On July 18, 2017, the Department of Finance released its much-anticipated consultation paper, “Tax Planning Using Private Corporations”, announced in the 2017 federal budget (the “consultation paper”). The consultation paper, along with the draft legislation released therewith, contain a number of fundamental changes to the taxation of private corporations and family trusts. The consultation paper proposes to address the following issues so as to ensure, in the government’s view, “greater fairness in the tax system”:
- income sprinkling;
- holding passive investments inside a private corporation; and
- converting income into capital gain.
If these proposals are implemented, they will have a significant impact on family trusts and on most Canadian business owners who use private corporations to carry out their businesses.
The Department of Finance perceives an advantage available to high-income individuals carrying on business through a private corporation. A private corporation can reduce income tax by causing income that would otherwise be realized by a high-income individual in the highest tax bracket to instead be realized via lower-income family members.
The tax on split income will extend to adults
Under the current regime, a special tax on split income (the “TOSI”), also known as the kiddie tax, under section 120.4, generally applies only to Canadian residents who have not attained the age of 18 and have a parent resident in Canada. The proposed amendments will significantly constrain income sprinkling between family members. Starting from 2018, the TOSI measures will extend to all Canadian resident individuals, whether minors or adults, where such individuals receive income from a related private corporation, unless the amount is reasonable in the circumstances based on the individuals’ labour contribution, the invested capital and previous returns and remuneration. The reasonableness of the amount will be based on what an arm’s-length party would have agreed to pay to the individual in the given circumstances. A more stringent test would apply for persons between the ages of 18 and 24.
The proposed TOSI regime will apply to adults notwithstanding the reasonableness test in the case of compound income (where income is derived from the investment of split income and certain other amounts of an individual under the age 25) and in the case of amounts brought into split income under a proposed anti-avoidance rule that applies in respect of certain property held or acquired to circumvent the TOSI rules.
The TOSI will broaden the scope of “split income”
The TOSI generally includes dividends on unlisted shares of a corporation (other than a mutual fund corporation) and income from a partnership or trust that is derived from a business, profession or rental activity of a related person. The proposed regime will broaden the definition of split income in subsection 120.4(2) to include income from certain types of debt obligations (such as debt issued by a private corporation), gains from dispositions after 2017 of certain property the income from which is split income and compound income on property that is the proceeds from income previously subject to the TOSI rules or the attribution rules for individuals under the age of 25. The current exclusion from a minor’s split income in respect of certain inherited property under the definition of excluded property in subsection 120.4(1) will also apply to individuals aged 18 to 24.
Subsection 160(1.2) will be extended to provide that an individual who has sprinkled income with a related individual between the ages of 18 and 24 may be held jointly and severally liable for the latter’s taxes.
An individual’s split income will be included in determining whether the individual qualifies for certain income-tested benefits, such as personal tax credits, age credits, GST/HST credits, Canada Child Benefits, Working Income Tax Benefits, and Tax on Old Age Security Benefits.
The proposed TOSI measures are expected to take effect in 2018.
The extension of the TOSI rules to adults will greatly impact the viability of implementing freeze transactions, where after the value of the corporation has been frozen, family members are issued growth shares in the corporation for nominal consideration.
Curtailing of LCGE multiplication
The Department of Finance intends to curtail the multiplication of claims to the lifetime capital gains exemption (the “LCGE”) by family members who, collectively, reduce capital gain tax on the disposition of property. Subsection 104(21.2) and section 110.6 are proposed to be amended to introduce three key measures.
First, individuals who are under the age of 18 will no longer be able to use the LCGE in respect of capital gains that are realized or accrued. This restriction combined with more stringent requirements on income splitting for persons between the ages of 18 and 24 significantly restricts the ability to include younger family members in tax planning.
Second, the LCGE will generally not apply to the extent that a taxable capital gain from the disposition of property is included in an individual’s split income. The reasonableness test to determine the individual’s split income will also be used to prevent individuals from claiming the LCGE on “unreasonable” portions of a capital gain.
Finally, gains that accrued during the time that property was held by a trust (with exceptions for spousal or common-law partner trusts and certain employee share ownership trusts) will no longer be eligible for the LCGE.
The proposed measures will apply to dispositions after 2017, subject to transitional rules in 2018. The Department of Finance will allow affected individuals to claim the LCGE pursuant to the current rules in respect of disposition of the eligible property by way of a deemed disposition for proceeds up to the fair market value of the property on a day in 2018. These measures will significantly impact common tax planning undertaken by owner-managed corporations, in which family members or a family trust often hold shares.
Extending reporting measures for trusts and partnerships
The consultation paper proposes to impose additional reporting requirements for trusts and partnerships. One change introduces tax reporting requirements for tax account numbers for trusts similar to the existing requirements for corporate and partnership tax account numbers. The other change requires partnerships and trusts to report interest amounts on T5 slips similar to the current requirements for corporations. These measures are expected to take effect in 2018.
