tax planning using private corporations. 25 2017... · using private corporations. september 25,...

USING PRIVATE CORPORATIONS.

September 25, 2017

TAX PLANNING

Canadian Tax Foundation

Outline

• Policy context

• Historical context: current rules

• Consultations: approaches put forward for discussion

• Key questions for discussion

2Department of Finance – September 2017

Increasing Incentives for Tax Planning Using

a Private Corporation

The growing gap between corporate and personal income

tax rates since 2000 has increased rewards associated with

tax planning in a private corporation…

… Over this period, a growing share of

high-income self-employed individuals have

chosen to incorporate

Department of Finance - July 2017 3

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

2000 2002 2004 2006 2008 2010 2012 2014 2016

Federal-Provincial Tax Rates

Combined Federal-Provincial

Small Business Rate: 14.4% (2017)

Combined Federal-Provincial

General Corporate Income Tax Rate: 26.7% (2017)

Top Combined Federal-Provincial Personal Income Tax

Rate: 51.6% (2017)

37.2

percentage

point gap

(2017)

0%

1%

2%

3%

4%

5%

6%

7%

8%

2001 2003 2005 2007 2009 2011 2013

Ta

xa

ble

Active

In

co

me

/ G

DP

Trend in Taxable-Active-Income-to-GDP Ratio, by Type of Business

Canadian Controlled Private Corporations (CCPCs)

Public Corporations and Private Corporations other than CCPCs

Individuals with Self-employment Income

Integration

• Low corporate tax rates on business income are intended to provide

a tax advantage as long as income is retained for active business

reinvestments.

• Income that is paid out of a corporation as a dividend is generally

meant to be subject to the same amount of tax as income received

directly by the individual.

Corporate taxes on earnings + Personal taxes on dividends = Personal

taxes on income earned directly

• Integration issue: incentive to hold savings financed by retained

earnings within corporations to save taxes

• This issue was recognized in 1972

4Department of Finance - July 2017

Historical context: Current rules

• Current system introduced in 1972

• Refundable taxes on investment income ensure integration when

business owner uses after-tax income to finance a passive portfolio

within a corporation

• In 1972, the introduction of Part V tax ensured integration when

using retained earnings to finance a passive portfolio

• Part V tax repealed on the basis that:

• It was seen as complex

• This added complexity was believed not necessary

I believe that these small corporations which enjoy the benefit of the lower rate of tax will, in fact, use these savings to expand their businesses, to improve their technology and to create more jobs for Canadians


Consultations

• Government is seeking input on best manner to eliminate deferral

advantages going forward

• Paper lays out two broad approaches:

• Reintroduction of Part V tax, with adjustments

• Introduction of a deferred taxation model

- A deferred taxation model could take various forms, two of which are described in the paper:

• Apportionment approach

• Elective approach


Reintroduction of Part V Tax

• Imposition of an upfront tax when retained earnings are used to

acquire passive investments

• This additional tax would bridge the gap with top PIT rate

- For example, a business eligible for the small business deduction would pay a 35% additional tax at the time of acquisition of portfolio assets

• Tax refundable if later on assets are used to reinvest in the business

• Need to keep track of income streams in order to apply the appropriate amount of tax when investment assets are purchased

• Passive investment income would continue to be taxed as per

current rules


Deferred Taxation Model: Apportionment Approach

• Need to track source of financing for passive investments in order to

estimate deferral

• Affects businesses at the moment of dividend payout:

• Affects tax outcomes at the moment a dividend is paid out, rather than when an investment asset is acquired

- But in effect, same overall outcome as Part V tax

• Those saving to reinvest in their business not materially affected

• Precision in tax outcomes, tailored to various business situations


Deferred taxation model: elective approach

• Minimizes needs for tracking, in favour of proxy methods

• Default tax treatment tailored to the case of a business using

retained earnings to finance portfolio investments

• Elections available for businesses with general rate income

• Under both approaches, options to keep current tax regime available

when investments finance with savings taxed at the personal level


Key questions for discussion

• Government is seeking feedback, in particular:

• What is the best approach to tackle the issue?

• How to minimize complexity, while achieving policy objectives?

• Capital dividend account: what is the appropriate scope of the new tax regime with respect to capital gains?

• Transition issues


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

Ted Cook, Director – Tax Legislation Division Department of Finance (Canada)

Income Sprinkling and Conversion of Dividends into Capital Gains

2 2017 Taxation of Private Corporation Policy Conference

INCOME SPRINKLING


Overview

● Tax-planning arrangements under which income that would otherwise have been taxed as income of a high-income individual in the absence of the “income sprinkling” arrangement is instead taxed as income of a lower-income individual, typically a family member of the high-income individual

● The intended effect of the arrangement is to have the income subject to a lower or nil effective rate of income tax by accessing otherwise unused tax attributes of the lower-income individual

● Tax benefits from income sprinkling increase with: The difference in tax rates between the transferor and the transferee

The amount of income that can be sprinkled

The number of individuals who can receive the sprinkled income

Income Sprinkling


Example

● In base scenario, net earnings are taxable at full PIT rates in the hands of the self-employed individual

● In the scenario where the individual incorporates, the after-CIT profits are paid out as dividends to the owners of the CCPC, including the individual’s spouse and adult child

● Taxes are reduced because the spouse and adult child do not pay federal tax on the dividend income

Income Sprinkling

CCPC

Owner Owner Spouse Child

Federal CIT (10.5%) n/a $23,000 n/a n/a n/a

Provincial CIT (4.5%) n/a $10,000 n/a n/a n/a

Federal PIT $49,000 n/a $11,000 $200 $200

Provincial PIT (ON) $30,000 n/a $9,000 $500 $500

Total tax $79,000

Average tax rate 36%

$54,000

25%

Net self-employment earnings of $220,000

Net profits of $220,000

Post-CIT $187K dividend allocated60%/20%/20% among Owner, Spouse and Child

Base Scenario:Self-employed Incorporated

$112,000 $37,000 $37,000


Dividends by Age

Income Sprinkling

0

100

200

300

400

500

600

700

800

900

1,000

0 2 4 6 810

12

14

16

18

20

22

24

26

28

30

32

34

36

38

40

42

44

46

48

50

52

54

56

58

60

62

64

66

68

70

72

74

76

78

80

82

84

86

88

90

92

94

96

98

10

0

No

n-e

lig

ible

div

ide

nd

s ($

mil

lio

n)

Age

2006

2010

2014


Issue

● The use of a private corporation in particular facilitates income sprinkling

arrangements

● Income sprinkling raises a number of tax policy concerns

High income individuals able to control income and to whom it is paid can obtain

tax benefits not available to those who do not control income

Erodes tax base

Income Sprinkling


Existing Rules

● Existing rules that constrain income sprinkling Longstanding rule restricts the deduction of expenses (including salary) if amount not reasonable

Attribution rules apply to gift arrangements to redirect income back to the high-income individual

Tax on split income (TOSI) introduced in 1999

● Existing rules not fully effective in constraining sprinkling with adults Attribution rules apply to spouses, but tax planning can circumvent the rules

Limited rules to address arrangements involving other adults (such as children)

Jurisprudence has limited the effective scope of some of the rules: 1998 Neumann decision (Supreme Court of Canada)

● Some structures have been identified that seek to circumvent the TOSI rules applicable to minors

Income Sprinkling


LCGE Multiplication

● The Lifetime Capital Gains Exemption (LCGE) provides an exemption in computing

taxable income in respect of capital gains realized by individuals on the disposition

of qualified farm or fishing property (QFFP) and qualified small business

corporation shares (QSBCS)

● By having family members (or a family trust) as shareholders of the QSBC, the

LCGE limit of each family member can be accessed on a disposition of the QSBCS

● This raises a concern the individuals may be able to claim the LCGE even though

they may not have invested in, or otherwise contributed to, the business value

reflected in the capital gains from the disposition of the QSBCS

Income Sprinkling


Policy Response

Proposals to address income sprinkling

● Expand TOSI rules to Canadian resident individuals, whether minor or adult, who receive ‘split income’

● Refine ‘split income’ definition Include new categories of amounts, such as corporate debt

Income received by an individual over 17 from a corporation will only be split income if a related individual (a ‘connected individual’) has a certain measure of influence over the corporation

● Introduce a reasonableness test to determine whether split income received by an individual over 17 will be subject to the TOSI The test is more stringent for individuals between 18 and 24

Income Sprinkling


Policy Response – LCGE Multiplication

Proposals to address LCGE multiplication

● Individuals will no longer qualify for the LCGE in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual attains the age of 18 years

● The LCGE will generally not apply to the extent that a taxable capital gain from the disposition of property is included in an individual’s split income

● Subject to certain exceptions, gains that accrued during the time that property was held by a trust will no longer be eligible for the LCGE

Transitional rules would allow affected individuals to elect to realize, on a day in 2018, a capital gain in respect of eligible property by way of a deemed disposition for proceeds up to the fair market value of the property

Income Sprinkling


CONVERSION OF DIVIDENDS INTO CAPITAL GAINS


Overview

● Dividends are taxed at a higher rate than capital gains, which are only one-half taxable

● Individual shareholders can reduce their income taxes by converting corporate income (e.g., amounts that would otherwise be paid out as dividends) into capital gains

● The federal and provincial tax savings in 2016 associated with converting dividends into lower-taxed capital gains is approximately $17,500 per $100,000 of conversions of ineligible dividends (at the average/highest

provincial tax rate for ineligible dividends paid from corporate earnings taxed at the small business rate)

$11,100 per $100,000 of eligible dividends (at the average/highest provincial tax rate for eligible dividends paid from corporate earnings taxed at the 15% general rate)

Conversion of Dividends


Section 84.1 – Dividend Treatment (applicable)

● Section 84.1 addresses individual tax avoidance that can arise when an individual sells shares of a Canadian corporation to another corporation related to the individual (e.g., owned by individual, spouse, siblings, children/grandchildren)

● Such share sales could, absent section 84.1, be used to convert dividends in the hands of the individual into lower-taxed capital gains, including gains eligible for the Lifetime Capital Gains Exemption (LCGE) This is because the related corporation could pay the individual with the proceeds of a

dividend from the Canadian corporation, which the related corporation can receive tax-free because the inter-corporate dividend deduction is available

● To prevent this result, the proceeds from the share sale are treated as a taxable dividend and not as a capital gain if section 84.1 applies



Section 84.1 – Capital Gains (inapplicable)

● Section 84.1 does not apply on a sale of shares by individuals to their

children, to any other related individual, or any arm’s length person

Individuals can claim capital gains treatment – including the LCGE, where

available – on a direct sale of shares to their children

It is not necessary for section 84.1 to apply in this case because the individual

purchaser would face dividend taxation if they attempt to withdraw earnings of

the corporation



Avoidance of Section 84.1 (cont’d)

● The conversion of dividends into lower-taxed capital gains ineligible for the

LCGE benefits owners of both large and small private corporations

● Section 84.1 applies only to sales by individuals to corporations and can be

avoided



Intergenerational Business Transfers

● It is argued by some that existing section 84.1 should be loosened with

respect to the LCGE to facilitate intergenerational business transfers

● The tax policy concern regarding intergenerational business transfers is

distinguishing a genuine sale, where the children carry on the business, from

a sale that facilitates the conversion of dividends into capital gains



Policy Response

● Proposed amendment to section 84.1 to address “multi-step” planning

● Proposed introduction of a supporting anti-avoidance rule to address other

transactions that could be used to convert dividends into capital gains

● Comments sought regarding whether, and how, it would be possible to

better accommodate genuine intergenerational business transfers while still

protecting against potential abuses


Disclaimer:




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.


