During the week of October 16th,the Finance Minister announced changes to the July 18, 2017 proposed legislation.

The proposal to limit the availability of the capital gains exemption to active shareholders will be scrapped.

The proposed rules for determining the “reasonableness” of dividends paid to non-active shareholders will be simplified. It appears that capital gains on the sale of private corporation shares still could be included in “split income”, by virtue of the definition of “split income”, taxed at the top rate, to the extent that the capital gain is not sheltered by the taxpayer’s available for the capital gains exemption.

The proposed changes to section 84.1 and proposed new section 246.1 which would convert in certain transactions capital gains or otherwise tax-free corporate distributions to taxable dividends will be scrapped. This means for now that the post- mortem “pipeline procedure” will remain, however still appearing to be dependent on implementation procedures as outlining in recent tax rulings.

A welcome announcement was that the federal tax rate applicable to the small business limit will be reduced from 10.5% to 10% effective January 1, 2018 and to 9% on January 1, 2019. With no Ontario changes, the combined federal and Ontario rate will be in 2019 13.5% from the present 15%. The rate on active business income in excess of the small business limit of the present 26.5% (combined federal & Ontario rate) will not change.

The suggested rules although not presently in proposed legislation, to revamp the taxation of passive income earned by private corporations as previously announced will leave the present rules intact for annual passive income of $50,000 or less, meaning the refundable tax treatment of such income will remain the same.

Refundable tax treatment is a mechanism for the corporation to obtain a dividend refund of federal tax previously paid on passive income when taxable dividends were paid. The concept of integration is that it should not be more or less costly to earn investment income directly or indirectly through a private corporation.

It appears that income in excess of this $50K limit will be effectively taxed at a higher rate, with the implication that there would no refundable tax treatment on this amount as suggested in July. This means that the absolute tax cost of earning investment income in a private corporation will increase significantly as opposed to earning it directly by the shareholder.

Revised proposed legislation will be released to amend the July 18th proposals, likely before the end of the year, however details with respect to changes to the taxation of corporate taxation may be released as part of the 2018 federal budget.

These rules where designed to cause a deemed taxable dividend to individuals who receive share consideration and/or a promissory note on a non-arm’s length transfer of shares of a corporation resident in Canada. This could occur where the share consideration has a paid-up capital greater than of the transferred shares and/or where a promissory note exceeds a notionally adjusted tax basis of the transferred shares.

For example, if father sold shares of Fatherco to Sonco at fair market value for a promissory note, section 84.1 would deem father to have received a taxable dividend equivalent to the promissory note. Whereas if father sold the shares first to son for a promissory note and then son would transfer those shares to Sonco at that fair market value (ie, his tax basis), there would not be a deemed dividend to father.

However, if father claimed his available capital gains exemption on the sale of the shares to son and son took a promissory note equivalent to that fair market value on a subsequent transfer to Sonco, Son would then have a deemed dividend because his notional tax basis for purposes of this tax provision would be nil.

The grind of the tax basis looks back to any prior non-arm’s length transfer of those shares or substituted shares where the capital gains exemption was claimed.

The July 18, 2017 proposed rules will now grind the tax basis for purposes of Section 84.1 on any individual share transfers where a capital gain was realized by a prior non-arms length transferor, regardless if the capital gains exemption was previously claimed by that prior transferor. The proposal is effective for transactions occurring after July 17th.

In the foregoing example, if father did not claim his available capital gains exemption on the sale of Fatherco shares to son, then 84.1 would not apply. Now it will apply on son’s transfer to Sonco.

The proposed revisions to the corporate surplus stripping rules (section 84.1 of the Income Tax Act) will affect the post-mortem pipeline procedure.

On death, shares of OPCO are deemed to be disposed at fair market value, triggering a capital gain if the shares do not vest in a surviving spouse or spousal trust.

The estate acquires the shares at this fair market value. The estate may sell or liquidate OPCO, resulting in corporate tax on the sale or distribution of appreciable corporate assets in addition to tax to the estate on a deemed dividend arising on the redemption of the shares held by the estate. The share redemption also causes a capital loss (assuming certain stop-loss rules are not in play) that may be carried back to the terminal tax return to eliminate the capital gain if this transaction is done within the first taxation year the estate. If the share redemption is done after the first year, then you would have double tax, tax at capital gains rates on the terminal tax return and a second tax at dividend rates to the estate with a combined tax close to 70%.

The commonly used “pipeline procedure” allows the estate to transfer the OPCO shares to NEWCO for a promissory note which would be repaid tax-free to the estate and then to the beneficiaries as a capital distribution, resulting in only capital gains tax on the terminal tax return.

