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Do your business-owning clients know how Finance’s proposed tax measures announced July 18 may affect them?

Read: How Finance’s tax proposals will squeeze biz owners

If not, reach out to corporate clients who are farmers, manufacturers, restaurateurs or franchise operators — anyone who owns a Canadian-controlled private corporation. These clients employ Canadians, buy Canadian goods and services and have a substantial impact on the Canadian economy.

Finance provided only 75 days — to October 2 — for Canadians impacted by these proposed measures to submit comments for review. Keep in mind that several of the proposed measures are slated to be implemented as of January 1, 2018, a mere 91 days after October 2.

You or your clients may also wish to contact local members of Parliament.

Read: Senate could study small biz tax proposals

The proposals

Now, let’s look at the proposed measures. In a recent column, we looked at Finance’s proposed tax measures concerning income sprinkling, specifically the expansion of tax on split income (TOSI).

Read: How proposed tax changes target income sprinkling

In this column, we take a closer look at measures designed to restrict the ability of related-party shareholders to shelter capital gains from the sale of qualifying capital property, such as qualified small business corporation (QSBC) shares and farm and fishing property, by using the lifetime capital gains exemption (LCGE).

Finance says related-party shareholders who are specified individuals (i.e., they receive split income), along with the business owner or practitioner, gain unfair tax advantages:

  • They report capital gains when they haven’t “invested in, or otherwise contributed to, the business [or practice] value reflected in the capital gains they realize on the disposition of property [QSBC shares or farm and fishing property].”
  • These reported capital gains may be eligible for the LCGE. And when multiple specified individuals are shareholders, multiple LCGEs are used to shelter the overall capital gain.
  • Had the specified individuals not been shareholders, it’s likely the overall capital gain would have been reported by the business owner or practitioner, and generated a tax liability, as the capital gain may have exceeded the business owner’s or practitioner’s LCGE.

Who’s potentially impacted?

All incorporated businesses and professional practices with related-party shareholders are potentially affected.

When shares of a CCPC are sold and they meet the definition of QSBC shares, individual shareholders can shelter the first $835,716 (2017) in capital gains by claiming the LCGE, provided they haven’t claimed it in previous years. The LCGE for QSBC shares is indexed annually. For farm and fishing property, the LCGE is a flat $1 million. If a CCPC has multiple shareholders, or there are multiple owners of a qualified farm or fishing property, multiple LCGEs can be used to shelter the overall capital gain.

Finance’s measures directed at restricting the multiplication of the LCGE by related-party shareholders are neither simple nor finalized. The uncertainty affects all stakeholders, including tax, legal and wealth planning professionals, along with clients who are contemplating or are in negotiations to sell qualified property over the next few years, or who are considering implementing an estate freeze, other corporate restructuring or wealth transfer event.

For all CCPCs, the shareholder register should be reviewed to identify which shareholders might be restricted in claiming the LCGE after 2017. If the CCPC might be sold to an arm’s-length third party or transitioned to the next generation after 2017, changes to shareholdings may need to be made in light of the proposed measures and the 2018 transitional rules.

To highlight the potential consequences of Finance’s proposed measures, let’s consider an example.

Modern Furniture and the Silver family

Modern Furniture Ltd. (Mod Co) is a successful furniture manufacturer that Jerry Silver, CEO, and wife Ann, CDO (Chief Design Officer), incorporated 15 years ago. They have worked side by side ever since. The shareholders’ equity of Mod Co is as follows:

Jerry Silver 26 Class A common voting shares $26
Ann Silver 26 Class A common voting shares $26
Sam Silver (age 25) 16 Class B common non-voting shares $16
Lauren Silver (age 21) 16 Class C common non-voting shares $16
Jake Silver in trust (age 16) 16 Class D common non-voting shares $16

Mod Co is known for its mid-century vibe, which has been much in demand the last five years. Recently, a competitor contacted Jerry and Ann to gauge their interest in selling Mod Co for $5 million in the next year or two. They’re giving the offer serious thought, as both are approaching 60 and none of their children has expressed interest in taking over the business. However, like many children of small business owners, Sam, Lauren and Jake have spent summers and after-school hours helping their parents and other Mod Co staff.

