BUDOVITCH LEGACY PLANNING – TAX UPDATE
GOVERNMENT TAKES AIM AT STANDARD TAX PLANNING USING PRIVATE CORPORATIONS
On July 18, 2017, the Department of Finance released legislative proposals (the “Proposals”) and a consultation paper dealing with tax planning using private corporations. It is hardly surprising, given the rhetoric and previous actions of this government, that they would introduce measures aimed at limiting certain tax planning for private corporations and business owners. However, the ferocity of the attack is more significant than expected and will have far-reaching implications for most shareholders of private corporations. The proposed measures include: 1) eliminating certain income splitting amongst family members; 2) eliminating the ability to multiply the capital gains exemption on the sale of a business; and 3) highly complex rules to neutralize the benefits of investing after-tax dollars in passive assets within a corporation.
Income splitting occurs when income that would otherwise be realized by a high-tax rate individual is shifted by paying dividends to family members subject to a lower or nil rate of tax. Under the Proposals dividends received by adults over the age of 18 from a business of a related individual (child in university receives dividend from parent’s corporation to pay for university) will taxed at the highest marginal rate should a “reasonableness test” not be met. Very generally, the reasonableness test will determine if the dividend received by the individual is reasonable given the recipient’s labour and/or capital contributions to the company and whether similar payments had been made to the recipient in the past. This test will be more difficult to meet if the family member is between 18-24 years old.
Lifetime Capital Gains Exemption (“LCGE”) Multiplication
A frequently utilized strategy for private corporations is to implement what is commonly referred to as an “estate freeze” and have a family trust own common shares of the corporation. The beneficiaries of the trust are typically the owner’s spouse and children so that upon the future sale of the business, each beneficiary of the trust can utilize the LCGE. The current exemption in 2017 is $835,714, which could be multiplied by the number of shareholders and thereby sheltering more of the proceeds on the sale from capital gains tax. Under the Proposals, family members under the age of 18 cannot claim the LCGE as well as beneficiaries of a trust if the gain accrued during a period in which the trust held the shares. If the shares are not held by a trust, but rather directly by a family member, the reasonableness test as described above would apply thereby drastically limiting the ability of any family member to utilize their LCGE.
Holding Passive Investments in a Private Corporation
This particular proposal, while likely having the most far-reaching impact on business owners, was the only proposal to not have draft legislation provided. Rather, the government provided alternatives to neutralizing the benefits of investing after-tax dollars in passive investments within corporations. The Liberals intend to remove the incentive to use private corporations as savings vehicles due to the lower tax rate within a corporation. For example, currently if a corporation is earning $300,000 and is being taxed at 15%, the corporation can theoretically invest $255,000 in passive investments. On the other hand, an employee in Ontario earning the same $300,000 will have approximately $176,000 to invest. Such a basic example (similar to the one used by the Liberals) fails to take into account certain advantages an employee has that a business owner does not, including but not limited to: a private health plan; vacation days; employer funded pension plan; Employment Insurance and most significant of all – less risk. A salaried employee has the benefit of knowing (within a finite range) of how much income they will earn in a given year. The business owner, however, does not have such comfort and may earn $500,000 in one year and $100,000 in another. The ability to invest in passive assets using after-tax corporate dollars was a way to mitigate such risk. The alternative proposals are highly complex and appear difficult and costly to administer. However, if any of these proposals are enacted into law, it will have a significant impact on the cost of investments made by business owners. The loss of being able to invest within your corporation in addition with the Proposals above, an increasing minimum wage and an increased tax rate of 53.53% results in more revenue for the Liberal platform and less for the business owner.
It is important to note that the proposals relating to taxing passive investments target passive income earned in a corporation and not the passive asset itself. Accordingly, since life insurance does not produce taxable income these rules should not affect corporate-owned life insurance. As it stands today, the Proposals do not impact the tax advantages of corporate-owned life insurance and in fact further reinforce that insurance should be utilized as a primary tool for family, tax and estate planning.