Tax Changes Impacting Professional Corporations Agenda Several - - PowerPoint PPT Presentation

Tax Changes Impacting Professional Corporations

Agenda

Several substantial changes to Federal income tax legislation impacting professionals since 2016:

• Specified partnership income (“SPI”) and specified corporate income (“SCI”);
• WIP rules for professionals;
• Investment income grind to small business limit (“SBD”);
• Refundable tax regime; and
• Tax on split income (“TOSI”)

2

New Rules for Partnerships

Old SBD Rules

• Original SPI rules targeted only the use of partnerships to multiply access to

small business limit.

̶ Effectively, CRA’s position was “one business, one business limit”. ̶ Corporate partners of a partnership share a single business limit in respect of the partnership, with their share being $500,000 x their percentage share of partnership earnings from an active business. ̶ A professional corporation whose sole active business was their interest in a professional partnership would often be entitled to a portion of this limit significantly less than their income allocation from the partnership. Several different structures were typically used to plan around the old SPI rules.

Old SBD Rules

PC PC PC Professional Partnership Partner Partner Partner

Old SBD Rules

PC PC PC Professional Partnership Professional Profesional Professional Mgmt Co. Mgmt Co. Mgmt Co. Services

SPI and SCI – New Rules

• Rules introduced for taxation years starting on or after March 22, 2016

̶ New concept of “specified corporate income”.

• SCI carve-out: a corporation (“SCI-Corp”) income from provision of goods and services to a

private corporation (“Recipient”) in which SCI-Corp, SCI-Corp’s shareholder or another non- arm’s length person holds an interest, unless all or substantially all of SCI-Corp’s income is earned from arm’s length customers.

• SCI-Corp’s carved-out income is not entitled to SBL, unless Recipient assigns portion of
• wn SBL to SCI-Corp.

Prevents use of stacked or sister corporations to access small business limit by having a holding company or sister company charge management fees to the professional corporation which holds the partnership interest.

SPI and SCI– New Rules

• New concept of “designated member” of a partnership.

‒ A designated member of a partnership is a CCPC that provides services or property to a partnership, where:

• it is not a member of the partnership; and
• one of its shareholders holds a direct or indirect interest in the partnership; or
• the CCPC does not deal at arm’s length with a person who holds a direct or indirect interest in

the partnership, unless the CCPC earns all or substantially all of its income from arm’s length customers

• Designated members of a partnership only have access to “specified partnership

business limit” to the extent that corporation which is a member of the partnership assigns a portion of its “specified partnership business limit” to the designated member.

Impact of New SPI and SCI Rules

• Most structures undertaken based on “old” pre-March 21, 2016 rules will no

longer produce desired result.

• Professionals who are members of a partnership will see their access to the small

business limit in respect of their active business income from the partnership (regardless of how derived or corporate structure) severely limited.

• Some planning alternatives still remain however, these may carry significant tax

risk or result in tax tail wagging the business dog. Even without SBD, PC’s still allow for substantial tax deferral (27% vs 48%).

̶ Note: SBD has only ever been a deferral, not a permanent tax saving.

WIP for Professionals

What is Work in Progress?

• No comprehensive definition of “work in progress” in the Income Tax Act (the “Act
• r ITA”).
• Paragraph 11 of CRA Archived IT-457R states that WIP must be given its ordinary

meaning, i.e. “partly finished goods or services which are in the process of completion and have not reached the stage where the taxpayer is required to include an amount in income pursuant to paragraph 12(1)(b)”.

̶ ITA 12(1)(b) requires income inclusion when an amount is “receivable”, which occurs legally on invoicing.

Current Legislative Scheme for WIP

• Section 9 requires profits be determined under well-accepted principles, under

which opening and closing inventory are taken into account.

• Section 10 governs recording of inventory.
• Section 34 provides election to exclude WIP for certain professions.

Professionals’ WIP - Inventory

• ITA 10(5) - Without restricting the generality of the section,

a) …work in progress of a business that is a profession is, for greater certainty, inventory

• f the taxpayer, …

‒ General principles of what constitutes “inventory” still governs, unless explicitly specified. ‒ “For greater certainty” suggests professional’s WIP = inventory under general principles even without ITA 10(5)(a).

Measurement Options

• ITA 10(1) – For the purpose of computing a taxpayer’s income for a taxation year

from a business… inventory shall be valued at the end of the year at the cost at which the taxpayer acquired the property, or its fair market value at the end of the year, whichever is lower, or in prescribed manner.

‒ Two choices:

• Lower of “cost” or fair market value (“FMV”), or
• A “prescribed manner”.

“Prescribed Manner” Measurement

• ITR 1801 – … for the purpose of computing the income of a taxpayer from a

business, all the property described in all the inventories of the business may be valued at its fair market value.

‒ Rather than lower of cost or FMV, taxpayer may choose to measure inventory simply at FMV.

What is “Cost”?

• Uncertainty regarding “correct” approach to measure “cost” of acquiring WIP for a

professional firm.

̶ Judgment required.

• While “cost amount” is defined in the ITA, no definition for “cost”.
• Where the ITA does not provide specific guidance, Canderel should be relied on.

̶ Method used to determine cost should be consistent with case law, well-accepted business principles and provides an accurate picture of the taxpayer’s profit for the year. ̶ Generally, an approach consistent with GAAP will be acceptable where not overridden by specific provisions of the ITA.

CRA’s View on Costing of Inventory

• CRA’s Archived IT-473R (1998) [paragraph 12]:

“… inventories of work in process … means the laid-down cost of materials plus the cost of direct labour applied to the product and the applicable share of

• verhead expense properly chargeable to production. Either direct costing, which

allocates variable overheads to inventory, or absorption costing, which allocates both variable and fixed overheads to inventory, is acceptable as a method of costing inventory, but the method used should be the one that gives the truer picture of the taxpayer's income. Prime costing, a method in which no overhead is allocated to inventory, is not accepted for income tax purposes as a method of costing inventory.”

