The DSK Experience – Autumn 2017
This is a very special edition of our DSK Experience newsletter. With the Liberal
government’s proposed tax changes, we feel it is our responsibility as your accounting
professionals to advise you, and to share our insights and opinion of these changes.
We do not feel they are in the best interest of business owners, and in fact will erode the
strength of our entrepreneurial community. Please contact us with questions.
Tax Planning Using Private Corporations
On July 18, 2017, the Department of Finance released a consultation document and draft legislation that will have a wide-reaching impact on all small businesses in Canada. While the documents reach a substantial number of pages, only 75 days have been allowed for consultation, providing the tax and small business communities very little time to digest and respond. The white paper provides three areas where the Liberal governments feels small business owners are getting an unfair tax advantage over “average” Canadians.
These areas are:
The shifting of income that would otherwise be realized by a high-income individual to family members subject to a lower rate of tax. This could include dividend sprinkling as well as the multiplication of the Lifetime Captial Gains Exemption.
Passive Investments Inside a Corporation:
A Canadian Controlled Private Corporation (CCPC) pays 15% corporate tax (in Ontario) on the first $500,000 of taxable active business income. By leaving after tax cash in a CCPC a larger pool of cash is available for investment than if the shareholder withdrew the funds and paid tax at the personal rate of up to 53.53%. The investment returns on the deferred taxes allow a quicker accumulation of assets.
Planning that allows a realization of a capital gain within a related group, which as historically allowed shareholders to extract cash at lower rates are being reviewed. Proposed draft legislation effective as of July 18, 2017 has been provided.
The current Liberal government feels that transactions that utilize the existing and long-standing rules which result in any of the above are loopholes that require closing, and have committed to doing so.
Common income sprinkling transactions would be having family members who are inactive or minimally active in a small business own shares of the CCPC. Dividends can then be paid to those family members out of after tax profits and, assuming they have lower income than the active shareholder, the family unit will pay less tax then if all dividends were paid to the active shareholder. This assumes all dividend recipients are at least 18 years of age. The same can be accomplished by flowing dividends through a family trust.
The proposed amendments would implement a “reasonableness test” which would apply to certain payments starting in 2018, including the dividends mentioned above. The test would consider (i) labour contributions, (ii) captial contributions and (iii) previous returns and remuneration paid to the individual from the business The test would be applied differently to an individual 18-24 years than it would be for an individual 25 and over. Should it be determined that any amount paid to the individual is not reasonable in the circumstances, tax at the highest marginal tax raate will apply to that portion of the income.
Also included in the income sprinkling measures are changes that will disallow the use of the Lifetime Capital Gains Exemption in certain circumstances. Specifically, gains accrued prior to an individual reaching the age of 18, gains that are deemed to not be reasonable, and gains that accrued during a period where the property is held by a trust will no longer to eligible for the LCGE.
Passive Investments Inside a Corporation
It is common practice for small businesses to accumulate additional funds inside the corporation. These funds can then later be used for business expansion, capital acquisition, to weather a bad year or ultimately to help fund an owner’s retirement. These funds are invested in passive investments to at least maintain value against inflation and to hopefully earn a more substantial return.
The investment income is taxed as earned at approximately 50% with a portion of that being refundable when the corporation pays it out to owners as a dividend. The owners then pay personal tax on the dividend. Here the government has proposed a method of deferred taxation to close the perceived loophole. A key element of this method is that the refundable tax on investment income earned by a CCPC would no longer be refundable if the funds used to make the investment were taxed at the small business tax rate. The investment earnings would still be taxed at a high rate of tax however.
In addition to eliminating the refundable tax on investment income, the new approach would also attempt to align the tax treatment of the passive income which is later distributed as dividends with that of the earnings which were used to fund the passive investment. So there would be different consequences upon distribution if the funds used to make the investment had been taxed at the small business rate, the general corporate tax rate, or if they were previously taxed at a personal level and contributed to a corporation.
If passive incomes are generated from investments the funds for which were previously taxed at the small business rate, any portfolio dividends generated on that investment would be treated as non-eligible dividends when flowed to the shareholder. Currently portfolio dividends retain character and are paid to the shareholder as eligible dividends and ultimately attract a lower personal tax rate. Additionally any capital gains generated off these investments would not result in the tax free portion of the gain being added to the capital dividend account of the corporation.
