As you are likely well aware, on July 18, 2017, the federal government introduced draft legislation, explanatory notes, and a consultation paper resulting in a fundamental overhaul of the system of taxation of private businesses, their shareholders and family members.
The original proposals were very broad based and essentially targeted every Canadian controlled private corporation. The proposal documents addressed four main areas:
- Income sprinkling
- Constraining access to the lifetime capital gains exemption (LCGE)
- Converting capital gains into dividends
- Corporate reinvestment
The main premise of the proposed changes is the government’s perception that our tax regime in unfair given that an employed person with a T4 cannot engage in the same tax planning as a business owner; the proposed changes would limit what a business owner can do to save or defer tax. Support for this premise is based on the government’s suggestion that common private company tax planning exploits “loopholes” in our tax regime. These are not loopholes (which occur when the drafted legislation does not accomplish the intended result and advantage is taken from the incorrect drafting), but are tax planning arrangements that have been imbedded in our tax system for many years and have been consistently sanctioned by the Tax Courts.
It is important to note that the tax planning is largely driven by the increasing gap between both: personal versus corporate tax rates and the tax rate applicable to dividend income versus capital gains. The movement in rates are the result of tax policy decisions made by government and in particular the trend of increasing personal tax rates versus decreasing corporate tax rates. To put things in perspective:
- The top personal tax rate in Ontario is 53.5%, whereas the regular corporate tax rate on business income is 26.5% and the small business tax rate is 15%;
- The preceding means that business income can benefit from a tax deferral of 27 to 38.5%;
- The top Ontario tax rate on non-eligible dividends is 45.3% versus a 26.7% rate on capital gains;
- The preceding reflects an 18.6% advantage for capital gains versus non-eligible dividends.
The initial tax proposals represented the biggest change to tax principles / legislation since the 1972 tax reform (and there’s not many of us who remember that!). That particular tax reform took 10 years, from start to finish, to be accomplished. This time, the government released the tax proposals in the middle of summer with a 75 day consultation period (the deadline for submissions was October 2, 2017) – with some measures applicable as of July 18, 2017 and other key measures to be implemented as of January 1, 2018.
After much political and editorial commentary and the federal government’s receipt of more than 21,000 submissions from business owners, supporting organizations and the tax community, no less than two weeks after the submission deadline, on October 16, 2017, it was announced by Finance Minister Morneau that the small business tax rate would be reduced from the current 10.5% to 10% as of January 1, 2018 and to 9% as of January 1, 2019. This had actually been a promise made during the last election which was quickly cancelled as part of the first Liberal government budget in 2016, but perhaps as part of a peace offering, has now been resurrected. Note, however, that there will be a corresponding increase to the tax rate on non-eligible dividends (paid out of income subjected to the small business tax rate) and that this, in certain circumstances could result in an overall tax increase – but this is somewhat nitpicking – the decline in the small business tax rate is a good thing. In addition, it was promised that changes to the original proposals would be announced through that week – being Small Business Week, after all.
As of today (October 25, 2017), here is what we know (there is a lot of detail still to come so stay tuned):
Existing legislation is already in place to limit dividend payments to minor children. These rules have been commonly referred to as the “Kiddie Tax”. The phrase “Kiddie Tax” is now referred to as “Tax on Split Income” or “TOSI” as this is the terminology used in the tax proposal documents. The proposed rules would extend the TOSI to dividends received or capital gains realized by any family member, regardless of age, in situations where the family member has not made what the government deems to be a sufficient “contribution” to the corporation (in the form of labour or capital) to justify the amount of the dividend received or capital gain realized. This has been widely criticized as creating a level of subjectivity that is overly complex, unmanageable, and impractical in the business world (how do you determine the amount of a “reasonable” dividend?) for business owners, their tax advisors and CRA to apply. As a result, Finance Minister Morneau announced that it is the “…Government’s intention to simplify the proposal to limit the ability of owners of private corporations to lower their personal income taxes by sprinkling their income to family members”. There was further commentary made as part of the government’s Fall Economic Statement presented on October 24, 2017, but it is not helpful. It appears that there will still be a reasonableness test for dividends paid to family members of all ages so it is unclear what will be simplified. We do not know anything more at this point – so just how these measures will be simplified is still to come – the government has stated that revised draft legislation will be released later this fall. There was no mention of a delay in the proposed implementation date of 2018. Assuming this will remain, paying dividends to family members in 2017 will be the focus as the year comes to a close – a “last kick at the can” so to speak.
Constraining Access to the Lifetime Capital Gains Exemption (LCGE)
The LCGE is an exemption available to all individual taxpayers to exempt an otherwise taxable gain on the disposition of certain private company shares and/or certain farm or fishing property. The amount of the lifetime exemption is indexed for inflation, and currently is approximately $835,000 ($1,000,000 for farm/fishing property) for gains occurring in 2017. Under the current rules, on an arm’s-length sale, there is no restriction on the ability to claim the LCGE by minority age children or spouses. Further, the family members need not own shares directly in the private corporation that are being sold; an indirect ownership and allocation of a taxable capital gain from a family trust is currently eligible for the LCGE.
