Update on Private Corporation Tax Changes
When the Department of Finance first announced the private corporation tax changes in July 2017 there were a lot of initial questions from the tax and financial planning community due to the scope of the changes. Over the last few months the details of the changes have slowly emerged, and we have received clarification on the changes that are going ahead. Below is an update of how these tax changes, passed into law on June 21, 2018, will be effective for tax years starting January 1, 2018:
Tax On Split Income (TOSI)
The Department of Finance has extended the definition of “TOSI” (Tax on Split Income) a.k.a. income splitting with family members. The previous rules (“Kiddie Tax”) applied only to children under the age of 18. In these cases, certain types of income received by a “specified person” (under 18) from a private corporation owned by a “specified shareholder” (related person) was taxed at the highest marginal rate. The new rules extended the application of the TOSI to individuals, over age 18, who receive income from a “related business”. Under the new rules, with some exceptions, family members not active in the business could be subject to the highest rate of tax (49.80% in BC and up to 54% in some provinces) on dividends and certain other income received from the company. These rules apply slightly differently for ages 18-24 than those 25 and over. In addition, most personal tax credits are also lost.
There are a few exceptions to the application of TOSI:
- “Excluded business” – If the individual is age 18 or older and is active in the day-to-day operations of the business, i.e. working an average of at least 20 hours per week on a regular basis in the current year, or in any of the five previous years, then they can receive income from the business without being subject to the top tax rates.
- “Excluded shares” – If the individual is over the age of 25 directly owns shares of the company with >10% of the votes and fair market value of the company, and meets additional criteria:
- It cannot be a professional corporation (i.e. accountant, lawyer, doctor, dentist, etc.);
- It must earn less than 90% of its income from the provision of services; and
- It must not earn more than 10% of its income from another related business.
- “Reasonable returns” – The individual can receive a “reasonable” return based on their contributions to the business (such as work performed for the business, investment of capital into the business, risk assumed, etc.)
If your corporate structure previously involved paying dividends to family members not directly involved in the day-to-day operations of the business, either directly from the company, through a holding company or a family trust, then unfortunately those types of arrangements may no longer be as tax efficient as they were.
This could mean less remuneration to children and spouses, resulting in larger dividends and salaries to the main, active shareholder of the company in 2018 and beyond. You may consider making additional RRSP contributions (if you have room) before February 28, 2019 to help reduce your tax burden. Contact your Hutcheson & Co. advisor to confirm the amount of RRSP contributions you should be making.
If you still plan on paying dividends or salaries to family members involved in the business, then you should start documenting the work that your family member does for the business (i.e. detailed job description, work logs, etc.) and implement ways for them to track the time spent working for the business (i.e. time sheets).
There may also be some restructuring of the company’s shareholdings required as individuals must now directly own the shares of the company to qualify under the “excluded shares” exception. You may want to roll existing shares out of the family trust or holding company, directly into the hands of the family member. However, legal and tax consequences should be discussed with your Hutcheson & Co. advisor before going down this route.
Passive investment income inside a corporation
The Department of Finance has indicated that they do not want taxpayers holding excess investments inside a corporation and taking advantage of perceived “tax loopholes” and deferrals. Finance has taken the position that if the company is able to generate enough funds to build a large investment portfolio then such a company no longer needs the help of the Small Business Deduction (SBD). The loss of the SBD would result in the company’s tax rate increasing from 12% (small business rate) to 27% (general corporate rate).
Finance has softened their original measures and have now agreed that small businesses should not be punished for maintaining an investment portfolio to save for business expansions, asset purchases, research and development, retirement or emergencies.
Companies (or groups of related companies) will be allowed to earn up to $50,000 of passive investment income, referred to as “Adjusted Aggregate Investment Income” or AAII, without any reduction to their SBD. Once companies earn more than $50,000 of AAII it will start to reduce the company’s SBD for the next fiscal year. Each $1 of AAII over $50,000 will reduce the company’s SBD by $5, effectively eliminating the entire SBD if more than $150,000 of AAII is earned by the company (or corporate group).
