Q & A on private corporation tax changes
Proposed tax amendments currently out for consultation could have a significant impact on various tax-mitigating strategies.
In this Q&A, Jack Courtney, Investors Group’s Vice President of Private Client Planning and Sheryl Troup, Director of Tax and Estate Planning, explain what’s being considered.
Q : Why has it been advantageous for professionals and business owners to set up a corporation?
A : TAX DEFERRAL
Income generated from an active business enjoys a low tax rate in comparison to personal rates of tax. Depending on the province, the first $500,000 of active income is only subject to tax ranging from 10.5% to 18.5%. Tax rates on active income over $500,000 are subject to tax rates ranging from 26% to 31%, which still compares favourably to top personal rates.
This tax deferral allows a corporation to pay down debt at a faster rate, or invest more back into its business, or, alternately, have more money available to invest in investments suchas stocks, bonds, mutual funds and real estate.
INCOME SPLITTING
Income splitting through the payment of dividends can reduce the overall tax bill for the business owner’s family. In Canada, each family member is taxed separately and has access to their own set of graduated tax rates. Paying a salary can be used for some income splitting, but salaries are subject to a reasonability test in relation to the services performed. Until these recent proposals, dividends could be used to optimize the use of each family member’s tax rates, creating greater after-tax spending power for each dollar earned.
LIMITED LIABILITY
The concept of a “corporation” was created to protect the assets of a shareholder from a company’s creditors and thereby encourage investment and business expansion. Limited liability protection is still important for many forms of business, but not all. Professionals, for instance, cannot use a corporation to escape personal liability for the professional services they provide.
Q : What is “active business income” and “passive investment income”?
A : The term “active business” is activity that is required to generate income, such as manufacturing, the sale of goods or the provision of services. In contrast, investment income such as interest, dividends, royalties and rent is considered “passive” as little or no activity is required to generate such income. The Income Tax Act contains special rules for income earned from a rental business, deeming the income to be passive unless the business employs more than five full time employees.
This distinction is important, as corporate tax rates on passive income tend to be higher than top personal rates. A portion of the tax on passive income is refundable when dividends are paid to a private corporation’s shareholders, however there is generally no tax deferral advantage to be gained by retaining investment income in a corporation.
Q ; What was the original intent of the lower corporate tax rates on income from an active business?
A : Lower corporate tax rates for active income allowed businesses to invest more money into their business and create more employment opportunities. Arguably, the original idea behind lower rates was not to encourage the retention of profit for passive investment. The July 18 policy paper from the Department of Finance points to the 1972 legislation that, along with the introduction of the small business deduction, introduced the present day refundable tax on investment income and a refundable tax when preferentially-taxed business income was retained and used to fund passive investments. However, this latter refundable tax was rescinded shortly after its introduction.
Q : What changes have been proposed?
A : The proposed changes can be summarized into three broad categories:
?Income Splitting: Limitations for income splitting with non-arm’s length persons, including restrictions on the ability to claim the lifetime capital gains exemption.
?Passive investments: Rules to discourage the retention of earnings within a private corporation for passive investment.
?Conversion of income into capital gains: Rules to negate the effectiveness of these type of transactions.
INCOME SPLITTING
Current Situation: There are several rules within the Income Tax Act that limit income splitting with non-arm’s length persons, typically those related to you:
?Reasonability tests on salaries: salaries paid to family members must be in line withduties performed and align with what one would pay to a third party for similar work
?Attribution of Income
?If property has been transferred or loaned to a related person to confer a benefit on that person, income will attribute back to the original owner of that property
?Corporate attribution” often applies in an estate freeze situation or whenever new shareholders are added to a corporate structure. The result is deemed an interest charge to the original shareholders when a spouse or minor children are brought on as shareholders, and 90% of the assets of the business are not utilized in an active business
?Kiddie tax on dividends and other forms of income splitting with a minor
?Highest marginal tax rate applies, thus eliminating any benefit from splitting income with minor children.
