I have previously written about the “Worldwide trend of attacking the use of corporations as a way to reduce or defer taxation for individuals“. This is a continuation of this discussion. The purpose of this post is, primarily to focus on the proposed changes, to the taxation of passive income earned by Canadian Controlled Private Corporations (“CCPCs”).
Note that “CCPCs” often DO qualify as Controlled Foreign Corporations (“CFCs”) for Canadian residents who are U.S. citizens! In the past, this has meant that Canadian residents with U.S. citizenship have needed to be aware of the U.S. Subpart F income attribution rules. As a result, many people struggling with possible applicability of the U.S. “transition tax” (described here and here) are also experiencing tax changes in Canada.
Tax evasion vs. tax avoidance
Canada’s “culture of taxation” and “culture of tax enforcement” is changing. On July 18, 2017 Canada’s Finance Minister, Bill Morneau issued a statement that included the following language. Pay attention to the highly charged emotive language.
In addition to efforts to combat international tax evasion and avoidance, our Government is looking closer to home, and is taking steps to address tax planning strategies and close loopholes that are only available to some—often the very wealthy or the highest income earners—at the expense of others. Currently there are signs that our system isn’t working as well as it should, specifically when it comes to private corporations. There are worrying trends. There is evidence that some may be using corporate structures to avoid paying their fair share, rather than to invest in their business and maintain their competitive advantage.
Tax Planning Using Private Corporations – Minister’s Letter – July 18, 2017
Canadian Controlled Private Corporations are not and never been used for “tax evasion”. Why would I begin with this obvious point? It’s because in July 2017 when Finance Minister Morneau unrolled his proposed tax changes, he suggested that owners of “CCPCs” were not paying their “fair share”. He made it sound like the shareholders of “CCPCs” were somehow operating outside the law. He made it sound as though they were “getting away with something”. Nothing could be further from the truth. The shareholders of “CCPCs” were operating within the framework of Canadian laws that had been in place since 1972. The shareholders of “CCPCs” were in “plain sight”. They were operating in full compliance with the law. There was NO PROBLEM with the conduct of the shareholders of “CCPCs”. Any undesirable consequences were associated with the law itself!
Part of the purpose of FATCA and the OECD “Common Reporting Standard” is to identify individuals who are using corporations to hide the identities of the owners of corporations. In some cases, assets are held in corporations to avoid the payment of tax altogether. In general hiding of assets inside a corporation and failing to disclose the corporation (where the disclosure is required by law) could be considered to be “tax evasion”. It is possible (but not certain), that some corporations discovered as part of the “Panama Papers”, were used for tax evasion. (See my nine part series about the Panama Papers here.) The advent of the OECD Common Reporting Standard (“CRS”) has made life “uncomfortable” for owners of corporations that are incorporated outside their country of “tax residence“. For example if a U.K. resident owns a corporation that is incorporated in Canada, the “beneficial ownership” of that Canadian corporation might be reported to the U.K. tax authorities. The beginning of CRS reporting has resulted in many countries offering “tax amnesty” for those who make “voluntary disclosures” and report their corporate interests. A recent example is the decision of Russia to offer “tax amnesty” for those who voluntarily disclose their offshore corporate interests to the Russian tax authorities. (Russia adopted CFC rules in 2015.)
Tax avoidance is a process of planning ones affairs in a way that (1) facilities compliance with the law and (2) minimizes the payment of taxes. Example of “tax avoidance” include: IRA, 401K, RRSP, TFSA, ISA, etc. Some shareholders of Canadian Controlled Private Corporations use these corporations to pay less tax on their business income than they would pay if they earned the income directly.
All of this is okay! All of this is the direct result of existing tax laws.
The existing tax laws encourage retirement and financial planning
From a Canadian perspective, a practical use of a “CCPC” is to (like an RRSP or a TFSA) accumulate capital for retirement. The owners of CCPCs do NOT have the pensions that are often available to certain kinds of employees (government or university employees). As a result, many shareholders of “CCPCs” use those corporations as private pension plans. It is because those entrepreneurs are NOT employees, and have no access to private pension plans, that they use “CCPCs” to create their own pension plans. Therefore, in many cases, an attack on “CCPCs” is an attack on the “pension plans” of the shareholders!
Really? What's unfair is the lavish pensions available to government employees and MPs and NOT private small business owners. https://t.co/9kBgFLGd56
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) August 7, 2017
— Finance Canada (@FinanceCanada) August 1, 2017
What exactly was Finance Minister Morneau upset about?
Finance Canada explains its background assumptions as follows:
Holding Passive Investments Inside a Private Corporation
Corporate income is taxed at lower rates than personal income, giving businesses more money to invest in order to grow their business, find more customers and hire more people. But there are times when private corporations earn income beyond what is needed to re-invest and grow the business. In these cases, those who own and control a private corporation have the opportunity to hold passive investments inside the corporation. The Government is of the view that fairness and neutrality require that private corporations not be used as a personal savings vehicle for the purpose of gaining a tax advantage. Passive investments held within privately-controlled corporations should be taxed at an equivalent rate to those held outside such corporations. The principles of fairness and neutrality are core building blocks of our tax system. The tax system contains many provisions that are aimed at making sure that an individual is indifferent between earning income through a corporation or directly. This concept is generally referred to as “tax integration”. Passive investment income earned in a private corporation is subject to specific taxation rules, further described in this chapter.
These rules were introduced in 1972, but an important component of the system that was envisioned at the time, the refundable tax in respect of ineligible investments, was rescinded shortly after its introduction. The rules that remain in place today in many cases fail to ensure that corporate owners are indifferent between holding passive investments within their corporation or in a personal savings account.
When a corporate owner uses earnings taxed at the corporate income tax rates to fund passive investments held within the corporation, it results in the realization of returns that exceed what individual investors saving in a personal investment account can achieve. The tax advantage conferred on private corporations—the lower rate of tax—was never intended to be used to realize higher personal savings.
The Government is considering approaches that will improve the fairness and neutrality of the tax system, such that savings held within corporations are tax
On February 27, 2018 Finance Minister Morneau proposed specific changes that would facilitate these objectives. Specifically the changes proposed in the February 2017 Morneau budget suggested the following two changes:
From the perspective of the Government of Canada and Finance Minister @Bill_Morneau lower corporate tax rates leave shareholders of CCPCs with more income "after tax income" to invest, which gives owners of CCPCs an unfair advantage. But this is only part of the problem 1/2 pic.twitter.com/SrJUxo0G4I
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) March 11, 2018
CCPCs had more "after tax" money in the CCPC to invest. But, "integration rules" imply that (1) investment income inside the company taxed at high rates and (2) the shareholder would receive a refund of CCPC taxes paid when dividend paid to shareholder – per @Bill_Morneau 2/2 pic.twitter.com/9bWIZQoETT
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) March 11, 2018
In order to understand the changes, it is necessary to how the taxation of “CCPCs” works. Specifically, one must understand the concept of “integration”.
Notice that Minister Morneau’s concerns revolve around (1) the accumulation of investment capital and (2) the taxation of income from that capital when invested. (These concerns were also the basis of the U.S. “Controlled Foreign Corporation” rules which are found in Sec. 951 – 965 of the Internal Revenue Code of the United States.) The U.S. “Controlled Foreign Corporation” rules are NOW being used to attribute previously untaxed “active income” to U.S. individual shareholder AKA “The Transition Tax“.
My next post will explain the taxation of “CCPCs” and the “integration rules”.