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.

Frightening GAAR Facts

One of my favourite scenes in one of my favourite movies, The Sting, has Robert Redford, a young and enthusiastic grifter, meeting Paul Newman, an older and wiser grifter. Redford is soliciting Newman’s help to exact revenge on mob boss Robert Shaw, who killed his friend. Sensing Newman’s hesitation, Redford challenges Newman:

Redford: You’re scared, aren’t you?

Newman: You’re damn right I’m scared. You’re talking about a guy who would kill a grifter over an amount of money that wouldn’t support him for a week.

When the General Anti-Avoidance Rule was first introduced some 22 years ago, the tax community was not overly concerned. The provision was too general. It had no teeth. The good old days went along pretty much the same in terms of aggressive tax planning for some time. Even the courts were somewhat reluctant to impose the GAAR, calling it a provision of “last resort”.

It’s now 2010, and all that has changed. The Supreme Court of Canada has now come down twice in favour of the GAAR . Tax shelter plans that were touted and sold in the 1990’s are being challenged and defeated in the 2000’s. The Quebec government has instituted reporting requirements and hefty penalties unless certain “aggressive” transactions are reported to them. The federal Minister of Finance has followed Quebec’s lead in proposing a “reportable transaction” regime.

Perhaps the most disturbing news comes from the Canadian Tax Foundation who this month reported some incredible statistics regarding the CRA and its increasing zeal for applying the GAAR. As you may be aware, any file that has a potential for a GAAR assessment must be referred to a special committee in Ottawa. Since its inception, the GAAR committee has recommended the application of the GAAR in 72 per cent of all cases brought to it.

Now, get this: Since the start of last year, 99 cases have been referred to Ottawa. The committee has chosen to apply the GAAR in 98 of them!

So, when a fresh-faced fearless tax man comes to me with a plan that might be a candidate for the GAAR, I look him in the eye with no qualms and I say, “you’re damn right I’m scared.”

A No-Lose Situation

In today’s environment, the transfer of a stock portfolio as part of a corporate reorganization or an attempt to realize losses must be handled carefully to ensure that accrued capital losses don’t vanish.

There are a number of situations in which a taxpayer may wish to make a transfer of a stock portfolio. For example, a substantial investment by an individual in U.S. stocks may be subject to estate tax. One way to sidestep this problem would be to transfer the portfolio to a Canadian holding company. In the course of a “purification” of a small business corporation for purposes of accessing the capital gains exemption, a stock portfolio may have to be transferred from an operating company to a holding company. Finally, an individual may wish to crystallize accrued losses while retaining the stock in order to shelter capital gains in the year, or the three prior years.

If a stock portfolio is to be transferred to a related party, knowledge of the “stop loss” rules contained in the Income Tax Act (“the Act”) is essential. There are a number of such rules that will affect losses in different ways, depending on the transaction.

Transfer by an Individual to a Corporation

The “superficial loss” rules generally deny capital losses where a taxpayer disposes of capital property and, within 30 days, an affiliated person has acquired the property. An individual is affiliated with a corporation when he or his spouse controls the corporation. The corporation must add the denied loss to the adjusted cost base (“ACB”) of the property it receives. Thus, a transfer of a stock portfolio with both gains and losses may be performed through the use of the rollover provisions in section 85 of the Act. The elected amount for the shares with accrued gains would be their ACB. For the shares with accrued losses, the elected amount cannot exceed the fair market value of the shares. The loss on the transfer will be added to the corporation’s ACB of the shares, and the rollover will effectively be completed.

Transfer by a Corporation

The superficial loss rules discussed above will not apply where the transferor is a corporation. Rather, if a corporation transfers loss property to an affiliated person, losses are “suspended” in the transferor’s hands. Corporations are affiliated where they are controlled by the same person, or affiliated persons. When the property is subsequently sold by the transferee to an arm’s length party, the loss is realized, and may only be used by the original owner. A capital loss may be of little use unless the original corporation incurs capital gains from other sources in the future.

Depending on the nature and reasons for the reorganization, there may be a number of solutions to the above problem. The transferor could retain a sufficient portion of the portfolio to ensure that future gains will be realized to offset the losses. Another answer might be to retain the stock portfolio, and transfer other assets into a new corporation.

