As part of the 2023 Federal Budget, the department of Finance introduced amendments to the General Anti Avoidance Rule (GAAR) to give the CRA more ammunition in combating what they see as abusive transactions. These amendments will become effective as of January 1, 2024.
The application of GAAR, as it exists today, can be determined by a three-prong test established through the Supreme Court of Canada where the following are applicable:
- a tax benefit arises from a transaction (or series of transactions),
- the primary purpose of the transaction is to obtain a tax benefit, and
- the transaction is found to be abusive meaning it is not within the spirit of the Income Tax Act.
The changes to the GAAR in the 2023 budget are to amend the “primary purpose” threshold to “one of the main purposes” which will cast a larger net. They have also introduced an economic substance rule for determining if there has been an abuse or misuse, so transactions lacking economic substance will be presumed to be an avoidance transaction.
There was also an addition of a penalty equal to 25% of the benefit obtained where GAAR applies unless the transaction was reported under the new disclosure requirements.
What this means to taxpayers is that anyone considering a surplus strip should consider doing so before December 31, 2023.
Background on Surplus Stripping:
In recent years many business owners have been looking for a tax efficient way of removing funds from their corporations. As the federal deficit increases and the government looks at ways to increase taxes, this type of tax planning will become more and more important. One of the strategies that is currently being utilized is Capital Gains Strip (CGS).
What is a Capital Gains Strip (CGS)?
A CGS is a structured transaction that allows for surplus funds to be removed from a corporation as a capital gain as opposed to a dividend. The advantage being that currently capital gains are taxed at a lower rate than dividends.
What is the benefit of a Capital Gains Strip?
The top income tax rate on a capital gain is 26.77% vs the top tax rate on an “other than eligible” dividend which is 47.74%. Let’s assume that an individual that is in a high tax bracket and has $1M of retained earnings in their corporation and wanted to extract those funds for personal use. The traditional method would be to declare a dividend and after tax that individual would be left with $522,600. If this same individual were to draw this amount out through a CGS they would be left with $732,300, which represents a tax savings of $209,700.
What is the downside of a Capital Gains Strip?
The downside of a CGS is that you have to pay the taxes now. A CSG of $1M would result in personal taxes payable of $267,700 in the current year. If the individual did not plan on drawing this money out of the corporation, they could have deferred this tax for some time and you would have to factor in the time value of money as you may be prepaying taxes.
Does a Capital Gains Strip make sense for you?
Anyone that has significant retained earning in their company that they have already taken out or plan on taking out in the short term could likely benefit from CGS planning because you are lowering the rate of tax that you are paying on the money coming out of the corporation.
Another example of an individual that may benefit from a CGS is an individual that has high draws each year and has a significant amount of personal income being taxed in the highest tax bracket. This individual can also benefit from a CGS by converting their annual income from salary or dividends into a capital gain and benefiting from the lower tax rate outlined above.
