On July 18, 2017, the Federal Government introduced some proposals and draft legislation which perhaps they’d hoped would be overlooked while Canadians enjoy their summer holidays.
But we’ve noticed.
This proposal announced a 3-prong attack on entrepreneurs – specifically:
- the ability of a business owner to split his or her income across members of the household is to be ended, as of 2018, via a broad expansion of the “tax on split income (TOSI)” rules
- the investment of the tax difference inside a private corporation is to be reviewed, with the intent of taxing away the advantages of the small business deduction; and
- the elimination of the possibility that a business owner might seek to extract funds from his or her corporation at capital gains tax rates, rather than as dividends.
Taxes on ‘Split Income’
The main tax incentive offered to Canadian business people over the past 40 to 50 years has been the ‘small business deduction’. It’s a special, low tax rate, applied to the ‘active business profits’ of Canadian private corporations. The rate, which varies by province (an attractive 13% in 2017, in BC, for example) is intended to partially compensate entrepreneurs for the risks they take, the employment they provide, the expenses they commit to, and their general lack of a social ‘safety net’ (pensions, unemployment insurance, severance and the like). This tax rate has proven itself over the decades to be an excellent way for entrepreneurs to save and accumulate assets – all fully within the law.
It should also be noted that the tax advantage of the small business deduction is designed to be given back, if, as, and when, funds are drawn from the corporation, as a dividend.
But not this time. This time, the Government has effectively stated that the small business deduction is an unfair advantage, as compared to an employee. Employees must face the ordinary rates of income tax on personal income. In BC, that rate could be as high as 48% in 2017 (it’s higher in many other provinces).
The fact that a 13% tax on profits results in 87% retained earnings has been accepted for decades, as ‘fuel’ for both business expansion, a cushion for financing the business, and investment. Now, it seems the government intends to (at least partially) tax back the difference, through as-yet-unspecified and likely very complicated means, including a 50% tax on investment income. This despite the fact that the capital invested in the corporation has already born some degree of tax (i.e., 13%). Further, once all that extra tax is paid the money is ‘stuck’ inside the company, requiring a dividend to get it out. Taxes on that dividend will be about 41% at the top margin.
Adding to the confusion, little thought or provision has been given to the fact that some of the capital invested may have been sourced elsewhere – for instance, the shareholder.
The long-established system of determining entitlement to dividends is under significant threat. There are countless situations whereby family members come to hold shares in a particular enterprise. Estate planning is certainly among them, and to the best of our knowledge, this long-established technique has not been prohibited (yet) by the Feds. Fundamental to estate planning is the concept that common shares (as they are generally called) carry with them an entitlement to pro-rata share in the value accretions, over time, of a private company. This would be after the priority claims of other share classes are brought into account.
This is going to send every income tax consultant in Canada back into their Income Tax Acts, since the definition of “split income” hasn’t been all that relevant to them – while the victims of such definition have been, up to now, mostly children who aren’t age 18, there hasn’t been much of a widespread outcry over all this. But now that the split income rules will apply to everybody, it seems these rules have effectively ambushed the retained earnings of any company in which family members have an equity interest.
If it passes, this proposal is going to invalidate a lot of estate planning, and cost successful Canadians millions in taxes.
Taxation of the ‘Passive’ Income of Private Corporations
The Government’s attack on the passive income of private corporations is, we suggest, ‘not ready for prime time’.
This proposal is unique in that it frankly admits that the boffins at the Department of Finance know they want to tax something, but they’re not quite sure how to do it. For examples of their thinking, they dig way back into the very beginning of the capital gain tax system, some 45 years ago ( ! ) when the tax system was completely different from what it is now. One of their proposals is a 50% tax to be applied to the investment income of a private corporation that is not directly invested into an active business – as if the alternative (investment in stocks and other things) were a ‘bad thing’.
Investments at their essence are simply “loans” made by the investor to the economy in general – usually, into the active businesses managed by third parties. This is the very definition of a ‘positive feedback loop”, ensuring robust and enduring growth of the economy, resulting in increased employment, and increased taxable income of, all Canadians.
Since when did that become illegal ?
