How will my business be affected by the new taxation of owner-managed business? Part 4: The conversion of income into capital gains

In the previous three parts of our series, we looked at several ways in which the Department of Finance’s proposed legislation could negatively affect Canadian business owners with new taxation laws. In particular, we examined the proposed changes to Passive Investment, Income Splitting, and the ECGD. Today we will explore, converting income into capital gains.

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Recap of Part 1: Passive Investment

The proposed tax changes will affect small business owners when they choose to invest in anything outside of their own organization – resulting in increased tax rates on those investments from 56% to 73%! Watch this video to find out how.

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Fourth Area of Concern: The Conversion of Income into Capital Gains

Today, we’ll conclude our series by addressing the Department of Finance’s final major area of concern: The conversion of income into capital gains.

The gap between the tax rate on dividend income and capital gains has been widening for several years. For example, in 2009, the top marginal rate for Ontarians receiving eligible dividends was 23.06% versus 23.20% for capital gains. By 2016, the dividend rate had jumped to 39.34% versus 26.77% for capital gains.

The reason that capital gains tax is low compared to dividend income is because only half of a realized capital gain is included in a person’s taxable income. If the inclusion rate was increased to either two-thirds or three-quarters, the top marginal rate would increase for Ontarians to 35.68% or 40.15% respectively, aligning with the taxation of dividend income.

The Department of Finance is concerned that transactions can be structured with corporations, where business owners can receive surplus funds at capital gains tax rates, rather than dividend income tax rates. Unfortunately, the Department of Finance’s draft legislation could potentially result in double taxation to individuals who own private corporations.

The proposed measures are rather complicated, so for the purpose of this newsletter, we’ll take a look at two examples of how double taxation could occur:

1. Assume that the last surviving parent dies owning shares of a corporation worth $2 million, having a nominal tax cost, and which does not qualify for the claiming of the ECGD (for more information, refer back to yesterday’s newsletter). Under present tax legislation, the parent’s estate would pay tax on the resulting capital gain. Typical post-mortem tax planning would have enabled the estate, through a corporate reorganization, to have benefited by extracting $2 million of surplus from the corporation without further tax consequences. This has been widely considered equitable, because the estate had paid capital gains tax on the $2 million of share value at death. Based on the proposed legislation, however, it would appear that if the same tax planning measures were adopted, not only would the estate pay capital gains tax on the $2 million of share value at death, but it will also pay tax on a dividend received of up to $2 million as well.
2. Assume an Ontario resident corporation owns an asset with an accrued capital gain of $1 million. If it was sold to an arm’s length person, it would suffer capital gains tax of approximately $250,000, with negligible additional personal tax arising when the after-tax proceeds are distributed by the corporation. On the other hand, based on this draft legislation, if the asset is sold to a non-arm’s length person, the new rules could potentially result in additional personal income tax of $226,500. This would arise because of the payment of the so-called tax-free capital dividend (half of the realized capital gain, which in this example would amount to $500,000), could instead be eliminated and be recharacterized as a regular taxable dividend, which would be subject to tax at a rate of 45.3% to an Ontarian.

While the proposed legislation claims to have the intention of levelling the playing field between CCPC’s and other Canadian taxpayers, in its current form it actually places business owners who have accumulated wealth in a corporation at a significant disadvantage to other taxpayers.

At Zeifmans, over 95% of our clients are privately-owned businesses – hundreds of whom have been working with us for more than a generation. Ensuring that Canadian business owners are supported by effective and beneficial succession and estate planning legislation is therefore of the utmost importance to our team.

We sincerely hope that the Department of Finance will reconsider the proposed legislation following the consultation process, and produce new legislation that benefits both CCPC’s and other taxpayers alike.

As the legislation is finalized and implemented, we will provide you with an update and invite you to a client seminar on the new legislation. We look forward to meeting with you in the near future to discuss the implications of this draft legislation and how it may impact you and your business.

For more information on this topic, contact your Zeifmans advisor or reach out to us at 416.256.4000 or info@zeifmans.ca.

Related news:

Part 1: Passive Investments

Part 2: Income splitting

Part 3: The enhanced capital gains deduction (“ECGD”)

Federal Government tax changes announced Oct 16

Oct 18 and 19 updates on the taxation of owner-managed businesses

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