Canada’s new Liberal government unveiled its first federal budget on March 22, 2016, headlined by a $29.4 billion deficit and plenty of spending measures designed to help the middle class. For high-net-worth investors and small business owners, however, the document also closes some lucrative tax incentives.
RBC Wealth Management Services was in Ottawa and participated in the federal budget lockup, giving an insider’s view of what our clients need to know.
Here are five items that could impact both your returns and your business.
1. Rescinding the small-business tax cut
Perhaps one of the bigger surprises in the budget was the decision to go back on a campaign promise to stick to progressive cuts in the small-business tax, previously legislated by the Harper Conservatives.
The Liberals had been expected to cut the rate – which applies to the first $500,000 of qualifying business income – as part of a multi-year decrease to nine percent by 2019. Instead, they will maintain the status quo of 10.5 percent, and the Liberals will amend legislation to keep it that way for the foreseeable future.
2. Switch funds
The budget will also make it more difficult to benefit from tax-efficient corporate class mutual funds, or “switch funds”. Typically, mutual funds are structured as individual trusts, but with switch funds, the mutual funds are structured as a corporation, with several funds within one corporate entity. This allows investors to shift between funds without realizing an actual sale, which would then trigger taxable gains or losses.
“If I wanted to rebalance my portfolio, but I don’t actually want to realize the gains, I can change to a different fund within that corporate class structure,” says Lily Chau, a financial advisory consultant at RBC Wealth Management.
The fund structure is popular with business owners or high-net-worth investors who have already used up their registered plan limits.
The new budget will bring that tax-advantage strategy to an end, and force the investor to realize the gain even if they switch funds within the corporate structure.
3. Linked notes
Also targeted are linked notes, which are debt obligations where the return on the note is linked to the performance of one or more reference assets or indexes. They’re popular among some investors as a low-risk investment that provides exposure to a variety of asset classes.
Because of its structure, the return on the note is constantly in flux and can usually only be determined shortly before it matures. And since the return is variable, investors don’t have to report the interest each year until the point when it actually matures, which is when all returns are reported.
“What investors do is actually sell it right before it matures, and then they can claim a capital gain instead of interest income,” says Chau. This strategy can be lucrative, she adds, because capital gains are taxed at 50 percent, while interest income is taxed at 100 percent.
Investors do this on a secondary market, which has been created by financial institutions so that investors can sell off the notes.
Beginning in October, investors will have to report part of the gain as interest income.
4. Small-business partnerships
The Liberals are also bringing to end a complicated tax advantage that has benefited certain small businesses and partnerships structured in such a way that multiplies access to the small business deduction (which lowers the corporate tax rate on active business income). These structures can be popular with professional firms, such as law firms or accounting firms.
While associated corporations or corporate partners have been expected to all share one $500,000 small-business deduction, some businesses have gotten around this by structuring themselves so as not to be associated with each other or be a corporate partner.
“People would structure their businesses in a way so as not to be associated, and therefore they would have several kicks at the can for the $500,000,” says Micaela De Goeas, a financial advisory consultant at RBC Wealth Management.
A simplistic example could be: Two companies owned by two different family members that work closely in conjunction with each other, like a supplier-producer relationship, which would allow each side of the business to qualify for its own $500,000 limit and the lower tax rate it allows.
As an example, in the case of an accounting firm, each accountant would incorporate him or herself and their professional corporation would provide services to the larger partnership. The professional would be a member of the partnership but their incorporated professional corporation would not be a corporate partner. Since each professional corporation is earning active business income and they are not a corporate partner, each corporation can claim their own small-business deduction.
Under the new rules, essentially, the professional corporations in a scenario as described above will have to share one $500,000 small business deduction. These new rules could have an effect on certain doctors, dentists, lawyers, accountants and others who structure their businesses in this way.
5. Corporate life insurance policies
Another move by the Liberal government closes loopholes that could impact the benefits to private companies who are beneficiaries of life insurance policies on their owners, which is often done to make sure the business can continue in the event of an unexpected death.
The rules allow a corporation to add an amount to their capital dividend account equal to the death benefit from the life insurance policy minus the adjusted costs base of the policy to the corporation. If the capital dividend account is positive, the company could pay out a tax-free dividend to the owners.
Previously, corporations could keep a lid on costs by structuring the policy so it’s actually owned outside of the corporation while keeping the corporation as the beneficiary.
“That way when the person dies and the policy pays into the corporation, the corporation doesn’t have an adjusted cost base, so it’s able to add all of the proceeds to the capital dividend account, and therefore pay out more tax-free to shareholders,” says De Goeas.
The new rules will change the amount that gets added to the capital dividend account of the corporation if the policy is not owned by the corporation.
Under the new rules, the adjusted cost base will affect the amount of the payout regardless of whether the corporation owns the policy or not.
This document has been prepared for use by the RBC Wealth Management member companies, RBC Dominion Securities Inc. (RBC DS)*, RBC Phillips, Hager & North Investment Counsel Inc. (RBC PH&N IC), RBC Global Asset Management Inc. (RBC GAM), Royal Trust Corporation of Canada and The Royal Trust Company (collectively, the “Companies”) and their affiliates, RBC Direct Investing Inc. (RBC DI) *, RBC Wealth Management Financial Services Inc. (RBC WM FS) and Royal Mutual Funds Inc. (RMFI). Each of the Companies, their affiliates and the Royal Bank of Canada are separate corporate entities which are affiliated. *Members-Canadian Investor Protection Fund. “RBC advisor” refers to Private Bankers who are employees of Royal Bank of Canada and mutual fund representatives of RMFI, Investment Counsellors who are employees of RBC PH&N IC, Senior Trust Advisors and Trust Officers who are employees of The Royal Trust Company or Royal Trust Corporation of Canada, or Investment Advisors who are employees of RBC DS. In Quebec, financial planning services are provided by RMFI or RBC WM FS and each is licensed as a financial services firm in that province. In the rest of Canada, financial planning services are available through RMFI, Royal Trust Corporation of Canada, The Royal Trust Company, or RBC DS. Royal Trust are provided by Royal Trust Corporation of Canada and The Royal Trust Company. If specific products or services are not offered by one of the Companies or RMFI, clients may request a referral to another RBC partner. Insurance products are offered through RBC Wealth Management Financial Services Inc., a subsidiary of RBC Dominion Securities Inc. When providing life insurance products in all provinces except Quebec, Investment Advisors are acting as Insurance Representatives of RBC Wealth Management Financial Services Inc. In Quebec, Investment Advisors are acting as Financial Security Advisors of RBC Wealth Management Financial Services Inc. RBC Wealth Management Financial Services Inc. is licensed as a financial services firm in the province of Quebec. The strategies, advice and technical content in this publication are provided for the general guidance and benefit of our clients, based on information believed to be accurate and complete, but we cannot guarantee its accuracy or completeness. This publication is not intended as nor does it constitute tax or legal advice. Readers should consult a qualified legal, tax or other professional advisor when planning to implement a strategy. This will ensure that their individual circumstances have been considered properly and that action is taken on the latest available information. Interest rates, market conditions, tax rules, and other investment factors are subject to change. This information is not investment advice and should only be used in conjunction with a discussion with your RBC advisor. None of the Companies, RMFI, RBC WM FS, RBC DI, Royal Bank of Canada or any of its affiliates or any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. ® Registered trademarks of Royal Bank of Canada. Used under license. © 2016 Royal Bank of Canada. All rights reserved.