Ottawa, ON Taxation of Investment Income. 25 2017/PowerPoints/3... · Disclaimer: This material is for ... To eliminate tax incentives for CCPC owners to retain “active” earnings,

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Tax Planning Using Private Corporations -

July 18, 2017:

Analysis and Discussion with FinanceOttawa, ON

Bruce BallCPA Canada,Alex LaurinC.D. Howe Institute,Jeffrey Trossman Blake, Cassels & Graydon LLP

Taxation of Investment Income

Disclaimer:








July 18, 2017:


Assessing the Policy Objectives of the Finance Proposals

3 2017 Taxation of Private Corporation Policy Conference

What is the policy objective for passive income proposal?

● To eliminate tax incentives for CCPC owners to retain “active” earnings, if

the goal is to hold “passive” investments for future personal consumption

● To eliminate a perceived “unfair” tax advantage to CCPC owners compared

to other investors

● Incentive to retain earnings fostered by low small-business income tax rate

leaving greater investment potential

● Tax “inequity” derived from partial relief of CCPC taxes on passive

investment income

Assessing the Policy Objectives


Three Key Observations

1. Measured against a consumption-based tax system with progressive

rates, the current CCPC tax regime has many unobjectionable features

2. General-rate earnings (retained for future personal consumption) enjoy no

significant tax advantages, and produce a suboptimal outcome when

measured against a consumption tax baseline; small-business-rate

earnings enjoy a tax outcome pretty much on par with personal retirement

savings.

3. The proposed regime would not level the playing field: it would leave small

business owners with significantly less tax-assisted retirement saving

opportunities than available to some others.



Features of PIT Regime

● Personal Investment Income

Under comprehensive income base, both the initial capital and the investment

income are taxed. Cascading of taxes on saving encourages consumption in the

present, and distorts investment choices (housing)

Under consumption tax base, tax cascading is avoided: retirement plans, TFSA,

other registered accounts

Real-world tax systems are hybrids

Canada’s PIT operates largely on a consumption tax basis (less than 20% of

investment income accumulations are subject to tax)



Features of CCPC Regime

● CCPC Income Regime

Income spent on “active” business consumption attracts no immediate tax

Retained income used for passive investments gets partial relief

Income distributed for personal consumption attracts personal taxes

PIT/CIT integration mechanism = no double taxation

Under perfect integration, business income used for personal consumption

would be taxed on a near consumption basis

Passive investment income sourced from earnings subject to the general CIT

rate is under-integrated = higher effective tax burden on income distributed for

personal consumption



Tax Illustrations: Is the Current CPCC Regime Equitable?

Net Wealth Available for Personal Consumption after Ten Years, 2017

$100,000 Initial Gross Investment, Provincial Average, 3% Rate of Return


Regime

Interest Dividends Capital Gains

Wealth ($) Gap Wealth ($) Gap Wealth ($) Gap

Salary IncomeTaxable Account 56,632 - 59,177 - 61,476 -

RRSP/TFSA 65,763 +16% 65,763 +11% 65,763 +7%

Current Regime:

CCPC Income

Small Bus. Rate 60,838 +7% 66,522 +12% 69,988 +14%

General Rate 56,204 -1% 60,933 +3% 63,825 +4%

Proposed Regime:

CCPC Income

Small Bus. Rate 56,068 -1% 58,324 -1% 60,937 -1%

General Rate 52,227 -8% 55,193 -7% 56,284 -8%


Unequal Tax-Assisted Retirement Wealth Opportunities

Maximum Tax-Assisted Career Accumulations of Retirement Wealth

$150,000 Salary at Retirement


Source: Pierlot and Siddiqi (2011). Actuarial valuations under standard assumptions assuming 35-year career.


