Removing Surplus at Capital Gains Rates

There are ways you can receive funds from your private corporation [(Opco)] at a lower personal tax rate than that which applies to funds distributed as taxable dividends or salary/bonuses. With careful planning, there are techniques to remove corporate surplus from a private corporation at capital gains tax rates.

Income you earn indirectly through Opco in the form of a taxable dividend is subject to both corporate income tax paid by Opco and personal income tax you pay when the income is distributed to you as a dividend. Normally, the dividends paid to you by Opco are “ineligible dividends” that are subject to a higher personal tax rate than eligible dividends received on shares of a public corporation held in a non-registered investment account.

The higher tax rate applicable to dividends received from Opco reflects the fact that Opco pays corporate taxes at a lower rate than a public corporation by virtue of the small business deduction. In theory, through a series of mechanisms referred to as the “tax integration” rules, the Canadian income tax system is designed so that the combined corporate and personal tax paid on income earned through a corporation and distributed as a dividend to an individual shareholder should be roughly equivalent to the income tax that would have been paid had the income been earned directly by the individual through an unincorporated business.

The dividend tax credit you can claim in respect of taxable dividends received from Opco is intended to provide a deduction that reflects the amount of tax already paid by Opco on the underlying income at the corporate level. In practice, however, tax integration has never been perfect due to continual fluctuations in personal and corporate federal and provincial tax rates. Consequently, there has always been a tax benefit or cost attached to the manner in which corporate income is taxed and distributed.

The other way in which income is distributed to you from Opco is in the form of a salary or bonus. Opco can claim a deduction in respect of payments such that underlying income is not subject to tax at the corporate level; however, the top personal tax rates on salary exceeds the top personal tax rates on dividends due to the availability of the dividend tax credit. Whether more total tax is paid on income taxed in Opco and paid to you as a dividend versus income paid to you by Opco as a salary or bonus depends on many factors, including the amount of income earned by Opco in the year and your personal tax rate.

Due to recent changes in corporate and personal tax rates, individual shareholders of private companies can obtain a significant tax benefit by effectively converting corporate distributions into lower-taxed capital gains, rather than paying dividends or salary. This strategy may be particularly beneficial for you since you are subject to taxes at the [highest] marginal tax rate in [Insert Client Province of Residence]. For example, in 2020, an individual resident in [Insert Client Province of Residence] who was otherwise subject to the top marginal personal income tax rate on ineligible dividends could save approximately [$18,000] in combined federal/provincial personal taxes by effectively converting $100,000 of corporate surplus into lower-taxed capital gains. The table below sets out the combined federal/provincial personal income tax rates in respect of capital gains, salary, and dividends. The table illustrates the significant tax rate advantage that can be obtained by “converting” dividends/salary into capital gains.

2020 Top Marginal Personal Tax Rate by Income Type (Taxable Income $220,000+ [Enter the dollar threshold of the top marginal tax bracket in Client’s province])

Notes:

* [Client Province’s 20XX] top marginal tax rate applies to taxable income over $220,000.

** In the case of salary, unlike a dividend, Opco is entitled to a deduction which reduces taxable income and taxes paid at the corporate level.

Specific Anti-Avoidance Rule (SAAR)

The strategy for distributing corporate surplus at capital gains rates described below requires taking certain tax planning steps to fall outside the scope of a SAAR contained in the

Income Tax Act

(the Act) that applies to certain non-arm’s length sales of shares of a private corporation by an individual to a corporation. Generally, the SAAR converts a capital gain into a deemed dividend in cases where an individual sells shares of a Canadian corporation to another non-arm’s length Canadian corporation, the two corporations are “connected” with each other for tax purposes immediately after the share disposition, and the individual receives non-share consideration (e.g., cash or a demand note) in exchange for the transferred shares and such non-share consideration exceeds the greater of:

1) the “hard” adjusted cost base (ACB) of the shares to the individual; and,

2) the paid-up capital (PUC) in respect of the transferred shares.

PUC reflects after-tax money invested by a shareholder in a corporation and can therefore be returned to the shareholder tax-free at any time as a return of capital. Hard ACB generally refers to shares with a cost basis that resulted from a taxable sale of shares, including either a non-arm’s length sale or a sale to a third-party. “Soft ACB”, on the other hand, generally refers to cost basis that was created in a transaction in which the capital gains deduction was claimed (i.e. such that personal tax was not paid on a capital gain triggered on the share sale). If the SAAR applies to a sale of shares of an individual to a non-arm’s length Canadian resident corporation, an immediate deemed dividend to the individual is generally triggered to the extent that non-share consideration (e.g., cash or a demand note) exceeds the greater of the PUC and the hard ACB of the shares.

The SAAR was primarily designed to prevent surplus stripping to the extent that the cost basis of an individual’s shares reflects capital gains realized by the individual (or a non-arm’s length individual) that were sheltered by the capital gains deduction (but for the SAAR, tax planning steps could be taken at any time to remove surplus from a private corporation tax-free up to the amount of the capital gains deduction, which is approximately $1M)). Consequently, the SAAR generally does not apply to corporate distribution strategies that involve a sale of shares of the private corporation by an individual to a corporation, provided that personal tax is paid by the individual on the capital gain triggered by the sale.

