Tax Planning Structures Being Curtailed
Further to Finance Minister Morneau’s March 22, 2017 Federal Budget’s commitment, on July 18, 2017, the Department of Finance has taken action to curtail three tax planning strategies utilized by incorporated businesses:
- Income Sprinkling
- Passive Investment Income retained in the corporation
- Capital Gains on selling the corporation rather than earning wages/dividends
Income sprinkling may be accomplished with the payment of dividends to lower income family members. Prior to proposed legislation concerning income sprinkling, dividends could be paid to lower income shareholders of a private corporation irrespective of any reference of capital contributed or degree of work performed for the private corporation by that person. To combat the government’s perceived tax inequality between business owners and their wage earning counterparts, enhancements to the “split income” (i.e. kiddie tax) rules have been proposed.
Under the draft legislation, where a related adult receives dividends from a private corporation, and the amount received is in excess of a reasonable amount, that excess amount will be taxed at the highest tax rate irrespective of the actual marginal tax rate of the dividend recipient. While reasonability cannot easily be defined, various factors will be considered. These factors include services rendered to the private corporation, assets at risk with the corporation and any previous returns and compensations from the private corporation. Note that these rules appear to have particular emphasis in relation to adult children between the ages of 18 and 24.
Passive Investment Income Planning Measures
Passive investment income planning may involve retaining funds within a corporation (after paying lower amounts of corporate tax as opposed to higher amounts of personal tax) and reinvesting those after-tax funds in passive investments (as opposed to being reinvested in business operations). This type of tax strategy is a fundamental foundation of tax planning previously used by business owners.
On July 18, 2017, the Department of Finance did not introduce any specific rules to address this perceived “tax avoidance”. Instead, the Department of Finance made some high level suggested legislative changes that it wishes to explore and has asked interested parties to make submissions (until October 2) related to these suggestions. Based on our preliminary review, it appears that a substantial increase in corporate taxes on retained earnings used to acquire passive investments (ie: not directly used in the active business of a private corporation) may be the ultimate result.
Capital Gains Tax Planning
Capital gains tax planning may involve complex transactions to extract income from a company in the form of capital gains as opposed to ordinary wages and/or dividends.
The Department of Finance introduced two separate measures to address tax reductions from capital gain planning.
The first relates to capital gains that qualify for the capital gain exemption. Any capital gain that accrues before a taxpayer’s 18th birthday or accrues while the shares are held by a family trust will no longer be eligible gains for the capital gains exemption
The second relates to capital gains realized on disposition of shares between related family members or other related corporations. The government believes taxpayers have circumvented the existing rules that convert such gains into dividends. Therefore, the rules have been enhanced by adding a “purpose test” that if met will allow for an exception for the rule to apply. Note that the government is interested in receiving comments on how to best integrate genuine inter-generational transfers of business corporations.
These recently introduced tax rules and suggested legislative changes represent the most comprehensive tax measures directed towards business owners and their families in recent memory. We are still in the process of reviewing and analyzing the myriad of intended and unintended tax consequences as they affect our entrepreneurial clients. At minimum, business owners should be revisiting their respective tax planning in light of these tax changes with a tax professional.
After conducting such a review, affected persons and businesses should consider providing their comments to the Department of Finance (see http://www.fin.gc.ca/activty/consult/tppc-pfsp-eng.asp) in addition to discussing the same with their local MP.