Our firm’s letter to Bill Morneau re: tax reform

From: Clayton Achen

Sent: September 7, 2017 4:53 PM

To: ‘bill.morneau@parl.gc.ca’; ‘fin.consultation.fin@canada.ca’;

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‘Salma.Zahid@parl.gc.ca’; George Henderson

Subject: Proposed small business tax reform

Attachments: AHLLP – Example of middle-class harm.pdf; STEP_Canada_Note_and_Examples_with_Outcomes.pdf

 

Dear Minister of Finance:

We are writing you regarding the July 18, 2017 Tax Proposals. Our firm has combined expertise in the study and application of domestic and cross-border income tax law totalling more than 60 years. We are members of the Canadian Tax Foundation (CTF), the Society of Trust and Estate Practitioners (STEP) and one of our partners currently serves as the president of the Entrepreneurial CPAs of Calgary (ECPAC). Our firm represents corporate clients who range from lower middle-class to wealthy; nearly all of whom will be negatively affected by the proposed, wide-sweeping tax changes.

Because it is our mandate, imposed by our clients, to understand and apply the wording of the draft legislation (which, unfortunately, most of Canada can not), we have studied it. We are very concerned that the proposals will have wide-sweeping effects which must not have been considered or intended at the time of their drafting. We will attempt to address the most basic of these concerns in this letter; however, there are far more issues than those addressed in this letter, issues which we do not have time to fully consider within the incredibly short consultation window.

We are not opposed to good tax reform. Since we can prove that even at the most basic level these proposals substantially miss-the-mark on good tax reform, we respectfully request that the government extend the consultation period to allow policy makers and the tax community the time needed (being much more than 75-days) to analyze how to achieve the government’s objectives of helping small business and the middle-class.

As a side note, we do not believe that Canadians who follow well established, precisely-worded tax laws are tax-cheats or are abusing ‘loopholes’, nor do we believe that they are being unfair to other hard-working Canadians. They are simply working within the confines of our excessively complex, precisely worded, well established and accepted Canadian laws. Our firm, our clients, and (based the banter on all social media channels and several of the attached articles) most involved Canadians find it incredibly offensive that the government uses this type of divisive rhetoric to express these positions. We view this type of divisive political language as inappropriate and counterintuitive to a productive conversation on good tax reform.

Background 

The March, 2017 Federal Budget included a notice that the Department of Finance was reviewing the taxation of Canadian private corporations regarding strategies, “that inappropriately reduce personal taxes of high-income earners” including income splitting/sprinkling,  holding investment assets in private corporations and the conversion of dividends into (lower-taxed) capital gains, and the Department would ”release a paper in the coming months setting out the nature of  these issues in more detail as well as proposed policy responses “

On July 18, 2017 the Department of Finance released a 63-page document – “Tax Planning Using Private Corporations” PLUS  27 pages of draft legislation PLUS 47 pages of explanatory notes to the legislation.  The draft legislation and explanatory notes speak to the income sprinkling and dividend-to-capital-gain issues.  The last time tax changes this wide-sweeping were introduced was in 1972 after several years of study and consultation. We believe that a similar effort is required to truly effect a meaningful and workable change to Canada’s small business tax regime.

Income “Sprinkling” – Tax on Split Income

Currently, deductions from corporate income must be reasonable in amount and business-related, not personal in nature (Sections 9 and 67, Income Tax Act (Canada) (“ITA”)).  Accordingly, salaries paid to family members of a private corporation owner must be reasonable, given all the facts and circumstances, to be deductible.

Dividends paid appropriately under corporate law to family members who are shareholders of a private company have been acceptable under the current tax law for many years – and supported by a Supreme Court decision. Sections 74 to 75.1, and particularly 74.4 of the Act tax income back to the payer, particularly for a corporation’s payments to other family members if those payments were indirectly attributed to another family member, say through a trust.  There are additional rules in Section 15 of the Act regarding amounts paid to persons related to shareholders and loans to shareholders / related persons by the company. These rules have also been in place for many years.