Holding passive investments inside a private corporation
The consultation paper proposes to eliminate a perceived advantage available to individuals who carry on business through a private corporation. Since corporate tax rates are lower than personal tax rates, such individuals have an incentive to retain excess funds arising from an active business within the corporation and cause the corporation to make passive investments directly rather than first distributing the funds to the shareholder(s) (and thereby incurring tax at the individual level at high personal tax rates). The current system imposes refundable taxes on passive income earned by a private corporation to approximate personal tax rates, with such refundable taxes generally being refunded to the corporation as dividends are paid to shareholders and taxed personally. However, no such additional taxes apply to align the excess funds available for the passive investment within the corporation to the after-tax amount that would be available to an individual to make the passive investment, which creates a benefit. According to the Department of Finance, the result is that corporate owners have the ability to earn more passive income than individuals who do not carry on business through a private corporation.
While the Department of Finance did not release any draft legislation to tackle this perceived problem, the consultation paper sets out the approaches under consideration. One approach would eliminate the refundability of taxes on investment income where earnings used to fund the investments were taxed at low corporate tax rates. That is, corporate tax on the passive investment income of private corporations would be equivalent to top personal tax rates, but no refund would be available as dividends are paid out. The characterization of any dividends as eligible or non-eligible paid by the corporation would follow the tax treatment of income used to fund the passive investment such that dividends paid by the corporation that are attributable to returns on passive investments funded from active small business income would be treated as non-eligible dividends. This means that, for example, dividends from publicly-traded stocks acquired using a corporation’s active business income would be distributed by the corporation as a non-eligible dividend and that the non-taxable portion of any capital gains would no longer be added to the capital dividend account.
To implement the foregoing, the Department of Finance is considering two methods – the apportionment method and the elective method. The apportionment method apportions the annual passive investment income of the corporation based on its cumulative share of earnings taxed at the small business rate, the general rate and amounts contributed by shareholders from their after-tax amount. The elective method provides for default tax treatment for a Canadian-controlled private corporation whereby passive income would be subject to non-refundable taxes and any dividends distributed from such income would be categorized as non-eligible dividends. Corporations would be able to elect out of this treatment if they are mostly taxed at the general rate. A further election would be available for corporations focused on passive investments to elect to maintain the current system in such a situation.
The Department of Finance has not determined how it will proceed in respect of this issue, but has released questions for consultation from interested parties. According to the Department of Finance, any new rules are expected to have limited impact on existing passive investments and time will be provided before any such proposal becomes effective. While it remains to be seen what form the rules will actually take, such changes will undoubtedly result in a significant increase, for corporate owners, in income tax on passive income generated from active business income.
Converting income into capital gain
Draft legislation proposing to expand the application of the anti-surplus stripping rule set forth in section 84.1 as well as add a new anti-stripping rule in new section 246.1 has been released. The proposed amendments further curtail tax planning meant to extract corporate surpluses as capital gains rather than as dividends.
Very generally, section 84.1 results in a deemed dividend arising on certain transfers of shares of a corporation held by an individual to a non-arm’s length purchaser corporation, where the individual receives non-share consideration and if the non-share consideration is in excess of the greater of (i) the “hard” adjusted cost base of the shares and (ii) the paid-up capital in respect of the shares. The “hard” adjusted cost base is currently meant to exclude any step-up in cost base arising from any capital gains realized on prior non-arm’s length transactions in respect of the share that was sheltered by the LCGE or pre-1972 surplus. The draft legislation proposes to cause section 84.1 to now exclude from “hard” adjusted cost base any capital gain – whether or not sheltered by the LCGE or pre-1972 surplus – realized on prior non-arm’s length transactions. As a result, shareholders would be precluded from extracting corporate surpluses as capital gains rather than taxable dividends through tax planning that involves undertaking prior non-arm’s length transactions to increase the cost of those shares and avoid section 84.1.
New section 246.1 will apply to deem an individual to have received a taxable dividend on amounts received or receivable from a non-arm’s length person, where as part of the transaction or series, there is a disposition of property or an increase or decrease to paid-up capital of the corporation and one of the purposes of the transaction or series of transactions was to effect a significant reduction or disappearance of assets of a private corporation in a manner that tax otherwise payable by the individual is avoided. As currently drafted, the rule could have broad implications as it appears to capture returns of paid-up capital and capital dividends if the purpose test is satisfied, both of which are ordinarily received by a shareholder tax-free.
The amendments to section 84.1 and the addition of section 246.1 are effective as of July 18, 2017.
The consultation paper proposes more than simply closing loopholes. The Department of Finance puts forward a revolution with respect to long-standing tax policy and, in some cases, puts an end to legitimate, well accepted and widely used structures. It will be interesting to see if the Department of Finance will, as a result of the consultation, narrow the scope of certain proposed provisions and the approach it will take to tackle the perceived benefit of holding passive investments in a holding corporation. As some of these measures will come into force only in 2018 or later, taxpayers still have an opportunity to review their structure and take action, to the extent possible, to reduce any potential negative impacts. Please contact any member of McCarthy Tétrault’s tax group to see how these proposed measures could affect you.