In its 2017 Federal Budget release, the Federal Government noted a continued concern with tax planning strategies involving private corporations. While no new measures or amendments to existing rules were released as part of the 2017 Federal Budget, Canadian tax practitioners had generally understood that proposed amendments would be forthcoming. These amendments were announced by the Minister of Finance this past Tuesday, July 18, 2017. They constitute an important and, in some cases, potentially fundamental shift in the taxation of Canadian private corporations and their shareholders.
The Federal Government has called for submissions regarding the new proposed amendments and, more generally, regarding three tax planning strategies or approaches which make use of private corporations:
- The “sprinkling” of income (for example, through the issuance and payment of dividends or other forms of income to family members) using private corporations. The Federal Government is concerned that such planning results in otherwise higher income individuals paying less than their fair share of tax by diverting what would otherwise be their own taxable income to family members who are likely subject to lower marginal tax rates;
- Holding a passive investment portfolio inside a private corporation, which may provide the owners of the private corporation with certain tax advantages as compared to investment portfolios that are owned by taxpayers personally; and
- Converting a private corporation’s regular income into capital gains, which can reduce the amount of tax payable by taking advantage of the lower tax rates on capital gains.
The language used in the Government’s release is strong and takes particular aim at these strategies and approaches, which it blames for causing unfairness within the Canadian tax system. In this respect, the Federal Government particularly compares certain tax benefits available to a private corporation and its principals to the case of income earned personally by an employee. The Federal Government highlights and emphasizes the potential difference in overall tax payable by the employee and the corporate principals in respect of the same amount of income as reason for the amendments proposed (and consultations requested) on Tuesday and the need to introduce a greater measure of “fairness” into the taxation of Canadian private corporations.
The Federal Government takes the position that income “sprinkling” arrangements allow high-income individuals to opt out of the personal income system to their own advantage. Three particular measures have been proposed by the Federal Government to address and remedy its concerns:
1. Extension to the tax on split income (“TOSI”) rules: Currently, the TOSI (often referred to as “kiddie tax”) applies only to children under the age of 17. The rules generally result in income derived from a private corporation and paid to children being subject to the highest marginal tax rate in the province of the children’s residence. Measures are proposed to broaden the TOSI to apply to adult individuals resident in Canada who receive income from the business of a related individual.
A “reasonableness” test is also proposed to determine whether income received by an individual who is otherwise “connected” to a business will be subjected to the rules. This reasonableness test will, inter alia, consider actual labour and capital contributions made by family members to a business in determining whether the income being paid to them is sufficiently “arm’s length”. Individuals aged between 18 and 24 will be subject to a more stringent test than those above the age of 24.
2. Constraining the Multiplication of the Lifetime Capital Gains Exemption (“LCGE”): The LCGE is generally available to be claimed by the owners of shares that meet the requirements for “qualified small business corporation shares.” By claiming the LCGE, a business owner may reduce the overall capital gains tax payable on the disposition of “qualified small business corporation shares” to the full extent of the available LCGE during the year in which the disposition occurs. In 2017, the LCGE limit is $835,714.
Conventional planning included the introduction of a family trust as part of a business family’s overall tax planning to own the common or growth shares of a small business corporation. Upon a sale or disposition of the shares, the trust would realize a capital gain but could allocate the gain to the beneficiaries of the trust (being, generally, members of the business family) in order for the beneficiaries to utilize their available LCGEs. The overall tax paid by a business family on the disposition of the small business corporation shares would be accordingly reduced.
The Federal Government questions the overall fairness of such planning. New measures are, therefore, proposed which would:
a) Apply an age limit in determining LCGE eligibility. Individuals would no longer qualify for the LCGE in respect of capital gains realized before the taxation year in which they attain the age of 18;
b) Introduce a “reasonableness” test that would be applied to determine whether the LCGE may be claimed by an individual in respect of a realized capital gain. This test would, in general, be the same as that which applies to the TOSI measures described above;
c) No longer permit individuals to claim the LCGE in respect of capital gains that accrue during a period in which a trust holds the property. While an exception would be provided for capital gains that accrue on property held by a spouse or common law partner trust, as well as certain employee trusts, the multiplication of the LCGE through a trust would no longer be permitted; and
d) Provide a special election to individuals for their 2018 taxation years to crystallize their available LCGEs up to the start of that year.
