Small business tax reform

It has been just over three months since the Federal Government introduced its highly controversial plan to overhaul Canada’s small business tax regime. Many of my clients are asking me ‘where do we stand? what is the plan?’ I regret to inform you that there is still significant uncertainty surrounding these proposals and, as of the date of writing this, we still have no updated legislation to reflect on.

Justin Trudeau and his Liberals have shown Canadians exactly how not to manage tax reform. While apparently labeling small business owners as loophole abusing tax cheats, the Finance Minster neglected to disclose, to the Ethics Commissioner, his own personal offshore (‘tax haven’) holding company in France. Further, he used a parliamentary ethics loophole by setting up a corporate structure, allegedly in order to continue to control his massive stake ($30+ million – 2015) in his public company, Morneau Shepell. It seems as if these proposed tax reforms, as well as a pension bill which Mr. Morneau sponsored (Bill C-27), could increase the value of Morneau Shepell shares. The theory goes that the laws which Bill Morneau is fighting to pass will/have increased his personal net worth dramatically. Intended or not, these optics stink:

• On October 19th, Bill Morneau announced that he would put his Morneau Shepell shares in a blind trust, which should have taken place 2 years ago when he took office. In his announcement, Mr. Morneau seemed surprised that Canadians have a problem with all of this. After all, he was following the law; just like most small businesses (which he accused of abusing loopholes) have been doing for the better part of 50 years.
• On October 24th, the NDP motion to close the ethics loophole which allows Bill Morneau to maintain control over his Morneau Shepell holdings while acting as Canada’s Finance Minister. The motion also called on Mr. Morneau to apologize to Canadians for his conduct. 100% of Liberal MPs voted against this motion.
• On October 26th, Bill Morneau announced that he would donate the approximately $5.3 million which his shares in Morneau Shepell have grown since he took office two years ago. This donation will very likely provide Mr. Morneau with a sizable tax credit / reduction in taxes leaving him a ‘net benefit’ position. Some see this as an obvious admission of wrong doing.
• On October ?? (anyone know the date?), the Opposition Finance Critic, Pierre Poilievre, lays out all of the issues in an incredible 20 minute speech (it is really good – watch it here) and he asks that the Prime Minister and Finance Minister reveal all of their vested interests to the Canadian public.
• On October 28th, Global News reported that Majority of Canadians think Liberal tax plans are about new revenues, not tax fairness: Ipsos poll.
• On October 30th the Globe and Mail reported that there are other Liberal MPs who are “…using the same ethics loophole as Morneau”. The number of opposition MPs enjoying these structures has not yet come to light. (It has since come to light that the Finance Minister is the only Cabinet Minister who is using this structure).

Canadian small businesses are the real casualty in all of this because, to date, they have received nothing from this government save bad news wrapped in uncertainty.

During small business week in October 2017, the government ‘sprinkled’ a series of announcements highlighting the changes it would make to its tax proposals. These changes are in response to the overwhelming number of submissions (apparently in excess of 21,000) from small businesses and their advisers and, presumably, in response to the political firestorm which the proposals have ignited. I’ve summarized what we know at this point – which, unfortunately, isn’t much.

Link: Backgrounder: Reducing the small business tax rate

On October 16, 2017, at a small business far far away from Ottawa and question period, Prime Minister Trudeau announced that he would execute the Conservative party’s 2015 budget plan to lower the small business corporate tax rate from 10.5% to 9%. A Liberal campaign promise was to execute these reductions, however in the 2016 budget Minister Morneau froze the declining rates at 10.5%. In an interesting show of ‘good faith’ the Prime Minister announced that the rate reductions would ‘continue as planned’. During this announcement, the Prime Minister was reluctant to let the Finance Minister speak (at all) or even respond to questions which were directed to him.

One of the problems leading to these proposed changes is the wide-gap between the small business tax rate (currently 10.5%) and the personal top marginal tax rate (currently 33%) – a spread of 22.5% which encourages people to shift income into a private company. It is interesting that the Liberals’ solution to this problem is to further widen that gap to 24%. The example in their Backgrounder refers to Jeremy, who owns a small restaurant. Jeremy will save $450/year in corporate taxes on $30,000 of corporate income, a savings which will enable him (somehow) to upgrade his restaurant’s kitchen; this is actually what the document says.

A pretext of these proposals is the offering of some assistance to the ‘middle-class’. The document highlights that this rate reduction will amount to a $7,500 tax savings for small businesses with net income of $500,000/year. Again, that’s middle-class small businesses with net income (after salaries and other expenses) of $500,000/year. Right. Actual middle-class families, say with a business earning $75,000/year, will ‘save’ $1,125/year in corporate taxes (or in Jeremy’s case, $450/year) – a savings which, in many cases, will be totally offset and undermined by the increased personal taxes due to the loss of income splitting. I expect that the net sum of these changes will result in quite a few middle-class small business owners paying more tax overall – achieving the government’s more realistic objective.

Also announced with the corporate tax reduction is an increase in the personal non-eligible dividend tax rate “The taxation of non-eligible dividends will be adjusted to reflect the lower small business tax rate to maintain integration of corporate and personal taxes.” For business owners who have built up retirement savings or other assets in their companies, their retirement fund is about to shrink at a rate equivalent to these personal tax increases. This personal rate increase does not account for the fact that the capital residing in these companies was accumulated at higher corporate tax rates.

