Practice Resources A Comparative Study of Business Structures Used by Professionals by David G. Thompson Thorsteinssons, Vancouver The following article was prepared by David G. Thompson, LL.B., of Thorsteinssons, Vancouver; website: http://www.thor.ca/. This article was first published by the Canadian Tax Foundation (http://www.ctf.ca/) as part of its 1995 Conference Report. Mr. Thompson received a B.Comm. degree (1979) and LL.B. degree (1983) from the University of British Columbia. Mr. Thompson was called to the British Columbia Bar in 1984 and has practised exclusively in taxation matters since 1985. Mr. Thompson is a registered trust and estate practitioner certified by the Society of Trust and Estate Practitioners. Mr. Thompson has lectured on taxation for the Association of Certified General Accountants of British Columbia, the Continuing Legal Education Society of British Columbia, the Institute of Chartered Accountants of British Columbia, the Law Society Professional Legal Training Course, Canada Customs and Revenue Agency and at various professional development seminars including the national and provincial tax conferences of the Canadian Tax Foundation. Mr. Thompson has written the materials on the Taxation of Domestic Trusts: Basic Course and the Taxation of Domestic Family Trusts: Advanced Course for the Institute of Chartered Accountants.
A Comparative Study of Business Structures Used by Professionals I. Introduction... 1 II. Employee... 1 III. Sole Proprietor... 4 IV. Partnerships... 5 V. Cost-Sharing Arrangements... 9 VI. Professional Corporations... 12 Income Splitting... 12 Tax Deferral... 13 Capital Gains Exemption... 15 Loss of Tax Deferral or Reserve... 17 VII. Management Corporations... 19 VIII. Management Limited Partnerships... 21 IX. Revenue Canada Scrutiny of Professionals... 22 Ineffective Transactions... 23 General Anti-Avoidance Rule... 23 Attribution by Virtue of Kieboom... 24 Subsection 56(2) Indirect Gift... 25 Attribution Rules... 26 Corporate Attribution Rule... 27 Invalid Trusts... 29 Notes... 30 The Law Society of British Columbia June, 2002
A Comparative Study of Business Structures Used by Professionals 1 I. Introduction This paper compares the tax consequences of various business structures used by professionals and then discusses the manner in which professionals have been scrutinized by Revenue Canada. II. Employee An employee must bring into income almost all benefits 2 and has little ability to claim any deductions. Therefore, high-income professionals seldom want to be employees unless their employer is a professional corporation that they control. 3 Only a few types of employee benefits are excluded from taxation under the Income Tax Act (Canada) (the Act ). 4 Non-taxable benefits include employer contributions to registered pension plans, group sickness or accident insurance plans, 5 private health services plans, deferred profit sharing plans and up to $25,000 of group term life insurance benefits. 6 One of the most common non-taxable fringe benefits is employer contributions to private health service plans which often cost $1,500 to $2,000 per employee per year. Where a management company is associated with a partnership and the partners are actively involved in the affairs of the management company, consideration should be given to paying the partners as employees of the management company. In addition to paying a nominal salary the management company could make contributions to its private health service plan for the employee/partners. Provided that the payment of salary and benefits to the partners as employees of the management company is reasonable, this can result in a savings in excess of the cost of the private health services plan premiums as a non-deductible personal expense becomes a fully deductible business expense that is not taxed in the employee s hands. 7 Where an employee is reimbursed to defray an employment related expense the reimbursement is not generally taxed because the employee has not enjoyed any economic benefit. 8 It is often difficult to determine whether an amount paid to an employee is a reimbursement of an employment related expense or a taxable benefit 9 and the tax planning opportunities in this area are limited because special fact patterns are required. Allowances for employee owned or leased vehicles used in the course of employment are taxed unless the allowance is reasonable in amount, the allowance is based on kilometres driven in the course of employment and the employee only has certain vehicle expenses reimbursed by the employer in addition to receiving the allowance. 10 The Law Society of British Columbia 1 June, 2002
Employment expenses are not deductible unless specifically provided for in the Act 11 and limited provision is made for the deduction of such expenses. In Latimer v. MNR, 77 DTC 84 (TRB) business deductions claimed by a chartered accountant were denied when it was determined that the individual was an employee rather than an independent contractor. 12 One deductible expense that is applicable to employed professionals is the annual membership dues necessary for maintaining professional status. 13 This provision has been interpreted quite narrowly and the deduction of closely related outlays is not permitted. For instance, membership dues of the Canadian Bar Association would not be deductible if paid by an employee: Gagne v. MNR, 83 DTC 474 at 478. While there is clearly a disadvantage to receiving income as an employee, simply incorporating is not the solution as the personal service business rules in the Act present a significant disincentive for employees to incorporate. When income earned by a corporation is characterized as personal service business income: 14 (i) (ii) the income is taxed at the top corporate tax rate; 15 and the only expense that may be deducted in determining personal service business income is remuneration actually paid in the particular year to the incorporated employee while other expenses, no matter how reasonable, are simply not deductible. 