But it gets worse: the TOSI rules, as of 2018, will have the additional result of forcing distributions from the holding company out to the business owner as the single outlet for these payments. That will ensure ‘compression’ of that income, with resulting top-rate taxation on the dividend.
The attack on accumulated income of private corporations clearly vacates decades of accepted tax and assessment practice. Most importantly, and apparently ignored in this Proposal document, is the long-established and accepted system of share rights and the general rights of corporate ‘common shares’ – those rights devolve upon such shareholders a pro-rata right to a share in the growth of the corporation’s assets, and the design of such rights to suit an individual’s particular needs and objectives. All the while adhering faithfully to all of the constantly-changing income tax laws that apply.
These rights strike to the heart of almost all estate plans. If you have counted on extracting the accumulated capital in your holding company to provide a reasonable retirement income for you and your spouse, these proposals could very significantly reduce both your options, and your wealth.
Capital Gains ‘Strips’
With regard to the concern for extraction of funds at capital gains rates, we note that there was a time in Canada when the taxes levied on dividends and capital gains were roughly equal, so there was no particular ‘fuss’ raised by cash extractions, when they occurred. However, relatively recently, we have seen the tax rate levied on dividends substantially increase, while capital gains rates are unchanged (and in the case of ‘qualified small business corporation shares’ (QSBC), hugely reduced).
Anti-avoidance rules have been written in copious quantity – the most recent changes were so tough that it was certainly the advice of this firm that it was pointless to attempt any sort of ‘artificial’ capital gain transaction, since the potential for a large penalty and interest, years after the fact, made the whole exercise unattractive.
But the Government’s paranoia about this obviously continues.
The Government both encourages and discourages entrepreneurship at the same time, particularly when it comes to capital gains and small businesses. Often touted is the $836K-plus, per-person, capital gains exemption as evidence of their ‘friendliness’ to entrepreneurs, but they do not emphasize the many, many ways in which you can be denied the exemption – or pay ‘minimum taxes’ even when you have managed to qualify.
And yet even more limitations on QSBC gains are introduced with this Proposal.
We might note that, for some incredible reason, this QSBC tax saving opportunity is specifically denied to taxpayers who might like to see their own children take over their business.
As the situation now exists, because the Government admits it cannot detect the difference between genuine and bona fide transfers of companies from one generation to the next and ‘artificial’ realizations of capital gains (resulting in taxation of corporate extractions at capital gains, vs. dividend, tax rates) nobody is allowed to get it.
However, this does suggest that there is one thing we should all be doing prior to January 2018: where possible and practical, we should consider an election to trigger a capital gain, so as to exploit the tax advantages that will expire after that date.
Nowhere in this proposal is there any reference or thought to the notion of compensation for those Canadians who might consider themselves swindled by the dramatically increased cost of extracting money from their corporations. It always hurts when the rules of the game have been changed – essentially amounting to retroactive taxation.
The people who compose legislation for the Federal Department of Finance would now appear to be mostly comprised of ‘thirty-somethings’ bent on social engineering through the tax code. They will probably have little to no knowledge or memory of the devastating consequences of past attempts to seize the wealth of Canadians (perhaps most famously by Pierre Trudeau’s Finance lieutenant Alan MacEachern, way back in 1981).
Today’s powerful computers, armed with the huge volumes of data provided to them on ordinary tax returns (including a detailed inventory of assets that is generally unrelated to the income being taxed) allows the law-writers to invent ‘what-if’ scenarios for the entire economy. Do they think of the Canadian economy as basically a zero-sum game, in which the profits to one group come at the expense of another ? Hopefully not.
An opportunity to present your views on these proposals has been given: 75 days (to October 1, 2017). Since the proposal was released in the depth of summer, awareness of it will come slowly – and possibly, too late. Much of the legislation relating to the proposals has already been drafted, so it’s ‘ready to roll’ on October 2nd, unless it’s stopped.
If you share with us the need to express your concerns, you can e-mail or write to the following places:
firstname.lastname@example.org or, write a letter to:
Tax Policy Branch
Department of Finance Canada
90 Elgin Street
Ottawa, Ontario K1A 0G5
A copy of your letter to your MP wouldn’t hurt, either.