Small-family-business-owners

Few stakeholders, including tax, legal and other financial services professionals, anticipated the complexity and extent of the Department of Finance’s proposed tax measures released on July 18. The proposed tax measures follow previously announced tax changes impacting Canadian-controlled private corporations (CCPCs) outlined in a December 2015 announcement and in the 2016 and 2017 federal budgets.

Finance didn’t simply target specific CCPC tax-planning strategies. Rather, it captured all CCPCs and appears to be eliminating any possibility of tax planning. As well, if the proposed measures pass, CCPCs will pay more in administration and compliance costs as corporate tax reporting will become more complex and detailed.

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

Who’s potentially impacted

All CCPCs could take a hit. That includes incorporated business owners and professionals who retain any net income at the corporate level and who have related-party shareholders. All CCPCs should review their existing structures to understand the potential impact on current compensation or income-splitting arrangements, or on future income or gains resulting from sale transactions. They should also determine what, if any, changes to their structures should be considered.

Sounds simple enough, right?

Unfortunately, the proposed measures aren’t simple, nor are they finalized. Stakeholders are in a state of flux when it comes to advising clients looking to incorporate, contemplating corporate restructuring for a variety of reasons, considering a wealth transfer event or regularly splitting income with related parties.

To highlight the potential impact of the proposed measures, consider the following client scenario, which illustrates the effects on income sprinkling.

Dr. Black and her professional corporation

Income sprinkling, also commonly known as income splitting, allows someone in a lower tax bracket to report income that otherwise would have been reported by someone else — often a related party — in a higher tax bracket. The intention behind income sprinkling is to reduce the collective tax liability of a family.

Currently, a CCPC can pay dividends to related parties as long as they’re shareholders of the CCPC, or can pay reasonable salaries to related parties when they’re employed by the CCPC. Under Canada’s progressive or marginal tax rate system, two spouses each reporting income of $75,000 pay less tax collectively than if only one spouse reports $150,000 in income.

Dr. Carol Black incorporated her dental practice, C. Black Dental Corporation (CB Co), 10 years ago. Black owns common shares of CB Co; her husband, Jeff, owns Class A preferred shares; son Michael (age 23) owns Class B preferred shares; and daughter Julie (age 19) owns Class C preferred shares. Jeff is a high school principal, Michael is starting his PhD in chemical engineering and Julie has completed her first year of a bachelor of science.

Black’s net income from the practice is about $250,000, and each year her tax advisor determines the non-eligible dividend required to cover her family’s lifestyle needs —$100,000 on an after-tax basis. Over the last four years, she paid Michael non-eligible dividends of $20,000 for tuition, rent and food expenses, and also paid Julie the same amount last year. All remaining funds after paying income taxes and dividends are invested in CB Co’s investment account.

Chart 1 looks at the corporate tax liability for CB Co and the personal tax liability of the Blacks using 2017 income tax rates.

Chart 1

Province B.C. Alta. Sask. Man. Ont. Que. N.B. P.E.I. N.S. Nfld.
Practice income  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000
Less corporate taxes1, 4  $31,250  $31,250  $31,250  $26,250  $37,500  $46,250  $33,750  $37,500  $33,750 $33,750
After-tax cash available  $218,750  $218,750  $218,750  $223,750 $212,500  $203,750  $216,250  $212,500  $216,250  $216,250
Dividend to Black2  $123,200  $122,600  $124,800  $138,500  $123,800  $134,800  $130,900  $132,900  $133,100  $131,100
Dividend to Michael3  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000
Dividend to Julie3  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000  $20,000
Total dividends paid  $163,200  $162,600  $164,800  $178,500  $163,800  $174,800  $170,900  $172,900  $173,100  $171,100
Total personal taxes  $23,200  $22,600  $24,800  $38,500  $23,800  $34,800  $30,900  $32,900  $33,100  $31,100
Total income taxes  $54,450  $53,850  $56,050  $64,750  $61,300  $81,050  $64,650  $70,400  $66,850  $64,850
Retained earnings
available to invest
corporately
 $55,550  $56,150  $53,950  $45,250  $48,700  $28,950  $45,350  $39,600  $43,150  $45,150
1.  Corporate tax rates as of June 30, 2017
2.  To generate $100,000 after tax; tax credits taken into account
3.  Michael and Julie don’t have tax liability
4.  CB Co qualifies for the active business rate in Quebec

As denoted in the chart, aggregate corporate and personal tax liabilities vary significantly across provinces (with a high of $81,050 in Quebec versus a low of $53,850 in Alberta), as does the resulting impact on retained earnings available to invest (a low of $28,950 in Quebec versus a high of $56,150 in Alberta). Black is depending on invested retained earnings for retirement.

