I. INCOME SPRINKLING. October 2, 2017

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1 October 2, 2017 Mr. Brian Ernewein General Director, Legislation Tax Policy Branch Department of Finance Canada 90 Elgin Street Ottawa ON K1A 0G5 Dear Sir or Madam: Re: Consultation on July 18, 2017 Tax Proposals We are writing to provide our comments and recommendations on the Tax Planning Using Private Corporations consultation paper (the Consultation Paper ) and accompanying draft legislation released by the Department of Finance (the Department ) on July 18, Like many others in the tax community, we would like to express our concern that the proposed measures unintentionally target small business owners in Canada, which may have a negative impact on innovation and the overall economic health in Canada. Given the magnitude of the tax reform proposed, the complexity of the provisions introduced, and the limited interpretative or illustrative guidance provided by the Department, the allotted 75-day consultation period simply does not allow enough time to understand and address the full impact of the proposals on Canadian taxpayers. We strongly encourage the Department to set aside the current proposals and start over with a longer, more meaningful consultation with stakeholders including members of the small business community. Notwithstanding our views on the current consultation process, please find below our comments and recommendations on each of the three proposed measures. I. INCOME SPRINKLING Small businesses in Canada have a long-standing history of sprinkling, or splitting income through the use of private corporations. This practice is in line with tax policy that was designed to allow entrepreneurs and small businesses to thrive and contribute to the Canadian economy, to recognize the risks small business owners shoulder and the sacrifices they make to create business and employment for others. This practice is permitted under current tax legislation and is supported by judgements issued by the Supreme Court of Canada ( SCC or the Court ).

2 The SCC ruled in favour of discretionary dividends paid to spouses in two cases: first in The Queen v McClurg 1 and again in Neuman v MNR 2. The Court has previously stated that there is no general scheme to prevent income splitting in the Income Tax Act 3 ( ITA or the Act ). The Court has also found that the quantum of one's contribution to a company, and any dividends received from that corporation, are mutually independent of one another 4. The same observation was made by La Forest J. in his dissenting reasons in McClurg (at p. 1073): With respect, this fact is irrelevant to the issue before us. To relate dividend receipts to the amount of effort expended by the recipient on behalf of the payor corporation is to misconstrue the nature of a dividend. As discussed earlier, a dividend is received by virtue of ownership of the capital stock of a corporation. It is a fundamental principle of corporate law that a dividend is a return on capital which attaches to a share, and is in no way dependent on the conduct of a particular shareholder [emphasis added]. The original tax on split income rules ( TOSI ) were first introduced in 1999, targeting split income (excluding capital gains) paid to minors. While the kiddie tax was subsequently expanded in 2011 to include capital gains realized by minors on non-arm s length transactions, the legislated income splitting rules to date have not been extended to adult individuals. In our view, the proposed income sprinkling rules create several challenges. In the absence of further guidance or clarification, the rules as drafted may apply more broadly than intended by the Department. The application of these rules depends heavily on the concept of reasonableness, which is subjective and likely to be defined inconsistently. Furthermore, the draft provisions, if enacted in their current form, can have a retroactive effect on many taxpayers, particularly on those who have previously undergone estate freezes or inherited shares from a deceased family member. The proposed income sprinkling rules will be reviewed separately as they apply to dividends and capital gains. DIVIDENDS Broad Application of Connected Individual and Specified Individual Definitions The proposed definition of connected individual in subsection 120.4(1) applies to a split portion in respect of dividend income earned personally or through a trust and interest income, whereas a broader test applies for business income. Paragraph (a) of the connected individual definition refers to control by the person or a group of persons, whereas paragraph (b) addresses situations where a person owns shares with a fair market value ( FMV ) equal to or greater than 10% of the total FMV of issued shares at a particular time. Based on these definitions and the expanded definition of a related person in subsection 120.4(1.1), it is possible for an individual to be both a specified individual and a connected individual for purposes of section Given the potential overlap of these two definitions, it is unclear why a specified shareholder is included in the proposed definition of a specified individual. Under the proposed rules, where a private corporation has more than one shareholder, it will be necessary to substantiate the reasonableness of dividends to all shareholders, regardless of whether they 1 91 DTC DTC Ibid at para Ibid at para 57. 2

