Canada’s New Tax Laws: Changes To The Taxation of Private Corporations

Canada’s New Tax Laws: Changes To The Taxation of Private Corporations

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This past July, the federal Liberal government proposed some major changes to the taxation of private corporations. These proposals, if enacted by Parliament, are likely to affect the majority of Canadian business owners who carry on business through a private corporation.

Income Splitting –

It’s become very commonplace in Canadian tax planning for owners of private corporations to include their family members as part-owners . The basic structure is: family members hold shares in the corporation, either directly or through a family trust. Typically, family members hold different classes of shares, which basically allows for a dividend to be paid to the different family members at the sole discretion of the corporation’s directors or other officers. Structuring in such a way allows for dividends to be paid to family members who are in a lower tax bracket than the others, particularly those who control the business. This process is usually referred to as “income splitting” or sometimes “dividend sprinkling” and its purpose is to lower the overall tax payable by the family.

Since 1999, the “kiddie tax” acted to prevent this sort of tax planning with family members under the age of 18. Under the kiddie tax, children under the age of 18 were subject to a tax at the highest marginal rate on dividends received from private corporations. Now, the government is proposing to extend the kiddie tax so that it applies to adults in respect of a business which a family member is a principal officer, director or agent. The Liberals did, however, include an exception to this new wider law, where it is reasonable in the circumstances for that adult family member to have received income from the corporation. This exception is intended to exempt those individuals who may have been legitimately working for the corporation and earning income similar to that which would have been paid to an arm’s length person. The reasonableness of any situation which rest upon (1) the contribution of labour by that individual to the corporation, (2) the contribution of capital by that individual to the corporation, and (3) any previous returns or remuneration.

Lifetime Capital Gains Exemption –

Since the late 1980s, Canadian taxpayers have been able to tax-shelter capital gains from the sale of qualified small business corporation shares, with each taxpayer having a lifetime limit amount. The draft paper on the new tax changes demonstrates that the Liberals have serious concerns with certain ownership structures which allow certain family members to use the capital gains exemption in the sale of a family-held corporation. As such, they’ve now proposed the following changes to the law:

1.       Family members under the age of majority will not be allowed to use the capital gains exemption.

2.       Equitable beneficiaries of a trust will also no longer be allowed to use the capital gains exemption on gains from the value of shares that accumulate during the period in which the trust held the shares.

3.       Family members who are subject to the Tax On Splitting Income in respect of a share will also not be allowed to use the capital gains exemption on those shares.

Passive Investment Income –

The Liberals really made in known in their consultation paper that they weren’t thrilled with the advantages that arise from earning business income through a corporation, rather than personally. Since corporations are taxed at a much lower rate than individuals on business income, it would obviously be more advantages to earn it through a corporation. Here in Ontario, the highest marginal tax rate for individuals is 53.53%, yet the corporate tax is much lower at either 15% (for business income earned by small business of up to $500,000) or 26.5% (the general corporate tax rate). This was done by design so as to encourage small business owners to reinvest their business profits back into the business. Now the federal government is expressing concern over the system’s fairness, or lack thereof, in that it is being widely used for passive investment, as opposed to reinvestment in the actual business.