Owner/Managers: Are You Ready for the Tax Changes?

Right around this time a year ago, we received the somewhat unexpected private company income tax proposals from our Federal Finance Department.  While they had hinted that these changes were coming, the form of these changes was a big surprise to many private company business owners and tax practitioners.  After significant public feed back was received, the new tax rules are now in place with the income splitting rules already in effect as of January 1, 2018.  The passive income rules will take effect for tax years that start after 2018.  The question is, now that we are at the midpoint of 2018 are you prepared for these changes?A reminder as to what these changes encompass:

Tax on Split Income (TOSI)

These changes that target adult taxpayers who use private corporations to ‘sprinkle’ income among family members. They are essentially an extension of the kiddie tax rules for minor children. The rules target income that would otherwise be taxed at a higher income tax rate which is distributed to a family member at a significantly lower tax rate or may not be taxable at all. The income under these rules includes dividends, interest and capital gains.

If a dividend or capital gain distributed to a family member is found to meet the definition of TOSI it will be taxed at the highest personal income tax rate i.e. Federal + Ontario combined rate for eligible dividend income in 2018 is 39.34% (46.84% for non-eligible dividends) and capital gains is 26.76%.

Conditions where certain individuals will be excluded from the rules include:

1. The business owner’s spouse who has meaningfully contributed to the business and is aged 65 or over
2. Adults aged 18 or over who have made a substantial labour contribution (average of 20 hours per week) during the year or in any of the last 5 years
3. Adults aged 25 years or over who own 10% of the corporation that earns less than 90% of its income from the provision of services and is not a professional corporation
4. Individuals who receive capital gains from QSBC shares if they would not be subject to the highest marginal tax rate on the gains under existing rules

If individuals aged 25 or over do not meet any of the exclusions, then they will be subject to a reasonableness test to determine income that will be subject to the highest marginal tax rate.  The reasonableness test considers what is a ‘reasonable return’ based on capital and labour contributions, risks they assumed and amounts previously paid to the individual.  They carry a certain element of subjectivity and time will tell in terms of how CRA will assess these factors.  There are some relieving provisions to accommodate certain situations such as income received from an inheritance, from the transfer upon marriage breakdown, deemed disposition upon death and income that would not have been subject to TOSI if it was earned by a deceased spouse in their last taxation year.

Passive income:

The new legislation involves the reduction in the small business deduction limit for Canadian-controlled private corporations (CCPCs) which have between $50,000 and $150,000 in investment income.  The rationale is that excess cash held in a CCPC should be reinvested in the business, if invested in a passive income investment portfolio there is an advantage over an employed person having the same available cash due to lower corporate tax rates. 

The new measures will affect those CCPCs that have business income that exceeds their reduced business limit; any income over the reduced business limit is taxed at the regular corporate tax rates.  The limits are based on assumptions that an investment portfolio will earn a return of 5% thus the business limit would be reduced where CCPCs have an investment portfolio that exceeds $1M of passive assets.  In other words, the limit would be reduced by $5 for every $1 of investment income above a $50,000 threshold such that it would be reduced to zero at $150,000 of investment income.

There are also changes that will be brought in to affect the tax planning options used to access refundable taxes on eligible dividends.  There will now be two ‘pools’ of refundable taxes on hand that will accumulate earnings from either active or passive income, which will then determine whether an eligible or ineligible dividend will be paid and whether refundable taxes will be accessible or not.  The effect of this will be an increase in the overall effective tax rate in situations where only ineligible dividends can be paid to shareholders. These rules are expected to be in place for tax years that begin after 2018 thus effective for tax years starting Jan 1, 2019.

In summary, if you are concerned that certain tax planning strategies that you have implemented in the past may no longer be tax effective, then we can help you to determine the best way to navigate the impact of the rules.  If you act now there is plenty of time to make plans and avoid last minute surprises that cannot be remedied.