Written by Jared Mackey and Darcy Moch
On July 18, 2017, Minister of Finance Bill Morneau announced sweeping changes to the way private businesses and their shareholders are taxed. The Government's proposals encompass three broad areas: (1) income sprinkling (i.e., using a private corporation to spread income among family members to create a tax savings); 2) earning passive investment income in a private corporation; and (3) converting a corporation's regular income into capital gains. The announcement was accompanied by draft legislation, explanatory notes, and a consultation paper. The proposals are subject to public input and comment for a 75-day period, ending October 2, 2017.
Since the proposals were released, the tax community has raised several concerns with respect to the impact on Canadian business owners. Rather than provide an extensive review of the technical aspects of the proposals, this piece summarizes some of major concerns raised thus far.
- Broad scope: The Government's proposals were ostensibly to close "loopholes" being used by the wealthiest Canadians and their private corporations. However, rather than targeting the top "1 percent" of individuals, the proposals will affect all small business owners, professionals, and family farms across Canada. If implemented, the proposals will result in a significant confiscation of assets from private businesses, and individuals of all income levels will see a reduction in their savings.
- Reducing Canadian competitiveness: As a result of recent increases in tax rates, federally and provincially, Canadian individuals are already subject to some of the highest tax rates in the world (e.g., 48 percent and 53.53 percent in Alberta and Ontario, respectively). Coupled with these rates, the Government's proposals are making Canada uncompetitive to live and carry on business. Wealthy individuals and businesses are leaving Canada or, as importantly, are not coming to Canada, which has and will lead to an overall decrease in the tax base. The lack of investment in Canada will also have the effect of decreasing the economic base, leading to less employment opportunities.
- Conflating equality with fairness: The Government has repeatedly stated its goal of improving fairness in the tax system. The Government's proposals, however, are more aptly described as targeting equality. Fair does not always mean equal. The reality of a business owner differs greatly from the reality of an employee, and treating them equally gives rise to new unfairness. The current flexibility in the Income Tax Act is a trade-off for the vast and unlimited amount of personal exposure and risk that business owners take relative to employees. The Government's proposals show a lack of recognition and appreciation for risk taking and, accordingly, may result in significantly less corporate investment and economic growth.
- The proposals are complex and unworkable: If the Government's proposals are enacted, the rules applicable to private corporations will become much more complicated. Compliance costs will increase, detracting from productive business activity. Vague and onerous reporting requirements may prove unworkable for many private businesses with limited accounting and tax professional resources.
- Abrupt changes: Many of the Government's proposals will potentially apply to all transactions occurring on or after July 18, 2017, and some rules will consider transactions occurring prior to that date. As a result, many private businesses and shareholders may inadvertently offend the new measures.
- Punitive level of tax on corporately-held passive investment income where capital arose from active business earnings: To fix a perceived unfair tax deferral advantage, the Government has proposed increasing the tax rate on corporately-held passive investment income where the capital arose from active business earnings. In Alberta and Ontario, the effective tax rates on this income could soar to 71 percent and 73 percent, respectively. These rates are punitive and cannot be considered fair.
- Bona fide business purpose for leaving retained earnings in a company: The Government's proposals encourage shareholders to remove all excess funds from a business, rather than prudently investing to mitigate business risk. There are often valid reasons for keeping active business profits in a company, including ensuring there is a safety net for economic fluctuations and unforeseen expenses, supporting growth and expansion, and supporting the business's credit rating. The current system is designed to encourage business owners to take on risk and reinvest in the economy.
- Passive income is not necessarily risk-free: The Government's proposals are not clear about what sort of investment income will be subject to higher tax rates. In many cases, such as investments in other private corporations and rental properties, so-called passive investment income is inherently risky.
- Private pensions: In contrast to employees, most business owners do not have access to pensions and employer-assisted retirement plans. In many cases, the business is the owner's only significant asset. The Government's proposals will curtail the ability of business owners to establish funds for retirement.
- Discouraging inter-generational transfers: The Government's proposals discourage the inter-generational transfer of private businesses and farms. Tax on death will increase and may potentially be subject to double tax where the deceased holds a greater than 10 percent investment in shares of a corporation and passes that corporation to a related family member. The proposals promote sales to unrelated purchasers, including foreign buyers and public companies.
- Distortion of the sale market for shares: The Government's proposals will make it more difficult for individual shareholders to claim the capital gains exemption. As a result, more buyers may avoid purchasing shares relative to assets, unless sellers offer a substantial discount.
- Income splitting: The Government's proposals will prevent many private businesses from paying dividends among family members, discouraging the ability to divide private business income. By basing taxation on an individual-by-individual basis, rather than a family unit basis, the proposals fail to recognize and appreciate indirect contributions spouses and common law partners may make to a successful business (e.g., a stay-at-home parent). Many competitive countries allow for some form of income splitting among family members by, for example, allowing for consolidated tax returns. The proposals will increase the overall tax burden of business owners, thereby making Canada less attractive relative to other countries. Notably, the Government has not indicated any plan to abandon pension splitting which more frequently benefits employees.
- Broad and vague drafting: To the extent that the Government has released draft legislation, the legislation is extremely broad, overbearing, and vague. For example, a proposed anti-avoidance rule would seemingly trigger unwarranted tax for common corporate transactions, such as selling corporate assets for a capital gain and distributing the proceeds as a dividend or repaying a shareholder loan. There will be tax advantages to large international corporations who are not impacted by these rules. The result is that privately owned Canadian businesses will be at a competitive disadvantage to public corporations and non-Canadian corporations.
Minister Morneau has indicated that legislation enacting the proposed tax changes will come "in an expeditious fashion" once the consultations are finished. In light of the constructive dialogue that is already occurring in the tax community and among private businesses, it is hoped that the Government will give further thought on how their proposals will affect the Canadian economy, whether additional tax will actually be collected, and whether tax "fairness" will actually be achieved.
If you would like assistance responding to the consultation paper, or if you have questions or concerns about the potential impact of the Government's proposals on your private business, please contact any member of our tax department.