LSUC Practice Gems:Essentials of the Privately Held

Company 2017September 25, 2017

Top 5 Tax Issues for Private

Corporations Before & After

Incorporation

James A. Fraser, Fraser Tax Law

Title should be…

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Top 5 Tax Issues for Private Corporations

After July 18, 2017

Overview: New Rules for Private

Corporations

Summary: The Proposed Changes

Expanding Tax On Split Income (“TOSI”)

Restricting access to Lifetime Capital Gains Exemption (“LCGE”)

Preventing conversion of income to capital gains (“surplus stripping”)

New regime for taxing passive income inside the corporation

New compliance obligations

Common structures affected by the Proposed Changes

Steps to take now

Considerations going forward

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Proposed Changes: Income Splitting

Income Splitting – What is it?

Structures that allow income otherwise taxed at a higher rate to

be split among individuals (typically within a family unit) taxed at

lower rates.

Income Tax Act (Canada) (“ITA”) already has robust anti-abuse

provisions to address impermissible forms of income splitting

(e.g., the “Kiddie Tax”)

However, the ITA does not currently prevent dividend

sprinkling with adult family members (18+)

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Proposed Changes: Expanding TOSI

The proposals greatly expand TOSI starting in 2018 by:

Applying the Kiddie Tax to “specified individuals”:

Adult children and other related individuals (including spouses, grandparents, siblings & in-laws, aunts/uncles, nieces/nephew)

Subjecting more types of income to the Kiddie Tax

Income on previous split income received by individuals under 25 years old

Gains on property dispositions if income from the property would otherwise be split income

Income from certain loans to corporations, partnerships or trusts

Amounts included in income because of a benefit conferred by another person

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Proposed Changes: Expanding TOSI

Exceptions to the proposed TOSI rules:

Under age 24: property is inherited from a deceased parent (or from another deceased, if full time student or disabled)

Over age 17: is it “reasonable” relative to what would have been paid by a business to an arm’s length person, having regards to:

Functions performed by the individual

Assets contributed by the individual

Risk assumed by the individual

All historical amounts already paid to the individual

Various limitations and practical difficulties with reasonableness test

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Proposed Changes: LCGE

Currently:

Canadian residents are entitled to the LCGE, presently $835,716 indexed annually, on the disposition of “qualified small business shares” and “qualified farm or fishing property”

No age restriction (subject to arm’s length requirementfor minors)

An individual beneficiary is entitled to the LCGE oncapital gains allocated by a trust provided theunderlying property qualifies

Trust structure facilitates “multiplying the LCGE”

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Proposed Changes: LCGE

Under the Proposed Changes:

No LCGE for minors or in respect of capital gains accrued

during minority

No LCGE for capital gains allocated through most trust

structures

No LCGE for capital gains if TOSI applies (i.e., capital gain

in excess of what’s “reasonable”)

New rules apply to dispositions after 2017

Special grandfathering rules for 2018

Deemed disposition election8

Proposed Changes: Surplus Stripping

Capital gains are generally taxed a lower rates than dividends

The spread between capital gain and dividend tax rates motivates transactions and structures the effectively convert what might otherwise be a dividend into a capital gain (surplus strip out of a corporation a lower tax rate)

Often referred to as “pipeline” transactions

Up to 15% tax savings

Eliminate double taxation in post-mortem context

New anti-avoidance rules against corporate surplus stripping in ITA s.

84.1 and s. 246.1

Ability to generate and take advantage of non-arm’s length “hard basis” eliminated

Deemed dividend treatment

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Proposed Changes: Passive Income

The proposals aim to remove the perceived advantage

of corporations’ ability to make passive investments with earnings subject to lower corporate tax rates compared

to what would otherwise be the case had earnings

flowed to an individual shareholder subject to higher

personal income tax rate

In Ontario, the tax deferral provided by the small business

deduction is approx. 38%.

Provides corporations with profits to grow and reinvest in the business

Also provides a larger initial pool from which to make

passive investments

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Proposed Changes: Passive Income

Finance proposes to increase the tax on corporate “passive

investments” funded from after-tax active business earnings

Reinvestment in active business assets that generally do not

produce passive investment returns (for example, inventory) are not

supposed to be affected

How to identify, track and tax passive investments and returns

thereon

Two broad approaches outlined in the proposals:

Immediate taxation proposal

Perceived as complex

Deferred taxation proposal

Estimates put effective tax rate on passive investments at 71%

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Proposed Changes: Compliance

The proposed TOSI rules are very complex

This presentation overly simplifies the proposal

Still waiting for final legislation, but based on the drafts small business owners can expect increased annual tax

compliance and planning costs

Will be a challenge for both practitioners and CRA to

interpret, implement and audit

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Structures potentially affected by the

Proposed ChangesStructures potentially affected:

Founder shares issued to both spouses or a family trust

Need to consider activity of specified individuals.

Management income splitting structures

Accounting and law firms services corporations

Hygiene structures

Interest bearing loans to related corporation;

Past family freezes where growth shares held by non-active

specified individual shareholders

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Affected Structures: Example 1

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50% 50%

Affected Structures: Example 2

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50% 50%

Affected Structures: Example 3

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Beneficiaries: Family

members including

spouse, adult children,

minor niece Freeze shares

Growth shares

Affected Structures: Example 4

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Beneficiaries: Family

members

Affected Structures: Example 5

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100% Interest

bearing

loan

Affected Structures: Example 6

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100%

***But daughter

is the primary

service provider

Steps to take now…

Identify potentially affected structures and let your clients know

Estate freezes, professional corporations, trust and partnership structures, non-active shareholders, estates

2017 is the last chance to income split/sprinkle

Current rules apply throughout 2017

New TOSI rules (if enacted) will apply starting in 2018

LCGE crystallization transactions in 2017

Revisit any post-mortem pipeline planning under consideration

The pipeline is dead unless a special carve-out is introduced

Consider whether historical transactions may affect current planning (i.e., “hard basis”, adjusted cost base)

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Considerations going forward

Wind up private corporations and family trusts?

Maybe

Depends on tax cost of doing so, competing interests (e.g., creditor-protection)

Reorganizations

Likely needed to bring existing structures into compliance

Whether to incorporate

Tax benefits won’t factor into the decisions nearly as much

LCGE still a consideration

Lower tax cost of reinvesting profits back into the active business

Asset protection purposes and if you may be able to access even one LCGE exemption and /or you will be using profits to invest back in the business and not for passive purposes.

Use of family trusts strictly for tax purposes may no longer be useful, but may still make sense for ownership and estate planning purposes

Wait and see what final legislation looks like

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Resources

Department of Finance – “Improving Fairness in the Tax System by Closing Loopholes and Addressing Tax Planning Strategies” (18 July 2017)

http://www.fin.gc.ca/n17/17-066-eng.asp

Moodys Gartner Tax Law LLP – “What do the new July 18, 2017 Canadian Private Corporation Tax Proposals Mean for You?” (29 August 2017, PPT slides)

CPA – “#Trending in Tax: Proposals Targeting Private Corporations”(12 September 2017, webinar)

Speakers: Jay Goodis, CPA, CA, Mac Kiloran, CPA, CA & Michael Goldberg

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THANK YOU!

James A. Fraser

Fraser Tax Law

2902-2300 Yonge Street

Toronto ON M4P 1E4

416.485.4414

james@frasertaxlaw.ca

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