25 September 2017 CTF Policy Conference, Morning Finance Session ("Setting the Stage")
This is a summary of the morning session of the Canadian Tax Foundation Policy Conference, Tax Planning Using Private Corporations: Analysis and Discussion with Finance, Monday, September 25, 2017, Infinity Convention Centre, Ottawa. The title of the Session was "Setting the Stage." The presenters were:
Ted Cook, Department of Finance, Director of the Tax Legislation Division, Tax Policy Branch
Maude Lavoie, Department of Finance, Director of the Business Income Tax Division, Tax Policy Branch
Andrew Marsland, Department of Finance, Senior Assistant Deputy Minister of the Tax Policy Branch
Extracts from the slides prepared by the Finance officials appear as bulletted points (and our summaries of their oral remarks are not bulletted.) We also include charts and tables prepared by them.
The late afternoon Finance Roundtable is summarized separately.
Maude Lavoie on passive investment income
I will begin with a brief overview of the policy context around the discussion of passive investment that was described in our Consultation Paper released on July 18th. I will then discuss the current rules’ historical context, and provide a brief overview of the approaches that are being described in the Consultation Paper with respect to passive investment, and discuss some of the key questions in this area.
This slide here provides a measure of the scope of the changes in our economy and the tax system over the last 20 years. What you can see on the left-hand side of that chart is the change in personal and corporate tax rates over time.
As it stands today, we have now have a 37-point difference between the top personal income tax rate and the small business rate. On the right hand side of the chart you can see the trends in the taxable income to GDP ratio for various categories of taxpayers. The top line in green shows the taxable income of public corporations over time. In the recent past it has been relatively stable. In contrast, the blue dotted line shows the increase in the taxable income of CCPCs. The grey line shows the self-employment income, which has been declining over time, as more and more people have chosen to incorporate.
Over a longer-term horizon, in 1972 there were about 240,000 corporations in Canada. In 2015 that number had reached 1.9 million, and of that number, 1.8 million were CPCCs - an eightfold increase in the number of corporations while at the same time Canada’s population grew by 1.6-fold.
- Low corporate tax rates on business income are intended to provide a tax advantage as long as income is retained for active business reinvestments
- Income that is paid out of a corporation as a dividend is generally meant to be subject to the same amount of tax as income received directly by the individual
- Corporate taxes on earnings + Personal taxes on dividends = Personal taxes on income earned directly
- Integration issue: incentive to hold savings financed by retained earnings within corporations to save taxes
- This issue was recognized in 1972
In the context of this discussion it is important to have in mind that the Canadian governments have decided over time to decrease corporate income tax rates to make sure that we maintain a competitive tax system in order to encourage economic growth and job creation. However, it is a core principle of our tax system that, when income is earned in a corporation and then distributed to shareholders as dividends, it should bear an amount of tax that is equivalent to what an individual would pay if that income had been earned directly. In practice, that means that the benefits of a lower corporate income tax rate can be accessed as long as the income is kept in the business - but once it is paid out to shareholders, those benefits end.
Generally speaking, the integration system works very well, but in the case of passive investments that are financed with retained earnings kept in a corporation, there is a deferral advantage to keeping those savings in the corporation, and those advantages result largely from the fact that a corporate owner can benefit from a bigger initial portfolio than someone who would have been paying personal income taxes on that income.
Historical context of current rules
- Current system introduced in 1972
- Refundable taxes on investment income ensure integration when business owner uses after-tax income to finance a passive portfolio within a corporation
- In 1972, the introduction of Part V tax ensured integration when using retained earnings to finance a passive portfolio
- Part V tax repealed on the basis that:
- It was seen as complex
- This added complexity was believed not necessary
- I believe that these small corporations which enjoy the benefit of the lower rate of tax will, in fact, use these savings to expand their businesses, to improve their technology and to create more jobs for Canadians
The key features of what we have in place today, governing the taxation of passive investments, were put in place in 1972. Broadly speaking, passive income that is taxed in a corporation would bear tax rates that are approximately 50%, a portion of which is refundable when dividends are paid out to shareholders. Together the refundable tax regime, the dividend tax credit and, in the case of capital gains, the capital dividend account, are all calibrated to ensure that there is integration when money that is used to finance a passive investment uses income that was previously taxed at the personal level. For instance, shareholder contributions to the business are reflected in paid up capital. When that is not the case, and where there are retained earnings, integration does not work as well. That was recognized in 1972 when the rules that were introduced were accompanied by Part V tax, that ensured that integration would be maintained in that context as well.
