On July 18, 2017, the Federal Government released a package of tax measures aimed to “improve fairness”, “close loopholes” and limit tax planning strategies that involve the use of private corporations. The suite of measures represents the most significant overhaul of the taxation of private corporations in Canada in approximately 40 years. This note summarizes many of the proposed amendments to the Income Tax Act (Canada) (the “Act”) and provides some preliminary suggestions for taxpayers affected by the proposed measures to consider.
Sprinkling of income using private corporations
The proposed measures extend the existing tax on split income for minors (the so-called “Kiddie Tax”) to adults in certain circumstances. New rules will be introduced to “help determine whether compensation is reasonable” based on a family member’s “contribution of value” and “financial resources” to the private corporation.
In general, the term “income sprinkling” refers to tax-planning arrangements whereby income that would have presumably been taxed in the hands of a high-income individual, is instead taxed as income of another lower-income individual. Previous attempts to limit income splitting tended to focus on minor children only.
Under the proposed measures, dividends and other amounts received from a corporation, by an adult family member of the principal of the corporation, will generally be subject to tax at the highest rate, subject to a reasonableness test. Absent the proposed amendments, there was generally no mechanism in the Act to treat these amounts as being subject to tax at any rate higher than that which otherwise applied to the recipient. A corporation paying an amount as a salary or bonus, however, has to justify such payment as reasonable in order to claim a deduction for the amount paid pursuant to section 67 of the Act. The proposed Kiddie Tax amendments amount to a significant new measure for the government to prevent what it considers inappropriate distribution of income among family members.
Under the proposed measures, an adult individual who receives split income will liable for tax at the highest marginal rate on the “unreasonable portion of income” from the business of a related individual. The proposals include:
- An expanded definition of a “specified individual” to include Canadian resident individuals, whether minor or adult, who receive split income.
- A new reasonableness test for the purpose of determining whether tax on split income applies to a specified individual who is an adult. Under the proposed measures, the reasonableness test is subject to the labour contributions and capital contributions of the adult individual. The reasonableness test is more restrictive for specified individuals age 18 – 24.
A series of proposed measures are specifically targeted at regulated professionals using private corporations as a means to lower their family’s overall tax burden. This can be seen as an extension of the attack on regulated professionals which began in earnest in Budget 2016, with a drastic overhaul of the specified partnership income rules. These revisions greatly curtailed the ability of certain professionals to access the reduced rate of tax available under the small business deduction.
The Government is also proposing to eliminate tax planning that encourages the proliferation of the lifetime capital gains exemption (“LCGE”) available on the disposition of shares of a qualified small business corporation. The proposed measures are to:
- Eliminate the ability for individuals to qualify for the LCGE in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual attains the age of 18 years.
- Eliminate the ability for individuals to claim the LCGE to the extent that a taxable capital gain from the disposition of property is included in an individual’s split income.
- Limit the ability to claim the LCGE on gains that accrue during the time when property is held by a trust.
The proposed measures are set to apply to dispositions made after 2017. Special transitional rules are proposed that will allow an individual to elect to realize a capital gain on eligible property in 2018 that is eligible for the LCGE under current rules.
Passive investment income
The tax deferral advantage on passive income (e.g. income derived from portfolio investments) is to be eliminated. At first this statement is confusing since investment income earned by a Canadian-controlled private corporation is taxed at approximately the highest personal tax rates. Since active business income, whether or not subject to the small business deduction, is taxed at less than the highest personal tax rates, corporations have the opportunity to invest funds not needed for their businesses. These corporations can invest greater amounts in passive investments than individuals who have paid more tax than the corporations on similar amounts of income;
Under the current rules under the Act, passive investment income can take on many forms, such as interest, dividends, rental income or capital gains. By retaining savings in a corporation, the tax benefit of saving within a private corporation often exceed the tax benefit of existing saving vehicles, such as registered retirement savings plans or tax free savings accounts.
A number of different tax systems, such as an apportionment or elective methods have been suggested to deal with this perceived abuse and Finance Canada has asked for comments on these alternatives. The proposed changes would generally affect corporate owners who are setting aside some of their corporate profits for passive investments, but should not impact taxes payable by corporations with no passive investment income.
Capital gains stripping
Since the spread between the tax of capital gains and dividends has increased substantially over the last few years, it is proposed to “put more teeth” in section 84.1. Section 84.1 has been around since 1985 and its purpose is to prevent taxpayers from removing or “stripping” surplus from a corporation in a tax-efficient manner. Transactions that permit section 84.1 to be avoided permit a taxpayer to treat gains on disposition of shares as capital gains, rather than taxable dividends, that are ineligible for the LCGE.
The current version of section 84.1 also allows, even in non-arm’s length situations, individuals to strip surplus from the corporation in an amount equal to the “hard” adjusted cost base of their shares.
An expanded anti-stripping rule is proposed by amendments to section 84.1. More specifically, the Act is amended to prevent individual taxpayers from using non-arm’s length transactions that “step-up” the cost base of shares of a corporation in order to avoid the application of section 84.1 on a subsequent transaction. The anti-stripping rule would apply to non-arm’s length transactions where it is reasonable to consider that “one of the purposes” of the transactions or series of transactions is to pay an individual shareholder non-share consideration out of a corporation’s surplus, to the extent that the hard adjusted base has been increased by an acquisition from a non-arm’s length transaction. Changes are also proposed to prevent removal of private corporation surplus that is taxed as a capital gain instead of as a dividend.
Proposed section 246.1 appears to catch at least two types of transactions. It is possible that more transactions could be affected.
First, it appears that the use of the popular “pipeline transaction” would deem a taxable dividend to be received by an individual even to the extent of the “hard” adjusted cost base of the shares. This is somewhat surprising since a number of favourable advanced tax rulings have been given for pipeline transactions where the CRA’s requirements were met. It is not certain how these new provisions will interact with the proposed amendments to section 84.1.
A second type of transaction that may be affected is the deliberation of subsection 55 (2) to trigger a capital gain and distribute the resulting capital dividend amount.
- The amendments to section 84.1 and the new s.246.1, if enacted are already effective. Some taxpayers may have ongoing structures that are impacted by these proposed measures and should undertake a review to determine if revisions are advisable.
- The anti-sprinkling rules come into effect in 2018. The salary/dividend mix of private corporations and their shareholders should be reviewed before 2018 and adjustments considered advisable made in 2017.
- LCGE planning should be re-visited. Planning considerations may include advising trustees to make tax-deferred distributions to beneficiaries sooner or contemplating use of the proposed election available for dispositions of eligible property in 2018.