Chart 1 looks at the personal tax liabilities of the Silver family if their Mod Co shares are sold in 2017 under the current tax legislation across the provinces.

Chart 1

Province (2017) B.C. Alta. Sask. Man. Ont. Que. N.B. P.E.I N.S. Nfld.
Sale price of Mod Co shares:  $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000 $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000
Proceeds allocated to:
Jerry — Class A common  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000
Ann — Class A common  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000
Sam — Class B common  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000
Lauren — Class C common  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000
Jake — Class D common  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000
Personal tax liability from sale of Mod Co shares1, 2, 3
Jerry  $127,900  $125,700  $130,600  $139,900  $141,100  $150,300  $144,300  $142,300  $147,100  $141,100
Ann  $127,900  $125,700  $130,600  $139,900  $141,100  $150,300  $144,300  $142,300  $147,100  $141,100
Sam  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Lauren  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Jake  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Total personal income taxes  $255,800  $251,400  $261,200  $279,800  $282,200  $300,600  $288,600  $284,600  $294,200  $282,200
After-tax proceeds from sale of Mod Co  $4,744,200  $4,748,600  $4,738,800  $4,720,200  $4,717,800  $4,699,400  $4,711,400  $4,715,400  $4,705,800  $4,717,800
1.  Assumes Jerry and Ann each report salaries of $100,000; Sam, a salary of $70,000 (third party); and Lauren, non-eligible dividends of $20,000
2.  None of the Silvers previously used their LCGEs, thus they have the full amount available. Also, Mod Co shares meet the definition of QSBC shares for purposes of the LCGE
3.  All Mod Co shares have nominal paid-up capital (PUC) and adjusted cost basis (ACB), and were acquired at the time of incorporation

As each of the Silvers owns common growth shares with nominal paid-up capital (PUC) and adjusted cost basis (ACB), the $5-million sale price and capital gain would be allocated pro-rata to the number of shares each respectively owns.

Given that the 2017 LCGE on QSBC shares is $835,716, Sam’s, Lauren’s and Jake’s capital gain of $800,000 each is fully sheltered. However, given the quantum of the capital gains and no income tax, it’s likely alternative minimum tax (AMT) will be triggered. Jerry and Ann each report a capital gain of $1.3 million; thus capital gains of $464,284 ($1,300,000 − $835,716) will be subject to tax. On an after-tax basis, the Silver family receives anywhere from $4,748,600 (Alta.) to $4,669,400 (Que.), less any AMT triggered, from the sale of their shares.

As previously stated, Finance is targeting how the Silvers benefit from income splitting:

  • With the sale of their Mod Co shares and their ability to claim the LCGE, Sam, Lauren and Jake each receive $800,000 in capital gains tax-free — as they haven’t worked full time at, or contributed capital to, Mod Co.
  • Given that the children own Mod Co shares and are allocated a portion of sale proceeds and resulting capital gains, the capital gains Jerry and Ann would otherwise have reported — taxable at the top marginal tax rate — are reduced.

Proposed measures to restrict multiplication of LCGE

Finance proposes the following measures on dispositions of qualified property and the ability to claim the LCGE on such dispositions after 2017:

