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Tax Planning Using Private Corporations

Published on October 2, 2017

September 29, 2017

Department of Finance Canada

Re:         Tax Planning Using Private Corporations

Dear Sir or Madam:

We are writing to provide comments on the above-referenced proposals released by the Minister of Finance on July 18, 2017.  The proposals focus on three broad issues identified in Budget 2017:

  • Sprinkling income using private corporations,
  • Holding a passive investment portfolio inside a private corporation, and
  • Converting a private corporation’s regular income into capital gains.

Our comments will address the first two of the three issues identified.

Sprinkling Income

The Reasonableness Test

Central to the implementation, compliance with and enforcement of the proposed new rules is a test of the reasonableness of shareholder and employee compensation to the extent the individuals being compensated are specified and/or connected individuals.   You have asked for input on whether the reasonableness test as proposed provides an appropriate mechanism for responding to income sprinkling.

You propose to assess reasonableness based on three factors:

  • Labour contributions,
  • Capital contributions, and
  • Previous returns/remuneration.

The third of these factors is extremely poorly explained in the main proposal document, and is not clarified by either the explanatory notes or the proposed legislation.  It is unclear to us, and will be unclear to most Canadians, how this factor will be applied to assess reasonableness.  Therefore, we recommend that your intentions be clarified.

The first two factors are an attempt to assess the reasonableness of the outputs of a business (salaries, dividends and capital gains) by reference to inputs to the business (labour and capital contributions).  It is our view that this approach is fundamentally flawed and does not recognize that the principal objective of a business is to ensure outputs exceed inputs.  It is not difficult to envisage numerous scenarios where a business earns profits in excess of the value of the labour and capital contributions attributable to its owners.  This is, in fact, why business owners start their businesses to begin with and accept all the associated inherent risks.  Your proposals suggest that in extracting these profits from the company, owners will be subject to Tax On Split Income (TOSI) with regard to any amounts that are in excess of what would be expected in arrangements involving parties dealing at arm’s length.

While you acknowledge that the reasonableness test depends on the facts of each case, and that the measurement of contributed value, or the evidence to support such contributions, will not always be straightforward, it is not clear how Canadians are to interpret the reasonableness of dividends paid to specified individuals.  

Salaries are already subject to reasonableness tests in section 67 and subsection 18(1) of the Income Tax Act (ITA), since they are an operating expense of a corporation.  The nature of a salary is compensation for labour contributions.  Your proposals seem to equate dividends with salaries in that they are compensation for contributions of some sort.  This is not consistent with rulings of the courts – see Melville Neuman v. R, 98 DTC 6297 (SCC), and does not recognize the differing tax treatment to which each of these forms of income is subjected.   It is not clear how you intend to distinguish salaries from dividends, given that you seem to see them both as forms of compensation for either labour or capital contributions.  If salaries are compensation for labour contributions and dividends are compensation for capital contributions, then that should be clarified.  Then the existing reasonableness test for salaries can be maintained and a new reasonableness test for dividends may be established. 

If dividends from Canadian small business corporations are to be considered compensation for labour contributions, then it follows they should also be considered earned income for the purposes of computing RRSP contribution room, and should be considered pensionable and insurable earnings in the calculation of CPP and EI benefits.  It also follows that they should be a deduction to the corporation in computing its taxable income.  This would fundamentally change the nature of dividends and their taxation, but would be consistent with the reasoning behind your proposals.

If dividends are to be considered compensation for capital contributions, and subjected to a reasonableness test based on what would be expected in an arm’s length relationship, the test would need to recognize the risk associated with the investment.  A reasonable rate of return for an investment in a Canadian small business cannot be equated to that of an investment in a public company.  Even among public companies, the rate of return is highly variable and directly related to the business risks.  Given the historical failure rates of Canadian small businesses and the related risk factors of such an investment, in our opinion, a “reasonable” rate of return would be extremely variable, and would need to be evaluated based on the facts of every small business.   

How are corporate taxpayers going to make and defend such an evaluation?  If a determination of reasonableness is left to CRA auditors, their workload can be expected to dramatically increase.  Since funding a massive increase in auditors is not mentioned in your proposals, we will assume that in practice, the determination will be left to business owners.  As you must know, the criteria that will be used to determine reasonableness will vary widely without further guidance and specificity.  Aggressive taxpayers will benefit from a more liberal interpretation, and accept the risks of an audit and reassessment.  More conservative taxpayers will restrict the dividends they pay while still being exposed to the risk of having to defend their decisions in the event of an audit.  Neither will have clarity on what is acceptable under the ITA.  

Unless the reasonableness test as set out in the proposal documents is clarified, the overall goal of fairness will be compromised and the consistency and certainty of Canadians’ ability to plan and manage their tax affairs will be diminished.

Capital Gains

In a situation where a company has operated successfully for many years and a significant asset, or a portion of the operations, is sold to an arm’s length party, the company will realize and pay corporate tax on a capital gain.  The company may then want to distribute the net proceeds from the sale to its shareholders in the form of taxable dividends, representing the portion of the net proceeds that was subject to tax, and capital dividends, representing the non-taxable portion of the net proceeds.

Assuming the shareholders have been compensated at reasonable levels on an ongoing basis for their labour and capital contributions, will the entire taxable dividend arising on the gain be considered TOSI to each of the shareholders?  If so, this is an outcome to which we object strenuously on the basis that it defeats your stated objective of improved fairness.  It is not fair to penalize successful entrepreneurs.