16 Personal service business is defined in subsection 125(7) of the Act as a business where a person providing services would be regarded as an employee but for the existence of the corporation and that person or a related person is a specified shareholder 17 of the corporation. Businesses that employ more than five full-time employees throughout the year or render such services to associated corporations are excluded from the personal service business definition. Incorporated professionals occasionally have concerns about the application of the personal service business rules but these concerns are commonly addressed by ensuring that the underlying relationship is one of hirer/independent contractor rather than that of an employer/employee. The decisions of the Tax Review Board in Gagne v. MNR, 83 DTC 474 and Latimer v. MNR, 77 DTC 84 are not directly on point but as they dealt with whether professionals were employees they are instructive with respect to determining whether a professional corporation is carrying on a personal service business. In both cases business deductions claimed by unincorporated professionals who purported to be independent contractors were denied because they were in fact employees. In each case the professional was bound to provide services exclusively to the employer, used the employer s office equipment and support staff and the manner in which they did their work was controlled and supervised by the employer. The factors that indicate that a person is an independent contractor include: (a) (b) a written contract indicating a hirer/independent contractor relationship; the ability to sub-contract and contract with other entities; The Law Society of British Columbia 2 June, 2002
(d) (d) (e) (f) (g) (h) remuneration by reference to billings; no minimum revenue guarantees; no fringe benefits; the provision of, or payment for, office space and equipment; no restrictions on hours of work; and ownership of clients and files by the person. The following factors indicate an employer\employee relationship: (a) (b) (c) (d) (e) payment of time-based remuneration; the ability to direct what files the worker will attend and the manner in which they will be attended to; establishment of working hours; the provision of fringe benefits; and exclusivity. Most professions have licensing and insurance requirements that identify a professional s status as an employee or independent contractor and it is absolutely essential that those requirements are considered. Revenue Canada s Tax Operation Manual ( TOM ) entitled Payroll Audit has a section entitled Factors to be Considered in Deciding the Payor-Worker Relationship 18 which discusses how an auditor should determine whether an individual is an employer or independent contractor. A separate section deals exclusively with professionals 19 in which the following points are noteworthy: (i) (ii) (iii) (iv) (v) in Revenue Canada s view a professional is less likely to be a servant than an independent contractor; because of the high degree of skill required by a professional and the fact that standards are often dictated by a professional body, payor control over a professional is necessarily more general than with non-professionals; if the professional is free to employ associate professionals or to engage substitutes this implies independent contractor status; if a professional is permitted to offer professional services to the public over and above the services provided for the payor, this suggests independent contractor status; and the ability to determine working hours, whether the professional has any fixed or guaranteed minimum salary and finally whether the professional gets benefits that the payor provides to its employees are other important indicators of employment status. The Law Society of British Columbia 3 June, 2002
If there is a risk that a business carried on by a corporation might be characterized as a personal service business then steps should be taken to mitigate the consequences. Bonuses to the owner/manager should always be paid in the year and expenses should be minimized. If the business is characterized as a personal service business but no expenses are denied under paragraph 18(1)(p), then if earnings are left in the corporation there will still be a 8.54% tax deferral and if the retained earnings are paid out as dividends to low rate taxpayers there will still be a 8.54% absolute savings. In the past, professional employees made large RRSP contributions in their last full calendar year of employment to benefit from a large deduction to offset top tax rate income earned in that year in anticipation of collapsing the RRSP in the following year when the individual had nominal income by virtue of the tax holiday arising from joining a partnership with a January 31 year end. That strategy backfired with dramatic results for the employees who borrowed to make large RRSP contributions in 1994 and then collapsed their RRSPs in early 1995 because of the new requirement for December 31, 1995 year ends for partnerships that have individuals as partners. In the future more employees will incorporate upon becoming a partner in jurisdictions where that is possible. In the past the advantages of incorporation, which are limited for partners, were of less significance than the tax holiday a new partner had by virtue of joining a partnership with a January 31 year end. In summary, few high-income professionals would be employees by choice because of the limited ability for tax planning unless they are employees of a professional corporation that they control or of a management company that they are associated with. III. Sole Proprietor Sole proprietors have more tax planning opportunities available to them than employees because unlike employees, sole proprietors are entitled to claim reasonable deductions except to the extent that they are specifically prohibited by the Act. 20 The tax deferral available for business income that was available to proprietors who established their year end just after December 31 was removed by the February 27, 1995 Federal Budget. 21 With the ability to defer tax in this manner gone one of the key distinctions between sole proprietors and employees is now gone. Regardless of whether or not a sole proprietor is incorporated, the payment of a reasonable salary to a spouse for his or her assistance with the practice should be considered. If Revenue Canada ever successfully challenges the deductibility of a spouse s salary on the basis that all or part of it was unreasonable, then double taxation would arise because the professional would lose the unreasonable portion of the deduction but the spouse would still be taxed on the full salary. As a practical matter, Revenue Canada is generally quite lenient with respect to the payment of a modest salary to a spouse provided the spouse has some involvement in the business. Large salaries are sometimes challenged and excessive salaries are sometimes penalized under subsection 163(2) of the Act. The Revenue Canada Tax Operation Manual which instructs its The Law Society of British Columbia 4 June, 2002