  1. Age limit — A person will no longer qualify to use the LCGE in respect of capital gains that are realized, or have accrued, before the taxation year in which the person turns 18. Thus, a minor specified individual will not be eligible to claim the LCGE on dispositions after 2017. To quantify the capital gain that accrued while the person is a minor, it appears Finance will require a valuation to determine the market value of the qualified property at the time the person turns 18 — a point-in-time value — and won’t average the capital gain over the number of years the property is owned.
  2. Reasonableness test — A person will no longer qualify to claim the LCGE on capital gains subject to the proposed TOSI measures. The reasonableness test outlined for TOSI (outlined in the previous article) will apply. Further, an adult specified individual won’t be eligible to claim the LCGE on dispositions after 2017 to the extent the capital gain:
    • accrued prior to the year in which the adult turns 18, as outlined above; and
    • is included in the individual’s split income under TOSI.
  3. Property held by a trust — Capital gains that accrue during the time the property (QSBC shares, or qualified farm and fishing property) is held by a trust will no longer be eligible for the LCGE. The proposed tax measures apply if the realized capital gain is distributed, or the property with an accrued gain is distributed in kind, to a beneficiary of the trust. Exceptions to the proposed measures are spousal or common-law partner trusts, alter ego trusts or certain employee trusts.

Read: The benefits of family trusts

Transitional measures

Similar to the election Finance introduced in its 1994 budget, when the $100,000 general capital gains exemption was eliminated, Finance proposes transitional measures to allow certain affected individuals to realize capital gains by an actual or deemed disposition in 2017 or 2018, and to claim the LCGE.

In brief, here are proposed transitional measures and prescribed elections:

  • Minor specified individual — There’s no transitional measure or election available for minors holding qualifying capital property after 2017. However, if an actual sale occurs in 2018 only, TOSI and the restrictions on claiming the LCGE won’t apply.
  • Adult specified individual — Prior to January 1, 2019, a prescribed election can be filed to deem a disposition of a qualifying property up to its current fair market value. The resulting deemed capital gain can be sheltered by claiming the individual’s available LCGE, and there’s a bump up of the qualifying property’s ACB on a go-forward basis.
  • Trust — Prior to January 1, 2018, all trusts should consider if any qualifying capital property should be deemed disposed of by the trust to trigger a capital gain to be distributed to beneficiaries; or if the property should be rolled out in kind to adult specified individual beneficiaries. Either of these scenarios allows adult specified individuals access to the aforementioned transitional measures and prescribed elections, as applicable. Admittedly, each scenario requires detailed steps and should be considered by the client’s tax advisor.
  • For the elective dispositions, Finance has shortened the QSBC 24-month holding period test to 12 months.

Impact of proposed measures

What’s the impact of Finance’s measures if Mod Co sells in 2019, as opposed to 2017?

  • Sam and Lauren would be considered adult specified individuals in 2018 and at the time of sale in 2019.
  • Jake would be considered a minor specified individual in 2018, and an adult specified individual in 2019 upon turning 18.
  • Jerry and Ann would be considered connected individuals to Mod Co and their children, as they are related to their children who are specified individuals to Mod Co, and they can exert influence over amounts paid to their children by Mod Co.

The measures shouldn’t impact Jerry and Ann, given their involvement in Mod Co operations from the start. Sam and Lauren should probably use the 2018 election to bump up the cost basis of their Mod Co shares in anticipation of the 2019 sale and claim their LCGEs. Note that additional capital gains realized on the sale of their Mod Co shares in 2019 (2019 sale proceeds less 2018 elected value) will be subject to TOSI.

In addition, as Lauren will be under 25 in 2019, subsequent income earned from the capital gain reported (less any income taxes paid from such) will be subject to TOSI until the year she turns 25, causing complexity in preparing her annual tax returns. As Jake is a minor specified individual in 2018, he can’t make an election, and his entire capital gain realized on the sale of the Mod Co shares in 2019 will be subject to TOSI. Further, subsequent income earned from the capital gain (less any income taxes paid from such) will be subject to TOSI until the year he turns 25, complicating his personal tax return as well.

Chart 2 outlines the difference in the family’s after-tax proceeds if Mod Co is sold in 2019.

