On July 18, 2017, Finance Minister Bill Morneau released draft legislation and other proposals, currently put forward for consultation, outlining changes with respect to tax planning using private corporations. The purpose of the proposed legislation is to close perceived loopholes and deal with tax planning strategies that are only available to certain taxpayers, namely shareholders of private corporations.
Income sprinkling and multiplication of the capital gains exemption
Income sprinkling is a tax arrangement which, but for the arrangement, would result in an individual reporting more income, dividends or capital gains. However, due to the arrangement, such income is reported by a lower-income individual, often a family member of the high-income individual.
Currently the Income Tax Act includes rules which limit the use of income sprinkling. With respect to salaries, such salaries are deductible to the private corporation only if they are reasonable based on work performed. Additionally, attribution rules will attribute income back to an individual who has transferred or loaned property to a non-arm’s length person at terms less than fair market value. Additionally, there is a tax on “split income” which applies when dividends and certain capital gains are allocated to minor children, also known as the “kiddie tax” rules. When the split income rules apply, the top marginal personal tax rate applies to such income (and most personal tax credits do not apply), thus eliminating any benefit of that income being earned by the minor.
The above provisions are not effective against income sprinkling with adults who have acquired their interest in the private corporation by appropriate means. As such, the government is proposing several measures to restrict the ability to income sprinkle. The main proposal involves extending the tax on split income provisions. The tax will now also apply to certain adult individuals who receive split income which is deemed to be unreasonable based on the labour or capital contributions made by the individual. These tests will be more rigorous for those aged 18-24.
Another restriction will be on the ability to claim the lifetime capital gain exemption. The key changes are:
- An age limit – an individual can no longer claim the lifetime capital gain exemption if they are under the age of 18, nor can they claim it on gains accrued while they were under the age of 18;
- No claim is available to the extent that the split income rules apply to the taxable portion of the capital gain; and
- Individuals can no longer claim the LCGE in respect of gains that accrue while a trust held the property (this will exclude spousal or alter ego trusts).
Holding a passive investment portfolio inside a private corporation
More than one approach is being considered to reduce or eliminate the tax deferral currently available when private corporations retain active business income and invest those funds corporately in passive investments. The tax deferral available when active business income is earned within a corporation provides that corporation with more after-tax dollars available for investment. Even though passive income within a private corporation is aggressively taxed (through the refundable tax regime), there are more funds available for the initial investment, thus corporate investing will result in more accumulated savings than if the investment had occurred personally.
The government is considering several approaches which will accomplish the following objectives:
- Preserve the intent of lower tax rates on active business income, to encourage growth and job creation; and
- Eliminate the tax-assisted financial advantages of investing passively through a private corporation.
At this time, no specific proposals have been provided and the government is requesting input from stakeholders prior to drafting proposed legislation on passive investments held within a private corporation.
Converting a private corporation’s regular income into capital gains
The ability to extract corporate surplus (generally considered to be accumulated after-tax earnings plus unrealized corporate net value) via a capital gain rather than through a dividend or a salary is generally referred to as surplus stripping. Currently there are provisions in the Income Tax Act which prevent surplus stripping in certain situations involving non-arm’s length parties; however, not all surplus strip transactions are caught by these rules, particularly when the lifetime capital gain exemption has not been claimed. The proposed changes would expand the rules currently contained within subsection 84.1 of the Income Tax Act to prevent individual taxpayers from using non-arm’s length transactions to create a stepped-up cost base of shares of a corporation, which can allow for the ability to strip surplus from a corporation at a preferential rate.
These proposals may also impact certain post-mortem planning strategies which seek to eliminate double taxation which can occur when the shareholder of a private corporation dies and the corporation is subsequently liquidated and wound up.