The following is a general summary of the new tax rules affecting business-owners announced by the Federal Minister of Finance on July 18, 2017.
Dividend and Capital Gain Sprinkling
1. Elimination of the preferential tax treatment for dividends paid by closely-held corporations to family members not involved in the business, effective for 2018. These dividends will be subject to the highest rate of tax with no offset for losses or any other deductions or credits available to reduce this tax.
2. Taxable capital gains on shares of private corporations held, either directly or through a trust, by family members who are not involved in the business are also subject to the highest rate of tax with no capital gains exemption available. These rules are effective for 2018, other than for certain limited grandfathering as explained below.
Capital Gains Exemption
3. Elimination of the ability of family members not involved in the business to claim the capital gains exemption, effective for 2018, with resulting taxable capital gains subject to the highest rate of tax.
4. Individuals involved in the business will only be able to claim the capital gains exemption on shares owned directly and not through a family trust, effective for 2018.
5. There will be a one time election to step up the cost base of shares that qualify for the capital gains exemption for all individuals, including those not involved in the business. Both directly held shares and those held in a trust will qualify. In brief, in 2018, taxpayers can choose a date in the year when the corporation qualifies for the exemption and elect to dispose of and reacquire the shares on that day. This 2018 election will only be available for majors and major beneficiaries of trusts - not minors. Other considerations with respect to the election:
- Valuations will likely be needed.
- Alternative minimum tax will likely be triggered for low income individuals.
6. For 2018 only, minors can claim the capital gains exemption on shares held directly or through a trust. It would appear that this relief will only be available if the shares were sold to an arm’s length party.
7. For the past few years, planning has allowed individuals to convert what would otherwise be a dividend from a private corporation (taxable at 40%-45%) to a capital gain that would be taxable at 25%. This was commonly referred to as “surplus stripping”. This planning involved the triggering of capital gains on private corporation shares in a related party context. This planning is eliminated effective July 18, 2017. There are however certain consequences from the changes to the rules that may or may not be intended by the Department of Finance that are also effective as of July 18, 2017:
- The ability of corporations to pay capital dividends to individuals.
- The increase of the tax rate on death from 25% to either 40% or 45% with respect to shares of private corporations.
- Double tax on the sale or transfer of shares between individual family members.
Future Potential Proposals (no set date and unclear if and how this will go through)
8. The government is displeased with the ability of incorporated businesses to invest their low taxed retained earnings in comparison to a fully taxed salaried individual and are looking for ways to equalize the playing field. One proposal is that future passive income and capital gains in a corporation will no longer give rise to refundable taxes or a capital dividend account. This would result in a combined corporate and personal tax rate of up to 70% on passive income and capital gains.
9. This punitive system is designed to encourage companies to pay out their after-tax earnings as dividends to individual shareholders, rather than investing these proceeds at the corporate level. The government has indicated that grandfathering will apply on pre-existing corporate retained earnings, but the mechanics of how this would work and whether it will apply to all situations is uncertain.