Canada

Public outcry forces Finance to back down on contentious tax proposals

TAX ALERT  | 

Following an unprecedented public backlash, the Department of Finance (Finance) announced a series of updates to the private company tax measures announced in July 2017.  An overview of the updates on the lifetime capital gains exemption (LCGE), income sprinkling, passive income proposals, and surplus stripping restrictions is covered in the following.

LCGE

In the July 2017 proposals, Finance proposed tax changes that would limit access to the LCGE where capital gain arose on the sale of private company shares. The July measures would limit the use of the LCGE for shareholders under 18, as well as adult shareholders not considered active in the business. Additionally, Finance sought to limit access to the LCGE where the private company shares are owned by a family trust.

In its update, Finance announced that the proposed measures to limit access to the Lifetime Capital Gains Exemption will be withdrawn. Finance did not disclose how access to the LCGE will interact with other proposals, including proposed changes to the income sprinkling rules.

Income sprinkling

Further to its goal of encouraging tax fairness, the Government expressed concern that high net worth individuals use private corporations to split income with family members in lower tax brackets and minimize the amount of personal income tax they owe.

Finance announced that it will be moving forward with proposed changes to income sprinkling rules, with a few caveats. Public response to the July 2017 proposals illuminated the complexity of the new rules, as well as some unintended consequences. Uncertainty surrounding the ‘reasonableness test’ drew considerable attention.

Finance assured taxpayers that more clarity around the ‘reasonableness test’ will be forthcoming, and promised to work to minimize the weighty compliance requirements these new rules impose, particularly in establishing contributions of family members to private businesses. We anticipate revised draft legislation later on this fall.

Passive income within private corporations

Finance provided more details on its proposals to curb the tax benefits of accumulating passive investments in private companies. Intent on following through with its election mandate to create tax fairness, the proposals originate from the Government’s belief that “an increasing number of Canadians – often high-income individuals – are using private corporations in ways that allow them to reduce their personal taxes.”  

In consultation with business owners, the Finance heard that savings in a private corporation create the security and freedom that underpins small business success. Consequently, Finance plans to set an annual $50,000 threshold for passive income on retained small business profits within a private company.  Passive income above this threshold will attract a higher rate of corporate tax.  Finance believes this yearly amount will provide adequate savings for both small business needs such as future investments as well as personal savings such as retirement.

The proposed new tax measures will apply going forward so as to grandfather accumulated profits to the implementation date.

Finance also intends to monitor the proposed passive investment rules to determine any situations wherein the new proposals should not be enforced. Examples include AgriInvest, a government savings account, and capital gains on the shares of small business corporations.

Following up on concerns raised by venture capitalists and angel investors, Finance also acknowledged the pivotal role these groups play in the growth and stimulation of the economy. Finance assured venture capital and angel investor sectors that incentives for developing companies will continue.

 Legislation to implement these measures will be included in the 2018 Federal Budget.   

Anti-surplus stripping rules

Finance announced that the proposed tax measures intended to prevent the conversion of income into capital gains will not proceed.  With these proposals, family-held businesses and private companies faced unintentional consequences in both intergenerational transfers and shareholder distributions respectively.

In light of this development, vanilla tax planning such as “pipeline planning,” designed to avoid double taxation upon death, may continue.

Other encouraging news included a Finance comment that it plans to improve the efficiency and ease of intergenerational transfers of farm operations and other small businesses.

Small business tax rate reduction

As part of its continued commitment to lower tax rates, the Finance announced a reduction in the small business tax rate to be phased in over the next two years.  The rate applicable to the first $500,000 of active business income will be reduced to 10 per cent from the current rate of 10.5 per cent, effective January 1, 2018, and then to 9 per cent, effective January 1, 2019.

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