Finance proposes changes to tax planning strategies for Private Corporations
Finance Minister Bill Morneau presented on July 18, 2017 a consultation paper recommending changes to some tax planning strategies currently available to business owners to reduce tax liability for private corporations. This announcement was anticipated in the 2017 Federal Budget released earlier this year, and will have a great impact in all Canadian private companies, including family businesses and professional corporations.
The 63-page document named ‘Tax Planning Using Private Corporations’ targets three key tax strategies used by private companies the government believes create unfair results to taxpayers in Canada:
- Income Splitting: reallocating income between family members to minimize the overall tax burden for the family.
- Redundant Assets/ Investment Portfolio: holding a passive investment portfolio inside a private corporation.
- Surplus Stripping: converting the regular income of a private corporation into capital gain.
Below is a summary of the measures proposed by the Government.
Income Sprinkling using Private Corporations
Commonly known as Income Splitting, this strategy is used to reduce taxes by shifting income from a high income earning individual to a family member who is subject to a lower income tax rate.
The current rules in place prevent these individuals to transfer income to their children under the age of 18 by taxing split income. The Government is proposing to extend the existing split income tax to adult individuals as well, but only when the split income is considered to be “unreasonable”. The reasonableness would be determined by various factors including labour and capital contribution to the company.
Family members between the age of 18-24 would face more restrictions under the proposed rules.
Lifetime Capital Gains Exemption
The document also proposes changes for the use of the Lifetime Capital Gains Exemption (LCGE). Children under the age of 18 will no longer be eligible for the LCGE. In addition to that, the exemption would also be restricted or eliminated to family members that were subject to the reasonableness provisions.
Passive Investment Income
Across Canada, corporate tax rates are generally lower than personal tax rates. The current rules in place allow for a tax deferral when owner managers retain the net earnings in the corporation rather than paying out dividends or salaries to themselves.
The Department of Finance believes that this tax deferral is resulting in significant advantage to business owners and is seeking feedback from the public on possible solutions that could help eliminate this perceived unfair advantage. A draft legislation has not yet been proposed in this regard. At this point, the document only suggests alternative methods to limit this tax deferral.
The document clearly states that proposed measures deal with passive income only and will not affect companies that reinvest the after-tax profits in the active business operations.
Converting Income into Capital Gains
Under the current tax system, capital gains are taxed at half the rate of regular income. This allows for individual shareholders to obtain a significant tax benefit by converting corporate surplus (subject to the regular tax rate) into lower-taxed capital gains. This strategy is commonly referred to as Surplus Stripping.
The Government is proposing two measures to prevent owner-managers from converting surplus income into capital gains:
- Expansion of the current anti-surplus stripping rules to cases where the shareholder’s adjusted cost base is increased in a taxable non-arm’s length transaction, and that allows for this cost base to be extracted.
- Introduction of a new anti-avoidance rule, focusing specifically on surplus stripping. The new rule would generally apply to non-arm’s length transactions.
The document proposes these measures to be effective as of the release date (July 18, 2017). Finance acknowledges that issues have been raised in regards to genuine inter-generational business transactions involving family members. The Government is seeking feedback from shareholders in regards to possible ways to accommodate such transaction while preventing abuses in the tax system.
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Your BGD advisor can help you understand the impact of these proposed measures in your business and personal matters. Contact us for more information.
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