Canadian Tax Foundation September 25, 2017

Transcription

1 . TAX PLANNING USING PRIVATE CORPORATIONS Canadian Tax Foundation September 25, 2017

2 Outline Policy context Historical context: current rules Consultations: approaches put forward for discussion Key questions for discussion Department of Finance September

3 Taxable Active Income / GDP Increasing Incentives for Tax Planning Using a Private Corporation The growing gap between corporate and personal income tax rates since 2000 has increased rewards associated with tax planning in a private corporation Over this period, a growing share of high-income self-employed individuals have chosen to incorporate 55% Federal-Provincial Tax Rates Trend in Taxable-Active-Income-to-GDP Ratio, by Type of Business 50% 8% 45% 40% 35% 30% 25% Top Combined Federal-Provincial Personal Income Tax Rate: 51.6% (2017) Combined Federal-Provincial General Corporate Income Tax Rate: 26.7% (2017) 37.2 percentage point gap (2017) 7% 6% 5% 4% 3% 2% 20% 1% 15% 10% 5% Combined Federal-Provincial Small Business Rate: 14.4% (2017) % Canadian Controlled Private Corporations (CCPCs) Public Corporations and Private Corporations other than CCPCs Individuals with Self-employment Income Department of Finance - July

4 Integration Low corporate tax rates on business income are intended to provide a tax advantage as long as income is retained for active business reinvestments. Income that is paid out of a corporation as a dividend is generally meant to be subject to the same amount of tax as income received directly by the individual. Corporate taxes on earnings + Personal taxes on dividends = Personal taxes on income earned directly Integration issue: incentive to hold savings financed by retained earnings within corporations to save taxes This issue was recognized in 1972 Department of Finance - July

5 Historical context: Current rules Current system introduced in 1972 Refundable taxes on investment income ensure integration when business owner uses after-tax income to finance a passive portfolio within a corporation In 1972, the introduction of Part V tax ensured integration when using retained earnings to finance a passive portfolio Part V tax repealed on the basis that: It was seen as complex This added complexity was believed not necessary I believe that these small corporations which enjoy the benefit of the lower rate of tax will, in fact, use these savings to expand their businesses, to improve their technology and to create more jobs for Canadians Department of Finance - July

6 Consultations Government is seeking input on best manner to eliminate deferral advantages going forward Paper lays out two broad approaches: Reintroduction of Part V tax, with adjustments Introduction of a deferred taxation model - A deferred taxation model could take various forms, two of which are described in the paper: Apportionment approach Elective approach Department of Finance - July

7 Reintroduction of Part V Tax Imposition of an upfront tax when retained earnings are used to acquire passive investments This additional tax would bridge the gap with top PIT rate - For example, a business eligible for the small business deduction would pay a 35% additional tax at the time of acquisition of portfolio assets Tax refundable if later on assets are used to reinvest in the business Need to keep track of income streams in order to apply the appropriate amount of tax when investment assets are purchased Passive investment income would continue to be taxed as per current rules Department of Finance - July

8 Deferred Taxation Model: Apportionment Approach Need to track source of financing for passive investments in order to estimate deferral Affects businesses at the moment of dividend payout: Affects tax outcomes at the moment a dividend is paid out, rather than when an investment asset is acquired - But in effect, same overall outcome as Part V tax Those saving to reinvest in their business not materially affected Precision in tax outcomes, tailored to various business situations Department of Finance - July

9 Deferred taxation model: elective approach Minimizes needs for tracking, in favour of proxy methods Default tax treatment tailored to the case of a business using retained earnings to finance portfolio investments Elections available for businesses with general rate income Under both approaches, options to keep current tax regime available when investments finance with savings taxed at the personal level Department of Finance - July

10 Key questions for discussion Government is seeking feedback, in particular: What is the best approach to tackle the issue? How to minimize complexity, while achieving policy objectives? Capital dividend account: what is the appropriate scope of the new tax regime with respect to capital gains? Transition issues Department of Finance - July

11 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Income Sprinkling and Conversion of Dividends into Capital Gains Ted Cook, Director Tax Legislation Division Department of Finance (Canada) Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials.

12 Taxation of Private Corporation Policy Conference INCOME SPRINKLING

13 Income Sprinkling Overview Tax-planning arrangements under which income that would otherwise have been taxed as income of a high-income individual in the absence of the income sprinkling arrangement is instead taxed as income of a lower-income individual, typically a family member of the high-income individual The intended effect of the arrangement is to have the income subject to a lower or nil effective rate of income tax by accessing otherwise unused tax attributes of the lower-income individual Tax benefits from income sprinkling increase with: The difference in tax rates between the transferor and the transferee The amount of income that can be sprinkled The number of individuals who can receive the sprinkled income Taxation of Private Corporation Policy Conference

14 Income Sprinkling Example Base Scenario: Self-employed Net self-employment earnings of $220,000 CCPC Owner Owner Spouse Child Federal CIT (10.5%) n/a $23,000 n/a n/a n/a Provincial CIT (4.5%) n/a $10,000 n/a n/a n/a Federal PIT $49,000 n/a $11,000 $200 $200 Provincial PIT (ON) $30,000 n/a $9,000 $500 $500 Total tax $79,000 Average tax rate 36% Net profits of $220,000 Incorporated Post-CIT $187K dividend allocated 60%/20%/20% among Owner, Spouse and Child $112,000 $37,000 $37,000 $54,000 25% In base scenario, net earnings are taxable at full PIT rates in the hands of the self-employed individual In the scenario where the individual incorporates, the after-cit profits are paid out as dividends to the owners of the CCPC, including the individual s spouse and adult child Taxes are reduced because the spouse and adult child do not pay federal tax on the dividend income Taxation of Private Corporation Policy Conference

15 Non-eligible dividends ($ million) Income Sprinkling Dividends by Age 1, Age Taxation of Private Corporation Policy Conference

16 Income Sprinkling Issue The use of a private corporation in particular facilitates income sprinkling arrangements Income sprinkling raises a number of tax policy concerns High income individuals able to control income and to whom it is paid can obtain tax benefits not available to those who do not control income Erodes tax base Taxation of Private Corporation Policy Conference

17 Income Sprinkling Existing Rules Existing rules that constrain income sprinkling Longstanding rule restricts the deduction of expenses (including salary) if amount not reasonable Attribution rules apply to gift arrangements to redirect income back to the high-income individual Tax on split income (TOSI) introduced in 1999 Existing rules not fully effective in constraining sprinkling with adults Attribution rules apply to spouses, but tax planning can circumvent the rules Limited rules to address arrangements involving other adults (such as children) Jurisprudence has limited the effective scope of some of the rules: 1998 Neumann decision (Supreme Court of Canada) Some structures have been identified that seek to circumvent the TOSI rules applicable to minors Taxation of Private Corporation Policy Conference

18 Income Sprinkling LCGE Multiplication The Lifetime Capital Gains Exemption (LCGE) provides an exemption in computing taxable income in respect of capital gains realized by individuals on the disposition of qualified farm or fishing property (QFFP) and qualified small business corporation shares (QSBCS) By having family members (or a family trust) as shareholders of the QSBC, the LCGE limit of each family member can be accessed on a disposition of the QSBCS This raises a concern the individuals may be able to claim the LCGE even though they may not have invested in, or otherwise contributed to, the business value reflected in the capital gains from the disposition of the QSBCS Taxation of Private Corporation Policy Conference

19 Income Sprinkling Proposals to address income sprinkling Policy Response Expand TOSI rules to Canadian resident individuals, whether minor or adult, who receive split income Refine split income definition Include new categories of amounts, such as corporate debt Income received by an individual over 17 from a corporation will only be split income if a related individual (a connected individual ) has a certain measure of influence over the corporation Introduce a reasonableness test to determine whether split income received by an individual over 17 will be subject to the TOSI The test is more stringent for individuals between 18 and Taxation of Private Corporation Policy Conference

20 Income Sprinkling Policy Response LCGE Multiplication Proposals to address LCGE multiplication Individuals will no longer qualify for the LCGE in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual attains the age of 18 years The LCGE will generally not apply to the extent that a taxable capital gain from the disposition of property is included in an individual s split income Subject to certain exceptions, gains that accrued during the time that property was held by a trust will no longer be eligible for the LCGE Transitional rules would allow affected individuals to elect to realize, on a day in 2018, a capital gain in respect of eligible property by way of a deemed disposition for proceeds up to the fair market value of the property Taxation of Private Corporation Policy Conference

21 CONVERSION OF DIVIDENDS INTO CAPITAL GAINS Taxation of Private Corporation Policy Conference

22 Conversion of Dividends Taxation of Private Corporation Policy Conference Overview Dividends are taxed at a higher rate than capital gains, which are only one-half taxable Individual shareholders can reduce their income taxes by converting corporate income (e.g., amounts that would otherwise be paid out as dividends) into capital gains The federal and provincial tax savings in 2016 associated with converting dividends into lower-taxed capital gains is approximately $17,500 per $100,000 of conversions of ineligible dividends (at the average/highest provincial tax rate for ineligible dividends paid from corporate earnings taxed at the small business rate) $11,100 per $100,000 of eligible dividends (at the average/highest provincial tax rate for eligible dividends paid from corporate earnings taxed at the 15% general rate)

23 Conversion of Dividends Section 84.1 Dividend Treatment (applicable) Section 84.1 addresses individual tax avoidance that can arise when an individual sells shares of a Canadian corporation to another corporation related to the individual (e.g., owned by individual, spouse, siblings, children/grandchildren) Such share sales could, absent section 84.1, be used to convert dividends in the hands of the individual into lower-taxed capital gains, including gains eligible for the Lifetime Capital Gains Exemption (LCGE) This is because the related corporation could pay the individual with the proceeds of a dividend from the Canadian corporation, which the related corporation can receive taxfree because the inter-corporate dividend deduction is available To prevent this result, the proceeds from the share sale are treated as a taxable dividend and not as a capital gain if section 84.1 applies Taxation of Private Corporation Policy Conference

24 Conversion of Dividends Section 84.1 Capital Gains (inapplicable) Section 84.1 does not apply on a sale of shares by individuals to their children, to any other related individual, or any arm s length person Individuals can claim capital gains treatment including the LCGE, where available on a direct sale of shares to their children It is not necessary for section 84.1 to apply in this case because the individual purchaser would face dividend taxation if they attempt to withdraw earnings of the corporation Taxation of Private Corporation Policy Conference

25 Conversion of Dividends Avoidance of Section 84.1 (cont d) The conversion of dividends into lower-taxed capital gains ineligible for the LCGE benefits owners of both large and small private corporations Section 84.1 applies only to sales by individuals to corporations and can be avoided Taxation of Private Corporation Policy Conference

26 Conversion of Dividends Intergenerational Business Transfers It is argued by some that existing section 84.1 should be loosened with respect to the LCGE to facilitate intergenerational business transfers The tax policy concern regarding intergenerational business transfers is distinguishing a genuine sale, where the children carry on the business, from a sale that facilitates the conversion of dividends into capital gains Taxation of Private Corporation Policy Conference

27 Conversion of Dividends Policy Response Proposed amendment to section 84.1 to address multi-step planning Proposed introduction of a supporting anti-avoidance rule to address other transactions that could be used to convert dividends into capital gains Comments sought regarding whether, and how, it would be possible to better accommodate genuine intergenerational business transfers while still protecting against potential abuses Taxation of Private Corporation Policy Conference

28 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Passive Income: Historical and Legislative Context and Comments Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials. Speaker name: David G. Duff Affiliation: Allard School of Law, University of British Columbia

29 Passive Income: Historical and Legislative Context and Comments Background to Proposals long-term reductions in corporate rates (general and small business) and recent increases in personal rates incentive to earn and retain income in a corporation (both for business and non-business purposes) lower tax on capital gains than dividends with LCGE and 50% inclusion rate incentive for surplus stripping individual unit and progressive rates incentive for income-splitting and multiplication of LCGE, facilitated by SCC decision in Neuman (1998), limited scope of TOSI in section 120.4, and provincial regulatory changes Taxation of Private Corporation Policy Conference

30 Passive Income: Historical and Legislative Context and Comments Is there a problem? 50% growth in CCPCs from 2001 to 2014 substantial increase in ABI of CCPCs as a share of GDP and decrease in self-employment income as a share of GDP revenue losses, efficiency/neutrality concerns, and implications for tax fairness (horizontal and vertical equity) are all these tax benefits necessary to encourage small businesses? Taxation of Private Corporation Policy Conference

31 Possible Structural Reforms Passive Income: Historical and Legislative Context and Comments reduce personal rates, increase corporate rates, adopt a single corporate rate, and/or adopt a dual rate income tax with higher and progressive rates on labour income and a lower flat rate on capital income repeal LCGE and increase capital gains inclusion rate to restore symmetry between effective tax rate on capital gains and dividends flatten rates and/or adopt a spousal or familial unit either generally or for specific tax benefits like the LCGE Taxation of Private Corporation Policy Conference

32 Passive Income: Historical and Legislative Context and Comments Alternatives to Structural Reforms rules denying low corporate rates (and LCGE) to specific categories of taxpayers, to income other than active business income (passive income), and/or to income used to acquire assets not used in an active business (passive investments) anti-avoidance rules to prevent surplus stripping attribution and other rules (like the TOSI) to regulate income-splitting and multiplication of LCGE Taxation of Private Corporation Policy Conference

33 Passive Income: Historical and Legislative Context and Comments Rules Excluding Specific Kinds of Taxpayers personal services businesses (incorporated employees) excluded from SBD after November 12, 1981 > 5 FTE exception (arm s length until 1984) additional 5% federal tax applicable after 2015 (so 33%) non-qualifying businesses (professional practices of accountants, dentists, lawyers, doctors, veterinarians, chiropractors and certain services businesses) excluded from SBD from 1979 to 1984 Quebec approach limits SBD to primary and manufacturing businesses or businesses with a minimum number of employees (at least 5,500 hours) Taxation of Private Corporation Policy Conference

34 Passive Income: Historical and Legislative Context and Comments Higher Rates on Passive Income portfolio dividends received by private or subject corporations refundable Part IV tax (similar to effective tax rate on non-eligible dividends) investment income of a CCPC not eligible for SBD, additional tax under section 123.3, partly refunded (but not fully integrated) includes income from property, income from a specified investment business [> 5 FTE exception], and net taxable capital gains excludes income from property incident or pertaining to an active business or used or held principally for the purpose of gaining or producing income from an active business cases generally recognize reasonable reserves for business purposes but not passive investments for later investment in active business Taxation of Private Corporation Policy Conference

35 Passive Income: Historical and Legislative Context and Comments Higher Rates on Income Used to Acquire Passive Investments refundable tax on ineligible investments enacted in 1972 and retroactively repealed in 1973 not actively considered by the Government at the present time due to liquidity issues alternative approach: deferred taxation with no dividend refund for tax on investment income, and tax on dividends (including dividends from the nontaxable portion of capital gains) based on the source of the capital used to acquire passive investments (apportionment or elective methods) consultation on any aspect of possible rule to tax corporate passive income Taxation of Private Corporation Policy Conference

36 Passive Income: Historical and Legislative Context and Comments Comments on Passive Income Proposals (1) deferral advantage from passive investment of retained corporate income is a legitimate concern, particularly for high-income earners who have already maxed out on tax-favoured savings vehicles deferred taxation is conceptually ingenious but not intuitively obvious and extremely complex (particularly for CCPCs) refundable tax on ineligible investments is more easily understood, much less complex, and more clearly consistent with the core purpose of the SBD to help CCPCs grow through internal finance Taxation of Private Corporation Policy Conference

