Canada: Where Do We Now Stand On The Canadian Private Corporation Tax Proposals?

Last Updated: October 23 2017
Article by Kenneth Keung and Kim G.C. Moody

What a roller-coaster of a week it's been! It seems like many moons ago when the Government announced – with offensive rhetoric – the contentious and divisive private corporation tax proposals on July 18, 2017, with an extremely short consultation period of 76 days. Businesses of all sizes and sectors rallied loudly against the proposals, and by the end of the consultation period, over 21,000 submissions were received by the government. Our firm has been actively involved in this process, such as submissions by the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada, engagement with legislators, an appearance at the Senate Standing Finance Committee, numerous media appearances and public seminars to educate the public about the proposals. Here is a partial list with various links below:

  1. Joint Committee Tax on split income and lifetime capital gains exemption submission;
  2. Joint Committee surplus stripping submission;
  3. Joint Committee passive income submission;
  4. Senate Standing Committee on National Finance hearing;
  5. Presentations to the public – with the most recent version that has updates for announcements of this week here; and
  6. Other material that we accumulated on our firm's private corporation tax proposals portal that can be viewed here.

The government must have been surprised by the ferocity of the outcry and therefore made a number of announcements over the course of October 16 to 19, 2017 to "tweak" the proposals. Although many issues remain and details are still pending, we are nonetheless happy to see that the government has backed off from some of the most problematic aspects of the proposals.

Proposal to limit access to the lifetime capital gain exemption:

Under the proposals, any capital gains accrued in the hands of a trust or a minor would have become ineligible for the lifetime capital gains exemption of $835,714 (annually indexed) for qualified small business corporation shares and $1,000,000 (not indexed) for qualified farming/fishing properties. The government was concerned about the availability of this exemption to family members of business owners, but the proposed measures had broad and adverse implications – with some of the proposals having retroactive/retrospective effect – to business succession and estate planning. Also, the proposals' complexity and accompanying short transitional period would have created significant difficulties for affected taxpayers.

On October 16, 2017, the government announced that they are no longer moving forward with measures that limit access to the lifetime capital gain exemption. While this is welcome news for businesses and their advisors (many of whom were in panic mode helping their clients fit into the transitional rules), the devil is in the details. For instance, it is uncertain whether the announcement meant that the entire proposed draft legislation dealing with the lifetime capital gain exemption is abandoned, or if certain aspects of it (such as the "unreasonable" amount of taxable capital gains realized by a "specified individual" being ineligible for the exemption) may be retained.

Proposal to prevent surplus stripping – proposed amendment to section 84.1 and proposed section 246.1:

One of the many shocks to practitioners from the July 18, 2017 proposals was the measures against the perceived mischief of "surplus stripping," i.e. the conversion of what would otherwise be highly-taxed dividend income into preferentially-taxed capital gains. The problem with the proposed measures was that rather than targeting specific situations the government perceived as offensive, they were drafted as a blunt instrument that could potentially capture everyday vanilla commercial transactions and in some cases, with retroactive effect. The impact these measures had on post-mortem planning, such as the elimination of the post-mortem pipeline, was particularly damaging. Also, the possibility of proposed section 246.1 applying to common arm's length transactions and existing capital dividend account balances had put many businesses in a bind.

Therefore, it was very good news when the government announced on October 19, 2017 that they are no longer moving forward with measures relating to the conversion of income into capital gains, which, presumably refers to the proposed amendments to section 84.1 and proposed section 246.1. It remains to be seen whether the proposed amendments to subsections 120.4(4) and (5) will also be abandoned. If the government goes ahead with the amendments to subsections 120.4(4) or (5), non-active family members disposing of private corporation shares on a non-arm's length basis (including deemed dispositions at death) would still not be able to access capital gains treatment or the lifetime capital gains exemption. We believe that such a result would be inconsistent with the government's announcement on October 19, 2017 and therefore we will look closely for this when draft legislation is eventually released. Despite the abandonment of the amendments to section 84.1 and proposed 246.1, there is no guarantee that new proposals will not be introduced in the future on surplus stripping. For instance, could the government increase the capital gains inclusion rate to address surplus stripping? While that might go a long way to preventing mischief, the government, earlier this year, appeared to have no interest in increasing the capital gains inclusion rate and given the rough ride they have had with the July 18, 2017 proposals, such an increase might be further political suicide.

