Tax Planning challenges for Private Corporations – Items need to consider
The 2017 Federal Budget has passed planned proposed changes on how private corporations are used to gain tax advantages comparing individuals. These changes impact all Canadian taxpayers who at most use small private companies, family-run businesses and incorporated professionals to split their income and optimize their taxes. Department of Finance got the significant heat after publishing their proposal on July 18, 2017. They never saw 21,000 comments letter in such a short period of time from all over Canada.
Unlike public companies, private corporations have fewer restrictions on tax planning which allowed Canadians to be as entrepreneurial as possible to create more jobs. These changes could impair the competitiveness of most of the private corporations. This is reflected in the quantity of the comments received by the Department of Finance.
The proposals focus on the main areas that the federal government believes provide unfair tax results regarding how owners of private corporations take advantage of favoured tax rates:
- Income splitting with family members involved in the business;
- Investment income generated in Corporation from portfolio owned;
- Strategies that convert regular income or dividend income of a private corporation into capital gains, which are taxed at lower tax rates referred to as “surplus stripping”. Due to the many complications because of the complexity of the two imposed measures proposed, the government dropped this proposal as well;
- The proposal to constrain multiplication of the Lifetime Capital Gains Exemption (LCGE) has dropped this proposal as it would have significantly limited access to LCGE. However, the government will be looking at this tax planning with more stringent income tests for reasonability and age.
Income splitting
Subject to a number of revisions the government is proposing to apply the tax on split income to any Canadian resident individual, regardless of age, who receives split income to the extent that the split income is determined to be “unreasonable”. An amount would be considered Unreasonable to the extent of what would be expected in a similar arm’s length arrangement. These proposals would be effective for 2018 and later tax years and may severely limit the ability of business owners to split income with family members.
Revised prosed reasonableness test
- Labor contributions made to the business are considered for individuals of any age that are receiving the income from a business of a related individual, with a more stringent test for the 18-24-year-old individual. This test looks at the extent to which the individual is actively engaged on a regular and continuous basis in the business.
- Capital investment contributions made to the business are also considered, with a more stringent test for the 18-24-year-old individuals. This test looks at whether the income earned on the contributions exceeds that computed at the CRA prescribed interest rate.
- Previous returns and remuneration (dividends and/or salary/wages) will also be considered in determining if the amount paid to the individual is reasonable.
The is no detailed paper from the Department on the definition of “unreasonableness” which is even more disappointing. Corporations are not provided with sufficient time to work on their tax restructuring.
Passive Investments within a private corporation
The consultation paper does not provide draft legislation at this time, however, it does provide a number of alternatives that the government is looking at to neutralize the benefits of investing after-tax active earnings in a corporation.
In an effort to limit the use of private corporations for gaining tax advantages, the government aim to eliminate the initial deferral available on earnings taxed in a corporation at 15% (small business deduction) or 26.5% (general business rate) when those after-tax dollars are used to invest in passive investments.
- Holding a passive investment inside a private corporation is a strategy available to those earning enough business income to hold savings within a corporate entity. Generally, the unintended advantages are realized by higher-income individuals, such as those whose annual savings go beyond the limits of tax-assisted savings vehicles (such as Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs)).
- Conversely, many smaller or less profitable private corporations would not be in a position to make significant passive investments, after paying out an income to the shareholders, paying the owner and employees’ salaries, paying down their debts or reinvesting for future growth (such as by buying new, up-to-date equipment).
The federal government is asking for further consultation around holding passive investments inside a private corporation.
There are few points to mention on this discussion: 1) Previous investments and income earned from those investments are protected from this legislature change; 2) Government is providing $50,000 de minimis threshold which will have “no tax change” will be applied; 3) Government should re-visit implications to venture capitals.
How does politics work?
The government tried to fix their reputation and reduce the savour in citizens’ mouth after being criticized for above amateur action. As you recall current government cancelled gradual reduction of Small Business Tax up to 9%. In October 2017, the government announced resurrecting previously abolished small business tax reduction. As a result, the rates are now scheduled to reduce up to 10% effective January 1, 2018, and 9% effective January 1, 2019.
The above-proposed measures are extremely complex and affect many private corporation owners and their corporate ownership structures. It is imperative that taxpayers discuss these proposals with their tax advisor as soon as possible.
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