The Part V tax was repealed shortly after it was implemented. It was seen as being complex, but it was also perceived at the time that business owners would not have an incentive to keep savings in a corporation, partly perhaps because the difference between the general corporate rate and the personal income tax was not as large as today.
No specific proposal yet
- Government is seeking input on best manner to eliminate deferral advantages going forward
- Paper lays out two broad approaches:
- Reintroduction of Part V tax, with adjustments
- Introduction of a deferred taxation model
- A deferred taxation model could take various forms, two of which are described in the paper:
- Apportionment approach
- Elective approach
- A deferred taxation model could take various forms, two of which are described in the paper:
So the Consultation Paper does not include any specific legislative proposal with respect to passive income. It is instead seeking input on various possible approaches that could be followed by the government. It discusses a possible reintroduction of Part V tax, and it also discusses other approaches that we have called deferred taxation models. The objective of those approaches are to remove the deferral incentives that currently exist to hold passive income in a corporation.
Reintroduction of Part V Tax
- Imposition of an upfront tax when retained earnings are used to acquire passive investments
- This additional tax would bridge the gap with top PIT rate
- For example, a business eligible for the small business deduction would pay a 35% additional tax at the time of acquisition of portfolio assets
- Tax refundable if later on assets are used to reinvest in the business
- Need to keep track of income streams in order to apply the appropriate amount of tax when investment assets are purchased
- This additional tax would bridge the gap with top PIT rate
- Passive investment income would continue to be taxed as per current rules
The Part V tax, which was also called a refundable tax with respect to ineligible investment, was designed to reduce the benefits of holding savings in a corporation, by effectively denying the small business deduction on income that was used to finance passive investment. In today’s context, a corporation earning income at a small business rate of 15% would bear an additional 35% in tax when purchasing passive assets under that model. The refundable tax was designed to be refundable when the money was then redeployed in the business, and it also went together with the refundable tax system that we have today on passive income.
The Consultation Paper is clear the government is not currently actively considering this approach, broadly because of our perception that this would have more of an immediate impact on businesses than some other approaches.
Deferred taxation model—apportionment approach
- Need to track source of financing for passive investments in order to estimate deferral
- Affect businesses at the moment of dividend payout:
- Affects tax outcomes at the moment a dividend is paid out, rather than when an investment asset is acquired
- But in effect, same overall outcome as Part V tax
- Those saving to reinvest in their business not materially affected
- Precision in tax outcomes, tailored to various business situations
- Affects tax outcomes at the moment a dividend is paid out, rather than when an investment asset is acquired
Under the approaches that we are referring to as deferred taxation models, there would be no additional tax payable when a passive asset is acquired. The passive income earned in the business would be subject to taxation rates that are similar to what they are today, but the tax would cease to be refundable. There are various examples that we put in the Consultation Paper to show that if the refundability of the taxes is removed, this ensures that when it is retained earnings that are used to finance passive investments, an amount of tax is borne that is similar to what an individual earning that income directly would pay.
The described deferred taxation model is the apportionment approach. Under that model, businesses would need to keep track of their income that is taxed at the low business rate, and the general rate, and also keep track of shareholder contributions and paid up capital. The objective of that tracking would be to make sure that when dividends are then paid out they receive the appropriate tax treatment - either as eligible dividends, ineligible dividends, and also dividends that could be attributed to paid up capital. Those contributions would continue to bear a tax burden that is similar to what exists today, because in those cases, the system is actually well calibrated.
Corporations that earned passive income and not active income could elect so that tracking income would not be necessary. The conditions for those elections are in the Paper, but basically when income in those corporations would have borne an equivalent amount of taxation as at the personal level, they would continue to be taxed as under the current regime.
