Taxation of Private Corporations: July 18, 2017 Proposals Presentation: September 18, 2017 Sam Lackman, Isabelle Nadeau, Jennifer Warner

Income Splitting What is income splitting? Income splitting is shifting income, such as dividends from a corporation, from a high income taxpayer to one or more low income taxpayers.

Income Splitting Income splitting prior to introduction of proposed new rules Prior to the introduction of the proposed new rules, it was generally possible to income split with spouses, adult children and other adult relatives, subject to certain conditions and limitations.

Income Splitting Estate freeze Before estate freeze: FOUNDER Common shares OPCO

Income Splitting Estate freeze After estate freeze: FAMILY TRUST Beneficiaries: Founder, Spouse & Children FOUNDER Preferred shares Common shares OPCO

Income Splitting - Proposed new rules Basics The proposed new rules apply starting in 2018. The proposed new rules expand the scope of TOSI – Tax On Split Income. TOSI is computed at the highest marginal tax rate. TOSI is payable by a “specified individual” on “split income” received from a business (corporation, partnership or trust) in which another individual (the Founder) is involved if the amount received by the “specified individual” is unreasonable in relation to his/her contribution to the business. Both the “specified individual” and the Founder must be resident in Canada for TOSI to apply.

Income Splitting - Proposed new rules “Specified individual” A “specified individual” is a person having one of the following family connections with the Founder: Spouse Minor child or grandchild Adult child or grandchild (including son/daughter in law) Parent Sibling Aunt/uncle Nephew/niece

Income Splitting - Proposed new rules “Split income” The most common types of split income are the following: Dividends/interest received from a corporation Interest/income received from a partnership Capital gain realized on the disposition of shares (or other property) where income derived from this property (such as dividends) would be split income.

Income Splitting - Proposed new rules “Split income” (continued) For “specified individuals” under the age of 25: Second generation income derived from split income FAMILY TRUST Beneficiaries: Founder, Spouse & Children FOUNDER Preferred shares Common shares OPCO

Income Splitting - Proposed new rules Involvement of the Founder in the payer business The rules are very broad. A situation may be caught even if the Founder’s involvement is limited. The most common connections are the following: The Founder factually controls the business, either alone or with a related group. The Founder owns at least 10% of the equity. The business is regulated (professional practice) and the Founder performs all or part of the services provided by the business. The Founder (or a non-arm’s length person) owns equity in the business and at least 10% of the property of the business was acquired from the Founder (or non-arm’s length corporations).

Income Splitting - Proposed new rules Contribution of the “specified individual” to the business – Basics The reasonableness test will be met if the amount received by the “specified individual” is the same as the amount received by an arm’s length party. The following is considered: Functions performed (labour) Assets contributed (capital) Risk assumed Amounts already received from the business There are specific guidelines/restrictions for labour and capital.

Income Splitting - Proposed new rules Contribution of the “specified individual” to the business – Labour contribution If the “specified individual” is between 18 and 24 years old, his/her labour contribution will only be acknowledged if he/she is actively engaged in the business on a regular, continuous and substantial basis. If the “specified individual” is 25 years old or older, the test is less stringent. The “specified individual” must simply be involved in the business. If more than 50% of income of a business is income from property (e.g. rental income and investment income), no labour contribution can be acknowledged for the “specified individual”. Starting in 2018, the labour contribution of a “specified individual” should be documented.

Income Splitting – Proposed new rules Contribution of the “specified individual” to the business – Capital contribution If the “specified individual” is between 18 and 24 years old, the amount that he/she receives from the business will only be considered to meet the reasonableness test if this amount does not exceed the prescribed rate of return on the investment (currently 1%).

Income Splitting - Proposed new rules Consequences No more income splitting where the “specified individual” does not work for OPCO or make any other type of contribution to OPCO. FAMILY TRUST Beneficiaries: Founder, Spouse & Children FOUNDER Preferred shares Common shares OPCO

Income Splitting - Proposed new rules Consequences (continued) Fully take advantage of income splitting opportunities in 2017. Take action to limit the impact of the proposed new rules on a future capital gain. FAMILY TRUST Beneficiaries: Founder, Spouse & Children FOUNDER Preferred shares Common shares OPCO

Lifetime Capital Gains Exemption (LCGE) Background What is the LCGE? The LCGE provides an individual with the ability to claim a deduction against a capital gain realized on the disposition of certain capital property. Each individual is entitled to a LCGE in the amount of $835,714 for 2017. This amount is indexed each year.