Leveling the Playing Field

● The proposed CCPC regime – in effect restricting business owners to

personal RRSP room to tax-effectively save for retirement – would not level

the field

● The proposed regime – if enacted – should be accompanied by a reform of

the tax-assisted retirement savings system that would equalize possibilities

● SB owners are at greater risk of insufficient RRSP room because of:

potential bankruptcy, fluctuating income, early withdrawals to fund business

● Annual income-based limits on retirement savings should be abandoned

and replaced with a uniform lifetime accumulation limit set to replicate

maximum DB accumulations


Disclaimer:








July 18, 2017:


Implementation and Technical Issues with the Finance Proposals


Outline of Proposal

Proposal would be to make refundable taxes non-refundable in certain

circumstances, as a way of promoting perceived horizontal equity between

business owners and employees

• Premise that business owners and employees are similarly situated is open to

serious debate – but that is not the purpose of this part of the discussion

• Refundable tax rates assume business owner is in top rate bracket

• not true for many small business owners, who would face significant tax increase

• this design flaw would need to be fixed

• Overall approach would result in dramatically different tax treatment of “active

income” (“AI”) and “passive income” (“PI”)

Policy Conference


Outline of Proposal

• Existing distinctions in domestic rules (between AI and PI) for CCPCs serve a

much narrower purpose – stakes are much higher in proposed regime

• New system would introduce a new policy – effectively taxing the rate “gap” as if

it had been immediately distributed

• This is achieved indirectly by making currently refundable taxes non-refundable;

overall effect is to (theoretically) put owner in same position as if “gap” had been

distributed and taxed immediately; therefore, effect is to tax corporation’s capital

• New concepts needed

Policy Conference


“Active” vs. “Passive” Income – Core Definition

Distinguishing AI from PI – Basic definition of PI

• Should income from property presumptively be classified as PI?

− If so, why?

− Income from property can include economically productive activities

• Leasing/licensing of property – real/personal/intangible property –

different rules?

− Early stage software development – is that income from property?

Policy Conference


“Active” vs. “Passive” Income – Core Definition

• Is a >5 employees test appropriate?

− If so, why?

− Current “specified investment business” definition serves a narrower purpose; stakes

now much higher

− Core service providers may not be employees

− Consider equivalence rules as in old Part XI ($250K rule)

− Rules should address provision of services by employees of affiliates and

partnership structures, as in definition of “investment business” in 95(1); paragraph

(b) of “specified investment business” is unduly narrow

• This is complicated!

Policy Conference


“Active” vs. “Passive” Income – “Excess” Passive Assets

Distinguishing AI from PI – Rules to delineate “excess” passive assets

• Rules should recognize business realities which may require seemingly

excess passive assets to be retained in corporation for good business

reasons having nothing to do with tax deferral

− Prudent cash management to plan for contingencies generally

− Retention of cash for possible identified extraordinary expenses

− Maintaining credit standing opposite bank or other creditors

Policy Conference



− Retention of cash for future acquisitions that can reasonably be

anticipated

− Retention of cash for possible future capital investment that can

reasonably be anticipated in machinery & equipment, real estate,

intangible property, R&D, etc.

− Concept needed to define what is meant by “excess” passive assets

Policy Conference



• Policy alternatives include a qualitative test or a bright-line test

− Qualitative test - what is “reasonable in the circumstances” – disputes likely

− Bright-line test could look to specific dollar thresholds and/or specific time

horizons (e.g., 36-month rule in FIE proposals – paragraph (d) of “qualifying

entity” definition in proposed subsection 94.1(1), Bill C-10, passed by House

of Commons Oct. 29/07)

− Trade-off among objectives of fairness, workability, likelihood of disputes

− This is complicated!

Policy Conference


“Active” vs. “Passive” Income – Inter-affiliate Payments

Active business income should not become “passive” just

because it is paid from one corporation to another

• For example, one company in the group may lease real or personal

property or lend money to the main operating company

• 129(6) adopts the principle that character does not change in limited

circumstances, and for the limited purpose for which it now applies

Policy Conference



−129(6) requires payor and payee to be “associated” corporations

for active business income to retain its character when paid

within the group

“associated” concept pertains to the SBD, so not appropriate for

this much larger purpose

Alternatives

“affiliated”

“non-arm’s length”

Minimum 10% votes/value test, as in 95(2)(a)(ii)

Policy Conference



consider other factors in designing inter-affiliate payments rule

apportionment of expenses and losses

payments involving partnerships

Policy Conference


“Active” vs. “Passive” Income – Inter-corporate Dividends

• For dividends, the “connected” test in Part IV determines whether

dividend is a “portfolio” dividend subject to 38-1/3% refundable tax

− In determining whether Part IV tax is non-refundable, is this the right

test?

