Canada: Chapter And Verse On CCPC Tax Changes: Not A Pretty Sight!

Last Updated: October 11 2017
Article by Samantha Prasad

The Liberal government had hinted that it was looking at new legislation with respect to private companies, and this past July they came through on their promises, announcing plans for sweeping changes. Bill Morneau, the Minister of Finance, is doing a cross-country "consultation" tour, which we hear is going over like a lead balloon. Despite government protestations to the contrary, there still may be some changes to the proposals coming down the pike. In the meantime, if you have an interest in a private company, read on to see what all the fuss is about. And hold on to your hat! It's not pretty.

Income Splitting

Currently, the "Kiddie Tax" rules provide that dividends received by persons under the age of 18 from related private companies and income from related partnerships (whether directly or through a trust) would be taxed at the top marginal rate. These rules, under the new proposals, have been substantially extended to apply to all related persons (and not just minors) where such persons receive income from a related private corporation, unless the amount is reasonable in light of the circumstances, having regard to certain criteria. Essentially, spouses, siblings, parents-in-law, and extended family members can be caught under the new rules and would have to pay tax at the top rates.

This Tax on Split Income (TOSI) is expanded to apply not only to dividend income, but also to include interest on loans, taxable capital gains, if the income on the shares would have been split income, as well as second-generation income if it is earned on income that was itself split income (so it's a compounded effect).

I noted earlier that there is a "reasonableness test." Essentially, in order for income not to be subject to this top tax rate, the income must be reasonable, i.e., it cannot be more than what would be paid to an arm's-length person for the same activities provided to the company. Factors to consider include actual work performed, the capital contributed for the shares issued to such persons, risk assumed by them, and compensation for services already completed. Note that the test is more stringent for persons between the ages of 18 and 24.

The short answer is that if a family member did not contribute money to the company or is not involved in the company's operations, then any dividend income paid to them will be subject to the top marginal tax rates. This will eliminate the ability to income split with any family member who is not involved in the business.

There is a specific exemption for minors and adult children who have income due to the death of a parent, or for persons that are disabled or attending full time school.

Capital Gains Exemption

Currently, every Canadian resident (regardless of age) is able to claim the lifetime capital gains exemption on the sale of shares of a qualifying private corporation (which gives you the first $800,000 – as indexed – tax-free). There are three proposed changes to these rules:

  1. Persons under the age of 18 are no longer able to claim the capital gains exemption. Specifically, any gains accrued before the person turns 18 will not be eligible for the exemption. So, even if a person is 19 years old, and the value of his or her shares accrued while such person was a minor, they could not claim the exemption.
  2. As a continuation of the tax on split income discussed above, if any amount of a taxable capital gain is included in split income, it will not be eligible for the capital gains exemption. So, if a family member is not involved in the company's business, then arguably the exemption is not available.
  3. Any capital gains accrued during the time that shares were held by a trust will no longer be eligible. This is a big change and will affect many family corporate structures where estate freezes were put in place with family trusts.

These new rules will come into effect in 2018; however, there is some transitional relief. If you file an election on your personal tax return by the due date for 2018, you can take steps to crystallize the capital gain and claim the capital gains exemption before the end of 2018. This will bump up your cost base by the capital gains exemption amount, so any future sale will benefit from a reduced capital gains tax.

Capital Gains within a Corporate Group

New measures were announced to eliminate the ability to pull out cash from a corporate group by way of a capital gain triggered within the corporate structure, rather than paying a dividend and being subject to a divided tax (which is a higher rate than capital gains).

Essentially, the current section 84.1 of the Income Tax Act (which re-characterizes capital gains as deemed dividends) will be expanded under the new proposals to deny the ability to trigger a capital gain at the corporate level and pay out a tax-free capital dividend to the shareholders. The new rules also include an anti-avoidance rule to deal with surplus stripping transactions through the use of capital gains to apply to situations that might not be captured by the newly expanded s. 84.1. Unlike the proposals for TOSI and the capital gains exemption, these new rules are to apply as of July 18, 2017.

Accumulating Funds in Private Corporations

One of the government's goals was to prevent the use of tax deferrals through the use of corporations, specifically on income derived from passive investments held in a corporation. Although the new proposals do not include actual legislation (like the first three proposals discussed above), the government outlined, at a very high level, certain options aimed at reducing the ability to defer tax on such types of incomes. These include:

  1. Investment income earned by a corporation will be taxed at the highest personal federal tax rate (33%) with the elimination of the refundable tax mechanism.
  2. Capital gains on such income will still be subject to 50% tax; however, the tax-free portion on such capital gains can no longer be paid out tax-free to an individual shareholder.
  3. Dividends taxed to individual shareholders will be based on the source of the funds (i.e., whether income was taxed at the small business rate or at the general corporate rate).

Keep in mind that the government did not announce any draft legislation regarding the passive income tax proposals, so we are still unsure as to what they are actually proposing or how they are going to go about it. All we know is that they are focusing on ways to reduce the ability for retained earnings that are reinvested to take advantage of the lower corporate tax rates. The government has announced a consultation period, and as I mentioned the Minister of Finance is facing the wrath of small business owners everywhere on his cross-country "consultation." Whether this will change anything or not remains to be seen.

For now, be proactive. If you are a shareholder in a private corporation, and/or  your family members are also shareholders, then I would suggest you speak to your tax advisors to understand how these rules will affect you and what you may be able to do to minimize the effects.

Previously published in The Fund Library on ​October 3, 2017 by tax and estate planning lawyer,  Samantha Prasad.​​​​

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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