On July 18, 2017 the federal government announced proposed tax changes which will have a significant impact on business owners. The main premise of the proposed changes is that the government feels it is unfair that an employed person with a T4 cannot do the same tax planning as a business owner; the proposed changes will limit what a business owner can do to save or defer tax.
Here is a brief summary of the impact of the proposed changes for business owners:
The concept of the “kiddie tax”, the income splitting rule that currently applies to minors, will apply to adult relatives as well. The highest rate of tax will apply to dividends, certain types of interest, and capital gains that are paid to/realized by adult relatives unless the amount can be justified as “reasonable” in the circumstances. The reasonable test will be based on level of participation in the business and/or capital invested in the business. There appears to be a more stringent reasonable test for 18 to 24 year olds, but essentially it will eliminate income splitting with all relatives, regardless of age, unless they are active in the business. This applies whether or not the adult relative owns shares or is a beneficiary of a trust that owns the shares.
These rules will apply to distributions in 2018 and subsequent years.
Capital Gain Exemption (CGE)
The CGE can be claimed when a business owner sells the shares of their small business company. In 2017, this would result in the ability to exempt from tax the first $835,000 of capital gain arising from the share sale. It has been common tax planning to multiply access to the CGE through family ownership of shares, either directly or through a family trust.
For dispositions arising in 2018 or subsequent years, the CGE can neither be claimed by a person under the age of 18, nor be claimed after they turn 18 in respect of value increases prior to turning age 18. For adult relatives, if the reasonableness test noted above applies in the case of a realized capital gain, not only is the capital gain subject to the highest rate of tax, but no CGE may be claimed.
In addition, starting in 2018, if the shares are held by a trust (other than an alter ego or joint partner trust), any value increase during the holding period will not qualify for the CGE. There will be the ability to make a one-time election in 2018 to increase the adjusted cost base (ACB) of the shares and claim the CGE, subject to some easing of the restrictions on qualifications for the CGE claim.
Between the restrictions on income splitting and the loss of the CGE, these rules will negate the use of a family trust for tax planning purposes.
Pipeline planning is a method to extract tax paid cost basis of small business company shares by transferring the shares to a different company in return for a promissory note. Essentially, as tax has been paid once it should not have to be paid again. Under the current rules, if son arranges for his company to buy from his mother, shares of her company, mother has to report a dividend instead of a capital gain. If son (not his company) buys the shares from mother, she reports a capital gain (not a dividend). Then, provided mother does not claim the CGE, such that she has paid tax on the capital gain, son can sell the shares to his own company for a promissory note, thereby accessing the tax paid cost basis (mother paid the tax on that value already) so son does not have to pay the tax again.
The government’s position is that a distribution of value from a small business company within the related group should always be taxed as a dividend, never as a capital gain. So the rule change – first, under the current rules, in the above example, note that the “pipeline” of the tax paid cost basis works provided mother did not claim the CGE. If she claims the CGE, it is not “tax paid” cost basis so son will have a dividend if he transfers the shares to his company for a promissory note. The change – reference to claiming the CGE will be eliminated from the rules. The rule will now apply if any person related to son (e.g. mother) reported a capital gain when they sold the shares, such that when son transfers the shares to his company in return for a promissory note, son will be required to report a dividend. This will result in double tax, wherein mother reports a capital gain and son reports a dividend on the same value. To avoid this double tax, mother will have to report a dividend or son will have to hold the shares personally until he sells to someone else.
The government acknowledges that a true intergenerational transfer of shares to an adult child’s corporation should be treated in the same manner as a sale to an arm’s-length corporation (mother should be able to report a capital gain and claim the CGE and son should be able to use a company to acquire the shares just like he could if he purchased the shares from anyone else). However, the government has claimed the inability to distinguish between a true intergenerational transfer and planning for mother to extract retained earnings at capital gains tax rates.
There was no mention of post-mortem pipeline planning, wherein mother dies and son inherits the shares, but it does appear that the new rules will also apply in this case. This could be a real problem for existing estates that have assumed that these rules would not be changed; there is a real possibility of a double tax problem.
These changes will apply to shares disposed of, and amounts received or that become receivable, on or after July 18, 2017.
Investment of Retained Earnings
The government feels that the tax deferral achieved by way of corporate tax rates, whether small business or general rates, being lower than the top personal tax rates should only be of benefit to the business owner if the after-tax retained earnings are reinvested in the business. The proposal is such that if invested in passive investments, there will be no tax deferral available. The justification is based on the perceived injustice that an employed person with a $220K T4 who wants to invest $20K only has $10K after tax to invest, while a business owner would have $17K ($20K less the 15% small business tax rate) to invest.
The government has proposed multiple options to address the aforementioned situation. One suggestion is that an additional tax be paid by the company to the extent that the retained earnings are not reinvested back into the business, tracking pools of income taxed at different rates. Another looks at an election based method that would cause the company to pay tax at high rates on all sources of income. In addition, it could be that the “connected company”/Part IV tax system would be replaced by a refundable tax to be paid on all inter-corporate dividends.
The issues of and proposed solutions to the investment of retained earnings have not been issued in draft legislation form, but are merely musings by the government that the rules should achieve the stated objective; it is now a question of how to get there.
These proposed rule changes are far reaching and will have a significant impact on small business owners/entrepreneurs, the very people often recognized for driving the economy and employment. The government has requested commentary from all stakeholders, but the consultation period is short – comments must be received by October 2, 2017.
Don Scott, FCPA, FCA is a Partner & Director of Tax Services at Welch LLP