Transfer Between Individuals

A transfer between affiliated individuals is subject to the superficial loss rules discussed earlier. The definition of affiliated individuals is restricted to persons who are spouses. Thus, a parent, for example, could transfer stock with accrued losses to a child, and realize the losses for tax purposes.

A planning opportunity exists if one spouse has accrued gains that need to be sheltered. The spouse with losses could transfer assets such that the superficial loss rules apply (care must be taken to avoid certain attribution rules). The accrued losses are effectively transferred from one spouse to the other.

Transfer to an RRSP

Specific rules deny losses where an individual transfers capital property to his RRSP. In effect, the loss is lost forever, since the RRSP is tax exempt. It may be possible to circumvent this rule by selling stock on the open market and repurchasing it immediately within the RRSP. The superficial loss rules will not apply. The CRA may apply the General Anti-Avoidance Rule in such a case. On the other hand, a delay of 30 days to circumvent the superficial loss rules does not seem to be offensive to the CRA.

GAAR Wars: The (Quebec) Empire Strikes Back

Not Quebec's Finance Minister

The Minister of Finance of Quebec has announced major new rules in the fight against “Aggressive Tax Planning” (“ATP”).

Remember the “Quebec Shuffle”? How about the Alberta-Resident Trust? These and other tax-planning strategies were once all the rage, saving tax dollars by exploiting differences among provincial tax rules. Before they became well-known, they were marketed by tax planners as “confidential” or “proprietary” tax plans, and clients would have to sign non-disclosure agreements before gaining access to these strategies. Often, the fees charged by tax advisors were contingent – based on the value of the taxes saved.

Although the provinces took steps to eliminate many of these plans by introducing specific legislation over the years, and despite the existence of the General Anti-Avoidance Rule (“GAAR”), last January the government of Quebec issued a discussion paper to float proposed rules to further combat ATP transactions.

On October 15, 2009, the Minister of Finance released Information Bulletin 2009-5, which outlines the final version of new rules that will immediately apply to Quebec taxpayers and their advisors.

Mandatory Disclosure

The centerpiece of the proposed legislation is the new reporting regime. These rules are largely based on the U.S. model of “Reportable Transactions”, which has been in place for some years.

In certain instances, taxpayers will now be required to report the details of a transaction (or series of transactions) to Revenue Quebec by the due date for filing their returns. Taxpayers will have to report a complete and detailed description of the facts and the tax consequences relating to the transaction.

There are two categories of transactions that must be reported:

  • Confidential transaction – where the tax advisor has demanded secrecy from the taxpayer regarding the plan; and
  • Transaction with conditional remuneration – where the tax advisor is being compensated based on some form of contingency arrangement. (this would exclude contracts for R&D and other tax credits)

The mandatory disclosure will apply to either of the above types of transactions; however, they will not apply unless the transaction in question results in a tax benefit of at least $25,000 or a deduction of at least $100,000.

Failure to file the information will result in onerous consequences – a penalty of $10,000 plus $1,000 per day up to a maximum of $100,000, as well as suspension of the limitation period for reassessment until the disclosure is filed.

New Punitive Rules Where GAAR Applies

The Minister proposes to extend the limitation period and assess penalties where a transaction is found to be subject to the GAAR.

Firstly, the normal reassessment period (currently 3 or 4 years) will be extended by a full three years. Furthermore, a penalty of 25% of the additional tax will be levied on the taxpayer; and finally, in all cases where GAAR applies, a promoter who markets the plan will be subject to a penalty of 12.5% of the consideration he receives.

Preventative Disclosure

In order to prevent the possibility of an extended limitation period and the penalties in GAAR cases, taxpayers can choose to disclose any transaction to Revenue Quebec on a voluntary basis. If the transaction is reported by the due date of the taxpayer’s tax return, then the application of the GAAR will not come with the extension of the limitation period for reassessments and the above penalties will not be imposed.

New Administrative Department

I suspect that the government will quickly become inundated with disclosures, especially since now, any over-zealous tax auditor could decide to extend the reassessment period by simply pulling out the “GAAR” card (an over-zealous tax auditor in Quebec? Dave, you can’t be serious!).

To this end, the government has established a division of Revenu Québec, called the Direction principale de la lute contre les planifications fiscales abusifs (hooray! another Quebec bureaucratic department!), where all of the disclosures must be sent, on a prescribed form, separately from tax returns .

Quebec has taken a bold step in the fight against tax avoidance. One wonders how long it will be before the federal rules follow suit.