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Disclaimer:
This material is for educational purposes only and is not intended to be
advice on any particular matter. No one should act on the basis of any
matter contained in these materials without considering appropriate
professional advice. The presenters expressly disclaim all liability in respect
of anything done or omitted to be done wholly or partly in reliance upon the
contents of these materials.
Tax Planning Using Private Corporations -
July 18, 2017:
Analysis and Discussion with FinanceOttawa, ON
Bruce BallCPA Canada,Alex LaurinC.D. Howe Institute,Jeffrey Trossman Blake, Cassels & Graydon LLP
Taxation of Investment Income
Disclaimer:
This material is for educational purposes only and is not intended to be
advice on any particular matter. No one should act on the basis of any
matter contained in these materials without considering appropriate
professional advice. The presenters expressly disclaim all liability in respect
of anything done or omitted to be done wholly or partly in reliance upon the
contents of these materials.
Tax Planning Using Private Corporations -
July 18, 2017:
Analysis and Discussion with FinanceOttawa, ON
Assessing the Policy Objectives of the Finance Proposals
3 2017 Taxation of Private Corporation Policy Conference
What is the policy objective for passive income proposal?
● To eliminate tax incentives for CCPC owners to retain “active” earnings, if
the goal is to hold “passive” investments for future personal consumption
● To eliminate a perceived “unfair” tax advantage to CCPC owners compared
to other investors
● Incentive to retain earnings fostered by low small-business income tax rate
leaving greater investment potential
● Tax “inequity” derived from partial relief of CCPC taxes on passive
investment income
Assessing the Policy Objectives
4 2017 Taxation of Private Corporation Policy Conference
Three Key Observations
1. Measured against a consumption-based tax system with progressive
rates, the current CCPC tax regime has many unobjectionable features
2. General-rate earnings (retained for future personal consumption) enjoy no
significant tax advantages, and produce a suboptimal outcome when
measured against a consumption tax baseline; small-business-rate
earnings enjoy a tax outcome pretty much on par with personal retirement
savings.
3. The proposed regime would not level the playing field: it would leave small
business owners with significantly less tax-assisted retirement saving
opportunities than available to some others.
Assessing the Policy Objectives
5 2017 Taxation of Private Corporation Policy Conference
Features of PIT Regime
● Personal Investment Income
Under comprehensive income base, both the initial capital and the investment
income are taxed. Cascading of taxes on saving encourages consumption in the
present, and distorts investment choices (housing)
Under consumption tax base, tax cascading is avoided: retirement plans, TFSA,
other registered accounts
Real-world tax systems are hybrids
Canada’s PIT operates largely on a consumption tax basis (less than 20% of
investment income accumulations are subject to tax)
Assessing the Policy Objectives
6 2017 Taxation of Private Corporation Policy Conference
Features of CCPC Regime
● CCPC Income Regime
Income spent on “active” business consumption attracts no immediate tax
Retained income used for passive investments gets partial relief
Income distributed for personal consumption attracts personal taxes
PIT/CIT integration mechanism = no double taxation
Under perfect integration, business income used for personal consumption
would be taxed on a near consumption basis
Passive investment income sourced from earnings subject to the general CIT
rate is under-integrated = higher effective tax burden on income distributed for
personal consumption
Assessing the Policy Objectives
7 2017 Taxation of Private Corporation Policy Conference
Tax Illustrations: Is the Current CPCC Regime Equitable?