37 Passive Income: Historical and Legislative Context and Comments Comments on Passive Income Proposals (2) tax on ineligible investments puts pressure on distinction between passive investments for business purposes and passive investments for personal wealth accumulation passive investment to finance later expansion? passive investment to finance parental leave? passive investment with mixed purposes (retirement and business emergencies)? consider combining a tax on ineligible investments with safe harbours or a threshold, which might also help address liquidity issues Taxation of Private Corporation Policy Conference

38 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Integration and the Taxation of Passive Income: An Economic Perspective Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials. Speaker name: Kevin Milligan Affiliation: Vancouver School of Economics University of British Columbia kevin.milligan@ubc.ca

39 Integration and Passive Income: An Economic Perspective Carter Commission V.4, p. 84 The system would neither encourage nor discourage the retention of earnings by corporations Taxation of Private Corporation Policy Conference

40 Integration and Passive Income: An Economic Perspective Roadmap Why integration? Do proposals improve integration? How much will the changes affect businesses? Caveats on Implementation Taxation of Private Corporation Policy Conference

41 What is Integration? Integration and Passive Income: An Economic Perspective Tax at individual level should reflect tax paid at corporate level. Or, all paths for a $ from profit to pocket should bear same tax. Also, no financial gain from readjusting location of savings. The system would neither encourage nor discourage the retention of earnings by corporations Taxation of Private Corporation Policy Conference

42 Integration and Passive Income: An Economic Perspective Why Integration? Neutrality: Target is for people to make same decisions under taxation as they would without taxation. This is a free-market goal: business decisions based on the business merits. This is the literal definition of economic efficiency for taxation Taxation of Private Corporation Policy Conference

43 Why Integration? Integration and Passive Income: An Economic Perspective Neutrality: Target is for people to make same decisions under taxation as they would without taxation. This is a free-market goal: business decisions based on the business merits. Retirement savings? Maternity leaves? Buffer savings? Saving for investment? These are all fine, but inside/outside firm should be a business decision Taxation of Private Corporation Policy Conference

44 Why Integration? Integration and Passive Income: An Economic Perspective Neutrality: Target is for people to make same decisions under taxation as they would without taxation. This is a free-market goal: business decisions based on the business merits. Retirement savings? Maternity leaves? Buffer savings? Saving for investment? These are all fine, but inside/outside firm should be a business decision. Reminder: the reason we have SBD is to facilitate investment. Not as a place to tax-advantage savings for those with large portfolios Taxation of Private Corporation Policy Conference

45 Integration and Passive Income: An Economic Perspective Ways Current Integration Falls Short It s notional: still get DTC when firm pays no tax. Can do direct passthrough of tax bills, e.g. Taiwan; franking in Australia Fed-Prov: one national gross-up rate for whole country. Tax-exempts like pension funds / RRSPs can t claim DTC. Capital gains rate is currently too low compared to dividends/wages. Firms claiming SBD have head-start deferral advantage for saving Taxation of Private Corporation Policy Conference

46 Does Proposal Improve Integration? Focus on high bracket: why? Integration and Passive Income: An Economic Perspective Flat rate on passive income calibrated for high-bracket investors. High-bracket investors more likely to have substantial passive portfolios. Low-mid bracket investors Currently disadvantaged for passive saving in CCPC. This shortcoming not addressed. More likely to have open RRSP/TFSA room for long-term savings Taxation of Private Corporation Policy Conference

47 Integration and Passive Income: An Economic Perspective Does Proposal Improve Integration? Current system is over-integrated: favours retained earnings inside firm. Current tax of passive income inside/outside firm is comparable but But savings inside the firm get a head start from light taxation of SBD. Proposed correction: remove RDTOH. Increases tax on passive income to compensate for head start. For a high-bracket Ontario investor, effective rate on passive income is 73%. Excessive? Need higher rate to balance big head start to achieve integration Taxation of Private Corporation Policy Conference

48 Integration and Passive Income: An Economic Perspective Does Proposal Improve Integration? Evidence #1: Try to replicate Finance Table 7 STATUS QUO STATUS QUO PROPOSAL INSIDE INDIVIDUAL INSIDE CCPC CCPC ITEM RATE SAVINGS SAVINGS SAVINGS Start with $100 of pre-corp tax active businss income Federal SBD tax rate 10.50% Ontario SBD tax rate 4.50% Starting Principal Interest at 3% 3.00% Special tax on passive income 50.17% RDTOH account 30.67% 8.37 Federal personal tax 33.00% ONT personal Tax 20.53% 7.00 Portfolio value at end of 10 years Refund of pre-paid tax RDTOH 8.37 Amount available for distribution as dividend Taxable personal income after grossup 17.00% Federal personal tax 33.00% ONT personal tax 20.53% Dividend tax credit, federal 10.52% Dividend tax credit, ONT 4.30% After-Tax Net Worth after 10 years Taxation of Private Corporation Policy Conference

49 Evidence #2: Observation Integration and Passive Income: An Economic Perspective Does Proposal Improve Integration? If system is currently properly integrated, there should be no advantage to retaining earnings. We observe financial planners advising clients to save in CCPC for tax savings. If system were today properly integrated, all that advice would be wrong Taxation of Private Corporation Policy Conference

50 How much will proposals matter? We need to keep the scale of the change in mind. Integration and Passive Income: An Economic Perspective Imagine $100,000 in passive portfolio; 5% interest. RDTOH is 30.67%, or $1,534. But this is taxed as non-eligible dividend at 45.30% (Ont, high bracket) So, RDTOH is worth $838 if paid immediately. This is <1% of principal, but knocks down rate of return. After 10 years, could affect terminal value of portfolio by 8-15% Taxation of Private Corporation Policy Conference

51 Integration and Passive Income: An Economic Perspective How much will proposals matter? Target savings: $33,333/yr of retained earnings over 3 5% interest. Maternity leave? Savings for new equipment? STATUS QUO STATUS QUO PROPOSAL PERSONAL INSIDE CCPC INSIDE CCPC ITEM TAXABLE Balance in RDTOH notional account at end of Year 3 $3,118 $0 Balance in CCPC retained earnings at end of Year 3 $0 $105,067 $105,067 No change to cash flow. $3,118 in RDTOH notional account Taxation of Private Corporation Policy Conference

52 Integration and Passive Income: An Economic Perspective How much will proposals matter? Terminal value of these savings once personal tax is paid. PERSONAL INSIDE CCPC INSIDE CCPC ITEM TAXABLE Balance in RDTOH notional account at end of Year 3 $3,118 $0 Balance in CCPC retained earnings at end of Year 3 $0 $105,067 $105,067 Balance on personal account at end of Year 3 $58,370 $59,189 $57,483 Status quo: CCPC beats personal by $819. Proposal: Personal beats CCPC by $ Taxation of Private Corporation Policy Conference

53 Integration and Passive Income: An Economic Perspective Carter Commission V.4, p. 84 The system would neither encourage nor discourage the retention of earnings by corporations Taxation of Private Corporation Policy Conference

54 Lots of important challenges await Caveats on Implementation Transition: how the grandfathering will work. Intercompany shareholdings; investments. We will hear more today! Integration and Passive Income: An Economic Perspective This is serious: Need to weigh the costs and benefits of proposals. Finance s response: are there non-messy fixes? Taxation of Private Corporation Policy Conference

55 Final thought This package is clearly a patch on a messy system. Integration and Passive Income: An Economic Perspective Should we wait for Carter 2.0 before acting? If we can t have it all, should we do anything? I argue: no We can all play fantasy tax reform. We must also ask: does this improve on status quo? Taxation of Private Corporation Policy Conference

56 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Tax Planning Using Private Corporations: Passive Income Jack Mintz The School of Pubiic Policy University of Calgary Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials.

57 Passive Income Rules Economic role of passive assets: Retained earnings held in passive assets provides liquidity. Provides equity finance for investment investment has been shown to be higher if firms have cash flow. Internal resources enable better firms to separate themselves from poor quality firms to raise equity and debt finance. Passive assets improve credit risk. Passive asset provides savings within the corporation for investors when withdrawn (this is the focus of the July 18 th proposals) Taxation of Private Corporation Policy Conference

58 Passive Income Rules Benefits of July 18 th Passive Income Rules Intent is to improve integration of corporate and personal taxes by clawing back deferral if active business income is invested in passive assets. Reduces (but does not achieve fully) neutrality between savings held inside and outside the CCPCs by investors. Reduces the incentive to create CCPCs rather than sole proprietorships or partnerships (no particular evidence provided on the size of the distortion U.S. studies (e.g. Austin Goolsbie suggest not large). Raises more revenue for government to lock-in high personal income tax rates levied in About $23 billion of passive income is roughly 16% of active business income (total industry passive income is 10% of operating income) Taxation of Private Corporation Policy Conference

59 Passive Income Rules Distortions/Complexity created by Passive Income Rules 1. Given limitations on full refundability of losses self-employed losses can be generally used against other personal income while losses trapped in a company rules lead to higher taxes on corporate risky investment. 2. Limits deferral with passive assets creates a bias towards deferral achieved through real assets, which could lead to sub-marginal investments. 3. Indifference works for investors at the top rate tax neutrality does not approximate for CCPC owners with marginal tax rates below the top rate. 4. Passive assets for business purposes, as opposed to savings, would need some sort of brightline test but difficult to properly do (eg. private equity investments by venture capitalists) Taxation of Private Corporation Policy Conference

60 Passive Income Rules Distortions/Complexity created by Passive Income Rules 5. Tax on passive income already results in a significant loss in real principal with non-tax sheltered assets. (Bond paying 3 percent with 2 percent inflation and 50% tax rate as real return of -0.5%). 6. Private companies becoming public or non-ccpc could avoid passive income rules leads to a new distortion with respect to ownership. 7. Rules are exceedingly complex especially with allocation method. 8. Few countries follow Canadian rules potential loss in tax competitiveness especially relative to the United States Taxation of Private Corporation Policy Conference

61 Marginal Effective Tax Rate Passive Income Rules Canada s Tax on Small Business not Competitive 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% $1M $2M $3M $4M $5M $6M $7M $8M $9M $10M $11M $12M $13M $14M $15M $16M $38M $39M $40M Size of Capital (CAD$ Million) Canada Small Business Entrepreneur USA Entrepreneur (S Corporation) USA Entrepreneur (Small Business) Taxation of Private Corporation Policy Conference

62 Passive Income Rules A Better Approach To reduce distortions and complexity as well as encourage growth: Consider an election to pass income of corporation to owner (egu.s. sub-chapter S corporations) Removes the distinction between passive and active business income. Reduces distinction between self-employed income and private corporate income. Treats losses similarly to self-employed income and therefore risk. Would eliminate benefit (if any left) of small business deduction. IIntroduce investment and employment tax credits instead to encourage investment. Given small business deduction is of little value with integration, move to single corporate income tax rate and dividend tax credit. Equalize capital gains and dividend tax rates Taxation of Private Corporation Policy Conference

63 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Taxation of Investment Income Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials. Bruce Ball CPA Canada, Alex Laurin C.D. Howe Institute, Jeffrey Trossman Blake, Cassels & Graydon LLP

64 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Assessing the Policy Objectives of the Finance Proposals Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials.

65 Assessing the Policy Objectives What is the policy objective for passive income proposal? To eliminate tax incentives for CCPC owners to retain active earnings, if the goal is to hold passive investments for future personal consumption To eliminate a perceived unfair tax advantage to CCPC owners compared to other investors Incentive to retain earnings fostered by low small-business income tax rate leaving greater investment potential Tax inequity derived from partial relief of CCPC taxes on passive investment income Taxation of Private Corporation Policy Conference

66 Assessing the Policy Objectives Three Key Observations 1. Measured against a consumption-based tax system with progressive rates, the current CCPC tax regime has many unobjectionable features 2. General-rate earnings (retained for future personal consumption) enjoy no significant tax advantages, and produce a suboptimal outcome when measured against a consumption tax baseline; small-business-rate earnings enjoy a tax outcome pretty much on par with personal retirement savings. 3. The proposed regime would not level the playing field: it would leave small business owners with significantly less tax-assisted retirement saving opportunities than available to some others Taxation of Private Corporation Policy Conference

67 Assessing the Policy Objectives Personal Investment Income Features of PIT Regime Under comprehensive income base, both the initial capital and the investment income are taxed. Cascading of taxes on saving encourages consumption in the present, and distorts investment choices (housing) Under consumption tax base, tax cascading is avoided: retirement plans, TFSA, other registered accounts Real-world tax systems are hybrids Canada s PIT operates largely on a consumption tax basis (less than 20% of investment income accumulations are subject to tax) Taxation of Private Corporation Policy Conference

68 Assessing the Policy Objectives CCPC Income Regime Features of CCPC Regime Income spent on active business consumption attracts no immediate tax Retained income used for passive investments gets partial relief Income distributed for personal consumption attracts personal taxes PIT/CIT integration mechanism = no double taxation Under perfect integration, business income used for personal consumption would be taxed on a near consumption basis Passive investment income sourced from earnings subject to the general CIT rate is under-integrated = higher effective tax burden on income distributed for personal consumption Taxation of Private Corporation Policy Conference

69 Assessing the Policy Objectives Tax Illustrations: Is the Current CPCC Regime Equitable? Net Wealth Available for Personal Consumption after Ten Years, 2017 $100,000 Initial Gross Investment, Provincial Average, 3% Rate of Return Regime Salary Income Current Regime: CCPC Income Proposed Regime: CCPC Income Interest Dividends Capital Gains Wealth ($) Gap Wealth ($) Gap Wealth ($) Gap Taxable Account 56,632-59,177-61,476 - RRSP/TFSA 65, % 65, % 65,763 +7% Small Bus. Rate 60,838 +7% 66, % 69, % General Rate 56,204-1% 60,933 +3% 63,825 +4% Small Bus. Rate 56,068-1% 58,324-1% 60,937-1% General Rate 52,227-8% 55,193-7% 56,284-8% Taxation of Private Corporation Policy Conference

70 Assessing the Policy Objectives Unequal Tax-Assisted Retirement Wealth Opportunities Maximum Tax-Assisted Career Accumulations of Retirement Wealth $150,000 Salary at Retirement Source: Pierlot and Siddiqi (2011). Actuarial valuations under standard assumptions assuming 35-year career Taxation of Private Corporation Policy Conference

71 Assessing the Policy Objectives Leveling the Playing Field The proposed CCPC regime in effect restricting business owners to personal RRSP room to tax-effectively save for retirement would not level the field The proposed regime if enacted should be accompanied by a reform of the tax-assisted retirement savings system that would equalize possibilities SB owners are at greater risk of insufficient RRSP room because of: potential bankruptcy, fluctuating income, early withdrawals to fund business Annual income-based limits on retirement savings should be abandoned and replaced with a uniform lifetime accumulation limit set to replicate maximum DB accumulations Taxation of Private Corporation Policy Conference

72 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Implementation and Technical Issues with the Finance Proposals Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials.

