Proposed taxation changes with significant implications for many Canadian private corporations

In July 2017, the Department of Finance announced the release of draft legislation which, if executed, will have a significant impact on Canadian business owners who operate their business through private corporations.   A brief overview of the four main areas of focus, is as follows.

Income “Sprinkling” (income splitting)

Private corporations often have ownership structures which involve multiple family members, either through the creation of a family trust orthrough direct ownership of corporate shares. Current tax rules provide for payment of dividends to all shareholders over the age of 18, allowing income to be split/allocated among adult family members. This “income splitting” allows dividends to be paid to family members in lower tax brackets resulting in reduced overall family taxes.  Income tax rules are already in place to prevent this form of tax planning with children under the age of 18. These rules (i.e., the kiddie tax) cause dividends received by minor shareholders of private corporations to be taxed at the highest marginal income tax rate. The new proposal is to extend the “kiddie tax” (now referred to as “TOSI”) to apply to adultshareholders who are related to the primary shareholder of a private corporation. Exemptions from the high-rate tax treatment are proposed in circumstances where the income received from the corporation by the adult shareholder is considered to be “reasonable”.  In order to determine reasonableness, the following factors must be considered respecting each shareholder: (a) labour contribution; (b) capital contributions, and (c) previous returns or remuneration, (d) risk.  A higher standard of reasonableness will be required for shareholders aged 18 to 24.

These new anti-income splitting rules are to be effective January 2018.


Lifetime capital gains exemption

Current tax rules provide taxpayers the ability to claim a capital gains exemption/deduction (up to a prescribed limit) against capital gains realized on the disposition of “qualifying small business corporation” shares. The current lifetime limit is $835,176 (indexed annually for inflation). Common corporate ownership structures involving family members, allow multiple shareholders to utilize their capital gains exemption on the sale of a family business.

To limit the use of the exemption, the Department of Finance has proposed the following changes:

  • The capital gains exemption will be eliminated for individual taxpayers under the age of 18;
  • The capital gains exemption will be eliminated for individual taxpayers over the age of 18, unless the same reasonableness tests/considerations outlined in the income sprinkling section above have been met; and
  • The capital gains exemption will be eliminated on a retroactive basis for individual Trust beneficiaries respecting gains accrued during the period the Trust owned the shares.

The proposal provides for an election that can be made before the end 2018 to crystallize a capital gain and claim the exemption respecting the increase in share value (capital gain) to the end of 2017.

These new lifetime capital gains exemption rules are to be effective starting in 2018.


Investment income

The Department of Finance is concerned with a potential tax advantage that arises when corporations involved in active business hold investments. Corporations are taxed at a significantly lower rate than individuals on business income. As a result, more after-tax dollars are available for investment if earned through and retained in a corporation. The government has indicated that this low corporate rate of income tax is unfair if the surplus funds are used for passive investment instead of reinvestment into active business.  The Department of Finance has proposed possible approaches to tax corporate passive investment income and/or investment assets in order to equate tax consequences of investing through a corporation to those of an individual investing outside of a corporation.  A concrete approach has not been determined at this time.

The effective date for these changes has not been provided.


Converting income into capital gains

Current tax rules restrict the ability for shareholders to extract funds from a private corporation in the form of a capital gain rather than a dividend.  This type of planning (though uncommon), can provide a significant tax advantage to the shareholders, as capital gains are taxed at a lower rate than dividends. Amendments are proposed to eliminate this type of planning, which may result in double taxation in certain instances.

 These changes are effective on or after July 18, 2017.


What happens now?

The Department of Finance is currently taking public feedback on the proposed changes during the consultation period, which ends October 2, 2017.  However, it is expected that all proposals other than those regarding passive investment income will be in place effective January 2018.

Do these changes affect me?

If any of the following situations apply to you, then you are likely to be affected by the proposed changes:

  • You operate your business through a corporation and pay salary and/or dividends to your spouse and/or children, or other family members. Note: this includes dividends paid to family members through a family Trust.
  • Shares of your corporation are owned by an individual under the age of 18.
  • Shares of your corporation are owned by your spouse and/or adult children, or other family members.
  • Shares of your corporation are owned by a Trust.
  • You operate your business through a corporation and have reinvested excess funds into corporate held investments. Note: this includes excess funds transferred to a holding corporation for investment purposes.

What do I do if I am affected?

For the immediate moment – do nothing.

We would like to speak with you on these matters as soon as possible, once the corresponding legislation has been clarified and finalized.

F.H. Black & Company will continue to proactively monitor these proposed changes on your behalf. We will be in touch shortly to review/discuss your specific business structure to determine how the changes will impact you.

In the interim, please feel free to contact our office if you have questions.