If your clients are incorporated professionals or owners of private corporations, they’ve now lost significant tax planning strategies. That’s because the government wants to level the playing field between those who use corporations to structure their finances and those who don’t.
Finance Minister Bill Morneau announced tax changes earlier this week that affect private corporations using strategies such as income sprinkling and holding passive investments inside their corporations.
If enacted, the government’s proposals are “the most significant overhaul we’ve seen since 1972 [for] the taxation of private companies,” says Dino Infanti, tax partner at KPMG Enterprise in Vancouver. He’s referring to the overhaul that introduced capital gains tax.
Michelle Connolly, vice-president of tax, retirement and estate planning at CI Investments in Toronto, says given the complexity and subjective nature of some aspects of the proposal, compliance will be onerous and costly for affected clients.
Here are some highlights sure to affect planning.
Kiddie tax expands
Income sprinkling typically involves issuing shares and paying dividends to family members with lower or no income to reduce the family’s overall tax burden. Tax on split income (TOSI) currently applies, also known as kiddie tax.
“Kiddie tax applies to first-generation income,” explains Connolly. “If an individual under the age of 18 receives a dividend [or other specific income], it’s automatically subject to top marginal tax rates.”
That could now apply to everyone — kiddie or not — who receives split income from a family business (aside from employment income).
“Tax on split income is far more broad-reaching than the kiddie tax measures today,” says Connolly.
TOSI will apply to adults who receive split income deemed “unreasonable.” A reasonableness test will apply, based on contributions of labour and capital, and on previous returns and remuneration. Generally, an amount is unreasonable if it exceeds what an arm’s-length party would agree to pay to a person.
Currently, reasonableness applies to salaries and wages paid to family members, not to the payment of dividends.
The test is also age-based, depending on whether the recipient of split income is between 18 and 24, or 25 and older. The age categories recognize there are more opportunities for income sprinkling with younger adult family members, says the proposal.
To demonstrate labour contributions, those aged 18 to 24 must be “actively engaged on a regular, continuous and substantial basis in the activities of the business,” says the proposal. It’s a more rigid test than for those who are older.
Infanti and Connolly both warn that the test is subjective, and Connolly adds that the measure could call into question company valuations and could prompt more audits. Further, the focus on age indicates Finance’s deep dive on tax loopholes, she says.
The proposal also places limits on accessing the lifetime capital gains exemption (LCGE). For starters, family members no longer qualify for the LCGE before the taxation year in which they turn 18.
Further, the LCGE generally won’t apply when a taxable capital gain from the disposition of property is included in a person’s split income. Also, gains that accrue during the time that shares are held by a trust will no longer be eligible for the LCGE. (Capital gains from spousal or common-law partner trusts or alter ego trusts are exceptions, as are employee trusts.)
The proposal removes a significant and commonly used planning tool, says Connolly.
For example, consider a business owner holding shares in a trust (for tax planning reasons or not). Previously, for any capital gains on shares sold, the owner could multiply the capital gains exemption through share distributions to beneficiaries. That’s no longer allowed.
The measure requires greater clarity in the calculation of capital gains, says Connolly. For example, in the case where a 12-year-old’s shares are held in trust and sold when the person is no longer a minor, it’s unclear how the LCGE would apply to gains realized for the years after age 18.
The LCGE measures apply to dispositions after 2017, with transitional rules proposed.
“There is an opportunity to look at those structures to […] think about how to crystallize any value to date,” says Infanti, referring to the transition. But going forward, “the ability to multiply the capital gains exemption via a trust [is] no longer available.” He adds that using a trust could still be valid for non-tax reasons, such as maintaining control.
Tax deferral squeezed
The feds’ aim is for passive investments held within private corporations to be taxed in the same way as those held by individuals. As it stands, corporations benefit from a tax deferral on active business income when earnings are retained and invested. Unlike with income sprinkling, no legislation has been developed yet to address passive investments.
“What they’re looking at is what tax legislation would remove incentive to retain significant amounts of passive assets [in the corporation] on an after-tax basis from active income,” says Connolly.
Proposed measures are complex, says Infanti. For example, the proposal discusses the apportionment method, which involves tracking income sources so that, when dividends are distributed to shareholders, tax is levied appropriately according to source.
Clients would have to track that income source going forward, on future-generation income, adds Connolly.
The proposal includes questions to elicit feedback about how best to treat passive income, as well as capital gains, and about potential transition issues. Comments will be received until October 2, 2017, at firstname.lastname@example.org.
With only 90 days from October 2 to year-end, and with tax legislation easily introduced by a ways and means motion, there’s potentially little time for business owners with calendar year-ends to adjust, says Connolly.
“The hope is this isn’t implemented January 1, 2018,” she says.