Proposed Tax Changes
The Canadian Government has released draft legislation that could affect entrepreneurs and private corporations. Here’s what you need to know.
On July 18, 2017 the Government of Canada released draft legislation aimed at private companies and their shareholders. The proposals are still in draft form and the government has been accepting comments and criticism. Many of the proposals are slated to be effective on January 1, 2018. The changes focus on the following three issues.
1. Income Sprinkling
From a legal point of view, dividends are to be paid to owners of a particular class of shares based upon the decisions of the company’s board of directors. Many family owned companies have different classes of shares owned by different family members. These companies can then declare dividends to low-income family members, so the family may spread income amongst family members effectively lowering the family’s overall tax burden. This technique is called income sprinkling.
The draft legislation considers imposing a series of reasonability tests to determine if the dividends were paid to family members who were actively involved in the business. The tests include:
- Examining the age of the recipient, as younger taxpayers are less likely to be principally involved in the business,
- Assessing how much capital the recipient invested in the company, and
- Determining if the recipient is active in the business daily and on a full-time basis.
If the taxpayer fails any of the tests, the provisions will deem the dividends to be taxed at the highest marginal rate, as if they were earned by the principal shareholder.
2. Tax on Passive Income in Corporations
A discussion paper was released by the federal government which addressed perceived tax benefits that private corporations have over unincorporated businesses. The discussion paper suggested radical changes to the taxation of passive investment income earned by a private corporation.
The paper proposed removing the capital dividend account entirely, and replacing the refundable tax mechanism with a non-refundable corporate tax at the highest marginal tax rate. The result would be a greatly increased corporate tax payable and a higher tax cost of investing within a corporate structure versus investing as an individual.
3. Use of Trusts to Access Capital Gains Exemption
Sometimes taxpayers wish to pass ownership of an incorporated business on to their children. Currently, various tax-efficient methods are used to achieve this goal. The draft legislation targets tax planning methods that crystallize a taxpayer’s Lifetime Capital Gains Exemption (LCGE) on non-arm’s length transactions. These situations include where an individual sells shares of a small business corporation to another private corporation that they are in some way related to, or where a trust sells those shares to another corporation and allocates the capital gains to its beneficiaries.
The draft legislation proposes that the LCGE only be available where individuals complete a sale of private corporation shares to any arm’s length entity or to non-arm’s length individuals therefore excluding any sales to non-arm’s length corporations. It proposes that, where the result of the transaction is to create non-taxed capital gains, any cash or debt paid to non-arm’s length persons on the sale be treated as a dividend. It will also reduce the cost basis of the shares sold to non-arm’s length persons to the cost of the shares before the non-arm’s length transaction.
The provisions in the draft legislation and discussion paper are complex and appear to target entrepreneurs and private corporations. If you have any questions, please contact Christopher Button, Partner, or any other team member at EPR Trillium LLP, Chartered Professional Accountants to discuss how the proposed changes will impact your business and financial wellbeing. Remember, your peace of mind is our purpose.