Scott Park, CPA, CA
In the 2017 Budget, the Canadian government signaled its intention to target specific tax planning strategies involving the use of private corporations to close tax loopholes and end tax planning strategies that give unintended advantages to some high-income earners at the expense of other Canadians.
The number of private corporations, specifically Canadian Controlled Private Corporations (“CCPC’s) has increased significantly over the past 15 years according to the government’s own figures. This trend can be explained by various reasons, however, the tax advantages afforded by tax planning in relation to owning a private corporation has encouraged many individuals to incorporate their business.
Many of our clients who are structured as a CCPC will inevitably be impacted directly by these proposed changes and will likely face an increase in their overall tax burden.
The Department of Finance and the Minister of Finance, Bill Morneau, recently released a consultation paper targeting three tax planning strategies:
Income sprinkling describes a range of tax planning arrangements that can result in income being taxed as income of another lower-income individual rather than entirely in the hands of the high-income individual. This strategy usually involves family members of the high-income individual. Specifically, the principals of the private corporation, can arrange for income distributions to be made typically by way of dividends to themselves and other individuals (typically family members) in a way that minimizes the overall amount of personal income tax paid on that income.
Currently, dividends can generally be paid from a private corporation to a family member who is a shareholder that is not “involved” in the business without consideration for the level of involvement or services/ contributions that the family member provides to the business.
The proposed changes would impact the ability of business owners to income split to family members who are not “involved” in the business. In simplified terms, payments received from a connected individual’s business would be taxed at the highest marginal tax rate, regardless of the amount of the income received. These measures will expand on the existing Tax on Split Income (“TOSI”) rules, commonly referred to as “Kiddie Tax” rules, to include all related adult family members and not just family members under the age of 18.
However, an exception would apply to payments made to adult family members by using a reasonableness test. A reasonableness test would be introduced for the purpose of determining whether TOSI applies to a specified individual who is an adult. If the split income amount received by an adult specific individual is reasonable within the meaning of this test, then the income would not be subject to the TOSI and tax at the highest marginal tax rate.
Holding Passive Investments Inside a Private Corporation
In BC, a corporation will either pay 13% (small business rate) or 26% (general rate) on active business income. Alternatively, an individual may pay a maximum rate of 47.7% on their income. The fact that corporate income is taxed at lower rates than personal income provides businesses more money to invest in additional resources to grow their business, find more customers, and hire more people. However, in some circumstances, private corporations earn income beyond what is required to re-invest and grow their business, which provides the business owner with the opportunity to use excess cash (retained net earnings) to purchase and hold passive investments inside the corporation. The purchasing power of a corporation using their own after-tax cash is greater than that of an individual using their own after-tax cash.
The Department of Finance now views this situation as an unfair aspect of our current taxation system. They have proposed some possible approaches to establish fairness in the tax treatment of passive investment income of a private corporation, so that the benefits of the corporate tax rates are directed towards investments focused on growing the business rather than conferring a personal investment advantage to the corporate owner.
The government is also eliciting feedback from stakeholders for possible additional alternatives that would achieve neutrality between individuals and corporations. At this time, it would seem that the government may favor an approach that imposes a non-refundable tax amount on the corporation’s passive income that would neutralize any deferral advantages that would otherwise be achieved. In the end, this proposed change will change the way business owners save their money.
Converting a Private Corporation’s Regular Income into Capital Gains
Income earned by an individual indirectly through a corporation is subject to both corporate income tax (when the income is earned by the corporation) and personal income tax (when the income is distributed as a dividend from the corporation to the individual). The Canadian income tax system is designed so that the combined corporate and personal tax paid on income earned through a corporation and distributed as a dividend to an individual shareholder is roughly equivalent to the income tax that would have been paid if the income had been earned directly by the individual. This is commonly referred to as “tax integration”.
A corporation distributes taxable dividends from its corporate surplus which, in general terms, is made up of its accumulated after-tax earnings. Through the operation of the dividend tax credit, an individual shareholder should in general retain on taxable dividends the same after-tax amount as the individual would have had if the corporate income had been earned directly by the individual. However, integration does not occur if corporate surplus is paid out in the form of tax-exempt, or lower-taxed, income such as capital gains. In effect, the income is not subject to the appropriate personal income tax and the income is subject to less tax than if the individual had earned the income directly.
Individual shareholders with higher incomes can 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”). Capital gains have a significant tax advantage in that only one-half of capital gains are included in income. Thus, tax planning arrangements have been developed to allow business owners to generate capital gain instead of receiving income as dividends or salary.
The government now wishes to implement new rules regarding “surplus stripping” that would effectively convert non-arm’s length capital gains into deemed dividends to ensure that tax planning cannot be utilized to generate capital gains as opposed to dividends or salary. This proposed change would certainly affect tax planning for business owners that may be considering inter-generational family business transfers.
At this time, these proposed tax changes are at the consultation stage. The result of any tax implications to owners of private corporations is still unknown; however, these measures will inevitably be a significant change to our tax system that all owners of private corporations need to be aware of.
In our opinion, the tone and direction of the measures outlined in the consultation paper is troubling. Many Canadians who own private corporations, particularly among family members, who have operated within the laws set out in the Income Tax Act, will soon face an increased tax burden.
The government is accepting submissions from stakeholders on these proposals until October 2, 2017. They are welcoming the feedback of all Canadians who want to contribute to addressing the issues set out in the consultation paper.
As further details are announced with regards to the proposed legislation, we will provide a follow up blog about the implications to keep you up to date and to deal with the fall out.
Disclaimer: The blogs posted on Scott Park & Co Inc. website provide information of a general nature. These blog posts should not be considered specific advice since each person's personal financial situation is unique and fact specific. Please contact us prior to implementing or acting upon any of the information contained in one of our blogs. Scott Park & Co Inc. cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.