On July 18, 2017, the federal government announced its intention to eliminate a number of tax planning strategies commonly used by small business owners. The proposed changes were widely contested and subsequently revised on October 16, 2017. The revisions included promises to simplify the proposal on income sprinkling and to provide draft legislation by the Fall of 2017.

Details were released on December 13, 2017 along with confirmation they will take effect in 2018. The “kiddie tax” will be expanded to include dividends paid to spouses and adult children that do not fall within any of the exclusions and do not meet a reasonability test.

Exclusions:

• Dividends paid to a spouse will be excluded from the new rules provided the business owner meaningfully contributed to the business and is aged 65 or over,
• Dividends paid to adults aged 18 or over will be excluded from the new rules provided the individual made a substantial labor contribution (generally, an average of 20 hours per week) to the business during the year or in any of the 5 previous years (the 5 previous years do not need to be consecutive). If the business is seasonal, the labour contribution requirement will only be applied for the part of the year in which the business operates. Records such as timesheets, schedules, log books or information contained in the payroll records will be used to establish the number of hours the individual worked in any given year,
• Dividends paid to adults aged 25 or over will be excluded from the new rules provided the adult owns at least 10% or more (measured in votes and value) of a corporation that earns less than 90% of its income from the provision of services and is not a professional corporation,
• Generally, the measures will not limit access to the lifetime capital gains exemption,

Reasonability test

For individuals between the ages of 18 and 24, dividends received must represent a reasonable return on property contributed to the business. The reasonableness criteria include:

• “Safe Harbour Capital Return”: the return on property contributed to the business will be reasonable provided it does not exceed a prescribed returned determined by a formula, and
• “Arm’s Length Capital”: the property contributed cannot be property derived from property income of a related business, borrowed under a loan or transferred from a related person.

For individuals aged 25 or over, payments that are reasonable based on the following criteria:

• Work performed in support of the business
• Property contributed directly or indirectly to the business
• Risk assumed in respect of the business
• Amounts paid or payable by any person or partnership to or for the benefit of the individual in respect of the business; and
• Other factors that may be relevant

Where an individual acquired property as a consequence of the death of another individual, special rules will apply for determining whether a dividend is excluded or reasonable or is a taxable capital gain from the disposition of excluded shares. 

Next Steps

Dividends paid to family members in 2018 and subsequent years that do not meet the “excluded” or “reasonableness” test will be taxed at the highest marginal tax rate.  We recommend that you speak to your professional tax advisor regarding paying dividends to family members prior to the end of the year.

The government has also confirmed its intention to limit tax deferral opportunities by retaining passive investments inside of a corporate. However, details will only be released in the 2018 Federal Budget.

We will continue to keep you informed of changes as they occur.

Cedric Paquin, CPA, CA, CFP
Wealth Planning Consultant

National Bank Financial is an indirect wholly-owned subsidiary of National Bank of Canada. The National Bank of Canada is a public company listed on the Toronto Stock Exchange (NA: TSX). The particulars contained herein were obtained from sources we believe to be reliable, but are not guaranteed by us and may be incomplete. The opinions expressed herein do not necessarily reflect those of National Bank Financial.

The concept of wealth preservation and the discussions that surround that concept usually happen with my clients either at or approaching retirement. Generally it’s a discussion that also happens concurrently with a risk tolerance analysis, but that doesn’t need to be the case. For example an advisor who’s hearing a young couple saying they want to preserve capital might confuse that with a conservative risk tolerance. Although that may be the case, it’s also quite possible that the client has a significant risk tolerance in the purest form of the discussion equity/fixed income ratio, but still wants to preserve wealth using defensive equity strategies. That client may have a need for higher returns, and a desire to preserve capital, and it may not be necessary, depending on risk tolerance, to move to a fixed income portfolio.  In other words, preservation of wealth and risk tolerance are not the same thing, and most advisors will often interchange the two. Assuming the discussion is actually one of preserving wealth, and not one of reducing risk tolerance, the below factors apply.

The preservation of wealth discussion usually happens at the late stages of saving or in the retirement years for most clients because that’s when they start drawing on their income or are starting to think about it. The easiest way to move to a preservation of wealth strategy is to change the asset allocation in a portfolio and to increase the fixed income component. The problem with that solution is that forces the client to be willing to accept reduced returns, and most people can’t afford that. In reality, in my view, there are better ways to do it without sacrificing returns.

Staying away from speculative stocks and sectors. This is a fairly simple and obvious one, but if investors want to preserve capital, they should stay away from speculative sectors, stocks that aren’t profitable, stocks that are trading a crazy multiples, and stocks that haven’t yet clarified or explained what their revenue model will eventually look like. Many of the pure growth plays in the markets would have these characteristics. If you can’t explain how your company is going to make money, if you aren’t currently making money, or if you don’t have a plan on how to monetize your idea, it’s probably best to stay away if preservation of capital is important. In this case, I would suggest sticking to sectors that have proven long term track records of generating profits and sustained growth, along with a slowly increasing dividend.

Replacing higher Beta equities with lower beta equities. Generally, this would be equivalent to replacing growth equities with dividend paying equities. For example, there’s an index that exists called the TSX Low Volatility index, and it targets the 50 stocks in Canada that have the lowest volatility. Not only has it historically done as good or better than the larger TSX index, but it has done it with less volatility. In theory, the way it protects wealth is that if ever there’s a market correction, the stocks should drop less than the broader index.

Adding Real assets to the portfolio. Specifically, REITs and Infrastructure are two sectors that I’ve liked for a long time. Real assets typically don’t correct as much in downturns, and provide consistent tax efficient income. If you actually take a step back and think about what you actually own when investing in these types of companies, you own actual buildings or infrastructure projects with proven long term cash flows. I always ask myself, in 20 years, what will my asset look like, and generally when considering these types of investments, they look good and have a strong likelihood of having kept its value.

Using alternatives such as Equity Linked GICs. This would be for a client who wants to have equity exposure while having the comfort of the guarantee associated with GICs. Clients can participate in the upside of the markets while having 100% of their principle protected. An easy way to preserve capital is to have the entire amount protected, and this allows for that.

Using a consistent rebalancing strategy. This is another oldie but goodie, and a simple way to protect capital. Every time the market rallies and your asset allocation get out of whack, by rebalancing, you take some profits off the table, reduce your exposure to markets, and protect yourself in the event of a market correction.

National Bank Financial is an indirect wholly-owned subsidiary of National Bank of Canada. The National Bank of Canada is a public company listed on the Toronto Stock Exchange (NA: TSX). The particulars contained herein were obtained from sources we believe to be reliable, but are not guaranteed by us and may be incomplete. The opinions expressed herein do not necessarily reflect those of National Bank Financial.