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Finance Department Tax Proposals - Advocating for a better process

On September 8th 2017, Stark & Marsh submitted our first letter to the Honorable William F. Morneau Minister of Finance regarding the proposed changes to tax legislations. Please click here to view our letter.
 
On September 29th 2017, we submitted our second letter which provides further specific comments regarding items contained in the proposed finance paper. Click here to view the letter.
 
The repercussions of the proposed changes could affect small business including our Agriculture industry substantially. Tax tools such as transfer of farm used commonly today as one of the many tax planning strategies could be eliminated.
 
What can you do?
  • We encourage all Canadians to submit their feedback to the Minister of Finance before the closing date of October 2nd. Instructions can be found on the Department of Finance’s website by clicking here.
  • Sign the petition available on change.org. We believe that there should be an extension made to the consultation period of the proposed changes. An extension of time would give many of those in the field the opportunity to finish harvest and then ask questions.

How might these changes impact me personally?

The shareholders of private corporations should consider a review of the consultation paper released by the Finance department on July 18, 2017 and should also consider providing comments to Finance by October 2, 2017. That paper includes significant measures and complex proposed rules and approaches to address certain tax planning strategies involving private corporations that Finance believes are inappropriate.

Stark & Marsh, CPA LLP can help you assess the impact of any potential changes to the taxation of private companies that may result from this consultation paper and the accompanying proposed legislation. For details on implications for your situation, contact us at Stark & Marsh, CPA LLP.

Farmers – we have also summarized below some of the implications of the new rules specifically to farms.

Income Splitting - These new rules will be effective in 2018.
Extension of the Tax on Split Income rules – often referred to as “Kiddie Tax” rules.
There are many private corporations where family members own shares in the operating company and it has also been a fairly common tax practice to set up a structure whereby a family trust owns shares in an operating company. In both situations dividends could be paid to the adult family members, such as spouses and children, who would pay tax at their graduated tax rate. For those adult family members who earned little or no other income the tax owing could be low on those dividends.

Except for some limited situations, the new legislation proposes to tax those dividends, as split income, at the highest tax rates which eliminate the income tax savings previously available. As well, the new rules propose to tax other kinds of income as split income, such as interest and capital gains, at the highest tax rate when paid to related adult family members. The new rules will be more restrictive for family members between the ages of 18 to 24. The new rules may not apply if the adult family member contributes significantly to the corporation by way of capital or involvement however the rules on this are unclear and CRA will have the discretion to determine if the amounts paid to the related adult family member are reasonable in the circumstances. It may be necessary to keep records of the family members’ involvement in the business and compare the payments to what another business would pay for that work to justify the amounts being paid.


Capital Gains Deduction - These new rules will be effective in 2018.

The capital gain deduction can be used to shelter a capital gain realized on the disposition of qualified small business shares up to a lifetime limit of $835,716 and qualified farm property (land and/or shares) to a lifetime limit of $1,000,000 in 2017. Tax planning strategies often include the use of a trust or direct shareholdings in order to multiply the number of lifetime capital gains deductions available to members of a family to shelter a capital gain arising on the sale of their company. The new rules will not allow the use of the capital gain deduction in the following situations; if the gains are considered to be split income (discussed above), if the recipient is a minor, any gains accrued while the recipient was a minor, any gains accrued while shares were being owned by a trust.

There will be an opportunity for trusts and individuals to make an election to report a deemed disposition to crystallize the capital gains exemption in 2018. However, this crystallization will only be available to adult beneficiaries and adult family member shareholders. This would allow the use of the capital gain deduction in situations where it will not be available later because of the new rules. This will require a determination of the fair market value (FMV) the property as there are penalties for using amounts higher than FMV.


Conversion of Capital Gains to Dividend Income – these new rules will be effective for transactions on or after July 18, 2017

There is a significant difference in the tax rate of a dividend and capital gains in part because only 50% of capital gain is taxable.

There is currently a rule that converts a taxable capital gain into a deemed dividend on a sale of corporate shares when a related person uses a corporation to purchase the shares and the person selling the shares uses the capital gain deduction to shelter the income. A new rule is being proposed that would extend this so that even in situations where the capital gain deduction is not being used the capital gain would be converted to a deemed dividend. It is usually more tax efficient to use a corporation to buy shares however this will not be the case for related persons.

Finance also proposes to introduce a separate anti-surplus stripping rule to address tax planning that it believes circumvents the rules on the conversion of a private corporation’s surplus into tax-exempt, or lower-taxed, capital gains. This anti-surplus stripping rule would generally apply to related person transactions where it is reasonable to consider that “one of the purposes” of a transaction or series of transactions is to pay an individual shareholder/vendor non-share amounts (e.g., cash) in a manner that involves a “significant disappearance” of the corporation’s assets. In such a case, the non-share amounts would be treated as a taxable dividend, instead of a capital gain. Finance also proposes treating payments out of the capital dividend account as a taxable dividend where the capital dividend account was created by transactions whose goal was to reduce the personal income tax of the shareholder.

