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TAX NOTES
July 2017
Future Amendments May Increase Tax on Passive Investments On July 18, 2017, the Department of Finance released a White Paper, draft legislation and explanatory notes which propose significant changes to the taxation of private corporations and their shareholders in the following areas: Income splitting with family members; The deferral of tax using private corporations; and Converting income into taxable capital gains. In this Tax Note, we consider the proposals relating to the deferral of tax using private corporations. Tax Policy Concerns When a person carrying on an active business through a private corporation earns business income, that business income will be taxed at a combined federal-provincial corporate income tax rate between 12.5% and 27% (using current Alberta rates). If the corporation earned $100,000 of business income, it would be able to reinvest up to $87,500 of after-tax income in property that produces passive income. When the corporation receives passive income, it will be subject to refundable taxes that should cause the corporation and its shareholder to pay tax on that passive income at approximately the same rate as if the shareholder had earned the income directly. In contrast, if an individual earns employment income, he or she will be subject to income tax at a combined federal-provincial rate of up to 48% (again using current Alberta rates). If the individual earned $100,000 of employment income and was taxed at the highest marginal rate, he or she would only be able to reinvest $52,000 of after-tax funds in income-producing property. This is $35,500 less than the shareholder of the corporation is able to invest in similar property. The effect of the initial $35,500 deferral is significant, even though the corporation and shareholder may ultimately pay tax on passive income at a higher rate than the individual due to underintegration. With income from the initial investment compounding over a 10-30 year investment horizon, the difference in net wealth between the corporation and shareholder versus the individual employee can be as high as 50%. Substantially all of this wealth gap would persist even if the individual employee invested in a TFSA. In opinion of the Department of Finance, there is no tax policy reason why the outcome for an employee and the outcome for an incorporated business owner should be different when both persons ultimately generate the same pre-tax income. 5000 SUNCOR ENERGY CENTRE 150 - 6th Avenue SW CALGARY, AB T2P 3Y7 Tel: (403) 260-3300 Fax: (403) 263-9649 Email: [email protected]
1980 MANULIFE PLACE 10180 - 101st Street EDMONTON, AB T5J 3S4 Tel: (780) 428-8310 Fax: (780) 421-8820 Email: [email protected]
100, 728 Spadina Crescent East Saskatoon, Saskatchewan S7K 3H2 Tel: (306) 952-0894 Fax: (306) 952-2439 Email: [email protected]
2 Proposed Solution The Department of Finance has not released draft legislation detailing how its proposed solution will be implemented, but the White Paper does outline Finance’s current thinking on this point. The proposal, as it currently exists, would represent a fundamental change to the taxation of passive investment income earned by private corporations. Passive income earned by most private corporations would no longer be subject to refundable taxes. Instead, a corporation subject to tax at Alberta rates would be required to pay non-refundable tax on its investment income at a rate of 50.67%. The net profits remaining could be reinvested or distributed to the shareholder as a dividend. How any dividend to a shareholder is taxed will depend on whether the dividend is paid from one of three new tax pools, with the allocation between pools to be made using either an “apportionment method” or an “elective method”. Under the apportionment method, a corporation would maintain three tax pools to which after-tax income from passive investments could be added: 1.
A shareholders’ contributions pool, which would reflect the paid-up capital of the corporation’s shares plus shareholder loans. Any dividends paid from this tax pool would be tax-free.
2.
A general rate income pool, which would reflect the corporation’s after-tax business income subject to tax at the general rate. Any dividends paid from this tax pool could be designated as eligible dividends and taxed at a preferential rate.
3.
A small business income pool, which would reflect corporation’s after-tax business income subject to tax at the small business rate. Any dividends paid from this tax pool would be non-eligible dividends.