July 18, 2017:


Speaker name: David G. Duff Affiliation: Allard School of Law, University of British Columbia

Passive Income: Historical and Legislative Context and Comments


Background to Proposals

● long-term reductions in corporate rates (general and small business) and

recent increases in personal rates – incentive to earn and retain income in a

corporation (both for business and non-business purposes)

● lower tax on capital gains than dividends with LCGE and 50% inclusion rate

– incentive for surplus stripping

● individual unit and progressive rates – incentive for income-splitting and

multiplication of LCGE, facilitated by SCC decision in Neuman (1998),

limited scope of TOSI in section 120.4, and provincial regulatory changes



Is there a problem?

● 50% growth in CCPCs from 2001 to 2014

● substantial increase in ABI of CCPCs as a share of GDP and decrease in

self-employment income as a share of GDP

● revenue losses, efficiency/neutrality concerns, and implications for tax

fairness (horizontal and vertical equity)

● are all these tax benefits necessary to encourage small businesses?



Possible Structural Reforms

● reduce personal rates, increase corporate rates, adopt a single corporate rate,

and/or adopt a dual rate income tax with higher and progressive rates on labour

income and a lower flat rate on capital income

● repeal LCGE and increase capital gains inclusion rate to restore symmetry between

effective tax rate on capital gains and dividends

● flatten rates and/or adopt a spousal or familial unit either generally or for specific

tax benefits like the LCGE



Alternatives to Structural Reforms

● rules denying low corporate rates (and LCGE) to specific categories of taxpayers,

to income other than active business income (passive income), and/or to income

used to acquire assets not used in an active business (passive investments)

● anti-avoidance rules to prevent surplus stripping

● attribution and other rules (like the TOSI) to regulate income-splitting and

multiplication of LCGE



Rules Excluding Specific Kinds of Taxpayers

● personal services businesses (incorporated employees) excluded from SBD after

November 12, 1981

● > 5 FTE exception (arm’s length until 1984)

● additional 5% federal tax applicable after 2015 (so 33%)

● non-qualifying businesses (professional practices of accountants, dentists, lawyers,

doctors, veterinarians, chiropractors and certain services businesses) excluded

from SBD from 1979 to 1984

● Quebec approach limits SBD to primary and manufacturing businesses or

businesses with a minimum number of employees (at least 5,500 hours)



Higher Rates on Passive Income

● portfolio dividends received by private or subject corporations – refundable Part IV

tax (similar to effective tax rate on non-eligible dividends)

● investment income of a CCPC – not eligible for SBD, additional tax under section

123.3, partly refunded (but not fully integrated)

● includes income from property, income from a specified investment business [> 5 FTE

exception], and net taxable capital gains

● excludes income from property incident or pertaining to an active business or used or

held principally for the purpose of gaining or producing income from an active business

● cases generally recognize reasonable reserves for business purposes but not passive

investments for later investment in active business



Higher Rates on Income Used to Acquire Passive Investments

● refundable tax on ineligible investments – enacted in 1972 and retroactively

repealed in 1973

not “actively” considered by the Government “at the present time” due to liquidity

issues

● alternative approach: deferred taxation with no dividend refund for tax on

investment income, and tax on dividends (including dividends from the non-

taxable portion of capital gains) based on the source of the capital used to

acquire passive investments (apportionment or elective methods)

consultation on “any aspect” of possible rule to tax corporate passive income



Comments on Passive Income Proposals (1)

● deferral advantage from passive investment of retained corporate income is a

legitimate concern, particularly for high-income earners who have already maxed

out on tax-favoured savings vehicles

● deferred taxation is conceptually ingenious but not intuitively obvious and extremely

complex (particularly for CCPCs)

● refundable tax on ineligible investments is more easily understood, much less

complex, and more clearly consistent with the core purpose of the SBD to help

CCPCs grow through internal finance



Comments on Passive Income Proposals (2)

● tax on ineligible investments puts pressure on distinction between passive

investments for business purposes and passive investments for personal

wealth accumulation

passive investment to finance later expansion?

passive investment to finance parental leave?

passive investment with mixed purposes (retirement and business

emergencies)?

● consider combining a tax on ineligible investments with safe harbours or a

threshold, which might also help address liquidity issues


Disclaimer:








July 18, 2017:


Speaker name: Kevin Milligan Affiliation: Vancouver School of EconomicsUniversity of British Columbia

[email protected]

Integration and the Taxation of Passive Income: An Economic Perspective


Carter Commission V.4, p. 84

“The system would neither encourage nor

discourage the retention of earnings by

corporations.”

Integration and Passive Income: An Economic Perspective


Roadmap

• Why integration?

• Do proposals improve integration?

• How much will the changes affect businesses?

• Caveats on Implementation.



What is Integration?

● Tax at individual level should reflect tax paid at corporate level.

● Or, all paths for a $ from “profit to pocket” should bear same tax.

● Also, no financial gain from readjusting location of savings.

“The system would neither encourage nor discourage the retention of earnings

by corporations.”



Why Integration?

● Neutrality: Target is for people to make same decisions under taxation as

they would without taxation.

This is a free-market goal: business decisions based on the business merits.

This is the literal definition of economic efficiency for taxation.



Why Integration?




● Retirement savings? Maternity leaves? ‘Buffer’ savings? Saving for

investment?

These are all fine, but inside/outside firm should be a business decision.



Why Integration?




● Retirement savings? Maternity leaves? ‘Buffer’ savings? Saving for

investment?

These are all fine, but inside/outside firm should be a business decision.

● Reminder: the reason we have SBD is to facilitate investment.

Not as a place to tax-advantage savings for those with large portfolios.



Ways Current Integration Falls Short

● It’s notional: still get DTC when firm pays no tax.

Can do direct passthrough of tax bills, e.g. Taiwan; ‘franking’ in Australia

● Fed-Prov: one national gross-up rate for whole country.

● Tax-exempts like pension funds / RRSPs can’t claim DTC.

● Capital gains rate is currently too low compared to dividends/wages.

● Firms claiming SBD have ‘head-start’ deferral advantage for saving.



Does Proposal Improve Integration?

● Focus on high bracket: why?

Flat rate on passive income calibrated for high-bracket investors.

High-bracket investors more likely to have substantial passive portfolios.

● Low-mid bracket investors

Currently disadvantaged for passive saving in CCPC. This shortcoming not

addressed.

More likely to have open RRSP/TFSA room for long-term savings.




● Current system is over-integrated: favours retained earnings inside firm.

Current tax of passive income inside/outside firm is comparable…but…

But savings inside the firm get a ‘head start’ from light taxation of SBD.

● Proposed correction: remove RDTOH.

Increases tax on passive income to compensate for ‘head start’.

For a high-bracket Ontario investor, effective rate on passive income is 73%.

Excessive? Need higher rate to balance big ‘head start’ to achieve integration.




Evidence #1: Try to replicate Finance Table 7


STATUS QUO

STATUS

QUO PROPOSAL

INDIVIDUAL INSIDE CCPC

INSIDE

CCPC

ITEM RATE SAVINGS SAVINGS SAVINGS

Start with $100 of pre-corp tax active businss income 100.00 100.00 100.00

Federal SBD tax rate 10.50% 10.50 10.50 10.50

Ontario SBD tax rate 4.50% 4.50 4.50 4.50

Starting Principal 46.50 85.00 85.00

Interest at 3% 3.00% 27.29 27.29

Special tax on passive income 50.17% 13.69 13.69

RDTOH account 30.67% 8.37

Federal personal tax 33.00%

ONT personal Tax 20.53% 7.00

Portfolio value at end of 10 years 53.41 98.60 98.60

Refund of pre-paid tax RDTOH 8.37

Amount available for distribution as dividend 106.97 98.60

Taxable personal income after grossup 17.00% 125.15 115.36

Federal personal tax 33.00% 41.30 38.07

ONT personal tax 20.53% 25.69 23.68

Dividend tax credit, federal 10.52% 13.17 12.14

Dividend tax credit, ONT 4.30% 5.38 4.96

After-Tax Net Worth after 10 years 53.41 58.52 53.94



Evidence #2: Observation

● If system is currently properly integrated, there should be no advantage to

retaining earnings.

● We observe financial planners advising clients to save in CCPC for tax

savings.

http://lmgtfy.com/?q=doctors+canada+incorporation+deferral+advantage

● If system were today properly integrated, all that advice would be wrong…


http://lmgtfy.com/?q=doctors+canada+incorporation+deferral+advantage


How much will proposals matter?

● We need to keep the scale of the change in mind.

● Imagine $100,000 in passive portfolio; 5% interest.

RDTOH is 30.67%, or $1,534.

But this is taxed as non-eligible dividend at 45.30% (Ont, high bracket)

So, RDTOH is worth $838 if paid immediately.

This is <1% of principal, but knocks down rate of return.

After 10 years, could affect terminal value of portfolio by 8-15%.




● Target savings: $33,333/yr of retained earnings over 3 years @ 5% interest.

Maternity leave? Savings for new equipment?


STATUS QUO STATUS QUO PROPOSAL

PERSONAL INSIDE CCPC INSIDE CCPC

ITEM TAXABLE

Balance in RDTOH notional account at

end of Year 3 $3,118 $0

Balance in CCPC retained earnings at end

of Year 3 $0 $105,067 $105,067

No change to cash flow.

$3,118 in RDTOH notional account



● Terminal value of these savings once personal tax is paid.


PERSONAL INSIDE CCPC INSIDE CCPC

ITEM TAXABLE

Balance in RDTOH notional account at

end of Year 3 $3,118 $0

Balance in CCPC retained earnings at end

of Year 3 $0 $105,067 $105,067

Balance on personal account at end of

Year 3 $58,370 $59,189 $57,483

Status quo: CCPC beats personal by $819.

Proposal: Personal beats CCPC by $887.


Carter Commission V.4, p. 84

“The system would neither encourage nor

discourage the retention of earnings by

corporations.”



Caveats on Implementation

● Lots of important challenges await…

Transition: how the grandfathering will work.

Intercompany shareholdings; investments.

We will hear more today!

● This is serious: Need to weigh the costs and benefits of proposals.

Finance’s response: are there non-messy fixes?



Final thought

● This package is clearly a ‘patch’ on a messy system.

● Should we wait for Carter 2.0 before acting?

If we can’t have it all, should we do anything?

● I argue: no

We can all play “fantasy tax reform”….

We must also ask: does this improve on status quo?


Disclaimer:








July 18, 2017:


Jack MintzThe School of Pubiic PolicyUniversity of Calgary

Tax Planning Using Private Corporations: Passive Income


● Economic role of passive assets:

Retained earnings held in passive assets provides liquidity.

Provides equity finance for investment – investment has been shown to be

higher if firms have cash flow.

Internal resources enable better firms to separate themselves from poor quality

firms to raise equity and debt finance.

Passive assets improve credit risk.

Passive asset provides savings within the corporation for investors when

withdrawn (this is the focus of the July 18th proposals).

Passive Income Rules


Benefits of July 18th Passive Income Rules

● Intent is to improve integration of corporate and personal taxes by clawing

back deferral if active business income is invested in passive assets.

● Reduces (but does not achieve fully) neutrality between savings held inside

and outside the CCPCs by investors.

● Reduces the incentive to create CCPCs rather than sole proprietorships or

partnerships (no particular evidence provided on the size of the distortion –

U.S. studies (e.g. Austin Goolsbie suggest not large).

● Raises more revenue for government to lock-in high personal income tax

rates levied in 2015. About $23 billion of passive income is roughly 16% of

active business income (total industry passive income is 10% of operating

income).



Distortions/Complexity created by Passive Income Rules

1. Given limitations on full refundability of losses – self-employed losses can

be generally used against other personal income while losses trapped in a

company – rules lead to higher taxes on corporate risky investment.

2. Limits deferral with passive assets – creates a bias towards deferral

achieved through real assets, which could lead to sub-marginal

investments.

3. Indifference works for investors at the top rate – tax neutrality does not

approximate for CCPC owners with marginal tax rates below the top rate.

4. Passive assets for business purposes, as opposed to savings, would need

some sort of brightline test but difficult to properly do (eg. private equity

investments by venture capitalists).



