Canadian Tax Fairness - A Counter Proposal
In case you haven’t heard the government is proposing massive changes to the taxation of Canadian Private corporations. These changes are drastic and full of unintended consequences. I am proposing some more simple changes would be better. Following are my thoughts on how the government could have addressed the issues in their proposal.
The changes were presented as attacking the wealthy, who were characterized as tax cheats. However there is no income or wealth test on these changes and they will apply to every incorporated small business in Canada.
Issue: Income Splitting
Through structuring the ownership of their company a family can currently have income from their family business taxed in the hands of any family member who is an owner of the company, after the corporation has paid tax on the income.
Proposal
This is deemed unfair if those family members are not actively involved in the business. Any dividends paid that are deemed unfair would automatically be taxed at the top tax rate regardless of the other family members’ level of income. The problem with this assumption is that dividends are the after-tax payment to the owners of a corporation for a wise investment, and the government proposal suggests that dividends are meant to be a non-wage payment for active participation in the business. No one who owns bank stock as an investment has to show up and mop the floor at their local bank branch in order to receive a dividend.
The proposed legislation provides an example of what might be a reasonable rate of return on preferred shares with a fixed dividend, they use 5%. I would suggest it is impossible to determine a reasonable return on investing in a private family business. Consider this:
If a GIC pays 1% with a 99.99% chance I get all my money back,
A preferred share of a public company pays 5% with a reasonable chance of your capital being safe,
An investment in the stock market will average 12-18% over the long term with a moderate risk of loss.
What is the reasonable rate of return for investing in a business with a 50% chance of failure, where your family member would be personally liable for any sales tax or employee deductions that are not paid? To be honest, investing in a family business is a risky decision and should allow for a return that reflects this high risk.
Recommendation
Option A
I am not suggesting that families that run small (or big) businesses deserve to be able to split income when other families cannot. In fact my first suggestion to solving this is to allow all families to split their income. It does not seem “fair” to have a family with two people making $30,000 a year pay less tax than a family where one parent stays home and the other makes $60,000. That is unless we are trying to discourage people from choosing to stay home to raise their children. I do realize this could potentially put single individuals at a disadvantage, but if properly structured this could be avoided. There are already certain tax credits (GST Credit, Canada Child Benefit and Ontario Trillium Benefits) where the eligibility test is based on household income so adding the option of filing a joint family return is feasible. The problem with this solution is that it would likely cost the government revenue rather than increase tax revenue.
Option B
The second option is a modification to the income splitting rules. My issue with the current proposal is that it ties dividends to labour. Nowhere else in Canadian taxation is effort a requirement to receive a return on investment. I am suggesting that regardless of the amount of effort, a member of a family business should be entitled to a return on the risk they have taken by being part of a family business. Family members are usually required to put up their own capital to start a business. If the business fails then they lose their investment (and possibly their house).
I would propose a two part solution. The first part would be have a variable small business limit (currently private corporations are eligible for a $500,000 small business limit with a 15% tax rate in Ontario). I would propose that the small business limit be determined based on the amount of revenue or the amount of wages paid. Perhaps a business with $120,000 in wages is only eligible for a small business limit of $60,000 (the precise ratio would need to be worked out to be “fair” for all). Any income above that would be taxed at the higher corporate tax rate of 26.5% (Ontario). For some of the businesses the government is targeting this will immediately increase tax revenue as the corporations would pay more taxes. This would avoid being unfair to the business as income taxed at the higher corporate rate is taxed lower when paid out as a dividend to the shareholders.
The second part of this solution would be to reverse the government proposal’s onus on “reasonability”. Instead of requiring the family member receiving the dividend (a return on investment) to contribute through labour to the business, the requirement could be that the primary business person first receives a “reasonable” remuneration (wage + dividend) and the remaining profits are available to be paid to the other shareholders. This could achieve the aim of making sure the primary driver of a business reports a significant portion of the business profits while still allowing the rest of the family to realize a reward for the financial risk they have taken. In order to simplify the enforcement of this I would propose that a reasonable amount be made into a mathematical formula to take out the subjective nature of the current proposal. Perhaps 60% of pre-owner / pre-tax profits up until a maximum and a smaller percentage after that.
Issue: Taxation of Passive Investments
Currently owners of small private corporations only pay 15% (Ontario) tax on some of the profits they leave behind in their business, versus personal tax rates between 35 - 53% (Ontario). This has been deemed unfair as the business owner has more capital to invest. Investment income earned in a corporation currently has very similar tax rates to the top personal tax rates on the same types of income (interest, dividends and capital gains are all taxed at different rates). This is meant to make you indifferent as to whether or not you invest through a corporation or personally. There is admittedly an advantage of the larger capital pool if you invest in the corporation with money earned through a business. Since the tax rates on interest are the same personally and corporately there is a portion of the corporate tax that is refundable when a dividend is paid to an individual (as the assumption is that the individual pays tax on the dividend). One of the current flaws in our tax system is private corporations are earning investment income subject to high tax rates, but getting the refundable portion back right away by paying dividends from the proceeds of their operating business not their investment portfolio.
Proposal
Part of the proposal is to remove the refundable portion of the tax. This would mean if a family business earned $100 of interest, they would pay $50 in tax inside their corporation. Then when the dividend is paid to an individual, it could be deemed as unreasonable (see the previous proposal) and be taxed at the top tax rate of 45.4%. That would leave $27 after corporate and personal tax of the interest earned - resulting in a tax rate of 73% which is too high.
