On July 18, 2017, the Department of Finance released a consultation paper and legislative proposals targeting tax planning using private corporations. The proposed changes are to address the Government’s view that high income earners who own private corporations can unfairly obtain tax advantages that are not available to others. These changes focus on limiting income sprinkling, deferral of taxes through holding passive investment portfolios inside a private corporation and converting a private corporation’s regular income into capital gains. The rules are complex and an overview of the proposed changes are outlined below.
Income sprinkling occurs in an arrangement where a high-income earner shifts income that would otherwise be taxed at a high-rate to family members who are in a low-rate or who are not otherwise subject to tax to minimize the overall amount of personal income tax paid on that income.
The current tax on split income (TOSI) rules apply to minors who are under 18 years old on certain types of income received such that the income is subject to top-rate tax.
The proposed measures will expand the application of the TOSI rules to include adults and amounts received would be subject to a reasonableness test. An amount would be considered reasonable in the context of the business if an arm’s length party would have agreed to pay the adult the same amount for the type of work performed, assets contributed, risks assumed and amounts previously paid. Amounts received that are not reasonable will be subject to top-rate tax.
The types of income subject to the TOSI rules will also be expanded and there will be additional rules applicable to individuals age 18 to 24.
There are also proposed measures to constrain the multiplication of claims to the lifetime capital gains exemption, especially where family trusts are used to facilitate the arrangement. The proposed measures would apply to dispositions after 2017, with certain transitional rules that would allow affected individuals to elect to trigger a capital gain in 2018.
As corporate income tax rates are generally lower than personal income tax rates, an individual who earns business income through a corporation and reinvests the after-tax retained earnings in passive investments will have more capital to reinvest than an individual who earns business income directly. This results in a tax deferral advantage that the Government perceives to be an unfair advantage conferred on private corporations.
The Government is considering approaches to preserve active business income earned in private corporations being subject to low-rate tax and to eliminate the tax deferral advantage of investing passively through a private corporation.
The approaches considered include eliminating the refundability of passive investment taxes where passive investments were funded by low-rate business income earned by the private corporation. The proposal also contemplates that capital gains resulting from the sale of passive investments will continue to be taxed at a 50% inclusion rate. However, the non-taxable portion of capital gains would not be credited to the capital dividend account. The objective is to neutralize any deferral advantages.
The Canadian income tax system is designed such that the combined corporate and personal income taxes paid on income earned in a corporation and distributed as salary or dividends to an individual result in approximately the same income taxes if the income had been earned directly by the individual, achieving what is commonly referred to as “tax integration”. If a private corporation can structure corporate surplus to be distributed as capital gains, which are subject to a more preferential tax rate, instead of salary and dividends, a tax benefit is achieved.
The Government proposes to extend the current anti-avoidance rules in non-arm’s length transactions and to add a separate anti-avoidance provision to address the conversion of a private corporation’s surplus into tax-exempt or lower-taxed capital gains.
The Government is inviting interested stakeholders to contribute their views and ideas on the proposed changes to achieve the policy objectives, with a consultation period deadline of October 2, 2017. These proposed changes are far-reaching and would impact many Canadians if enacted.
For more information on this proposed policy contact one of Smythe’s tax advisors here.