Tax Update August 14, 2017

Transcription

1 Tax Update August 14, 2017

2 Overview On July 19, 2017, we issued a Tax Alert regarding Potential Changes to Tax Planning Using Private Corporations, and we have had an opportunity to review these changes in more detail. On July 18, 2017, the Federal Liberal government announced proposed legislative changes that will have a far reaching tax impact on private companies and their shareholders. The draft legislation, if enacted, would result in significant policy changes to the taxation of: 1. Payments to shareholders of private companies (page 2), 2. The conversion of a private corporation s income into capital gains (page 5), 3. Income from passive investments inside a private corporation (page 7), and 4. Capital gains realized on the sale of certain private company shares (page 9). As a member of DFK Canada, representatives of our DFK Canada Tax Committee have compiled four papers that summarize the proposed changes and the potential impact on the taxation of small businesses and their owners. What Are We Doing? We have been reviewing these proposals in detail to determine the impact to our clients, and we have contacted the Department of Finance to seek clarity on the proposals. We have also recommended to the Department of Finance that specific changes be made to the proposed legislation including measures that would allow for reasonable transitional rules. As part of DFK Canada, we will continue to pro-actively seek changes to these proposals by discussing their impact with our clients and by encouraging them to contact local MP s to advise them of the far reaching impact these rule changes will have on their small business. We have compiled a list of articles that have been written on why these proposed complex tax changes that will adversely affect most private businesses and their owners are unfair and should not be implemented. Please click on the following link to review these articles. Those most impacted by the proposals are being portrayed as the wealthiest of Canadians. We know otherwise. We will continue to keep our clients up to date as we continue to learn more about the proposed changes. Other Suggested Articles John Nicola s Thoughts on Proposed Tax Reform Tax Planning RIP ( ) Income splitting: Is it time to re-visit a 1966 Canadian tax reform idea? Growing Concerns with Proposed Amendments Affecting Private Businesses and their Shareholders Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 1

3 Potential Changes to Payments to Shareholders of Private Companies Written By: Mark Hunter, CPA, CA Tax Partner, Taylor Leibow Overview of Proposed Changes In 1999, responding to various family structures that split income amongst family members, the federal Department of Finance introduced a tax on split income (TOSI) that eliminated any tax benefit on income split with children under the age of 18. The TOSI mandated the top personal tax rate apply to dividends paid by private corporations, or income allocated via a partnership or trust, to family members who were under the age of 18. The proposed legislation announced in July by the Finance department will significantly increase the reach of the TOSI to include amounts paid to certain adult individuals who receive split income. Specifically, the new legislation will: i. expand the meaning of specified individual (individuals to whom the highest personal tax rate will apply); ii. introduce a reasonableness test to determine whether an amount is unreasonable and therefore subject to the highest tax rates; iii. introduce the concept of a connected individual ; iv. expand what income the TOSI rules will apply to. Specified Individual TOSI applies to individuals who are specified individuals. Under the proposed legislation a specified individual is a Canadian resident, regardless of age, who receives split income derived from a business of a related individual who resides in Canada. Reasonableness Test The proposed legislation would apply TOSI to any specified individual s split income when the amount of income is deemed unreasonable according to certain legislated tests. Specifically, under the proposed changes, an amount would be unreasonable if it exceeds what an arm s-length (non-related) person would have agreed to pay the specified individual considering the recipient s: Labour Contributions, the extent to which: o for an adult specified individual age 18-24, the individual is actively engaged on a regular, continuous and substantial basis in the activities of the business; and o for an adult specified individual age 25 or older, the individual is involved in the activities of the business (e.g., contributed labour that could have otherwise been remunerated by way of salary or wages). Capital contributions, the extent to which: o for an adult specified individual age 18-24, the amount exceeds a legislatively-prescribed maximum allowable return on the assets contributed by the individual in support of the business; and o for an adult specified individual age 25 or older, the individual has contributed assets, or assumed risk, in support of the business. Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 2

