Proposed Strategies Aimed at Private Corporation Tax Planning from the Department of Finance
On July 18th, 2017, Finance Minister Bill Morneau announced the next steps the Department of Finance would be taking to improve the fairness in the Canadian tax system. The government’s objective is to address tax strategies used by high-income individuals through private corporations to gain “tax advantages.”
The three scenarios specifically addressed in the draft legislation that could impact high-income individuals include:
- Sprinkling income through private corporations,
- holding a passive investment portfolio inside a private corporation,
- and converting a private corporation’s regular income into capital gains.
1. Sprinkling income using private corporations
What is it?
A private corporation’s ability to reduce a high-income individual’s taxable income by sprinkling said income to low-tax rate family members who may or may not be actively involved in the corporation.
How could it impact you?
The proposal will tighten rules surrounding tax on split income (TOSI) strategies. This includes expanding rules for dividends and other amounts paid to include adult family members, with specific attention being paid to adults aged 18 to 24. Previously, the “kiddie tax” rules only focused on children under the age of 18.
The rules will ensure dividends or other amounts paid by a private corporation using a TOSI strategy are reasonable. A reasonable amount would be consistent to what would be paid to an unrelated individual and considers the following factors of a family member’s ties to a private corporation, including:
- Labour contributions: involvement in the activities of the business;
- Capital contributions: contributed assets or assumed risk in support of the business; and
- Previous returns/remunerations: all amounts previously paid to the individual in respect to the business.
In situations where a family member has received dividends or other amounts that are considered unreasonable, the top marginal tax rate would be applied.
The proposed changes to income sprinkling also addresses strategies involving the multiplication of the lifetime capital gains exemption, generally through the use of family trusts.
The Department of Finance has stated that they expect the proposed rules to be effective as of 2018.
2. Holding a passive investment portfolio inside a private corporation
What is it?
Holding investment portfolios inside private corporations to defer personal tax consequences on passive income earned.
How could it impact you?
The proposed changes aim to eliminate tax deferral benefits. These will not impact active business income or passive income used for business operations.
3. Converting a private corporation’s regular income into capital gains
What is it?
Individual shareholders of private corporations who use tax strategies to repurpose corporate income into capital gains in order to take advantage of the lower tax rate that’s applied to capital gains. This includes estate planning in order to eliminate possible double taxation on death.
How could it impact you?
The proposed changes address private corporation tax strategies aimed at circumventing the anti-avoidance rules (section 84.1 of the Income Tax Act) and anti-stripping rules by removing an exception to section 84.1, where a corporation’s shares were disposed to a related corporation in order to increase or step up the cost basis of that seller’s shares.
The Department of Finance has stated that the rules are effective as of the date of the released discussion paper and draft legislation, July 18, 2017.
If you have questions, we have answers
The proposed changes may have dramatic implications for Canadian private corporations and their shareholders. The Department of Finance is receiving comments on the proposals until early October. The Department of Finance has asked for public feedback on the proposed changes. Additional information will be available in the near future.
Check back to learn more. We’ll release information as it becomes available, along with our analysis of the tax implications and actions required.
If you have questions, please contact your DMCL advisor.
Written by Eric Harris, Tax Manager