How to use BVI or other offshore non-CCPCs to save tax on investment income
Canadian tax lawyer and accountant David Rotfleisch the risks (and rewards) of the British Virgin Islands tax avoidance strategy
TORONTO – Most Canadian small businesses operate as CCPCs (Canadian controlled private corporations) which are entitled to many tax advantages, such as a lower tax rate for active business income up to $500,000 annually. However, there has been a recent trend for wealthy Canadians to convert existing Canadian controlled private corporations to non-CCPC status in order to save tax on the investment income. This has typically taken place through continuing the CCPC in an offshore jurisdiction, typically the British Virgin Islands (BVI).
The Canada Revenue Agency (CRA) is starting to challenge this type of tax arrangement under the General Anti-Avoidance Rule (GAAR) and a small number of cases have been appealed to the Tax Court of Canada by Canadian tax litigation lawyers acting on behalf of the taxpayers. In fact, the Department of Finance's recent proposed draft legislation regarding Income Tax Mandatory Disclosure Rules published in February 2022 specifically targeted transactions that manipulate CCPC status to avoid anti-deferral rules applicable to investment income.
Investment income earned by non-CCPCs is taxed at a lower tax rate
A CCPC is defined in s.125(7) of the Income Tax Act as a private corporation that is not controlled directly or indirectly by any non-resident or public corporation, or a combination of both. Generally speaking, a CCPC has the following tax advantages:
- It is taxed at a much lower rate (12.2% in Ontario) for the first $500,000 of its active business income as opposed to 26.5% for active business income earned by a non-CCPC;
- It is entitled to tax credits equal to 35% of the scientific research and development expenses; and
- A Canadian resident may utilize their lifetime capital gain exemption ($914,000 for 2022) by disposing of their qualifying CCPC shares.
However, the investment income earned by a CCPC is taxed at around 50% so there is no incentive for individuals in a higher tax bracket to earn investment income via a CCPC. This 50% includes an amount paid to a notional account called the Refundable Dividend Tax on Hand (RDTOH) which is designed to prevent corporate tax deferral. All or part of the RDTOH at the end of the tax year is refunded if a corporation pays taxable dividends to its shareholders during the tax year. On the other hand, the combined federal and provincial rate on investment income earned by a non-CCPC is subject to a general corporate tax rate of around 27% (26.5% in Ontario) which offers an opportunity to defer and save tax on investment income.
How to use a non-CCPC for investment income
A fairly recent advanced tax planning strategy for small business owners is to first carry on a business as a CCPC for the tax benefits, and then convert the CCPC into a non-CCPC right before it realizes a capital gain or other investment income so that it will be taxed at lower rate.
There are two ways to create a private corporation that is a resident in Canada but not a CCPC:
- Give voting control to one or more non-residents, or
- Continue the corporation to a foreign jurisdiction while it is still controlled by Canadians.
Regarding the first method, the simplest way is to issue voting shares with no equity value to a non-resident. However, this may not always be available in any given situation.
The second method converts a CCPC into a non-CCPC by continuing into a foreign jurisdiction while the central mind and management of the corporation remains in Canada. Under s.250(5.1) of the Income Tax Act, a continued corporation is treated as having been incorporated in the jurisdiction into which it is continued. For example, a corporation that was originally incorporated in Canada but was subsequently continued to the BVI ceases to be treated as having been incorporated in Canada, therefore it is no longer deemed to be resident in Canada although it may remain resident by keeping its central management and control in Canada. Therefore, it no longer qualifies as a CCPC.
Potential risks from the General Anti-Avoidance Rule (GAAR)
One of the most popular jurisdictions for continuation is the British Virgin Islands (BVI). However, it is the CRA's view that if the sole purpose of switching a corporation to a foreign jurisdiction such as the BVI is to avoid Canadian tax, it is abusive of the Income Tax Act and GAAR should disallow the favourable tax treatment by taxing the investment income at 50% instead of 26.5%. At this moment, our Canadian tax lawyers are aware of four non-CCPC avoidance cases waiting for trial at the Tax Court of Canada with a total amount of tax at issue of about $17 million. This is presumably just a fraction of the actual number of cases utilizing the strategy that have not yet been audited by CRA.
The tax planning strategy to change CCPC status via either continuation of a CCPC into a foreign jurisdiction to become a non-CCPC or issuing skinny voting shares with nominal redeemable amount to non-residents have been implemented many times to help business owners save taxes on investment income. However, the Department of Finance has made it clear in its recent proposed draft legislation regarding Income Tax Mandatory Disclosure Rules that manipulating CCPC status to take advantage of lower tax rates on investment income will be subject to their scrutiny. The publication goes even further by listing the two specific methods mentioned above as examples that will be designated by the CRA for disclosure in prescribed form and manner for the purpose of s.237.4 of the Income Tax Act.
Aside from this, there is still a risk from GAAR and case law hasn't provided enough guidance. The Supreme Court of Canada has made it clear that tax avoidance is not tax evasion and a transaction may not be abusive to the Income Tax Act even if it is designed for a tax avoidance purpose.
David J Rotfleisch, CPA, JD is the founding tax lawyer of Taxpage.com and Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law corporate law firm and is a Certified Specialist in Taxation Law who has completed the CICA in-depth tax planning course. He appears regularly in print, radio and TV and blogs extensively.
With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, cryptocurrency traders, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax audit representation and tax litigation.