To say that I am overwhelmed would be a massive understatement. Finance Minister Bill Morneau just announced the Trudeau government’s plan to destroy tax planning as we know it. This is likely the largest proposed amendment to the Income Tax Act since Tax Reform in 1972. But while the Carter Commission was appointed in 1962, tabled its report in 1966, and tax reform took place in 1972, Morneau has already drafted legislation and proposed a 75 day consultation period.
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As all of his predecessors have done, he has looked at tax provisions that were implemented for good and valid reasons, and labelled them as “loopholes”. Labelling something as a loophole makes for a good sound bite, but it is inaccurate. A loophole is a provision that yields an unintended result.
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These proposals are an attack on small business and investment companies. It represents a massive tax grab, in the name of fairness. With taxes likely to come down in the U.S., it is not unreasonable to expect an exodus of professionals, particularly doctors and dentists, and an outflow of investment dollars.
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The changes are so extensive, and the transition will be so complex, that I can do no more than summarize the proposed changes. Additional memos will follow over the coming days and weeks to explain these changes in detail.
Income Splitting
As I suggested in my pre-Budget newsletter, the government is proposing to extend the “kiddie tax” rules to other family members. If dividends are subject to the tax on split income, they will be taxed at top personal rates, eliminating any benefit of paying dividends to other family members.
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The way our system works in respect of dividends, a taxpayer in Ontario with no other income can earn up to approximately $33,000 of dividends from a Canadian company with no tax.
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The government proposes the following:
to extend the tax on split income (TOSI) to apply to certain adult individuals who have amounts included in split income, but generally only to cases where the amount is unreasonable under the circumstances. In addition, the measures would expand the circumstances in which the TOSI applies, including the types of income that are considered to be split income. The TOSI would continue to not apply to income received by an individual as salary or wages (i.e., employment income).
To introduce a “reasonableness” test for dividends. Currently, an expense must be reasonable to be deductible. So paying a 6 year old a large salary to empty trash cans on Saturday morning might be treated as unreasonable and, thus, not deductible to the company. It is clear from decades of decided cases, that there is no such test regarding dividends.
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The reasonableness test is proposed to apply differently based on the age of the adult specified individual (i.e., whether the individual is between 18 and 24 or is 25 or older).
An amount would not be considered reasonable in the context of the business to the extent that it exceeds what an arm’s-length party would have agreed to pay to the adult specified individual, considering the following factors:
labour contributions the extent to which:
for an adult specified individual age 18-24, the individual is actively engaged on a regular, continuous and substantial basis in the activities of the business; and
for an adult specified individual age 25 or older, the individual is involved in the activities of the business (e.g., contributed labour that could have otherwise been remunerated by way of salary or wages). and
capital contributions based upon assets are contributed to the business or risks are assumed in respect of the business
In the past, if income has been attributed to, say a spouse or parent, the income earned from the investment of those funds has not been subject to attribution. The proposal will extend the TOSI to this “secondary” income.
Additional changes to the TOSI rules are proposed. The following is a list of the material proposed changes.
The definition ‘split income’ would be extended to include:
income from certain types of debt obligations (e.g., debt that is issued by a private corporation and that is not publicly traded) currently interest on debt is not subject to kiddie tax; and
gains from dispositions after 2017 of certain property the income from which is split income.
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Lifetime Capital Gains Exemption
In the Federal Budget of May 23rd, 1983, the then Minister of Finance introduced a Lifetime Capital Gains Exemption (LCGE) which, when fully phased in, was intended to give each Canadian taxpayer up to Five Hundred Thousand Dollars ($500,000.00) of tax-free capital gains. The general exemption was eliminated in 1993, but an exemption still exists for “qualifying small business corporation shares”. The exemption will currently shelter approximately $824,000 of capital gains, due to indexing.
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Many taxpayers have family trusts which, along with the ability to sprinkle dividends, allow the capital gains exemption to be extended to family members.
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Three general measures are proposed to address LCGE multiplication.
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a) Age limits
The first measure would apply an age limit in determining LCGE eligibility. Specifically, individuals would no longer qualify for the LCGE in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual attains the age of 18.