Lifetime Capital Gains Exemption (LCGE) Background (continued) The LCGE can be used to reduce the tax cost of capital gains realized from the disposition by an individual of: Qualified small business corporation shares (“QSBC shares”) (i.e. shares of an active business carried on in Canada) and Qualified farm or fishing property.

Lifetime Capital Gains Exemption (LCGE) Background (continued) Under the current legislation, where corporate structures are created with a discretionary family trust as one of the shareholders, there is the possibility to multiply the LCGE among the family members of the Founder. For example, a Founder with a spouse and two children could potentially reduce the capital gain realized on the sale of QSBC shares by $3,342,856 ($835,714 * 4) thereby resulting in a potential tax savings of approximately $890,000.

Lifetime Capital Gains Exemption (LCGE) Background (continued) Typical structure FAMILY TRUST Beneficiaries: Founder, Spouse & Children FOUNDER Fixed value voting preferred shares Common shares ACB: $10 FMV: $10,000,000 OPCO

Lifetime Capital Gains Exemption (LCGE) Proposed Measures Starting in 2018, the following changes to the LCGE have been proposed: The LCGE will no longer be available to minors; The value of property that appreciates while held by a minor will not be eligible for the LCGE; The LCGE will not be available on gains that accrue while property is held in a trust (there are certain trusts that are excluded from this rule, none of which are the traditional family trust);

Lifetime Capital Gains Exemption (LCGE) Proposed Measures (continued) The LCGE will not be available to the extent the taxable capital gain is included in “split income” As mentioned in the previous section, if the shares sold are held by a specified individual, such as a child of the Founder, who is not active in the business of the corporation, the taxable portion of the capital gain (50%) on the disposition of such shares would be subject to tax at the top rate of taxation, and the LCGE would not be available.

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – LCGE and Minors For dispositions occurring after 2017, minors will no longer be able to claim the LCGE, unless they turn 18 in the year of the disposition. The portion of a capital gain that accrues on a QSBC share before the taxation year in which the individual turns 18 is not eligible for the LCGE.

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – LCGE and Trusts Under the current rules, if QSBC shares are held by a discretionary family trust, the taxable capital gain resulting from the disposition of such shares could be allocated to more than one beneficiary of the trust. The multiplication of the LCGE will no longer be possible under the proposed changes. Any gain accrued after 2017 on QSBC shares held by a discretionary trust will not be eligible for the LCGE. This rule also applies if the shares held by the discretionary trust are distributed to a beneficiary and the individual beneficiary subsequently disposes of the shares. The capital gain accrued while owned by the trust after 2017 cannot be reduced by the LCGE.

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – Transitional Rules Eligible taxpayers will be able to crystalize their LCGE, which may otherwise be denied under the proposed legislation. This election can be made on any day in 2018 on eligible property. To qualify for the election, the following definitions apply: Eligible taxpayer – An individual, other than a minor, who has available LCGE. Eligible Property is property owned continuously from the end of 2017 until the end of the taxpayer’s disposition day, including QSBC shares and qualified farm or fishing property.

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – Transitional Rules (continued) For shares held by a trust, a trust eligible for the election includes a trust that is a personal trust whereby: the amount of the capital gain resulting from the election would be a capital gain of one or more individual beneficiaries; the beneficiary has been a beneficiary of the trust from the end of 2017 until the disposition time; and the beneficiary is resident in Canada at the end of the trust’s election year end (2018).

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – Transitional Rules (continued) Generally, the shares of a private corporation must be owned by an individual or trust for at least 24 months prior to a sale and the assets used in the business in Canada must represent at least 50% of the total assets of the corporation during the 24-month period preceding the sale. The transitional rules reduce the 24-month requirement to 12 months for purposes of being eligible to file the election. At the time the election is made, 90% of the assets of the corporation must be used in carrying on an active business in Canada.