Deferred taxation model - elective approach
- Minimizes needs for tracking, in favour of proxy methods
- Default tax treatment tailored to the case of a business using retained earnings to finance portfolio investments
- Elections available for businesses with general rate income
- Under both approaches, options to keep current tax regime available when investments finance with savings taxed at the personal level
The paper also discusses an elective approach. Under that approach, there would be no need for tracking. There would be a default tax system whereby passive income would be assumed to be financed from small business income and therefore all dividends paid out would be treated as ineligible dividends. For corporations that for instance only earn general rate income there would be an election available so that their dividends could be treated as eligible dividends under certain conditions. In that model, there would also be an election for corporations that only earn passive income.
Key questions for discussions
- Government is seeking feedback, in particular:
- What is the best approach to tackle the issue?
- How to minimize complexity, while achieving policy objectives?
- Capital dividend account: what is the appropriate scope of the new tax regime with respect to capital gains?
- Transition issues
That is a very quick and broad overview of the approaches put forward in the Consultation Paper. Over the course of the day, panels will go into more details of what we are proposing.
This slide provides some examples of key questions on which we hope to hear feedback from you today and throughout all the course of the consultations. For instance, what would be the best approach to tackle the issue? We are interested in ideas on how to make sure that the new rules when introduced are not too complex for businesses while achieving the policy objective.
With respect to capital gains, we are interested in views on what should be the scope of the new tax regime. For instance, in the Paper, we discuss a case of corporations selling the shares of a CCPC that they control and that is engaged in active activities and ask questions about whether or not the new system should apply to those cases. We also want to hear about any specific transition issues that we should have in mind while developing those rules.
Ted Cook on income sprinkling and surplus stripping
- Tax-planning arrangements under which income that would otherwise have been taxed as income of a high-income individual in the absence of the “income sprinkling” arrangement is instead taxed as income of a lower-income individual, typically a family member of the high-income individual
- The intended effect of the arrangement is to have the income subject to a lower or nil effective rate of income tax by accessing otherwise unused tax attributes of the lower-income individua
I will discuss income sprinkling and the conversion of dividends into capital gains. In each case, after seeking to frame the policy issue, I will discuss the policy response contained in the July 18 paper, and then speak to the broad thrust of the comments received. The consultation period goes through to October 2nd, and even though a number of additional submissions are expected, we have heard quite a bit with respect to the topic so far. The difference between the passive investment income proposal, and income sprinkling and conversion of dividends into capital gains, is that for the latter we provided draft legislation, in addition to the consultation paper, for comment.
- Tax benefits from income sprinkling increase with:
- The difference in tax rates between the transferor and the transferee
- The amount of income that can be sprinkled
- The number of individuals who can receive the sprinkled income
Income sprinkling refers as a general matter to tax arrangements by which income, which is effectively earned by one individual (presumably, a higher-income individual), is instead taxed as the income of a lower income individual, who typically a member of the higher income individual’s family. The intended effect of these arrangements is to have such income subject to a lower tax rate or a nil tax rate by accessing the tax attributes of the other individual. Such attributes can be access to: a lower marginal tax rate schedule; personal tax credits such as the basic personal amount; deductions in computing taxable income; and (as discussed later) the lifetime capital gains exemption.
In going through examples, you will see that the benefits of income sprinkling increase with an increase in the difference in tax rate between the transferor and transferee (or perhaps one should say, the sprinklor and sprinklee because it might not be a direct transfer). It also increases with the amount of income that is being sprinkled and the number of individuals receiving that sprinkled income.
