Proposed Changes to Tax Planning
Published September 9, 2017
On July 18, 2017, the Federal Minister of Finance released a consultation paper to address certain tax planning strategies using private corporations. After deeming these strategies advantageous to the wealthy and unfair to the middle class, the paper made several proposals to amend the current rules.
Far from simply closing loopholes, as the paper suggests, the proposed changes amount to a largescale reform of three common tax planning strategies: income sprinkling, passive investments and surplus stripping. If implemented, these reforms will negatively impact almost all small business and professional corporations, wealthy and middle class alike.
Income sprinkling is a strategy used to lower personal income taxes whereby a high-earning individual, generally subject to the highest marginal tax rate, transfers some of their income to a low-earning family member, generally a spouse or adult child, that is subject to a lower marginal tax rate. For tax purposes, the transferred income is attributed to the low-earning individual, making it subject to the lower marginal tax rate.
The paper proposes changes that will affect two main forms of income sprinkling: income splitting and multiplying lifetime capital gains exemptions.
Income splitting generally occurs when a business owner provides shares in their business corporation to a family member and then pays that family member dividends that would have otherwise been paid to the business owner.
Currently, the tax system prevents income splitting with minor children, so that dividends paid to children under 18 years old are taxed at the highest marginal rate. The paper proposes to extend this tax treatment to adults, so that dividends paid to any family member, child or adult, are taxed at the top marginal rate.
The only exception to this treatment will be for family members who contribute to the business. These family members will still be able to receive a reasonable income for their contributions without incurring adverse tax consequences. Acceptable contributions will be in the form of labour and capital investment. However, the only amounts exempt will be those that are reasonable given the contribution the family member provides and any previous compensation paid to them. Anything above reasonable compensation will be taxed at the highest marginal rate. Further, family members aged 18-24 will have a much higher reasonableness test than those aged 25 and older.
These new rules will apply to all family members of those “connected” to the business corporation. A “connected” person is someone who holds strategic influence, earnings influence, equity influence or investment influence over the business corporation. This includes those who control the business corporation, whose services provide the business’ main revenue, who own more than 10% of the business corporation or who provided more than 10% of the business corporation’s property.
Multiplying the Lifetime Capital Gains Exemption (LCGE)
The LCGE is a tax credit available to all Canadians that eliminates the capital gains tax otherwise payable on certain types of transactions. Each Canadian has, in their lifetime, an $835,714 tax credit (as of 2017) to be used against capital gains on the sale of qualified small business corporation shares or qualified farm property. Any capital gain above that amount is subject to normal capital gains tax.
One tax strategy used to reduce this excess capital gains tax is to apply the LCGE of multiple people, such as the business owner’s spouse and children, on a transaction that exceeds the business owner’s LCGE limit. This can be achieved by giving shares of the business corporation to family members or by putting shares of the business corporation into a family trust of which the family members are beneficiaries.
The paper proposes several changes to prevent multiplying LCGEs. First, the LCGE will no longer apply to any capital gains that accrue while a taxpayer is under 18 years old. Second, the use of an LCGE will be subject to the same reasonableness test described above. That is, the LCGE will not apply to gains that are unreasonable given the taxpayer’s labour and capital investment contributions. And third, the LCGE will not apply to capital gains that accrue while the subject property is held in a trust (other than an alter ego trust and certain employee share ownership trusts).
Passive Investments in Corporations
Under the current tax rules, corporations are a useful tool for personal investments. Compared to tax rates on salaries, corporations have very low income tax rates on their active business income. This is so that they have more money available to grow the business. However, this excess money can also be placed in passive investments, which do not grow the business but instead grow the business owner’s personal savings. The effect is similar to an RRSP: there is more money to invest today, and tax is only payable when it is cashed-out.
Income earned from passive investments inside a corporation are taxed immediately and at a high rate. Yet, using active business income of the corporation, the current rules make it possible to refund this tax immediately, deferring some, if not all, until a later date. Further, capital gains earned in a corporation are taxed at half the normal rate, whereas capital gains earned in an RRSP are eventually taxed at the taxpayer’s full marginal rate. This is all to say, with some planning and excess business income, passive investments in private corporations can offer advantages equal to or better than an RRSP.
The paper suggests that these passive investment benefits are unfair and need changing. However, it does not provide a definite proposal on how this will be done. Instead, it discusses several approaches that might be used, with the overarching goal of continuing to encourage business growth while also eliminating the passive investment benefits described above.
One of the discussed approaches is to eliminate the refundable tax paid on passive investment income. The tax would instead be made non-refundable, which would eliminate the deferral advantage. Another proposal is to eliminate some of the preferential capital gains treatment corporations receive.
The paper’s discussion of passive investment income leaves readers with little more than the assurance that changes, of some kind, are forthcoming. Fortunately, it also states that, whatever changes are made, they will only apply going forward, and the impact on existing passive investments will be “limited”.
Despite the differences between the taxation of business income and the taxation of employment income, the tax system’s end-goal is to tax income earned in a business at the same rate as income earned from employment. However, there are currently mechanisms by which business owners can convert income from their corporations into capital gains, which are taxed at half the rate of income earned from employment. This effectively circumvents the goal of equal taxation.
The paper has identified a series of transactions often used to achieve this circumvention, known as surplus stripping, and proposes measures by which they will be eliminated. Important to note is that these changes are proposed to take effect as of the day of the consultation paper, July 18, 2017. Meaning, if the proposals eventually become law, any attempted surplus stripping done today will be retroactively taxed under the new rules.
Prior to the paper’s release, business owners could strip surplus income from their business by selling their corporation, which contained surplus income, to another corporation owned by the same business owner, then reselling the original corporation to a third corporation also owned by that business owner. The owner would incur a capital gain on the first sale, but the third corporation could pay the business owner cash on the second sale. This cash would come from the surplus income of the original corporation, which otherwise would have been taxed at twice the rate.
After the paper’s release, transactions as described above will not result in favourable tax treatment. Rather, they will be subject to more tax than if the transactions were not attempted at all. This punitive result is meant to discourage business owners from even attempting to circumvent the rules.
Another note on this tax rule is that, in addition to surplus stripping transactions, it also applies to legitimate inter-generational transfers of a business from the owner to their children as part of a succession plan. The result is that, depending on how the transaction is structured, either the business owner or their child incurs worse tax treatment than if they had been dealing with a complete stranger. This issue existed prior to the paper’s proposed changes, yet the paper does not make proposals on how it is to be fixed. Rather, it requests input from the public and discusses potentially using the American approach, which is to allow the beneficial tax treatment on a sale to a child but only if, after the sale, the owner is completely removed from the business and its operation.
The Government will be accepting comments on the paper’s proposals until October 2, 2017. Submissions can be sent to firstname.lastname@example.org, and instructions regarding submissions can be found here.
If any business owners or persons affected would like to reach out to their local MP to voice their concerns, a list of Nova Scotia’s MPs can be found here. Patterson Law has also prepared a letter in opposition to the proposed changes that can be signed, or personalized, and sent to local MPs, found here.
For now, the consultation paper is not law, and nothing yet is confirmed. This makes tax planning at this point in time difficult and likely premature. Patterson Law’s tax team will be monitoring the course of these proposals closely, and will develop new tax planning strategies as soon as the Government has committed to any changes.
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Please note that this article is meant to provide information only and is not intended to confer legal advice or opinion. If you have any further questions please consult a lawyer. Please note as well that many of the statements are general principles which may vary on a case by case basis.