How Finance s new proposals will affect tax planning for private companies 1 August, 2017
Today s presenters Gabriel Baron Tax Partner Private Client Services practice EY Ryan Ball Tax Partner Private Client Services practice EY Page 2
Agenda How did we get here? Scope of the proposals Increased tax on corporate reinvestment in passive assets Income sprinkling restrictions Lifetime Capital Gains Exemption (LCGE) restrictions Capital gains tax increase ( conversion of capital gains into dividends) What happens next? Questions Page 3
Background and history: How did we get here? Liberal election platform document [from www.liberal.ca] "We will ensure that Private Corporation (CCPC) status is not used to reduce personal income tax obligations for high-income earners rather than supporting small businesses...particularly as high-income individuals use CCPC status as an income splitting tool" Federal budget 2016 Speculation of capital gains and stock option tax increases Elimination of Conservative s income splitting Family Tax Cut credit ($2,000 max value tax credit) Federal budget 2017 Speculation of capital gains tax increases One-page warning about private company tax reform July 18, 2017 Comprehensive proposals Page 4
Scope of proposals Every private company in Canada may be impacted in some manner by the proposals Proposal paper includes commentary on: Corporate reinvestment proposals Income splitting Lifetime Capital Gains Exemption (LCGE) Capital gains taxation Draft legislation and explanatory notes released on income splitting, LCGE and capital gains taxation Page 5
Scope of proposals Typical family corporate structure Spouse 1 Spouse 2 Children beneficiaries Fam Trust Beneficiary relationship Corp Benef. 60% 20% 20% HoldCo OpCo Page 6
Taxation of corporate reinvestment Page 7
Taxation of corporate reinvestment What s targeted? Spouse 1 Spouse 2 Children beneficiaries Fam Trust Beneficiary relationship Corp Benef. 60% 20% Dividends 20% Dividends HoldCo Dividends OpCo Page 8
Taxation of corporate reinvestment Current system Corporations taxed at lower rates than individuals on business earnings when reinvested in corporate environment (the deferral ) On fully-distributed basis, indifferent between earning funds in corporation or personally Passive investment earnings taxed at high rates, and also indifferent today between corporate or personal investment on fully-distributed basis Page 9
Taxation of corporate reinvestment Current example: initial business earnings Personal Corporate Income $100,000 $100,000 Corporate tax (27,000) $73,000 Personal tax (50,000) (23,000) After-tax funds $50,000 $50,000 Example on active business earnings Hypothetically representative tax rates from Department of Finance: Corporate general tax rate: 26.70% High-rate personal tax, ordinary income: 50.37% High-rate personal tax, eligible dividend income: 32.29% Page 10
Taxation of corporate reinvestment Current example: passive investment earnings Personal Corporate Income $100,000 $100,000 Corporate tax (50,000) 50,000 Dividend refund 30,000 Taxable dividend 80,000 Personal tax (50,000) (34,000) After-tax funds $50,000 $46,000 Example on passive Canadian investment earnings (income and the taxable portion of capital gains) Hypothetically representative tax rates from Department of Finance: Corporate investment tax rate: 50.37% Refundable component of tax, when sufficient dividends paid: 30.67% High-rate personal tax, ordinary income: 50.37% High-rate personal tax, ordinary dividend income: 42.02% Page 11
Taxation of corporate reinvestment Proposed system Objective is to remove benefit of tax deferral when passive investments acquired from business-taxed earnings Two broad systems proposed for input/comment: #1: Current tax method: 1972 Approach levies refundable tax on business earnings invested in ineligible passive assets Government appears to not be pursuing this proposal Page 12
Taxation of corporate reinvestment Proposed system #2: Deferred tax method: leave current systems generally in-place EXCEPT remove refundable component of investment tax Applies to investment earnings on corporately taxed retained earnings used to invest in passive assets Double tax results on distributed investment earnings After tax return in corporate investment scenario will proxy same return as if funds had been personally distributed and invested Depending on province of taxation, immaterial advantage may remain to using corporate investment vehicle No tax-free distributions (Capital Dividend Account, or CDA ) for ½ portion of capital gain not subject to tax Discussion on when, if at all, tax free CDA permitted on corporate gains in limited situations Page 13