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – Transitional Rules (continued) Transitional rules are proposed to allow a minor, who has not turned 18 in 2018, to use his or her LCGE where he or she disposes of his or her QSBC shares to a third party purchaser in 2018. The capital gain in this particular instance will not be treated as “split income” of the minor. This transitional rule will also apply in the event a discretionary trust disposes of the shares and allocates the taxable capital gain to a minor.

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – General Consideration In light of the proposed measures, the 2018 election will be a useful tool, particularly for adult individuals holding a direct interest in a corporation in which they are not actively involved or adult individuals allocated shares of a corporation by a discretionary family trust. The election will result in the use of the individual’s LCGE to increase the cost base of their shares and reduce the tax liability that would result on a future sale of the shares.

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – General Consideration (continued) A number of considerations should be reviewed before choosing to make the 2018 election. Some of these considerations include: Determination of alternative minimum tax (“AMT”) which may apply when an individual claims the LCGE. This tax is recoverable over a period of 7 years. Will the benefits of electing be worth the cost of AMT? Will the AMT be fully recoverable? Should crystallizing the LCGE begin in 2017 to minimize the impact of the AMT?

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – General Consideration (continued) Are we using the LCGE of an individual which may otherwise be used in the future when active in a different business of which he or she has ownership? Is there anything we have to do in 2017 and /or in 2018 to “purify” the target corporation? Purifying (removing redundant assets from the corporation) may be required in order for the asset tests to be met for the shares to qualify as QSCB shares. A valuation of the target corporation at the time of the deemed disposition will be required.

Lifetime Capital Gains Exemption (LCGE) Proposed Measures – General Consideration (continued) The proposed measures include a penalizing provision in the event an eligible taxpayer over-estimates the fair market value of his or her shares. Thus, careful attention will need to be given to the reasonableness of the method of valuation. It remains to be seen if CRA will provide guidance to taxpayers with respect to such a reasonableness test. If shares are owned by a discretionary trust, consider winding up the trust and distributing the shares of the corporation to the beneficiaries actively involved in the business. This will allow Founder and/or others, if they qualify, to continue to accrue capital gains eligible for the LCGE. Individuals not active in the business will see their income and capital gain treated as split income and taxed at the top rate. A transfer to a Canadian resident beneficiary can be done on a tax-free basis, while a transfer to a non-resident beneficiary will result in a deemed disposition at FMV.

Proposed Measures What Next? What do we do with existing structures having discretionary trusts? Trusts remain a tool that provides protection of the assets held by the trust from creditors. Trusts may be used to provide flexibility and control by the trustee (Founder) over assets. Although QSBC shares held in a trust will no longer be eligible for the LCGE, the assets held in a trust will be excluded from death taxes and distributed to the next generation on a tax deferred basis. Essentially skipping one generation of taxation.

Proposed Measures What Next? (continued) Are estate freezes still relevant? FOUNDER OPCO

Proposed Measures What Next? (continued) FOUNDER CHILD 1 CHILD 2 Preferred Common Common shares shares shares OPCO

Proposed Measures What Next? (continued) An estate freeze may still be beneficial under the new rules as it freezes the value of the shares of the Founder, thereby minimizing tax liability on death. Where a business is transferred to children, an estate freeze remains the most efficient way of introducing these children as shareholders.

Anti Surplus Stripping Rules Changes To Section 84.1 Section 84.1 is a provision of the Act that, under certain circumstances, deems what would otherwise be a (lower-taxed) capital gain to be a (higher-taxed) dividend. Previously, Section 84.1 only applied in situations where an individual, trust or partnership transferred shares to a non-arm’s length corporation, after a previous transfer had not been subject to tax, e.g. if the previous transferor had used the LCGE. Revised section 84.1 expands the application of the rules in Section 84.1 to apply to all non-arm’s length sales of shares from an individual to a corporation, even when the shares being sold have already been subject to tax.