We also think your proposal to eliminate the Lifetime Capital Gains Exemption for family members and beneficiaries of family trusts is not reasonable given that they share in the inherent risks of operating a family business.  See further comments in the gender equity section to follow.

Gender Equity

Your proposals do not seem to recognize that the success of an entrepreneur is not solely due to his or her inputs.  The spouse often plays a very significant role in the success of a business without necessarily contributing labour or capital directly.  Frequently, the family home (that is owned 50% by the spouse) is leveraged to provide financing for the business.   Significant contributions can be made to strategic planning and business operating decisions by way of discussions around the kitchen table.  Does society not value the contributions of non-participating spouses?  Family law would suggest otherwise.  Decisions in that area recognize the significant contributions played by non-active spouses and deem the value to be 50% of the value of the business in the event of a marital breakdown.  Will any reasonableness test for dividend payments to non-active spouses take these factors into account?

The proposed changes will unfairly affect many companies.  Consider the following example.  A husband and wife jointly start a company, each holding 50% of the issued and outstanding common shares.  The business operates successfully for ten years, with each of the shareholders contributing equally to the active operations and each being compensated on a reasonable basis over this time.  They then decide to start a family and the wife withdraws from active participation in the company to focus on raising the children.  Accordingly, she declines to draw a salary as her active contributions to the company are minimal.  The proposals suggest that dividends paid out of the company’s net earnings during the time the wife is inactive will be considered TOSI for her.  (Note that since the company has only one class of shares, any dividends must be paid pro-rata on the issued and outstanding shares, such that for the husband to receive dividends, the wife must also receive them.)  Is this your intention?  Does this seem equitable and consistent with our mutual desire for Canadian families to grow and thrive?  Does the answer to this question change if the situation continues for several years before the wife returns to active involvement, or if she does not return at all?  Does it seem fair that the shareholders be required to incur the costs of a corporate reorganization to avoid TOSI?  Even worse might be the situation where the spouse is required to sell her shares in the family company to avoid TOSI.  Surely, this cannot be the improvement in fairness you purport to be seeking.

Interpretation, Application, and Enforcement

In Canada, we have a self-reporting tax assessment system, and it is therefore vital that the tax laws be clear.  Without clarity, taxpayers are unsure what amounts to report as income and what amounts are allowable as deductions and tax credits.   Nor can a taxpayer organize their business and organizational structures in the most effective manner.  The proposals, particularly the reasonableness test in the context of income sprinkling, fall short of the clarity required to provide taxpayers with certainty that what they are filing is consistent with the intent of parliament as enacted in the ITA.

Enforcement of the proposals will be challenging in the extreme, and it will fall to the courts to interpret what is meant by the various provisions.  This will only occur after CRA auditors reassess taxpayers for TOSI on what they determine to be unreasonable amounts, and the taxpayers endure the inconvenience and cost of objecting to those reassessments and pursuing remedy through CRA Appeals and then the tax court.  This should be avoided, if at all possible, by clarifying what is intended in the drafting of the legislation.

CRA audits, reviews, and pre and post-assessment verifications already pose an unrecoverable cost to taxpayers and their advisors.  It is generally held that good tax policy results in reductions to compliance efforts and costs, rather than increases.  The proposals as presented seem to be headed in the wrong direction and in our opinion will increase compliance efforts and costs.


If it is your intent to impose a reasonableness test on dividends, the above issues, among the many others you will be receiving from concerned Canadians, need to be addressed so that clarity is paramount and taxpayers can file their returns with a confident understanding of the rules.

An alternative course of action, leading to a very different set of proposals, would be to clearly resolve whether the Canadian tax system should continue to be an individual-based system or a family-based system.  Our current individual-based system allows for several exceptions where the family is perceived to be the primary taxation target rather than the individual.  Thus, we allow pension splitting for seniors receiving pension income, spousal contributions to RRSP’s for lower-earning spouses, tax credits based on family income, optional allocation of medical expenses and donation credits to the most favourable spouse, and many other measures that are inconsistent with an individual-based system.

Revising our taxation system to make the family the primary target of taxation would simplify the tax rules enormously, rendering certain of the attribution rules irrelevant and indicating clearly to Canadians that families are valued and supported by their government.  This would also increase consistency with the family law systems in Canada where contributions of the spouse are implicitly recognized in separation and divorce agreements.

Your proposals generally reflect your view that Canadian small business owners have too many advantages under the present system.  Wouldn’t it be simpler to raise the corporate tax rate to bring it closer to the top rate of personal tax? 

Passive Investments

Briefly, we think the proposals related to the taxation of passive investment income negatively and dramatically affect the retirement and estate planning of small business owners, and should be withdrawn entirely.  At a minimum, the consultation period should be extended to ensure the concerns of Canadians are fully understood and that any new legislation accurately implements the intent of parliament.  We think the current system of integration works well to ensure that the combined tax on business and personal income is very close to the tax that would be paid by an individual earning a comparable income.   Introducing a complex new set of rules, including grandfathering provisions, to try and compensate for the additional investment funds available after small business tax is paid, is a misguided concept that ignores a host of differences between small business owners and employees. We are sure you will hear much more about this from other Canadians.

We thank you for the opportunity to provide comments, and look forward to your response.

Yours truly,


Connelly & Koshy, CPA, Professional Corporation