auditors on auditing professionals raises the payment of salaries to family members as an item for review. 22 While sole proprietors are in a much better position to minimize tax than employees, there is much greater opportunity for tax planning as an employee of a professional corporation. It is not surprising that in the provinces that permit incorporation many high-income sole proprietors have incorporated over the last eleven years. 23 As discussed later the main impediment to incorporation is the fact that most professionals must become current in their tax reporting when they incorporate. As individual proprietors become current in their tax reporting over the next 10 years as they gradually recognize December 31, 1995 income, I expect that even more sole proprietors will incorporate. IV. Partnerships Income is calculated at the partnership level rather than the partner level and then allocated to the partners on the last day of the fiscal period. This means that the partners must agree on making discretionary deductions. In the past, partnerships could create a tax deferral by having a fiscal period ending just after the calendar year. Further, rather than merge some partnerships created new partnerships of which the old partnerships were the partners to get multiple year tax deferrals. A further deferral was available to incorporated partners because the corporate year end could be set at a date that is just before the partnership year end. These deferrals have been eliminated by the February 27, 1995 Federal Budget for most professional partnerships. Partnerships are sometimes used as a means of deferring capital gains that would otherwise arise on the sale of partnership interests to incoming partners. The sale would be affected by a new partner being admitted by making a capital contribution that is credited to the capital account of the existing partners who benefit by being able to make additional withdrawals of capital upon or shortly after the new partner s admission. In theory, the existing partners would not have to account for those withdrawals until he or she ultimately withdraws from the partnership. At that time a capital gain would be realized by virtue of the retiring partner s negative adjusted cost base created because partnership draws have exceeded partnership income. This type of transaction was considered by three different courts in the Stursberg case. 24 In Stursberg a new partner contributed $162,500 to a partnership and an identical amount was simultaneously paid out to Mr. Stursberg whose partnership interest went from 40% to 15%. Mr. Stursberg took the position that he simply received a distribution of capital from the partnership. There was no doubt that in substance Mr. Stursberg sold a partial partnership interest and Revenue Canada reassessed him on that basis. The Tax Court of Canada took a substance-over-form approach in upholding Revenue Canada s reassessment. The Federal Court Trial Division held that the payment to Mr. Stursberg was not a distribution of partnership capital because a distribution should be restricted to payments that are proportionate among partners. The Federal Court of Appeal rejected these approaches The Law Society of British Columbia 5 June, 2002
and instead stated that a tax-free distribution of capital the distribution must result in a reduction or other alteration of the partnership capital. In Mr. Stursberg s case no such alteration occurred because the $162,500 distribution was matched by the $162,500 contribution. Based on the Court of Appeal s decision it should be possible to time the contributions and subsequent distributions so that there would be an alteration of partnership capital there by making it difficult to apply the Stursberg case. Revenue Canada recently revised paragraph 3 of Interpretation Bulletin IT-338R2 (which is the Revenue Canada position Mr. Stursberg relied on) and that paragraph now states in part: If a new partner acquires a partnership interest from one or more of the existing partners, in a transaction that is outside the partnership, there will be a disposition of all or a part of the partnership interests of one or more of the existing partners. Furthermore, there may be a disposition of all or a part of a partnership interest when the capital contribution by a new partner (or by an existing partner wanting an increased partnership interest) is not left within the partnership and is withdrawn by one or more of the existing partners. See Richard K. G. Stursberg v. The Queen, [1993] 2 CTC 76, 93 DTC 5271 (FCA), in which the Court concluded that there was a disposition of part of a partner s partnership interest in a transaction when the reduction in that partner s partnership interest was followed by a corresponding increase in another partner s partnership interest. In this decision, the reduction in the partner s partnership interest was found to be a disposition, and not a distribution of partnership capital under subparagraph 53(2)(c)(v), because there was no change in the overall capital of the partnership. However, in large professional firms where there is a high frequency of partners joining and leaving the firm on a yearly basis, generally, there will not be a disposition by the existing partners of a part of their partnership interests. If the distinction between the taxable versus non-taxable admission of partners is whether the contribution of capital resulted in a change of partnership