There’s a glimmer of hope in the Department of Finance’s consultation paper released July 18 — at least for family businesses. Aside from that, however, there aren’t many positives for small business owners.
The tax community is reeling from Finance’s proposals in general, which the government says “improve the fairness of Canada’s tax system.”
Jesse Brodlieb, partner in Dentons’ taxation group in Toronto, disgrees. “The average wage earner doesn’t have the same risk profile as the average small business owner, and the tax rates ought to reflect that,” he says.
And James Kraft, vice-president and head of business advisory and succession planning at BMO Wealth Management, takes issue with the breadth of the proposals compared to the size of the problem. “To save $250 million in tax loss, this is completely overdone,” he says.
The (scant) good news
Starting with the positive, the government has agreed to consult on ways “to better accommodate genuine intergenerational business transfers while still protecting against potential abuses of any such accommodation.”
Right now, it’s often more profitable to sell a business to an outsider than a family member, thanks to an anti-avoidance rule in Section 84.1 of the Income Tax Act. In brief, if a parent sells their corporation to a child’s holding company, the sale can be taxed as a dividend — even though selling to a stranger would result in a capital gain (read more here). That means the parent can’t access the lifetime capital gains exemption (LCGE) to shelter the sale proceeds. This and other consequences means 84.1 is “colloquially known as the most litigated section of the Tax Act against tax planners,” says Ali Spinner, a tax partner at Crowe Soberman in Toronto.
Groups as diverse as the Chicken Farmers of Canada and the Conference for Advanced Life Underwriting (CALU) have asked the government to amend the dividend treatment for genuine family transfers.
Finance’s consultation comes just a few months after the House of Commons defeated a private member’s bill that would have created an exception to section 84.1 for share transfers from a corporation’s owner to a child or grandchild. The bill, which failed in February 2017, would have required the child to own the business for at least five years after the transfer for the exception to apply (unless the buyer dies). Under the bill, the exception would not have applied to transactions above $15 million, and CRA could request additional paperwork.
For its part, CALU has previously suggested other carve-outs such as requiring the owner to be a minimum age to access the exemption (e.g., 50 or 55) and limiting the exception to the portion of the capital gain that can be offset by the lifetime capital gains exemption.
Finance will accept comments until October 2, 2017, at firstname.lastname@example.org. Interested parties can also cc their MPs.
And now, the bad news: the government has proposed tightening another aspect of 84.1.
Pipeline planning threatened
Currently, Section 84.1 makes it so that if a shareholder shelters a capital gain under the LCGE, the shareholder cannot extract cash from the corporation. People were getting around this, however, by using a series of self-dealing transactions to convert surplus funds, which would normally be distributed via salary or dividends, into capital gains and then deliberately paying tax on it (i.e., not sheltering the gains under the LCGE). This workaround is known as surplus stripping.
The Department of Finance is targeting surplus stripping, saying that even if the shareholder converts funds into capital gains and pays tax on it, they still cannot extract cash without being taxed again. The proposals make it so the shareholder’s only option to extract funds, besides selling, is through salary or dividend.
This also affects something called pipeline planning, says Brodlieb. This type of planning is designed to reduce double taxation on death for private company shareholders. (A CRA position states that the company stays active for at least a year after the owner’s death for this to work.)
Here’s how pipeline planning works: when a shareholder dies, her shares are deemed disposed (but her estate still owns them), and she pays capital gains tax on her terminal return. Pre-proposals, “You could then transfer those shares to another non-arm’s length company for a promissory note without realizing any more tax,” he says, effectively having the shares only be taxed as capital gains. “The company could pay down that note without further tax to the shareholder, whether it’s the estate or the children.” On a $10-million gain, the capital gains tax would be about $2.5 million.
Under the proposals, 84.1 would be revised so that the transfer to the company for the promissory note would trigger a dividend, even though the shareholder already paid capital gains tax on her terminal return. At current dividend tax rates of about 45%, doing the pipeline on a $10-million gain would trigger $7 million in tax: $2.5 million due to the deemed disposal on death, and $4.5 million due to the dividend.
Such conditions would negate the value of the pipeline, meaning it’d be better to sell the shares to a non-arm’s length company before death, or to sell to an unrelated third party.
“It’s a punishment for holding shares until you die,” says Brodlieb, who expresses frustration with the proposals. “At this point, why would you work for yourself? You’re penalized at every turn — and when you die, they kick you in the pants again.”
If these policy changes come into effect, they would be retroactively effective July 18, 2017. Again, comments can be submitted until October 2.