If you are the owner of a private corporation you should be concerned about the commentary that is coming from the Department of Finance. In the Federal Budget of March 2017, Finance expressed their concern that private corporations were being used by high income Canadians to obtain tax advantages that were not available to other Canadian tax payers. That concern has led to the release on July 18th 2017, of a consultation paper along with draft legislation. Finance is currently asking for input from interested parties and stakeholders and has stated that the consultation period will end on October 2, 2017. At this point, whatever happens after that date is anyone’s guess, but speculation is high that changes will be introduced to close what the Department perceives as abusive practices relating to private corporations.
Specifically, there are three specific tax planning strategies employed by private corporations that the department is most concerned with:
Sprinkling income using a private corporation
Income tax paid on income from a private corporation can be greatly reduced by causing that income to be received in the form of dividends by individuals who would pay tax at a much lower rate or not at all. These dividends are usually paid to adult children or other family members who are shareholders of the private corporation or to a family trust. By “sprinkling” the income in this manner the amount of income tax paid can be greatly reduced.
Holding a passive investment portfolio inside a private corporation
One of the reasons to have a private corporation is to retain income that is not required for living and lifestyle expenses. Since the tax rate on business income is lower than personal tax rates this allows the surplus to be invested eventually resulting in a much larger investment portfolio than if it had been accumulated by investing personal after-tax income.
Converting a private corporation’s income into capital gains
Income from a private corporation is usually taxed as either salary or dividends. The government is concerned about a financial manoeuver that has been employed through a series of private corporation transactions that result in corporate distributions being taxed as a capital gain.
The government is concerned that these and other tax planning strategies that can be employed private corporations are not available to average Canadian tax payers many of whom earn their income as salaried employees. The July 18th 2017 consultation paper announced the government’s intentions to deal with these issues. Quoting from this paper these are as follows:
- “The Government is seeking input on proposed rules that would distinguish income sprinkling from reasonable compensation for family members”. Reasonableness of this compensation based on the family member’s contribution will be one of the determining factors;
- “The Government is seeking input on possible approaches to neutralize the tax-assisted financial advantages of investing passively through a private corporation”. The stated intention is to maintain the economic advantages of having a lower tax rate on “active” business income earned by corporations. In other words, their focus is on passive investment income earned in the corporation;
- “The Government is introducing proposed changes to tax rules to prevent the surplus income of a private corporation from being converted to a lower-taxed capital gain and stripped from the corporation”. At the same time as the consultation paper was released Finance also published detailed legislative proposals for comment that would accomplish their objectives in this area.
A large number of interested parties and stakeholders are or will be making submissions to Finance with respect to the consultation paper and the proposed changes to the tax rules. After October 2017 we should have a clearer picture of what steps the government will be taking. In the meantime, if you are a private corporation owner employing any of these strategies you should be discussing this matter with your professional advisors.