The “kiddie tax” or “tax on split income” (abbreviated as “TOSI”) has been in place since 2000.  Dividends paid to minor children from companies in which their parents or related persons have a significant interest are taxed at the highest tax rate to the children, and the children lose their personal tax credits.  Capital gains realized by minors on sale of their private company shares to a related person are also taxed at the highest dividend rates.  Parents are jointly liable for this tax.

The proposals extend the “tax on split income” (“TOSI”) to dividends paid to ANY family members which are not based on the “contribution” of the family member to the company; thus, dividends to spouses and adult children would now be subject to the “tax on split income” to the extent the tax authorities determined such dividends were not reasonable based on the contributions of that family member. We can assure the minister that several of our clients of all income levels (including those who are decidedly middle class) currently utilize so called “income sprinkling” as a long-accepted practice. Our concerns on this specific matter are as follows:

  • It is a mathematical fact that under the proposals families who have corporations and pay dividends in amounts lower than the top tax bracket will pay more in tax than a similarly incomed employee (see attached article from Achen Henderson LLP). This inequity is caused by our current integration tax rates, therefore, while attempting to ‘level the playing field’ the proposals inadvertently ask the incorporated entrepreneur paying dividends to pay more tax than a salaried employee;
  • Despite the government’s objective to assist the middle-class, we have proven mathematically that the proposed rules will increase a middle-class family’s taxes on the payment of dividends. This applies at all income levels above the personal exemption amounts. Our attached mathematical examples prove this at levels starting at $60,000 in family income (decidedly middle class). This seems contrary to the Liberals’ policy of supporting the middle-class;
  • Because “contribution” (or “meaningful contribution” – a term which has been used by the Finance Minister publicly on several occasions) has not been defined in the proposed legislation, we are concerned that CRA tax auditors will make such determinations well after the fact, in variable and discretionary ways, leading to additional (and un-definable) burdens of proof being placed on those who we trust to grow Canada’s economy and employ Canada’s workforce;
  • Resolution of such disputes will be left to our court system, which is already over-capacity, placing financial hardship on entrepreneurs and strain on our already over-burdened court system;
  • Private companies will be left with little or no time to make changes in their organizations to accommodate the new rules. For example: owners of the same class of shares are legally entitled (under corporate law) to receive pro-rata dividends, forcing a family into the top marginal tax bracket on a portion of their income when they clearly do not belong in that tax bracket. Corporate reorganizations are complex, beyond the scope of the average small business practitioner (who advises the bulk of Canadian small business), and most reorganizations take a good amount of time to ensure they are executed properly according to our (already excessively complex) tax laws. Certainly, longer than the 3 months left between the end of your consultation period and December 31, 2017;

The draft legislation also extends the “TOSI” rules to other types of income: interest on loans from family members, the secondary or subsequent income earned from prior dividends, and capital gains realized by family members on their shares in the corporation. These rules will apply to minor children AND any individuals who are related to a “specified shareholder” (a person who holds 10% or more of the company’s shares).

For example, should a parent loan funds to an adult child’s company to start or support the child’s business, the parent could be taxed at the highest rate if the interest was not considered “reasonable”.  It is also extremely common for a parent or relative to acquire shares in a new venture as part of a loan deal.  Dividends on those shares would be subject to the new “TOSI” reasonableness rules and potentially taxed at the highest marginal tax rates. Because the bulk of our clients’ start-up financing is obtained from family members via loans and equity (because ALL professional financiers are reluctant to finance start-ups) our concern is that these proposals will discourage start-up and growth financing (by family) of small business. A market rate of return on a high-risk endeavour is much higher than any prescribed rate. We expect that tax auditors will have unbridled power to disagree with what a market rate of return is, leading to further litigation and hardship in small businesses or, worse, reducing amount of start-up or expansion capital available to them. In our practice, we are certain that these rules will stifle business start-ups and expansions.