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b) Reasonableness test
The second measure would introduce a reasonableness test in determining whether the LCGE applies in respect of a capital gain. The reasonableness test would be the same as that which applies in respect of the TOSI measures described above in respect of adult specified individuals. In effect, to the extent that a taxable capital gain from the disposition of property is included in an individual’s split income, the LCGE would not apply in respect of the capital gain from the disposition.
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c) Trusts
The third measure would no longer permit individuals to claim the LCGE in respect of capital gains that accrue during a period in which a trust holds the property. An exception would be provided for capital gains that accrue on property held by:
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A spousal or common-law partner trust or alter ego trust (or a similar trust for the exclusive benefit of the settlor during the settlor’s lifetime), where the individual claiming the LCGE is the trust’s principal beneficiary. This exception recognizes that the current tax rules constrain the terms of these trusts in a way that prevents the sprinkling of capital gains.
Certain employee share ownership trusts, where the individual (i.e., as a beneficiary entitled to the capital gain) is, in general terms, an arm’s length employee of the employer sponsor of the arrangement. This exception recognizes the use of employee trust arrangements, in appropriate circumstances, to encourage investment by employees in the businesses that employ them, thereby helping those businesses to grow, create jobs and innovate.
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The measure would apply whether the trust realizes the capital gain and makes it payable to a beneficiary or alternatively, the trust distributes (by way of a so-called ‘rollover’) property with an accrued gain to a beneficiary where the gain is later realized on a disposition of the property. The measure would not prevent trusts that are currently eligible to undertake rollovers to beneficiaries from continuing to do so; however, unless one of the above exceptions applies, no deduction would be allowed under the LCGE in respect of the capital gain that is ‘transferred’ from a trust on a rollover of property to a beneficiary. .
Election
The proposed measures would apply to dispositions after 2017. However, special transitional rules are proposed. The transitional rules would allow affected individuals to elect to realize, on a day in 2018, a capital gain in respect of eligible property by way of a deemed disposition for proceeds up to the fair market value of the property. The election would be available for property owned by the individual continuously from the end of 2017 until the day of the deemed disposition. Capital gains realized under the election would generally be eligible for the LCGE using the current tax rules (i.e., the rules as they apply to dispositions before 2018). For this purpose, certain requirements (e.g., regarding the ownership of, value of and, in some cases, activities in respect of, the property), that in order to claim the LCGE in respect of the disposition of a property must be met over a 24-month period before the disposition, would be treated as satisfied if they are met during the 12-month period preceding the elective disposition.
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This is similar to the election that was available in 1994 prior to the repeal of the general capital gains exemption, whereby a taxpayer could elect to trigger the capital gain in respect of property and claim the exemption.
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Use of Holding Companies
Corporations generally pay a lower rate of tax on their business income. For a Canadian controlled private corporation this can be as low as 15% on its first $500,000 of business income.
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Standard tax planning has been to pay out salaries or dividends and then to keep any
excess funds in the corporation, or in a related corporation, for investment purposes.
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This allows for larger investments because the additional personal tax is deferred until funds are withdrawn from the corporation.
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We have a very complex set of rules to “integrate” the corporate and personal tax, so there is no tax rate advantage to investing through a corporation or personally.
Morneau has proposed, for discussion, alternative approaches to eliminate the advantage of leaving funds in a corporation for investment purposes. This includes,
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a) Apportionment Method
One method being proposed would be to track the source of income used to acquire each investment asset owned by a corporation, along with the investment income that the asset generates. Obviously, such a system would be very complex in practice. Alternative methods are contemplated.
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One such method would involve an apportionment of annual passive investment income that would be based, going forward, on the corporation’s cumulative share of earnings taxed at the small business rate and the general rate, as well as amounts contributed by shareholders from their after-tax income. This would translate into three possible tax treatments for these amounts when distributed as dividends—eligible dividends, non-eligible dividends, or dividends that would be received tax-free at the shareholder level.
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The apportionment method would introduce the requirement that corporations keep track of the three pools described above. These additional requirements could be seen as introducing new complexity in the tax system.
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This somehow reminds me of Alan MacEachen’s proposal in his infamous November, 1981 Budget, to require streaming of interest income and expenses, which was then determined to be too complex.