Distortions/Complexity created by Passive Income Rules

5. Tax on passive income already results in a significant loss in real principal

with non-tax sheltered assets. (Bond paying 3 percent with 2 percent

inflation and 50% tax rate as real return of -0.5%).

6. Private companies becoming public or non-CCPC could avoid passive

income rules – leads to a new distortion with respect to ownership.

7. Rules are exceedingly complex especially with allocation method.

8. Few countries follow Canadian rules – potential loss in tax competitiveness

especially relative to the United States.



Canada’s Tax on Small Business not Competitive


0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

$1M $2M $3M $4M $5M $6M $7M $8M $9M $10M $11M $12M $13M $14M $15M $16M $38M $39M $40M

Marg

inal E

ffecti

ve T

ax R

ate

Size of Capital (CAD$ Million)

Canada Small Business Entrepreneur USA Entrepreneur (S Corporation) USA Entrepreneur (Small Business)


A Better Approach

● To reduce distortions and complexity as well as encourage growth:

Consider an election to pass income of corporation to owner (egU.S. sub-chapter S

corporations)

Removes the distinction between passive and active business income.

Reduces distinction between self-employed income and private corporate income.

Treats losses similarly to self-employed income and therefore risk.

Would eliminate benefit (if any left) of small business deduction. IIntroduce

investment and employment tax credits instead to encourage investment.

Given small business deduction is of little value with integration, move to single

corporate income tax rate and dividend tax credit. Equalize capital gains and dividend

tax rates.


Disclaimer:








July 18, 2017:


Bruce BallCPA Canada,Alex LaurinC.D. Howe Institute,Jeffrey Trossman Blake, Cassels & Graydon LLP

Taxation of Investment Income

Disclaimer:








July 18, 2017:


Assessing the Policy Objectives of the Finance Proposals


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


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.



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)



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



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


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%


Unequal Tax-Assisted Retirement Wealth Opportunities

Maximum Tax-Assisted Career Accumulations of Retirement Wealth

$150,000 Salary at Retirement


Source: Pierlot and Siddiqi (2011). Actuarial valuations under standard assumptions assuming 35-year career.


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


Disclaimer:








July 18, 2017:


Implementation and Technical Issues with the Finance Proposals


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


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


“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


“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


“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



− 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



• 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


“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



−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



consider other factors in designing inter-affiliate payments rule

apportionment of expenses and losses

payments involving partnerships

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


“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


“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



● 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



● 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



● 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



● 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



● 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



● 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



• 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


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


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


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


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


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


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


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


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:








July 18, 2017:


Possible Alternatives to Finance Proposals


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


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


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


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


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


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


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


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


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


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


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

Disclaimer:








July 18, 2017:


Sandra MahDLA Piper (Canada) LLP

H. Michael DolsonFelesky Flynn LLP

Taxation of Investment Income: Practitioner Perspectives on Proposals and Potential Issues

2 2017 Taxation of Private Corporations Policy Conference

Syllabus

● Policy issues

● Anticipated legislative issues

● Anticipated behavioural response and real-world results

Practitioner Perspectives


Policy Issues

● Intergenerational equity issue:

Proposed changes level playing field within some cohorts, not between them

Even intra-cohort levelling may be superficial

Cascading gender equity and racial equity implications

Cascading vertical equity implications



Policy Issues

● If tax policy objective is to prevent tax-motivated incorporation, entire

package may be a poorly targeted solution

Similar to issues with continued approach to PSB corporations

For many incorporated services businesses, incorporation is payer’s choice

Significant non-neutrality due to payroll taxes and provincial laws

Benefits disproportionately enjoyed by payers:

Consider employees vs. contractors in Calgary 2015-16

Payers advertise purported tax benefits to workers so workers don’t revolt

● Admittedly less of an issue for professionals

● Is this policy negatively affecting how CCPCs will finance their businesses



Policy Issues

● Foreign solutions to this problem do not seem to have been considered

Some may be better or worse than what is proposed, but should be canvassed

● Example: Netherlands minimum salary regime

Corporation must pay controlling shareholder wages equal to the lesser of:

Greater of (i) €45,000; and (ii) 75% of corporation’s pre-wage taxable income; and

Proven wages of a similarly-skilled worker

75% requirement inapplicable if shareholder generated <90% of profit

If shareholder is underpaid, imputed employment income plus penalty

● Might satisfactorily address passive income and income splitting issues,

while potentially being simpler



Policy Issues

● Is the small business deduction still viable?

Are the significant recent efforts to preserve integrity worth the effort?

● Is integration still good tax policy?

Proposed regime represents significant departure from integration principle

Apportionment method might achieve integration over long horizon using Milligan’s

assumptions, but that is not what integration has historically been about



Legislative Issues

● Finance is probably downplaying the complexity of the apportionment

method for passive income

Likely end result will be something similar to a domestic equivalent of the FA

surplus rules, in order to prevent chicanery

Not clear how loans (for shareholder or inter-corporate) would factor in

Not clear how losses will be allocated or tracked

Not clear if assets can change status from passive to active

Not clear how dividends will be paid



Legislative Issues

● Elective method requires assumptions too simplistic to work in practice

Why is it reasonable to assume that shareholder contributions are not used to

make passive investments?

What if SBD-electing corporation earns $600,000 of income?

What if corporation is unsure whether or not its income qualifies for the SBD?

Real problem for potential PSB corporations or potential SIB corporations

Extreme unfairness if workers are not causing PSB proliferation

● Here, the benefits of simplicity are illusory given the complexity of transition



Legislative Issues

● Proposed regime will place considerable pressure on both bright-line tests

and common-law tests relating to active vs. passive income

Considerable additional tax wedge between ≤5 full-time employees and >5 full-

time employees for, say, property rental businesses

Likely to encounter Ensite-type litigation surrounding use or risking of income-

producing properties in active business

Incentive for characterizing two potentially separate businesses (e.g. real estate

development and real estate leasing) as a single business



Legislative Issues

● Will capital gains realized on disposition of business assets/goodwill

continue to generate CDA?

White Paper suggests not, if source of gain is reinvested corporate income

This seems to be an improper result



Legislative Issues

● “Control” is too high a threshold for an investment in another corporation to

generate a CDA-increasing capital gain

Creates punitive result if two or more arm’s length corporations go into business

More realistic threshold required, along the lines of FA status

● “Exclusively” is an unattainable threshold for subsidiary’s investment in

business assets

More realistic threshold would resemble the QSBC share test

● Other circumstances may exist where capital gains should generate CDA



Legislative Issues

● Important aspects of proposed regimes lack sufficient detail to provide

meaningful comment:

Is the election one time or for each fiscal year for the Elective Method?

Potential limited use of election - only those corporations that have significant

passive investment or immaterial passive investments

Investment corporation election

Effects of election if made by existing corporation, and timing and types of transfer

that will result in transfer tax

How will grandfathering be accomplished?

Will it phase out over time?

Care will have to be taken to avoid capital lock-in effect



Legislative Issues

● Extension of regime to non-CCPCs may have unintended negative effects

Private corporations used by non-residents to make investments in Canada

No tax policy reason to be concerned about deferred personal income, Canada

can’t tax that income anyway

Extension of regime without caution would materially increase effective tax rate,

decrease foreign investment in Canada

But increased tax cost would largely be payable to foreign governments

Canadian tax revenues could be less than under current regime

● Better idea would be to limit extended regime to private corporations

controlled by Canadian residents



Legislative Issues

● Non-refundable tax rate is likely too high

Assumes CCPC shareholders in top income bracket

Others have provided calculations demonstrating effect on lower bracket

taxpayers

Consider tax consequences for minority shareholders

● Assumption that all persons with CCPC investment income are top rate

taxpayers is not sound

There are reasons to hold investments in a CCPC rather than RRSP/TFSA, so

not simply people who have maxed out contributions

For example, may wish to invest in real estate or a non-eligible small business

Increases the number of taxpayers subject to tax beyond the top income bracket



Taxpayer Responses



Taxpayer Responses

● Considerable uncertainty going forward

Clients anticipate CPC will promise to repeal anything that is enacted

Preservation of existing regime for grandfathering, etc., and limited short-term

revenue impact means promise is credible

● Rate and rule change fatigue

Changes to subsection 55(2) and SBD rules still being processed

Federal rate increases plus Alberta rate increases

Considerable anger and willingness to be very aggressive



Taxpayer Responses

● If taxpayers believe rules will eventually be repealed, easy options to defer

income or mitigate impact until expected repeal:

Invest in non-income producing investment properties (i.e. Amazon.com shares)

that will generate capital gains at an undetermined future time

FA-based options

Use business profits to pay down debts instead of saving



Taxpayer Responses

● Clients can avoid proposed rules by making riskier investments:

Without CDA, no disincentive to engage in adventure or concern in the nature of

trade, especially since no passive income generated

House “flipping” or development versus proven commercial rental properties

Working interests in oil & gas properties

Financing leases for tangible personal property

Reinvest in business or invest in other business to non-advisable extent

Significant tax distortion between business and passive investment opportunities

with same pre-tax rate of return



Taxpayer Responses

● Numerous other techniques to defeat rules, for example:

Buy-bump or buy-bump-sell transactions for shareholders of corporations with

significant accrued gains on capital assets

Invest in widely-held, non-SIFT partnerships to earn business income

● More aggressive options obviously exist



Questions?


Disclaimer:








July 18, 2017:


Speakers: Albert Baker (moderator), David Christian, Michael Wolfson, Rachel Gervais

September 25, 2017

INCOME SPRINKLING PANEL

Disclaimer:








July 18, 2017:


Speaker name: David ChristianCompany: Thorsteinssons, LLP

INCOME SPLITTING –BACKGROUND AND HISTORY


INCOME SPLITTING - BACKGROUND

● There is no general policy in the Income Tax Act (Canada) that prevents

income splitting – Neuman v. The Queen, 98 DTC 6297 (SCC)

● However, the Income Tax Act (Canada) has always contained anti-

avoidance rules relating to income splitting



● Income War Tax Act

No specifically defined attribution rules. Subsection 4(4) read:

A person who, after the first day of August, 1917, has reduced his income by the transfer or assignment

of any real or personal, movable or immovable property, to such person's wife or husband, as the case

may be, or to any member of the family of such person, shall, nevertheless, be liable to be taxed as if

such transfer or assignment had not been made, unless the Minister is satisfied that such transfer or

assignment was not made for the purpose of evading the taxes imposed under this Act or any part

thereof.



● By the time of tax reform in 1970, the rules had evolved into a more familiar

form:

Attribution of income from property transferred to a spouse or to a person under

19

Both attribution rules applied while transferor alive and resident in Canada

No attribution of business income, income from loaned property, or second-

generation income



Denial of deduction of salary paid by a spouse to a spouse (no inclusion to

recipient, so no double taxation)

Similar rule for remuneration by a partnership in which a spouse is a partner

Rule that gave discretion to Minister to allocate income of a spousal partnership

to one spouse alone

Attribution rule for transfer of rights to income



● Post-tax reform: the modern attribution rules take shape:

Attribution of income and gains from property transferred to spouse

Retention of rules on remuneration of spouses, including partnerships (later

replaced by subsection 103(1.1))

Attribution of income from property transferred to spouse



Attribution of income, but not gains, from property transferred to a person under

18

No attribution of business income, income from loaned property, or second-

generation income

No corporate attribution – passive income can be split by transfer to a

corporation in which spouse or minor holds a share interest

Transfers of rights to income taxable: see subsections 56(2) and (4)



● Expansion of the attribution rules – 1985 Budget

“[Income splitting] was easy, efficient, and anomalous....What was a tolerated

tax-planning device soon became an industry, and like all other tax-planning

industries, it became a perceived menace to the Department of Finance that

had to be erased….As seems to be the case recently with so many legislative

amendments that try to erase a simple planning technique, the amendments

introduced complexities and difficulties that far outweighed the menace they

were intended to cure.”

