In the March 22, 2017 federal budget, the government announced that, in order to achieve a more equitable tax system, tax planning strategies involving private corporations of high-income earners would be reviewed. The government’s stated intention is to improve what it sees as the tax system’s fairness by reducing perceived inequities between those who receive favourable tax treatment through private corporations and those who pay tax directly as individuals.
On July 18, 2017, the Department of Finance released a CONSULTATION PAPER on the taxation of private corporations, including proposed legislation on three specific tax topics:
- Income splitting;
- Earning passive investment income in a corporation; and
- Converting a corporation’s ordinary income into lower-taxed capital gains.
The scope of the proposals went beyond the expectations of most taxation professionals and, if enacted, will negatively affect how all Canadian business owners carry on business through a private corporation. The proposals represent a broad-based change to the way the Canadian tax system has been set up to support small businesses to date. Moreover, in some instances, they seek to equate taxation for small business owners with that of salaried employees, without recognizing the additional risk involved in running a business. This could create a disincentive to be a small business owner.
The consultation paper asks for input from interested parties by October 2, 2017, and tax professionals and professional organizations have been working on submissions to encourage amendments to the legislation. At Kerr Financial, we are keeping a close eye on these submissions and are continuing to review the potential impact of the proposed changes. We encourage anyone with a private corporation to reach out to us to review the implications for their structure and their estate plans.
The following is a brief summary of the three areas that would be affected by the proposed legislation:
Income splitting with family members
Two common means of splitting income with family members are in jeopardy:
Tax on split income – The current rules specify that income received by minor children from certain sources, such as dividends from private companies, are taxed at the highest marginal tax rate. The proposals (which are set to take effect in 2018) will extend this treatment to any Canadian resident who receives income from a related business, unless the income is “reasonable in the circumstances” based on rules set out by the CRA. The objective is to prevent the allocation of corporate-related income to family-member shareholders who otherwise are not involved in the business. The proposals will add complexity and uncertainty for family businesses by giving the CRA discretion to judge if amounts paid to adult family members are reasonable, given their contributions to the business.
Lifetime capital gains exemption restrictions – Canadians are exempt from tax for up to $835,000 of capital gains on the disposition of qualified small business corporation shares. The proposals to take effect in 2018 will eliminate the ability to claim this exemption on certain gains, such as those realized for minor children or accrued while the shares were held by a family trust. This could have negative impact on family businesses, which often use trusts as common tools for estate planning or business succession. There are transitional rules proposed that will require action before the end of 2017, so businesses should review their structure
Passive investment income earned through a private corporation
Under the current rules, holding portfolio investments inside a private corporation can provide owners of such corporations with certain tax advantages, compared to personal investment portfolios. While there is no legislation drafted to address this activity, the government has proposed broad measures that could be used by the CRA to reduce these advantages. This will add complexity and change long standing ways in which corporate and personal income tax is integrated under existing taxation rules. Any resulting rule changes will only apply for periods after legislation is actually introduced. Small business owners will need to revisit how they are planning to fund their retirement.
Converting regular corporate income into capital gains
Individual shareholders with higher incomes can currently obtain a significant tax benefit if they successfully convert corporate surplus that should be taxable as dividends, or salary, into lower-taxed capital gains. Such conversions are commonly referred to as “surplus stripping”. The government has proposed measures to prevent taxpayers from using such strategies effective as of July 18, 2017. It is important to note that the draft legislation will also eliminate a common post-mortem planning strategy to eliminate the double taxation that can otherwise occur when a taxpayer dies owning shares of a private company.
The material provided by the Department of Finance is extremely complex and is sure to increase Canadian private corporations’ compliance burden if the proposals become law. If you believe you might be affected by these proposed tax changes, contact us as soon as possible to understand how these new rules will impact your family’s current financial and estate plan, find ways to maximize tax splitting with your family members in 2017 — while you still can — and identify solutions that can be put in place if the new tax rules become applicable in 2018.