Softened private tax measures for private equity in Federal Budget
There was much anticipation around the 2018 Budget and with good reason given the uncertainty created with the 2017 mid-summer release of the private company proposals. We gathered some of the key tax takeaways for private company investors in this video and article.
Passive income proposals
The 2017 private company proposals were of particular concern to angel investors, venture capitalists and family offices given the threat of a higher tax rate of up to 73 per cent on passive income from investments held in Canadian controlled private corporations (CCPCs). Many private investors employ private corporations from which to deploy capital or structure investments, and the proposals would have presented challenges in attracting capital for investment in Canadian small businesses. In a welcome turnaround, the Budget has eliminated the proposed tax increase on passive income and replaced with the softer measures below.
Small business deduction
The small business deduction reduces the rate of tax payable by a CCPC on its first $500,000 of active business income and must be shared between associated corporations. Under the current rules, the small business deduction is gradually phased out for associated CCPCs having between $10 million and $15 million of taxable capital.
Budget 2018 proposes a reduction to the small business deduction for passive income earned over $50,000 with the small business deduction being eliminated at $150,000 of passive income. The proposal is applicable for taxation years beginning after 2018. The reduction will be computed on an associated corporate group basis and will work together with the existing reduction for taxable capital (i.e., whichever mechanism results in the greater reduction will apply). Passive income for these purposes is based on the existing definition of “aggregate investment income” with the following modifications:
- taxable capital gains (and losses) will be excluded if they are from the disposition of a property that is used principally in an active business carried on primarily in Canada by the CCPC or by a related CCPC;
- taxable capital gains (and losses) will be excluded if they are from the disposition of a share of another connected CCPC where all or substantially all of the fair market value of the assets of the business are attributable directly or indirectly to assets that are used principally in an active business carried on primarily in Canada, and certain other conditions are met;
- net capital losses carried over from other taxation years will be excluded;
- dividends from non-connected corporations will be added; and
- income from savings in a life insurance policy that is not an exempt policy will be added, to the extent it is not otherwise included in aggregate investment income.
Many investors may not currently have access to the small business deduction in their associated CCPC portfolio investments under our current tax rules for a variety of reasons and will be unaffected by this change. For those that are able to access the small business deduction in their current CCPC investee entities, the Federal Budget measures are comforting news. Generally, the gains on sales of property used in an active business carried on in Canada are excluded from the computation of passive income on qualifying property dispositions. Gains on such dispositions of qualifying portfolio companies should not impact the ability of other associated CCPC portfolio investments to claim the small business deduction where they are currently able to do so.
Tracking of refundable taxes
A second measure proposed for private companies will limit the ability to access corporate refundable tax created from most types of passive income by paying an eligible dividend. This measure also applies for taxation years beginning after 2018. A CCPC may pay an eligible dividend to the extent of its general rate income pool (GRIP) balance. This pool is generated from active business profits taxed at the general corporate rate and from eligible portfolio dividends received from non-connected corporations. There are generally no additions to this pool from passive investment income. The policy rationale for this new measure is that eligible dividends should not unlock corporate refundable tax that was paid on passive income apart from eligible dividends received from non-connected corporations. This measure will be implemented by splitting the existing refundable tax account into two separate notional accounts. Only non-eligible dividends will now generally result in a refund of corporate refundable taxes previously paid on passive income.
At-risk rules for partnerships
The current at-risk rules provide that a partner of a limited partnership cannot access losses of the partnership in excess of their at-risk amount. This can generally be thought of as their contributed capital and income less any partnership allocations of losses and other tax preference items. Losses allocated to a partner in excess of their at-risk amount are not deductible and may be carried forward and deducted in computing taxable income in a future year if the limited partner’s at-risk amount in the partnership has become positive. Any undeducted limited partnership losses of the limited partner are reflected in the adjusted cost base of the partnership ultimately reflected in the capital gain realized on a disposition of the partnership interest.
In a recent case (Canada v. Green), the courts found that where a partnership is itself a partner of a limited partnership, the losses in excess of available at-risk amount by the bottom partnership may be allocated by the top-tier partnership to its partners providing that partners of the top-tier partnership had sufficient at-risk available. Budget 2018 effectively reverses this decision by clarifying the longstanding understanding of the at-risk rules as discussed above will apply even in a tiered partnership structure.
These measures will be effective for taxation years ending before and after Budget Day (i.e., retroactive effect).
GST/HST and investment limited partnerships
Budget 2018 confirms the government’s intention to proceed with these proposals with the following changes:
- Budget 2018 proposes to modify the September 8, 2017, proposal so that the GST/HST applies to management and administrative services rendered by the general partner on or after September 8, 2017, and not to management and administrative services rendered by the general partner before September 8, 2017, unless the general partner charged GST/HST in respect of such services before that date.
- In addition, Budget 2018 proposes that the GST/HST be generally payable on the fair market value of management and administrative services in the period in which these services are rendered. This addition to the September 8, 2017, proposal effectively adds a measure that ensures the reporting of the tax payable in respect of taxable management and administrative services rendered by the general partner is not deferred beyond the period in which the services were rendered to the investment limited partnership.
- Budget 2018 proposes to allow an investment limited partnership to make an election to advance the application of the special HST rules as of January 1, 2018. This addition to the proposal provides investment limited partnerships with the option to elect to have the special HST rules be applicable a full year earlier than would have been possible under the original September 8, 2017, proposal.
Consultations on the GST/HST holding corporation rules
A Goods and Services Tax/Harmonized Sales Tax (GST/HST) rule, commonly referred to as the ‘holding corporation rule,’ generally allows a parent corporation to claim input tax credits to recover GST/HST paid in respect of expenses that relate to another corporation. This rule provides that, the expenses are generally deemed to have been incurred in relation to commercial activities of the parent corporation, where the parent corporation:
- resides in Canada, and
- incurs expenses that can reasonably be regarded as being in relation to shares or indebtedness of a commercial operating corporation (a corporation where all or substantially all of the property is for consumption, use or supply in commercial activities), and
- is related to the commercial operating corporation, and the expenses are generally deemed to have been incurred in relation to commercial activities of the parent corporation.
The government intends to consult on certain aspects of the holding corporation rule, particularly with respect to the limitation of the rule to corporations and the required degree of relationship between the parent corporation and the commercial operating corporation. At the same time, the government intends to clarify which expenses of the parent corporation that are in respect of shares or indebtedness of a related commercial operating corporation qualify for input tax credits under the rule.
Consultation documents and draft legislative proposals regarding these issues will be released for public comment in the near future.
At RSM Canada, we expect that the majority of these changes will be met as largely welcome news. There will be some increase in complexity associated with compliance, but not to the degree forecasted with the 2017 version of these proposals. Speak to your RSM advisor to discuss your tax planning and structuring opportunities.