Gaps Identified by Finance:
The above rules do not discourage the payment of dividends to:
?adult children, even if the children have had no involvement in the business of the corporation and even if the corporation derives all of its revenue from passive investments
?a spouse from a corporation that qualifies as a “small business corporation” – a company where 90% or more of the assets are used in an active business – even if the spouse has had no involvement in the business.
Additionally, even when the split income rules applied to minors, if those funds were subsequently invested by the minor, the income earned from that investment was no longer subject to the split income rules. As such, there may have been a continued incentive for private corporations to still pay minors a dividend that was subject to the split income tax provisions knowing that future investment income would be taxed at significantly lower personal tax rates.
PROPOSED LEGISLATION:
Expansion of Kiddie Tax and Introduction of a New Reasonability Test
Under the proposed legislation, all dividends paid to adults 18 years of age or older who are related to a “connected individual” will be taxed at top personal rates unless a reasonability test is met. A connected individual is a person who has influence over the corporation. The test focuses on labour and/or capital contributions to the business. For shareholders aged 18 to 24, the tests are more rigorous and essentially require young adults to be actively engaged in the business on a regular and continuous basis.
Restricted Ability to Claim the Lifetime Capital Gains Exemption (LCGE)
The new proposals significantly restrict the ability to claim the lifetime capital gain exemption available upon the disposition of certain qualified property. The proposed measures include:
?No ability for minors to claim the LCGE
?No ability to claim the LCGE on value which accrued while the taxpayer was a minor
?No ability to claim the LCGE on value which accrued while the property was held by a trust (exemptions provided for spousal or alter ego trusts)
?No ability to claim the LCGE if the capital gain is considered to be split income
Holding Passive Investments inside a Private Corporation
Finance has expressed its intention to eliminate the tax assisted advantage to retaining active earnings in a corporation for investment. The lack of draft legislation has created a great deal of uncertainty on the impact of future legislative proposals. It is anticipated that once actual legislation is tabled, it will apply for taxation years beginning in 2018 and later.
Two approaches were discussed in the Finance paper:
One approach is to re-introduce a refundable tax on active earnings that would apply if active earnings were retained for passive investment. On its face this approach would only discourage the future retention of income in a corporation for passive investment. However, Finance has indicated that it is not inclined to adopt this approach.
The other approach is to introduce changes to the taxation of passive income and capital gains within a corporation, which would arguably discourage the ongoing retention of earnings from a year prior. These measures could include:
?Eliminating eligible dividend treatment on dividend income from publicly-traded stocks
?Eliminating the addition to the capital dividend account for the non-taxable portion of capital gains
?Removing the refundable nature of a portion of the Part I tax that applies to aggregate investment income
Without legislation and clear guidance from the Department of Finance on how they would implement their objective, it is hard to comment on the potential impact of these changes.
Converting Income into Capital Gains
Converting income to capital gains bypasses the traditional methods of extracting value from a corporation in the form of a salary or a dividend, which attracts higher personal rates of tax than capital gains. The Canadian tax system is meant to achieve tax integration. When a corporation pays a dividend out of after-corporate tax profits, the personal dividend tax credits are meant to place the taxpayer in the same position they would have been had they earned that income outside of the corporate structure.
A similar outcome is achieved when a corporation pays a salary, since the corporation claims an expense from income, thus eliminating the corporate tax on that profit, leaving only the personal tax.
Through a series of transactions involving the transfer of shares of an existing corporation to another related corporation, a shareholder can extract value (cash) from a corporation as a capital gain. Using this strategy, a shareholder can save anywhere from 4% to 20% in tax depending on the province and whether eligible dividend rates would have applied.
There are anti-avoidance measures within the Income Tax Act that will convert capital gains to taxable dividends when shares are transferred to a related corporation. However, that only applies in a situation where the cost base of the share has been increased through the past or present use the of the lifetime capital gains exemption and non-share consideration is received by the shareholder.
The new legislative proposals will convert capital gains to dividends in any situation where shares are sold to a non-arm’s length corporation for non-share consideration and where the cost base in shares was created by a prior non-arm’s length disposition.