In order to determine the tax treatment of dividends paid from passive investments the source of the funds used will need to be tracked. Depending on source of funds used for the investment that could result in up to three separate pools and tax treatments. Alternatively a corporation could elect to revoke access to the small business tax rate and have dividends paid out to shareholders be treated as eligible dividends. The corporation would still pay an increased, non-refundable tax on investment income though.
Converting Income into Capital Gains
The concern being discussed in this section is that, through a series of transactions, corporation owners are able to turn after tax corporate surpluses which should be paid out as dividends into lower taxed capital gains. Such conversions are commonly referred to as “surplus stripping”. These are the most complex transactions contemplated in the government’s white paper.
While the Income Tax Act already contains provisions to eliminate surplus strip transactions, it is the government’s position that these provisions are too narrow and that they should be expanded upon, and that new anti-striping rules should be introduced. It is common practice for small businesses to accumulate additional funds inside the corporation.
Some Concerns with the Proposals Set Forth
There are many concerns with the proposals as presented by the Liberal Party, and include technical concerns with the draft legislation, policy concerns with the increasing taxes on small businesses and concern that the proposals are inconsiderate of the realities to which small businesses operate.
From a technical perspective, draft legislation that has been provided is ambiguous, and in some cases significantly broader than it needs to be. Of significant concern is that the proposed legislation uses the words “reasonable” and “reasonably” a combined 21 times. “Reasonable” is at best a subjective position and must be determined and argued on a case by case basis. As with all tax administration, employees of the Canada Revenue Agency will make the initial determination of what is “reasonable” with appeals, and ultimately appeals to the Tax Court of Canada taking the better part of a decade to work their way through the system to provide some guidance. This will be a compliance nightmare and incredibly difficult to administer as well as to plan for. Additionally the proposed legislation on anti-stripping transactions is poorly worded and far too broad. If taken at face value it is possible that mundane transactions such as a repayment of a shareholder loan could be caught by the proposed rules and be taxed as a dividend to the recipient.
As mentioned, these proposals do not line up with the realities of running a small business. The income splitting proposals refer to an inactive spouse, but the truth is, even if one spouse is running the business day in and day out, it is incredibly unlikely that the other spouse has absolutely nothing to do with the business. From being a sounding board for major decisions, using the home equity line of credit to make a loan to cover payroll or rolling up their sleeves and pitching in when things get busy in a family owned business, the inactive spouse is a myth. Regarding passive assets, when is an asset really passive, even if it’s a GIC or stock? Many companies require liquid assets in order to stay onside with banking covenants. While the Federal government is able to ignore it’s debt to equity ratio, most banks aren’t as understanding when it comes to small business.
Of significant concern is that while these are some of the broadest, farthest reaching tax change proposals in recent memory, very little time has been allocated for consultation. The white paper was released in summer while Parliament was on summer break, and many professionals on holidays, and provided only a 75 consultation period. While a vast majority of tax professionals, business owners and even some Liberal MPs have made it clear that they view these proposals as flawed, the Prime Minister and Minister of Finance have given no indication of willingness to modify the proposals or delay implementation.
Impact On Small Business Owners
If the proposed changes are implemented, small business owners will need to re-examine all tax plans that currently exist. This includes compensation management and accumulation of additional funds within a corporation.
For those who have structured their companies to be owned by discretionary family trusts, the trust documents will need to be reviewed and a determination made as to if it is the proper course of action to distribute the shares owned by the trust.
While the government insists that the proposals are not retroactive, the impact of the changes certainly are. Corporations with one active spouse, but where both spouses are shareholders, which have accumulated passive assets over the years with the intent of paying dividends to both spouses in retirement will be impacted heavily. Under the proposed tax on split income rules the dividend paid now to the non-participating spouse will be taxed at the highest marginal tax rates instead of at progressive rates. So while the rules don’t change the past they gut a tax and retirement plan that followed all rules for possibly decades while accumulating assets. The net effect of these proposed changes will be increased taxes to small business owners as well as increased costs of compliance and a greater chance of disagreements with the Canada Revenue Agency.
WHAT TO DO?
Drouillard Sambrook Kingston LLP strongly urges all small business owners to write their members of Parliament, as soon as possible, voicing your strong opposition to these proposals, and at the very least calling for an extension to the consultation period. We would also encourage everyone to sign the electronic petition at https://petitions.ourcommons.ca/en/Petition/Sign/e-1239.