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Last updated: Sep. 22, 2017
FBC’s tax team has analyzed the looming changes for tax legislation being tabled by the federal government.
There is a lot of rhetoric and emotion around the legislation; in addition to much confusion on its impact.
Our tax consultants and advisors are receiving many questions about the changes.
There are many proposed changes which can lead to higher taxes; but 3 key items stand out:
- Sharing income among your family may increase annual tax bills.
- You may be taxed on excess cash reserves (also referred to as passive investment income) you set aside in your business.
- When you transfer your business to your children you may pay substantially higher taxes.
Our team has drafted scenarios to help illustrate the potential impact.
The Smith Family
As 2018 winds down, John and his wife Jane wrap up their 30th year of operating their farm. Both work full time hours carrying about $500,000 of annual operating expenses.
Their two children, Pat and Susan (aged 22 and 18 respectively), also contribute significantly. Each works seasonally during the year, working out to on average 25 hours/week during the calendar year.
With current tax planning strategies, the Smith’s pay themselves a monthly draw. At year end they work with a tax advisor to determine net income.
They declare dividends and split them among four family members; and leave excess cash inside their business.
In 2018, the Smiths paid themselves a combined $200,000 in dividends and grew their cash reserves by $200,000 for future “rainy days”. Their cash reserves now sit at $400,000.
The Smiths Are Asked to Pay $7,500 in Additional Taxes
In 2018, the Smiths split the dividend income by paying $60,000 to both Jane and John, and $50,000 to each child representing the shared workload.
They expect to pay approximately $68,000 in taxes.
But CRA deems the income allocated to the two kids is unreasonable. They rule 85% of the income must be allocated to John and Jane and 7.5% allocation to each child.
The new tax bill is $75,500.
This occurs because the proposed legislation doesn’t define what is acceptable income splitting with children and CRA decides on an appropriate split.
Excess Cash Reserves
The Smiths Are Asked to Pay $22,000 in Additional Taxes
In 2019, the Smiths want to purchase a truck for Pat who is entering university and withdraw dividends of $100,000.
CRA determines that $300,000 is sufficient cash reserves for their farm at year end (vs. $400,000). The difference, $100,000, is deemed “passive” investment income.
They are asked to pay $73,000 in combined corporate and personal taxes on those dividends.
Under current rules they would have only paid combined taxes of $51,000.
This occurs because legislation puts the onus on the business owner to prove what are acceptable cash reserves. But CRA has ultimate decision-making powers to decide what is appropriate.
If CRA classifies some of your cash reserves as passive investment income, you are taxed at the new higher rate when withdrawing those funds.
Note: the consultation papers haven’t specified the new, increased rates but tax analysts across Canada are estimating it will be 73%.
Intergenerational Transfers
Susan Is Asked to Pay $215,000 in Additional Taxes
It’s now 2021. After 33 years, John and Jane are retiring and decide to transfer the farm to Susan, now 21, who wants to operate the farm.
Three years after the transfer, Susan decides she’d rather become a veterinarian and sells the farm. The land in the sale is valued at $1,000,000. Note: The original cost of the farm land was a nominal value.
Susan will have to pay taxes totaling $215,000.
Under today’s rules she would have paid no taxes as the first $1 million of land valuation is exempt from tax.
This higher tax bill occurs because under the proposed changes, capital gains accumulated on land prior to Susan turning 18 is not eligible for the exemption.
In total, the family owned the farm for 33 years. When Susan sells the land, she can only claim a pro-rated capital gain exemption on 3 of the 33 years of accrued gains.
The fact Jane and John owned the land for 30 years of this ownership period does not matter.
In our example, instead of $1,000,000 exemption, Susan is only eligible for a $151,515 exemption resulting in a massive tax bill.
Summary
These scenarios are hypothetical situations and used for illustration purposes only. The impact to you could be smaller or larger depending on your personal circumstances and where you reside.
But we hope these scenarios help to demonstrate the negative impact these legislative changes can have on your farming operation.
Should you have any questions about how this tax legislation will impact you, feel free to contact your FBC tax advisor.
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