Taxation of corporate reinvestment Future example: initial business earnings Personal Corporate Income $100,000 $100,000 Corporate tax (27,000) $73,000 Personal tax (50,000) (23,000) Consequence of investing surplus? After-tax funds $50,000 $50,000 No change to taxation and distribution of business earnings under proposals However, what happens to taxation of the investment income earned on the $73,000 corporate surplus? Compare investment in passive assets generating 10% rate of return on either: Personal $50,000: would generate $5,000 of income Corporate $73,000: would generate $7,300 of income Page 14
Taxation of corporate reinvestment Future example: passive investment earnings Personal Corporate Income $5,000 $7,300 Corporate tax (3,600) 3,700 Dividend refund N/A Taxable dividend 3,700 Personal tax (2,500) (1,200) After-tax cash $2,500 $2,500 Effective rate 50.00% ~66.00% Page 15
Taxation of corporate reinvestment Potential income tax rates on investments If after-tax business earnings subject to Small Business Deduction, reinvestment in income/gains produces: ~71% tax rate on investment income ~51% tax rate on capital gains If after-tax business earnings subject to general corporate rate, reinvestment in income/gains produces : ~66% tax rate on investment income ~49% tax rate on capital gains Page 16
Taxation of corporate reinvestment Other issues Highly technical discussion material on other issues Proposed grandfathering for existing investments No guidance on how grandfathering will be implemented Existing investments? Existing business retained earnings for future investments? What about accrued but untaxed gains (real estate, business goodwill etc)? Preservation of grandfathering, or forced drawdown of funds on first in first out basis? Unclear when proposals would apply subsequent to the consultation period Proposal document indicates time will be provided before any such proposal becomes effective Page 17
Taxation of corporate reinvestment Other issues Proposed preservation of existing refundable tax system for investment-only companies. Unclear scope of this grandfathering Unclear what is meaning of passive investment? Proposals silent on permanent life insurance investments Proposal also indicated will consider/address: Evaluation whether should apply to non-ccpc private companies (no mention of public companies though) System will not be undermined by complex cross-border structures and activities Page 18
Income sprinkling restrictions Page 19
Income sprinkling What s targeted? Spouse 1 Spouse 2 Children beneficiaries Fam Trust 60% 20% 20% HoldCo OpCo Page 20
Income sprinkling Current system Kiddie Tax top marginal rate tax to specified individual on split income Attribution rules rules in place to limit the transfer of investment type income to minor children and spouses Ability to pay discretionary dividends to adult children and spouses Maximum savings depends on the province of residence $25,000 - $35,000 annual tax savings per-person per-year as a point of reference on transfer of $220,000 taxable income to no-income individual Page 21
Income sprinkling Proposal to increase tax #1 Expand the base of specified individuals subject to kiddie tax Proposed to include other related individuals (adult children, parents, spouses) and expanded definition of related (aunts, uncles, nieces, nephews) Adults included if the split income is derived from a business carried on by a related person Derived includes directly or indirectly Business carried on includes businesses inside a corporation, trust or partnership Business carried on also includes the year or previous year Possible for both spouses to be specified individuals in respect of the same business? Page 22
Income sprinkling Proposal to increase tax #2 Expanding the base of split income subject to kiddie tax Income on previous split income Gains from property that would produce split income Income (eg. interest) from loans to a corporation, partnership or trust in certain situations (eg. Loan to parent s wholly owned corporation) Amounts included in income because of a benefit conferred by another person Page 23
Income sprinkling Excluded amounts For individuals over 17, amounts that are reasonable in the circumstances 25 or over year old test, reasonably paid by arm s length party for: Assets contributed to the business Labour contributions to the business 18-24 year old test, more restrictive Labour only if active on a regular and continuous basis Only prescribed maximum return allowed on assets contributed Anti-avoidance to limit labour contributions to businesses that provide passive income or hold passive assets Page 24