3 actively contribute to the corporation s business (in which case they are referred to as principals ) or are passive investors. Under the proposed changes, whenever there is a person who is a specified individual and another person is a connected individual, the reasonability of the dividend will generally be considered a split portion 5 and subject to TOSI. When the principal of the corporation has family members who are connected individuals, the principal s dividend will be considered a split portion if the amount is determined to be not reasonable. This may result in lost access to the graduated marginal tax rates for not only the non-principal individuals receiving split income, but also for the principal. Many types of incorporated businesses will be impacted: A corporation with more than one related shareholder. Regardless of whether the preferred shares of a non-active, related shareholder are valued at an amount equal to or greater than 10% of the total issued shares, the non-active shareholder and the principal would be specified individuals and connected individuals. Dividends distributed to the principal must be substantiated as reasonable, whereas dividends distributed to the non-active shareholder would be considered a split portion and subject to TOSI. A corporation owned by more than one related shareholder. Where each shareholder owns greater than 10% of the value of total issued shares, all shareholders will be both connected individuals and specified individuals, and therefore will be required to substantiate the reasonableness of dividends received. A corporation where preferred shares have been issued to parent shareholders as part of family succession planning and the preferred shares are being redeemed over time. Not only do the changes to proposed section 84.1 prevent the ability for family members to transact at capital gain rates, any dividends on the preferred share redemption can be subject to TOSI 6. Furthermore, dividends distributed to the second generation of the family can also be subject to TOSI. A corporation where a loan has been provided by a family member. The interest on the loan would not only be subject to the reasonability test in paragraph 20(1)(c), but also to TOSI, which may result in double taxation on the same income. The effect of the draft proposals is that income earned or realized by an individual who is connected to a private corporation under many circumstances may be considered split income subject to the TOSI rules, unless the amounts are considered reasonable. Concept of Reasonableness The explanatory notes accompanying the Consultation Paper provide that: For an amount to be included in the "split portion" of an amount under this reasonableness test, it must also be reasonable to consider that it exceeds what would have been paid or payable by the operating entity to the individual if the operating entity and the individual were dealing at arm's length. In making this determination, the following factors are relevant: 5 As defined in proposed subsection 120.4(1). 6 Refer to Appendix 1 for an illustrative example. 3

4 the extent of the individual's labour contributions to the source business prior to the amount being paid or becoming payable (e.g., looking at the quantity of work performed and arm's length comparables for similar work); the assets contributed by the individual, directly or indirectly, in support of the source business; the risks assumed by the individual in respect of the source business; and the total of all amounts that were previously paid or that became payable, directly or indirectly, by any person or partnership to or for the benefit of the individual in respect of the business. 7 The explanatory notes to proposed paragraph 120.4(1.1)(e) 8 state that subparagraphs 120.4(1.1)(e)(ii) and (iii) contain rules that apply for purposes of determining whether amounts received by individuals are reasonable. However, the draft provisions and the accompanying explanatory notes provided limited guidance for very specific circumstances and, in our view, do not address many other situations where the reasonableness of an amount may have to be determined. The anti-avoidance rule in clause 120.4(1.1)(e)(ii)(A) provides that an individual is deemed not to have performed functions in respect of a source business if the principal purpose of the business is to derive income from property, or at least 50 percent of the income of the business is either from property or from taxable capital gains realized from the disposition of property. This removes the availability of a safe harbour under the reasonability test on an asset sale. For example, consider a sale of goodwill, which will be treated as a capital gain. In the year of the sale, the dividends paid from capital gains will not have the safe harbour of reasonability with respect to work performed, and therefore can only be considered reasonable based on capital contributed or risk taken by the dividend recipient. This can result in dividends or other income distributed on all asset sales to be subject to TOSI. A similar situation arises for corporations with passive income, where such corporations will not only be subject to the punitive measures under the three options currently contemplated in respect of the passive income regime (addressed in Section II below), but the dividends distributed from these corporations will be subject to TOSI where there is more than one related shareholder in the company. The second anti-avoidance rule in clause 120.4(1.1)(e)(ii)(B) provides that an individual is deemed not to have contributed assets in support of a source business to the extent that the individual either received the assets as split income, or if they acquired the assets in connection with a related person who has provided financial assistance to the individual. Many entrepreneurs starting up businesses cannot obtain bank financing on their own and instead rely on direct financing or financing assistance in the form of guarantees from family members. The asset contributions carved out under this provision will raise the overall business tax cost to such entrepreneurs, which can become a deterrent to establish new Canadian businesses. Other than the rules discussed above and proposed clause 120.4(1.1)(e)(ii)(C) 9, there is little direction in the proposals or accompanying technical documents as to how these reasonability tests are to be interpreted and applied, which leads to a number of issues including the ones discussed below. 7 Private Corporations Amendments to the Income Tax Act and Regulations Explanatory Notes, page Ibid at page In respect of property of a source business acquired as a consequence of death. 4

