Legislative proposals and a consultation paper issued on July 18, 2017, target three tax planning strategies that, in the government’s view, use private corporations to gain unfair tax advantages for high-income individuals. The releases result from the government’s commitment, as stated in its March 22, 2017 budget, to review this area and propose a policy response. The submission deadline for public comment is October 2, 2017.
The new rules are complex. Stay tuned for further updates and insights.
Offensive strategies and responses
The three strategies that are being targeted and the government’s proposed responses are outlined below.
1. Income sprinkling
Income sprinkling occurs when income that would otherwise be realized by a high-tax rate individual is shifted (for example, through dividends or capital gains) to family members subject to a lower or nil rate of tax.
The “tax on split income” limits income-splitting techniques that seek to shift certain types of income from a high-income individual to a low-income minor (i.e. an individual under 18).
The legislative proposals extend this rule to additional types of income and to income shifted to adults in certain cases.
For example, the tax could apply to indebtedness (e.g. interest) received by an individual from a debtor corporation, partnership or trust if other amounts (e.g. dividends) received by that individual from the debtor would be split income.
In addition, when applying the tax on split income, dividends and other amounts received from a business, by an adult family member of the principal of the business, may be subject to a reasonableness test, which will be stricter for 18 to 24 year olds.
An amount paid to an adult family member will be considered reasonable if it is consistent with what a person who is not an adult family member would receive having regard to:
- the labour contributions of the individual to the activities of the business
- the assets contributed or risks assumed by the individual in respect of the business, and
- the previous returns and remuneration paid to the individual in respect of the business
If the amount is not reasonable, the top-rate tax will apply to the split income.
The legislative proposals also address other income sprinkling issues, including the multiplication of the lifetime capital gains exemption.
2. Holding a passive investment portfolio inside a private corporation
Because corporate tax rates are generally much lower than personal rates, private corporations can facilitate the accumulation of earnings that can be invested to earn passive income.
In the government’s view, the current system does not achieve its objective of removing incentives to hold passive investments within a corporation. This leads to unfair tax results, whereby a corporate owner may frequently prefer to retain business income, for passive investment purposes, within his or her corporation, rather than paying it out and investing directly as an individual.
The government is considering the changes required to establish fairness in the tax treatment of passive investment income of a private corporation, so that the benefits of the corporate income tax rates are directed towards investments focused on growing the business, rather than conferring a personal investment advantage to the corporate owner.
Once a new approach is determined for the tax treatment of passive investment income, the government will consider how to ensure that the new rules have limited impact on existing passive investments. The government will introduce a detailed proposal following these consultations, and will provide time before the new proposal becomes effective.
The government has suggested alternative approaches to eliminate the tax deferral advantage on passive income earned by private corporations.
The approaches eliminate refundable taxes on investment income from certain sources. Although they maintain the 50% capital gains inclusion rate, the non-taxable portion of capital gains from these sources would not increase the capital dividend account.
The objective is to make the system neutral going-forward.
3. Capital gains
If a private corporation’s regular income that would normally be paid as a salary or dividend to a principal is converted into corporate capital gains, funds can be distributed at the lower tax rates on capital gains.
The legislative proposals will expand the existing anti-avoidance rule in section 84.1 of the Income Tax Act that deals with transactions among related parties aimed at converting dividends and salary into capital gains.
The draft proposals also include a new anti-avoidance provision (section 246.1) that applies to amounts that are received or become receivable after July 17, 2017.
The new rule is intended to prevent the distribution of corporate surplus (in general, unrealized corporate value less liabilities) to an individual shareholder resident in Canada, which would otherwise be distributed as a taxable dividend, on a tax-reduced or tax-free basis in a non-arm’s length context.
The government notes that it has been suggested that a genuine intergenerational transfer of shares of a small business corporation to an adult child’s corporation should be treated the same as a sale to an arm’s length corporation. However, a major policy concern is distinguishing a genuine intergenerational transfer from a tax avoidance transaction undertaken among family members.
The government is interested in the views and ideas of stakeholders regarding whether, and how, it would be possible to better accommodate genuine intergenerational business transfers while still protecting against potential abuses of any such accommodation.
Source: PwC Canada