In the March 2017 Federal Budget, the Department of Finance announced that it was studying certain aspects of the taxation of private corporations and that a consultation paper would be released later in the year.
On July 18, 2017, the Department of Finance released the consultation paper along with legislative proposals (“Proposals”) affecting tax planning involving private corporations. In particular, it proposed restrictions on income splitting, the ability to multiply the lifetime capital gains exemption, the ability to convert income into capital gains (“surplus stripping”), and passive income held by private corporations. Due to considerable backlash in the months following from Canadian small business owners, farmers, fishers, professionals, and experts, Minister Morneau advised over a series of announcements in October 2017 that the government would not be proceeding with proposed measures in relation to the multiplication of the lifetime capital gains exemption and surplus stripping transactions, but it would be proceeding with proposals related to income splitting opportunities available to private company shareholders and proposals related to passive income held by private corporations.
On December 13, 2017 the government introduced simpler measures related to income splitting and provided updated draft legislation, and advised we could expect to see more details in relation to passive income held by private corporations in the 2018 Federal Budget.
Income splitting is a tax planning arrangement where income that would otherwise have been taxed as income of a high-income family member is transferred to and taxed as income of a lower-income family member. Effective January 1, 2018, the government eliminated some income splitting strategies used by small businesses to sprinkle income to family members who are not directly involved in the business.
The “tax on split income” rules (also known as the “TOSI” rules or “Kiddie Tax” rules) provide that dividends received by a person under the age of 18 from related private corporations and income from related partnerships are taxed at the highest marginal rate. In the Proposals, the government proposed extending the Kiddie Tax rules to include all family members or “related persons”, unless the situation falls under certain exceptions determined by applying complex set of criteria. After considerable criticism in the months that followed, the government introduced simplified measures in December 2017, including a series of “bright-line” tests to determine more easily whether a family member (a spouse or child) is actively engaged in the business. A family member will be eligible to receive income from the business and be taxed at his or her marginal rate if:
- the family member is aged 25 or over and owns at least 10 per cent of the votes and value of the private corporation (that is not a professional corporation) that derives less than 90% of its revenue from the provision of services;
- the family member is aged 18 or older and has made a “meaningful direct labour contribution” – defined as 20 hours per week of labour contribution – to the private corporation in the year or any five previous tax years;
- the family member is the business owner’s spouse, provided the business owner meaningfully contributed to the business and is aged 65 or older;
- the family member is aged 25 or older and does not meet any of the exclusions in (1) - (3) above, but passes the “reasonable test”, based on certain criteria; or
- the family member is aged 18 to 24 and does not meet any of the exclusions in (1) - (3) above, but passes a stricter application of the “reasonable test”, based on certain criteria.
The reasonableness test will require the family member to show that the income or dividend received was reasonable based on the person’s labour contribution to the business, capital contribution to the business, and business risks assumed by them. If the reasonable test is not met, the amounts received by the family member will be taxed at the highest personal income tax rate.
The government also introduced further exemptions from TOSI, in relation to:
- the gain received by a family member which results from the disposition of shares of a qualified small business corporation or farm property;
- gain that is realized by an individual on his or her death;
- an amount that is derived from property transferred to a family member as part of a settlement upon the breakdown of the person’s marriage or common-law partnership;
- dividends that represent a reasonable return on a family member’s capital contribution to the business; and
- compound income.
While legislation is still in draft form, the government has announced that once passed, the effective date for the income splitting rules is January 1, 2018. Fortunately, taxpayers will have until the end of 2018 to make any changes to the structure of their corporations to meet the reasonableness test.
Lifetime Capital Gains Exemption
The government will not be moving forward with its proposal to limit access to the Lifetime Capital Gains Exemption (“LCGE”). In the Proposals, the government announced its intention to constrain the eligibility to limit the ability of family members to multiply access to the LCGE, including eliminating the exemption for any gain accrued while a person was a minor or while the shares were held by a trust. Minister Morneau has since confirmed the government will not be proceeding with this portion of the Proposals.
Conversion of Income into Capital Gains (“Surplus Stripping”)
The government will not be moving forward with proposed measures relating to the conversion of income into capital gains. In the Proposals, the government announced its intention to eliminate the ability for certain individuals to pull cash out of a corporation by way of a capital gain triggered within the corporate structure, rather than paying a dividend and being subject the higher tax rate applied to dividends. Minister Morneau has since confirmed the government will not be proceeding with these proposed measures.
Passive Income Held by Private Corporations
In the Proposals, concern was expressed about tax deferrals on passive income held by private corporations and suggested options for reducing the ability to defer such tax. While no draft legislation has yet been proposed, in October 2017 the government advised that they will ensure that business owners will have the flexibility to save for contingencies such as lean years or sickness, or for retirement, and provided assurances that past investments and income thereon will be protected. Details and proposed legislation will be included in the 2018 Federal Budget. Once passed, these rules will apply on a go-forward, rather than a retroactive, basis.
One additional item worthy of note is the Ministry’s reduction of the small business tax rate from 10.5 per cent in 2017 to 10 per cent, effective January 1, 2018, and to 9 per cent, effective January 1, 2019.