capital it is easy to understand why frequent changes in large professional firms would not result in dispositions because it is less likely that the overall capital would change. However, because the test is simply whether there has been a change in partnership capital, this form of planning remains available to small firms provided contributions are not followed by immediate offsetting withdrawals. A big difference between partnerships and sole proprietors is that partners can not incorporate as tax effectively as sole proprietors. This is because the specified partnership income rules 25 force partners to share the annual $200,000 small business limit in respect of partnership income with other partners irrespective of whether or not these partners are incorporated. For example, assume that a corporate partner is entitled to 20% of the partnership income from a partnership and that the other three partners have not incorporated. The Law Society of British Columbia 6 June, 2002
Although the corporate partner may be entitled to a separate $200,000 annual business limit, only $40,000 of the partnership income would qualify for the limit. 26 This, along with the loss of tax deferral that occurs upon incorporation, explains why few partners of large partnerships have incorporated. Where permitted by law, more partners will incorporate in the future as they become current in their tax reporting over the next ten years as they recognize their December 31, 1995 income. However, the advantages of incorporating will be modest for partners who do not have a significant share of partnership income. Second tier professional corporations are sometimes used in an attempt to avoid the specified partnership income restriction. Such a structure uses a second tier corporation that typically holds the shares of the corporate partner. The Law Society of British Columbia 7 June, 2002
Although the two corporations would be associated and would have to share a separate small business limit, the second tier corporation would arguably not be caught by the specified partnership income rules and its income would not be personal service business income by virtue of paragraph (d) of the definition of personal service business in subsection 125(7). Further, subsection 129(6) deems the income of the second tier corporation, that would otherwise be income from property or business other than active business, to be income from active business to the extent the income arose from the corporate partner, an associated company, claiming a deduction against active business income. If the second tier corporation lent the corporate partner funds that were used in the partnership s active business, then the interest received from the corporate partner by the second tier corporation would be deemed to be active business income by subsection 129(6). The decision in Norco Developments Ltd. v. The Queen, [1985] 1 CTC 130 (FCTD) is authority for the proposition that it is the corporation rather than the partnership that is making the payment for the purposes of subsection 129(6). The key to this structure working is that the payments from the corporate partner to the second tier corporation must be reasonable and that generally requires that the professional be an employee of the second tier corporation which in turn provides professional services of the professional to the corporate partner which in turn provides the services of the professional to the partnership. These structures are susceptible to attack on the basis that: The Law Society of British Columbia 8 June, 2002
(i) (ii) (iii) (iv) the fee paid from the corporate partner to the second tier corporation is unreasonable and therefore not deductible (this would lead to double taxation); the general anti-avoidance rule might apply to tax the consolidated income earned in excess of the specified partnership income limit at the top corporate tax rate; if more than one partner tried to implement a second tier corporation subsection 256(2.1) might apply to deem all of the corporations to be associated; 27 and if all income is paid through to the top corporation, the top corporation might be characterized as a defacto partner. The double tiered structure should be considered by professionals who believe that Revenue Canada cannot successfully argue that the fee paid from the corporate partner to the second tier corporation is unreasonable and who either leave all surplus in the second tier corporation for investment or pay out all income from the second tier corporation to low tax rate dependents. If Revenue Canada was to successfully argue that the specified partnership income rules applied to the second tier corporation the professional would still be ahead in these circumstances in connection with dividends paid to low tax rate taxpayers (because the net tax cost would have still been reduced from 54.16% to 45.62%) and in connection with funds retained in the second tier corporation for a long period of time because the upfront tax deferral of 8.54% would gradually offset the ultimate risk of disintegration. Professional partnerships are normally in existence because of commercial reasons rather than tax reasons. In recent years many professionals have left partnerships for both commercial and tax reasons and that has contributed to the increase in professional corporations and cost-sharing arrangements. V. Cost-Sharing Arrangements Cost sharing arrangements have been common in the medical profession for many years and they are becoming increasingly more popular in other professions. The increased popularity is due to the tax and commercial advantages of being an incorporated sole proprietor rather than an incorporated partner. While significant tax advantages may accrue through joining a cost-sharing arrangement rather than a partnership, there may be some risk that Revenue Canada may deny those advantages if: (i) (ii) notwithstanding the form of the new arrangement, the cost sharing associates are still partners; or in the case of a partnership that is broken up to become a cost sharing association, the corporations formed thereafter are deemed to be associated with each other. The Law Society of British Columbia 9 June, 2002
