Transition Planning – Never too Early & July 18 Proposed Tax Changes Presented by Vern H. Peters, CPA, CA – Tax Partner (2018/02/13)

Topics Transition Planning Land Companies Asset freeze July 18 Income Tax Proposals What’s scrapped? December 13 – Income Splitting To come (March 2018?) – Passive Assets

Land Companies

Land Companies Agriculture producers have been and continue to be inclined not to have land owned inside of a company. Not sure why that is. From an income tax perspective, it makes the most sense to own farmland in a company.

Land Companies If purchasing farmland at today’s prices, a company provides more after tax dollars for the land purchase or principal payments on the mortgage For a Canadian-controlled private corporation, the first $500,000 of active business income will be taxed at 11%. Personal income tax rates vary from 25.5% to 47.5%

Land Companies Could currently have land with significant equity owned outside of a company Transfer the land to the company, utilize the capital gains deduction (CGD) and create a large shareholder’s loan Pay no tax on the transfer Able to pay tax at 11% in the company and repay the shareholder’s loan without further income tax consequences

Land Companies It is becoming more common for a company to purchase the shares of another company that contains only farmland The individual vendor can claim the CGD on the sale of the shares

Land Companies Should land be owned by the operating company? Likely not A land company will assist with estate planning, exiting farming and situations where one no longer wants to actively farm, but would like to retain ownership of the land

Land Companies For estate planning, one may not be able to provide sufficient other assets to non-farming children. Some of the value in the land may need to be provided to non-farming children. Likely best that non-farming children are not shareholders in the operating company. Having a separate land company allows them to participate in the land ownership.

Land Companies Estate planning (cont’d) If there are concerns that non-farming children would prevent the farmland being used as security for expanding the operation, you could establish two land companies – one for the farming child and one for the non-farming children.

Land Companies Separate land companies will provide income tax benefits where there is a total exit from farming or a partial exit with sale of operating assets, but retention of land.

Land Companies On total exit, if land was contained in the operating company, other operating assets would need to be liquidated and the after tax cash removed prior to selling the shares of the operating company. For example, let’s say that there was $1 million left after the sale of operating assets. Immediate income taxes could be as high as $398,000.

Land Companies Total exit (cont’d) If had a separate land company, would still liquidate operating assets in the operating company, but would not need to remove the after tax cash prior to selling the shares of the land company. Could withdraw cash from the operating company over a period of years reducing the tax rate on the dividends from 40% to 23%

Land Companies Total exit (cont’d) Not possible to create a separate land company without creating income tax consequences immediately prior to the share sale. Better to have a separate land company where the creation of that company is not linked to a subsequent sale.

Land Companies On partial exit, where land was contained in the operating company, the company shares would no longer qualify for the capital gains deduction or tax free intergenerational rollover. More than 10% of the fair market value of the assets will consist of inactive assets, i.e., cash and investments received on liquidation of the operating assets.

Land Companies With a separate land company, the shares of that company can continue to qualify for the CGD and tax free intergenerational rollover. One could reorganize and create a separate land company after partial exit where the land was contained in the operating company.

Land Companies Let’s look at an example of creating a land company where land is currently owned personally This example is for retiring parents. Goal in retirement to have non-taxable cash flows. However, the structure could be used well before retirement to create non-taxable cash flows.

Land Companies Dad Mom 50% 50% Farmer Farms Ltd. FMV of Farmer Farms Ltd. is $2.2 million Dad & Mom own some farmland personally worth $2.2 million and cost of $200,000

Land Companies Dad Mom Son 50% 50% 100% DM Farms Ltd. Farmer Farms Ltd. Loan owing to DM $2.2 million (secured) Tax paid shareholders’ loan owing to Dad and Mom for $2.2 million from DM Farms Ltd. DM owns farmland with a FMV and cost of $2.2 million

Asset Freeze

Asset Freeze Two children may want to farm Do not recommend having two brothers in the same company Each may want control of their own company May not be able to get along Expensive to split a company with two brothers – could be at least $37,000 for accounting fees

Asset Freeze Set up two new companies – one for each son Parents’ company transfers inventory and equipment to each company on an income tax deferred basis Receive preferred shares Redeem the preferred shares in exchange for promissory notes

