As I said in my summary last week, I plan to send out a series of newsletters dealing with the massive changes proposed by Finance Minister Morneau. Again, these are the largest changes to our system since 1972, and will completely change the way that private corporations and their shareholders are taxed. The Liberals say that this is all in the name of fairness – Lies, Lies and More Lies. There is nothing fair about any of these changes.
In theory, the idea that, all things being equal, two taxpayers with the same income should pay the same amount of tax, is perfectly fair and reasonable. BUT ALL THINGS ARE NOT EQUAL. This simplistic view is, at best, ingenuous, and at worst an outright lie. Morneau is too smart a business man to believe in the simplistic view. The idea that someone who risks everything by running his or her own business, creating jobs and wealth, funding his or her own pension and medical insurance is no different than an employee who goes to work, is guaranteed a paycheque, often has a pension and medical insurance and has nothing at risk, is ludicrous.
There are some time lines that need to be considered in looking at the changes:
Converting income into capital gains
This is an extremely technical provision applicable in relatively few situations. This provision is effective for transactions taking place on or after July 18th, 2017.
So, although this change can be significant, there is nothing to be done to change transactions that have already taken place. Accordingly, I will deal with this in a future newsletter.
Taxation of Investment Income in Private Corporations
This change will likely be huge for many small businesses and professionals. The change is proposed to take effect starting in 2018.
There are a couple of approaches suggested by Finance Minister Morneau and there will be consultation over which approach might be best.
Since we don’t know what the change will be, there is no urgency to go into detail about the different options.
There is no question that small business owners and professionals take advantage of the ability to split income with family members through the payment of dividends. Mr. Morneau has labelled this as a loophole.
A loophole is an unintended tax consequence. Nothing could be further from the truth. In 2005, for example, the Liberal Government of Ontario, in order to avoid an increase in the amount that OHIP could pay to any doctor, changed its corporate law to allow doctors and dentists to include family members as shareholders for exactly this purpose. In correspondence with the Ministry in those years about allowing other professionals to include family members, the Ministry specifically stated that this was an advantage given to doctors as a result of caps imposed on OHIP billings. So not only is this NOT A LOOPHOLE, since it was done deliberately, but it was part of an agreement with the Ontario Liberal government and now the Federal Liberals are going to unilaterally penalize the doctors for complying with their agreement.
In a huge departure from history, and contrary to countless decided cases at every level including the Supreme Court of Canada, the Liberal Government is going to impose a “reasonableness” test on the payment of dividends by private companies. Unlike business expenses, which must be reasonable to be deductible, there has never been such a test related to dividends, which are paid out of after-tax corporate income.
In 1999 Liberal Finance Minister Paul Martin introduced “kiddie tax”. This is a tax applied only to taxpayers under the age of 18 who receive certain types of income, primarily dividends from private companies. The kiddie tax taxes those dividends, or other forms of income, at the top personal tax rates, removing any tax benefit from the payment of those dividends. Interest payments were exempt from kiddie tax, as was any income generated by funds that were subject to kiddie tax and then were re-invested.
Finance Minister Morneau proposes to extend the kiddie tax rules, now labelled Tax on Split Income (TOSI) to the payment of dividends to other family members, where the amount of dividend is “unreasonable”. One of the tests to determine if the income will be subject to the TOSI, is whether it was received from a corporation in which a related individual has a material interest. The new rules extend the definition of “related” to include uncles, aunts, nieces and nephews.
The test for reasonableness will depend upon contributions of labour or capital by the individual to the company.
The reasonableness test is proposed to apply differently based on the age of the recipient of the dividend (i.e., whether the individual is between 18 and 24 or is 25 or older).
For an adult age 18 to 24, in order for a dividend to be “reasonable” the recipient of the dividend must be actively engaged on a regular, continuous and substantial basis in the activities of the business. For an individual over the age of 24, they must be involved in activities that could have been compensated by way of salary.
If the recipient contributed capital to the business, the dividends might be treated as reasonable. But dividends paid to family members on “dividend only” shares, often used by doctors, dentists, and other small businesses, will not be considered to be reasonable.
The big problem, both for taxpayers and for the Canada Revenue Agency, will be the nature of the review that the CRA will conduct to determine what is “reasonable”. This will be a nightmare for taxpayers who will then have to spend time and money objecting to assessments based upon what a CRA auditor determines is reasonable. For the CRA, there is no possible way that they will be able to keep up with necessary work to determine what is reasonable for every shareholder in any private companies that are being audited.
The definition ‘split income’ will also be extended to include:
Interest income received from private corporations;
Income generated from the re-investment of funds that were originally subject to TOSI; and
gains from dispositions after 2017 of certain property the income from which is split income.
IMMEDIATE ACTION REQUIRED
It will be years before the Courts make any determinations of what “reasonable” means in the context of the new TOSI rules.
But it is clear that 2017 will be the last year that there will be any tax advantage to paying significant dividends to family members, either directly or through a family trust. From now until the end of the year, it will be important to pay out dividends to family members to take advantage of lower tax rates.
The table below gives some approximate tax liabilities in the 2017 taxation year for an Ontario taxpayer with no income other than dividends from a private company. As you can see, it is important to meet with your advisors to determine what dividends should be paid in 2017.
A word about the Capital Gains Exemption
There are other provisions that need to be considered in detail related to the TOSI, including the application of TOSI to capital gains and capital dividends.
It is also important to know that the lifetime capital gains exemption (LCGE) will be taken away from many taxpayers. Shares owned by taxpayers under age 18 will not qualify for the LCGE, nor will shares that have been owned by a family trust. If the dividends paid in respect of shares would be subject to the TOSI, the shares will not qualify for the LCGE.
Taxpayers will be entitled to make an election at some time in 2018 to trigger accrued gains in respect of qualified small business corporation shares in order to claim the LCGE. This is similar to the election that was available in 1994 when the general capital gains exemption was repealed.
The key to making the election will be that the shares must qualify for the LCGE. I have written many times about the LCGE and what is required for shares to qualify. The major test is based upon the ratio of active business assets to cash and investment assets.
It is vitally important that you contact your advisors to make sure that any excess cash and investment assets are transferred out of your active business corporation in order to ensure that the shares will qualify for the LCGE. If the shares don’t qualify, the LCGE will not be available.
The Liberal Government has set up a scenario where taxpayers will be forced to spend substantial time and money getting proper advice to deal with tax changes that, as the Government admits, will not raise significant tax revenue.
The next few months will certainly be interesting. As the curse says, “May you live in interesting times”.
I’m sorry to say that there will be more newsletters to follow concerning these proposed changes.