CRA’s View on Costing of Inventory (Cont’d)

• CRA VIEWS 2018-0743031E5

̶ “our position expressed in paragraph 12 of Interpretation Bulleting IT-473R has not changed” ̶ “the total cost of professional labour including employee benefits should form part of the cost of WIP” ̶ “when a taxpayer chooses the direct costing method, fixed overheads do not have to be included in the cost of WIP. Consequently, in such a case, costs related to the rental

• f office space or premises would not have to be included in the cost of WIP because

they constitute fixed overheads.”

Is the Cost of the Partner/Proprietor Part of “Cost”?

• CRA VIEWS 2018-0743031E5

‒ “when a partner or owner of a business that is a profession contributes to WIP, no amount representing the partner's or proprietor's time needs to be included in the cost

• f the WIP.”

This interpretation does not contemplate situations where the partner’s time is charged to the partnership as a separate free from a non-partner corporation.

Approaches to Measuring Cost

Therefore, “cost” of WIP should include:

• Material
• Direct labour
• Applicable share of overhead:

̶ Direct costing (variable overheads to inventory); or ̶ Absorption costing (allocates both variable and fixed overheads to inventory).

• Direct costing is substantially less involved and will result in lower cost of WIP, which

should maximize deferral (within confines of CRA administrative policy)

• For accountants and lawyers using direct costing, most of WIP’s cost should relate to

salaries, wages and benefits of staff charged to the engagement.

̶ Get this right and WIP cost unlikely to be materially “wrong”

• For example, determine hourly cost of each employee and multiply by hours charged to

engagement to determine cost in WIP

• Alternatively, could take “revenue” in WIP (i.e. hours x charge out rates), and back out average

percentage of charge-out rate that relates to profit and fixed overhead

̶ Most substantial direct overhead – supervision and management – is baked right into WIP already

What is FMV?

• ITA 10(4) specifies the FMV of a professional’s WIP to be “the amount that can

reasonably be expected to become receivable in respect thereof after the end of the year”.

• What does that mean – many different interpretations possible:

̶ Amount recoverable with highest likelihood; ̶ Probability-weighted average of each recovery outcome; ̶ WIP x historical recovery percent; ̶ Apply GAAP style conservativism or not; ̶ Client-by-client basis, or is overall determination acceptable? ̶ Does “the amount … receivable” permit time-value discount?

What is FMV? – Cont’d

• The method most closely resembling the words of ITA 10(4) appears to be to determine

the recoverable amount with the highest likelihood, with no discounting.

• Contingency fees may pose significant challenge:

̶ Cost seems to be a fair approach to valuing contingency work, unless the professional is certain they will lose money on the contract ̶ CRA VIEWS 2018-0743031E5

• “[with respect to]…services in exchange for contingency fees, sometimes, a portion or all of these

fees cannot be known or determined until after an event or a time occurring after the taxation year during which the designated professional provided the services…In this situation…the FMV of such WIP of the designated professional would be nil. However, it was brought to our attention that, in certain situations, it is possible, at the end of the year, to establish an amount that can reasonably be expected to become receivable in respect of this WIP after the end of the taxation

• year. In this case, our view is that the FMV of this WIP should correspond to this amount.”
• The underlined view seems unusually permissive and inconsistent with 10(4)(a). If FMV of WIP is nil,

then why embark on the engagement? Simply put, while favorable to professionals in some circumstances, this position is nonsensical.

̶ Our view is that FMV on contingency engagements should be based expected value (i.e. probability weighted assessment of fee outcomes).

Method Used to Determine Cost or FMV - Consistency

• ITA 10(2.1):

̶ “Where property described in inventory is valued at end of a year in accordance with a permitted method, that method shall be used in the valuation of property described in the inventory at the end of the following year, unless taxpayer has concurrence of the Minister.”

• Beginning with taxation years starting on or after March 22, 2017, professionals must

value their WIP consistently from year to year, unless they obtain the Minister’s approval.

̶ Changes not requiring Minister’s approval as per CRA (IT-473R):

• Changing from average cost method for costing inventory to FIFO;
• Changing from direct costing to absorption costing;
• Using different (reasonable) methods to derive FMV; or
• Adopting standard costing.

̶ Changes requiring Minister’s approval as per CRA.

• Changing from lower of cost and FMV on an item by item basis to valuing the entire inventory at its

FMV.

• Valuation method used should provide a true picture of the professional’s income.

Valuation of Inventory for Income Tax Purposes Lower of Cost and FMV - Example

Inventory Item Salaries, Wages & Benefits Travel Disbursements Total Cost Billable Amount (FMV) Lower of Cost & FMV Engagement 1 100 10 5 115 170 115 Engagement 2 1,000 15 30 1,045 1,300 1,045 Engagement 3 700 25 25 750 600 600 Engagement 4 800 75 35 910 900 900 Engagement 5 2,000 200 50 2,250 3,000 2,250 Totals 5,070 $ 5,970 $ 4,910 $ (1) (1) Value of inventory pursuant to ss. 10(1)

Practical Issues – Valuation of WIP – Measuring Cost and FMV

• For many professionals, the FMV of most contracts in WIP is likely to exceed cost

̶ FMV will not need to be computed for each contract, but only those where a loss is anticipated. ̶ Main issue will be the determination of cost

• While time consuming, doable given the nature of most professionals’ businesses.
• Determining the cost of WIP will allow professionals to defer the profit on their

WIP revenue.

̶ Benefit from deferral will exceed cost (especially given the high corporate and personal tax rates faced by many professionals). ̶ Alternative for professionals is to value their WIP at FMV, which will result in accelerated recognition of income for tax.

