On July 18, the Federal Government announced their intention to restrict certain tax planning strategies available to shareholders of private corporations that they felt unfairly benefit business owners over salary-earning Canadians. The consultation period during which stakeholders were allowed to provide comments on the proposals ended on October 2, 2017. Ottawa’s original proposals were met with widespread criticism from the business community. As a result, during Small Business Week, October 16 - 20, some revisions were announced. The below summarizes the original proposals as well as where we currently stand.
Income sprinkling is a method utilized by some business owners to share income with family members in a lower tax bracket, through the family member receiving dividends from the corporation. This results in the family’s overall tax bill being reduced. Using this structure can also allow multiple family members to access to the Lifetime Capital Gains Exemption (LCGE) upon sale of a company. Ottawa estimates about 50,000 families use these types of strategies in order to save at tax time.
The government proposed a reasonableness test on the amount of dividends received by a family member. The reasonableness test would look at the family member's involvement in the running of the business. Interest and dividends received on top of what the test deemed to be a reasonable amount would be taxed at the top marginal tax rate. Ottawa also initially proposed restrictions on use of the Lifetime Capital Gains Exemption (LCGE). First, individuals would not be eligible to claim a LCGE for gains realized while they were minors. Individuals would also not be able to claim a LCGE for gains accrued for property that was held for them within certain trusts (like family trusts). Finally, gains realized by family members would be subject to the same reasonableness tests as above.
The government will be simplifying their proposal for income sprinkling but will still move forward with introducing a reasonableness test. Details on how they plan to enact this legislation are forthcoming. The effective date of this proposal will be January 1, 2018. Ottawa will not move forward with the measures aimed at restricting use of the Lifetime Capital Gains Exemption (LCGE) as their proposal would have severe consequences on intergenerational transfers of a business.
Passive Investments within Private Corporations
The owner of a business that is generating excess cash on top of what they require to survive or utilize in business operations can take advantage of a tax deferral that is not available to salaried employees. The excess income generated can be invested in passive investments within the corporation. This allows the business owner to shield this excess income from personal tax rates. Since the excess income has been taxed at a lower corporate rate, this leaves more funds available for investment which allows for a higher level of compounding. Salaried employees are not in a position to be able to shield unlimited income. The business owner would eventually have to pay themselves dividends but in the meantime, Ottawa felt that this deferral advantage gave them an unfair advantage over salary-earning Canadians.
Current corporate tax rules allow additional capital that is not paid out to the owners or used in the business to be left and invested within the corporation. The July 18th proposal did not detail how Ottawa plans to curb this tax deferral but did suggest some methods that could include high tax rates on investment income earned within a corporation.
The government has since announced that income earned on past investments will be protected. There will be a $50,000 limit (equivalent to $1 million in savings, based on a 5-per-cent rate of return) on allowable passive income earned in a year within a corporation. Ottawa claims that this will provide some flexibility for business owners to hold savings for purposes such as sick leave, maternity leave or retirement, however concerns have been voiced that the proposed $50,000 threshold is not nearly high-enough for mid to large-sized organizations that employ several dozens to hundreds of employees. The draft legislation on this aspect of the proposal will be part of Budget 2018.
Converting a private corporation’s regular income into capital gains
According to current income tax rules, when a capital gain is incurred by an individual, 50% of it is included in the taxable income of that individual. Dividend payments also have favourable tax treatment when compared to regular income but are not treated as favourably as capital gains. Therefore, if the owner of a private corporation is able to structure payments from their company as capital gains instead of dividends, they are able to pay a lower effective tax rate.
Ottawa's initial proposal with regard to this issue was to amend an existing section of the Income Tax Act that would make it so that transactions that are aimed at deliberately triggering capital gains and then removing them from the corporation would be deemed to be dividends.
Ottawa will no longer move forward with their plan to restrict the conversion of income into capital gains. Owners of incorporated businesses across several industries argued that the proposal would severely impact their ability to transfer a business between generations without incurring a large tax liability. The proposed change would have also caused challenges with taxation upon death.
After the July package of federal tax reforms was released, it caused major concern amongst small business owners across several industries and provinces. More than 75 major business associations joined together to form one of the biggest business coalitions the country has ever seen, in an attempt to have their concerns heard. As a result, Ottawa has made some major changes and has dropped proposals that would have caused unintended negative consequences. There are more details and likely, more amendments to come to ensure that the tax reform package truly is beneficial for the middle class that Ottawa is purporting to help.