Canada

2016 and 2017 tax changes impact professionals

TAX ALERT  | 

In this article, we review the three key tax changes and proposed changes that are affecting professionals and professional services firms:

2016 Federal Budget - Limits the use of the small business deduction (SBD)

2017 Federal Budget – Work-In-Progress for certain professionals

July 18, 2017 Department of Finance – Tax proposed changes for private corporations

More updates are expected to be published in the Federal Budget 2018.

2016 Federal Budget - Limits the use of the small business deduction (SBD)

Effective for taxation years beginning after March 22, 2016, legislative changes which have been passed into law, limit access to the SBD for partnerships and corporate structures.  The structures that are impacted are those that provide property or services to a partnership or another corporation with common ownership. The 2016 Federal Budget introduced the following new concepts that have closed previous gaps in the legislation that allowed for the unintended multiplication of the SBD.

Partnerships

Budget 2016 extended the specified partnership income rules to partnership structures in which a Canadian Controlled Private Corporation (CCPC) provides (directly or indirectly, in any matter whatever) services or property to a partnership during a taxation year of the CCPC where, at any time during the year, the CCPC or a shareholder of the CCPC is a member of the partnership or does not deal at arm’s length with a member of the partnership. In general terms, for the purpose of the specified partnership rules:

  • a CCPC will be deemed to be a member of a partnership throughout a taxation year if;
  • it is not otherwise a member of the partnership in the taxation year,
  • it provides services or property to the partnership at any time in the taxation year,
  • a member of the partnership does not deal at arm’s length with the CCPC, or a shareholder of the CCPC, in the taxation year, and
  • it is not the case that all or substantially all of the CCPC’s active business income (“ABI”) for the taxation year is from providing services or property to arm’s length persons other than the partnership;
  • a CCPC that is a member of a partnership (including a deemed member) will have its ABI from providing services or property to the partnership deemed to be partnership ABI; and
  • the specified partnership income limit (SPI limit) of a deemed member of a partnership will initially be nil (as it does not receive any allocations of income from the partnership). However, an actual member of the partnership who does not deal at arm’s length with a deemed member of the partnership will be entitled to notionally assign to the deemed member all of or a portion of the actual member’s SPI limit in respect of a fiscal period of the partnership that ends in the deemed member’s taxation year. (Where the actual partner is an individual, the assignable SPI limit of all members of the partnership will be determined as if they were corporations.)

In essence, if you are a member of a partnership and property or services are provided (directly or indirectly) to that partnership through a non-member CCPC of which you are a shareholder (or are related to a shareholder), that CCPC may be considered a designated member of the partnership. A designated member will no longer be entitled to its own SBD. The CCPC will only have access to the SBD to the extent that its related partner assigns to it that partner’s portion of the partnership’s $500,000 business limit.  

Corporations

Tax changes announced in the Budget 2016 provided that a CCPC’s ABI from providing services or property (directly or indirectly, in any manner whatever) in its taxation year to a private corporation will be ineligible for the small business deduction where, at any time during the year, the CCPC, one of its shareholders or a person who does not deal at arm’s length with such a shareholder has a direct or indirect interest in the private corporation. This ineligibility for the small business deduction will not apply to a CCPC if all or substantially all of its active business income for the taxation year is earned from providing services or property to arm’s length persons other than the private corporation. A private corporation that is a CCPC will be entitled to assign all or a portion of its unused business limit to one or more CCPCs that are ineligible for the SBD because they provided services or property to the private corporation.

In essence, if you are a member of a partnership and property or services are provided (directly or indirectly) to that partnership through a non-member CCPC of which you are a shareholder (or are related to a shareholder), that CCPC may be considered a designated member of the partnership. A designated member will no longer be entitled to its own SBD. The CCPC will only have access to the SBD to the extent that its related partner assigns to it that partner’s portion of the partnership’s $500,000 business limit.  