Anti Surplus Stripping Rules Changes To Section 84.1 (continued) In the past, as long as tax had been paid on any previous non-arm’s-length transfers, planning could have been implemented, in certain cases, to convert a dividend (taxed at 43.84% at the highest marginal rate in Quebec) into a capital gain (taxed at 26.65% at the highest marginal rate in Quebec). After the changes to Section 84.1, such planning would result in an overall tax rate of 70.5% - double-taxation! Therefore, the changes to Section 84.1 effectively preclude, and potentially penalize, any planning involving the non-arm’s-length transfer of shares to a corporation to reduce the tax rate to anything lower than the rate on dividends paid. These changes apply to transfers that occur on or after July 18, 2017.

Anti Surplus Stripping Rules New Section 246.1 Anti-avoidance or catch-all provision which taxes distributions, including capital dividends, as taxable dividends if: A Canadian-resident individual received an amount from a non-arm’s length person as part of a series of transactions involving a disposition of property or an increase or decrease in PUC of shares; AND It can reasonably be considered that one of the purposes of the transaction was to effect a significant reduction or disappearance of the assets of a private corporation where any part of the tax otherwise payable by an individual in respect of the distribution is avoided. Finance advises to compare with what the tax would have been had the individual received all amounts as a taxable dividend immediately prior to the transaction(s). Applies in respect of amounts that are received or receivable on or after July 18, 2017.

Anti Surplus Stripping Rules New Section 246.1 - Applicability New section 246.1 as proposed has very broad applicability, and the July 18, 2017 proposals do not provide examples of what types of situations it intends to attack. It would seem, however, to apply to a series of transactions where there is a disposition of a capital property within a non-arm’s-length corporate group in a cashless transaction, since the capital dividend account (“CDA”) addition generated allows corporate surplus that would otherwise be distributed as a taxable dividend to flow up to the individual as a tax-free capital dividend e.g. transfer of a building held by a corporation owned by Father to a corporation owned by Son – 50% of capital gain normally credited to Father’s corporation’s CDA would not be, and any amounts subsequently paid out in that series of transactions would be taxed as dividend income in Father’s hands.

Anti Surplus Stripping Rules New Section 246 Anti Surplus Stripping Rules New Section 246.1 – Applicability (continued) In fact, based on the broad wording, new section 246.1 could theoretically apply to transform any receipt that is a capital dividend, or any proceeds on disposition of a capital property into a taxable dividend as long as corporate property is transferred to an individual as part of the series of transactions.

Anti Surplus Stripping Rules Post- Mortem Planning – Subsection 164(6) Solution Potential for double tax on shares of a private corporation held by an individual at the time of death – gain on deemed disposition in final return of the deceased, followed by gain realized when corporation sells assets and distributes proceeds to estate or heirs. One option to avoid double taxation is to wind-up the corporation subsequent to death, with the Estate paying tax on the proceeds from the wind-up of the company as a dividend resulting in a capital loss that can be carried back to the terminal tax return and applied against the capital gain from the deemed disposition on death – the subsection 164(6) solution.

Anti Surplus Stripping Rules Post- Mortem Planning – Subsection 164(6) Solution (continued) The subsection 164(6) solution results in a tax rate of 43.84% (highest marginal Quebec rate for non-eligible dividends) e.g. tax of $219,200 on a corporation worth $500,000. The subsection 164(6) solution must be implemented no later than the end of the first taxation year of the Estate.

Anti Surplus Stripping Rules Post- Mortem Planning – Pipeline Strategy INDIVIDUAL IMMEDIATELY PRE-DEATH Investment Holdco owns a portfolio of passive investments. 100 Common shares PUC = Nominal ACB = Nominal Investment Holdco (Value on Death = $500,000)

Anti Surplus Stripping Rules Post – Mortem Planning – Pipeline Strategy (continued) ESTATE 100 Common shares PUC = Nominal ACB = $500,000 Investment Holdco (Value on death - $500,000) Deemed disposition in terminal return of deceased taxpayer – tax at 26.65% or $133,250. Estate receives the 100 Common shares that, due to deemed disposition, have ACB of $500,000.

Anti Surplus Stripping Rules Post – Mortem Planning – Pipeline Strategy (continued) ESTATE $500,000 promissory note NEW HOLDCO PUC = Nominal ACB = $500,000 INVESTMENT HOLDCO Estate sells shares of Investment Holdco to New Holdco for $500,000 promissory note.