73 Policy Conference Outline of Proposal Proposal would be to make refundable taxes non-refundable in certain circumstances, as a way of promoting perceived horizontal equity between business owners and employees Premise that business owners and employees are similarly situated is open to serious debate but that is not the purpose of this part of the discussion Refundable tax rates assume business owner is in top rate bracket not true for many small business owners, who would face significant tax increase this design flaw would need to be fixed Overall approach would result in dramatically different tax treatment of active income ( AI ) and passive income ( PI ) Taxation of Private Corporation Policy Conference

74 Policy Conference Outline of Proposal Existing distinctions in domestic rules (between AI and PI) for CCPCs serve a much narrower purpose stakes are much higher in proposed regime New system would introduce a new policy effectively taxing the rate gap as if it had been immediately distributed This is achieved indirectly by making currently refundable taxes non-refundable; overall effect is to (theoretically) put owner in same position as if gap had been distributed and taxed immediately; therefore, effect is to tax corporation s capital New concepts needed Taxation of Private Corporation Policy Conference

75 Policy Conference Active vs. Passive Income Core Definition Distinguishing AI from PI Basic definition of PI Should income from property presumptively be classified as PI? If so, why? Income from property can include economically productive activities Leasing/licensing of property real/personal/intangible property different rules? Early stage software development is that income from property? Taxation of Private Corporation Policy Conference

76 Policy Conference Active vs. Passive Income Core Definition Is a >5 employees test appropriate? If so, why? Current specified investment business definition serves a narrower purpose; stakes now much higher Core service providers may not be employees Consider equivalence rules as in old Part XI ($250K rule) Rules should address provision of services by employees of affiliates and partnership structures, as in definition of investment business in 95(1); paragraph (b) of specified investment business is unduly narrow This is complicated! Taxation of Private Corporation Policy Conference

77 Policy Conference Active vs. Passive Income Excess Passive Assets Distinguishing AI from PI Rules to delineate excess passive assets Rules should recognize business realities which may require seemingly excess passive assets to be retained in corporation for good business reasons having nothing to do with tax deferral Prudent cash management to plan for contingencies generally Retention of cash for possible identified extraordinary expenses Maintaining credit standing opposite bank or other creditors Taxation of Private Corporation Policy Conference

78 Policy Conference Active vs. Passive Income Excess Passive Assets Retention of cash for future acquisitions that can reasonably be anticipated Retention of cash for possible future capital investment that can reasonably be anticipated in machinery & equipment, real estate, intangible property, R&D, etc. Concept needed to define what is meant by excess passive assets Taxation of Private Corporation Policy Conference

79 Policy Conference Active vs. Passive Income Excess Passive Assets Policy alternatives include a qualitative test or a bright-line test Qualitative test - what is reasonable in the circumstances disputes likely Bright-line test could look to specific dollar thresholds and/or specific time horizons (e.g., 36-month rule in FIE proposals paragraph (d) of qualifying entity definition in proposed subsection 94.1(1), Bill C-10, passed by House of Commons Oct. 29/07) Trade-off among objectives of fairness, workability, likelihood of disputes This is complicated! Taxation of Private Corporation Policy Conference

80 Policy Conference Active vs. Passive Income Inter-affiliate Payments Active business income should not become passive just because it is paid from one corporation to another For example, one company in the group may lease real or personal property or lend money to the main operating company 129(6) adopts the principle that character does not change in limited circumstances, and for the limited purpose for which it now applies Taxation of Private Corporation Policy Conference

81 Policy Conference Active vs. Passive Income Inter-affiliate Payments 129(6) requires payor and payee to be associated corporations for active business income to retain its character when paid within the group associated concept pertains to the SBD, so not appropriate for this much larger purpose Alternatives affiliated non-arm s length Minimum 10% votes/value test, as in 95(2)(a)(ii) Taxation of Private Corporation Policy Conference

82 Policy Conference Active vs. Passive Income Inter-affiliate Payments consider other factors in designing inter-affiliate payments rule apportionment of expenses and losses payments involving partnerships Taxation of Private Corporation Policy Conference

83 Policy Conference Active vs. Passive Income Inter-corporate Dividends For dividends, the connected test in Part IV determines whether dividend is a portfolio dividend subject to 38-1/3% refundable tax In determining whether Part IV tax is non-refundable, is this the right test? Anomalies in the connected test 186(2) has been interpreted as a count-the-shares rather than countthe-votes test; corporations can be related without being connected Unusual to require more than 10% rather than 10% or more Taxation of Private Corporation Policy Conference

84 Policy Conference Active vs. Passive Income Inter-corporate Dividends From a policy perspective, is the connected test really the correct test to distinguish AI from PI? Consider whether dividend received from non-arm s length (but not connected ) corporation should be subject to permanent Part IV tax What about dividend from arm s length, active corporation in which investor has (say) a 9% interest? Part IV tax applies, but is it appropriate for that tax to be permanent? Discussion raises more fundamental question of what is meant by reinvestment in the business Taxation of Private Corporation Policy Conference Should rules create a tax incentive for investing in affiliated, rather than unaffiliated active businesses? Why? There should be a coherent basis for making the distinction

85 Policy Conference Active vs. Passive Income Capital Gains Capital gain could arise from disposition of asset used to earn AI ( active asset ) or PI ( passive asset ) Proposals would change the integration rules by denying CDA as a way to tax the rate gap Should distinguish capital gains from dispositions of passive vs. active asset Capital gain from disposing of active asset is, in effect, a way of realizing the value built up in the active business Taxation of Private Corporation Policy Conference

86 Policy Conference Active vs. Passive Income Capital Gains Appreciation may be the result of any number of factors: - creation or enhancement of goodwill, - development of trade names or brands, - discovery of a technological breakthrough, - valuable supply or distribution agreements, - appreciating land values, - luck, and - an innumerable list of other factors Taxation of Private Corporation Policy Conference

87 Policy Conference Active vs. Passive Income Capital Gains If and when the corporation disposes of a tangible or intangible asset used in the business, the resulting gain does not conceptually resemble a passive return Gain represents current realization of expected future cash flows It follows that there is a fundamental distinction between capital gains realized from disposition of an asset used in an active business and other capital gains (for example, from disposing of a publicly traded portfolio investment) Taxation of Private Corporation Policy Conference

88 Policy Conference Active vs. Passive Income Capital Gains This distinction is recognized in the foreign affiliate rules These rules are a good starting point for designing a new system These rules draw a distinction between property used in carrying on an active business ( excluded property ) and other property Taxable capital gains from dispositions of excluded property are excluded from the definition of foreign accrual property income ( FAPI) Taxation of Private Corporation Policy Conference

89 Policy Conference Active vs. Passive Income Capital Gains Excluded property definition takes account of the possibility that the disposing affiliate may dispose of an active business by selling shares of a lower tier subsidiary Shares of a foreign affiliate that derive all or substantially all of their value from property used in an active business are thus defined as excluded property Determination of excluded property status of shares can be complicated in practice Taxation of Private Corporation Policy Conference

90 Policy Conference Active vs. Passive Income Capital Gains While foreign affiliate system was designed to achieve different legislative objectives, it provides a good starting point Taxable capital gain derived from a disposition of an asset used in an active business should be regarded as AI, and the accompanying non-taxable portion should be added to CDA Treatment of such gains as passive income seems conceptually flawed Taxation of Private Corporation Policy Conference

91 Policy Conference Active vs. Passive Income Capital Gains Rules needed to treat shares of certain corporations as excluded property under the new regime 10% test similar to foreign affiliate definition makes some sense If private corporation realizes gain from disposing of shares of a foreign affiliate that meet the current excluded property definition, taxable portion of that gain ought to be classified as AI under the new regime and not treated as PI Taxation of Private Corporation Policy Conference

92 Policy Conference Active vs. Passive Income Capital Gains Gains from dispositions of goodwill, trademarks and other intangibles used in a business: Gain on sale would have been regarded as business income prior to recent changes to replace ECE regime with Class 14.1 Should those changes affect AI/PI distinction? Taxation of Private Corporation Policy Conference

93 Policy Conference Classification of Losses If loss is realized, need to determine whether active or passive Similar to distinction between active losses and FAPLs in foreign affiliate rules Rules will be needed to track surplus accounts Taxation of Private Corporation Policy Conference

94 Policy Conference Source of Capital Income derived from capital not sourced from lightly taxed income is not intended to be subject to new regime Premise of consultation paper is that a system is needed to distinguish: Capital derived from lightly taxed business income (income on which should be subject to non-refundable corporate taxes), from Capital derived from other sources (income on which should still be eligible for refundable treatment) Taxation of Private Corporation Policy Conference

95 Policy Conference Source of Capital Non-refundable corporate tax should not apply to: Investment income derived from capital contributed by shareholder in non-rollover transaction No rate gap asset came in from after-tax dollars of shareholder Investment income derived from capital acquired by corporation through issuance of debt/equity/other securities in non-rollover transaction (e.g., borrowing, share offering) No rate gap asset came in from after-tax dollars of investor Investment income derived from capital acquired by corporation from a foreign source dividend, interest or other payment No rate gap asset came in from foreign source Taxation of Private Corporation Policy Conference

96 Policy Conference Source of Capital Need to create and track several surplus or similar accounts to give effect to these principles Need special rules for rollovers, amalgamations, wind-ups, divisive reorganizations Revisit active/passive distinction in FIE proposals and FAPI rules Developing coherent rules is complicated! Taxation of Private Corporation Policy Conference

97 Policy Conference Transition Government states that new rules will apply only going forward How to achieve this without byzantine transitional rules? Non-refundable taxes amount to a tax on the capital represented by the rate gap Apparent ~73% all-in tax on investment income is designed to tax the rate gap as if it had been immediately distributed Unless and until it is distributed, this is capital of the corporation elimination of refundability will erase a potential future corporate asset (the refund) as the new system comes into effect Taxation of Private Corporation Policy Conference

98 Policy Conference To make changes truly prospective: Transition Income derived from capital accumulated before new regime takes effect (and income derived from that income) should not be subject to non-refundable taxes That capital was accumulated in a regime in which high taxes on private corporations investment income were temporary/refundable Will require a determination of aggregate passive assets on coming-into-force date, and tracking of surplus account, ordering rules, etc Taxation of Private Corporation Policy Conference

99 Policy Conference Scope of Application CCPCs vs. foreign-controlled corporations premise of proposed regime is a Canadian resident individual owner- not true for foreign controlled corporation special 10-2/3% tax already applies only to CCPCs in recognition of this basic difference competitiveness issue would have to deal with branch tax if proposed to extend new regime to foreigncontrolled corporations Taxation of Private Corporation Policy Conference

100 Policy Conference Reality of Under-integrated System If all benefits of deferral are to be eliminated, the under-integrated system leaves those considering a new business with a heavy cost to get limited liability, unless they plan to reinvest substantially all profits in the business in perpetuity, rather than earmarking a portion of profit for future consumption at some point Elective check-the-box system could help Fine-tune rules to mitigate under-integration, don t just assume underintegration away Taxation of Private Corporation Policy Conference

101 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Possible Alternatives to Finance Proposals Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials.

102 Policy Conference Other Possible Alternatives Check the Box Flow Through Impose a Refundable Tax on Ineligible Investments? Repeal or Replace the Small Business Deduction? Increase the corporate refundable tax rate? Comprehensive Tax Review? Taxation of Private Corporation Policy Conference

103 Policy Conference Check the Box Flow Through Integration and debate around use of tax deferral is less relevant if shareholders can be taxed on income as a flow through Can set corporate and personal rates without same concern around integration if there is a safe harbour for private corporation owners to pay single level of tax at personal rate if they so choose A lower tax rate could be applied on business income to provide an incentive similar to SBD (similar rule under consideration in US?) Seems like an approach worth study if starting a brand new tax system Significant transitional issues? Taxation of Private Corporation Policy Conference

104 Policy Conference Impose a Refundable Tax on Ineligible Investments? Was referred in the consultation paper but dismissed Makes the most theoretical sense for what Finance is trying to do? The best way to prevent the accumulation of investment income on the tax deferral is to prevent you from investing it in the first place? Works best if: One single source of income where after-tax use is a concern One good use of assets and one bad Would create need for complicated rules in concept and application, and would have adverse business implications such as waiting for tax refunds when passive assets are repurposed for business use Taxation of Private Corporation Policy Conference

105 Policy Conference Repeal or Replace The Small Business Deduction? Is the Small Business Deduction the Issue? Using 10-Year accumulation rationale, is retaining general rate income (GRI) for investments a significant issue if no income sprinkling/gain planning? Practically, any benefit provided from investing the deferral is eaten away by the under integration on GRI and/or investment income Investing cash in a private corporation and earning investment income is also not an issue (pure investment corporation, conceded in paper) Is after-tax SBI the only materially contentious source of investments? If so, would it make more sense to focus on the small business deduction? Following charts use Finance Table 7 assumptions with actual rates for Taxation of Private Corporation Policy Conference

106 Policy Conference 10-Year Net Worth Analysis General Rate Business Income Personally Corporation Adv./Disadv. BC $61,110 $62,015 $905 Alberta 60,706 60, Saskatchewan 61,043 62,536 1,493 Manitoba 57,495 55,506-1,989 Ontario 53,370 54,885 1,515 Quebec 53,658 54, New Brunswick 53,671 56,858 3,187 Nova Scotia 52,757 49,344-3,413 PEI 56,209 55,069-1,140 Newfoundland & Labrador 56,302 49,902-6,400 Assumed Rates Used by Finance 57,535 60,457 2, Taxation of Private Corporation Policy Conference

107 Policy Conference 10-Year Net Worth Analysis Income Eligible for the SBD Personally Corporation Advantage BC $61,110 $65,113 $4,003 Alberta 60,706 64,555 3,849 Saskatchewan 61,043 66,485 5,442 Manitoba 57,495 61,025 3,530 Ontario 53,370 58,510 5,140 Quebec 53,658 57,549 3,891 New Brunswick 53,671 58,095 4,424 Nova Scotia 52,757 56,993 4,236 PEI 56,209 59,279 3,070 Newfoundland & Labrador 56,302 60,766 4,464 Assumed Rates Used by Finance 57,535 63,207 5, Taxation of Private Corporation Policy Conference

108 Policy Conference 10-Year Net Worth Analysis Observations Small business income: Provincial numbers fairly consistent integration on SBI generally works Province of Finance NW > All provinces other than Saskatchewan Average NW advantage is $4,200 Is this significant on $100,000 of SBI? General Rate Income (GRI) Keeping GRI in a corporation and paying it out later as a dividend represents a cost in many provinces, investing the deferral helps reduce the cost The integration on investment income is imperfect as well Unclear any changes are needed on GRI without more study? Results do vary based on the rate of return & type of income Taxation of Private Corporation Policy Conference

109 Policy Conference Is the Small Business Deduction an Issue? Considerations and questions that could be considered: In terms of the growth in the number of private corporations, do we know how much growth is directly related to reinvesting the value of the SBD in passive assets? If the government deals with income sprinkling and capital gain planning, how many taxpayers would set up private companies in the future for passive investment tax planning purposes? Motivation often based on multiple factors? Taxation of Private Corporation Policy Conference

110 Policy Conference Is the Small Business Deduction an Issue? Considerations and questions that should be considered: If the possibility of reinvesting the SBD saving is a concern, would amending, replacing or just repealing the small business deduction reduce the growth of private corporations used for passive investment tax planning purposes? Redesign the SBD as a more targeted tax expenditure designed to reward economic growth, positive impact on economy and risk taking (rather than tracking and dealing with corporations investing it)? Taxation of Private Corporation Policy Conference

