Written by RLB, Chartered Professional Accountants
On the morning of July 19th, the offices of RLB came alive with action. I’m sure many other accounting firms also experienced the same sense of liveliness in the middle of what is generally a very quiet time in our industry. The culprit for our sudden burst of action… Finance Minister Bill Morneau and his consultation paper presenting tax changes for private corporations in 2017 and 2018.
As you may have guessed, the changes presented were not favourable ones. What are these new rules that will so negatively impact your current mood you may ask? The details of the proposed changes are summarized below… I ask only that you don’t blame the messenger.
You may be one of many business owners that pay dividends or salaries to spouses and children. You look at compensation as a family unit by allocating the cash that each family member requires directly from the corporation and taking advantage of lower marginal tax brackets.
The Minister has proposed that any dividends or salaries paid to spouses or children (regardless of their age) will be subject to a reasonableness provision. Any income distributed in excess of this reasonable amount will be taxed at the highest marginal personal tax rate. So “how will the government determine which amounts are reasonable and which are not?” That is a very good question and in fact, it is one that doesn’t actually have an answer as of yet. The only details provided thus far indicate that they will consider past and current labour contributions as they relate to salaries paid, as well as past and current capital contributions as they relate to dividends. Further, they have noted that there will be additional restrictions placed on children between the ages of 18 and 25.
In other words, income splitting as you currently know it will be a thing of the past. Be prepared for the personal tax liabilities of your family unit to increase… Potentially by a significant amount.
These changes are currently in draft legislation format and, if passed, will be effective January 1, 2018. There will be an opportunity to take advantage of the current tax regime until the end of 2017 so be prepared to do some tax planning.
Capital Gains Exemption
The capital gains exemption (CGE) can be claimed when the shares of a qualified small business corporation (QSBC) are sold and all of the necessary conditions are satisfied. In 2017, a business owner would be able to exempt the first $835,714 of capital gain arising from the sale of his or her QSBC shares. It has been a common tax planning technique to multiply this exemption by having family members own shares of the corporation either directly or through a family trust.
Under the proposed changes, this type of planning will be a thing of the past as the following restrictions would be implemented for dispositions in 2018 or subsequent years:
- The CGE will not be available for individuals under the age of 18.
- The CGE will not be available for individuals over the age of 18 in respect to value that has accumulated prior to that individual reaching the age of 18.
- For adult relatives, the reasonableness test as outlined in the income splitting section above will kick in, so not only will the CGE not apply, but the capital gain will be taxed at the highest personal tax rate.
- If the shares are held by a family trust (and many other types of trusts), they will no longer qualify for the CGE. In certain circumstances, there will be the ability to make a one-time election in 2018 to increase the adjusted cost base of the shares and claim the CGE, but any subsequent increases in value will not qualify for the exemption. This election may not be available in many cases, such as for trust beneficiaries who are minors.
To summarize, these rules will negate the use of family trusts for tax planning purposes and will significantly increase the tax on the sale of small business corporation shares.
These changes are also currently in draft legislation format and, if passed, will be effective January 1, 2018. There will be an opportunity for tax planning to maximize CGE claims before the end of the year.
Converting Income into Capital Gains
There are currently rules in place under Section 84.1 of the Income Tax Act that require shares sold from an individual to a non-arm’s length corporation (for example, a corporation owned by the individual) to be taxed as dividend income to the individual as opposed to a capital gain. Otherwise individuals may structure corporate distributions which would otherwise be classified as dividends as capital gain income.
There are new rules that propose to expand the anti-avoidance rules in Section 84.1 to apply to non-arm’s length sales to corporations even where the shares were sold to a related person and to apply to non-arm’s length sales of capital assets by corporations to indirectly trigger reduced overall tax rates. Now when a related person sells to a holding company they will be deemed to receive a taxable dividend, and a corporation may have its capital dividend account (CDA) restricted when it has capital gains on sale of capital assets. These proposed changes do target an area that has been exploited in the past. There are however two areas that will be compromised under these new rules as outlined below.
Post Mortem Planning
There is currently the potential for double taxation on the death of a shareholder. First the deceased shareholder is deemed to have sold his or her shares on the date of death and reports a capital gain. When the corporation subsequently sells the assets of the corporation and distributes the proceeds to the deceased’s estate or its beneficiaries there is a second level of tax.
