In July, the Canadian government proposed dramatic changes to federal tax rules that apply to small-business owners and entrepreneurs. Intended as a crackdown on what Ottawa considers the “unfair” (but not illegal) exploitation of certain loopholes, the business community and opposition Conservative Party consider the most “radical” tax overhaul in 50 years that is itself unfair. With the 75-day public consultation period now about halfway complete, major misconceptions over what is an undeniably complex set of proposals exist. Below, BNN takes a look at some of the most significant aspects of the government’s plan.
1. INCOME SPRINKLING
Critics of the proposal claim it represents a new and unwelcome change in policy direction from the federal government. However, David Duff argues the crackdown on “income sprinkling” – one of the three key pillars of the planned changes – is part of a process that has been underway for decades.
“This has been an evolution,” Duff, director of the Centre for Business Law at the University of British Columbia, told BNN via telephone; stressing that the evolution has been more about limiting the scope of small-business tax deductions beyond simply restricting income sprinkling, which he noted did not become an issue until the late 1990s. Yet since 1972, when the current small-business taxation regime was created, Duff explained Ottawa has been slowly closing loopholes.
Until the first reforms of the system in the early 1980s, for example, employees of larger businesses were allowed to incorporate themselves on an individual basis, thus allowing them to reap the benefits of corporate employment while receiving small business tax advantages.
It took another 15 years before, in 1999, the Liberal government of Prime Minister Jean Chrétien introduced the first version of what has come to be known as the “kiddie tax”. The move prevented small business owners from “sprinkling” part of their income to children under 18-years-old in order to lower her or his overall tax burden.
The restriction was tightened further in 2013 under Conservative Prime Minister Stephen Harper.
What Ottawa is proposing to do here, UBC taxation professor Tran Chung explained to BNN via telephone, is expand the “kiddie tax” beyond just those under 18-years-old to the entire household. Exemptions will be made for employees working in family businesses, meaning the target of the proposed changes is specifically those Canadians using income sprinkling solely as a means of paying less taxes.
2. THE TIMELINE
Ottawa contends the 75-day consultation period is plenty of time for the government to connect with the small-business community, gauge their reactions and make whatever changes might be necessary to the draft legislation before introducing it to the House of Commons.
History suggests otherwise.
The consultation period Ottawa has set for its proposed changes is barely one tenth of the 24 months of consultations the government held in the early 1970s before the current system was enshrined into law in 1972.
Critics of the proposal are virtually unanimous in their desire to see the government at the very least extend the consultation period beyond its current early October expiry.
Further, the proposed changes are planned to take effect relatively quickly: as of Jan. 1, 2018 for income sprinkling restrictions and retroactive application of the other changes.
3. ENTREPRENEURS VS. EMPLOYEES
Key to Ottawa’s argument that the current federal tax system gives entrepreneurs an unfair advantage over salaried employees is an apples-to-apples comparison of how much a typical member of each group pays in total taxes.
Jamie Golombek, managing director of tax and estate planning for CIBC Private Wealth Management, gave BNN an example via telephone of a salaried employee in a top tax bracket paying a rate as high as 53 per cent compared to a small business owner earning an equal amount but paying a rate as low as 15 per cent.
At first glance, Golombek argues, it might appear as if the incorporated taxpayer is paying just a fraction of the salaried taxpayer’s burden, but he points out the small business owner would still have to pay the remaining 38 per cent of taxes whenever the money was removed from the business. “So the total taxes paid would be the same,” Golombek said, “the difference is just the timing… the government doesn’t like that it is not getting all of its taxes up front.”
It is not that simple, counters Duff of UBC’s Centre for Business Law. Even if the same amount of tax is eventually paid on the initial income, he points out being able to start with a higher initial source of capital will translate directly to higher returns in the future.
“So if I’m going to leave my income in a corporation for longer and subsequently the returns will be higher, then I would still be better off than if I did not have that option available to me if I were a salaried employee,” Duff said.
There is also more than one type of small-business owner, points out UBC tax professor Chung, and they should not necessarily be treated the same.
“If an individual incorporates a professional service and does income sprinkling, I think shutting that down is fair,” he said. “But for a business owner that actually opens, say, a store, I think that dividend sprinkling should be allowed. The difference is the capital required and the risk required. An individual professional assumes little additional risk and capital by incorporating, whereas startup capital for a small business usually comes from friends and family.”
4. THE REASONABLENESS TEST
Among the most widely criticized aspects of the proposed changes has to do with a “reasonableness test” Ottawa wants to introduce for small-business owners who “sprinkle” their business income among other family members in order to reduce the family’s overall tax burden.
While the government has been increasingly restricting the use of this practice for decades, the latest proposal introduces an additional hurdle: justification.
If the proposed reasonableness test gets enshrined in law, any dividends from a business owner paid to family members will need to be proportional to that family member’s contribution to the business; either via capital contributions or labour.
Opponents to this measure often evoke images of an army of auditors descending on Canadian small businesses to arbitrarily decide what dividends are reasonable and which are not.
“It just adds a lot of greyness and perhaps a lot of potential for litigation,” is how UBC tax professor Chung explains the concern.
CIBC’s Golombek went as far as to say “it might” require the Canadian Revenue Agency to hire more auditors to conduct the test.
Introducing such a test would be new for the small business community broadly, but Duff at UBC’s Centre for Business Law argues it has been employed effectively in a very similar context for decades.
“The [reasonableness test] rule the government is proposing is based on the rules that have existed for a long time for partnerships, so we have experience in a very similar context with rules that maybe people have forgotten about but they have long been applied,” he said. “Ideally, clarity in rules is a good thing, but sometimes you need to have standards like reasonableness in order to prevent avoidance.”
5. PASSIVE INVESTMENT INCOME
Perhaps the aspect of the federal government’s proposal that’s most difficult to understand is the plan to target passive investment income, which refers to profits made off of investment accounts held within a corporation. Those profits are taxed at a lower rate than regular investment income, with the purpose being to give small businesses a method of building up capital they can use to reinvest in and grow the business.
However, Ottawa argues entrepreneurs are unfairly using their passive investment income to save for their own personal retirement -- an option salaried Canadians do not have.
Despite the appearance of giving an advantage to incorporated Canadians, UBC’s Chung argues it is anything but. “I don’t think this is a loophole at all,” he said. “I think there is a misconception… the lower tax rate threshold is only available on business income. If a company earns business income and investment income, the investment income earned by a Canadian private company would still be subject to a much higher tax rate.”
It is also unclear whether passive investment income is truly an attractive retirement-savings vehicle.
According to an analysis by UBC economist Kevin Milligan, building retirement savings using TFSA and RRSP contributions would provide virtually the same tax advantages. The only people who would get more advantages, Milligan found, would be those with large portfolios over and above what they could hold inside a TFSA and/or RRSP. That is the exact group of people Ottawa is attempting to target with its proposal.