Thursday, December 28, 2017

Family Members as Part-Time Workers

This continues consideration of the revised proposals on income splitting through a family corporation. The government released these revisions on December 13, 2017. If passed into law in their current form, the proposals will apply as of the start of 2018.

The revised proposals contain an exemption for an over-age-17 family member who is actively engaged on a “regular, continuous and substantial basis” in the activities of the family business corporation.

This will be a difficult question of fact in many cases. However, a de minimis rule allows a family member to qualify for this exemption if the family member works an average of 20 hours per week in the business during a taxation year. If the business operates on a seasonal bases, the average is for only the portion of the year in which the business operates.

If the family member has met the 20-hour per week minimum for any five previous taxation years (including years before 2018), the family member will be exempt from the proposals even during years in which the family member does not work an average of 20 hours per week.

A qualification has to be made in respect of capital gains. In order for a capital gain on the sale of shares to be exempt from the income-splitting proposals under this exemption, the family member must have met the 20-hour per week standard during five previous taxation years (not just the year of the sale). The five years need not be consecutive.

The 20-hour per week exemption applies in respect of any family corporation, including service corporations and professional corporations.

If a family member wants to rely on the 20-hour per week exemption, the family member will have to keep careful track of hours worked in the business. As the 20-hour minimum is an average, the family member may have to work more than 20 hours per week if the family member takes vacation time. The family member may (but does not have to) receive a reasonable salary for the work. The primary advantage of meeting the 20-hour per week average is that the family member can receive dividends without having to justify the dividend.

A signed employment agreement is advisable, but careful tracking of time worked is more important. In the case of an audit, the onus of proof is on the taxpayer.

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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.

Revised Income-Splitting Rules Released

On December 13, the federal government released its revised proposals on income-splitting.
If passed into law, the rules will be effective as of the start of 2018. While it will take time to fully analyze the rules, the following general points can be made at this point.

The proposals will not apply to any dividends paid during 2017. If passed into law, the proposals apply only as of January 1, 2018.
Revisions to corporate structures do not need to be finalized prior to the end of 2017. Corporate structures can be revised in early 2018 in order to take the proposals into account.
The new rules specifically target professional corporations and corporations that derives 90% or more of their income from the provision of services. A professional corporation is one that carries on the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor.
The new rules will not apply to an individual over the age of 24 who earns income from a non-professional corporation that earns less than 90% of its income from the provision of services, provided that the individual has at least a 10% interest in the corporation. The 10% interest has to include at least 10% of the voting shares and at least 10% of the value of all issued shares.
If a person is 65 years of age and over and has been active in the corporate business in the past, that person can split income with his or her spouse (even if the person has retired from the business). This will be important for retirement plans.
If an adult works in the business for an average of at least 20 hours per week, the income splitting rules will not apply to amounts paid to that adult.
The rules will no longer be extended to nephews, nieces, uncles and aunts.

Further analysis of specific aspects of these new proposals will follow.

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Thursday, October 19, 2017

Holding Corporation Investment Income

On October 18, the federal government released some tidbits of information about changes to its proposals in respect of investment income earned by corporations that invest active business earnings that have been taxed at the small business rate. In July, the government had proposed to impose special rules on such earnings.

While we will have to wait until the 2018 federal budget for details, the October 18 announcement indicates the following.

Any new rules will apply only on a go-forward basis. Presumably, this means (at the earliest) the date of the 2018 federal budget. Federal budgets are usually in the spring of the year.

Any new rules will apply to neither past investments nor income earned from those past investments. Presumably, past investments refers to investments in place at the time that the new rules come into effect.

Any new rules will apply only in respect of passive investment income of a corporation that exceeds $50,000 per year. Presumably, this is in addition to any income earned from past investments.

This is welcome news, although much will depend on the details that will be released as part of the 2018 budget. Presumably, the proposals will have to set up notional tax accounts, one for tracking income from pre-budget investments and one for tracking income from post-budget investments. Presumably, a corporation will be able to sell pre-budget investments and re-invest the sale proceeds without losing the grandfathering status. But we will have to wait and see.

It seems that the government is releasing snippets of information about changes as trial balloons to gauge reaction. Or perhaps the government is merely following the time-honored advice given by Machiavelli in The Prince: always release good news slowly over a long period of time.

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Pipeline Still Possible?

On October 19, the federal government continued in the almost-daily announcement of reforms to its original July 18 tax reform proposals.

This latest reform announcement indicates that the government will not be moving forward with measures relating to the conversion of income into capital gains.

As has been the case all week, the actual announcement is vague. Even worse, one has to be a tax professional in order to understand the announcement. The announcement is also misleading, because the change merely allows taxpayers to avoid double taxation.

To illustrate the point, take a simple example. Assume that an individual (a parent) dies and leaves shares of a private family corporation to the parent's children.  As a result of the parent's death, the shares undergo a deemed disposition for tax purposes at fair market value. This usually results in payment of capital gains tax. To keep the numbers simple, assume that the deceased had no cost in the shares and that the shares had a date-of-death value of $100. This results in a $100 capital gain and requires payment of about $24 in tax.

This is a deemed capital gain. No actual sale has occurred, which means that the estate has no cash to pay the tax. In order to pay this tax on the deemed capital gain, the estate usually has to extract cash from the corporation.  If the corporation pays a $100 dividend to the estate, however, the estate will have to pay about $41 in tax on that dividend.  That results in total tax of $65 on a taxable value of $100.

In order to avoid this double taxation, the estate can implement a post-death corporate reorganization. This form of reorganization is called a "pipeline" by tax practitioners (but has nothing to do with oil flowing from Alberta).  The reorganization allows the estate to extract $100 from the corporation without payment of the extra $41 in tax. This always seemed fair, given that the Income Tax Act had imposed the original $24 capital gains tax on the death of the parent. The post-death reorganization merely allowed that already-taxed value to be extracted as an amount that had already been taxed (which was indeed the case).