Comparison of self-employment, and incorporation/sprinkling
This slide essentially is an example appearing in the Consultation Paper. On the left hand side are the tax results for a self-employed Ontario individual with $220,000 of income, being a tax bill of approximately $79,000. If on the other hand, if that individual incorporated and sprinkle that income between the individual, a spouse and an adult child, this example suggests (although this depends on the parameters) that the overall tax bill is reduced to $54,000. Thinking about the factors discussed in the previous slide, if the income were higher, there could be more in absolute savings; and if their income were lower, the benefits would be lower. Respecting the difference in marginal rates for the sprinklor and the sprinklee, we have assumed that the spouse and adult child do not have any other income. As a result, the tax liability with respect to the dividends is very low. If they had other income, the sprinkling would be less effective as they would start higher on their marginal rate schedule. If the individual had more adult children, the benefits of sprinkling would increase – and if there were no adult child, the benefits would be reduced.
Dividends paid to children ages 18-22
There is also a Table in the Consultation Paper, which is quite telling regarding what is happening in the real world. This looks at non-eligible dividends by age. For those ages zero to 17, there are almost no non-eligible dividends, which is that’s likely as a result of the current kiddie tax, or tax on split income (“TOSI”). Then, there is a significant increase between ages 18 to 22, then a dip, and then it marches up as what would be expected in terms of a normal distribution.
What this suggests is that there is significant payment of dividends in the ages of 18 to 22. One of the articles in the popular press has suggested that some of these dividends are being paid out to take advantage of children who are pursuing post-secondary education, so that these dividends are being used to take advantage of the fact that they do not otherwise have a significant income, and they use those amounts to perhaps pay for their education.
- The use of a private corporation in particular facilitates income sprinkling arrangements
- Income sprinkling raises a number of tax policy concerns
- High income individuals able to control income and to whom it is paid can obtain tax benefits not available to those who do not control income
- Erodes tax base
What do we see as the issue? The private corporation provides particular flexibility in facilitating what we think of as income sprinkling arrangements. The private ownership of a business allows greater flexibility and control in determining the ownership of the business and how the allocation of the ownership of that business is structured, and also provides for greater flexibility in terms of how distributions of profits of that business are managed.
This raises a number of tax policy issues. I have characterized sprinkling as involving higher income individuals, as higher incomes mean they are more likely to get the benefits of income sprinkling, and they are able to control their income and to whom that income is paid to obtain tax benefits not available to the non-incorporated context. In effect, this represents an opportunity in applicable circumstances to effectively opt out of the progressivity of the tax system. As shown by Maude I some of her charts, this has impacts on the taxpayer base as there is income moving from the personal income tax system to the corporate one, and then between income-tax payers. There are also administrative implications as CRA seeks to replace existing rules.
Current sprinkling rules
- Existing rules that constrain income sprinkling
- Longstanding rule restricts the deduction of expenses (including salary) if amount not reasonable
- Attribution rules apply to gift arrangements to redirect income back to the high-income individual
- Tax on split income (TOSI) introduced in 1999
The current rules were designed to or have the effect, to a greater or lesser extent, of constraining income sprinkling in particular circumstances.
The first of these is the basic rule in section 67: in order for an expense to be deductible in computing the income of a business, it must be reasonable in the circumstances. That applies to all expenses, including payments of salary or other fees to anyone, including family members.
There are attribution rules that apply, in the context of gift arrangements, to redirect income in particular circumstances back to the individual who made the gift. There also is the tax on split income, which was introduced in 1999, and imposes flat top-rate taxation on minors (below 18 years of age) on private company dividends and income derived by a trust or partnership from the business of a related individual.
Limitations in current sprinkling rules
- Existing rules not fully effective in constraining sprinkling with adults
- Attribution rules apply to spouses, but tax planning can circumvent the rules
- Limited rules to address arrangements involving other adults (such as children)
- Jurisprudence has limited the effective scope of some of the rules: 1998 Neumann decision (Supreme Court of Canada)
- Some structures have been identified that seek to circumvent the TOSI rules applicable to minors
These existing rules in the Income Tax Act have not been fully effective in constraining income sprinkling with adults. Although the attribution rules apply to spouses, tax planning can be used to circumvent them and obtain a different tax result. There are only limited rules to address arrangements which involve other adults, including adult children of a taxpayer.
