“Hope for the best. Prepared for the worst.”
“War”. “Donald Trump”. “The Toronto Maple Leafs win the Stanley Cup”. These are the type of subject matters that make front page headlines. “Tax”. Not exactly something that stirs the imagination and makes it to the front page.
Well, things certainly changed in the summer of 2017. The Government introduced a consultation paper in July 2017 that sent shockwaves through the tax and business community at large. The paper addressed a number of matters but in particular focused on the taxation of private corporations and the purported devious manner in which they were used to save tax through income sprinkling techniques and the ability to accumulate significant amounts of investment assets. Some of the proposals suggested in the government paper would have resulted in an overall tax rate of 73% or more on certain types of income passed through a private company. They had to be kidding.
The Federal Budget issued in February 2018 was anxiously anticipated. How bad would it be? How crazy complicated would the new system be? Was the Government setting us up? They certainly prepared us for the worst based on the what they released in the summer. Tax practitioners and business people hoped for the best. What was the best? Would they scrap these proposals entirely because they were too complicated to implement?
So, what did we get? As we will explain below…something in between.
On July 18, 2017 the Federal Government released a controversial package of new tax measures affecting private corporations and their shareholders that proposed a major overhaul of the tax system as we know it. There were four main tax planning strategies targeted:
- Income sprinkling
- Reinvestment of after-tax corporate earnings in passive investments
- Multiplying access to the lifetime capital gains exemption
- Conversion of income into capital gains
Following the introduction of these proposals and a large outcry from various stakeholders including the tax community, the government backed off on the last two measures, but continued to devise rules to combat the first two strategies.
In December 2017, the government released draft legislation to attack income sprinkling that takes effect in 2018. The Federal Budget tabled on February 27, 2018 addressed the taxation of passive income earned by a corporation introducing rules that commence in 2019.
The following is a brief overview of the proposed changes and how they affect the tax landscape for private corporations and their shareholders. We will attempt to outline just how your private corporation has been affected by these two new sets of rules. One thing is for certain……..these rules will add to the rampant complexity that prevails in our existing tax world.
Tax on Split Income (TOSI) Rules
The Canadian tax system taxes each individual separately at marginal tax rates that increase as the individual’s income level rises. “Income sprinkling” (also known as income splitting), involves redirecting income from high-income earners to lower-income family members, usually through the payment of private company dividends or through the allocation of certain types of other income from partnerships or trusts. There are currently several rules in place which limit the ability of a business owner to sprinkle income and capital gains amongst family members. These measures include various attribution rules and the so called ‘kiddie tax’ rules that typically apply to minors (those under age 18) and/or spouses. Starting in 2018, new rules have been introduced that will apply to most family members irrespective of age with some specific exceptions.
These rules have conveniently been tabbed with the acronym “TOSI” (Tax on Split Income). Split income includes private company dividends, capital gains and certain income from partnerships and trusts (that includes income derived from a related business and certain rental property income) . Any income caught by the TOSI rules will be taxed at the top marginal tax rate, thereby negating any tax benefit from income splitting.
There are some interesting exclusions from the TOSI rules, some of which inject considerable subjectivity into our tax regime. These exclusions are age dependent and are summarized below.
Age 18 and older
These new rules focus on an individual’s contribution to the business, a concept historically unique to the recipient of private company dividends and other types of passive income. These rules apply to any family member age 18 and older and provide additional exceptions to those over age 24.
For income earned to be excluded from the TOSI rules, the family member must be engaged in the activities of the business on a regular, continuous and substantial basis. The rules suggest that this test is met if the related person worked for 20 hours or more per week during the current tax year or in any five prior (not necessarily consecutive) years.
If this test is not met and the related person is 25 years of age or older, income can also be excluded from the TOSI rules if the recipient owns shares that have at least 10% of the votes and value of the company. Unfortunately, this exception does not apply to professional corporations or service businesses. This exception only applies to the direct ownership of shares and not shares owned by a trust. It may be advisable to transfer shares out of the trust to the direct beneficiary to avoid TOSI.
If either of these two exclusion tests are not met, a ‘reasonability’ test is a last resort. What is reasonable? This will depend on factors such as the extent of the person’s labour contributions, the assets contributed, and the risks assumed. It will be interesting to see how these rules will be applied in practice and whether they will bog down a system that is already stretched to its limits. One thing is certain: documentation will become far more important!
Age 18 to 24
The rules are even more onerous if a taxpayer is 18 to 24 years old and did not meet the above-noted ‘20 hours or more per week’ test. Any amount paid to this group, in excess of a reasonable return (the highest prescribed rate of interest in effect for a quarter in the year) based on their capital contributions, will be subject to TOSI.
Other noteworthy exclusions to TOSI exist for seniors (those age 65 and older), and in respect of assets received on a marital breakdown or an inheritance. The former exception aligns with rules that allow seniors to split their pension income. TOSI also does not apply to arms-length sales of shares that are eligible for the capital gains exemption. It is important to note that paying a salary to a related person is not included under the TOSI rules and remains subject to the reasonability standards that have historically been in place.
Tax Implications to our Clients:
- Dividends and other income (excluding salaries) paid to family members directly or indirectly through trusts are now subject to TOSI rules and will be taxed at the top marginal tax rate unless an exclusion is met
- There is no longer any tax benefit to paying dividends to family members in lower tax brackets unless a TOSI exception is met
- Documentation of hours worked, capital contributions and risks assumed should be kept with corporate records to support TOSI exclusions, if applicable
- The creation of family trusts is no longer a strategy for income splitting purposes, however trust planning can still be useful in the context of selling a business and multiplying the capital gains exemption
Passive Income Earned by a Private Corporation
The taxation of Canadian controlled private corporations (“CCPCs”) has been largely based on the concept of integration, in which income earned in a CCPC and paid out to its shareholders as a dividend should bear a comparable level of tax to income earned by an individual directly without a corporation. In order to avoid ‘double taxation’ on income earned by a corporation (i.e. paying corporate tax and then paying personal tax on the related dividend), dividends paid out of a corporation are taxed at lower rates recognizing that corporate tax has already been paid on the income distributed as a dividend.