Today's announcement is welcome. It would have been preferable, however, for the government to have called a spade a spade and to have announced that it was withdrawing a proposal that would have resulted in double taxation of value on death. The government continues to tar entrepreneurs with an implied "tax cheat" brush by referring to the withdrawal of a measure that would have prevented the conversion of income into capital gains.

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Monday, October 16, 2017

Government not proceeding with Restrictions on Capital Gains Exemption

On October 16, the federal government announced its first concrete modification to the sweeping income tax changes that it had proposed on July 18.

The media has focussed on the phased reduction to the low income tax rate that applies to the first $500,000 of active business income earned by a Canadian-controlled private corporation. The federal rate on such income will decline to 10% at the start of 2018 and to 9% at the start of 2019. Tax rate cuts are always welcome, although they sometimes have the taint of bribing taxpayers with their own money.

The more significant change was the decision not to proceed with restrictions on capital gains exemption claims. The capital gains exemption provides each Canadian resident with the opportunity to earn up to $1 million in tax-free capital gains on the sale of qualifying farm and fishing assets and just over $835,000 in tax-free capital gains on the shares of qualifying active business corporations. On July 18, the government proposed numerous restrictions, including the following.

No capital gains exemption would be available for capital gains that accrue while eligible assets are held inside a trust.
No capital gain exemption would be claimable by an individual under the age of 18.
A capital gains exemption would be claimable only to the extent that an individual could be considered to have “earned” the exemption through actively working in the business in question.

The government now indicates that it will not be proceeding with these restrictions. That is good news.

The government seems to be recognizing the difference between wages and investments. Capital gains are, after all, an investment return. If I purchase shares of Microsoft and the shares increase in value, I have made a good investment. It does not matter that I have not personally contributed anything to that increase in value. I may be completely computer-illiterate – it does not matter. I benefit from that increase in value because I was astute enough to invest in a good business.

It is to be hoped that this recognition of the difference between wages and investments will continue to guide the government’s modifications to its July 18 income tax proposals. We will have to wait and watch.

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Sunday, July 23, 2017

The Old are Young Again

It’s not exactly the fountain of youth, but many Canadians might soon be treated for tax purposes as if they were once again under 18 years of age. Enabling legislation has to be passed into law, but this might come into effect as soon as 2018.

Currently, Canadian income tax law applies a special tax – colloquially referred to as the “kiddie tax” -- if a minor child receives dividends or other income that has been generated by activities of a parent. For example, this special tax might apply if a parent carries on business through a private corporation and the child receives dividends from the corporation. If the special tax applies, the dividend is taxed at the top marginal tax rate applicable to that form of dividend – as if the child were a top-rate taxpayer. This removes any income-splitting benefit.

Under current law, the kiddie tax ceases to apply in the year that the child reaches age 18. This means that income splitting can start in the year that a child has his or her 18^th birthday. As well, income can be split with one’s spouse and with other adults.

Starting in 2018, the government intends to significantly extend the “kiddie tax” rules. The special tax will apply to all individuals – including spouses and adult children – who are related to the principal of the business. For these extended rules, relatives will also include uncles, aunts, nieces and nephews (who are not normally related for income tax purposes).

The rules will apply to income that is received directly on shares owned by the related individual or indirectly on shares held through a family trust.

A limited exception will apply to the extent that income paid to the related individual is reasonable in light of services that the individual actually provides to the business. In general, the related individual will be able to receive salary or dividends provided that the aggregate amount of the salary and dividends does not exceed what would have been paid to an unrelated individual performing the same services. A more restricted exception applies if the individual is between the ages of 18 and 24.

The new rules will not totally prevent income-splitting with other family members. However, income splitting after the end of 2017 will require that the family member actually work for the business and will be limited to a level that is reasonable in light of those services.

The proposed rules will not affect other forms of income-splitting techniques, such as loans made to a spouse at the prescribed rate of interest.

The new proposals are included in draft legislation that was released on July 18, 2017. This draft legislation includes significant other changes that will be described in future blogs.

The federal government has invited comments on the draft legislation. Comments can be made prior to October 2, 2017 by sending the comments to fin.consultation.fin@canada.ca.

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Wednesday, July 19, 2017

Major Tax Changes to Private Corporation Taxation

On July 18, the federal Finance Minister released his promised consultation paper on the taxation of private corporations. The paper includes draft legislation, most of which will be effective at the start of 2018 but some of which is effective as of announcement date -- July 18, 2017.

The immediate measures seem to prevent the use of pipeline planning to prevent double taxation of the value inherent in private corporation shares held on death. Double taxation of this value can arise if the estate withdraws funds from the corporation to pay the capital gains tax triggered by the death of the shareholder. While it will still be possible to avoid double taxation, the new rules seem to require use of the technique of triggering a capital loss by redeeming the shares held by the deceased in order to trigger a capital loss that can be applied to offset the capital gain triggered by the death. While this avoids the double taxation, it results in taxation of the date-of-death value as a deemed dividend (at a higher tax rate) rather than as a capital gain. The carry-back technique is also subject to strict time limits (so that the ability to avoid the double taxation can be lost if one does not act promptly).

It will take some time to work through the implications of the various immediate and proposed changes. These provisions fundamentally alter long-standing estate planning techniques.

The release is characterized as a consultation paper, but is a consultation paper that includes changes that are effective immediately (assuming that the enabling legislation is passed into law by the current federal parliament). One can expect that the government will receive lots of comments on the package before the comment deadline expires on October 2, 2017. Comments can be sent to fin.consultation.fin@canada.ca.

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