On July 18th the Department of Finance announced sweeping tax change proposals related to the taxation of private corporations. Many tax experts noted that these were the most extensive tax changes in Canada in over 40 years.
The key parts of these proposals were:
- Income sprinkling – the proposed changes would make dividends paid to family members who are not actively involved in a corporation subject to a reasonableness test. Any dividends determined not to be reasonable would be taxed at the top marginal tax rate.
- Passive investments inside a corporation – the proposed changes would dramatically increase the tax rate on investment income earned inside a corporation.
- Converting income into capital gains – the proposed changes would prohibit transactions aimed at converting income into capital gains for the purpose of reducing the tax rate on the income. The draft legislation released with these proposals would also have a significant impact on taxes when selling a business or farm to a family member and on the death of a business owner.
The Government received an unprecedented amount of negative feedback on the original proposals and over 21,000 submissions were made to the Department of Finance during the consultation period which ended on October 2nd. As a result of this negative feedback, the Government made a series of announcements during the week of October 16th which modified, and in some cases eliminated, the proposed tax changes. The announcements modifying the original proposals were as follows:
- October 16 – the Government announced that they would “…simplify the proposal to limit the ability of owners of private corporations to lower their personal income taxes by sprinkling their income to family members who do not contribute to the business.” Additional details were not released as to how the proposals would be simplified, however it appears that the Government will be providing additional guidance related to the reasonableness test and factors to be considered in determining reasonable compensation.
- October 16 – the Government also announced that “…it will not be moving forward with proposed measures to limit access to the Lifetime Capital Gains Exemption.” It is unclear which specific proposed measures are being withdrawn. It appears to be related to the ability of a family member who is a shareholder, but who is not active in the business, to claim his or her Lifetime Capital Gains Exemption on the sale of the business. However we will have to wait to see revised draft legislation in order to determine exactly what this statement means.
- October 16 – somewhat unexpectedly, and unrelated to the original proposed tax changes, the Government also announced that they would be lowering the Federal small business tax rate from 10.5% to 10% on January 1, 2018, with a further reduction to 9% on January 1, 2019.
- October 18 – the Government announced that a) all past investments accumulated inside a corporation and the income earned from those investments will be grandfathered under existing tax rules; b) a $50,000 threshold on passive income in a year (equivalent to $1 million in savings, based on a nominal 5% rate of return) will be subject to existing tax rules and passive income above this threshold will be subject to a new, higher tax rate; and c) incentives are in place so that Canada’s venture capital and angel investors can continue to invest in innovation. These announcements mean that many companies will be able to continue to save (within certain limits) for an unexpected downturn, maternity leave, large equipment purchase, etc. without facing the substantial tax increase they would have faced under the original proposals.
- October 19 – the Government announced that they “…will not be moving forward with measures relating to the conversion of income into capital gains.” Therefore the extremely negative tax consequences on the death of a business owner which would have occurred under the original proposals will not be introduced.
- October 20 – the Government announced that they want to “…ensure incentives are maintained so venture capital and angel investors can continue to invest in the next generation of Canadian innovation. The Government will work with the venture capital and angel investment sectors to identify how this can be best achieved.”
It is unclear how the Government will implement the $50,000 passive investment income threshold while simultaneously protecting and encouraging passive investment by angel investors and venture capital.
While these revisions are certainly welcome improvements over the original proposals, the tax changes are still incredibly complex and there are still numerous unanswered questions regarding the legislative details which are absent from these announcements. For example, even with additional guidance regarding reasonableness, how do you calculate the value of the contribution of a family member? Why is income sprinkling for business owners considered wrong but income sprinkling of pension income is considered acceptable? Will CRA interpret reasonableness in the same manner as taxpayers? Will the $50,000 threshold for passive investment income be indexed to inflation? Does the $50,000 threshold apply to gross income or net income after deducting related expenses? How will the Government distinguish between some investments in passive assets and investments held by angel investors or venture capital inside corporations?
Many of these proposed tax changes and revisions are expected to be effective January 1, 2018. Therefore, even with significant details yet to be provided by the Government, you should talk to your tax advisor now to begin planning for the implementation of these rules. Depending on your circumstances there may be steps you can take to minimize the impact of these changes on you and your business.
Note: All quotes included herein are taken from Department of Finance new releases on the dates noted above. The news releases are available at http://www.fin.gc.ca/news-nouvelles/nr-nc-eng.asp.