Tax alert: Proposed changes to tax planning strategies for private corporations

On July 18, 2017, the federal government released draft legislation and a consultation paper that targets a number of the standard tax planning strategies that private corporations and their shareholders have implemented for many years. Specifically, the proposed changes would impact the ability to income split, multiply the family capital gains exemptions, invest in passive investments inside a corporation, and convert income into capital gains.

Here is a summary of the proposed changes:

Income Splitting

Many private corporations have structures in place that allow dividends or other income to be paid or allocated to adult family members who are in lower income tax brackets. This is an effective and legitimate way to reduce the overall family tax liability under the current rules. The proposed changes will limit income splitting to those individuals who are actively involved in the business. The proposed rules introduce a reasonableness test to determine the amount of income that can be split with a family member who is actively involved in the business. At this point, it is unclear how the reasonableness test will work in practice, but it is meant to allow a family member to earn income in the same manner that a non-related individual would in the same circumstances. The proposed changes will be effective for 2018 and future taxation years.

Multiplying the Capital Gains Exemption

As with income splitting, many private corporations have structures in place that allow multiple family members to claim their capital gains exemption if the corporation is sold. The proposed changes will only allow adult family members who meet a reasonableness test (same test as for income splitting) to claim the capital gains exemption, and capital gains that accrue on shares owned by a family trust will no longer qualify for the capital gains exemption. The proposed changes will be effective for 2018 and future taxation years.

Investing in Passive Investment

With corporate tax rates on business income being significantly lower than the top personal tax rates, corporations have been investing their surplus funds in passive investments rather than paying them to their shareholders. The government announced that it intends to introduce a tax on retained earnings of a corporation that are used to invest in passive investments rather than in the corporation’s active business. Several complicated potential rules were mentioned, but they have yet to decide exactly how this tax would be applied.

Converting Income to Capital Gains

Some individual shareholders have implemented strategies to extract retained earnings from their corporations and pay tax at the capital gains tax rates, rather than at dividend or salary tax rates, which are higher. The proposed changes will eliminate this type of planning effective July 18, 2017.

At this point, there are many unanswered questions regarding these proposed changes and the government is seeking comments from the tax community by October 2, 2017. We expect to receive more guidance and clarity on these rules in the months ahead.

In the meantime, please contact your Fuller Landau advisor to discuss how these proposed changes may impact you, your family, and your business. If you’re new to Fuller Landau, partner Gord Jessup, head of our Tax department, would be happy to help.