Tax Planning Using Private Corporations - The Liberal’s go with Piecemeal Announcements

I have pushed back my second post on tax efficient investing to next week so I can comment on the Traveling Libburys tax damage control tour (instead of Dylan, Petty, Lynne, Harrison and Orbison, we got Justin Trudeau, Bill Morneau and Bardish Chagger).

The tour this week made stops in Stouffville Ontario, Hampton New Brunswick, Montreal Quebec and Erinsville, Ontario. At each location, the government provided a new tax morsel and comment on its tax proposals. However, without any details, many people are still not quite sure what the proposals really say or look like. A friend told me this is like a Trump tweet; do you take them at face value or is there more to them?

This is what we were told last week by the Prime Minister and Finance Minister in respect of the taxation of private corporations.

Income Splitting

The government announced the following in respect of the income splitting proposals:

• It has committed to lower the small business tax rate to 10 per cent, effective January 1, 2018, and to 9 per cent, effective January 1, 2019. To be clear, this reduction is a drop from the current 10.5% rate and the provincial tax still needs to be added on. So for example in Ontario, the rate will drop to 14.5% from 15% for 2018.

• The proposals 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 will remain.

• It will simplify the proposed measures with the aim of providing greater certainty for family members who contribute to a family business. Specifically, "the Government will work to reduce the compliance burden with respect to establishing the contributions of spouses and family members including labour, capital, risk and past contributions, better target the proposed rules, and address double taxation concerns". I would suggest this will be much easier said than done and I would expect this determination to be fraught with issues.
  
• It will not be moving forward with proposed measures to limit access to the Lifetime Capital Gains Exemption. I would not be surprised to see specific exclusions in the 2018 budget to this rule, such as excluding the exemption for those under 18.

Passive Income Proposals

This proposal was probably the most contentious issue to most small business owners who felt the initial proposal would impact their retirement planning and ability to fund the ups and downs of a business. The government gave a little here, but given the potential massive complexity of tracking passive income and the fact they say only 3% of the businesses will be caught by the rules, this is the one area I feel they should have left the status quo. Not one tax professional I spoke to understood how this is really going to work and could see any type of legislation that will not cause massive complexity and extra accounting costs to small businesses.

Here is what the government said:

• The new rules will not apply to existing savings and income from those savings (thus some kind of tracking mechanism will have to be put in place. I see this as an accounting and tax nightmare, how do you track amounts contributed from this pot of funds back into the business and then taken back out, let alone track the income earned from the existing pot of funds. Are the original funds referenced going to be current investments only, at cost or fair market value, will they include cash in the business or is the initial savings the current retained earnings)?

• The existing rules will apply on investment income earned from new savings up to a maximum of $50,000 of passive income in a year (equivalent to $1 million in savings, based on a nominal 5% rate of return). To the extent investment income from new investments exceeds $50,000 in a year, the new punitive tax rates will apply. The wording here is very simplistic and has been interpreted differently already by many commentators. The devil will be in the details.
• Incentives are in place so that Canada’s venture capital and angel investors can continue to invest in the next generation of Canadian innovation.

Capital Gain Stripping

Finally, the government announced these proposals will not move ahead. This is a head-scratcher. As  I noted in my last blog post on this topic, many would argue some of the tactics used here while legal, were aggressive. The issue in relation to capital gains stripping was the proposals were causing business transition issues and double taxation on death by not being able to use a "pipeline" planning technique to prevent double tax.

This is what the government said:

• They will not be moving forward with measures relating to the conversion of income into capital gains. "During the consultation period, the Government heard from business owners, including many farmers and fishers that the measures could result in several unintended consequences, such as in respect of taxation upon death and potential challenges with intergenerational transfers of businesses. The Government will work with family businesses, including farming and fishing businesses, to make it more efficient, or less difficult, to hand down their businesses to the next generation".

The National Post reported (sorry link has disappeared) that Mr. Morneau said “What I’m announcing this morning is we’re going to take a step back and reconsider that aspect of our tax reform proposal,” and "the government will instead embark on a year of consultations aimed at developing new proposals".

