Tax reform focuses on three issues identified in Budget 2017:
- Sprinkling income using private corporations, which can reduce income taxes by causing income that would otherwise be realized by a high-income individual facing a higher personal income tax rate to instead be realized (e.g., via dividends or capital gains) by family members who are subject to lower personal tax rates or who may not be taxable at all.
- Holding a passive investment portfolio inside a private corporation, which may be financially advantageous for owners of private corporations compared to other investors. This is mainly due to the fact that corporate income tax rates, which are generally much lower than personal rates, facilitate the accumulation of earnings that can be invested in a passive portfolio.
- Converting a private corporation’s regular income into capital gains. This has subsequently been withdrawn On July 18, 2017 the Minister of Finance announced the details of their discussion paper and asked for feedback, and as a result on October 16, 2017 a news release from the Federal Government stated: Ottawa announced its plans today to cut the small business Federal tax rate from 10.5% per cent to nine per cent by 2019, 10% for 2018 & 9% for 2019.
The government will not be moving forward with the proposed measure to limit access to the Lifetime Capital Gains Exemption. This is a tax exemption on capital gains and was one of the areas of change that particularly concerned farmers and fishers.
The legislation is expected to be introduced with the 2018 federal budget. Draft legislation should be issued prior to that date. The capital-gains tax proposal has been dropped.
This was one of the first of two retreats that have been announced. The second one relating to passive income was released two days later. On Wednesday October 18, 2017 The Department of Finance announced they would change on how tax on passive income would be calculated to assist most private corporations. $50,000 of passive investment income, annually, will not be subject to the super tax. Previously accumulated passive investments inside private corporations will not be subject to the $50,000 and will be ‘grandfathered’ along with any income earned on these investments in the future.
The finance minister said there’s between $200 billion and $300 billion in assets sitting in the passive investment accounts of just two per cent of all private corporations — or about 29,000 companies out of 1.8 million private corporations. The intent is to focus on those corporations.
One other tax change of note is that the Ontario government announced on November 13 that it would reduce the provincial tax rate from 4.5% to 3.5% starting January 1, 2018.
1. Sprinkling income using a private corporation
Income sprinkling involves diverting income from a high-income individual to family members with lower personal tax rates, or who may not be taxable at all.
Jonah and Susan are neighbours living and working in Ontario. Jonah and Susan live with their spouses and children who have no significant sources of income, other than as described below. Although Jonah and Susan each earn $220,000 in 2017, Susan’s household pays about $35,000 more tax than Jonah’s household. This is because Susan earns $220,000 as an employee. As an individual with $220,000 in employment income, she pays about $79,000 in income tax for the year. Jonah has an incorporated consulting business that earns $220,000 before taxes and salary. Jonah provides the consulting services for the corporation. The corporation qualifies for the small business deduction in respect of its income from the business. Jonah owns the voting shares in the corporation. Jonah’s spouse and two children, ages 19 and 21, also own shares in the corporation, for which they paid very little. The corporation pays Jonah $100,000 in salary, and pays its remaining after-tax profits in equal amounts to the spouse and children as dividends. The dividends are taxable income of the spouse and children.
After accounting for all corporate and personal income tax, Jonah’s family pays of taxes $35,000 less than the amount of tax paid by their neighbour, Susan, on the $220,000. The government is intending to extend the tax on split income (TOSI) rules and to introduce reasonableness tests on those over 18 receiving income from a private corporation. There will be one rule for adults 18 to 24 and another for 25 or older.
2. Passive Investment Income
Corporate income is taxed at lower rates than personal income, giving businesses more money to invest in order to grow their business. But there are times when private corporations earn income beyond what is needed to re-invest and grow the business. In these cases, those who own and control a private corporation have the opportunity to hold passive investments inside the corporation. The Government is of the view that fairness and neutrality require that private corporations not be used as a personal savings vehicle for the purpose of gaining a tax advantage. Passive investments held within privately-controlled corporations should be taxed at an equivalent rate to those held outside such corporations.
When an individual holds money inside a corporation, not to invest it in growing the business, but simply to shield it from the higher personal tax rate, it is deemed to create an unfair advantage.
An employee (in Ontario) earning a salary of $300,000 and gets a bonus of $100,000 pays approximately $50,000 in taxes on the bonus while a corporation with the same income only pays $15,000. This leaves $85,000 to invest, an extra 70%.
The corporation’s owner will have to pay personal taxes upon dividend distribution, the strategy still provides the owner with a significant tax deferral advantage derived from the fact that he or she is the owner of an incorporated business—an advantage not available to most other Canadians.
If both the individual and the corporation invest their after-tax money (the individual $50,000 and the corporation $85,000) at the same interest rate the corporation would gain more than double the return on investment as the individual.
Toronto, August 31, 2017 – 35 organizations from across the country have come together to form the Coalition for Small Business Tax Fairness—a unified voice to oppose the federal government’s tax proposals that would dramatically change the way incorporated small businesses are taxed in Canada. This includes The Canadian Federation of Independent Business (CFIB), the Canadian chamber of Commerce and the Canadian Construction Association.
“These proposals, while intended to target the wealthy, will hurt middle-class business owners from every sector of the economy. These are shop owners, farmers, doctors, financial planners, homebuilders and trades in all sectors—the entrepreneurial families who are the backbone of the economy and responsible for the majority of the job creation in Canada,” said Dan Kelly, President of the Canadian Federation of Independent Business (CFIB) and member of the Coalition. “Our coming together highlights the urgency of combating these proposals which, if legislated, would signify the biggest changes to the business tax system in decades.”