Samuel Minzberg, 1986 CTF National Tax Conference



● After the 1985 Federal Budget the “modern” form of the attribution rules is

introduced:

Attribution of income and gains from property transferred to spouses, and of

income from property transferred to minor children and nieces and nephews

Specific trust attribution rules

The introduction of the corporate attribution rule

Attribution of income from loaned property unless a commercial rate of interest

paid

No attribution of business income or second-generation income



● The effect of subsection 56(2)

The Minister of National Revenue attempted to apply subsection 56(2) of the

Income Tax Act (Canada) to discretionary dividends paid on shares

Result was the McClurg and Neuman cases at the Supreme Court of Canada,

which found subsection 56(2) did not apply to dividends, regardless of

contribution - or lack of it – by the shareholder receiving the dividend



● Reaction to Neuman: the kiddie tax

Commencing in 2000, section 120.4 imposed an effective prohibition on splitting

income with minors by imposing the top marginal tax rate on “split income”

received by the minor.

The kiddie tax broke with prior models by taxing split income at the top marginal

rate to the recipient, and making a parent jointly and severally liable with the

minor for the tax, rather than attributing the income to where it was “supposed”

to go

Effect of kiddie tax: eliminate incentive to split income with minors



● Later developments:

Pension income splitting permitted for 2013 and subsequent years

The “family tax cut”, which permitted splitting of income by all taxpayers,

implemented for 2014, was repealed after 2015 by the new government

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Speaker name: Michael WolfsonCompany: University of Ottawa

CCPCs and Income Sprinkling: (Some of) the Numbers


Acknowledgements

● Social Sciences and Humanities Research Council -- funding

● Statistics Canada – data assembly and front-line analysis

● Neil Brooks, Mike Veall, Scott Legree, Brian Murphy – co-authors

● Canadian Tax Journal – editorial and peer review

● Disclaimer – my own views; full responsibility rests with Michael Wolfson


How the Empirical Analysis Was Done

T2S50

Share

Owners T2s &

GIFIs for

CCPCs

T1s

Individuals

& Families

T4s

T5s

Increment in

Retained Earnings

“Full

Income”

etc.

• all data linked and analyzed

within Statistics Canada’s

secure environment

• challenging record linkages

• GIFI data “calendarized”

• unable to link trusts

• no data on share

ownerships < 10%, nor on

voting control

• only family members living

at same address

• ⇒ under-estimates re

sprinkling?


Percentage of filers with over 10% ownership shares in at least one

CCPC, 2001 to 2011, by total T1 income deciles and top groups

Decile 1 < 5,800

Decile 2 < 11,900

Decile 3 < 16,900

Decile 4 < 21,700

Decile 5 < 27,500

Decile 6 < 34,100

Decile 7 < 41,500

Decile 8 < 51,600

Decile 9 < 68,800

P90-95 < 86,700

P95-99 < 163,300

Next 0.9 < 577,000

Next 0.09 < 2,305,700

Top 0.01 ≥ 2,305,700


Number of CCPCs directly owned by owners, by total T1

income group, 2011Decile 1 < 5,800

Decile 2 < 11,900

Decile 3 < 16,900

Decile 4 < 21,700

Decile 5 < 27,500

Decile 6 < 34,100

Decile 7 < 41,500

Decile 8 < 51,600

Decile 9 < 68,800

P90-95 < 86,700

P95-99 < 163,300

Next 0.9 < 577,000

Next 0.09 < 2,305,700

Top 0.01 ≥ 2,305,700


Complexity of CCPC ownership: Maximum number of

levels of ownership, by total T1 income group, 2011

Decile 1 < 5,800

Decile 2 < 11,900

Decile 3 < 16,900

Decile 4 < 21,700

Decile 5 < 27,500

Decile 6 < 34,100

Decile 7 < 41,500

Decile 8 < 51,600

Decile 9 < 68,800

P90-95 < 86,700

P95-99 < 163,300

Next 0.9 < 577,000

Next 0.09 < 2,305,700

Top 0.01 ≥ 2,305,700


Trend Effects of Including CCPC Undistributed Income in

the Measurement of Income Inequality


Average Amounts of Directly Owned CCPC Income by (After-

Tax + Capital Gains + Direct CCPC) Income Quantile, 2011


Income Sprinkling: Widely Disseminated Advice“Small business owners who employ family members for income-sharing purposes

need to pay a reasonable salary, and be able to show the paperwork behind the

pay. But what’s reasonable? . . .Unfortunately, the CRA doesn’t have a hard and fast

rule for what’s deemed an acceptable salary. But if you pay the family member what

you would pay a typical employee, the CRA would have little reason to discount the

deduction. To determine a realistic wage isn’t difficult, though. Career websites list

average wages for jobs in numerous industries. According to the federal

government’s Job Bank site, the median hourly wage for an office clerk is $18 an

hour, for instance, although the site indicates you could go as high as $28 and still

be in the right ballpark.” Kira Vermond, “One Way To Reduce Small-Business

Taxes: Income-Splitting,” Globe and Mail, Monday, May 4, 2015

(www.theglobeandmail.com/report-on-business/small-business/sb-tools/one-way-to-

reduce-small-business-taxes-income-splitting/article24207847/).


quote from

2005 ON

budget

(page 159)


Numbers of CCPCs by Industrial Classification

Restaurants Lawyers Doctors


3.47 Evaluation requirements for direct program spending. Direct program

spending is subject to …. (evaluation) over a five-year cycle. The policy defines

evaluation as the systematic collection and analysis of evidence on the

outcomes of programs to make judgments about their relevance, performance,

and alternative ways to deliver them or to achieve the same results.

3.48 Evaluation requirements for tax-based expenditures. …the policy

requirement to evaluate programs does not apply to tax-based expenditures.

3.77 Conclusion … overall we concluded that the Department fell short on

managing tax-based expenditures. We reached this conclusion because these

expenditures were not systematically evaluated and the information reported

did not adequately support parliamentary oversight.

Spring 2015 Report 3 on “Tax-Based Expenditures”

http://www.oag-bvg.gc.ca/internet/English/parl_oag_201504_03_e_40349.html

http://www.oag-bvg.gc.ca/internet/English/parl_oag_201504_03_e_40349.html


Incomes of Individuals Working in the “Offices of Doctors”

● n.b. these incomes are

after subtracting salaries

and office expenses paid

by the “Offices”, both

CCPCs and self-employed

● there were over 7,500

doctors in 2011 receiving

more that $350,000 on their

T1s

● doctors owning CCPCs had

much more total family

income

● not yet known how much

was from “sprinkling”

Numbers of Doctors by Individual Income and Ownership of a Private Company

Income ($000s) Reported on Individual Income Tax Returns

$100-$200 $200-$350 $350-$500 > $500 > $100

Does not Own a CCPC 10,050 8,120 2,750 960 21,880

Owns a CCPC 18,300 8,110 2,480 1,390 30,280

Totals 28,350 16,230 5,230 2,350 52,160

Average Family Incomes ($000s) of Doctors and

Their Immediate Families Plus Income Retained in a CCPC

Income ($000s) Reported on Individual Income Tax Returns Income ($000s) Reported on Individual Income Tax Returns

$100-$200 $200-$350 $350-$500 > $500

Does not Own a CCPC 240 337 483 730

Owns a CCPC 378 498 673 1,402


Between $1,996 and $4,600 of private income, GIS benefits reduce at its regular rate of 50% (GAINS is gone and the new top up hasn’t begun to reduce)

Between $4,600 and $8,400 in private income, GIS benefits reduce at a rate of roughly 92% (50% for the regular GIS benefit + 42% for the increased GIS top-up which reduces within this zone)

For the first $1,996 of private income, benefits reduce at 100%(50% for regular GIS + 50% for GAINS). This is the same as before.

After $8,400 of private income, GIS benefits again reduce at a rate of 50% (The top-up is completely gone)

Compare

Effective

Income Tax

Rates for Low

Income

Seniors, the

“Poverty Trap”

from 50 to

100% (and

higher)


Concluding Comments

● first time: shining a statistical light into a dark corner of Canada’s income tax

this kind of analysis is not easy, but as concluded by the AG, it needs to be done,

done well, and made available to Parliament and the public on a regular basis

● CCPCs are widely used especially among those with the highest incomes

● income sprinkling appears to involve a significant (individual + corporate) income tax

revenue cost, possibly on the order of at least $500 million per year

it is horizontally inequitable = unfair

it induces an important non-neutrality in the tax system, thereby encouraging non-

productive tax planning costs in addition to its revenue costs

● while powerful vested interests complain loudly about having to pay tax at top rates as

high as 50%, hundreds of thousands of Canada’s seniors face much higher effective

income tax rates, and no one seems to care

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Speaker name: Rachel Gervais Company: BDO Canada LLP

Income Splitting –Technical Summary of Proposed Legislation


Tax on Split Income (TOSI)

Applies by virtue of S.120.4(2) “Specified Individual”* will be subject to the top personal tax rate for the year on the individual’s “Split

Income”* for the year

Proposals extend rules to apply to all Canadian resident individuals who

included in income certain amounts that are derived from a business that is, or

was, sufficiently linked to a related individual who is resident in Canada

Proposals apply to minors and adult family members

To apply the new rules, must consider new or modified definitions, new

reasonableness tests for certain types of income of individuals 18 years of age

and older, and anti-avoidance rules * Revised definitions under S. 120.4(1) of the Act


Revised Definition of “Specified Individual” – S. 120.4(1)

Age Current TOSI Proposed TOSI

Under age 18

(minor)

• Canadian resident

throughout the year

• Parent resident in

Canada at any time

during the year

• At no time in the year

was a non-resident

Canadian resident at end of the year*

At any time during the year either:

• Parent resides in Canada, or

• A related individual resides in Canada, and the minor receives certain income

derived from a business of that related individual

Age 18 or older

(adult)

Not applicable Canadian resident at end of the year*

At any time during the year a related individual resides in Canada, and the adult

receives certain income derived from a business of that related individual.

* Where individual dies in the year, Canadian resident immediately before death

Note: for purposes of the proposed rules, related person is extended to include aunts, uncles, nieces or nephews


New definition of “Connected Individual” – S.120.4(1)

Sets out factors applicable when considering the degree of connectivity between an

individual and a corporation relevant for:

Definition of specified individual in determining whether a business is sufficiently linked to a related

individual, when looking at whether income is derived from that business

Definitions of split income (income from indebtedness under para. (d) of the definition of split income),

related source, and split portion (i.e. for the purposes of applying the reasonableness test under

Subparagraph (b)(ii) of the definition of split portion)

A connected individual in respect of a corporation includes an individual resident in

Canada who can be shown to meet any of the following conditions set out in paragraphs

(a) through (d) of the definition:a) Strategic influence

b) Equity influence

c) Earnings influence

d) Investment influence


“Specified Individual” - Example

● Facts:

Mr. and Mrs. X

X Corp. incorporated in 1990. Upon incorporation, Mr. and Mrs. X each subscribed for 50% of the common

shares of X Corp for a nominal amount.

Mr. X was never active in the business and worked part-time for another employer while spending a significant

amount of time caring for their child X Jr.

Mrs. X ran the business and its value grew considerably

X Jr. became involved in the business and by 2016, was running the business by himself.

In early 2016, the X family undertook a standard “freeze” for X. Corp – Mr. and Mrs. X each exchanged their

common shares for fixed value, redeemable and retractable preferred shares with an aggregate redemption

value of $4M. X Jr. subscribed for all the newly issued common shares of X Corp. for a nominal amount

Plan was for each of Mr. and Mrs. X to receive approximately $100K of dividends annually by way of share

redemptions of their preferred shares throughout retirement – Standard “Wasting Freeze”

This $200K would represent the majority of Mr. and Mrs. X’s annual retirement income. They will also receive

Canada Pension Plan payments.


