TAX PLANNING RULES FOR PRIVATE CORPORATIONS. November 23, 2017

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1 TAX PLANNING RULES FOR PRIVATE CORPORATIONS November 23, 2017

2 Presenter Mark McGinnis CPA, CA Tax Partner University of Waterloo Bachelor of Mathematics 2

3 CORPORATE TAXES - HISTORICAL BACKGROUND INTEGERATION AND EQUALIZATION Decision to incorporate should be tax neutral through to the individual taxpayer Dividend tax credit to individual for tax paid by corporation No deferral permitted on passive income SMALL BUSINESS TAX + DIVIDEND TAX = PERSONAL TAX RATE PASSIVE INCOME TAX + REFUNDABLE TAX = PERSONAL TAX RATE 2006 Eligible dividend rules provided tax neutrality for business income taxed at the high rate achieving full integration. 3

4 TAX LAW THE NEW REGIME Inland Revenue Commissioners v. Duke of Westminster Every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be. If he succeeds in ordering them so as to secure this result, then, however unappreciative the Commissioners of Inland Revenue or his fellow tax-payers may be of his ingenuity, he cannot be compelled to pay an increased tax. Trudeau Doctrine Any person who arranges their affairs in a manner that does not maximize the immediate amount of tax is using loopholes to avoid paying their fair share of taxes. 4

5 NEW RULES # FEDERAL BUDGET ISSUE SMALL BUSINESS TAX RATE IS LOW ENOUGH Enacted tax rate reductions scheduled for the 2017, 2018 and 2019 calendar years are repealed Federal small business rate fixed at 10.5% for 2016 and future ISSUE MULTIPLE SMALL BUSINESS DEDUCTION CLAIMS Specified corporate income rules Specified partnership business limit Specified partnership income Taxable capital calculation rules Effective for tax years beginning after March 21,

6 NEW RULES # FEDERAL BUDGET ISSUE MULTIPLE SMALL BUSINESS DEDUCTION CLAIMS Expansion of de-facto control rules ISSUE TAX NOT BEING PAID FAST ENOUGH End of billed-basis accounting for specified professionals, phased in over two tax years Effective for tax years beginning after March 21, 2017 REVIEW OF TAX PLANNING STRATEGIES ANNOUNCED 6

7 NEW RULES #3 JULY 18, 2017 PROPOSALS ISSUE INCOME SPRINKLING Expanding KIDDIE TAX rules to adults if the income is sourced from a corporation or business linked to a related person Exception for reasonable return on investment or effort based on cumulative efforts, assets and risks compared to accumulated income ISSUE CAPITAL GAINS EXEMPTION MULTIPLICATION CGE not available for gains realized by a trust, gains accruing prior to a rollout from a trust, and gains accruing before age 18 ISSUE SURPLUS STRIPPING New provisions that recharacterize proceeds of disposition from capital gain or repayment of tax paid cost base to dividends, retroactive to 1984 ISSUE CORPORATE TAX DEFERRAL Discussion of possible methods that could be used to discourage retaining profits for investment purposes 7

8 ROLLBACK ANNOUNCEMENTS SEPTEMBER 8, 2017 Phase in period for billed-basis accounting changed from two years to five years OCTOBER 16, 2017 Small business tax rate reductions reinstated (consequential increase to tax rate on ordinary dividends) Government will not be moving forward with measures to limit access to the Capital Gains Exemption Corporations with family members who meaningfully contribute to the business will not be impacted by the proposed measures on income sprinkling 8

9 ROLLBACK ANNOUNCEMENTS CONTINUED OCTOBER 18, 2017 All past investments and income earned from those investments will be protected from the new passive corporate income rules Businesses permitted to save for contingencies and growth Safe harbour $50,000 annual threshold on passive income Incentives for venture capital and angel investors Measures will be released in 2018 budget OCTOBER 19, 2017 Announcement that the government will not be moving forward with measures relating to conversion of income into capital gains 9

10 WHERE ARE WE NOW 2016 SMALL BUSINESS INCOME RULES Legislation enacted Effective for years beginning after March 21, 2016 BILLED BASIS RULES and DE-FACTO CONTROL DEFINITION Draft legislation issued September 8, 2017 Effective for years beginning after March 21, 2017 INCOME SPRINKLING Notice of ways and means, but no formal draft legislation Effective 2018 CORPORATE TAX DEFFERAL No details or legislative text until 2018 budget No announced effective date. Retroactive? 10