Income sprinkling Examples that no longer work Estate freeze dividends paid to an adult child that hasn t provided any services New corporation dividends paid to spouse that provides no capital or services Split income dividend paid to a child. Child reinvests after tax proceeds in own business venture Page 25
Income sprinkling Examples that should still work Income paid to individual that is already subject to highest marginal rate of tax Reasonable salaries Dividend paid to 25 year old spouse provided amount is reasonable considering capital and labour provided Splitting eligible pension income on personal tax return Note: unclear whether anti-avoidance proposals may extend to prescribed rate investment loans made to spouses and children where public investment income earned Page 26
Income sprinkling When do proposed rules apply? New proposals would become effective for the 2018 calendar tax year of individuals Evaluate what strategies should be utilized prior to the end of 2017 to mitigate exposure to the new proposals Page 27
Lifetime capital gains exemption (LCGE) restrictions Page 28
Life time capital gains exemption What s targeted? Spouse 1 Spouse 2 Children beneficiaries Fam Trust 60% 20% 20% Opco Page 29
LCGE Current System Available to all taxpayers on disposition of qualifying property Amount of exemption $835,000 ($1M for farm property) Certain ownership and use tests Eligible gains are exempt from tax Ability to use exemption for all family members on an arm s length sale of qualifying property Ability to allocate taxable gains out of family trust Page 30
LCGE Proposals to increase tax No more LCGE for individuals under 18 Includes gains that are realized or accrued while minor No more LCGE for gains realized or accrued by a family trust, even if property rolled out of trust to beneficiaries No more LCGE on gains from property that would otherwise produce split income Introduces a reasonability test to the amount of the gain that has accrued based on provision of labour or capital to the business Page 31
LCGE Transitional rules Generally effective for dispositions occurring after 2017 Elective provision to trigger gains in 2018 and still qualify Increase tax cost for future sale Some relief to holding period tests Election form must be filed (generally April 30, 2019) Transitional rules do not appear to work for minors where shares not sold arm s length by December 31, 2018 Page 32
LCGE Next steps Review existing structures for possible use of transitional relief Don t forget about alternative minimum tax Consider necessary changes to current structure Need to weigh commercial reasons to use trusts against ability to access LCGE Page 33
Conversion of capital gains into dividends Page 34
Capital gains conversion to dividends What s targeted? Spouse 1 Spouse 2??? Children beneficiaries 60%??? 20% 20%??? Fam Trust HoldCo??? OpCo Page 35
Capital gains conversion to dividends Current system Capital gains are realized on death Where shares of private company held, can utilize tax paid attributes of shares to draw funds from corporation to mitigate double tax Capital gains realized amongst transfers of related parties (where appropriate taxes are paid) produce hard tax cost in the assets. Tax paid assets can be sold to related corporations for cash, shareholder loans, etc. Does not apply to gains sheltered by LCGE or pre-1972 value Corporate capital gains are generally integrated with personal rates, and funds can be disbursed to individual shareholders at rates comparable to personal capital gains Page 36
Capital gains conversion to dividends Proposed systems Two draft legislative anti-avoidance proposals Both proposals apply effective July 18, 2017, regardless of whether transactions initiated prior to July 18 th Potentially a retroactive tax increase as examples will illustrate Government indicated willingness to evaluate exclusions for legitimate intergenerational business transfers, however unclear when that may apply Page 37
Capital gains conversion to dividends Proposed systems #1: Limit or suppress hard tax cost of private company shares where any related party has realized gain, and shares are subsequently transferred to related corporation Applies for gains during life or death Applies regardless if capital gains tax have been paid Forever tracing of share history Results in tax increase on death, or potential for double tax (see example) Unclear how rule will interact with capital gains tax antiavoidance proposal #2 Rule applies to transfers on/after July 18, 2017, but captures suppressed tax cost arising from pre-july 18 th transactions (retroactive tax increase?) Page 38
