Department of Finance Release - Tax Planning Using Private Corporations
The Department of Finance released a proposal on July 18, 2017 that may change the landscape for Canadian small business owners.
The proposal covered three main areas that are a focus to tax planning for private corporations. The three areas highlighted are:
1) Income Sprinkling
Many small businesses are family-owned, with the entire family owning shares in the corporation directly or indirectly. There are many benefits to this not just from a tax point of view, but also for the long-term viability of the business. The Department of Finance proposed the following updates:
A) Tax on Split Income (TOSI)
Previously, TOSI had mainly been associated with the term “kiddie-tax”, which resulted in any payments to children under the age of 18 being taxed at the highest rate. The draft legislation includes a plan to expand the meaning of “specified person” and to widen the range on what is considered split income.
In order to expand the definition, they are proposing to include a reasonability test. Essentially, any money paid to family members will have to meet a ‘reasonability test’ through either work performed, capital contributed, risk assumed or previous services completed. The intention is for the reasonability test to be stricter for those aged 18-24.
B) Capital Gains Deduction
The lifetime capital gains exemption was a tool utilized by many entrepreneurs on the eventual sale of their business. This tool allowed them to shelter the gain created by growing their small business. The changes proposed would include the elimination of allocating a capital gain to minor children, as well as multiplying the lifetime capital gains exemption through the use of a Trust. This is a highly contentious issue as tax-planning commonly revolved around a structure whereby a business owner’s capital gain exemption was multiplied by their family members. This one would hurt….A LOT!
2) Passive Investments in a Private Corporation
The proposed plan for passive investments held in corporations is to prevent the use of a tax deferral by holding investments in a corporation. By using corporate tax dollars for investments, businesses are able to generate greater returns than those that are investing personally taxed funds. Rather than withdrawing funds from a corporation, being taxed personally and then investing, business owners had the option of investing directly through a corporation, using funds that have only been taxed in the corporation (which is usually lower than the personal rate).
Although unclear as to how they plan on implementing this, there is the potential for the removal of refundable tax or the requirement of businesses to track where income to fund investments has come from. All currently proposed changes would result in a substantial increase in reporting requirements.
3) Converting income to capital gains
A strategy employed by some businesses is to remove cash from a business through the use of capital gains rather than general income. As capital gains rates are lower than a dividend or salary, small business owners were benefiting from a reduced tax bill. Effective immediately, this strategy is no longer accepted by the CRA.
Although all of these are simply proposed legislation, with a period to October 2, 2017 to receive feedback, it is important to be aware of the changes, as well as the potential impact on your business. As the laws and regulations are constantly changing, it is important to be in contact with your advisor.