On Tuesday July 18, 2017, the Department of Finance (“Finance”) released several proposed changes that will affect tax planning using private corporations. The main focus of these proposed changes is on tax planning strategies that involve:
- Sprinkling income amongst family members using private corporations;
- Multiplication of the Lifetime Capital Gains Exemption “LCGE” (currently $835,714); and
- Holding passive investment portfolios inside private corporations.
Income Sprinkling and Reasonableness Test
The term “income sprinkling” refers to tax plans that result in income being taxed at a lower rate on an individual’s tax return, when that income might otherwise be taxed at a higher rate on another family member’s tax return.
To mitigate the effect of income sprinkling, Finance is proposing to introduce a reasonableness test for individuals aged 18 and over who receive dividends from private corporations. Under the proposals, the amount of dividends would be reasonable if it is what an arm’s length party would have agreed to pay the individual. This will be based on several factors such as labour contributions and capital contributions to the private corporation. The specifics of these tests are yet to be determined. These same tests would apply to dividends paid from a private corporation to a Family Trust and then to the individual.
Multiplication of the LCGE
To address the multiplication of the LCGE they are proposing several measures:
- An age limit – Specifically, individuals would no longer qualify for the LCGE before the taxation year in which the individual attains the age of 18;
- A reasonableness test – This could be similar to the one mentioned above; and
- Limiting the LCGE – Finance is proposing to limit the claim of the LCGE in respect of capital gains that accrue during a period in which a Family Trust holds the shares.
Investments Held by Private Companies
Funds available for investment will often grow faster in an operating company because corporate tax rates are generally lower than personal income tax rates. These investment portfolios then generate passive income within private companies. Finance is proposing to limit passive investment portfolios in private corporations, but they have not specifically indicated what they plan to do to limit them. They appear to be concerned with the fact that a private corporation can hold a larger portfolio than an individual would be able to hold if the corporate after-tax funds were instead paid out as dividends to the individual shareholders. The individuals would only have their personal after-tax income to invest, which would of course be a lower amount.
Next Steps
It is important to note that these are only proposed changes, and exact specifics are unknown at this time. Finance is seeking input on these proposed changes until October 2, 2017. If you feel inclined, they are inviting interested parties to submit comments to fin.consultation.fin@canada.ca.
We will continue to analyze these complex proposals and monitor their developments over the coming weeks. Most of these rules are effective from 2018, so there will likely be some tax planning to consider before the end of 2017. Please feel free to contact us if you have any questions.