The Act does not define the meaning of partnership and whether a particular arrangement constitutes a partnership will depend on the common law and the Partnership Act (British Columbia). The main characteristic of a partnership is the carrying on of business in common with a view to sharing a profit. Therefore, the essence of a cost sharing arrangement must be the sharing of expenses rather than profit. Otherwise, there may be some question as to whether the relationship is a de facto partnership. I caution against the creative sharing of expenses as a round about way of sharing profit. Where an existing partnership is converted into a cost sharing arrangement there is a concern that even if Revenue Canada accepts the new arrangement as a cost sharing arrangement that any professional corporations that are subsequently formed would be associated by virtue of subsection 256(2.1) of the Act so that they must share a single $200,000 small business limit. Subsection 256(2.1) is an anti-avoidance provision that states that where it may reasonably be considered that one of the main reasons for the separate existence of one or more corporations is to reduce the amount of tax that would otherwise be payable under the Act, the corporations are deemed to be associated. It is not uncommon for partnerships to evolve into cost sharing arrangements and only formally dissolve the partnership some years later. In these cases it will be much more difficult for Revenue Canada to argue that subsection 256(2.1) could apply because the potential advantages of incorporation were arguably already present. Cost sharing arrangements raise the issue of whether the relationship between the parties is one that involves the taxable re-supply of property or services for GST purposes. Different GST results occur depending on whether a person acquiring property and services acts as an agent for, or makes a re-supply to, the other person. Where a person acts as an agent, GST is paid on the purchase by the agent and recovered from the principal as part of the reimbursement for the expense. The principal is able to claim any input tax credit that is available. Where the person acquiring the taxable property or services does not act as an agent, tax is charged on both stages of the transaction, i.e. on the initial acquisition and on the subsequent re-supply. In a re-supply situation, both parties would be able to claim input tax credits if they are involved in commercial activities. Determining whether a cost sharing arrangement involves a resupply of goods and services is important to ensure correct GST accounting even where the situation is a wash for GST purposes, i.e., all the parties would otherwise be entitled to claim full input tax credits ( ITC ) for any GST paid. Where an agency relationship exists and the agent improperly claims an ITC for the GST paid, the agent may be assessed for the amount of the ITC claimed plus interest and penalty. Where a re-supply occurs and the first party incurring the expense does not collect the applicable tax, it may be assessed for the GST collectible plus interest and penalty. 28 The peril of improperly accounting for GST is much greater where the parties are engaged in an exempt activity such as providing most medical or dental services and the initial supply is not taxable since a characterization of the relationship as a re-supply can result in a loss of the nontaxable nature of the initial supply. A common example is the sharing of employee salaries. 29 In a cost sharing arrangement among a group of medical practitioners, if the practitioner who pays the salaries does not act as an agent the contributions by the other practitioners for their The Law Society of British Columbia 10 June, 2002
proportionate share of the salaries could be seen by Revenue Canada as payment for a taxable supply of receptionist and other services. In this situation, the practitioner paying the salaries could be assessed for non-collection of GST plus penalty and interest. Determining whether a person acts as an agent or for his or her own account is a question of fact based on general legal principles. 30 Revenue Canada has taken the position that in establishing whether a person will be considered to be an agent of another person the onus is on the parties determine whether an agency relationship exists. The term agency has been defined as follows: Agency is the relationship that exists between two persons when one, called the agent, is considered in law to represent the other, called the principal in such a way as to be able to affect the principal s legal position in respect of strangers to the relationship by the making of contracts or the disposition of property. 31 Accordingly, in determining whether an existing relationship is one of agent-principal the key feature that must be present is that the agent must be able to bind the principal in contractual relationships with third parties. An agency relationship may be implied and need not be apparent to third parties. It is advisable that written cost sharing agreements substantiate that payments for property and services are reimbursements for acquisitions of property and services by an agent. 32 It is not necessary, however, that the person (or persons) selected to act as agent be appointed an agent in respect of all matters. That is, an agency relationship can be limited to certain matters between two or more parties. 33 Special factors must be considered when structuring and documenting an agency relationship that also involves employees, e.g., a cost sharing arrangement among a group of medical practitioners. While it is possible to have a situation involving multiple employers, it is also important that any commercial concerns that arise as a result of a multiple employer relationship be identified and addressed. For example, there may be an issue as to the ability of employees to make multiple claims under the provisions of employment standards legislation. Similarly, there may be concerns with respect to wrongful dismissal claims by employees. As a practical matter, where a group of doctors is practising in association and the apparent employer of the staff is the association (which is not a legal entity) each of the doctors is likely a de facto employer. To the extent that these commercial concerns can be resolved, a multiple employer relationship can be established but must address issues such as source deduction, withholding requirements, control and supervision of employees and so on. One approach is to appoint one of the participants in the arrangement as the agent of all the other participants in paying employees and making source deductions and remittances to Revenue Canada. The supporting documentation should also ensure that each of the participants is accorded the rights and responsibilities of an employer. The Law Society of British Columbia 11 June, 2002
