19 Jul 2017
Tax Planning Using Private Corporations – Changes on the Horizon
Written by: Lyndon Braun, CPA, CA
As hinted in the March 22, 2017 Federal Budget, the Department of Finance today released a consultation paper and draft income tax legislation that identifies significant tax changes to tax planning using private corporations.
In today’s sophisticated world, the majority of businesses of any size are structured as corporate entities. For many of our clients, they carry on business as private corporations and, as such, the implications of these changes are significant. The overall tax burden to many of these private corporations is likely to change if these reforms are enacted. While there is some uncertainty as to what the final legislative changes will look like, this consultation paper and draft legislation do paint a picture that darkens the outlook for many business owners.
The Department of Finance has proposed draft legislation and/or conceptual changes to impact the following perceived loopholes in our taxation system:
- Sprinkling income using private corporations;
- Holding of passive investment assets inside a private corporation; and
- Converting a private corporations’ regular income into capital gains.
The Department of Finance has proposed draft legislation effective after 2017 that will significantly impact the ability of business owners to pay various types of income to family members who are not “involved” in the business. Whether these payments are being made directly to family members as shareholders or as beneficiaries through a family trust, any payments received from a connected individual’s business will now potentially be subject to tax at the highest marginal rate. An exception applies if those payments represent what someone would pay at fair market value for those family members’ services or capital contributions to the business. Additionally, the ability to split capital gains and the use of the lifetime capital gains exemption of family members not otherwise involved in the business will also be severely limited.
The proposals to limit income splitting are being achieved through an implementation and/or expansion of the Split Income (sometimes referred to as “Kiddie Tax”) rules to expand these rules to include all related adults. Essentially any income received by an adult individual from the business of another related individual will be subject to a test to determine if that amount is reasonable in relation to their contributions in either labour/effort and or capital contributions to the particular business. If the adult receives a dividend and their contribution is not considered reasonable, that income will now be taxed at the highest marginal tax rate. It is also proposed that these Split Income rules be expanded to include capital gains, not just dividends.
Further, it is proposed that the lifetime capital gains exemption will be restricted for all dispositions after 2017. This will be done by restricting the exemption for individuals that are subject to the Split Income rules, for gains that are realized or accrued prior to individuals reaching the age of 18, and any gains that are realized or accrued during the time that the property was held by a trust.
Holding Passive Investments Inside a Private Corporation
Prudent tax planning currently suggests that incorporated business owners who intend to save some of their business earnings should do so in a corporation. A company in BC will pay tax at a rate of either 13% (small business rate) or 26% (general rate). Alternatively, individuals pay a maximum rate of 47.7% on their income. As a result there can be a significant deferral achieved in retaining net earnings in a corporation to invest rather than paying out dividends or salary to the owner manager. This provides additional investable capital, which when compounded annually can lead to an increase in overall equity.
The Department of Finance has determined this to be an unfair aspect of our taxation system and has provided a detailed analysis of several possible solutions to eliminate this inequity.
The final resolution to the perceived problem is still uncertain and the government is eliciting feedback on suggested possible approaches. However, at this time it would appear that they plan to impose some sort of additional level of non-refundable income tax on passive income to make up for the additional capital that corporations have available to invest. The additional tax burden imposed on passive income and its eventual withdrawal by shareholders would effectively eliminate any of the deferral available by investing within a corporation. This will have a drastic impact on how business owners save their money.
Converting Regular Income to Capital Gains
Under our current tax regime, capital gains have a significant tax advantage in that they are taxed at only ½ the tax rate of regular income. As a result, tax planning has been developed to allow business owners to generate capital gains instead of receiving income as either a salary or a dividend.
The Department of Finance has long held that the Income Tax Act does not permit business owners to achieve this result under current tax law. Their belief has been tested through the Court system with varied results.
As a result, in response to the lukewarm response they’ve received in the Courts, they have decided to implement changes to the rules regarding surplus stripping. The proposed rules will prevent business owners and related individuals from triggering capital gains in order to strip out corporate surplus to be taxed at much lower rates.
These rules will effectively convert non-arm’s length capital gains to deemed dividends to ensure that tax planning can’t be achieved to generate capital gains as opposed to dividends or salary. One significant impact of these changes will be on post-mortem planning for business owners and could result in double taxation of corporate surplus to the estate.
The consultation paper is just that, a consultation paper. There is no guarantee that the draft legislation or proposals by the Department of Finance will be implemented as proposed. However the consultation paper does follow the initial warning made in March that changes are coming.
Concerned taxpayers and organizations have until October 2, 2017 to provide feedback to the Department of Finance.
The tone of the consultation paper is worrisome. In many instances the Department of Finance refers to private corporations as not paying their fair share or that they are somehow shirking their responsibilities to pay taxes. The use of the language and rhetoric to condemn small and medium sized business owners is patently unfair. The Department of Finance was well aware of how the previous tax legislation was being used, in fact prudent planning under the current tax legislation motivated taxpayers to saving within their corporations to minimize their annual tax burden; its how the system was designed. To now penalize owners of private corporations for working within the tax rules that they designed and implemented is a worrying development. In our opinion this is unfair, but also provides insight to the Government’s intent.
Business owners should brace themselves for significant changes. At Manning Elliott we will continue to unravel the implications of these changes and to keep you abreast of the proposed legislation. We will look to communicate important information to you and to provide consulting and advisory services to you in order to ensure that you are not only aware of these pending tax changes, but also so you can deal with their implementation as efficiently as possible.
Should you have any questions or concerns, please contact a member of the Manning Elliott Tax team at 604-714-3600, as we would be happy to discuss these issues with you.
The above content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent changes. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.