Optimizer

2017 Optimizer Special Edition

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Proposed Tax Legislation Has Adverse Consequences to Private Corporations


Significant proposals were released today with respect to tax planning strategies involving private corporations. In the 2017 federal budget the government said they were reviewing the use of strategies that reduce the personal taxes of high-income earners, including:

•  Income splitting (referred to as “income sprinkling” in the budget) with lower income family members using private corporations

•  Holding passive portfolio investments inside a private corporation

•  Converting a private corporation’s regular income into capital gains

The proposals are summarized in this special edition of The Optimizer. The new rules are complex, so this publication is only intended to be a high level overview of what the changes are and how they affect privately held businesses.


Income Splitting Using Private Corporations


Two significant changes are proposed:

1.  Adding a “reasonableness” test to dividends paid to family members

2.  Eliminating or restricting eligibility to the capital gains exemption in certain situations


Resonableness Test on Dividends


Tax on split income (“TOSI”, also informally referred to as the kiddie tax) is an existing rule that applies to certain capital gains and dividends earned by minors from private company shares (with some exceptions). Income subject to TOSI is taxed at the top tax rate (53.53% in Ontario) which eliminates any incentive of income splitting. TOSI does not apply to salaries, but CRA has the ability to challenge the reasonableness of salaries paid to family members. There is no similar “reasonableness” test for dividends like there is for salaries, and TOSI is currently not applicable to dividends paid to adults.

The government is proposing to expand TOSI to individuals age 18 or older and in receipt of an “unreasonable” amount of income derived from a business of a related individual residing in Canada. This can include dividends paid to family members in an owner-managed business carried on through a private corporation.

The “reasonableness” test will differ depending on the age of the individuals. In the context of an owner-managed business carried on in a private corporation, the amounts paid to spouse or adult children shareholders cannot exceed what the owner-manager would pay to an arm’s length person. The reasonableness test will consider the labour and capital contributions of the spouse and adult children, and higher scrutiny is placed on amounts paid to individuals in the 18 to 24 age range.

There will be specific anti-avoidance rules where TOSI will apply regardless of the reasonableness test. For example, seeding an adult family member under age 25 with a onetime dividend subject to TOSI with the anticipation of earning investment income in a lower tax bracket in subsequent years will result in that compound or second generation income also being subject to TOSI.

With this change, CRA will have broad authority to challenge the reasonableness of dividends paid to family members and have the ability to reassess this income at the top rate of tax. It is unclear at this point how CRA will administer the new rules, and with the guidance in the consultation papers released today being vague, there will surely be future court cases debating what makes a dividend a “reasonable” amount.

The changes will apply for 2018 and subsequent taxation years.


Changes to the Capital Gains Exemption


The government is proposing the following modifications to the lifetime capital gains exemption:

• Eliminating the exemption for qualifying capital gains realized by minors. When the individual is no longer a minor, they would continue to be ineligible to claim the exemption on any portion of the gain accrued during the time he or she owned the property as a minor.

• Introducing a reasonableness test on qualifying capital gains realized by adults. The test would be the same as the one described above for the income splitting proposals.

• Eliminating the exemption for any accrued gain during the time in which the property was held by a trust (subject to certain exceptions for spousal trusts, alter ego trusts and employee share ownership trusts).

The measures would be effective for dispositions after 2017 and transitional relief would be available to allow affected individuals to elect to trigger a disposition of the property in 2018 and utilize the current tax rules. The 24 month holding period and asset tests of the capital gains exemption would be reduced to 12 months for the purposes of this transitional election.

Just like with dividends, CRA will now have broad authority to challenge claims of the capital gains exemption on the grounds of “reasonableness”, and this could result in reassessments where the capital gain exemption is not just lost, but the gain also taxed at the highest tax rate. With only vague guidance of what makes a capital gain “reasonable”, affected taxpayers may wish to consider electing under the transitional rules to crystallize their exemptions.


Holding Passive Investments Inside a Private Corporation


An owner-manager earning business income in a private corporation can take advantage of the low corporate tax rates available on business income and have more after-corporate tax dollars to reinvest into a corporate investment account than an individual who earns business income personally and reinvestments the after-tax proceeds into an personal investment account.

The owner-manager also has more after-tax dollars available to reinvest if the investment is made at the corporate level as opposed to paying out the after-corporate tax proceeds as salary or dividends before reinvesting at the personal level.

While the tax on the subsequent investment income is effectively taxed the same with or without the use of a corporation, there is more initial capital available for investment when it comes from the after-tax dollars of corporate business earnings.

The government is still considering various approaches to eliminate this perceived tax advantage and will be taking consultations on 4 different approaches until October 2, 2017. No proposed legislation was released today on this matter.


Converting Regular Income into Capital Gains


Capital gains are subject to less tax than salary or dividends since capital gains are only half taxable. There is an existing anti-avoidance rule that prevents the stripping of corporate surplus out as a capital gain in non-arm’s length transfers. Through complex corporate reorganizations involving multiple non-arm’s length corporations, it is possible to circumvent this existing rule and gain access to favourable capital gain treatment on distributions that would otherwise be considered a dividend. The draft legislation released today prevents this type of planning opportunity for dispositions on or after July 18, 2017.

A new anti-avoidance rule is also introduced that broadly targets any tax planning strategy aimed at converting corporate surplus into lower-tax capital gains.


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Editor:

Brook Scarr, CPA, CA
Partner, Taxation

All rights reserved. Permission to reproduce or copy in any form or means is prohibited without the express written consent of SF Partnership, LLP. All information contained in this publication is general in nature, and should not be construed as professional advice. Readers are urged to consult their professional advisors before taking any action based on this publication. ©SF Partnership, LLP 2017