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Tax Planning Using Private Corporations Federal Government Proposals
July 18, 2017
Presented to the Ottawa Real Estate BoardNovember 30, 2017
Jason Valente, Tax Manager, Logan Katz LLP Harold Feder, Partner, Brazeau Seller Law
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Overview of Recent Tax and Economic Factors Impacting Small Businesses and Private Corporations
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2016 Federal BudgetPersonal
– 4% increase in marginal tax rate on income > $220K to 53.5% (combined Federal/Ontario)
Corporate– Significant reduction in opportunities to have multiple access to the SBD (15%
tax rate on income < $500K) applicable to corporations that are part of partnerships or corporate groups
Impact: Increase of corporate tax rate from 15% to 26.5% for such corporations, thereby reducing opportunities for corporate tax deferrals by over 10%
Affected: Broad reaching rules which affect many non‐professional corporate groups. Includes many professionals, mostly lawyers, doctors, veterinarians, architects
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June 2016 –Canada Pension Plan Expansion
Current CPP premiums – 4.95% of salaries to maximum of $55,300 (current YMPE)– Maximum amount per employee = $2,564.10
Effective 2023 (phased‐in beginning 2019)– 5.95% of salaries to YMPE– 4% of salaries > YMPE to $82,700– Maximum amount per employee = $4,513
Impact: Increases in payroll costs to all employees, in particular to high paying employee environmentDe‐motivation for implementation of private pension plansReductions in salaries??
Affected: All sectors of the economy
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May 2017 – Ontario Minimum Wage Increases
Current $11.40October 2017 $11.60January 1, 2018 $14.00January 1, 2019 $15.00
Impact: Increase salary costsIncrease payroll costs (CPP/EI/EHT)
Affected: Retail; hospitality, etc.
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Section 55(2) of Income Tax Act –Intercompany Dividends
Federal Budget 2015• Introduction of new rules which significantly limit the possibility of declaring and paying dividends from an operating corporation to a holding (parent) corporation, on a tax‐deferred basis
Impact: Limits the movement of funds for legitimate business purposes, e.g. creditor proofing, acquisition of property
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Scientific Research and Experimental Development ‐ Erosion of Tax Credits
Federal Budget 2012• Reduction of general tax credit rate from 20% to 15%• Elimination of credits applied to capital assets• Reduction of proxy percentage from 65% to 55% of direct labour• Reduction of inclusion of amounts for arm’s length contract
payment to 80%
Ontario Budget 2016• Reduction of Ontario Innovation Tax Credit from 10% to 8%• Reduction of Ontario Research and Development Tax Credit from
4.5% to 3.5%
Impact: Lowered incentives to invest in R&D?
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Apprenticeship Tax Credit…More Erosion!
Ontario Budget 2015• Reduction to annual maximum credit from $10,000 to $5,000
• Reduction of eligibility period of an apprenticeship program from 48 months to 36 months
Impact: Lower incentives for businesses to invest in training and in youth
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July and September 2017 – Interest Rate Increases of 0.25% each by Bank of Canada
Impact: Higher borrowing costs
Affected: Leveraged businessesExpanding businesses
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Budget 2017
• Taxation of work in process
Impact: Timing of taxes levied on work in process
Affected: Lawyers and accountants
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August 2017 – Re‐negotiation of NAFTA
• Unknown outcome• Uncertainty of impacts on economy: manufacturers/exporters
• Advantages to Canadian businesses expected to be reduced
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July 18, 2017 – AND NOW THIS…
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Proposed Tax Changes
On July 18, 2017, Department of Finance Consultation “Paper” focusing on three issues (including some draft legislation)
1. Income Sprinkling2. Holding Passive Investments Inside a Private
Corporation3. Converting Income into Capital Gains
Significant changes to the taxation of all small businesses in Canada
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Income Sprinkling
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Income Sprinkling
• Range of tax planning to redirect income to family members with lower taxable income– Ability to distribute dividends to lower taxed family members
– Ability to distribute capital gains on the sale of shares of a CCPC to lower taxed family members
– Ability to multiply access to the Lifetime capital gains exemption
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Income Sprinkling
• These lower income family members have the following tax attributes:– Lower marginal tax rates – tax savings– Personal tax credits– Certain deductions such as Lifetime capital gains exemption
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Common Uses
• Remunerate lower income family members• Fund long periods of non employment (maternity leave, disability)
