Your business owner clients may think of themselves as middle class, but according to the Trudeau government, they aren’t.
In its 2017 federal budget, “Building the Middle Class,” the government reveals it will be reviewing how private corporations create unfair advantages for “high-income individuals.”
And what exactly is a “private corporation”? While the budget doesn’t specifically define the term as Canadian-controlled private corporations, our experts agree that CCPCs are being targeted.
“I read between the lines,” says Paul Woolford, tax partner with KPMG Enterprise in Toronto.
“A private corporation that’s Canadian-controlled has a low tax rate on the first $500,000 of business income.”
The budget documents specifically point to three strategies used by private-corporation owners. Let’s look at each in detail, and how the Department of Finance might address them.
What it is: This happens when a business owner has adult children and/or a spouse in lower tax brackets and makes them shareholders of her company, either directly or via a family trust as beneficiaries. When the business pays dividends to those shareholders, they pay taxes on those dividends at a lower rate than the business owner.
“The tax objective would be to reduce the family income tax liability,” says Woolford.
This can also occur if a business owner does an estate freeze, taking preferred shares and having her children (or the trust) own common shares. That way, future growth and dividend income go to the children. Again, it’s possible that the children are in lower tax brackets, and therefore the family unit pays less tax overall.
Nancy Graham, portfolio manager with PWL Capital in Ottawa, points out that corporate tax has already been paid on the dividends, since dividends are paid out of profit.
Non-tax reasons to do it: Woolford says that family members as shareholders is fairly common. And there are plenty of non-tax reasons for it. Estate freezes, for instance, assist with succession planning and allow the principal shareholder to plan for a fixed tax liability. And, he says, “it enables insurance and other planning opportunities to come into play that protect the estate and the individual. None of that, in my mind, is offensive. That’s just good planning.”
Besides, Graham says that, in her experience, there’s a limited window for business owners to sprinkle income in the first place.
“You only do it when you have a big differential in tax rates,” she says. “The big differential is probably in the first $60,000 a year of people’s income.” And she points out that once children start making their own income – usually during post-secondary or a few years after graduating – the tax advantages of paying them dividends are much lower or eliminated altogether.
How it could be curtailed: Finance could disallow letting family trusts own shares of CCPCs, suggests Woolford, or you can only income sprinkle to a certain level.
As for family members who own shares directly, “it’s difficult for me to understand how the government could restrict who owns the shares of a viable business,” he says. Since that might not be possible, “what they might do is if a family member owns the shares, then [the shares] will be capped to the dividend rate equal to the market, which might be 6%.”
Graham says if Finance cracks down on family share ownership, it could lower the appetite for people to start businesses. “There are a lot of people who are doing entrepreneurial things for whom this would be a hit,” she says.
For its part, the budget document says, “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.”
Holding passive investments in a private corporation
What it is: Our experts agree that this refers to CCPCs changing their character so they are no longer CCPCs. Why is that advantageous?
CPCCs are subject to a refundable tax regime that initially taxes passive investment income at around 50%. Some of that is later refunded if the corporation pushes out dividends, at a rate of $1 for each $3 of taxable dividends paid. (Learn more here.) But it’s not always feasible to pay dividends to shareholders.
Non-CCPCs do not fall under this regime.
“If a corporation that earns passive investment is not a CCPC, it would benefit from a much larger tax deferral,” says Alexandra Spinner, partner at Crowe Soberman LLP in Toronto. “In Ontario, it would only pay 26.5% corporate tax, and not pay the personal level of taxation until those dividends are withdrawn.”
She emphasizes that taxes are only deferred, not saved.
Non-tax reasons to do it: In some cases, the owner of a CCPC may genuinely leave Canada and become a non-resident. In that case, the corporation she controls is no longer a CCPC, and incidentally can take advantage of the lower tax rate on passive investment income.
How it could be curtailed: Woolford, who says that CCPCs changing character for tax reasons is uncommon, suggests that Finance may tighten the rules on who can hold non-CCPC shares.
Currently, the Income Tax Act only defines what a CCPC is not, rather than what it is.
Converting dividends to capital gains
What it is: There are several ways private companies can do this. Here are some examples.
If a family trust owns shares that have gained in value, and the trust has been in place longer than two years, it can sell the shares and allocate the capital gain among family members, says Woolford. The family members can then use their individual lifetime capital gains exemptions (worth $835,716 for 2017) to shelter the gains. (The corporation must qualify as a CCPC and carrying on an active Canadian business in Canada.)
Another way: intercorporate dividends between Canadian companies can be tax-free if they’re paid out of what’s known as safe income, says Woolford. (In brief, safe income is “earnings that have been taxed in a company and retained,” he explains.) But if you pay a dividend to a corporate shareholder greater than a company’s safe income, the excess could be re-characterized as a capital gain. That means the ultimate individual shareholder may ultimately pay capital gains tax, instead of dividends tax, on the excess.
Non-tax reasons to do it: For the first example, the trust could be selling its shares because the owners are exiting the business. For the second example, it may be necessary to pay dividends in excess of safe income if the shareholder recently bought shares and hasn’t accumulated sufficient safe income.
How it could be curtailed: Finance could make it so there’s only one long-term capital gains exemption per family unit, suggests Wolford. And it could further tighten the safe income rules (that section of the Tax Act, 55(2), was also examined in the 2016 federal budget). “And they’re already pretty tight,” Woolford says.
What is a Canadian Controlled Private Corporation?
The Income Tax Act defines a CCPC by saying what it’s not. For instance, it’s not:
- controlled by non-residents,
- controlled by public or publicly traded corporations, or
- listed on a designated stock exchange.