The proposed new rules would affect some commonly used planning known as the pipeline method of reducing the double taxation that can occur on the death of the shareholder of a private corporation. On the death of a shareholder, the shares are deemed to be sold at FMV and the resulting capital gain is taxed on the final personal tax return. The beneficiary of the shares then has a cost base on the shares equal to the FMV however if the shares can not be sold and the corporation is wound-up the net assets are taxed as dividends and the cost base of the shares can not offset the dividend income, hence the double tax issue; once on the death of the shareholder and second on the withdrawal of the assets from the corporation. The pipeline method utilizes the cost base and turns it into a tax free shareholder loan however with the new rules that will no longer be possible. There is an alternative method however it is often not as tax efficient as the pipeline method.

 

Having investments inside a private corporation – no effective date has yet been announced
The government has proposed to increase the income tax on a corporation investing surplus funds. The government’s concern is that an active company subject to low tax rates has significantly more to invest than if the funds were paid to the individual shareholder and all taxes were paid. The current rules already include higher tax rates for corporations (a portion of which is refundable when dividends are paid out) on passive investment income which are intended to match the tax rates that an individual would pay on the same income. The current rules however do not consider that there are more surplus funds to invest than outside a corporation. The proposed changes would remove the ability to get the refundable portion of the tax back when the surplus funds used to make the investment came from income taxed at the low corporate rates.

The distribution of the after tax income from the investments is also proposed to change so it follows the taxation of where the funds came from. For example, when surplus funds come from income taxed at the low business tax rate then the dividends from after tax investment income would be treated as non-eligible dividends. Currently eligible dividends from public company investments can be paid out as eligible and the non-taxable portion of capital gains from investments can be paid out as tax free dividends however this would change if the new rules take effect.
This issue gets very complicated in terms of tracking the sources of surplus funds and the type of dividends that get paid and could result in more detailed record-keeping requirements.

 

Farms

Income splitting

  •  As with other businesses, farms set up as corporations that pay dividends to spouses or children will be at risk for higher income taxes unless they can justify the amounts as reasonable and CRA agrees.

Capital gains deduction (CGD) – on qualified farm property (farm land, interest in a family farm partnership, shares in a family farm corporation)

  •  Children under age 18 will not be allowed to use their CGD on any sale of qualified farm property,
  • any capital gains on qualified farm property allocated out a family trust will not be eligible for the CGD,
  • individuals will not be able to use the CGD on a capital gain from any qualified farm property where such gain accrued before they turned age 18. This will be a big problem in all situations where the parents or grandparents roll farm assets to the children on a tax free basis and those assets were owned at a time before the child turned age 18. In such cases the child cannot use the CGD on that portion of the gain when they sell the farm assets. This will require some determination of when the gain accrued which could be problematic and expensive.
  • the new income splitting rules will affect any gains of farm corporation shares or farm partnership interests for children or spouses. To the extent that gain is unreasonable, which is based on various factors, in will not be eligible for the CGD but rather subject to the highest tax rate,
  • there is an opportunity for individuals to elect to report a deemed capital gain in 2018 to take advantage of the CGD before the new rules kick in however we note the following potential issues
    • appraisal and valuation cost
    • alternative minimum tax could apply especially since the accrued gain will likely have to all be reported in 2018, income tested deductions could also be affected
    • if the individual received the farm property which they are electing on within the last 3 years from a parent or grandparent using a tax free rollover there could be a problem. An existing rule may cause the gain to be attributed back to the parent/grandparent who may not realize that and/or may have already used up their lifetime limit of the CGD
    • children under age 18 cannot elect on corporation shares so would have to actually sell the shares to take advantage of the CGD before the new rules apply.
    • eligible farm property will need to qualify for the CGD for at least one year before the election which can take place at any date in 2018. Consider taking steps to ensure the farm assets qualify as soon as possible if you may want to use the election.


Conversion of Capital Gains to Dividend Income

 It has been a fairly routine strategy for farmers to sell their farm land and/ or farm partnerships to their own corporation, or a child’s corporation, in order to use the CGD to shelter the gain and be able to withdraw tax free cash from their corporation. Although it is not entirely clear as the new rules are complex, some tax experts are advising that this strategy may be an issue as CRA could require you to report the amount received as a taxable dividend.
Although there was already a restriction whereby parents/grandparents could not use the CGD when selling farm corporation shares to their children’s corporation, the new rules will result in the parents being taxed as dividends resulting in higher amounts of income tax when they would have otherwise have been taxed on capital gains.
 These rules result in parents/grandparents being financially better off selling to unrelated parties rather than to children/grandchildren.


Having investments inside a private corporation

 It is already better to have less than 10% of assets as non-farm assets for the CGD and tax free rollover rules. Under the new rules, it may be even more beneficial to hold a minimal amount of non-farm assets inside a corporation as it appears such assets will attract additional income taxes. This will provide more incentive not to rent out the farm land but rather to structure any land use by others as custom work or joint ventures that have enough features so that the arrangement is seen as actively farming.

 

Summary
The new rules will require most privately held businesses which are owned by corporations or trusts to determine if the ownership structure is still appropriate as well as evaluating the election to trigger the capital gain deduction. Businesses that currently pay dividends to family members will need to reevaluate if that should continue or change to some other method of payment. Many businesses will also have their income tax cost and compliance costs increase because of the new rules and complexity.

Please visit the Department of Finance’s website for the option to provide your personal commentary.

 

 
 
 

 

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