On July 18th Federal Finance Minister, Bill Morneau, proposed material tax changes for business owners with a short period of time for consultation from the public. Since then, there has been substantial media coverage and backlash from the business community, including farmers. We want to remind you that the deadline to speak to your MP is October 2nd.
Today, Brett Wilson, entrepreneur and former dragon on Dragons Den said:
“The tax act – the changes that are being put in place right now make no sense.”
“I wish Bill, or William as his mother must call him, was at the table here ready to be chastised for this. Because he started out by making comments like ‘We’re out to get them.’ That implies no sense of fairness, but there’s a sense that there’s an enemy to be got. And the enemy is the businessman, is the entrepreneur, the farmer, the doctor, the local businessman – that’s who they’re catching in this nest.”
“We [entrepreneurs] don’t have a cushy, pushy pension like many, if not all.”
Overview
Mr. Morneau expressed in the March budget that the Liberals are displeased with Canadians using corporations for tax planning. Mr. Morneau cited that such tax planning strategies are “unfair” and benefit the wealthy. The reality is that the majority of the Canadian economy is comprised of small businesses. These changes would have a material impact on business owners and the economy.
The proposals are aimed towards:
- Income sprinkling
- Passive income
- Converting income to capital gains
Let’s go over the first two briefly, as the third proposal is a reasonable change and would have less of an impact.
Income Sprinkling
Some business owners have family members working for the company which get paid a salary or issue shares which pay dividends, to reduce the family’s overall tax liability. There are currently rules to prevent paying an unreasonable salary to family members that is incommensurate with their involvement in the business. There are also “kiddie tax” rules preventing paying salary or dividends to children under the age of 18.
Now, the government wants to extend the “kiddie tax” rules to restrict paying adult children salary or dividends under the age of 24. Adult children under 24 would be permitted to earn income from the business if they contribute a reasonable amount to the business – by means of labour or capital. Otherwise income will be taxed at the highest marginal tax rate.
Families have also used strategies to issue small business shares to family members, thereby multiplying the lifetime capital gains exemption (LCGE), sheltering up to $835,715 (in 2017) of capital gains for each shareholder on small business shares. Family trusts are also sometimes used to multiply the LCGE. As of 2018, capital gains accrued while an individual is a minor cannot be sheltered, nor would shares held by a family trust be eligible for the LCGE.
Passive Income
Small businesses currently pay income tax of 15% on income under $500,000 generated from active operations. If the owners do not need all of the income for personal use or for further business operations, excess income is usually left in the corporation and invested. Income earned on the investment portfolio is called passive income because it is income not generated by the main business operations.
I.e. if a business generates $100,000 of income, it pays $15,000 in corporate tax and $85,000 is left in the corporation to invest in a portfolio. Income generated on the portfolio is taxed within the corporation. When the owner withdraws the investments for personal use, they then pay personal taxes at their marginal tax rates. Thus, keeping income is a corporation allows for a larger amount to be invested, defers some taxes until the owner withdraws from the corporation, albeit the combined taxes paid (corporate and personal) are actually higher doing so – paying up to 55.97%. The government views that business owners have an unfair advantage even though they end up paying more in taxes by investing in a corporation.
The government wants to consider ways to stop these so-called “unfair loopholes.” It is looking for comments on implementing:
1. A refundable tax on passive investment portfolios in a corporation, which would be refunded when the capital is paid out of the corporation or used in active business operations, or
2. That current refundable taxes on passive income not be refundable if the investments were from excess business income taxed at a lower rate
Is our tax system complicated enough yet?
There is still time to speak to your MP with your thoughts.
I would be surprised if the government is able to enact these proposals. If they do I suspect they would not last very long, especially regarding passive income. These changes would have a material impact on small businesses and the economy. Let's keep aware of the next few months to see what verbiage comes from the government. In any event, rest assured that there are various other prudent tax planning strategies available for business owners.
All examples are for illustrative purposes only and are not intended to provide individual financial, investment, tax, legal or accounting advice. This material is for general information and is subject to change without notice. Every effort has been made to compile this material from a reliable source. However, we cannot guarantee that information will be accurate, complete and current at all times. Before acting on any of the above, please make sure to see a financial professional for advice based on your personal circumstances.