In Budget 2017, the Canadian Federal Government announced its intention to target tax planning strategies involving private corporations. The Government indicated at the time that despite recent measures to limit planning arrangements, it was continuing its review of such tax planning strategies. It also noted that it intended to review features of the income tax system that have an "inappropriate, adverse impact of genuine business transactions involving family members".
On July 18, 2017 (the "Consultation Date"), the Minister of Finance (Canada), the Honourable William Morneau, released the Government's proposals to address tax planning commonly used by private corporations and their owners in the form of a paper (the "Consultation Paper") and draft legislation amending the Income Tax Act (Canada) (the "Tax Act") to implement certain of the proposed measures.
The Government addresses three broad issues in the Consultation Paper:
- Sprinkling income using private corporations;
- Holding a passive investment portfolio inside a private corporation; and
- Converting a private corporation's regular income into capital gains.
Selected proposals and tax measures are detailed below.
Details of the Proposed Tax Measures
The Consultation Paper notes that the Government has imposed a progressive personal income tax system with five marginal tax rates ranging between 15 percent and 33 percent that apply at different taxable income thresholds. The Government is concerned with arrangements that effectively transfer income that may otherwise be taxable in the hands of a high-income individual to a family member subject to lower tax rates resulting in lower tax receipts for the Government ("income sprinkling").
The Tax Act currently has a number of provisions that deny or limit the potential benefits of income sprinkling, but the Government believes that additional measures are necessary with a particular focus on investments in private corporations.
Proposed Tax Measures
The measures proposed by the Government fall into three categories:
- Extension of the tax on split-income ("TOSI") provisions;
- Restricting claims under the lifetime capital gains exemption (the "LCGE"); and
- New tax reporting obligations applicable to trusts and partnerships.
TOSI The TOSI provisions were previously known as the "kiddie tax" because they applied to certain "split-income" of persons under 18 years old. These rules are to be extended to adults. Split-income, in general terms, includes dividends from unlisted shares (other than from a mutual fund corporation), and income from a partnership or trust derived from a business of a related person. Where the TOSI provisions apply, the split-income is subject to the highest marginal rate of tax.
The Government proposes that the split-income of adults become subject to the TOSI rules, subject to certain reasonableness tests. The reasonableness tests would subject split-income to the TOSI rules where the income amount is not considered reasonable in that it exceeds what a hypothetical arm's length party would have agreed to pay having regard to the labour and capital contributions of the person receiving the split-income. In the case of adults receiving split-income who are between 18 and 24 years of age, the reasonableness tests are more onerous in only crediting labour contributions where the individual is "actively engaged on a regular, continuous and substantial basis" in the business and in limiting the return of such individual's capital contributions to a prescribed maximum rate that is the same as the rate applicable under the Tax Act's attribution rules.
There are additional proposed changes to the TOSI provisions. Split-income would include income from most debt obligations issued by a private corporation, gains from dispositions of property that generate split-income and, for persons under 25, income earned on previously-taxed split-income (i.e. compound income). The extension of the TOSI rules would generally apply for the 2018 and later taxation years.
LCGE New restrictions are also proposed for claims under the LCGE. The LCGE is proposed not to be available for gains realized or accrued prior to the taxation year in which an individual becomes 18 years old. Second, the LCGE is proposed not to be available where the taxable capital gain is split-income, subject to reasonableness tests corresponding to those discussed above. Finally, the LCGE is proposed not to be available on capital gains accruing while the property was held by a trust, with certain exceptions. This is meant to prevent the multiplication of LCGE claims by the beneficiaries of a trust. The changes to the LCGE would apply to dispositions after 2017 subject to special transitional rules.
Reporting The Consultation Paper also proposes additional information reporting requirements for trusts and new T5 slip requirements for partnerships and trusts. These new reporting requirements would apply for the 2018 and subsequent taxation years.
The income sprinkling measures will add further tax complexity for private corporations and their owners. Reasonableness tests are difficult to administer both in the context of a self-assessment tax system and for CRA auditors. The Government has a history of losing tax appeals in the courts where the Government relied on reasonableness standards. Presumably, it believes that this time will be different.
The more onerous reasonableness test for persons receiving split-income who are between 18 and 24 is unusual. Additional tax burdens are typically not imposed on one age cohort of adults compared to adults of different ages. The Government is concerned that opportunities for income sprinkling are more numerous in the case of young adults in general. However, such age discrimination invites a challenge under the equality provisions of section 15 of the Canadian Charter of Rights and Freedoms. Limiting returns on capital invested by young adults in private corporations to a prescribed rate under the reasonableness test is particularly egregious as it ignores actual returns on equity achieved by the corporation.
Passive Investments Inside a Private Corporation
The Consultation Paper states that tax fairness and neutrality require that private corporations not be used as a "personal savings vehicle" for purposes of gaining a tax advantage. The Government acknowledges that while there is a policy reason as to why corporate income is taxed at lower rates, generally allowing such corporations to reinvest more of their capital for business purposes, this preferential treatment should not be given to passive investments held in private companies. Rather, passive investments should be taxed the same whether held in a private corporation or outside the corporation. The Consultation Paper asserts that the current rules regarding the taxation of income in a private corporation were never intended to be used to realize higher personal savings.