“Specified Individual” - Example

● Analysis under proposed TOSI rules:

Both Mr. and Mrs. X will be “Specified Individuals”

Related individual (X Jr.) resides in Canada and Mr. and Mrs. X receive income (dividends)

derived from a business carried on by corporation of which X Jr. is a specified shareholder.*

All dividends received by way of share redemption by Mr. and Mrs. X may be subject to TOSI

Mr. X – Clearly subject to TOSI on dividends as he was never active in the business at all

Mrs. X – Possibly subject to TOSI on dividends – Will depend on reasonableness test

discussed later – i.e. What is reasonable given Mrs. X’s past contributions to X Corp and past

compensation prior to retirement?

* X Jr. would also meet the criteria outlined in the proposed new definition of “connected individual” contained in S.120.4(1) which

may be relevant if the fact pattern was different and X. Jr was not a specified shareholder as defined in S. 248(1)


“Specified Individual” – Discussion of Example

● Becoming specified individuals will reduce Mr. and Mrs. X’s retirement income significantly –

Planning was implemented assuming marginal rates on share redemption dividends. Now

potentially subject to highest marginal rate on every dollar received

● Retroactive Taxation? - $4M of preferred share value accumulated prior to 2017.

Appropriate to now tax all that value at highest marginal rates?

● How will X Corp’s cash flow be impacted? – Will now require significantly more cash to give

Mr. and Mrs. X equivalent amounts of retirement income as planned.

● How much time and money will X Corp./X family need to spend to justify reasonableness of

Mrs. X’s dividends? – How much money did she draw in the past?

● What happens on death if Mr. and Mrs. X pass away with unredeemed preferred shares

outstanding? – Could entire remaining value be taxed at dividend rates? – See proposed

S.120.4(4) – More facts would be required to answer this question


Revised Definition of “Split Income” – S. 120.4(1)

Category Current TOSI Proposed TOSI

Private company taxable dividends, S.15 shareholder

benefits

Paragraph (a) Paragraph (a) – no change

Business income from a partnership Paragraph (b) Paragraph (b) – change for “related source” definition

Business income from a trust Paragraph (c) Paragraph (c) – change for “related source” definition

Income from indebtedness Not applicable Paragraph (d) – new

Taxable capital gains and income from the

disposition of certain property

Not applicable Paragraph (e) – new

Section 246 amounts (conferred benefits) Not applicable Paragraph (f) – new

Reinvested – split income, income subject to the

attribution rules and capital dividends where certain

conditions met (for individuals under the age of 25)

Not applicable Paragraph (g) - new


New Definition – “Split Portion” – S. 120.4(1)

For a specified individual who is 18 years of age or older, it will generally be necessary to determine if there is a “split

portion” of the amount of their split income. Only the “split portion” will be subject to TOSI (subject to the anti-

avoidance rule under S. 120.4(1.1)(d))

Category of split income Paragraph of the definition Reasonableness Test

Amounts under paragraph (g) of split

income – of individuals under the age of 25

Paragraph (a) No

All amounts of split income, except those

covered in paragraphs (e) and (g) of that

definition

Paragraph (b) Yes*

Amounts under paragraph (e) of split

income – taxable capital gains and income

from the disposition of certain property

Paragraph (c) Yes**

* Based on contribution factors (arm’s length view) and what has been paid/payable. Must also consider anti-avoidance rules, restriction rules for 18 – 24,

deeming rule for inherited property (S.120.4(1.1)(e)(ii) and (iii))

** Test requires consideration of whether certain income from the property would be considered split income


Example – “Split Income” – Paragraph (e)

● Facts

Mr. A owns 60% of the common shares of A. Corp. He runs the business independently

The other 40% of the common shares are owned by Mr. A’s uncle (age 50) who

contributed $40,000 to subscribe for share capital when A. Corp was incorporated.

There was no intention to income split with Mr. A’s uncle, he was simply a source of

start-up capital. Mr. A’s uncle is not (and never was) involved in the management of the

business

The shares of A. Corp are being sold by the current shareholders after 2017 to arm’s

length purchasers. A capital gain will be realized upon sale by each of the current

shareholders.

None of the shareholders have ever received any dividends on the common shares


Example – “Split Income” – Paragraph (e)

● Is Uncle’s gain on the disposition of shares subject to TOSI?

Uncle is a “specified individual” in respect of A. Corp’s business

Resident in Canada

Related to Mr. A (Proposed S. 120.4(1.1) – uncles and nephews are related)

Business of A. Corp is carried on by Mr. A. and Mr. A is a specified shareholder* of A. Corp.

Uncle’s gain on the disposition is included in Paragraph (e) of the definition of “split income” Uncle is a “specified individual”

Uncle has a taxable capital gain from the disposition of property

The property is a share of the capital stock of a corporation which is not a public company or mutual fund corporation

Would paragraph (c) of the “split portion” definition exclude this gain from TOSI?

Appears as though we would need to determine if the capital gain would have been included in split income had it been

received as an amount included in Paragraphs (a) – (d) of the definition of “split income” (i.e. as a dividend, business

income or income from indebtedness)

How can we answer this? Does the reasonableness test apply? If so, what would be reasonable given Uncle’s original $40,000

contribution?

* Also a connected individual however not relevant given particular fact pattern


“Split Income” – Paragraph (e) – Discussion of Example

● If the gain is subject to TOSI:

Why should Uncle’s gain be treated differently than that of an arm’s length investor? He

was simply a source of start-up financing who happened to be Mr. A’s Uncle – No

income splitting intention

What if Uncle wanted to claim LCGE on his gain realized? No longer available under

proposed rules to constrain LCGE multiplication*

What if Mr. A. wanted to increase his interest in the company and purchase his Uncle’s

shares? – If gain subject to TOSI, would gain be taxed at dividend rates? – If proposed

Section 120.4(4) applies, gain would be taxed as a non-eligible dividend

* Assumes no election made to crystallize LCGE under proposed S. 110.6(18)


Constraining the Capital Gains Exemption

Background

The government is particularly concerned that the current LCGE rules can be

used to “multiply” the LCGE so that it is available to family members who are not

involved in the business

The government:

views that these individuals may not have effectively contributed to the business;

is also concerned about the use of family trusts, primarily those that are

discretionary, to allocate capital gains and income among family members



New Restrictions on Minors

Proposed age limit so that minors will no longer qualify for the LCGE in respect

of capital gains that are realized, or that accrue

LCGE will no longer be available to minors regardless of whether the child is

involved in the business

If minor acquires qualifying property and disposes of it when they are an adult,

the increase in the value of the property during the time the individual was a

minor will not be eligible for the LCGE

It may be necessary to have a valuation of the shares completed at the beginning of the

taxation year in which the minor turns 18 years old



Tying the use of the LCGE to the new TOSI Rules

• Proposals provide that the LCGE will generally not apply if the taxable capital

gain arising from a disposition is included in an individual’s split income

• If an amount is not included in TOSI only because the recipient of the income

is already taxed at the top marginal tax rate, restriction on LCGE can apply

• If a taxable capital gain (TCG) from the disposition of a property is included

in individual’s split income, then the amount that the individual can deduct

under the LCGE in computing the TCG is reduced by 2 times the amount of

the TCG included in computing the individual’s split income



How Property in Trusts is Affected

• New limits for beneficiaries of a trust from claiming any LCGE on dispositions

• In order for an associated gain from property held by a trust to be eligible for

the LCGE, it must be designated by an “Eligible LCGE Trust”

• An “Eligible LCGE Trust” includes:

• A spousal or common-law partner trust or alter ego trust where the individual

claiming the LCGE is the trust’s principal beneficiary;

• Certain employee share ownership trusts, where the individual beneficiary is an

arm’s length employee of the employer sponsor of the arrangement



How Property in Trusts is Affected

• Trust measures would apply in situations where the trust realizes a capital

gain and allocates it to a beneficiary, and also where the trust elects to

transfer the property with an accrued gain to a beneficiary who realizes the

gain at a later date on a disposition

• These measures would not prevent trusts that are currently eligible to

undertake rollovers to beneficiaries from continuing to do so; however,

unless an exception applies, no deduction would be allowed under the LCGE

in respect of the capital gain that is ‘transferred’ from a trust on a rollover of

property to a beneficiary



Election for Deemed Disposition in 2018

• Transitional rules provide for grandfathering of certain dispositions that occur

in 2018, allowing an individual to elect to realize in 2018, a capital gain in

respect of eligible property by way of a deemed disposition for proceeds up

to the FMV of the property

• Transitional rules provide an opportunity for property that currently does not

qualify for the capital gains exemption in 2017 to be purified as proposed

legislation will reduce the holding period from 24 months to 12 months

• This means that the purification process must happen before December 31,

2017 in order for the crystallization to occur in 2018


Panel Discussion

Disclaimer:








July 18, 2017:


Allan Lanthier (Moderator)Retired Partner, EY LLP

Greg BellKPMG LLP

Mark BrenderOsler, Hoskin & Harcourt LLP

Bruce HarrisPwC LLP

Robert RaizenneOsler, Hoskin & Harcourt LLP

Surplus Stripping


Topics

Surplus stripping - history and policy framework

Section 84.1 and section 246.1

Share transfers – inter vivos and on death

Issues – transition; double taxation; uncertain results

Intergenerational transfers

Allan Lanthier - September 25, 2017


Two streams of surplus stripping rules

● First Stream: Shareholder/corporation rules (mostly complete by 1926)

Initial versions of 84(1), 84(2), 84(3), 15(2)

● Second Stream: Other ways to surplus strip: 84.1, 246.1

History of second phase is more complicated

There was an antecedent to 84.1, which returned in 1977

246.1 antecedents (32A(2) – 138A – 247(1))

Repealed in 1948, restored in 1963, repealed again in 1988

Allan Lanthier - September 25, 2017


1917 Act – Perfect Integration

Corporate rate = 4%

Top personal rate = 25%

Tax deferral potential on

corporate earnings, both

business and investment = 21%

Corporate tax fully integrated

with personal tax

Robert Raizenne - September 25, 2017


1917 Act – Perfect Integration

BUT – Shareholder immediately taxable on undistributed income UNLESS Minister determines

(i) no avoidance motive, and (ii) undistributed income not in excess of needs of business

BUT – Attribution of undistributed income reversed in 1918, retroactive to 1917; rule became

no attribution unless Minister concluded avoidance, and undistributed income was in excess of

needs of business

Other features of 1917 Act:

1. Shareholder / corporation transactions reviewable

2. Capital gains not taxed: the original sin?



The Amendments Begin

● Stock dividends made fully taxable as dividends from 1918

● IRC v. Burrell, [1924] 2 K.B.: UK CA holds “winding-up dividend” constitutes proceeds on capital account

● 84(2) prototype enacted in response to Burrell

Broad meaning subsequently given to “winding-up” notion in subsection 84(2):

● MNR v. Merritt, [1942] S.C.R. 269: winding-up is not a term of art

● Amendment in 1948 adds “directly or indirectly” language; Testimony of W.R. Jackett, HoC Standing Committee on

Banking and Commerce:

“ ‘Or what would have been’ refers to the case where there was no actual distribution, proper distribution, or property of the

corporation to the shareholders … one case would be where a corporation ceased carrying on business and the

shareholders just took the property according to some arrangement without going through the proper winding up and

distribution of assets” … to catch a “subterfuge”

● Conn Smythe, [1970] S.C.R. 64

● MacDonald, 2013 FCA 110



1926 Budget – a “big budget”

Continuing manifestations of “tax avoidance”

House of Commons Debates, 1926, Georges Henri Boivin, Minister of

Customs and Excise:

“We want to obviate the practice, followed by certain corporations, of escaping the

payment of taxation by allowing their profits to remain as reserve for a year or two

and then distributing those profits in other ways than in the form of dividends to

shareholders, as for instance, by the purchase of stock at a premium, or by

reducing capital stock for more than its value at the time it was sold”



1926 Budget – Details

1. At a time of declining tax rates, there was a conscious choice to terminate integration:

not politically palatable

2. Additional avoidance rules enacted, including:

84(1) – capitalization of earnings

84(3) – share redemptions

84.1 – NAL share transfers

15(2) / Shareholder loans

Deemed dividends limited to available undistributed income on hand (UIOH)

3. Intercorporate dividend deduction legislated

4. “Personal corporation” rule causes “holding companies” to be taxed on an attribution basis

Prototypes



1938-1950

1938 Enactment of section 32A: Treasury Board direction

C. Fraser Elliott, Commissioner of Taxation:

“By reason of the amendments referred to and other amendments, it can be stated generally that, neither

directly nor indirectly, can the earned surplus of a company be put out of the channel of taxation under

any name or scheme, on distribution. It will be taxed, whether done by way of ordinary dividend, winding

up, stock dividend, premium, loan, or through controlled or personal corporations”

1943 32A amended: Treasury Board direction expressly extended to “surplus stripping” transactions

1945 Ives Report



1938-1950 (continued)

1948 Income Tax Act Previous rules carried over, with some exceptions; Treasury Board direction references to “surplus stripping”

deleted

Shareholder benefit rule – subsection 15(1) – added

1949 Dividend tax credit prototype added to alleviate double taxation

1950 Carter Commission: where one Canadian corporation acquires control of another, at a time when the other

corporation has undistributed income on hand, such undistributed income will become “designated surplus”

and a dividend will not pass tax-free between the corporations to the extent that it is paid out of the designated

surplus

Designated surplus rules proved complex and ineffective and interfered with business transactions



The Oracle Speaks: W.R. Jackett, 1960 CTF Conference

“…, the law has always been constructed on the basis that the tax on the distributions to

individuals was only deferred and must ultimately be paid.”