Anti Surplus Stripping Rules Post – Mortem Planning – Pipeline Strategy (continued) ESTATE $500,000 promissory note AMALCO Assets- ACB = FMV = $500,000 New Holdco and Investment Holdco amalgamate. Amalco “bumps-up” ACB of its portfolio investments to FMV.

Anti Surplus Stripping Rules Post – Mortem Planning – Pipeline Strategy (continued) ESTATE Has $500,000 ACB portfolio of securities AMALCO (No assets) Amalco’s portfolio of securities distributed tax-free to Estate as repayment of promissory note. Only tax paid was the $133,250 in deceased’s final return, as opposed to $219,200 using subsection 164(6) solution. Pipeline strategy can be done at any time (i.e. not limited to first year of Estate as is the case with subsection164(6) solution).

Anti Surplus Stripping Rules Post – Mortem Planning – Planning Eliminated? Changes to Subsection 84.1 may result in the Estate being deemed to receive a taxable dividend from the receipt of the shares of the private corporation if the Estate does not deal at arm’s-length with the deceased (rather than the capital gain on the deemed disposition on death). Should this be the case, the tax would be $219,200, or the same as under the 164(6) solution, plus the $133,250 capital gains tax in the deceased’s terminal return, for a total tax of $352,450 or 70.5%! If implementation of Pipeline Strategy was commenced before July 18, 2017, and all that remains today is the promissory note from Amalco to the Estate, the repayment of the promissory note and dissolution of Amalco could also result in the application of new section 246.1, triggering a second taxable dividend being deemed to be received by the estate, resulting in another $219,200 tax liability for the estate.

Anti Surplus Stripping Rules Post – Mortem Planning – Planning Eliminated? (continued) Should this be the case, it would result in an overall tax rate of 87.68%! Furthermore, if the July 18, 2017 proposals are implemented as proposed, the subsection 164(6) election may no longer be effective in certain circumstances, thereby resulting in double tax at a rate of 87.68% as well! It is hoped that Finance will consider these harsh results and propose modifications to alleviate them once the consultation period is over on October 2, 2017.

Holding Passive Investments in a Private Corporation Finance’s Perceived Problem Integration in the Canadian tax system ensures that passive investment income earned by a private corporation and then distributed to an individual is taxed at more or less the same tax rate as passive investment income earned directly by an individual. The system of integration does not distinguish the source of the funds being passively invested in a private corporation.

Holding Passive Investments in a Private Corporation Finance’s Perceived Problem (continued) Finance perceives an inequity in instances where the source of the funds being invested in a private corporation is income taxed at (lower) corporate tax rates (18.5% or 26.9% in Quebec) as opposed to funds that had originally been taxed at (higher) personal tax rates (up to 53.31% in Quebec). This is because there is more principal available for the private corporation to invest compared to the individual’s income taxed at the higher personal tax rate before being invested. As a result, a shareholder who uses a private corporation to accumulate passive investments will ultimately be left with more cash than the individual who makes these passive investments directly.

Holding Passive Investments in a Private Corporation Proposed Solutions In order to correct this perceived inequity, Finance seeks to implement a new tax regime which would tax passive investment income earned in private corporations and sourced from profits from an active business (income taxed at the SBD rate or general corporate tax rate) at higher rates. Finance proposes and seeks comments on several alternative methods: a) Apportionment Method b) Elective Method c) Corporations Focused on Passive Investments

Holding Passive Investments in a Private Corporation Proposed Solutions (continued) After the consultation period is over, Finance will choose one of the Apportionment Method or Elective Method. Regardless of which of the 2 above-mentioned methods is selected, private corporations will be given the option to choose, as an alternative, the method for corporations focused on passive investments. The following slides will take a brief look at each of these proposed methods.

Holding Passive Investments in a Private Corporation Proposed Solutions – Apportionment Method Track after-tax corporate income in 3 separate pools: small business rate, general corporate rate, and shareholder contributions. Allocate passive investment income earned in the corporation to these pools. Corporations can then designate which pool dividends are paid from: non-eligible dividends (pool accumulated from income taxed at small business rate), eligible dividends (pool accumulated from income taxed at general corporate rate) or tax-free dividends (pool accumulated from shareholder contributions). Would be very difficult to keep track of earnings and pools.

