Canada: Update On July 18th Proposed Tax Changes Affecting Private Corporations – What You Should Consider Doing Before The End Of 2017

Last Updated: November 7 2017
Article by MaryAnne Loney

On July 18, 2017 the federal government released a paper detailing three proposed changes to the Income Tax Act affecting private corporations. Concurrently, it released draft legislation for two of the proposed changes. The public consulting period for the proposed changes ended on October 2, 2017.

Tax practitioners, professional bodies, and the business community have responded forcefully against the proposed changes and mainstream media has picked up the story. The Minister of Finance has since made several announcements in response.

This article will ignore the political debate and will instead focus on what owners of private corporations should know about the changes, and what they may want to do before the end of 2017.

The effect and status of each of the proposed changes

The proposed changes address three different areas and much of the commentary and debate has merged them together. We will consider each proposed change individually.

1. Tax on Passive Investment Income

Status of legislation: no draft legislation.

Unlike the other changes discussed below, the government did not release any draft legislation related to this proposal. Instead, all the paper did was identify what the government considers a problem – that the tax deferral corporations receive on active business income allows shareholders of private corporations to invest and profit from a larger initial investment amount than employees or unincorporated sole proprietors.

The government identified a few options for addressing this "problem", and suggested that their preferred option was to effectively tax passive investment income earned in a corporation at a high enough rate that the after-tax income shareholders would receive would be the same amount they would have received if they had taken the money out and invested it personally, thereby offsetting the benefit of the tax deferral from investing money held in the corporation.

While many people have had a lot to say about this proposal, it is important to emphasize that as there is no draft legislation much of the commentary has been speculative.

Implementation date: Unknown.

While the paper suggested the government was considering implementing this proposal effective in 2017, at a policy conference put on by the Canadian Tax Foundation on September 25, 2017, (the "CTF Conference") a representative of the Department of Finance noted that as there is no draft legislation there is not yet an implementation date.

From a practical standpoint, if the government is going to review in good faith and incorporate the commentary provided during the consulting period, having draft legislation prepared by January 1, 2018, will be difficult.

Government's comments: They think this is a problem, but are not sure how to fix it.

Comments by the Finance Minister and representatives of the Department of Finance at the CTF Conference made it clear that the government considers it a problem that owners of private corporations can use the corporate tax deferral to give them an advantage when it comes to their personal savings.

However, the government also admits that it has not determined the finer details about practically how to address the issue.

On October 16, 2017, the Finance Minister said that up to $50,000 in investment income (the equivalent of $1 million in savings, based on a nominal 5% rate of return) would not be subject to the new tax. He stated that the changes would not affect current investments in private corporations as, while they have not figured out exactly what the mechanism would be, they plan to allow current investments to be grandfathered such that they can continue to take advantage of the current tax treatment.

Our comments: Wait.

While it appears that the government would like to do something in terms of taxing passive investment income in corporations, it is unclear what, if anything, will come of this proposal. Further, given the Department of Finance's promise that any passive investments currently held in corporations will be grandfathered allowing them to continue to take advantage of the current rules, there is no reason to not continue to invest business profits held in corporations until we know more.

2. Restrictions on surplus stripping

Status of legislation: Draft legislation released but apparently will not proceed.

Surplus stripping is essentially taking business profits in the form of capital gains instead of dividends. This creates a tax savings as capital gains are effectively taxed at a lower rate than dividends.

The government has had concerns with surplus stripping since a few months after the release of the first income tax act in 1917, and taxpayers realized that if they sold their business rather than liquidating it and taking out the money as dividends they would save a lot of tax.

There are already provisions in the Income Tax Act that aim to stop surplus stripping by selling a corporation to a related corporation for the purposes of triggering a capital gain, or when the capital gains exemption has previously been used. The government has released draft legislation that expands this so that only an arm's length sale will not be caught.

Tax practitioners are concerned because it appears the draft legislation may catch many capital gains previously considered perfectly acceptable. Worse, the provisions do not just turn a capital gain into dividends, but can result in an amount being taxed twice, first as a capital gain at the time of the non-arm's length sale and then as a dividend when the funds are taken out of the corporation.

Tax practitioners were concerned because it appeared that the draft legislation would catch many capital gains previously considered to be perfectly acceptable. Worse, the provisions not only turned a capital gain into dividends, but also resulted in amounts being taxed twice; first as a capital gain at the time of the non-arm's length sale, and again as a dividend when the funds are taken out of the corporation. This would have caught transactions already completed and severely penalized intergenerational transfers of a business.

Implementation date: N/A

The draft legislation was proposed to be effective from the date it was first announced (July 18, 2017). However, on October 19, 2017, the Department of Finance indicated they will not be moving forward with measures relating to the conversion of income into capital gains.

Government's comments: Not proceeding.

One of the primary concerns of opponents to the legislation, and a problem acknowledged by the government, was that this legislation imposed significant tax costs to "true" transfers of a business to the next generation as opposed to an arm's length party. As an example, under the proposed legislation a mother and father selling their corporation to an arm's length party would have received a capital gain and been taxed at a lower rate, but a mother and father selling their corporation to their son's holding corporation would have been taxed as if they had received the sale proceeds as a dividend.

