Four major ways the proposed tax changes will affect small and mid-sized private businesses
You’ve likely heard a lot of discussion about the government unveiling plans in July to change several aspects of how private corporations are being used for tax planning. While not all of the specific details are known, if these rules are passed they will have a significant financial impact on many small and mid-sized private corporations and their shareholders. The government is accepting feedback regarding the proposed changes until October 2, 2017.
Should the proposed changes go ahead as planned, they will have a significant impact on 4 aspects of tax planning for private corporations:
You’ve likely heard a lot of discussion about the government unveiling plans in July to change several aspects of how private corporations are being used for tax planning. While not all of the specific details are known, if these rules are passed they will have a significant financial impact on many small and mid-sized private corporations and their shareholders. The government is accepting feedback regarding the proposed changes until October 2, 2017.
Should the proposed changes go ahead as planned, they will have a significant impact on 4 aspects of tax planning for private corporations:
1. The New Proposal Aims to Restrict Income Splitting
Many private corporations have structures in place that allow for income splitting with other family members who may or may not be active in the business. This is considered good planning under the existing tax rules.
Income splitting involves shifting income from a family member in a high income tax bracket to a family member in a low income tax bracket. This can be an effective way to reduce the overall family tax bill. This is usually achieved by paying corporate dividends to the lower income family members, either directly or through a family trust. There are already rules in place that eliminate the benefit of income splitting with children who are under 18 years of age. These rules apply the highest personal tax rate to income received by a minor. As a result, you can not use the lower tax rates of a minor to income split. For tax purposes, this is referred to as tax on split income (“TOSI”).
The proposed changes will extend the TOSI rules to adult family members and implement a “reasonableness test”. The TOSI rules will apply to amounts received by adult family members if the amount is unreasonable given their contribution to the business. If passed, these new rules would apply in 2018 and future years.
The ‘Reasonableness Test’
According to the proposed changes, the ‘reasonableness test’ will be an assessment of the family members’ contribution to the business. The test will look at what an arm’s length person would receive given their role in the business, assets contributed to the business, risk assumed in the business, and all historic amounts received from the business. There is a stricter test for family members who are between the ages of 18 and 24. The TOSI rules will apply to any amount of income that is determined to be unreasonable.
2. The New Proposal Aims to Restrict the Multiplication of the Lifetime Capital Gains Exemption
Similar to income splitting, many private corporations have structures in place that will allow multiple family members to claim their capital gains exemptions on the sale of the family business. The family member must own shares of the private company directly or through a family trust. This is an effective way to lower the capital gains tax on the sale of the company.
The proposed changes will eliminate the ability for the capital gains exemption to be claimed on any gains that accrued on shares while the individual was a minor or on any gains that accrued on shares owned by a family trust. In addition, if the income on the shares that are owned would be subject to the TOSI rules than no capital gains exemption will be available on the sale of those shares either. These proposed changes will make it difficult for other family member to use their capital gains exemptions in 2018 and future years.
Transitional rules were announced that will allow adults to file an election in 2018. This election will allow adult family members to increase their cost base in the shares they own (directly or through a family trust) up to their capital gains exemption limit.
3. The New Proposal Aims to Change How Passive Income is Handled
Under the current tax system, many business owners have invested the after-tax profits of their business in to passive investments (e.g. public company stocks or rental properties). By doing this, there are more after-tax dollars to invest inside the corporation when compared to taking the money out and investing personally because no immediate personal tax is paid. The business owner still pays personal tax, but only when the money leaves the business.
The current proposal involves changing the rules so that a shareholder that invests inside a corporation is in the same financial position as they would be if they took the money out of the corporation, paid personal tax on it, and then invested the after-tax personal dollars. Many of these rules are still unclear but if these rules are passed the benefits of investing inside a corporation could be eliminated. The government has indicated that these rules are not intended to impact current investments but until the rules are finalized we can’t be certain that this will be the case.
4. The New Proposal Aims to Close Converting Income to Capital Gains
Some taxpayers were entering in to transactions for the sole purpose of reducing tax on distribution from their corporations. These strategies allowed taxpayers to pay the capital gains tax rate on the distributions rather than the higher dividend tax rates that they would have paid had they not done this type of planning.
The new proposal will ensure that taxpayers who enter into this type of planning arrangement pay tax at the dividend tax rates regardless of how they structure the distribution. These rules would be effective as of July 18, 2017.
How Can You Prepare for the Proposed Changes?
It is important to remember that these proposed tax changes are not yet set in stone. The government is accepting feedback until October 2nd, so we encourage our clients to raise any concerns they may have by contacting their MP or sending an email to the Department of Finance Canada at fin.consultation.fin@canada.ca.
In the meantime, there are some steps you may consider taking now, to minimize the fallout of these potential changes, such as reviewing the share ownership structure for your business and maximizing any existing income splitting opportunities in 2017. To ensure that your business is ready for these proposed changes, contact one of our accounting and tax experts today.