July 18th, 2017 Bill Morneau, the Finance Minister, released draft legislation, explanatory notes and a consultation paper that we have been waiting for since the 2017 Federal budget.
There are four areas that the proposal will impact entrepreneurs that are operating as a private corporation:
- Corporate reinvestment
- Income splitting
- Lifetime capital gains exemption
- Capital gains conversion to dividends
Corporate Reinvestment:
Currently private corporation tax rates are lower than personal tax rates, resulting in a greater amount of after-tax earnings available for reinvestment when compared to income earned personally. This deferral of personal tax is eliminated when the earnings are distributed to individual shareholders as dividends (concept know as tax integration). The current system provides business owners an opportunity to reinvest a greater amount into the corporation. There is no restriction on the types of investments that can be made (from equipment for active business to passive income generating assets like permanent life insurance, real estate, loans and marketable securities). Currently income from passive investments is taxed at higher rates when earned in a corporation. There is a refund mechanism in place to ensure that the income that is paid to shareholders is not taxed twice.
The government believes that the deferral of tax is an advantage that corporations have over unincorporated individuals. The proposal looks to remedy this by increasing the tax on corporate passive investments funded from after-tax business earnings. The proposal would potentially remove the refundable component of investment tax that would result in the after tax return in a corporation to be similar to the return an unincorporated individual would have. However, the tax rate of the passive income in aggregate (paid within the corporation and then by the individual when the dividend is paid out) could be as high as 70%. Additionally, the proposal also eliminates the tax-free capital dividend account (used to pay out tax free dividends for the 50% tax free portion of corporate capital gain).
If you have passive investments in your private corporation as part of your overall tax planning strategy, you will want to revisit the plan with your accountant or advisor to understand the impact of these changes may have on your plan. Draft legislation was not provided for corporate reinvestments. The proposal on corporate reinvestment is subject to public input and comment. Be sure to voice your opinion (see “Next Steps”).
Income Splitting
The current system allows private corporations to issue shares to family members (spouse and adult children) at nominal cost providing the business a mechanism to share profits. This provides the family business an opportunity to income sprinkle as a means to use the lower marginal tax brackets available to lower income family members. However, the existing legislation limits dividend payments to minor children (“kiddie tax”) and transferring passive income to a souse (“attribution”).
The proposed legislation will increase the base of individuals (“specified individuals”) subject to the kiddie tax to include adult children and other related individuals. Additionally, the types of income that will be subject to the expanded kiddie tax have been broadened. The proposal does exclude amounts received by an individual 18 and over that are reasonable in the circumstances. The determination of reasonable will depend on the circumstance, which will factor in the age of the individual and what contribution (monetary or labour) was invested in the business. The reasonableness test will depend on the facts of each case.
The proposal could impact estate freezes where parents transfer the future growth in value of a business to the next generation. Any dividends paid to the next generation, which has not provided services or capital to the business, would trigger payment in the highest marginal tax rate. A lot of small business owners operating a successful business through a private corporation have used this strategy to plan for the future. Likewise a spouse that owns shares in a family business, but provides no capital or services to the business will be taxed at the highest marginal rate. The draft legislation for this proposal is to be effective for the 2018 calendar year.
Lifetime Capital Gains Exemption:
Currently the lifetime capital gains exemption (LCGE) provides the shareholders of qualified small Canadian corporations exemption on gains realized on the dispositions of shares. The amount of the lifetime exemption is approximately $835,000 in 2017 and is indexed for inflation. The current LCGE is available to minor children and spouses. The shares can currently be owned by a family trust and allocation of the gain to the beneficiaries is eligible for the LCGE upon disposition.
Draft legislation has been proposed to limit access to the LCGE. The exemption will no longer be available to gains accruing in years while the individual was under 18. The LCGE will no longer be available if the gain would otherwise be included in the split income rules covered above, limiting the ability of family members from claiming LCGE on gains where they are silent shareholders or did not contribute resources to the business.
Capital Gains Conversion to Dividends
Capital gains can be realized on dispositions of property, including private corporation shares. Currently tax legislation prohibits an individual from benefiting from the lower capital gains tax when selling shares from one corporation to another of a company in which the selling corporation has greater than 10% investment. In such a circumstance the capital gain would be recategorized as a dividend.
In the proposal there is draft legislation that is effective July 18, 2017. This legislation would prohibit the use of tax cost in shares of a corporation where the tax cost to the taxpayer includes sales or gains realized by a person not dealing at arm’s length. The gain may be subject to capital gains and dividend tax. Alternatively the government is considering the possibility of recharacterizing any distribution from a corporation into a taxable dividend under certain circumstances.
What Can You Do?
See your accountant to determine the impact the proposed legislation may have on your business and tax planning. Additionally, voice your opinion by writing to your MP (sample letter from Tax Templates Inc. ) and let them know how these rules will negatively impact entrepreneurs, their families and their employees. Also write to the Department of Finance (fin.consultation.fin@canada.ca) to voice your concerns.
If you have any questions or would like to discuss the impact on your business, contact us.