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August 23, 2017

Tax Planning Using Private Corporations – Changes on the Horizon – Part 2

The Department of Finance Canada released a consultation paper and draft legislation which will negatively impact the taxation of private corporations and their shareholders. This proposed legislation will increase the tax burden on entrepreneurs to a point which will negatively impact the growth of small businesses in Canada and the national economy.

The communication released by the Minister of Finance, Bill Morneau, states that these changes will “equalize” the taxation of employees and entrepreneurs but this equalization does not take into consideration the benefits employees receive that entrepreneurs do not.  Increasing the tax burden on entrepreneurs will not put employees and entrepreneurs on the same footing.  This new legislation will decrease an entrepreneurs’ motivation to start a business in Canada and we could see a “brain drain” of qualified professionals who see the tax burden in Canada as too onerous.

We have highlighted some of the significant impacts this new legislation will have on business owners below.

Taxation of Passive Income in Private Corporations

The Department of Finance Canada wants to “eliminate that tax deferral advantage on passive income earned by private corporations”.

Private corporations are taxed at a rate that is lower than the average individual tax rate. This lower corporate tax rate permits integration; an equalization of tax on income earned by an individual versus income earned by a corporation and distributed to an individual.  Finance believes that the lower corporate tax rate provides an unfair benefit as a corporation may have more after tax dollars to invest in passive assets. 

In its search for fairness Finance is ignoring the risks associated with small businesses.  An employee is entitled to sick pay, vacation pay, job security, severance and in some cases a pension.  Many entrepreneurs use passive assets held in a corporation to fund these benefits, for their rainy day or retirement fund or to keep funds available to reinvest in the business to meet the business’ obligations.

Finance did not comment on the fact that investments held in pensions grow tax free and are not taxed until the funds are distributed.  This seems at odds with the Minister’s argument for fairness – passive income earned in a corporation is taxed while passive income earned in a pension is not. 

Tax Increases to Private Holding Companies

The Department of Finance indicated their intent to improve the fairness of the taxation system by implementing tax increases to private corporations that hold passive investments. While these changes are just theoretical at this point, they do paint a grim picture for future investments made within a holding company that are of a passive nature (rental, dividend, royalty or interest income).

To illustrate, consider an ordinary BC corporation that owns a rental property:

Assuming $100 of rental income is earned, the corporation would pay $49.70 in corporate taxes. This would leave $50.30 remaining to be distributed to the shareholders as a dividend. This $50.30 dividend results in $20.43 of personal taxes to the shareholders, meaning that only $29.87 remains of the $100. This is a tax rate exceeding 70% on investment income!

Now let’s consider capital gains earned by that same corporation.  Let’s assume that this corporation sells the rental property for a $1,000 gain. The corporation would pay $248.50 of corporate taxes on the sale of the rental property. This would leave $751.50 of funds available to distribute to the shareholders as a dividend and would result in personal taxes of $305.18. The net result is $446.32 of the $1,000 remaining after taxes for the shareholders – a tax rate of over 55% on capital gains.

Considering the current rates are 47.7% for income and 23.85% for capital gains respectively, these proposals represent significant tax increases that are clearly not “fair”.  The proposed changes unduly penalize business owners and jeopardize their ability to plan for retirement.

Income Splitting

A married couple sets up a company to start their own small business. They both work diligently at the business, only drawing a modest salary and making significant sacrifices to achieve their business goals. A few years later, one spouse stays home to raise the children while the other spouse continues to manage the business.  Both work hard in their respective roles in order to achieve their family goals.

Over the years, the business becomes very successful and the company is able to pay dividends to the spouses.

Under the proposed new rules the spouse that did not continue to work in the business will be taxed at the highest marginal tax rate on dividends received.  In addition, that spouse may not be entitled to claim the capital gains deduction upon the eventual sale of the shares of the Company.

Compare the above results with another scenario.  Assume the same facts as outlined above except that, instead of staying home, the couple decides to send the children to Government provided $10 a day child care allowing both spouses to continue working in the business.

In the second scenario, the spouses pay less tax on the dividends/salary and capital gains realized as the effort matches the compensation and the family consumes more government services but also pays less tax. How does that make any sense?

Loss of Capital Gains Deduction

The proposed new tax rules apply to a gain on sale of shares of a family controlled private company.  Consider the following scenario. 

Husband, Wife and an unrelated third party (Mr. X) start a business in a corporation and own the shares equally. Husband is the only shareholder who works in the business.  Wife does not actively work in the business but makes strategic decisions with Husband and helps in the family home so that Husband can continue to make the business successful.  Mr. X does not work in the business and is not involved in the day to day or strategic decisions.  He is a silent investor. 

Several years later, the company is sold to an arms-length party for $3M. Husband, wife and Mr. X will each have a gain of $1 million (taxable capital gain of $500,000 each) as the cost of the shares is nominal.  Mr. X and Husband can both shelter most of their gain subject to tax by claiming their Capital Gains Deduction (“CGD”).  Wife however will not be able to claim her CGD and the entire taxable capital gain of $500,000 will be subject to tax at the top marginal tax rate. 

Neither Mr.X nor Wife have worked in the business and although wife was involved in strategy discussions with her husband, Wife will be taxed at the top marginal rate of 47.7% (in BC) while Mr. X will be able to shelter most of the gain with his CGD.  Also Mr.X will be subject to tax at his marginal rates on any gain not sheltered by his CGD because he is not related to husband.  How can this possibly be fair?

Double Taxation on Death

Mrs. X passes away holding 100% of the shares of a private company called Opco.  Her original investment in Opco was nominal but the value of Opco increased to $1 million at the time she passed away.  A capital gain of $1 million will be reported on Mrs. X’s final tax return.  When Opco repurchases its shares, Mrs. X’s estate will realize a taxable dividend of $1 million.  Without planning, double taxation will arise on the shares of Opco in the form of a capital gain (in Mrs. X’s final tax return) and a dividend (in the estate’s tax return).

Post mortem planning can be put into place so that only one layer of tax is paid by Mrs. X and her estate.  One of the planning tools historically blessed by the CRA allow the $1 million increase in the value of Opco to be taxed as a capital gain in Mrs. X’s final tax return and not be taxed in her estate.

Under the proposed legislation, this strategy will no longer be available.  As a result, the only available option to eliminate the double taxation arising on the shares of Opco is to ensure that the shares are repurchased by Opco in the estate’s first taxation year.

If Opco has business operations and does not have liquid cash, how can it fund this repurchase?  How can the shares of Opco be redeemed without selling all of its assets or taking on debt so that the company’s operations are no longer viable?

This resulting double taxation does not seem fair.

What Can You Do

Tax policy is used to drive behavior.  If we eliminate the tax benefits that are available for an entrepreneur what are the chances that this person will stay in Canada and take the risk to open up a business.

These proposals are in the discussion stage until October 2nd.  We ask that you join the discussion in three ways:

You could include the following comments in your communication:

  • A significant number of professionals and small businesses will set up outside of Canada impacting job creation and the economy.
  • Entrepreneurs should be compensated for the risks taken by allowing them certain tax benefits.
  • A simpler “fix” to income splitting is to permit joint tax returns to be filed by spouses which will provide equality to employees and entrepreneurs alike.
  • The additional tax compliance burden on small business is unfair and certain businesses will not be able to afford to pay professionals to meet these obligations.

Should you have any questions or concerns, please contact a member of the Manning Elliott Tax team at 604-714-3600, as we would be happy to discuss these issues with you.

The above content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent changes. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.