Chart 2

Province (2019)1 B.C. Alta. Sask. Man. Ont. Que. N.B. P.E.I. N.S. Nfld.
Sale price of Mod Co shares:  $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000 $5,000,000  $5,000,000 $5,000,000  $5,000,000  $5,000,000
Proceeds allocated to:
Jerry — Class A common $1,300,000  $1,300,000  $1,300,000  $1,300,000 $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000
Ann — Class A common $1,300,000  $1,300,000  $1,300,000  $1,300,000 $1,300,000 $1,300,000  $1,300,000  $1,300,000  $1,300,000  $1,300,000
Sam — Class B common  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000
Lauren — Class C common  $800,000  $800,000  $800,000 $800,000  $800,000  $800,000  $800,000 $800,000 $800,000  $800,000
Jake — Class D common  $800,000 $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000  $800,000
Personal tax liability from sale of Mod Co shares1, 2
Jerry $127,900  $125,700  $130,600  $139,900  $141,100 $150,300  $144,300  $142,300  $147,100 $141,100
Ann  $127,900  $125,700  $130,600  $139,900  $141,100  $150,300  $144,300  $142,300  $147,100  $141,100
Sam3  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Lauren3  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Jake4  $190,800  $192,400  $191,000  $201,600  $214,100  $213,200  $213,200  $205,500  $216,000  $205,200
Total personal income taxes  $446,600  $443,800  $452,200  $481,400  $496,300  $513,800  $501,800  $490,100  $510,200  $487,400
After-tax proceeds from sale of Mod Co  $4,553,400  $4,556,200  $4,547,800  $4,518,600  $4,503,700 $4,486,200  $4,498,200  $4,509,900  $4,489,800  $4,512,600
Difference in after-tax proceeds from sale of Mod Co in 2019 due to Jake being a minor specified shareholder prior to 2018  $(190,800) $(192,400)  $(191,000)  $(201,600)  $(214,100) $(213,200)  $(213,200) $(205,500)  $(216,000)  $(205,200)
1.  Assumes 2019 personal tax rates and the LCGE for QSBC shares are the same as in 2017
2.  None of the Silvers previously claimed their LCGEs, thus they have the full amount available. Also, Mod Co shares meet the definition of QSBC shares for purposes of the LCGE
3.  Sam and Lauren file prescribed election forms in 2018, reporting $800,000 as fair market value of their respective shares based on sale agreement, thus assume no additional gain in 2019
4.  As Jake is a minor in 2017 and 2018, he can’t use prescribed election

As shown, the reduction in after-tax proceeds from the sale of Mod Co in 2019 is substantial and is a direct result of Jake owning shares (held in trust in his name). Finance’s proposed measures on restricting specified parties from claiming the LCGE will cost the Silvers on average $204,300 when the sale of their Mod Co shares occurs (a high of $216,000 in N.S. to a low of $190,800 in B.C.).

As an alternative, what’s the impact if Mod Co’s common shares are owned by the Silver Family Trust, with all family members as beneficiaries?

The trustees must first choose whether to trigger a deemed capital gain in the trust or roll out the qualifying property to beneficiaries. Given a pending sale in 2019, let’s presume the trustees decide to roll the Mod Co shares out to select beneficiaries in 2017. In all likelihood, the trust is discretionary, so the Mod Co shares would be distributed in kind to everyone but Jake, since he’s under 18: TOSI would apply to any capital gain he reports, and he won’t qualify to claim the LCGE. In addition, TOSI would apply to second- and later-generation income on capital gains received by Lauren and Jake until the year they turn 25.

The rollout of Mod Co shares from the trust must occur prior to December 31, 2017, as shares must be held personally by Jerry, Ann, Sam and Lauren for 12 months to use the LCGE election prior to December 31, 2018. The planning for such is detailed and complicated, and should be overseen by a tax advisor.

Chart 3 outlines the difference in after-tax proceeds to the Silver family in 2019 after rolling the shares out from the trust.