The government apparently decided the "unintended consequences, such as in respect of taxation upon death and potential challenges with intergenerational transfers of business" were significant enough that for now they will not be proceeding with the proposed changes.

Our comments: This is the end...for now...

The very significant "unintended consequences" of this legislation had tax practitioners extremely worried, so we are pleased to see it has been abandoned. That being said, "surplus stripping" is something the government hates, and has hated for a long time (regardless of what party is in power). As a result, we would not be surprised if the government continues to look at ways to address surplus stripping while avoiding the specific problems with this draft legislation. Therefore, while we can continue to take advantage of "pipeline" planning and other surplus stripping techniques for now, we would not be surprised if we see the government attempt to further limit them in the future.

3. Restrictions on income splitting

Status of legislation: Draft legislation released.

Under corporate law, a corporation may pay dividends to any of its shareholders holding shares authorized to receive dividends. As a result, by issuing shares to multiple family members, corporations can split the dividends between family members such that they can take advantage of multiple individuals' lower marginal tax rates. This is referred to as "sprinkling" by the government, but more commonly known as income splitting.

The Income Tax Act already had provisions to stop income splitting with minors by taxing the amounts received caught by the legislation ("Split Income") at the top marginal tax rate. The draft legislation proposes to characterize dividends and capital gains earned by adults in certain circumstances that do not meet a reasonableness test as Split Income as well. Capital gains will not just be taxed at the top marginal rate, but will also be treated as taxable dividends which are taxed at a higher rate than capital gains.

The proposed "reasonableness" test will be more difficult for adults under 25 years of age and family trusts to satisfy.

The draft legislation also greatly limits the ability of families to access multiple Lifetime Capital Gains Exemptions, including through family trusts.

Implementation date: January 1, 2018

The proposed legislation will affect payments received starting in 2018

Government's comments: You can still pay "reasonable" dividends.

The government said they will be proceeding with these proposed changes, but they will be "simplifying" the proposals and "family members who meaningfully contribute to the business will not be impacted by the proposed measures on income sprinkling".

Additionally, on October 16, 2017, the Finance Minister announced the government "will not be moving forward with proposed measures to limit access to the Lifetime Capital Gains Exemption".

Our comments: It really comes down to what the government decides is "reasonable".

We are pleased to hear they are not proceeding with limiting the Lifetime Capital Gains Exemption. Until we see the revised draft legislation, however, it will be difficult to judge what impact their "simplifying" of these proposals will have.

It is clear that corporations are no longer going to be able to pay tens of thousands of dollars in dividends to the president's 19 year old child while he or she attends university. The government is of the opinion that income splitting with those under 25 years old is an unfair tax "loophole" and no one is fighting very hard to defend this practice. Further, given societal shifts such that kids are usually dependent on their parents up into their early to mid-twenties, this change is in line with current tax legislation preventing income splitting with minor children.

However, income splitting with older adults, especially spouses, is much more complicated. Here there has been a strong backlash and the question of what is reasonable is much more subjective.

That being said, the legislation does leave a lot of room for interpretation. If the CRA interprets "reasonable" broadly the final impacts may not be as bad as many fear.

What to do in 2017

As indicated, we do not recommend making any changes at this time to passive investments held in private corporations. In fact, given the government's statements regarding grandfathering, if anything there may be an argument to build up passive investments incorporation at this time.

As the proposed surplus stripping changes have been abandoned, surplus stripping planning may continue... for now.

However, as there is a reasonable chance the income splitting provisions will be implemented in some form, but they will not come into effect until 2018, here there are some planning opportunities for 2017. We suggest you consider the following:

  • Pay extra dividends in 2017 to shareholders, particularly those under 25, who will likely be caught by the expanded tax on "split income".

    This will likely be the last year you can pay dividends without worrying about whether they are unreasonable to adults so take advantage of it.
  • Consider whether it may make sense to have shares likely subject to the new tax on split income repurchased or redeemed by the corporation in 2017. Specifically, corporations should review whether it continues to make sense for shares to be owned by individuals under 25 years of age, by family trusts, and by family members who have never provided significant contribution to the business.

    As indicated, in the draft legislation capital gains are considered to be Split Income and treated as dividends, so if you dispose of shares caught by the split income rules after 2017, that gain will be taxable at a much higher rate. Therefore, where it is very clear the shares will be caught, it may make sense to avoid this issue by repurchasing the shares in 2017. The challenge is, especially for shareholders over 25, it may not be clear if the shares will be caught once the legislation is finalized and the CRA has had a chance to interpret it.

What, if anything, is advisable to do will depend on individual circumstances, so we recommend speaking to a tax practitioner.

Conclusion:

Thanks to recent announcements by the Minister of Finance, while we still have questions regarding what the specific legislation will look like, we have a much clearer picture as to what will happen.

As some of the planning opportunities for dealing with the expansion of the tax on Split Income are only available until the end of the year, owners of corporations who suspect they may be impacted by these changes should consider as soon as possible whether they want to take steps to minimize their impact before year end.

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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