On October 19, 2017, the Department of Finance Canada issued a news release advising that it will not move ahead with proposed measures intended to target the conversion of income into capital gains. The announcement is the result of public consultations made concerning draft legislation contained in the July 18, 2017, proposals impacting private corporations.

The announcement today is another in a series of news releases from this week. For more detail on previous announcements this week please refer to Taxation of private corporations and their shareholders.

As a matter of background, under Canadian tax law, paid-up capital generally may be returned to shareholders on a tax-free basis, provided there is sufficient adjusted cost base in the underlying shares. However, retained earnings are distributed as a dividend. Under corporate law, there is no requirement that retained earnings must be distributed first. Section 84.1 of the Income Tax Act (Canada) (the “Act”) was introduced to prevent the removal of corporate surplus, or “surplus stripping” on a tax-free basis on amounts that would otherwise be taxed as dividends. The anti-surplus stripping rules are intended to prevent the creation of paid-up capital or the stripping of retained earnings on account of capital by means of a reorganization, related party sale, or other transaction. The anti-surplus stripping rules do not apply to (i) a disposition by a corporation, (ii) arm’s length dispositions, or (iii) a taxpayer who transfers shares in situations where the corporation whose shares are transferred would not be connected with the purchaser corporation after the disposition.

On July 18, 2017, the Department of Finance Canada released Part D of Tax Planning Using Private Corporations – Converting Income into Capital Gains (the “Proposals”). The Proposals include an amendment to section 84.1 and the introduction of a new section 246.1 to address concerns regarding the conversion of corporate surplus into tax-exempt, or lower-taxed, capital gains. The amendments, in general terms, deem a taxable dividend to be realized in an attempt to prevent surplus stripping. Significant is the fact that, under the proposed amendments, any previous gain realized in a transaction involving a non-arm’s length party would no longer be included in the adjusted cost base of a share transaction for purposes of section 84.1 of the Act. The amended rules, as proposed, could create unanticipated taxpayer behaviour – namely, incentivize business owners to sell private corporations to arm’s length parties rather than family members.

Today the Department of Finance Canada announced that, after consulting with Canadians, they would not move forward with measures relating to the conversion of income into capital gains. The announcement comes after taxpayers expressed concern regarding how the proposed measures may result in the unintended consequences described above. More specifically, business owners highlighted how the proposed measures inhibit the intergenerational transfer of businesses and increase uncertainty of taxation on the death of an individual.