5 Impact on Executed Estate Freezes The reasonableness test will impact a significant number of taxpayers that have previously undergone corporate reorganizations, including those that have undertaken estate freezes. Any future redemptions on shares issued as part of such past reorganizations can be impacted by the proposed rules. Consider the example of a retired husband and wife who effected an estate freeze of their small business corporation several years ago, and have been redeeming preferred shares issued to them in the course of the freeze at an amount of $40,000 each annually. Their son is now the principal of the corporation and is responsible for the day-to-day operations of the business. The combined tax liability of the couple each year under current legislation is approximately $5, Under the draft proposals, as they are no longer active in the operations of the business, no longer have capital invested in the company and no longer have any risk assumed in relation to the business, it appears that the deemed dividends on the redemption of their preferred shares will be subject to TOSI. Their combined annual tax liability can increase to over $36,000 even if both spouses were active in the business before retirement. In this situation, the proposals clearly have a retroactive effect on taxpayers. Impact of Subparagraph 120.4(1.1)(e)(iii) on Family Farms This provision contains rules for applying the reasonableness test to individuals between the ages of 17 and 25. Clause (A) provides that the amount of an individual s return based on their labour contributions that will be considered reasonable will be based on the extent to which the individual is actively engaged on a regular, continuous and substantial basis in the activities of the business. Clause (B) provides that the amount of an individual s return based on their capital contributions to and risks assumed in respect of the business that will be considered reasonable will be limited to the prescribed rate of return set out in paragraph 4301(c) of the Income Tax Regulations. While public statements have been made that the proposals will not impact family farming businesses, the proposals as currently drafted may indeed apply to many such businesses. Family farm operations often have complex structures which may include shares of farm corporations and interests in farm partnerships. The very nature of the family farm generally means that all family members contribute to it, including children who often work on the farm after school and on weekends. Under the wording in proposed clause (A), there is a risk that the part-time labour contributed by those between the ages of 17 and 25 will not be considered substantial involvement, which means dividends distributed to these individuals will not meet the reasonability requirement and therefore will be subject to TOSI. Furthermore, as the proposals do not appear to contemplate past contributions, which may be substantial on a cumulative basis, such contributions may remain unrecognized for tax purposes. Additionally, capital gains on the disposition of shares of family farm corporations and family farm partnership interests will not be exempted from the proposed split income rules. This provision also creates challenges for farm partnerships. To illustrate, consider a farm partnership that is equally owned by two siblings. In years of high profitability, the siblings would have income more than what would be paid to an unrelated employee; the Minister may view their respective shares of partnership income to be unreasonable and therefore subject to TOSI. In this situation, it is unclear how this provision, which applies to income that is considered not reasonable, is intended to interact with ITA 10 Based on 2017 marginal tax rates for non-eligible dividends, excluding available tax credits. 5

6 section 103, which requires a reasonable allocation of partnership income. The Department may want to consider excluding individuals over the age of 25 from the reasonableness test in respect of partnerships as the reasonability of partnership income is already addressed in section 103. Retroactive Effect of Clause 120.4(1)(b)(iii)(D) In determining whether an amount is a split portion of an amount in respect of an individual, proposed clause 120.4(1)(b)(iii)(D) in the split portion definition looks to whether the amount exceeds what would have been paid or payable by an operating entity dealing at arm s length with the individual having regard to the total of all amounts that, before the end of the year, were paid or that became payable, directly or indirectly, by any person or partnership to or for the benefit of the individual in respect of the source business. This is particularly troublesome because historical payments to the individual that were not previously subject to TOSI can restrict the corporation s ability to pay a reasonable dividend or allocation of income in the future. The retroactive impact of this proposed provision can be mitigated by removing the phrase before the end of the year from this clause in the split portion definition. Interaction of Split Income Paragraph (e), Subparagraph 120.4(1.1)(e)(i) and Subsection 164(6) The provisions as currently drafted do not provide any relief for dispositions that occur upon the death of an individual. Proposed paragraph 120.4(1.1)(e) applies to individuals over the age of 17. If such an individual s taxable income, determined as though the split income deduction under paragraph 20(1)(ww) was taken, is greater than the dollar amount in paragraph 117(2)(e), the split income for the year is deemed to be nil. Consider an example where the sole individual shareholder of a private corporation with a value of $500,000 passes away in early January. We assume for these purposes that dividends from the corporation would be subject to TOSI. On death, a deemed taxable capital gain of $250,000 is realized and classified as split income under paragraph (e) of the new definition in proposed subsection 120.4(1). This is the deceased individual s only income for the taxation year. After the deduction under paragraph 20(1)(ww), this individual would have net and taxable income of nil, but the income tax payable on the split income would be approximately $134,000. Where the estate of the deceased individual later redeems the shares and carries back the losses under subsection 164(6) 11, there would be no taxable income in the individual s terminal return for the losses to offset. Paragraph 164(6)(f) provides that in computing the taxable income of the deceased taxpayer for a taxation year preceding the year of death, no amount may be deducted in respect of an amount referred to in paragraph (c); the net capital losses realized would be added to the deceased taxpayer s non-capital loss balance, but again, the terminal return would have no taxable income against which the non-capital losses can be used. As a result of the deceased individual having taxable income less than the dollar amount in paragraph 117(2)(e) in the year of death, the estate will pay tax on the full $500,000 value of the corporation as deemed dividends when this value has already been subject to TOSI in the hands of the deceased individual. Compare this to a similar scenario where the individual passes away at the end of the year instead of in January, and the individual has an additional $250,000 of income from other sources. The individual s total income in the year of death would be $500,000; after subtracting the $250,000 split income capital gain, taxable income would be $250,000. As this exceeds the paragraph 117(2)(e) dollar amount, the 11 Assuming the estate qualifies are a graduated rate estate. 6