− Anomalies in the “connected” test

186(2) has been interpreted as a “count-the-shares” rather than “count-

the-votes” test; corporations can be related without being connected

Unusual to require “more than 10%” rather than “10% or more”

Policy Conference


“Active” vs. “Passive” Income – Inter-corporate Dividends

− From a policy perspective, is the “connected” test really the correct test to

distinguish AI from PI?

Consider whether dividend received from non-arm’s length (but not

“connected”) corporation should be subject to permanent Part IV tax

What about dividend from arm’s length, active corporation in which investor

has (say) a 9% interest? – Part IV tax applies, but is it appropriate for that tax

to be permanent?

Discussion raises more fundamental question of what is meant by

“reinvestment in the business”

Should rules create a tax incentive for investing in affiliated, rather than

unaffiliated active businesses? Why?

There should be a coherent basis for making the distinction

Policy Conference


“Active” vs. “Passive” Income – Capital Gains

• Capital gain could arise from disposition of asset used to earn AI (“active asset”)

or PI (“passive asset”)

• Proposals would change the integration rules by denying CDA as a way to tax

the rate “gap”

− Should distinguish capital gains from dispositions of passive vs. active asset

− Capital gain from disposing of active asset is, in effect, a way of realizing the value

built up in the active business

Policy Conference



● Appreciation may be the result of any number of factors:

- creation or enhancement of goodwill,

- development of trade names or brands,

- discovery of a technological breakthrough,

- valuable supply or distribution agreements,

- appreciating land values,

- luck, and

- an innumerable list of other factors.

Policy Conference



● If and when the corporation disposes of a tangible or intangible asset used

in the business, the resulting gain does not conceptually resemble a passive

return

● Gain represents current realization of expected future cash flows

● It follows that there is a fundamental distinction between capital gains

realized from disposition of an asset used in an active business and other

capital gains (for example, from disposing of a publicly traded portfolio

investment)

Policy Conference



● This distinction is recognized in the foreign affiliate rules

● These rules are a good starting point for designing a new system

● These rules draw a distinction between property used in carrying on an

active business (“excluded property”) and other property

● Taxable capital gains from dispositions of excluded property are excluded

from the definition of “foreign accrual property income” (“FAPI)

Policy Conference



● Excluded property definition takes account of the possibility that the

disposing affiliate may dispose of an active business by selling shares of a

lower tier subsidiary

● Shares of a foreign affiliate that derive “all or substantially all” of their value

from property used in an active business are thus defined as excluded

property

● Determination of “excluded property” status of shares can be complicated in

practice

Policy Conference



● While foreign affiliate system was designed to achieve different legislative

objectives, it provides a good starting point

● Taxable capital gain derived from a disposition of an asset used in an active

business should be regarded as AI, and the accompanying non-taxable

portion should be added to CDA

● Treatment of such gains as passive income seems conceptually flawed

Policy Conference



● Rules needed to treat shares of certain corporations as excluded property

under the new regime

● 10% test similar to foreign affiliate definition makes some sense

● If private corporation realizes gain from disposing of shares of a foreign

affiliate that meet the current “excluded property” definition, taxable portion

of that gain ought to be classified as AI under the new regime and not

treated as PI

Policy Conference



• Gains from dispositions of goodwill, trademarks and other intangibles used in a

business:

− Gain on sale would have been regarded as business income prior to recent changes

to replace ECE regime with Class 14.1

− Should those changes affect AI/PI distinction?