It should be noted that the SBD is, in fact, is a deferral of tax and not an absolute tax savings due to the concept of integration, which provides a correlation between corporate, dividend and personal tax rates. Integration ensures the government eventually receives its approximately 54 cents on every dollar earned (assuming the top marginal tax rate), whether it is earned through a corporation first and then paid out to the shareholders, or earned by the shareholders directly. For income earned through a corporation, the tax rate paid by the shareholder on dividend income is adjusted to account for the tax rate paid by the corporation. Thus, income that is taxed at the higher, non-small business rate in a corporation can be paid to its shareholders as eligible dividends, which are taxed favourably at the personal level. On the other hand, income taxed at the small business rate in a corporation must be paid to the shareholders as ordinary dividends, which are taxed at a higher rate.

Assuming that your structure is similar to the one described below, the Professional Corporation and the Management Corporation will be required to share the SBD for taxation years beginning after March 22, 2016.  More importantly, the SBD will be shared among all the partners of the Partnership and the Management Corporation.

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2017 Federal Budget – Work-In-Progress for certain professionals

The pre-budget rules previously allowed certain professionals such as lawyers who complete work over months or, in some cases, years to defer taxation on the associated income until the work was completed and invoiced. This allowed professionals to better match the recognition and payment of tax with the cash receipts for a particular taxation year.

The proposals under the budget of March 22, 2017, state that every professional must include year-end work-in-progress (WIP) into taxable income effective for taxation years beginning after March 21, 2017. WIP for professionals typically represents unbilled professional time and costs incurred in the rendering of services to clients. This is often captured in the form of a professional’s “charge-out” rate, which represents their cost, overhead and some profit component. The policy change results in an acceleration of tax collection, but the total amount of tax effectively remains the same such that professionals should not be worse off on a total tax basis with respect to any particular billing. The new rules do not apply to contingent fee arrangements.

On September 8, 2017 the Department of Finance released draft legislation for public comment which included additional relief for WIP of professionals. The original budget announcement provided for a 2-year phase-in period for the new rules allowing professionals to reduce some of the upfront impact of the changes. The September 8, 2017 draft legislation now contemplates a 5-year phase-in period. The changes will operate as follows for taxation years beginning after March 22, 2017 (in most instances the first year of impact will be the year ending December 31, 2018):

  1. 1st taxation year – 20 per cent of the lower of cost or fair value of unbilled WIP included in income
  2. 2nd taxation year – 40 per cent of the lower of cost or fair value of unbilled WIP included in income
  3. 3rd taxation year – 60 per cent of the lower of cost or fair value of unbilled WIP included in income
  4. 4th taxation year – 80 per cent of the lower of cost or fair value of unbilled WIP included in income
  5. 5th taxation year – the full amount in respect of WIP must be included in computing the income from a professional business.

The relief is only available where the taxpayer elects to exclude WIP in computing income in the last taxation year that begins before March 22, 2017.The extension of the transition period from 2 to 5 years provides professional firms with the opportunity to absorb the tax impact of these changes over a longer time horizon to better manage the cash outlay associated with any additional tax liability.

Based on the above changes we assume that professional firms will account for the WIP accordingly on their 2018 T5013 Partnership Information Returns.

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July 18, 2017 Department of Finance – Tax proposed changes for private corporations

As you may know, there has been significant noise in the business community over the past four months regarding the July 18, 2017 Department of Finance private company proposals.  Depending on your corporate structure, one or both of the remaining proposed changes will impact you [1].

Structures that are impacted under the Finance proposals

  1. Private corporation, trust or partnership structures where related individuals are shareholders or receive income from the business (directly or indirectly through a trust);
  2. Private corporations holding passive investments funded from active business profits (i.e. corporate profits that have been retained or that are distributed to a holding company and have never been subject to personal tax).