7 amount of split income would be deemed nil. The individual would not be subject to TOSI and would pay tax at the regular marginal rates. Furthermore, if the estate later desired to carry back losses under subsection 164(6), there would be income available to offset the amount. The value of the private corporation would not be subject to double taxation. Based on the above, the proposals lead to two very different outcomes depending on when in the taxation year a person passes away a variable that arguably cannot be controlled by a taxpayer. Other issues under the proposed legislation arising from the death of a taxpayer will be discussed in greater detail in Sections II and III. CAPITAL GAINS Interaction of Split Income Definition Paragraph (e) and Split Portion Definition Paragraph (c) Similar to the concerns raised earlier, the lack of guidance on the concept of reasonableness creates challenges in determining how to interpret the four reasonableness tests for purposes of paragraph (c) in the proposed definition of split portion, which appear to require an analysis of whether a capital gain is reasonable as though it were a dividend from an arm s length party. This is conceptually impractical as: (i) the corporation may not even be a party to the contract for the disposition, and (ii) the manner in which arm s length parties set dividend policies is based on a myriad of factors such that it would be impossible to identify a standard dividend amount that a capital gain can be measured against. Subsection 120.4(4) Pursuant to proposed subsection 120.4(4), if a specified individual would have a taxable capital gain on a disposition of private corporation shares to a non-arm s length person, the amount of the gain is deemed not to be a taxable capital gain but instead twice the amount is deemed to be an ineligible dividend. This provision will apply unless the taxable capital gain is an excluded amount 12. The provision will not apply to capital gains arising from dispositions that would be excluded from split income. In a situation where three sisters (Sisters 1, 2 and 3) are shareholders of a corporation, and Sister 2 and Sister 3 acquire the shares held by Sister 1, this provision could subject Sister 1 to the reasonableness tests and recharacterize her capital gain to be an ineligible dividend. We question why this provision is even necessary; if the Minister determines the amount of consideration for the disposition to be unreasonable in the circumstances, subsection 69(1) could presumably be relied on to adjust the proceeds. Not only does this provision appear redundant in such situations, but it does not result in equitable treatment of arm s length and non-arm s length dispositions even where the terms of such dispositions are the same. In this scenario, it is also unclear as to whether Sisters 2 and 3 would have hard or soft basis in respect of the shares acquired from Sister 1 on a future disposition of the shares to a corporation for purposes of section Conflicting Application of Section 84.1 vs. Subsection 120.4(4) Where an individual taxpayer realizes a capital gain on the transfer of private corporation shares to a holding corporation but receives only share consideration, section 84.1 would not apply to trigger a deemed dividend. However, under proposed subsection 120.4(4), this transaction could result in the 12 As defined in proposed subsection 120.4(1). 7

8 recharacterization of the capital gain to an ineligible dividend. In this situation, it is unclear whether section 84.1 or subsection 120.4(4) would govern the transaction. As such, the Department needs to provide clarity on the ordering of how these provisions should be applied. Conflicting Application of Section 70 vs. Subsection 120.4(4) While no guidance has been provided by the Department as to whether subsection 120.4(4) applies to capital gains realized upon death of a taxpayer, a strict reading of the proposed legislation suggests that it could. Consider a situation where the sole shareholder of a private corporation (a specified individual ) passes away, triggering a capital gain equal to the value of the shares at that time. The shares of the corporation are to be transferred directly to the shareholder s 30-year-old son; therefore, the conditions for the application of subsection 120.4(4) are met and the capital gain is not an excluded amount. The capital gain on death determined under section 70 could then conceivably be converted to an ineligible dividend under subsection 120.4(4). Clarity in the ordering of these provisions is required to determine the deceased taxpayer s tax liability. Impact of Lifetime Capital Gains Exemption ( LCGE ) Changes on Farm Corporations We respectfully disagree with the inference in the Consultation Paper that the LCGE was historically only intended to be utilized by family members that actively contributed to a business, and that the current application of the law to multiply access to the LCGE is inappropriate. Rather, the LCGE was a purposeful policy put in place to encourage investment in small business. The legitimacy of LCGE planning is supported by the fact that no changes were made to the LCGE rules when the income splitting provisions were introduced in 1999 and later revised in Consider a parent ( Dad ) who holds farm corporation shares or land eligible for the farm intergenerational rollover provisions 13 and the LCGE. Once Dad passes away and these assets are passed on to his adult child, the new restrictions on the ability to access the LCGE will cause a problem if Dad owned the shares or land prior to the child turning 18 years of age 14. Assume in this situation that Dad had utilized his full LCGE but the adult child has not. Under current legislation, the property may be transferred on a rollover basis from Dad to the child upon death with the idea that the child would later claim the LCGE to offset the gain on a future disposition. Under the proposed rules, if this is done, a portion of the future gain realized by the child will be ineligible for the LCGE specifically, the portion of the gain that accrued while the shares or land were owned by Dad and the child was under 18 years of age. It appears that a partial designation of proceeds on Dad s terminal return under subsection 70(9.01) will not alleviate this result: in order for gains accrued while Dad held the property and the child was under the age of 18 to be eligible for the LCGE, there must have been a disposition of the property from Dad to the child at FMV after the child turned 18 years old. If the conditions in paragraph 110.6(12.1)(a) apply, then under paragraph 110.6(12)(c), the ineligible portion of the future gain is the excess of the FMV at the time the child turned 18 over Dad s cost amount at that time. If a partial designation of proceeds is made on Dad s terminal return, it would increase the adjusted cost base ( ACB ) of the shares or land and reduce the child s future gain, but the child will still be left with a portion of the resulting gain being ineligible for the LCGE. 13 Subsections 73(4) and 70(9.2). 14 Based on our experience, this is often the case for family-operated farms. 8

