Invesco Fundamentals – Page 3

New 33% tax bracket effect on passive income in private corporations

No doubt there was disappointment in the business quarter when the 2016 Federal Budget held the small business corporate tax rate at 10.5%. It was scheduled to decline by half points to reach 9% in 2019. Taking an optimistic view, this may only be a reflective pause, given that the Liberal government had earlier stated its intention to reduce the rate to that level. We shall see.

The news is even less rosy for those same business owners when considering the implications of the new 33% top bracket tax rate that was ushered in with the “middle class tax cut.” Not only will this new rate apply to personal income over $200,000, it also affects passive income inside their corporations. And the impact could be most costly to the smallest of those small business owners if they fail to adjust how they manage their corporate investments.

Corporate-personal tax integration

The proper functioning of our tax system is based in part on the integration of personal and corporate taxes. Absent such a coordinated approach, the use of a private corporation – especially a Canadian-controlled private corporation (CCPC) that uses the small business tax rate – could lead to unintended tax benefits or unfair tax costs.

Integration is carried out using a number of mechanisms at the corporate level and on passing income from corporation to individual as shareholder. Business owners would have some familiarity with integration when they think of the following two-stage process of how their dividends are taxed:

The grossed-up dividend is the amount used to calculate the shareholder’s initial tax due as if he or she had earned the income out of which the corporation paid the dividend
This initial amount is reduced by the dividend tax credit (representing the tax revenue the Canada Revenue Agency (CRA) already collected from the corporation) to arrive at the shareholder’s net tax bill

Tax system’s response to passive corporate income

While the gross-up/tax-credit process applies on a dividend distribution from corporation to individual, there remains the matter of how to deal with undistributed income.

When that income is reinvested to generate more business income, there is no problem from a tax policy perspective. Indeed, one of the main purposes of the small business rate (which is actually in the form of a deduction from the general corporate rate) is to enable greater reinvestment and business growth than would otherwise be the case if a higher tax rate applied, whether the business was run as a sole proprietorship or through a corporation.

But where excess corporate cash is not going back into operations and instead placed into portfolio investments, a problem arises. As only the corporate portion of the ultimate tax bill has yet been paid, more cash is being passively invested than would be possible in the shareholder’s hands. As the small business rate is intended as a business booster and not a portfolio bonus, the tax system’s answer is to impose a tax cost that emulates the corporation as a top-bracket personal taxpayer. In a sense, it is the reverse of the gross-up on dividends, but in a much more complex way.

Integration mechanisms, 2016 and beyond

Not only is a CCPC not entitled to use the small business deduction on its investment income, but it also faces an additional tax on that income, specifically the Part I refundable tax. This is tracked in the corporation’s tax records as refundable dividend tax on hand (RDTOH), a portion of which is refunded from the CRA to the corporation when taxable dividends are paid to shareholders. However, Canada-sourced dividends are subject to a different rate as Part IV tax, all of which is refundable. On the other hand, foreign dividends are given a reduced RDTOH credit.

Suffice it to say, there are a lot of moving parts, the full details of which are beyond the scope of this brief article. As to the changes, the increase in the top personal tax rate from 29% to 33% necessitates adjustments to these integration mechanisms, the clearest illustration being the four-percentage-point increase in the Part I refundable tax. The rest of the changes are produced here for reference, without getting into the underlying calculations.

Taken together, the changes make it a bit more punitive to earn investment income in a CCPC beginning in 2016. A shareholder whose personal income tax bracket is below $200,000 should take particular note, and perhaps consider adjusting how and when income is taken out of a corporation. And for all affected corporations, a closer look at the tax efficiency of investment choices in corporate accounts may be in order, to explore if and how exposure to RDTOH may be mitigated.

TABLE: Corporate-personal integration mechanisms

When to revise your Will

Do new rules for trust taxation warrant a review?

For some people, even the thought of creating a Will casts a pall over their mood. Yes, a Will deals with a person’s death, but the broader process of estate planning is about caring for the most important people in your life, and having an up-to-date Will is central in that process.

But how do you know if you are really “up to date”?

While there’s no black-and-white answer to that question, there are principles that can be used as a guide. And within that inquiry, recent changes to the taxation of trusts may be sufficient to prompt a review and potentially a revision.

When to have a Will

Estate planning is about taking care of yourself now and in the future, and taking care of the people around you – now, in the future and when you are no longer there.

Sometimes the need for a Will is obvious: There is a significant other or a child, or a house or business with employees. Consider though a parent forced to deal with the intestacy of a twenty-something child, or an unanticipated large insurance payout or court award from an accidental death.

