You’re travelling through another dimension – your next stop, the Twilight Zone
ROD SERLING, introduction,The Twilight Zone (season 2)
For those of us who have been in the tax community for any significant amount of time (almost 40 years in my case), this describes what year end tax planning feels like this time around. Tax life as we have known it is over.
This year, more than ever, it is important to get proper, professional advice.
1. Small Business Deduction (SBD)
The Small Business Deduction (SBD) is really a tax credit, rather than a deduction. It reduces the corporate income tax rate applying to the first $500,000 (the small business limit, or SBL) per year of qualifying active business income of a Canadian-controlled private corporation CCPC). A group of associated corporations must share the Small Business Limit (SBL) of $500,000. The difference in the tax rate is approximately 13.5%. In Ontario, paying the low rate of tax rather than the full rate on $500,000 of net income represents a tax saving of approximately $65,000. There are technical rules to determine whether corporations are associated, but, in simplified terms, associated corporations generally have common control, or control by related parties including cross ownership.
The 2016 Federal Budget changed the rules, so that companies receiving income from other “related” entities, even if they are not associated, would no longer be entitled to the SBD. This represents a 13% tax increase.
In keeping with the long Liberal tradition of trying to kill a mouse with an elephant gun, even companies that have operated on a strictly arm’s length basis for decades will find themselves caught by these new rules, just because they may be owned by related individuals.
In some cases, relationships can be changed to avoid these new rules, but care must be taken.
2. Inter-Corporate Dividends
Section 55 of the Income Tax Act is an anti-avoidance provision designed to prevent taxpayers from avoiding capital gains by the payment of inter-corporate dividends, such as a dividend from an operating company to its holding company. Any dividend since April 21st, 2015 that is caught by these rules will be re-characterized as a (taxable) capital gain rather than a tax-free dividend.
There has been a longstanding exception to the application of Section 55 in the case of dividends paid between related corporations, unless the dividend was be part of a series of transactions ending in an arm’s length sale – if there was no sale transaction contemplated, the dividend would be safe (this is a bit overly simplistic, but the gist of it is correct).
Under the changes to Section 55 (granted, introduced by the Harper government) ordinary cash dividends paid to a related corporation will no longer automatically be exempt.
There is a concept known as “safe income”. As long as an inter-corporate dividend does not exceed the company’s safe income, the dividend will not run afoul of the new rules. Accordingly, it will now be necessary to perform safe income calculations in most cases where cash dividends are paid between related corporations.
Unfortunately, there is no definition of safe income in the Act, but it is (simplistically) the post-1971 after-tax retained earnings determined on a tax basis (and subject to certain adjustments in the Act).
There are steps that can be taken to ensure that an inter-corporate dividend escapes the new rules, but they have to be done carefully and, again, will require professional advice.
Clients need to be aware that a transaction that used to be limited to a directors’ resolution to declare a dividend will now be replaced with a, reasonably, complex set of transactions to accomplish the same result.
AND, for those clients who don’t understand why their accounting costs have increased, it will be necessary for your accountant to prepare an historical ongoing calculation of the company’s safe income going back to day 1.
3. Taxation of Professionals’ Work in Progress (WIP)
The 2016 Budget also introduced a change in the way that the work in progress of certain professionals would be taxed.
For the purpose of computing income, the inventory of a business is included at the lesser of its Fair Market Value or its cost. Work in progress (WIP) of a business that is a profession is the inventory of that business. For professionals, WIP is, essentially, a measure of unbilled time and the cost of supplies incurred on a particular matter.
Since 1972 most businesses have had to report their income on an accrual basis, not on a cash basis. However, a Department of Finance commentary at the time stated, with respect to professionals, that “because of the difficulty in valuing unbilled time, the legislation provides that work in progress need not be brought into income unless the taxpayer chooses to do so.” Accordingly, professionals practising in the listed professions have had the option to exclude their year end WIP in computing their income. This often allowed the professional to defer the recognition of this income until retirement when, in theory, he or she would pay a lower rate of tax, and formed an important part of long term retirement planning for many professionals.
For taxation years beginning after March 21st, 2017 (for most this would be the 2018 taxation year), the listed professionals (accountants, dentists, lawyers, medical doctors, veterinarians, and chiropractors) will be required to include their WIP at the lower of its cost or its fair market value in computing their income for tax purposes. To ease the transition, the existing WIP will be includable in income over a 5 year period.
Oddly, the “difficulty in valuing unbilled time” of which the Finance Department spoke seems to have disappeared.
Aside from the additional tax cost, valuing WIP can be difficult. Determining what does and does not have to be included will add yet another level of complexity and expense for taxpayers. Once gain, this will require professional assistance.
4. Tax on Split Income (TOSI)
The introduction of the new Tax On Split Income (TOSI) rules was one of the most controversial provisions introduced by the Liberals in July, 2017. Although it was amended slightly, it still remains unmanageably complex and onerous. It must be recognized that this is a direct attack on professionals and small businesses who have done their estate and retirement planning based on rules that have been in force for decades. Although touted as a measure to ensure that “wealthy professionals” pay their fair share, it is also an attack on the families of painters, plumbers, electricians and any other business whose revenue depends upon the provision of services.
