Avoiding the Power of Attorney Tax Trap
One of the last problems you’d expect creating a power of attorney is suddenly to find your company losing a bunch of tax advantages because the Canada Revenue Agency decides you and the person you appointed in the power of attorney have related companies.
If your company is small and Canadian-controlled, it gets certain tax advantages; however, CRA doesn’t want you to break a large company into a bunch of small pieces to multiply those tax advantages. If you give each of those pieces to a different person, but maintain control through powers of attorney, CRA will still consider all those pieces to be one company.
Unfortunately, CRA doesn’t recognize the difference between a general power of attorney used to control a company, and an enduring power of attorney used to help someone when they’re incapacitated.
Here’s an example of the trap that can happen if you’re not careful with a power of attorney:
(Disclaimer: this is not tax advice; it is a simplified illustration of the small business tax rules and how they’re applied with respect to control and powers of attorney.)
I’ll give you two scenarios. The first one illustrates what CRA is trying to avoid, and the second one illustrates what it catches by accident.
First Scenario: Avoiding Multiplication of the Small Business Deduction
Patricia Hindenburg has three adult children: Roberta, Paulina, and Bonzo. She runs a clothing company, Whole Lotta Cashmere Fashions Inc., with stores in the Kitsilano, Yaletown, Commercial Drive, and Marpole neighbourhoods. Whole Lotta Cashmere Fashions is doing very well. Last year, it earned $2,400,000 before tax. The company is a Canadian-Controlled Private Corporation (CCPC), and is eligible for the Small Business Deduction. The Small Business Deduction means that instead of paying about 35% income tax on $2.4M, Whole Lotta Cashmere Fashions only pays that on $1.9M. The first $500,000 is taxed at about 10%. (Again, these are not the real tax rates and I’m simplifying the calculations.)
Patricia realizes that if she split the company into four companies, each owned by a different person, the companies would together pay 10% on $2,000,000, and only $400,000 would be caught by the higher tax rate. She splits the company into four, giving one to each of her children and keeping one for herself. This way, each of the four companies will be eligible for the Small Business Deduction – each will only pay 10% on its first $500,000 of earnings.
To make sure that the companies remain successful and operating just the way she likes, Patricia asks her kids each to grant her power of attorney over their voting shares in their companies.
She now has control over all four companies. Their combined income is still around $2,400,000; but she believes the collection of companies has a Small Business Deduction of $2,000,000 instead of $500,000. She expects to pay 10% on $2,000,000 and 35% on $400,000.
CRA does not allow this. Because of the powers of attorney that give Patricia control over all of the companies, CRA taxes them as one big company the same way it did before the split.
This seems fair. If the companies are truly independent, they should each get the Small Business Deduction; but if you split a big company into a bunch of smaller ones and you maintain control over them, you don’t get a bunch of Small Business Deductions.
Second Scenario: Getting Tax-Trapped in Incapacity Planning
Stephanie Edwards has a metalworks shop, Icarus Metalworks Inc., that is doing very well. She has apprenticed each of her five children, Adriana, Murray, Nicole, Dickens, and Jan, in the art and trade of blacksmithing.
A few years ago, Adriana and Dickens decided they prefer ceramics, and they opened their own company, Can I Play With Porcelain Ltd.
Last year, Icarus earned $700,000. Can I Play With Porcelain did pretty well too; it earned about $450,000.
Icarus should pay 10% on the first $500,000, and 35% on the remaining $200,000. Can I Play With Porcelain is under the limit for the Small Business Deduction, and should only pay 10% on all $450,000 of its earnings.
Unfortunately, after all these years of literally bending iron and steel to her will, Stephanie has serious joint problems. She is finding it hard to write. This has her thinking about making sure her kids can take care of things for her if (and when) she’s unable.
Stephanie thinks carefully about her kids, and who would be in the best position to help her. She decides to grant an enduring power of attorney to her eldest, Adriana. The power of attorney is, as is the case with most enduring powers of attorney, unrestricted and it is effective from the moment it is signed. Stephanie wants to make sure that Adriana can help her even while her mind is still capable, because she doesn’t know for how much longer she’ll be able to sign cheques, etc., given her joint problems.
Here’s the trap:
The CRA determines that the power of attorney allows Adriana to use Stephanie’s shares to control Icarus. This is true – Adriana can do anything on behalf of Stephanie that has to do with finances (including business, real estate, and legal matters).
Icarus Metalworks Inc. and Can I Play With Porcelain Ltd. are now considered related companies. Can I Play With Porcelain Ltd. loses its Small Business Deduction. Between the two companies, the first $500,000 is taxed at 10% and the remaining $650,000 is taxed at 35%.
Is there a way around this? YES!
We prepare two powers of attorney, both enduring, both restricted (in exactly opposite ways), and we make one of them “springing.” (I’ll explain what that means in a moment.)
Main Enduring Power of Attorney:
Stephanie grants an enduring power of attorney to Adriana, effective immediately, and without any limits or restrictions except that Adriana may not use it to vote or in any other way act on Stephanie’s shares of her company, Icarus Metalworks Inc.
This will probably cover about 95% of what Stephanie needs Adriana to do.
Springing Enduring Power of Attorney:
Eventually, Stephanie may lose capacity and need Adriana to take control of her company. At that point, the benefit of Adriana controlling Stephanie’s shares will outweigh the tax consequences. There’s also the slim hope that by then, the Income Tax Act will be amended so as not to catch enduring powers of attorney anymore.
Stephanie grants a second enduring power of attorney to Adriana, but this one has two limitations in it.
It only applies to Stephanie’s shares of her company to avoid any confusion regarding which power of attorney applies in any given situation.
Also, it is not effective until Stephanie loses capacity. This is called a “springing” power of attorney. It springs into effect only when Stephanie is no longer capable of managing her affairs.
This prevents CRA from considering the companies to be related until it’s absolutely necessary, and this is a recognized technique among lawyers who practise regularly in the areas of estate and incapacity planning.