Converting a private corporation’s income into capital gains

Anti-surplus stripping rules

Changes are proposed to prevent individual taxpayers from using non-arm’s-length transactions that increase the cost base of shares of a corporation and avoid the application of Section 84.1.  Section 84.1 is intended to prevent corporate surplus from being removed at the lower capital gains tax rates instead of the higher dividend tax rates where an individual sells shares of the corporation to a non-arm’s- length corporation.

Two measures are proposed:

  1. Anti-avoidance rule to be expanded – will expand to apply to situations where the cost base of shares is increased in taxable non-arm’s length transactions. The purpose is to prevent a taxpayer from extracting corporate surplus on a subsequent sale to a non-arm’s length company to the extent that the cost base of the shares is a result of previously realized non-arm’s length capital gains.  In some cases a capital gain will be realized on the initial sale of shares as well as a deemed dividend on the subsequent non-arm’s length sale of those shares.  This would result in punitive double taxation.
New anti-stripping rule – the proposed rule will apply to prevent the distribution of corporate surplus to an individual shareholder resident in Canada on a tax –reduced or tax-free basis in a non-arm’s length transaction, where that surplus would otherwise be distributed as a taxable dividend.  It will apply where it can reasonably be concluded that one of the purposes of the transaction (or series of transactions) is to cause a significant reduction or distribution of the assets of the private corporation in such a manner that the tax on the amounts received is less than what the individual would have paid if the corporation had paid them a taxable dividend immediately before the transaction.

Lifetime capital gains exemption

The concern here is that common ownership structures can allow multiple family members to make use of their capital gains exemption (CGE) from the sale of a family-owned business.

Under the proposals, the capital gains exemption will be denied in the following circumstances:

  1. Individuals under the age of 18 will not be allowed to use the CGE;
  2. Beneficiaries of trusts will no longer be permitted to access the CGE with respect to gains on the value of shares that accrue during the period in which the trust holds the shares: and
  3. Individuals who are subject to TOSI with respect to a share will not be able to use the CGE on the sale of such shares.

A transitional rule would allow an election to be made by the end of 2018 to crystallize a capital gain and claim the CGE so as to increase the adjusted cost base of the “qualified small business corporation” shares.

The above is included in draft legislation, and, if enacted, both are effective July 18, 2017 which hits targeted planning immediately.

Additional consideration is to be given as whether there is an adverse impact on genuine business transactions involving family members.  There could be an issue in certain cases on the transfer of a business from one generation to another within a family because the lifetime capital gains exemption would not be available.

 

 

The government is proposing a review of tax planning strategies in three areas:

  • Income sprinkling using private corporations
  • Converting a private corporation’s income into capital gains
  • Holding a passive investment portfolio inside a private corporation
  • Income sprinkling using Private Corporations

    Income sprinkling, also known as income splitting or shifting, generally occurs when income that would otherwise be earned by a high tax rate family member is taxed in the hands of family members who are taxed at lower marginal rates of tax.  The income sprinkling is often achieved by the use of a private corporation and has, until recently, been a perfectly legal and acceptable tax planning strategy.

    The Income Tax Act presently contains rules which are aimed at preventing income sprinkling in certain circumstances – attribution rules and the kiddie tax rules (tax on split income, or TOSI).

    Expanding the tax on split income (TOSI) rules:

    Existing rules

  • Prevent transfer of certain types of income from high-income earning individuals to their children under 18 by taxing it at the top federal income tax rate.
  • Types of income
  • Dividends received from a private corporation of a related individual
  • Income from a partnership or trust derived from a business or rental activity of a related individual.
  • Presently do not apply not adult children.
  • Presently do not apply to wages and salaries (except for a reasonableness test).
  • Proposals

    Extend the TOSI rules to apply to any Canadian resident individual, regardless of age, to the extent that the split income is determined to be unreasonable.

  • Extend the meaning of a specified individual to include adults (18 and over).
  • Creates two categories of specified individuals (SI): minor SI’s and adult SI’s. The distinction between minors and adults will be relevant in applying a reasonableness test to determine whether the TOSI rules would apply to an adult SI.
  • Reasonableness Test

  • Subject the adult individuals’ split income to a reasonableness test that considers the individual’s labour and capital contributions to the corporation as well as previous dividends and remuneration received.
  • The test would be subject to stricter tests for individuals 18-24 years of age.
  • Labour Contributions - are they actively engaged on a regular and continuous and substantial basis in the activities of the business – for those over 25 years of age it will be sufficient to show the specified individual was involved in the business.

    Capital Contributions - reasonableness test for SI’s between 18-24 will be set at a legislatively prescribed maximum in respect of an allowable return on assets contributed by the individual in support of the business.

    For those SI’s over 24, the reasonableness test will consider the extent that the individual contributed assets, or assumed risk, in support of the business and will consider all previous amounts paid or payable to the individual in respect of the business.

    If the amount is determined not to be reasonable then the top marginal tax rate will apply to the amount.

    New definition of “connected individual” – proposed as a means of determining whether an adult specified individual’s income from a corporation (or trust of a partnership in certain circumstances) is to be treated as split income.

    Proposals are to also expand TOSI to include:

  • Income from certain debt obligations,
  • Capital gains from the sale of shares the income from which is subject to TOSI, and
  • Compound income on property that is the proceeds from income previously subject to the TOIS rules or the income attribution rules (this will only apply to individuals under the age of 24.
  • The above is proposed to be effective after 2017.

     

    After a very busy first half of the year, we've earned some downtime to enjoy the warmer weather!  So, effective July 4, our office will be closing an hour earlier each day.  Our Summer and Fall office hours will be 8:00am - 4:00pm, Monday through Friday.

    nesteggThere are many fraud types, and new ones are invented daily. Some are imaginative, some are aggressive, and some appear legitimate!
    Be vigilant if you receive, either by telephone, mail, text message, or email, a communication that claims to be from the Canada Revenue Agency (CRA) requesting personal information such as a Social Insurance Number, credit card number, bank account number, or passport number.
    These scams may insist that this personal information is needed so that you can receive a refund or a benefit payment. Cases of fraudulent communication could also involve threatening or coercive language attempting to scare you into paying a fictitious debt to the CRA. Other communications may urge you to visit a fake CRA website where you are then asked to verify your identity by entering personal information. These are scams and you should never respond to these fraudulent communications or click on any of the links provided.
    Canada Revenue Agency will never:
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    • Leave personal information in a voice mail;
    • Threaten or use nasty language.
    If you are in doubt about the validity of a communication claiming to be from the CRA, don’t panic! Ask your accountant to verify the information given, or call CRA at 1-800-959-8281 (individuals) or 1-800-959-5525 (businesses) to verify. Don’t call the number displayed as it may be fraudulent.
    If the communication is a scam, you can report it to the Canadian Anti-Fraud Centre online, or by calling 1-888-495-8501.

    With the announcement regarding the 2017 Federal Budget, there are a number of changes that may affect you, your family, or your business. Please review the commentary here for all the details and contact us for assistance: 2017 Federal Budget Commentary