Business Law, Taxation law, Litigation, Succession, Taxation law

Proposed Tax Changes - Action plan for 2017

Aug 31st, 2017

By Frank Zylberberg

By now virtually all of you will have read or heard about the drastic changes to our tax system proposed by the federal Minister of Finance on July 18, 2017.

Many of the changes are indicated to be effective as of January 1, 2018, though some are effective July 18, 2017. It is hoped that there will be some easing up announced this fall after the October 2, 2017 deadline for submissions of suggested changes by interested parties.

It is also hoped that there will be ample clarification as to the effect of the rules on transactions that were well under way by July 18, 2017, since the transitional application rules are shockingly bereft of details.

The purpose of this memorandum is not to elaborate or dwell on the proposed changes, but to discuss actions that should be considered this year, should the changes be enacted substantially in their current form:

  1. Many business owners have structured their companies in such manner that permits dividends to be “sprinkled” among some or all of the family members in equal or unequal amounts so as to take maximum advantage of lower income tax brackets.
  2. The ability to income split effectively was removed many years ago insofar as children under the age of 18 in the particular year are concerned. This restriction has now been expanded to include all family members not active in the business, but the restriction will only come into force in 2018. Therefore not only should such dividends be paid in 2017, but depending on the anticipated financial needs of the family in 2018, the amount of dividends should be increased to amounts that take advantage of all lower tax bracket rates of family members.
  3. The above restrictions appear to be aimed at companies carrying on a business. The ability to declare dividends to adult family members may still exist when the company in question has passive investments and is not carrying on an active business. We encourage you to contact us to discuss your particular situation.
  4. Companies carrying on a business pay taxes on profits at a rate ranging from approximately 18% to 26%. Many business owners not requiring all the funds generated by the business in the year, choose to leave a portion of the after-tax profits in the company or a holding company for passive investment. Though this has been a common practice since the mid 1970’s, the Minister of Finance finds it to be inequitable and a discussion has been initiated as to how to remove this perceived unfairness. Regardless of the nature of the changes, they will undoubtedly not be palatable to many.
  5. One of the harshest proposals would remove the ability to distribute the untaxed one-half of capital gains realized by the investment portfolio tax-free by means of a capital dividend. As the final changes become clear, you may wish to consider adjusting your portfolio before the end of the year, realizing capital gains and distributing the tax-free capital dividends resulting from such dispositions.
  6. Both above strategies should be considered in unison. You should be aware that if you are going to realize capital gains this year whether by adopting the above strategy or otherwise, it may be worthwhile to pay taxable dividends in addition to the tax-free capital dividends – this has the effect of lowering the tax the company pays on the taxable portion of the capital gains. Therefore, in addition to paying dividends to family members in lower tax brackets, consider stopping your salary draws and replacing them by dividends.
  7. Needless to say the strategies discussed in paragraphs 5 and 6 are drastic insofar as they accelerate taxes which might otherwise be payable in a future year. Therefore they should only be considered once the proposed changes have become final.
  8. Many owners have structured their businesses so that family members can all potentially use their capital gains exemption upon a sale of shares of the business. (Currently the exemption allows an individual to avoid taxes with respect to approximately $835,000 of such capital gains). Severe restrictions on the use of the capital gains exemption will commence in 2018:
    1. only the individuals who are appropriately active in the business and/or have made appropriate capital investments in the business will have access to the exemption;
    2. if a trust holds the shares of the company, no beneficiary of the trust will be able to use the capital gains exemption in respect of such shareholdings.
  9. There is, however, the opportunity to file an election in the 2018 taxation year whereby the capital gains exemption can be claimed under the old rules. There may, however, be reasons to commence triggering the exemption in 2017.
  10. For a shareholder to benefit from the capital gains exemption, there are various requirements that the company in question must meet. For example, for two years preceding the date upon which the exemption is triggered, more than 50% of the assets of the company must consist of assets (including inherent goodwill) used in its active business; on the date the exemption is claimed, this requirement must be met with respect to more than 90% of the assets of the company.
  11. If your company has met these conditions, it may be advisable to examine having some of the beneficiaries with lower incomes trigger a portion of their capital gains exemption in 2017. In our tax system, an individual triggering the maximum capital gains exemption may be subject to alternate minimum tax. To mitigate such tax it may be advisable to crystallize, for example, one-half of the exemption in 2017 and elect with respect to the balance of the available exemption in 2018.
  12. What about the shares of companies which have not met the above-mentioned two year asset based test? The rules relating to the ability to elect in 2018 to use the capital gains exemption are generous in that the said asset based test must only be met for twelve months before the date of the election in 2018. It is therefore vital that action be taken before December 31, 2017 to “purify” the company and move non-business assets elsewhere. This is often complex to achieve tax-free and should be examined with us forthwith.
  13. Many of you have trusts with all family members as discretionary beneficiaries. Ensuring that your company meets the asset based conditions for the capital gains exemption may be your last kick at the can for having all family members use the capital gains exemption by means of the above elective process. This presumes, however, that the shares of the business owned by the trust have grown in value such that each member of the family could elect a capital gain of $835,000. What about those trusts holding shares with a value insufficient for all family members to elect fully?
  14. For example, assume that the shares of a business held by a trust have a value of $2 million. The husband is active in the business; the wife practices her profession elsewhere; both children are in university and one of the children has expressed a strong desire to come into the business after graduation. Consideration should be given to using the wife’s full exemption of $835,000; the exemption of the child who will not come into the business should also be fully used; the balance of approximately $330,000 should be used with respect to the child who will potentially be involved in the business. Appropriate measures should be taken to ensure that the children are equalized in the Wills of the parents. The reason that no allocation has been made with respect to the father is that presumably he will be active in the business for a sufficient time in the future such that his shares will grow by $835,000 at which point he will have enough equity to use his exemption.
  15. In the foregoing example, one problem is that it has been assumed that the father and the child who will join the business in the future will have access to the capital gains exemption. However this is only true if the shares of the business are reorganized since, under no circumstances, will any beneficiaries of a trust have access to the capital gains exemption by reason of the trust’s shareholding. This begs the general question as to the utility of trusts in the future. The following are factors to consider:
    1. in the foregoing example, it is possible to restructure the shares of the company such that the father and the child who is interested in joining the business in the future will both have shares which will grow in value to exactly equal their available capital gains exemption and then the shares will automatically be capped at such value;
    2. the idea would be to have the trust remain in force and benefit from any growth in value of the business in the future in excess of the amount of value required to maximize the capital gains exemption of those family members active in the business;
    3. it should not be forgotten that trusts are still one of the best tools to implement successful estate plans.
  16. Finally, this is an appropriate time to consider succession in your family business. The new rules regarding income splitting and the capital gains exemption are complex. The theme that emerges, however, is that to escape the impact of the rules it will not be enough for family members to hold shares of the business; they will have to be actively involved or have capital invested in the business. As already noted, there will be an impetus for the founders to elect to use their exemptions and to perhaps extract capital from the business or from a holding company by means of the triggering of capital gains and dividends. There may be effective ways of providing such capital to family members, in a secured manner, so that even the inactive ones can avoid the above-mentioned restrictions.