If you’ve just returned from vacation and wondering what’s new in the tax world, you’d better sit down and take a pill. On July 18, finance minister Bill Morneau rolled out the federal government’s proposals designed to “close loopholes and deal with tax planning strategies that involve the use of private corporations”. In short, Finance is proposing to tax an axe to many of the tax strategies that have been available to small business owners and professionals up until now.
The proposals are complex, comprehensive and wide-ranging, covering the following main areas of tax planning:
- Income sprinkling
- Multiplication of the capital gains exemption
- Converting a private corporation’s regular income into capital gains
- Holding investments inside a private corporation
This strategy involves the splitting of income to take advantage of lower marginal tax rates available to family members. Many rules have been put in place over the years to curtail this practice. Most notably, the tax on split income (TOSI), or “kiddie tax” applies the highest marginal tax rates to certain dividends paid to minor children.
With the new proposals, the TOSI will no longer be limited to minor children. Complex new rules will apply the TOSI to dividends paid to adult individuals unless such dividends are reasonable in light of that individual’s labour contributions and/or capital contributions to the corporation.
The TOSI will also be expanded to apply to capital gains on property, the income from which was subject to the TOSI. Further, it will also apply (for individuals under age 25) to “compound income” that was previously subject to attribution rules or the TOSI.
These proposals are scheduled to apply to for the 2018 and later years.
Multiplication of the capital gains exemption
A capital gains exemption (CGE) of up to $800,000 (indexed) is currently available to any individual on the sale of qualifying shares of a private company. Issuing shares to family members, either directly or through a trust, is a common way to multiply this tax benefit.
The finance minister has proposed a three-pronged approach that will eliminate the multiplication of the CGE:
Age limit: The CGE will no longer be available to individuals where the gain occurs in any year before the individual reaches the age of 18 years.
Reasonableness test: In essence, this rule will deny the CGE on any gain on the sale of shares if the gain from those shares is subject to the TOSI measures described above.
Trusts: With exceptions for spouse or alter ego trusts the GCE will no longer be available on any gain on a share that is held by a family trust.
These proposals will apply to dispositions after 2017. However, there will be transitional rules that will allow an elected deemed disposition at any time in 2018. The fair market value of the shares would have to be determined, and the qualification criteria for the CGE will be treated as being satisfied if they are met at any time in the preceding 12 months.
Converting a private corporation’s regular income into capital gains
Normally, a distribution of a corporation’s retained earnings is considered a dividend and taxed as such. The top rate on dividends is approximately 44%. Strategies have been used with varying degrees of success to arrange for dividends to be transmogrified into capital gains, which are taxed at 25%. This involves the utilization of the high cost base on shares that have been acquired through a non-arm’s length transaction that had previously triggered a capital gain. Current rules are in place to curtail such “surplus stripping” in limited circumstances. Section 84.1 effectively forces a return to dividend treatment where the capital gains exemption was claimed on the previous capital gain.
The government proposes to extend these rules to any situation where a non-arm’s length transaction involved even a fully taxable capital gain. This proposal is meant to address what has become known as the “pipeline” transaction.
The pipeline has been used extensively in recent years as a post-mortem planning tool to avoid double-taxation where the capital is deemed to occur on the death of a corporate shareholder. Unless the current proposals are altered, the pipeline strategy will no longer be available to an estate.
These proposals will take effect for all dispositions that occur after July 18, 2017. There will be no room for transitional planning.
Holding investments inside a private corporation
One of the long-standing advantages of incorporation is the tax deferral that comes with lower rates on business income. Once the retained income has accumulated over time, the company will have a larger amount available for investment. This has been a great contributor to the retirement of many small business owners. However, it is an advantage that salaried persons or those who don’t incorporate cannot access. Accordingly, the government proposes to eliminate it.
Of all the proposals announced, this is the only one that is not fully developed with draft legislation. The Minister has included some suggested strategies to deal with the issue, each one complex in its own right, and generally altering the system of integration currently in place by eliminating the effect of the corporate tax deferral for future passive investment.
The Minister acknowledges that there currently exists a significant amount of capital invested within private corporations, and it is not his intent to affect these holdings. Any new rules will have effect on a going-forward basis.
These proposals are subject to a consultation period which will end on October 2, 2017. Interested parties should write to the Minister of Finance with any concerns before that date. I suspect that it will be an interesting and eventful autumn for the tax community.