Introduction
Delivering on the promise made in the 2017 Budget, Finance Minister Bill Morneau recently announced a number of proposed changes to the rules relating to tax-planning strategies using private corporations. These proposed changes were outlined in the consultation paper issued on July 18, 2017. The goal is to “create a fair economy that works for the middle class”. According to the Ministry of Finance (“Finance”), the proposed rules are intended to ensure that high-income individuals cannot use certain tax rules to gain an “unfair advantage”. Finance is mainly concerned with the following practices: income sprinkling, multiplication of the Lifetime Capital Gains Exemption (“LCGE”), holding passive investments inside a private corporation and converting income into capital gains. The consultation paper contains detailed discussion and analysis of the proposed changes, which we summarize in this article.
Income sprinkling
Income sprinkling (splitting) refers to a number of tax-planning techniques that enable a shareholder of a private corporation to divert some of the income to family members, who are in lower tax brackets compared to the shareholder. This arrangement is based on utilizing the lower marginal tax rates and personal credits of the family members and could result in significant tax savings. According to Finance, this arrangement is “fundamentally unfair, and erodes the tax base and the integrity of the tax system.” It would appear that the intent of the proposed legislation is to ensure that an owner-manager would be subject to the same level of tax as an unincorporated self-employed individual. In order to achieve this result, Finance proposes to extend the rules relating to the tax on split income (“kiddie tax”).
The current kiddie tax rules apply only to specified individuals, who are under the age of 17 before the beginning of the taxation year (i.e. minors). The income that is subject to this tax includes dividends paid by private corporations and income from a partnership or a trust that is derived from a business, profession or rental activity of a related person.
The proposed rules will expand the application of kiddie tax to adult specified individuals. In addition, a reasonableness test will be introduced in situations where kiddie tax applies to an adult. The purpose of the test is to determine the “reasonable” portion of income received by an adult specified individual, given their labour and/or capital contributions to the corporation. Under these rules, the kiddie tax will only apply to the portion deemed unreasonable as determined by the test. This reasonableness test will be more stringent for an adult specified individual age 18-24, compared to those age 25 or older.
If these proposed rules are enacted, they will come into effect at the start of 2018.
Lifetime Capital Gains Exemption multiplication
Under the current rules, it is possible to multiply the LCGE by holding the shares of a private corporation through a family trust. This result can be achieved if each individual beneficiary of the family trust is able to utilize his or her own LCGE. For example, if there are four individual (Canadian resident) beneficiaries of the trust, it may be possible to shelter a $3,342,864 gain on the sale of a private corporation (i.e. $835,716 x 4).
Finance found these “multiplication” arrangements unfair and proposed several rules, which will restrict the LCGE multiplication. First, LCGE cannot be claimed by individuals who are under the age of 18 at the time the capital gain is realized. Second, LCGE cannot be claimed on a portion of a capital gain that was subject to kiddie tax. Finally, LCGE cannot be claimed on a portion of a capital gain that accrued during the time the property was held by a trust.
These proposed measures would apply to dispositions after 2017. However, Finance proposed special rules providing taxpayer relief. Under these rules, an individual can elect to realize a capital gain on an eligible property by triggering a deemed disposition at fair market value in 2018. This election would enable a taxpayer to utilize the current LCGE rules.
Holding Passive Investments Inside a Private Corporation
In most cases, a private corporation is subject to a lower tax rate compared to an individual. As a result, it is possible to accumulate higher after-tax investable capital inside a private corporation. In other words, a corporation will have more to invest at the outset as compared to an individual earning the same amount of income personally. Finance does not view this as a fair result. Therefore, several alternative approaches were introduced. These approaches differ in the level of complexity, but they are intended to ensure that an individual is indifferent between investing personally or through a corporation. At this stage, Finance has not decided on any specific approach and has invited public input.
Converting Income Into Capital Gains
Capital gains are taxed at much lower rates compared to other forms of income. This tax treatment provides an incentive to implement certain structures that enabled individuals to convert income into capital gains and as a result pay less tax. The proposed legislation takes aim at such arrangements. Specifically, application of section 84.1 will be expanded and will prevent taxpayers from increasing the cost base of shares of a corporation in non-arm’s length transactions. In addition, the Government is proposing to add a separate anti-stripping provision, which will prevent surplus stripping via capital gains, in case the new section 84.1 is not sufficient.
These proposed rules would be effective as of July 18, 2017.
Next Steps
While Finance is seeking feedback on the proposed legislation, history indicates (i.e. new Section 55 rules) that substantial changes are doubtful. It is likely that these proposed changes will be enacted into law and the tax landscape will change dramatically as a result. Income splitting strategies will become more complex and CRA will have significant discretion in determining what is considered reasonable income for a family member. Moreover, it will no longer be possible to multiply the LCGE using a family trust structure.
Given these looming changes, there are still some opportunities to realize tax savings through income splitting strategies in 2017. Moreover, the transitional rules provide a valuable opportunity to realize a capital gain on the shares of a private corporation and utilize the current LCGE rules.
If you are concerned about the impact of the upcoming changes on your tax situation, please contact S+C Partners for assistance.