VI. Professional Corporations The provinces of Alberta, British Columbia and Nova Scotia permit most professionals to incorporate while in other provinces only certain professionals are permitted to incorporate. A common element in the legislation is the incorporated professional s loss of limited liability visa-vis his or her professional responsibilities. In Alberta only the professionals may be shareholders of a professional corporation while in British Columbia family members and family holding companies are permitted to be shareholders of professional corporations. It is difficult to understand why some professionals, such as engineers, have always been entitled to incorporate while others have not. It is also difficult to understand why only seven types of professionals (accountants, dentists, lawyers, medical doctors, veterinarians, and chiropractors) have historically been singled out for special treatment under the Act. 34 The widest possible scope for tax planning is available to professionals who are the employee/owners of a professional corporation. Incorporation is only possible if it is permitted by the professional s governing body and Revenue Canada takes the position that such permission is necessary before it will accept the corporation for tax purposes. 35 Professional corporations may be able to obtain all of the benefits of a single $200,000 small business limit at which Canadian-controlled private corporations 36 are taxed at a tax rate of 23.12% on the first $200,000 of active business earned in Canada each year. 37 Virtually all the advantages of incorporation are based on corporate income being taxed at the low tax rate on the first $200,000 of active business income. As partners must share a single $200,000 small business limit, and while employees cannot effectively incorporate because of the way personal service business income is taxed, sole practitioners and members of small partnerships are in the best position to incorporate. The main advantages of incorporation are: (v) (vi) (vii) income splitting with low rate dependents; the tax deferral advantage; and use of the basic $100,000 lifetime capital gains exemption on the transfer of a professional practice to the corporation. Income Splitting The income splitting advantage arises where the professional corporation can pay dividends to shareholders who are low tax rate dependants of the professional. Currently, an individual resident in British Columbia, without any other source of income, can receive about $23,950 of dividends tax-free by virtue of the basic personal tax credit and the dividend tax credit. 38 The effective tax rate on the first $23,950 of dividends paid to such an individual is the underlying corporate tax rate. Therefore, if the corporate tax rate is the 23.12% rate, then the effective tax The Law Society of British Columbia 12 June, 2002
rate for such an individual is 23.12% resulting in a significant benefit that can be achieved through income splitting. If the corporate tax rate is the basic 45.62% corporate rate, then the effective tax rate of paying dividends to such an individual is 45.62% and little benefit can be achieved because the top individual tax rate is 54.16%. The following diagram shows the disposable income available to a high rate and low rate individual resident in British Columbia in respect of $100 of business income that qualifies for the low corporate tax rate. Tax Deferral The biggest single opportunity a professional now has for tax deferral arises in respect of the low rate of the tax applicable to the first $200,000 of active business income earned primarily in Canada by Canadian-controlled private corporations. The deferral advantage arises because a corporation pays tax at a lower tax rate on active business income than a high rate individual taxpayer. The top marginal tax rate in 1995 for an individual resident in British Columbia with a taxable income of $78,202 is 54.16% Therefore, if a taxpayer pays tax at the top marginal rate, he or she can legitimately defer the payment of tax of about $.31 on each dollar of taxable income by leaving money in a corporation for investment or the repayment of debt. In 1995 there is no greater yearly tax deferral advantage than $62,080 which occurs with corporate income of $200,000. This is because active business income in excess of $200,000 per year is taxed at a corporate rate of 45.62% resulting in a greatly reduced deferral advantage of $.0854 per dollar of income but more importantly a potential tax cost of $.1135 per dollar of The Law Society of British Columbia 13 June, 2002
