On July 18, 2017, Liberal Federal Minister of Finance, Bill Morneau announced the release of a consultation paper and draft legislation to address areas where the federal government feels that some owners of private corporations have gained unfair tax advantages.
While the proposed amendments have been characterized as closing “loopholes” in Canadian tax laws and ensuring the payment of the “ fair share of tax” by all Canadians, the tax proposals and draft legislation released by the Department of Finance will completely change the way in which private corporations and its shareholders have been taxed for over 40 years.
It is widely considered that the proposed changes are not closing “loopholes” but rather … complete tax reform for the taxation of private corporations.
The consultation paper and draft legislation proposes tax changes in the following areas:
• Income splitting
• Multiplication of the lifetime capital gains exemption (LCGE)
• Holding of passive investment portfolio inside a private corporation; and
• Converting private corporation income into capital gains.
Income splitting is a common tax planning arrangement where income that would be taxed in the hands of high income individual is being taxed in the hands of a lower income earner, typically a family member.
While the proposed measures are complex, the government is proposing to apply a reasonableness test on the amounts paid as split income. An amount paid would not be considered reasonable if it exceeds what an arm’s length party would have agreed to pay to the adult considering their labour and capital contributions to the business and any risk assumed by the individual. The reasonableness test will be applied based on the age of the adult. It is more restrictive for adults age 18-24 as opposed to those age 25 or older.
These measures would effectively prohibit the payment of dividends to family members (typically, spouses and children) that are not actively involved in the business.
These measures would apply to the 2018 and later taxation years.
Lifetime Capital Gains Exemption (LCGE)
The proposed changes apply to owners who plan on selling their business in the future.
The current tax rules allow you to multiply the LCGE on the sale of your business if your family members also own shares in the private corporation either directly or indirectly through a family trust. Under the existing rules, family members under the age of 18 could claim their LCGE on the sale of the business.
The government proposes to disallow the use of the LCGE for family members under the age of 18. Further, for adults age 18 or over, the new reasonableness test described above for income splitting would be used to determine whether the adult could claim their LCGE.
The impact of these measures is to disallow an individual from claiming the LCGE unless they are actively involved in the business.
The proposed rules would apply to dispositions after 2017.
Based on 2017 capital gains rates, the “worst case” scenario would be an owner can only shelter $835,716 of any possible capital gain under the proposed rules as opposed to sheltering an additional $835,716 for each LCGE used by a family member who have ownership in the business either directly or indirectly.
Holding passive investments inside a private corporation
Corporate business income is taxed at lower rates than personal income. As a result, business owners have more money to invest in and grow their business. When the business has earned more income than is needed to grow the business, the business owner can invest the “passive” investments inside the corporation.
The government feels there is an unfair tax advantage as the business owner can invest “more” money inside the corporation which could potentially yield higher returns as compared to investing the funds personally. Stated another way, the business owner could save more money inside a corporation that would ultimately be available for personal use when withdrawn from the corporation as compared to withdrawing the money now, paying personal income tax on the withdrawals and then investing the money personally.
The government has NOT proposed draft legislation to address this perceived unfair tax advantage but has offered a plan that is beyond the scope of this publication.
In essence, the government is proposing an approach that would include changes to the way that passive income is taxed in the individual’s hands when distributed from the private corporation as dividends to the shareholders. As. Well, depending on the approach taken, passive income earned in the corporation could be taxed differently. If implemented, there will be less incentive to accumulate investments inside a private corporation.
Given there is no proposed legislation, there is significant uncertainty about what the final proposals will look like, the timing of such changes and the ultimate tax impact to taxpayers. It is widely expected that any tax changes would NOT be applied retroactively.
Converting private corporation regular income into capital gains
Personal tax rates on dividends and salary are higher than capital gains rates. As a result, the government is concerned that high income shareholders are taking surplus amounts out of private corporations as capital gains that should be taxed as dividends or salary.
The proposals advanced by the government would have a significant tax impact on estate planning upon the death of a taxpayer and on intergenerational sale of businesses from one family member to another such as a parent to a child.
For estate planning, the proposals could cause an increase in “death taxes” on shares and create the potential for double taxation. The proposed legislation completely eliminates the possibility of using tax planning arrangement used on death called “pipeline planning”.
Further, the proposals could cause increased disadvantage to intergenerational transfers as compared to a sale to a third party.
The proposed rules would be effective immediately.
The commentary above is intended to give you a brief overview of the proposals advanced by the Federal government and should not be taken as specific tax advice. We are aware of the uncertainty that this has caused you.
The proposed changes impact the partners of Bruce & Monahan in the same fashion as they impact you, so we too are closely following the developments.
Once the Federal Government provides an update on the proposed changes, which could include changes or modifications, we will proactively research and develop a tax plan for each of you ensuring you are best suited to meet the new reality of the tax reform.
Call to Action
We feel it is essential for active involvement of all owners of private companies who could be affected by the proposals.
We suggest you contact your local MP to explain how the proposed changes impact you and your family. You can also contact Finance Minister Morneau and Prime Minister Justin Trudeau. While the proposed changes are at the FEDERAL taxation level, we also feel you should tell your story to provincial MLAs as the changes will have a negative impact on economic growth in our province.
The federal government has set a deadline of Oct. 2, 2017, for comments on the proposed changes.
Please share your concerns before then by emailing firstname.lastname@example.org