On Tuesday, July 18, 2017 the Minister of Finance, Bill Morneau, released a consultation document regarding tax planning strategies used by private corporations. The March 22, 2017 federal budget announced the federal government’s intention to review three specific tax planning arrangements: 1) sprinkling income using private corporations, 2) holding a passive investment portfolio inside a private corporation, and 3) converting a private corporation’s regular income into capital gains. Each of these topics is addressed in detail in the consultation document and has been summarized below:
Sprinkling income using private corporations
Income splitting refers to transferring income from a higher income earning family member to a lower income earning family member (such as a spouse or child). Where the family members are in different tax brackets, income splitting can reduce the total taxes paid by the family. The consultation document indicates that certain forms of income splitting are desirable (such as pension income splitting) but that tax benefits from income sprinkling via private corporations should be further restricted.
A common example would be a private corporation that has three shareholders: the owner-manager, his or her spouse and a family trust of which their children are beneficiaries. Income splitting may have historically been achieved by the payment of dividends to the spouse and adult children (via the family trust) to utilize those individuals’ lower marginal tax rates on an annual basis.
Extension of the tax on split income (“TOSI”) rules
In 1999, the TOSI rules (commonly referred to as “kiddie tax”) were introduced to restrict such income splitting with minor children. Where applicable, these rules result in a minor child paying tax on the income received at the top marginal tax rate.
Effective January 1, 2018, the government proposes to extend the TOSI rules to individuals 18 years of age and over where income has been received from a private company in which a family member is a principal and the amount received is considered unreasonable. Amounts would be considered unreasonable where the amount is greater than what would have been paid to an arm’s length party for their labour and/or capital contribution. The proposed reasonableness test is more stringent for those aged 18 to 24 as individuals in this age group are perceived to have historically benefitted disproportionately due to otherwise low income levels.
Constraining multiplication of the lifetime capital gains exemptions (“LCGE”)
The LCGE is available to individuals that dispose of qualified small business corporation (“QSBC”) shares with an exemption limit of $835,716 per individual in 2017. Historically, tax planning may have been done to access multiple capital gains exemptions (i.e. for multiple family members). Subject to transitional rules for elective dispositions in 2018, three measures are proposed to limit such planning as follows:
- Age limits: Capital gains realized or accrued by individuals before reaching the age of 18 will not be eligible for the LCGE.
- Reasonableness test: Capital gains included in TOSI would not be eligible for the LCGE.
- Trusts: Capital gains accrued while held by a trust would not be eligible for the LCGE with an exception for spousal or common-law partner trusts, alter ego trusts and certain employee share ownership trusts.
Should the above proposals come into legislation, taxpayers with LCGE multiplication strategies in place may wish to consider making an election to realize a capital gain in 2018 in order to utilize the LCGE under the transitional rules.
Holding a passive investment portfolio inside a private corporation
It is fairly common for clients with a private corporation to hold some portion of their investment portfolio within the corporation. There are various reasons for this including the tax deferral associated with retaining profits from an operating business within a corporation. i.e. Where funds existed that were not required for reinvestment in the business and the shareholders had no immediate personal cash needs, the personal taxes associated with distributing the funds as dividends could be deferred. Where the funds were invested within the corporation for the long term, this tax deferral could significantly increase the investment return. At this time, the government is considering various options to limit such tax deferral benefits. While corporate investors that have previously benefitted from this strategy likely won’t welcome these changes, they may be comforted by the fact that the indicated intent is for these rules to apply on a go-forward basis so as to limit the impact on existing corporate investments.
Converting a private corporation’s regular income into capital gains
Draft legislation intended to further restrict corporate surpluses from being converted into capital gains is proposed to be effective July 18, 2017. In limited circumstances, planning may have been done to benefit from the generally lower capital gains tax rates.
Owners of private corporations will want to follow this process closely with legislation expected to be introduced in the fall following the consultation period. For further details, please refer to the documents on the government of Canada website.
The information provided in this article is a simplified general summary and is not intended to replace or serve as a substitute for professional advice. Professional tax advice should always be obtained when dealing with taxation issues as each individual’s situation is different. This information has been obtained from sources believed to be reliable but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. This information is subject to change and ATB Securities Inc., ATB Investment Management Inc. and ATB Insurance Advisors Inc. reserves the right to change the information without prior notice, and does not undertake to provide updated information should a change occur. ATB Financial, ATB Investment Management Inc., ATB Securities Inc. and ATB Insurance Advisors Inc. do not accept any liability whatsoever for any losses arising from the use of this document or its contents.