Proposed Tax Changes
September 8, 2017
How it could affect your business and why you should immediately engage with the public consultation
On July 18, 2017, the Department of Finance announced proposed changes to the Income Tax Act aimed at eliminating what it perceived as illegitimate tax strategies used by small business owners, including farmers. The portions of the Act that are to be amended deal with ways businesspeople, including farmers, share income with family members to reduce their tax payable and with the capital gains exemption. These changes are likely to have an effect on your farm or small business.
Existing rules, commonly called the “kiddie tax” rules, prevent business owners from sharing income with children under 18 through partnerships, trusts and through dividends or rent paid from the parents’ corporation. The new rules will apply to people over 18 and will expand the kinds of income that are caught to include capital gain from the sale of shares in a corporation or interests in a partnership. When a person receives income (other than salary which is controlled by different rules) from a business owned by a related party, or earns capital gain on the sale of shares of a private corporation, CRA will look at whether the amount is “reasonable” given the work done for the business, the capital contributed to the business, risks assumed on behalf of the business, and what other compensation (such as salary) the person receiving payment has received from the business. Any income over what CRA thinks is “reasonable” will be taxed at the highest marginal rate, even if the principal of the business is not being taxed at that rate. Additionally, if the person receiving income is 18-24, the government will apply much more stringent rules to determine whether what they receive is reasonable:
1) Unless the child is working for the business “on a regular, continuous and substantial basis”, they will not be treated as having worked at all.
2) If the child contributes capital, “reasonable” return on capital will be restricted to a prescribed rate set by the government
Imagine farm children age 18-24 helping out during the busy seasons but not continuously. This work will be completely discounted under the new rules when determining whether a dividend is reasonable.
Some farmers and small business owners have their children and spouses subscribe for common shares in their corporation so that if and when the shares are sold, some of the capital gain will go to their children, both to “split income” and to use the child’s capital gains exemption. This is also being targeted. If the government decides that the contribution of labor and capital by the child is insufficient, the proceeds of sale can be considered “split income” and the capital gain will be taxed at the highest rate and not be eligible for the capital gains exemption. If the sale is to a related party, it won’t even be treated as capital gain but as a dividend, with even worse tax treatment. This can be a major problem where two brothers are farming together and one brother is buying out the other’s family.
Spouses often receive dividends as well as salary and the proposals are discriminatory, dismissing legitimate contributions of a spouse, usually the woman.
Capital Gains Exemption:
Currently every Canadian has a lifetime capital gains exemption permitting them to shelter up to $1,000,000 of capital gain on farm property or $824,176 on the shares of non-farm businesses. Only farmers, fishermen and small business owners hold assets that qualify for capital gains exemption. The government is proposing to make a number of changes:
1) Minors cannot claim the capital gains exemption: if Mom and Dad are killed in a car accident, leaving farm property or shares of their farm corporation to their 12 year old child, if the child has to sell the property he or she cannot use the capital gains exemption.
2) If property was held by anyone, including a parent or grandparent, while the current owner was under 18 and the property rolled to the current owner, the capital gain that accrued between the original owner receiving the property and the current owner turning 18 is not eligible for the capital gains exemption. This is the case however long ago the property was obtained and however long ago the child turned 18. Basically these provisions limit use of the farm rollover and capital gains exemption over generations.
For example, Mom and Dad buy land in 2002, when their son is 4 years old. They farm until 2022. When they retire, they gift the land to their son, who farms until 2042, at which point he sells to a third party. Their son needs to determine what the fair market value of the land was in 2016, when he turned 18, even though he didn’t own the property at the time, because the gain that accrued between 2002 and 2016 does not qualify for the capital gains exemption.
Another example: A has two sons, B and C, both of whom want to farm. B turned 18 in 2010, C turned 18 in 2015. The value of Canadian farmland has appreciated tremendously since 2010. A divided and gifted his land equally to B and C in 2019, who farm together for several years. Differences in risk tolerance and goals cause B and C to conclude they cannot continue in business together and that one has to buy the other out. Due to the appreciation between 2010 and 2015, if C buys out B, B will have access to the capital gains exemption on much more of the capital gain that if B buys out C. The tax treatment of these brothers is hugely different based purely on their birth order even if they received the land on the same day. This is completely unjust and will likely distort the decision of who buys out whom and for how much based on artificial tax considerations.
It was once popular to have young children subscribe for shares in the parent’s corporation. If you did, you would need to know what the fair market value of your corporation was when the child turned 18, and the difference between what they paid (usually $1 per share) and the value when they turned 18 is ineligible for the capital gains exemption. Even where the child only obtained the land or shares after turning 18, if they received the shares on a tax deferred rollover, the difference between the cost base to the parent and the value when the child turned 18 is not eligible for the capital gains exemption.
Some of the proposed changes are especially damaging to taxpayers whose corporations are held by a Family Trust:
3) Starting January 1, 2018, family trusts can no longer be used to allocate capital gains to beneficiaries to use their capital gains exemptions
4) Capital gains on property that was received from a trust after January 1, 2018, will not be eligible for the capital gains exemption to the extent that the capital gains accrued while the property was held by the trust. If the proposals pass in their current form, many trusts may need to be wound up before the end of the year after careful planning.
The government has proposed allowing taxpayers to file an election in 2018 which will allow people to cause a deemed disposition to use the capital gains exemption under the old rules. As currently drafted, this election has serious traps – if you received land or shares as a gift from a parent after Jan 1 2015, the capital gain will attribute to the parent or grandparent you received it from because of a 3 year holding period imposed by the Income Tax Act. Also, all of the capital gain is realized in one year, so even if you use the capital gains exemption to eliminate capital gains tax, there may be alternative minimum tax or loss of government benefits (clawback of old age security or child tax credit for example) for 2018. For a Manitoban with a low income, the alternative minimum tax could be as much as $50,000. The one time election favors the wealthy who can use it and pay the alternative minimum tax over ordinary Canadians who cannot afford a $50,000 tax bill. If you elect over what CRA believes to be the fair market value of the property you are electing on, the new provisions contain extremely harsh penalties, so everyone will be forced to retain appraisers and business valuators.
The government is targeting critical tax planning strategies used by many farmers and small businesspeople and doing so retroactively. Every farmer and small business owner needs to review their situation with their professional advisers, and if possible contact the government and let them know what these changes will do to your business and your ability to pass it on to the next generation. The government is trying to compare business owners, who have variable income, no benefit plan or pension through work, no job security to salaried employees who have reliable income and possibly benefit plans, pensions and job security – not a fair comparison. Business owners assume risks that employees do not, and often go long periods taking little income so that the profits of the business can be reinvested in the business. A farm child is probably not being paid what a hired hand would demand working 18 hour days to harvest the crop, but under the new income splitting rules could be denied the ability to receive dividends without paying punitive tax rates because they were under 25 when they did much of the work. The new rules are also vague – it is nearly impossible to know what CRA will think an acceptable dividend will be in many cases particularly where contributions to the business are important but not easily translated into dollars.
Public consultations on the changes end on October 2 – they began just before harvest and end at a time when many farmers are still in the fields.