3. Supporting measures to Improve the Integrity of the Tax System: In addition to the above-outlined measures, the Federal Government also proposes that the requirement to issue T5 returns in respect of interest payments be extended to partnerships and trusts in much the same manner as they presently apply to corporations. It follows that trusts which are the recipients of debt (such as prescribed rate loans) would be required to issue a T5 return to the lender in respect of the interest payable on such debt.
Holding Passive Investments inside a Private Corporation
The Federal Government suggests that planning which involves holding passive investments within a private corporation creates a financially advantageous situation for the owners of the private corporation as compared to other taxpayers. According to the Government, this is “mainly due to the fact that corporate income tax rates, which are generally much lower than personal rates, facilitate the accumulation of earnings that can be invested in a passive portfolio.” The Government suggests that the current system in place “does not achieve its objective of removing incentives to hold passive investments within a corporation in a broad range of […] situations”.
Although the Federal Government does not, at this time, propose any specific amendments to the Income Tax Act (Canada) to address this perceived unfairness, it does discuss certain methods which could be applied to address and potentially remedy its main concerns. Some of these methods may constitute a fundamental shift in the manner in which private corporations are taxed in respect of passive income. Consultations are requested regarding the possible methods suggested by the Federal Government. It is expected that groups within the tax and private client services industries will be making submissions to the Federal Government in the coming weeks to voice their views and concerns.
Converting Income into Capital Gains
Section 84.1 of the Income Tax Act (Canada) is an anti-avoidance rule that generally applies when an individual sells shares of a Canadian corporation to another Canadian corporation on a non-arm’s length basis and the individual receives non-share consideration (e.g. cash) for the shares in excess of the greater of two amounts: the adjusted cost base of the shares to the individual and the shares’ paid-up capital. The Federal Government is concerned that section 84.1 can be avoided and that tax payable can be thereby reduced by converting amounts that would otherwise be paid as dividends or salary to capital gains, which are subject to a lower rate of tax.
The Federal Government accordingly proposes that section 84.1 be amended to prevent 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. This will be achieved by extending the current rules in subsection 84.1(2) to cases where cost base is increased in a taxable non-arm’s length transaction. The Federal Government also proposes that the Income Tax Act (Canada) be amended to add a separate anti-stripping rule to counter tax planning intended to circumvent the application of Income Tax Act (Canada) provisions which are otherwise designed to prevent the conversion of a private corporation’s surplus into tax-exempt capital gains.
Studying the New Proposals and Next Steps
The amendments to the Income Tax Act (Canada) proposed by the Federal Government, as well as the potential methods to be applied to eliminate the perceived advantage available to taxpayers who hold passive investments in a private corporation, are detailed and complicated. Miller Thomson LLP’s Corporate Tax and Private Client Services teams are presently engaged in a detailed review of these proposals and look forward to the opportunity of collaborating with key industry organizations on submissions to the Federal Government. We will be providing you with additional information, analysis and insights in due course after we have had an opportunity to study and consider more carefully the Federal Government’s proposals.
In spite of the proposed new measures announced by the Federal Government on Tuesday, there remain very legitimate and important reasons for tax and legal planning involving the use of private corporations and trusts. Although the Federal Government’s proposals may result in the loss of certain previously available tax advantages, other key benefits appear still to be available. Most notable among these benefits is the use of family trusts to facilitate the tax-deferred, inter-generational transfer of private corporation shares to family members (often children and grandchildren) who are resident in Canada—a key component of many business succession plans. The Federal Government has also in no way eliminated the benefits provided to private corporation owners who engage in common “estate freeze” transactions. These transactions may also be critical to business succession plans and to a business family’s overall tax planning.