111 Policy Conference Increase the corporate refundable tax rate? This was action government took previously would more of the same help? Issues: At the end of the day, the tax is returned when dividends are paid - tax deferral was effectively invested? Not refunded if passive assets invested in business punitive? For the same reasons discussed before, take a good look at the SBD? Taxation of Private Corporation Policy Conference

112 Policy Conference Comprehensive Tax Review? Passive income proposals suggested in paper would make for a complicated tax system and seem to assume other aspects of the tax system are effective and should remain in place (e.g. small business deduction) Paper assumes aspects that are theoretically part of the system but are not working in reality (e.g. integration) Ensure key drivers of the tax system make sense before adding more complication around them? A review of other countries indicates what Canada is examining would be fairly unique blazing a trail brings risk? Are there better ways to deal with the key issues of concern? Taxation of Private Corporation Policy Conference

113 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Taxation of Investment Income: Practitioner Perspectives on Proposals and Potential Issues Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials. Sandra Mah DLA Piper (Canada) LLP H. Michael Dolson Felesky Flynn LLP

114 Practitioner Perspectives Syllabus Policy issues Anticipated legislative issues Anticipated behavioural response and real-world results Taxation of Private Corporations Policy Conference

115 Practitioner Perspectives Intergenerational equity issue: Policy Issues Proposed changes level playing field within some cohorts, not between them Even intra-cohort levelling may be superficial Cascading gender equity and racial equity implications Cascading vertical equity implications Taxation of Private Corporations Policy Conference

116 Practitioner Perspectives Policy Issues If tax policy objective is to prevent tax-motivated incorporation, entire package may be a poorly targeted solution Similar to issues with continued approach to PSB corporations For many incorporated services businesses, incorporation is payer s choice Significant non-neutrality due to payroll taxes and provincial laws Benefits disproportionately enjoyed by payers: Consider employees vs. contractors in Calgary Payers advertise purported tax benefits to workers so workers don t revolt Admittedly less of an issue for professionals Is this policy negatively affecting how CCPCs will finance their businesses Taxation of Private Corporations Policy Conference

117 Practitioner Perspectives Policy Issues Foreign solutions to this problem do not seem to have been considered Some may be better or worse than what is proposed, but should be canvassed Example: Netherlands minimum salary regime Corporation must pay controlling shareholder wages equal to the lesser of: Greater of (i) 45,000; and (ii) 75% of corporation s pre-wage taxable income; and Proven wages of a similarly-skilled worker 75% requirement inapplicable if shareholder generated <90% of profit If shareholder is underpaid, imputed employment income plus penalty Might satisfactorily address passive income and income splitting issues, while potentially being simpler Taxation of Private Corporations Policy Conference

118 Practitioner Perspectives Policy Issues Is the small business deduction still viable? Are the significant recent efforts to preserve integrity worth the effort? Is integration still good tax policy? Proposed regime represents significant departure from integration principle Apportionment method might achieve integration over long horizon using Milligan s assumptions, but that is not what integration has historically been about Taxation of Private Corporations Policy Conference

119 Practitioner Perspectives Legislative Issues Finance is probably downplaying the complexity of the apportionment method for passive income Likely end result will be something similar to a domestic equivalent of the FA surplus rules, in order to prevent chicanery Not clear how loans (for shareholder or inter-corporate) would factor in Not clear how losses will be allocated or tracked Not clear if assets can change status from passive to active Not clear how dividends will be paid Taxation of Private Corporations Policy Conference

120 Practitioner Perspectives Legislative Issues Elective method requires assumptions too simplistic to work in practice Why is it reasonable to assume that shareholder contributions are not used to make passive investments? What if SBD-electing corporation earns $600,000 of income? What if corporation is unsure whether or not its income qualifies for the SBD? Real problem for potential PSB corporations or potential SIB corporations Extreme unfairness if workers are not causing PSB proliferation Here, the benefits of simplicity are illusory given the complexity of transition Taxation of Private Corporations Policy Conference

121 Practitioner Perspectives Legislative Issues Proposed regime will place considerable pressure on both bright-line tests and common-law tests relating to active vs. passive income Considerable additional tax wedge between 5 full-time employees and >5 fulltime employees for, say, property rental businesses Likely to encounter Ensite-type litigation surrounding use or risking of incomeproducing properties in active business Incentive for characterizing two potentially separate businesses (e.g. real estate development and real estate leasing) as a single business Taxation of Private Corporations Policy Conference

122 Practitioner Perspectives Legislative Issues Will capital gains realized on disposition of business assets/goodwill continue to generate CDA? White Paper suggests not, if source of gain is reinvested corporate income This seems to be an improper result Taxation of Private Corporations Policy Conference

123 Practitioner Perspectives Legislative Issues Control is too high a threshold for an investment in another corporation to generate a CDA-increasing capital gain Creates punitive result if two or more arm s length corporations go into business More realistic threshold required, along the lines of FA status Exclusively is an unattainable threshold for subsidiary s investment in business assets More realistic threshold would resemble the QSBC share test Other circumstances may exist where capital gains should generate CDA Taxation of Private Corporations Policy Conference

124 Practitioner Perspectives Legislative Issues Important aspects of proposed regimes lack sufficient detail to provide meaningful comment: Is the election one time or for each fiscal year for the Elective Method? Potential limited use of election - only those corporations that have significant passive investment or immaterial passive investments Investment corporation election Effects of election if made by existing corporation, and timing and types of transfer that will result in transfer tax How will grandfathering be accomplished? Will it phase out over time? Care will have to be taken to avoid capital lock-in effect Taxation of Private Corporations Policy Conference

125 Practitioner Perspectives Legislative Issues Extension of regime to non-ccpcs may have unintended negative effects Private corporations used by non-residents to make investments in Canada No tax policy reason to be concerned about deferred personal income, Canada can t tax that income anyway Extension of regime without caution would materially increase effective tax rate, decrease foreign investment in Canada But increased tax cost would largely be payable to foreign governments Canadian tax revenues could be less than under current regime Better idea would be to limit extended regime to private corporations controlled by Canadian residents Taxation of Private Corporations Policy Conference

126 Practitioner Perspectives Taxation of Private Corporations Policy Conference Legislative Issues Non-refundable tax rate is likely too high Assumes CCPC shareholders in top income bracket Others have provided calculations demonstrating effect on lower bracket taxpayers Consider tax consequences for minority shareholders Assumption that all persons with CCPC investment income are top rate taxpayers is not sound There are reasons to hold investments in a CCPC rather than RRSP/TFSA, so not simply people who have maxed out contributions For example, may wish to invest in real estate or a non-eligible small business Increases the number of taxpayers subject to tax beyond the top income bracket

127 Practitioner Perspectives Taxpayer Responses Taxation of Private Corporations Policy Conference

128 Practitioner Perspectives Taxpayer Responses Considerable uncertainty going forward Clients anticipate CPC will promise to repeal anything that is enacted Preservation of existing regime for grandfathering, etc., and limited short-term revenue impact means promise is credible Rate and rule change fatigue Changes to subsection 55(2) and SBD rules still being processed Federal rate increases plus Alberta rate increases Considerable anger and willingness to be very aggressive Taxation of Private Corporations Policy Conference

129 Practitioner Perspectives Taxpayer Responses If taxpayers believe rules will eventually be repealed, easy options to defer income or mitigate impact until expected repeal: Invest in non-income producing investment properties (i.e. Amazon.com shares) that will generate capital gains at an undetermined future time FA-based options Use business profits to pay down debts instead of saving Taxation of Private Corporations Policy Conference

130 Practitioner Perspectives Taxpayer Responses Clients can avoid proposed rules by making riskier investments: Without CDA, no disincentive to engage in adventure or concern in the nature of trade, especially since no passive income generated House flipping or development versus proven commercial rental properties Working interests in oil & gas properties Financing leases for tangible personal property Reinvest in business or invest in other business to non-advisable extent Significant tax distortion between business and passive investment opportunities with same pre-tax rate of return Taxation of Private Corporations Policy Conference

131 Practitioner Perspectives Taxpayer Responses Numerous other techniques to defeat rules, for example: Buy-bump or buy-bump-sell transactions for shareholders of corporations with significant accrued gains on capital assets Invest in widely-held, non-sift partnerships to earn business income More aggressive options obviously exist Taxation of Private Corporations Policy Conference

132 Practitioner Perspectives Questions? Taxation of Private Corporations Policy Conference

133 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON INCOME SPRINKLING PANEL Speakers: Albert Baker (moderator), David Christian, Michael Wolfson, Rachel Gervais Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials. September 25, 2017

134 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON INCOME SPLITTING BACKGROUND AND HISTORY Speaker name: David Christian Company: Thorsteinssons, LLP Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials.

135 INCOME SPLITTING - BACKGROUND There is no general policy in the Income Tax Act (Canada) that prevents income splitting Neuman v. The Queen, 98 DTC 6297 (SCC) However, the Income Tax Act (Canada) has always contained antiavoidance rules relating to income splitting Taxation of Private Corporation Policy Conference

136 Income War Tax Act INCOME SPLITTING - BACKGROUND No specifically defined attribution rules. Subsection 4(4) read: A person who, after the first day of August, 1917, has reduced his income by the transfer or assignment of any real or personal, movable or immovable property, to such person's wife or husband, as the case may be, or to any member of the family of such person, shall, nevertheless, be liable to be taxed as if such transfer or assignment had not been made, unless the Minister is satisfied that such transfer or assignment was not made for the purpose of evading the taxes imposed under this Act or any part thereof Taxation of Private Corporation Policy Conference

137 INCOME SPLITTING - BACKGROUND By the time of tax reform in 1970, the rules had evolved into a more familiar form: Attribution of income from property transferred to a spouse or to a person under 19 Both attribution rules applied while transferor alive and resident in Canada No attribution of business income, income from loaned property, or secondgeneration income Taxation of Private Corporation Policy Conference

138 INCOME SPLITTING - BACKGROUND Denial of deduction of salary paid by a spouse to a spouse (no inclusion to recipient, so no double taxation) Similar rule for remuneration by a partnership in which a spouse is a partner Rule that gave discretion to Minister to allocate income of a spousal partnership to one spouse alone Attribution rule for transfer of rights to income Taxation of Private Corporation Policy Conference

139 INCOME SPLITTING - BACKGROUND Post-tax reform: the modern attribution rules take shape: Attribution of income and gains from property transferred to spouse Retention of rules on remuneration of spouses, including partnerships (later replaced by subsection 103(1.1)) Attribution of income from property transferred to spouse Taxation of Private Corporation Policy Conference

140 INCOME SPLITTING - BACKGROUND Attribution of income, but not gains, from property transferred to a person under 18 No attribution of business income, income from loaned property, or secondgeneration income No corporate attribution passive income can be split by transfer to a corporation in which spouse or minor holds a share interest Transfers of rights to income taxable: see subsections 56(2) and (4) Taxation of Private Corporation Policy Conference

141 INCOME SPLITTING - BACKGROUND Expansion of the attribution rules 1985 Budget [Income splitting] was easy, efficient, and anomalous...what was a tolerated tax-planning device soon became an industry, and like all other tax-planning industries, it became a perceived menace to the Department of Finance that had to be erased.as seems to be the case recently with so many legislative amendments that try to erase a simple planning technique, the amendments introduced complexities and difficulties that far outweighed the menace they were intended to cure. Samuel Minzberg, 1986 CTF National Tax Conference Taxation of Private Corporation Policy Conference

142 INCOME SPLITTING - BACKGROUND After the 1985 Federal Budget the modern form of the attribution rules is introduced: Attribution of income and gains from property transferred to spouses, and of income from property transferred to minor children and nieces and nephews Specific trust attribution rules The introduction of the corporate attribution rule Attribution of income from loaned property unless a commercial rate of interest paid No attribution of business income or second-generation income Taxation of Private Corporation Policy Conference

143 INCOME SPLITTING - BACKGROUND The effect of subsection 56(2) The Minister of National Revenue attempted to apply subsection 56(2) of the Income Tax Act (Canada) to discretionary dividends paid on shares Result was the McClurg and Neuman cases at the Supreme Court of Canada, which found subsection 56(2) did not apply to dividends, regardless of contribution - or lack of it by the shareholder receiving the dividend Taxation of Private Corporation Policy Conference

144 INCOME SPLITTING - BACKGROUND Reaction to Neuman: the kiddie tax Commencing in 2000, section imposed an effective prohibition on splitting income with minors by imposing the top marginal tax rate on split income received by the minor. The kiddie tax broke with prior models by taxing split income at the top marginal rate to the recipient, and making a parent jointly and severally liable with the minor for the tax, rather than attributing the income to where it was supposed to go Effect of kiddie tax: eliminate incentive to split income with minors Taxation of Private Corporation Policy Conference

145 INCOME SPLITTING - BACKGROUND Later developments: Pension income splitting permitted for 2013 and subsequent years The family tax cut, which permitted splitting of income by all taxpayers, implemented for 2014, was repealed after 2015 by the new government Taxation of Private Corporation Policy Conference

146 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON CCPCs and Income Sprinkling: (Some of) the Numbers To edit your Header/Footer select <View> <Slide Master> (Delete this box) Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials. Speaker name: Michael Wolfson Company: University of Ottawa

147 Acknowledgements Social Sciences and Humanities Research Council -- funding Statistics Canada data assembly and front-line analysis Neil Brooks, Mike Veall, Scott Legree, Brian Murphy co-authors Canadian Tax Journal editorial and peer review Disclaimer my own views; full responsibility rests with Michael Wolfson Taxation of Private Corporation Policy Conference

148 How the Empirical Analysis Was Done T1s Individuals & Families Full Income etc. T2S50 Share Owners T4s T5s Increment in Retained Earnings Taxation of Private Corporation Policy Conference T2s & GIFIs for CCPCs all data linked and analyzed within Statistics Canada s secure environment challenging record linkages GIFI data calendarized unable to link trusts no data on share ownerships < 10%, nor on voting control only family members living at same address under-estimates re sprinkling?

