Canada: Tax Proposals Affecting Private Companies And Their Shareholders: What Does This Mean?

This is the first in a series of posts arising out of the Liberal Government's paper "Tax Planning Using Private Corporations".

The Liberal Government announced in the March 2017 Budget that it was reviewing the use of tax planning strategies involving private corporations. The Government's view was that these strategies inappropriately reduced personal taxes of high-income earners. A promise was made to release a paper setting out the nature of these issues in more detail as well as proposed policy responses.

On July 17, 2017 Finance Minister Bill Morneau tabled a consultation paper, "Tax Planning Using Private Corporations" (the "Paper"). Draft legislation was also tabled to enact certain of the proposals. If enacted as proposed, there will be sweeping changes to income splitting strategies, the availability of the capital gains exemption, and the use of trusts. It is clear that the taxation of investment holding companies will also be significantly affected.

While the process is styled as a consultation, the content, the length of the paper (63 pages) and the existence of draft legislation makes it is clear that the Government is far along in its thinking and has both well-developed and strongly held views.

Currently, the attribution rules deal with income splitting strategies involving spouses, common law partners and minor children. Distributions to minor children may be subject to the so-called kiddie tax (in technical terms, Tax on Split Income or TOSI)which effectively subjects the income to tax at the highest marginal rate without access to personal credits. The Paper proposes an extension of the TOSI to family members (spouses, common law partners and adult children) who are shareholders of a corporation, partners or beneficiaries of a trust. The TOSI will be subject to a reasonableness rule that, among other things, measures the contribution of the recipient to the business and takes into consideration other income earned. The TOSI will also extend to capital gains and income from reinvested after-tax income that was subject to the TOSI. Finally, no lifetime capital gains exemption will be available on shares that gave rise to TOSI.

Currently, a lifetime capital gains exemption of $835,714 is available to offset the capital gains arising on the sale of shares of private companies provided certain conditions are met. The Paper includes fundamental changes to the ability to claim the lifetime capital gains exemption. The capital gains exemption will no longer be available with respect to capital gains that are realized or that accrued before the year in which the individual attains the age of 18. Further, no capital gains exemptions will be available on shares held by an adult family member that gave rise to TOSI.

The Paper proses that after 2017 it will generally no longer be possible for beneficiaries of a trust (other than a spousal, common law partner or alter ego trust) to access the capital gains exemption. This will also be true for capital gains on shares sold where the shares had been distributed by a trust to a beneficiary. As this is a fundamental change, the proposals contain limited transitional rules.

Most of the changes are to come into effect on January 1, 2018.

The Paper outlines proposals to eliminate what it sees as an incentive to invest passively within a corporation. The focus of the proposals is to have savings in a corporation taxed in a manner that is equivalent to savings held by individuals. In general terms, regardless of the form, the effect of the proposals will be to increase the taxes payable on investment income earned by a corporation.

At the present time, only 50% of capital gains are included in income and subject to tax. In 2016 and 2017 there was pre-budget speculation that the government would increase the capital gains inclusion rate. At page 51 of the Paper the government states that it "will continue to treat capital gains as eligible for the 50-per-cent inclusion rate".

During a 75-day consultation period, the Government hopes that "Canadians will tell them where they have it right and where improvements can be made". The timetable leaves little time for the Government to consider the input and effect any modification to the proposals in advance of January 1, 2018.

It is clear that the tax landscape for Canadian entrepreneurs is about to undergo a profound change.

The next posting will deal with how the Paper deals with the lifetime capital gains exemption.

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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