Net Wealth Available for Personal Consumption after Ten Years, 2017
$100,000 Initial Gross Investment, Provincial Average, 3% Rate of Return
Assessing the Policy Objectives
Regime
Interest Dividends Capital Gains
Wealth ($) Gap Wealth ($) Gap Wealth ($) Gap
Salary IncomeTaxable Account 56,632 - 59,177 - 61,476 -
RRSP/TFSA 65,763 +16% 65,763 +11% 65,763 +7%
Current Regime:
CCPC Income
Small Bus. Rate 60,838 +7% 66,522 +12% 69,988 +14%
General Rate 56,204 -1% 60,933 +3% 63,825 +4%
Proposed Regime:
CCPC Income
Small Bus. Rate 56,068 -1% 58,324 -1% 60,937 -1%
General Rate 52,227 -8% 55,193 -7% 56,284 -8%
8 2017 Taxation of Private Corporation Policy Conference
Unequal Tax-Assisted Retirement Wealth Opportunities
Maximum Tax-Assisted Career Accumulations of Retirement Wealth
$150,000 Salary at Retirement
Assessing the Policy Objectives
Source: Pierlot and Siddiqi (2011). Actuarial valuations under standard assumptions assuming 35-year career.
9 2017 Taxation of Private Corporation Policy Conference
Leveling the Playing Field
● The proposed CCPC regime – in effect restricting business owners to
personal RRSP room to tax-effectively save for retirement – would not level
the field
● The proposed regime – if enacted – should be accompanied by a reform of
the tax-assisted retirement savings system that would equalize possibilities
● SB owners are at greater risk of insufficient RRSP room because of:
potential bankruptcy, fluctuating income, early withdrawals to fund business
● Annual income-based limits on retirement savings should be abandoned
and replaced with a uniform lifetime accumulation limit set to replicate
maximum DB accumulations
Assessing the Policy Objectives
Disclaimer:
This material is for educational purposes only and is not intended to be
advice on any particular matter. No one should act on the basis of any
matter contained in these materials without considering appropriate
professional advice. The presenters expressly disclaim all liability in respect
of anything done or omitted to be done wholly or partly in reliance upon the
contents of these materials.
Tax Planning Using Private Corporations -
July 18, 2017:
Analysis and Discussion with FinanceOttawa, ON
Implementation and Technical Issues with the Finance Proposals
11 2017 Taxation of Private Corporation Policy Conference
Outline of Proposal
Proposal would be to make refundable taxes non-refundable in certain
circumstances, as a way of promoting perceived horizontal equity between
business owners and employees
• Premise that business owners and employees are similarly situated is open to
serious debate – but that is not the purpose of this part of the discussion
• Refundable tax rates assume business owner is in top rate bracket
• not true for many small business owners, who would face significant tax increase
• this design flaw would need to be fixed
• Overall approach would result in dramatically different tax treatment of “active
income” (“AI”) and “passive income” (“PI”)
Policy Conference
12 2017 Taxation of Private Corporation Policy Conference
Outline of Proposal
• Existing distinctions in domestic rules (between AI and PI) for CCPCs serve a
much narrower purpose – stakes are much higher in proposed regime
• New system would introduce a new policy – effectively taxing the rate “gap” as if
it had been immediately distributed
• This is achieved indirectly by making currently refundable taxes non-refundable;
overall effect is to (theoretically) put owner in same position as if “gap” had been
distributed and taxed immediately; therefore, effect is to tax corporation’s capital
• New concepts needed
Policy Conference
13 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Core Definition
Distinguishing AI from PI – Basic definition of PI
• Should income from property presumptively be classified as PI?
− If so, why?
− Income from property can include economically productive activities
• Leasing/licensing of property – real/personal/intangible property –
different rules?
− Early stage software development – is that income from property?
Policy Conference
14 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Core Definition
• Is a >5 employees test appropriate?
− If so, why?
− Current “specified investment business” definition serves a narrower purpose; stakes
now much higher
− Core service providers may not be employees
− Consider equivalence rules as in old Part XI ($250K rule)
− Rules should address provision of services by employees of affiliates and
partnership structures, as in definition of “investment business” in 95(1); paragraph
(b) of “specified investment business” is unduly narrow
• This is complicated!