In its discussion paper, Finance says corporations like CB Co provide the following tax-planning advantages, from which taxpayers like Black benefit unfairly:

  • choice in compensation (salary versus dividends);
  • flexibility in amount of compensation;
  • ability to invest more for retirement given the preferential active business corporate tax rates; and
  • ability to pay family members dividends to lower the family’s tax burden.

For instance, since Michael and Julie are shareholders of CB Co, Black can pay them dividends to cover their university needs, and the dividends are taxed in their hands, at their respective marginal tax rates, since they’re both over age 18 and aren’t subject to kiddie tax. Since each can claim the basic personal tax amount, tuition tax credit and dividend tax credit, it’s likely they’ll pay little or no personal income tax.

It’s evident from the paper that Finance conducted extensive research on when and why such advantages occur and how they’re created. Case in point is the use of the income sprinkling strategy when related parties are over the age of 18 and attend post-secondary institutions. In its discussion paper, Finance tracks non-eligible dividends reported in 2006, 2010 and 2014 by age, and states, “The total amount of dividends earned by those in the 18-21 age group exceeds the amounts earned by each of the 22-25 and 26-29 age groups. There is no economic rationale for why the 18-21 age group would earn more dividend income […]. This anomaly […] suggests the presence of dividend sprinkling, because the tax benefits of income sprinkling are higher, on average, when adult children of high-income filers are younger and have lower income.”

Finance’s proposed tax measures to prevent income sprinkling

Finance says current tax legislation doesn’t effectively deal with income sprinkling involving adult family members, notably spouses or children over the age of 18, nor does it capture compound income — also known as income on income, or second- or later-generation income. To rectify these perceived loopholes and to distinguish income sprinkling from reasonable compensation for related parties, Finance proposes:

  • expanding the tax on split income (TOSI);
  • constraining multiplication of claims to the lifetime capital gains exemption (LCGE); and
  • supporting measures to improve the integrity of the tax system in the context of income sprinkling.

Introduced in 2000 and expanded in 2014, TOSI — commonly known as kiddie tax — applies to certain types of income received by a minor child whose parent is a Canadian resident. Such income is taxable at the top combined marginal tax rate, and only the dividend tax credit or foreign tax credit can be applied to reduce income taxes owing.

Finance proposes to expand TOSI measures by:

  • introducing the definition of a “connected individual,” which broadens the concept of split income received by adult related parties, specifically adults related to another adult who has influence (strategic, equity, earnings and investment) over a CCPC;
  • establishing reasonable tests that consider labour and capital contributions for the purpose of determining whether TOSI legislation applies to income paid to adult related parties;
  • expanding the definition of “specified individual” to include adult related parties who receive split income, with more stringent restrictions applying to those under 25; and
  • expanding split income to include certain types of debt obligations; capital gains from the disposition of property, the income from which is split income; and, for specified individuals under the age of 25, income that is the proceeds from income previously subject to TOSI, meaning second- and later-generation income.

The proposed TOSI measures appear to capture all related-party income and gains, except if they meet one of the few exceptions Finance deems genuine and fair.

Under the proposed TOSI measures, Black would be a connected individual to CB Co and to Michael and Julie. As Michael and Julie have contributed neither capital nor labour to CB Co, they wouldn’t meet the listed exceptions under the proposed measures that demonstrate their dividend income is reasonable or fair. If the expanded TOSI measures become law, Michael’s and Julie’s non-eligible dividends would be taxed at the top combined marginal rate and would generate a higher tax liability than if allocated to and reported by Black.