Chart 3

Province (2019)1 B.C. Alta. Sask. Man. Ont. Que. N.B. P.E.I. N.S. Nfld.
Sale price of Mod Co shares:  $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000  $5,000,000
Mod Co shares distributed by Trust, thus proceeds allocated to:
Jerry  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000
Ann  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000  $1,665,000 $1,665,000  $1,665,000  $1,665,000
Sam  $835,000  $835,000  $835,000  $835,000  $835,000  $835,000  $835,000  $835,000  $835,000  $835,000
Lauren  $835,000  $835,000  $835,000  $835,000 $835,000  $835,000  $835,000  $835,000  $835,000  $835,000
Jake  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Personal tax liability from sale of Mod Co shares1, 2
Jerry  $215,000  $213,300  $217,800 $231,800  $238,800  $247,600  $241,600  $236,000  $245,600  $235,400
Ann  $215,000  $213,000  $217,800  $231,800  $238,800  $247,600  $241,600  $236,000  $245,600  $235,400
Sam3  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Lauren3  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Jake4  $-  $-  $-  $-  $-  $-  $-  $-  $-  $-
Total personal income taxes  $430,000  $426,300  $435,600  $463,600  $477,600  $495,200  $483,200 $472,000  $491,200  $470,800
After-tax proceeds from sale of Mod Co $4,570,000  $4,573,700  $4,564,400  $4,536,400  $4,522,400  $4,504,800  $4,516,800  $4,528,000  $4,508,800  $4,529,200
Difference in after-tax proceeds from sale of Mod Co in 2019 from 2017, due to Silver Family Trust originally owning shares  $(174,200)  $(174,900)  $(174,400)  $(183,800)  $(195,400)  $(194,600)  $(194,600)  $(187,400)  $(197,000) $(188,600)
1.  Assumes 2019 personal tax rates and the LCGE for QSBC shares are the same as in 2017
2.  None of the Silvers previously claimed their LCGEs in the past, thus they have the full amount available. Also, Mod Co shares meet the definition of QSBC shares for purposes of the LCGE
3.  Post trust rollout, Sam and Lauren file prescribed election forms in 2018, reporting $835,000 as fair market value of their respective shares based on sale agreement, thus assume no additional gain in 2019
4.  As Jake is a minor in 2017 and 2018, he doesn’t roll out Mod Co shares

As shown, the reduction in after-tax proceeds from the sale of Mod Co in 2019 after the trust rollout is noteworthy. The reduction is due to Jerry and Ann reporting higher capital gains, given Jake is a specified minor individual. Their additional capital gains, in excess of their LCGEs, will likely be taxable at the top marginal tax rate. In this case, Finance’s measures on restricting the LCGE will cost the Silvers on average $186,500 in additional taxes (a high of $197,000 in N.S. to a low of $174,200 in B.C.). Also, as mentioned previously, Sam and Lauren will likely pay AMT.

What can advisors do

Finance aims to restrict the ability of related party shareholders who are identified as specified individuals to use the LCGE and otherwise benefit from owning qualifying property, especially if related parties are under the age of 18; 18 to 24 years of age; and not involved in the property’s day-to-day operations or practice.

Advisors should thus reach out to corporate clients — especially owners of a QSBC or qualified farm and fishing property, if such property would qualify for the LCGE and may be sold or transitioned in the future.

Further, such clients should be prompted to reach out to their tax advisors to determine what necessary planning should be considered and what changes should be implemented once the proposed measures are finalized and passed into law.

Time is of the essence as any transitional measures and prescribed elections made in contemplation, or upon the passing of, the proposed measures must occur between now and 2018.

Also read:

Finance tax proposals threaten family business planning

How early to tackle business transition issues

Ontario businesses to take $23-million hit from reforms: coalition

Understand your business-owning clients

Michelle Connolly, CPA, CA, CFP, TEP, is vice-president, Tax, Retirement and Estate Planning at CI Investments. MConnolly@ci.com
Originally published on Advisor.ca
See all comments Recent Comments

David Senft

Thank you for your great explanation on one part of the proposed changes. Could you comment on how the new tax changes will affect “passive income” within a small Corporation.

Thursday, Sep 7, 2017 at 4:37 pm Reply

MELISSA.SHIN.1

Thank you David, we have passed this along to the author.

Thursday, Sep 7, 2017 at 8:12 pm

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