in recognition of the particular advantage in income splitting with this age group, given many 18 to 24 year-olds are lower income earners and/or are enrolled in post-secondary institutions. For example, the labour contributions of an adult aged 18 to 24 will not be considered for the purpose of the "reasonableness" test unless the individual is actively engaged on a regular, continuous and substantial basis in the activities of the business. Further, an amount of income received by an adult aged 18 to 24 will not be considered "reasonable" based on that individual's capital contribution (for example, the amount paid to subscribe for shares in a private corporation) to the extent that it exceeds a prescribed maximum allowable return on the assets contributed.

Lifetime Capital Gains Exemption (LCGE) Restrictions. The proposal includes denial of the LCGE for minors, trust beneficiaries and adult shareholders who do not materially contribute to the underlying business. The LCGE currently exempts from taxable income (up to a lifetime limit, in 2017 of $835,716) capital gains realized by an individual on the disposition of qualified small business corporation shares and qualified farm or fishing property. The proposals seek to prevent multiplication of the LCGE via distributing eligible capital gains among family members through various common structures, including discretionary family trusts to permit the use of the LCGE of multiple family members to reduce the resulting taxable capital gain. The proposals would prevent LCGE multiplication in three ways (but provide transitional rules to allow taxpayers to elect, in 2018, to crystallize capital gains and utilize the current LCGE rules):

  • Minors. Individuals would no longer be eligible to claim the LCGE for capital gains realized or accrued before the taxation year in which the individual attains the age of 18 years.
  • Split-income. The LCGE would be denied to the extent that capital gains are "split income". Capital gains would be considered "split income" if income from the property disposed of would have been considered split income. For example, if dividends paid on shares in a private corporation would be split income if received by a spouse, then capital gains received by that spouse arising from the disposition of the shares will be considered "split income".
  • Trusts. The LCGE would be denied on capital gains that accrued while the property was held by a trust (subject to certain narrow exceptions).

EXPANSION OF CAPITAL GAINS STRIPPING MEASURES

The proposals include changes to the rules that prevent shareholders of private corporations from extracting after-tax retained earnings by realizing capital gains on shares instead of paying tax on dividends (i.e. "capital gains stripping") through related-party transactions. But, unlike the anti-income sprinkling measures, the proposed capital gains stripping measures will be retroactive to July 18, 2017 if implemented. In general, two main changes are proposed:

Limited "step-up" in cost base. The changes would prevent certain related-party transfers of shares that seek to artificially "step-up" the cost base in advance of a subsequent disposition to a related corporation. Currently, the rules operate to prevent surplus stripping in excess of the "hard" cost to an individual of their share – ignoring any cost attributable to capital gains for which the LCGE was claimed (i.e. "soft" cost). The proposals would expand the "soft" cost concept to all non-arm's length sales.

New anti-surplus stripping rule. A new anti-avoidance rule would address non-arm's length transactions where one of the purposes is to pay an individual shareholder non-share consideration (e.g. cash) that is otherwise treated as a capital gain in a manner that strips the corporation's assets. Amounts received in applicable transactions will be re-characterized and taxed as dividends.

CONSULTATION ON CORPORATIONS HOLDING PASSIVE INVESTMENTS

The federal government is considering measures that eliminate the tax-assisted financial advantages of holding passive investments within a private corporation that arise due to the lower corporate tax rate (compared with personal rates) and the available deferral of tax using a private corporation. It has not yet released draft legislation; however, the consultation paper summarizes two possible approaches to neutralize this advantage and details associated measures that would need to be adopted in tandem with these changes (such as new tax pools for determining how dividends will be taxed under the new regime):

Non-refundable tax. One approach is the removal of the refundable feature of the excess tax on passive investment income of a Canadian-controlled private corporation where the earnings used to fund passive investments were taxed at a low corporate rate (i.e. major reform of the refundable dividend tax on hand regime).

Restricted capital dividend regime. A second approach is to cease crediting the non-taxable portion of capital gains to a corporation's capital dividend account where the capital was sourced using income that was taxed at the low corporate rate (for example, a capital gain on a passive investment held in the corporation).

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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