Tax Planning: Income Sprinkling, Passive Investments, & Capital Gain Conversion, Study notes of Finance

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USING PRIVATE CORPORATIONS

TAX PLANNING

Technical Briefing

Outline

• Context
• Key Features of the Income Tax System
• First Strategy: Income Sprinkling
• Second Strategy: Passive Investment Income
• Third Strategy: Converting Income into Capital Gains
• Conclusion

Need for Action

• The basic structure of the existing tax system has been in place since 1972
• Since that time:

o The structure of the economy has evolved

o The tax system has undergone important changes

o Tax planning strategies used by private corporations have grown more

sophisticated

• The focus is on private corporations given the scope of the tax planning they provide

Increasing Incentives for Tax Planning Using

a Private Corporation

The growing gap between corporate and personal income tax rates since 2000 has increased rewards associated with tax planning in a private corporation… … Over this period, a growing share of high-income self-employed individuals have chosen to incorporate 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 2000 2002 2004 2006 2008 2010 2012 2014 2016 Federal-Provincial Tax Rates Combined Federal-Provincial Small Business Rate: 14.4% (2017) Combined Federal-Provincial General Corporate Income Tax Rate: 26.7% (2017) Top Combined Federal-Provincial Personal Income Tax Rate: 51.6% (2017)

percentage point gap (2017) 0% 1% 2% 3% 4% 5% 6% 7% 8% 2001 2003 2005 2007 2009 2011 2013 Taxable Active Income / GDP Trend in Taxable-Active-Income-to-GDP Ratio, by Type of Business Canadian Controlled Private Corporations (CCPCs) Public Corporations and Private Corporations other than CCPCs Individuals with Self-employment Income

Key Features of the Income Tax System: Integration

• Low corporate tax rates on business income are intended to provide a tax advantage as long as income is retained for active business re-investments
• But income that is paid out of a corporation as a dividend is generally meant to be subject to the same amount of tax as income received directly by the individual Corporate taxes on earnings + Personal taxes on dividends = Personal taxes on income earned directly
• This is the concept of ‘integration’ – it applies the progressive personal income tax schedule to income paid out of the corporation, adjusted for tax at the corporate level

Integration Example

8

• A high-income individual earns an extra $100. The overall after-tax outcome is generally similar whether that income is earned by an individual directly (i.e., via salary) or indirectly (i.e., via her corporation and paid out as a dividend) Salary + $ Personal income tax - $ After-tax income $ Individual Business income + $ Corporate income tax - $ Income after corporate tax $ On distribution as dividend: Personal income tax - Dividend income grossed up - PIT rates applied - Claim dividend tax credit - $ Total tax paid $ After-tax income $ Corporate Owner Department of Finance - July 2017

First Strategy:

Income Sprinkling – An Example

• Jonah and Susan are Ontario neighbours, each earning $220,

o As a business owner , Jonah is able to divert income to three adult family

members who have no other sources of income

o As an employee , Susan can’t do this. She therefore pays $35,000 more in

tax ($79,000 minus $44,000) 10 Jonah Susan Total earnings $220,000 $220, Salary paid $100,000 $220, Dividends paid to family members (after corporate tax) $102,000 - Total tax paid (personal and corporate) $44,000 $79, After-tax income $176,000 $141, Department of Finance - July 2017

First Strategy: Income Sprinkling

• The Income Tax Act has rules that curtail income sprinkling. For example:

o Expenses paid by a business, such as salary, must be reasonable in order to be

deductible for income tax purposes

o Tax on split income subjects minors (individuals age 17 and under) to top tax

rate on dividends received from private corporations, as well as certain other income from businesses of family members

• However, current rules do not fully respond to many income sprinkling strategies

Second Strategy:

Passive Investment Income - Context

• Corporations can earn “active business income ” (income earned from conducting a business) and/or “passive income” (e.g., derived from portfolio investments)
• Proposed measures deal with passive income only and will not affect the taxation of active business income

Second Strategy:

Passive Investment Income - An example

Employee Corporate Owner Gross Income to Invest $100,000 $100, Corporate Income Tax - $15, Personal Income Tax $53,550 - Net Income Available to Invest $46,450 $85, 14

• An employee and a corporate owner each make one-time investments from $100,000 of pre-tax income, and hold them for ten years Department of Finance - July 2017

Passive Investment Income – Proposal

• The proposal would eliminate the tax deferral advantage on passive income earned by private corporations and

o Preserve the intent of the lower corporate taxes: support growth and jobs

o Re-establish fairness by ensuring that private corporations’ owners do not have

access to tax preferred savings options not available to others

• The objective is to make the system neutral on a go-forward basis

Third Strategy:

Converting Income into Capital Gains

• For higher-income individuals, dividends are taxed at a higher tax rate than capital gains, which are only one-half taxable
• As a result, income taxes can be reduced by converting dividends (and salary) that would otherwise be received from private corporations into lower-taxed capital gains
• There is an anti-avoidance rule that deals with transactions among related parties aimed at converting dividends and salary into lower-taxed capital gains
• This rule is being circumvented
• It is proposed to amend the income tax rules to address such tax planning

Annex: Proposed Measures to Address Income

Sprinkling

• Under the proposed changes to the tax on split income (TOSI) rules, an amount paid to an adult family member will be considered reasonable if it is consistent with what a person who is not an adult family member would receive having regard to:

o the labour contributions of the individual to the activities of the business;

o the assets contributed or risks assumed by the individual in respect of the

business; and

o the previous returns/remuneration paid to the individual in respect of the

business

• In recognition of the particular concerns with income sprinkling involving family members aged 18-24 under the current rules, the proposed reasonableness test is stricter for amounts paid to these family members

Annex: Income Sprinkling – Low-Rate Dividends

20 Low-Rate Dividends Reported on T1 Returns, By Age of Filers ($million) 0 100 200 300 400 500 600 700 800 900 1000 Non

• eligible dividends ($ million) Age 2006 2010 2014
• For high-income earners, benefits of income sprinkling are higher when adult children are younger