The 1926 amendments were designed to treat all non-dividend distributions from the

corporation to the shareholder as “deemed” dividends.

“However, there are other means of escaping the second tax: … by using provisions in the Act

designed for some other object to put the individual shareholders in possession of all or a

substantial part of the undistributed corporate earnings without paying the second tax on them.

… Examples of these means are: (a) transactions making use of the exemption for inter-

company dividends; (b) transactions making use of exempt entities; and (c) transactions

making use of [non-residents].”



1963 – Enactment of section 138A

● Carter Report: A Major Weakness of the Present System of Taxing Corporations – “Surplus Stripping”

● General anti-surplus stripping rule added to Act

● Carried over intact to 1972 Reform Act as subsection 247(1)

● Amended in 1986 to remove ministerial discretion

● Repealed in 1988 as part of GAAR reshuffle:

Technical Notes: “Because the scope of that general anti-avoidance rule is broad enough to cover

the transaction to which subsection 247(1) was intended to apply, that subsection is no longer

necessary”

Methodologies of two rules are not the same

● No substantial judicial guidance

● C.W. Primeau, “Surplus Stripping: The Departmental View” (1974) 22:5 Canadian Tax Journal 421-429.



1977 Budget

● Designated surplus rules repealed

● Modern 84.1 enacted



1980 – Finance comments on 247(1)

“When it became clear that the designated surplus approach was not effective, a

"ministerial discretion" provision was introduced in 1963 to contain a groundswell of

surplus-stripping developments. In the absence of a reasonable and workable system,

this created taxpayer uncertainty, further administrative difficulties and otherwise

unnecessary expenditure of time and effort in the planning of business transactions

and in the enforcement of the law.”

“Its continued presence is indicative of the genuine difficulty in designing workable

rules to determine the tax on surplus distributions where there is a differential

treatment of dividends and capital gains.”



Post-GAAR case law comments on “scheme” in the Act

Pre-Canada Trustco

● McNichol, 97 DTC 111, per Justice Bonner:

“the scheme of the Act calls for the treatment of distributions to shareholders of corporate property as income”

and other provisions of the Act demonstrated “the existence of a legislative scheme to tax as income all

distributions by a corporation to a shareholder, even those of a less orthodox nature than an ordinary dividend”

● RMM, 97 DTC 302, per Justice Bowman:

“The Income Tax Act, read as a whole, envisages that a distribution of corporate surplus to shareholders is to

be taxed as a payment of dividends. A form of transaction that is otherwise devoid of any commercial

objective, and that has as its real purpose the extraction of corporate surplus and the avoidance of the

ordinary consequences of such a distribution, is an abuse of the Act as a whole.”




Post-Canada Trustco

● Evans, 2005 TCC 684, per Justice Bowman: “The only basis upon which I could uphold the Minister's application of section 245 would be to find that there is some

overarching principle of Canadian tax law that requires that corporate distributions to shareholders must be taxed as dividends,

and where they are not the Minister is permitted to ignore half a dozen specific sections of the Act. This is precisely what the

Supreme Court of Canada has said we cannot do”

“[McNichol and RMM] were early general anti-avoidance rule cases and we did not have the benefit of the Supreme Court of

Canada's guidance that we have today. If we had had the benefit of the Supreme Court of Canada's views, our analysis might

have been quite different.”




Post-Canada Trustco (continued)

● McMullen, 2007 TCC 16, per Justice Lamarre: “In conclusion, the respondent has not persuaded me, or has not presented any evidence establishing, that there was any abuse of the

Act read as a whole, or that the policy of the Act read as a whole is designed so as to necessarily tax corporate distributions as

dividends in the hands of shareholders.”

● Collins & Aikman, 2009 TCC 299, per Justice Boyle: No scheme against surplus stripping – applies comments from Evans and McMullen.

2010 FCA 251: “We see no reason to conclude that the limited scope of [84.1 and 212.1] was anything other than a deliberate policy

choice by Parliament.”




Post-Canada Trustco (continued)

● Copthorne, 2011 SCC 63, per Justice Rothstein: “What is not permissible is basing a finding of abuse on some broad statement of policy, such as anti-surplus stripping, which is not

attached to the provisions at issue”

Tax Court: “While the Act contains many provisions which seek to prevent surplus stripping, the analysis under subsection

245(4) must be firmly rooted in a unified textual, contextual and purposive interpretation of the relevant provisions. As such,

reliance on a general policy against surplus stripping is inappropriate to establish abusive tax avoidance”

● Gwartz, 2013 TCC 86, per Justice Hogan: Crown abandoned position that there is a scheme against surplus stripping in the Act

Justice Hogan finds no scheme – cites Copthorne, McMullen, Collins & Aikman

● Descarries, 2014 TCC 75, per Justice Hogan: “the Act does not contain any general prohibition stating that any distribution by a company must be done in the form of a

dividend”



CRA Recent Administrative Practice

From 2014 APFF Roundtable: « En toute déférence, il nous apparaît qu'on doit plutôt, selon nous, tenir compte dans cette analyse, de

l'alinéa 82(1)b), de l'article 121 ainsi que des paragraphes 84(1), 84(2), 84(3), 84(4) et 15(1) L.I.R. supportant une politique fiscale qui a pour but d'imposer exclusivement sous forme de dividendes les surplus d'une société versés directement à leurs actionnaires qui sont des particuliers. »

« Ces dispositions reflètent, selon nous, une politique fiscale claire et non ambiguë de la part du ministère des Finances, qu'on appelle communément les Règles d'intégration, laquelle est également appuyée par toute une série d'autres dispositions (entre autres, l'article 84.1 L.I.R. ainsi que les paragraphes 84(2), 246(1) et 245(2) L.I.R., en tenant compte de l'ancien paragraphe 247(1) L.I.R. et particulièrement des notes explicatives du ministère des Finances se rapportant à ce paragraphe) ayant pour but d'éviter que les particuliers actionnaires obtiennent indirectement les surplus d'une société sous une forme autre qu'un dividende. En somme, dans une situation comme dans l'affaire Descarries, les Trois opérations d'évitement constituent, selon nous, un abus des Règles d'intégration. »




From 2014 APFF Roundtable (continued): « Compte tenu de ce qui précède et des décisions défavorables rendues par la CCI à l'égard de l'analyse des

paragraphes 84(2) et 245(2) L.I.R. dans le cadre de dossiers impliquant des dépouillements de surplus, l'ARC croit nécessaire, avec déférence pour la position prônée par la CCI, de s'adresser à la Cour d'appel fédérale ou à la Cour suprême du Canada pour qu'un tribunal supérieur, d'une part, confirme la portée très large du paragraphe 84(2) L.I.R. établie récemment par la Cour d'appel fédérale dans l'affaire MacDonald, et d'autre part, statue sur la présence ou non d'un plan spécifique de la L.I.R. visant à imposer toute distribution directe des surplus d'une société canadienne à titre de dividendes imposables entre les mains de ses actionnaires qui sont des particuliers; ainsi que d'un plan spécifique de la L.I.R. pour contrer également les dépouillements indirects des surplus d'une telle société. »




From 2015 CTF Roundtable: The CRA is nevertheless concerned with surplus stripping arrangements and has expressed those concerns to

the Department of Finance

The CRA will still maintain its position of applying the GAAR and/or subsection 84(2) to cases like The Queen v. Macdonald where a taxpayer uses losses or other tax shelter to reduce a capital gain realized as part of a surplus stripping scheme

Also, the CRA will rely on the reasoning in Descarries where a taxpayer seeks to extract corporate surplus in a manner contrary to the object, spirit or purpose of specific anti-avoidance provisions, such as sections 84.1 and 212.1


Proposed changes to 84.1 and related issues


Surplus Stripping

● CRA has previously asserted there is a general scheme in the Act against surplus stripping

Removing retained earnings of a corporation by way of capital gains rather than dividends

See, for example, Technical interpretation 2012-0433261E5, published June 18, 2013

“Notwithstanding the recent decision in Gwartz et al. v. The Queen, 2013 TCC 86, the CRA

intends, at the next opportunity, to demonstrate to the Court that there is a specific scheme of

the Act for taxing the distribution of surplus of a Canadian corporation as a taxable dividend in

the hands of individual shareholders and that there is also an overall scheme of the Act

against surplus stripping.”

● The courts have found that the Act does not contain a general scheme to prevent surplus stripping

See Evans v. The Queen, 2005 TCC 684, The Queen v. Collins & Aikman Products Co., 2010

FCA 251 and Copthorne Holdings Ltd. v. The Queen, 2011 SCC 63

Gregory Bell - September 25, 2017


Surplus Stripping “Scheme”

● Evans (2005 TCC) - GAAR rejected“The only basis upon which I could uphold the Minister's application of section 245 would be

to find that there is some overarching principle of Canadian tax law that requires that

corporate distributions to shareholders must be taxed as dividends, and where they are not

the Minister is permitted to ignore half a dozen specific sections of the Act. This is precisely

what the Supreme Court of Canada has said we cannot do.”

“Counsel argues that this case is similar to Justice Bonner's decision in McNichol … and

mine in RMM … . These cases were early general anti-avoidance rule cases and we did not

have the benefit of the Supreme Court of Canada's guidance that we have today. If we had

had the benefit of the Supreme Court of Canada's views, our analysis might have been

quite different.”

