The federal government, through the budget released on March 22, 2017 and the consulting paper released on July 18, 2017, has proposed several significant changes impacting private corporations in Canada.
For decades, Canadians have incorporated private corporations to benefit from ownership structures involving additional family members. These structures allow for dividends to be paid to family members in a lower tax bracket in an effort to reduce the overall tax burden.
There have been restrictions on income splitting with children under the age of eighteen for a number of years (the “Kiddie Tax”). The proposed changes implementing Tax on Split Income (“TOSI”) seeks to extend the Kiddie Tax to apply to adults in family controlled businesses. TOSI will result in those individuals to whom it applies to be taxed on dividend income received from privately controlled family corporations at the highest marginal rates. This can exceed fifty percent (50%) in many provinces.
The government has also proposed expanding the definition of what constitutes split income to include interest on loans as well as to taxable capital gains if the income on the shares would have been split income.
The government has proposed allowing for a reasonableness standard. The goal is to exempt adults from the higher tax rate if the income received is commensurate with what the corporation would have paid an arm’s length individual.
The reasonableness factors are:
- contribution of labour
- capital contributed
- risk assumed
- previous remuneration
Individuals between the ages of 18 and 24 will be subject to a more rigorous reasonableness standard as the government is concerned about income splitting with young adults as they are considered to more likely be in a lower tax bracket.
Once the changes come into effect there will be unforeseen impacts on how various tax credits are calculated as well. The new anti-income splitting rules are scheduled to be effective starting in 2018.
LIFETIME CAPITAL GAINS EXEMPTION
For a number of years, Canadian entrepreneurs have been able to benefit from a lifetime capital gains exemption on the disposition of shares of qualifying Canadian Controlled Private Corporations (“CCPCs”). The maximum exemption for 2017 is $835,716.
By Hussein Kudrati and Thomas Brown
The government has proposed eliminating the lifetime capital gains exemption on the shares of CCPCs in the following circumstances:
- individuals under the age of 18
- any capital gain on shares held before the age of majority
- the capital gain that accrues on shares while held by a personal/family trust
- taxable capital gains that fall under the new split income rules
- capital gains allocated to an individual by a trust governed by an Employee Profit Sharing Plan (“EPSP”)
These new rules shall take effect in 2018. The federal government has included a transitional rule in their proposal that allows individuals the opportunity to make an election by the end of 2018 to lock in a capital gain and claim the capital gains exemption. The effect of such an election will reduce the individual’s capital gain on a subsequent sale of the subject shares.
PASSIVE INVESTMENT INCOME
In Ontario, the highest marginal tax rate for individuals is 53.53%, whereas the corporate tax rate is 15.0% on business income up to $500,000 and 26.5% thereafter. Consequently, there are significantly more after-tax dollars available for investment if income is being earned through and retained in a corporation.
The government is concerned that this tax benefit is unfair if the surplus funds are used for passive investment rather than reinvestment in the business, and the consultation paper states that the lower corporate tax on business income was never intended to facilitate higher personal savings.
The consultation paper does not state specific measures that are to be introduced to address the government’s concern but rather serves to put businesses on notice that a change in this policy is likely in the near future.
CONVERTING INCOME TO CAPITAL GAINS
The current personal tax rate scheme has led to planning that results in corporate surpluses being taxed at capital gains rates instead of dividend rates. The recently proposed rules supplement existing anti-avoidance rules by converting capital gains triggered on a disposition of shares to a related party to dividends which are subject to higher personal tax rates. This change eliminates the benefit of post-mortem pipeline planning. The proposed changes strengthening the anti-avoidance tax rules are effective immediately.
WORK IN PROGRESS FOR PROFESSIONALS
Accountants, dentists, lawyers, and doctors shall no longer be able to elect to exclude the value of work in progress (“WIP”) in calculating their income for fiscal years that begin on or after March 22, 2017, if your practice operates on a calendar year, that would be the year beginning January 1, 2018.
The Federal Budget proposes implementation of this change over a two-year time frame. For the first year, 50% of the WIP must be included in income at year’s end. In the second and subsequent years, 100% of the WIP must be included in income.
The proposed new rules are complicated and will impact private corporations across Canada. Business owners should contact their legal and financial advisors before these changes take effect to review their current corporate structure and estate plan to minimize the impact of the proposed changes.