On July 18, 2017, the Department of Finance for Canada released information regarding proposed tax legislation changes aimed at restricting some of the tax planning and deferral benefits associated with Canadian private corporations. It is expected that these changes will have a significant impact on how the earnings of Canadian private corporations and related distributions to their shareholders will be taxed, and therefore it will be important to understand these rules and consider the impact of their potential application on a go forward basis.
There are three separate proposals which are at various stages of implementation and are aimed at the following areas:
The government has expressed concerns over the fact that under the current tax system, significant flexibility exists for corporations to split income earned from a business among shareholders who are related to the principal shareholder of the corporation (i.e. spouses or children) through the issuance of dividends. By issuing dividends to related shareholders who pay tax at lower marginal tax rates a significant tax advantage can often be gained over individuals who earn income through employment (or through a business structured as a sole proprietorship) and do not have the option to distribute earnings to related persons.
In order to address this concern, the Department of Finance has issued proposed legislation changes which would significantly restrict the ability for a private corporation to issue dividends to related persons who do not contribute to the business of the corporation in a meaningful way, and have such dividends taxed at a lower marginal tax rate. Under the proposed rules, income received from a Canadian private corporation by an individual who is resident of Canada (referred to as a specified individual at the end of the year end will be subject to a reasonableness to the extent that the income received is derived from the business of a related individual.
The reasonableness test described as part of the proposed legislation is aimed at determining to what extent the income received by a specified individual exceeds the amount that an arms length party would have agreed to pay the individual considering the following factors:
Labour contributions, the extent to which:
- for an adult specified individual age 18-24, the individual is actively engaged on a regular, continuous and substantial basis in the activities of the business; and
- for an adult specified individual age 25 or older, the individual is involved in the activities of the business (e.g., contributed labour that could have otherwise been remunerated by way of salary or wages).
Capital contributions, the extent to which:
– for an adult specified individual age 18-24, the amount exceeds a legislatively-prescribed maximum (using the same rate used for purposes of the tax attribution rules) allowable return on the assets contributed by the individual in support of the business; and
– for an adult specified individual age 25 or older, the individual has contributed assets, or assumed risk, in support of the business.
To the extent that the amount paid to the specified person is not considered reasonable the top marginal tax rate will apply to the split income. The proposed legislation also includes similar measures to restrict the multiplication of the lifetime capital gains exemption through the issuance of share capital to related individuals.
These new rules are set to come into effect starting on January 1, 2018, and although it is not yet known how the rules will be applied, consideration should be made as to how they may affect your corporation’s ability to distribute income to its shareholders at lower marginal tax rates. As the rules will not apply to distributions made during the 2017 calendar year, it may be beneficial to consider paying additional dividends prior to December 31, 2017 in order to take advantage of lower personal tax rates which may not be available on similar distributions made in subsequent years.
Holding passive investments inside a private corporation
Part of the government’s focus of concern over the perceived unfair benefits of earning business income through a private corporation, in comparison to earning income personally, includes the ability for corporations earning active business income to invest retained earnings which have not yet been subject to personal taxes in passive investments (assets not used for the purpose of earning active business income) held by the corporation. The result of the current rules is that individuals who invest in passive investments through a private corporation have a higher amount of after tax income to invest than that of an individual, resulting in higher investment returns, especially where the investments are retained in the corporation for a significant period of time.
The July 18th release by the Department of Finance includes proposed measures to reduce the benefit available from investing in passive investments through a private corporation. The proposal put forward includes several suggested approaches that are being considered in order to achieve this result which include proposals to either introduce an additional refundable tax on the investment of active business income in passive assets, or eliminated the existing refundable taxes and addition to the corporation’s capital dividend account balance in relation to capital gains incurred on passive investments held in a corporation in favour of higher non-refundable tax rates on this type of investment income. The government will assess these options over the coming months with the goal of developing legislation that eliminates the financial advantages of investing passively through a private corporation, while also ensuring that there is minimal impact on existing passive investments held by private corporations.
As these proposed measures have not yet been put forward in the form of legislation, there is currently no timetable for when any such measures may come into effect.
Converting income into capital gains
The final proposed legislation change introduced involves the expansion of anti-avoidance rules which are included in Section 84.1 of the Income Tax Act for the purpose of preventing the conversion of income from the withdrawal of corporate surplus, into taxable capital gains (often referred to as surplus stripping). Under the current rules, this can sometimes be achieved by undergoing a transfer of the shares of a corporation to another non-arms length corporation for consideration consisting of shares of the non-arms length corporation. Such a transaction can be used to trigger a capital gain on the transfer of shares while at the same time increasing adjusted cost base of the subject shares, sheltering the shares from future capital gains when sold to a third party.
In order to restrict this type of surplus stripping, the government has introduced legislation which would expand the existing anti-avoidance rules in Section 84.1 in order to include cases where the cost base of shares is increased in a non-arms length transaction. The draft proposals will apply to any amounts received or receivable after July 17, 2017.
Additional information regarding the proposed legislation changes can be found at the link below:
Please contact Nineteen Seventeen Chartered Professional Accountants if you have any questions or concerns about how these proposed legislations may affect you or your corporation and how planning can be done to ensure that you continue to earn and distribute income from your corporation in a tax efficient manner.
Nineteen Seventeen Chartered Professional Accountants is a Calgary based accounting firm focused on helping individuals and businesses with their financial reporting, taxation planning, and compliance.