December 21, 2017
July 18, 2017 is a date that will likely live in infamy within the tax and business community. This was the date the Finance Minister announced the most significant, fundamental changes to the taxation of private corporations and their shareholders since 1972. The months that have followed have seen a series of announcements related to these changes, each of which supported, modified or “clarified” the original announcements in some fashion. As 2017 draws to a close, we at Daye & Partners wanted to provide our clients and friends with an update on the proposed changes, and the expected timelines going forward.
As most Canadians involved in small businesses are no doubt aware, the Minister of Finance, Bill Morneau, released a consultation paper on July 18, 2017 entitled “Taxplanning Using Private Corporations”. This paper identified perceived tax advantages and inequalities arising from the use of private corporations and proposed the government’s solutions to address the three most significant areas of concern: Income Sprinkling among family members, the deferral of tax resulting from the accumulation of Passive Investments in corporations and the conversion of dividend income to capital gains (commonly known as Surplus Stripping). At that time, draft legislation was also released related the measures to counter income sprinkling and surplus stripping.
A 75 day consultation period followed, during which tax professionals, industry groups, business leaders, small business owners and members of the general public submitted responses to these proposals – an astounding amount of responses totalling over 21,000 were received by the Government. Since that time, the Government has made a series of announcements releasing additional guidance and draft legislation related to income sprinkling.
Following is a summary of the current status of proposed measures related to each of the identified areas.
The draft legislation was released with the consultation paper on July 18, 2017 targeting income sprinkling. This legislation proposed an extension of the “Tax on Split Income” (TOSI) or “kiddie tax” rules to any Canadian resident, regardless of age, where that person receives split income from a business of a related individual. These rules would also look through family trusts and partnerships. In addition, the draft legislation introduced a reasonability test, so that income which is based on the labour and capital contributions of the individual (typically a spouse or child). Individuals aged 18 to 24 would be subject to a more stringent reasonability test than those over 25.
Additional legislation was released on December 13, 2017 which narrowed the definition of a related person to exclude aunt, uncles, nieces and nephews, bringing the definition back in line with definitions used elsewhere in the Income Tax Act. The revised legislation specifically excludes income resulting from property transferred in respect of a separation agreement in the context of a breakdown of a marriage or common-law partnership, a taxable gain resulting from the death of a taxpayer and taxable capital gains resulting from the disposition of Qualified Farm Property or Qualified Small Business Corporation Shares. The reasonability test is also extended to consider risks assumed (e.g. through the guarantee of loans) and there is a slight easing of the definition of reasonable rate of return on Arm’s Length Capital provided by individuals aged 18 to 24.
Finally, the December 13, 2017 legislation introduced several categories of individuals who could be eligible to receive income that would be excluded from the TOSI rules:
1) The business owner’s spouse, provided that the owner “meaningfully contributed” to the business and is aged 65 or over. This exclusion is meant to align with the rules related to the pension income splitting provisions. There are provisions to ensure a surviving spouse can continue to benefit from the exclusion on the death of the business owner. In addition, individuals receiving income from inherited property will be able to use the contributions of the deceased to determine if the TOSI rules should apply.
2) Adults aged 18 or over who have made a substantial labour contribution (generally an average of at least 20 hrs/week) to the business during the year or during any 5 previous taxation years. If the business is seasonal, this test only needs to be met for the portion of the year the business is active. The five qualifying years do not need to be consecutive.
3) Finally, there is an exclusion for adults aged 25 or over who own 10% or more of the votes and 10% or more of the fair market value of a corporation where at least 90% of the corporation’s business income for the prior taxation year was not derived from the provision of services and the corporation is not a professional corporation. This exception will not apply corporations where all or substantially all of its income is derived from a related business to a professional corporation or service company. This would prevent a service business from accessing this exclusion by using a non-service entity. Taxpayers will have until the end of 2018 to meet the 10% share ownership threshold.
The proposed legislation in this area will be effective January 1, 2018.
The July 18, 2017 consultation paper identified several areas of concern with respect to passive income earned within a corporation. In particular it took issue with the ability of the corporation to accumulate and invest excess earnings, allowing the corporation to benefit from a larger investment base than an individual, being the difference between the corporate tax rate and the personal tax rate. The paper was not accompanied by legislation, but it did contain a couple of potential approaches to address the issue. The paper called for submissions with alternative approaches and suggested that existing passive investments held by corporations would be grandfathered and the new rules would only apply to new investments.
