Private corporations and their favourable tax treatment are now in the tax man's sights. The specific target is income and other benefits passed on to shareholders who are not actively engaged in the corporation's business, such as a business owner's spouse or adult children.
In July, the federal government proposed legislation intended to end tax planning that, in its view, allows executives of private corporations to gain unfair tax advantages by transferring income to family members. If the regulations as proposed become law, dividends and other amounts paid by the corporation to family members would be taxable at the top marginal rate rather than at the lower rate normally payable on dividend income.
"The scope of the proposals, if enacted, will negatively affect how all Canadian business owners carry on business through a private corporation," according to a recent commentary from Kerr Financial Group, a Toronto- and Montreal-based firm specializing in investment, tax and estate planning for multi-generation families. "The proposals represent a broad-based change to the way the Canadian tax system has been set up to support small businesses to date. In some instances, they seek to equate taxation for small-business owners with that of salaried employees, without recognizing the additional risk involved in running a business."
The proposals will affect three areas of tax-saving strategy related to private corporations:
Income splitting
This tax-saving technique, sometimes called "income sprinkling," has been popular among business owners for many years, as it has allowed them to effectively transfer income to adult family members by paying them salary or dividends, even though they do not have active roles in the company's operations. The assumption is these family members have modest incomes and therefor this income will be taxed at a lower tax rate than had the company executive received this income personally.
Under existing rules, minors (those under age 18) cannot receive such income without having it taxed at the top personal income-tax rate. This restriction is known as the Tax on Split Income, or "kiddie tax." The proposed new regulations will effectively extend this restriction to all family members -- unless it can be proven they are in fact valid employees or otherwise have legitimate tasks worthy of remuneration.
The proposals also would force high taxation on interest paid to a family member on money lent by them to the corporation, if that person also received dividends or other amounts from the company.
However, the CRA will allow an amount paid to an adult family member to be taxed at their own personal rate if the situation passes a four-pronged reasonableness test. The amount paid must not exceed what normally would be paid to a third-party person in regard to the individual's labour contributions to the business; assets contributed to the business; risks assumed in relation to the business; and past compensation received from the business.
The test will be even stricter for family members aged 18 to 24, as they will have to prove they are involved in the business on a "regular, continuous and substantial basis."
Another proposal will prevent the use by minor children of the lifetime capital- gains exemption on the sale of qualified small-business corporation shares. This also would apply to gains from the sale of such shares if they are held by a family trust. In other words, shares must be held personally by those age 18 and over, and subject to the above reasonableness test, to qualify for the exemption.
Converting corporate income into capital gains
A second technique to be disallowed is the conversion of regular corporate income into capital gains, which are then distributed to high-income shareholders and taxed at the lower capital-gains rate. (Only one half of capital gains are subject to tax, which results in less onerous taxation than on dividends and other income. Furthermore, capital losses realized from any investment during the year or in previous years may be used to reduce the amount of a capital gain.)
The capital-gains-use restriction is to be imposed under the Income Tax Act's existing broad anti-avoidance rules, and would apply to any capital-gain amounts received or receivable after July 17, 2017.
Passive investments held within a private corporation
Private corporations are sometimes used to hold passive investments that ultimately are intended for personal profit. Typically, a corporate owner may prefer to keep business income invested within the corporation so that it will be taxed at a lower corporate rate. Separate from the proposed new legislation, the government is contemplating restricting the use of corporate umbrellas for personal investments.
"Under the current rules, holding portfolio investments inside a private corporation can provide owners of such corporations with certain tax advantages, compared to personal investment portfolios," says the Kerr commentary. "While no legislation has been drafted to address this activity, the government has proposed broad measures that could allow the CRA to reduce these advantages. This will add complexity and change longstanding ways in which corporate and personal income tax is integrated under existing taxation rules. Any resulting rule changes will only apply for periods after legislation is actually introduced."
The proposed legislation eliminating these various tax advantages is complex, not to mention the possible threat to corporate-held investments. Small-business owners should consider seeking professional advice to understand how these complex new rules will affect their retirement and estate planning, before changes take effect when legislation is enacted, probably early next year.
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