The July 18, 2017 proposals of the Minister of Finance generated a lot of discussion and debate last summer among tax practitioners, professionals, business owners and the general public. Over the course of the consultation period, the Department of Finance received more than 21,000 written submissions. An overview of the July 18, 2017 announcement and proposed legislation can be found here. So, where are we now?
The proposals contained two provisions intended to prevent taxpayers from converting amounts that would otherwise be paid by corporations as dividends or salary to capital gains, which are subject to a lower tax rate.
The two proposed provisions were amendments to: (i) existing section 84.1 to restrict individuals from using non-arm’s length taxable transactions to “step up” the cost base of shares of a corporation; and (ii) new section 246.1, which would have caused an individual to be considered to receive a taxable dividend in broad, uncertain circumstances where the individual has received an amount from a corporation and one of the purposes of the transaction was to pay the individual cash (or other non-share consideration) in a manner that involves a significant reduction or disappearance of the corporation’s assets.
These two proposed anti-surplus stripping provisions disproportionately impacted intergenerational transfers of family-held businesses and eliminated post-mortem (and inter vivos) pipeline planning. They also eliminated hybrid planning involving the triggering of capital gains on the transfer of corporate-owned assets to result in a capital gain within the corporation allowing the tax-efficient distribution of assets by the corporation either as a dividend or a repurchase of shares.
The anti-surplus stripping proposals were to apply as of July 18, 2017 and even had retroactive effect in certain circumstances.
Fortunately, on October 19, 2017, the Department of Finance announced that the government will not be moving forward with the measures relating to the conversion of income into capital gains. The government indicated that, in the coming year, it will continue its outreach to farmers, fishers and other business owners to develop proposals to better accommodate intergenerational transfers of businesses while protecting the fairness of the tax system.
While the Department of Finance has decided not to proceed with the proposals regarding the conversion of income into capital gains at this time, it is our view that new proposals to restrict surplus stripping will likely be introduced in the coming year, perhaps as part of the 2018 federal budget. We, therefore, recommend that taxpayers who are contemplating intergenerational transfers of shares, pipeline planning, hybrid planning or other planning to access corporate value as a capital gain consider the implementation of such planning before any new measures are announced by the Department of Finance.
Tax on Split Income (“TOSI”) and the Lifetime Capital Gains Exemption (“LCGE“)
The proposals to prevent income splitting, also referred to as income sprinkling, were in the form of amendments to sections 120.4 and 110.6. These amendments were intended to prevent splitting income with family members by taxing certain income at the top personal tax rate and to prevent the multiplication of the LCGE among family members by limiting access.
The section 120.4 rules, colloquially known as the “kiddie-tax” or “TOSI” rules, currently apply to certain sources of income, or split income, received by individuals under the age of 18 years. If TOSI applies, that split income is taxed at the top personal tax rate, and personal tax credits (with the exception of the dividend tax credit and the foreign tax credit) are denied.
The proposed amendments to section 120.4 significantly extend the application of the TOSI rules, such that the TOSI regime will now also apply to spouses, adult children and other family members (including aunts, uncles, nieces and nephews), and to additional sources of income, including income earned from reinvested split income or compounded income. A new reasonableness test will determine the portion of split income that would be subject to tax at the top personal tax rate and the portion of split income that would be taxed at the individual’s personal marginal rate. This test considers whether the income received by the family member is reasonable given their contribution to the business, such as labour, capital or equity, and/or risk.
The proposed amendments to sections 120.4 and 110.6 are complex and affect many very common planning strategies utilizing private corporation share ownership structures, either directly or through the use of a trust.
Good news and bad news. On October 16, 2017, the Department of Finance announced that the government intends to abandon the proposal to limit access to the LCGE. However, it still intends to move forward with the proposed TOSI regime, but will release revised draft legislation, to be effective for the 2018 and subsequent taxation years, that will purportedly simplify the rules.
While simplification of the proposed TOSI rules is welcome, December is just around the corner, and details are still lacking. However, it is never too early to plan. Taxpayers affected by the proposed TOSI rules may consider the following:
- Pay a large dividend in 2017 to a family member not active in the business. This may result in some pre-payment of tax, but the tax rate may be much lower. To limit access to the funds, non-cash methods of paying a dividend, such as a stock dividend or paid-up capital increase, might be used.
- Consider reorganizing the corporation so that family members do not hold the same class of shares, allowing for some flexibility in declaring dividends.
- Review any unanimous shareholder agreement, loan agreement, or other business or financial arrangement with family members.
- Revisit compensation strategies. Salary and wages are not affected by the TOSI rules but must be reasonable for the corporation to claim a corresponding deduction.
It may be tempting to simplify the corporate structure by having family members that are not active in the business sell or gift their shares to the active family member to avoid TOSI. However, without proper planning, a sale or gift of shares to a family member may result in a taxable disposition and may also trigger attribution rules in respect of dividends on, and gains from, a sale of the shares. It is to be noted that family members not active in the business still (for now, at least) have access to the LCGE on the sale of qualifying shares.
Holding Passive Investments inside a Private Corporation
The Department of Finance has announced that it will be releasing draft legislation with respect to the taxation of passive investments inside a private corporation in Budget 2018, including grandfathering provisions. That draft legislation is anticipated to be extremely complex to achieve the objectives of the Department of Finance and any planning now would likely be premature.