149 Percentage of filers with over 10% ownership shares in at least one CCPC, 2001 to 2011, by total T1 income deciles and top groups Taxation of Private Corporation Policy Conference Decile 1 < 5,800 Decile 2 < 11,900 Decile 3 < 16,900 Decile 4 < 21,700 Decile 5 < 27,500 Decile 6 < 34,100 Decile 7 < 41,500 Decile 8 < 51,600 Decile 9 < 68,800 P90-95 < 86,700 P95-99 < 163,300 Next 0.9 < 577,000 Next 0.09 < 2,305,700 Top ,305,700

150 Number of CCPCs directly owned by owners, by total T1 income group, 2011 Decile 1 < 5,800 Decile 2 < 11,900 Decile 3 < 16,900 Decile 4 < 21,700 Decile 5 < 27,500 Decile 6 < 34,100 Decile 7 < 41,500 Decile 8 < 51,600 Decile 9 < 68,800 P90-95 < 86,700 P95-99 < 163,300 Next 0.9 < 577,000 Next 0.09 < 2,305, Taxation of Private Corporation Policy Conference Top ,305,700

151 Complexity of CCPC ownership: Maximum number of levels of ownership, by total T1 income group, Taxation of Private Corporation Policy Conference Decile 1 < 5,800 Decile 2 < 11,900 Decile 3 < 16,900 Decile 4 < 21,700 Decile 5 < 27,500 Decile 6 < 34,100 Decile 7 < 41,500 Decile 8 < 51,600 Decile 9 < 68,800 P90-95 < 86,700 P95-99 < 163,300 Next 0.9 < 577,000 Next 0.09 < 2,305,700 Top ,305,700

152 Trend Effects of Including CCPC Undistributed Income in the Measurement of Income Inequality Taxation of Private Corporation Policy Conference

153 Average Amounts of Directly Owned CCPC Income by (After- Tax + Capital Gains + Direct CCPC) Income Quantile, Taxation of Private Corporation Policy Conference

154 Income Sprinkling: Widely Disseminated Advice Small business owners who employ family members for income-sharing purposes need to pay a reasonable salary, and be able to show the paperwork behind the pay. But what s reasonable?...unfortunately, the CRA doesn t have a hard and fast rule for what s deemed an acceptable salary. But if you pay the family member what you would pay a typical employee, the CRA would have little reason to discount the deduction. To determine a realistic wage isn t difficult, though. Career websites list average wages for jobs in numerous industries. According to the federal government s Job Bank site, the median hourly wage for an office clerk is $18 an hour, for instance, although the site indicates you could go as high as $28 and still be in the right ballpark. Kira Vermond, One Way To Reduce Small-Business Taxes: Income-Splitting, Globe and Mail, Monday, May 4, 2015 ( Taxation of Private Corporation Policy Conference

155 Taxation of Private Corporation Policy Conference

156 quote from 2005 ON budget Taxation of Private Corporation Policy Conference (page 159)

157 Numbers of CCPCs by Industrial Classification Restaurants Lawyers Doctors Taxation of Private Corporation Policy Conference

158 Spring 2015 Report 3 on Tax-Based Expenditures 3.47 Evaluation requirements for direct program spending. Direct program spending is subject to. (evaluation) over a five-year cycle. The policy defines evaluation as the systematic collection and analysis of evidence on the outcomes of programs to make judgments about their relevance, performance, and alternative ways to deliver them or to achieve the same results Evaluation requirements for tax-based expenditures. the policy requirement to evaluate programs does not apply to tax-based expenditures Conclusion overall we concluded that the Department fell short on managing tax-based expenditures. We reached this conclusion because these expenditures were not systematically evaluated and the information reported did not adequately support parliamentary oversight Taxation of Private Corporation Policy Conference

159 Incomes of Individuals Working in the Offices of Doctors Numbers of Doctors by Individual Income and Ownership of a Private Company Income ($000s) Reported on Individual Income Tax Returns $100-$200 $200-$350 $350-$500 > $500 > $100 Does not Own a CCPC 10,050 8,120 2, ,880 Owns a CCPC 18,300 8,110 2,480 1,390 30,280 Totals 28,350 16,230 5,230 2,350 52,160 Average Family Incomes ($000s) of Doctors and Their Immediate Families Plus Income Retained in a CCPC Income ($000s) Reported on Individual Income Tax Returns $100-$200 $200-$350 $350-$500 > $500 Does not Own a CCPC Owns a CCPC , Taxation of Private Corporation Policy Conference n.b. these incomes are after subtracting salaries and office expenses paid by the Offices, both CCPCs and self-employed there were over 7,500 doctors in 2011 receiving more that $350,000 on their T1s doctors owning CCPCs had much more total family income not yet known how much was from sprinkling

160 For the first $1,996 of private income, benefits reduce at 100% (50% for regular GIS + 50% for GAINS). This is the same as before. Between $1,996 and $4,600 of private income, GIS benefits reduce at its regular rate of 50% (GAINS is gone and the new top up hasn t begun to reduce) Between $4,600 and $8,400 in private income, GIS benefits reduce at a rate of roughly 92% (50% for the regular GIS benefit + 42% for the increased GIS top-up which reduces within this zone) After $8,400 of private income, GIS benefits again reduce at a rate of 50% (The top-up is completely gone) Compare Effective Income Tax Rates for Low Income Seniors, the Poverty Trap Taxation of Private Corporation Policy Conference from 50 to 100% (and higher)

161 Concluding Comments first time: shining a statistical light into a dark corner of Canada s income tax this kind of analysis is not easy, but as concluded by the AG, it needs to be done, done well, and made available to Parliament and the public on a regular basis CCPCs are widely used especially among those with the highest incomes income sprinkling appears to involve a significant (individual + corporate) income tax revenue cost, possibly on the order of at least $500 million per year it is horizontally inequitable = unfair it induces an important non-neutrality in the tax system, thereby encouraging nonproductive tax planning costs in addition to its revenue costs while powerful vested interests complain loudly about having to pay tax at top rates as high as 50%, hundreds of thousands of Canada s seniors face much higher effective income tax rates, and no one seems to care Taxation of Private Corporation Policy Conference

162 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Income Splitting Technical Summary of Proposed Legislation To edit your Header/Footer select <View> <Slide Master> Speaker name: Rachel Gervais Company: BDO Canada LLP (Delete this box) Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials.

163 Tax on Split Income (TOSI) Applies by virtue of S.120.4(2) Specified Individual * will be subject to the top personal tax rate for the year on the individual s Split Income * for the year Proposals extend rules to apply to all Canadian resident individuals who included in income certain amounts that are derived from a business that is, or was, sufficiently linked to a related individual who is resident in Canada Proposals apply to minors and adult family members To apply the new rules, must consider new or modified definitions, new reasonableness tests for certain types of income of individuals 18 years of age and older, and anti-avoidance rules * Revised definitions under S (1) of the Act Taxation of Private Corporation Policy Conference

164 Revised Definition of Specified Individual S (1) Age Current TOSI Proposed TOSI Under age 18 (minor) Age 18 or older (adult) Canadian resident throughout the year Parent resident in Canada at any time during the year At no time in the year was a non-resident Not applicable Canadian resident at end of the year* At any time during the year either: Parent resides in Canada, or A related individual resides in Canada, and the minor receives certain income derived from a business of that related individual Canadian resident at end of the year* At any time during the year a related individual resides in Canada, and the adult receives certain income derived from a business of that related individual. * Where individual dies in the year, Canadian resident immediately before death Note: for purposes of the proposed rules, related person is extended to include aunts, uncles, nieces or nephews Taxation of Private Corporation Policy Conference

165 New definition of Connected Individual S.120.4(1) Sets out factors applicable when considering the degree of connectivity between an individual and a corporation relevant for: Definition of specified individual in determining whether a business is sufficiently linked to a related individual, when looking at whether income is derived from that business Definitions of split income (income from indebtedness under para. (d) of the definition of split income), related source, and split portion (i.e. for the purposes of applying the reasonableness test under Subparagraph (b)(ii) of the definition of split portion) A connected individual in respect of a corporation includes an individual resident in Canada who can be shown to meet any of the following conditions set out in paragraphs (a) through (d) of the definition: a) Strategic influence b) Equity influence c) Earnings influence d) Investment influence Taxation of Private Corporation Policy Conference

166 Specified Individual - Example Facts: Mr. and Mrs. X X Corp. incorporated in Upon incorporation, Mr. and Mrs. X each subscribed for 50% of the common shares of X Corp for a nominal amount. Mr. X was never active in the business and worked part-time for another employer while spending a significant amount of time caring for their child X Jr. Mrs. X ran the business and its value grew considerably X Jr. became involved in the business and by 2016, was running the business by himself. In early 2016, the X family undertook a standard freeze for X. Corp Mr. and Mrs. X each exchanged their common shares for fixed value, redeemable and retractable preferred shares with an aggregate redemption value of $4M. X Jr. subscribed for all the newly issued common shares of X Corp. for a nominal amount Plan was for each of Mr. and Mrs. X to receive approximately $100K of dividends annually by way of share redemptions of their preferred shares throughout retirement Standard Wasting Freeze This $200K would represent the majority of Mr. and Mrs. X s annual retirement income. They will also receive Canada Pension Plan payments Taxation of Private Corporation Policy Conference

167 Specified Individual - Example Analysis under proposed TOSI rules: Both Mr. and Mrs. X will be Specified Individuals Related individual (X Jr.) resides in Canada and Mr. and Mrs. X receive income (dividends) derived from a business carried on by corporation of which X Jr. is a specified shareholder.* All dividends received by way of share redemption by Mr. and Mrs. X may be subject to TOSI Mr. X Clearly subject to TOSI on dividends as he was never active in the business at all Mrs. X Possibly subject to TOSI on dividends Will depend on reasonableness test discussed later i.e. What is reasonable given Mrs. X s past contributions to X Corp and past compensation prior to retirement? * X Jr. would also meet the criteria outlined in the proposed new definition of connected individual contained in S.120.4(1) which may be relevant if the fact pattern was different and X. Jr was not a specified shareholder as defined in S. 248(1) Taxation of Private Corporation Policy Conference

168 Specified Individual Discussion of Example Becoming specified individuals will reduce Mr. and Mrs. X s retirement income significantly Planning was implemented assuming marginal rates on share redemption dividends. Now potentially subject to highest marginal rate on every dollar received Retroactive Taxation? - $4M of preferred share value accumulated prior to Appropriate to now tax all that value at highest marginal rates? How will X Corp s cash flow be impacted? Will now require significantly more cash to give Mr. and Mrs. X equivalent amounts of retirement income as planned. How much time and money will X Corp./X family need to spend to justify reasonableness of Mrs. X s dividends? How much money did she draw in the past? What happens on death if Mr. and Mrs. X pass away with unredeemed preferred shares outstanding? Could entire remaining value be taxed at dividend rates? See proposed S.120.4(4) More facts would be required to answer this question Taxation of Private Corporation Policy Conference

169 Revised Definition of Split Income S (1) Category Current TOSI Proposed TOSI Private company taxable dividends, S.15 shareholder benefits Paragraph (a) Paragraph (a) no change Business income from a partnership Paragraph (b) Paragraph (b) change for related source definition Business income from a trust Paragraph (c) Paragraph (c) change for related source definition Income from indebtedness Not applicable Paragraph (d) new Taxable capital gains and income from the disposition of certain property Not applicable Paragraph (e) new Section 246 amounts (conferred benefits) Not applicable Paragraph (f) new Reinvested split income, income subject to the attribution rules and capital dividends where certain conditions met (for individuals under the age of 25) Not applicable Paragraph (g) - new Taxation of Private Corporation Policy Conference

170 New Definition Split Portion S (1) For a specified individual who is 18 years of age or older, it will generally be necessary to determine if there is a split portion of the amount of their split income. Only the split portion will be subject to TOSI (subject to the antiavoidance rule under S (1.1)(d)) Category of split income Paragraph of the definition Reasonableness Test Amounts under paragraph (g) of split income of individuals under the age of 25 All amounts of split income, except those covered in paragraphs (e) and (g) of that definition Amounts under paragraph (e) of split income taxable capital gains and income from the disposition of certain property Paragraph (a) Paragraph (b) Paragraph (c) No Yes* Yes** * Based on contribution factors (arm s length view) and what has been paid/payable. Must also consider anti-avoidance rules, restriction rules for 18 24, deeming rule for inherited property (S.120.4(1.1)(e)(ii) and (iii)) ** Test requires consideration of whether certain income from the property would be considered split income Taxation of Private Corporation Policy Conference

171 Example Split Income Paragraph (e) Facts Mr. A owns 60% of the common shares of A. Corp. He runs the business independently The other 40% of the common shares are owned by Mr. A s uncle (age 50) who contributed $40,000 to subscribe for share capital when A. Corp was incorporated. There was no intention to income split with Mr. A s uncle, he was simply a source of start-up capital. Mr. A s uncle is not (and never was) involved in the management of the business The shares of A. Corp are being sold by the current shareholders after 2017 to arm s length purchasers. A capital gain will be realized upon sale by each of the current shareholders. None of the shareholders have ever received any dividends on the common shares Taxation of Private Corporation Policy Conference

172 Example Split Income Paragraph (e) Is Uncle s gain on the disposition of shares subject to TOSI? Uncle is a specified individual in respect of A. Corp s business Resident in Canada Related to Mr. A (Proposed S (1.1) uncles and nephews are related) Business of A. Corp is carried on by Mr. A. and Mr. A is a specified shareholder* of A. Corp. Uncle s gain on the disposition is included in Paragraph (e) of the definition of split income Uncle is a specified individual Uncle has a taxable capital gain from the disposition of property The property is a share of the capital stock of a corporation which is not a public company or mutual fund corporation Would paragraph (c) of the split portion definition exclude this gain from TOSI? Appears as though we would need to determine if the capital gain would have been included in split income had it been received as an amount included in Paragraphs (a) (d) of the definition of split income (i.e. as a dividend, business income or income from indebtedness) How can we answer this? Does the reasonableness test apply? If so, what would be reasonable given Uncle s original $40,000 contribution? * Also a connected individual however not relevant given particular fact pattern Taxation of Private Corporation Policy Conference

173 Split Income Paragraph (e) Discussion of Example If the gain is subject to TOSI: Why should Uncle s gain be treated differently than that of an arm s length investor? He was simply a source of start-up financing who happened to be Mr. A s Uncle No income splitting intention What if Uncle wanted to claim LCGE on his gain realized? No longer available under proposed rules to constrain LCGE multiplication* What if Mr. A. wanted to increase his interest in the company and purchase his Uncle s shares? If gain subject to TOSI, would gain be taxed at dividend rates? If proposed Section 120.4(4) applies, gain would be taxed as a non-eligible dividend * Assumes no election made to crystallize LCGE under proposed S (18) Taxation of Private Corporation Policy Conference

174 Constraining the Capital Gains Exemption Background The government is particularly concerned that the current LCGE rules can be used to multiply the LCGE so that it is available to family members who are not involved in the business The government: views that these individuals may not have effectively contributed to the business; is also concerned about the use of family trusts, primarily those that are discretionary, to allocate capital gains and income among family members Taxation of Private Corporation Policy Conference

175 Constraining the Capital Gains Exemption New Restrictions on Minors Proposed age limit so that minors will no longer qualify for the LCGE in respect of capital gains that are realized, or that accrue LCGE will no longer be available to minors regardless of whether the child is involved in the business If minor acquires qualifying property and disposes of it when they are an adult, the increase in the value of the property during the time the individual was a minor will not be eligible for the LCGE It may be necessary to have a valuation of the shares completed at the beginning of the taxation year in which the minor turns 18 years old Taxation of Private Corporation Policy Conference

176 Constraining the Capital Gains Exemption Tying the use of the LCGE to the new TOSI Rules Proposals provide that the LCGE will generally not apply if the taxable capital gain arising from a disposition is included in an individual s split income If an amount is not included in TOSI only because the recipient of the income is already taxed at the top marginal tax rate, restriction on LCGE can apply If a taxable capital gain (TCG) from the disposition of a property is included in individual s split income, then the amount that the individual can deduct under the LCGE in computing the TCG is reduced by 2 times the amount of the TCG included in computing the individual s split income Taxation of Private Corporation Policy Conference

177 Constraining the Capital Gains Exemption How Property in Trusts is Affected New limits for beneficiaries of a trust from claiming any LCGE on dispositions In order for an associated gain from property held by a trust to be eligible for the LCGE, it must be designated by an Eligible LCGE Trust An Eligible LCGE Trust includes: A spousal or common-law partner trust or alter ego trust where the individual claiming the LCGE is the trust s principal beneficiary; Certain employee share ownership trusts, where the individual beneficiary is an arm s length employee of the employer sponsor of the arrangement Taxation of Private Corporation Policy Conference