4 The following is an example of the application of the proposed new TOSI rules provided by the Department of Finance in its summary document Tax Planning Using Private Corporations. Morgan carries on a freight forwarding business through a corporation. Morgan owns all the voting shares of the corporation. Morgan s 26-year-old child, Jesse, is an accountant and, except as described below, does not participate in the freight forwarding business. Jesse owns dividend eligible shares of the corporation, which Jesse purchased for $1. Jesse s shares do not participate in the growth of the corporation. Both Morgan and Jesse are Canadian residents. During the fiscal year, the corporation paid Jesse for accounting services he performed on behalf of the corporation. The amount paid by the corporation was equivalent to what the corporation would have paid an arm s-length party to perform the services. The corporation also declared and paid a $100,000 dividend on the shares held by Jesse. The dividend income received by Jesse will not meet the reasonableness test and will, therefore, be subject to the TOSI. Although Jesse is involved in the activities of the business, Jesse s contributions were limited to providing accounting services. Jesse purchased the shares for $1, and, therefore, did not contribute assets or assume risks in respect of the business in any material way. Finally, although Jesse provided accounting services to the business, the business already paid Jesse for the fair market value of these services. If on the other hand, Jesse had contributed significant assets to the corporation, for example by purchasing shares from the corporation for a cash payment of $100,000, then Jesse would be permitted under the reasonableness test to a reasonable return on this investment without the return being subject to the TOSI. Further, if Jesse had been 24 instead of 26, the reasonableness of Jesse s dividend would be determined using a higher standard of labour contribution and impose a prescribed maximum return on the $100,000 contributed to the corporation. The department of finance s proposed expansion of the TOSI to adult recipients, as well as the requirement to determine what is reasonable, will greatly increase the administrative burden. The burden to whom? It s unclear. Will it be the burden of the payor or the recipient? Regardless, it will be a burden none-the-less. Connected Individual The proposed addition of the connected individual test applies in respect of income from a corporation. The connected individual definition provides a link for the purposes of the TOSI rules between the specified individual who receives an amount, the corporation from which the amount is derived and the connected individual who is related to the specified individual and has a presumed degree of influence over the circumstances in which the amount is paid. A connected individual in respect of a corporation would mean an individual (other than a trust) who is resident in Canada where any of the following conditions are met: Strategic Influence: the individual has factual control of the corporation alone or as part of a related group of persons; Equity Influence: the individual owns property representing 10% or more of the equity value of the corporation; Earnings Influence: with respect to a service corporation the individual or a related individual owns shares of the corporation and either the individual s services are the primary contributor to the activities or the revenues of the corporation s business, or the individual performs all or part of the services and, for the corporation to carry on the service business, the performance of those services is regulated under the laws of Canada, a province or territory; Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 3

5 Investment Influence: 10% or more of the value of the corporation s property is derived from property acquired from the individual or from another corporation in respect of which the individual is a connected individual. Adult family members of connected individuals who receive dividends will be required to determine what amount, if any, is unreasonable. In the above example, Jesse is the specified individual, and Morgan would be the connected individual. Expand What Income the TOSI Will Apply To The various types of income that the TOSI would apply to is expanded to include: Interest income from loans to private companies, partnerships or trusts, Capital gains from the disposition after 2017 of certain property the income of which would be split income, and In the case of a minor specified individual and adult specified individuals under age 25, income from property that is the proceeds from income previously subject to the TOSI or the attribution rules ( reinvested income ). Potential Impact if Changes Become Law If these measures are implemented, the ability of a business owner to split income with family members in a tax efficient manner through a corporation, partnership or family trust will be severely restricted. If, at any time, the business owner wishes to distribute income to a shareholder, partner or beneficiary they will need to assess the reasonableness of amount being paid and whether the recipient will risk paying tax on the income at the highest personal tax rate or not. Practically speaking, the draft legislation is short on direction on what is reasonable. How will the individual determine the value of work done for a business, what are reasonable rates of returns, or who can receive distributions that are not split income when a business is run with little shareholder involvement? What Should You Do Now? Consider: reviewing current tax planning measures to determine the impact the new rules will have, paying larger than normal dividends to various family members who are currently not Specified Individuals by the end of 2017, for Specified Individuals over the age of 24, having them lend the large dividend back into the private company and have them collect interest at a reasonable rate. Specified Individuals between the ages of 18 and 24 could lend back to the private company but be limited to the prescribed interest rate, which is currently 1%, assessing which shareholders under the revised definition will become Specified Individuals and, be affected by the new legislation in 2018, by starting to document the contribution these shareholders are making to the business to support the reasonableness of payments made. Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 4

