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November 10, 2017

LEGAL UPDATE – BUDGET 2018: FROM FIRE TO FRYING PAN

 

Date: March 5, 2018
Author: Karen D. Stilwell

Budget 2018 was released on February 27, 2018 and, with its release, came a degree of closure to the drama that unfolded following the July 18, 2017 announcement of a package of proposed changes to the taxation of Canadian private corporations and their shareholders. The changes as initially proposed threatened to both suddenly and fundamentally rearrange the framework that has defined the taxation of private corporations in Canada for decades. The mere announcement destabilized small and medium sized incorporated business and galvanized tax professionals across the country. All were duly stirred from summer slumber.

Seven months have passed. In the intervening period the federal government has retreated significantly from its initial set of proposals. It did this first through a series of announcements during “Small Business Week” in October, 2017, indicating that certain of the more devastating proposed technical changes to the surplus stripping rules would be abandoned. Then, on December 13, 2017, revisions to the initial proposal for changes to the taxation of dividends received by family members from incorporated family business were published. Finally, last week, Budget 2018 set out the long awaited legislative changes to the taxation of corporate passive income.

Life is not about to get easier for the small or medium sized business owner. Without exception, the changes in their current iteration increase the overall tax and compliance burden for small and medium sized incorporated business. But, whereas we were originally promised changes that would wreak havoc on the fundamentals of taxation of private Canadian corporations, the prognosis has improved. We were promised fire, but we appear to have landed in the frying pan.

Here is your need-to-know about the corporate tax changes as they stand today:

Passive Income:  Two significant changes to be made to the taxation of passive income earned in a corporation are effective for taxation years that begin after 2018:

  • Straight Line Reduction of Small Business Limit: Budget 2018 reduces the small business limit of a CCPC on a straight-line basis between $50,000 and $150,000 of investment income. For each $1 of “adjusted aggregate investment income” earned by a corporation over $50,000, the small business limit will be reduced by $5. “Adjusted aggregate investment income” is a new term defined with reference to the existing concept of “aggregate investment income” but excludes, among other things, taxable capital gains from property used principally in an active business. This measure interacts with the existing rules that reduce access to the small business deduction based on taxable capital employed in Canada between $10-$15 million. For corporations that are subject to limits on the small business deduction under both this new passive investment rule and under the existing taxable capital rules, the reduction to be applied will be the greater of the two.
  • Changes to RDTOH: In order to prevent indirect deferral of tax on passive income earned in a corporation, Budget 2018 creates two new RDTOH accounts: eligible RDTOH (ERDTOH) and non-eligible RDTOH (NERDTOH). This measure is designed to prevent the generation of a tax refund from the RDTOH account through the payment of eligible dividends derived from active income. ERDTOH will track refundable tax paid under Part IV on eligible portfolio dividends while NERDTOH will track refundable taxes paid under Part I on investment income and under Part IV on non-eligible portfolio dividends. Refunds from NERDTOH will only be achieved from the payment of non-eligible Moreover, an ordering rule will ensure that when a non-eligible dividend is paid, the NERDTOH account will be debited ahead of the ERDTOH account. For CCPCs, existing RDTOH balances will be allocated among the two accounts. The ERDTOH account will be allocated the lesser of the existing RDTOH balance and 38.5% of the GRIP balance. The remainder will be allocated to the NERDTOH account. This measure creates added compliance complexity for small business, but preserves integration on a flow-through basis.

Tax on Split Income: The final version of the rules governing the taxation of dividends received by family members from incorporated business were released on December 13, 2017.  The new rules significantly constrain the ability once commonplace to split income among family members through discretionary dividend and family trust structures. To the extent that the new rules create space for continued income splitting, several of the new rules contain a degree of vagueness and uncertainty that will be intolerable for many taxpayers.

Listed below are a few highlights of the new regime which became effective January 1, 2018:

  • Regular, Continuous and Substantial Engagement: Income splitting remains permitted with an individual age 18 and over the individual is engaged in the business on a “regular, continuous and substantial basis” in that year or in any five previous years. An individual who works an average of 20 hours per week in the business is deemed to have been engaged in the business on a “regular, continuous and substantial basis” and, in all other cases, the question will be determined based upon the particular facts and circumstances.
  • Excluded Shares: Income splitting remains permitted with an individual age 25 and over on shares that qualify as “excluded shares”. These are shares of corporations:

(i) that earn less than 90% of their income from a service business;
(ii) that are not professional corporations; and,
(iii) of which the individual owns at least 10% of the votes and value.

The concept of “service business” is not defined. Individuals have until the end of the calendar year to meet the 10% votes and value criterion in order to qualify for income splitting throughout 2018.

  • Reasonable Return: Income splitting remains permitted with an individual age 25 and over if the return obtained by the individual on his or her share is considered reasonable having regard to work performed, property contributed, risks assumed and other relevant factors.
  • Active Spouse Over Age 65: The new rules allow income to be split with a non-active spouse once the active spouse has reached age 65. This rule is also available to professional corporations and service-based businesses.
  • Capital Gains Exemption: The new rules do not, as originally proposed, prevent access to the capital gains exemption by non-active family members.

Under this new regime, income splitting is now less the rule and more the exception. The new regime is also complex and highly fact sensitive. As a result, it is recommended that anyone accustomed to income splitting under the old regime consult with a tax specialist for advice on whether and how it might be possible to preserve such treatment under the new rules.

Conclusion

By far, the frying pan we find ourselves in is preferable to the fire we were promised. While we breathe a collective sigh of relief that cooler heads prevailed, the result nonetheless is that tax complexity continues to grow, the compliance burden on small business mounts and questions about tax fairness remain unanswered.  If we have learned anything from the last seven months, it is that it is time for a comprehensive review of income taxation in Canada.

For more information, contact Karen Stilwell, Tax Partner at Connors Stilwell.

This document also available for download as a PDF

This document contains information only and does not provide legal advice. Contact Connors Stilwell or another lawyer for advice related to your personal situation.

 

 

Karen Stilwell
Karen Stilwell
Karen is a tax and corporate lawyer whose practice is focused on corporate and personal tax planning for business owners. She advises clients on tax and corporate matters relating to corporate reorganizations, sales and acquisitions of businesses, and estate planning. Karen’s practice also includes advising on GST/HST and other commodity tax matters for business owners, charitable organizations and others. Additionally, Karen has significant experience in tax litigation and dispute resolution with the Canada Revenue Agency, including broad experience with appeals to the Tax Court of Canada, applications to provincial superior courts for rectification and other discretionary relief, applications for judicial review in the Federal Court of Canada and Federal Court of Appeal and applications to the CRA’s Voluntary Disclosures Program. Read more about Karen here

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