Where a dividend may be subject to the split income rules, from 2018 and on, any income earned by the recipient on those funds will also be subject to the highest tax rate.  It appears a company now has to track where and how these dividends are invested and what income is earned from the particular dividend. Our obvious concern is that this adds a tremendous amount of complexity to our tax system and creates an additional burden on companies to track additional tax features on top of to the already onerous tracking of safe income, GRIP, RDTOH, CDA to name a few. Our understanding was that the Liberals’ goal was to simplify our tax system and this is, very obviously, contrary to that goal.

The proposals also impose a reasonability test on the access to the lifetime capital gains exemption, retroactively, on existing company structures where non-active shareholders or trusts own the growth shares of a company. These structures were created by Canadians with the understanding that our tax system is relatively stable, and that both spouses would be entitled to the lifetime capital gains exemption on the sale of their family company’s shares. In many cases the total gain on the sale of a company would not exceed a single lifetime capital gains exemption, say that of a managing shareholder, however since the proceeds must be attributed to both shareholders (under corporate law on sale or family law at divorce) the new rules’ retroactive effect would see the tax on the sale of the business on more of the proceeds where there would otherwise be none (or less) if there were transitional rules to allow a company to re-arrange its affairs according to the new rules. The proposals provide no transitional relief to gift or transfer the shares to the managing spouse.

Furthermore, the inequity this creates between spouses who jointly own a family business devalues the role of the stay-at-home half of an entrepreneurial family by telling them that their ‘contribution’ is less ‘meaningful’ or valuable than the working spouse’s contributions. It is our view that this is sexist, devalues stay-at-home parents and is simply not a Canadian way of doing things. This policy is contrary to the Liberals’ campaign promise of promoting gender equality.

Capital gains restrictions

The “unreasonable” portion of a capital gain earned by any related persons, not only minor children, when the corporation’s shares are sold to a related party, is now also taxed as a dividend at the highest rate.  If parents, for example, sell the shares of their company to their children and one spouse, say the stay-at-home spouse, is not active in the company, all or a portion of their capital gain would be taxed as a dividend at the high rates.  A sale of one’s company to a third party attracts much less tax than a sale to family members. As families sell their business to third parties (often large corporations, particularly in the case of family farms) we are particularly concerned that this will shift Canada’s businesses away from entrepreneurialism in favor of ‘big-business’. Again, this is not Canadian and is obviously contrary to the Liberals’ platform of supporting middle-class small businesses.

The proposed rules also limit the capital gains exemption on sales to arms’ length parties. For dispositions from Jan 1, 2018 and on, NO capital gains exemption is allowed for the capital gains on private corporation shares earned by minors, except a transitional allowance for third party sales. We believe this transitional provision encourages many of our small business clients to sell their businesses and exit the Canadian workforce before the end of 2017.  The portion of any capital gain in the future that accrued when the shareholder was under age is also ineligible for the exemption. This includes gains which accrued to a minor or trust prior to these announcements which were legitimately eligible for the minor’s gains exemption. For example, if a 25-year-old family member realizes a capital gain in 2019 (for example), the portion of the gain that accrued prior to age 18 will not be subject to the exemption.  There is also NO capital gains exemption for any shares held in trusts. Accordingly, these capital gains limiting provisions are completely retroactive, back to the creation of these structures and the settling of these trusts. It is clear from Mr. Morneau’s communications (in person, on line, and in the consultation document) that the intention of these proposals is not to be retroactive, however the proposed legislation is clearly retroactive on this topic.

We can confirm that these new rules limiting access to the lifetime capital gains exemption have prompted at least one of our clients (who is a major employer and job creator in Calgary) to entertain long-standing offers to sell their businesses to a larger international firm. This transaction will likely cost many employees their jobs. This transaction, and the fact that our client (a major job creator) will likely relocate to a friendlier jurisdiction 20+ years before their normal retirement date is a direct result of their incentive to sell their business within the next year to an unrelated third party (call it ‘mega-corp’) given the transitional proposals. It is frightening to us that these serial entrepreneurs will leave Canada several years before their retirement.