Policy Conference
15 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – “Excess” Passive Assets
Distinguishing AI from PI – Rules to delineate “excess” passive assets
• Rules should recognize business realities which may require seemingly
excess passive assets to be retained in corporation for good business
reasons having nothing to do with tax deferral
− Prudent cash management to plan for contingencies generally
− Retention of cash for possible identified extraordinary expenses
− Maintaining credit standing opposite bank or other creditors
Policy Conference
16 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – “Excess” Passive Assets
− Retention of cash for future acquisitions that can reasonably be
anticipated
− Retention of cash for possible future capital investment that can
reasonably be anticipated in machinery & equipment, real estate,
intangible property, R&D, etc.
− Concept needed to define what is meant by “excess” passive assets
Policy Conference
17 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – “Excess” Passive Assets
• Policy alternatives include a qualitative test or a bright-line test
− Qualitative test - what is “reasonable in the circumstances” – disputes likely
− Bright-line test could look to specific dollar thresholds and/or specific time
horizons (e.g., 36-month rule in FIE proposals – paragraph (d) of “qualifying
entity” definition in proposed subsection 94.1(1), Bill C-10, passed by House
of Commons Oct. 29/07)
− Trade-off among objectives of fairness, workability, likelihood of disputes
− This is complicated!
Policy Conference
18 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Inter-affiliate Payments
Active business income should not become “passive” just
because it is paid from one corporation to another
• For example, one company in the group may lease real or personal
property or lend money to the main operating company
• 129(6) adopts the principle that character does not change in limited
circumstances, and for the limited purpose for which it now applies
Policy Conference
19 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Inter-affiliate Payments
−129(6) requires payor and payee to be “associated” corporations
for active business income to retain its character when paid
within the group
“associated” concept pertains to the SBD, so not appropriate for
this much larger purpose
Alternatives
“affiliated”
“non-arm’s length”
Minimum 10% votes/value test, as in 95(2)(a)(ii)
Policy Conference
20 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Inter-affiliate Payments
consider other factors in designing inter-affiliate payments rule
apportionment of expenses and losses
payments involving partnerships
Policy Conference
21 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Inter-corporate Dividends
• For dividends, the “connected” test in Part IV determines whether
dividend is a “portfolio” dividend subject to 38-1/3% refundable tax
− In determining whether Part IV tax is non-refundable, is this the right
test?
− Anomalies in the “connected” test
186(2) has been interpreted as a “count-the-shares” rather than “count-
the-votes” test; corporations can be related without being connected
Unusual to require “more than 10%” rather than “10% or more”
Policy Conference
22 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Inter-corporate Dividends
− From a policy perspective, is the “connected” test really the correct test to
distinguish AI from PI?
Consider whether dividend received from non-arm’s length (but not
“connected”) corporation should be subject to permanent Part IV tax
What about dividend from arm’s length, active corporation in which investor
has (say) a 9% interest? – Part IV tax applies, but is it appropriate for that tax
to be permanent?
Discussion raises more fundamental question of what is meant by
“reinvestment in the business”
Should rules create a tax incentive for investing in affiliated, rather than
unaffiliated active businesses? Why?
There should be a coherent basis for making the distinction
Policy Conference
23 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Capital Gains
• Capital gain could arise from disposition of asset used to earn AI (“active asset”)
or PI (“passive asset”)
• Proposals would change the integration rules by denying CDA as a way to tax
the rate “gap”
− Should distinguish capital gains from dispositions of passive vs. active asset
− Capital gain from disposing of active asset is, in effect, a way of realizing the value
built up in the active business
Policy Conference
24 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Capital Gains
● Appreciation may be the result of any number of factors:
- creation or enhancement of goodwill,
- development of trade names or brands,
- discovery of a technological breakthrough,
- valuable supply or distribution agreements,
- appreciating land values,
- luck, and
- an innumerable list of other factors.
