Expanded Horizons: Proposed reforms to small business taxation

Has politics ever been this exciting? 

Our very own Prime Minister recently graced the cover of Rolling Stone magazine, while the President of the United States is a former reality TV star. Now, perhaps more than ever, it is important to filter the noise and ascertain what matters.

Almost lost in the recent noise was the signaling for an overhaul of the Canadian tax system by The Honourable Bill Morneau, Canada’s Minister of Finance.

This comes as a follow up to Budget 2017, where Morneau promised to issue a paper addressing three specific tax planning strategies involving private corporations. This promise culminated with a Consultation Paper, addressing strategies that the Federal Government believes offer tax advantages to high-income individuals not available to other Canadians. The strategies targeted for review include: income sprinkling, passive investments within a private corporation, and converting a private corporation’s regular income into capital gains. 

The Consultation Paper delivered on July 18, 2017 was accompanied by proposed legislation and can be best summed up with the following statement from Morneau:

When you have an economy that works for the middle class, you have a country that works for everyone. That's the spirit in which we are asking Canadians for input into how to close loopholes and address tax planning strategies that give unfair tax advantages. Many of the richest Canadians are unfairly exploiting the tax rules designed to help businesses thrive. We know that businesses, including small businesses, help grow the Canadian economy. These tax advantages are in place to help these businesses reinvest and grow, find new customers, buy new equipment and hire more people. We want to make sure those rules are used to do just that, and not to give unfair tax advantages to certain – often high-income – individuals.

The paper raises concern over the significant increase in the use of private corporations, particularly in the professional services sector. This sector alone has seen the number of corporations triple over the past 15 years and has been a target for the government.

The recurring use of “professionals”, “loopholes”, and “unfair tax advantages” however, is potentially detractive and may create bias for the public and the media. Take for instance, the idea that corporations within the professional sector tripled over the past 15 years. Perhaps it was just a coincidence—professional corporations were introduced to Ontario professionals in the early 2000’s.

The proposals contained within the consultation paper would see several traditional tax strategies eliminated. At a high level, the draft proposals highlight a desire to ensure the owner of a business is treated the same as an employee from a tax perspective (here the definition of “fair” is being equated to one of equality). This is problematic as there are differences in the risks assumed by business owners and employees. Consider an employee who is provided a guaranteed salary and is entitled to severance and/or EI if he or she loses his or her job. Furthermore, the employee receives paid vacation and may have a retirement plan and/or savings plan sponsored by his or her employer. How do you equate that with the entrepreneur who has risked everything?

It is apt to stop here and discuss the proposed changes.

 

Sprinkling income using private corporations:

Income sprinkling, or as it is more commonly referred to “income splitting”, involves the shifting of income, typically in the form of dividends from the private corporation to family members who are often subject to lower personal tax rates. Restrictions currently exist for the payment of salaries from a corporation and to dividends payable to minors.

Effective for 2018 the government is seeking to further limit the ability to “sprinkle” dividends to adults (including those to the spouse). The proposed rules would ensure dividends are subject to a reasonableness provision, with any amount paid in excess to be taxed at the high income parent or partner’s tax rate. Defining reasonableness will be a question of fact and extremely difficult to assess, though the proposed rules will be more rigorous for those age 18-24. Considerations for reasonableness will include labour contributions and a review of the capital contributed to the business. A major issue that still needs to be addressed is that the idea of reasonableness is subjective and would likely only be determined after the fact. 

The paper addresses a further concern with multiplying access to the Lifetime Capital Gains Exemption (“LCGE”)[1]. The proposal will eliminate access to the LCGE for children under the age of 18 and will either restrict or eliminate the LCGE for other family members based upon the reasonableness provisions. Further, the proposal will no longer permit the LCGE to be applied against capital gains allocated out of a family trust. 

These rules will be effective commencing 2018, with little exception. As stipulated within the paper, those who wish to contest the proposal are asked to identify alternative mechanisms.

 

Passive investments within a private corporation:

The government’s basic concern here is the small business owner taking advantage of the tax deferral[2].