There is a (very) short window to reorganize shares held by trusts or minors – however, we may not know what the final law is untill after the October 2 consultation deadline (or at worst until budget 2018) and until further study or update by the Department of Finance. The tax proposals do include 2018 deemed disposition election provisions, where one can deem to dispose of the private company shares, increase the cost basis of those shares for the future and claim the capital gains exemption, under the prior rules. HOWEVER, this election is not available for shares owned by minors, those under age 17 before 2018.  Minor children can access the capital gains exemption only by an actual disposition of their shares before the end of 2018.  This would include shares sold by a trust.  For instance, the trust or minors could sell their shares to parents or siblings who are of age. Therefore the proposals are completely retroactive (and unworkable for even the most seasoned tax professionals) which is contrary to the Finance Minister’s words that the proposals are not retroactive.

Dividend to Capital Gain planning

Currently a shareholder could withdraw cash from their private corporation by dividend, or they could pay tax at the lower capital gains tax rate by selling shares of the corporation. The shareholder could sell their shares to their holding company, and that “holdco” is now indebted to them for the share investment. The shareholder would then have the original corporation pay a dividend to the holding company (dividends between corporations are, generally, tax free). The holding company would repay the shareholder. The shareholder has received cash from the corporate at a reduced tax rate. We are generally not opposed to changes surrounding these proposals in a non-post-mortem scenario.

Similar structures are often used in post-mortem tax planning, called a “pipeline” transaction to ensure that tax on the growth or a privately held company shares at death are taxed the same as growth on the shares of a publicly held company – which is fair by all measures. The legislation was implemented intentionally to ensure fairness in tax at death. It is not a ‘loophole’ to be closed. The shareholder is first deemed to dispose of their shares at fair value on death and pay tax on that capital gain in the final personal tax return.  However, should the company be wound up after the death (as is the case in many estate planning scenarios), there will also be tax payable on dividends or distributions, effectively a second layer of tax which equates to ‘double tax’ or even ‘triple tax’ (see attached examples produced by STEP).

Subsection 164(6) of that Act is another affected post-mortem strategy which was originally implemented to promote tax fairness on the death of a shareholder. It allows a loss carry back on the wind up after death, and while it remains available under the new proposals, it would now be unworkable for deaths prior to July 18, 2017 (see STEP example attached). The window to effect the loss carry back is shorter and contradictory to other estate planning and legally imposed timelines such as the ‘executor’s year’.  Under any scenario, post mortem tax on private (family) company shares under the proposals will be between 41.29%-65% (depending on timing) in Alberta under the proposed legislation.

We believe that it would be fair for the government to continue to allow pipeline planning and extend the loss carry-back timeline in 164(6) planning beyond the ‘executor’s year’. This fairness would ensure that tax applied on private company’s shares (post-mortem) at the same rate as personally held public company shares, being 24% at the highest marginal rate in Alberta.

Proposals re investment assets held in private corporations

The Department of Finance perceives an advantage for private corporations to hold investment assets “beyond what is needed to re-invest and grow the business”. They are concerned that a corporation has more after-tax dollars to invest, given the lower private corporation tax rates, than an individual would have.

The consultation paper does agree that, under the current rules, investment income earned in a private corporation is integrated – the corporate taxes on investment income plus the individual owner’s personal tax on dividends from this income approximates the personal tax on investment income earned directly. Private corporations pay a high rate of tax on investment income which is refundable and refunded when the owner receives that income as a dividend. The non-taxable portion of a capital gain realized by the company creates a “capital dividend account” which may be withdrawn free of tax in the future, to preserve the 50% non-taxable portion of capital gains. Thus integration is currently achieved.

Despite the integration of investment income, Finance believes it is “unfair” that a shareholder may prefer to retain investments in the corporation rather than withdrawing the funds and investing personally. The paper proposes an additional 50% non-refundable tax on a private company’s investment income and eliminates the tax free portion of capital gains earned by the corporation.   These measures would raise the overall tax on investment income earned in a corporation and paid out to a shareholder to over 70%. We appreciate that this must be an unintended consequence of these proposals and so it must be adjusted as there is no scenario where greater than 70% tax is fair to anyone.

