Expanding split income rules
Lifetime capital gains exemption restrictions
Taxation of capital gains
On July 18 2017 the Department of Finance released its consultation policy paper on the taxation of private corporations first announced in Budget 2017, along with proposed legislation on some of the topics addressed.
The minister's introductory letter acknowledges the government's objective of reducing taxes on the middle class and raising taxes on the richest 1% of Canadians. However, the proposed changes will have much broader implications than the government's stated mandate. If enacted, the proposals will significantly affect most Canadian private corporations, including family businesses, farmers, independent contractors, self-employed tradesmen and tradeswomen, and incorporated professionals. Further, new income-splitting proposals specifically target stay-at-home spouses and young Canadians who are attending post-secondary education.
Under the guise of closing tax loopholes, the minister is seeking to enforce a central shift in long-standing tax policy. Most issues addressed are not tax loopholes, but are an intricate part of a complex tax system that has been in place for decades to support small businesses. The most dramatic proposals seek to equate the tax treatment of self-employed incorporated business owners with that of individual salaried employees without acknowledgement of their fundamental non-tax differences, including the inherent risk in starting and operating a small business.(1)
The breadth and scope of such proposals merit close scrutiny. Every client with a private corporation should reach out to determine the implications of the proposals for their own structure.
The Department of Finance will accept submissions on these proposals until October 2 2017. This update provides an initial summary of their potential impact.
The proposed legislation expands the scope of the tax on split income (TOSI) (also known as the 'kiddie tax') to prevent non-arm's length persons from splitting income and decreasing their overall tax burden. The proposed legislation, as drafted, will introduce significant uncertainty for closely-held businesses.
The present TOSI rules under the Tax Act apply to the income of minor children from certain sources (eg, certain dividends on private corporation shares, allocations of trust income and partnership income) and capital gains realised on dispositions of property to non-arm's length persons. Such income is taxed at the highest marginal rates.
The proposals extend the TOSI rules to apply in general to any Canadian resident who receives income from a related business unless the income is "reasonable in the circumstances". The reasonableness of the amount is based on a set of factors intended to correspond to the expected return in an arm's length arrangement. These factors include:
- labour contributions to the business;
- capital contributions; and
- previous returns or remuneration.
A stricter reasonable test would apply for those between the ages of 18 and 24, compared to the test applied to adults 25 or older. The proposals also expand the types of income subject to the TOSI rules and the scope of the family and business relationships relevant when considering whether the TOSI rules apply.
If enacted, the proposed changes to the TOSI rules will apply to the 2018 taxation year onwards.
Lifetime capital gains exemption restrictions
At present, the Tax Act provides an exemption for up to C$835,716 (in 2017) of capital gains realised on the disposition of qualified small business corporation shares and C$1 million of capital gains realised on the disposition of qualified farm and fishing property for all Canadian resident individuals over their lifetime.
The proposals would generally eliminate the ability to claim the capital gains exemption:
- on gains that accrued before the individual turned 18;
- if income on the property was subject to TOSI; or
- on gains that accrued while the property was held by a trust (other than a spousal or common law partner trust, or certain trusts established to hold shares for employees).
These changes could adversely affect family businesses that have undertaken common estate planning transactions, especially where shares are held by a trust or family members.
The proposed changes apply to dispositions occurring after 2017. However, transitional rules are proposed which will require many businesses to review their structure and consider taking steps before the end of 2017.
The consultation paper outlines the government's view that the rules applying to passive investment income earned in private corporations provide an unfair deferral advantage when compared to income earned personally. This view arises from the different tax rates that apply to corporate income when compared to personal income such that after-tax earnings in a corporation available for reinvestment, due to lower rates, are greater than the amounts available personally.
While draft legislation was not released on this topic, the Department of Finance summarised the broad approaches that it is considering to reduce the advantages of investing passively through a private corporation. These approaches include:
- eliminating the refundability of passive investment taxes;
- denying access to the lower eligible dividend tax rates on distribution of corporate earnings where the underlying earnings used to fund passive investments were taxed at lower corporate rates; and
- denying the addition of the non-taxable portion of a capital gain to the capital dividend account of a corporation when the gain arose on the disposition of passive properties.
To determine which income would be subject to these consequences, the proposals float an apportionment method which achieves neutrality by tracking the source of funds used for investment. Alternatively, an elective method would impose a default tax treatment unless the taxpayer elects otherwise, without the need for tracking. To maintain the present system, a further election is envisioned for passive investment-focused corporations which are already in a tax neutral state. The proposals include an exception where investments in the corporation are funded by after-tax income of a shareholder taxed at the personal rate.
No draft legislation was included with the consultation paper and the Department of Finance has asked for input on several questions. It stated that any new rules would apply only for periods after the release of draft legislation and on a go-forward basis.
The proposals include amendments to Section 84.1 of the Tax Act and the introduction of a new anti-avoidance rule in to Section 246.1 of the act. These changes are intended to prevent transactions that allowed individuals to extract corporate surplus from private corporations at capital gains rates instead of the higher dividend rates without the application of Section 84.1 as it is drafted at present.
While the proposed amendments target transactions viewed as inappropriate by the Department of Finance, as drafted, they will eliminate one of the two widely accepted post-mortem planning strategies used to solve the double-taxation problem when an individual dies owning shares of a private corporation with an unrealised capital gain. The proposed changes apply effective from the announcement date, July 18 2017.
For further information please contact Leonard Gilbert at Thorsteinssons LLP by telephone (+1 416 864 0829) or email ([email protected]). The Thorsteinssons LLP website can be accessed at www.thor.ca.
(1) For comments on the policy objectives, see here.