When passive income is earned, it would be apportioned between the three pools based on their relative balances at the conclusion of the preceding taxation year. The corporation would have to designate a dividend as having been paid from a particular pool and reduce that pool balance at the time that the dividend is paid. Under the elective method, the corporation would not maintain a shareholders’ contribution pool, but would maintain either a general rate income pool or a small business income pool. Which of the two income pools is maintained will depend on whether the corporation has made a subsection 89(11) election: the presumption is that a corporation that has not elected will fund all of its investments using retained earnings from a small business, while a corporation that has elected is presumed to have funded its investments using retained earnings from a full-rate business. Regardless of which of these methods is adopted, dividends received from a public corporation will only increase the income pool to which they are eligible. Further, the non-taxable portion of capital gains not attributable to the shareholders’ contribution will not increase the corporation’s capital dividend account unless the capital gain is realized on a disposition of business assets or shares of an operating corporation. Finally, if all or substantially all of a corporation’s income is from passive
3 investments, it is contemplated that the corporation would be entitled to elect for all of its income to be taxed as passive income using the current refundable tax regime. Implications for Taxpayers Assuming that legislation similar to the Department of Finance’s concept is enacted, the immediate impact of this regime on corporations and shareholders will depend in large part on the transitional rules affecting existing corporate investment. The White Paper does not indicate what transitional relief would be provided, but Finance’s stated intention is for there to be a limited impact on existing passive investments. If this intention is carried out, then the impact on taxpayers would be limited to investments acquired using a private corporation’s future after-tax business income. Given the possibility of generous grandfathering rules, it may be advantageous for corporations that intend to invest in passive assets to accelerate the realization of income in 2017 and 2018 and, if possible, to make the desired investments in 2017 and 2018. By doing so, they may maximize the amount subject to grandfathering and preserve as large a deferral benefit as possible. When investable income from a business carried on by a corporation is earned in the future, it is not obvious that private corporations should change their behaviour in retaining the cash and investing in passive assets. The corporation and its shareholder remain better off until such time as the corporation pays dividends to the shareholder, and so tax benefits comparable to existing tax benefits could be obtained if the shareholder can reduce his or her effective personal income tax rate on dividends (for example, through a series of transactions in which the taxpayer ceases to be a resident of Canada before receiving a dividend). The new regime may also create an additional incentive for private corporations to invest in assets that will not generate income or capital gains for a long period of time. If these rules are enacted in substantially the form proposed, careful planning will be required in relation to future dispositions of investments in subsidiaries or business assets by private corporations. It will be absolutely critical for these private corporations and their shareholders that the shares or assets disposed of are “good” assets, such that the disposition of assets will result in an increase in a private corporation’s capital dividend account. Notwithstanding the Department of Finance’s expressed desire that any legislation relating to the taxation of passive investments be as simple as possible, it is overwhelmingly likely that the new regime will complex and will feature difficult, time-intensive compliance requirements. As a result, it is likely that considerable additional compliance costs will be incurred by private corporations, particularly if the apportionment method is ultimately adopted as the basis for the new regime.
July 2017
Future Amendments May Increase Tax on Passive Investments On July 18, 2017, the Department of Finance released a White Paper, draft legislation and explanatory notes which propose significant changes to the taxation of private corporations and their shareholders in the following areas: Income splitting with family members; The deferral of tax using private corporations; and Converting income into taxable capital gains. In this Tax Note, we consider the proposals relating to the deferral of tax using private corporations. Tax Policy Concerns When a person carrying on an active business through a private corporation earns business income, that business income will be taxed at a combined federal-provincial corporate income tax rate between 12.5% and 27% (using current Alberta rates). If the corporation earned $100,000 of business income, it would be able to reinvest up to $87,500 of after-tax income in property that produces passive income. When the corporation receives passive income, it will be subject to refundable taxes that should cause the corporation and its shareholder to pay tax on that passive income at approximately the same rate as if the shareholder had earned the income directly. In contrast, if an individual earns employment income, he or she will be subject to income tax at a combined federal-provincial rate of up to 48% (again using current Alberta rates). If the individual earned $100,000 of employment income and was taxed at the highest marginal rate, he or she would only be able to reinvest $52,000 of after-tax funds in income-producing property. This is $35,500 less than the shareholder of the corporation is able to invest in similar property. The effect of the initial $35,500 deferral is significant, even though the corporation and shareholder may ultimately pay tax on passive income at a higher rate than the individual due to underintegration. With income from the initial investment compounding over a 10-30 year investment horizon, the difference in net wealth between the corporation and shareholder versus the individual employee can be as high as 50%. Substantially all of this wealth gap would persist even if the individual employee invested in a TFSA. In opinion of the Department of Finance, there is no tax policy reason why the outcome for an employee and the outcome for an incorporated business owner should be different when both persons ultimately generate the same pre-tax income. 5000 SUNCOR ENERGY CENTRE 150 - 6th Avenue SW CALGARY, AB T2P 3Y7 Tel: (403) 260-3300 Fax: (403) 263-9649 Email: [email protected]
1980 MANULIFE PLACE 10180 - 101st Street EDMONTON, AB T5J 3S4 Tel: (780) 428-8310 Fax: (780) 421-8820 Email: [email protected]
100, 728 Spadina Crescent East Saskatoon, Saskatchewan S7K 3H2 Tel: (306) 952-0894 Fax: (306) 952-2439 Email: [email protected]
2 Proposed Solution The Department of Finance has not released draft legislation detailing how its proposed solution will be implemented, but the White Paper does outline Finance’s current thinking on this point. The proposal, as it currently exists, would represent a fundamental change to the taxation of passive investment income earned by private corporations. Passive income earned by most private corporations would no longer be subject to refundable taxes. Instead, a corporation subject to tax at Alberta rates would be required to pay non-refundable tax on its investment income at a rate of 50.67%. The net profits remaining could be reinvested or distributed to the shareholder as a dividend. How any dividend to a shareholder is taxed will depend on whether the dividend is paid from one of three new tax pools, with the allocation between pools to be made using either an “apportionment method” or an “elective method”. Under the apportionment method, a corporation would maintain three tax pools to which after-tax income from passive investments could be added: 1.
