written on behalf of Feigenbaum Law
In July, the Finance Minister announced proposed tax changes that, if passed, will affect private corporations. The stated purpose of the changes is to crack down on individuals using corporations to pay less taxes.
Following the announcement, the Minister launched a 75-day consultation period on three proposed changes:
- Restrictions on “income splitting” (i.e. business owners shifting a portion of income to family members through salary or dividends);
- Curtailing “passive investment income” (i.e. investment of money left in a corporation for purposes other than investing in growth);
- Limiting opportunities to convert a corporation’s regular income into capital gains.
These proposed changes are causing widespread outrage among business owners across the country, with #taxfairness becoming a popular hashtag on Twitter.
The Canadian Federation of Independent Business, representing more than 100,000 members across Canada told CBC News that it has heard increasing dissent about the tax changes.
The proposal seeks to eliminate many common income splitting strategies used by small businesses. “Tax sprinkling”, where the principal of a business “sprinkles” income to family members through paying them salary, wages, or dividends is a particular focus.
Current tax rules already prevent unreasonable salary or wages from being paid to family members who are not earning that compensation. For instance, the “tax on split income” (TOSI), also known as the “kiddie tax” prevents dividends from being paid to minor children (i.e those under 18) to be taxed at a lower tax rate.
Under current rules, the TOSI does not apply to adults (i.e spouses and children over 18). Adults can be shareholders of a private corporation and receive dividends, with the dividends then taxed at the adult shareholder’s personal graduated income tax rate.
The proposals seek to extend the TOSI to dividends and other amounts that adult shareholders receive from corporations. Any such amounts received may become subject to a “reasonableness” test, which will require the recipient to show that the amount they received is reasonable given their contributions (i.e. labour) to the activities of the business, the level of risk they assumed for the business, and any previous amounts that were paid to them. If the recipient does not meet the reasonableness test, the amount they received will be taxed at the highest personal income tax rate. The test will be stricter if the family members receiving money is between 18-24 years old.
Passive Investment Income
Income generated by a corporation is eligible for a tax rate of about 15% on the first $500,000 of active business income, lower than the personal income tax rate.
In the past, business owners have used this for tax planning purposes. For instance, where a business owner does not require all of the earnings from the business to support their lifestyle, they can leave the remaining amount within the corporation to invest and be taxed at the lower rate.
The Finance Minister is exploring ways in which the limit the benefit of leaving excess earning within a corporation.
Historically, families have taken advantage of the lifetime capital gains exemption (LCGE) which, in 2017, can be used to shelter up to $835,716 of capital gains on small-business corporation shares which qualify.
LCGE can be used a tax planning method to shelter gains on family business. A family trust (where family members, including minors are the beneficiaries) hold the common shares of an active business. Where there is a sale of the shares to a third-party purchaser, the capital gains would be realized by the trust, and gain would be allocated to one or more of the beneficiaries. If that beneficiary did not claim their LCGE, they could then claim that exemption in order to shelter some or all of the gains allocated to them.
However, the Finance Minister is now seeking to restrict this. Beginning after 2017, capital gains realized by a family member will no longer be permitted to be sheltered with the LCGE if the gains were accrued while that person was a minor. In addition, where the gains were accrued while a family trust held the shares, ad adult beneficiary will not be able to claim the LCGE. Lastly, the LCGE exemption will also be subject to a reasonableness test.
As the 75-day consultation period continues, we will continue to follow developments in this matter, and will provide updates as they become available. In the meantime, if you have questions about tax planning, or are curious about how these potential changes will affect your current tax plan, contact us. Our unparalleled knowledge of both US and Canadian tax makes us leaders in this field. We offer services to clients in the US, Canada and around the world. Contact us to learn more about how we can help or call us at (905) 695-1269 or toll free at (877) 275-4792.