Contradicted his own judgment in RMM v. Canada (1997 D.T.C. 302 (TCC))


Section 84.1


Non-Arm’s Length Sale of Shares

● Individual sells shares of Privateco to non-arm’s length corporation

(Newco) to realize a capital gain

● Consideration is a promissory note

● Cash of Privateco to be used to repay promissory note

Might amalgamate or redeem high adjusted cost base (“ACB”)

shares

No 55(2)

● However, under existing rules (and no change under proposed rules)

84.1(1)(b) - Individual deemed to receive a dividend of $99

instead of a capital gain of $99

Dividend equal to amount of note in excess of greater of

“hard” ACB and PUC of Privateco shares

Same result if Individual uses CGE




● Individual sells shares to non-arm’s length corporation to realize a

capital gain

● Consideration is high-basis / high paid-up capital shares

● Cash of Privateco to reduce PUC of Newco shares

Might amalgamate or redeem high ACB shares

No 55(2)

● However, under existing rules (and no change under proposed

rules)

84.1(1)(a) – PUC of Newco shares reduced to $1

PUC reduced to greater of “hard” ACB and PUC of

Privateco shares

Same result if Individual uses CGE




● Parent sells Privateco shares to Child

(i.e. a non-arm’s length individual) for

cash to realize capital gain

● Child sells Privateco shares to Newco for

Promissory Note

● Cash of Privateco to be used to repay

promissory note




Under Existing Rules

● 84.1 does not apply

● Parent has capital gain

Parent has sold shares to child

84.1 can only apply if Parent sells shares

to a non-arm’s length corporation

Child not deemed to receive a dividend

Child has “hard” ACB in shares of

Privateco

Provided Parent does not claim

capital gain exemption (“CGE”)

84.1(2)(a.1)(ii)





● 84(2) could possibly apply

84(2) deems amounts distributed

“in any manner whatever” to a

shareholder to be a dividend

Can apply if cash of Privateco is

considered to be distributed on

discontinuance, winding-up or a

reorganization of Privateco’s

business




Under Proposed Rules

● 84.1 applies to Child

Child deemed to receive dividend of $99

Capital gain realized by Parent does not

create “hard” tax ACB

See proposed amendment to

84.1(2)(a.1)(ii)

Previous dispositions by non-arm’s

length persons does not create “hard”

ACB





● 84.1 applies to Child

Child deemed to receive dividend of $99

Capital gain realized by Parent does not create

“hard” tax ACB

See proposed amendment to 84.1(2)(a.1)(ii)

Previous dispositions by non-arm’s length

persons does not create “hard” ACB

Even if intermediate sale to third-party



Non-Arm’s Length Sale of Shares – 84.1

● Department of Finance Explanatory Notes

“The objective of [the amendment] is to ensure that an individual cannot use more than

the greater of their so-called “hard” arm’s length share cost and the PUC of their share

to extract corporate surplus on a tax-free basis or as capital gains from a corporation.”

● The amendments to section 84.1 apply in respect of dispositions that occur

on or after July 18, 2017.


Transitional Issues


Transitional/Technical Issues

Pipeline Planning

● Estates holding high ACB shares where it was planned that pipeline planning be implemented

● Impacted by 84.1

● May no longer be possible or practical to carry out 164(6) planning, (for example, July 18, 2017 is

more than one year after death)

For existing pipeline notes or high-PUC shares, could new 246.1 apply on payment of the note or

return of PUC?



Transitional/Technical Issues

Interaction with Tax on Split Income

● Is 120.4(4) necessary?

Based on the changes to 84.1 and the LCGE rules, 120.4(4) should not be

necessary

● If 120.4(4) is not repealed should 84.1 be amended?

Where 120.4(4) applies, an individual is deemed to have an ineligible dividend

equal to twice the taxable capital gain

There should be an exception in 84.1(2)(a.1)(ii) to create hard ACB in

recognition that the gain has already been taxed as a dividend


Non-arm’s Length/ Intergenerational Transfers


Non-arm’s Length/Intergenerational Transfers

● 84.1 generally applies on the transfer of shares of a corporation between siblings and between parents and their children

Privateco is owned 50/50 by two siblings

FMV of a 50% interest is $3 million

ACB is nominal

Gain qualifies for the LCGE

Tax rate on capital gains is 25%

Tax rate on non-eligible dividends is 45%

● The income tax arising on a sale by one sibling is as follows:



Non-arm’s length/Intergenerational Transfers

● Recommendations

An exception to 84.1 should be provided to facilitate “true” dispositions of shares

of corporations between family members (inter vivos and testamentary)

The exception could include a number of conditions to ensure that the proposed

disposition is not a disguised surplus strip, for example:

Limit to sales of “active businesses”

Limit to sales of a significant portion of a shareholder’s interest

Limit the rate of return on any share consideration


Impact on Post-Mortem Planning


Post-Mortem Considerations

Is it the policy intent to tax an individual at the ineligible dividend rate on death?

Is there a change in policy regarding double tax and the ability to increase the

ACB of capital properties held by a corporation to mitigate double tax?



Post-Mortem Planning - Summary

“Pipeline” Planning

Impacted by 84.1 amendments

Existing pipeline notes or shares might be impacted by proposed 246.1

164(6) Planning

Enhanced 164(6) planning impacted by proposed 246.1



Post-Mortem Planning

● Pipeline – Existing Rules

Objective

Limit tax as a result of death to tax on capital gain realized by deceased

Can be implemented any time after death of shareholder

Subject to certain constraints

● Pipeline – Proposed Rules

Based on draft legislation, pipeline transactions will result in deemed dividend to estate



84.1 Amendment – Impact on Post-Mortem “Pipeline” Planning

● Individual A passes away

● Individual A owned shares of Privateco

with low ACB and paid-up capital (“PUC”)

● Individual A deemed to have capital gain

of $99 on death

Subsection 70(5)

● Estate of A has high ACB in shares of

Privateco




● Estate transfers shares of Privateco to Newco for a

promissory note or shares with high PUC (“Pipeline”)

● Pipeline is to prevent double taxation on value of shares

held at death

Deemed gain on death

Dividend on eventual distribution of Privateco’s

assets

● Planning steps may involve amalgamating Newco and

Privateco to “bump” ACB of Privateco’s capital property

88(1)(d) bump is potentially available

Eliminates gains on Privateco’s assets that were

reflected in gain on the shares of Privateco





● Individual has capital gain on death

70(5)

● Estate is not deemed to have a dividend

84.1 does not apply

Estate has “hard” ACB in Privateco

shares

84(2) does not apply

If certain conditions are met under

CRA guideline




● Estate is deemed to receive dividend of $99

See proposed amendment to 84.1(2)(a.1)(ii)

Previous dispositions by non-arm’s length

persons does not create “hard” ACB

Estate and Individual A would be considered

non-arm’s length

● Significant impact to many estate plans

Is this result intended?




Bump Issues

● There must be an acquisition of control as a consequence of death

(88(1)(d.3)) – this is often unrealistic

● Bump denial rules

● There may not be bump room as a consequence of a previous

estate freeze

88(1)(d) limits the available bump of the ACB of Privateco’s assets

to:

The amount by which the amount determined under

88(1)(b)(ii) (ACB) exceeds:

Cost amount of property and cash held by the

subsidiary immediately before the winding up less debts

of the subsidiary and certain other adjustments




164(6) – Existing Rules

Eliminates capital gain from deemed disposition on death

Wind-up company or redeem shares and receive distribution as a dividend

Rules require that the steps be implemented within one year of death

The estate must be a graduated rate estate




164(6) Enhanced Planning– 246.1 could apply

Involves redemption of Privateco shares to

create a capital loss carry back and a

dividend

Planning enhanced by internal transfer of

capital property to create CDA and RDTOH

This planning increased the ACB of the

property


Potential changes to proposed/enacted legislation


Recommendations

● Tax deemed gain on death as a dividend to the extent of safe income

Safe income is a measurement of the after-tax income which has not been

distributed to a shareholder

If the intent is to put a person who has incorporated in the same position as a

person who has not incorporated then only undistributed income should be

taxed at dividend rates

● Tax remaining gain at capital gains rate

The balance of the inherent gain in the shares should be taxed at capital gains

rates as it represents inherent gains in the underlying assets of the corporation



Recommendations

● Simplify 164(6)

Introduce a new election to treat all or a portion of the capital gain on death as a

dividend on the final return

An exception would be provided in 84.1 equal to the elected amount

Corresponding increase in the ACB of the share

● Simplify legislation to eliminate double tax on death

Bump rules in 88(1)(d) are too complicated and often not a solution

Introduce a new election to increase the ACB of capital property held by a

corporation to the extent of gain recognized on death



Summary

● Transitional/Technical Issues

Relief should be provided from the application of 84.1 where an individual has

passed away prior to July 18, 2017

Clarification should be provided that 246.1 will not apply to existing notes/PUC

created on pipeline planning

120.4(4) should be repealed or alternatively “hard ACB” should be created

under 84.1 where 120.4(4) applies

● Non-arm’s length/intergenerational transfers

An exception to 84.1 should be provided to facilitate “true” dispositions of shares

of corporations between family members (inter vivos and testamentary)



Summary

● Tax on Death/Post Mortem Issues

The inherent gain on shares of a private company should be taxed at dividend

rates to the extent of safe income, the balance of the gain should be taxed at

capital gains rates

164(6) should provide a new election to treat the gain on death as a dividend on

the final return (an exception would be provided in 84.1 equal to the elected

amount)

An election should be provided to increase the underlying ACB of assets of a

private corporation by the amount of the capital gain recognized on death


Surplus Stripping

New Section 246.1


Policy Concerns Underlying New 246.1

● “…a separate anti-stripping rule to counter tax planning that circumvents the specific provisions of the

tax law meant to prevent the conversion of a private corporation's surplus into tax-exempt, or lower-

taxed, capital gains. In general, the anti-stripping rule would apply to non-arm's length transactions

where it is reasonable to consider that "one of the purposes" of a transaction or series is to pay an

individual shareholder/vendor non-share consideration (e.g., cash) that is otherwise treated as a

capital gain out of a private corporation's surplus in a manner that involves a significant disappearance

of the corporation's assets. In such a case, the non-share consideration would be treated as a taxable

dividend.“

● Put differently, converting corporate surplus/taxable earnings that should be taxable as dividends into

capital gains at individual shareholder level

i.e. the opposite of what subsection 55(2) produces at corporate level

Brender & Harris - September 25, 2017


246.1 - Overview

● Interaction with other surplus stripping rules

Section 84.1

subsection 84(2)

● Broadly speaking, targets two categories of transactions

“classic” surplus stripping transactions - McNichol, Evans, MacDonald, among

others

Is new 246.1 intended to be 84(2) on steroids?

CDA, PUC and boot generating transactions

Internal vs external CDA generation?



246.1 - Architecture

● amount receivable directly or indirectly by an individual resident in Canada

● amount receivable directly or indirectly in any manner whatever from a NAL person

● series of transactions

disposition of property

Increase or reduction of PUC

● It can reasonably be considered that

one of the purposes

reduction or disappearance of assets

tax otherwise payable and in consequence of any distribution of property of a corporation

is avoided



246.1 – Non-Arm’s Length Context

● Internal step-up transactions

ECP crystallizations

Internal CDA generation transactions

Post-mortem estate planning

CDA streaming



Example 1 – ECP Step-up transactions

● Announced repeal of the eligible capital property regime effective as of

January 1st, 2017

● Many taxpayers internally disposed (e.g. section 85) of ECP in 2016 to

trigger ECA taxable at low corporate business income rate

Prepayment of tax at low corporate rate ≈ 27%

Creates CDA which can be paid to shareholder tax free

Cheaper than taxable dividend (≈ 40% for eligible and ≈ 44% for ineligible)

No tax cost to the corporation if gain sheltered by non-capital losses or other tax

attributes




• Opco transfers intangibles/goodwill to NewCo

triggering a $5M gain: $2.5M taxable as

business income

• Opco’s CDA is increased by 50% of the

triggered gain

Business

Assets

NewCo

Opco

Taxpayer

ECP

Shares




• Opco pays cash dividend to Taxpayer or

increases PUC, thereby triggering a

deemed dividend and increasing ACB

• Opco elects for capital dividend treatment

under 83(2)Business

Assets

NewCo

Opco

Taxpayer

ECP

Increase in the

shares’ ACB

Deemed

dividend

→ Capital

dividend




● If 246.1 applies: Taxable dividend of $2.5M

CDA decreased by $2.5M Permanent loss of CDA

● Consider the following scenarios: Cash CDA dividend paid before July 18

246.1 does not apply

Cash CDA dividend paid on or after July 18 246.1 apply?

