TAX ALERT! TAX ALERT!
Finance Minister Bill Morneau announced on Tuesday July 18th that the Liberal government has released draft legislation and a consultation paper for the purpose of amending the Income Tax Act. The objective of the draft legislation is to target tax benefits enjoyed ultimately by the shareholders of private or professional corporations, as in Dentistry Professional Corporations (DPCs). The Liberal government campaigned on a platform which labeled the tax benefits given to these shareholders as “unfair.” If this draft legislation proceeds, it would appear that the government is going to make good on it’s campaign promises and eliminate or limit income splitting, the ability to utilize multiple capital gains exemptions on a single sale, the deferral of passive investment income and the conversion of what would be regular income into a capital gain.
We believe these proposals are significant and will likely have a significant effect on the practice sale market. If you think you might be selling your practice in the next few years, call us so that we can help you strategize around these likely changes at CRA. Some preliminary specifics are as follows:
Effective at the beginning of 2018, private corporations will only be able to pay dividends to shareholders who are actively involved in the business of the corporation. This would eliminate the ability of corporations to pay dividends to non-arms length shareholders who are not involved in the corporation’s business. In other words, this would eliminate the ability of the corporation to distribute a portion of the profits of the corporation to low tax rate shareholders (think non-involved spouses and children and presumably trusts). Essentially the purpose is to ensure that all individuals receiving dividends will be paying tax at the highest possible tax rate. Anticipate some degree of uncertainly around the definition of “actively involved”.
Multiple Capital Gains Exemption
Effective July 18, 2017, assuming the legislation is enacted, the use of the Capital Gains Exemption will not be available to family trusts and non-active adult shareholders, presumably based on the same reasonableness test applied to the proposed income splitting restrictions. This will eliminate the tax planning strategy of having multiple family members as shareholders of a DPC with the intent of utilizing multiple Capital Gains Exemptions on the sale of the DPC.
Many of our clients spend less than they make, and as a result, have sizable investments within their DPCs. Professional corporations currently pay a much lower rate of tax (15.5% in Ontario) on their profits than individuals would on similar profits (variable but assume about 40% to 45%). The proposed legislation would increase the tax rates such that the corporation, or its shareholders, would lose the benefit of investing low rate retained earnings within the corporation. It appears that the execution of this proposal will be complex and beyond the scope of this TAX ALERT.
Regular Income Conversions
The most normal way of personally withdrawing profits from a professional corporation is by way of salary, management fees or dividends. Each of these methods will become “regular” taxable income in the hands of the recipients. In some cases, a vendor, on the sale of their practice or DPC, will inflate the price by the amount of the cash equivalent of the DPCs investments. This has the effect of converting retained earnings that would normally be regular taxable income on withdrawal from the DPC into capital gains on the sale of the DPC. This would mean that one half of the capital gain would be received by the vendor tax free – a very significant tax savings. When this strategy is used, it is often used between related parties. The proposed draft legislation which would take effect July 18th, 2017 would eliminate the ability of such a transaction.
What Does All Of This Mean?
This obviously means that the tax life of DPC owners will become more complicated. It also means that dental practice ownership will become less profitable and generate less after-tax cash flow for their owners. Dental practices will become less profitable, and by all rights, the lower after-tax returns will result in downward pressure on the value of dental practices. All of this is coming with a backdrop of increasing interest rates which will also have a negative impact on practice values.
By way of final thought, it is very clear that the Liberal government is making good on its promises of increasing the tax burden of professionals, particularly dentists. Any dentist thinking of selling within the next couple of years should be selling now in an effort to avoid these, and any further negative changes, to the tax act which could further affect the values being seen today.
If you have a dental practice that you think you may sell within the next few years, call Derek Hill or Cassandra Paolella at 905-984-5816 or toll-free at 866-853-5344 so we can help properly plan your timing in light of the coming changes as set out above.
Please note we are not tax lawyers or tax advisors; the above is our interpretation of a variety of tax briefs provided by a number of different sources. We urge all dentists with professional corporations to contact their tax advisors in a very timely fashion.