Tax decisions you can make now to get ahead of the Liberalsâ€™ proposed changes
With the consultation period surrounding the proposed private corporation tax changes coming to an end on Mon. Oct. 2 (the deadline for making submissions), business owners are left to wonder if they should be taking any action in light of the proposed rules.
The not-so-simple answer is: it depends.
The proposed measures focused on three areas: income sprinkling among family members, including the multiplication of the lifetime capital gains exemption, passive investment income earned within corporations and converting dividends into capital gains.
Here are some steps you may wish to consider now, if the rules come in as proposed.
By sprinkling income from a corporation among family members, rather than having one individual receive all of the income, the overall tax paid by the family may be reduced if some of the family members are taxed at a lower tax rate than the individual or pay no tax at all. Currently there are anti-avoidance measures in place to limit this, such as the current “kiddie tax” that results in certain dividends paid to children under age 18 being taxed at the highest rate.
Effective for 2018, the proposed changes would expand the kiddie tax rules so that they would apply to more types of income and would also cover certain adults (the “split income” rules).
The new “split income” rules would look at whether income received by an adult individual is “reasonable,” taking into account the person’s labour and capital contributions to the business along with any previous returns and remuneration, in comparison to a situation where an arm’s-length investment was made.
These new rules will likely affect anyone who has done an estate freeze. An estate freeze is a corporate reorganization whereby the fair market value of a business is “frozen” by exchanging common shares for preferred shares, with a redemption value equal to the fair market value of the company. New common shares that accumulate future growth are then commonly issued to family members or, more commonly, to a trust that has family members as beneficiaries. The new rules will subject dividends paid on most shares received on an estate freeze to tax at the highest rate. If those shares are sold at a gain, this gain would also be considered split income and taxed at the highest rate.
The rules for individuals under age 25 are more expansive. For the purposes of determining a “reasonable” return on a capital contribution, this age group will be limited to receiving a rate of return equal to the government’s prescribed rate of interest (currently 1 per cent until Dec. 31, 2017). Even if the individual provided labour to the corporation, unless this labour was “regular, continuous and substantial,” any dividends paid in excess of the prescribed rate will be subject to the split income rules.
So, if your private corporation has other shareholders, such as your spouse, partner, or other adult relatives as shareholders, consider whether it makes sense to pay additional dividends to family members who are in lower tax brackets in 2017 to maximize any income sprinkling opportunities before the proposed rules could increase the tax rate on such income in 2018.
Also, starting next year, consider delaying dividend payments to related adults who have made capital contributions to a private corporation until they have reached 25 years of age and review your dividend compensation strategy for any related adults over age 25 for services provided to your private corporation as they could potentially be considered split income and subject to tax at the top rate.
Finally, you may wish to review the share structure of your private corporation to determine if more than one shareholder own shares of the same class. Corporate law might require you pay the same amount of dividends to all shareholders of the same class of shares. If you cannot pay dividends to one shareholder without causing another shareholder to be taxed at the highest tax rate on dividends received by them, you may consider a corporate reorganization so that the shareholders own shares of different classes.
Multiplying the Lifetime Capital Gains Exemption (“LCGE”)
The government is also concerned that the LCGE is being multiplied within related groups, often by having a family trust be a shareholder, allowing more than one individual to claim the LCGE to reduce the taxable capital gain realized on the sale of private corporation shares. Effective for dispositions after 2017, three measures were proposed to prevent this from occurring. First, the LCGE would not be available for gains, either realized or accruing, before an individual is 18 years old. Second, if a capital gain is subject to the new tax on split income rules discussed above, then it is not eligible for the LCGE. And finally, except for certain exceptions, beneficiaries of trusts would no longer be able to claim the LCGE.
Transitional rules, however, have been proposed to permit some shareholders to elect to “crystalize” a capital gain in 2018 so that they can still claim the LCGE. Crystallization is the act of recognizing a capital gain (or loss) for tax purposes which doesn’t necessarily involve an actual sale to a third-party.
If you are planning to file the election to crystalize the LCGE in 2018, more than 50 per cent of the assets within your corporation must be used in an active business for at least one year prior to the election. As a result, consider whether any steps need to be taken before Dec. 31, 2017 to reduce the non-active assets in your corporation so that this test is met at some point in 2018 if you plan to make the election. For instance, non-active assets can be used to pay down debt or a bonus could be paid to the active shareholder(s) out of non-active assets.
In addition, if you are planning to make the election to claim the LCGE, consider whether a valuation of the corporation will be necessary so that the LCGE can be claimed on the deemed capital gain arising on all or a part of the increase in value of the shares. Substantial penalties could apply if an inaccurate fair market value is used for the election.