ITA 34 Election

• ITA 34 was a “relief” provision introduced with ITA 10(5):

‒ In computing the income of a taxpayer for a taxation year from a business that is the professional practice

• f

an accountant, dentist, lawyer, doctor, veterinarian

• r

chiropractor, the following rules apply:

(a) Where the taxpayer so elects in the taxpayer’s return of income under this Part of the year, there shall not be included any amount in respect of work in progress at the end of the year, and (b) Where the taxpayer has made an election under this section, paragraph (a) shall apply in computing the taxpayer’s income from the business for all subsequent taxation years unless the taxpayer, with the concurrence of the Minister and on such terms and conditions as are specified by the Minister, revokes the election to have that paragraph apply.

This election is no longer available for taxation years beginning on or after March 22, 2017 and no longer results in deferral in taxation years beginning on or after March 22, 2017 for taxpayers who had previously elected under this paragraph.

New Rules

Phased Elimination of WIP Deduction

• Phased elimination of WIP deduction (deferral) for professionals starting with

taxation years beginning on or after March 22, 2017.

• Transitional rules (subsection 10(14.1)).
• Deferred profit in WIP to be brought into income over two years (initially), with this

later being revised to five years.

WIP – Elimination of Deduction

• 34(a) amended to include new criterion for WIP deduction (bolded):

̶ Exclude WIP from income for a taxation year only if both of following conditions met:

• Taxpayer elected under 34(a), and
• The taxpayer’s taxation year began before March 22, 2017.
• 34(b): “paragraph (a) will apply in computing the taxpayer’s income for all

subsequent years”.

̶ So, for taxation years beginning on or after March 22, 2017, no WIP deduction from income, regardless of whether the taxpayer elected under 34(a) or not.

WIP – Income Inclusion

• The elimination takes us back to section 9 principles that profits be determined

under well-accepted principles, under which opening and closing inventory are taken into account.

̶ WIP is inventory under subsection 10(5) ̶ Profit is GAAP income, except where it’s not

• WIP resulting from percentage of completion method revenue recognition policy:
• “Unbilled revenue” carried at its FMV
• Not cost amounts capitalized to inventory.
• Subsection 10(1) says inventory

shall be valued at lower of its cost or FMV at end of year, or in a prescribed manner.

• Therefore, if using percentage of completion method for accounting, should determine cost

embedded in the WIP. Otherwise would need to include full amount of WIP in income.

WIP – 5 Year Transitional Period

• New subsection 10(14.1) allows professionals to phase-in the income inclusion

relating to their WIP for each year over five years:

̶ Year 1 (first year beginning on or after March 22, 2017): the cost or FMV of the professional’s WIP at the end of the taxation year will be deemed to be 1/5 of the amount otherwise determined ̶ Year 2: cost or FMV of WIP at the end of the taxation year deemed to be 2/5 ̶ Year 3: cost or FMV of WIP at the end of the taxation year deemed to be 3/5 ̶ Year 4: cost or FMV of WIP at the end of the taxation year deemed to be 4/5 In Year 5 and after, the full cost or FMV is used in determining the professional’s WIP.

Impact of Rule Change on Professionals

• Professionals who have not elected under 34(a) should not be impacted by the

new rules as they would have been obligated to include their year-end WIP in taxable income at lower of cost and FMV (or at FMV).

̶ Note: if the 34(a) election was not made in a taxation year preceding March 22, 2017, then not eligible for 10(14.1) transitional rule.

• For those professionals who have made the election, the impact of these new

rules will vary based on how financial statements have been prepared.

Percentage Completion Method of Accounting (WIP at FMV)

• Financial statements prepared using percentage of completion method, e.g.

̶ Staff are assigned a “charge-out rate” that exceeds their hourly cost to the business ̶ Staff hours multiplied by these charge-out rates are recognized in revenue when the staff hours are recorded, with the corresponding adjustment recorded to WIP as a balance sheet asset until such time as the WIP is invoiced to the customer ̶ Staff costs are expensed as they are incurred

• Professionals can choose to report WIP on same basis for tax (FMV is a

prescribed manner), but this accelerates the recognition of this income for tax

• If using lower of cost and FMV method, will need to determine the cost of their

WIP at each taxation year end. If they continue to use percentage of completion method, will deduct WIP from income for tax each year and include the cost of their inventory in income each year (accounting income – WIP on balance sheet + cost of inventory = income for tax)

• The profit on WIP will be deferred until invoiced (prior to these changes, all

revenue was deferred until invoicing while costs were recognized as incurred)

Accounting for WIP at FMV - Example

• Dec. 31,

2016

• Dec. 31,

2017

• Dec. 31,

2018

• Dec. 31,

2019

• Dec. 31,

2020

• Dec. 31,

2021

• Dec. 31,

2022

• Dec. 31,

2023 Total Income Accounting & Tax "Balance Sheet" Current year ("CY") WIP (@FMV) $250,000 $1,000,000 $300,000 $325,000 $350,000 $375,000 $400,000 $0 Prior year ("PY") WIP (@FMV) $0 $250,000 $1,000,000 $300,000 $325,000 $350,000 $375,000 $0 WIP cost $100,000 $400,000 $120,000 $130,000 $140,000 $150,000 $160,000 $0 Lower of cost & FMV [s. 10(1) rules] $100,000 $200,000 $120,000 $130,000 $140,000 $150,000 $160,000 $0 Deemed cost of WIP [ss.10(14.1)] N/A N/A $24,000 $52,000 $84,000 $120,000 N/A N/A Tax cost of WIP $0 $0 $24,000 $52,000 $84,000 $120,000 $160,000 $0 Adjust WIP to lower of cost, FMV $0 $0 $276,000 $273,000 $266,000 $255,000 $240,000 $0 T5013 or T2 Schedule 1 Accounting Income $1,000,000 $1,500,000 $800,000 $875,000 $925,000 $950,000 $1,000,000 $1,000,000 $8,050,000 PY S.34(a) deduction $250,000 $1,000,000 CY S.34(a) deduction ($250,000) ($1,000,000) 10(1) WIP valuation adjustment ($276,000) ($273,000) ($266,000) ($255,000) ($240,000) 12(1)(b) inclusion $276,000 $273,000 $266,000 $255,000 $240,000 Taxable Income $750,000 $750,000 $1,524,000 $878,000 $932,000 $961,000 $1,015,000 $1,240,000 $8,050,000 TRANSITIONAL YEARS

Completed Contract Method of Accounting (WIP at Cost)

• Financial statements prepared using completed contract method, e.g.