Policy Conference


Classification of Losses

• If loss is realized, need to determine whether “active” or “passive”

− Similar to distinction between “active” losses and FAPLs in foreign affiliate rules

− Rules will be needed to track “surplus” accounts

Policy Conference


Source of Capital

Income derived from capital not sourced from “lightly taxed” income is

not intended to be subject to new regime

• Premise of consultation paper is that a system is needed to distinguish:

− Capital derived from “lightly” taxed business income (income on which “should” be

subject to non-refundable corporate taxes),

from

− Capital derived from other sources (income on which should still be eligible for

refundable treatment)

Policy Conference


Source of Capital

• Non-refundable corporate tax should not apply to:

− Investment income derived from capital contributed by shareholder in non-rollover

transaction

No rate “gap” – asset came in from after-tax dollars of shareholder

− Investment income derived from capital acquired by corporation through issuance of

debt/equity/other securities in non-rollover transaction (e.g., borrowing, share

offering)

No rate “gap” – asset came in from after-tax dollars of investor

− Investment income derived from capital acquired by corporation from a foreign

source dividend, interest or other payment

No rate “gap” – asset came in from foreign source

Policy Conference


Source of Capital

• Need to create and track several “surplus” or similar accounts to give effect to

these principles

• Need special rules for rollovers, amalgamations, wind-ups, divisive

reorganizations

• Revisit active/passive distinction in FIE proposals and FAPI rules

• Developing coherent rules is complicated!

Policy Conference


Transition

Government states that new rules will apply only “going forward”

●How to achieve this without byzantine transitional rules?

●Non-refundable taxes amount to a tax on the “capital” represented by the

rate “gap”

− Apparent ~73% “all-in” tax on investment income is designed to tax the rate “gap” as

if it had been immediately distributed

− Unless and until it is distributed, this is capital of the corporation

− elimination of refundability will erase a potential future corporate asset (the refund)

as the new system comes into effect

Policy Conference


Transition

• To make changes truly prospective:

− Income derived from capital accumulated before new regime takes effect (and

income derived from that income) should not be subject to non-refundable taxes

− That capital was accumulated in a regime in which “high” taxes on private

corporations’ investment income were temporary/refundable

− Will require a determination of aggregate passive assets on “coming-into-force” date,

and tracking of “surplus” account, ordering rules, etc.

Policy Conference


Scope of Application

CCPCs vs. foreign-controlled corporations

• premise of proposed regime is a Canadian resident individual owner- not true

for foreign controlled corporation

• special 10-2/3% tax already applies only to CCPCs in recognition of this basic

difference

• competitiveness issue

• would have to deal with branch tax if proposed to extend new regime to foreign-

controlled corporations

Policy Conference


Reality of Under-integrated System

• If all benefits of deferral are to be eliminated, the under-integrated system

leaves those considering a new business with a heavy cost to get limited

liability, unless they plan to reinvest substantially all profits “in the business” in

perpetuity, rather than earmarking a portion of profit for future consumption at

some point

• Elective check-the-box system could help

• Fine-tune rules to mitigate under-integration, don’t just assume under-

integration away

Policy Conference

Disclaimer:








July 18, 2017:


Possible Alternatives to Finance Proposals


Other Possible Alternatives

● “Check the Box” Flow Through

● Impose a Refundable Tax on Ineligible Investments?

● Repeal or Replace the Small Business Deduction?

● Increase the corporate refundable tax rate?

● Comprehensive Tax Review?

Policy Conference


Check the Box Flow Through

● Integration and debate around use of tax deferral is less relevant if

shareholders can be taxed on income as a flow through

● Can set corporate and personal rates without same concern around

integration if there is a “safe harbour” for private corporation owners to pay

single level of tax at personal rate if they so choose

● A lower tax rate could be applied on business income to provide an incentive

similar to SBD (similar rule under consideration in US?)

● Seems like an approach worth study if starting a brand new tax system

● Significant transitional issues?

Policy Conference


Impose a Refundable Tax on Ineligible Investments?

● Was referred in the consultation paper but dismissed

● Makes the most theoretical sense for what Finance is trying to do?

• The best way to prevent the accumulation of investment income on the tax

deferral is to prevent you from investing it in the first place?

• Works best if:

− One single source of income where after-tax use is a concern

− One good use of assets and one bad

• Would create need for complicated rules in concept and application, and would

have adverse business implications such as waiting for tax refunds when

passive assets are repurposed for business use

Policy Conference


Repeal or Replace The Small Business Deduction?

● Is the Small Business Deduction the Issue?

• Using 10-Year accumulation rationale, is retaining general rate income (GRI) for

investments a significant issue if no income sprinkling/gain planning?