Finally the existing jurisprudence has had the impact of limiting the effective scope of some of the tax rules that are currently part of the system. I note specifically the Neuman decision, which entailed a classic plan for dividend sprinkling from a lawyer’s corporation to a spouse. The Court essentially held that as long as the dividend is valid at law, there is no benefit conferred on the shareholder’s spouse who receives the dividend, and that an evaluation of shareholder effort is not relevant to determining who should be subject to tax in respect of dividends. As well, our own analysis has suggested that there are some structures out there that seek to circumvent the application of the TOSI (tax on split income) applicable to minors with respect to certain types of income.
Policy concern re lifetime capital gains exemption (LCGE) multiplication
- The Lifetime Capital Gains Exemption (LCGE) provides an exemption in computing taxable income in respect of capital gains realized by individuals on the disposition of qualified farm or fishing property (QFFP) and qualified small business corporation shares (QSBCS)
- By having family members (or a family trust) as shareholders of the QSBC, the LCGE limit of each family member can be accessed on a disposition of the QSBCS
- This raises a concern the individuals may be able to claim the LCGE even though they may not have invested in, or otherwise contributed to, the business value reflected in the capital gains from the disposition of the QSBCS
In addition to “basic” income sprinkling, we have identified multiplication of the lifetime capital gains exemption as an additional issue. The LCGE provides an exemption in computing taxable income from capital gains in respect of qualifying property and, as a result, there is an incentive to engage in planning that has capital gains of the relevant property recognized by other shareholders in order to increase the access to the exemption. That can be effected through direct ownership by family members of shares of, for example, a QSBC, or by way of trust planning which has the added advantage, as the disposition time approaches, of choosing the LCGE claimants in order to maximize access to the LCGE.
The policy concern from a Finance perspective is that LCGE claimants may be chosen not with respect to any particular person’s involvement or contribution - or even, during the relevant time, ownership of the property that is subject to the LCGE - but rather the choice will be made primarily in order to access the tax benefit of the LCGE.
Policy responses re sprinkling and LTGE
- Proposals to address income sprinkling
- Expand TOSI rules to Canadian resident individuals, whether minor or adult, who receive ‘split income’
- Refine ‘split income’ definition
- Include new categories of amounts, such as corporate debt
- Income received by an individual over 17 from a corporation will only be split income if a related individual (a ‘connected individual’) has a certain measure of influence over the corporation
- Introduce a reasonableness test to determine whether split income received by an individual over 17 will be subject to the TOSI
- The test is more stringent for individuals between 18 and 24
The policy response to income sprinkling set out in the Paper has three main components.
The first is a general expansion of the TOSI. As mentioned, the existing TOSI only applies to the minors (under 18), and applies on a largely bright-line basis, so that if dividends are being paid from a private corporation, there is not an assessment of the minor’s involvement in the corporation. The minor is just simply potentially subject to TOSI.
There is a proposed expansion of the TOSI rules to adults. A distinction is made between those 18 to 24, and those 25 and older.
The second response entails the addition of a test of a connected individual. Recognizing that we are dealing with adult economic actors, it is not possible to apply the expanded rule in respect of all dividends. The application of the rule to income received by a corporation will only be potentially applicable in respect of a corporation for which there is a connected individual. A connected individual would be a related person who has a requisite measure of control or influence in respect of the corporation, for example, the person who has legal control or earns all of the revenue in respect of the corporation on whose shares the dividends are paid.
Finally is the proposal of a reasonableness test, which is one of the main issues. At its heart, the reasonableness test looks at whether or not the amount is in excess of what would have been paid by an arm’s length party based on the labour contribution of the person receiving the income, the capital contribution of the person receiving the income, the risks assumed in respect of the source business by the person receiving the income, and what other amounts (perhaps by way of salary or dividends) have been paid to the individual.
As mentioned, Neuman essentially looked only at the validity of the dividend as a matter of corporate law. However, as a policy matter, we think that it is appropriate to look beyond that to determine whether or not the income is appropriately the income of the person receiving it, or should be taxed otherwise. The proposed test distinguishes between those aged 18 to 24, and those 25 plus. For those 18 to 24, there is a more stringent test requiring the activity to be on a regular, continuing and substantial basis and provides a limitation on returns in respect of capital contribution.
