On July 18, 2017, Minister Morneau announced the “next steps in improving fairness in the tax system by closing loopholes and addressing tax planning strategies”. A consultation paper was released along with draft legislation and explanatory notes. These proposed rules represent a major policy shift in the taxation of private corporations and their shareholders including widely-accepted tax strategies such as having a spouse hold shares in the business without being actively involved on a day-to-day basis.
The proposed rules are aimed at several tax practices that, in the view of the Department of Finance, are “being used to gain unfair tax advantages”. Many commentators have a different opinion. These tax practices include the following:
- Income sprinkling. Income, including dividends, interest, and capital gains, received by family members will be subject to a “reasonability test”, effective January 1, 2018 if enacted as proposed. The proposed rules will tax “split income” received by both adult and minor family members at a rate of 48% (in Alberta). A reasonable amount is one that an arm’s length shareholder would expect to receive given the labour performed, assets contributed, and risk assumed in relation to the business. Every amount received by a family member (parents, children, siblings, aunts/uncles, and nieces/nephews) will need to be reviewed to determine whether it is captured by this new rule. Reasonability tests can be difficult to administer and it is difficult to provide advice with any degree of certainty.
- Multiplication of the lifetime capital gains deduction. The lifetime capital gains deduction will be denied to taxpayers under the age of 18 and to a family member to the extent the capital gain is not “reasonable”. Further, the lifetime capital gains deduction will no longer be available to any gains accrued before the individual turned 18 or while the property was held in a trust. There is an election that may be available in 2018 to realize a capital gain under the “old” rules and planning that can be completed in 2017. These rules will be effective January 1, 2018 if enacted as proposed.
- Converting regular income into capital gains. The expansion of a current anti-avoidance rule and an addition of a general “anti-surplus-stripping” provision that will apply to transactions effective July 18, 2017. This will limit the ability to complete a “pipeline transaction”, which is often used by an estate to eliminate double taxation arising from the death of a shareholder, and the ability to transfer corporations from one generation to another. The new general rule may have very broad application and may apply to common transactions involving shares of corporations.
- Retaining passive investments in a corporation. Currently, business owners can use retained earnings, taxed at a low rate, to invest in passive investments and save for a rainy day or their retirement. Using the consultation paper’s tax rates, the combined corporate and personal rate on passive income would be 71% and the combined corporate and personal rate on capital gains would be 57% for investments held in the corporation and funded from retained earnings. The actual effective tax rate will be different in Alberta. No draft legislation was released and there is no effective date.
The proposed tax changes are complicated and are only very briefly summarized above. If you would like to find out more about how these proposed rules will impact you, please contact one of our tax lawyers.