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Posted: Sep 13, 2017
n July 18, 2017, federal Finance Minister Bill Morneau introduced legislation to close “tax loopholes” that were allowing private corporations to receive certain levels of income at rates preferential to that of an employed taxpayer.
As oilfield service companies tend to fall into this category, the proposed changes will have an impact on the sector and how businesses develop their financial strategies.
The legislation was set to address the following:
- Income sprinkling among business owners and their family members;
- Investment income in private corporations; and
- Conversion of certain income in a company to capital gains.
TAX ON SPLIT INCOME (TOSI)
Income sprinkling (more commonly known as income splitting), is a concept where dividends may be paid to different family members to reward them for their contributions, while also allowing access to their marginal rates. The result is income that, in the absence of the particular arrangement, would have been taxed as income of the high-income individual, is instead taxed as income of another lower income individual. Tax savings is then achieved by accessing the lower marginal tax rates of the family members.
The proposed legislation, to be effective January 1, 2018, is intended to restrict income from companies to family members who are not actively involved in the business or do not have substantive investment in the business. TOSI already exists to prevent income splitting with minors.
Expanded Tax Reach
The draft legislation proposes to expand the definition of what is subject to TOSI to include interest on loans, capital gains if the income on the shares would have been subject to a higher tax rate and certain allocations of income that would be subject to a higher tax rate for people under 25 years old. The proposed legislation is also broadened its application to adult family members, including spouses and children.
Further, the legislation aims to restrict income splitting through a family trust. Income of beneficiaries will be subject to the same TOSI restrictions; as well, growth in shares that occurs within a family trust will be considered an ineligible dividend and no longer have access to the capital gains exemption.
It should be noted there is an opportunity to utilize the capital gains exemption for capital held by a trust through the filing of a special election with the taxpayer’s 2018 income tax return. Capital gains on shares held by minors will never qualify for the capital gains exemption.
The result of an application of TOSI is that the individual will pay tax at the highest personal rates.
Reasonability of Income
To be considered reasonable, amounts paid by the corporation, through wages, dividends, interest on loans, and capital gains, must be comparable to what a business would pay an arm’s length person in that same situation.
Consider a small incorporated business with the shares held equally by both spouses. Spouse A is actively engaged in the corporation; Spouse B stays at home to raise their children, but assists with general bookkeeping duties. The corporation generates $150,000 to $200,000 of income on an annual basis.
Under the current rules, the corporation may allocate income of $25,000 to $100,000 to Spouse B to access lower marginal tax rates and reduce the total tax liability of the couple. Under the proposed rules, application of TOSI would result in the income allocated to Spouse B being potentially taxed higher than if the actively engaged shareholder, Spouse A reported the funds personally.
Family Trusts Affected
At a later stage in the corporation’s life cycle, a family trust may be introduced to the shareholdings of a corporation. This is often done for a variety of reasons, including estate planning.
The family trust can also facilitate income splitting among multiple beneficiaries, and as such, can allocate capital gains to utilize the lifetime capital gains exemption (LCGE) among multiple beneficiaries. The proposed legislation shuts down the multiplication of the capital gains exemption by eliminating the eligibility of the growth on the shares during the period that the trust owns the shares. This change significantly reduces the utility of family trusts.
What to Do
If enacted, the rules will apply effective January 1, 2018. Corporations will need to consider the “reasonability” of their income allocations; however, what is considered reasonable is currently unclear and will likely be fact driven for each situation.
Access to the capital gains exemption will be significantly restricted and although there is an election available in 2018 to capitalize on the exemption, it is recommended that, where possible, a gain be triggered in 2017 under the current regime.
There will be work that needs to be completed, including potential purification and valuations of the business. It is best to visit your local Advisor as early as possible.
PASSIVE INVESTMENT INCOME IN A CORPORATION
Business income is generally taxed at lower rates than personal income, leaving corporations with more funds available to further invest in the business. When a corporation’s earnings are beyond what is needed to re-invest and grow the business, the corporation may invest in passive investments (portfolio stocks, real property, etc.).
The perception is that this is an unfair advantage to corporations, as small business owners may achieve greater returns on passive investments held through their corporation than individuals holding the investments personally.
Re-Invested Earnings Targeted
Under the existing taxation rules, there is a refundable tax applied to the earnings of passive investments which is recovered when the assets are distributed to shareholders in the form of dividends. The theory of integration suggests passive income taxed first at the corporate level and then again at the personal level should result in the same amount of tax as if the earnings had been earned personally all along.
The target really becomes restricting the low tax initial investments. The proposed rules extend the target to the reinvested earnings, as these would be higher in the corporation and an unfair advantage over personally-held investment earnings.