• Finance post secondary education of adult children
• Fund large purchases (home, investments)
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OPCO
Holdco
FT
OPCO
Holdco
OPCO
SP1 SP2 K1K2
SP1 SP2 K1K2
SP1SP2K1K2
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Government Concerns
• Current rules are limited and don’t address all income splitting – Section 67, various attribution rules, current TOSI rules “kiddie tax”
• No contribution to the business• Benefits increase as the number of eligible family members increase
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TOSI – Tax on Split Income
• In the past known as kiddie tax– Dividends, business income, capital gains on sale to a related person
• Expansion of the rules– TOSI will apply to all Canadian residents (regardless of age);
– From a related business; and,– Unless reasonable
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Tax on Split Income• Split income currently includes:
a) Unlisted dividends and shareholder benefitsb) Partnership incomec) Trust income
• Proposed additional inclusions:d) Income from loans and other debt e) Taxable capital gains realized on properties the
income from which would be split incomef) Income from conferred benefitg) Income earned on split income if the individual is
under age 25 (secondary income)
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Specified Individuals• Current
Essentially resident in Canada and under age of 18 at the end of the year.
• Proposed expansion‐ Resident in Canada at the end of year (or immediately before death if dies in the year);
‐ Related to another individual who is resident in Canada (at any time in the year) and is either;• A parent of the individual (if individual is not 17 at the start of the
year); or,• Related to the individual (expanded definition) ‐ includes aunt,
uncle, niece and nephew.‐ The income above is derived from a business; and,‐ The parent/related individual meets a control threshold for the business
(generally a “connected individual”).
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Expanded Scope of Tax on Split Income
• Split portion – generally, income and taxable gains from property will be included in a specified individual’s “split portion” to the extent that the income or gains represent an unreasonable return given the specified individual’s contributions of labour and capital, as well as the risks assumed and amounts payable:‐ Income received by an adult who is a specified individual will now be subject to a reasonableness test;
‐ Stricter rules governing the reasonableness of a return on shares or debt for a specified individual under age 25; or,
‐ Related individuals include aunts, uncles, nieces, nephews and trusts deemed not dealing at arm’s length.
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Reasonableness Criteria25 and Over
• LabourDoes not exceed what would have been paid to an arm’s length party given the functions performed by the specified individual in respect of the business.
• Capital Does not exceed what would have been paid to an arm’s length party given the assets contributed by the specified individual in respect of the business.
• RiskDoes not exceed what would have been paid to an arm’s length party given the risks assumed by the specified individual in respect of the business.
• Previous returns/remunerationAll previous amounts paid or payable.
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Reasonableness Criteria (Cont’d)18‐24
Same reasonableness requirements as specified individuals 25 and over EXCEPT:
• Labour No labour contribution deemed to have been performed except to the extent that the individual is actively engaged on a “regular, continuous and substantial basis in the activities of the source business”.
• CapitalAny return in excess of the prescribed rate on the capital contributed by the specified individual is deemed to be unreasonable.
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Income Sprinkling ‐ Capital Gains
• Any gains on the sale of shares to non‐arm’slength parties – Full gain treated as an ineligible dividend
• Any gains on the sale of shares to arm’s lengthparties Taxable capital gain is TOSI taxed at highest marginal rate
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October 16, 2017 Update –Income Splitting
• Government intends to move forward with measures to limit income sprinkling
• Changes will be made to simplify the proposals and reduce the compliance burden– Gov’t stated that “Corporations with family members who meaningfully contribute to the business will not be impacted by the proposed measures on income sprinkling”
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October 16, 2017 Update –Income Splitting
• Government will introduce reasonableness tests:– for adult family members aged 18‐24– as well as those 25 and older– demonstrate their contribution based on four basic principles – whether they have made a contribution through any combination of the following:• Labour contributions;• Capital or equity contributions to the business;• Taken on financial risks of the business, such as co‐
signing a loan or other debt; and/or,• Past contributions in respect to previous labour,
capital or risks.
