On July 18, 2017, the Department of Finance released a comprehensive package of proposed legislative changes aimed at private corporations and their shareholders. These changes deal with long- standing practices available to private corporations and their shareholders, such as income splitting with family members, converting earnings to capital gains, and investing excess corporate earnings. According to the Minister’s letter accompanying these legislative changes, the government’s intention is to “help businesses grow, create jobs and support their communities”. The government aims to accomplish these objectives by “proposing solutions to close loopholes and deal with tax planning strategies that involve the use of private corporations”. However, upon a more detailed review of the proposed legislation, it becomes evident that the new rules are likely to harm the small businesses that they are allegedly intended to help.
Minister Morneau recognizes that “businesses big and small are the lifeblood of our economy”. In fact, according to Statistics Canada, small businesses accounted for approximately 98% of all Canadian employer businesses as of December 2015. Moreover, these small businesses employed over 8 million individuals in Canada and contributed an average of 30% to the GDP. Based on these statistics, it is clear that small businesses are the engine that drives the Canadian economy.
Over the past 50 years, the Canadian tax system recognized the fundamental difference between entrepreneurs and employees. Entrepreneurs face significant risks when starting a business. They work long hours to get the business off the ground, provide personal guarantees to obtain financing, rarely take vacations and do not have guaranteed pensions. This is clearly not the case with employees. Our tax system provides various incentives to compensate entrepreneurs for the risks that they regularly face. However, the proposed legislation will eliminate these incentives and harm the small business owners. Let us examine some of these proposals in more detail.
In one of the examples in the consultation paper, we are introduced to Susan and Jonah who are neighbours living in Ontario. They both make $220,000. However, since Susan is an employee she pays $35,000 more tax than Jonah, who has an incorporated consulting business. Jonah is able to lower his family’s tax bill by sprinkling income with his spouse and children. This is a prime example of what Mr. Morneau thinks is unfair. But is it? As previously discussed, an entrepreneur Jonah, faces significantly more risk running his own business compared to Susan, who is an employee. As such, he is able to generate a higher after-tax return (due to higher risk) by utilizing the incentives such as income splitting, which are available to him under the Canadian tax system. However, if the proposed rules are enacted into law, then the income paid to Jonah’s spouse and children, above what the Department of Finance considers to be reasonable, will be taxed at the highest marginal rates as split income. This would effectively eliminate the incentive, which was previously available to Jonah.
The proposed legislation discusses reasonableness tests focusing on labour and capital contributions, as well as previous remuneration, designed to determine the amount of split income. While a good idea in theory, it is clear that these reasonableness tests will be a highly contested area. For example, one of the examples presented in the explanatory notes illustrates the reasonable rate of return on a capital contribution. In the example, Rasmin advances $100,000 to his sibling’s company in exchange for preferred shares. What is the appropriate rate of return on an investment in a highly illiquid, closely held private company? According to the Ministry of Finance, it is only 4-6%! One could expect such a rate of return on the preferred shares of a listed, blue-chip, public corporation. Certainly, an investment in a risky private company would warrant a much higher rate of return. This is just one of the examples, where the views of taxpayers and the CRA may diverge.
These proposed income splitting rules may have a punitive effect on individuals who have incomes in lower tax brackets. For instance, consider John and Sarah who are 50/50 shareholders in a small business. Their capital contribution was nominal. They each drew $50,000 from the business in the form of ineligible dividends. Initially, Sarah worked in the business full time, but now stays at home to take care of their two children. John continues to run the business and they each continue to draw $50,000 in dividends. According to the new rules, Sarah’s income will now be subject to tax at the highest marginal rate. Clearly, these proposed rules are highly punitive to individuals like Sarah. They result in the income being taxed at the highest marginal rate, even though the family’s overall income is nowhere close to the top marginal tax bracket limit.
Passive investments inside the corporation
Another area that Minister Morneau is targeting with the proposed rules, is the build up of the investable assets inside a corporation used for passive investing. The consultation paper discussed three potential solutions and the Government is asking for feedback as to the best one. It is clear that the intention is to discourage saving inside a corporation. Based on some of the proposals, the result will be a 73% tax.
The main issue with passive investing, is that small businesses are typically highly cyclical and unpredictable. This is why it is important to maintain surplus cash in order to persevere through business downturns and unexpected shocks. Moreover, excess cash may be needed in the future for business expansion. Finally, business owners do not have guaranteed pensions, as many employees do. As such, investing inside a corporation allows them to save for their own retirement without relying on the Government to provide for them. Canadians tend to save too little for retirement, yet the Liberal government appears to discourage saving by entrepreneurs.
The proposed changes also include the amendments to Section 84.1 and 246.1, which have far-reaching consequences for post-mortem tax planning strategies, such as “Pipeline” planning. The “Pipeline” strategy was useful in avoiding double tax, which could arise on death in certain circumstances. However, the proposed rules aimed to prevent surplus stripping render the “Pipeline” strategy obsolete. It is unclear, whether this was an intended effect. Moreover, the rules do not contain any grandfathering provisions for those estates that started the “Pipeline” planning prior to the announcement of these rules. These rules have extensive consequences in post-mortem planning scenarios. According to an article written by Michael Goldberg, Mac Killoran and Jay Goodis some small business owners could face tax rates as high as 93% if these proposals are enacted into law.
Short consultation period
Based on the aforementioned discussion, it is clear that these proposed changes will not simply close the “loopholes”, but will result in fundamental changes to the taxation of private corporations in Canada. With that in mind, the 75-day consultation period is woefully insufficient to properly assess the far-reaching consequences of the proposed changes on private businesses and their owners. Striving to make the tax system more fair and efficient is a worthy endeavour. However, it is important to solicit feedback from all stakeholders involved and design rules that will result in a truly fair tax system.
Small businesses are the backbone of the Canadian economy. These businesses and their owners will face numerous challenges in the next few years – increases in the minimum wage, probable interest rate hikes, mounting household debt and fierce competition from U.S. firms. The proposed changes are likely to harm the small businesses and their owners by removing the incentives to own a small business. These changes will stifle the entrepreneurial spirit and discourage younger generations to start their own businesses. If these proposed changes are enacted into law, then many hard working Canadians may move their businesses to a more business-friendly country.