6 Converting Income into Capital Gains Potential Changes Written by: Deanna Muise, BCom, CPA, CA, TEP Partner, Taxation, KRP Group The Current Rules on Capital Gains from Sales of Shares In general, when an individual sells shares of a corporation for an amount in excess of what they paid for the shares, they realize a capital gain. Depending upon the assets of the company and the personal tax history of the vendor, the capital gain may or may not be eligible to be offset by a capital gains deduction such that no personal tax is paid. Currently, an anti-avoidance rule results when a sale made to a non-arm s length corporation (1) is essentially tax-free. The tax policy is that individuals should not be able to extract funds from their own company (or a non-arm s length company) and trigger a capital gains deduction in order to pay no tax. In these cases, from a tax perspective, the sale results are treated as a dividend and taxes would have to be paid. The Proposed Changes On July 18, 2017, the Department of Finance released draft legislation to further extend the reach of this antiavoidance provision to apply to all transactions where a non-arm s length person realizes a capital gain on shares regardless of whether any tax results from the transaction. The new policy is that individuals should not be able to extract any funds from their own company at capital gains rates, but should always pay the higher dividend rates. The proposed changes will cause genuine hardships and problems for families, including: Potential double tax upon the death of a shareholder as a result of the elimination of the pipeline plan (2) ; and Potential double tax upon the transfer of a family business from one generation to the next. Finance did note in their discussion paper that it would consider views and ideas of ways, it would be possible to better accommodate genuine intergenerational business transfers while still protecting against potential abuses of any such accommodation. The Department has also proposed to introduce a broad new anti-avoidance rule that will apply to all transactions where an individual has received a distribution from a company on a tax-reduced or tax-free basis in a non-arm s length context and treat those amounts as taxable dividends. The Department refers to this a surplus stripping. The Explanatory Notes to the Draft Legislation provide that these rules apply to: the portion of the amount received or receivable, directly or indirectly, by an individual in a taxation year, as part of a transaction or event, or series of transactions or events, if the following conditions are met: a) the individual is resident in Canada in the taxation year; b) the amount was received or receivable, directly or indirectly in any manner whatever, from a person with whom the individual was not dealing at arm s length (including in situations where an accommodating third party that purportedly deals at arm s length with the individual is used as an intermediary to avoid subsection (1)); Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 5

7 c) as part of the transaction, event or series, there is a disposition of property or an increase or reduction in the paid-up capital in the capital stock of a corporation; and d) it can reasonably be considered that one of the purposes of the transaction, event or series was to effect a significant reduction or disappearance of assets of a private corporation (including assets that the private corporation acquires or holds an interest in, directly or indirectly) at any time in a manner such that any part of tax otherwise payable under the Act by the individual with respect to the portion, and in consequence of any distribution of property of the corporation, is avoided. In other words, where an individual is able to extract funds, either directly or indirectly, from a non-arm s length company at a tax rate lower than they would have paid on a dividend, this rule will apply to treat the receipt as a taxable dividend. The rules specifically note that where amounts are added to the capital dividend account ( CDA ) as a part of the series of transactions resulting in the distribution, the CDA will be reduced by that amount and any amounts received will be treated as regular taxable dividends. The Problems with Finance s Approach While the extension of these anti-avoidance provisions eliminates the ability of certain taxpayers to engage in plans that allowed them to obtain funds from non-arm s length companies at reduced tax rates, it also destroys many legitimate planning opportunities to avoid double taxation. What Should You Do? As these proposed tax changes may have a significant impact on your planning, please call us prior to considering any transactions to sell shares and/or to extract retained earnings from your company. (1) A non-arm s length company is one you and/or persons related to you directly or indirectly control. This concept can be expanded beyond related individuals where non-related parties act in concert. For instance, where one of your good friends facilitates a transaction as an intermediary with the result that you realize a capital gain instead of a dividend, you will very likely be considered to be acting in concert and hence, related for purposes of these provisions. (2) Pipeline Plan is one that allows the beneficiaries of an estate to avoid tax on shares they inherit where the deceased relative paid tax upon the deemed disposition of those shares on their death. The plan gives recognition to the fact that tax has already been paid on the shares up to their value on the date of death. Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 6