Specifically, the Government is focusing on the effective tax paid on the source of the earnings used to fund passive investments in private corporations. While the current rules are intended to achieve neutrality when corporate and personal taxes are combined, partial tax deferral opportunities may arise where funds are not distributed and instead are used by the corporation for passive investments. Accordingly, the Government states that it intends to: (i) keep the lower tax rates on active business income earned by corporations, and (ii) eliminate the advantages of investing passively through a private corporation.
As noted in the Consultation Paper, the Canadian Government in 1972 had developed an approach (which was implemented but immediately repealed) aimed at dealing with the passive income issue. The 1972 approach was a refundable tax in respect of ineligible investments which imposed the general corporate income tax rate on such investments. A corporation could obtain a refund of the upfront tax paid on the disposition of the passive investment asset if the corporation reinvested the proceeds in business operations. The Government acknowledges that implementing the same approach now would not be possible due to changes in the tax system since the 1972 approach was introduced. There could also be liquidity issues that arise if the 1972 approach were implemented without modification as there could be delays in obtaining tax refunds.
Proposed Tax Measures
The Government proposes a modified approach to replace the current regime with one that would still impose a tax rate (approximately) equal to the highest marginal tax rate for individuals on the passive investment income of private corporations but would remove the refundability of such taxes where the amounts used to fund the passive investments were taxed at the corporate rates. To properly implement the modified approach, the tax treatment of the passive income distributed as dividends will need to take into account the tax rate that applied to the funds used for the passive investment and, therefore, the source of the funds for each passive investment must be tracked.
In the Consultation Paper, the Government proposes two alternate methods to track the source of the income used to acquire each passive investment:
- Apportionment Method: This method would involve an apportionment of the passive income based on the corporation's cumulative share of earnings taxed at the small business rate and the general rate as well as amounts contributed by shareholders from their after-tax income. The result is three possible tax treatments which include eligible dividends, non-eligible dividends, and "tax-free" distributions. This method would require keeping track of three tax pools but, the Government argues, would be based on information that is either already computed for tax purposes or readily available to a private corporation.
- Elective Method: This method would subject private corporations to a default tax treatment subject to an election. Under the default treatment, passive income earned by a Canadian-controlled private corporation would be subject to non-refundable taxes equal to the highest marginal tax rate and dividends paid from such income would be treated as "non-eligible" dividends. The default method essentially assumes that all passive income is funded using income taxed at the small business rate (even though some or most of the income could be taxed at the general rate) and that no shareholder contributions (i.e. already taxed at individual rates) are used to fund passive investments.
Under the elective treatment, additional non-refundable taxes would apply on passive income, and dividends paid from such income would be eligible for the higher dividend tax credit rate. The election would remove the corporation's access to the small business tax rate. The elective method would be more appropriate, for example, for a corporation that earned either all, or a significant portion of, its income at the general rate.
The Government further proposes that, under either method, another election would be available for corporations focused on passive investments. Under the passive income corporation election, all income generated by the entity would be taxed at a level that approximates the highest marginal income tax rate. All income earned by the passive income entity would be subject to refundable taxes (i.e. added to RDTOH and refunded upon payment of sufficient dividends).
Finally, the proposals contemplate that while capital gains remain eligible for the 50 percent inclusion rate, the non-taxable portion of capital gains would no longer be credited to the capital dividend account where the source of the capital investment is income taxed at corporate income tax rates.
Draft legislation was not released with the Consultation Paper but will be released after further consultation.
The proposals are obviously complex and, if implemented, will be an additional significant compliance burden for private corporations. The proposals place a great deal of reliance on a business income versus passive income distinction. That distinction can be quite tenuous in many circumstances, as reflected in the case law. The proposals will also incentivize reinvestment in current or new business operations and therefore could distort the underlying economics, and the resulting business decisions, for private corporations.
Converting Income into Capital Gains
Income earned by an individual indirectly through a corporation is subject to tax at both the corporate level, when the income is earned by the corporation, and the personal level, when income is distributed to the shareholder. The Canadian tax system has mechanisms in place intended to preserve "tax integration" which is the principle that the combined corporate and personal income tax paid on income earned through a corporation should be the same as the personal income tax paid on income earned directly.
The Government's concern is that while the operation of the dividend tax credit should result in tax integration, the integration does not occur if distributions of corporate surplus are made from tax-exempt, or lower taxed, income. In particular, the Government is concerned about "surplus stripping" where a shareholder converts corporate surplus that would normally be taxable as dividends, or salary, into capital gains.
The third proposed measure in the Consultation Paper focuses on the anti-avoidance rule contained in section 84.1 of the Tax Act. Section 84.1 currently applies, generally, where an individual disposes of shares of a Canadian corporation to another corporation that does not deal at arm's length with the first corporation and the two corporations are then "connected" with each other for purposes of section 84.1 of the Tax Act. Where section 84.1 applies, a dividend is deemed to be paid where the individual receives non-share consideration (such as cash or a promissory note) in excess of the greater of: (i) the adjusted cost base of the shares to the individual, and (ii) the paid-up capital in respect of the shares.
