written by Patrick O’Neil, Lawyer with with Burchell MacDougall LLP
By now, you have probably heard of the tax changes proposed on July 18, 2017, but you may be wondering, how do these affect my small business?
Of particular importance, the proposal seeks to make changes to income sprinkling, which occurs when a high-income earner attributes a portion of his or her income to a lower-income earner. Income sprinkling is currently limited in certain circumstances such as payments to minor dependents. The July 18th proposal seeks to reduce income sprinkling to a broader spectrum of individuals, including spouses, adult children, parents, siblings, aunts, uncles, nephews and nieces.
The proposal outlines a “reasonableness” test, which assesses an individual’s contribution to the business, and considers whether the dividend received is reasonable in light of these contributions. The reasonableness test looks at what the business would have had to pay a third party to perform similar functions, contribute similar assets, or assume similar risks, while also considering any compensation previously provided to the individual who received the dividend.
If the amount received is more than what the business would be expected to pay a third party, the payment is considered “unreasonable”, and the top personal tax rate will apply. For individuals under 24, payments are considered unreasonable unless the individual is “actively engaged on a regular, continuous and substantial basis”. As a result, the proposal may eliminate income sprinkling for many individuals between 18-24, who are studying in university or college, and thus, unable to commit full-time hours to the business. The proposed application date for these changes is January 1, 2018.
The reasonableness test may also impact the ability for a business to secure funding from a family member. If the relative contributing money to the business is not active within the business, under the proposed rules, the dividends declared to that individual would not be “reasonable”, and would therefore any dividends would likely be taxed at the highest personal tax rate.
The proposal also looks to limit the multiplication of the lifetime capital gains exemption, characterizing many types of capital gains that had previously been eligible for the lifetime capital gains exemption as ineligible, including:
● capital gains allocated from a trust,
● capital gains of an individual who is a minor
● capital gains accrued while an individual was under 18; or
● capital gains that arise as a result of income splitting that is deemed unreasonable.
Aside from income sprinkling, the proposal seeks to promote fairness and equality by removing the perceived advantage of using earnings subject to the small business corporate tax rate for investment purposes. The advantage stems from the retained earnings of a business as compared to the retained earnings of an individual, as a result of the differing rates of taxation (corporate tax rate vs. personal tax rate).
However, while there may be a perceived advantage when considering the retained earnings of a business vis-à-vis an individual, the approaches proposed do not take into consideration factors which may burden a business owner and not an individual.
The explanatory notes indicate that the Department of Finance is seeking to prevent “an individual from avoiding tax that would ordinarily arise on a taxable dividend” (Explanatory Notes – Department of Finance). The proposal seeks to change how the surplus of a business is extracted by its shareholders, by preventing the removal of a surplus by a capital gain as opposed to a dividend paid to the shareholder.
Additionally, a shareholder’s ability to use certain estate or succession planning techniques designed to facilitate the sale of a business will be constrained by the proposed changes. The proposal intends to treat the sale of a business to a family member as a dividend rather than a capital gain, resulting in a tax increase on the sale of the business. The proposal does not plan on treating sales of a business to a third party in a similar fashion, which may discourage some business owners from selling to family members.
The proposed tax changes will add significant administrative costs to running a small businesses. Transactions traditionally exercised with a view to being practical from a tax perspective may no longer be prudent, or even viable. Furthermore, many existing succession plans may subject your business, and its shareholders, to a significant increase in taxes. The consultation period for comments on these proposed tax changes expired on Oct. 2, 2017.