8 Proposed Changes to Small Business Passive Investment Income Taxation Written by: Paul Morton, CPA, CA, CFP, TEP Partner, Ginsberg Gluzman Fage & Levitz, LLP Overview of Proposed Changes Many small businesses hold and invest their retained earnings within the corporation. This income is subject to a special set of taxation rules. Currently, a temporary tax is levied on this investment income, or passive income. When investment income is paid out to shareholders, they are able to claim a refund on the temporary tax. The Department of Finance s proposals aim for an individual to pay the same amount of tax on investment income, regardless of whether the income was earned personally or through a corporation. The proposals eliminate the perceived advantages of investing the after-tax income in a corporation. The proposals outlined by the Department are designed to achieve the following outcome: Investment income would be taxed at a rate approximately equal to the top personal tax rates, similar to how they are taxed today. Under the current rules, some taxes on investment income are refundable when dividends are paid to shareholders. The newly proposed methods eliminate refundable taxes where the original income was taxed at the lower small business corporate tax rates. For investment income earned on retained active business income that was originally taxed at the small business tax rates, the non-taxable portion of capital gains can no longer be added to the Capital Dividend Account (CDA). The CDA are funds that can be paid tax free to shareholders. The two methods proposed are as follows: Method 1: Apportionment Method Track the source of income into three pools: o Corporate earnings taxed at the small business rate o Corporate earnings taxed at the general rate o Shareholder loans and other contributions to the company Each year, investment earnings would be apportioned to the three pools above, all of which have different tax treatments, If a dividend is paid in a particular year, the business owner would designate from which pool a dividend was paid. This method is cumbersome and requires business owners to track how their investment income is earned. This can be onerous. Method 2: Elective Method Assumes that all investment income is funded by income that was earned at the small business rate Investment income earned by a company is subject to non-refundable tax of about 50% When investment income is distributed, the dividend would be a non-eligible dividend Companies could elect for dividends from investment income to be eligible dividends, but the company would then not get the lower small business tax rate on active income Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 7

9 This method is less cumbersome for business owners than the apportionment method but would force business owners to decide if they want to access the small business deduction on active income, or pay higher taxes on their investment income. Other Potential Methods Finance has also invited submissions that would include alternate methods to the above. Companies Focused on Portfolio Investments (Holding Companies) For holding companies that are not taxed at the low corporate tax rates, the system will remain mostly unchanged. The main change for holding companies is that under the old rules, dividends received from a related company were generally exempt from tax. Going forward, the dividends from related companies will be subject to refundable tax rules, similar to dividends from portfolio investments. As a result, holding companies will have less capital to invest. There will still be advantages of using holding companies: The estate freeze will still be available, where the taxes on the death of a parent can potentially be reduced, and the benefit from the growth in value of a portfolio is passed to the next generation. By paying dividends from an operating company to a holding company, the capital has more creditor protection. Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 8

