August 8, 2017

Private company tax planning – Proposals and Consultation

As indicated in the 2017 Federal budget, the Department of Finance has been concerned with tax planning involving private corporations (Budget 2017). On July 18, 2017, Finance released a discussion paper including draft legislation for some of the items discussed in the paper. Most of the proposed measures apply to the 2018 and subsequent taxation years, except for the proposed “anti-surplus stripping” rules which apply on or after July 18, 2017.

This article will provide an overview of the proposals and will be followed up with further articles that will go into more detail in each area. In general, this is significant. The measures will limit income splitting opportunities, multiplication of the capital gains exemption and other tax strategies. The rules suggested are complicated. Added to the already complex changes resulting from changes to inter-corporate dividends (Budget 2015 Changes – Potential impact on Inter-corporate dividends) and changes to the small business deduction that expanded the situations where the small business limit must be shared, we have a recipe for pain. All these measures will, together, represent a fundamental tax policy shift that will disincent individuals from starting, owning and growing a business. Responding to this will have to be political not technical.

The main areas of concern and focus for Finance, in the 2017 budget and the discussion paper, are as follows:

◾ Income sprinkling using private corporations;
◾ Holding a passive investment portfolio inside a private corporation; and,
◾ Converting a private corporation’s regular income into capital gains.

Draft legislation was released for the proposed measures to address income sprinkling. In general, income sprinkling involves reducing tax by causing income that would otherwise be taxed at high personal tax rates to be realized by a family member who is subject to lower personal tax rates.
The measures significantly expand the scope of the “kiddie tax” (which tax the recipient at the highest marginal tax rate) on split income by extending it to any Canadian resident who receives income from a related business, if the income received is “unreasonable” having regard to labour and capital contributed to the business by the individual. Income earned by 18-24-year-olds will be subject to a higher degree of scrutiny. The proposals also expand the scope of the kiddie tax by including “compound” income (income earned from an investment that is subject to kiddie tax). In general, this “reasonableness” test introduces greater uncertainty to the tax treatment of dividends or other amounts that might be subject to the kiddie tax.

The proposals also address multiplication of the lifetime capital gains exemption (LCGE), another income sprinkling issue. They eliminate the LCGE on capital gains:

◾ that accrued before the taxation year in which the individual turns 18;
◾ if income on the property was subject to kiddie tax; or
◾ that accrued while the property was held by a trust (other than a spousal, common law partner trust or certain trusts to hold shares for employees).

This would restrict the ability to claim the LCGE in many common estate planning transactions (where, for example, a family trust holds the new common shares after an estate freeze). It will also complicate the act of claiming the LCGE when part of the ownership period occurs while an impugned trust held the shares or the individual was a minor. Establishing the valuation of the property relating to the impugned ownership period would be important. Transitional relief in the form of a one-time election in respect of existing gains in 2018 is proposed.

In relation to passive investment income the concern is that individuals who carry on a business through a corporation can leave their business income (which is very favourably taxed at the small business rate or the general corporate rate) in the corporation to make passive investments. Because of the difference in personal versus corporate tax rates, there is more available to invest from business income earned in a corporation than if that business income were earned by the individual as a sole proprietor.

The current system taxes passive investment income in a corporation at a rate approximating personal rates by imposing a refundable tax. However, it does not align the amount available to invest within the corporation to that which would be the case if the business income were earned personally.
Finance did not release draft legislation to address the treatment of passive investment income inside a corporation. It floated possible approaches that it could take and sought input and feedback on these approaches. A new regime would replace the current system of refundable taxes with a non-refundable tax (generally equivalent to the top personal tax rate) and would apply on a “go-forward” basis. Let’s just say, this is a very controversial proposal. More to follow here!

The final area of concern relates to converting a corporation’s regular income into capital gains. Capital gains are taxed at lower rates than regular income, eligible and non-eligible dividends. Draft legislation was released applicable on or after July 18, 2017 to prevent “surplus stripping.” The existing provision (section 84.1), which recharacterizes capital gains as dividends, intended to prevent surplus stripping, has proved inadequate.

Amendments are proposed to this section and a new anti-avoidance, anti-surplus, stripping rule is proposed. The main concern from an estate planning perspective is if these rules apply to post-mortem “pipeline” planning. That could impair tax planning that is intended to avoid double-tax at death – tax on the deemed disposition of shares held by the deceased at death and tax on the winding up of the company.

In summary, if income cannot be distributed to and split with other family members, it could mean more trapped surplus. More trapped surplus may simply mean reinvestment in the business such that the business values grow and ultimate capital gains tax liabilities are higher. Limiting the ability to claim the capital gains exemption will only mean that more of that gain will be taxable. Insurance to provide liquidity, to pay higher capital gains tax on death, is an obvious solution. It is still to be determined how the proposed changes will influence the investment of trapped surplus at the corporate level. What we do know is that passive assets held by a corporation will be subject to a different, less beneficial regime of tax than what we have currently. Will life insurance provide a long-term tax effective distribution solution? Also, if post-mortem pipeline planning is impacted, insured share redemption may be the best answer to the double tax problem on death.

Finance is seeking feedback by October 2, 2017. You can rest assured that there will be feedback!


Source: Manulife, August 2017