One paragraph in the October 19, 2017 announcement stated the following: In the coming year, the government will continue its outreach to farmers, fishers and other business owners to develop proposals to better accommodate intergenerational transfers of businesses while protecting the fairness of the tax system." This is of course a very vague statement, but it is in line with the July 18, 2017 consultation paper's discussion on trying to accommodate genuine intergenerational business transfers. Reading between the lines, could the government be contemplating the resurrection of the NDP MP Guy Caron's 2016 private member Bill C-274, whereby it was proposed that surplus stripping be allowed on certain intergenerational transfers by means of a special carve-out from existing section 84.1? If something along those lines is enacted, it would be good news for Canadian business and farm/fishing property owners. While Mr. Caron's private member bill certainly had obvious technical problems, it might be a good inspirational starting point on how to achieve the objective of enabling more tax efficient intergenerational transfers.

Now that we have gotten the good (but details lacking) news out of the way...

Proposal on treatment of corporate passive income:

Unlike the other parts of the July 18, 2017 proposals which were accompanied by draft legislation, the proposal for corporate passive income was in the form of a consultation paper. In short, what was proposed was to render the refundable dividend tax on hand (RDTOH) account or Canadian controlled private corporations (CCPC) no longer refundable and to cause the non-taxable portion of capital gains to no longer be includable in the capital dividend account (CDA). Effectively, a 50% permanent upfront corporate tax (exact rate would depend on the province) would be imposed on passive income realized by a CCPC. In comparison, under the current regime 30.7% of the 50% upfront tax on passive income is refundable upon eventual distribution. Adding the proposed 50% permanent corporate tax to personal tax applicable on eventual distribution, the effective tax rate on corporate passive income could exceed 70%. In theory, this regime should cause the ultimate return on corporate passive investment to be equal to the return of an employee investing her or his after-tax earnings. However, due to under-integration of the tax system in most provinces and the 50% upfront corporate tax being a flat tax irrespective of income level, the impact of the proposal could actually leave owners of private corporations significantly worse off than an employee with respect to passive investments, particularly where the investment is funded by general corporate rate income.

It was therefore disappointing news when the government announced on October 18, 2017 that they will forge ahead with the proposal and release draft legislation as part of federal 2018 budget, albeit with a few tweaks to soften the impact:

  • All "past investments" and the income earned from those investments will be protected;
  • A de minimis threshold of $50,000 of passive income per year, for which "there will be no tax increase;" and
  • The government will work with the venture capital and angel investment sectors so that the changes will not negatively impact them.

The assurance of grandfathering relief is of course comforting to taxpayers with significant assets already accumulated inside private corporations, but again, the devil is in the details. For instance, we do not know what exactly will be grandfathered. It could be a ring-fencing of existing corporate passive investment, or some kind of measure based on, say, retained earnings to date or current fair market value of all corporate assets. And grandfathering based on what date? July 18, 2017, October 18, 2017 or upon the release of draft legislation in 2018? Also, how exactly will grandfathered assets be tracked, given assets can be disposed of and cash is fungible, or will grandfathering simply be lost when a grandfathered asset is disposed of? Presumably, rules will be need to cause grandfathering to cease when ownership of the corporation changes hands. Such details and questions aside, ultimately the grandfathering regime will have to strike a fine balance between protecting corporate assets accumulated prior to these changes, and the inherent unfairness of allowing one population of corporate investors preferential tax treatment (a 30.7% rate advantage, presumably throughout the lifetime of the corporate owner) that is not accessible to the rest of country.

The de minimis threshold of $50,000 of passive income per year is trumpeted by the government as the solution to ensure that the proposed 50% upfront permanent tax will apply only to the wealthiest of corporations. Many speculated that this $50,000 threshold will be implemented through an annual allowable maximum on additions to the RDTOH. Setting aside the debate whether $50,000 is the right number, there are still many unanswered questions regarding this de minimis rule. For example, how will this be applied with respect to capital gains, which by nature, will be "lumpy", i.e. appreciation is accrued each year until being realized as a large lump sum eventually, and what portion of the non-taxable portion of such capital gain can be added to CDA? What if the capital gain is on the disposition of a business asset, for example, the real estate in which the active business is carried on? It does not appear to be consistent with the government's message of encouraging business investments if such gains will be caught by these punitive rules.