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October 16, 2017 Update –Income Splitting
Observations:• Will family members who reach some level of contribution be able to receive dividends without restriction?
• Need to wait for revised legislation, later this fall
• 2017 will be the last year to pay dividends without considering the contribution of the individual
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Lifetime Capital Gains Exemption
• TARGET: “Multiplication” Arrangements• Proposals intended to limit access to LCGE to persons actively involved in creating the gain
• No LCGE (as of January 1, 2018):– Gains included in split income of Taxpayer– Gains accrued or realized before the year in which the Taxpayer turned 18
– Gains accrued on property while held by Trust
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October 16, 2017 Update –Lifetime Capital Gains Exemption
• The government will not be going forward with these proposals
• The impact of the TOSI rules on the LCGE is still a mystery; devil is in the details
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Holding Passive Investments Inside a Private Corporation
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Integration of Business Income
$38,500 $27,000
Business income $100,000
Ontario corporate tax rate15.0% 15,000 26.5% 26,500
Net income85,000 73,500
To an individual:Ontario top personal tax rate
on salary 53.5%
on ineligible dividends 45.3% 38,505on eligible dividends 39.3% 28,886(after gross up and dtc)
Net to individual if dividend $46,495 $44,615
Net to individual if salary $46,500 $46,500
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Integration of Investment IncomeInvestment income $1,000
Portfolio Capital Gains Dividends Interest
Corporate tax ‐ federal and ON $251 $383 $502
Refundable dividend tax on hand 153 383 307
Net corp. tax after taxable dividends $98 $0 $195
Available to individual shareholder $902 $1,000 $805
Capital dividend account $500 n/a n/a
To an individual:tax free CDA $500 ‐ ‐if ineligible dividend 45.3% $182 $453 $365
Net to individual $720 $547 $440
if eligible dividend 39.3% $158 $393 $316
Net to individual $744 $607 $489
If received personally 53.5% $733 same as $465above
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Holding Passive Investments Inside a Private Corporation
• Deferral of income is a major benefit of incorporating a business
• Deferral of income allows for:– Savings to grow your business;– Self insure against lost earnings, provide a buffer for periods of lower earnings (lack of job security);
– Securing lines of credits;– Contingencies (e.g. sickness); – Saving for retirement; and;– Diversification of risk.
• It was felt the government did not acknowledge these realities
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Concerns Identified in the Paper
• Government view is that fairness and neutrality require that private corporations not be used as a personal savings vehicle for the purpose of gaining a tax advantage
• The ability to invest a larger pool of capital e.g., $85,000 vs. $46,500– Increased income potential
• Employees are not afforded such an advantage
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Proposals• Aimed at discouraging corporate passive investments • Will not apply when invest after tax corporate funds in the business
(equipment & inventory)• No draft legislation to date ‐ expected in 2018
3 methodsa) The “1972” approach
Deferred taxation approaches:b) Apportionment method, orc) Elective method
• Special election for corporations primarily holding passive investments
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Proposals (Cont’d)a) 1972 Approach
• Corporate refundable tax on ineligible investments• Corporate refundable tax on passive incomeRefundable tax still in effect• Refundable tax on passive income repealed one year after in
1973 due to complexity and to encourage small business expansion, reinvestment and job creation
Discussion paper comments• Additional 35% refundable tax on earnings not used to acquire
active assets• Full refund when funds used in active business• A discussion that the government not actively considering
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Proposals (Cont’d)Deferred Taxation Proposals• No tax would be levied at the time a passive investment acquired.• Maintain current upfront corporate income tax on passive income
– But no RDTOH• Effectively, the 50% corporate tax on passive income becomes a permanent tax• Align tax treatment of passive income distributed as dividends with that of
earnings that are used to fund passive investments• Differentiate between: small business rate, general rate & amounts contributed
by shareholders:a) Non‐taxable portion of capital gain no longer included in CDA, and can no longer be
distributed tax‐free;b) Dividends on portfolio dividends no longer treated as eligible dividends.