9 The result of the proposed changes to subsection 110.6(12) is that existing rollover provisions designed specifically for farmers will no longer function as intended. The cumulative effect of the gains on farm corporation shares or land ineligible for the LCGE over multiple generations will be tremendous. If this is an unintended result for farming businesses, further changes to the proposed legislation must be made to exempt such businesses. Impact on Small Business Service Providers The new definition of connected individual in subsection 120.4(1) sets out the degree of connection between an individual and a corporation for certain aspects of the TOSI rules. An individual who is resident in Canada will be a connected individual in respect of a corporation at any time when any of the specified conditions are met. Under the condition in paragraph (c) of this definition, an individual is a connected individual if the individual or a related person owns equity in the corporation and the corporation carries on a service business, where the services are primarily attributable to the individual, or the services are regulated and are performed all or in part by the individual. The TOSI proposals continue to focus on eliminating tax planning opportunities available through the use of professional corporations 15 ; however, the proposals also impact small business service corporations such as those providing electrician, plumbing, or other contracting services, where the principals are personally providing the services offered by the corporation. In these situations, given a principal s level of active involvement in the corporation, it seems counterintuitive that dividends paid to the principal may be subject to TOSI. We have prepared several examples in Appendix 1 for your consideration to demonstrate certain problematic aspects of the proposals. RECOMMENDATIONS The proposed income sprinkling rules present many challenges and have the potential to affect all private corporations with family members as shareholders, regardless of income level. The rules as currently drafted will lead to several unintended consequences and rely heavily on the concept of reasonableness. Given that there is no common-law guidance in Canada on what constitutes a reasonable dividend or a reasonable capital gain, it is startling that there is little direction provided by the Department in trying to make this determination. In the absence of objective and detailed guidance, the criteria proposed by the Department will likely be applied inconsistently across the country, which is contradictory to the Taxpayer Bill of Rights. Furthermore, disagreements between the Minister and taxpayers as to what reasonableness means may result in the tax courts being overburdened with cases to solely determine if a dividend amount is reasonable. As a result, the administration and enforcement of the rules as currently drafted may prove to be costly. We are of the view that changes are not required to the current TOSI and attribution rules. However, if the Department moves forward, we recommend the following: Engage in a comprehensive review of private business in Canada to gain a better understanding of the various contributions made by family members to start and grow a business. 15 Further to the 2016 changes to the small business deduction legislation, which were widely viewed as targeted toward professional corporations. 9

10 Provide exemptions to ensure protection for farmers as well as grandfathering for retired shareholders who engaged in legitimate estate planning in the past. Exclude spouses and common law partners from the proposed TOSI rules. Exclude capital gains from the definition of split income - Based on our experience, capital gains that do not qualify for the LCGE tend to be significant in value, such that the gains would be taxed at the top marginal rates anyway. There is no clear benefit to adding this layer of complexity to the TOSI rules when they would have limited application to individuals that may be viewed as truly wealthy. II. PASSIVE INVESTMENT INCOME IN A CORPORATION In line with one of the recommendations detailed in the 1966 Royal Commission on Taxation report, Canada s current tax system is based on the principle of integration: income earned through a private corporation and distributed to its shareholders is taxed at approximately the same rates as if the shareholders had earned that income directly. In 1972, E.J. Benson, then Minister of Finance, introduced the concept of a refundable tax on Canadiancontrolled private corporation ( CCPC ) portfolio investment income 16 which was intended to address an inequity between taxes payable by individuals and corporations on passive income that existed at the time. Under this concept, an additional tax is applied to corporate passive investment income when earned, but would be fully or partially refunded to the corporation when distributed to its shareholders. This additional refundable tax bridges the gap between the corporate and personal income tax rates, such that the tax payable by corporations on passive investment income approximates what an individual in the top tax bracket would pay on the same income. The proposals contemplated in the Consultation Paper assume there is a tax advantage to holding investments in a private corporation, when, in fact, no such advantage exists once the subsequent personal taxes on distribution from the corporation are paid. As such, it is questionable as to whether these proposals are necessary, as the potential results of these measures are contrary to the concept of integration. Furthermore, the proposed measures are expected to present significant administrative challenges if legislated. In its Consultation Paper, the Department stated that in its view, fairness and neutrality require that private corporations not be used as a personal savings vehicle for the purpose of gaining a tax advantage. 17 This statement appears to be premised on the assumption that all corporations are subject to a low rate of tax and that the only reason to save funds within a corporation is to minimize taxes. It seems that the paper overlooks the core business reasons why a company would invest excess funds in any given year to save, many of which are discussed below. Historically, the Canadian government (the Government ) has encouraged Canadians to save, and has in fact indicated that many people are not saving enough for their retirement. The current tax regime is based on policy that was put in place to encourage small business in Canada to invest and grow, and to encourage Canadians to create and fund their own retirement. Those business owners who succeeded, and who will not have to rely on various social programs as they age, will now be penalized in the form of 16 CANADA, Minister of Finance, Budget 1973, Hon. John N. Turner, February 19, Tax Planning Using Private Corporations, Department of Finance Canada, July 18, 2017, page

