Summary – The Facts
Income splitting as we currently know it, using dividends, is dead. There will be no income splitting with any family members unless they provide services to the business or in a few other very exceptional circumstances. If they provide services to the business, the amount that can be paid will be restricted to a “reasonable amount” (this means “very small” or none in most cases). Other income splitting plans, using loans and through other means are also effectively shut down. Proposed legislation has been supplied on this issue.
Capital gains exemption splitting on the sale of Qualified Small Business Corporation (“QSBC”) shares will be eliminated. A special, one-time opportunity to lock in and utilize the Capital Gains Exemption of family members will be available in 2018 (this is called a “crystallization”); however specific actions to obtain access to this opportunity may be required before the end of December of 2017.
Earning passive income in your corporation will be severely hampered by increased effective tax rates. The “flow through tax rate” (in other words, to get that income into your personal hands) may be as high as 70%. No proposed legislation has been supplied on this proposal yet.
The intentional conversion of income into capital gains has been severely restricted (you might say eliminated). This measure is aimed at eliminating tax strategies which are only rarely available to change income or dividends into capital gains which are taxed at lower tax rates.
As a result of these changes, most of our corporate clients will pay significantly more tax each year and in their retirements.
What is not changing is your ability to claim business deductions. Contrary to some of the ill-conceived comments already sent to the Department of Finance by some professional organizations, the tax treatment of your overhead costs, salaries to non-family employees and other business expenses is not going to change.
Unintended Consequences – The Facts
Income Splitting:
- A tremendous amount of audit activity will be created by the “reasonableness test” applicable to payments to family members. This will be very expensive for both the taxpayer and the government. It is almost impossible to prove that an amount paid to a person is “reasonable” in the circumstances.
- Loans to spouses or guarantees by one spouse to another will result in the lender and/or the guarantor being taxed on the resulting income. Among other problems with this, it will generally result in the family homemaker never being in a position to obtain investment assets of their own without the income being taxed in the other spouse’s hands (unless they have independent means or if they get divorced). This may affect “prescribed rate loans” that have already been setup.
- Certain groups of entrepreneurs and professionals will find loss of these tax savings sufficient to justify their departure from Canada – “brain drain.”
Capital Gains Exemption Splitting:
- Any date in 2018 can be selected to elect for the family member shareholders to realize the gain and utilize their QSBC Capital Gains Exemption; however, the company must meet very stringent conditions in 2017 in order for the Exemption to be available in 2018. Many companies will fail to undertake these “purification transactions” on time and will be denied access to the Exemption.
- For each family member’s capital gains exemption that can be utilized, the future tax savings could be up to $200,000. This savings would only be realized on the eventual share sale of your business.
- A second and more exacting purification transaction will be required by most companies on the exact day that the crystallization is to occur in 2018.
- An accurate value of the company must be obtained at both the date in 2017 described above and at the date in 2018. Severe penalties will apply if the value used at the 2018 date is more than 10% different than the “actual value” of the shares on that date. As a result, at least one and possibly two formal (expensive) valuations will be required in order to avoid these potential penalties.
- Many family member shareholders will be subject to Alternative Minimum Tax (“AMT”) on this crystallization. AMT is generally a refundable tax and in many cases, the refund is obtained over several subsequent years (up to 7 years) by applying it against other income of that person in those years; however, with income splitting eliminated and with many of these beneficiaries much younger than they would have been for a sale in the normal course, they will be unable to ever recover this refundable AMT.
- Claiming the QSBC Capital Gains Exemption is a highly complex area and we expect that the CRA tax audit department will have a field day reviewing compliance with the stringent conditions for claiming the Exemption, reviewing the often complex purification transactions and requesting formal valuation documents, reviewing them and disputing the values used.
- This will be an expensive process and we believe it may become impossible for Canada’s accountants and lawyers to get all of the purification transactions done before the end of 2017.