The proposals do recognize that private corporations can pay high rate tax and that shareholders contribute funds to their companies; accordingly, a couple different alternatives are suggested to stream investment income such that the pro rata amount of investment income from small business rate earnings/ investments pays the high tax.  Both alternatives, the “apportionment method” and the “elective method” are complex and retain the 70% / near 70% overall tax rates on investment income; as proposed, the record-keeping would not be easy or simple. 70% tax is not fair by any measure and these calculations are not ‘cooked-up’ as certain academics would have you believe.

The government recognizes that currently many Canadian private corporations hold significant amounts of “passive” investment assets. The proposals are intended to apply on a go-forward basis and Finance will determine in the future how to apply the new regime to not impact current investments. There are no details available for how Finance intends to ensure that existing passive assets, and their income streams, held in a private company will be unaffected. It is our concern that whatever device is arrived at to achieve this will either add incredible complexity to our tax system or will, in fact, have retroactive effect.

The proposals do not recognize that there are many good reasons for a private corporation to keep and invest excess cash in the corporation such as:

  • To save for future business expansion;
  • To provide a cushion for future operations in an economic downturn;
  • To protect and grow savings for eventual retirement of the company’s shareholders;
  • It is generally unknown at the time of the passive investing within a corporation which of the above situations would apply to the business, so by asking shareholders to remove excess funds from their companies to invest in things like RRSPs is like asking small-business owners to be clairvoyant (most business owners cannot accurately predict the future);

Business owners generally do not have other safety nets against risk, and don’t generally have other pension plans. The government seems to be suggesting that business owners pay into RRSP’s and TFSA’s and further savings are “unfair”. For the above noted reasons, this insinuation is false and presumes that the ongoing economics of every small-businesses are completely predictable. There are many more economic surprises in small-business than in employment, so this insinuation is contrary to the governments objective of achieving fairness.

For the above reasons, we are concerned that the effects of these proposals may be retroactive and penalize those who have built a retirement pension within a CCPC according to well established tax law that has been in place for the better part of 50 years. No one should be penalized for following Canada’s well-established tax laws; that is also not fair.

We respectfully request  the government ensures that any changes to the tax law in this area apply to income earned from passive assets which are acquired after the laws are passed, and not before (however we cannot offer suggestions as to how this might be administered or workable). Also, we believe that a company should be encouraged to retain a certain amount of passive capital for a rainy-day fund or future expansion and so believe that some capital threshold should be specified to the accumulation of such funds, similar the taxable capital thresholds relating to the access to the small business deduction.

In conclusion

We are not opposed to good tax reform; however the current proposals do not represent good tax reform. Lowering the small business limit, imposing capital limits for passive investments, raising the capital gains inclusion rates, requiring minimum number of employee thresholds to access the small business limit are a few alternative approaches. We believe that the current proposals will encourage tax evasion and the exercise of excessive discretion by the CRA. We believe the proposals would make Canada less attractive to new start-ups and will substantially contribute to Canada’s brain-drain. Many, many experts agree with us –  see the attached listing of articles for proof. The only people who seem to support these changes are uninformed citizens and certain academic economists.

Tax professionals are the front-line of Canada’s tax system and we do not appreciate the additional fees that you are about to ask Canadians to pay us to work through our insanely complex tax system. Canadian entrepreneurs deserve better solutions than a haphazard patchwork of increasingly complicated tax law. They deserve a stable, predictable and fair tax regime that works for all Canadians. – but we are simply the interpreters of Parliament’s words and intentions so please make sure you record them correctly.

Please do better than what has been proposed – Canada deserves better than this

 

As always, please do not hesitate to contact our office with any questions you might have. We would welcome a discussion with any of you as we are genuinely interested in making our tax system better.

Sincerely,

 

 

Clayton E. Achen, CPA.CA, TEP       Carol Sadler, CPA.CA, CPA (IL-US), TEP       George Henderson, CPA.CA

Partner, Achen Henderson LLP       Partner, Achen Henderson LLP           Partner, Achen Henderson LLP

clayton@achenhenderson.ca          carol@achenhenderson.ca                 george@achenhenderson.ca

 

AHLLP – Example of middle-class harm

STEP – 6 Examples of of harmful effects to Canadians