Canada: Tax Letters: 2018 Federal Budget – Business Income Tax Measures

Passive Investment Income Earned by Private Corporations

The Budget proposes to introduce measures to reduce perceived tax advantages where a private corporation earns passive income. The announcement that such measures were going to be introduced was first made on July 18, 2017, along with other substantive measures intended to reduce the ability of taxpayers to sprinkle income among family members. The Budget proposals bear little resemblance to the measures initially announced.

The Budget proposes two sets of new provisions. One set is intended to reduce the $500,000 business limit otherwise available to a group of associated Canadian-controlled private corporations (CCPCs) where the group earns a significant amount of passive income. The second set reduces, but does not eliminate, the ability of a corporation to obtain refunds of refundable dividend tax on hand (RDTOH) by paying eligible dividends as compared to non-eligible dividends.

$500,000 Business Limit Reduction

The business limit of an associated group of CCPCs is already reduced where the group's "taxable capital employed in Canada" exceeds $10,000,000.

The proposed provisions will reduce the group's business limit on a straight line basis where the group earns "adjusted aggregate investment income" between $50,000 and $150,000. The reduction will be $5 for every $1 of investment income. Consequently, a group's business limit will be reduced to zero (5 × $100,000 = $500,000) in a particular year if its adjusted aggregate investment income is $150,000 or more.

A group's adjusted aggregate investment income for the year will be based on aggregate investment income, as determined in computing the amount of RDTOH, and is subject to the following adjustments:

  • Dividends from non-connected corporations will be added.
  • Taxable capital gains will be excluded to the extent that they arise from the disposition of assets used principally in an active business carried on primarily in Canada by the CCPC or a related CCPC.
  • Taxable capital gains will also be excluded to the extent that they arise from the disposition of shares of a connected CCPC where all or substantially all of the fair market value of the assets of the connected CCPC is attributable to assets that are used principally in an active business carried on primarily in Canada.
  • Net capital losses carried over from other taxation years will be excluded.
  • Income from savings in a life insurance policy that is not an "exempt policy" will be added to the extent it is not otherwise included in aggregate investment income.

This reduction to the business limit is based on income for the year that ended in the preceding calendar year.

This proposal will apply to taxation years that commence after 2018 with no grandfathering of passive income earned on existing investments. Consequently, all future investment earnings will be included in this annual test, regardless of when the applicable investments were accumulated.

The reduction of a corporation's business limit for a particular year will be equal to the greater of the reduction under the existing taxable capital rule and the proposed rule.

Anti-avoidance measures will discourage transactions designed to delay or avoid the new rules. One such transaction might otherwise have been the creation of a short taxation year. Another might have been the transfer of property to a related but unassociated corporation.

Changes to RDTOH

Currently, a dividend refund is available to a corporation at the rate of 38 1/3 per cent of taxable dividends paid to the extent that there is an available balance of RDTOH at the corporation's year-end. The taxable dividends paid can be either non-eligible dividends or eligible dividends. There is a tax advantage where eligible dividends are paid.

The Budget proposes to introduce measures that will generally allow a CCPC to recoup RDTOH only on the payment of non-eligible dividends. An exception will apply to RDTOH arising on the payment of Part IV tax on eligible portfolio dividends. Such RDTOH can be recouped on the payment of eligible dividends.

To accomplish this, the Budget proposes to create an "eligible RDTOH" account and a "non-eligible RDTOH" account. As indicated above, eligible RDTOH will include only Part IV tax paid on the receipt of eligible portfolio dividends. All other RDTOH will be included in the non-eligible RDTOH account.

If a corporation pays a non-eligible dividend, it recoups non-eligible RDTOH before it recoups eligible RDTOH. If it pays an eligible dividend, it can recoup eligible RDTOH. Any taxable dividend paid, either eligible or non-eligible, will entitle the corporation to a refund of eligible RDTOH.

The existing RDTOH of a CCPC will first be allocated to its eligible RDTOH account to a maximum of 38 1/3 per cent of its general rate income pool (GRIP). The remainder, if any, of its existing RDTOH balance will be allocated to its non-eligible RDTOH account. All of the existing RDTOH of other corporations will be allocated to their eligible RDTOH account.

This measure will apply to taxation years that commence after 2018. An anti-avoidance measure will prevent the deferral of the new measures by creating a short taxation year.

Income Sprinkling Measures

Overview

The Budget confirms that Finance will proceed with the implementation of the December 13, 2017, draft proposals that address income sprinkling involving private corporations.

The Tax on Split Income (TOSI) regime that existed prior to 2018 (commonly referred to as the "kiddie tax" rules), impacted only Canadian-resident minors. It essentially taxed at the top marginal rate certain types of income that they earned, including taxable dividends or shareholder benefits from private company shares, income allocations from partnerships or trusts that were derived from the business or profession of a related person, and 100 per cent of capital gains from non-arm's-length sales of private company shares (such gains were converted to non-eligible taxable dividends).

The December 13, 2017, draft legislative proposals represent a major broadening of the old TOSI rules and will become effective as of January 1, 2018.

The proposed TOSI rules can apply to any Canadian resident, regardless of age. Further, types of income in addition to those under the old rules described above could be caught. Such income types include interest on debt obligations from private corporations and certain partnerships and trusts, taxable capital gains from the sales of partnership or trust interests that either generate TOSI or derive part of their value from private company shares, and taxable capital gains on arm's-length sales of private company shares. With respect to the latter, however, the TOSI rules will not apply to the arm's-length sale of qualified small business corporation shares (QSBC shares) that are eligible for the lifetime capital gains exemption even if the lifetime capital gains exemption is not claimed.

