Canada: Update – Tax Measures Targeting Privately Held Corporations

Last Updated: October 27 2017
Article by Devry Smith Frank LLP

On July 18, 2017, the Department of Finance released a set of proposals to amend the Income Tax Act (the "July 18 Proposals"). The position taken by the Department of Finance and the rhetoric surrounding the July 18 Proposals were that the proposed tax measures were designed to "improve the fairness of Canada's tax system by closing tax loopholes and amending existing rules to ensure that the richest Canadians pay their fair share of taxes and that people in similar circumstances pay similar amounts of tax".

The July 18 Proposals were roundly criticized by the tax and business communities, with town hall meetings, conferences and consultations held across the country. In addition, over 21,000 written submissions were made to the Federal Government during the consultation period, which ended October 2, 2017.

The key elements of the July 18 Proposals were based on changes to the following 4 key areas:

  1. Lifetime Capital Gains Exemption ("LCGE")

The LCGE exempts holders of qualified small business corporation shares and holders of qualified farm or fishing property from tax on capital gains of up to $1 million arising from a sale or disposition. The Federal Government was concerned that methods to multiply the LCGE, using family trusts, for example, unfairly permit more than one taxpayer to claim the LCGE and thereby reduce the tax payable on the disposition of private company shares, or qualified farm or fishing property. The July 19 proposals sought to significantly restrict the availability of the LCGE.

  1. Income Splitting

Income splitting refers to the practice through which income earned through a corporation is "sprinkled" among family members, rather then all paid to one individual. This practice allows a taxpayer to reduce his family's overall tax bill by shifting income from higher-income taxpayers to lower-income taxpayers.

  1. Passive Investment Income

Active business income earned in a corporation is taxed at a much lower rate than employment income earned by an individual. Because of the tax deferral available when retained earnings are kept in a corporation, there is more after-tax income available to invest in a corporation than if that same amount of income was earned personally. As such, Finance perceives this to be an inherent unfair "advantage" to private company shareholders.

  1. Converting Income into Capital Gains

The Government's proposals seek to address certain transactions that they consider to be abusive, specifically certain post-mortem transactions, which convert income which would otherwise be taxable at higher corporate tax rates to capital gains, which are taxed at significantly lower rates.

On October 3, 2017, the Department of Finance issued a Press Release, in which Finance Minister Bill Morneau acknowledged the concerns regarding the July 18 Proposals raised by the public, the tax community, and business owners, and suggesting that the Government may take steps to make amendments to the proposed legislation based on feedback Finance had received.

On October 16, 2017, the Department of Finance issued an announcement of changes to the July 18 Proposals in light of the consultations and further to its October 3rd announcement. The highlights of the proposed changes are:

1. Reduction in the federal small business tax rate from 11% to 10% effective January 1, 2018 and to 9% effective January 1, 2019.

2. No changes to the LCGE. Finance stated that "the Government will not be moving forward with the measures that would limit access to the Lifetime Capital Gains Exemption".

3. Income Shifting. Finance confirmed that it will continue with its proposals to terminate income shifting to lower-income family members who do not contribute to the business. However, Finance stated that it will introduce "reasonableness tests" for adult family members who will be asked to demonstrate their contribution to the business.

On October 18, 2017, the Department of Finance issued a further announcement targeting passive income earned within private corporations. In this Press Release, the Government stated that it will continue with its intended measures to limit the tax-deferral opportunities related to passive investments; however, it will provide some relief by allowing business owners to build savings for business purposes or for retirement. The Government has announced that businesses can continue to save for contingencies or future investments based on a threshold of $50,000 of passive income per year. Any income above this threshold will presumably be subject to higher rate of taxation as set out in the July 18 Proposals.

Draft legislation implementing these proposed changes will be released as later this fall or as part of Budget 2018.

We can help. Tax planning opportunities are available to assist Canadian taxpayers in optimizing their affairs to obtain a favourable tax outcome.

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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