In my opinion, everyone who is legally capable of executing a Will should do so.

Having a Will provides certainty, not just about who will receive what, but also because it allows for tailored planning of when an inheritance will be distributed, and how the process will be managed. In this last respect, there is little ability to manage tax concerns without having worked through the issues ahead of time and having executed a Will designed to manage remaining contingencies.

When to review your Will

What then may prompt the review of a Will? (And when I say “prompt,” I am suggesting that a call to your lawyer may be in order to ask whether there is a need to discuss implications.) I would put it into the following three categories, in order of priority:

Changes to the people

This includes you, a dependent, a Will beneficiary, an immediate family member (whether or not a beneficiary), an executor, or a trustee or guardian
Beginning or end of a close personal relationship, whether or not legally married
A birth, adoption, death, mental capacity concern or significant health event
Immigration, emigration or change in citizenship
A change in liability exposure, such as a bankruptcy, being joined in a lawsuit, signing a guarantee or starting a business

Changes to the property

Sale of a large asset, especially if it is the subject of a specific Will bequest
A windfall, such as an inheritance, court award or lottery prize
A theft, loss or consumption, including a marked decline in or withdrawal from an investment account, especially for an RRSP/RRIF plan where a beneficiary designation factored into inclusion or exclusion of beneficiaries in a Will
Ownership change or transfer, including loans or gifts to Will beneficiaries, a change to bank signing authority, or addition of a joint owner on investments or real estate
Cancellation or loss of life insurance (for example, on retirement from employment) where the plan proceeds or a beneficiary designation factored into Will planning

Passage of time

Even if you and the property have remained effectively the same, the legal landscape may have shifted beneath you. It is difficult to say exactly how much time would be appropriate, but I would suggest no more than five years. The principal sources of law are as follows:

Case law – Judicial decisions where the strategies, circumstances and facts may have relevance to your situation and planning decisions
Provincial law – Changing legal entitlements and administrative processes, for example, Ontario creating a more stringent estate-administration tax-reporting regime and Alberta now treating a marriage as not revoking a pre-existing Will
Federal law – Mainly changes to tax legislation that could have an impact on drafting Wills and on the administration of estates and trusts

Trust tax changes

First proposed in the 2013 Federal Budget and passed into law in 2014, as of the beginning of 2016, testamentary trusts have lost most of their previous tax preferences.

A testamentary trust is created under a person’s Will. Up to the end of 2015, such a trust was entitled to graduated-tax-bracket treatment, similar to an individual’s personal tax treatment. Though taxable from its first dollar of income, the trust would initially be subject to the lowest combined federal-provincial rate then work its way up through the tax brackets. As of 2016, the top federal-provincial rate – near or exceeding 50% in most provinces – applies throughout.

There are two key exceptions to the new rules, bringing two new acronyms into the lexicon:

Graduated rate estate (GRE) – For the first 36 months of a deceased’s estate, graduated tax brackets will remain available. However, the rules are complex, and if not carefully navigated, the preferential treatment may be lost
Qualified disability trust (QDT) – Ongoing graduated-tax-bracket treatment may be available to a testamentary trust with a beneficiary who is qualified for the disability tax credit

In the past, an estate-planning lawyer may have recommended the creation of one or more testamentary trusts and drafted the Will accordingly. Today, those trusts may have little or no benefit and may turn out to be an impediment to efficient estate administration. For those who have benefited from what was good planning in the past, it may be time to call the lawyer and discuss appropriate planning in this new environment.

Selling an advisor’s book [3/8]– Getting the best price

[Eight-part series, current to publication date only]
1 – Why and how do we prepare
2 – Finding the right buyer
3 – Getting the best price
4 – Tax issues overview
5 – Incorporation issues overview
6 – Caveats and limitations
7 – Selling when incorporated vs. unincorporated?
8 – Ways to get paid

3 – Getting the best price

So far, we’ve reviewed general tax and legal considerations when selling your book, as well as common questions buyers and sellers will ask. This article will discuss how to value your book, and how to negotiate with buyers to get the best price.

Both buyers and sellers often want to get to “the number” for a book sale [DASH] whether that refers to a multiple of commissions, percent of assets under administration or other simple calculations. While fundamentally there must be a book of assets to operate on, the makeup of the book and the efficiency of the practice currently housing it can vary widely. Just as an advisor would not recommend that a client purchase a stock or fund based solely on its current dividend yield, these single-criterion measures may be easy to derive, but simplistic in terms of arriving at the true value of a practice.