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b) Elective Method
As an alternative to the apportionment method, the Government could introduce a method whereby private corporations would be subject to a default tax treatment, unless they elect otherwise. The choice between the default tax treatment or the elective treatment would determine whether passive income would be treated as eligible or non-eligible dividends when distributed to shareholders, without the need for tracking.
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Specifically, under the default tax treatment, passive income earned in a CCPC would be subject to non-refundable taxes (at rates equivalent to the top personal income tax bracket), and dividends distributed from such income would be treated as “non-eligible” dividends.
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Investment Holding Companies
Under both the apportionment and elective methods, it is suggested that a further election would be possible for corporations focused on passive investments.
With our current system of integration, when a corporation uses earnings that were taxed at the personal level to fund a passive investment (e.g., paid-up capital), and that corporation is not engaged in an active business and only earns passive income, the current tax system is neutral and does not result in tax incentives to hold the passive investment inside a corporation. Maintaining the current tax system in these situations might be maintained, for corporations that would make that election.
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That election would result in all income generated by the entity being taxed as passive investment income (and therefore taxed at a level that approximates the top personal income tax rate). Where the shareholders of the corporation are not individuals, for example a holding company that invests in shares of other companies, dividends received would be subject to an additional refundable tax, the intent of which would be to bridge the gap between the corporate tax rate and the personal income tax rate. The additional tax would, in effect, ensure that the corporate passive investment is funded with an after-tax amount that is comparable to what would be available to an individual investor at a top personal income tax rate. The government suggests that this would be necessary to ensure neutrality, as corporate owners could otherwise transfer funds taxed at low corporate income tax rates to another corporation of the group, and continue to benefit from tax advantages. All income earned within the entity would be subject to refundable taxes. The additional tax on passive investment income would be added to the RDTOH, and RDTOH balances would be refunded upon distribution of income via dividends.
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Currently, a holding company receiving dividends from a “non-connected” company pays a refundable Part IV tax which is then refunded when the company pays dividends to its individual shareholders.
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It appears, without having done a detailed review of the draft legislation, that the proposal will impose a refundable tax all inter-corporate dividends.
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This is, of course, in addition to the relatively recent changes to Section 55 that attempts to catch many inter-corporate dividends and to convert them into taxable capital gains.
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Marginal Tax Rate of the Corporate Investor (Holding corporations)
Taxes on passive income would be aligned with that of an individual earning income at the top personal income tax rate. Similar assumptions are also made in other sections of the Income Tax Act, for example, those that relate to the tax treatment of trusts.
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Taxation of Capital Gains
The distinction currently made in the tax system between active and passive sources of income is is well-established. The Government claims that it intends to continue to use recognized practices in the development of a new taxation model for passive investment income.
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In particular, the Government will continue to treat capital gains as eligible for the 50-per-cent inclusion rate and to apply passive investment taxes on such income. However, the proposed system contemplates that the non-taxable portion of capital gains would no longer be credited to the capital dividend account under the proposed tax system, where the source capital of the investment is income taxed at corporate income tax rates. For example, the appreciation in value of a publicly-traded stock giving rise to a capital gain would be subject to the new rules. That said, the Government will be considering whether additions to the capital dividend account should be preserved in certain limited situations.
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Converting Income into Capital Gains
One complex and, potentially, expensive, provision of the Income Tax Act, is found in Section 84.1. It applies when an individual transfers shares of one corporation to another corporation. If the section applies, income that might otherwise be taxed as a capital gain can be treated instead as a dividend, and thus taxed at a higher rate. This provision is often a hindrance in inter-generational transfers of a business.
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There is a draft legislative provision to expand the reach of Section 84.1. I will discuss this in an upcoming newsletter.
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Transition
Aside from grossly underestimating the time necessary for consultation, if they are truly interested in consultation, the transition from the current system to the new system will be overwhelming.
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The additional complexity of the tax system, already much too complicated will add huge compliance costs and generate untold amounts of work for lawyers, accountants and tax advisors.
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Conclusion
As you can see from the length of this newsletter, which is really only a summary of the proposals, there is a whole new world awaiting us, and it is not a good place.
Although there are still hurdles for the government to bring these provisions into effect, rest assured that some version of them are coming.
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Steps should be taken before these provisions come into force.
I would be happy to discuss these steps with you.
Aside from this, please try to enjoy your summer.
-Chuck