Policy Conference
25 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Capital Gains
● If and when the corporation disposes of a tangible or intangible asset used
in the business, the resulting gain does not conceptually resemble a passive
return
● Gain represents current realization of expected future cash flows
● It follows that there is a fundamental distinction between capital gains
realized from disposition of an asset used in an active business and other
capital gains (for example, from disposing of a publicly traded portfolio
investment)
Policy Conference
26 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Capital Gains
● This distinction is recognized in the foreign affiliate rules
● These rules are a good starting point for designing a new system
● These rules draw a distinction between property used in carrying on an
active business (“excluded property”) and other property
● Taxable capital gains from dispositions of excluded property are excluded
from the definition of “foreign accrual property income” (“FAPI)
Policy Conference
27 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Capital Gains
● Excluded property definition takes account of the possibility that the
disposing affiliate may dispose of an active business by selling shares of a
lower tier subsidiary
● Shares of a foreign affiliate that derive “all or substantially all” of their value
from property used in an active business are thus defined as excluded
property
● Determination of “excluded property” status of shares can be complicated in
practice
Policy Conference
28 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Capital Gains
● While foreign affiliate system was designed to achieve different legislative
objectives, it provides a good starting point
● Taxable capital gain derived from a disposition of an asset used in an active
business should be regarded as AI, and the accompanying non-taxable
portion should be added to CDA
● Treatment of such gains as passive income seems conceptually flawed
Policy Conference
29 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Capital Gains
● Rules needed to treat shares of certain corporations as excluded property
under the new regime
● 10% test similar to foreign affiliate definition makes some sense
● If private corporation realizes gain from disposing of shares of a foreign
affiliate that meet the current “excluded property” definition, taxable portion
of that gain ought to be classified as AI under the new regime and not
treated as PI
Policy Conference
30 2017 Taxation of Private Corporation Policy Conference
“Active” vs. “Passive” Income – Capital Gains
• Gains from dispositions of goodwill, trademarks and other intangibles used in a
business:
− Gain on sale would have been regarded as business income prior to recent changes
to replace ECE regime with Class 14.1
− Should those changes affect AI/PI distinction?
Policy Conference
31 2017 Taxation of Private Corporation Policy Conference
Classification of Losses
• If loss is realized, need to determine whether “active” or “passive”
− Similar to distinction between “active” losses and FAPLs in foreign affiliate rules
− Rules will be needed to track “surplus” accounts
Policy Conference
32 2017 Taxation of Private Corporation Policy Conference
Source of Capital
Income derived from capital not sourced from “lightly taxed” income is
not intended to be subject to new regime
• Premise of consultation paper is that a system is needed to distinguish:
− Capital derived from “lightly” taxed business income (income on which “should” be
subject to non-refundable corporate taxes),
from
− Capital derived from other sources (income on which should still be eligible for
refundable treatment)
Policy Conference
33 2017 Taxation of Private Corporation Policy Conference
Source of Capital
• Non-refundable corporate tax should not apply to:
− Investment income derived from capital contributed by shareholder in non-rollover
transaction
No rate “gap” – asset came in from after-tax dollars of shareholder
− Investment income derived from capital acquired by corporation through issuance of
debt/equity/other securities in non-rollover transaction (e.g., borrowing, share
offering)
No rate “gap” – asset came in from after-tax dollars of investor
− Investment income derived from capital acquired by corporation from a foreign
source dividend, interest or other payment
No rate “gap” – asset came in from foreign source
Policy Conference
34 2017 Taxation of Private Corporation Policy Conference
Source of Capital
• Need to create and track several “surplus” or similar accounts to give effect to
these principles
• Need special rules for rollovers, amalgamations, wind-ups, divisive
reorganizations
• Revisit active/passive distinction in FIE proposals and FAPI rules
• Developing coherent rules is complicated!
Policy Conference
35 2017 Taxation of Private Corporation Policy Conference
Transition
Government states that new rules will apply only “going forward”
●How to achieve this without byzantine transitional rules?