178 Constraining the Capital Gains Exemption How Property in Trusts is Affected Trust measures would apply in situations where the trust realizes a capital gain and allocates it to a beneficiary, and also where the trust elects to transfer the property with an accrued gain to a beneficiary who realizes the gain at a later date on a disposition These measures would not prevent trusts that are currently eligible to undertake rollovers to beneficiaries from continuing to do so; however, unless an exception applies, no deduction would be allowed under the LCGE in respect of the capital gain that is transferred from a trust on a rollover of property to a beneficiary Taxation of Private Corporation Policy Conference

179 Constraining the Capital Gains Exemption Election for Deemed Disposition in 2018 Transitional rules provide for grandfathering of certain dispositions that occur in 2018, allowing an individual to elect to realize in 2018, a capital gain in respect of eligible property by way of a deemed disposition for proceeds up to the FMV of the property Transitional rules provide an opportunity for property that currently does not qualify for the capital gains exemption in 2017 to be purified as proposed legislation will reduce the holding period from 24 months to 12 months This means that the purification process must happen before December 31, 2017 in order for the crystallization to occur in Taxation of Private Corporation Policy Conference

180 Panel Discussion Taxation of Private Corporation Policy Conference

181 Supplementary 2011 Data on CCPCs and Income Taxes M. C. Wolfson for the CTF Conference, Monday, September 25, 2017 caveat: preliminary estimates ( hot off the press ); they have not had the benefit of my usual careful checking and re-checking caveat: family members include only those co-resident background: based on several years of effort to assemble tax administrative data, up to now untouched by human thought derived from special tabulations performed at Statistics Canada responsibility: Michael Wolfson riffs from this morning: David Duff As we all know Jack Mintz There are no data

182 basic graphs women have lower incomes than men Preliminary Estimates! though within income groups, ownership of CCPCs is similar

183 Preliminary Estimates!

184 Financial Characteristics, Selected T1 Income Groups mean T2 GROSS CCPC income mean T2 addition to retained earnings mean CCPC dividends paid to family gender T1 total income group ($000s) CCPC owner number of T1 filers (000s) mean T1 wages ($000s) mean T1 GROSS selfempl ($000s) mean T1 NET selfempl ($000s) ($000s) mean T2 NET CCPC income ($000s) ($000s) ($000s) male <0 no yes female <0 no yes male no 5, Preliminary yes Estimates! female no 4, yes male no yes , female no yes , male >500 no yes , , female >500 no yes , ,

185 Financial Characteristics, Selected T1 Income Groups mean T2 GROSS CCPC income mean T2 addition to retained earnings mean CCPC dividends paid to family gender T1 total income group ($000s) CCPC owner number of T1 filers (000s) mean T1 wages ($000s) mean T1 GROSS selfempl ($000s) mean T1 NET selfempl ($000s) ($000s) mean T2 NET CCPC income ($000s) ($000s) ($000s) male <0 no yes female <0 no yes male no 5, Preliminary yes Estimates! female no 4, yes male no yes Does negative ,245.1 income female no mean you 45.8 are poor? yes , male >500 no yes , , female >500 no yes , ,

186 Financial Characteristics, Selected T1 Income Groups mean T2 GROSS CCPC income mean T2 addition to retained earnings mean CCPC dividends paid to family gender T1 total income group ($000s) CCPC owner number of T1 filers (000s) mean T1 wages ($000s) mean T1 GROSS selfempl ($000s) mean T1 NET selfempl ($000s) ($000s) mean T2 NET CCPC income ($000s) ($000s) ($000s) male <0 no Preliminary yes female <0 no Estimates! - - yes male no 5, yes female no 4, yes male no yes , female no Yes, 267.8CFIB, there 45.8 are CCPC - owners - with - - male >500 yes , middle and low incomes but the no yes dollar amounts 84.4 involved 2,555.1 are 1,371.6 not large female >500 no yes , ,

187 Financial Characteristics, Selected T1 Income Groups mean T2 GROSS CCPC income mean T2 addition to retained earnings mean CCPC dividends paid to family gender T1 total income group ($000s) CCPC owner number of T1 filers (000s) mean T1 wages ($000s) mean T1 GROSS selfempl ($000s) mean T1 NET selfempl ($000s) ($000s) mean T2 NET CCPC income ($000s) ($000s) ($000s) male <0 no Preliminary yes female <0 no Estimates! - - yes male no 5, These are high income CCPC owners yes female no 4, and the dollar amounts at play are large yes male no yes , female no yes , male >500 no yes , , female >500 no yes , ,

188 Typical Taxpayer (= Hypothetical) Examples of Tax Savings from Income Sprinkling ($) produced by a leading tax consultancy (KRP) compares 100% of income received by one person as salary with use of CCPC to achieve an equal split using dividends simplifying assumptions, e.g. no credits or deductions except basic, spousal, and CPP Tax Payable in Ontario Tax Payable in Alberta Before-tax Assumed if Received if Received Difference if Received if Received Difference Income Splittees via Salary via CCPC = Tax Saving via Salary via CCPC = Tax Saving 73, ,008 11,586 1,422 11,694 11, , ,427 33,122 11,305 39,075 33,014 6, , ,843 41,812 37,031 69,318 43,016 26, , ,843 60,120 18,723 69,318 57,580 11, , , ,076 32, , ,734 24,145 1,000, , ,962 33, , ,958 25,921

189 Main New Messages re Income Sprinkling tax savings for those with incomes below $150k are small claims that addressing sprinkling is an attack on small businesses with incomes at or below $73k (e.g. CFIB) are baseless scaremongering within income groups, women are about as likely to have ownership of CCPCs as men; but women are in lower income groups claims that sprinkling proposals are an attack on women also very weak tax savings from sprinkling at higher incomes are on the order of tens of thousands of dollars farmers and restaurant owners above $200k appear even more likely to be using CCPCs than doctors recall Auditor General: tax-based expenditures were not systematically evaluated and the information reported did not adequately support parliamentary oversight. (para 3.77, Spring 2015 Report) again caveat: these are preliminary results

190 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Surplus Stripping Disclaimer: This material is for educational purposes only and is not intended to be advice on any particular matter. No one should act on the basis of any matter contained in these materials without considering appropriate professional advice. The presenters expressly disclaim all liability in respect of anything done or omitted to be done wholly or partly in reliance upon the contents of these materials. Allan Lanthier (Moderator) Retired Partner, EY LLP Greg Bell KPMG LLP Mark Brender Osler, Hoskin & Harcourt LLP Bruce Harris PwC LLP Robert Raizenne Osler, Hoskin & Harcourt LLP

191 Topics Surplus stripping - history and policy framework Section 84.1 and section Share transfers inter vivos and on death Issues transition; double taxation; uncertain results Intergenerational transfers Taxation of Private Corporation Policy Conference

192 Two streams of surplus stripping rules First Stream: Shareholder/corporation rules (mostly complete by 1926) Initial versions of 84(1), 84(2), 84(3), 15(2) Second Stream: Other ways to surplus strip: 84.1, History of second phase is more complicated There was an antecedent to 84.1, which returned in antecedents (32A(2) 138A 247(1)) Repealed in 1948, restored in 1963, repealed again in Taxation of Private Corporation Policy Conference

193 1917 Act Perfect Integration Corporate rate = 4% Top personal rate = 25% Tax deferral potential on corporate earnings, both business and investment = 21% Corporate tax fully integrated with personal tax Taxation of Private Corporation Policy Conference

194 1917 Act Perfect Integration BUT Shareholder immediately taxable on undistributed income UNLESS Minister determines (i) no avoidance motive, and (ii) undistributed income not in excess of needs of business BUT Attribution of undistributed income reversed in 1918, retroactive to 1917; rule became no attribution unless Minister concluded avoidance, and undistributed income was in excess of needs of business Other features of 1917 Act: 1. Shareholder / corporation transactions reviewable 2. Capital gains not taxed: the original sin? Taxation of Private Corporation Policy Conference

195 The Amendments Begin Stock dividends made fully taxable as dividends from 1918 IRC v. Burrell, [1924] 2 K.B.: UK CA holds winding-up dividend constitutes proceeds on capital account 84(2) prototype enacted in response to Burrell Broad meaning subsequently given to winding-up notion in subsection 84(2): MNR v. Merritt, [1942] S.C.R. 269: winding-up is not a term of art Amendment in 1948 adds directly or indirectly language; Testimony of W.R. Jackett, HoC Standing Committee on Banking and Commerce: Or what would have been refers to the case where there was no actual distribution, proper distribution, or property of the corporation to the shareholders one case would be where a corporation ceased carrying on business and the shareholders just took the property according to some arrangement without going through the proper winding up and distribution of assets to catch a subterfuge Conn Smythe, [1970] S.C.R. 64 MacDonald, 2013 FCA Taxation of Private Corporation Policy Conference

196 1926 Budget a big budget Continuing manifestations of tax avoidance House of Commons Debates, 1926, Georges Henri Boivin, Minister of Customs and Excise: We want to obviate the practice, followed by certain corporations, of escaping the payment of taxation by allowing their profits to remain as reserve for a year or two and then distributing those profits in other ways than in the form of dividends to shareholders, as for instance, by the purchase of stock at a premium, or by reducing capital stock for more than its value at the time it was sold Taxation of Private Corporation Policy Conference

197 1926 Budget Details 1. At a time of declining tax rates, there was a conscious choice to terminate integration: not politically palatable 2. Additional avoidance rules enacted, including: 84(1) capitalization of earnings 84(3) share redemptions 84.1 NAL share transfers 15(2) / Shareholder loans Deemed dividends limited to available undistributed income on hand (UIOH) 3. Intercorporate dividend deduction legislated Prototypes 4. Personal corporation rule causes holding companies to be taxed on an attribution basis Taxation of Private Corporation Policy Conference

198 Enactment of section 32A: Treasury Board direction C. Fraser Elliott, Commissioner of Taxation: By reason of the amendments referred to and other amendments, it can be stated generally that, neither directly nor indirectly, can the earned surplus of a company be put out of the channel of taxation under any name or scheme, on distribution. It will be taxed, whether done by way of ordinary dividend, winding up, stock dividend, premium, loan, or through controlled or personal corporations 32A amended: Treasury Board direction expressly extended to surplus stripping transactions Ives Report Taxation of Private Corporation Policy Conference

199 1948 Income Tax Act (continued) Previous rules carried over, with some exceptions; Treasury Board direction references to surplus stripping deleted Shareholder benefit rule subsection 15(1) added Dividend tax credit prototype added to alleviate double taxation Carter Commission: where one Canadian corporation acquires control of another, at a time when the other corporation has undistributed income on hand, such undistributed income will become designated surplus and a dividend will not pass tax-free between the corporations to the extent that it is paid out of the designated surplus Designated surplus rules proved complex and ineffective and interfered with business transactions Taxation of Private Corporation Policy Conference

200 The Oracle Speaks: W.R. Jackett, 1960 CTF Conference, the law has always been constructed on the basis that the tax on the distributions to individuals was only deferred and must ultimately be paid. The 1926 amendments were designed to treat all non-dividend distributions from the corporation to the shareholder as deemed dividends. However, there are other means of escaping the second tax: by using provisions in the Act designed for some other object to put the individual shareholders in possession of all or a substantial part of the undistributed corporate earnings without paying the second tax on them. Examples of these means are: (a) transactions making use of the exemption for intercompany dividends; (b) transactions making use of exempt entities; and (c) transactions making use of [non-residents] Taxation of Private Corporation Policy Conference

201 1963 Enactment of section 138A Carter Report: A Major Weakness of the Present System of Taxing Corporations Surplus Stripping General anti-surplus stripping rule added to Act Carried over intact to 1972 Reform Act as subsection 247(1) Amended in 1986 to remove ministerial discretion Repealed in 1988 as part of GAAR reshuffle: Technical Notes: Because the scope of that general anti-avoidance rule is broad enough to cover the transaction to which subsection 247(1) was intended to apply, that subsection is no longer necessary Methodologies of two rules are not the same No substantial judicial guidance C.W. Primeau, Surplus Stripping: The Departmental View (1974) 22:5 Canadian Tax Journal Taxation of Private Corporation Policy Conference

202 Designated surplus rules repealed Modern 84.1 enacted 1977 Budget Taxation of Private Corporation Policy Conference

203 1980 Finance comments on 247(1) When it became clear that the designated surplus approach was not effective, a "ministerial discretion" provision was introduced in 1963 to contain a groundswell of surplus-stripping developments. In the absence of a reasonable and workable system, this created taxpayer uncertainty, further administrative difficulties and otherwise unnecessary expenditure of time and effort in the planning of business transactions and in the enforcement of the law. Its continued presence is indicative of the genuine difficulty in designing workable rules to determine the tax on surplus distributions where there is a differential treatment of dividends and capital gains Taxation of Private Corporation Policy Conference

204 Post-GAAR case law comments on scheme in the Act Pre-Canada Trustco McNichol, 97 DTC 111, per Justice Bonner: the scheme of the Act calls for the treatment of distributions to shareholders of corporate property as income and other provisions of the Act demonstrated the existence of a legislative scheme to tax as income all distributions by a corporation to a shareholder, even those of a less orthodox nature than an ordinary dividend RMM, 97 DTC 302, per Justice Bowman: The Income Tax Act, read as a whole, envisages that a distribution of corporate surplus to shareholders is to be taxed as a payment of dividends. A form of transaction that is otherwise devoid of any commercial objective, and that has as its real purpose the extraction of corporate surplus and the avoidance of the ordinary consequences of such a distribution, is an abuse of the Act as a whole Taxation of Private Corporation Policy Conference

205 Post-GAAR case law comments on scheme in the Act Post-Canada Trustco Evans, 2005 TCC 684, per Justice Bowman: The only basis upon which I could uphold the Minister's application of section 245 would be to find that there is some overarching principle of Canadian tax law that requires that corporate distributions to shareholders must be taxed as dividends, and where they are not the Minister is permitted to ignore half a dozen specific sections of the Act. This is precisely what the Supreme Court of Canada has said we cannot do [McNichol and RMM] were early general anti-avoidance rule cases and we did not have the benefit of the Supreme Court of Canada's guidance that we have today. If we had had the benefit of the Supreme Court of Canada's views, our analysis might have been quite different Taxation of Private Corporation Policy Conference

206 Post-GAAR case law comments on scheme in the Act Post-Canada Trustco (continued) McMullen, 2007 TCC 16, per Justice Lamarre: In conclusion, the respondent has not persuaded me, or has not presented any evidence establishing, that there was any abuse of the Act read as a whole, or that the policy of the Act read as a whole is designed so as to necessarily tax corporate distributions as dividends in the hands of shareholders. Collins & Aikman, 2009 TCC 299, per Justice Boyle: No scheme against surplus stripping applies comments from Evans and McMullen FCA 251: We see no reason to conclude that the limited scope of [84.1 and 212.1] was anything other than a deliberate policy choice by Parliament Taxation of Private Corporation Policy Conference

207 Post-GAAR case law comments on scheme in the Act Post-Canada Trustco (continued) Copthorne, 2011 SCC 63, per Justice Rothstein: What is not permissible is basing a finding of abuse on some broad statement of policy, such as anti-surplus stripping, which is not attached to the provisions at issue Tax Court: While the Act contains many provisions which seek to prevent surplus stripping, the analysis under subsection 245(4) must be firmly rooted in a unified textual, contextual and purposive interpretation of the relevant provisions. As such, reliance on a general policy against surplus stripping is inappropriate to establish abusive tax avoidance Gwartz, 2013 TCC 86, per Justice Hogan: Crown abandoned position that there is a scheme against surplus stripping in the Act Justice Hogan finds no scheme cites Copthorne, McMullen, Collins & Aikman Descarries, 2014 TCC 75, per Justice Hogan: the Act does not contain any general prohibition stating that any distribution by a company must be done in the form of a dividend Taxation of Private Corporation Policy Conference