The adjusted cost base for purposes of section 84.1 is generally the "hard" cost base which does not include "soft" costs such as cost that represents capital gains that were effectively tax-free to the individual because for example, the LCGE or pre-1972 valuation day cost.
The Government appears to be concerned that section 84.1 does not apply in certain situations where "hard" cost is established due to capital gains even if the taxpayer did pay tax. The example in the Consultation Paper is as follows:
- An individual sells shares of their private corporation to another non-arm's length corporation for fair market value consideration in the form of shares in the capital of the purchasing corporation. The sale results in a taxable capital gain to that individual and sets the cost of the acquired share to the individual to fair market value; and
- The individual then sells the acquired share to another non-arm's length corporation for consideration that includes non-share consideration. Section 84.1 should not normally apply in this second transaction due to the "hard" cost that was established in the previous step.
The Consultation Paper compares this result with the alternative transaction where the individual receives fair market value proceeds in cash in the first step, which would be treated as a taxable dividend rather than capital gains. In effect, the Government is saying that the purpose of section 84.1 is broader than preventing V-Day or LCGE strips but that section 84.1 should be expanded to a broader surplus stripping rule applicable to all non-arm's length transactions.
The Consultation Paper does acknowledge that while courts are generally upholding the CRA's assessments in cases where surplus is converted into capital gains eligible for the LCGE or in regards to pre-1972 surplus and in situations where corporate surplus is extracted in the course of the winding-up or discontinuance of the business of the corporation, the courts have generally permitted the extraction of corporate surplus as capital gains if such gains are not eligible for the LCGE (and do not involve pre-1972 surplus) and that courts have held, in general, that there is no general policy against surplus stripping in the Tax Act.
Intergenerational Business Transfers
As mentioned in Budget 2017, the Government continues to consider whether the current income tax system has an inappropriate or adverse impact on genuine business transactions involving family members, especially in the case of a transfer of the family business between generations and whether the LCGE should be available to the transferor.
The Government acknowledges that a major policy concern in the implementation of any tax measures would be distinguishing between genuine intergenerational transfers and tax avoidance. To this end, the Consultation Paper refers to "hallmarks" of a genuine intergenerational transfer where:
- the vendor ceases to have factual and legal control of the transferred business;
- the intent of the new owner is to continue the business as a going concern long after its purchase;
- the vendor will not have any financial interest in the transferred business; and
- the vendor does not participate in the management or operations of the business after the transfer.
The Consultation Paper refers to the rules in the US tax system which, generally, provide a bright line rule that simulates an arm's length sale of the business where the vendor no longer has any interest or involvement in the transferred corporation after the sale. The Government is interested in the views of stakeholders in respect of this issue.
Proposed Tax Measures
The Consultation Paper includes draft legislation that extends section 84.1 to cases where the cost base is increased in a taxable non-arm's length transaction. The overall result in the draft legislation is that an individual will not be able to extract more than the greater of their "hard" arm's length cost in shares and the paid-up capital of the shares on a tax-free basis or as a gain.
The Government also proposes to add a separate anti-surplus stripping rule, in new section 246.1, to apply in non-arm's length circumstances where it is reasonable to consider that "one of the purposes" of the transaction or series of transactions is to pay, to an individual shareholder, non-share consideration that is otherwise treated as a capital gain out of a private corporation's surplus in a manner that involves a significant disappearance of the corporation's assets. If applicable, the non-share consideration would be treated as a taxable dividend.
It is proposed that these measures apply to shares disposed of on, or after, the Consultation Date and in respect of amounts that are received, or become receivable, on or after the Consultation Date.
Questions remain as to whether, and the extent to which, amended section 84.1 and new section 246.1 will affect "pipeline" transactions, a common post-mortem tax planning technique to mitigate double taxation, and certain transactions that involve subsection 55(2) in a non-arm's length transaction to deliberately cause capital gains treatment on a corporate distribution.
The Government's recognition that genuine intergenerational transfers of small businesses are legitimate from a tax policy purpose is helpful and presumably is intended to address anticipated criticisms of the proposals discussed above. But, of course, the policy debates will be on exactly what the Government chooses to be the line between appropriate intergenerational transfers and tax avoidance.
Further Actions and the Consultation Process
One of the purposes of the Consultation Paper is to seek input from stakeholders in respect of the proposed measures. The Government is looking for comments on among other things:
- with respect to the proposed income sprinkling rules, how to determine whether compensation is reasonable taking into consideration the family member's contribution of value and financial resources to the private corporation;
- with respect to the passive income rules, the preferred method to implement (i.e. the apportionment method or elective method) and also the criteria and broad considerations that the Government should consider in selecting a method; and
- with respect to the surplus stripping rules, specific comments on the proposed amendments to section 84.1 and new section 246.1 and also views of stakeholders and commentators in respect of how to accommodate intergenerational business transfers.
The Government invites interested parties to submit comments by October 2, 2017.