Liberals Bow to Public Pressure on Tax Changes
Since July 18, 2017, it has been difficult to watch the news without hearing commentary on the Department of Finance’s tax proposals (the “Initial Proposals”), which would have resulted in a fundamental shift in the taxation of Canadian private companies and their shareholders. These proposals have been universally lambasted for nearly the entire 75-day consultation process. Last week, Minister of Finance Bill Morneau took to the road and released a series of changes to the Initial Proposals, extending an olive branch to the business community. While details are sparse, it appears the Liberals have decided to change tack, albeit only in part.
The July 18, 2017 Proposals
The Initial Proposals sought to implement three “pillars” of “tax fairness”: (1) restricting income sprinkling, including the multiplication of the lifetime capital gains exemption; (2) reforming the taxation of passive investments inside a private corporation; and (3) prohibiting the conversion of dividends into capital gains.
The media parade of the next few months demonized these proposals. Criticisms ranged from the difficulty in interpreting the rules, to outrage at a theoretical 73% tax rate on passive investments, to concerns about post-mortem planning and intergenerational business transfers. While some of the widespread panic may have been based on misinformation, it was clear that the rules had serious issues.
After months of pushback, media tours, internal caucus meetings, and inflammatory rhetoric, the Liberals have given us a first glimpse of their revised plan for these three “pillars”. Each pillar is adjusted in some way, and some may even be abandoned entirely.
Income Splitting and the Capital Gains Exemption
The Department of Finance confirmed it will proceed with implementing restrictions on income sprinkling. That is, the Liberals intend to prevent private business owners from splitting income with their spouses in many cases. However, the release was not all bad news.
A major concern with the Initial Proposals was that it was unclear how to compensate a spouse or adult child who was actively involved in the business, such as in a family business. The rules originally included a vague “reasonableness” standard and turned everyday compensation decisions into a grey area of risk.
The Liberal government has confirmed it is concerned by these grey areas. While “reasonableness” will still come into play, the rules will be relaxed to “reduce the compliance burden with respect to establishing contributions of spouses and family members”. Their objective is to ensure that where adult family members “meaningfully contribute” to the business, they will not be affected by the new anti-income splitting rules. A different standard is expected for adults between the ages of 18-24, and adults aged 25 and up.
At a minimum, we know that the legislation is expected to focus on four principles in determining whether an amount of income is “reasonable” to pay to a family member:
- contributions of labour;
- contributions of capital or equity;
- assumption of risks; and
- past contributions of labour, capital, or risks.
Although we have yet to see legislation, these principles appear to be a step in the right direction compared to the Initial Proposals. While the benefit of income sprinkling will be reduced for many small and medium-sized businesses, there is a glimmer of hope remaining that family-operated enterprises will be given some clarity on how to operate without undue tax risk and harsh compliance burdens.
Lifetime Capital Gains Exemption
The Department of Finance has indicated that it will not be moving forward with the measures that limit access to the lifetime capital gains exemption. This is welcome news to any business owners who make use of family trusts.
It remains to be seen how far the Department of Finance will be backing off of this particular proposal. While it clearly stated it will not move forward with those measures, it also indicated that the emphasis was to protect estate planning and intergenerational transfers for family farms. Additionally, there is some indication that they may still proceed with restrictions on the use of the lifetime capital gains exemption by minors.
Draft legislation for income sprinkling and the capital gains exemption is expected to be released in Fall 2017, to be effective on January 1, 2018. We will continue to provide updates as these rules become clear.
Taxation of Passive Investments within a Corporation
One of the most contentious items stemming from the Initial Proposals was the intention to change the taxation of passive investments in a private corporation. Draft legislation was not provided, but various alternatives were proposed.
Last week, the Department of Finance confirmed that it will be continuing forward to introduce this legislation. However, they have pulled back in part and provided some new comforts, albeit minor ones.
The Department of Finance will attempt to tax passive investments in private corporations quite aggressively. However, they have introduced a new $50,000 investment income threshold. The first $50,000 of investment income is expected to be excluded from the new, aggressive rules. Additionally, the Department of Finance is considering whether to exclude capital gains from the new passive investment tax regime, which could prove to be a boon to private corporations seeking private investment capital.
Finally, the Liberals have reaffirmed their intention to grandfather existing passive investments and the income therefrom. We have received no hints about implementation, but we anxiously await this legislation, as the grandfathering system could bring complexity and substantial compliance costs.
The Department of Finance expects to release details of these proposals in Budget 2018.
Conversion of Dividends into Capital Gains
This proposal did not receive the same media attention as the other two. Regardless, many small business owners and farmers have been concerned about how the new rules would impact intergenerational wealth transfers and post-mortem estate planning. In many cases, these rules could result in substantial and unexpected tax burdens for intergenerational transfers of wealth, whether before or after death.
While, the Department of Finance has confirmed that it will not be moving ahead with these proposals, it remains to be seen whether all or any part of these proposals will remain in any new legislation.
Conclusion and Invitation for Discussion:
The Liberals have clearly accepted the Initial Proposals were a mistake. However, they have not fully relaxed their commitment to those rules, and many objectionable elements remain. For the time being, it appears small and medium business owners will face new compliance and tax burdens with respect to passive investment income in their corporations and splitting income with inactive family members. The remaining uncertainty will not be quelled until draft legislation is released.
We will continue to update our website with information as it becomes available. In the interim, however, we would recommend you contact a lawyer in our Tax & Estate Planning group to discuss whether your current business structure is affected by these new rules, and how to better structure to meet your goals and objectives.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.