My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, July 24, 2017

Tax Planning Using Private Corporations - The New Liberal Proposals

I am going to set aside my summer "Best of The Blunt Bean Counter" series for one week, to provide my comments on the new tax proposals for private corporations set forth by the Liberal government last week.

Tax Planning Using Private Corporations - The New Liberal Proposals

On July 18th, Finance Minister Bill Morneau released a consultation paper and related draft legislation proposing changes to how private corporations will be taxed moving forward in the name of tax fairness. I would suggest most private business owners and professionals using PC's in particular (the government seems to take umbrage with professionals) are going to be very upset by these proposals.

Fairness is subject to personal interpretation. I could argue it is not fair government workers get gold plated pension plans while the rest of us have no company plans or restricted defined contribution plans and need to save for retirement through RRSPs and TFSAs. I could also argue that is not fair entrepreneurs who risk their life savings will now under these proposals end up tax neutral with their employees who take no risk. Rant over, let's get to the proposals

Income Splitting

Many private business owners pay salaries to family members and have structures where family members own shares. The government is proposing that effective for 2018 and later, any salaries or dividends paid to a spouse or child regardless of age (currently there are kiddie tax rules for children under 18) will be subject to a reasonableness provision (what an arms-length person would be paid) and any remuneration in excess of the reasonable amount will now be taxed at the top marginal personal rates of the parent. How the government will determine reasonableness is a good question. In any event, income splitting will be severely curtailed

Some specific reasonableness proposals include:

1. Determination of labour contributions by children. The rules will be different for those 18-24 than for those are 25.

2. Review of capital contributed to the business. Again based on age bracket tests.

These rules will significantly change how many families remunerate the family unit.

In addition to restricting salaries and dividends, the proposals will also restrict the use and multiplication of the capital gains exemption ($835,716 for 2017). Children under 18 will no longer qualify for the LCGE ("Lifetime Capital Gains Exemption") and for other family members that were subject to the reasonableness provisions; the LCGE will be restricted or eliminated.

Capital gains allocated out of a family trust will now generally not be eligible for the LCGE.

These rules will be effective for 2018, however, transitional rules are being proposed.

Passive Investments in Corporations

Currently if a corporation earns less than $500,000 the company pays tax at 15.5% in Ontario and a similar amount in each province. This results in a tax deferral, not a tax saving of up to 38%. This deferral provides corporations money to grow and invest and create jobs. The government is concerned that where this money is not used to grow the company but invested passively in GIC's stocks, others companies, real estate, etc. it is unfair when compared to a salaried person. The government is proposing to now tax this 38% deferral.

The proposals of how to do this are beyond complicated and I really don't understand the concern here (the government is asking for feedback to determine to how best implement this, thus, there is no timeline on these provisions as of yet). This is a tax deferral on risk capital and not an absolute tax saving. As per my various posts on whether to use a RRSP or leave the money in your corporation, many small biz owners are leaving money in their corporations and using this money to fund their retirement; so this will have a huge impact on many people.

Converting income into capital gains

The proposals include various provisions to prevent income from being converted into capital gains. I have no issue with this general provision as much of the planning is a pure tax play. However, as of now, some tax commentators suggest the proposals appear to have potentially created possible double tax on death where standard "pipeline planning" is undertaken. Essentially where the estate would have had a capital gain, that gain may become a dividend which is taxed 15-20% higher than the capital gain. Many private business owners have purchased insurance to cover their estate tax and the insurance may now be insufficient.These measures will be effective as of July 18, 2017.

What Now?

The proposals are very complex and I have simplified them for discussion purposes above. We need to see the final legislation after the consultation period and work through the implications before definitive answers and planning can be undertaken.

That being said, will you have to close down or wind-up your private corporation or professional corporations or wind up your family trust?

My preliminary thoughts are if your corporation has large retained earnings there would be a significant tax cost to wind up your corporation and thus you would likely still maintain the company (I say this because it appears the proposals will not impact prior earnings and/ or prior refundable taxes earned and thus, these retained earnings would not be subject to the potentially punitive rules). If your company's retained earnings are not significant, the answer will be less obvious and there will be other issues to consider such as asset protection and the adjusted cost base of partnership interests for professional corporations etc.

While new corporations will not have the same income splitting and tax deferral benefits, they will still likely make sense for asset protection purposes and if you may be able to access even one LCGE exemption and /or you will be using profits to invest back in the business and not for passive purposes.

The incorporation of new professional corporations likely will no longer make sense for tax deferral purposes if all the PC income is taxed at the highest marginal rate, but they may still make sense for other reasons, but I would expect their use to be curtailed.

Family Trusts will likely continue to make sense for ownership and estate planning purposes but may no longer be useful for tax only purposes

It is too early to definitively answer any of the above questions, but those are my initial thoughts.

In conclusion, the impact of these proposals is potentially massive. This is in essence a regime change and not a tinkering of the current rules. Unfortunately, I don't think most small business owners have any idea what is about to hit them in the next few months.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.