On July 18, 2017, the Government introduced proposed amendments to the Income Tax Act (Canada) (the “Act”) that could have profound implications for the taxation of private corporations and their shareholders. The amendments are intended to address certain tax planning strategies involving the use of private corporations that the Government has portrayed as giving “unintended advantages to some high-income earners at the expense of other Canadians.”
The Government has invited submissions on the proposals until October 2, 2017, and has indicated that it will continue to review the issue and will finalize the legislative proposals after the consultation period. At this point, it is unknown how open the Government will be to making changes to the proposed amendments before they are finalized.
The proposed amendments target, in particular, certain forms of income splitting and the conversion of income to capital gains. The proposed changes are broadly outlined below.
Income Sprinkling
The concept of “income sprinkling” refers to strategies designed to shift income from an individual subject to high marginal income tax rates to other individuals, typically family members, who are subject to lower marginal income tax rates.
The Act already includes various measures intended to limit the scope of income splitting, including the tax on split income (“TOSI”) commonly referred to as the “Kiddie Tax”. The TOSI currently applies tax at the top marginal rate on certain income received by minors under the age of 18. It also limits the deductions and credits that can potentially be claimed against such income. The proposed amendments to the legislation target income splitting through a significant expansion of the TOSI rules.
The proposed rules will apply the TOSI to certain adult individuals who have received unreasonable amounts from a business linked to a related individual. An amount would be considered unreasonable, and therefore potentially subject to the TOSI, to the extent that it exceeds what would be paid to an arm’s-length person taking into account work performed, assets contributed, risks assumed, and amounts previously paid. As noted above, income subject to the TOSI will be subject to tax at the top marginal rate, with limited deductions and credits.
The types of income that are potentially subject to the TOSI have expanded. For example, individuals under the age of 25 years will be subject to TOSI on income earned from the investment of income that was previously subject to the TOSI rules.
We note that the new rules also contain additional restrictions applicable to individuals aged 18 to 24, including more restrictive reasonability tests.
The proposed changes to income sprinkling would apply for taxation years beginning January 1, 2018.
Lifetime Capital Gains Exemption
The Government has also proposed a series of measures intended to curtail the ability of taxpayers to multiply the lifetime capital gains exemption (“LCGE”) via other family members. Notably:
The proposed changes to the LCGE would apply for taxation years beginning January 1, 2018. Special transitional rules would allow certain eligible taxpayers, including individuals and personal trusts, to elect to realize a capital gain in 2018 and use their LCGE under the current tax rules. Note that there are a number of criteria that must be met for a taxpayer to be eligible for the election.
The Act currently includes various mechanisms intended to prevent taxpayers from engaging in certain “surplus-stripping” transactions whereby corporate surplus is extracted as a capital gain (subject to favourable tax rates) rather than a dividend through the use of certain non-arm’s length transactions. These rules typically convert proceeds received by the taxpayer into a deemed dividend for income tax purposes.
The Government has proposed several amendments intended to further restrict taxpayers from engaging in “surplus-stripping” transactions. These rules will apply to all transactions occurring after July 18, 2017.
In addition to the proposed amendments discussed above, the Government has reiterated its intention to eliminate the tax-deferral advantage provided to private corporations that invest active business income that has been subjected to low corporate income tax rates, into passive investments held within the corporations.
Although the Government has not yet introduced draft legislation on this topic, the Government has offered some comments on possible approaches that it is considering. One such option is the elimination of the refundability of passive investment taxes where the investments were funded using active business income subject to low corporate tax rates. Another such option is the elimination of the capital dividend account where taxable capital gains are realized on investments acquired using active business income subject to low corporate tax rates.
The Government is also seeking comments and submissions on this topic during the aforementioned consultation period, with a view toward developing proposed amendments after the consultation period has ended.
The proposed amendments to the Act could have profound implications for the taxation of private corporations and their shareholders. Please contact your D&H Group LLP advisor if you have any questions or concerns.
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