Special to the Financial Independence Hub
The proposed changes to the Income Tax Act that the Minister of Finance, the Honourable Bill Morneau, has released have real-world implications. The consultation period ends October 2, 2017, so now is the time to make your voice heard. Call or email your member of Parliament, or Minister Morneau directly.
I recently had a meeting with a high-tech entrepreneur in an internet-based business. He is very conservative and has not carried out any tax planning. His wife helps him but he does not do any income splitting with her. He has about $1 million in his corporate bank account for possible business use, but has not invested it and just earns minimal bank interest. The hype about the proposals has caused him to take notice of his tax affairs and meet with me.
I told him that under the new proposals income splitting with his wife, other than a fair salary for services performed, will be prohibited. His wife will probably not be able to participate in the lifetime capital gains exemption. If he decides to invest his retained earnings, there may be an additional tax on his income. He is now thinking about lifestyle and whether he wants to leave the country. I fully expect to prepare a memo for him about becoming non-resident.
Minister Morneau’s proposed tax changes will have the effect of causing an exodus of Canadian entrepreneurs for more business-friendly jurisdictions.
I had lunch with accountants a few days ago and they reported the same types of conversations with high-tech clients. They are considering leaving the country. Now, some won’t because of the education of their children, to be close to aging parents, adult children,or because they like their Canadian lifestyle. Others will decide it’s more important to maximize after-tax income and that it makes sense to move offshore.
70% of Canadians work for firms with 100 or fewer employees
Remember, statistics show that the vast majority of Canadians — 70 per cent — who are the economic engine of this country, work for companies with between 1 and 100 employees: the very targets of these new measures, and who are able in many cases to pack up and leave.
This is not just the view of tax professionals. Ryan Holmes, the CEO of social media internet company Hootsuite, was reported as saying on Sept 14, 2017 that the proposals are causing a lot of concern to business owners and that “I think you need to be very favourable at the small end of the market.”
I was recently contacted by a Liberal MP who is very opposed to what his government is doing. He has an entrepreneurial background and he realizes the impact of these proposals.
The philosophy behind the proposals is to “level the playing field” and the example given in the release is an individual living in Ontario and earning salary of $220,000 versus his neighbour who earns the same amount through a private corporation and is able to reduce taxes through income sprinkling.
The discussion is silent about the couple living next door and earning $110,000 each who pay less in tax then their neighbours where one spouse earns $220,000 and the other spouse takes care of the kids. The discussion doesn’t mention progressive tax rates which mean that the more you earn the higher the rate of tax paid, not just the amount of taxes paid. In the US, joint returns are filed by couples so there is no need for spousal income splitting, unlike in Canada.
There is a lot of misinformation or plain misunderstanding of the facts. Andrew Coyne said in a commentary in the National Post on Thurs Sept 14, commenting on the Conservative party approach that: “What we have heard instead is a full-throated roar of protest at the very idea of asking the owners of private corporations to pay the same tax as their unincorporated counterparts earning the same income.”
This is wrong.
The Canadian income tax system is integrated with respect to personal and corporate income earned by a small Canadian corporation. This means that if income is earned personally or is earned in a small corporation and paid out in dividends to the owner, the tax is the same. True, there is a deferral of the second stage of tax until that dividend is paid but that is a deferral, not a reduced rate of tax, and that is not what Andrew Coyne said.
Finance Minister Morneau said in a recent op-ed that: “For passive investment income to provide an advantage over and above what is available to every Canadian through RRSPs and TFSAs, a business owner needs to earn more than $150,000. That is because the more you earn, the more you stand to benefit from these tax planning strategies. No wonder some estimate that two-thirds of the wealthiest 0.01 per cent own a CCPC.” Correct, and he makes my point about progressive tax rates. Of course, the more you earn, the more you benefit from tax savings strategies. That is because the more you earn, the higher your rate of taxation.
Employees have minimal skin in the game
What is also concealed is that the salaried employee and the entrepreneur are not on a level playing field to start with. An employee has minimal, if any, “skin in the game” and no risk other than job loss.
The business owner risks capital and effort in what may be a losing business. If unsuccessful the house and all assets are usually lost and the family is devastated. The “overnight success” takes many long years of hard work with little if any compensation. The two neighbours are not in the same position. The entrepreneur is the main driving force behind the Canadian economy and takes significant risk.
Income sprinkling proposal a bonanza for tax lawyers
The first proposal targets income sprinkling. The father of our Prime Minister famously said the government has no business in the bedrooms of the nation. While these proposals may not actually invade bedrooms of small business owners, they certainly encroach on the kitchen and family room.
There will be a “reasonableness” test on any income sprinkling. This will be a bonanza for us tax lawyers who love to litigate nebulous terms like reasonableness, which will include labour and capital contributions to the business, risk assumed and previous returns or remuneration. Reminders of a planned Marxist economy?
There will be also be restricted rules for adult family members aged 18 to 24. This will be a treasure trove for Charter lawyers, who will be able to argue this is prohibited discrimination based on age.
Another part of the anti-sprinkling offensive is aimed at the small business or family farm lifetime capital gains exemption. The capital gains exemption would be unavailable for value that accrued while a shareholder was under 18. So you won’t be able to have adult children who received shares as minors benefit from the exemption. Further despoliation of tax incentives for small business.
Insidious attack on passive income
The second proposal is, to my mind, the most insidious.
It attacks passive income earned in small corporations. Remember that passive income earned in a corporation is presently taxed at the same rate as if earned by the individual (since our tax system is integrated to prevent a tax benefit from earning investment income in a corporation), the avoidance of the second stage of taxation when profits are removed from a corporation by the shareholder (and taxed on receipt by the shareholder) is now being assailed.
How is it being targeted? We don’t know. The concept is so difficult (not to mention unfair) that Finance doesn’t know how to implement it. If enacted, the rules will make accountants bald and rich.
With the top marginal rate in Ontario at almost 54% so the taxman is the senior partner in your pay cheque, and the latest anti-small business proposals, expect less investment in small business and more entrepreneurs leaving for lower-tax more business-friendly jurisdictions.
David J Rotfleisch, CPA, JD is the founding tax lawyer of Rotfleisch & Samulovitch P.C., a Toronto-based boutique tax law firm. With over 30 years of experience as both a lawyer and chartered professional accountant, he has helped start-up businesses, resident and non-resident business owners and corporations with their tax planning, with will and estate planning, voluntary disclosures and tax dispute resolution including tax litigation. www.Taxpage.com and firstname.lastname@example.org