●Non-refundable taxes amount to a tax on the “capital” represented by the
rate “gap”
− Apparent ~73% “all-in” tax on investment income is designed to tax the rate “gap” as
if it had been immediately distributed
− Unless and until it is distributed, this is capital of the corporation
− elimination of refundability will erase a potential future corporate asset (the refund)
as the new system comes into effect
Policy Conference
36 2017 Taxation of Private Corporation Policy Conference
Transition
• To make changes truly prospective:
− Income derived from capital accumulated before new regime takes effect (and
income derived from that income) should not be subject to non-refundable taxes
− That capital was accumulated in a regime in which “high” taxes on private
corporations’ investment income were temporary/refundable
− Will require a determination of aggregate passive assets on “coming-into-force” date,
and tracking of “surplus” account, ordering rules, etc.
Policy Conference
37 2017 Taxation of Private Corporation Policy Conference
Scope of Application
CCPCs vs. foreign-controlled corporations
• premise of proposed regime is a Canadian resident individual owner- not true
for foreign controlled corporation
• special 10-2/3% tax already applies only to CCPCs in recognition of this basic
difference
• competitiveness issue
• would have to deal with branch tax if proposed to extend new regime to foreign-
controlled corporations
Policy Conference
38 2017 Taxation of Private Corporation Policy Conference
Reality of Under-integrated System
• If all benefits of deferral are to be eliminated, the under-integrated system
leaves those considering a new business with a heavy cost to get limited
liability, unless they plan to reinvest substantially all profits “in the business” in
perpetuity, rather than earmarking a portion of profit for future consumption at
some point
• Elective check-the-box system could help
• Fine-tune rules to mitigate under-integration, don’t just assume under-
integration away
Policy Conference
Disclaimer:
This material is for educational purposes only and is not intended to be
advice on any particular matter. No one should act on the basis of any
matter contained in these materials without considering appropriate
professional advice. The presenters expressly disclaim all liability in respect
of anything done or omitted to be done wholly or partly in reliance upon the
contents of these materials.
Tax Planning Using Private Corporations -
July 18, 2017:
Analysis and Discussion with FinanceOttawa, ON
Possible Alternatives to Finance Proposals
40 2017 Taxation of Private Corporation Policy Conference
Other Possible Alternatives
● “Check the Box” Flow Through
● Impose a Refundable Tax on Ineligible Investments?
● Repeal or Replace the Small Business Deduction?
● Increase the corporate refundable tax rate?
● Comprehensive Tax Review?
Policy Conference
41 2017 Taxation of Private Corporation Policy Conference
Check the Box Flow Through
● Integration and debate around use of tax deferral is less relevant if
shareholders can be taxed on income as a flow through
● Can set corporate and personal rates without same concern around
integration if there is a “safe harbour” for private corporation owners to pay
single level of tax at personal rate if they so choose
● A lower tax rate could be applied on business income to provide an incentive
similar to SBD (similar rule under consideration in US?)
● Seems like an approach worth study if starting a brand new tax system
● Significant transitional issues?
Policy Conference
42 2017 Taxation of Private Corporation Policy Conference
Impose a Refundable Tax on Ineligible Investments?
● Was referred in the consultation paper but dismissed
● Makes the most theoretical sense for what Finance is trying to do?
• The best way to prevent the accumulation of investment income on the tax
deferral is to prevent you from investing it in the first place?
• Works best if:
− One single source of income where after-tax use is a concern
− One good use of assets and one bad
• Would create need for complicated rules in concept and application, and would
have adverse business implications such as waiting for tax refunds when
passive assets are repurposed for business use
Policy Conference
43 2017 Taxation of Private Corporation Policy Conference
Repeal or Replace The Small Business Deduction?
● Is the Small Business Deduction the Issue?
• Using 10-Year accumulation rationale, is retaining general rate income (GRI) for
investments a significant issue if no income sprinkling/gain planning?
− Practically, any benefit provided from investing the deferral is eaten away by the
under integration on GRI and/or investment income
• Investing cash in a private corporation and earning investment income is also
not an issue (pure investment corporation, conceded in paper)
• Is after-tax SBI the only materially contentious source of investments?
• If so, would it make more sense to focus on the small business deduction?