The Consultation Paper recognizes the potential challenges associated with the reasonableness test and whether it is an appropriate mechanism, and also some of the evidentiary and factual challenges that the determination of a reasonable dividend would raise, and seeks comments on how that test might be better crafted.
Policy Response re LCGE multiplication
- Individuals will no longer qualify for the LCGE in respect of capital gains that are realized, or that accrue, before the taxation year in which the individual attains the age of 18 years
- The LCGE will generally not apply to the extent that a taxable capital gain from the disposition of property is included in an individual’s split income
This group of measures also proposes some changes to address LCGE multiplication. First, is a proposal based on the existing TOSI rule, that gains accruing or realized while a person is under 18 would not eligible for the LCGE. This rule applies to particular properties, and the LCGE will generally not be available to the extent that the capital gain from the disposition of property is included in an individual’s split income.
Finally, subject to certain exceptions, gains that accrued while property was held by a trust will no longer be eligible for the LCGE. Such exceptions are to meant allow the LCGE in those contexts where ownership by the trust is essentially a proxy for ongoing ownership by the beneficiaries of the trust, such as for certain arm’s length employee shareholder ownership programs.
Sprinkling/LTCG feedback to date
- Dividends are taxed at a higher rate than capital gains, which are only one-half taxable
- Individual shareholders can reduce their income taxes by converting corporate income (e.g., amounts that would otherwise be paid out as dividends) into capital gains
- The federal and provincial tax savings in 2016 associated with converting dividends into lower-taxed capital gains is approximately
- $17,500 per $100,000 of conversions of ineligible dividends (at the average/highest provincial tax rate for ineligible dividends paid from corporate earnings taxed at the small business rate)
- $11,100 per $100,000 of eligible dividends (at the average/highest provincial tax rate for eligible dividends paid from corporate earnings taxed at the 15% general rate)
Before turning to the conversion of dividends into capital gains, what has Finance heard so far?
There has been a lively debate about the basic premise of the policy in terms of whether it is appropriate to apply this test and seek to look at the reasonableness of the dividends paid. In particular, there has been discussion that the test that has been proposed does not recognize the indirect contributions of family members in the context of businesses, and particularly those by spouses.
A question to be asked is whether there is an important distinction between the relationship between family members arising in the context of a private corporation as contrasted to spouses who support their other spouse in the context of unincorporated business or even on a salaried basis.
People have suggested that the proposal will have implications for investment and on attracting and retaining professionals.
There have been questions about the compliance burden in terms of whether or not the reasonableness test is difficult to apply, and will create uncertainty. I would argue that the reasonableness test should be fairly straightforward to apply in some of the cases where sprinkling is currently occurring. As mentioned earlier, the Paper requests comments on the application of the reasonableness test and how it can be appropriately applied.
Finally, there have been comments made with respect to the potential implication of the sprinkling measures in the context of certain planning, particularly in the context of post-mortem and succession planning.
Conversion of dividends into capital gains
Turning now to the conversion of dividends into capital gains, capital gains are half-included in income, and often that will result in a lower effective tax rate than the equivalent amounts being received as dividends subject to the dividend tax credit. Consequently, there is an incentive for individuals to try to plan their affairs so that amounts are received as capital gains rather than as dividends.
This slide shows that potential savings in respect of the conversion of $100,000 of ineligible or eligible dividends in 2016 could be up to $17,500 in the case of ineligible dividends and roughly $11,000 in the case of eligible dividends.