Extremely complicated anti-avoidance rules will surely be needed to prevent taxpayers from multiplying the $50,000 threshold through the use of multiple corporations. As well, clear legislation will be needed to provide clarity on what constitutes passive income. The vagueness of the current legislative regime and jurisprudence on the matter of property income versus business income may be passable for an upfront tax that is refundable, but it certainly will not be acceptable when the differentiation leads to a 30.7% permanent rate differential. Also, as the government has indicated, the regime will need to be configured to accommodate corporate venture capital and angel investors, for whom the $50,000 per year limit will not be workable, and whatever rules arising from this will certainly be complicated.

All these complications will be on top of the complexity described in the July 18, 2017 consultation paper and will require the tracking of additional numerous pools of income. For example, under the proposed apportionment method described in the consultation paper, passive income will be proportionately assigned to either a general rate income pool, small business rate income pool, and a shareholder's after-tax income pool but with the October 19, 2017 announcement, there will be even more pools that will have to be tracked. We have no doubt that the legislation needed to implement these corporate passive income rules will be extremely complex – perhaps the most complex we have seen in our collective careers in tax. While such complexity is fascinating to us tax geeks, it will not be good for business. Since July 18, 2017, the prospect of the new corporate passive income regime has had a drastic chilling effect on private capital markets and the October 18, 2017 announcement, with its lack of details, has alleviated little of the concerns.

Despite the rhetoric that these proposals will unlock corporate "dead money," we can't help but feel that the government is merely justifying a blatant tax grab. Regardless of ideological leanings, it should be obvious that passive investments are not "dead money" unless it is bundle of cash hidden underneath a mattress. Even money that is deposited in banks would be immediately deployed in the economy as loans and therefore such "dead money" statements are complete nonsense.

We continue to hold the opinion that the corporate passive income proposals should be dropped completely in order to bring back certainty and prevent economic damage that has already and will continue to occur.

Proposal on income sprinkling:

The proposal on income sprinkling represented the bulk of the draft legislation released on July 18, 2017. Overly simplified, the draft rules expand the existing "kiddie tax" regime to adults so that private business income beyond a "reasonable" amount received by certain related adults is automatically subject to top marginal tax rates and loses sheltering of personal tax credits. The proposed regime has been heavily criticized due to its broadness, complexity and the fact that it ignores the indirect contribution and risks assumed by family members of a business owner (especially spouses).

As part of the October 16, 2017 announcement, the government stated that they will move forward with the income sprinkling proposals but will work to reduce the compliance burden with respect to establishing the contributions of spouses and family members. While this is certainly a disappointing development, there may be silver linings if one read between the lines.

In the version of the rules contained in the July 18, 2017 draft legislation, top marginal tax rates automatically apply to certain income or capital gains received by an individual if the amount exceeds what would have been paid by an arm's-length entity, having regard to functions performed, assets contributed, risks assumed by the individual as well as all historical payments to the individual. The draft legislation was not clear on whether historical contributions could be taken into account, and the requirement to consider historical payments was particularly troublesome because of its retroactive effect and the administrative burden of compiling such information. The October 16, 2017 announcement appears to clarify that the final version of the rules will take into account past contributions by an individual (which will be helpful to retired business owners who still own an interest in the business). The announcement also omitted the historical payments factor. Whether this omission is intentional or not remains to be seen, but we could be left with three factors to consider for the reasonableness test: functions, assets and risks. If so, this would make the rules easier to apply. Another interesting observation is that the government now uses the term "labour contributions" instead of "functions ... performed," and that may be another attempt to simplify the rules.

