On July 18, 2017, the Department of Finance issued a discussion paper and some proposed legislation for income tax changes for private corporations. The Department of Finance accepted submissions on the proposals until October 2, 2017. They received over 21,000 written responses.
The proposed changes targeted three main areas:
- Income Sprinkling
- Holding Passive Investments Inside a Private Corporation
- Converting Income into Capital Gains. During the week of October 16, 2017, the Department of Finance issued daily news releases relating to the proposed changes.
Small Business Tax Rate Reduction
On October 16, 2017, the finance minister announced reductions in the small business income tax rate. In Saskatchewan, this rate applies to the first $500,000 of active taxable income for Canadian-controlled private corporations. The current combined federal and provincial rate in Saskatchewan is 12.5%. This will reduce to 12% on January 1, 2018 and 11% on January 1, 2019.
Capital Gains Deduction
Limiting multiplication of the capital gains deduction (CGD) with family members was initially included with the income sprinkling proposals. On October 16, 2017, the finance minister announced that it will not be moving forward with the proposed measures to limit access to the lifetime CGD.
On October 18, 2017, the finance minister announced that up to $50,000 of annual income from new passive investments would still be subject to the old rules. He also reaffirmed that past investments would be subject to the old rules. We anticipate that the new rules will be effective starting in 2018.
Under the old rules, inactive income such as interest and rent was initially taxed at a rate of 50.42%. This rate was reduced to 19.75% when dividends were paid to individuals.
Under the new rules, inactive income on new passive assets that exceeds $50,000 will be subject to the tax rate of 50.42%. However, this rate will not be reduced when dividends are paid to individuals. By the time this income has been flowed through to the individual, the combined rate of corporate and individual income tax will be approximately 70%.
Converting Income into Capital Gains
On October 19, 2017, the finance minister announced that the government will not be moving forward with the measures relating to the conversion of income into capital gains. He also indicated that the government will work with farmers, fishers and other business owners to develop proposals to better accommodate intergenerational transfers of businesses.
The initial proposals focused on two main areas. One was with respect to pipeline strategies. The other was a new anti-avoidance provision that seemed to apply to almost any disposition of property to a related private company.
Pipeline strategies are commonly used after the death of a shareholder where the shares of a private company are bequeathed to someone other than a spouse and the shares do not qualify for the CGD. On death, the shares are deemed to be disposed at fair market value. This results in a taxable capital gain. The executors must then examine alternatives to avoid double taxation on an eventual wind up of the company. Otherwise the beneficiary shareholders would be subject to taxation on a winding up dividend in addition to the taxes paid by the deceased on the deemed disposition.
One option would be to wind up the company in the first tax year of the estate. This would result in a taxable deemed dividend. However, there would also be a capital loss on the windup that could be carried back to the final return of the deceased. This eliminates double taxation. However, one has now paid income tax at dividend rates instead of capital gains rates. The highest marginal rate in Saskatchewan for dividends is 39.62% versus 23.88% for capital gains. A pipeline strategy allows the beneficiaries to retain access to the lower rate for capital gains.
The proposed anti-avoidance provision was quite broad and could have applied to many transactions. It could have applied to a farmer transferring farmland to his or her own company. That individual would have utilized the CGD to eliminate income tax at the personal level. The farmer would have received a shareholder’s loan. Payments on the loan would not be taxable to the individual. The proposed anti-avoidance provision would have taxed the amount received as a taxable dividend. The provision could also have applied to the transfer of farm partnership interests or transactions that generated a capital dividend. Capital dividends can be received tax free from the company. The proposed anti-avoidance provision could convert the capital dividend to a taxable dividend.
Where Are We Now?
Draft legislation will still be provided to parliament for two of the three original areas:
- Income Sprinkling and
- Holding Passive Investments Inside a Private Corporation.
The proposed measures to limit access to the lifetime CGD have been removed. The government will continue to address all other areas contained in the proposed changes.
Dividends paid to adult family members from a private corporation and partnership income allocations to adult family members will be subject to reasonability tests. The reasonability tests are comprised of labour contributions and capital contributions (assets contributed and risks assumed). Taxpayers will need to account for all previous returns and remuneration. The portion of the dividends or partnership income allocations that are unreasonable will be subject to income tax at the highest marginal rate. The rules will be more restrictive for family members ages 18 to 24.
The proposals have become more complex. All of the original proposals remain in place. In addition, private corporations will need to determine if the annual income from new passive assets exceeds $50,000. Income on previous passive assets is subject to the old rules. The first $50,000 of income on new passive assets is subject to the old rules. Income in excess of $50,000 on new passive assets is subject to the new rules. With regards to new passive assets one will also need to track the source of the passive asset, i.e., if it came from income subject to the general rate or low rate of tax.
The following rules will also apply to certain types of income received on new passive assets where the amounts are included in the income in excess of $50,000:
- The non-taxable portion of capital gains will not be added to the capital dividend account.
- Dividend income from publicly traded stocks will not be added to the general rate income pool (GRIP). Dividends paid from GRIP are eligible dividends that are subject to a lower rate of income tax at the individual level.
The next step for the government will be the tabling in parliament of a notice of ways and means motion to implement the proposed changes relating to income sprinkling, passive investments and the corporate income tax rate reduction. There was speculation that this may occur during today’s economic update. Hopefully the final draft legislation will be available, at the latest, within the first two weeks of November. We will provide a further update after the final draft legislation has been released.
Please contact your Stark & Marsh representative with any questions or concerns you may have.