Chart 2 outlines what Black’s personal tax liability would be if she paid herself sufficient non-eligible dividends to generate $140,000 on an after-tax basis to cover her family’s personal lifestyle needs, including Michael’s and Julie’s post-secondary tuition, rent and food expenses, in light of the proposed TOSI tax measures. Black’s additional personal tax liability would also reduce potential retirement savings that would accumulate in CB Co.

Chart 2

Province B.C. Alta. Sask. Man. Ont. Que. N.B. P.E.I. N.S. Nfld.
Practice income  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000  $250,000
Less corporate taxes1, 4  $31,250  $31,250  $31,250  $26,250  $37,500  $46,250  $33,750  $37,500  $33,750  $33,750
After-tax cash available  $218,750  $218,750  $218,750  $223,750  $212,500  $203,750  $216,250  $212,500  $216,250  $216,250
Dividend to Black2,3  $183,500  $180,100  $183,000  $204,500  $186,800  $201,100  $197,000  $196,300  $200,400  $194,000
Dividend to Michael  $0  $0  $0  $0  $0  $0  $0  $0  $0  $0
Dividend to Julie  $0  $0  $0  $0  $0  $0  $0  $0  $0  $0
Total dividends paid  $183,500  $180,100  $183,000  $204,500  $186,800  $201,100  $197,000  $196,300  $200,400  $194,000
Total personal taxes  $43,500  $40,100  $43,000  $64,500  $46,800  $61,100  $57,000  $56,300  $60,400  $54,000
Total income taxes  $74,750  $71,350  $74,250  $90,750  $84,300  $107,350  $90,750  $93,800  $94,150  $87,750
Retained earnings available to invest corporately  $35,250  $38,650  $35,750  $19,250  $25,700  $2,650  $19,250  $16,200  $15,850  $22,250
Difference in cumulative tax liability and retained earnings available to invest corporately due to proposed expanded TOSI  $(20,300)  $(17,500)  $(18,200)  $(26,000)  $(23,000)  $(26,300)  $(26,100)  $(23,400)  $(27,300)  $(22,900)
1.  Corporate tax rates as of June 30, 2017
2.  To generate $140,000 after tax to support Michael and Julie; tax credits taken into account
3.  Michael and Julie each transfer tuition tax credit to Carol ($5,000 × 15%, the lowest tax rate)
4.  CB Co qualifies for the active business rate in Quebec

With no other changes to Black and CB Co, other than eliminating non-eligible dividends paid to Michael and Julie and increasing Black’s non-eligible dividend to cover lifestyle needs, the proposed TOSI measures cost the Black family an additional $23,100 on average in personal income taxes (a high of $27,300 in Nova Scotia to a low of $17,500 in Alberta).

What advisors can do

Advisors should reach out to incorporated business owner and professional clients who regularly declare and pay dividends to their spouses or children, or who are contemplating doing so. CCPC clients should consult their tax advisors to determine if additional planning or corporate restructuring should be considered in 2017, or if 2017 dividends should be increased in contemplation of the proposed TOSI measures — one last kick at the can, so to speak.

Also read:

Finance tax proposals threaten family business planning

Pension splitting: special rules and planning opportunities

Case study: Small business owner debates expansion

All about dividend taxation

Selling a book when incorporated vs. unincorporated

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 McDonald

Mark Reid, I have just read your response to my comment. Perhaps I should not have used the words “fair rate” since I did not think that they would have been interpreted in a technical way. I cannot truly believe that anyone actually would state, “Oh, I am not going to work overtime and be paid more money because I will have to pay more income tax.”

Wednesday, Aug 30, 2017 at 9:55 am Reply

Mark Reid

David a fair rate would be a flat tax rate, where everyone pays the same amount of tax on every dollar. However, with a progressive tax rate, getting taxed more for additional dollars earned, creates a disincentive to earn more money, especially when tax strategies are eliminated. From the example it can be seen that there is less money in the corporation for investment, which further reduces funds in the private sector. All this is doing is putting more money into the public sector, and their investment strategies are questionable at best.

Tuesday, Aug 22, 2017 at 12:29 pm Reply

David McDonald

I am not sure why this raises hackles. The sample reads like a case of tax avoidance. Neither child supplies any benefit to the corporation. Why should income tax not be paid at a fair rate?

Wednesday, Aug 9, 2017 at 3:54 pm Reply

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