• Individual shareholders then pay up to 45% in Ontario on the dividend income when paid out
• This intentional tax increase results in up to > 70% total tax on corporate passive income
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Integration of Investment Income
153 383 307
$500
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Effect of Proposals on Tax on Investment Income
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Deferred Taxation Approach
• Problems based on source of investment funds
• Business income taxed at two rates• Additional source of funds initially taxed at personal tax rates (e.g. Capital contributions)
To create more “equity”, two proposals:• Apportionment method; or,• Elective method
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The Deferred Taxation Approach• The deferred taxation approach acknowledges a problem in terms of
aligning the tax treatment of passive income distributed as dividends with the tax treatment of the earnings that are used to fund said passive investments:‐ Passive investment funded with earnings subject to the small business tax rate has the largest initial capital head‐start, and therefore dividends paid out from such passive investment should be subject to a higher personal tax rate;
‐ Passive investment funded with earnings subject to the general corporate tax rate would have less of an initial head‐start, and therefore dividends therefrom should be subject to a lower personal tax rate;
‐ And, where earnings used to fund passive investment were initially taxed at personal tax rates, e.g. capital contributed by the shareholder, no inherent advantage and should result in no further personal tax after the new corporate tax is levied on such passive income.
• To achieve this, an “apportionment method” or an “elective method” is proposed
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Deferred TaxationApportionment Method
• Private corporations – different pools for passive income earned from:i. Retained earnings subject to general corporate tax rateii. Retained earnings subject to the small business tax rateiii. Corporate capital from shareholder’s after‐tax income – a new shareholders’
contribution pool
• After‐tax investment income each year allocated to each of the three pools, based on the prior year‐end balances. The corporation designates which pool the dividends are paid from:i. Dividend from GRIP → eligible dividend;ii. Dividend from small business income pool → non‐eligible dividend; or,iii. Dividend from the shareholders’ contribu on pool → tax‐free distribution
• Under this method, public company dividends not automatically eligible dividends and non‐taxable portion of capital gain no longer CDA, but will be apportioned using this method
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Deferred Taxation Elective Method
• Avoids tracking requirements• All private corporations subject to the “default treatment”,
unless a corporation elects otherwise• Under default treatment, corporations assumed to earn all
passive income from retained earnings subject to the small business corporate tax rate. Any passive income distributed automatically treated as non‐eligible dividends.
• If election is made, the corporation loses access to the small business rate
• Eligible dividends paid from all after‐tax passive and business income
• No preferential treatment for passive income earned from shareholders’ contribution
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Deferred Taxation Special Election for Holdco’s
• Government contemplating a special election for corporations focused on passive investments (Holdco’s)
• All income of the entity being taxed as passive investment income, but the refundability under the existing rules will be retained
• Where Holdco receives funding from a intercorporate dividend, additional refundable tax will apply to ensure the starting capital is subject to equivalent amount of tax as an individual investor at top marginal rates
• Details are currently lacking regarding this election
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Example of Apportionment Method
Source: Tax Planning Using Private Corporations Department of Finance, July 2017
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Example of Elective Method
Source: Tax Planning Using Private Corporations Department of Finance, July 2017
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October 18, 2017 Update – Passive Investments Inside a Private Corporation
Government stated:• moving forward with measures to limit the deferral benefits within private corporations with some changes:– Ensured that investments already made, including future income earned from such investments are protected
– Included a passive income threshold of $50,000 per year for future, go‐forward investments (equivalent to $1 million in savings based on a nominal 5% rate of return)
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October 18, 2017 Update – Passive Investments Inside a Private Corporation
Unknowns:• Draft legislation and explanatory notes to be released as part of Budget 2018.
Proposals will apply on a go‐forward basis• No technical description of how the passive investment income will apply• What will be grandfathered?
