Canada: Canada's New Estate Tax

Last Updated: September 15 2017
Article by Michael A. Goldberg

On July 18, 2017, the Federal Liberal government working with the Federal Department of Finance released a report and series of widespread proposals and draft legislation (Proposals) that are intended to make the most radical reshaping of the Canadian income tax system in a generation. The Proposals target a single segment of Canadian society – Canadian private corporations, their owners, and the families of their owners.1 The Government has defended these changes as being fair to the "middle class" and necessary to defend the Canadian tax base.

CANADA'S NEW ESTATE TAX EXPLAINED

For purposes of this discussion, I will focus on two sets of changes in the Proposal.

Tax on Split Income Rules that tax capital gains as Dividends

The Income Tax Act (Canada) (the "Act")2 deems a person to dispose of his or her capital property, such as shares of a Canadian private or public corporation, as a result of death or emigration from Canada (collectively, "Deemed Dispositions"). These Deemed Dispositions create taxable events where the value of the shares at the time of the Deemed Dispositions is in a gain or loss position even though the shareholder will still own the shares and will not have received any proceeds from the sale that he or she can use to pay the Deemed Disposition taxes.

Under the Proposals, Deemed Dispositions of corporate securities (for this discussion we'll focus on shares only) of Canadian private corporations will be taxed as top tax rate dividends rather than as capital gains taxed at the shareholders marginal tax rates, regardless of the age3 of the shareholder unless the owner can establish that his or her personal contribution of human and/or financial capital met certain uncertain and difficult-to-meet hurdles in the discretion of the Canada Revenue Agency (CRA).4

The effect of this aspect of the Proposals will be to eliminate marginal tax rate taxation for adults who are subject to this element of the Proposals and to increase the tax rates on Deemed Dispositions for many shareholders of Canadian private corporations from the top marginal tax rate of 26.76% to the top marginal tax rate applicable to dividends of 45.30%.5  This tax increase will apply if the affected shareholder acquired their interest in the Canadian private corporation with no or nominal consideration and, in many cases, the tax increase will also apply even where the acquisition has been made with their own assets and/or borrowed funds.  In their current form, the Proposals will apply to all existing or accumulated value in Canadian private corporations – not just on value that appreciates after July 18, 2017.

The Proposals do not impact the capital gains rate realized by investors in public corporation shares in any way or form.6 As a result, Deemed Dispositions of such shares will continue to attract tax at ordinary marginal capital gains rates subject to a maximum tax rate of 26.76%. This will be true whether the person acquiring the shares received the shares as a gift,7 with his own wealth or whether he acquires the shares with borrowed funds, including borrowed funds from non-arm's length persons at favourable interest rates.8

Ostensibly the additional level of taxation applicable to the Canadian private corporation shareholder is intended to overcome the unfairness that non-active family holders of such shares are able to enjoy capital gains treatment in situations where they have taken little or no financial risk to generate such gains. Excellent articles have been written9 that make it clear that many if not most family members holding such shares have indirectly borne the risks of building the business.  Regardless of such arguments, no explanation has been provided as to why public market share transactions should be treated differently from Canadian private corporate share transactions in respect of the taxation of capital gains.

Many articles have also noted that, combined with other changes in the Proposals (including those discussed below), this particular change will favour business owners selling the family business to arm's length parties instead of passing the business on to family members.  In addition, those articles have made it clear that the combined impact of the Proposals as a whole will provide significant advantages to public, foreign, and other large entities to acquire Canadian private corporations and, in many situations, will effectively eliminate the ability for owners of Canadian private corporations to utilize their lifetime capital gains exemptions.

Surplus Stripping Rules that will cause Canadian Private Corporation Shareholders to Pay Dividends a Second Time

By their nature, publicly traded shares tend to be liquid.  As a result, owners of such shares are generally able to sell them to fund their capital gains taxes arising on Deemed Dispositions in a straightforward manner.

Shareholders of Canadian private corporations do not have the luxury of ready liquidity.  There is often no market to sell the shares in a satisfactory manner that ensures the value of the shares is not compromised and within the time limits in the Act to pay taxes on the Deemed Dispositions.