̶ Staff costs on uncompleted contracts/engagements are not expensed as they are incurred but are instead recorded to WIP at cost; ̶ Amounts invoiced on uncompleted contracts/engagements are deducted from WIP or alternatively recorded as a deferred revenue liability; or ̶ Revenue and profit on a contract is recognized when it is completed

• The professional in this case knows what the cost of their WIP is. They will no

longer be able to deduct their WIP from income for tax.

• Once the transitional period has ended and any temporary differences resulting

from the phase-in of WIP have been reversed, income for tax and accounting should be the same, all else being equal.

Accounting for WIP at Cost - Example

• Dec. 31,

2016

• Dec. 31,

2017

• Dec. 31,

2018

• Dec. 31,

2019

• Dec. 31,

2020

• Dec. 31,

2021

• Dec. 31,

2022

• Dec. 31,

2023 Total Income Accounting & Tax "Balance Sheet" WIP cost for accounting $200,000 $225,000 $200,000 $175,000 $150,000 $300,000 $225,000 $0 Deemed cost of WIP [ss.10(14.1)] N/A N/A $40,000 $70,000 $90,000 $240,000 N/A N/A Tax cost of WIP $0 $0 $40,000 $70,000 $90,000 $240,000 $225,000 $0 Adjust WIP to lower of cost, FMV $0 $0 $160,000 $105,000 $60,000 $60,000 $0 $0 T5013 or T2 Schedule 1 Accounting Income $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $8,000,000 PY S.34(a) deduction $200,000 $225,000 CY S.34(a) deduction ($200,000) ($225,000) CY 10(1) WIP valuation adjustment ($160,000) ($105,000) ($60,000) ($60,000) $0 $0 PY 10(1) WIP valuation adjustment $160,000 $105,000 $60,000 $60,000 $0 Taxable Income $800,000 $975,000 $1,065,000 $1,055,000 $1,045,000 $1,000,000 $1,060,000 $1,000,000 $8,000,000 TRANSITIONAL YEARS

No Accounting for WIP

• Financial statements are prepared such that revenue is not recorded until it is

billed and costs are expensed as they are incurred

• Just as with the percentage of completion method, the professional will need to

calculate the cost of their WIP at each taxation year end

• In calculating their income for tax, the cost of the professional’s WIP will be an

income inclusion

̶ Alternatively, their FMV will be an income inclusion if that method chosen

No Accounting for WIP - Example

• Dec. 31,

2016

• Dec. 31,

2017

• Dec. 31,

2018

• Dec. 31,

2019

• Dec. 31,

2020

• Dec. 31,

2021

• Dec. 31,

2022

• Dec. 31,

2023 Total Income Accounting & Tax "Balance Sheet" WIP cost for accounting $0 $0 $0 $0 $0 $0 $0 $0 Wage & other costs of unbilled work $200,000 $150,000 $300,000 $125,000 $100,000 $250,000 $180,000 $0 Deemed cost of WIP [ss.10(14.1)] N/A N/A $60,000 $50,000 $60,000 $200,000 N/A N/A Tax cost of WIP $0 $0 $60,000 $50,000 $60,000 $200,000 $180,000 $0 Adjust WIP to lower of cost, FMV $0 $0 ($60,000) ($50,000) ($60,000) ($200,000) ($180,000) $0 T5013 or T2 Schedule 1 Accounting Income $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $8,000,000 PY S.34(a) deduction $0 $0 CY S.34(a) deduction $0 $0 CY 10(1) WIP valuation adjustment $60,000 $50,000 $60,000 $200,000 $180,000 $0 PY 10(1) WIP valuation adjustment ($60,000) ($50,000) ($60,000) ($200,000) ($180,000) Taxable Income $1,000,000 $1,000,000 $1,060,000 $990,000 $1,010,000 $1,140,000 $980,000 $820,000 $8,000,000 TRANSITIONAL YEARS

Corporate Passive Income Tax Changes

• Rather than a broad denial of Refundable Dividend Tax on Hand (“RDTOH”) refund and

tax-free capital dividend [previous proposal] , the government instead introduced a much more limited two-pronged mechanism:

i. A grind of the $500,000 SBD “business limit” for private corporations earning more than $50,000 of passive investment income in the preceding year, and ii. A new restriction that most RDTOH will be refundable upon payment of a non-eligible dividend (which, at top marginal rates, is taxed at 42%, compared to 32% for eligible dividends).

• Effective tax years beginning after 2018 (with anti-avoidance measures).

The New Business Limit Grind

The Business Limit Grind

• Subsection 125(5.1) [the existing business limit grind when taxable capital exceeds $10

million] is modified so that the grind is the greater of (a) the taxable capital grind and (b) the new grind below:

̶ The business limit otherwise determined/$500,000 x 5 x (E − $50,000), where E is the adjusted aggregate investment income (“AAII”) of the corporation (or any corporation with which it is associated at any time in the tax year) for each taxation year of the corporation (or associated corporation) that ended in the preceding calendar year.

• E.g. if the taxation period is July 1 2019 to June 30 2020, then the “preceding calendar year” that the AAII

grind is based on is each taxation year ending within Jan 1 – Dec 31 2019.

̶ This means a $5 grind of the small business limit (starting from the top of the limit) for every $1

• f corporate passive income earned for each tax year ending in the preceding calendar year.

The small business limit therefore grinds to $0 when passive income reaches $150,000.