The corporate distribution strategy referred to above could be implemented, for example, by taking the following steps:

• Step 1: You transfer shares of Opco (the “transferred shares”) that have a high FMV and a low ACB to Opco in exchange for redeemable preferred shares (the “Opco preferred shares”) and a new class of common shares of Opco (the “new common shares”). The new common shares are similar to the transferred shares, but have some different attributes which ensures that the old shares are considered to have been disposed of for tax purposes. An election is filed under section 85 of the Income Tax Act in respect of the share exchange, and an elected amount (i.e. the deemed amount of consideration for the transferred shares) is chosen that is equal to the FMV of the transferred shares. Since the shares are transferred under section 85, certain other automatic rollover provisions contained in the Act will not apply to the share exchange and a capital gain is triggered in respect of which you pay personal taxes (i.e. at capital gains tax rates). The new common shares have a nominal value and ACB. The Opco preferred shares have a FMV and hard ACB equal to the FMV of the transferred shares and nominal PUC;
• Step 2: The Opco preferred shares are sold to Holdco [(i.e. another private corporation controlled by client, that either already exists or is incorporated in another step)] at FMV in exchange for preferred shares of Holdco that have a PUC and hard ACB equal to their redemption value (the Holdco preferred shares);
• Step 3: Opco redeems its preferred shares held by Holdco, and cash is transferred from Opco to Holdco in payment of the redemption amount. The resulting inter-corporate dividend (i.e. since the Opco preferred shares have nominal PUC) is deductible by Holdco and no refundable Part IV tax is payable on the dividend, provided that Opco has no eligible or non-eligible refundable dividend tax on hand balance; and,
• Step 4: Holdco uses the proceeds from the share redemption to make a tax-free return of capital to you that is equal to the amount of the capital gain triggered in Step 1.

Note: In lieu of the Holdco preferred shares, the Opco preferred shares could instead be sold to Holdco in exchange for a promissory note of equal value.

There are certain costs to implementing the above strategy, including professional fees related to the filing of tax elections, the preparation of the purchase and sale agreements (with a price adjustment clause), [the cost of incorporating of a new company], and [the cost of valuing the shares of Opco (it is important that a good faith attempt is made, using a fair and reasonable valuation method, to arrive at the FMV of the transferred shares)]. Net of these costs, the strategy should result in savings generally equal to amount of surplus removed from Opco multiplied by the difference between your marginal personal tax rate on dividends and your marginal personal tax rate on capital gains.

It must also be considered whether the CRA would challenge the above corporate distribution technique by seeking to apply the general-anti avoidance rule (the GAAR). The CRA has had mixed results when seeking to apply the GAAR to transactions designed to convert dividends (or salary) into lower-taxed capital gains. Several such challenges have been brought before the tax courts. Generally, the tax courts have only shown a willingness to uphold the application of the GAAR in respect of such planning where it also involves offsetting the relevant capital gain with the capital gains deduction or with unrelated carryforward losses (or in certain cases where the extraction of the corporate surplus occurs in the course of the winding-up, discontinuance or reorganization of the business of the corporation). In cases where personal taxes are paid on the relevant capital gain, courts have held that it is not abusive to extract corporate surplus in the form of capital gains as opposed to a dividend or salary. In fact, the courts have specifically indicated that planning of this nature is not abusive, and that the Act does not contain a general policy requiring an individual to remove surplus in the form of dividends or salary rather than capital gains. In response to these court cases, the CRA has stated that it does not intend to challenge transactions that effectively convert dividends to capital gains by applying the GAAR, provided that personal tax is paid on the capital gain.

Notably, in 2017, the Government considered amending the Act to introduce a new anti-avoidance rule that would have effectively ended the ability to convert dividend distributions into lower-taxed capital gains. However, after significant stakeholder criticism, the proposals were abandoned. The Government did, however, enact the Tax on Split Income (TOSI) rules to limit income splitting opportunities. In this regard, we could also discuss strategies that involve both splitting income without the TOSI applying, while at the same time removing corporate surplus at capital gains rates.

[Practitioner Note: Consider, for example, the use of a triangular structure in which Opco is owned by a discretionary trust in respect of which an Investco is a beneficiary (see, for example, CRA Views Document 2018-0778661C6), coupled with a two-step inter-vivos pipeline that enables surplus to be distributed to family members in the form of capital gains taxed at the personal marginal tax rate of an adult beneficiary of the trust. The transactions must be structured carefully if the intention is to split income without the TOSI applying. For example, this type of planning will generally not be effective if a related person actively manages the investment business of Investco, thereby resulting in Investco meeting the definition of a “related business”. Furthermore, it is advisable to set-up a separate Investco trust beneficiary in respect of each family member (i.e. since under paragraph 120.4(1)“related business”(c), a “related business” includes a business carried on by a corporation in which the following conditions are met: i) a source individual in respect of the specified individual owns shares of the corporation or property that derives, directly or indirectly, all or part of its fair market value from such shares, and ii) the total FMV of the shares and later described property that is owned by the source individual equals at least 10% of the total FMV of the shares of the corporation, regardless of whether a related person is actively engaged in managing the investments of Investco).]

Please call me with any questions you have about the above corporate distribution planning technique. Our team of experienced tax professionals would be happy to work with you in implementing a tax-efficient corporate surplus distribution strategy.