On July 18, 2017, the Department of Finance released a consultation document and draft legislation containing proposals that, if enacted, will significantly affect many private companies and their shareholders. Here is a brief summary of the proposed changes and how they will impact business owners.
Income sprinkling refers to splitting income with family members who are in a lower tax bracket. Existing “kiddie tax” rules in the Income Tax Act limit income sprinkling to minors by taxing dividends paid to the minor at the top personal tax rate. The current proposal would extend the concept of the “kiddie tax” to adult relatives as well. The highest rate of tax will apply to dividends, certain types of interest, and capital gains paid to or realized by adult relatives unless the amount can be justified as a “reasonable” amount. The reasonableness test will be based on the level of participation of the relative in the business (similar to how salary is currently treated) and/or the capital that they have invested in the business.
These new rules, if enacted, will apply to distributions in 2018 and subsequent years.
The Department of Finance also proposes to limit the multiplication of the lifetime capital gains exemption (CGE). For dispositions of qualified small business corporation shares arising in 2018 or subsequent years, the CGE cannot be claimed by a person under the age of 18 or claimed after they turn 18 in respect of value increases that accumulated prior to them turning 18. For adult relatives, if the proposed reasonableness test applies in the case of a realized capital gain, then not only is the gain subject to the highest rate of tax, but no CGE may be claimed. In addition, if the shares of the corporation are held by a trust (other than a joint partner or alter ego trust), any increase in value during the holding period will not qualify for the CGE.
The proposal indicates that there will be the ability to make a one-time election in 2018 to increase the adjusted cost basis of qualifying small business corporation shares and claim the CGE.
RETAINED EARNINGS AND PASSIVE INCOME
The Department of Finance is seeking to address the advantage created by the deferral of tax available through Canada’s current integrated corporate and personal tax regimes, whereby incorporated taxpayers who have more money to invest inside their corporations have an advantage over employees who pay full personal tax rates on their income and then use those after tax funds to invest. Advocates against the proposed changes argue that these funds which are held in the corporation will be used as retirement savings since shareholders of private corporations do not have company pension plans. The Department of Finance has proposed a number of methods which could be adopted to eliminate this advantage. One suggested approach is that an additional tax be paid by the corporation to the extent that the retained earnings are not reinvested back into the business. Another suggested approach looks at an election based method that would cause the company to pay tax at high rates on all sources of income instead of tracking different pools of income at different tax rates.
These issues identified by the Department of Finance and their proposed solutions have not been issued in draft legislation form (as opposed to the above on income sprinkling which has been rolled out in draft legislation) but are merely suggestions by the Department of Finance that they feel should achieve their stated objective. The suggested approach also proposes that the non-taxable portion of capital gains from these sources would no longer increase the capital dividend account.
Tax strategies that include triggering capital gains within a related group of companies, which historically has allowed shareholders to extract cash at lower rates via the capital dividend account, is being addressed. Proposed legislation would eliminate the advantage of these related group transactions going forward, and as currently worded, may have an impact on historical transactions as well.
These proposed changes will affect the majority of small business corporations and not just the wealthy as the government has suggested. The Department of Finance has requested commentary from all stakeholders, however, the consultation period is short as all comments must be received by October 2, 2017. We are currently discussing our concerns with local Members of Parliament during this consultation period.
If the proposals are enacted there are some potential planning options that can be undertaken in 2017 including paying higher dividends to lower income adult family members than what would have otherwise been paid and/or clearing out the capital dividend account that is currently built up in your company.
Given that these proposals are not enacted legislation we would advise that you discuss your current structure with your McCay Duff representative so that the appropriate steps can be put in place to meet your tax planning needs.
The full proposal from the Department of Finance and how to participate in the consultation process can be found at this address: https://www.fin.gc.ca/activty/consult/tppc-pfsp-eng.asp.
For more information on this topic, please contact your McCay Duff advisor.