Since release of the Department of Finance’s Tax Consultation on Private Corporations on July 18, 2017, there has been much discussion and debate over the proposals. Below are a number of issues that have been raised, in addition to those noted in the basic discussion of the proposals (see VTN 433(5)).
Since release of the Department of Finance’s Tax Consultation on Private Corporations on July 18, 2017, there has been much discussion and debate over the proposals. Below are a number of issues that have been raised, in addition to those noted in the basic discussion of the proposals (see VTN 433(5)).
1) TAX ON SPLIT INCOME (TOSI)
Broadly, the Government is proposing to extend the tax on split income (TOSI, commonly referred to as “kiddie tax”) to persons not acting at arm’s length with the business principal(s) where amounts are considered unreasonable based on such factors as labour and capital contributed, risk assumed, and prior remuneration. The TOSI will remain inapplicable to employment income, and to portfolio investment income, except for compounding income as discussed below.
A) Reasonability of the Amounts from the Business – There is concern that the determination of whether a payment is reasonable or not will be costly and uncertain. Such concerns and questions posed relating to this determination include the following, for example:
- Should the reasonability of a dividend be based solely on risk, capital and labour as indicated in the proposal? How is one factor balanced against another?
- How does one account for the “right” input at the “right” time, luck, and factors outside the control of the shareholders?
- Can all of the profits of a successful corporation be traced to reasonable returns based on contributions? Is the amount of a reasonable dividend equal to reasonable salaries (for labour), interest (for capital), and guarantee fees (for risk) or would the reasonable dividend be lower as there is no deduction for the corporation, and a lower tax cost for the individual?
- How can a reasonable return for financing by a non-arm’s length person be determined?
The fourth component in measuring reasonability is a consideration of previous amounts received by the shareholder. This implies that the total amount of profits eligible to be reasonably distributed to each shareholder must be calculated on a historic basis. In other words, it appears as if the summary of value associated with function/labour, risk, and capital contribution from the beginning of a taxpayer’s involvement must be netted against the sum of their remuneration. It is uncertain whether contributions and receipts prior to obtaining an ownership interest would be included.
B) Paying Extra Dividends in 2017? – As the extended TOSI rules are not proposed to come into effect until 2018, some practitioners may be motivated to maximize dividend payments in 2017 to ensure access to the marginal tax rates one last time before the change. While appropriate in some circumstances, consideration should be given to non-tax and business issues that are associated with paying dividends. Such factors include:
- Impact on Future “Reasonability” Calculations – As noted above, it appears that the reasonability analysis should be done on an ongoing basis, considering past remuneration and contribution. If a large dividend is paid in 2017, it may impact the taxation of future dividends.
- Corporate Law Restrictions – Due to the provincial/territorial corporate laws, an entity may be restricted from making a dividend payment (for example, if they fall offside on a solvency or liquidity test).
- Joint and Several Liability (Section 160) – A number of Court decisions have found that dividends paid to a nonarm’s length shareholder constitute an amount that an individual receives for less that fair market value consideration. As such, if the corporation has (or will have) a tax liability at the time the dividend is paid, the dividend recipient could be held jointly and severally liable for the corporation’s debt.
- Other Familial Considerations – While family members of the business principal may be shareholders, the principal may wish not to pay a large dividend to an uninvolved adult child for a number of reasons, one of which may be for fear of “spoiling” or “ruining” the adult child.
C) Second Generation Income – Prior to the proposals, the TOSI did not apply to income earned on income (second-generation income).For example, consider a child who received $100,000 subject to the TOSI. The child could then invest the after-tax amount in certain other assets such as an investment portfolio or GIC.Investment earnings from the second corporation would not generally be subject to TOSI. Under the TCPC proposals, this second-generation income will also be split income subject to the TOSI. In addition, second-generation income will be split income where the first-generation income was subject to one of various provisions (Sections 56, 74, or 74.1 to 74.5) attributing it to a different taxpayer.
As well, investments acquired with funds received from capital dividends will be subject to the same TOSI rules if taxable dividends on the share would have been subject to either TOSI or the attribution rules.These rules will apply to individuals up to age 24. Similar rules
will apply to investments held through trusts.D) Significant Impact on Low Income
D) Significant Impact on Low Income Earners – Consider a small corporation with $70,000 in earnings.Assume that the shares are held 50/50 between a married couple; however, only one is involved in the company while the other is not. Also, assume that $10,000 in corporate tax is paid and $30,000 in ineligible dividends is paid to each spouse. In the past, there would be nominal personal tax and $10,000 in corporate tax. Essentially, the family unit would net $60,000. Had the $70,000 been earned directly by one spouse as an employee,the family’s total tax bill would be roughly the same.
Under the proposed TOSI rules, the $30,000 received by the nonparticipating spouse will now be taxed at the top non-eligible dividend rate. In Ontario in 2017, for example, the applicable rate is 45.3%. This would increase the family’s total tax liability to approximately $23,590 ($10,000 corporate tax, plus $13,590, 45.3% of $30,000). As such, families with mid to low incomelevels will have to be extremely diligent to not pay out “unreasonable” dividends subject to the TOSI.
Further, while it is easy to determine that nothing should be paid to a family member with no participation, determining what would be reasonable amounts for some activity is much more challenging.Although a salary will be non-deductible to the extent it is unreasonable, the cost of added corporate tax, especially if the small business deduction is available, will be significantly less than the cost of TOSI where a family member has lower income levels.
E) Unincorporated Business – While much of the focus has been on the impact of these proposals on private corporations, even unincorporated entities such as partnerships and trusts may be impacted. In some cases, two or more individuals may be carrying on a business as a partnership without realizing it as such. Even partnerships without a formal Partnership Agreement may be impacted.
