Proposed Changes to Address the Conversion of Income into Capital Gains, Part 1

by in Canadian Government News and Updates
Proposed Changes to Address the Conversion of Income into Capital Gains, Part 1
For the past weeks, our blogs have been focused on the proposed changes that the Government announced to address tax planning strategies used by private corporations.  We’ve already reviewed the proposed changes to the first two strategies: income sprinkling and holding passive investments in the corporation. 

This week, we’ll take a look at the proposed changes to address the third tax planning strategy – converting a private corporation’s regular income into capital gains.

This strategy, according to the Department of Finance, can reduce income taxes by taking advantage of the lower tax rates on capital gains.  Generally, income is paid out of a private corporation in the form of salary or dividends to the principals, who are taxed at the recipient’s personal income tax rate.  However, for capital gains, only half of capital gains are included in income, resulting in a significantly lower tax rate on income that is converted from dividends to capital gains. 

According to the Department of Finance, individual shareholders with higher incomes are able to obtain a significant tax benefit if they successfully convert corporate surplus that should have been taxed as dividends or salary into lower-taxed capital gains. 

In the Department of Finance’s proposal, it seeks to make amendments to Section 84.1 of the Income Tax Act.  Section 84.1 is a rule put in place to ensure that a corporate distribution is properly taxed as a taxable dividend when an individual sells shares of a corporation to a non-arm’s length corporation.  Otherwise, the corporation could pay out some portion of its surplus to the non-arm’s length corporation as a tax deductible inter-corporate dividend, and the non-arm’s length corporation could then use that surplus to pay the individual.  As a result, the individual could receive the equivalent of a dividend but would have a capital gain on the sale for income tax purposes.

Generally, this section applies when an individual sells shares of a Canadian corporation to another Canadian corporation on a non-arm’s length basis and the individual receives non-share consideration for the shares in excess of the greater of two amounts:  the adjusted cost base of the shares of the individual and the paid-up capital gain in respect of the shares.

Section 84.1 treats the non-share consideration received by the individual in excess of the greater of the two amounts as a taxable dividend, where it applies.

So what is the problem with this section of the income tax act? We’ll answer this question on our next blog! Stay tuned for part 2!

Remember, there is an ongoing public consultation with regards to these proposals.  We encourage everyone to participate in the consultations or write to your MP so we can let them know how these proposals can be harmful to our business.

Source: http://www.fin.gc.ca/activty/consult/tppc-pfsp-eng.pdf 
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