Owners of private corporations should be concerned about proposed tax changes being explored by the Department of Finance. In the Federal Budget of March 2017, Finance expressed their concern that private corporations were being used by high income Canadians to obtain tax advantages that were not available to other Canadian tax payers. That concern led to the release of a consultation paper along with draft legislation last July. Finance asked for input from interested parties and stakeholders during a consultation period that ended in October 2017.
What happens now is anyone’s guess and most likely, we will probably have to wait until the Spring to find out. There were three specific tax planning strategies employed by private corporations that the department was most concerned with:
- Sprinkling income using a private corporation;
- Holding a passive investment portfolio inside a private corporation;
- Converting a private corporation’s income into capital gains.
During the consultation period a large number of interested parties and stakeholders made submissions to Finance with respect to the consultation paper and draft legislation. In addition, on December 13, 2017 the Standing Senate Committee on National Finance released its report and recommended that the proposals related to income sprinkling and passive investments be withdrawn or deferred until 2019. We will have to wait to see if this report has any impact.
In the meantime, Finance has released draft legislation which clarifies their position on the above three issues.
Sprinkling income using a private corporation
Income tax paid on income from a private corporation can be greatly reduced by causing that income to be received in the form of dividends by individuals who would pay tax at a much lower rate or not at all. These dividends are usually paid to adult children or other family members who are shareholders of the private corporation or to a family trust. By “sprinkling” the income in this manner, the amount of income tax paid can be greatly reduced.
A recent clarification indicates that the government intends to expand the TOSI (taxation of shareholder income) rules by extending the “kiddie tax” (tax paid on income and dividends paid to children under the age of 18) to include adults up to the age of 25. There may be exceptions to those who are actively engaged at work in the business.
Individuals over the age of 25 may also be affected by the new proposed rules – for example spouses who are not actively engaged in the business.
Holding a passive investment portfolio inside a private corporation
One of the reasons to have a private corporation is to retain income that is not required for living and lifestyle expenses. Since the tax rate on business income is lower than personal tax rates this allows the surplus to be invested eventually resulting in a much larger investment portfolio than if it had been accumulated by investing personal after-tax income.
Finance has subsequently announced that there will be a threshold of $50,000 annual passive income. This amount was derived by equating it to the income of $1 million generating a 5% rate of return. Any amounts over this threshold would be taxed punitively.
Converting a private corporation’s income into capital gains
Income from a private corporation is usually taxed as either salary or dividends. The government is concerned about a financial manoeuver that has been employed through a series of private corporation transactions that result in corporate distributions being taxed as a capital gain.
For now, the government has backed off on this provision but may reconsider it in the future.
Very soon we should have a release of the final legislation and a full understanding of how private corporations will be affected. In the meantime, if you are a business owner continue to consult with your professional advisors and determine what measures you may have to take.