On July 18, federal Finance Minister Bill Morneau introduced draft legislation to fundamentally overhaul the system of taxation for private companies, their shareholders and family members. These proposals are broad-based and will undoubtedly affect all Canadian private businesses – not just incorporated professionals.
What are the proposed changes?
The changes can be broken down into three categories, income-splitting, lifetime capital gains exemption, and the taxation of income reinvested into passive investments. Here’s a quick overview of each of these proposed changes:
Income Splitting
Income splitting is defined as diverting income from an individual with high income to a family member with low income. Using the example of a family business, the splitting of income between a spouse and adult child would result in significantly lower taxes paid than compared to one individual earning the full amount as employment income.
There are already rules in place to address salaries and wages to family members – requiring work to be done and the compensation to be reasonable, yet the proposed changes are over 20 pages in length and are so complex, small business owners do not have the time or financial resources (to pay accountants) to sort out the new rules which are full of fine print and technical traps. Further complexity is added by placing limits on the degree to which dividends may be distributed from small businesses to its (including various family members) individual owners.
This will impact adult children who attend post-secondary institutions and spouses who administer the home front to allow their significant other the means to earn that income.
Lifetime Capital Exemption
The Department of Finance has proposed three new constraints on eligibility aimed at limiting the ability of Canadian taxpayers to multiply access to the lifetime capital gains exemption.
Without getting into the details of each of these constraints which are quite technical and complicated, the net effects of these changes are that an orderly transition of ownership within families becomes cost prohibitive and does not encourage, and possibly discourages families to maintain ownership of a business within the family through well planned succession strategies.
Taxation of Passive Investment Income
Currently, corporate business income is taxed at a lower rate than personal income, which leaves corporations more money to invest in their business. If a private corporation doesn't need to reinvest all of its earnings to expand the business and isn't ready to reinvest – they may choose to invest those earnings in passive investments, and earn a return on these investments while holding the funds for future business needs. The government is proposing to eliminate this perceived tax advantage by increasing the tax rate substantially on earnings from corporate after-tax income reinvested in passive investments that are not related to the corporation’s active business. The net effect of the changes is to force business owners to distribute surplus liquidity, which attracts taxation, then invest those funds personally, the income from which would also be subject to personal tax rates. Prudent business owners often take comfort from a strong financial foundation to their business, knowing that unforeseen risks can emerge causing financial hardship. This is when having the financial cushion is invaluable.
These changes do not adequately reward the entrepreneurs who take enormous personal and financial risks, they discourage business investment, and punish business owners for maintaining a conservative, financially prudent, balance sheet. The Government has proposed these changes under the guise of “fairness” and closing certain perceived “loopholes”. While tax policy must strike a balance between encouraging the right business behaviours with ensuring the Government gets their fair share, to compare business owners with salaried employees and attempt to achieve a so-called “level playing field” is not only impractical, but unwise.
Business owners are the lifeblood of our economic engine, and tax policy needs to both attract and reward individuals who assume the risks and liabilities of building businesses.
The government has given taxpayers and professionals 75 days (until Oct. 2, 2017) to provide submissions on the proposals, and we will be submitting our feedback within the next few days.
Our View
In our view, these tax changes are bad for businesses and bad for Canada. While there is always room for improvement in tax policy, the proposed changes are not a step in the right direction. Conversely, we are recommending that the following approach be taken:
1. Extend the consultation period for at least 6 months. The complexity and potential magnitude of the changes need to be more fully understood and evaluated to determine whether the outcomes will be sufficiently beneficial.
2. Look to make additional changes to tax policy that creates the kind of business environment which encourages entrepreneurship, attracts small business investment capital, and aligns with the government desire to be global leaders in science, innovation, and economic development.
3. The small business tax regime should have fairness as a guiding principle, and we are opposed to blatant misuse of tax rules to avoid paying reasonable taxes.
4. Further changes introduced into the small business tax rules need to emphasize the importance of simplicity. Complexity layers on additional costs for compliance, ultimately reducing competitiveness. Business owners and investors make better business decisions when the tax environment they face is manageable to understand, and provides sufficient rewards for taking risk.
Please encourage other Canadians to help prevent these changes from being enacted. We urge you reach out to your friends and colleagues and have them make their opinions heard in Ottawa either by responding to the invitation for comments from the Department of Finance, at the following link: https://www.fin.gc.ca/activty/consult/tppc-pfsp- eng.asp, or by making contact with your Member of Parliament.