− Practically, any benefit provided from investing the deferral is eaten away by the

under integration on GRI and/or investment income

• Investing cash in a private corporation and earning investment income is also

not an issue (pure investment corporation, conceded in paper)

• Is after-tax SBI the only materially contentious source of investments?

• If so, would it make more sense to focus on the small business deduction?

• Following charts use Finance Table 7 assumptions with actual rates for 2017

Policy Conference


10-Year Net Worth Analysis – General Rate Business Income

Policy Conference

Personally Corporation Adv./Disadv.

BC $61,110 $62,015 $905

Alberta 60,706 60,755 49

Saskatchewan 61,043 62,536 1,493

Manitoba 57,495 55,506 -1,989

Ontario 53,370 54,885 1,515

Quebec 53,658 54,575 917

New Brunswick 53,671 56,858 3,187

Nova Scotia 52,757 49,344 -3,413

PEI 56,209 55,069 -1,140

Newfoundland & Labrador 56,302 49,902 -6,400

Assumed Rates Used by Finance 57,535 60,457 2,922


10-Year Net Worth Analysis – Income Eligible for the SBD

Policy Conference

Personally Corporation Advantage

BC $61,110 $65,113 $4,003

Alberta 60,706 64,555 3,849

Saskatchewan 61,043 66,485 5,442

Manitoba 57,495 61,025 3,530

Ontario 53,370 58,510 5,140

Quebec 53,658 57,549 3,891

New Brunswick 53,671 58,095 4,424

Nova Scotia 52,757 56,993 4,236

PEI 56,209 59,279 3,070

Newfoundland & Labrador 56,302 60,766 4,464

Assumed Rates Used by Finance 57,535 63,207 5,672


10-Year Net Worth Analysis – Observations

● Small business income:

• Provincial numbers fairly consistent – integration on SBI generally works

• “Province of Finance” NW > All provinces other than Saskatchewan

• Average NW advantage is $4,200 – Is this significant on $100,000 of SBI?

● General Rate Income (GRI)

• Keeping GRI in a corporation and paying it out later as a dividend represents a

cost in many provinces, investing the deferral helps reduce the cost

• The integration on investment income is imperfect as well

• Unclear any changes are needed on GRI without more study?

● Results do vary based on the rate of return & type of income

Policy Conference


Is the Small Business Deduction an Issue?

● Considerations and questions that could be considered:

• In terms of the growth in the number of private corporations, do we know how

much growth is directly related to reinvesting the value of the SBD in passive

assets?

• If the government deals with income sprinkling and capital gain planning, how

many taxpayers would set up private companies in the future for passive

investment tax planning purposes? Motivation often based on multiple factors?

Policy Conference


Is the Small Business Deduction an Issue?

● Considerations and questions that should be considered:

• If the possibility of reinvesting the SBD saving is a concern, would amending,

replacing or just repealing the small business deduction reduce the growth of

private corporations used for passive investment tax planning purposes?

• Redesign the SBD as a more targeted tax expenditure designed to reward

economic growth, positive impact on economy and risk taking (rather than

tracking and dealing with corporations investing it)?

Policy Conference


Increase the corporate refundable tax rate?

● This was action government took previously – would more of the same help?

● Issues:

• At the end of the day, the tax is returned when dividends are paid - tax deferral

was effectively invested?

• Not refunded if passive assets invested in business – punitive?

• For the same reasons discussed before, take a good look at the SBD?

Policy Conference


Comprehensive Tax Review?

● Passive income proposals suggested in paper would make for a complicated

tax system and seem to assume other aspects of the tax system are

effective and should remain in place (e.g. small business deduction)

● Paper assumes aspects that are theoretically part of the system but are not

working in reality (e.g. integration)

● Ensure key drivers of the tax system make sense before adding more

complication around them?

● A review of other countries indicates what Canada is examining would be

fairly unique – blazing a trail brings risk?

● Are there better ways to deal with the key issues of concern?

Policy Conference

Documents

Ottawa, ON Taxation of Investment Income. 25 2017/PowerPoints/3... · Disclaimer: This material is for ... To eliminate tax incentives for CCPC owners to retain “active” earnings,