11 SPECIFIED CORPORATE INCOME Owner or Group Spouse(s) or Trusts Primary Business Service Billings Support Business 11

12 SPECIFIED CORPORATE INCOME OLD RULES Each company had a separate $500,000 small business limit Up to $1,000,000 taxed at low rate NEW RULES If the two companies have a common shareholder, or any shareholder of one company is related to any shareholder of the other Income from fees received by Support Business are not eligible for the small business deduction Exception if over 90% of Support revenue is from third parties Small Business Limit can be assigned from Primary to Support if Primary does not need the full $500,000 Single customer - maximum $500,000 taxed at low rate 12

13 SPECIFIED PARTNERSHIP BUSINESS LIMIT Partner Partner Partner Professional Corp Service Billings Professional Partnership 13

14 SPECIFIED PARTNERSHIP BUSINESS LIMIT OLD RULES Professional Corp has a $500,000 small business limit Not required to prorate based on partnership ownership NEW RULES Professional Corp is a designated partner Fee revenue is deemed to be partnership income Specified partnership income (eligible for SBD) is deemed to be nil Other partners can assign unused Specified Partnership Business Limit to Professional Corp, but total can not exceed $500,000 Ownership link effectively deems Professional Corp to be a partner 14

15 TAXABLE CAPITAL FOR SBD LIMIT PURPOSES SPOUSE 1 SPOUSE 2 CORP 1 CORP 2 CORP 3 15

16 TAXABLE CAPITAL FOR SBD LIMIT PURPOSES OLD RULES CORP2 election under 256(2)(b)(ii) broke association between CORP1 and CORP3 CORP2 was not associated with either CORP1 or CORP3 CORP2 taxable capital disappeared from both groups NEW RULES CORP2 election under 256(2)(b)(ii) still breaks association between CORP1 AND CORP3 CORP2 is still associated with both CORP1 and CORP3 CORP2 taxable capital will affect SBD limit of both CORP1 and CORP3 16

17 CONTROL IN FACT LEGAL CONTROL Person or persons who by virtue of share ownership can elect a majority of the board of directors CONTROL IN FACT Person who has influence that result in factual control of the company separate from shareholding rights 2016 court case restricted interpretation of existing provision, new legislation overrides case and re-establishes broad interpretation. 17

18 SMALL BUSINESS CHANGES - SUMMARY NEW RULES ARE MECHANICAL SBD multiplication structures no longer effective One business = one small business deduction Potential for unfair overreach in small markets Elections and designations will make filings more complex Forms do not exist for some elections Broad drafting (no minimum ownership) makes it very difficult to plan around. Only exemption is third party revenue. 18

19 BILLED BASIS ACCOUNTING Unbilled work in progress for certain professionals Accountants, lawyers, doctors, dentists, veterinarians Old rule can elect for value to be zero until billed New rule treated the same as inventory like any other business Costs need to be carried as inventory (not expensed) Lower of cost or fair market value Five year phase in 20% of cost per year Does not apply to contingency fee engagements 19

20 PASSIVE INVESTMENTS - ISSUE NO TAX DEFERRAL ON PASSIVE INCOME IN CORPORATION Corporate tax rate on interest is 50.2%, public dividends is 38.3% Top personal tax rate on interest is 53.5%, public dividends 39.3% CONCERN IS CAPITAL AVAILABLE TO INVEST Individual investment (top rate) 46.5% of income Small business 85% Large business 73.5% Personal dividend on original capital will equalize but there will be more after-tax investment income from the higher initial investment 20

21 PASSIVE INVESTMENTS RATE CHANGES PROPOSED AMENDMENTS Eliminate refundable portion of corporate tax Eliminate capital dividend account from corporate gains TOP INTEGRATED TAX RATE 73.5% on income 39.8% on capital gains 21

22 PASSIVE INVESTMENTS WHICH INCOME? INVESTED CAPITAL FROM THREE SOURCES Tax paid shareholder contributions Small business rate retained earnings General rate retained earnings Many companies have a blend of capital from all three PROPOSED OPTIONS Apportionment apply new rules to investment income based on proportion of source, recalculated each year Election company can elect to be treated as single source with trade-offs on rates and credits 22

