In 2016, the federal government eliminated ways to maximize the small business deduction. Earlier this year, the government took aim at tax deferral opportunities afforded to certain professionals, including lawyers, by proposing to eliminate billed-basis accounting.
Now, in a consultation paper released July 18, the federal government proposes measures to constrain the use of private corporations to gain tax advantages. These measures, which the government wants to take effect in 2018, will dramatically impact lawyers and our clients carrying on business in professional and private corporations.
The federal government’s proposals attack three tax-saving strategies through private corporations: 1) income sprinkling; 2) passive investment income; and 3) converting income into capital gains.
Income sprinkling refers to splitting income with family members in a lower tax bracket. Existing rules under the Income Tax Act limit income sprinkling by requiring expenses to be reasonable, and taxing dividends paid to minors at the top tax rate (commonly known as the “kiddie tax”). However, the federal government’s position is that the current rules are not sufficiently robust.
The government proposes to extend the kiddie tax to include adult Canadian resident individuals who receive split income. A reasonableness test would determine whether tax on split income should apply to the adult. This test would be stricter for those between 18 and 24 years old. Reasonableness would be determined by looking at contributions to the business, as well as risks assumed and previous returns and remuneration paid to the individual. Any amounts found to be not reasonable would be subject to the top tax rate.
The federal government is also proposing to constrain access to the Lifetime Capital Gains Exemption. Currently, an individual can shelter capital gains realized on the disposition of qualified small business shares up to a lifetime limit of $835,716 (indexed annually). The concern is the claim for the LCGE by family members who have not contributed to the business.
Access to claim the LCGE would be restricted by: 1) individuals under 18 would not qualify for the LCGE; 2) the LCGE would generally not apply if the taxable capital gain from the disposition of property is included in an individual’s split income; and 3) gains while the property was held by a trust would not be eligible for the LCGE.
These proposals do not affect law firms as much as other businesses given the restrictions on who can be a shareholder of a law practice. However, they significantly alter the landscape for many businesses and professionals who have used income sprinkling to reduce taxes.
A benefit of a private corporation is the ability to defer income tax. Given the lower tax rates on private corporations, there are more after-tax funds to invest. While shareholders are taxed personally when the funds are withdrawn, they can defer withdrawing these funds, thereby deferring the tax. The corporation can reinvest these tax-deferred funds to earn income, with potentially significant compounding effects. Professionals and business owners have used this tax deferral opportunity as a way to save for retirement.
The government proposes to eliminate the tax deferral advantage on passive income earned by private corporations. The government explains that lower corporate tax rates were intended to apply only to active business income and not as a means of maximizing personal savings. These proposals will negatively affect how professionals and other small business owners fund their retirement.
Converting income into capital gains
Dividends are taxed at a higher tax rate than capital gains. There is, therefore, a tax advantage to withdrawing earnings as a capital gain rather than a dividend. This is known as surplus stripping. Though there is an anti-avoidance rule, it is being circumvented. The government proposes to eliminate this practice by taxing the funds as a capital gain and as a dividend when extracted. This effectively forces the shareholder to extract funds through a salary or dividend.
By eliminating many of the tax advantages to private corporations, the proposals demonstrate a disregard for the risks that business owners and professionals take when creating a business. Many small business groups and professionals are already voicing their opposition to the proposals. The federal government has invited comments and suggestions on the proposals until Oct. 2. If approved, the proposals will take effect in 2018.
Given the dramatic changes the proposals make to the structure and planning of professional and private corporations, it is imperative that your clients are aware of the potential changes and they seek advice on how they could be impacted.