It is the federal government’s perception that certain tax planning strategies have given private corporations an unfair tax advantage, especially high income individuals. As a result, on July 18, 2017 the government issued a consultation paper that specifically targets private corporations in three areas of tax planning:
In my April, 2017 article I explained how income splitting works. To quickly summarize this taxation approach, a corporation issues dividends (or ‘pays’) to a shareholder who may or may not be active in the company. This dividend income is assessed at a low tax rate. Under the government’s current proposal, any such dividends which exceed a “reasonable amount” will be taxed at the top federal marginal tax rate of 33%. For example, if the wife is active in the family-owned company and her lower tax rate husband is not, unless the husband contributed other assets to the corporation or is personally at risk, any dividend that is issued to the husband will be taxed at the highest federal tax rate. The amount that is considered reasonable (an amount which would be paid to an arm’s length party for the same contribution) is still eligible for the “income splitting” of old.
Family trusts that hold shares of a private corporation are also targeted. Any gains that would otherwise have been reduced by the multiplication of the lifetime capital gains via multiple beneficiaries will be eliminated. The proposals include transitional rules and an election procedure to crystallize how businesses affected will proceed with this moving forward.
Dividends to children, nieces and nephews (between the ages of 18 and 24) of the principal owner of a private corporation will be subject to a stricter test of reasonability than an adult aged 25 or older. What constitutes a ‘reasonable amount’ of dividends to this age group will be limited to what an unrelated individual would be paid for the same functions performed, or a rate of return on a contributed capital to that of the prescribed rate (currently 1%), or a combination thereof. Any amount in excess of a reasonable amount will be taxed at the highest marginal tax rate.
Holding passive investment portfolios inside a private corporation is also targeted under the federal government’s proposal. Investment income inside a private corporation is already taxed at the highest rate – the tax rate in British Columbia on investment income is 49.67%, while that same income would be taxed at 47.70% if held personally. What offends the government is that a corporation has more after-tax funds to invest than those of an individual. This is the result of the corporation paying tax at rates from 13% to 26%, whereas a sole proprietor could be paying tax from 0% to 47.70% in British Columbia. You can refer to my March, 2017 article that goes into more detail on this.
The government believes, and proposes to eliminate the refundable dividend tax and the capital dividend account as a means to equalize the playing field between individuals and corporations. In reality, this will create double taxation on the investment income earned in a corporation.
The federal government has proposed new and amended rules to prevent surplus stripping of corporations. They prefer that corporations distribute surplus through taxable dividends. Taxpayers would ordinarily undertake tax planning to reduce their overall tax burden. The proposed rules severely limit or reduce a taxpayer’s ability through tax-planning to convert what otherwise would be taxable dividend income (taxed at 31.3% if the dividends are eligible and 40.95% otherwise in British Columbia) into capital gains (23.85%) or tax-free receipts (capital dividends or repayment of shareholder loans).
The federal government’s proposals are open to comment until October 2, 2017. These new rules are complex and the information above only provides a surface view of the proposed changes. There are a number of specifics the government still needs to work through. They also wish to further consider gender implications, and will hopefully provide further specifics in this area in the near future.
BDO will be submitting feedback to the government on these targeted and complex changes on behalf of our clients. We welcome your views on the proposals that have been released. Please check back for more information in future articles or contact me at BDO directly to help determine the impact of the proposals on your private corporation tax planning.
Article provided by:
Jonathon (Tug) McGraw, BCOMM, CPA, CA
BDO Canada LLP
Jonathan can be reached at: firstname.lastname@example.org