If the idea was to stop income splitting with family members, this could have been done by simply extending the current TOSI rules (generally referred to as the “kiddie tax”) to, say, age 24 in stead of 18.
Instead, Morneau has introduced rules so complex that they are incapable of being administered.
In tabling some revisions last December, Morneau said, in part:
Following extensive consultations with small business owners, professionals and experts, the Government is taking steps to make the tax system more fair with
simplified measures that are easy to understand and implement.
Today, the Government published details of its proposals to simplify and improve the treatment of income sprinkling, which are proposed to be in effect for the 2018 tax year and beyond.
The current, and immediately previous, Chief Justice of the Tax Court of Canada have both stated publicly that the Tax Court does not have the capacity to cope with the volume of legislation that these new rules will generate.
Given the uncertainty about what these rules actually mean, most professionals will be advising their clients to object to any assessment under these provisions. Those objections will sit in a file for - without exaggeration - the next 10 or 15 years, until the Supreme Court of Canada rules on these provisions.
Moodys Gartner LLP have been in the forefront of the tax profession’s fight for fair tax provisions. Kenneth Keung, Director of their Canadian Tax Advisory Services, has prepared a flow chart to show how the new TOSI rules will operate, and to show just how simple they will now be. With their kind permission, I am including a link to that “simple” flow chart.
There are steps that can and should be taken to ensure that dividends can be paid to family members, including changing share ownership structures. Dividends paid to a family trust, for example will not be exempt from the new rules, so steps could be taken to put shares directly into the hands of family members.
Companies will have until the end of 2018 to meet the new ownership rules and have them applicable for the entirety of 2018.
It is more crucial than ever to get good tax advice when contemplating dividends to family members. I would be pleased to discuss this with you to ensure the optimum tax result.
5. Passive Investment Income
Probably the most controversial, and onerous, provisions introduced were the provisions dealing with the taxation of passive investment income in a Canadian-controlled private corporation (CCPC).
Although the Minister clearly lied when he stated that the new rules would “grandfather” any accumulated capital and the income earned on that capital, Liberal Members of Parliament, in their canned, scripted, responses to concerns expressed to them, argued that they honoured their promise to grandfather pre-2018 capital because the income generated was not being taxed at a higher rate than before. This is, at best, disingenuous, and at worst, an outright lie.
As a matter of fact, with the exception of changing the way that refundable taxes will be applied, the actual tax on investment income is not being increased, whether from pre-2018 capital or post-2017 capital.
For those CCPC’s that only have investment income, this is good news.
However, for CCPC’s that have both investment income and business income, whether in one company or in associated companies, the tax on their active business income could increase by up to $65,000 annually.
Under the rules introduced in the Budget, if a CCPC and its associated corporations earn more than $50,000 of passive investment income in a given year, the amount of income eligible for the small business deduction (discussed above) would be gradually reduced.
The SBL will be reduced by $5 for every $1 of investment income above the $50,000 threshold (equivalent to $1 million in passive investment assets at a 5% return), such that the business limit will be reduced to zero at $150,000 of investment income (equivalent to $3 million in passive investment assets at 5%).
The Minister used the example of a CCPC generating a 5% return on its investment assets. Using that example, a CCPC with passive investment assets of less than $1 million will continue earn up to $500,000 in active business income and be taxed at the small business tax rate.
A CCPC with passive investment assets of $1.4 million at the same rate of return can earn up to $400,000 in business income per year and be taxed at the small business rate. This represents a tax increase of $13,500 in respect of the $100,000 that is now taxed at the higher rate.
A CCPC with passive investment assets of $3 million or more pays the higher corporate tax rate on all its business income.
The tax paid by a CCPC on its investment income, in Ontario, is 50.2%. More interesting is the fact that a public company in Ontario pays only 26.5% on the same investment income.
As I stated above, if a CCPC earns $50,000 of investment income, there is no change to the tax paid on the active business income.
However, if the CCPC earns $150,000 of investment income, assuming a full $500,000 of active business income, the tax cost in respect of the additional $100,000 is $115,200.
This is the actual investment income tax of $50,200 PLUS the $65,000 of additional tax on its active business income.
This is the government that continually claims that they are trying to benefit the middle class.
Is it any wonder that capital is fleeing from Canada?
A portion of the tax paid by a CCPC in respect of investment income is refundable when dividends are paid to the company’s shareholders, but as discussed above, there are new complex rules governing the payment of dividends to both individuals and to related companies.
The of all of this is that steps need to be taken before the end of 2018 to shelter, as much as possible, the investment income earned in a CCPC that also carries on an active business.
This year more than ever it is important to get solid professional advice before the end of the year.
I would be pleased to assist in negotiating the new Twilight Zone.