In the Federal Budget 2017, the Canadian government announced its intention to address specific tax planning strategies involving the use of private corporations – ones that can lead high-income individuals to gain tax advantages not available to most Canadians.
To address these issues, the Canadian government recently proposed tax changes to ensure greater fairness in the tax system. However, these proposed changes will not only impact those high-income individuals, but also small-business owners.
Here are the three issues identified in Budget 2017:
1) Income sprinkling using private corporations: This strategy was used to reduce income taxes for high-income individuals by allowing that income to instead be realized by family members who are subject to lower personal tax rates.
The government wants to restrict the ability to pay salaries or dividends to children between ages of 18 and 24 by applying a “reasonableness test” to assess the child’s contribution to a business. The government proposes three measures to deal with “unfair” benefits to higher-income individuals:
- Extension of Tax on Split Income (TOSI) rules to certain adult individuals who have unreasonable amounts of split income. An amount would be considered unreasonable if it exceeds what an arm’s length party would have agreed to pay to the individual, considering their labour and capital contributions.
- Constraints on the multiplication of claims to Lifetime Capital Gains Exemption (LCGE). Individuals will not qualify for LCGE until they reach the age of 18. There will be a reasonableness test similar to TOSI. It will not be permitted for individuals to claim LCGE with respect to capital gains accrued during a period in which a trust held the property. However, there will be exceptions on some capital gains accrued on the sale of a property.
- Supporting measures to improve the integrity of the federal tax system. This can be done by introducing tax reporting requirements with respect to a trust’s tax account number and introducing measures where T5 slip requirements apply to partnerships and trusts in ways similar to corporations.
2) Holding passive investments inside a private corporation: This strategy could be financially advantageous for private corporations owners compared to other investors, as corporate income tax rates are generally much lower than personal rates. If a business owner doesn’t need all of their earnings to support their lifestyle, it’s common to leave the rest in the corporation to invest, earning passive income.
The government will consider approaches that can both preserve the intent of the lower tax rates on active business income and eliminate the tax-assisted financial advantages of investing passively through a private corporation.
The government has proposed two approaches to deal with this issue:
- The 1972 Approach: This approach is aimed at limiting deferral opportunities associated with passive investments, composed of two elements:
- A refundable tax with respect to ineligible investments, designed to reduce the potential benefits of tax deferral on passive investments, by effectively imposing an additional refundable tax when preferentially-taxed business income was retained and used to fund a passive investment.
- A refundable tax on annual passive investment income.
- Alternative Approach: The current regime of refundable taxes would be replaced with one that would maintain a tax rate on the passive investment income of private corporation equivalent to top personal tax rates. This would generally remove the refundability of passive investment taxes where earnings used to fund passive investments were taxed at low corporate tax rates.
3) Converting private corporation’s regular income into capital gains: Private corporation owners can reduce income taxes by taking advantage of the lower tax rates on capital gains. The Canadian income tax system is designed for tax integration, meaning that combined corporate and personal tax paid on income earned through a corporation and distributed to individual shareholders is roughly equivalent to the income tax that would have been paid if income had been earned directly by the individual.
However, the government says that shareholders who earn higher income obtain a significant tax benefit when they convert corporate surplus into lower-taxed capital gains. This has been done using a complex set of steps involving selling some shares to another company related to the shareholder. The government plans to close such loopholes by extending current rules in subsection 84.1 of our tax law, which was intended to prevent this type of tax planning.
If you have any further questions about the proposed tax changes impacting your small business, be sure to consult Sidhu & Associates Chartered Professional Accountant.