S. 84.1 dividend treatment
- Section 84.1 addresses individual tax avoidance that can arise when an individual sells shares of a Canadian corporation to another corporation related to the individual (e.g., owned by individual, spouse, siblings, children/grandchildren)
- Such share sales could, absent section 84.1, be used to convert dividends in the hands of the individual into lower-taxed capital gains, including gains eligible for the Lifetime Capital Gains Exemption (LCGE)
- This is because the related corporation could pay the individual with the proceeds of a dividend from the Canadian corporation, which the related corporation can receive tax-free because the inter-corporate dividend deduction is available
- To prevent this result, the proceeds from the share sale are treated as a taxable dividend and not as a capital gain if section 84.1 applies
- Section 84.1 does not apply on a sale of shares by individuals to their children, to any other related individual, or any arm’s length person
- Individuals can claim capital gains treatment – including the LCGE, where available – on a direct sale of shares to their children
- It is not necessary for section 84.1 to apply in this case because the individual purchaser would face dividend taxation if they attempt to withdraw earnings of the corporation
In the absence of a rule like section 84.1, there would be an incentive for an individual who wished to extract amounts from a corporation to simply set up a second holding corporation, sell their shares of their corporation to the second corporation, then use a tax-free intercorporate dividend up to the purchaser, and then pay that amount out as the proceeds of disposition. S. 84.1 addresses this situation where a person sells shares of a Canadian corporation to another corporation related to the individual (and it could be a corporation held by the individual, or by a spouse, or children). To prevent the conversion of capital dividends into capital gains, where 84.1 applies it deems a taxable dividend to the extent that non-share consideration exceeds the greater of PUC and cost base.
Avoidance of s. 84.1
- The conversion of dividends into lower-taxed capital gains ineligible for the LCGE benefits owners of both large and small private corporations
- Section 84.1 applies only to sales by individuals to corporations and can be avoided
It is relevant to note that 84.1 does not apply to the sale of shares by individuals to their children if there is a direct sale to their child, to any other related individual, or any arm’s length person. The reason there is not a policy concern with a sale to a related person is that surplus (i.e., potential dividends) of the corporation simply remain in corporate solution, and if it is later extracted, it will be subject to appropriate dividend taxation at that time.
We have observed that s. 84.1 is a technical provision that applies on very express terms, and taxpayers have come up with a number of different types of plans which seek to avoid its application in order to achieve indirectly the result that I discussed earlier. I am not going to go into the particular planning (probably other panels will), but suffice it to say that this planning is out there, and the courts have generally been receptive to it in the last little while except to the extent that the planning to avoid s. 84.1 seeks to extract amounts that would otherwise be tax exempt under the lifetime capital gains exemption or otherwise.
Intergenerational business transfers
- It is argued by some that existing section 84.1 should be loosened with respect to the LCGE to facilitate intergenerational business transfers
- The tax policy concern regarding intergenerational business transfers is distinguishing a genuine sale, where the children carry on the business, from a sale that facilitates the conversion of dividends into capital gains
That is the basic thrust of s. 84.1.
One of the particular issues that has arisen, particularly in the context of this consultation, is the role of s. 84.1 in intergenerational business transfers. I had mentioned that s. 84.1 does not apply in the context of a direct sale to child, but it would apply on the sale of a share owned by a parent to a corporation owned by the parent’s child, because that could facilitate the kind of planning we discussed earlier. The tax policy concern is to distinguish between a genuine intergenerational transfer for children carrying on the business to the kind of non-arm’s length planning I referred to earlier which is really aimed at extracting surplus that should otherwise be subject to dividend taxation on payment out to the parent.
Quebec has put some legislation in place. In addition, there is an earlier private member’s bill which also sought to loosen up s. 84.1. This is a point of consultation in the Paper.
Policy response re surplus stripping
- Proposed amendment to section 84.1 to address “multi-step” planning
- Proposed introduction of a supporting anti-avoidance rule to address other transactions that could be used to convert dividends into capital gains
- Comments sought regarding whether, and how, it would be possible to better accommodate genuine intergenerational business transfers while still protecting against potential abuses
So, what’s the policy response contained in the Consultation Paper?
The first is a proposed amendment to s. 84.1 to address what is characterized here as multi-step planning, in particular, to prevent the use of non-arm’s length transactions to step up the cost base prior to the transaction which allows the extraction of surplus. Essentially, the proposal limits the cost base to the hard cost base arising on non-arm’s length transactions.
Second, is the proposed introduction of a supporting anti-avoidance rule (s. 246.1) that would seek to counter tax planning that circumvents the code of provisions of the Act that would otherwise prevent the conversion of corporate surplus into low tax or tax exempt capital gains.
