What are the proposed tax changes on converting regular income into capital gains?
The Canadian government is proposing tax changes to prevent private corporations from converting surplus income to a lower-taxed capital gain and stripping it from the corporation. This targets larger private corporations.
The Canadian tax system is built on the concept of tax integration. Based on the view of principles of fairness and neutrality, tax integration aims to ensure that an individual is indifferent between earning income through a corporation or directly as the after tax results should be the same.
Currently corporate tax rates are lower than personal tax rates; however, when after tax profits earned in a corporation flow out to an individual the net result is comparable to the net result had the individual earned it directly. However, high income shareholders can obtain tax benefit if they successfully convert corporate surplus that could have been distributed as dividends or salary into lower-taxed capital gains. This is commonly known as surplus stripping and takes advantage of a current mismatch in section 84.1 of the Income Tax Act.
This government considers this an aggressive tax avoidance measure which uses non-arm’s length transactions to step-up the cost base of the shares in order to avoid the application of section 84.1 on a subsequent transaction. The shares are first sold to a non-arm’s length corporation at fair market value in exchange for a share of the other corporation. This results in a capital gain to the vendor and increases the tax cost of the acquired share to fair market value. The individual is then able to sell the acquired share to another non-arm’s length corporation and receive cash equal to the fair value of the share without treating the cash as a taxable dividend. The proposed changes would extend the current rules in section 84.1 to ensure the intended policy applies across all such transactions.
The issue is how to accommodate genuine inter-generational business transfers. There is an argument that genuine inter-generational business transfers (where the parent will no longer have control of the company the child intends to continue the company, the parent no longer has any financial interest in the company and the parent is no longer participating in the operations and management of the company) should continue to be able to use this technique as it makes the tax similar to that paid on an arms length sale.
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