The lack of mention of an "arm's-length" standard in the announcement, combined with the statement that impacted business owners will be "asked to demonstrate their contribution through any combination [of functions performed/assets contributed /risks assumed]" suggests that the government may be contemplating some sort of bright-line test whereby a business owner who has made a certain minimum threshold of contribution of functions, assets and/or risks assumed will not be capped to any maximum allowable income or capital gain. If that is the case, it would be a significant improvement to the July 18, 2017 version, and will result in a lot more certainty and reduced compliance burden for business owners going forward.

Notwithstanding, the fact that taxpayers and advisors like us have to "read between the lines" of press releases to guess what the government is proposing is, to put it mildly, unsettling. At least the government appears to be heading into a more reasonable direction, but nobody can say for certain until the next round of draft legislation is released.

Proposed reduction of the small business tax rate:

The previous government enacted scheduled reductions to the federal corporate small business income tax rate (applicable only to the first $500,000 of active business income) to an eventual 9% rate by 2019. However, the scheduled reduction was cancelled by the current government as part of their 2016 budget and as a result, the federal small business rate has remained at 10.5%. Along with the announcements that the government is pushing ahead with tax changes regarding income sprinkling and corporate passive income, the Liberals announced that they will reinstate the previous government's scheduled rate reductions as follows: 10% effective January 1, 2018 and 9% effective January 1, 2019.

We have no doubt the small business tax rate reductions were brought back to the table as a sweetener to the bitter medicine of the July 18, 2017 tax proposals. Although we hate to protest a tax rate decrease, we believe this reduction is wrong-headed. Firstly, the small business tax rate is the main driver behind the large discrepancy between current corporate and personal tax rates which ultimately incentivizes surplus stripping (to trade a >40% effective tax rate on dividends paid out from small business tax rate income, for a ~25% effective tax rate on capital gain) and retaining business earnings inside corporations for passive investment (to, again, avoid the >40% personal tax on dividends). Further reducing the small business corporate tax rate exacerbates this imbalance of the tax system and is completely contrary to what the government was trying to achieve with the surplus stripping and passive income proposals.

Secondly, the reduction of the small business tax rate necessitates an increase in the effective tax rate of dividends paid out of small business income tax rate corporate income, i.e. "non-eligible dividends." This is confirmed, albeit cryptically, in the footnote of the Backgrounder released on October 16, 2017. Thus, at best, the reduction is a deferral of tax until eventual distribution. On the other hand, this could work out to be a net tax increase since a go-forward increase in the effective tax rate on non-eligible dividends is a tax increase on all historical retained earnings previously subject to the pre-reduction small business tax rate.

Bottom line: we do not believe a further reduction of the small business tax rate is the correct policy choice and it does not negate the negative impact the tax proposals will have on business owners and the economy. In fact, notable economists, such as Dr. Jack Mintz, have argued that the small business tax rate regime should be dismantled completely. With the complexity of the small business deduction amendments that were brought into law last year, we agree with Dr. Mintz and have previously written here that consideration should be given to eliminating the small business deduction.

What do we think the government should do?

We and the tax advisor community have proclaimed over and over again that Canada is due for a comprehensive tax reform. An apt analogy we have seen made is of an old house, on which patches and additions have been added over the years. At some point, a complete gutting and renovation will be required. This is the state of our tax system. The last major tax reform in Canada was in 1972, based on the work of the Carter Commission of 1966. The Canadian Income Tax Act is due for another unbiased comprehensive review. Adding more ugly patches and unsupported additions is not the way to go.

In the meantime, we await further direction from the government regarding the passive income proposals and the next round of draft legislation to address the income sprinkling proposals. Hopefully the experience of the last week – and from July 18, 2017 to date – whereby tax proposals are put forward with offensive rhetoric and election style press releases are released over a week, will soon go into a box to be remembered as an ugly time in Canadian tax history.

Moodys Gartner Tax Law is only about tax. It is not an add-on service, it is our singular focus. Our Canadian and US lawyers and Chartered Accountants work together to develop effective tax strategies that get results, for individuals and corporate clients with interests in Canada, the US or both. Our strengths lie in Canadian and US cross-border tax advisory services, estateplanning, and tax litigation/dispute resolution. We identify areas of risk and opportunity, and create plans that yield the right balance of protection, optimization and compliance for each of our clients' special circumstances.

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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Authors
Kenneth Keung
Kim G.C. Moody
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