The impact of these proposals on taxpayers

Taxpayers that are currently income splitting with family members will have until the end of December 31, 2017 to access the graduated rates on split income. Although revisions to the draft legislation remain to be released, impacted individuals are encouraged to review their situation with their tax advisor to determine if payments should be increased before the end of the year, as the new income splitting rules (TOSI) take effect on January 1, 2018. Payments before the end of the year should only be made to individuals 18 years old or older to avoid paying tax at the highest marginal tax rate on such amounts. Beginning January 1, 2018 any payments made to a spouse or children regardless of the age will be subject to tax on the highest marginal rate unless certain criteria are met with respect to their contributions to the business. The current guidance we have from the Department of Finance indicates that continued access to the graduated rates on income received by a related individual must be reasonable vis-à-vis the contribution the individual makes to the company be it financial or participatory. There is no formal guidance on determination of what may be considered a reasonable return on an individual’s financial or participatory contribution to a business and taxpayers will be challenged to make this assessment given the various inputs that have to be considered in the determination. These measures will impact professional firms and their current trust and other tax structures.

The latest update from the Department of Finance was on December 13, 2017.  At that time, amendments to the initial proposals were released which in part provided some guidance for determining whether a family member’s involvement in a business is sufficient to exclude them from the TOSI, that is, tax at the top marginal rate on non-salary income and gains on the sale of shares. The TOSI will not apply in the following situations:

  • A business owner who is 65 years of age or older who splits income with a spouse;
  • The splitting of capital gains realized on the sale of qualified small business corporation shares or qualified farm or fishing property (i.e. property that would be eligible for the lifetime capital gains exemption);
  • Where amounts are paid to a person aged 24 or older who works more than twenty hours a week in the business in the year in question or in any five prior years;
  • Where amounts are paid to a person aged 24 or older who owns at least 10 per cent of the votes and value of shares of the corporation carrying on the business, except for professional corporations (i.e. legal, accounting and various medical practices) or certain other service businesses; and
  • Where property is received by inheritance; in such case the recipient is put in the same place as the deceased owner as if the recipient was a continuation of the former owner

Individuals aged 25 or over who do not meet any of the above exclusions would be subject to a reasonableness test to determine how much income, if any, would be subject to the TOSI. In certain cases, adults aged 18 to 24 who have contributed to a family business with their own capital will be able to use the reasonableness test on the related income.

As mentioned above, the revised income sprinkling measures are proposed to be effective for the 2018 and subsequent taxation years. That said, the amendments effectively include a transition year whereby persons who wish to rely on the 10 per cent share ownership safe harbour exception have until the end of 2018 to organize their affairs.

On October 18, 2017, the Department of Finance announced that they are moving forward with measures to limit the deferral of the tax benefits of passive investments within a private corporation through additional tax on passive income in excess of an annual threshold. The Department of Finance has determined that an annual passive income threshold of $50,000 per year (based on $1,000,000 of passive investments and an assumed return of 5 per cent) in a private corporation will provide sufficient savings for business purposes (funding for contingencies and future investments) and personal savings (funding for sick leave, parental leave and retirement). The Department of Finance has confirmed that the additional taxes will apply on a go-forward basis thus ensuring future income from current passive investments will not be subject to the new passive investment regime.  The Department of Finance stated that it is examining the key design aspects of the passive investment rules to consider circumstances in which the new rules should not apply (for example, capital gains realized on the sale of shares of a corporation engaged in an active business and income from AgriInvest, a self-managed producer-government savings account).  

Along with the TOSI update on December 13, 2017 the Department of Finance also confirmed its intention to move forward with proposals to limit tax deferral opportunities related to passive investments in a private corporation, the details of which will be included in the 2018 federal budget. 

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[1] On October 16, 2017 and October 19, 2017, the Department of Finance announced that it would not be moving forward with limiting the access of the lifetime capital gains exemption, distributions being re-characterized as a non-eligible taxable dividends and the restrictions on the conversion of income into capital gains (“anti-surplus stripping rules”).

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