WEBINAR: What do the Recent Tax Changes mean for my business and my family?

While some of us were enjoying Canada’s abundance of parks and lakes this July, the Department of Finance and Minister Bill Morneau were busy introducing tax changes that represent the most significant changes to our tax system since the 1970s.  These changes will impact virtually every private company in Canada, as well as the retirement and estate plans of their shareholders and their families. 

In the 2017 Federal Budget, Finance announced that it would conduct a review of tax planning strategies involving private corporations and that it would introduce a consultation paper on this issue. Finance said it would review specific tax planning strategies including:

• Income splitting amongst family members using private corporations

• Converting a private corporation’s income into capital gains

• Holding a passive investment portfolio inside a private corporation.

In 2015, the government stated in its election platform that it would ensure that Canadian-controlled private corporation (CCPC) status would not be used to reduce the income tax obligations of high-income earners.

 

Here is how these changes may impact you:

Income splitting rules

The new income splitting rules are largely intended to reduce the tax benefits associated with dividend income being paid to family members of certain shareholders of private corporations.  If a shareholder has influence on a corporation (either strategic, earnings or equity influence), family members of that shareholder will be subject to additional scrutiny with respect to the income they receive from that corporation.  Family members include children of the shareholder, but also will extend to uncles, aunts, nieces and nephews.  The potential implications could be:

—   Dividends received by family members that are above what is considered “reasonable” based on the individual’s contribution of time or capital to a corporation will be taxed at the highest marginal rate

—   Current structures that involve family members participating in future growth of the corporation and eventually participating in the value derived from a sale of the business will not achieve the same benefits and results

For example, consider the Smith family.  Jane Smith started Smith Enterprises Ltd. out of her garage in Saskatoon, Saskatchewan in the seventies.  Over the years, the company has grown in size to the point where they now employ 25 people and Jane estimates the company is worth $4 million.  Jane’s husband,  Randy, was educated as a teacher, but in 1995 he retired early in order to assist Jane and raise their two children, Bobby and Sandy, who are now 30 and 28 respectively.  Several years ago, Jane restructured the share ownership so that Randy, Bobby and Sandy all have share ownership, as it was important to her that her family participate in the family business that has been such a big part of their lives.  Bobby is involved in the business as the controller, and Sandy is a teacher and does not work in the business.  They both earn $60,000 per year.    Jane appreciates how hard both of her children work, and for the last few years she has decided to pay them each a $30,000 dividend from the company to help them pay down their mortgages.  As well, Jane and Randy are each paid a dividend of $100,000 per year. 

Under the new income splitting rules, the dividends to Jane’s family will be subject to a reasonableness test.  Because Bobby works in the business, if Jane can demonstrate that the dividend is reasonable compensation for effort, the dividend will be taxed at Bobby’s marginal tax rate of 33.5%.  Sandy does not work in the business, so taking his teaching income into account, the tax rate on his dividend will be 40%.  As well, unless Randy can demonstrate a contribution to the business, his dividend will be taxed at 40% instead of a blended rate of 17.5%.    The total family tax on distributions from the company will increase by $27,500 from $48,500 to $76,000.  This will be an annual additional cost if these types of dividends are to be paid each year.  Most likely these tax savings were reinvested back into the business which means that the changes will result in lower cash flow for Jane’s business. 

The key feature of the new rules is a concept of contribution to the business.  If the shareholders cannot demonstrate and value the contribution of effort or capital with respect to the business, they will be subject to the higher tax rates. 

These rules are not simply limited to annual income distributed to the family.  When a business is sold, further limitations will limit the family members’ ability to use their lifetime capital gains exemption.  Under current rules, family members who are shareholders in the business can share the proceeds of the business with family shareholders and access each person’s capital gains exemption.  Under the proposed changes, after January 1, 2019, the capital gains exemption cannot be claimed by family members unless they are over the age of 18, and will only relate to the portion of the gain that accrued after they turned 18.  Furthermore, the amount of the exemption that can be claimed will be subject to the same reasonableness tests that apply to the dividends.  Therefore, if Smith Enterprises Ltd is sold, Bobby may be able to shelter a portion of the gain using the lifetime capital gains exemption, but Sandy will be subject to tax at the highest marginal rates.  This will increase the taxes payable by approximately $200,000 for each capital gains exemption lost.    

Conversion of dividends to capital gains

Legislation introduced in July prevents individuals from converting what would otherwise be a dividend (taxed at the highest marginal rate of 40% to 45%, depending on the province) into a capital gain (taxed between 23% and 27% at the highest marginal rate).  These changes will impact planning that could have taken place in the past by related parties who were able to take advantage of the fact that capital gains tax rates were lower than the tax on dividends. 

 These changes may have a significant impact to succession of the business and estate planning.  Consider Jane and Randy Smith’s estate plan.  When Jane and Randy pass away, the estate will pay tax on the value of Smith Enterprises Ltd.  Under the old rules, the estate, through common tax planning methods, would pay approximately 25% tax on the value of Smith Enterprises Ltd.  Under the new rules, the previous planning is not available and double taxation may apply, resulting in an overall effective tax rate which could be as high as 70%. 

Jane is also thinking about what might happen if she decides to sell the business.  Bobby is interested in taking the business over in the future or alternately the family could sell the business to a competitor.  If Jane sells her shares to an arm’s length party, she would be taxed on a capital gain, with a tax rate of 24%.  She may also be able to use her lifetime capital gains exemption to reduce that tax further.  After paying tax, she would have a little over $3 million to be invested for retirement.  If she sells her shares to Bobby, she would have to take all of the income as a dividend resulting in an effective tax rate of 40%.  Under the new rules,  she would have $600,000 less for retirement as her after-tax proceeds would be $2,400,000.    

Passive income changes

The Department of Finance has also outlined changes to the accumulation of passive investments by corporations.  The stated purpose is to ensure that shareholders and employees end up with the same amount of after tax savings personally regardless of where the investments are held.  The concern is that private companies are utilizing the benefits of tax deferral to accumulate passive investments, a benefit that is not available to employees who “get a paycheque every two weeks”.  The result of the proposed changes would be additional tax paid on investment income which could range from 57% on capital gains to 71% on interest income. 

Jane Smith would like to set aside investments in her corporation to save for her eventual retirement as well as the “rainy day” when she might require additional financing for growth or expansion, but there would be a disadvantage to her in holding passive investments in Smith Enterprises Ltd.  As well, if she was to sell all or part of the assets of the business when she retires, she would be required to liquidate Smith Enterprises Ltd.  at the time of the sale and pay the highest marginal rates or be subject to potentially higher tax rates if she does not distribute the funds and instead invests in passive investments. 

What do you need to do now?

These tax changes will have significant impact on many private companies, families of the shareholders, and succession and estate plans.  Please consult your tax advisor on how these rules will impact you.  Given the wide-reaching nature of these changes, you’ll want to study their impact and assess what actions should be taken now and before 2018. 

As part of our efforts to inform AMC members, we are offering an exclusive webinar on September 19 from 12:00 pm to 1:00 pm CST (11:00 pm to 12:00 pm MST).  To register, please contact Ty Hamil at admin@a-m-c.ca

The consultation period on these changes is open until October 2, 2017, so consider writing to your Member of Parliament, or making a submission fin.consultation.fin@canada.ca to provide your thoughts on the proposed changes.  Further information can be found on the Department of Finance webpage at http://www.fin.gc.ca/n17/17-066-eng.asp. 

 

Sarah Tkachuk, CPA, CA, FEA

Partner, KPMG Enterprise

stkachuk@kpmg.ca

Visit the KPMG Enterprise site at kpmg.ca/staycurrent