The other issue that could result from both this change and the proposed change regarding income splitting that a dividend must be reasonable, is that there is likely no reasonable amount someone should earn from investment income. That means that someone could potentially sell their business, end up with the sale proceeds in their corporation to use as their retirement income (say $20,000 a year) and end up paying 45.3% tax on that dividend since they did not expend any labour in the subsequent years to earn it. That would be a drastic tax rate for someone who after Old Age Security and Canada Pension could have as little as $35,000 in income.
Recommendation
Rather than completely take away the refundable tax. I would suggest that my above proposal to reduce the small business limit would narrow the gap between what an unincorporated individual would have to invest and that of an incorporated small business. In addition to this I would propose that the refundable portion of tax remain, but instead of being payable when a dividend is paid, the refundable tax is paid when that company uses its investment account(s) to either pay dividends or make capital investments. This would eliminate the current advantage of paying a dividend from operating income to reduce the tax on investment income. It would allow the corporation to receive refundable tax when the investment income is paid out as a dividend. It would also provide an additional benefit, that if a small business used that investment account to save for a downturn, or for a major purchase, the company would receive some of that refundable tax back, which would likely be a huge boost for a small businesses either in a slow time, or a time for major expansion. That is a policy that would level the playing field and encourage economic growth for small businesses.
Issue: Capital Dividend Account
Currently in Canada if an individual realizes a capital gain (selling something for more than you bought it for, like a stocks or a building, not your inventory) only half of that gain is taxable and added to income. The current rule, to be “fair”, says that if a corporation realizes a capital gain that the corporation will only pay tax on half of the gain, and the other non-taxable portion is added to a special account called a capital dividend account (CDA). The CDA amount can then be paid out to the shareholders tax free to put them in the same spot as the individual.
Proposal
Under the proposals regarding investment income, there is a suggestion that capital gains earned inside a corporation would no longer be eligible for the same “fair” tax-free half of capital gains. The proposal does not explicitly state that this rule would only apply to passive investments. So it is possible that a family business could sell the assets of the business and be subject to double the tax if they happened to own that business in a corporation rather than if they had been unincorporated. What of the parent’s corporation who owns shares in a few businesses run by her children? If one of those businesses is sold and she realizes a capital gain, will that be taxed fairly or will that parent be subject to double the tax purely because they own the shares through a corporation?
Recommendation
My overriding thought on this, is changing the way the capital dividend account works could create tremendous opportunities for double taxation, which is not “fair”, and the purported intent of these changes is to make things “fair”. My first recommendation would be to scrap this idea all together. However if the government suspects that the current rules are being abused by private corporations with passive investment portfolios, then an option would be to leave the rules the same, with the same tweak I recommend above. The non-taxable portion of the capital gain could be subject to refundable tax, until the capital dividend is paid, and the investment portfolio is sufficiently reduced.
Issue: Converting Income to Capital Gains
There is a growing trend among high income individuals to arrange transactions so that income is taxed as a capital gain rather than salary or dividends. The reason this is being done is that capital gains are taxed at ½ the rate of salary and lower than dividends.
Proposal
The proposal is set to close this “loophole” that allows for this to happen. The problem is that the proposal along with the other ones mentioned above is structured in a way that could result in a 93% tax when the owner of a corporation passes away and the value is inherited by their children. Hopefully this is not what the government intended to be “fair”.
The other flaw in this is that it does not address the current unfairness in the tax act whereby it is more expensive to pass a family business to your children than it is for an unrelated third party to purchase it.
Recommendation
I would suggest this proposal needs some more work and exceptions. Instead of increasing the tax on inter-generational transfers let’s at least make them fair equal to the cost of transferring to a third party.
Also if the rules are going to be changed to eliminate wealthy private company owners from converting regular income into capital gains, perhaps the government should also revisit their election promise to make changes to the stock option benefits that allow many top executives of publicly traded companies, truly wealthy Canadians, from taking stock options instead of salary since that income is taxed at ½ of what would be a 53.5% tax rate in Ontario. The government announced it was not going to pursue changes to this law as stock options are frequently used to by start-ups to attract talent. I can also agree with that option. However instead of ignoring this potentially huge additional source of revenue, the estimate was $750 million or 3 times that of the small business tax changes, why not make the existing stock option rules more specific. I would recommend that the stock option rules remain unchanged for individuals with income under the top tax rate of $220,000 (in Ontario), and then for income over that the stock option benefit be reduced to eventually have stock options taxed the same as salary for the wealthy. Another option would be to put a time limit on the current treatment of stock options so that if the options were issued in the first 5 years of a start-up the old rules apply, but if stock options were issued to the CEO of a bank that has been around for 100 years the current rules do not apply and are no longer as generous.
Conclusion
I believe that these tax proposals were put forth too soon, and without adequate consultation from the tax community. The current proposals are are aimed at solving a few areas of “unfairness” however will likely result in causing more problems than they solve. The recommendations above are purely my own thoughts as a generalist accountant who serves family businesses. Imagine how much better the actual solutions could be if we included the minds of our country’s top tax specialists who understand these laws and consequences much better than I.
My optimistic hope is that the government will abandon their current proposals which are painting business owners as tax cheats and dividing Canadians against each other. Instead I hope to see the government engage in a process of bringing Canadians together by including the entire country on tax reform.
Sincerely,
Tim Miron, CPA, CA
Partner
BLR, LLP Chartered Professional Accountants