In March 2017, the Liberal government presented its second federal budget. The budget didn’t include any changes to personal or corporate tax rates, and despite widespread speculation, did not change the capital gain inclusion rate or limit the use of the small business deduction for professional corporations. The government will continue its review to target inefficient tax measures and identify opportunities to reduce tax benefits that help the wealthiest Canadians rather than the middle class.
What the federal government did announce is that it is conducting a review of tax reduction strategies that use private corporations.
Specifically, the government stated that it’s reviewing:
“… the use of tax planning strategies involving private corporations that inappropriately reduce personal taxes of high-income earners. In doing so, the Government will also consider whether there are features of the current income tax system that have an inappropriate, adverse impact on genuine business transactions involving family members.
The Government intends to release a paper in the coming months setting out the nature of these issues in more detail as well as proposed policy responses. In addressing these issues, the Government will ensure that corporations that contribute to job creation and economic growth by actively investing in their business continue to benefit from a highly competitive tax regime.”
Examples of what the government will review, according to the 2017 budget, include:
- Holding an investment portfolio inside a private corporation – accumulating and passively investing earnings within a corporation, as corporate tax rates are generally much lower than personal rates.
- Sprinkling income using private corporations – causing income that would otherwise be realized by an individual taxable at a high personal tax rate to instead be realized (for example, through dividends or capital gains) by family members subject to a lower tax rate.
- Converting a private corporation’s regular income into capital gains – causing income that would normally be paid as a salary or dividend to a principal to instead be converted into corporate capital gains, allowing funds to be distributed at a much lower tax rate.
These are common tax practices. The two key benefits of incorporating your business are tax deferral on active business income and income splitting. Here’s a look at the benefits of each strategy and how potential changes could affect clients using them.
Private corporations in Canada
Don’t underestimate the potential effects of changes to the tax rules related to private corporations. They could potentially affect millions of Canadians. According to Statistics Canada:
- 1.7 million Canadians own 10% or more of a Canadian Controlled Private Corporation (CCPC)
- CCPC owners represent 6.4% of all tax filers
- Western provinces have the highest rate of CCPC ownership
And don’t underestimate the federal government’s desire for change. Academic researchers and Statistics Canada have been analyzing CCPCs and income inequality statistics for the past several years, and have concluded that CCPC use has understated the income inequality issue.
Tax deferral on active business income
To encourage entrepreneurship, the federal and provincial governments provide a tax deduction for Canadian-controlled private corporations (CCPC). In most provinces, the first $500,000 of business income is taxed at a much lower rate, reducing the amount of tax the business might otherwise have to pay. Shareholders can enjoy this tax deferral for as long as they leave the money in the corporation. Once they withdraw the money, whether as dividends or salary, they have to pay more personal taxes. This creates an opportunity for shareholders to invest any surplus profits in the corporation.
In the 1990s, the government curtailed this practice by slapping a high income tax rate on investment income. But smart tax planners have created tax-efficient strategies for corporate investors.
For more information on tax-efficient strategies for corporate investors, see:
It will be interesting to see what measures the government may introduce to further limit tax deferrals on active business income. If you currently have clients using the small business deduction, consider having a conversation with them about these changes.
Income splitting spreads taxable income among family members in a household to reduce taxes paid by the household. Canada has a gradual tax bracket system. As you earn more money, each additional dollar is taxed at a higher rate. The benefit of income splitting is that by spreading the taxable income among household members, each member may be subject to a lower tax rate, even if the total taxable income as a household hasn’t been reduced.
For business owners, income splitting can be done by issuing dividends to family shareholders, or by paying family members a salary for work performed for the business. In 2002, the federal government enacted a measure commonly known as the “Kiddie Tax.” Dividends from a CCPC to a minor are now subject to the highest marginal tax rate.
Income splitting is a widely used strategy. Tax measures to curtail this practice could affect many Canadians and significantly reduce after-tax cashflow to many households. For retired business owners or retired professionals who use this practice to split income between spouses, any efforts to curtail the practice could have a significant negative impact on their retirement income.
Converting income into capital gains
Converting income into capital gains is a more complicated concept. There are several corporate re-organizations and structures that can pay shareholders cashflow that can be taxed as capital gains when they would ordinarily be taxed as salary or dividends. There have already been tax changes to capital gains, and the government’s mention of this in the budget suggests more changes may be coming.
What this means for you and your clients
The probability of new tax changes for private corporations is high. If we look at history, and combine that with the announcement of a $532-million budget allocation to increased tax compliance, there is the potential for increased audits and new tax initiatives.
The government has yet to release its paper and any proposed policy responses related to CCPCs. We don’t yet know which (if any) tax rules may change, or whether certain tax strategies will have limits imposed, or be eliminated entirely.
Even with this uncertainty, it’s worth having a conversation with clients who may be affected to ensure they’re aware of the government’s ongoing review. Clients may be able to:
- Talk to their tax advisor to assess their current tax position and corporate structure.
- Take advantage of tax saving opportunities now (such as declaring dividends to shareholders), before any potential changes take place.
Times of change? Be the centre of influence clients need
The government has committed to providing more information in the coming months. You can play a pivotal role if and when change occurs – and can reassure clients that you’ll be there to help them meet any challenge. This could include developing new wealth strategies, conducting investment reviews, coordinating meetings with a client’s other professional advisors, or introducing your client to outside expertise they may need. The importance of being a centre of influence to your clients can’t be overstated – learn more here.
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Jennifer Poon is Director of Advanced Planning, Wealth, Sun Life Financial. Jennifer, in partnership with the Wealth Distribution team, works with advisors to help them apply the structures of Sun Life Global Investments and Sun Life Financial wealth products. She helps advisors understand how wealth products can be used in clients’ tax and estate plans. In addition, Jennifer provides expert support, national training and knowledge sharing of relevant tax topics to support Sun Life’s Sales Distribution teams. Jennifer received an HBBA from Wilfrid Laurier University. She holds the Chartered Accountant (CA), and Certified Financial Planner (CFP) designations. Jennifer joined Sun Life Financial in 2014 from Fidelity Investments where she was Director, Product Solutions. Jennifer has 13 years of experience in financial services and a proven record of delivering results through innovative strategies and process improvement. With a passion for public speaking, she has a unique ability to thoughtfully and effectively share complicated concepts in useful, relative terms.