23 PASSIVE INVESTMENTS MITIGATION GRANDFATHERING New rules will not apply to existing investments or income generated from those investments What is start date? Value of investments or retained earnings? How to track separate accounts, allocation? ANNUAL THRESHHOLD - $50,000 Fixed or indexed? Integration with grandfathered positions? Large gains / lumpy income? 23

24 PASSIVE INVESTMENTS - SUMMARY POOR COMMUNICATION BY FINANCE Did not attempt draft legislation in July release Application and transition likely to be very complex but minimal guidance issued to date UNINTENDED (OR INTENDED) CONSEQUENCES Too complex or expensive, income will just be taken personally Government gets funds instead of investment by entrepreneurs RECOMMENDATIONS Wait for legislation? 24

25 Tax on Split Income (TOSI) using private corporations Andrew Bernstein CPA, CA Tax Manager November 23, 2017

26 Tax on Split Income (TOSI) using private corporations The Incentive to Income Split Shift income from high income earners to lower income earners to take advantage of credits and/or lower marginal tax rates Tax Free Income (2017 rates) (Assumes no other income) Ordinary Income: $11,635 Non-eligible dividends $33,305 Eligible Dividends: $51,635 Savings to top marginal rates (Per split) Ordinary Income (220K): $36,500 Non-Eligible dividends ($188K):$35,725 Eligible Dividends ($159K): $35,725 26

27 Tax on Split Income (TOSI) using private corporations Current rules to prevent income splitting: 74.1, 74.2, and 74.3: General Attribution rules Transfers or loans of property between spouses and minor children for less than FMV consideration 74.4: Corporate attribution rules Transfers or loans of property to a corporation if main purpose to reduce the person s income and benefit a spouse or related minor 56(4.1) Loan s between non-arm s length parties with main purpose to income split 75(2) Reversionary Trust Rules 103(1.1) partnership allocations that are unreasonable S. 67 denial of deductions for unreasonable salaries 56(2) and (4): Specific Anti Avoidance rule for Indirect payments and transfers of rights to payments 27

28 Tax on Split Income (TOSI) using private corporations What does dividend income sprinkling refer to? Paying dividends to multiple family members which would have otherwise been received by the primary owner/manager Objective to utilise the lower marginal tax rates of family members to achieve an overall lower family tax bill Different structures to achieve income sprinkling, typically resemble the following: Trust Beneficiaries: 1) Owner Manager 2) Spouse 3) Child 1 4) Child 2 Family Trust Control Shares OPCO Owner Manager Control Shares Spouse Child 1 Discretionary Dividend Shares OPCO Child 2 28

29 Tax on Split Income (TOSI) using private corporations History and current rules to prevent dividend sprinkling: Neuman, [1998] 3 C.T.C. 177 CRA argued that 56(2) should apply to dividends in a family dividend sprinkling situation Supreme court disagreed with CRA! Shareholders don t need to contribute services to a corporation to be entitled to a dividend Dividends belong to the corporation until they re paid and noone else Tax on Split Income Rules TOSI introduced in 1999 to prevent dividend sprinkling with minor children <18 years old Kiddie Tax on income not caught by attribution rules 29

30 Tax on Split Income (TOSI) using private corporations Current Tax On Split Income (TOSI) rules Split-Income of a Minor (child under 18 at the end of the year) is taxed at the highest marginal tax rate No personal tax credits allowed, only DTC and FTC Applied the highest marginal rate of tax to Split Income Eliminates the benefits of dividend sprinkling with minors New proposals for expanded TOSI (Tax On Split Income) January 1, 2018 expansion of the Kiddie Tax concept to resident adult specified individuals sufficiently linked to a source business. Age based rules: <18 years old 18 to 24 years old 25 and older New Reasonableness Test Applies differently based on age-group 30

31 Tax on Split Income (TOSI) using private corporations What types of income are Split Income subject to TOSI? Dividends, S/H loans, taxable benefits from private corporations Capital gains on non arm s length disposition of shares in a private corporation (recharacterized as dividends) Minor s income from a trust or partnership providing property or services to a relative, or a corporation in which a relative is a specified shareholder (>10% of the shares of any class) Minor s income from business or rental operation of a trust or partnership in which a related person is an active participant Expansion of Split Income subject to TOSI Interest on debt Arm s Length Taxable Capital Gains (if the income on the shares would be Split ) Additional benefits conferred directly or indirectly by a person Secondary income (<25) TOSI not generally applicable to public corp. / mutual funds 31

