The federal government last week took another step towards implementing sweeping tax changes that could have a disproportionate impact on small and medium-sized business owners across Canada.
The Trudeau Liberals announced plans for a 75-day consultation period during which they’ll be seeking feedback on changes to three common tax-planning strategies for private corporations. The government’s intention to review these measures was first outlined in the 2017 budget and now that public consultations are underway, we’re getting a better sense of just how serious they are about cracking down on perceived unfairness in the tax system.
None of these proposed changes are good news for entrepreneurs, although two are particularly troubling. Just how detrimental could the amendments be? Let’s review the (relatively) good, the bad and the ugly of the measures under review:
“The Government is introducing proposed changes to tax rules to prevent the surplus income of a private corporation from being converted to a lower-taxed capital gain and stripped from the corporation.”
This has long been a contentious corporate tax-planning strategy, and one that we’ve never recommended to our clients. In this case, the government is right: some individuals have abused the mechanism allowing them to extract surplus revenue from corporations at capital gains rates instead of dividend tax rates. The government is proposing to tighten Section 84.1 of the Income Tax Act, which currently sets rules around the taxation of corporate distributions of income as taxable dividends when shares of one corporation are sold to another (both of which might be owned by the same person). This effectively allows individuals to extract corporate surplus at capital gains rates as opposed to dividend rates on the sale for income tax purposes. The CRA is angling to amend Section 84.1 to prevent surplus income from being stripped from a corporation and taxed at a lesser rate as a capital gain.
While this is one mechanism that can easily be tweaked to prevent unfair tax-planning, the change should be executed with caution. Depending on how the legislation is written, it could over-reach and have a negative impact on legitimate post-mortem estate planning, specifically pipeline planning. We’ll be watching the government’s actions closely and weighing in further once legislation is tabled.
“The Government is seeking input on proposed rules to distinguish income sprinkling from reasonable compensation for family members. The rules would help to determine whether compensation is reasonable, based on the family member’s contribution of value and financial resources to the private corporation.”
To do so, the government is planning to apply a “reasonableness” test to curb income being sprinkled out to family members, and thus providing a tax benefit. The reach of the so-called kiddie tax–introduced to stop business owners from paying dividends to their minor children–is being expanded to include anyone to whom corporate income is being distributed. The test for 18 to 24-year-olds will seek to determine whether the individual is contributing their labour on a day-to-day basis and making a significant and sustained contribution to the business. The test for those older than 25 is less stringent, and will seek to determine whether the individual is contributing to the business in a way that requires remuneration.
Now, the legislation specifies that the test only applies to “specified individuals” (this used to mean someone under the age of 18 who received split income such as dividends from a private corporation of a related individual). The new proposal would expand this scope to include all Canadian resident individuals who receive split income in certain circumstances–if the dividend is deemed reasonable under the proposed rules, it won’t be considered split income–and who receive dividends from a private corporation consisting of “connected shareholders.” This is another new term which essentially means a Canadian resident who has a significant influence over the company.
But what about sprinkling income to those who have made capital contributions to the business? When it comes to injections of capital from 18 to 24-year-olds, the government will determine appropriateness based on legislation-prescribed maximums. For anyone older, they’ll look at whether the individual contributed significant assets or assumed some degree of risk with their capital contribution.
If the government deems the income received to have been unreasonable, they’ll apply the higher rate of tax on that income, effectively negating the business owner’s ability to split income.
If the legislation passes in its current form, owners of professional corporations, specifically doctors and dentists, will feel the most acute tax-planning pain due to their reliance on income sprinkling. But they’re not the only ones. Any entrepreneur who has taken the time to develop a comprehensive tax-planning strategy that includes income sprinkling will also be affected.
We believe this legislation has several flaws as currently drafted. First, income sprinkling has been a longstanding tool to help entrepreneurs mitigate the burdens of starting, operating and growing a business. Remember, entrepreneurs lack a safety net such as pensions or benefit plans. They create jobs, pay taxes and are the backbone of our economy. It’s entirely reasonable to continue to allow income sprinkling to help mitigate the risk of business threats such as market upheaval or recessions which could cripple a business at any point. And the last thing we need to do is discourage Canadians from founding companies, investing in innovation and expanding their domestic operations.
Another key question that needs to be addressed: what happens when someone invests in a startup? What’s a reasonable contribution to the business that would justify dividends being paid out to them? We sincerely hope the government will address these key points when finalizing their bill following the consultation period.
That’s because the proposed changes to income sprinkling rules for individuals who own or operate private corporations are potentially regressive and unfair. And they’ll only earn the government a projected $250 million a year in extra revenue–hardly a massive enough windfall to justify such draconian action.
One more point: in addition to the proposed constraints on income sprinkling, Finance Minister Bill Morneau is also looking to curtail tax-planning strategies currently used to multiply the enhanced lifetime capital gains exemption. Again, this will have a major impact on entrepreneurs, which I’ll cover in greater detail in a subsequent blog.
“The Government is seeking input on possible approaches to neutralize tax-assisted financial advantages of investing passively through a private corporation. Modifications to the current system will be designed to preserve the growth objectives of the lower taxes on active business income earned by corporations. The Government will continue to review this issue and, following consultations, will develop concrete legislative proposals.”
So, this is essentially a trial balloon floated by the CRA to test public opinion. At the same time, its passage could be a foregone conclusion with only the details left to be ironed out if the government is determined to broaden the scope of its tax clampdown. Rest assured if the change takes effect, entrepreneurs will take a major hit.
The government is saying that, because many entrepreneurs earn income through a corporation on which they pay tax at the corporate rate, the additional capital they have left to invest–assuming they don’t use that excess income in the business or pay it out to themselves personally–gives them an unfair advantage over the average salaried Canadian. In turn, the government argues, business owners are investing for their own benefit and not that of their corporation. Now, the government is proposing to effectively eliminate the refundable tax system in respect to those invested retained earnings, thereby negating the benefit of the existing tax deferral.
Under the current refundable tax system, entrepreneurs may, indeed, pay a lesser corporate tax rate and have more to invest than they would otherwise. But what if the owner-manager doesn’t invest directly in the business, but invests indirectly by using those extra funds to make a capital purchase such as a commercial property? The government’s proposal doesn’t seem to be taking a scenario such as this into account. Again, their intention seems to be to attempt to level the playing field between business owners and salary-earning Canadians without considering that entrepreneurs use passive corporate investment portfolios as a nest egg (remember, they typically don’t have pensions or benefit plans). They are also not guaranteed an income from one year to the next.
Many of our clients are forced to forego taking a salary when times are tough, often to save the jobs of their employees. Their passive corporate investment portfolios can be a lifeline in these situations, allowing them to keep their personal finances afloat until the business recovers.
Now, it seems they might lose this indispensable corporate tax-planning tool.
So, what should business owner-operators do to prepare as these corporate tax-planning changes loom large? At this point, nothing. Until we know more and have finalized legislation to review, the government’s exact direction remains unclear. There’s no sense incurring added legal or accounting costs to prepare for changes that may or may not come into effect.
What is important is keeping these developments on your radar and staying in close contact with your accountant. Whatever form the final legislation takes, the government will provide a phase-in period to allow business owners to adjust their tax-planning strategy accordingly. Until then, understand that some change is going to come.
We can only hope that the proposed legislation is watered down enough to mitigate the damage to entrepreneurs and their organizations.
Armando Iannuzzi, Partner, KRP