That said, common rules can constrain parties’ negotiations. Simply put, if a suggested price significantly departs from street wisdom, it may be rejected out of hand. Conversely, a figure that directly mimics one of those quick calculations may be accorded an undeserved air of legitimacy.

It will benefit both parties to establish a negotiating range that reflects the true business proposition. To do that, the usual starting point is to look at free cash flow.

Free cash flow analysis

Free cash flow analysis begins by using the real data of a business to determine its historic gross cash flow. The focus is on the recurring flow, minus the cost to collect it. “Free” cash flow is the net amount in hand that is not required to go back into operations. Armed with this history, you can project the expected future cash flow, as modified by a subjective review of its quality and feasibility.

Having established the expected stream, the next step is to determine current value. This is done by applying an appropriate discount rate (a percentage) in order to commute the stream into a current figure. The discount rate is essentially what a given buyer requires as compensation for using current money to buy a future (and uncertain) payment stream.

When examining an advisor’s practice, a buyer should distinguish between one-time charges and recurring revenue. The buyer will pay for the latter, again based on an expectation of its continuation. Relevant quality criteria might include the consistency and reliability of particular sources, whether receipts have been smooth or lumpy year-to-year, and any observed trends.

Where there’s been growth, the source of that growth is important. Organic growth may be considered as more of a built-in feature as compared to client expansion or turnover.

Lastly, a buyer should expect some attrition, as an ownership change may cause clients to go elsewhere.

Buyer’s capacity

Even with a thorough cash flow analysis, the buyer must still be able to put resources toward making that cash flow happen.

To see if that’s possible, the buyer should gauge the operational capacity of her current practice, including her own time and attention. Can the seller’s book be brought in without having to add resources? And if additional resources will be required, what are they, what will they cost and when can they be put in place? This brings attention back to free cash flow, since it factors into the buyer’s cost of realization, influencing the amount the buyer would be willing to pay.

Negotiation

Getting initial guidance from an experienced lawyer can help an advisor get started on the right foot; greater involvement under a formal retainer can follow. Here are some considerations:

Non-disclosure agreement

Once discussions with a potential buyer have begun in earnest, it’s advisable to have a non-disclosure agreement (NDA). The idea is to preserve confidentiality of any disclosure, and restrict the current and future use of it. Importantly, the agreement should also cover the fact that negotiations are underway, as leaks could unsettle clients and employees. While this obviously serves to protect the seller’s interests, it also benefits the buyer in that it preserves the value the buyer seeks to acquire.

Recitations and terms

It’s common for negotiations to span many months. During the course of those discussions, parties will make statements that may or may not be intended to be relied upon.

A good practice is to jointly build a memorandum of understanding to serves as a continuing check that the parties are seeing eye-to-eye. This document can feed into the formal contract eventually prepared by a lawyer. Once in that form, the respective and mutual premises can be laid out as recitations that form the foundation for what the parties commit to do under the contract terms.

Restrictive covenant

Just as a seller wishes to preserve the practice’s integrity with an NDA during due diligence, a buyer needs to protect the purchased product post-close. This can be achieved through a restrictive covenant in the contract, also known as a non-competition agreement.

A restrictive covenant has four components: who, what, when and where: e.g., the seller will not provide retail investment advice for two years from closing within the province of Manitoba. This example is illustrative only; careful and detailed drafting is required to assure that it clearly records intentions, and that it is enforceable. The Shafron case provides an example of a poorly drafted covenant (see “Shafron v. KRG Insurance Brokers,” below).

Anticipating disputes

Differences of interpretation can arise in even the most amicable situations, and taking a dispute to court can be costly. So, include dispute resolution terms in a contract.

At the same time, parties should understand that finely drafted contract terms may have little effect on an unscrupulous person; if you do not trust your buyer’s commitment, think carefully before committing yourself by executing the contract.

Shafron v. KRG Insurance Brokers, 2009 SCC 6

Shafron sold his property/casualty insurance practice to KRG, after being an employee of KRG and predecessors for 14 years. He executed a restrictive covenant not to compete within the “Metropolitan City of Vancouver.” There was no such legal place. KRG invoked the covenant when Shafron accepted work in Richmond, a municipality bordering the City of Vancouver.

The Supreme Court of Canada ruled that term was unreasonably ambiguous. Courts are not there to read down such provisions, as this could invite parties (particularly employers) to draft overly broad provisions, expecting the court to trim them to what is reasonable.

Note that a higher level of scrutiny is applied where the restrictive covenant is a term within an employment contract, as employers usually have more negotiation power.