Changes to the taxation of private corporations: What you need to know

In July 2017 and in the following 2018 Budget, the federal government announced significant changes to the taxation of private corporations.

The first change is the new “Tax on Split Income” (“TOSI”) rules. A common income splitting plan involves having various family members as shareholders of a corporation where each is paid dividends by the corporation. This permits family members in lower tax brackets (often children and spouses) to receive money from the corporation at a lower tax rate than that of the person primarily involved in the business. Generally speaking, income and capital gains of a person derived from private corporation shares (note that the rules include trust and partnership income as well) where a “related person” (a related person is a spouse or common-law partner, child or other descendant, sibling or spouse or common-law partner of a child/other descendant or sibling (i.e. in-laws)) is involved in the private corporation’s business will be subject to the new TOSI rules and taxed at the highest marginal rate.

There are some limited exclusions to the TOSI rules.

The first exclusion is where the payments are made to the spouse of the involved business person and the involved business person is aged 65 or older.

For individuals over the age of 18 and under the age of 25, the following exclusions apply:

1. Dividends on the shares of a private corporation inherited from a deceased parent;
2. Dividends on the shares of a private corporation inherited from any deceased person where the individual is enrolled full-time in post-secondary education or where the individual is entitled to the disability tax credit;
3. Dividends on the shares of a private corporation transferred as a result of a separation agreement or judgement resulting from breakdown of marriage or common-law relationship;
4. Capital gains from disposition of qualified farm or fishing property or qualified small business corporation shares, even if the capital gains exemption is not claimed;
5. Dividends on the shares of a private corporation where the individual is actively engaged in the business of the corporation on a regular, continuous and substantial basis during the year or during any of the five preceding years. This is the “excluded business” exclusion from the TOSI rules. Whether an individual is considered to be engaged in the business on a “regular, continuous and substantial” basis is a factual determination or will be deemed if the individual worked an average of 20 hours per week in the business; and
6. There are two additional exclusions, the “safe harbor capital return” and “reasonable return in respect of arm’s length capital” exclusions, which are unlikely to be used or met.

For individuals aged 25 years and over, the same exclusions as for individuals aged 18 – 24 apply, as well as the following:

1. Dividends on “excluded shares”. The “excluded shares” exclusion applies where:

• less than 90% of the private corporation’s income in the previous year was from services;
• the private corporation is not a professional corporation;
• the individual aged 25 and over owns shares with a minimum of 10% of the votes and value of the private corporation; and
• less than 10% of the income of the private corporation in the previous year was deemed from another related business not carried on by the corporation;

This is a key exclusion that will likely be relied on frequently.

There are a number of issues concerning the definition of “excluded shares” which may result in the inapplicability of the exclusion. For example, it is not clear whether shares of private corporations carrying on service businesses such as trades and restaurants will qualify as “excluded shares”. The shares of many holding companies will not qualify for the “excluded shares” exclusion as income from a subsidiary carrying on a business is income from another related business and must stay below the 10% threshold in order to be able to qualify. Also, shares held by trusts will not qualify because the shares must be held by an individual to qualify under the “excluded shares” exclusion.

2. There is also a “reasonable return” exclusion for an individual aged 25 and over which is less likely to be used or met.

3. The new TOSI rules are complex and are effective as of January 1, 2018.

The 2018 Budget also targets the taxation of passive investments held within a private corporation for taxation years beginning after 2018. One major change is the reduction of the limit for the purpose of the small business tax rate for a private corporation and its associated corporations that collectively earn more than $50,000 of passive investment income in a year. The limit is reduced by $5 for every $1 of investment income earned over $50,000, resulting in the limit being zero where a private corporation earns $150,000 of passive investment income.

The rules discussed in this article are complicated. This article represents a very brief overview of the changes and is provided for general information only. It does not cover all of the intricacies of the rules and should not be relied on as legal advice. Consult your tax advisor for further details and specific questions with respect to these changes and how they might affect your business.