41

The Business Limit Grind – Cont’d

• E.g. $75,000 of AAII grinds the SBD limit by $125,000 [$75,000 is $25,000 in excess of $50,000].

But the grind starts at the top of the limit, so as long as the associated group earns less than $375K

• f active business income, there will be no impact.

42

Business Limit Grind – Example #1 From Explanatory Notes

• A Co has a July 1 to June 30 taxation year. For taxation year ending (“TYE”) June 30,

2020, it has taxable capital of $14 million and AAII of $100,000.

• Not associated with any other corporation, and no other reductions in small business limit.
• For TYE June 30, 2021, the grind to A Co’s small business limit will be the greater of:

a) the usual taxable capital grind in paragraph 125(5.1)(a) of $400,000 [$500,000 x (0.225% x ($14,000,000 - $10,000,000))/$11,250, and b) the new AAII grind in paragraph 125(5.1)(b) of $250,000 [$500,000/$500,000 x 5 x ($100,000 - $50,000)].

• Therefore, for TYE June 30, 2021, A Co’s small business limit is $100,000.

43

Business Limit Grind – Example #2 From Explanatory Notes

• A Co has a July 1 to June 30 taxation year.
• B Co has a Jan 1 to Dec 31 taxation year.
• A Co and B Co are associated.
• At all relevant times, taxable capital employed in Canada of A Co and B Co totals

less than $10,000,000, i.e. no taxable capital grind.

• For TYE June 30, 2020, A Co has AAII of $80,000.
• For TYE Dec 31, 2020, B Co has AAII of $60,000.
• A Co and B Co share the $500,000 business limit every year, so that each gets

$250,000.

44

Business Limit Grind – Example #2 From Explanatory Notes – Cont’d

• A Co’s business limit for TYE June 30, 2021:

̶ Grind will be $250,000 / $500,000 x 5 x ($140,000 - $50,000) = $225,000. ̶ Therefore, A Co’s business limit becomes $25,000, or $250,000 less $225,000.

• B Co’s business limit for TYE Dec 31, 2021:

̶ Grind will be $250,000 / $500,000 x 5 x ($140,000 - $50,000) = $225,000. ̶ Therefore, B Co’s business limit also becomes $25,000.

• Result makes sense, because a $140,000 AAII in the associated group should

mean a total grind of $5 x $90,000. Thus, it makes sense that A Co and B Co has $50,000 business limit combined remaining.

“For Each Taxation Year of the Corporation…”

• The AAII is used to grind the business limit is the AAII “for each taxation year of the

corporation, or associated corporation, as the case may be, that ended in the preceding calendar year”.

• Therefore, if there were multiple year-ends in the preceding calendar year, AAII of those

multiple year-ends need to be considered.

• E.g. Professional Corp has the following taxation years:

̶ February 28, 2017 to January 31, 2018: AAII $40,000; ̶ February 1, 2018 to December 31, 2018: AAII $50,000; and ̶ January 1, 2019 to December 31, 2019: AAII $60,000.

• The first year these rules apply is tax year beginning after 2018, i.e. Jan 1, 2019 to Dec

31, 2019. For this year, the small business grind will be based on $90,000 of AAII. Resulting in $200,000 grind in small business limit.

What is AAII?

• AAII is a new definition, and it refers to the current aggregate investment income

definition, but with certain modifications. It includes:

• a. Taxable capital gain minus allowable capital loss, but excluding:
• Gains/loss accrued while the property (or substituted property) was held by a non-CCPC;
• Gains/loss on property that is “active asset” of the corporation at the time of disposition;
• A. “Active asset” is a point in time test, and it means property that is, at that time, either:

i. Used principally in an active business carried on primarily in Canada by the corporation or by a related CCPC;

• ii. Shares of a “connected” corporation [within the normal meaning under Part IV tax] that

would qualify as QSBC if they were held by an individual instead; or

• iii. Interest in a partnership in which 1) the corporation owns 10% or more, 2) throughout a 24-

month period, >50% of the FMV of the partnership’s property attributable to “active assets”, and 3) at time of disposition, all or substantially all of the FMV of the property attributable to “active assets”. This is a more challenging test to meet than the QFP historical use tests. In many cases, farmland or shares of the capital stock of a family farm which would meet the QFP requirements may not meet the active asset point in time test.

• Note that claim of capital loss carryforward against the gain will not decrease AAII.

What is AAII? - Cont’d

• b. Income (minus loss) from property, including dividends received but excluding any

dividends from a “connected” corporation.

• Includes any income from a “specified investment business”; so actively earning rent from

real or actively earning dividends or interest will not get the income out of these rules, unless the investment activities employ >5 full time employee.

• Includes any foreign-source property income, e.g. foreign accrual property income (“FAPI”)

will be counted as part of AAII.

• If FAPI is included in AAII, foreign accrual tax (“FAT”) claimed will not reduce AAII.
• Income in a exempt corporate life insurance policy not included in AAII.
• Note that a business of leasing property other than real estate is not a specified investment
• business. Therefore, a business of leasing equipment is not AAII
• Note: Dividends received from controlled foreign affiliates do not increase AAII as the

definition of connected corporations does not preclude foreign corporations.

AAII – Example #1

• RECo

earns income from building rental which is normally income from property.

• Per existing subsection 129(6), amounts paid by an

associated corporation that is deductible from an active business of the associated corporation is deemed not to be income from property, for purpose of the definition of “aggregate investment income”.

• Since

AAII refers to the definition

• f

“aggregate investment income”, the deeming rule in subsection 129(6) should equally apply. Hopefully, the CRA will clarify this is indeed the case.

• Therefore, the rental income earned by RECo should not

be AAII and should not impact Professional Corp’s small business limit.

• Of course, if RECo also earns rent from tenants other

than Professional Corp, such rental income would be AAII.