Currently to avoid this double taxation there are two options. The first involves winding up a company or redeeming all of the estate’s shares, paying tax on the proceeds from the company as a dividend, and creating a loss that can be carried back against the original capital gain reported at the date of death of the deceased. This option must be implemented within one year of the death of the shareholder and is subject to several restrictions which may reduce the loss, but may effectively treat any gain on shares as dividend income. The second option involves creating a holding company and transferring the estate’s shares of the corporation to the holding company in exchange for a tax-paid promissory note; effectively treating any gain on shares as a capital gain.
Although the second option appropriately applies the current rules and is used to avoid double taxation in a legitimate circumstance, the new rules will eliminate this option making estate tax compliance more difficult, and in many circumstances more costly.
Sale of Capital Assets
Currently if assets are sold from one corporation to another corporation, 50% of the capital gain is included in the capital dividend account for the corporation that sold the assets and can be distributed to shareholders on a tax free basis. The other 50% is subject to net corporate tax at a rate of 19.5%. The difference can be distributed to shareholders as a taxable dividend. The capital dividend is the mechanism that ensures integration as an individual that sells assets does not pay tax on 50% of the capital gain.
The new anti-avoidance rule that has been proposed will remove the capital dividend part of the transaction. It targets corporations that intentionally enter in to an asset sale arrangement with a non-arm’s length company to extract tax free distributions via the capital dividend account. Major concerns with the proposed legislation is that the rule does not specify that it applies to non-arm’s length transactions and legitimate asset sale transactions will be caught even where tax reduction was not a factor in undertaking the transaction. The result will be that any corporation that sells assets to an arm’s length corporation may also fall in to these rules and will not be allowed capital dividend treatment.
These changes are currently in draft legislation format but will be effective July 18, 2017 when the proposal was released. If there are any transactions currently in progress that fall under these rules implementation should cease until further information is provided whenever possible.
Passive Investments in Corporations
One of the main benefits that business owners get from incorporating is that of flexibility with regards to retirement planning. They pay corporate tax rates as low as 15% (assuming they have income of less than $500,000) and can invest the difference within the corporation. Alternatively if they were to draw that income from the corporation they would pay tax at their marginal personal tax rate (up to 53.53%) and invest the difference personally. By deferring the personal tax liability business owners have far more money available to invest for retirement, or for other purposes such as future business expansion.
The Minister has proposed that income from passive assets (stocks, bonds, GIC’s, real estate, etc.) will now be subject to significantly higher tax rates. There will be no advantage to investing within a corporation. This is a significant change that will cause a great difference in the ability for business owners to save and plan for retirement, etc.
Unlike the other proposed changes, the passive income changes are not in draft legislation yet. They have only been suggested in a consultation paper and it is unclear how these changes would be implemented. This would clearly be a significant change to the corporate tax system that we currently know and love so we can only hope that these changes are reconsidered.
How to Prepare for the Changes
First, it is important to understand that at this time these are proposed rules. We will need to review the final legislation before any planning is implemented. The Minister is seeking input to these proposals until October 2, after which time we expect to get additional information. Our hope is that the actual rules have more leniency and flexibility than the proposed changes.
The most important thing that you can do is stay informed every step of the way until the final legislation is presented. Ensure that your advisors know what is happening and are prepared to provide planning options specific to your needs. There will be planning opportunities available before the end of 2017 – be ready to take advantage of those opportunities quickly.
Understand that whether there are changes to the proposed rules or not there will be significant impact on how you are currently paying tax and planning for the future. Things are going to change and you need to be prepared for that change.
Every business is different and will have a different set of circumstances that relate to these changes. Be mindful that the right answer will not look the same for all. As with your current tax planning, you will need a solution that is tailored for you and your circumstances.
We’re always here to help and we happily serve our clients from our offices in Guelph, Kitchener, Fergus, and Orangeville!
Please contact our team at 1-866-822-9992 to discuss any questions you may have or in order to set up a meeting to talk to you directly about the proposed changes.
Melissa Vinden, CPA, CA Senior Manager firstname.lastname@example.org
Leanne Radcliffe Manager email@example.com