In its 2017 federal budget, the Department of Finance announced it would be releasing a paper for consultation on the taxation of private corporations, reviewing tax-planning strategies that were used by private corporations and their shareholders to obtain what it called “unfair tax advantages.”
The government released a consultation paper on these issues on July 18, 2017, which included a number of proposed legislative amendments to address the policy concerns raised in the federal budget. If implemented, the proposed changes will have a significant impact on many private Canadian businesses, including small and family businesses and incorporated professionals, and will reverse many years of accepted tax planning for business owners.
Below is a summary of the proposal.
Passive investment income
Due to low corporate income tax rates, private corporations have the opportunity to invest after-tax funds in passive investments (guaranteed investment certificates or GICs, stocks, bonds) with a higher initial capital base compared with individuals who earn their income directly. The government is concerned with the fairness and neutrality of the current system and the tax-deferral opportunities for private corporations, and it has proposed various measures to address these concerns.
The proposed changes are aimed at eliminating the refundable tax system on passive investment income earned by private corporations to neutralize the financial advantages of investing through a corporation compared with investing directly as an individual. It also is aimed at eliminating the inclusion of the non-taxable portion of capital gains to the capital dividend account in certain situations.
The government is seeking input on these proposals. It is intended that any new rules would apply only on a go-forward basis.
Anti-income-splitting rules
Income sprinkling is a concept that refers to reducing income taxes that would otherwise be realized by a high-income and high-tax-rate individual to instead be realized by lower-income and low-tax-rate family members. The government has proposed various measures to address these concerns, including the extension of the tax on split income (TOSI), or “kiddie tax,” rules. The current kiddie tax rules apply to individuals under the age of 18 and effectively tax the split income at the highest marginal tax rate. The proposed changes would expand the individuals subject to the TOSI rules, effectively including any Canadian resident individual (i.e., spouse, adult children) who receives income from a business of a related individual.
The proposed changes would include a new “reasonableness test” for adult individuals to determine if the new TOSI rules would apply. The test would consider labour and capital contributions to the company by the individual, and would apply differently based on the age of the adult individual (whether the individual is between 18 and 24 or is 25 or older).
The proposed changes to the tax on split income apply to the 2018 and following taxation years.
Converting income into capital gains
The consultation paper also addresses a far less common tax-planning technique that is intended to allow a shareholder to extract retained earnings from a private corporation as a capital gain rather than as a dividend. The draft legislation includes an amendment to extend Section 84.1 of the Income Tax Act and a new anti-avoidance rule to be included in Section 246.1 of the act, which are intended to deter such planning. The proposed changes apply immediately.
Next steps
As part of the consultation process, Finance has requested comments on the discussion paper by October 2, 2017. It is expected that all proposals other than those with respect to passive investment income will be in force in 2018. If and when enacted, the tax rule changes outlined in the consultation paper and draft legislation will increase tax exposure for all Canadian family-owned businesses and professionals operating as a corporation.
The new rules are complex and will undoubtedly have consequences that were not intended by the government. It is very important for businesses to review their current corporate structure to determine the impact of the proposed changes. Given the proposed effective dates for the proposed changes, income-sprinkling strategies should be considered before the end of the 2017 tax year. Additionally, the proposed transitional rules should be reviewed to determine if any action is required in 2018.