Capital gains conversion to dividends Proposed systems #2: Re-characterization of certain tax-free distributions from corporation into taxable dividend Summary description of proposal: Amount received directly/indirectly by individual resident in Canada as part of transaction or series of events As part of transaction/series, there is a disposition of property or increase/decrease of paid-up capital of a corporation Can reasonably be considered that one purpose of transaction/series was to significantly reduce assets of a private corporation, such that as a consequence of the distribution of the amount, tax has been avoided Applies to amounts received on/after July 18, 2017, regardless if transaction/series commenced prior to July 18 th Page 39
Capital gains conversion to dividends Proposed systems Ambiguous as to when proposal #2 may apply, particularly in ordinary course transactions: Repayment of shareholder loans arising from sales of assets to corporation? Return of tax-paid capital funded from assets that were disposed of by the corporation? Sales of corporate assets producing capital gains (for example commercial real estate), unclear whether permitted to extract the ½ tax-free capital gain component (CDA)? Interacting with proposal #1, if corporation s assets sold following death to fund winding-up of corporation, are shareholders subject to double tax? Strong technical submissions anticipated to Dept. of Finance to address ambiguity and potential grandfathering Page 40
Capital gains conversion to dividends Example of proposal #1: Estate of Surviving Spouse Intent to gift HoldCo shares HoldCo Children beneficiaries Facts of Example Surviving spouse died in March 2017 Children intend to use available pipeline tax planning Capital gains tax bill of ~$252,000 paid by Estate Hypothetical Dept. of Finance tax rates used $1,000,000 GICs Page 41
Capital gains conversion to dividends Example of proposal #1: Estate of Surviving Spouse $1,000,000 tax paid note $1,000,000 tax-free intercorporate dividend Children beneficiaries HoldCo2 HoldCo Facts of Example Surviving spouse died in March 2017 Children intend to use available pipeline tax planning Capital gains tax bill of ~$252,000 paid by Estate Hypothetical Dept. of Finance tax rates used $1,000,000 GICs Page 42
Capital gains conversion to dividends Example of proposal #1: Existing pipeline planning Impact of new proposal Alternative existing 164(6) planning HoldCo value $1,000,000 $1,000,000 $1,000,000 Estate tax (252,000) (252,000) (420,000) $748,000 $748,000 $580,000 Additional tax to kids - (420,000) - Final after-tax funds $748,000 $328,000 $580,000 Effective rate 25.20% 67.20% 42.00% Tax on death to private corporation owners could be 2.5x its current rate under proposals To avoid double/triple tax, alternative available planning may be used, however: Tax rate significantly higher under alternative planning May not be commercially feasible since typically requires a winding-up of the corporation subject to tax Fact that death occurred before July 18, 2017, irrelevant under proposals Page 43
Capital gains conversion to dividends Example of proposal #2: Shareholder HoldCo1 $1,000,000 Value of commercial real-estate Facts of Example $1M of commercial realestate to be sold as capital gain One purpose of sale is enable shareholder to extract proceeds from business for personal use (eg buy cottage) Hypothetical Dept. of Finance tax rates used Page 44
Capital gains conversion to dividends Example of Proposal #2: Today Proposals Gain $1,000,000 $1,000,000 Corporate tax (251,000) (251,000) Dividend refund 153,000 153,000 $902,000 $902,000 Tax-free CDA dist. $500,000 - Taxable dividend 402,000 902,000 Personal tax (169,000) (379,000) After-tax funds $733,000 $523,000 Effective rate 26.70% 47.70% Note! Even if real estate sale completed prior to July 18, 2017, distribution of funds/cda after July 18 th caught if part of the same transaction or series of events Page 45
What happens next? Page 46
What happens next? Commentary period closes October 2, 2017 Review existing planning arrangements Understand and identify exposure to new rules Analyze potentially retroactive nature of capital gains proposals Identify planning ideas to implement before rule changes Adjusting structures on go-forward basis Get involved and have your say! Business groups Local MPs Submissions to finance Page 47
Page 48 Questions?
Contact us Gabriel Baron Tax Partner, Private Client Services Practice 416.932.6011 gabriel.baron@ca.ey.com Ryan Ball Tax Partner, Private Client Services Practice 306.649.8225 ryan.ball@ca.ey.com Page 49