LSUC Practice Gems:Essentials of the Privately Held
Company 2017September 25, 2017
Top 5 Tax Issues for Private
Corporations Before & After
Incorporation
James A. Fraser, Fraser Tax Law
Title should be…
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Top 5 Tax Issues for Private Corporations
After July 18, 2017
Overview: New Rules for Private
Corporations
Summary: The Proposed Changes
Expanding Tax On Split Income (“TOSI”)
Restricting access to Lifetime Capital Gains Exemption (“LCGE”)
Preventing conversion of income to capital gains (“surplus stripping”)
New regime for taxing passive income inside the corporation
New compliance obligations
Common structures affected by the Proposed Changes
Steps to take now
Considerations going forward
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Proposed Changes: Income Splitting
Income Splitting – What is it?
Structures that allow income otherwise taxed at a higher rate to
be split among individuals (typically within a family unit) taxed at
lower rates.
Income Tax Act (Canada) (“ITA”) already has robust anti-abuse
provisions to address impermissible forms of income splitting
(e.g., the “Kiddie Tax”)
However, the ITA does not currently prevent dividend
sprinkling with adult family members (18+)
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Proposed Changes: Expanding TOSI
The proposals greatly expand TOSI starting in 2018 by:
Applying the Kiddie Tax to “specified individuals”:
Adult children and other related individuals (including spouses, grandparents, siblings & in-laws, aunts/uncles, nieces/nephew)
Subjecting more types of income to the Kiddie Tax
Income on previous split income received by individuals under 25 years old
Gains on property dispositions if income from the property would otherwise be split income
Income from certain loans to corporations, partnerships or trusts
Amounts included in income because of a benefit conferred by another person
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Proposed Changes: Expanding TOSI
Exceptions to the proposed TOSI rules:
Under age 24: property is inherited from a deceased parent (or from another deceased, if full time student or disabled)
Over age 17: is it “reasonable” relative to what would have been paid by a business to an arm’s length person, having regards to:
Functions performed by the individual
Assets contributed by the individual
Risk assumed by the individual
All historical amounts already paid to the individual
Various limitations and practical difficulties with reasonableness test
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Proposed Changes: LCGE
Currently:
Canadian residents are entitled to the LCGE, presently $835,716 indexed annually, on the disposition of “qualified small business shares” and “qualified farm or fishing property”
No age restriction (subject to arm’s length requirementfor minors)
An individual beneficiary is entitled to the LCGE oncapital gains allocated by a trust provided theunderlying property qualifies
Trust structure facilitates “multiplying the LCGE”
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Proposed Changes: LCGE
Under the Proposed Changes:
No LCGE for minors or in respect of capital gains accrued
during minority
No LCGE for capital gains allocated through most trust
structures
No LCGE for capital gains if TOSI applies (i.e., capital gain
in excess of what’s “reasonable”)
New rules apply to dispositions after 2017
Special grandfathering rules for 2018
Deemed disposition election8
Proposed Changes: Surplus Stripping
Capital gains are generally taxed a lower rates than dividends
The spread between capital gain and dividend tax rates motivates transactions and structures the effectively convert what might otherwise be a dividend into a capital gain (surplus strip out of a corporation a lower tax rate)
Often referred to as “pipeline” transactions
Up to 15% tax savings
Eliminate double taxation in post-mortem context
New anti-avoidance rules against corporate surplus stripping in ITA s.
84.1 and s. 246.1
Ability to generate and take advantage of non-arm’s length “hard basis” eliminated
Deemed dividend treatment
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Proposed Changes: Passive Income
The proposals aim to remove the perceived advantage
of corporations’ ability to make passive investments with earnings subject to lower corporate tax rates compared
to what would otherwise be the case had earnings
flowed to an individual shareholder subject to higher
personal income tax rate
In Ontario, the tax deferral provided by the small business
deduction is approx. 38%.
Provides corporations with profits to grow and reinvest in the business
Also provides a larger initial pool from which to make
passive investments
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Proposed Changes: Passive Income
Finance proposes to increase the tax on corporate “passive
investments” funded from after-tax active business earnings
Reinvestment in active business assets that generally do not
produce passive investment returns (for example, inventory) are not
supposed to be affected
How to identify, track and tax passive investments and returns
thereon
Two broad approaches outlined in the proposals:
Immediate taxation proposal
Perceived as complex
Deferred taxation proposal
Estimates put effective tax rate on passive investments at 71%
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Proposed Changes: Compliance
The proposed TOSI rules are very complex
This presentation overly simplifies the proposal
Still waiting for final legislation, but based on the drafts small business owners can expect increased annual tax
compliance and planning costs
Will be a challenge for both practitioners and CRA to
interpret, implement and audit
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Structures potentially affected by the
Proposed ChangesStructures potentially affected:
Founder shares issued to both spouses or a family trust
Need to consider activity of specified individuals.
Management income splitting structures
Accounting and law firms services corporations
Hygiene structures
Interest bearing loans to related corporation;
Past family freezes where growth shares held by non-active
specified individual shareholders
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Affected Structures: Example 1
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50% 50%
Affected Structures: Example 2
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50% 50%
Affected Structures: Example 3
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Beneficiaries: Family
members including
spouse, adult children,
minor niece Freeze shares
Growth shares
Affected Structures: Example 4
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Beneficiaries: Family
members
Affected Structures: Example 5
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100% Interest
bearing
loan
Affected Structures: Example 6
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100%
***But daughter
is the primary
service provider
Steps to take now…
Identify potentially affected structures and let your clients know
Estate freezes, professional corporations, trust and partnership structures, non-active shareholders, estates
2017 is the last chance to income split/sprinkle
Current rules apply throughout 2017
New TOSI rules (if enacted) will apply starting in 2018
LCGE crystallization transactions in 2017
Revisit any post-mortem pipeline planning under consideration
The pipeline is dead unless a special carve-out is introduced
Consider whether historical transactions may affect current planning (i.e., “hard basis”, adjusted cost base)
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Considerations going forward
Wind up private corporations and family trusts?
Maybe
Depends on tax cost of doing so, competing interests (e.g., creditor-protection)
Reorganizations
Likely needed to bring existing structures into compliance
Whether to incorporate
Tax benefits won’t factor into the decisions nearly as much
LCGE still a consideration
Lower tax cost of reinvesting profits back into the active business
Asset protection purposes and if you may be able to access even one LCGE exemption and /or you will be using profits to invest back in the business and not for passive purposes.
Use of family trusts strictly for tax purposes may no longer be useful, but may still make sense for ownership and estate planning purposes
Wait and see what final legislation looks like
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Resources
Department of Finance – “Improving Fairness in the Tax System by Closing Loopholes and Addressing Tax Planning Strategies” (18 July 2017)
http://www.fin.gc.ca/n17/17-066-eng.asp
Moodys Gartner Tax Law LLP – “What do the new July 18, 2017 Canadian Private Corporation Tax Proposals Mean for You?” (29 August 2017, PPT slides)
CPA – “#Trending in Tax: Proposals Targeting Private Corporations”(12 September 2017, webinar)
Speakers: Jay Goodis, CPA, CA, Mac Kiloran, CPA, CA & Michael Goldberg
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THANK YOU!
James A. Fraser
Fraser Tax Law
2902-2300 Yonge Street
Toronto ON M4P 1E4
416.485.4414
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