The commentary paper did not include proposed legislation, but rather outlined proposed methodology for determining the tax treatment for dividends paid from passive investments. Specifically addressed were the following issues:
- Remove the refundability of passive investment taxes where earnings used to fund passive investments were taxed at low corporate tax rates;
- Align the tax treatment of passive income distributed to shareholders as dividends with that of the earnings used to fund the passive investments; and,
- Treat all income received from portfolio investments as non-eligible dividends, and deny the capital dividend account inclusion on gains realised on passive investments.
The government proposed two possible methods for taxing passive investment income:
The Apportionment Method – Income will be pooled and tracked based on tax treatment (i.e. subject to small business rate, general corporate rate or personal rate); dividend distributions to shareholders will be eligible, ineligible or tax-free, depending on pool.
The Elective Method – Income is taxed at the highest personal rate and distributed as non-eligible dividends; or, a corporation could elect to apply additional non-refundable taxes on passive income with distributions being treated as eligible dividends.
Passive investment accumulation often happens when there is a low capitalization requirement, such as contractors with low equipment needs. In some cases, additional funds are pooled for shareholder retirement or reinvestment in the business as a rainy day fund or expansion fund, often through a separate holding corporation.
What to Do
Without specific legislation the course of action is unclear, except that passive investments may result in increased tax to your corporation, and potentially additional record keeping requirements. Your MNP Advisor will keep you up-to-date on the progress of the legislation and impact of the changes to you and your business.
CONVERSION OF INCOME TO CAPITAL GAINS
Often, there was an arbitrage available between the tax rates on income earned in a corporation and extracted as dividends, and the tax rates incurred on capital gains extracted from a corporation. The new legislation aims to eliminate planning around such arbitrage.
The existing legislation sought to prevent individuals from using their lifetime capital gains exemptions on sales to related corporations by recharacterizing the proceeds as dividends. New measures propose to eliminate tax planning that allows shareholders of a company to withdraw corporate surplus as capital gains.
The federal government has also introduced a general anti-surplus stripping rule targeting strategies that circumvent specific rules of the Income Tax Act. Under this rule, transitioning a family business to a child or other family member can potentially result in higher income taxes than if the business was sold to an unrelated third party, thus limiting the options available for business succession. This rule may also apply where a taxpayer is perceived to have withdrawn corporate earnings in a tax-advantaged manner.
Estate Planning / Succession Affected
When a person dies, they are deemed to dispose of their assets at fair market value. This can lead to double taxation as the deemed disposition can result in capital gains and the subsequent liquidation to the estate can be treated as a dividend.
There is a relieving provision available, but the requirements are often difficult to meet. As such, it was not uncommon for the estate to sell the shares (with a tax-paid cost base) to a new corporation as a means of avoiding the double tax. The proposed legislation prevents such a tax strategy and creates uncertainty in post-mortem tax planning.
In family transitions, parents usually want to be compensated for their business as their equity is often a retirement fund or part of an equalization strategy for their estate. In an arm’s length scenario, the parents could sell their shares to a corporate purchaser and utilize their capital gains exemptions.
Capital Gains Loss
A concern with the existing legislation is they are unable to undergo a similar transaction with their children’s corporations. Parents would have to sell the shares to their children at fair value and recognize the taxes on the sale (no utilization of the lifetime capital gains exemption); the child could then structure the purchase to repay mom and dad at preferential corporate rates (an option still available to arm’s length parties).
The proposed legislation introduces further difficulty in the implementation of fair value intergenerational transfers by forcing the purchasing child to repay mom and dad at after-tax personal dollars.
Often, land and buildings are held outside of an active corporation to provide a means for shareholders to receive a retirement income upon exiting the business, or for creditor protection. Under the proposed legislation, where a property is held inside the corporation and sold to a related party at fair market value, the resulting capital gain will not have its untaxed portion added to the capital dividend account, and any extractions of assets will be treated as a dividend unless a purpose test is met.
The purpose test is a safe haven for transactions that do not intend to be “stripping” transactions; however, viewed in hindsight many of them will have that result and as such, the appearance of intention.
What to Do
A review of any ongoing or intended succession or estate plan should be done to determine the effect of the new rules. Given the effective date of this legislation will be retroactive to July 18, 2017, there may be an immediate need to review such planning, should the proposals be enacted. Some papers are reflecting that under the combination of proposed legislation, the effective tax rate of an unplanned estate can be upwards of 73 percent, so proper structuring is more critical than ever.
Further, any transfers of assets should have a well-documented and analysed purpose.
The federal government has provided a 75-day consultation period which ends on October 2, 2017. MNP will be making a submission to the finance ministry within that time frame. The legislation is broad in the context that this will disrupt existing structures and strategy for small and medium-sized business in a way that has not been seen in more than 30 years.
For many small businesses in oilfield services, this will mean paying more tax. Many media outlets and tax professionals have called this tax reform, as opposed to new legislation, and the provisions are difficult to navigate. Your MNP Advisor can help you chart the best outcome for your business and family.
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