The taxation of capital gains from the non-arm's length sale of private company shares by a minor will remained unchanged: 100 per cent of such capital gains will still be converted to non-eligible taxable dividends. Further, the ability of adults to sell QSBC shares to non-arm's-length parties without triggering the TOSI will remain intact. TOSI will not apply to capital gains arising from the sale of farming or fishing properties that qualify for the lifetime capital gains exemption — again, even if the lifetime capital gains exemption is not claimed.

Exclusions

Several exclusions from TOSI must be considered in order to determine if the tax applies. No adult of any age is subject to TOSI on income from an unrelated business. Also, the proposals introduce some "bright line" tests as well as a general reasonableness test that could operate to exclude an individual from the new TOSI rules. These tests are not mutually exclusive and vary based on the age of the individual in question.

An adult of any age will not be subject to TOSI on income derived from an "excluded business", i.e., one in which the individual is actively engaged on a "regular, continuous and substantial basis" in the taxation year in which the income amount is received, or in any five previous taxation years that need not be consecutive. This generally requires that the adult work in the business for at least an average of 20 hours per week during the part of the year that the business operates. However, if this 20-hour threshold is not met, it would be a question of fact whether or not the individual is actively engaged in the business on a regular, continuous and substantial basis.

Income derived by adults over the age of 24 from "excluded shares" is not subject to TOSI. To meet the definition of an excluded share, several conditions must be met.

  • The individual in question must directly own at least 10 per cent of the votes and value of the corporation.
  • The corporation must earn less than 90 per cent of its income from the provision of services.
  • The corporation cannot be a professional corporation, such as those carried on by medical doctors, dentists, accountants, lawyers, chiropractors and veterinarians.
  • All or substantially all of the corporation's income cannot be derived from a related business in respect of the individual.

If taxpayers restructure their corporations in order to meet the excluded share definition by the end of 2018, this exception will be available to them for the entire 2018 taxation year. Taxpayers and their advisors may want to pay particular attention to this exclusion when setting up a new corporation or undergoing a traditional estate freeze, as it is conceivable that it may be relied upon heavily in these contexts.

If income earned by the spouse of a business owner aged 65 or more would not be subject to TOSI had the business owner earned it directly, then the spouse's income would not be subject to TOSI. There is no requirement that the spouse be aged 65 or over for this exclusion to be met.

There are various exclusions for inherited property.

Taxable capital gains arising from the deemed disposition on the death of an individual as well as income derived from property acquired on the breakdown of a marriage or common-law partnership are also excluded from TOSI.

If none of the above exclusions from the TOSI rules apply, the reasonableness tests must be considered. This is because only income in excess of a "reasonable return" will be subject to TOSI.

For adults over the age of 24, a reasonable return will take into account various factors, including labour contributions, property contributions, risk assumed, historical payments, and any other relevant factors. As these factors do not include any thresholds in terms of hours worked or amounts contributed, there is a high degree of subjectivity with this test.

For adults between the ages of 18 and 24, what is considered to be a reasonable return is more precisely defined, but greatly limited. Only capital contributed will be considered.

Tax Support for Clean Energy

Capital cost allowance (CCA) Classes 43.1 and 43.2 provide accelerated CCA rates for investments in specified clean energy generation and conservation equipment. Class 43.2 was introduced in 2005 and is currently available in respect of property acquired before 2020. The Budget proposes to extend eligibility for Class 43.2 by five years to include property acquired before 2025.

Artificial Losses Using Equity-Based Financial Arrangements

A corporation can generally deduct dividends received on a share of a corporation resident in Canada (a "Canadian share"). However, the current "dividend rental arrangement" rules deny this deduction where the main reason for an arrangement is to enable the taxpayer to receive a dividend on a Canadian share, and the risk of loss or opportunity for gain or profit accrues to someone else.

The Government is concerned that certain taxpayers are still engaging in abusive arrangements that are intended to circumvent the dividend rental arrangement rules and result in an artificial tax loss on the arrangement. Consequently, the Budget proposes an amendment which broadens the dividend rental arrangement rules and securities lending arrangement rules in order to prevent taxpayers from claiming a deduction for inter-corporate dividends received in situations where substantially all of the opportunity for gain or profit or risk of loss in respect of a Canadian share rests with certain persons other than the taxpayer. Similar rules are proposed to clarify situations in which a dividend compensation payment can be deducted.

These proposed rules are generally effective for dividends paid, or dividend compensation payments made, on or after February 27, 2018.

Stop-Loss Rule on Share Repurchase Transactions

The Budget proposes an amendment to the dividend stop-loss rule to decrease the tax loss on a repurchase of shares held by the taxpayer as mark-to-market property where it receives a tax deductible inter-corporate dividend on the repurchase. This amendment generally reduces the tax loss by the full amount of the deemed dividend.

This proposal will apply to share repurchases occurring on or after February 27, 2018.

At-Risk Rules for Tiered Partnerships

In response to a recent Federal Court of Appeal ruling, the Budget proposes to restrict the allocation of losses to members of a top-tier partnership in tiered partnership structures for taxation years that end on or after February 27, 2018, including losses incurred in tax years that ended prior to that date. The allocable losses of a second-tier partnership will be restricted by the at-risk amount of the top-tier partnership, and unused losses will not be eligible to be carried forward indefinitely. Such unused losses will be added to the adjusted cost base of the partnership interest of the second-tier partnership.

Health and Welfare Trusts (HWT)

An HWT is a trust established by an employer to provide health and welfare benefits to its employees. Since the tax treatment of HWTs is not set out in the ITA, CRA has published an administrative position which sets out the requirements of HWTs and the income tax consequences.

The Budget proposes to discontinue the application of CRA's administration position after the end of 2020 in order to encourage conversion of such trusts to employee health and life trusts for which there are specific rules in the ITA. The Department of Finance has requested comments by June 29, 2018, on the transitional rules.

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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