Tax Planning Using Private Corporations
On July 18, 2017 Finance Minister Bill Morneau released his much anticipated consultation paper proposing changes to how private corporations are used to gain tax advantages. The proposals outlined in the consultation paper are significant and will affect everyone who owns a private corporation.
The following three items are targeted in the consultation paper:
· Income splitting
· Holding passive investments inside a private corporation
· Converting income into a capital gain
These proposals quickly follow other changes such as the limitation of the small business deduction which are troublesome for small business owners. Are these new proposals a continued attack on entrepreneurs?
The proposed changes are targeting those individuals who do not actively contribute to a corporation either in terms of labour or capital. Therefore, these individuals may be subject to tax at the highest marginal rates on any income received from the business. Also, the proposals aim to restrict the availability of claiming the lifetime capital gains exemption, currently at $835,716, on those individuals not active in the business.
HOLDING PASSIVE INVESTMENTS INSIDE A PRIVATE CORPORATION
The Department of Finance perceives that there is an unfair benefit to private corporations that invest after-tax retained earnings in passive investments. These proposals intend on raising taxes paid by private corporations in these instances, so that any benefit in retaining funds in a corporation is reduced or eliminated.
Passive investment income earned by a Canadian-controlled private corporation is taxed at a rate approximately the same as the highest personal tax rates. However, active business income earned by a corporation, whether or not subject to the small business deduction, is taxed at less than the highest personal tax rates. Corporations have the ability to invest excess funds not required for their ongoing operations. Therefore, corporations can invest larger amounts in passive investments than individuals who have paid more tax on similar amounts of income. The Department of Finance finds this offensive.
CAPITAL GAINS STRIPPING
Section 84.1 of the Income Tax Act currently applies to ensure that a majority of corporate distributions are treated as dividends. There are limited situations where the distribution of corporate surpluses, that would otherwise be treated as dividends, are converted to capital gains. These proposals plan to eliminate this type of planning.
LIFETIME CAPITAL GAINS EXEMPTION (“LCGE”)
The proposals plan to eliminate the multiplication of the LCGE available on the disposition of qualified small business corporation shares. After 2017, the LCGE will not be available to qualifying shares held through a family trust. Also, there are proposed restrictions on qualifying shares held by adults that are not active in the corporation.
CAPITAL DIVIDEND ACCOUNT (“CDA”)
Capital gains will continue to be eligible for the 50% inclusion rate. However, these proposals plan to eliminate the addition of the non-taxable portion of the capital gain to the CDA.
The above highlights the significant changes outlined in the Department of Finance’s 63 page report. Needless to say, these proposals represent the most significant overhaul to the taxation of private corporations since 1971. Many of the planning opportunities have been in place since that time to provide for an effective integration of personal and corporate tax. The level of complexity, compliance costs and general business distraction will increase.
The present Income Tax Act allows for CRA to determine whether expenses are incurred to generate income and are reasonable in the circumstances. The wording used in the Department of Finance document is troublesome. It appears to accuse private corporations of not contributing to the economy or not paying their fair share of taxes. There is no mention of the risks involved in owning a private corporation.
The Department of Finance is consulting with the public concerning these proposals. The deadline for submissions was October 2, 2017. We will continue to monitor and advise our clients as developments occur.