PUC increase out of CDA before July 18, ROC on or after July 18 246.1 apply?

● Assume ECP step-up was done in contemplation of an arm’s length sale of Newco in 2017 Opco disposes of Newco shares to AL purchaser for cash in 2017 (before or after July 17)

Opco pays a 2.5M CDA dividend to Taxpayer on or after July 18, 2017 246.1 apply?



Example 2 – repayment of shareholder loans

• Shareholder Loan rule in 15(2)

• Loan of $100K included in income if not repaid in the year following the end of the taxation

year in which Opco made the Loan

• Assume Opco is a CCPC that carries on an active business

• Several different ways Taxpayer could repay the Loan



Example 2 – Salary alternative

● Assume Opco earns $227,043

● Highest personal tax bracket = 53.53% (Fed. + Ontario)

● Salary needed to repay the Loan = $215,192.60

● Personal tax on salary = $115,192.60

● Net corporate tax = $3,140 ($227,043-215,192) x 26.5%

● Total corp/personal tax = $118,332

Salary of $215,192.60



Example 2 – Dividend alternative


● Effective tax rate for eligible dividend = 39.34% (Fed. + Ontario)

● Eligible dividend needed to repay the Loan = $164,853.28

● Corporate tax on $227,043 = $60,166

● Personal tax = $64,853

● Total corp/personal tax $125,020

Note lack of integration compared to salaryDividend of $164,853.28



Example 3 – Capital gain alternative


● Opco also realizes $137,893 capital gain on the transfer to NewCo resulting in $68,946 addition to CDA

● Opco pays $68,946 CDA and $51,193 eligible dividend for TP to net $100K

● Total tax = $95,272 [$60,166 + $20,139 + $13,445 +$1,522 refundable tax]

Opco

Newco

Trigger capgain

of

Assets

Taxpayer

Repayment

of Loan

capital

dividend

& eligible

dividend

1

2 3



Example 3 – Comparison

● Scenario 1 – Salary

Tax cost = $118,332

● Scenario 2 – Taxable dividend

Tax cost = $125,020

● Scenario 3 – Capital gain

Tax cost = $95,272

● Would 246.1 apply to scenario 3?



Example 4 – Internal capital gain

To be updated

Safe Income = $1M

FMV = $10M



Example 4 – Internal capital gain

• Holdco transfers Opco to Newco triggering

capital gain of $1M

• Holdco pays $500K capital dividend

• Section 246.1 apply to dividend, portion of

dividend?



Example 5 – Planning to avoid double tax

Holdco

• Estate’s ACB equals FMV at time of death

• Holdco transfers certain property to Sub to

trigger capital gains to allow payment CDA and

RDTOH on redemption of Estate’s preferred

shares. Purpose is to avoid double tax.

• Other property of Opco sold for cash

• Capital loss in estate carried back under

subsection 164(6).

• Does 246.1 apply with respect to CDA created

on property transferred to Sub?

• What about CDA created on third party sales?

Estate

SubProperty

Preferred

shares

Children



Example 6 – Planning to access LCGE

● X owns 1000 common shares of Opco - nominal ACB/PUC

● FMV of Opco is $1M

Active business assets = $800M

Excess cash = $200K

● In light of new rules affecting LCGE, X wants to elect to crystallize gain

● Purification required:

X exchanges 200 commons for 200,000 fixed value preferred shares

X rolls preferred shares to Holdco

Opco redeems preferred shares

● Consequences:

Does 55(2) apply to redemption? Redemption results in reduced gain/FMV

Bona fide reorganization? If 55(2) applies, capital gain and CDA addition

Does 246.1 apply to CDA distribution by Holdco?



Other Possible Areas of Concern

● CDA streaming

Resident and non resident shareholders

Holdco realizes gains on sale of assets

Distribute CDA to resident shareholders

● Donation of listed securities

Holdco donates securities to registered charity/private foundation

Taxable capital gain is nil

Full CDA addition

● Stepping up ACB/PUC where 84.1 does not apply

Individual sells shares of non-connected corporations to Holdco at FMV

Holdco issues boot or high PUC shares

Holdco distributes cash to repay note or return capital

● Corporate Owned Life Insurance

Policy, disposition of property, CDA addition – series of transactions?



246.1 – Arm’s Length Context

● Text of new 246.1 is extremely broad

● Explanatory notes ambiguous

● Is 246.1 intended to apply to bona fide commercial transactions?

Sale of assets

Leveraged buy-outs

Sale subject to earn out

Converting arm’s length basis into PUC

Interaction with 55(2)



Example 7 - Arm’s Length Sale of Assets

• Opco sells assets to an arm’s length third party, Buyco

• Opco realizes capital gains & pays CDA dividend to Individual

• Series includes a disposition of property, amount received from NAL person

and CDA dividend



Example 8 - Arm’s Length Sale: Balance of Sale

• Buyco acquires Opco shares from Individual for cash payable at closing and

balance of sale

• Buyco amalgamates with Opco and uses cash from Opco’s operations to

pay off balance of sale

• Is 246.1 intended to apply to the balance of sale?

• Distinguish “future” versus “current” cash of Opco to fund balance of sale?



Example 9 - Arm’s Length Sale: Leveraged Buyout

• Buyco purchases Opco shares from Individual

• Buyco uses its own cash and funds borrowed from a third-party to satisfy

purchase price in full at closing


pay off the third-party debt

• Is 246.1 intended to apply to the portion of the purchase price that was debt

financed?



Example 10 - Arm’s length Sale Subject to Earn-Out

• Buyco acquires Opco shares from Individual for cash payable at closing and

balance of sale subject to an earnout maximum


satisfy the earnout

• Is 246.1 intended to apply to the earnout payments?

• Distinguish “future” versus “current” cash of Opco to fund balance of sale?



Example 11 – PUC step up to hard ACB

• Individual acquires Opco shares in arm’s

length transaction

• Arm’s length ACB of Opco shares = $1M

• PUC = $1

• ACB for 84.1 = $1M

Individual

Is 246.1 intended to be a domestic 212.1?



Example 11 – PUC step up to hard ACB

Is 246.1 intended to be a domestic 212.1?

Individual

• High ACB/low PUC shares transferred to Holdco

• Individual's ACB/PUC of Holdco shares = $1M

• 84.1 does not apply – “Hard ACB”

• Opco pays $100K taxable dividend to Holdco

• Holdco distributes $100K to individual as a

reduction of PUC

• Does 246.1 apply?



Example 12 – Interaction with 55(2)

Sister Brother

SIOH = 2 M

FMV = 10 M

• OPCO redeems shares from BCo for $5M

• Subsection 55(2) applies – Bco realizes

capital gain of $4M

• Does 246.1 apply if Bco pays a capital

dividend paid of $2M?

• What if Bco sells Opco shares to Sco for

$5 million resulting in $2.5M gain and

$2.5M of CDA?


Classic Surplus Stripping


"Classic" Surplus Stripping: MacDonald v The Queen

3. Declared dividends

JS

PC

PC

601

5. Endorsement

of cheques

4. Endorsement

of cheques

6. PC wound up

1. Purchase

of shares for a

note from JS

2. Transfer of shares

of PC to 601 for a

note from 601

Taxpayer

1. Taxpayer sold shares of PC to his brother-in-law JS in exchange for a promissorynote from JS equal to the value of the netassets of PC less a $10,000 spread

• Sale to individual was necessary to avoidthe application of s. 84.1

• Total consideration $525,000

2. JS transferred the shares of PC to hisholding company (“601”) in exchange for apromissory note from 601 of $525,000

3. PC declared dividends to 601 immediatelyafter the steps above in the amount of (i)$500,000 and (ii) $10,000. A third dividendof $25,000 was declared several monthslater. Dividends were payable by cheques

4. 601 endorsed the cheques to JS

5. JS endorsed the cheques to the taxpayer

6. PC was wound up



MacDonald - Decision

● Tax Court : 84(2) not applicable given that Note 1 was not property of OpCo. When MacDonald received payment pursuant to Note 1, he received such payment qua

creditor – no longer shareholder of Opco.

GAAR does not apply as there is no misuse or abuse of 84(2) (“not an anti-surplus stripping provision”), 3 (the Act permits the triggering of capital gains to be offset by capital losses), and 128.1(4) (capital gain on departure could have been offset by capital losses).

● Federal Court of Appeal: the winding-up of a corporation is “a process” and the phrase “in any matter whatever” in 84(2) requires a more global perspective. Opco’s property “ended up through circuitous means in the hands” of Macdonald and

therefore the only reasonable conclusion is that 84(2) applies.



MacDonald - Decision

● FCA decision not appealed, but is questionable

● Court influenced by fact that corporate property found its way into the hands

of the shareholder

At the beginning of the date PC had cash and MacDonald was a shareholder,

and at the end of the day MacDonald had PC's cash

● What if purchase was instead financed with Bank debt?

MacDonald restricted to its facts?



Limits of 84(2) on "classic" surplus strip

● Assume a fact pattern slightly different from that of MacDonald:

Vendor sells shares of Opco, which has undistributed surplus, to a non-arm’s

length individual

NAL buyer borrows from Bank and pays cash to Vendor with proceeds of Bank

loan

NAL buyer transfers shares of Opco to Newco

Opco winds up and distributes cash to Newco

Newco distributes cash to NAL buyer, who repays the Bank loan



On or After July 18, 2017

Opco

Intercorporate

dividend upon

OpCo’s wind up

Cash for OpCo’s shares

NAL Buyer

Dropdown of

OpCo into

NewCo for

shares with

high PUC or a

Note

Return of Capital or

Note Repayment

1

2

3

Newco

VendorBank

4

5

Loan from arm’s

length 3rd party

Loan Repayment6

• 84(2) does not apply because Vendor

does not receive Opco's property

• 84.1 does not apply to Vendor because

Vendor does not transfer to a

corporation

• 84.1 now applies to NAL Buyer - NAL

Buyer has soft ACB in Opco shares

• 246.1 should not apply to NAL Buyer

because 84.1 already applies

• 246.1 applies to Vendor ?



Classic surplus strip – 246.1

● Now assume no third party lender, but Buyer deals at arm’s length with

Vendor

Pre-July 18, 2017

84.1 does not apply to Vendor or Buyer

84(2) applies to Vendor based on MacDonald reasoning since Opco cash ends up in

Vendor's hands

84(2) does not distinguish between arm's length and non-arm's length transactions

Under new rules


84(2) applies to Vendor

246.1?



Classic Surplus Strip and 246.1

● Now assume the same facts as previous example, but AL Buyer borrows

from Bank to finance acquisition of Opco

Pre-July 18, 2017


84(2) arguably does not apply since Opco cash does not end up in Vendor's hands

GAAR?

Under new rules


246.1?



Concluding Remarks

● 246.1 – a “specific general anti-avoidance rule”

Catch-all provision where 84.1 and 84(2) do not apply

should it reconcile with subsection 88(2)

Is there now clearly a scheme in the Act against surplus stripping?

Overreaching - could apply to transactions that are not surplus strips

● As drafted, results in reliance on CRA for guidance

Guidance through explanatory notes insufficient

● A more targeted rule is recommended - rules should be clear for such common place transactions as paying dividends and

disposing of property

● Principle of Integration - punitive effect of section 246.1

Asymmetrical vs symmetrical approach

How does 246.1(3) work?

Part III tax – effect of excess CDA election



Concluding Remarks

● Consider surplus stripping rule akin to subsection 55(2) at the individual shareholder level – pro rata distribution of

taxed/SIOH and untaxed surplus

● Is CDA denial appropriate? Possible alternatives to CDA denial

Hybrid surplus

Ordering rule

CDA suspension

● Non-arm’s length persons and “accommodating” parties

When is a third party an accommodating party?

● Better transitional rule - Section 246.1 should not apply to CDA arising from before July 18, 2017 (i.e. no

retroactivity)

● If taxation rates change, what then? Will 246.1 be repealed?



Thank you

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