32 Tax on Split Income (TOSI) using private corporations Sufficient link to a source business concept For adult specified individuals only income sourced from a business in which the receiving individual has a sufficient link is subject to TOSI Investment Holdco? Dispositions of Capital Property used in business? Sufficient link depends on the connection of a related person to the corp., ptnrshp., or trust from which bus. Income received: Corporation: Direct/Indirect control and/or >10% of the FMV of issued shares OR can influence Partnerships/Trusts: Involved in business or rental activities / has an interest / is a beneficiary Impact of expansion of related individuals concept Includes uncles, aunts, nieces and nephews 32

33 Tax on Split Income (TOSI) using private corporations The Reasonableness Exception Presumption that income received from a corporation, partnership or Trust will be at high rates unless reasonable Reasonable return for inputs/contributions The concept of reasonable will also be important to determine whether TOSI applies to: Taxable capital gains on arm s length dispositions of shares/ interest in partnership or Trusts / debts Related party transactions/re-organisations Critical to demonstrate reasonableness of Income to carve it out of split income! Retroactive / cumulative Subjective and ambiguous Administrative Burden 33

34 Tax on Split Income (TOSI) using private corporations What is considered reasonable? A. Depends how old the recipient is and their contributions <18 yrs. of age: Nothing is Reasonable yrs. of age: -If actively engaged full-time, FMV of contributions (nothing for part-time) -Prescribed rate (currently 1%) on capital Over 24 yrs. of age: -FMV of contributions -FMV considering assets and risks assumed on capital and investments -Anti Avoidance: Principal purpose to derive income from property -Cumulative / Reduced by previous dividends/salaries/compensation -Secondary income is only included for < 24 yrs. of age -Special exclusion on income from inherited property for < 24 yrs. of age 34

35 Tax on Split Income (TOSI) using private corporations Uncertainties with TOSI: Government Statement October 16: Corporations with family members who meaningfully contribute to the business will not be impacted by the proposed measures to income sprinkling What does this mean: Marketing the policy but no real changes intended? Safe harbour amounts / terms? Other changes in proposed legislation? Update promised in Fall

36 Tax on Split Income (TOSI) using private corporations Other possible implications and observations: Non Arm s length capital gains impact on tax re-organization LCGE Crystallisation limitations Post-Mortem planning (deemed div. / loss carry back?) Review family transfers Transfer within family (to owner manager?) Remove unnecessary shares / separate classes LCGE restriction retracted? 36

37 Tax on Split Income (TOSI) using private corporations Considerations for 2017 and Beyond 2017 Payment of Dividends? Trigger capital gains/ LCGE Crystallisation Beyond Consider Payment of salaries rather than dividends Family financing considerations 37

38 Update on CRA audit activities Andrew Bernstein CPA, CA Tax Manager November 23, 2017

39 Supplement: Update on where CRA is focusing their audit efforts What have we experienced since last year? Budget 2016: Tax Fairness and a strong Financial Sector Promised additional investment to crack down on tax evasion and tax avoidance all in the name of achieving Tax Fairness. Tax Fairness? Disguised preliminary attack on small business? Tax evaders, aggressive tax planners, and the high risk segments of the population? Year 1 of 5 of $444.4 investment already translating into more audits of middle class and incorporated small businesses 39

40 What has CRA been up to this past year? Widespread corporate audits of specific claims -Professional Fee Letters -Small Business Deduction Letters -Personal Services Business (PSB)? -Specified Investment Business (SIB)? -GST/HST? Other Common audits: Comprehensive Payroll and subcontractor audits; general audits of revenues and expenditures; Employment expenses audits (automobile / business use of home) Interprovincial Income allocation corporate program 40

41 Other concerns regarding CRA s recent audit focus on small business Significant overhaul of tax regime to comply with Significant ambiguity and subjectivity Learning curve for taxpayer s and auditors alike Little guidance on various uncertain areas Changes to Voluntary Disclosure Program (VDP) Taxpayer s may be unable to come forward to correct their tax affairs Increased audit activity means more likely CRA may find the delinquency and assess penalties before the issue becomes statute barred Final opportunity to submit under the old program is January 1,

42 Thank You Questions? Andrew Bernstein Shimmerman Penn LLP Tel:

43 Questions?