In recent years, CRA has questioned the distribution of the promissory note and has taken the position that the distribution is a deemed dividend under another provision of the Act because it was regarded as a distribution on the winding up or discontinuance of the business carried on by OPCO. However, CRA has issued a number of tax rulings that if OPCO was not wound up for a specific period, they would not assess this deemed dividend. If it was assessed then you could have both capital gains tax on the terminal tax return and tax as a dividend upon the repayment of the promissory note assuming the shares were not redeemed within the first taxation year of the estate.

A transfer after July 17th of OPCO shares by the estate to Newco will regardless of the tax rulings, will cause a deemed dividend to the estate due to the revisions to section 84.1.

To date there has been no comments on the status of potential pipeline transactions that are currently waiting for confirmation of their ruling requests.

At the end of the day, the revisions to section 84.1 will convert taxation at capital gains rates to taxation at dividend tax rates.

If the proposed July 18, 2017 legislation is passed, commencing in 2018, tax at top marginal tax rates may apply to dividends paid directly or indirectly through a family trust to an adult. Previously this tax burden or what was commonly called “kiddie tax” applied to dividends paid on private corporation shares to a minor directly or indirectly from a family trust.

What now is called split income or split portion, the basis of this taxation will now include capital gains arising on the disposition of private corporation shares held by minors and by adults, held directly or indirectly from a family trust, as well as to income earned on split income to those ages 18-24.

The capital gains exemption (“CGE”) that would otherwise be available on the sale qualified small business corporation shares (“QSBC”) to the vendor or to the trust beneficiary may also be denied. Prior to 2018, one could allocate the capital gain realized in the trust to any discretionary beneficiary regardless of age and therefore multiply the CGE times the number of beneficiaries. Commencing in 2018, for purposes of the CGE, the value accrued while the vendor was a minor is excluded from the portion otherwise eligible for the CGE.

Generally speaking, the new rules will apply if the recipient was not active in the business, the amount paid exceeds a prescribed rate of return or the recipient did not assume sufficient risk. The active business test is tighter for those older than age 17 and younger than age 25. This is CRA’s concept of a reasonable test that presently lacks sufficient guidance on how to interpret and to implement it.

With respect to dividends, any type of shareholding could be affected, even common shares or special/ preferred shares that were issued as part of an estate freeze years earlier, where in most cases, the shareholder is no longer active in the business.

For those potentially affect by this high rate tax commencing in 2018, one may consider paying additional dividends by the end of 2017 to get them up to the top tax bracket.

There is a special 2018 election where one may bump the basis of the shares to fair market value as at the date of the election selected at any time in 2018, using the pre-2018 rules. The shares must be QSBC shares which means that at the date of the election, 90% of the fair market value of the assets must be used in an active business carried on in Canada, and during the preceding 12 months, a 50% test in lieu of 90% must be met. For normal sales the 12 months is 24 months. If the election is contemplated say for December 31, 2018, the CCPC must meet the 50% test by the end of this year which not a lot of time to purify the corporation of non-active assets such as a passive investment and excess cash not required for working capital.

The election should be considered where there is significant unrealized appreciation in the shares and of course if it is anticipated that the corporation may not be a QSBC in a future year, regardless if the shares are owned directly or held by a family trust. Valuations may be considered here.

The election is not available for minors unless there is an actual disposition in 2018.

Certification of IRS Form W-7  ITIN application form

Effective  April 17, 2017, the IRS reinstated  foreign  or non-U.S. certified acceptance agents that were disbanded  on January 1, 2017. Therefore I can certify or alternatively  review your W-7 to ensure it is complete and accurate.  You will need to submit your original passport or obtain a certified copy of the passport from Passport Canada if you wish to self-prepare the W-7 without my certification. With certification, we just need a photocopy of the passport.

The ITIN is needed for:

non-U.S persons filing U.S. tax return 1040NR, the W-7 is attached to the return
persons claiming an exemption for a non-U.S. person as an eligible dependent on a U.S. tax return
non-U.S. persons completing IRS Form W8-ECI/W8-Ben that is required for waivers for reduced withholding of the otherwise 30% U.S. non-resident tax, say on gross rental income and other passive income
purchasers of U.S. real estate from a non-U.S. person completing IRS Form 8288A or 8288-B (application for reduced withholding) on the sale of U.S. real estate
There have been changes to the process as announced in June 2012 and in November 2012 by the IRS.
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