Over time, the CRA came to accept a practice that put Canadian private corporation shareholders on a more even footing with public shareholders by allowing Canadian private corporation shareholders to draw funds out of Canadian private corporations to the extent that their shares had been paid for with after tax dollars or had been the subject of Deemed Dispositions.10 However, the Government has targeted this practice in the Proposals and, as of July 18, 2017, it is no longer possible take advantage of this concession.11

Instead, the Government has taken the position that the only way for Canadian private corporation shareholders to access Canadian private corporation funds is through the receipt of dividends or as a result of the deemed receipt of dividends on the repurchase of shares. Requiring dividend (deemed dividend) tax treatment to access corporate funds will typically result in additional tax payable on the same shares at tax rates of 45.30%. 12 This additional level of taxation will apply to all Canadian private corporation shareholders – even the founders of such entities who have directly risked their financial and human capital to create equity in their Canadian private corporation shares.

The combination of the two changes discussed in this article will potentially tax the same gains twice at 45.30% each time.  As a result, the combined effect of the full force of these elements of the Proposals will nearly completely expropriate the equity of many Canadian private corporation shareholders.13

It is unclear why either of the two changes described in this article need to be made to the Act.  This is particularly true since these changes will result in exacerbating the pre-existing unfair tax treatment of Canadian private corporation shareholders when compared to the tax treatment of gains available to shareholders of public corporations.

Concluding comments

The purpose of this article is to attempt to point out a particularly egregious effect of certain elements of the Proposals on Canadian private corporations, their owners, and the families of their owners.  However, the focus of this article on these particular problems is not intended to take away from the many other technical, policy, and other flaws that the Proposals create in their interaction with one another and the preexisting provisions of the Act, as well as the broader risks to the Canadian economy that may result if the Proposals are implemented.  For these reasons and the reasons that have been expressed elsewhere, including by me,14 in my opinion the implementation of the Proposals should be suspended if not completely abandoned.

Footnotes

1 Although elements of the Proposals will also impact partnership and trust arrangements, this article will focus only on corporate arrangements.

2 Unless otherwise noted all statutory references are to the Act.

3 Similar provisions previously applied only to minors.

4 See proposed changes to the tax on split income (TOSI) rules in section 120.4 of the Act and, in particular, subsections 120.4(4) and (5).

5 All tax rates utilized in this article are based on combined Federal and Ontario tax rates. It is assumed that top combined Federal and Ontario marginal tax rates apply to all personal income tax amounts.

6 This may also generally be true for shareholdings of other large widely-held conglomerates whether domestic or foreign.  This article will only discuss publicly traded shares.

7 If the gift recipient is a spouse or minor certain attribution rules will apply that may negate the benefit of marginal rates while that person remains a spouse or minor.

8 Provided the interest rates charged meet certain minimum standards (currently 1% interest rates would need to be charged by the lender).

9 Please feel free to contact me to obtain a selection

10 Often referred to as pipeline planning.  The CRA's administration of this concession was often criticized for being arbitrary but at least it ensured that owners of Canadian private corporation shares could in many cases be treated similarly to those holding publically traded securities.

11 This element of the Proposals targets so-called "surplus stripping" and catches a host of other transactions that the Government does not approve of.  In our view there are much better ways to deal with issues associated with surplus stripping but that is a discussion for a different article.

12 In some cases, where strict criteria can be met, the provisions of the Act may permit the total tax to be reduced to 45.30% (this is sometimes referred to as subsection 164(6) planning) - still nearly double the tax cost applicable to the public company shareholder.  Unfortunately, due to changes introduced by the Proposals it will generally be much more difficult to use the Act to reduce the tax rate to even this level.

13 For more see a prior article written by me with Mac Killoran and Jay Goodis, "Is a 93% Tax Rate Fair to Canadian Small Business Owners" www.mindengross.com/resources/news-events/2017/08/02/is-a-93-tax-rate-fair-to-canadian-small-business-owners.

14 Ibid.

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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