Here is an article from Manulife Financial on the discussion paper released by CRA on July 18th.

It addresses the taxation of passive investment income in a CCPC. As Manulife puts it, this may be the most philosophically contentious part of the discussion paper.

I will let you read and decide for yourself to see what you think and we will all wait for CRA to come down with their final proposal later this year.

Thanks again to Manulife for allowing ACES advisors to circulate this document.
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In our view, the most philosophically controversial aspect of the July 18, 2017 proposals involving private company tax planning (see AAMOT Private company tax planning – Proposals and Consultation) is the potential measures that would deal with “Holding passive investments inside a private corporation.” We will discuss below the premise of the discussion which we feel is philosophically controversial. The good news is it appears that existing passive assets will be grandfathered. Since there is no target date and no draft legislation, these will likely be the last of the measures to be finalized and more likely to benefit from the, no doubt, massive feedback which is expected.

In essence, the basis of the discussion relates to two issues:

that an incorporated entity that invests in passive investments should be stripped of the “unfair” advantage of having more to invest when using retained earnings that represent after-tax profit from active business income (that was previously taxed at the small business or general corporate rate) for passive investing; and

that the tax rules should put the corporation into the same position as an individual who earned salary, paid tax at the highest marginal tax rate and invested the after-tax amount into a passive investment.

Because the existing system already adjusts for tax at the time of distribution (putting the shareholder in the same or very close to the same position as if they had earned the income personally), really, all this is about is the initial “advantage” and compounding this over time. So, the proposals suggest the following possibilities:

making the refundable tax levied on passive investment income of a corporation non-refundable;

making access to the lower eligible dividend rate unavailable for passive investments funded with active business income (for example, portfolio dividends from publicly traded securities being treated as non-eligible dividends on distribution to the private company shareholder);

removing the addition of the non-taxable portion of capital gains to the capital dividend account in respect of passive investments funded from active business income; and

recognizing and giving credit for capital contributed by a shareholder that has been taxed personally and passively invested corporately.

The discussion paper doesn’t ask for consultation on the basic premise but rather on the manner in which the system should be implemented. It proposes two approaches to determine the tax treatment of dividends paid from passive investments and seeks input on which one to choose – the “apportionment method” or the “elective method.”

How about input on the basic premise?!

These proposals ask us all to join in the fiction that business owners, who may or may not also work in the business and earn employment income, should be equated with employees and that the separate legal entity of a corporation should be ignored and conflated with the shareholder as employee. It is this philosophy that we find so difficult to agree with.

Small business owners take personal risks (borrow money personally; mortgage and re-mortgage a personal residence; personally guarantee corporate debt; etc.) to start, build and grow a business. Small businesses create employment for others, not just the owner-manager him/herself. The incorporated business itself is a separate legal entity that could start new businesses with its capital, some of which may be passively invested. Although incorporated professionals might be viewed as the target for these measures, they would apply to all private corporations earning active business income that do not reinvest the after-tax profits in active business assets.

The “apportionment method” would require tracking of the source of capital – whether it be income taxed at the small business rate, income taxed at the general corporate rate, or tax-paid capital contributed by the shareholder. Annual passive investment income would be apportioned based on the proportion in these pools and the treatment of a dividend as eligible, non-eligible and capital, when passive investment income is distributed, would relate to the proportions in these pools.

The “elective method” would dictate that, by default, passive investment income would be treated as non-eligible dividends when paid to the shareholder. Corporations could elect to treat the dividends paid from passive income as eligible dividends at the cost of foregoing the small business deduction.

The proposals could have a large impact when passive investments are funded by after-tax profits from active businesses. Where this is so, tax efficiency will remain important for portfolios held within corporations for passive investment purposes. This is due to the fact that the type of investment income (i.e. interest, eligible dividends and capital gains) will continue to be taxed at top rates within the corporation based on the source of income earned. However, as noted earlier, the proposals would result in none of the corporate tax attributed to the passive income being refundable. The corporate portfolio’s underlying investments would NOT impact the personal tax treatment of the dividends paid to shareholders and funded by the passive portfolio. Instead, the shareholder’s personal tax treatment will depend on the source of business income used to fund the passive investment portfolio. This impact may be most noticeable in relation to capital gains earned within a corporation since, under the proposals, the non-taxable portion of the capital gain would no longer create a tax-free capital dividend for the shareholder.

For corporations “focused on passive investments” – investment holding companies – the discussion paper suggests a further election may be available to maintain the current system. It appears that Finance intends to allow individuals to form investment holding companies with assets held personally (for example, for creditor protection or to manage US Estate tax issues), without the proposed system applying (i.e. refundable tax would remain refundable). If the election is made, the proposals contemplate an additional refundable tax on dividends flowed to another corporation (i.e. to a holdco) to put that corporation in the same position as an individual using after-tax dollars to invest. This additional tax would be added to the refundable dividend tax on hand (RDTOH) of the recipient corporation. As such, tax efficient investments with low taxable distributions and opportunities to earn Canadian dividend income and realize capital gains, like corporate class mutual funds, may remain viable options within this context. Consequently, existing strategies for corporate investment may not need to be disturbed. The measures also contemplate splitting off investment assets into an investment focused corporation and electing into this system.

The measures also express recognition of the fact that “existing stocks of passive assets in Canadian private corporations are significant” and that any new rules would apply on a “go-forward basis.” This suggests that it is business as usual for existing passive assets and there is no need to change the corporation’s current investment philosophy. While the intent to protect these existing passive assets is clear, it is unclear how it is going to be implemented. What exactly is meant by, “the Government will consider how to ensure that the new rules have limited impacts on existing passive investments.”? Will there be a starting pool to recognize this? Will the new system run in parallel to the old system in these situations, increasing the compliance and complexity burden?

Although life insurance is considered a “passive asset” for purposes of the active/passive asset tests relating to qualification for the lifetime capital gains exemption, it would only produce passive investment income on a disposition of the policy. A collateral assignment of a life insurance policy does not constitute a disposition of a policy, nor would the payment of life insurance death benefits (other than the payment of the fund value on first death under a multi-life policy in excess of certain limits). To the extent that after-tax profits are retained corporately and not re-invested in active business assets (which may not happen due to the imposition of this new system), corporate-owned life insurance may be an alternative to passive investments.

Will life insurance provide a long-term tax effective distribution solution? More to follow on this in a future article.

Until these measures are nailed down, we’re not saying anything definitive!

July 2017

FOR ADVISOR USE ONLY
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