11 additional non-refundable corporate taxes and higher integrated taxes when a functioning system of tax integration already exists. IMPACT OF PROPOSED MEASURES ON INTEGRATION The methods contemplated in the consultation paper eliminate the refundable taxes on investment income earned on passive investments such that an individual is indifferent to holding these investments personally or through a private corporation. The following is a comparison of the effective tax rates applicable under the methods proposed in the consultation paper. The proposed methods will be discussed in further detail below. As shown above, the near-perfect integration that exists in the current Canadian tax system will cease to do so under the proposed measures, resulting in overall tax rates of up to 71%. While the alternatives contemplated will likely discourage passive investment in a private corporation going forward, they can also adversely impact a middle-class income earner in the absence of transitional relief for any such income that has already been earned. BONA FIDE BUSINESS REASONS TO SAVE As alluded to earlier, the proposed measures do not consider the many practical reasons why a business owner is required to save funds in their corporation, most of which are unrelated to the minimization of taxes: i. Banking Considerations Many corporations require the use of bank financing to meet operational cash flow requirements, acquire capital assets or fund business expansions. Lenders not only require a down payment, but also require 11

12 specific financial ratios to be met. Some of the most common ratios include debt to equity requirement, debt service, working capital and working capital ratios, among others. In those regions of the country that have been particularly hard hit by the recent economic downturn, banks have tightened their lending practices and are rigorously reviewing and enforcing these covenants. If passive investments or excess cash are extracted from companies when times are good, the company may have their loans called when times are tough. Further, when looking to the great recession of 2008, conventional capital dried up and companies were not surviving as they were not able to find capital. The most successful companies had built capital for a rainy day and were able to survive, and some were able to thrive compared to their competition, due to having access to funds to maintain market share, hire available talent, etc. ii. Angel Investors There are many start-up enterprises that are not able to obtain financing to start their venture, and they rely on angel investors to provide the capital to start. These investors are often private companies that have built a portfolio, and are using their investments to help other start-ups. This grows the economy and helps many millennials become entrepreneurs and foster innovation. That opportunity could be lost should these passive income proposals be enacted. iii. Fluctuations in the Economy Businesses need a strong balance sheet and strong working capital to survive economic fluctuations, particularly those downturns with a long duration; for example, the current state of the oil and gas industry. Those companies that are able to save during good times are able to keep staff employed during bad times and to continue to contribute to the growth of the Canadian economy. iv. Capitalization Decisions Some businesses that do not want to rely on bank financing or incur the added cost of paying interest need the ability to save for future expansions. Corporations should have the business choice of how to fund these expansions and the proposed rules do not allow for that. For example, if corporate investments and investment income are subject to the new proposed tax rates, no allowance is made if those funds are later utilized for ongoing business operations, for business expansion or to fund the purchase of operating assets. 12 v. Retirement Savings Small business owners generally do not have a pension for retirement. Many do not utilize their Registered Retirement Savings Plans ( RRSPs ) or Tax-Free Savings Accounts ( TFSAs ), as that would tie up capital that they may need at a moment s notice in their business; essentially, their companies are their pension plan. To not allow business owners who have worked to build a successful business to have the opportunity to fund their retirement without a punitive layer of tax is detrimental to entrepreneurship. Furthermore, retirement savings in a private corporation cannot be split between

