With the release of the 2017 federal budget in March, the Liberal government had indicated changes coming to the way private corporations may be used for tax planning. Following this, the Department of Finance then released a consultation paper targeting three specific tax-planning strategies using private corporations.
These tax-planning strategies are quite common and, as a result, many business owners could be impacted if the proposed changes become law.
And this has stirred some raucous debate within the business community. Given this, we briefly explore what might happen based on the proposed changes, although the changes in law may end up being quite different from what’s currently proposed.
“Sprinkling Income” using private corporations
Currently, this strategy can reduce taxes by shifting income from high-income earners, typically at top marginal rates, by paying dividends to family members in lower tax brackets. This is commonly known as “dividend sprinkling” or “income sprinkling.”
The proposed changes would involve rules to distinguish income sprinkling from reasonable compensation. Reasonable compensation would be determined based on the family member’s contribution of value and financial resources to the corporation. These measures would include:
- Extension of the rules governing tax on split income (TOSI). This will apply to certain individuals who receive split income when the amount in question is unreasonable. An adult who receives split income would be liable for the tax on split income on the “unreasonable” portion of the income. This could include expanding the meaning of “specified individual,” a reasonableness test (individuals 18 and over), introducing the meaning of “connected individual,” as well as additional changes to the TOSI rules.
- Limiting multiplication of claims to the lifetime capital gains exemption (LCGE). Currently, family trusts may be used to facilitate arrangements whereby the LCGE limits of multiple family members are used to reduce capital gains tax. This arrangement permits multiple family members to claim the exemption even though the family member(s) may not have invested in, or otherwise contributed to, the business value reflected in the capital gains they realize.
To address this, the proposed changes include age limits (e.g., no longer qualifying for LCGE on capital gains realized or accrued before the age of 18), a reasonableness test and trusts (e.g., gains accrued during the time a property is held in trust are no longer eligible for the LCGE, with certain exceptions).
- Supporting measures to improve the integrity of the tax system in the context of income sprinkling by introducing the following:
- Tax reporting requirements with respect to a trust’s tax account number, similar to the requirements for corporations and partnerships regarding their tax account numbers (i.e., “business numbers”).
- Measures on T5 slip requirements for interest amounts apply to partnerships and trusts in the same circumstances that they apply to corporations.
Holding a passive investment portfolio inside a private corporation
Currently, corporate income is taxed at lower rates versus personal income. When the owner of a private corporation uses earnings taxed at the lower corporate tax rates to fund passive investments held within the corporation, this can result in a tax deferral advantage due to after-tax income invested passively within the corporation being more than the after-tax income earned personally. Some may argue that this creates an unfair benefit to owners of private corporations.
The government is considering the changes required to establish fairness in the tax treatment of passive investment income of a private corporation, so that the benefits of the corporate income tax rates are directed towards investments focused on growing the business, rather than conferring a personal investment advantage to the corporate owner.
The approaches considered will aim to:
- Preserve the intent of the lower tax rates on active business income earned by corporations.
- Eliminate the tax-assisted financial advantages of investing passively through a private corporation.
- Ensure that no new avenues for avoidance are introduced.
Converting a private corporation’s regular income into capital gains
Presently, income earned by an individual indirectly through a corporation is subject to both corporate income tax (when the income is earned by the corporation) and personal income tax (when the income is distributed as a dividend from the corporation to the individual).
The Canadian income tax system is designed so that the combined corporate and personal tax paid on income earned through a corporation and distributed as a dividend to an individual shareholder is roughly equivalent to the income tax that would have been paid if the income had been earned directly by the individual. This is commonly referred to as “tax integration.”
However, integration does not occur if corporate surplus is paid out in the form of tax-exempt, or lower-taxed, income. In effect, the income is not subject to the appropriate personal income tax and the income is subject to less tax than if the individual had earned the income directly.
Individual shareholders with higher incomes can obtain a significant tax benefit if they successfully convert corporate surplus that should be taxable as dividends, or salary, into lower-taxed capital gains (such conversions are commonly referred to as “surplus stripping”). Effectively, this reduces income by taking advantage of lower tax rates that apply to capital gains.
The government seeks to amend Section 84.1 of the Income Tax Act to prevent individual 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. In general terms, this will be achieved by extending current rules that result in a so-called ‘soft’ cost base if the LCGE is claimed to cases where cost base is increased in a taxable non-arm’s length transaction, and by ensuring that those rules apply in a way consistent with this policy objective.
They also propose that the Income Tax Act be amended to add a separate anti-stripping rule to counter tax planning that circumvents the specific provisions of the tax law meant to prevent the conversion of a private corporation’s surplus into tax-exempt, or lower-taxed, capital gains.
You can find more information about these proposed changes in the Department of Finance’s consultation paper, which you can also share your comments on by emailing [email protected] by October 2.
CWB Wealth Management provides discretionary portfolio management and investment advisory services, as well as a range of financial planning, products and services. If you have questions about how these proposed changes may impact your business, get in touch with us today.