Holding Passive Investments in a Private Corporation Proposed Solutions – Elective Method – Default Treatment Default Treatment – passive income earned in a Canadian Controlled Private Corporation (“CCPC”) would be subject to non-refundable taxes at rates equivalent to the top personal income tax bracket, and dividends distributed from such income would be treated as non-eligible dividends. ½ of capital gains included in income but no credit to Capital Dividend Account No preferred treatment for passive income earned on contributed capital In Quebec, this default treatment could result in a total tax rate (when distributed to an individual at the highest marginal tax bracket) of 74%! Under the default treatment, the corporation would still be able to claim the Small Business Deduction on its active business income.

Holding Passive Investments in a Private Corporation Proposed Solutions – Elective Method – Elective Treatment Elective Treatment - passive income earned in a CCPC would be subject to non-refundable taxes at rates equivalent to the top personal income tax bracket, and dividends distributed from such income would be treated as eligible dividends. ½ of capital gains included in income but no credit to Capital Dividend Account Unclear if preferred treatment would be given for passive income earned on contributed capital In Quebec, this elective treatment could result in a total tax rate (when distributed to an individual at the highest marginal tax bracket) of 72%! Under the elective treatment, the corporation would NOT be able to claim the Small Business Deduction on its active business income i.e. its active income would be taxed at the general corporate rate

Holding Passive Investments in a Private Corporation Proposed Solutions – Corporations Focused on Passive Investments All income, whether active business income or passive investment income, taxed as passive investment income. Current refundable tax system continues to apply. Additional refundable taxes would apply to inter-corporate dividends received. It is unclear whether existing Capital Dividend Account rules would continue to apply to capital gains realized by the corporation.

Holding Passive Investments in a Private Corporation Commentary and Conclusion At the end of the day, the government is seeking to penalize those individuals who source their savings from excess active business earnings (eg. an operating corporation) and retain these savings in the same corporation or a related corporation. Unlike the proposals discussed earlier, no draft legislation has been released with respect to the taxation of passive investment income in private corporations, and no implementation date has yet been proposed. In a piece published in The Globe and Mail on September 5, 2017, Finance Minister Bill Morneau stated: “For those business owners and professionals who have saved and planned for their retirement under the existing rules, I want to be clear: We have no intention of going back in time. Our intent is that changes will apply only on a go-forward basis and neither existing savings, nor investment income from those savings, will be touched.”

Q&A

Crowe BGK Tax Advisory Group Canadian Tax Sydney Berger, CPA, CA, TEP Partner T: +1 (514) 908-3603 s.berger@crowebgk.com   Mathieu Ouellette, CPA, CA, LL.M. Tax Partner T: +1 (514) 908-3624 m.ouellette@crowebgk.com   Sam Lackman, CPA, CA Senior Tax Manager T: +1 (514) 908-1219 s.lackman@crowebgk.com   Sergio Di Marco, CPA, CA Senior Tax Manager T: +1 (514) 908-1011 s.dimarco@crowebgk.com   Isabelle Nadeau, B.C.L., LL.B, LL.M. Tax Tax Manager T: +1 (514) 908-3625 i.nadeau@crowebgk.com   Jennifer Warner, LL.B, LL.M. Tax Tax Manager T: +1 (514) 908-0038 j.warner@crowebgk.com  

Crowe BGK Tax Advisory Group Sales Tax & U.S. Tax Services Jean-François Senécal, LL.B., D. Fisc. Tax Manager T: +1 (514) 908-1012 jf.senecal@crowebgk.com   Marie-Gabrielle Bronsard, M. Tax Indirect Tax Manager T: +1 (514) 908-3606 mg.bronsard@crowebgk.com   Luc Picard, CPA, CA Leader, U.S. Tax Services T: +1 (514) 908-3631 l.picard@crowebgk.com   Paul Garellek, CPA (Illinois) Senior Manager U.S. Tax Services T: +1 (514) 908-1203 p.garellek@crowebgk.com