As a result the government has backed down on one initiative entirely and modified one other. In addition there have been issues relating to Minister Morneau’s personal finances also that are muddying the waters.
Federal Tax Initiative Part 2
In part one of this article we gave a general overview of the government’s intentions and gave examples of how business owners benefit from tax savings and tax deferrals that are not available to employees.
I liken this by comparing my son’s job with mine. He works a 36.5-hour week, gets paid for overtime, never gets laid off or suffers reduced hours and always gets his vacation time, has a great benefits package and can retire with full pension and continuing benefits at age 55. Even if he doesn’t save a dime he will never go hungry. I have owned my own business for some 30 years and while we never went hungry we got close a couple of times. I must rely on myself for benefits, retirement funding and the other perks that my son enjoys. On the other hand, the amount of income tax I pay is at a lower marginal rate than him because I get write-offs and deferrals not available to him. That’s life and that is why so many business organizations don’t want the government taking away the advantages we have that compensate us for missing out on what many employees enjoy.
There are two tax strategies we need to explore – Income Sprinkling and Holding a passive investment portfolio inside a private corporation
At the time of writing this article our federal parliament is in recess, so we are not hearing of any changes at present. However, before they politicians took off they did some more tweaking to the process.
One major concern is that the promised details of the new regulations have not been released. The changes are expected to be effective January 1, 2018 but won’t be finalized until the 2018/9 budget is approved. So, how are we going to be able to do any tax planning for January 1 when we don’t know the details?
On December 14, just before the six-week recess the Finance Minister made some more concessions, this is even though on December 13, 2018 the Senate national finance committee said he should shelf his controversial tax plan entirely. He said there will be new exemptions for certain family situations. He reconfirmed that the effective implementation date would be January 1, 2018. He argued that dividends under the new rules will not be payable until 2019. “they will have 12 months to figure it out. We think that is entirely appropriate and consistent with past practice”, was his comment.
Income Sprinkling: Provisions to be included are new exemptions for adult family members who work at least 20 hours per week in the business and for adults 25 and over who won 10% or more of a corporation that is not a professional corporation. (A law or accounting firm or doctors’ office). Company owners aged 65 or older will be allowed to split income along the current lines of pension splitting. This would allow them to put some of their income into the hands of a spouse at a lower rate of tax. The previous strategies regarding children and family member aged 18 to 24 covered in part 1 of this article are still in play.
Likely the safest income for family members is salary that is shown on a T4. To earn a salary the person becomes an employee of the company and his or her remuneration is subject to CPP and worker compensation premiums (WSB/WCB). Check with your accountant to determine if they are subject to EI premiums.
Duties for family members can cover quite a range of activities. Normally payment for areas of work that require confidentiality or dealing with money issues can be paid at relatively high rates due to the confidential nature of the work and the risk of white collar crime. With the changes to online banking the risk of white collar crime has grown so the records need to be monitored diligently. Online banking reduces the exposure the bank faces but can increase the company exposure as sometimes passwords are given to employees who are not signatories to the bank account, or where those passwords can be accessed by unauthorized personnel. Bank account monitoring is not an activity that needs to be done from the office but can be done from a remote location. Reviewing online deposits, online payments and standing orders and payroll payments along with monitoring that statutory payments are set up accurately and in a timely manner and ensuring funding is in place to honour those commitments is a huge undertaking, many companies do not release how exposed they are. An extension of this area would also be credit card monitoring to ensure costs are coded accurately and that no personal expenses get booked to the business
Holding a passive investment portfolio inside a private corporation: This is the second area where the new tax rules are going to come into play. The current proposal is that the first $50,000 of passive income in the year would not be subject to the super tax. Thus, a company with $1 million invested at 5% would not pay additional tax.
The concern here is that businesses need to build up reserve funds for business investments and for financing lean times. Without the additional resources that this measure is destroying they won’t be able to do this.
The following is an extract from the government website (https://www.fin.gc.ca/n17/data/17-099_1-eng.asp)
The Government is moving forward with measures to limit the deferral benefits of passive investments within private corporations while:
Ensuring that investments already made by private corporations’ owners, including the future income earned from such investments, are protected. The measures will only apply on a go-forward basis;
Protecting the ability of businesses to save the funds they need for contingencies or future investments, such as the purchase of equipment, hiring and training of staff or business expansion;
Including a passive income threshold of $50,000 per year for future, go-forward investments (equivalent to $1 million in savings based on a nominal 5 per cent rate of return) to provide more flexibility for business owners to hold savings for multiple purposes, including savings that can later be used for personal benefits such as sick leave, parental leave, or retirement. There will be no tax increase on investment income below this threshold; and
Ensuring that as the Government moves forward with tax changes, incentives are maintained so that Canada’s venture capital and angel investors can continue to invest in the next generation of Canadian innovation. The Government will work with the venture capital and angel investment sectors to identify how this can be best achieved.
A question that some of my clients ask is “If my Holding Company sells its Operating Company the Holding Company will have future investments generating more than $50,000 in passive income each year, what are the tax implications of that?” And of course, I can’t say with certainty. The most likely scenario may encourage the owner not to sell.
So, here we are in early 2018 with no real clarity on how we should be doing our tax planning. This is a state of limbo that is upsetting many business owners and would-be owners. Do check with your accountants as this is an evolving process.
The contents of this article are general in nature as no official implementation had been made at time of writing.
This article is reproduced with the permission of Plumbing & HVAC Magazine and was written by Ronald Coleman.