Important Changes Proposed for the taxation of Canadian Private CorporationsIndu
On July 18, 2017, the Canadian Federal Finance Minister, Bill Morneau, announced the release of a consultation paper and draft legislation with respect to the taxation of Canadian Private Corporations. If the legislation is enacted, the amendments will have an intense impact on the taxation of private corporations and business structures that Canadian business owners have had for many years.
The Government’s proposal targets on the following:
- Income Splitting
- Lifetime Capital Gains Exemption
- Passive Investment Income
- Converting income into capital gains
It is not unusual for the business owners to structure their business with family members by allowing them to hold shares of the corporation directly or through a family trust. Under this structure, family members or the family trust often hold different classes of shares which allow for dividends to be paid to different family members at the discretion of the directors of the Corporation or the trustees of the family trust. Through this structure, dividends can be paid to family members who are in a lower tax bracket (“Income Splitting”) than the family member who controls the business in order to reduce the overall tax burden.
The “kiddie tax” rule was introduced in 1999 to prevent the income splitting arrangement with children under the age of 18. Under these rules, children under 18 are subject to a tax at the highest marginal tax rate on dividends received from private corporations. In the new proposal the governments intent to extend the kiddie tax, which is now referred to as “Tax on Split Income”(“TOSI”) to apply to adults in respect of a business of which a family member is a principal.
However, the government also proposed some exception to the above where it is “reasonable” for the adult individual to have received income from the Corporation. The exemption will be applied if the Corporation can justify that the amounts are paid by the Corporation are consistent with what it would have agreed to pay an arm’s length person. The proposal stipulates the following factors to be considered in making a determination of “reasonable”:
- Contribution of Labor
- Contribution of capital; and
- Previous returns/remunerations
A higher standard of reasonableness is proposed for individuals between the age of 18 and 24 rather than those over the age of 24, as the government has expressed particular concern with splitting income with young adults who are more likely to be in a lower tax bracket.
The new anti-income splitting rules are to be effective starting in 2018.
Lifetime Capital Gains Exemption
Since 1988, the shareholders of a privately held corporation have been able to get the benefit of capital gains exemption from the disposition of “qualified small business corporation “up to a lifetime limit. Currently, each Canadian is entitled to a capital gains exemption of up to $813,600 on certain small business shares, as well as qualified farm and fishing properties. Under the proposals, the capital gains exemption will be denied in the following circumstances:
- Individuals under the age of 18 will not be allowed to make use of the capital gains exemption;
- Beneficiaries of trusts will no longer be permitted to make use of the capital gains exemption with respect to gains in the value of shares that accrue during the period in which the trust holds the shares;
- Individuals who are subject to the TOSI with respect to a share will not be able to make use of the capital gains exemption on the sale of such shares.
The government has recognized concerns with common ownership structures that allow multiple family members to make use of their capital gains exemption on the sale of a family owned business.
The proposals include a transitional rule that will allow an election to be made by the end of 2018 to claim capital gains exemption so as to increase the adjusted cost base of the “qualified small business corporation “shares. Making such an election will reduce the individual’s capital gain on a subsequent sale of the shares.
The new rules are to be effective starting in 2018.
Passive Investment Income
The Consultation paper identifies a concern with respect to a potential advantage that arises from earning business income through a corporation rather than individually. Corporations are taxed at a lower rate than individuals on business income. In Ontario the Corporate tax rate is either 15% (business income up to $500,000) or 26.5% (general corporate tax rate), while the highest marginal tax rate for individuals is 53.33%. This will give the corporations the advantage of having more after tax dollars available for investment. The government has expressed concern
that this advantage is unfair if the after-tax funds are used for passive investment rather than reinvestment in the business.
The consultation paper does not specify the measures that are to be introduced to address the government’s concerns.
Converting Income into capital gains
Amendments are proposed to the anti-surplus stripping rule in section 84.1 of the Income Tax Act to shut down the option of shareholder to extract retained earnings from a private corporation as a capital gain rather than as a dividend (capital gains are taxed at a lower rate than dividends).
These changes would apply on or after July 18, 2017.
This article provides information of a general nature only. It does not provide any legal advice, nor can it or should it be relied upon. If you have any specific legal questions, please contact our office and speak to one of the members of our Business Law Practice Group.