Thus, I think it fair to say, we may not have heard the end of these rules and the Liberal's will likely move to judiciously carve out the aggressive stripping while ensuring succession and estate planning are not side-swiped.

As noted at the outset, we are lacking clarity. We have no details, legislation, examples or FAQ, let alone confirmation or whether the effective date of these proposals has changed? We still have partial or full tax planning paralysis because of these ad hoc proposals and revisions.

In my humble opinion, the main miss here is the passive rules. The complexity of these rules will be overwhelming for such little tax gain to the government.

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.

What Small Business Owners Need to Know - Intercorporate Dividends are not Necessarily Tax-Free Anymore

For many years, it has been standard tax planning to pay any excess cash from your operating company (“Opco”) as a dividend to your holding company (“Holdco”) for asset protection, retirement planning or other investment or business reasons. Where your Holdco is connected to your Opco (in general terms, Holdco is connected where it owns more than 10% of the votes and value of Opco), those dividends will flow tax-free to your Holdco. Where Opco has refundable dividend tax on hand, a dividend paid to Holdco can trigger Part IV tax; so speak to your accountant first.

[Note: As discussed in my blog post the Capital Gains Exemption is Not a Gimme, you may not always want your Opco to be owned directly by your Holdco].

The government became concerned taxpayers were utilizing the tax-free nature of intercorporate dividends to defer or reduce capital gains tax, especially prior to the sale of a business. Thus, the 2015 Federal budget introduced anti-avoidance rules (draft legislation was released in July, 2015 with request for comments) effective for dividends received by a corporation on or after April 21, 2015. These anti-avoidance rules have caused uncertainty in respect to the payment of what were prior to the budget, tax-free intercorporate dividends.

Currently there are “capital gains stripping " anti-avoidance rules contained in Section 55 of the Income Tax Act. These rules have been in place for years and generally are only problematic where there is a contemplated or actual sale to an arm’s length person and the payment of a dividend and an ownership change are part of the same series of transactions. These rules are very complex, but in basic terms, dividends can be paid tax-free to the extent the corporation has what is known as “safe income”, which in simplistic terms is essentially income earned by the corporation after tax. To the extent the corporation does not have safe income, the dividend in whole or part will be converted to a capital gain.

The new rules are broad and now not only catch the arm’s length sales noted in the prior paragraph, but will now capture dividends for which the purpose of the dividend “is to significantly reduce the value of the share”. This is why the new rules are troublesome. When is the standard dividend planning noted in the first paragraph, a dividend to reduce the value of a corporation’s shares?

The rules leave taxpayers and their advisors in the positions of needing to prove that the significant reduction of value that obviously occurs when the operating company pays excess cash to its Holdco is not the intended purpose of the dividend. The issue is more vexing when you consider that often the reduction of the value of Opco was intended, but was not done for tax purposes, but for business or investing purposes.

We are left with uncertainty where large dividends are paid to a holding company, including where the dividend was paid for asset protection purposes and then loaned back to the Opco. The CRA has stated that “lumpy dividends” (large one-time payments) may be considered to have been paid to reduce the value of a share, which is disconcerting.

There are other concerns including stock dividends, but they are beyond the scope of this blog post.

You should discuss with your accountant whether intercorporate dividends should be deferred until there is further clarity in respect of the legislation or whether it is prudent to undertake a calculation of safe income (which are expensive and time consuming) prior to paying a dividend, even if not in contemplation of a sale.

To reflect how much uncertainty and confusion there is with these rules; I am going to have a double disclaimer today. In addition to my usual disclaimer at the bottom of my post, I will again inform you; do not act on any of the general information in this blog post without discussing the issue with your accountant.

I will also not address or answer any of the comments and questions on this post, because of the uncertainty of the rules.

Small Business Owners - Get on my Mailing List

If you are an owner-manager and/or a shareholder in a corporation and would like to be on my corporate mailing list, please email me at bluntbeancounter@gmail.com

I will be sending out specific mailings on matters of importance to small business owners and I am considering, depending upon the interest, holding a roundtable for small business owners who are in the Toronto area.

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.