208 From 2014 APFF Roundtable: CRA Recent Administrative Practice «En toute déférence, il nous apparaît qu'on doit plutôt, selon nous, tenir compte dans cette analyse, de l'alinéa 82(1)b), de l'article 121 ainsi que des paragraphes 84(1), 84(2), 84(3), 84(4) et 15(1) L.I.R. supportant une politique fiscale qui a pour but d'imposer exclusivement sous forme de dividendes les surplus d'une société versés directement à leurs actionnaires qui sont des particuliers.» «Ces dispositions reflètent, selon nous, une politique fiscale claire et non ambiguë de la part du ministère des Finances, qu'on appelle communément les Règles d'intégration, laquelle est également appuyée par toute une série d'autres dispositions (entre autres, l'article 84.1 L.I.R. ainsi que les paragraphes 84(2), 246(1) et 245(2) L.I.R., en tenant compte de l'ancien paragraphe 247(1) L.I.R. et particulièrement des notes explicatives du ministère des Finances se rapportant à ce paragraphe) ayant pour but d'éviter que les particuliers actionnaires obtiennent indirectement les surplus d'une société sous une forme autre qu'un dividende. En somme, dans une situation comme dans l'affaire Descarries, les Trois opérations d'évitement constituent, selon nous, un abus des Règles d'intégration.» Taxation of Private Corporation Policy Conference

209 CRA Recent Administrative Practice From 2014 APFF Roundtable (continued): «Compte tenu de ce qui précède et des décisions défavorables rendues par la CCI à l'égard de l'analyse des paragraphes 84(2) et 245(2) L.I.R. dans le cadre de dossiers impliquant des dépouillements de surplus, l'arc croit nécessaire, avec déférence pour la position prônée par la CCI, de s'adresser à la Cour d'appel fédérale ou à la Cour suprême du Canada pour qu'un tribunal supérieur, d'une part, confirme la portée très large du paragraphe 84(2) L.I.R. établie récemment par la Cour d'appel fédérale dans l'affaire MacDonald, et d'autre part, statue sur la présence ou non d'un plan spécifique de la L.I.R. visant à imposer toute distribution directe des surplus d'une société canadienne à titre de dividendes imposables entre les mains de ses actionnaires qui sont des particuliers; ainsi que d'un plan spécifique de la L.I.R. pour contrer également les dépouillements indirects des surplus d'une telle société.» Taxation of Private Corporation Policy Conference

210 From 2015 CTF Roundtable: CRA Recent Administrative Practice The CRA is nevertheless concerned with surplus stripping arrangements and has expressed those concerns to the Department of Finance The CRA will still maintain its position of applying the GAAR and/or subsection 84(2) to cases like The Queen v. Macdonald where a taxpayer uses losses or other tax shelter to reduce a capital gain realized as part of a surplus stripping scheme Also, the CRA will rely on the reasoning in Descarries where a taxpayer seeks to extract corporate surplus in a manner contrary to the object, spirit or purpose of specific anti-avoidance provisions, such as sections 84.1 and Taxation of Private Corporation Policy Conference

211 Proposed changes to 84.1 and related issues

212 Surplus Stripping CRA has previously asserted there is a general scheme in the Act against surplus stripping Removing retained earnings of a corporation by way of capital gains rather than dividends See, for example, Technical interpretation E5, published June 18, 2013 Notwithstanding the recent decision in Gwartz et al. v. The Queen, 2013 TCC 86, the CRA intends, at the next opportunity, to demonstrate to the Court that there is a specific scheme of the Act for taxing the distribution of surplus of a Canadian corporation as a taxable dividend in the hands of individual shareholders and that there is also an overall scheme of the Act against surplus stripping. The courts have found that the Act does not contain a general scheme to prevent surplus stripping See Evans v. The Queen, 2005 TCC 684, The Queen v. Collins & Aikman Products Co., 2010 FCA 251 and Copthorne Holdings Ltd. v. The Queen, 2011 SCC Taxation of Private Corporation Policy Conference

213 Evans (2005 TCC) - GAAR rejected Surplus Stripping Scheme The only basis upon which I could uphold the Minister's application of section 245 would be to find that there is some overarching principle of Canadian tax law that requires that corporate distributions to shareholders must be taxed as dividends, and where they are not the Minister is permitted to ignore half a dozen specific sections of the Act. This is precisely what the Supreme Court of Canada has said we cannot do. Counsel argues that this case is similar to Justice Bonner's decision in McNichol and mine in RMM. These cases were early general anti-avoidance rule cases and we did not have the benefit of the Supreme Court of Canada's guidance that we have today. If we had had the benefit of the Supreme Court of Canada's views, our analysis might have been quite different. Contradicted his own judgment in RMM v. Canada (1997 D.T.C. 302 (TCC)) Taxation of Private Corporation Policy Conference

214 Section 84.1

215 Non-Arm s Length Sale of Shares Individual sells shares of Privateco to non-arm s length corporation (Newco) to realize a capital gain Consideration is a promissory note Cash of Privateco to be used to repay promissory note Might amalgamate or redeem high adjusted cost base ( ACB ) shares No 55(2) However, under existing rules (and no change under proposed rules) 84.1(1)(b) - Individual deemed to receive a dividend of $99 instead of a capital gain of $99 Dividend equal to amount of note in excess of greater of hard ACB and PUC of Privateco shares Same result if Individual uses CGE Taxation of Private Corporation Policy Conference

216 Non-Arm s Length Sale of Shares Individual sells shares to non-arm s length corporation to realize a capital gain Consideration is high-basis / high paid-up capital shares Cash of Privateco to reduce PUC of Newco shares Might amalgamate or redeem high ACB shares No 55(2) However, under existing rules (and no change under proposed rules) 84.1(1)(a) PUC of Newco shares reduced to $1 PUC reduced to greater of hard ACB and PUC of Privateco shares Same result if Individual uses CGE Taxation of Private Corporation Policy Conference

217 Parent sells Privateco shares to Child (i.e. a non-arm s length individual) for cash to realize capital gain Non-Arm s Length Sale of Shares Child sells Privateco shares to Newco for Promissory Note Cash of Privateco to be used to repay promissory note Taxation of Private Corporation Policy Conference

218 Non-Arm s Length Sale of Shares Under Existing Rules 84.1 does not apply Parent has capital gain Parent has sold shares to child 84.1 can only apply if Parent sells shares to a non-arm s length corporation Child not deemed to receive a dividend Child has hard ACB in shares of Privateco Provided Parent does not claim capital gain exemption ( CGE ) 84.1(2)(a.1)(ii) Taxation of Private Corporation Policy Conference

219 Non-Arm s Length Sale of Shares Under Existing Rules 84(2) could possibly apply 84(2) deems amounts distributed in any manner whatever to a shareholder to be a dividend Can apply if cash of Privateco is considered to be distributed on discontinuance, winding-up or a reorganization of Privateco s business Taxation of Private Corporation Policy Conference

220 Non-Arm s Length Sale of Shares Under Proposed Rules 84.1 applies to Child Child deemed to receive dividend of $99 Capital gain realized by Parent does not create hard tax ACB See proposed amendment to 84.1(2)(a.1)(ii) Previous dispositions by non-arm s length persons does not create hard ACB Taxation of Private Corporation Policy Conference

221 Non-Arm s Length Sale of Shares Under Proposed Rules 84.1 applies to Child Child deemed to receive dividend of $99 Capital gain realized by Parent does not create hard tax ACB See proposed amendment to 84.1(2)(a.1)(ii) Previous dispositions by non-arm s length persons does not create hard ACB Even if intermediate sale to third-party Taxation of Private Corporation Policy Conference

222 Non-Arm s Length Sale of Shares 84.1 Department of Finance Explanatory Notes The objective of [the amendment] is to ensure that an individual cannot use more than the greater of their so-called hard arm s length share cost and the PUC of their share to extract corporate surplus on a tax-free basis or as capital gains from a corporation. The amendments to section 84.1 apply in respect of dispositions that occur on or after July 18, Taxation of Private Corporation Policy Conference

223 Transitional Issues

224 Transitional/Technical Issues Pipeline Planning Estates holding high ACB shares where it was planned that pipeline planning be implemented Impacted by 84.1 May no longer be possible or practical to carry out 164(6) planning, (for example, July 18, 2017 is more than one year after death) For existing pipeline notes or high-puc shares, could new apply on payment of the note or return of PUC? Taxation of Private Corporation Policy Conference

225 Interaction with Tax on Split Income Is 120.4(4) necessary? Transitional/Technical Issues Based on the changes to 84.1 and the LCGE rules, 120.4(4) should not be necessary If 120.4(4) is not repealed should 84.1 be amended? Where 120.4(4) applies, an individual is deemed to have an ineligible dividend equal to twice the taxable capital gain There should be an exception in 84.1(2)(a.1)(ii) to create hard ACB in recognition that the gain has already been taxed as a dividend Taxation of Private Corporation Policy Conference

226 Non-arm s Length/ Intergenerational Transfers

227 Non-arm s Length/Intergenerational Transfers 84.1 generally applies on the transfer of shares of a corporation between siblings and between parents and their children Privateco is owned 50/50 by two siblings FMV of a 50% interest is $3 million ACB is nominal Gain qualifies for the LCGE Tax rate on capital gains is 25% Tax rate on non-eligible dividends is 45% The income tax arising on a sale by one sibling is as follows: Taxation of Private Corporation Policy Conference

228 Non-arm s length/intergenerational Transfers Recommendations An exception to 84.1 should be provided to facilitate true dispositions of shares of corporations between family members (inter vivos and testamentary) The exception could include a number of conditions to ensure that the proposed disposition is not a disguised surplus strip, for example: Limit to sales of active businesses Limit to sales of a significant portion of a shareholder s interest Limit the rate of return on any share consideration Taxation of Private Corporation Policy Conference

229 Impact on Post-Mortem Planning

230 Post-Mortem Considerations Is it the policy intent to tax an individual at the ineligible dividend rate on death? Is there a change in policy regarding double tax and the ability to increase the ACB of capital properties held by a corporation to mitigate double tax? Taxation of Private Corporation Policy Conference

231 Pipeline Planning Post-Mortem Planning - Summary Impacted by 84.1 amendments Existing pipeline notes or shares might be impacted by proposed (6) Planning Enhanced 164(6) planning impacted by proposed Taxation of Private Corporation Policy Conference

232 Post-Mortem Planning Pipeline Existing Rules Objective Limit tax as a result of death to tax on capital gain realized by deceased Can be implemented any time after death of shareholder Subject to certain constraints Pipeline Proposed Rules Based on draft legislation, pipeline transactions will result in deemed dividend to estate Taxation of Private Corporation Policy Conference

233 84.1 Amendment Impact on Post-Mortem Pipeline Planning Individual A passes away Individual A owned shares of Privateco with low ACB and paid-up capital ( PUC ) Individual A deemed to have capital gain of $99 on death Subsection 70(5) Estate of A has high ACB in shares of Privateco Taxation of Private Corporation Policy Conference

234 Post-Mortem Planning Estate transfers shares of Privateco to Newco for a promissory note or shares with high PUC ( Pipeline ) Pipeline is to prevent double taxation on value of shares held at death Deemed gain on death Dividend on eventual distribution of Privateco s assets Planning steps may involve amalgamating Newco and Privateco to bump ACB of Privateco s capital property 88(1)(d) bump is potentially available Eliminates gains on Privateco s assets that were reflected in gain on the shares of Privateco Taxation of Private Corporation Policy Conference

235 Post-Mortem Planning Under Existing Rules Individual has capital gain on death 70(5) Estate is not deemed to have a dividend 84.1 does not apply Estate has hard ACB in Privateco shares 84(2) does not apply If certain conditions are met under CRA guideline Taxation of Private Corporation Policy Conference

236 Post-Mortem Planning Under Proposed Rules Estate is deemed to receive dividend of $99 See proposed amendment to 84.1(2)(a.1)(ii) Previous dispositions by non-arm s length persons does not create hard ACB Estate and Individual A would be considered non-arm s length Significant impact to many estate plans Is this result intended? Taxation of Private Corporation Policy Conference

237 Post-Mortem Planning Bump Issues There must be an acquisition of control as a consequence of death (88(1)(d.3)) this is often unrealistic Bump denial rules There may not be bump room as a consequence of a previous estate freeze 88(1)(d) limits the available bump of the ACB of Privateco s assets to: The amount by which the amount determined under 88(1)(b)(ii) (ACB) exceeds: Cost amount of property and cash held by the subsidiary immediately before the winding up less debts of the subsidiary and certain other adjustments Taxation of Private Corporation Policy Conference

238 Post-Mortem Planning 164(6) Existing Rules Eliminates capital gain from deemed disposition on death Wind-up company or redeem shares and receive distribution as a dividend Rules require that the steps be implemented within one year of death The estate must be a graduated rate estate Taxation of Private Corporation Policy Conference

239 Post-Mortem Planning 164(6) Enhanced Planning could apply Involves redemption of Privateco shares to create a capital loss carry back and a dividend Planning enhanced by internal transfer of capital property to create CDA and RDTOH This planning increased the ACB of the property Taxation of Private Corporation Policy Conference

240 Potential changes to proposed/enacted legislation

241 Recommendations Tax deemed gain on death as a dividend to the extent of safe income Safe income is a measurement of the after-tax income which has not been distributed to a shareholder If the intent is to put a person who has incorporated in the same position as a person who has not incorporated then only undistributed income should be taxed at dividend rates Tax remaining gain at capital gains rate The balance of the inherent gain in the shares should be taxed at capital gains rates as it represents inherent gains in the underlying assets of the corporation Taxation of Private Corporation Policy Conference

242 Simplify 164(6) Recommendations Introduce a new election to treat all or a portion of the capital gain on death as a dividend on the final return An exception would be provided in 84.1 equal to the elected amount Corresponding increase in the ACB of the share Simplify legislation to eliminate double tax on death Bump rules in 88(1)(d) are too complicated and often not a solution Introduce a new election to increase the ACB of capital property held by a corporation to the extent of gain recognized on death Taxation of Private Corporation Policy Conference

243 Transitional/Technical Issues Summary Relief should be provided from the application of 84.1 where an individual has passed away prior to July 18, 2017 Clarification should be provided that will not apply to existing notes/puc created on pipeline planning 120.4(4) should be repealed or alternatively hard ACB should be created under 84.1 where 120.4(4) applies Non-arm s length/intergenerational transfers An exception to 84.1 should be provided to facilitate true dispositions of shares of corporations between family members (inter vivos and testamentary) Taxation of Private Corporation Policy Conference

244 Tax on Death/Post Mortem Issues Summary The inherent gain on shares of a private company should be taxed at dividend rates to the extent of safe income, the balance of the gain should be taxed at capital gains rates 164(6) should provide a new election to treat the gain on death as a dividend on the final return (an exception would be provided in 84.1 equal to the elected amount) An election should be provided to increase the underlying ACB of assets of a private corporation by the amount of the capital gain recognized on death Taxation of Private Corporation Policy Conference