Finally, comments are sought regarding whether and how it is possible to better accommodate intergenerational transfers, while still protecting the tax base against abuses from non-arm’s length transactions.
Feedback re surplus stripping
Generally, the basic policy goal of preventing the conversion of dividends into capital gains has had broader acceptance than the other two aspects that we have talked about.
There have been particular concerns regarding the impact of the proposed amendments on so-called pipeline transactions, and I would characterize the comments on that as two-pronged. The first is the application of the rules to deaths that occurred prior to the release of the paper; the second is the going-forward issue regarding whether the policy result is appropriate and, if so, whether other rules such as s. 164(6) need to be revisited in order to more accurately reflect the policy on taxation of these amounts.
There have been comments on the scope of the rules, especially the potentially broad wording of s. 246.1.
Finally, there have been comments regarding intergenerational transfers and the impact of the proposed rules on succession-planning and s. 84.1. That is an area where we have specifically requested comments. To date, we have not seen many specific proposals about how we could design a rule that accommodates genuine transfers. (The U.S. does have such a rule, but it is rigidly worded, so it is unclear whether it would be appropriate here.)
Andrew Marsland on responses to common misconceptions
I would like to sum up with a few observations.
A lively debate has followed the release of the July Private Corporations Consultation Paper. That debate has raised a range of important issues, such as: the appropriate support that the tax system provides for risk-taking by business-owners; the theory of integration and the importance of neutrality; how the tax rules impact female entrepreneurs, the appropriate unit of taxation; and, indeed the structure of the tax system itself. Those are all important issues, worthy of further discussion.
While the proposals themselves have prompted a great deal of debate on their merits, there has been some misunderstanding of what the proposals intend to do, and how they would apply. This has led many Canadians to express concern.
I will comment on a number of areas of misunderstanding.
The first area relates to the income-sprinkling proposal. It has been suggested that these proposals will make it harder for business-owners to compensate family-members for their role in the business.
There is nothing in the proposals that affect the long-standing s. 67 rules, and how they pertain to salaries paid to family-members and others. Neither is the proposal intended to apply to reasonable dividends to family-members who are making contributions to the business.
The proposed changes are intended only to apply to persons receiving amounts that are not in line with their contributions to the business.
Salaries v. dividends
There is also concern that, even if owners pay salaries instead of dividends to family-members who work for them, they would be subject to a yet-to-be-defined reasonableness test.
As we know, the reasonableness concept is not new to the Income Tax Act – which is not to say, of course, that there are not challenges in applying this approach in the context of dividends. Indeed, the July 18th paper acknowledges as much. The government has made it clear that this is an important fairness issue.
A common misconception we have heard is that existing retirement savings are being targeted. Unsurprisingly, people who have made irreversible decisions regarding their savings would be extremely upset if a proposal were to materially affect those plans.
The government has made it clear that it has no intention of going back in time. The proposals are prospective only. As the paper indicated, the intention is not to materially impact existing passive investments, nor the tax-treatment arising therefrom.
Tax rate on passive investment income
Another discussion item has been the tax-rate that would apply to investment income earned by a corporation. We feel this is less of a misunderstanding than an apples-and-oranges comparison – since the analysis leads to a 73% tax-rate, the focus is strictly on the nominal amount of investment income.
I think it is fair to say that the concern in this area somewhat misses the point, which is that an individual earning income and saving it through a corporation should achieve a similar outcome as one saving it directly. Because the net after-tax savings of those two individuals are essentially the same, it must be that their effective tax-rate is essentially the same. To conclude otherwise would be to suggest that the two individuals have a different ability to save on an after-tax basis.
Concern over business savings
There has been concern that businesses would no longer be able to save for downturns or to invest in future expansion. In the paper, an important consideration about passive investment income was to preserve the liquidity that is provided by low corporate tax-rates, particularly the small business rate.
This seemed to us to be an important drawback to the 1972 Part V approach, and is why the paper focuses on adjusting the deferral on dividends paid out to the corporation.