Over the past 4 years or so, we have experienced an unprecedented increase in the complexity of private company taxation. With another Liberal government recently elected, which is supported by the NDP and Green Party, we can certainly expect further tax changes which will more likely than not include increasing tax rates. Of particular concern is the rumor that both the Liberals and NDP support the idea of raising the capital gains inclusion rate from 50% to 75%. With this in mind, the capital gains strategy (No. 3 below) which has been very popular in recent years will likely become even more so in advance of our next Federal budget and possibly a fall economic update. It remains to be seen how long the planning outlined below will continue to be available and taxpayers shouldn’t wait until it’s too late.
Please keep in mind that the information contained herein does not represent tax or legal advice and is for informational purposes only. Appropriate professional advice is required before relying on any information contained herein, whether used for planning, tax filings or otherwise.
Before undertaking any type of planning, the TOSI rules should be analyzed on a case by case basis.
1. Estate Planning Basics ( click for diagram)
In many cases, it will make sense for mom and dad (Generation 1) to implement and estate freeze in favour of their children and possibly grandchildren (Generations 2 and 3). Typically, a family trust with a corporate beneficiary would be used as part of the estate freeze structure. Some of the benefits of this type of planning include:
- Tax deferral on future accrued capital gains (26% tax deferral on future gains);
- Probate savings (1.5% of estate value). Yes, despite the Milnes decision, Primary and Secondary Wills are still being used;
- Purification for the Capital Gains Exemption and also for an “excluded amount” from the TOSI rules;
- Possible multiplication of the Capital Gains Exemption;
- Maybe possible depending on the client situation to achieve income splitting, although a detailed review of the TOSI rules would be required;
This type of planning should be considered for any business owner who is looking to transition corporate assets (either during life or on death) to a subsequent generation.
2. Prescribed Rate Loan (click for diagram)
This strategy involves making a loan (typically cash is used) to a spouse or family trust. In most cases we would use a family trust such that control is not lost over the assets being lent. In order to achieve income splitting, the person making the loan must charge interest at a minimum of the prescribed rate in effect at the time the loan is made. As a result of the TOSI rules, it is important that the family trust not be viewed as carrying on a related business.
Currently, the prescribed rate is 2%. Income splitting is achieved where the trust allocates its investment income (in excess of the 2% interest cost) to lower income beneficiaries. For example, if $500,000 was lent to a family trust which earned an 8% return, and the trust allocated the 6% net return (after paying the 2% interest cost) to beneficiaries of the trust who had no other income (say three minor children), the tax savings would be approx. $16,000 per year.
This type of planning should be considered where there is significant investment income being earned by a single taxpayer and there are other family members (typically spouses, children, and grandchildren) with little or no income.
3. Capital Gains Planning (click for diagram)
As the personal tax rates have increased, the tax spread between dividend income and capital gains has grown. As a result, planning has developed whereby a taxpayer creates a capital gain as a means of extracting corporate funds. For example, if an individual taxpayer where to extract $1,000,000 of corporate funds as a capital gain, instead of paying a non-eligible dividend, the tax savings would be $206,400.
| Capital Gain | Eligible Dividend | Non-Eligible Dividend | |
| Amount to be distributed | $1,000,000 | $1,000,000 | $1,000,000 |
| Tax Rate | 26.76% | 39.34% | 47.40% |
| Tax Payable | $267,600 | $393,400 | $474,000 |
| Amount received by individual | $732,400 | $606,600 | $526,000 |
The original July 18, 2017 draft proposals that were released by the Department of Finance would have prevented this type of planning going forward. Since those proposals were later withdrawn, some practitioners are of the view that this type of planning is still viable planning, at least for the time being. However, a word of caution is warranted. This type of planning is very technical and not necessarily free from CRA scrutiny. Although the case law that has evolved in this area over time has generally been in favor of taxpayers, there are number of technical mishaps that could occur that could result in CRA challenge.
This type of planning should be considered by those who have a slightly higher risk tolerance with their tax planning. This planning can be particularly effective where a taxpayer has a large shareholder loan balance (or anticipates a large balance) owing to the company that needs to be repaid to avoid an income inclusion.
4. Post-Mortem Pipeline Planning (click for diagram)
Similar to the capital gains planning described above, the post-mortem pipeline planning is a mechanism where the deceased’s estate can extract corporate funds at capital gains rate. This type of planning is generally accepted by the CRA, provided certain technical requirements are followed. Other post-mortem planning may also be appropriate, such as a loss carryback or bump transaction. Depending on the client situation, the TOSI rules may need to be considered as part the planning.
This type of planning should be considered where an executor of an estate is looking to wind up and distribute corporately owned assets to the deceased’ s beneficiaries.