F) Business Structures – Consideration should be given to the rights and classes of the shares of a corporation. If both spouses have the same class of shares, it may not be possible to differentiate dividend payments between spouses. As such, consideration may be given to reorganizing the corporate structure such that each spouse has a separate class of shares and/or to remunerate the participating member via salary.Likewise, attention should be paid to a Partnership’s Agreement as it may dictate how profits should be allocated to partners. This Agreement may restrict partners from using discretion in allocating amounts.
2) SHARE SALES
A) Gains subject to TOSI – The lifetime capital gains exemption (CGE) will not be available, or limited, in a number of scenarios, such as where the asset to be sold generated income that was subject to TOSI. Consider a nonparticipating spouse that acquires a share in the corporation.Any gains accrued on the shares disposed that are considered to be “unreasonable” are not eligible for the lifetime CGE.
B) Non-Arm’s Length Share Sales – “Unreasonable” capital gains which arise from dispositions to a non-arm’s length person may also be converted to ineligible dividends(Subsections 120.4(4) and (5)). As those gains are considered TOSI, they are subject to tax at the highest rate, and no personal tax credits can be applied.
3) CONVERTING INCOME INTO CAPITAL GAINS (SECTION 84.1)
A) Elimination of Pipeline Planning on Death – Prior to the TCPC proposals, where an individual died holding shares of a private corporation, the individual or their Estate would generally be subject to capital gains (pipeline planning) or deemed dividend (Subsection 164(6) loss carryback planning) taxation.
However, the proposed extension of Section 84.1 will result in the non-arm’s length acquirer (the Estate in this case) not inheriting the seller’s (the deceased individual’s) hard adjusted cost base, even though capital gains tax had already been paid on the deemed disposition at death. This results in the typical previous “pipeline” planning, where only capital gains taxation is experienced, being eliminated. The proposals will effectively result in double tax, a capital gain on the deemed disposition of the private corporation shares at
death, and a deemed dividend in the Estate.
B) Payment to a Non-Arm’s Length Individual (Section 246.1)– In general terms, proposed new Subsection 246.1(1) provides that an individual is deemed to have received a taxable
dividend in a taxation year equal to the portion of an amount received or receivable by the individual in the year where:
- the individual is a Canadian resident individual;
- the individual received the amount from a non-arm’s length person;
- as part of the series, there is a disposition of property or an increase or reduction in paid-up capital; and
- one of the purposes of the transaction was to effect a significant reduction or disappearance of assets of a private corporation in a manner which avoids tax otherwise payable.
This provision is worded broadly and may apply in a significant number of scenarios. While it appears that the purpose of the provision is to prevent the removal of corporate value at reduced tax rates, the effect is that identified amounts received by an individual from the corporation may be considered taxable dividends.
Some commentators have expressed concern that the payment of a capital dividend to a shareholder may get caught under these provisions, resulting in a tax-free capital dividend to be deemed to be a taxable dividend. Similarly, the repayment of a shareholder loan could be caught. There are also concerns that proceeds from a corporate owned life insurance policy may also fall afoul of these provisions, such that no amount is added to the capital dividend account (currently, the proceeds less adjusted cost basis is added). This could significantly impact estate planning and whether there is adequate life insurance to fund a buy-out or redemption of shares.
4) NUMBERS/FACTS IN THE MEDIA
A) The 73% Tax Rate on Passive Earnings? A number of commentators have noted that certain earnings on passive investments would be taxed at a 73% rate. The proposals suggest a couple of alternatives to taxing earnings on passive investments where the capital for the investments is derived from active business income. One alternative considers eliminating the refundable portion of the corporate investment tax. By doing so, after considering corporate tax and personal tax on the dividend paid to the shareholder, the effective tax rate on these earnings is about 73% (for an individual in the top marginal bracket).
This change is intended to equalize the after-tax cash retained by an individual who invests funds on which personal tax, and not the lower corporate tax rate on active business income, has been paid. As an individual’s personal marginal tax rate decreases, the total tax rate would decrease. However, the result will be less after-tax cash retained by lower income individuals who invest in a corporation, rather than personally, with the disadvantage growing the lower their average personal tax rate.
B) The $150,000 Income Earner is not Impacted?A number of Government officials have stated either that the proposals will either not affect, or not be targeted at, those earning less than $150,000. While the proposals are very broad, it is likely that these statements were made in respect of the passive income proposals. Government officials have clarified that earned income up to this level would create maximum RRSP contribution room ($145,722 in 2017 earnings will generate maximum contribution RRSP room for 2018). In addition, TFSA contribution room for the year will allow for a tax-free savings plan. Earnings beyond this point will not generate further RRSP contribution room. As such, those earning less than this level should not be impacted, due to alternative mechanisms to save and defer tax.
Tax paid by the $50,000 vs. $250,000 Income Earner A high-ranking Government official has stated that a person earning $50,000 a year should not pay higher taxes than people who make $250,000 a year. As no public comment has yet been made to provide an explanation as to how this claim would be achieved, a number of commentators have tried to determine a scenario where the above may exist.An individual earning $50,000 in wages would pay roughly $8,300 in personal tax (in Ontario in 2017). A corporation earning $250,000 at the lowest rate of 15% would pay $37,500 (in Ontario in 2017). Therefore, the overall tax would be greater for the $250,000 earner in a corporation than that of the $50,000 earner, even before any personal tax is considered.If the comment was made in the context of a tax rate rather than the total absolute tax amount, a former Chair of the Canadian Tax Foundation, Kim Moody, opined that income splitting would have to be conducted amongst 17 persons to achieve the claim (stated to the Minister of Finance at the CPA One Conference on September 24, 2017)