– How will they define grandfathered assets?• Just current investments? What about sale and purchases using existing investments
– Is grandfathering lost if asset is sold for cash and then reinvested?• Based on some sort of measurement? Retained earnings invested, or fair value of all investments?
• The threshold of $50,000 Is this the right threshold? How will this be implemented? Rules will be needed to prevent taxpayers from multiplying the $50,000 through the use of multiple
corporations How will it apply to capital gains? Lumpy
• What portion of non‐taxable gain will go into the CDA account?
• What is passive income? Legislation required to provide clarity on what constitutes passive income
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General Comments• Proposals will reshape many long‐term savings and
retirement strategies• Will have to examine merits of maintaining a corporation• Keep current structures. Any tax planning done today
would be speculative Consider building up investments prior to new rules taking effect
• Unclear from the proposals as to whether or not rules would apply to permanent life insurance investments
• Uncertainty looms in regards to other investments:– Investing in an arm’s length private corporation (October 18,
2017 government said they will look into this)
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Converting Income Into Capital Gains
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October 19, 2017 Update – Converting Income Into Capital Gains
• Government announced that it will not be moving forward; and,
• They will be consulting to develop proposals to better accommodate intergenerational business transfers.
Observations• Concerns raised by the July 18th proposal removed for
now:– Pipeline planning– Some intergenerational business transfers– Garden variety CDA payments
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Planning Considerations
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Dividend Sprinkling 2017
• Identify shareholders affected by TOSI• Anticipate cash needs• Consider large dividend payment in 2017
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Determine the Possible Impact on you and corporate structure
• There is no one size fits all solution• First, go back to the reasons for incorporation and the structure adopted
Qualitative reasons: Limited liability (isolate personal and business transactions) Creditor protection Required to There are many owners. Track ownership and distribution of earnings Estate planning Wealth transfer Risk diversification Retirement planning
Quantitative Reasons (Tax reasons): Income splitting Ability to use the LCGE on a sale Tax deferral
• Second, determine Impact of the changes– What are the involvement of family members?– Impact on the investments
• Third, determine the course of action (some possibilities) Savings
• Use of individual retirement plans to save» RRSP ‐ will require higher salary income» IPP in a corporation
• Use of proposed passive investment thresholds Income splitting
• Rethinking remuneration going forward
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Discussion of Remuneration going forward ‐2018
• Need to consider revised proposals (not finalized)• Determine how to support dividends or salary to family members– Documentation of past and current contributions
• Timesheets?• Job description?• Evidence of work?• Employment contract?
• Review dividend vs. salary mix
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Salary to family members
• Not subject to TOSI rules– Subject to usual restrictions of the ITA (Section 18(1)(a) and Section 67)
• Subject to CPP, EI and EHT
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Dividends to family members
• If TOSI an issue:– Does each shareholder own a different class of shares?• Reorganization required?
– Look over shareholder agreements. Does it permit unequal dividend or salary payments?
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Use of Family Trusts to Hold Private Company Shares
• Trust are good vehicles – New proposals need to be considered – Income sprinkling – Need to assess if you want growth to a trust instead of
individuals• Flexibility
– Continued control– Deferral of beneficiary declaration – provides time to assess
many unknowns with respect to family realities ‐intergenerational transfer, future remuneration
– Confidentiality• Still provide flexible estate planning tools
– capital gains deferral on death
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Continued use or the use of a private corporation to hold passive investments
• Things to consider:– Continued opportunity to take advantage of the deferral to invest
• Existing assets grandfathered• $50,000 limit threshold
» Government acknowledgement of the need to invest in corporation for other than business expansion
• Possible Holdco election• Timing future distributions ‐ marginal tax rate planning to create permanent tax savings
• Corporation or separate holding company may still play a role in the accumulation of assets for retirement (BUT the ability to save here may be limited)– May be part of an overall plan which utilizes RRSP/IPP solutions as well as
corporate investments to accumulate assets• Removing passive assets from a corporation at this time is not advisable.
– These are proposals at this stage. Already changed once– Let the process play out
