The Morneau Massacre of 2017


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

Income Sprinkling

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.

Loophole Repairs, Part Two

In this post, we continue our list of loophole repairs made by the federal government in recent months.

Loophole #3 – Flow-Through Share Donations

In an effort to encourage charitable giving, the law was changed a few years ago to allow a person to donate publicly traded stock to a registered charity without having to recognize and pay tax on any capital gain on the disposition of the stock.

In an effort to facilitate the funding for the exploration of natural resources, tax laws have for many years provided for the existence of “flow-through shares”. Essentially, a resource company issues shares to a taxpayer and then allocates, or “flows through” its exploration expenses, which can be fully deductible to the shareholder. This deduction has its consequences – it reduces the tax cost of the share so that a capital gain will apply if it is sold.

A loophole was created when tax planners found a way to combine the two incentives described above. A taxpayer purchases a flow-through share, receives the related resource deductions, then donates the share to a registered charity, claiming a donation credit, without having to recognize the gain on the disposition of the share. This strategy effectively reduced the cost of making a donation to near zero.

The Fix:

The 2011 federal budget proposes to eliminate the above loophole by restricting the capital gain exemption on donation of shares to the amount by which the value of the donated share exceeds the amount that was originally paid for it (as opposed to the reduced cost), thereby reinstating the tax on the gain attributed to the deductions allowed.

Loophole #4 – Interest on “Adjustable” Loan

Generally, a corporation or partnership records transactions on an accrual basis for tax purposes. When interest is payable on a loan, but remains unpaid at year-end, a deduction is available for “accrued interest” on the loan.

In the case of Collins, a partnership accrued interest on a loan where the principal could be reduced at the borrower’s option by making a final payment before a certain date. Interest, however, continued to accrue on the original principal amount until the option was exercised. The interest was never paid, but the accrued deductions were allowed.

The Fix:

The proposed legislation now provides that in cases where a taxpayer has a “right to reduce” an amount in respect of an expenditure, it cannot make a deduction in respect of that expenditure in excess of the reduced amount.

Loophole #5 – Arm’s Length Interest Payments

Historically, interest paid to non-residents of Canada are subject to withholding tax which can be as high as 25%. There are certain exemptions, one of which now applies to all interest paid to arm’s length parties.

In the case of Lehigh Cement Limited, a company was paying interest to a related foreign person, and was required to deduct withholding tax. In order to circumvent this requirement, the interest portion of the payments were sold to an arm’s length bank. Guarantees were given, and the bank was duly compensated for its trouble, and a loophole was created.

The Fix:

The government has now changed the wording of the withholding tax exemption. Rather that applying to interest paid to a non-arm’s length person, the withholding tax will now also apply to interest paid in respect of a debt owed to a non-arm’s length person.

Loophole Repairs, Part One

Years ago, when I was first introduced to a tax practitioner, I was compelled to ask him for a list of loopholes I could use in preparing my tax returns so I would pay little or no taxes. After all, that’s what they did, right?

I later learned, of course, that you can avoid paying some taxes all of the time, you can avoid paying all taxes some of the time, but you can’t avoid paying all taxes all of the time. (I think Bob Dylan said that).

Which brings me to the subject of this two-part post – you guessed it – tax loopholes. Rather, the federal government’s recent assault on some tax planning strategies that it has finally seen enough of.

Loophole #1 – Tax Deferral Using Partnerships

Once upon a time a self-employed person starting up a new business could defer income tax by simply choosing an off-calendar fiscal period. While individuals report their taxes every calendar year, the income they reported from a business was based on the earnings for the fiscal period ending in the calendar year. For example, an attorney with a fiscal year end of January 31, 1991 would not have to pay taxes on income for that year until April of 1992, even though 11 months of that income was earned in 1990.

In 1995 the rules were changed to force any individual or partnership with individuals as partners to report their income on a calendar year basis.

That change, however, did not apply to corporations. Nor did it apply to partnerships, all the members of which are corporations. Therefore, a common tax planning tool for a company would be to enter into a partnership with another corporation. The partnership could establish a year-end that was different from the company’s fiscal year, thereby deferring tax on income earned through a partnership.

The Fix:

The 2011 federal budget proposes to eliminate the deferral for corporations earning income through a partnership where the company has a significant interest in the partnership. Partnership year-ends will now have to coincide with the fiscal period of the corporation.

Loophole #2 – Kiddie Capital Gains

In the early 1990’s, family trusts were all the rage. Income splitting with your children was possible by placing shares of a company in a trust. The beneficiaries of the trust could be your children, and dividends paid to the trust were allocated to the beneficiaries. Children with no other sources of income could earn up to $30,000 of dividends without paying any tax!

In 1995, the government eliminated this benefit by introducing the “kiddie tax”. Essentially, now, any dividends paid to a minor child will be taxed at the highest tax rates for individuals.

The above rule, however, does not apply to capital gains. Therefore, a trust could, for example, sell a portion of its shares to a related person and allocate the capital gain to a minor child, thereby skirting around the kiddie tax.

The Fix:

Proposals in the 2011 federal budget take aim at the above loophole by extending the kiddie tax to any capital gain earned by a minor child on a sale to a non-arm’s length party where a dividend on the share would have been subject to the tax. The capital gain will be treated as a dividend, and will not be eligible for the capital gains exemption.

In our next post, more loophole repairs!!