A shareholders’ contributions pool, which would reflect the paid-up capital of the corporation’s shares plus shareholder loans. Any dividends paid from this tax pool would be tax-free.
2.
A general rate income pool, which would reflect the corporation’s after-tax business income subject to tax at the general rate. Any dividends paid from this tax pool could be designated as eligible dividends and taxed at a preferential rate.
3.
A small business income pool, which would reflect corporation’s after-tax business income subject to tax at the small business rate. Any dividends paid from this tax pool would be non-eligible dividends.
When passive income is earned, it would be apportioned between the three pools based on their relative balances at the conclusion of the preceding taxation year. The corporation would have to designate a dividend as having been paid from a particular pool and reduce that pool balance at the time that the dividend is paid. Under the elective method, the corporation would not maintain a shareholders’ contribution pool, but would maintain either a general rate income pool or a small business income pool. Which of the two income pools is maintained will depend on whether the corporation has made a subsection 89(11) election: the presumption is that a corporation that has not elected will fund all of its investments using retained earnings from a small business, while a corporation that has elected is presumed to have funded its investments using retained earnings from a full-rate business. Regardless of which of these methods is adopted, dividends received from a public corporation will only increase the income pool to which they are eligible. Further, the non-taxable portion of capital gains not attributable to the shareholders’ contribution will not increase the corporation’s capital dividend account unless the capital gain is realized on a disposition of business assets or shares of an operating corporation. Finally, if all or substantially all of a corporation’s income is from passive
3 investments, it is contemplated that the corporation would be entitled to elect for all of its income to be taxed as passive income using the current refundable tax regime. Implications for Taxpayers Assuming that legislation similar to the Department of Finance’s concept is enacted, the immediate impact of this regime on corporations and shareholders will depend in large part on the transitional rules affecting existing corporate investment. The White Paper does not indicate what transitional relief would be provided, but Finance’s stated intention is for there to be a limited impact on existing passive investments. If this intention is carried out, then the impact on taxpayers would be limited to investments acquired using a private corporation’s future after-tax business income. Given the possibility of generous grandfathering rules, it may be advantageous for corporations that intend to invest in passive assets to accelerate the realization of income in 2017 and 2018 and, if possible, to make the desired investments in 2017 and 2018. By doing so, they may maximize the amount subject to grandfathering and preserve as large a deferral benefit as possible. When investable income from a business carried on by a corporation is earned in the future, it is not obvious that private corporations should change their behaviour in retaining the cash and investing in passive assets. The corporation and its shareholder remain better off until such time as the corporation pays dividends to the shareholder, and so tax benefits comparable to existing tax benefits could be obtained if the shareholder can reduce his or her effective personal income tax rate on dividends (for example, through a series of transactions in which the taxpayer ceases to be a resident of Canada before receiving a dividend). The new regime may also create an additional incentive for private corporations to invest in assets that will not generate income or capital gains for a long period of time. If these rules are enacted in substantially the form proposed, careful planning will be required in relation to future dispositions of investments in subsidiaries or business assets by private corporations. It will be absolutely critical for these private corporations and their shareholders that the shares or assets disposed of are “good” assets, such that the disposition of assets will result in an increase in a private corporation’s capital dividend account. Notwithstanding the Department of Finance’s expressed desire that any legislation relating to the taxation of passive investments be as simple as possible, it is overwhelmingly likely that the new regime will complex and will feature difficult, time-intensive compliance requirements. As a result, it is likely that considerable additional compliance costs will be incurred by private corporations, particularly if the apportionment method is ultimately adopted as the basis for the new regime.
