I was blissfully enjoying my quiet vacation after a typically hectic tax season and hoping to relax for the rest of the summer, when I was hit with the July 18th, 2017 tax proposals by the Department of Finance (“Finance”) that means to eliminate certain “unfair tax practices” used by private corporations.
Below is a brief explanation of these very complex proposals which will significantly impact the taxation of private corporations and their shareholders. These proposals focus on three key tax planning strategies used by private corporations:
- “income sprinkling” using private corporations,
- converting a private corporation’s income into lower taxed capital gains, and
- the taxation of investment income earned inside a private corporation.
This article focuses on #1 and #3 only.
#1 – Income Sprinkling Using Private Corporations
Income sprinkling involves reducing income taxes by causing income that would otherwise be realized by an individual at a high personal tax rate to instead be realized by family members who are taxed at lower personal tax rates. The most common form of income sprinkling is the payment of dividends from a private corporation to lower-income family members either directly (if they own shares in the company directly) or through a trust (if they are a beneficiary of a trust which owns shares in the corporation).
Finance is proposing to address income sprinkling by extending the “kiddie tax” rules to apply to adult individuals where the amount of “split” income is “unreasonable” under the circumstances. Factors that will be considered in making this determination include the individual’s labor and capital contributions to the business, the risks assumed by the individual with respect to the business and previous returns to the individual from the business. If an amount is determined not to be reasonable, the individual will be taxed at the top marginal tax rate on the split income received; regardless of the individual’s level of income.
These rules are even more restrictive for family members aged 18 to 24 where a “reasonable” amount will be limited to a legislatively prescribed maximum amount allowing a return on assets contributed by the individual in support of the business. These rules will apply to 2018 and subsequent taxation years.
#2 – Limitations on Claiming the Lifetime Capital Gains Exemption
Finance proposes to no longer allow individuals to qualify for the lifetime capital gains exemption for capital gains that are realized or that accrue before the year in which they turn 18 years of age. Furthermore, gains that accrue during the time that property is held by most trusts (there are certain exemptions) will no longer qualify.
There are proposed special transitional rules that will allow affected individuals to elect to realize a capital gain by way of a deemed disposition of the property for proceeds of disposition at an elected amount between the adjusted cost base and fair market value of the property on any day in 2018 and to claim the capital gains exemption to exempt such capital gain from tax if qualified. This measure will apply to dispositions after 2017.
# 3 – The Taxation of Investment Income held inside a Private Corporation
Finance also proposes to tax private corporations that earn income on investments at a higher tax rate than currently on the basis that private corporations allow the company to accumulate earnings at a much lower tax rate than had the earnings been earned by the shareholder. For instance, a small business corporation may accumulate retained earnings from its business at an effective tax rate of 12.5% (the small business tax rate in BC); whereas the same income earned by the shareholder would be taxed at his or her marginal tax rate which, in BC, could be as high as 47.7%.
Finance has offered some possible approaches to ensuring neutrality amongst these situations, but each results in a much higher tax rate on investment income earned by a private corporation on its accumulated earnings than currently.
The proposals range from elimination of the refundable tax paid on investment income, elimination of the capital dividend account on capital gains realized within a private corporation or taxing business income that is not reinvested in the corporation’s business at a much higher tax rate subject to recovery of the extra taxes paid when such income is paid out to the shareholder as a dividend or reinvested in the business.
However, there are no concrete proposals at this time and we will have to wait to see how this proposal unfolds. This change is intended to apply after 2017 and on a go-forward basis and with limited impact on existing passive investments; but how such transitional rules will be applied is uncertain.
Application of these Proposals
Unfortunately these tax changes will affect most, if not all, private corporations and not just the so called “wealthy business owners.” Consequently, all private corporations should be aware of these proposals and should proactively address their tax consequences, which, because of their broad nature and their complexity, may be unintended.
