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)).

2017-10 TAX CONSULTATION ON PRIVATE CORPORATIONS

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)