Canada has two corporate tax rates on business income – the first $500,000 of business income is taxed at a rate of 13.5% in 2018 (combined Federal/Ontario) and 26.5% on business income over this $500,000 ‘business limit’. Since these rates are considerably lower than the top personal tax rate of 53.5%, the government was concerned that corporations were being used to improperly accumulate investment assets.
Investment Income and Refundable Tax
Because of this dual corporate rate on business income, dividends paid out of CCPCs are taxed at different tax rates depending on the business tax rate paid by the corporation. Dividends paid out of corporate income that was subject to the 26.5% rate will be subject to lower personal tax rates. These dividends are as follows:
- Non-eligible dividends are those paid out of corporate surplus that was subject to the 13.5% corporate tax rate. These dividends will be subject to a 47% top marginal tax rate.
- Eligible dividends are those paid out of corporate surplus that was subject to the 26.5% corporate tax rate. These dividends will be subject to a 39% top marginal tax rate.
The concept of integration also applies to investment income earned by a private corporation. Investment income in CCPCs is taxed at rates comparable to the top personal tax rates. To achieve integration on investment income, a portion of the tax paid on investment income is “refundable” when dividends are paid. Dividends paid out of investment income are also considered to be ineligible dividends subject to the higher rate of personal tax. This refundable portion of the tax paid is recoverable by the corporation when it pays a dividend (either eligible or non-eligible) to its shareholders at a rate of $38 1/3 for every $100 of dividends paid.
Under the current system, corporate taxpayers that had both business and investment income did not have to stream the payment of dividends to match the type of corporate tax that was paid on the underlying dividend payment. Thus, the corporation could pay the lower taxed eligible dividend and still recover the refundable tax thus achieving a better overall combined corporate-personal tax rate on the original sourced income.
Starting in 2019 that will no longer be the case. The Budget proposal is designed to ensure that a CCPC will not be entitled to the refund of refundable tax on eligible dividends that were generated from business income. Dividends received from public companies (known as portfolio dividends) are also included in this eligible dividend pool. A CCPC will only get the refundable tax back when the dividend is an eligible dividend paid from this pool of portfolio dividends or when an ineligible dividend is paid from investment income. Thus, the new provisions are designed to ensure that the two integration streams match up and that tax savings can’t be derived by paying the lower taxed dividends (other than from the portfolio dividend pool) to obtain the refundable tax.
Tax Implications to our Clients:
- Future dividend refunds will only be issued to a corporation on the payment of non-eligible dividends, except if portfolio dividends are received by a corporation
- Investment decisions within a corporation should be reviewed giving consideration to acquiring assets that yield higher eligible portfolio dividends
- A corporation should consider paying an eligible dividend in 2018 to recover its balance of refundable tax
Phase out of the Business Limit
Effective for taxation years that begin after 2018, a private corporation’s $500,000 business limit will decrease at the rate of $5 for every $1 of investment income earned once a corporation earns more than $50,000 of investment income. The business limit will be nil when a corporation earns $150,000 of investment income in a year. Assuming a 5% investment rate, these rules will apply when a CCPC has over a $1M of investment assets and the 13.5% tax rate will be lost when a company has $3M of investment assets. Investment income for these purposes includes the taxable portion of gains on the sale of investments and interest and dividend income from portfolio investments. Capital losses from other years will not be available to reduce this income. This rule can not be avoided by transferring investment assets to a related corporation.
This ‘phase out’ measure will only affect those CCPCs that currently benefit from the 13.5% small business tax rate and only to the extent that business income exceeds the reduced business limit. This measure will not apply to CCPCs that solely earn investment or rental income nor will it have any major impact on professional corporations that own partnership interests in widely held partnerships. Furthermore, it will not impact any large corporations who were already not receiving the small business deduction because their capital exceeds $15M.
Do you remember when the Finance Minister promised you that your investment assets would be grandfathered. There is NO grandfathering here. If you can’t trust your Finance Minister, who can you trust.
Tax Implications to our Clients:
- For shareholders of private corporations who have accumulated significant wealth in their private corporations of approximately $1M, access to the small business tax rate may be reduced or eliminated, resulting in more active business income being taxed at 26.5% instead of 13.5%
- No impact to CCPCs that solely earn investment or rental income nor corporations that do not currently benefit from the small business deduction or earn less than $50,000 per year in investment income
- CCPCs’ investment strategy decisions and remuneration decisions should be reviewed
- Investment decisions within a corporation should be reviewed including considering acquiring assets that throw off business income, if possible
Does Incorporation Still Make Sense?
The short answer is ‘YES’!
The 2018 Budget proposals did not have an impact on the significant tax deferral available to CCPCs earning business income. This tax deferral ranges from 27% to 40% depending on the availability of the small business deduction. The bottom line remains……… if you do not require a significant amount of your income to fund your lifestyle, incorporation could still be beneficial depending on your fact situation.
With these new rules for private corporations, closer consideration should be given to investment decisions and remuneration strategies; however, these proposed changes do not eliminate the main benefits of incorporation as they have existed in the past.
Please contact your GCSE advisor if you have any questions or concerns regarding your corporation.