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Impact of Proposed Changes to Income Tax Act

Published on August 23, 2017

Impact of Proposed Changes to Income Tax Act

A Brief Analysis of Proposals to Address Tax Planning Using Private Corporations

On July 18, 2017, the Minister of Finance publicly announced proposed changes to the taxation of private corporations in Canada.  Comments on the proposals are being sought until October 2, 2017, after which time the government will consider submissions received and then introduce amendments to the Income Tax Act necessary to give effect to the proposals.

Early press coverage has been mixed in its quality, with some sensational reports suggesting the proposals are outrageous and overwhelming, and others suggesting the proposals do not go nearly far enough to address the real issues.  The proposed changes are significant and far-reaching, and will affect the tax planning structures that have been put in place for many of our clients.  They can be broken down into three main categories: income sprinkling, holding passive investments in a private corporation, and converting income into capital gains.

Income Sprinkling

This refers to the payment of dividends (or salary) to family members of the principal owner of a Canadian Small Business Corporation that the government considers to be unreasonable.  There has long been a provision in the Act to disallow the payment of unreasonable salaries to family members, but the proposed changes extend this to dividends, which until now were not considered to be “earned”.  This was resolved in the courts several years ago with the clear conclusion that dividends are not earned, but follow from the ownership of shares in a corporation that carry an entitlement to dividends, either at a fixed rate, or more commonly in the case of small private corporations, at the discretion of the Board of Directors. 

The proposals overturn this by introducing a reasonableness test for dividends paid to individuals aged 18 or over (dividends paid to minors are already taxed at the top rate).  A dividend will be considered reasonable where it corresponds to what an unrelated person would be paid considering their labour contributions or their capital contributions to the firm.  Amounts previously paid will also be considered in determining what constitutes a reasonable dividend.  Where the dividend does not pass the test, it will be subject to the new rules for Tax on Split Income, and the amount considered unreasonable will be taxed at the top rate.

A second element of the income sprinkling changes relate to constraining the multiplication of eligibility for the Lifetime Capital Gains Exemption.  Gains that accrue on property held by minors will no longer be eligible.  And a source providing income that is determined to be unreasonable will also not be eligible for the exemption should it be sold at a gain.  Finally, and perhaps most importantly, gains that accrue during the time property is held by a trust will no longer be eligible, with very limited exceptions.  The strategy widely used to allocate capital gains to trust beneficiaries, who in turn could claim the exemption, will no longer be available.

Holding Passive Investments in a Private Corporation

The current tax system in Canada is designed on a principle of integration, essentially meaning income earned by an individual should be taxed at the same rate as income earned by a corporation and then paid to the individual.  This system has worked well in Canada and continues to work as intended.  Recent amendments to the rates have been successful in ensuring integration is functioning almost perfectly in all the provinces of Canada where corporate income is paid out to owners as it is earned. 

The Ministry of Finance perceives unfairness in the system where the funds are not paid out to owners, and are not reinvested in the active business operations of the private corporation.  Where the funds are retained and invested for the long-term benefit of the corporation’s owners, the Ministry’s view is that corporate owners are being given an unfair advantage.

The proposal provides a rationale for change based on this perceived advantage.  Where the corporation’s earnings are taxed at the favourable rates available to small businesses, the corporation has more after-tax funds to invest than would an individual earning the same income.   Thus, more income is earned on the investments, and the compounding effect over many years leads to a considerable discrepancy between the total investment portfolio held by a corporation and the portfolio that would be held by an individual earning the same initial amount. 

In the Ministry’s view, this represents an unintended use of the small business deduction, and it proposes changes to the tax mechanisms applied to corporate investment income that will equalize the long-term earnings from passive income held in a corporation with those of an individual.  This aspect of the proposals is still under consideration and no legislation has yet been drafted.

Converting Income into Capital Gains

This will not be relevant for most of our clients, but the proposed changes will address some issues that have arisen in the application of specific rules in the Income Tax Act designed to prevent “income stripping”, essentially taking the retained earnings of a corporation as a capital gain rather than as a dividend.  The strategies used to do this are almost always unsuccessful since the rules already existing in the Act are extremely complex, but generally effective.   Nonetheless, the Ministry proposes changes to the key sections of the Act to strengthen the rules and ensure they cannot be overcome by complex planning strategies that have at times succeeded in the past.

Summary

The changes are significant, particularly the first two issues, and some thought and planning should be given to how our strategies may be adapted to ensure your needs continue to be met in the most tax-efficient way possible.  In some cases, the strategies in place may continue to function well and in other cases significant changes may be warranted.  If you would like to discuss these matters further, please be in touch to arrange a meeting where we can evaluate your particular situation and develop strategies together that will ensure your continued success.