Tax Planning Using Private Corporations - The Liberal’s go with Piecemeal Announcements

I have pushed back my second post on tax efficient investing to next week so I can comment on the Traveling Libburys tax damage control tour (instead of Dylan, Petty, Lynne, Harrison and Orbison, we got Justin Trudeau, Bill Morneau and Bardish Chagger).

The tour this week made stops in Stouffville Ontario, Hampton New Brunswick, Montreal Quebec and Erinsville, Ontario. At each location, the government provided a new tax morsel and comment on its tax proposals. However, without any details, many people are still not quite sure what the proposals really say or look like. A friend told me this is like a Trump tweet; do you take them at face value or is there more to them?

This is what we were told last week by the Prime Minister and Finance Minister in respect of the taxation of private corporations.

Income Splitting

The government announced the following in respect of the income splitting proposals:

• It has committed to lower the small business tax rate to 10 per cent, effective January 1, 2018, and to 9 per cent, effective January 1, 2019. To be clear, this reduction is a drop from the current 10.5% rate and the provincial tax still needs to be added on. So for example in Ontario, the rate will drop to 14.5% from 15% for 2018.

• The proposals to limit the ability of owners of private corporations to lower their personal income taxes by sprinkling their income to family members who do not contribute to the business will remain.

• It will simplify the proposed measures with the aim of providing greater certainty for family members who contribute to a family business. Specifically, "the Government will work to reduce the compliance burden with respect to establishing the contributions of spouses and family members including labour, capital, risk and past contributions, better target the proposed rules, and address double taxation concerns". I would suggest this will be much easier said than done and I would expect this determination to be fraught with issues.
  
• It will not be moving forward with proposed measures to limit access to the Lifetime Capital Gains Exemption. I would not be surprised to see specific exclusions in the 2018 budget to this rule, such as excluding the exemption for those under 18.

Passive Income Proposals

This proposal was probably the most contentious issue to most small business owners who felt the initial proposal would impact their retirement planning and ability to fund the ups and downs of a business. The government gave a little here, but given the potential massive complexity of tracking passive income and the fact they say only 3% of the businesses will be caught by the rules, this is the one area I feel they should have left the status quo. Not one tax professional I spoke to understood how this is really going to work and could see any type of legislation that will not cause massive complexity and extra accounting costs to small businesses.

Here is what the government said:

• The new rules will not apply to existing savings and income from those savings (thus some kind of tracking mechanism will have to be put in place. I see this as an accounting and tax nightmare, how do you track amounts contributed from this pot of funds back into the business and then taken back out, let alone track the income earned from the existing pot of funds. Are the original funds referenced going to be current investments only, at cost or fair market value, will they include cash in the business or is the initial savings the current retained earnings)?

• The existing rules will apply on investment income earned from new savings up to a maximum of $50,000 of passive income in a year (equivalent to $1 million in savings, based on a nominal 5% rate of return). To the extent investment income from new investments exceeds $50,000 in a year, the new punitive tax rates will apply. The wording here is very simplistic and has been interpreted differently already by many commentators. The devil will be in the details.
• Incentives are in place so that Canada’s venture capital and angel investors can continue to invest in the next generation of Canadian innovation.

Capital Gain Stripping

Finally, the government announced these proposals will not move ahead. This is a head-scratcher. As  I noted in my last blog post on this topic, many would argue some of the tactics used here while legal, were aggressive. The issue in relation to capital gains stripping was the proposals were causing business transition issues and double taxation on death by not being able to use a "pipeline" planning technique to prevent double tax.

This is what the government said:

• They will not be moving forward with measures relating to the conversion of income into capital gains. "During the consultation period, the Government heard from business owners, including many farmers and fishers that the measures could result in several unintended consequences, such as in respect of taxation upon death and potential challenges with intergenerational transfers of businesses. The Government will work with family businesses, including farming and fishing businesses, to make it more efficient, or less difficult, to hand down their businesses to the next generation".

The National Post reported (sorry link has disappeared) that Mr. Morneau said “What I’m announcing this morning is we’re going to take a step back and reconsider that aspect of our tax reform proposal,” and "the government will instead embark on a year of consultations aimed at developing new proposals".

Thus, I think it fair to say, we may not have heard the end of these rules and the Liberal's will likely move to judiciously carve out the aggressive stripping while ensuring succession and estate planning are not side-swiped.

As noted at the outset, we are lacking clarity. We have no details, legislation, examples or FAQ, let alone confirmation or whether the effective date of these proposals has changed? We still have partial or full tax planning paralysis because of these ad hoc proposals and revisions.

In my humble opinion, the main miss here is the passive rules. The complexity of these rules will be overwhelming for such little tax gain to the government.

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.

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.