My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, September 11, 2017

Tax Planning Using Private Corporations - A Philosophical and Critical Review

I am back from my summer break. Today, I comment on the Liberal tax proposals put forth in July, in respect of the taxation of private corporations. I have a feeling I may be writing on this topic several times this year.

On July 24th, I wrote a blog post on the Liberal government’s proposals for tax planning using private corporations. As these proposals were released mid-summer, it took a while for small business owners and professionals to understand the potentially complex and punitive nature of these proposals. If you want to read an updated summary with recommendations on this issue,
this report by BDO Canada is very good.

I can tell your first hand that there is a lot of anger among business owners for what they consider a totally misguided government notion that business owners should be treated in exactly the same manner for tax purposes as their employees who take none of the business and financial risks and the implication private business owners are abusing the tax system. Opposition has been growing throughout the summer and there is a mounting backlash from professionals and small business owners against these proposals. Based on email responses I have been CC'ed on, local MPs are taking this issue seriously. Whether this pressure will cause Prime Mister Justin Trudeau and/or Minister of Finance Bill Morneau to change their stance on this issue remains to be seen.
Whether you philosophically believe these proposals are fair (and based on feedback both publicly and to my email inbox, most of my readers think they are not fair), these rules will create a very negative climate. Just as importantly, there is currently tax paralysis, as advisors are not sure what the rules are and will be and thus, they cannot properly assist their clients. One way or another, a clear path needs to be set as soon as possible.

I could provide a laundry list of reasons why I feel these proposals unfairly target small business owners and professionals, but that is not my objective for this post. What I want to discuss is the feedback I have received from those affected by the proposals, other accountants, and employees who may not feel as aggrieved.

The proposals target three specific areas:

1. Converting Income into Capital Gains

2. Income Splitting

3. Taxation of Passive Income

Converting Income into Capital Gains


When people speak frankly about this proposal, there is generally unanimous consent that the proposals for the conversion of income into capital gains are “fair”. I don’t think that if this proposal was released in a typical budget that it would cause much consternation. There is concern however; that the government has to distinguish between aggressive tax planning and tax planning that avoids double tax (such as pipeline planning upon death).

Income Splitting


When discussing this topic, most business owners and professionals feel these proposals are punitive and generally unfair save one provision (the capital gains exemption – which I discuss below). These proposals in general will prevent family income splitting (as the income will be taxed at the highest marginal tax rate) unless there is reasonable compensation and the compensation is based on labour and capital contributed.

Where I have discussed these proposals with people that are employees, in general they feel the proposals are unfair to restrict income splitting with spouses, but they tend to agree with the government that income splitting with children should be eliminated.

Business owners feel the income splitting rules are unfair is that they look at their business as a family business, not a business owned by a sole individual, even if that individual is the only one actually working the business full-time. For example, many spouses who do not work in the business either gave up a full or part-time career to enable the business owner to work the hours required. Spouses in many small businesses are sounding boards and consultants. When a spouse comes home they discuss over dinner or drinks decisions to be made regarding expansion, employee issues, equipment purchases, etc. The unpaid “consulting or sympathetic listening time” for spouses is immense. This does not even account for the family time lost due to the crazy hours worked by entrepreneurs. Children are often called in to assist with a new business in many ways for no pay and/or to have time to spend with the parent/owner.

Most business owners feel it is fair for spouses and children to own shares in a family corporation. Although when pushed, in general they feel that the $835,716 small business capital gains exemption should be restricted to spouses only and at most children over 18 years of age. Non-business owners feel that children should have no access to the capital gains exemption.

So in summary, I would suggest most business owners and non-business owners feel these proposals are extremely unfair in respect of spouses, but many non-business owners and some business owners feel the restrictions on income splitting with children are reasonable for those at least under the age of majority.

Taxation of Passive Income


As noted in my July 24th blog post, where a corporation earns less than $500,000 the company pays tax at 15% in Ontario and a similar amount in each province. This results in a tax deferral, not a tax saving of up to 38%. Where corporations earn income in excess of $500,000, or in the case of many professional corporations where access to the small business exemption is limited (they must share the $500k exemption with all their partners), the tax rate is 26.5% in Ontario and similar in most provinces, resulting in a tax deferral of 27% or so. The proposals effectively eliminate the tax deferral for all income not re-invested back into the active business.

I would say these rules have antagonized small business owners, professionals and tax advisors the most and there is unanimous consent these rules are not required and unnecessarily punitive. The reasons for this are as follows:

1. Unlike the income splitting and capital gains stripping rules, in general, these rules only result in a deferral of income tax, not an absolute saving.

2. This deferral has been used extensively by small business owners and professionals to create their own retirement fund. The fact that the government is considering removing the ability to save for retirement within a corporation has many people going apoplectic. The reason for this is essentially twofold. Firstly, business owners are furious the government is not providing any benefit for the risk they take for starting and owning a business and secondly, they look at government employees with gold plated pension plans and ask what right does the government have to prevent them from trying to create their own retirement fund?

3. Any new rules will be unbelievably complex and expensive for the business owners and advisors to administrate, especially given there is only a tax deferral and not an absolute tax savings. How do you track excess income earned between corporate use and passive use when they are often intermingled in some manner?

I have found that when you take emotion out of this issue, there is some agreement that the capital gains stripping and income splitting with children proposals were fair. However, the other proposals are considered prejudicial against high income earners, punitive, complex and totally ignore the risk that business owners must accept in starting a business. Finally, I think the Liberals are missing a very important consideration: that being mindset. When you tax people at 53% and restrict the benefits to start a business, you stunt business growth, create more underground transactions, and cause some of your best and brightest to leave the country. This does not even consider the massive spending power you are taking out of the economy by reducing the discretionary income of typically the highest spending Canadians.

Update


A couple important updates, one on this topic and one on the work-in-progress transition period announced in the 2017 Federal Budget.

In this editorial by the Finance Minister in The Globe and Mail, Mr. Morneau states the following " For those business owners and professionals who have saved and planned for their retirement under the existing rules, I want to be clear: We have no intention of going back in time. Our intent is that changes will apply only on a go-forward basis and neither existing savings, nor investment income from those savings, will be touched". This statement at least clarifies the passive income rules will at worst be go forward rules.

In this March, 2017 blog post on the federal budget, I discussed that professionals would no longer be allowed to deduct their work-in-progress ("WIP") from their taxable income and their current WIP deduction would be subject to a two year addback transition period (2018 & 2019) that would result in harsh income tax consequences for many. Late last week the government released draft legislation regarding the 2017 budget proposals and they have changed the transition period for WIP that has to be brought into taxable income to 5 years (20% a year starting in 2018 through 2022) from the initial two year proposal.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.