Link: Backgrounder: Income Sprinkling Using Private Corporations

On the same day, the government announced that it will be moving ahead with its plans to end so called ‘income sprinkling’ and provided some calculations to show how income sprinkling can lower your family’s effective tax rate by using a private company. In its numerical example, the government uses a baseline of $180,000 in corporate income and a mixture of salaries and dividends to a spouse and multiple children. To take a more subtle example: In a family business with $75,000 corporate income, splitting only dividends with only your spouse: this family can currently use income ‘sprinkling’ to reduce its overall tax burden by around 1.6% (2017 Alberta rates, is this really offensive?) assuming no other personal income is earned. The drop in the corporate tax rate by 1.5% (from 10.5%-9%) will net this family a corporate tax saving of $1,125, however they will be paying more than this in personal taxes due to their inability to split income between spouses – a net tax increase for this decidedly middle-class family.

One of the biggest complaints on the sprinkling issue is the wording in the draft legislation which would give the CRA unbridled discretion to maximize the personal tax rate on any dividend it perceived to be offensive under these proposals. This is because the proposals would allow the CRA to determine what they think is a reasonable contribution by a family member to a private company in order to receive dividends from that company. In an attempt to address these concerns, the government says it will clarify which contributions by family members to private companies are worthy of dividends. The document lists 4 ways in which contributions are to be measured:

1. Labour Contributions;
2. Capital or equity contributions to the business;
3. Taking on financials risks of the business, such as co-signing a loan or other debt; and/or;
4. Past contributions in respect to previous labor, capital or risks

Unfortunately, we will have to wait and see what the revised legislation looks like before we can advise our clients on existing or future corporate structures with family members as shareholders, which adds to this extended uncertainty. It seems clear that businesses will have a new requirement to start keeping some sort of records in order to substantiate a family member’s contribution to the business if they are to receive dividends. Absent well drafted legislation, it will likely take our Courts several years to define Finance’s intentions on this topic.

The document also mentions that “the Government will not be moving forward with measures that limit access to the LCGE”. There are certain areas in the proposed legislation where ‘reasonability’ tests, similar to those in the above income sprinkling rules, apply in order for someone to access their Lifetime Capital Gains Exemption (LCGE). It is unclear if the government intends to move forward with those reasonability tests. Draft legislation has not yet been provided and so the scope of this announcement is still not clear.

Link: Backgrounder: Passive Investment Income

On October 18, 2017, at another small business far away from Ottawa and question period, Bill Morneau announced that he will release what I expect to be some of the most complex changes to the passive income regime, ever. This announcement seems to contradict the objective of simplifying our tax system. We still have no idea what these changes will look like, and we will apparently have to wait until the 2018 budget to find out. The highlights of his announcement are:

• $50,000/year worth of investment income will be allowed in a private corporation with no increased tax rate, although it is not specific about which tax rate will apply to this $50,000.
• There is no clarity provided on what happens if a company earns greater than $50,000, presumably one of the “68-73% tax” scenarios presented in the consultation document will kick in.
• There will be grandfathering of old investments under the old passive income regime, apparently. Note that the last time the Liberal Government told us their proposals would not be retroactive they released draft legislation full of retroactive effects.
• There will be some concession for private equity and ‘angel’ investors. Again, no details have been provided.

By my count there could be up to 5 different ways in which income in private companies could taxed (up to 5 ‘buckets’ of income), and we still have NO actual details on what this will look like, which is very unsettling for Canadian private companies. This low $50,000 threshold simply doesn’t work for larger private corporations who have to maintain substantial cash reserves in order to fund massive payroll expenses because they employ LOTS of people. Also, this policy will keep small businesses small by limiting their ability to accumulate the substantial funds required to facilitate larger expansions.  These changes, along with the elimination of Canada’s long standing acceptance of ‘income sprinkling’, would put pension eligible employees at a clear advantage over Canadian small business owners. This is because a pensioner is eligible to split their pension income with their spouse, and they are able to amass pensions well in excess of this new, arbitrary, passive income threshold.

I find it fantastically irresponsible of the Finance Minister of Canada to announce such wide sweeping changes without providing any real details. We can expect draft legislation on this as part of the 2018 budget so small businesses can expect 5+ months of more uncertainty with regards to these changes.

Link: Backgrounder: Support for Farming and Farm Families

On October 19, 2017, at another small business far away from Ottawa and question period, the government announced that it “…will not be moving forward with measures relating to the conversion of income into capital gains”.  These proposals were problematic as they aimed to substantially increase the tax rate on inter-generational transfers of small businesses (compared to third party sales) and to double or, in certain cases, triple the tax payable on the death of a shareholder of a small business, while leaving the owners of public companies with a favorable tax rate at death. This backtracking is welcome news, however the government’s initial presentation of and subsequent retreat on these issues shows that the Finance Department and the Finance Minister, perhaps, did not understand what they were doing when they developed the first draft. At minimum, it shows that tax experts were not consulted in advance of the July 18, 2017 release, which is unsettling.

I believe that dropping these proposals altogether is the most prudent course of action for this Liberal Government. It wouldn’t be surprising to see a further retreat away from the July 18th proposals. On that note, right now is a great time to send your MP an email to let them know what you think. If you’ve done so already, it’s a great time to send a reminder. Small businesses and farmers, it turns out, have a pretty loud voice when they need to be heard