245 Surplus Stripping New Section 246.1

246 Policy Concerns Underlying New a separate anti-stripping rule to counter tax planning that circumvents the specific provisions of the tax law meant to prevent the conversion of a private corporation's surplus into tax-exempt, or lowertaxed, capital gains. In general, the anti-stripping rule would apply to non-arm's length transactions where it is reasonable to consider that "one of the purposes" of a transaction or series is to pay an individual shareholder/vendor non-share consideration (e.g., cash) that is otherwise treated as a capital gain out of a private corporation's surplus in a manner that involves a significant disappearance of the corporation's assets. In such a case, the non-share consideration would be treated as a taxable dividend. Put differently, converting corporate surplus/taxable earnings that should be taxable as dividends into capital gains at individual shareholder level i.e. the opposite of what subsection 55(2) produces at corporate level Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

247 Overview Interaction with other surplus stripping rules Section 84.1 subsection 84(2) Broadly speaking, targets two categories of transactions classic surplus stripping transactions - McNichol, Evans, MacDonald, among others Is new intended to be 84(2) on steroids? CDA, PUC and boot generating transactions Internal vs external CDA generation? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

248 Architecture portion of amount receivable directly or indirectly by an individual resident in Canada portion of amount receivable directly or indirectly in any manner whatever from a NAL person series of transactions disposition of property Increase or reduction of PUC It can reasonably be considered that one of the purposes of transaction or seriest to effect a significant reduction or disappearance of assets in a manner such that tax otherwise payable and in consequence of any distribution of property of a corporation is avoided if 246.1(1) applies to portion, reduction of CDA account by full amount of non-taxable part of capital gains realized as part of the series Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

249 Internal step-up transactions Non-Arm s Length Context ECP crystallizations Internal CDA generation transactions Post-mortem estate planning CDA streaming Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

250 Example 1 ECP Step-up transactions Announced repeal of the eligible capital property regime effective as of January 1 st, 2017 Many taxpayers internally disposed (e.g. section 85) of ECP in 2016 to trigger ECA taxable at low corporate business income rate Prepayment of tax at low corporate rate 27% Creates CDA which can be paid to shareholder tax free Cheaper than taxable dividend ( 40% for eligible and 44% for ineligible) No tax cost to the corporation if gain sheltered by non-capital losses or other tax attributes Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

251 Example 1 ECP Step-up transactions Taxpayer Opco transfers intangibles/goodwill to NewCo triggering a $5M gain: $2.5M taxable as business income Opco Opco s CDA is increased by 50% of the triggered gain Shares Business Assets NewCo ECP Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

252 Example 1 ECP Step-up transactions Deemed dividend Capital dividend Taxpayer Opco Increase in the shares ACB Opco pays cash dividend to Taxpayer or increases PUC, thereby triggering a deemed dividend and increasing ACB Business Assets NewCo Opco elects for capital dividend treatment under 83(2) ECP Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

253 If applies: Taxable dividend of $2.5M CDA decreased by $2.5M Permanent loss of CDA Example 1 ECP Step-up transactions Consider the following scenarios: Cash CDA dividend paid before July does not apply Cash CDA dividend paid on or after July apply? PUC increase out of CDA before July 18, ROC on or after July apply? Assume ECP step-up was done in contemplation of an arm s length sale of Newco in 2017 Opco disposes of Newco shares to AL purchaser for cash in 2017 (before or after July 17) Opco pays a 2.5M CDA dividend to Taxpayer on or after July 18, apply? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

254 Example 2 repayment of shareholder loans Shareholder Loan rule in 15(2) Loan of $100K included in income if not repaid in the year following the end of the taxation year in which Opco made the Loan Assume Opco is a CCPC that carries on an active business Several different ways Taxpayer could repay the Loan Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

255 Example 2 Salary alternative Assume Opco earns $227,043 Highest personal tax bracket = 53.53% (Fed. + Ontario) Salary needed to repay the Loan = $215, Personal tax on salary = $115, Net corporate tax = $3,140 ($227, ,192) x 26.5% Total corp/personal tax = $118,332 Salary of $215, Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

256 Example 2 Dividend alternative Assume Opco earns $227,043 Effective tax rate for eligible dividend = 39.34% (Fed. + Ontario) Eligible dividend needed to repay the Loan = $164, Corporate tax on $227,043 = $60,166 Personal tax = $64,853 Total corp/personal tax $125,020 Note lack of integration compared to salary Dividend of $164, Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

257 Example 2 Capital gain alternative Assume Opco earns $227,043 Opco also realizes $137,893 capital gain on the transfer to NewCo resulting in $68,946 addition to CDA Opco pays $68,946 CDA and $51,193 eligible dividend for TP to net $100K Total tax = $95,272 [$60,166 + $20,139 + $13,445 +$1,522 refundable tax] 2 capital dividend & eligible dividend Taxpayer Newco Repayment of Loan 3 1 Trigger capgain of Opco Taxation of Private Corporation Policy Conference Assets Brender & Harris - September 25, 2017

258 Scenario 1 Salary Tax cost = $118,332 Scenario 2 Taxable dividend Tax cost = $125,020 Scenario 3 Capital gain Tax cost = $95,272 Would apply to scenario 3? Example 2 Comparison Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

259 To be updated Example 3 Internal capital gain Safe Income = $1M FMV = $10M Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

260 Example 3 Internal capital gain Holdco transfers Opco to Newco triggering capital gain of $1M Holdco pays $500K capital dividend Section apply to dividend, portion of dividend? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

261 Example 4 Planning to avoid double tax Estate Property Holdco Preferred shares Sub Children Estate s ACB equals FMV at time of death Holdco transfers certain property to Sub to trigger capital gains to allow payment CDA and RDTOH on redemption of Estate s preferred shares. Purpose is to avoid double tax. Other property of Opco sold for cash Capital loss in estate carried back under subsection 164(6). Does apply with respect to CDA created on property transferred to Sub? What about CDA created on third party sales? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

262 Example 5 Planning to access LCGE X owns 1000 common shares of Opco - nominal ACB/PUC FMV of Opco is $1M Active business assets = $800M Excess cash = $200K In light of new rules affecting LCGE, X wants to elect to crystallize gain Purification required: X exchanges 200 commons for 200,000 fixed value preferred shares X rolls preferred shares to Holdco Opco redeems preferred shares Consequences: Does 55(2) apply to redemption? Redemption results in reduced gain/fmv Bona fide reorganization? If 55(2) applies, capital gain and CDA addition Does apply to CDA distribution by Holdco? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

263 Other Possible Areas of Concern CDA streaming Resident and non resident shareholders Holdco realizes gains on sale of assets Distribute CDA to resident shareholders Donation of listed securities Holdco donates securities to registered charity/private foundation Taxable capital gain is nil Full CDA addition Stepping up ACB/PUC where 84.1 does not apply Individual sells shares of non-connected corporations to Holdco at FMV Holdco issues boot or high PUC shares Holdco distributes cash to repay note or return capital Corporate Owned Life Insurance Policy, disposition of property, CDA addition series of transactions? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

264 246.1 Arm s Length Context Text of new is extremely broad Explanatory notes ambiguous Is intended to apply to bona fide commercial transactions? Sale of assets Leveraged buy-outs Sale subject to earn out Converting arm s length basis into PUC Interaction with 55(2) Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

265 Example 6 - Arm s Length Sale of Assets Opco sells assets to an arm s length third party, Buyco Opco realizes capital gains & pays CDA dividend to Individual Series includes a disposition of property, amount received from NAL person and CDA dividend Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

266 Example 7 - Arm s Length Sale: Balance of Sale Buyco acquires Opco shares from Individual for cash payable at closing and balance of sale Buyco amalgamates with Opco and uses cash from Opco s operations to pay off balance of sale Is intended to apply to the balance of sale? Distinguish future versus current cash of Opco to fund balance of sale? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

267 Example 8 - Arm s Length Sale: Leveraged Buyout Buyco purchases Opco shares from Individual Buyco uses its own cash and funds borrowed from a third-party to satisfy purchase price in full at closing Buyco amalgamates with Opco and uses cash from Opco s operations to pay off the third-party debt Is intended to apply to the portion of the purchase price that was debt financed? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

268 Example 9 - Arm s length Sale Subject to Earn-Out Buyco acquires Opco shares from Individual for cash payable at closing and balance of sale subject to an earnout maximum Buyco amalgamates with Opco and uses cash from Opco s operations to satisfy the earnout Is intended to apply to the earnout payments? Distinguish future versus current cash of Opco to fund balance of sale? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

269 Example 10 PUC step up to hard ACB Is intended to be a domestic 212.1? Individual Individual acquires Opco shares in arm s length transaction Arm s length ACB of Opco shares = $1M PUC = $1 ACB for 84.1 = $1M Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

270 Is intended to be a domestic 212.1? Individual Example 10 PUC step up to hard ACB High ACB/low PUC shares transferred to Holdco Individual's ACB/PUC of Holdco shares = $1M 84.1 does not apply Hard ACB Opco pays $100K taxable dividend to Holdco Holdco distributes $100K to individual as a reduction of PUC Does apply? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

271 Example 11 Interaction with 55(2) Sister Brother OPCO redeems shares from BCo for $5M SIOH = 2 M FMV = 10 M Subsection 55(2) applies Bco realizes capital gain of $4M Does apply if Bco pays a capital dividend paid of $2M? What if Bco sells Opco shares to Sco for $5 million resulting in $2.5M gain and $2.5M of CDA? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

272 Classic Surplus Stripping

273 "Classic" Surplus Stripping: MacDonald v The Queen Taxpayer 5. Endorsement of cheques JS 1. Taxpayer sold shares of PC to his brotherin-law JS in exchange for a promissory note from JS equal to the value of the net assets of PC less a $10,000 spread 1. Purchase of shares for a note from JS 4. Endorsement of cheques Sale to individual was necessary to avoid the application of s Total consideration $525,000 PC JS transferred the shares of PC to his holding company ( 601 ) in exchange for a promissory note from 601 of $525, Transfer of shares of PC to 601 for a note from 601 PC 3. Declared dividends 3. PC declared dividends to 601 immediately after the steps above in the amount of (i) $500,000 and (ii) $10,000. A third dividend of $25,000 was declared several months later. Dividends were payable by cheques 6. PC wound up endorsed the cheques to JS 5. JS endorsed the cheques to the taxpayer 6. PC was wound up Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

274 MacDonald - Decision Tax Court : 84(2) not applicable given that Note 1 was not property of OpCo. When MacDonald received payment pursuant to Note 1, he received such payment qua creditor no longer shareholder of Opco. GAAR does not apply as there is no misuse or abuse of 84(2) ( not an anti-surplus stripping provision ), 3 (the Act permits the triggering of capital gains to be offset by capital losses), and 128.1(4) (capital gain on departure could have been offset by capital losses). Federal Court of Appeal: the winding-up of a corporation is a process and the phrase in any matter whatever in 84(2) requires a more global perspective. Opco s property ended up through circuitous means in the hands of Macdonald and therefore the only reasonable conclusion is that 84(2) applies Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

275 MacDonald - Decision FCA decision not appealed, but is questionable Court influenced by fact that corporate property found its way into the hands of the shareholder At the beginning of the date PC had cash and MacDonald was a shareholder, and at the end of the day MacDonald had PC's cash What if purchase was instead financed with Bank debt? MacDonald restricted to its facts? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

276 Limits of 84(2) on "classic" surplus strip Assume a fact pattern slightly different from that of MacDonald: Vendor sells shares of Opco, which has undistributed surplus, to a non-arm s length individual NAL buyer borrows from Bank and pays cash to Vendor with proceeds of Bank loan NAL buyer transfers shares of Opco to Newco Opco winds up and distributes cash to Newco Newco distributes cash to NAL buyer, who repays the Bank loan Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

277 On or After July 18, Loan from arm s length 3 rd party Cash for OpCo s shares Vendor 2 Bank 84(2) does not apply because Vendor does not receive Opco's property NAL Buyer 6 Loan Repayment 84.1 does not apply to Vendor because Vendor does not transfer to a corporation 3 Dropdown of OpCo into NewCo for shares with high PUC or a Note Newco 5 Return of Capital or Note Repayment 84.1 now applies to NAL Buyer - NAL Buyer has soft ACB in Opco shares should not apply to NAL Buyer because 84.1 already applies 4 Intercorporate dividend upon OpCo s wind up applies to Vendor? Opco Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

278 Classic surplus strip Now assume no third party lender, but Buyer deals at arm s length with Vendor Pre-July 18, does not apply to Vendor or Buyer 84(2) applies to Vendor based on MacDonald reasoning since Opco cash ends up in Vendor's hands 84(2) does not distinguish between arm's length and non-arm's length transactions Under new rules 84.1 does not apply to Vendor or Buyer 84(2) applies to Vendor 246.1? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

279 Classic Surplus Strip and Now assume the same facts as previous example, but AL Buyer borrows from Bank to finance acquisition of Opco Pre-July 18, does not apply to Vendor or Buyer 84(2) arguably does not apply since Opco cash does not end up in Vendor's hands GAAR? Under new rules 84.1 does not apply to Vendor or Buyer 246.1? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

280 Concluding Remarks a specific general anti-avoidance rule Catch-all provision where 84.1 and 84(2) do not apply should it reconcile with subsection 88(2) Is there now clearly a scheme in the Act against surplus stripping? Overreaching - could apply to transactions that are not surplus strips As drafted, results in reliance on CRA for guidance Guidance through explanatory notes insufficient A more targeted rule is recommended - rules should be clear for such common place transactions as paying dividends and disposing of property Principle of Integration - punitive effect of section Asymmetrical vs symmetrical approach How does 246.1(3) work? Part III tax effect of excess CDA election Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

281 Concluding Remarks Consider surplus stripping rule akin to subsection 55(2) at the individual shareholder level pro rata distribution of taxed/sioh and untaxed surplus Is CDA denial appropriate? Possible alternatives to CDA denial Hybrid surplus Ordering rule CDA suspension Non-arm s length persons and accommodating parties When is a third party an accommodating party? Better transitional rule - Section should not apply to CDA arising from before July 18, 2017 (i.e. no retroactivity) If taxation rates change, what then? Will be repealed? Taxation of Private Corporation Policy Conference Brender & Harris - September 25, 2017

282 Taxation of Private Corporation Policy Conference Thank you

283 Friends vs. Family 50 % 50 % Uncle CEO 50 % 50 % Nephew Manager of Customer Relations and HR Best Friends Successful Business Inc. TOSI will not apply to dividends On sale: Capital gain (graduated rates) LCGE (provided conditions met) Taxation of Private Corporation Policy Conference Successful Family Business Inc. Both specified individual and connected person TOSI could apply to (some/all of) dividends and capital gains based on reasonableness Compliance burden and risk of CRA reassessment

284 US Public Company How much of capital gain subject to TOSI depends on reasonableness Portion of capital gain subject to TOSI No LCGE Taxable capital gain taxed at highest marginal rate 23.85% Taxation of Private Corporation Policy Conference Who do we sell to? 50 % 50 % Successful Family Business Inc. Sale of Shares by Uncle to Niece Does 120.4(4) apply? Answer depends on reasonableness If not reasonable, not an excluded amount Result: No LCGE Gain taxed as ordinary dividend %

285 The challenge of being family in a friends and family raise 10% A B C 30% 30% 30% Next Best Thing Tech Company A, B and C are not related A s mother participates in a friends and family round of financing and invest $100,000 for 10% of common shares A s mother has no role in Next Best Thing Tech Company post-fundraise except as shareholder Mother and A are both a specified individual and a connected individual Will dividends and capital gains be subject to TOSI? Taxation of Private Corporation Policy Conference