On October 18, 2017, the Minister of Finance announced that the new passive income rules would be released in the 2018 Budget and reiterated that “all past investments and the income earned on those investments would be protected.” Mr. Morneau also indicated that the new rules would apply to passive income earned over an annual threshold of $50,000. No indication was given as to when these new rules would be effective.
Under the current rules, when an individual sells shares of a Canadian corporation to another Canadian corporation on a non-arm’s length basis, there is an anti-avoidance provision which applies to prevent the individual from taking back more non-share consideration (i.e. cash or promissory loans) than the tax paid cost base or paid up capital. This rule prevents individuals from recognizing a capital gain which could be sheltered with the capital gains exemption and extracting cash from the corporation on a tax free basis.
The draft legislation released on July 18, 2017 suggested a tightening of these rules to prevent an individual shareholder from using a non-arm’s length transaction to “step-up” the cost base of the shares, which would effectively result in double taxation. An additional “anti-stripping” rule was proposed which would apply where one of the purposes of the transaction or series of transactions is to pay non-share consideration that is otherwise treated as a capital gain out of a private corporation`s surplus in a manner that involves the significant disappearance of the corporation`s assets. The combination of these rules would have made it prohibitively expensive to transfer share ownership to related parties. These new rules would have been applicable to payments made on or after July 18, 2017.
On October 19, 2017, the Minister of Finance announced that this portion of the July 18, 2017 proposals would not be implemented.
One of the most common questions we have encountered this fall is “What do I need to do about these new rules?” Unfortunately, the answer is not as satisfactory as we might wish it to be:
1) Consider paying extra dividends to family members in 2017. This option has some merit to it. If in the future, the ability of the corporation to pay dividends to that family member is potentially in jeopardy or if the individual will need to draw extra income in the next few years, then this might be the year to pay an extra amount of dividends. When determining how much to pay the individual, we need to make sure that we consider the implications of the extra income on income tested benefits. If the extra income results in clawbacks of subsidies or if the extra income makes the recipient ineligible for benefits, the cost of paying the extra income could outweigh the benefits.
2) Consider paying salaries instead of dividends. If the individual in question is actively working in the business, a reasonable salary can be paid as compensation. This may attract less attention and may be easier to calculate than a reasonable rate of return on various contributions. The amount paid still needs to be reasonable and documentation is still required.
3) Document the contributions of various family members. In the future it may become more important to ensure that amounts paid to individuals are reasonable given the individual’s contributions to the business. Or, the individual may be or may become eligible to have income paid to them excluded from TOSI on the basis that they have made a significant labour contribution in the current year or in 5 previous taxation years. In order to take advantage of these exemptions, it will be necessary to be able to demonstrate the efforts and contributions of various family members. Starting the process of documenting this seems prudent.
4) Consider restructuring shareholdings to allow the corporation to stream dividends. Depending on the existing corporate structure, it may be necessary to restructure the share holdings to allow for the payment of dividends to some shareholders and not to others. This isn’t a step to be considered lightly, and we recommend that any restructuring be discussed with your accountant and legal counsel before proceeding.
5) Sit tight and stay up to date on the developments in this area. This seems like simple advice, but the truth is that the rules are still under development and are likely to change before they are implemented. We have very little guidance on what the passive income changes are going to look like, what the exemptions to those rules will look like, how the grandfathering provisions will work or even what the effective date for grandfathering will be. As tempting as it might be to try to react to the rules announced, we don’t have enough information to do so in an informed manner. It is entirely possible that “planning” around these rules without full knowledge of what they will look like will have negative effects (e.g. tainting investment pools that otherwise would have been grandfathered or drawing significant capital out of the company on a taxable basis that would have been grandfathered if left in the corporation).
6) Watch for details in Budget 2018. We have been promised additional details on the passive income proposals in the 2018 federal budget. The Finance Minister withdrew the proposed rules surrounding surplus stripping, but the underlying issue still exists and may prompt the introduction of alternative proposals to address the concern. The root of the issue is the gap between the tax rate on capital gains and dividends. There have been a lot of commentators who have suggested that increasing the capital gains inclusion rate from 50% to 75% would significantly narrow this gap and therefore take away the much of the incentive to structure transactions to result in a capital gain versus a dividend. After Budget 2017, the Finance Minister indicated that a change to the inclusion rate was not being considered at that time; however it is a relatively simple solution to the surplus stripping problem, so it might be an option under consideration.
In closing, we at Daye & Partners understand that these are challenging and uncertain times. We encourage any of our clients or friends who have question about these changes to contact their Daye & Partners Representative to discuss the changes and their implications. We will continue to follow these developments and update our contacts when changes are certain.