What about the tax reform conducted by the Canadian government and Finance Minister Morneau ?
Today in Canada, there is a highly competitive corporate tax system with advantages for corporations investing to grow their businesses. Canada’s corporate income tax rate is the second lowest in the G7.
The issue is that current tax rules provide opportunities for those owning private corporations to legally obtain tax advantage that are not available to other Canadians. In fact, they are paying less than their fair share. The Finance Minister Morneau is currently campaigning for his tax reform, which he hopes to implement to reduce the unfairness of this situation he is denouncing.
According to the government, there is a need for action. Indeed, the basic structure of the existing tax system has been in place since 1972. The fact is that things have changed since that time: the structure of the economy has evolved, the tax system has undergone important changes, tax planning strategies used by private corporations have grown more sophisticated. So the focus is on private corporations, which includes private Tech corporations, given the scope of the tax planning they provide.
Let’s analyse the proposed changes for Private Corporations:
Morneau has three key tax planning strategies he is aiming to change or eliminate completely. These practices are the ones which can be used by corporations and Tech businesses’ owners to obtain tax advantages.
Sprinkling income using private Tech corporation — shifts income from an individual facing a higher personal income tax rate to a family member who is subject to lower personal tax rates or who may not be taxable at all.
There are several proposed measures for this practice:
- The government proposes to extend the existing tax on split income for minors to apply to adults in certain circumstances.
- Under the proposed changes to the tax on split income (TOSI) rules, an amount paid to an adult family member will be considered reasonable if it consistent with what a person who is not an adult family member would receive having regard to: the labour contributions of the individual to the activities of the business, the assets contributed or risks assumed by the individual in respect of the business, the previous returns/remuneration paid to the individual in respect of the business.
- Dividends and other amounts received from a business, by an adult family member of the principal of the business, may be subject to a reasonableness test, which will be stricter for 18–24 year old. So the government wants to restrict the ability pay salary or wages or dividends to adult children between the age of 18–24. Reasonableness will be based on the contributions made by the family member to the business. To the extent the amount is not reasonable, top-rate will apply.
- Measures are also proposed to address other income sprinkling issues, including the multiplication of claims to the Lifetime Capital Gains Exemption.
- Supporting measures to improve the integrity of the tax system in the context of income sprinkling.
Holding Passive investments Inside a Private Tech Corporation — may lead to a higher wealth accumulation than if the passive investment portfolio were held in a personal savings account. Indeed, tax rate for corporations is lower than tax rate for high-income individuals.
Corporations can earn “active business income” (income earned from conducting a business) and/or “passive income” (e.g., derived from portfolio investments). Proposed measures deal with passive income only and will not affect the taxation of active business income.
Here are the proposed measures for this second practice knowing that the government is exploring ways to limit the benefit of leaving excess earnings inside the corporation to grow in a passive investment portfolio:
- The proposal would eliminate the tax deferral advantage on passive income earned by private corporations. It will also preserve the intent of the lower corporate taxes to support growth and jobs. Moreover it will re-establish fairness by ensuring that private corporations’ owners do not have access to tax preferred savings options not available to others. Another goal is ensuring that non new avenues for avoidance are introduced.
- The objective is to make the system neutral on a go-forward basis. This will necessitate the introduction of new tax rules.
Converting a private corporation’s regular income into Capital Gains — reduces income taxes by taking advantage of lower effective tax rates on capital gains.
For higher-income individuals, dividends are taxed at a higher tax rate than capital gains, which are only one-half taxable. As a result, income taxes can be reduced by converting dividends (and salary) that would otherwise be received from private corporations into lower-taxed capital gains.
There is an anti-avoidance rule (section 84.1 of the Income Tax Act) that deals with transactions among related parties aimed at converting dividends and salary into lower-taxed capital gains. The fact is that this rule is being circumvented.
To counter the circumvention of the rule, the government proposes to amend the income tax rules to address such tax planning. The project is amending the Income Tax Act to add a separate anti-stripping rule to counter tax planning that circumvents the specific provisions of the tax law meant to prevent the conversion of a private corporation’s surplus into tax-exempt, or lower-taxed, capital gains.
Potential consequences over Private Tech Corporations:
Each of these proposals regarding these three different tax planning strategies could have various consequences for technology companies.
Income Sprinkling — if a manager of a corporation has family members as shareholders, whether directly or indirectly through a family trust, this legislation may require him to defend the reasonability of the work performed. It may require the manager to have formal job descriptions for people. Record keeping and documentation will be important, as will establishing a methodology for determining and justifying reasonableness.
If there are preferred shares outstanding, consider paying dividends on the preferred shares rather than the common shares, as they may be reasonable based on capital contributed.
There may be a renewed bias to remunerate family members with salaries as opposed to dividends.
Being forced to change the business structure of the company or to develop a new remuneration strategy could also be other consequences of the measures.
It is important to know that the proposed changes to income sprinkling rules for individuals who own or operate private corporations are potentially regressive.
Passive Investments — if someone currently earns passive investment income through a private corporation, the proposed changes may result in a higher rate of tax on future distributions of this income and potentially more detailed record-keeping requirements at the corporate level.
People may not be able to rely so much on these investments in case of difficulties. In fact, entrepreneurs use passive corporate investment portfolios as they do not have pensions or benefit plans. Moreover, it can also be a lifeline in a risky situation (recession…) until the business recovers. These things could change with the government’s proposals.
Capital Gains — these proposed changes from the government create complexities in the disposition of assets, shares, transition or succession of a business and estate planning.
All these announcements were not particularly well received and many people called for the suspension of such measures. Following the various demands of the different stakeholders, the government has announced to think about new proposals that should be announced very soon. It is therefore a matter to be followed closely to know what will be the next moves of the government on this reform.
Sources: Department of Finance