Earning Passive Income in a Corporation:
Taxpayers will effectively be penalized in the future where they have:
- taken dividends historically,
- have used corporate savings instead of maximizing their RRSP’s in previous years, and/or
- have started saving for retirement late in life with the comfort of relying on their ability to utilize corporate savings and investments to “catch up.”
If the rules are implemented as proposed wealthy taxpayers with significant corporate investment portfolios may see their retirement incomes almost double by paying the Canadian corporate distributive tax (dividend tax at 41%) and then legally fleeing Canada to a tax haven – “capital flight.”
Converting Income into Capital Gains:
- Double taxation on death will result under the current proposals. Much of the estate and insurance planning for families will need to be revisited and, in some cases, it is likely that family assets will be lost in order to pay tax bills on death.
- New plans and strategies are already coming to light to facilitate circumventing these rules. We expect that a whole “industry” may develop to assist with this. Audit activity will be further elevated on almost all capital gains transactions.
Attack on Entrepreneurs and Professionals and the Wealthy – Opinion
Some of these proposals are legitimate measures designed to close aggressive tax reduction strategies. Others appear to simply be an attack on entrepreneurs and professionals who have taken years out of their lives and very significant financial risks to start and develop businesses and to get educations to allow them to earn a better income. However, they all start earning income later and they start saving for retirement much later. They do not have pensions, they do not have government or other benefits and they do not get Employment Insurance. These people carry an immense amount risk and stress that employees do not and yet the Liberal Government has the stated objective of taxing them on the same basis as employees. This group of people employs almost 50% of the population in Canada. Their retirement savings strategies (allowing them to catch up for years spent going to school and building their businesses up) are being attacked.
Deals made with the Provinces to pay doctors less by allowing them to incorporate and reduce their taxes through income splitting are being circumvented by the Federal Government who holds the purse strings closed on Medical Payment transfers to the Provinces. Will our doctors stay in Canada while they could make significantly more money in the US and pay less tax? What will happen to our healthcare system?
Will fewer people be willing to take on the risks and stress of starting and building a business in Canada? Will the investment capital which businesses and construction require in Canada stay in Canada or will it be chased away into international tax havens like the Bahamas, the Cayman Islands or the Turks and Caicos?
Action Plan
If you are concerned about these proposals, there are steps that you need to take.
- Recognize that some of these proposals are here to stay.
- Raise awareness of all of these issues with your advisors, colleagues, friends, family and employees. Send them emails, copies of articles, phone them or simply talk with them.
- Sign any and all petitions which circulate.
- Contact and help to mobilize and support any business and professional organizations you belong to or that you can join.
- We intend to draft several different letters which our clients can send to the government. You should plan to customize those letters and send at least four physical, snail mail letters out:
- to your Member of Parliament (MP),
- to the Department of Finance,
- to the Honorable Bill Morneau,
- to Prime Minister Justin Trudeau
- Share copies of these letters with your advisors, colleagues, friends, family and especially your employees. If small businesses employ almost half of the population, we can assemble a mighty voice. If your business would be better off in the USA that is something you might want to suggest to your employees – perhaps they should participate in this process. Perhaps they should think very carefully about who they vote for in the next election.
- Inform your employees of the impact this may have on them. Many privately owned Canadian businesses will have to limit or freeze wage increases. This may also result in lay-offs and wage roll backs at some businesses.
- If you would like to also send an email to your MP, feel free to do so, but recognize how easy it is to ignore emails.
Some have said that the Liberal Government is simply paying lip service requesting input on these proposals because they released their proposals in the middle of the summer and allowed such a short time-frame for comments (75 days from mid-July). This does not give us much time but if we can make enough noise, they will notice.
Imagine your MP receiving a petition with 100,000 names on it. Now, imagine your MP receiving 100,000 individual letters. Did you know that no postage is required on a letter to your MP if sent to their Parliamentary Address? The same goes for a letter to the Prime Minister of Canada. We will provide contact information with the proposed correspondence.
