Twenty years after the Notorious B.I.G. (along with Puff Daddy and Mase) released the hip-hop single "Mo Money Mo Problems", Canada's own Notorious B.F.M. (Honourable Bill Francis Morneau, Minister of Finance) released an updated and tax-focused take on the hip hop classic that, for some, will mean "Less Money Mo' Problems".
In this paper on tax planning using private corporations, Minister Morneau sets out a series of proposed tax reforms that could significantly impact private corporations, business owners, incorporated professionals, and other individuals who have relied on legal tax planning structures. These reforms, if implemented, will hinder previously legal tax-planning strategies such as:
- splitting income among family members ("income sprinkling")
- utilizing multiple lifetime capital gains exemptions
- converting dividend income into capital gains
- investing in passive investments within private corporations
Except for changes to capital gains conversions (which are effective as of July 18, 2017), the proposed changes will come into effect in 2018. However, it appears that the Department of Finance is still looking for the best way to implement some of these reforms. Between now and October, the department is undertaking public consultation concerning the proposed changes and it is possible that the details may change depending on the volume and nature of feedback received. Given that tax reform played a significant role in the Liberal's election platform, owners of private corporations should not simply hold their breath and hope the changes go away. At this point, the best course of action for anyone potentially impacted by the changes is to:
- provide comments to the federal government on the changes themselves as well as implementation details (this can be done by sending comments to email@example.com) and
- engage your taxation and legal teams on how your business structure might be impacted and what you should be doing to prepare
Income Splitting / "Sprinkling"
Owners of private corporations often "split" or "sprinkle" income earned from their business through payments of dividends, interest or employment income to adult relatives. Once sprinkled, they become taxed at comparatively lower rates in the hands of the recipients.
The proposed changes to the Income Tax Act would restrict the ability of shareholders to split income with relatives1 unless the payments satisfy a vaguely-defined "reasonableness" test. This test, which we anticipate will be the subject of many tax disputes, will look at factors such as:
- the labour or services contributed to the business by the recipient
- the assets contributed by the recipient, directly or indirectly, in support of the source business
- the risks assumed by the recipient in respect of the source business
- the total of all amounts that were previously paid to or for the benefit of the recipient
Under the new rules, any "split income" that does not satisfy the reasonability test (which will be the case in many current split income arrangements), will be taxable at the highest rate.
Capital Gains Exemptions
Currently, each Canadian is entitled to a lifetime capital gains exemption of over $800,000. This means each individual can sell their interest in a business and not be taxed on the first $800,000+ of capital gain. Where multiple family members are either shareholders or beneficiaries of a trust that owns an interest in a business, each of them can use their capital gains exemption on the sale of the business – essentially "multiplying" the capital gains exemption.
The proposed changes to the Income Tax Act will:
- eliminate the use of the lifetime capital gains exemption for children under 18
- in many cases prevent the multiplication of the capital gains exemption through structures that attempt to allocate gains to non-arm's length individuals
- tax any increase in the value of a business while owned through a trust at a significantly higher rate by making these gains ineligible for treatment as capital gains
The total impact of these changes will be that many trust structures aimed at maximizing available capital gains on the sale of the business will not be as effective after December 31, 2017. In fact, many of these trust structures may actually prevent owners from accessing capital gains tax treatment for increases in the value of the business from and after January 1, 2018.
Converting Income to Capital Gains
The proposed changes also contain anti-avoidance rules pertaining to "dividend stripping". "Dividend stripping" is a process by which income from a private company can be "stripped" out and converted into capital.2 Proposed changes to the Income Tax Act will prevent this type of planning from and after July 18, 2017 (the date the paper was released).
Passive Investment Income
The last proposed change will concern the use of corporate profits to invest in passive investments. Some business owners use money within the corporation (which has only been taxed at the corporate tax rate) to invest in passive income such as publicly-traded securities as opposed to making these investments with personal money (which has been taxed at higher rate). The principle is simple: if you start with more money, your investment should grow more quickly.
The Department of Finance perceives this practice as unfair to taxpayers who only have the option of investing personally. It is seeking recommendations on how to regulate this investment so as to level the playing field. While it appears that the Department has yet to decide on how to implement this change, it is intent on seeing changes take effect in 2018.
To paraphrase the 2007 Notorious B.I.G. classic in the 2017 Canadian context:
It's like it's less money we'll come across
And more problems we see
Full certainty regarding "what they want from me" will only come once final legislative changes are brought into effect in 2018. In the meantime, the more business income that relies on the now-scrutinized but previously acceptable tax planning practices, the more tax-planning problems that a business and its owners will have.
For those businesses and business owners who want to be proactive in managing these problems, now is the time to provide input to the federal government (remember: the call for comments closes on October 2, 2017) and to engage your advisory team (tax advisors, lawyers and estate planners) to ensure that you are ready for the changes in 2018 – which is only a short five months away.
1 The proposed reforms include additional restrictions for family members between the ages of 18 and 24.
2 For those interested in how it works: The shareholder exchanges shares in the private corporation for shares (and cash) of a related company (i.e. holding company), using the section 85(1) rollover to defer taxation on the disposition of the shares. The shareholder then avails herself of the lifetime capital gains exemption on the amounts paid in cash. In the end, the shareholder continues to control the private company (and holding company) and has "stripped" out income without paying taxes (as she would have in the case of a taxable dividend).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.