Tax Planning Through the Use of Private Corporations (August 2017)

You may have heard about the recent consultation paper that was released by the Department of Finance on July 18, 2017. It addressed tax planning through the use of private corporations, specifically including, among other things, income splitting and holding passive investments within a private corporation. As the effects of these proposals are far reaching, we wish to bring them to your attention. The government is seeking input on its proposals by October 2, 2017. We will ensure to keep you apprised of the resulting changes, if any.

Following is a brief overview of some of the proposed changes effective for the 2018 and subsequent taxation years that if enacted will have the biggest impact on our small business clients.

Income splitting using private corporations

Tax planning arrangements using income splitting often results in income that would have been taxed in the hands of a high-income individual being taxed in a lower-income individual, typically a family member. The result is minimizing the overall personal tax paid on this income. Due to the fact that a salary must be “reasonable” in the circumstances, this was often done via the payment of dividends to a spouse or adult child.

The government is proposing to extend the “reasonableness” test to any Canadian resident individual who receives split income and expand the types of income that would be considered to be split income. An amount would not be considered to be reasonable if it exceeds what an unrelated person would have agreed to pay the adult, considering the labour and capital contributions of the individual to the business, the risk assumed, as well as all previous returns or remuneration paid to the individual in respect of the business.

The proposed changes will affect the majority of incorporated small businesses. Income splitting in many family situations would no longer be advantageous, resulting in an increase in overall taxes paid.

Holding passive investments inside a private corporation

Active corporate business income is taxed at lower rates than personal income, which results in businesses having more after-tax cash available to reinvest in their businesses. When businesses earn more than is needed, the business owner has the opportunity to hold passive investments within the corporation. The federal government feels that this may result in the realization of after-tax returns that exceed what an individual investor could have achieved with personal investments and savings.

The federal government has offered a plan which would effectively tax the passive investment earnings in the corporation at the top personal income tax rate and remove the perceived unfair advantage. It would effectively eliminate any deferral advantage that arises with incorporation.

As a result of this, we would expect corporations with these types of income to have a higher tax burden which would result in less funds available for investment portfolios maintained in the corporation.

The full consultation document can be found on the Department of Finance website www.fin.gc.ca.

As indicated above, the proposed changes are far reaching and will impact the majority of incorporated small businesses in Canada. If you have questions about how your business may be directly impacted, please contact our office to book an appointment to discuss it with us.