The government has allowed only a 75 day window to respond to the proposals (to October 2nd 2017), after which they will consider the responses and then finalize the proposals before the end of 2017. Even though the proposals are not yet finalized, it is not too early to start considering these proposals and to consider what changes to your private corporation’s business and structure are necessary to minimize the impact of these proposed changes.
These proposals have been announced on the basis that they target wealthy business owners who are unfairly taking advantage of the tax system; but the truth is that these proposals affect all private businesses whether large or small. The proposals have been sold under the guise of “tax fairness” including, cracking down on income sprinkling by private corporations, not allowing private business owners to convert higher taxed regular income into lower taxed capital gains and to significantly increase the tax on a private corporation’s investment income because they have unfairly been allowed to build up their investments from the success of their businesses at small business tax rates at the expense of not reinvesting in their businesses.
These assertions are simply not accurate and don’t take into account all the factors and issues that face a small business owner. For example, no consideration was made of the risks a small business owner faces in starting and operating his or her business, the lack of government support and security given to small business owners that an employee would normally get [such as private pension plans, employment insurance, severance in case an employee loses his or her job, employer-provided medical coverage, no paid vacation or sick time and the like]. Small business owners often invest most of their savings and put their personal assets at risk when starting their business. These should also be factored into the equation when comparing the taxation of private business owners to employees and whether this is “fair”.
I can only imagine what my private business clients’ reaction will be when I tell him or her that they better get back to work because they won’t be able to afford to send their kids to university or go on vacation or meet family expenses because their family tax bill will be substantially higher in 2018.
The government has rationalized this restriction on the basis that a private business owner can lower the family tax burden by sprinkling income amongst lower income family members; whereas an employee has to shoulder the full tax burden and ends up paying more than the small business owner.
What the government has failed to consider in the equation are the significant risks the family has taken to start the business, nurture it and to make it a success. Business owners routinely put all of their assets at risk, including their home and savings, in order to finance the business and forfeits the many securities that an employee typically receives, such as a pension plan, employment insurance coverage, severance in case of job loss, paid vacation and time off and private medical plan coverage.
How is this factored into the equation? If we take away many of the rewards a small business owner receives if he is successful, won’t this skew the risk-reward ratio so that these entrepreneurs will no longer take the risks necessary to launch a business? I fear this will be the case and will significantly reduce entrepreneurism, innovation and risk-taking in our economy and which will reduce economic activity and jobs.
A small business owner can no longer pay dividends to those family members where it cannot be shown that they have contributed significant assets in support of the business, been engaged in the activities of the business or have taken significant risks with respect to the business because these new rules will tax the dividends to them at the highest marginal tax rate.
For instance under the proposed new rules, we can no longer pay a dividend to a stay-at-home spouse because it will now be considered “unreasonable” because the spouse never contributed any assets to the business, was not involved in the activities of the business nor taken any significant risks with respect to the business.
Consider a young husband and wife who started an electronics import-export business and had pledged their home and all of their savings to start the business several years ago. The wife stayed at home to raise their 3 children so the husband could work in the business to make it a success. The business was ultimately a success and all the bank loans and personal guarantees were no longer needed. In 2018, the business will earn $200,000 after small business taxes are paid by the corporation. Usually the corporation would pay $100,000 of dividends to each of the husband and wife on the shares they own in the company. The corporation must now, however, not pay any dividends to the wife because they would be considered “unreasonable” based on the parameters set by the government and to avoid the wife paying substantially higher taxes than if such income were paid out to the husband. This will cost the family an additional $19,000 of taxes per year.
What about all of the wife’s work at home to raise the family and to take care of the household and the risks she took years ago to start the business? Unfortunately the government does not consider the joint risk and joint sacrifices the couple made in respect of the business to be relevant.
I imagine she will also question whether as a shareholder of the company, she has certain rights to be paid out of the company’s profits? Of course, but the government has put restrictions on the amount of dividends that can reasonably be paid without invoking these rules. Furthermore, we will now have to restructure the shareholdings in the company so that dividends can only be paid to the husband. This will of course come with considerable cost and other potential tax issues.
