Federal budget measures put surplus stripping at risk

With the new raft of tax measures unveiled in the federal budget last week, Canadian business owners and incorporated professionals may be seeing the end of a strategy to lessen the tax bite from taking large amounts of cash out of their private corporations.

The capital gains strip, otherwise known as surplus stripping, involves a series of transactions through which money is extracted as part capital gains, part taxable dividends from a corporation.

“It's usually about satisfying cash flow needs in the short term … specifically, if someone needs a lump sum in the next few years,” says Andrew Feindel, portfolio manager and investment advisor at Richie Feindel Wealth Management with Richardson Wealth (pictured above, left). “A perfect candidate for a capital gains strip could be someone who wants to buy a cottage and wants to buy it personally, or if they’re making a down payment for a home, where they need a significant chunk out of their corp.”

Feindel and his partner, Kyle Richie, work with doctors at their practice. To consider surplus stripping as an option, they look at situations where millions of dollars would be taken from the corporation, and most of the client’s money is in the corporation.

“It's all about getting that lump sum in a less tax-damaging way than the normal course, which is to take it out in dividends,” Richie (above, right) says. “For those who don’t need a large lump sum, have other adequate CDA, or are withdrawing less than $300,000 per year in dividends, we would not recommend surplus stripping.”

The capital gains strip has gained increased attention since 2017, when the federal government first floated a “tax fairness” regime which would have killed the strategy. The government quickly pedalled back from that plan after discovering it would have sideswiped farmers and threatened inter-generational succession planning for business owners more broadly.

Now, surplus stripping is at risk once again. While the most recent federal budget doesn’t contain measures targeting the strategy specifically, some of the changes can limit the strategy’s application for Canadian controlled private corporations.

“To the extent that the budget changes will narrow the range of permissible share sales that qualify for capital gains treatment (and instead are treated as deemed dividends), that can be viewed as curtailing possible surplus-stripping strategies,” Brian Ernewein, senior advisor, National Tax at KPMG in Canada, told Wealth Professional.

The federal government’s announcement regarding alternative minimum tax rules is another potential point of concern for surplus stripping. According to Ernewein, the changes to the AMT may have some impact on the tax treatment of capital gains, including capital gains on private-company share transfers.

“In requiring 100% of capital gains (other than gains qualifying for the lifetime capital gains exemption) to be included in the AMT base, and raising the AMT tax rate to 20.5%, large amounts of capital gains may become subject to a tax rate nearly 25% higher than the top ‘regular’ personal tax rate that currently applies,” Ernewein says.

The federal budget’s proposals to amend the general anti-avoidance rule (GAAR) may also be a potential concern for planning around surplus stripping, KPMG in Canada told WP. But since the proposed GAAR changes raise numerous policy and interpretive issues, it’s unclear exactly what impact, if any, a revised GAAR may have.

According to Feindel and Richie, the changes announced in the budget effectively rule out the capital gains strip as a planning option for doctors in almost every scenario. As the new rules are set to take effect on January 1, 2024, that could create a sense of urgency for those who want to use the option while it’s still on the table – though they don’t encourage that thinking.

“I've respectfully disagreed with people who have done it because they thought the government might shut down the option at some point. Yes, they got money out of their corporation. But that wasn't their goal,” Feindel says. “I personally believe capital gains strips analysis should be done by a financial planner, someone who’s aware of the pros and cons. It’s certainly not a solution that fits everyone in all situations.”