The techniques used to extract value from a corporation as capital gains are also used upon the death of a shareholder to reduce or eliminate potential for double taxation. The “pipeline method” capitalizes on the estate being able to sells its high ACB shares to a new corporation and withdraw, tax-free, cash up to the ACB of the shares of the deceased shareholder. Thus, the only taxable event is the deemed disposition triggered upon death for the value accrued on the shares up until the time of death. Liquidating the company later doesn’t trigger a second tax event for the beneficiaries with respect to the value at the time of death. Without this method, planning for double tax will become more complex and expensive.
These proposals, if adopted, would be affective the date of the release of the consultation paper, which was July 18, 2017.
Q : What is “income sprinkling”?
A : Income sprinkling is the specific wording outlined in the government’s proposals. It is meant to differentiate from other income splitting techniques deemed acceptable by
the government, such as pension splitting. Income sprinkling is an arrangement whereby income that is claimed by lower-income persons would be claimed by a related higher-income earner, but for the arrangement.
Q : How important is the lifetime capital gains exemption?
A : The Lifetime Capital Gain Exemption for shares of a small business corporation is currently at $835,715. For qualified farm and fishing property, the exemption is $1 million. This can mean significant personal tax savings – anywhere from $185,000 to $223,000 depending on province of residency – for someone who is disposing of these types of qualified properties. The ability to multiply the exemption with respect to the disposition of a single business or qualified property reduces the overall personal taxation associated with the disposal of that qualified asset, often resulting in greater after-tax proceeds available for the individuals.
Q : What can we expect to happen in the next couple of months?
A : These proposals are currently in the consultation stage, meaning the government has invited various stakeholders to review these plans in-depth and provide comments and concerns. The government is also inviting stakeholders to provide alternative solutions that meet the stated objectives they are trying to accomplish with the new legislation. The consultation process is important as stakeholders often highlight areas of unintended consequences. That can cause the government to amend the proposed legislation.
The consultation period is over on October 2, 2017. After that, the commentary will be reviewed and the legislation that is currently drafted may be tabled in the House of Commons either with or without amendments based on stakeholder comments. With respect to the proposed changes for passive investing within a private corporation, we anticipate a lengthier delay as there is at present no draft legislation. It is plausible that once the Department of Finance drafts this legislation, it may be put up for further consultation.
Q : If I already have a corporation set up, is there anything I should do now?
A : Dividend Payments Prior to Year End – The draft legislation extending the application of the Tax on Split Income (Kiddie Tax) to adult shareholders, if passed into law, will be effective for the 2018 taxation year. If you are at or near the top personal bracket and there are shareholders in your family that are in lower tax brackets, it may be worthwhile paying dividends to your family that are greater than the dividends paid in prior years, as this may e the last chance to take full advantage of a particular shareholder’s marginal tax brackets.
Passive Investments – The lack of clarity on how the government intends to address passive investments has created a great deal of uncertainty that will exist until more concrete proposals are released. An approach that introduces a new refundable tax, similar to the 1972 approach, could only affect investment decisions on go forward basis. However, approaches that eliminate the existing refundable tax on investment income and the capital dividend mechanism could cause business owners to evaluate whether to retain capital in a corporation that is not directed towards the generation of active business income.
There are other retirement investment strategies, such as the use of an Individual Pension Plan, which may become more attractive under this new legislation and will still require a corporation to implement.
We are in a wait and see stage. Any changes to existing arrangements should be discussed with your accountant.
Q : If I was thinking about incorporation or reorganizing my existing company what should I do?
A : Any plans to incorporate or reorganize an existing company need to be re-evaluated in light of these proposals. If the primary motivation for incorporation is enhanced income splitting and tax deferred investing, then you should discuss with your tax advisors whether the implementation of plans should be put on hold until we have further clarity on the final proposals.
Corporate structures meant to reduce the owner managers’ exposure to creditors, free up cash flow for the repayment of business debt or allow for an expansion of business operations likely still make sense.
A final word
It’s still not clear what the full impact of these proposed changes will be, so, for now, taking a wait and see approach is best. Stay in contact with your accountant and financial planner, though, so when more concrete rules do come out, you’ll be able to adjust quickly.