Savings for Retirement
My small business client will also have to work longer in order to save additional money for retirement because the government is going to substantially increase the taxes that their company will have to pay on its investment income on its investments that were diligently saved up for retirement. Such taxes may be up to 2&1/2 times the amount of taxes that would have been paid under current rules.
For example, consider a small business owner who has worked extremely hard over the past 30 years to save up $1,500,000 in their private company that is going to be invested for retirement. The small business owners expects to earn a 4% per year return on the investments in the company, to pay corporate taxes on such income at a rate of 19% and then to pay out $72,000 a year as dividends to the small business owners (a husband and wife) for the rest of their lives.
Because the small business owners have no other sources of income (other than a small amount of Old Age Security Pension) they expect they will pay no further income taxes on the $72,000 of dividends received annually. They figure that even though Vancouver is a very expensive place to live, they should be able to live modestly on these savings in the company for the rest of their lives.
However they now fear with these proposals, that they will now have to pay taxes on the investment income earned in the corporation at a substantially higher tax rate (50% instead of 19%); so that in order to pay out $72,000 of dividends a year for the rest of their lives, the company must have substantially more than $1,500,000 in savings. This will require them to work several more years in order to make up for the shortfall created as a result of the substantially increased taxes that the company will have to pay on its investment income.
Needless to say every private business owner who operates their business through a private corporation will be profoundly affected by these new rules and will need to alter their family’s plans from curtailing current spending because the family will have less funds because of a substantially increased family tax burden to the business owner being required to work several more years to make up for all the additional taxes they will incur on their retirement savings within their private corporation.
This is the last thing a small business owner needs to worry about right now given the very tough business environment they face, increased government regulation, significant changes brought on by technology change, and a heightened level of scrutiny and reporting to the Canada Revenue Agency, to name but a few.
Although we don’t know the final form of the rules, if such rules are implemented as currently proposed, we know that the traditional way a private corporation pays out its income to family members by paying dividends to them will be significantly curtailed; unless it can be shown with some degree of certainty that such family member has contributed to the family business by means of involvement in the activities of the business, assets contributed in support of the business or risks assumed in respect of the business.
Therefore, other income-splitting techniques will need to be considered such as:
- Paying reasonable salaries to family members who are involved in the activities of the business that is consistent with the wages that would have been paid to an arm’s-length employee.
- Using other income-splitting techniques such as prescribed rate loans allowing other family members to make investments that are not caught under these rules and the income attribution rules.
- Maximizing the use of company sponsored pension plans that accumulate retirement savings on a tax-deferred or preferential basis such as individual pension plans and retirement compensation arrangements.
Private companies should also try to minimize their passive investments by repaying any shareholder loans to the company as soon as possible and paying out any tax free amounts (such as tax free capital dividends) to the shareholder.
As well, consideration should be made to increasing the amount of taxable dividends that are paid out to shareholders that are not caught under than these new rules (even though this would increase personal taxes) in order to reduce the level of a company’s passive investments. In addition, because of the proposal to substantially increase the taxes on a company’s investment income, it would make sense that a company’s investments be held for a longer time and not be turned over frequently in order to defer taxes on accrued gains.
Although the government has noted that it is their intent that the new rules regarding the taxation of investment income in a private corporation apply on a go-forward basis and have limited impact on existing passive investments, one must be wary of these transitional rules and be ready to trigger gains on investments held in a private corporation before the end of 2017, in case the tax rates on such gains under the new regime in 2018 are much higher.
Needless to say, there is still great uncertainty over these proposed rules given they are not final, because of their complexity and uncertainty over how the Canada Revenue Agency will apply them in practice.
We strongly encourage small business owners to voice their concerns over these proposals by writing to their MP and for members of business groups or professional organizations to lobby them to make a submission to the Government.
We will keep you informed of these proposals as they progress. But in the meantime, if you would like to get more information or to discuss your particular situation, please contact your DMCL Tax and Business Advisor.