• Mr. A

Professional Corp RECo Professional Business Building

Lease

AAII – Example #2

• Parentco rents building to Childco
• Parentco is not associated with Childco

(therefore, 129(6) exception does not apply)

• Rent is considered to be AAII
• Business limit of Professional Corporation

will be reduced for purposes of calculating small business deduction

50

Professional Corp Childco Dad Son Wife

Building Business

AAII – Example #3

• Investee pays dividend to Professional Corporation

̶ Professional Corporation has >10% votes and value of Investee; therefore connected. ̶ Not AAII.

• Professional Corporation’s capital gain on sale of Investee

shares:

̶ Not AAII, if shares are “active assets”. ̶ Connected? Yes. ̶ QSBC if shares were held by an individual?

• Is Investee a small business corp at the time, i.e. all or substantially all

Canadian active business assets?

• Throughout previous 24 months, not owned by anyone other than

Professional Corporation or a related person?

• Note the deeming rule in s.110.6(14)(f) that deems treasury shares to have

been held by an unrelated person unless certain conditions are met.

• Throughout 24 month, meet the 50% Canadian active business assets

test?

• Note the usual modification if Investee held other subsidiaries.
• What if Investee dividend re-characterized as capital gain under

s.55(2)? Same “active assets test” should apply.

Mr.A Professional Corporation

dividend

Investee

Capital Gain 11%

AAII – Example #4

• Professional Corp A:

̶ Investment income will be either income from property

• r capital gain. All AAII.
• Professional Corp B:

̶ Investment income will be either investment from a specified investment business or capital gain. All AAII.

• Professional Corp C:

̶ Active trading is a business (e.g. trading in commodities futures and hedging). It is also not a “specified investment business” – because flipping stocks or other financial instruments is not “deriving income from property”. Therefore, not AAII. ̶ Should be the same result even if a manager is hired to day trade.

• Professional Corp D:

̶ Not AAII.

Professional Corp A Professional Corp B Professional Corp C Professional Corp D

Passive Portfolio Exempt corporate life insurance Commodity futures portfolio Portfolio actively managed to earn dividends with

• ccasional capital gain

AAII – Example #5

• Professional Corp invests its portfolio in stocks that

are not dividend paying.

• The plan is to liquidate for capital gains when Mr. A

retires and Professional Corp no longer needs the small business deduction anyways.

• No

AAII until capital gains are realized, and Professional Corp gets full small business deduction.

• Alternatively, time dispositions in a specific tax year

so that only that year’s small business limit is impacted (easier said than done).

• Mr. A

Professional Corp

Portfolio focused on non-dividend paying capital gain stocks

AAII – Example #6

• To avoid AAII exceeding $50,000 each year,

Professional Corp transfers portfolio to Mr. A.

• Fixes AAII issue, but be careful to manage:

˗ The transfer will trigger any accrued gains or losses in the portfolio. ˗ The transfer will cause a shareholder loan debit, which needs to be cleared out by a salary or dividend before the end of the year subsequent to the transfer.

• Pull funds out then combine with a prescribed rate

loan strategy or a second generation income seeding strategy to at least get some income sprinkling benefits?

• Mr. A

Professional Corp

Passive portfolio Transfer

AAII – Example #7

• Often a retired partner will receive an income

distribution from a professional partnership as part

• f a “pension” arrangement
• Even as a minority limited partner in a, FPC is

considered to be carrying on the business of the partnership.

• This business income is not considered income

from property, and therefore is not AAII.

Former Professional Corporation (“FPC”) Professional Partnership Business

10%

Retired Partner

AAII – Example #8

• Mr. A

Professional Corp U.S. RealCo

• FAPI derived from a controlled foreign affiliate is

included in AAII.

• U.S. RealCo earns passive rental income and is

subject to US income tax.

• Any foreign accrual taxes paid by U.S. RealCo will

not reduce AAII.

• Therefore even though there could be no net income

inclusion, the business limit can be reduced.

• Appears that in addition to the FAPI being included in

AAII, the underlying property income will also be included.

̶ Definition of Associate Corporations does not exclude foreign corporations.

U.S. CAN

Result of AAII Grind to Small Business Limit

Active Business Income Below Reduced Limit

• Professional Corp has $300,000 of Canadian active business income
• Professional Corp has $90,000 of AAII in TYE in preceding calendar year from

land rental to Childco

• Professional Corp’s taxable capital below $10,000,000
• Professional Corp’s small business limit becomes $300,000. As Professional

Corp only needs $300,000 of the limit, its small business deduction (“SBD”) is not affected

Result of AAII Grind to Small Business Limit

Active Business Income Above Reduced Limit– Overall Tax

We have integration. All good?

The impact to the SBD will actually be in the subsequent year, but presented together for simplicity.

Same facts, except Opco has $500,000 of Canadian active income. Active Passive 500,000 $ $90,000 11% tax on SBD income of $300,000 33,000 $ 27% tax on general rate income of $200,000 54,000 $ 51% tax on passive income 45,900 $ less, 31% RDTOH refund 27,900

• $

Corporate tax 87,000 $ 18,000 $ After-tax cash 413,000 $ $72,000 GRIP created on $200K 144,000 $ <-- 72% of $200,000 31.7% personal tax on $144K of eligible dividend 45,648 $ 42.5% personal tax on remainder as non-eligible dividend 114,325 $ 30,600 $ Personal tax 159,973 $ 30,600 $ ETR Total tax 246,973 $ 48,600 $ 295,573 $ 50.1%

Result of AAII Grind to Small Business Limit

Active Business Income Below Reduced Limit – Marginal Tax

But of course, that’s not the full picture, we need to see the ultimate impact when the funds are distributed to the ultimate shareholder.