It may be beneficial to reduce the size of investment portfolios held in the corporate group by declaring dividends to shareholders and selling the investments in order to pay the dividends to avoid reduction of the group’s SBD.
If any planning can be done with the timing of the AAII it is recommended that most of the AAII be triggered in one year so that only a single year’s SBD is impacted, instead of spreading AAII over several years and reducing multiple years’ SBD.
It will also be important to match capital gains and capital losses in the same year, as capital losses of previous years will not impact the calculation of current year AAII, and subsequent years’ capital losses cannot be used to adjust previous years’ AAII calculation. You should discuss the timing of significant capital gains/losses with both your financial advisor and your Hutcheson & Co. advisor to ensure the most tax efficient strategy is followed.
Changes to Refundable Dividend Taxes
When companies earn investment income, a certain portion of the corporate taxes are refundable by way of Refundable Dividend Tax on Hand (RDTOH) which can reduce taxes as a dividend refund when the company pays a dividend out to its shareholders. Previously it did not matter if these dividends paid were “non-eligible” or “eligible” dividends (slightly better tax treatment). Either type of dividend would have triggered the dividend refund.
Under the new rules starting in 2019 the ability to receive a dividend refund will be more restricted. Essentially the previous RDTOH pool will be split into two new refundable tax pools; the Non-Eligible Refundable Dividend Tax on Hand (NERDTOH) and the Eligible Refundable Dividend Tax on Hand (ERDTOH).
There will be a transition from the company’s current RDTOH to the two NERDTOH and ERDTOH pools. The transitional ERDTOH pool is calculated as the lesser of: the company’s existing RDTOH balance, and 38 1/3% of the company’s General Rate Income Pool (GRIP) balance. Future ERDTOH will only be generated when a company receives eligible dividends from its investment portfolio of public company shares.
The transitional NERDTOH balance will consist of the opening RDTOH balance less any ERDTOH determined above. NERDTOH will be generated by all other types of passive investment income, other than portfolio dividends from public companies.
Some tax planning may be required to ensure that GRIP and RDTOH balances are maximized before 2019. It may be beneficial to generate RDTOH by triggering capital gains, as well as ensuring GRIP and RDTOH balances exist in the same company in corporate groups, and not as one company with a lot of RDTOH but no GRIP, and vice versa.
Payment of intercorporate dividends and “safe income”
Previously when paying dividends from one related company to another (e.g. from the operating company (OpCo) to a holding company (HoldCo), or a subsidiary to a parent company) the dividends were not subject to corporate taxes unless specific circumstances applied. Now that Section 55(2) of the Income Tax Act has been broadened there is a risk that these types of dividends could be recharacterized from “tax-free intercorporate dividends” to capital gains distributions, which would be subject to corporate tax at rates of about 25%.
Some circumstances in which Section 55(2) may apply:
- Dividends to move cash from OpCo to HoldCo;
- Dividends from OpCo to HoldCo to protect OpCo’s assets from creditors;
- Dividends from OpCo to purify the company for Qualified Small Business Shares and Lifetime Capital Gains Exemption purposes; and
- Dividends from OpCo to HoldCo to extract some of OpCo’s accumulated asset value.
To reduce the risk of Section 55(2) being applied intercorporate dividends should only be paid out of “safe income on hand”, i.e. after-tax retained earnings in the corporation.
Before any further intercorporate dividends are paid between related companies, it is recommended that the amount of “safe income on hand” be reviewed by your Hutcheson & Co. advisor in order to determine the amount of dividends that can be paid between the companies to minimize the risk of Section 55(2) being applied.
Considering these tax changes, we recommend that you review your company’s tax planning strategy with your advisor at Hutcheson & Co. as soon as possible to determine what type of action, if any, may be required.