Tax Planning Changes for Private Corporations: Where Do We Stand and What Should We Do?
Over the past few months, the Federal Government has refined its previous July 18, 2017 proposal with more announcements expected in the near future. Pressured by a large public outcry, Finance Minister Bill Morneau has revisited the means by which his agency will address strategies used by high-income individuals through private corporations to gain “tax advantages”. We previously summarized the Department of Finances proposed strategies in our tax bulletin dated July 24, 2017.
The three scenarios specifically addressed by the Department of Finance were:
- 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.
WHAT HAS CHANGED SINCE THE JULY 18, 2017 PROPOSAL?
1. SPRINKLING INCOME THROUGH PRIVATE CORPORATIONS
WHAT IS IT?
A private corporation’s ability to reduce a high-income individual’s taxable income by sprinkling income to low-tax rate family members, who may or may not be actively involved in the corporation.
Example: An owner of a private corporation who sits in the highest personal tax bracket pays his wife, who has limited involvement in the corporation, in order to withdraw money from the corporation at a lower effective tax rate.
JULY 18, 2017 PROPOSED RULES
The proposal was aimed at tightening rules surrounding tax on split income (“TOSI”) strategies by expanding rules on dividends and other amounts paid, previously referred to as the “kiddie tax” rules, to include adult family members, with specific attention to adults aged 18 to 24.
Amounts paid to individuals caught under these rules now have to meet a reasonableness test, considering the individual’s ties (labour, capital, etc) to the private corporation. Amounts determined to be unreasonable will be subject to tax at the highest individual tax rate.
The proposed changes also addressed strategies involving the multiplication of the lifetime capital gains exemption, generally through the use of family trusts.
WHAT CHANGED?
The Government is still moving forward with the TOSI rules, however it will simplify the income sprinkling measures. The reasonableness test will focus on a combination of the following:
- Labour contributions;
- Capital or equity contributions;
- Financial risk taken; and
- Previous contributions of the above.
The Government specifies that corporations with family members who meaningfully contribute to the business will not be impacted. Revised draft legislation will be revealed shortly and changes are expected to be effective January 1, 2018.
Finance also announced they are not moving forward with the proposed measures to limit access to the lifetime capital gains exemption.
HOW CAN WE HELP?
The proposed rules are expected to be effective as of 2018, causing 2017 to be the last chance to income split. It is important to have a DMCL advisor review your corporation’s current tax situation to plan accordingly.
2. HOLDING A PASSIVE INVESTMENT PORTFOLIO INSIDE A PRIVATE CORPORATION
WHAT IS IT?
Holding investment portfolios inside private corporations to gain tax advantages over holding investment portfolios personally.
JULY 18, 2017 PROPOSED RULES
The proposed rules were aimed at eliminating these tax advantage by increasing tax rates on investment income earned within a private corporation.
WHAT CHANGED?
On October 18, 2017, the Government announced they will be moving forward with measures to limit tax deferral opportunities relating to passive income. Stating that a $50,000 threshold on passive income in a year (equivalent to $1 million in savings earning a 5% rate of return) will be exempt from the new rule. It is important to note that all past investments and the income earned from those investments will be protected from the proposed rules.
Finance will release details of its passive investment income measures as part of the 2018 Federal Budget (usually March). No indication has been provided of how the new regime will be structured and when it will take effect. However, it is possible for an effective date of January 1, 2018.
HOW CAN WE HELP?
It is unclear how Finance will proceed with the proposed rules to grandfathered passive investments or how they plan to track future passive investments. Discussions on protecting current passive investments or minimizing expected passive income from future investments, should be done prior to the end of 2017.
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 to take advantage of the lower tax rate that is applied to capital gains. This includes estate planning to eliminate double taxation on death.
JULY 18, 2017 PROPOSED RULES
The proposed changes were directed around strategies circumventing the anti-avoidance rules (section 84.1 of the Income Tax Act) and anti-stripping rules. These strategies were used by shareholders to extract surplus (a share’s excess value) from private corporations at a beneficial tax rate through the conversion of income into capital gains. The proposed rules restricted the ability for families with private corporations to pass ownership onto the next generation in a tax effective manner.
The Department of Finance stated the rules are effective as of July 18, 2017.
WHAT CHANGED?
In October 19, 2017, Finance announced they were not moving forward with the proposed measures relating to the conversion of income into capital gains. The Government has stated “it will work with family businesses, including farmers and fishing business, to make it more efficient, or less difficult, to hand down their business to the next generations.” However, the potential rules caught under section 84.1 may go ahead.
HOW CAN WE HELP?
With additional information expected in the near future, your DMCL advisor is here to help walk you through these changes.
For more information on these proposals and how they may impact you, please contact DMCL advisor.