Asset Freeze Dad Mom Parent Co Son 1 Son 2 Son 1 Co Son 2 Co Promissory note Promissory note Son 1 Co Son 2 Co Both new companies contain inventory and equipment

Asset Freeze What have we accomplished? Have reduced the cost to split into two companies during the parents’ lifetime The only assets in Parent Co. are the notes receivable. It will be easier and cheaper to split this company between the two sons on the last of the parents to die

July 18 Proposed Income Tax Changes

July 18 Tax Changes On July 18, 2017 the Department of Finance issued a discussion paper and some draft legislation that addressed three areas relating to private corporations: Income splitting Passive investments Conversion of income into capital gains

July 18 Tax Changes Scrapped from the original proposals Initially included with the income splitting proposals were limitations for multiplication of the CGD with family members. Conversion of income into capital gains This area also included a very broad piece of draft legislation that many were concerned could apply to transactions such as transferring land or a farm partnership interest to a company

July 18 Tax Changes Scrapped proposals (cont’d) The broad piece of legislation could have converted what would have been a non-taxable amount from a company to a taxable dividend

Income Splitting Modified draft legislation reintroduced on December 13, 2017 Previously had rules to tax dividend income and certain partnership income received by a minor child from a related private company or partnership Tax on split income (TOSI) – taxed at the highest marginal income tax rates Top rate for ineligible dividends in Saskatchewan is 40%

Income Splitting Draft legislation focuses on expansion of TOSI Most professional corporations and service companies will not be able to dividend sprinkle with inactive family members More restrictive rules for family members aged 18 to 25 Effective for dividends paid after 2017

Excluded Shares Dividends paid on excluded shares are not subject to TOSI This is the best way to remove concerns with respect to TOSI where a spouse or children over the age of 25 do not have significant involvement in the following areas: Work performed Property contributed Risks assumed

Excluded Shares Excluded Shares Are not shares of a professional or service corporation Also cannot be a company that obtains greater than 10% of its income from a professional or service corporation Shares owned by an individual over the age of 25 where the share ownership constitutes at least 10% of votes and value

Excluded Shares (cont’d) Currently have some uncertainty with respect to holding companies and investment companies Is the 10% of income rule applicable to all holding companies? Excluded share definition refers to business income. Is investment income of an investment company included in this?

Excluded Business Dividends received by a family member from an excluded business will not be subject to TOSI An excluded business is one in which the family member has either worked an average of at least 20 hours per week in the previous year or in any 5 previous years Seasonally adjusted. Not sure what that means for a grain farm.

Income Splitting For those aged 25 and older who are not able to access the excluded shares or business rules Will need to determine if dividends are reasonable with respect to work performed, property contributed and risks assumed Tracked during entire period of share ownership

Income Splitting For those aged 18 to 25 who are not able to access the excluded business rules Can receive a reasonable return on property contributed.

Income Splitting Other rules Can split income with a spouse when the principal active shareholder is 65 or older Dividend income from shares received as the result of death or marriage breakdown can be excluded Deemed capital gains on death are excluded

Passive Assets There has been no draft legislation Expected to be introduced with the federal budget in March Expected to be effective January 1, 2018 Existing rules Investment income initially subject to income tax at 50 2/3% Reduced to 20% when dividends paid to individuals

Passive Assets Proposed rules Investment subject to income tax at a rate of 50 2/3% with no refundable portion By the time investment income has flowed through to the individual, the overall tax rate is 70% Passive assets that existed on December 31, 2017 are subject to the old rules

Passive Assets Proposed rules (cont’d) First $50,000 of income from new passive assets is subject to the old rules Non-taxable portion of capital gains from passive assets under the new rules not added to the capital dividend account

Passive Assets Proposed rules (cont’d) Dividend income from publicly traded stocks will not be added to the general rate income pool (GRIP).  Dividends paid from GRIP are eligible dividends that are subject to a lower rate of income tax at the individual level Can still continue to defer income tax on the initial after tax dollars that created the passive asset

Passive Assets Cash rent received on farmland is a passive income In the future, where farmland would have been converted from active to passive use, one will need to determine if possible to retain active status

Additional Change On a brighter note, the income tax rates for active business income are reducing In 2017 the rate was 12.5% Reducing to 12% for 2018 Reducing to 11% for 2019