What is the marginal tax on the $40,000 AAII that is over $50,000 (assuming no distribution)? Active Passive Active Passive 500,000 $ 50,000 $ 500,000 $ 90,000 $ 11% tax on SBD income 55,000 $ 33,000 $ 27% tax on non-SBD income 54,000 $ 51% tax on passive income 25,500 $ 45,900 $ Net corporate tax 55,000 $ 25,500 $ 87,000 $ 45,900 $ Total corporate tax 80,500 $ 132,900 $ GRIP created (72% of general rate corporate income)

• $

144,000 $

• $

RDTOH created (31% of passive income) 15,500 $ 27,900 $ Marginal tax on $40,000 AAII over the $50,000, assuming no distribution: 52,400 $ MTR: 131% Tax on $50,000 AAII Tax on $90,000 AAII

Result of AAII Grind to Small Business Limit Active Business Income Below Reduced Limit – Marginal tax

Regardless of integration, large incentive not to exceed $50,000 of AAII where the SBD is relied on.

A result of the steep claw back of the SBD

What is the marginal tax on the $40,000 AAII that is over $50,000 (assuming full distribution)? Active Passive Active Passive 500,000 $ 50,000 $ 500,000 $ 90,000 $ Corporate tax,before RDTOH refund 55,000 $ 25,500 $ 87,000 $ 45,900 $ RDTOH refund 15,500

• $

27,900

• $

Net corporate tax 55,000 $ 10,000 $ 87,000 $ 18,000 $ After-tax cash 485,000 $ 485,000 $ 31.7% personal tax - eligible dividend

• $
• $

144,000 $ 45,648 $ 42.5% personal tax - non-eligible dividend 485,000 $ 206,125 $ 341,000 $ 144,925 $ Personal tax on distribution 206,125 $ 190,573 $ Combined corporate & personal tax 271,125 $ 295,573 $ Marginal tax on $40,000 AAII over the $50,000, assuming full distribution: 24,448 $ MTR: 61% Tax on $50,000 AAII Tax on $90,000 AAII

Planning to Minimize AAII

• Reasonable

expenses, including reasonable

• verhead

expenses, may be allocable against income from property to minimize AAII.

̶ A portion of salaries paid to the owner could be considered to be for the purpose of earning AAII. ̶ Reasonable portions of building expenses may be allocated to property income (land rental, etc).

• Consider restructuring direct use of debt.

̶ Professional corporation could liquidate investments held and repay business debt. ̶ A new loan could be obtained for investment purposes. ̶ The debt’s direct use is now to produce property income resulting in a decrease in AAII. ̶ Risk CRA would take the position that the debt’s indirect use is for some other purpose and reassess on that basis.

Anti-Avoidance Re: Transferring Property to Related but Unassociated Corporations

• Private corporations may be incentivized to shift passive investment income
• utside the associated groups, in order to protect business limit. To prevent this:

̶ Corporations are deemed “associated” if:

a) The corporation loans or transfers property, directly or indirectly, to the other corporation; b) The other corporation is related but not associated; and c) It may reasonably be considered that one of the reasons of the loan or transfer was to avoid the business limit grind.

Deemed Association – Example

• Husband owns 100% of Professional Corp.
• Wife owns 100% of Investco.
• Professional Corp loans property to Investco,

allowing Investco to earn investment income.

• Corporations are related but not associated

before application of 125(5.2) anti-avoidance provision.

• Loan of property to Investco reduces AAII of

Professional Corp and its associated group.

• 125(5.2) may operate to deem Investco and

Professional Corp to be associated for the purposes of the business limit reduction for AAII.

63

Professional Corp. H Investco W Loan

Anti-Avoidance Re: Transition Year-Ends

• The passive income small business limit grind starts applying for tax years

beginning after 2018.

• Still time for planning to reduce AAII during 2018 (to reduce impact when rules

start applying for years starting in 2019).

• However, if the taxpayer causes a short tax year that begins before 2019 and

ends after 2018, and one of the reasons for causing this short year end is to defer application of the grind, then the effective date for this passive income grind is accelerated to cover that short tax year.

Anti-Avoidance Re: Transition Year-Ends – Cont’d

• Example:

̶ Professional Corp’s normal tax year-end is Jan 1 to Dec 31, and it has substantial AAII. ̶ For its Jan 1 – Dec 31, 2019 tax year, its small business limit would be reduced by the AAII of its Jan 1 – Dec 31, 2018 tax year. ̶ Professional Corp requests (and receives) approval for a new year-end on October 31, 2018, resulting in the following tax years:

• Jan 1, 2018 to Oct 31, 2018;
• Nov 1, 2018 to Oct 31, 2019; and
• Nov 1, 2019 to Oct 31, 2020.

̶ By doing this, the AAII grind does not apply until the Nov 1, 2019 to Oct 31, 2020 tax year, and also, the AAII taken into account for that year would be the 12-month AAII between Nov 1, 2018 to Oct 31, 2019. ̶ If one of the reason was to achieve this deferral, then the AAII grind starts applying in the Nov 1, 2018 to Oct 31, 2019 tax year and will consist of the 10-month period

• f Jan 1 to Oct 31, 2018.

Technical “Loophole” with Merger?

• What if two corporations amalgamate:

̶ Paragraph 87(2)(a) deems the amalgamated entity to be a new corporation. ̶ There appears to be no continuation rule that deems the predecessor entities to continue into the amalgamated entity for purpose of the new passive income grind.

• Same issue with a wind-up, where the wound-up subsidiary is not the same entity

as the parent.

• Can you avoid the AAII grind by engineering an amalgamation or wind-up every

year (so that the corporation or any corporation that it is associated with at any time in the year does not have any tax year ending in the preceding calendar year)? Technically appears to be so.

• But Finance will likely realize this sooner rather than later, so don’t bank on it.

GAAR may also apply especially if it is done annually.

The New Refundable Dividend Tax on Hand Rules

Perceived abuse under the current rules:

• Prof. Corp.

To fully recover the RDTOH, Private Co pays an eligible dividend

• f

$40,000 from GRIP. ABI $800,000 Passive income $50,000 Active business income over $500,000 is subject to general corporate rate, and creates GRIP of $216,000, i.e. 72% of $300,000 Passive income generates RDTOH

• f

$15,500, i.e. 31% of $50,000. Passive income does not create GRIP, because non-eligible dividend combined with the RDTOH refund results in proper integration. Result: fully recovered RDTOH (which was generated from investment income) by paying out an eligible dividend rather than a non-eligible dividend.