10 Proposed Changes to Capital Gains Realized on the Sale of Certain Private Company Shares Overview of Proposed Changes The Department of Finance proposals include measures to limit the ability to claim the lifetime capital gains exemption (LCGE) on dispositions after The LCGE is an exemption available to Canadian residents in respect of capital gains realized on the disposition (sale or transfer) of certain types of property. On the disposition of a qualified small business corporation shares, the exemption is up to a lifetime limit of $835,716 (2017) of capital gains. On the disposition of qualified farm and fishing property, the lifetime limit is up to $1 million. The proposals are intended to target common planning strategies that multiply the LCGE, whether through a family trust or otherwise, by having shares held by family members. The proposals introduce significant restrictions to the circumstances in which the LCGE is available. Under the proposed measures, the LCGE would be denied or reduced in the following situations: Individuals under the age of 18 will no longer qualify for the LCGE in respect of capital gains that accrued prior to the year the individual turns 18. Where the individual is an adult, no LCGE would be available on taxable capital gains from dispositions subject to the expanded Tax on Split Income (TOSI) rules. (1) Capital gains that accrue during the period a Trust holds the property will not qualify for the LCGE, subject to certain exceptions. (2) This would include property that was previously held by the Trust that was distributed to a beneficiary of the Trust on a rollover basis. The proposals include a transitional rule that would permit an election in 2018 to realize a capital gain in respect of eligible property held at the end of 2017 (similar to the 1994 election rules). This election provides an opportunity to lock in the capital gain before the end of 2018 where the ability to use the LCGE would otherwise be lost. Potential Impact of the Changes If these measures, along with the additional restrictions on income splitting with individuals aged 18 to 24, are implemented, the ability to include younger family members in tax planning will be significantly restricted after The ability to allocate accrued gains in the value of the property held by a Trust will also be eliminated. While these proposals may achieve the intended government objectives (prevent multiplication of the LCGE with non-active related individuals), it will also (likely inadvertently) frustrate legitimate estate planning measures which are currently in place. The proposals will impact not only many of the current Trust structures, but also structures where related individuals directly hold shares of property that would otherwise qualify for the LCGE. In these cases, the ability to claim the LCGE would be restricted under the expanded TOSI (1) rules. The proposed rules include the additional complexity of determining reasonability of an individual s efforts in the operations of the business, or the risk associated with the capital they contributed to the company. Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 9

11 What Should You Do Now? First, the earliest these proposed amendments will be formally tabled will not be until after the end of the 75- day consultation period ending October 2, There is time for us to make a case against these measures. If the proposals go ahead as stated, consider taking advantage of the 2018 election to crystallize the accrued capital gains. To use the LCGE, it is imperative that the property is qualifying at the time of the election. This may require some planning to ensure surplus assets are extracted from the corporation prior to the election. The 2018 election to use the LCGE will not be available to minor beneficiaries of Trusts. A minor child is eligible to claim the exemption only if an actual disposition takes place in For an active beneficiary of the Trust (perhaps in a business succession scenario where an adult child is taking over the business), the cost of losing access to the LCGE may exceed other benefits such that you should consider having the beneficiary hold the growth shares directly. Other Benefits of the Use of a Trust That Remain in Place As access to multiple LCGE s is only one benefit of the use of a Trust in a corporate structure, we caution that a thorough review and understanding of the objectives of your structure should be undertaken before any actions are taken. For example, the use of a Trust to hold your operating company is commonly used to achieve certain other objectives (tax and non-tax), including but not limited to: To maintain control over Trust property; To allow for movement of surplus funds from one corporation to another related corporation; Allow flexibility in transfer of ownership of the company at a later date without being bound to a decision made today; Allow flexibility of income determination for family members who are actively engaged in the business. As each situation is unique, we recommend that you speak with your advisor to determine the best approach for you. (a) (b) Generally, the tax on split income rules would apply if the income is not reasonable in the circumstance. See our related article Payments to Shareholders of Private Companies. Stricter requirements will be imposed on payments to individuals between the ages of 18 and 24. The exceptions include spousal or common law partner trusts, alter ego trusts and certain employee share ownership trusts. Kenway Mack Slusarchuk Stewart LLP Avenue SW Suite 1500 Calgary AB T2R 1L kmss.ca Page 10