The deferral is designed to allow corporations to grow, reinvest, and create jobs. The government’s concern is where the deferral is being passively invested.  The examples provided by the government highlight the benefit of having additional funds to invest and focus on those in the highest tax bracket (i.e. the “1%”). The suggestion is that the current system “does not achieve its objective of removing incentives to hold passive investments within a corporation…”.[3]

The consultation paper includes a discussion of certain methods which may be applied, though does not propose any specific amendments to address these concerns. The suggested approaches are beyond complicated and are designed to impact 100% of private corporations even though the concern of the government is limited to top “1%”.  It might be a lack of understanding of the tax system or perhaps the government does not believe small business owners should be able to save for their retirement or their next business venture.  Expect a significant number of submissions relating to this over the coming months.       

 

Converting income into capital gains:       

The proposals here focus on amendments within section 84.1 of the Income Tax Act (“ITA”), which prevent taxpayers from using non-arm’s length transactions to increase the cost base of shares of a corporation. Further, the proposals seek an amendment to include an anti-stripping rule designed to counter certain tax planning methods that circumvent provisions of the ITA.  These provisions are intended to prevent the conversion of a private corporation’s surplus into tax-exempt capital gains.

On the surface the rules are reasonable. The planning in question is a clear abuse of the rules and creates a true unfair advantage to wealthy business owners. The rules as proposed, however, create the potential for double taxation where traditional “pipeline” planning occurs. While complex rules are being considered, perhaps the easiest solution is to increase the capital gain inclusion rate. Given the “noise” regarding the increase to the inclusion rate prior to the budget this could be the intended plan after all.

 

Where to from here?

This is not the first time that the entrepreneurial spirit has been attacked, nor will it be the last.  If you recall, one of the initial actions taken by this government was to offer a tax break for the “middle class” on the backs of the “wealthy”.  The solution appeared simple and reasonable: create a new tax bracket to redistribute the income of the wealthy. The introduction of this tax bracket, however, does not target simply the “wealthy”’; it also captures income arising from the deemed disposition triggered upon death. With billions of dollars of wealth set to transfer within the next decade, it is not surprising that the government wants their share. A majority of this wealth will come from the value of the private corporations integral to the Canadian economy.

 

The impact of the proposals is significant and would revolutionize the taxation for private corporations. Unfortunately, much of the commentary is focused on the financial industry and not the small business owner. The onus should therefore be on the advisors to discuss these changes with their clients and ensure their voices are heard. Together we might be able to ensure reasonable changes are adopted that benefit all of Canada.

Consultation on the proposed tax reforms is open until October 2, 2017 and submissions can be made directly to fin.consultation.fin@canada.ca.

For further proposal details you are encouraged to view the many summaries provided by various accounting and law firms across Canada. For full access to the proposals, the Finance Department has released their Consultation Paper and accompanying PowerPoint to the public. You may also consider connecting with your local Member of Parliament.

 

And for those who are curious where you hard earned tax dollars go I leave you with this: 100 years of tax.

 

[1] $835,716 for 2017.

[2] The tax deferral is created as the corporate tax rate on active business income is often lower than the taxes paid if the income was earned personally. This is not a tax savings as the deferral is negated once the funds are paid from the corporation to its shareholders. 

[3] Consultation paper, “Tax Planning Using Private Corporations”, p.38.


August 2017

This article was provided courtesy of Chris Geldert, CPA, CA, CEA. 

Chris Geldert joined the Financial Horizons family in 2013 and is excited to be able to continue providing first class resources advisors should come to expect from their MGA. As a Chartered Accountant with over a dozen years in the insurance industry Chris works to bridge the gap between client’s professional advisors. From developing and presenting strategies, to providing independent recommendations on products suited to the client’s needs and risk comfort levels, Chris works to assist advisors grow their practice. 

The writer can be contacted at:

Disclaimer: This article is intended to provide general information only and should not be considered as legal, accounting or taxation advice. Before acting on any of the information contained within this article, or before recommending a course of action, make sure your clients seeks advice from a qualified professional. Any examples or illustrations used in this article have been included to help clarify the information presented in this article and should not be relied on by you or your client in any transaction.