Change to the RDTOH Regime

New Eligible vs. Non-Eligible RDTOH

• The RDTOH is replaced by new:

̶ Eligible refundable dividend tax on hand (“ERDTOH”). ̶ Non-eligible refundable dividend tax on hand (“NERDTOH”).

• ERDTOH will consist of:

̶ Part IV tax paid on portfolio eligible dividends, i.e. not connected under Part IV. ̶ Part IV tax paid on dividends from connected corporation to the extent it relates to a refund of ERDTOH to the payor corporation.

• NERDTOH will consist of:

̶ Generally speaking, 30.67% of a CCPC’s aggregate investment income. ̶ Part IV tax paid on portfolio non-eligible dividends, , i.e. not connected under Part IV. ̶ Part IV tax paid on dividends from connected corporation to the extent it relates to a refund of NERDTOH to the payor corporation.

New Eligible vs. Non-Eligible RDTOH – Cont’d

• Dividend refund when an eligible dividend is declared will be the lesser of:

̶ 38.3% of the eligible dividends paid. ̶ ERDTOH at the end of the year.

• Dividend refund when a non-eligible dividend is declared will total A + B:
• A. Lesser of 38.3% of the non-eligible dividends paid, and the NERDTOH at the end of

the year, and

• B. If 38.3% of the non-eligible dividends paid exceeds NERDTOH, then the remaining

ERDTOH balance.

• To put it simply, refundable tax on passive investment income will go into

NERDTOH, which is only recoverable if sufficient non-eligible dividend is paid.

• Prof. Corp.

Portfolio Income: Eligible dividend from portfolio investment: $40,000 Interest income $30,000 Taxable capital gain $10,000 Assume starting ERDTOH/NERDTOH balance nil: ERDTOH: Part IV tax on eligible dividend = 38.3% x $40,000 = $15,320. NERDTOH: 30.7% x ($30,000 + $10,000) = $12,280. $5,000 of eligible dividends $40,000 of non-eligible dividends The dividends paid will result in the following dividend refund: 1) $5,000 of eligible dividends will provide for $1,916 refund from ERDTOH 2) $40,000 of non-eligible dividends will provide for full $12,280 refund from NERDTOH, plus $3,052 refund from ERDTOH.

ERDTOH/NERDTOH Example

Recovering ERDTOH with Non-Eligible Dividends

• While ERDTOH can be refunded using

non-eligible dividends it is generally not preferred.

• Using non-eligible dividends to generate

a refund of ERDTOH results in a net cashflow.

• ERDTOH is created upon receipt of

eligible dividends subject to Part IV tax

• Therefore it is advisable to flow these

through to the shareholders for net tax

• f 31.7% opposed to leaving in the

corporation at 38.3% (Part IV tax rate).

Eligible Dividend Income 10,000 $ Tax (Part IV) 38.3% 3,833 $ ERDTOH Dividend Refund 3,833

• $

Net Corporate Tax

• $

Non-eligible Dividend 10,000 $ Personal Tax 42.5% 4,250 $ After-Tax Cash 5,750 $ Effective Tax Rate 42.5% Dividend Refund 38.3% Cost 4.2%

RDTOH Transition

• The new definitions and dividend refund regime apply for tax years that begin after 2018.

Subsection 129(5) determines opening ERDTOH and NERDTOH.

• The opening ERDTOH for the first tax year these rules apply will be the lesser of:

̶ What the corporation’s opening RDTOH would have been under the old rules, and ̶ The corporation’s opening GRIP balance x 38.3%.

• The portion of RDTOH not qualified to go into ERDTOH will become the opening

NERDTOH.

• Special rules apply where the corporation has elected to be a non-CCPC (subsection

89(11) election), or where the corporation was not a CCPC in the preceding tax year.

• **Planning** During the remainder of 2018, maximize refund of any RDTOH, or maximize

GRIP in the corporation that has RDTOH.

TOSI

TOSI Targets Professionals

• Shares of a professional corporation and corporations whose business income is

at least 90% derived from provision of services are specifically excluded from “Excluded Shares”,

̶ “Excluded shares” are generally last available “out” from TOSI if recipient:

• Is not actively engaged on a regular, continuous and substantial basis in the business in

current year or any of preceding five years, or

• Does not work an average of 20 hours per week in the business
• Relatively rare (although not unheard of) for spouse of a professional to

contribute substantial property to a professional corporation.

• May still pay spouse a salary from professional corporation or management

corporation, but must be “reasonable”

Will TOSI Apply?

• Assume:

̶ Spouse is not actively engaged on a regular, continuous and substantial basis in the business in current year or any of preceding five years ̶ Spouse does not work an average of 20 hours per week in the business ̶ Spouse has not contributed substantial property to the business

• Will TOSI apply to the taxable dividends paid by Management Corp. to Spouse?

Professional Corp. Management Corp. Professional Spouse

Will TOSI Apply?

• Assume:

̶ Spouse is not actively engaged on a regular, continuous and substantial basis in the business in current year or any of preceding five years. ̶ Spouse does not work an average of 20 hours per week in the business. ̶ Spouse has not contributed substantial property to the business.

• Will TOSI apply to the taxable dividends paid by Professional Corp. to Spouse?

Professional Corp. Professional Spouse

Will TOSI Apply?

• Assume:

̶ Spouse is not actively engaged on a regular, continuous and substantial basis in the business in current year or any of preceding five years. ̶ Spouse does not work an average of 20 hours per week in the business. ̶ Spouse has not contributed substantial property to the business.

• Will TOSI apply to the taxable dividends allocated to Spouse by Family Trust?

Professional Corp. Professional Spouse Family Trust Management Corp.