The proposals sought to severely restrict access to the LCGE in a number of ways; no LCGE for periods when the person is under the age of 18, no LCGE for periods that the shares are owned by a trust and no LCGE if the above referenced TOSI rules apply to the shareholder. Not going into a lot of detail here because Finance Minister Morneau also announced that the government “…will not be moving forward with proposed measures to limit access to the Lifetime Capital Gains Exemption”. Nothing else was said about this so it is still unclear as to what this really means, particularly since the above noted TOSI rules were tied into these LCGE proposed rules. If it does mean that all of the proposed measures are to be fully withdrawn, it is a bit surprising, as the multiplication of the LCGE among family members (including minority age children), if anything, could be seen as “unfair”. We will have to wait and see just what will come next.
Converting Capital Gains into Dividends
The government has a problem here because the tax burden on a capital gain can be significantly less than the tax burden on a dividend. Common planning arrangements, which are all perfectly legal under the current tax rules, provide an avenue for corporate distributions to be taxed as capital gains and not dividends which can lead to material tax savings. Some tax provisions limit this type of planning, however where those rules do not apply, CRA has attempted to suggest the scheme of our tax system should always tax a corporate distribution as a dividend (and not a capital gain) – the Tax Courts have not agreed with CRA on many occasions. The proposed measures intended to legislate the premise that all corporate distributions must be subject to tax as dividends. These measures, without going into too much technical detail, were pervasive and complex with the potential for double taxation of the same gain/income. The proposals would have also penalized family business succession such that the transfer of a private business to the next generation could lead to a higher tax burden than a sale to a non-related party. In fact, when it comes to access to the LCGE, this problem already exists.
Well the government has backed down again – Finance Minister Morneau said “…the Government will not be moving forward with measures relating to the conversion of income into capital gains. During the consultation period, the Government heard from business owners, including many farmers and fishers that the measures could result in several unintended consequences, such as in respect of taxation upon death and potential challenges with intergenerational transfers of businesses”. Even better news, he also said “The Government will work with family businesses, including farming and fishing businesses, to make it more efficient, or less difficult, to hand down their businesses to the next generation”. But yes, the details are still to come.
The government apparently has another problem – one that has existed for more than 40 years but is just now coming to the forefront. As noted previously, private companies benefit from tax rates that are lower than the equivalent personal tax rates – this is presumably an incentive for entrepreneurs to take the risk of operating a business and to allow for more funds to be reinvested in a business. A federal small business tax rate of 9% would lead to a combined rate of 13.5% in Ontario compared to a top personal rate of 53.5% – which is a 40% corporate advantage. The results would be similar in the other provinces in Canada. It is important to note that the tax advantage is really a tax deferral because once corporate surplus is distributed as a dividend then the combined corporate / personal tax is comparable to the personal tax that would have been incurred if the income had been earned personally. However, the government perceives that there is an unfair advantage if a private business owner keeps the “tax deferral” in the company and does not reinvest the after-tax funds in the business and instead invests in passive type investments. This is seen as “unfair” since, inside the company, there is a greater pool for investment (after paying only 13.5% tax) as compared to an individual paying tax at 53.5%. The contemplated framework for these proposed measures (note for this part there was no draft legislation and no implementation date – just a discussion paper) are very complex and would be very difficult to implement in the “real world” of private business. So, in response to the detailed submissions and criticisms, what did Mr. Morneau have to say? Not that the measures would be withdrawn, but:
In further developing these measures, the Government will ensure that:
- All past investments and the income earned from those investments will be protected;
- Businesses can continue to save for contingencies or future investments in growth;
- A $50,000 threshold on passive income in a year (equivalent to $1 million in savings, based on a nominal 5-per-cent rate of return) – an amount that is exceeded by only about 3 per cent of corporations – is available to provide more flexibility for business owners to hold savings for multiple purposes, including savings that can later be used for personal benefits such as sick-leave, maternity or parental leave, or retirement; and
- Incentives are in place so that Canada’s venture capital and angel investors can continue to invest in the next generation of Canadian innovation.”
This suggests that the new rules will only apply where passive income exceeds $50,000 after taking into account existing investments / passive income. But, what does this mean? How will existing investments “be protected”? Will there be a need to track “before” and “after” pools of investments? If yes, when a dividend is paid by the company, which pool does it come out of? What does $50,000 of passive income mean? The examples by the government only consider interest income. How will dividends or capital gains be treated? When will the new rules be implemented (not mentioned but likely a few years away)? The commentary gave way to a flood of questions but was short on details. Unfortunately, we will not know much more until the 2018 Federal budget some time next spring – that is when the government suggests that the details of the proposed measures will be released – hold on to your hats!
The recent announcements mitigate some of the very legitimate concerns of business owners and their advisors with respect to the contemplated tax proposals. It is unfortunate that the exercise has created uncertainty for business owners and legitimate frustration with the process. It is evident that the process could have been managed more effectively – proper communication and collaboration between the government and the business community may have led to a tax policy exercise that was satisfactory to all parties. We would also hope that the policy objectives of the government consider the significant contribution that small and medium sized businesses make to the Canadian economy.