“We see these approaches to managing people’s affairs through a private corporation as creating an unfair playing field……We’re trying to tighten these loopholes to make sure that it’s fair.”
Doesn’t sound like taxes for small business owners are going down, does it? The above is from federal finance minister Bill Morneau’s July 18 announcement outlining some of the measures the government is proposing to help level what they perceive to be an unfair playing field.
Since the announcement we’ve been thinking about the potential implications of these changes and digesting comments from a variety of different tax experts. We agree with one expert who opined that “fairness is subject to personal interpretation”. Unfortunately adhering to these proposed changes won’t be subject to personal interpretation so the bottom line is that we encourage all small business owners, especially those using private corporations in conjunction with saving for retirement or for the benefit of their families as a whole, to seek expert tax advice ahead of these changes coming into effect.
How did this come about?
Taking a step back, the reason that small businesses were given preferential tax treatment in the first place was to encourage them to reinvest in growth opportunities, employ more people, contribute to the Canadian economy in a more meaningful way and that would be good for Canada – hard to argue with that. Of course all rules, especially tax rules, end up with unintended consequences. The current government feels that many small business owners and their families have been taking advantage of opportunities (loopholes) in the legislation which allow for further savings when it comes to their personal taxes. Furthermore, they seem to be particularly concerned about the increased “corporatization” of certain professions that has taken place over the last 10-15 years in order to reduce tax bills. As not everyone is a small business owner, the tax advantages are deemed to be unfair to those who aren’t.
What are the specific areas that are deemed to be unfair?
- Income sprinkling – income sprinkling is a strategy where a business owner looks to save tax by distributing income, dividends and capital gains to other members of his or her family in order to take advantage of multiple sets of graduated tax rates (i.e. pay other family members who are in a lower tax bracket) or exemptions, in order to lower the overall family tax bill. There are already rules (known as tax on split income “TOSI” or “the kiddie tax”) in place that disincentivize business owners from paying minor children and other family members who don’t actually work in the business. Proposed legislation would seek to expand these rules. It would also look to curtail and in some cases eliminate the use of multiple lifetime capital gains exemptions “LCGE” across multiple family members. The new rules are expected to apply for the 2018 and later tax years with some provisions for transition for affected individuals.
- Passive investments held in a private corporation – lower corporate tax rates mean that business owners have an opportunity to retain funds not required for reinvestment into the business and invest those funds in “passive” investments such as stocks, bonds and mutual funds in corporately held investment accounts. While there is no direct tax savings on corporate passive investment income, there is a tax deferral gained by the business owner by not paying out the funds and being taxed at the personal level before investing in personal investment accounts. By keeping the funds in the corporate the business owner starts with a higher amount and defers paying tax until it is ultimately paid out as a dividend. The current government deems this to be unfair because non-business owners don’t have the same tax deferral opportunity. Implementation of potential changes are likely to be very complex and the government has initiated a consultation period to receive feedback from various constituents before drafting legislation. In any case, changes are expected to apply on a go-forward basis and therefore not likely to impact existing passive investments.
- Tax planning designed to convert income into capital gains – there are rules in place to prevent business owners from entering into transactions that are effectively used to remove surplus cash from a corporation and have it taxed lower as a capital gain rather than as dividend income – the government is proposing to expand these rules.
From what we’ve read, it seems draft legislation is more or less in place for items 1 and 3 . For item 2, passive investments, while the government is seeking consultation, we’d expect the consultation / feedback requested by the government to not address if but how to implement change and furthermore how to limit unintended or adverse consequences. Small business owners having a higher tax bill is unfortunately not likely to be considered to be an adverse or unintended consequence!
What should you do?
Until final versions of the legislation are announced it is probably too early to do any meaningful tax planning, and we wouldn’t expect the answer in most cases to be to wind up all corporately held investments. However, we would expect tax experts to be very busy at the end of 2017 and into 2018 trying to figure this out and implement appropriate strategies so we would advise that business owners get ahead of this and start asking their tax advisors how these changes might impact their specific situation.