13 spouses under the proposed TOSI rules despite the ability for spouses to split pension income under paragraph 60(c); this contradicts the principle of fairness that these proposals are meant to embody. COMPETITIVE DISADVANTAGE OF A CCPC CCPCs who earn income from a specified investment business ( SIB ) are comparatively disadvantaged when compared to other entities in Canada: Real Estate Investment Trusts ( REITs ) pay 0% tax; Public companies pay 27% tax; and Foreign owned companies pay 27% tax. In comparison, CCPCs currently pay 50 2/3% 18 tax, 30 2/3% of which is refunded when dividends are paid. The proposals in the Consultation Paper envision a 50% permanent tax and elimination of the capital dividend on capital gains. This would be almost double what other corporations will be paying, including foreign-owned companies. It is difficult to understand how the Government will encourage Canadian investment into Canadian markets when non-residents are given more favourable tax treatment. This can pose a significant risk to the Canadian economy. The cost of real estate in certain markets across the country are evidence of what can take place when foreign purchasers influence our markets. If CCPCs are given a disincentive to be property owners and landlords, foreign investment in Canadian real property will continue to rise. Additionally, public REITs are commonly owned by pension funds for flow-through tax purposes. The income that flows through these entities is not taxed until it is withdrawn from the pension plan by the recipient pensioner. In these cases, the income will likely also be subject to income splitting, further putting CCPC owners at a disadvantage given the proposed income splitting rules that will only apply to them. CCPCs are already disadvantaged when they earn SIB income as there is a significant loss of integration, which represents an actual tax cost to hold these investments in a CCPC. The proposed measures are expected to further heighten the disadvantage. Under the current regime, the refundable portion of investment income tax is too low. If the Government wants to incentivize business owners to extract funds to personal retirement investments, then the refundable amount should exceed the tax rate on dividends; this is currently not the case. CORPORATE PASSIVE INVESTMENTS VS. RRSPs According to the Consultation Paper, the use of private corporations for passive investments provides taxassisted benefits in accumulating savings that are not available to individuals that earn income directly as 18 Calculated as 38 2/3% federal tax and a 12% provincial tax. 13

14 employees. While that appears to be the case in the specific examples provided in the Consultation Paper, it is not true in all instances. Consider three individuals who each earn $200,000 per year, living in Ontario, but are earning income from different sources. Each individual would like to save $50,000 of pre-tax income. Jack is an employee and pays an effective combined marginal tax rate of 35.88%, leaving him with after-tax cash of $128,000 (rounded). He has an option to invest in a tax-sheltered investment vehicle like an RRSP, or may have a registered pension plan ( RPP ) through his employer. o Employee with an RRSP - If he invested $26,010 into his RRSP, he would receive a refund of $12,477, calculated at the marginal tax rate on his earnings above $150,000. In order to be consistent in the analysis, he invests these funds into a taxable personal portfolio and therefore has total investments of $38,487. He would retain approximately $102,000 of his annual income to cover living expenses. o Employee with an RPP - If he worked for an employer with an RPP, we have assumed his employer would fund 50% of the pension, or $13,005. The employee would still have a refund of $12,477 to invest in a taxable portfolio, for $38,487 of annual investment, which would have cost him $13,005 of his own funds. He would retain approximately $115,000 of his annual income to cover living expenses. o Employee with a Taxable Portfolio - If he saves $50,000 of his pre-tax income in a taxable portfolio, he would have $32,060 annually to invest. He would be left with approximately $96,000 to cover living expenses. Rose has a private company and has access to the small business deduction. The corporate tax liability for the year is 15%, or $30,000, leaving retained earnings of $170,000. If the company invests $50,000 of its pre-tax dollars, it would have $42,500 annually to invest, which is leading the Department to adduce there is an inherent flaw in the system. There is $127,500 available to distribute to the shareholder. o Rose will receive an ineligible dividend of $127,500 each year, and will pay personal taxes of $25,473 per year at her effective marginal tax rates, leaving her with $102,027 after tax to pay for living expenses. Jordan has a private company that does not have access to the small business deduction. This company earns active business income, and is subject to a tax rate of 26.5%, leaving retained earnings of $147,000. If the company invests $50,000 of its pre-tax earnings, it would have $36,750 annually to invest. There is $110,500 available to distribute to the shareholder. o Jordan will receive an eligible dividend of $110,250 each year, and will pay personal tax of $12,359 per year using his marginal effective tax rates, resulting in approximately $98,000 of after-tax cash for living expenses. A comparison of the composition of annual cash flow for the above scenarios is shown below. 14

15 The employee with an RRSP and the entrepreneur investing in the corporate taxable portfolio both have approximately $102,000 to fund their lifestyle. The employee with a taxable portfolio has approximately $96,000 of after-tax cash available, taking into account the $32,060 used to invest. The shareholder of the corporation that is taxed at the general rate retains $98,000, having invested $36,750. Interestingly, the employee in receipt of a RPP retains the most after-tax cash, at $115,000, which is 13% higher than the employee investing in a personal RRSP, and 20% higher than the employee investing in a taxable portfolio. What becomes apparent in the above analysis is that the annual cash available for investment under each scenario is comparable, and any perceived advantages a corporate shareholder may have are negligible. It would not be reasonable to compare the annual cash invested under the various scenarios. Instead, it is necessary to consider what is happening to the real wealth of the employee versus the entrepreneur. To illustrate, we have extrapolated these scenarios to consider the impact on real wealth for an employee versus a CCPC and its shareholders. The employee would have a taxable portfolio or registered account, and the CCPCs would have a taxable portfolio. The following tables illustrate the portfolio fair market values after 25 years and the after-tax annual retirement cash flows for an employee, compared to investment within a CCPC. 15

