As part of the 2017 federal budget in March, the government indicated it would review certain tax reduction strategies now available to private corporations. MD has been tracking developments closely, on behalf of our physicians who are incorporated.
On July 18, Finance Minister Bill Morneau followed up with the release of the Department of Finance’s long awaited policy paper entitled “Tax Planning Using Private Corporations”. It outlines proposed legislative changes open to a 75-day public consultation period, ending October 2, 2017.
The 63-page paper targets three areas of the Income Tax Act that the Liberal Government felt allowed the wealthiest Canadians to use private corporations to obtain unfair tax advantages. These include:
- Sprinkling income using private corporations (what we at MD call the Income Splitting Advantage)
- Holding a passive investment portfolio inside a private corporation (what we at MD call the Deferral Advantage)
- Converting a private corporation’s regular income into capital gains
With public consultations underway, we offer a high level summary of these issues and our preliminary analysis of the potential impact on our clients:
1. The Income Splitting Advantage
Background: Current tax legislation allows adult shareholders (age 18 and older) to receive dividend income from private corporations regardless of the nature of their involvement in the operations. This has allowed our incorporated physicians to sprinkle, or split, corporate income with adult family members who are shareholders through the use of dividends. Provided the adult family members are in lower tax brackets than the physician, significant tax savings can result.
Current tax legislation also provides that if minor children (under the age of 18) receive dividends from a family owned corporation, the minor child will pay tax at the highest marginal tax rate and will be denied access to many personal tax credits on that income. This punitive tax is commonly referred to as “kiddie tax”.
Proposed changes: The policy paper proposes legislation to extend “kiddie tax” rules to dividend income earned by adult family members subject to a new “reasonableness” test. This test would consider the extent to which a family member contributed labour or capital to the corporation. The reasonableness requirements are more strict for adult family members who are 18 to 24 years old, versus those 25 or older.
Dividend payments to adult family members that do not meet the reasonableness test would be subject to the highest marginal tax rates and the loss of some personal tax credits, similar to the current “kiddie tax” regime.
Timing: This proposed legislation would be effective for 2018 and subsequent years.
What it means for incorporated physicians and other professionals: We would expect that the majority, if not all, of our incorporated MD clients who pay dividends to their spouse and/or adult children shareholders would be impacted by these proposed changes.
The end result would be higher rates of tax payable on dividend income than are currently paid. Income splitting in many family situations would no longer be advantageous.
As this is a high level summary, we encourage MD clients to discuss your specific circumstances with your tax advisor to assess potential personal impact.
2. The Deferral Advantage
Background: Currently, active business income eligible for the small business deduction is taxed within a private corporation at a combined federal and provincial rate of approximately 15%. When compared to the highest personal tax rate of approximately 50% on salary/business income this means that an incorporated physician could defer some 35% in tax by earning medical practice income through a corporation. (These rates are approximate and for illustrative purposes only.)
This additional 35% in tax is generally payable at a future date, once the physician extracts the surplus earnings from the corporation by way of a dividend. If the physician does not need all corporate earnings on an annual basis, that personal layer of tax can be deferred indefinitely, allowing investment income to compound.
The Liberal Government perceives this build-up of a passive investment portfolio through the deferral of tax to be unfair to the average Canadian who must earn his or her income personally and pay personal rates of tax on the income.
Proposed changes: The policy paper does not provide legislative proposals to alter current rules. Instead, it introduced a new concept of taxation on passive income earned within private corporations that would effectively eliminate the deferral advantage.
The concept being introduced for consultation is complex and is a fundamental shift from the current system of taxation for private corporations.
The Policy Paper is asking for additional public input on the concept as described in the paper.
Timing: The Policy Paper does not address timing.
What it means for incorporated physicians: All incorporated MD physicians generally use the benefit of tax deferral to their advantage. The Policy Paper clearly illustrates the Government’s intent to eventually reduce or eliminate the tax deferral advantage available inside a corporation.
As this proposal is at a conceptual level only, the extent to which MD clients may ultimately be impacted is not clear.
We would expect, however, that incorporated MD clients will have a higher tax burden than they currently experience, ultimately reducing funds available for passive investment portfolios maintained in a corporation.
3. Converting a private corporation’s regular income into capital gains
Background: Under current tax legislation, the personal tax rate applicable to capital gains is significantly less than the personal tax rates applicable to salary/self-employed income as well as non-eligible and eligible dividend income.
Type of Income
Average Top Marginal Tax Rate
As a result, current tax strategies use the provisions of the Income Tax Act to convert income that would otherwise be taxed as salary or dividends into capital gains.
Proposed changes: The policy paper includes proposed legislation to amend a provision of the Income Tax Act that will eliminate certain tax strategies in use today that convert what would be dividend income into capital gain income.
Timing: To be effective for transactions entered into on or after July 18, 2017.
What it means for incorporated physicians: We have not historically seen wide use of strategies to convert the character of income among incorporated MD clients. We do not expect these proposed changes to be widely applicable to our clients.
Our next steps
We continue to review and analyze the details of the proposals, to assess the impact of these proposed changes on our clients. As well, we will continue to work closely with the CMA through the consultation process.
We will share additional information as it becomes available.
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About the Author
Eileen Maltinsky CPA, CA, CFP is Vice President with the Taxation Services Team at MD Financial Management. She leads the team of tax professionals responsible for providing tax solutions, tax planning and tax compliance for the MD group of companies.More Content by Eileen Maltinsky