income when corporate income is taxed at the 45.62% rate and then paid out to a high tax rate shareholder. Investing with the retained earnings of a professional corporation makes excellent sense, because in addition to having more to invest, generally speaking, passive investment income (rent, interest, royalties), capital gains and portfolio dividends are taxed at virtually the same tax rate regardless of whether the income is earned by a corporation and distributed to a shareholder or earned by the individual directly. The following diagram shows that a taxpayer who pays tax at the top rate currently has a tax deferral advantage of about 1.87% by earning passive investment income through a corporation rather than directly. 39 Further, there is a 1.34% reduction in tax by earning the income through a corporation and then paying a high rate taxpayer a dividend. The integration of investment income earned by a Canadiancontrolled private corporation and paid by way of dividend to a top-rate individual taxpayer does not always work in practice because refundable dividend tax on hand is only refunded at a rate of $1 for every $3 of dividends paid. If integration really was a goal then there should be a $1 refund for every $2.79 of dividends paid. A form of over-integration may be achieved if a corporation earns both active business income and specified investment business income and dividends are paid because refundable dividend tax on hand is paid out as dividends are first paid regardless of whether or not it could be said that the dividends relate to retained earnings generated from active business income or specified investment business income. There is no need to wind up a professional corporation when a professional ceases practising through that corporation. If the professional corporation has built up retained earnings the shareholders would then be in a position to take out funds in the most tax effective manner during retirement. For this reason professional corporations are sometimes viewed as a second RRSP and are arguably more effective for building up savings for retirement. Although investment income in a corporation is not sheltered from taxation as it is in a RRSP, the applicable tax rate is 22.84% in respect of active business income earned by Canadian-controlled The Law Society of British Columbia 14 June, 2002
private corporations. Once an individual has personal taxable income in excess of $29,590 the effective tax rate of making contributions to an RRSP is 33.1526% and climbs to 44.4194% at income over $78,201. At that high tax rate the tax incurred by taking salary to make an RRSP contribution is almost double the low corporate tax rate. Reduction in Tax Personal Taxable Income 1995 Personal Marginal Tax Rate by Taking $1 in Salary to Make an $.18 RRSP Contribution Effective Marginal Tax Rate After RRSP Contribution CCPC Small Business Corporate Tax Rate Disadvantage of Taking Salary for RRSP Contribution $29,590 26.44% 4.76% 21.68% 23.12% -1.44% $53,292 40.43% 7.28% 33.15% 23.12% 10.03% $59,180 44.53% 8.02% 36.51% 23.12% 13.39% $62,192 49.67% 8.94% 40.73% 23.12% 17.61% $78,201 51.12% 9.20% 41.92% 23.12% 18.80% $78,201+ 54.17% 9.75% 44.42% 23.12% 21.30% Long term capital oriented investments made by a professional corporation are not taxed on an accrual basis and should be made in a corporation rather than an RRSP if the professional has a choice. Capital Gains Exemption Even though the basic lifetime capital gain exemption was repealed in 1994, use can still be made of it by some professionals who intend to incorporate by filing an election under subsection 110.6(19) of the Act in respect of their goodwill. 40 The election permits professionals to create a gain on their goodwill as of February 22, 1994 which will effectively increase the cost of their goodwill. Using the basic $100,000 capital gains exemption to create a $100,000 shareholder credit on a tax free basis allows a professional to net $100,000 at an effective tax rate of 23.12%. This results in a large one time tax savings/deferral of $88,077 if the professional would otherwise pay tax at the top tax rate on that income. To net $100,000 to repay the professional, the corporation would only have to earn $130,073 and pay tax of $30,073. For the professional to net $100,000 personally, the professional would otherwise have to earn $218,150 and pay tax of $118,150, assuming the professional pays tax at the top marginal rate. 41 The Law Society of British Columbia 15 June, 2002
Selling goodwill to a professional corporation before 1972 was attractive because there was no tax on the sale of goodwill. Needless to say, before 1972 this practice was popular and was abused by some taxpayers. Revenue Canada challenged some of these sales, both with and without success, on the basis that the taxpayer was appropriating property from the corporation by getting back excessive value for the sale of goodwill to the corporation. These taxpayers were reassessed under subsection 15(1) of the Act. 42 In recent years there have been many arms length sales of professional goodwill for significant amounts which demonstrate that many professionals have significant saleable goodwill. However, there is an inherent risk in valuing the fair market value of the goodwill sold to professional corporations by certain professionals. If it turns out that the professional s goodwill in fact has no value because it is purely personal, then instead of creating a tax free shareholder credit of $100,000, the professional will be considered to have received a fully taxable shareholder appropriation of $100,000 resulting in tax of $54,160. This would be highly undesirable because $29,601 of corporate tax would have to be paid by the professional corporation before it could pay the professional $100,000, such that the total cost of netting $100,000 would be tax of $83,761. The valuation issue is even more acute where a gain is created by fling an election under subsection 110.6(19) 43 of the Act because of the 110% rule. That rule is designed to prevent individuals from electing upon unrealistically high values by reducing the cost of any such assets by the amount that the elected amount exceeds 110% of the fair market value of the asset. Pursuant to subsection 14(9) of the Act, this can result in an immediate business income inclusion under paragraph 14(1)(a) of the Act. Finally, a professional is not limited to using the basic lifetime capital gain by selling goodwill to a professional corporation. Rather, a professional might consider selling capital assets to the professional corporation that have additional adjusted cost base by virtue of making the The Law Society of British Columbia 16 June, 2002