16 FMV of Portfolio After 25 Years of Contributions $2,500, $2,000, $1,500, $1,000, $500, FMV of Portfolio at 25 Years Once the annual investment has grown at a pre-tax rate of return of 7% (upon which the non-registered portfolios will be taxed) for 25 years, the employee with the registered accounts will have over $2.2 million in their portfolio, while the CCPC taxed at small business rates would have $1.56 million, the CCPC taxed at general rates would have $1.35 million, and the employee with a taxable portfolio would have $1.4 million. It should be noted that the employee with a taxable portfolio would be able to liquidate this investment and would not have incurred taxes in this scenario, as there were no capital gains built into the analysis. Comparatively, while the corporation s ACB of the portfolio would equal its FMV, the funds need to be drawn from the corporation, which would incur personal taxes at dividend rates. It should also be noted that the comparison of a CCPC to an employee with a fully taxable portfolio is unreasonable, as the employee earning T4 income would have created earned income and contribution room for a registered portfolio. The employee would have benefitted from the years of compounded, tax-free growth in the registered portfolio. Our analysis shows that it is the employee, not the shareholder, who will have an investment advantage. Cash Flow in Retirement When analyzing the after-tax cash flow available in retirement, both the passive income and TOSI proposals must be considered. As these corporations are likely no longer earning active business income, the reasonability test would not be met and TOSI would likely apply. 16

17 Comparison of Investment to Retirement Cash Flow 200, , , , , , , , , , Pre-Tax Amount to Invest Annual Cash Flow - Pre Tax Annual Cash Flow - After Tax (Marginal) Post-Tax Amount to Invest Annual Cash Flow - After Tax (TOSI) The employee with the registered portfolio has a significant advantage in comparison to the employee with a taxable portfolio or the entrepreneur with the taxable portfolio. Using the employee with a taxable portfolio as a baseline scenario as shown below, in no situation whether under current or proposed legislation is holding the investment in the CCPC considered to be an advantage. Employee with Taxable Portfolio as Baseline Default - No SBD Default - SBD Apportionment - No SBD Apportionment - SBD Current No SBD Current with SBD Employee Taxable Employee - RPP Employee - RRSP 0% 20% 40% 60% 80% 100% 120% 140% 160% TOSI Access to Marginal Rates 17

18 As noted earlier, one must also consider the ability of pensioners to implement income splitting with their spouse under paragraph 60(c), and for RRSP investors to achieve some form of income splitting by acquiring spousal RRSPs. When these considerations are reviewed in aggregate, the entrepreneur shareholder can be the one that is disadvantaged when compared to an employee. Challenges in Managing Business Risk without Passive Investments If business owners remove cash from their corporations, many could end up in violation of banking covenants, which may cause lenders to call in existing debt. In cyclical economic climates, many businesses will simply not be able to continue operating, which could lead to more severe recessions and increased unemployment in many sectors. Furthermore, if business owners remove funds and place them in creditor-protected pension vehicles as advocated by the Government, owners will have more inclination to walk away in tough economic times: their capital would already have been extracted and creditor protected, leaving little incentive to keep the business operating. This can lead to a significant reduction of small businesses in Canada. Consider the following example, which illustrates the above business risks when no excess cash is left in a corporation carrying on an active business. Peter owns a small pizzeria in Ottawa, Ontario. Over the last 10 years, Peter has built up a loyal customer base because of his famous wood-burning oven. This year, the pizzeria made a profit for the first time. It is expected to continue earning a pre-tax profit of $100,000 per year before paying a salary to Peter. Next year, Peter s famous wood-burning pizza oven breaks and will cost $40,000 to replace. The bank has determined the restaurant to be a high-risk enterprise and therefore will not lend him the money to replace the oven Outcome under Current Legislation Peter was advised to take a salary of $50,000 per year to support his living expenses. The remaining $50,000 could be left behind in the corporation, on which tax of $7,500 would be paid, leaving the corporation with $42,500. His advisors explained that it is wise to leave excess funds in the corporation in case future unexpected business expenses arise. They also let him know that he is able to invest the $42,500 in the corporation, allowing him to meet two goals: plan for unexpected expenses and begin saving towards retirement. Under this approach, when the pizza oven broke, he had liquid investments of $42,500 within the corporation. He could sell these investments and use the proceeds to buy a new pizza oven. 2. Outcome under Proposed Passive Income Measures Peter heard on the news that investing in passive assets within his private corporation would now result in tax rates on investment income as high as 73%. Fortunately, he also heard a quote from the Department that these proposals would only affect individuals making more than $150,000 per year. Since he makes less than $150,000, the Department stated that the best strategy is for him is to pay himself a salary and maximize his RRSP and TFSA contributions. As such, Peter paid himself a salary of $100,000, contributed $18,000 to his RRSP, and paid personal income tax of $18,600. After covering his