• Following charts use Finance Table 7 assumptions with actual rates for 2017
Policy Conference
44 2017 Taxation of Private Corporation Policy Conference
10-Year Net Worth Analysis – General Rate Business Income
Policy Conference
Personally Corporation Adv./Disadv.
BC $61,110 $62,015 $905
Alberta 60,706 60,755 49
Saskatchewan 61,043 62,536 1,493
Manitoba 57,495 55,506 -1,989
Ontario 53,370 54,885 1,515
Quebec 53,658 54,575 917
New Brunswick 53,671 56,858 3,187
Nova Scotia 52,757 49,344 -3,413
PEI 56,209 55,069 -1,140
Newfoundland & Labrador 56,302 49,902 -6,400
Assumed Rates Used by Finance 57,535 60,457 2,922
45 2017 Taxation of Private Corporation Policy Conference
10-Year Net Worth Analysis – Income Eligible for the SBD
Policy Conference
Personally Corporation Advantage
BC $61,110 $65,113 $4,003
Alberta 60,706 64,555 3,849
Saskatchewan 61,043 66,485 5,442
Manitoba 57,495 61,025 3,530
Ontario 53,370 58,510 5,140
Quebec 53,658 57,549 3,891
New Brunswick 53,671 58,095 4,424
Nova Scotia 52,757 56,993 4,236
PEI 56,209 59,279 3,070
Newfoundland & Labrador 56,302 60,766 4,464
Assumed Rates Used by Finance 57,535 63,207 5,672
46 2017 Taxation of Private Corporation Policy Conference
10-Year Net Worth Analysis – Observations
● Small business income:
• Provincial numbers fairly consistent – integration on SBI generally works
• “Province of Finance” NW > All provinces other than Saskatchewan
• Average NW advantage is $4,200 – Is this significant on $100,000 of SBI?
● General Rate Income (GRI)
• Keeping GRI in a corporation and paying it out later as a dividend represents a
cost in many provinces, investing the deferral helps reduce the cost
• The integration on investment income is imperfect as well
• Unclear any changes are needed on GRI without more study?
● Results do vary based on the rate of return & type of income
Policy Conference
47 2017 Taxation of Private Corporation Policy Conference
Is the Small Business Deduction an Issue?
● Considerations and questions that could be considered:
• In terms of the growth in the number of private corporations, do we know how
much growth is directly related to reinvesting the value of the SBD in passive
assets?
• If the government deals with income sprinkling and capital gain planning, how
many taxpayers would set up private companies in the future for passive
investment tax planning purposes? Motivation often based on multiple factors?
Policy Conference
48 2017 Taxation of Private Corporation Policy Conference
Is the Small Business Deduction an Issue?
● Considerations and questions that should be considered:
• If the possibility of reinvesting the SBD saving is a concern, would amending,
replacing or just repealing the small business deduction reduce the growth of
private corporations used for passive investment tax planning purposes?
• Redesign the SBD as a more targeted tax expenditure designed to reward
economic growth, positive impact on economy and risk taking (rather than
tracking and dealing with corporations investing it)?
Policy Conference
49 2017 Taxation of Private Corporation Policy Conference
Increase the corporate refundable tax rate?
● This was action government took previously – would more of the same help?
● Issues:
• At the end of the day, the tax is returned when dividends are paid - tax deferral
was effectively invested?
• Not refunded if passive assets invested in business – punitive?
• For the same reasons discussed before, take a good look at the SBD?
Policy Conference
50 2017 Taxation of Private Corporation Policy Conference
Comprehensive Tax Review?
● Passive income proposals suggested in paper would make for a complicated
tax system and seem to assume other aspects of the tax system are
effective and should remain in place (e.g. small business deduction)
● Paper assumes aspects that are theoretically part of the system but are not
working in reality (e.g. integration)
● Ensure key drivers of the tax system make sense before adding more
complication around them?
● A review of other countries indicates what Canada is examining would be
fairly unique – blazing a trail brings risk?
● Are there better ways to deal with the key issues of concern?
Policy Conference
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