110.6(19) election. If these assets are shares, then subsection 84.1(1) must be considered and in all cases the corporate attribution rule in section 74.4 must be considered. Loss of Tax Deferral or Reserve Historically the biggest impediment to incorporation has been the loss of tax deferral suffered by the professional upon incorporation. The problem is now the loss of the proposed 10 year reserve for December 31, 1995 income. Most professionals have fixed their fiscal year end at January 31 which had the effect of deferring 11 months of income. For instance, income for the fiscal period ending on January 31, 1995 is taxed in 1995 notwithstanding the fact that eleven of those months were earned in 1994. Historically, professionals lost this deferral advantage on incorporation, resulting in the doubling-up of income, because as an employee the professional will pay tax on employment income when the professional receives it. For instance, if a professional began practising as an employee of a professional corporation on February 1, 1995, the professional s income earned from February 1, 1994 to January 31, 1995 would be included in the professional s 1995 taxation year and the professional would also receive 11 months of employment income in 1995. This brings 23 months of income into the professional s 1995 taxation year and the professional needs a strategy to deal with that. The Law Society of British Columbia 17 June, 2002
There are several possible strategies for dealing with this type of cash flow problem: (i) (ii) (iii) salary and dividend withdrawal from the professional corporation would be limited during the initial year(s) of incorporation by the professional living off savings; shareholder loans and deferred bonuses could be used (note that the professional will be assessed a deemed interest benefit on the shareholder loans under subsections 15(1) and 80.4(1) of the Act and if loan is outstanding for long it may be added into the professional s income under subsection 15(2)); or the $100,000 capital gains exemption could be utilized on the sale of goodwill, or other asset, to the professional corporation to create a large shareholder loan which could be withdrawn tax-free. Due to the changes proposed in the 1995 Federal Budget for fiscal periods that end after 1995, a professional can no longer take advantage of subsection 25(1) of the Act. That subsection provided for an election that permitted certain professionals to extend a shortened fiscal period so that it would end on the date that it would normally have ended and effectively spread the doubling up problem over two years. The new ten year reserve for December 31, 1995 business income will be lost for professionals who incorporate because carrying on a profession will not be a substituted business for the purposes of proposed subsection 34.2(3). However, as professionals gradually become more current in their taxes as more of the section 34.2 reserve is included in their income, it will become easier to incorporate and for that reason there will be many more professional corporations in ten years. The Law Society of British Columbia 18 June, 2002
VII. Management Corporations Management corporations were at one time the most common tax planning structure used by professionals. With the advent of GST, and to a lesser extent the use of professional corporations, the number of management corporations has decreased significantly. For all but the smallest firms, management corporations still provide a relatively simple means to both defer tax and income split. The main limitations of management corporations are their limited earning capacity and the increased GST expense which is not recoverable for professionals involved in certain health care professions which provide exempt supplies. Nevertheless, there are still many situations where the use of management corporations should be considered. The limitation on the profitability of management companies is that the markup charged to the professional firm must be reasonable. To the extent the markup is not reasonable that portion of the deduction claimed by the professional firm could be disallowed pursuant to subsection 69(1) resulting in double taxation because additional tax would be payable by the firm and even though the management company would still be taxed on all its income. The reasonableness of management fees was an area of considerable debate until about fifteen years ago. Revenue Canada now generally accepts that a 15% markup can be charged on nonprofessional services provided by a non-arms length management corporation to a sole proprietor or partnership. 44 Revenue Canada takes the position that the markup cannot be applied on expenses that are directly attributable to the practice of the profession such as salary of professional employees, professional fees and dues, eduction costs and malpractice insurance. If the markup is higher than 15% then it may be subject to challenge. The 15% markup is simply a administrative guideline and not a level determined by the courts as each case will turn on its facts. 45 The 15% management fee generally represents active business income that qualifies for the low rate of tax on the first $200,000 of active business income earned by a Canadian-controlled private corporation and that is the key to a management corporation working as a tax efficient structure. Income of a management corporation will not qualify for the low rate of tax if it is either specified investment business income or personal service business income. These types of income are taxed at a rate of 52.29% 46 rather than 23.12%. If a management corporation has less than five full time employees throughout the year then there will be a risk that its income will be specified investment business income or possibly personal service business income. The specified investment business classification will apply if the principal purpose 47 of the management corporation s business is to earn income from property (interest, dividends, rents but not leasing personal property or royalties) and it does not have more than five full time employees employed throughout the year. In Revenue Canada s view the principal purpose of a corporation s business must be determined annually by considering the original purpose for commencing the business, the history of the business, and the manner in which the business is currently carried on. There is sometimes a risk that the specified investment business characterization will apply to a small management corporation which has less than five full-time The Law Society of British Columbia 19 June, 2002