Small Business Tax Changes

If you haven't been living under a rock for the past two months or so, you've probably been bombarded with information about the tax changes the Liberal government are proposing.

Most of the rhetoric spread about in major media these days can be summed up as recycled opposition material to the changes led by the Canadian Medical Association, Canadian Federation of Independent Business, Canadian Pharmacists Association, and of course the master heartstring pullers – farmers.

The other side of the news stories comes straight from the government, particularly Finance Minister Bill Morneau, defending the proposed changes in the face of pretty intense pressure.

I think it's important to get a reality check and figure out exactly what the impact of these changes will be. We all know that doctors won't all leave to practice in the U.S., farms will not disintegrate, and commerce will carry on as usual – despite the threats.

Three Big Changes

I've read the proposed legislation changes and they're quite complex. One thing is certain, they don't make the tax code any easier to decipher. But I'll try briefly sum up the changes for you.

1. No More "Income Sprinkling"

Under current legislation and common practice, anyone can set up a Canadian Controlled Private Corporation (CCPC) and list their spouse, adult children, or family trusts as shareholders regardless of their capital contributions.

They can then distribute business profits to the shareholders as dividends and/or capital gains. These types of distributions are taxed at much lower rates than regular income. After the tax credit or capital gains inclusion rate, the effective tax rate can be about half the rate paid for regular employment income.

The proposed legislation changes the rules so business income can only be distributed to shareholders who can pass a "reasonableness" test. This means work performed or capital provided to the business. If you don't perform any work or capital for the corporation, don't expect the get any income taxed at extremely low rates.

Opinion: This change makes a lot of sense to me, especially how it pertains to adult children and trusts. The spousal distribution is a bit more difficult for the government to defend as spouses are likely capital contributors – especially if they were married at the time the corporation was formed. Tax rates for dividends are complex, but it makes sense for shareholders who contribute capital to be able to receive a reasonable dividend on their investment at a tax-advantaged rate. In the end, I think there are many situations where spouses will still be able to receive dividends at low tax rates after the proposed changes take place. However, spoiled rich kids should not be able to get low tax dividends every year to buy 5th wheel RVs and Mexican vacations while doing nothing in the family business.

2. No Tax Advantages for Passive Investments Held in Corporations

Currently a CCPC can invest in passive investment instruments with their capital contributions or accumulated business profits. They can invest in stocks, bonds, GICs, rental real estate, etc. However, there are tax differences between small business corporations and corporations set up for the primary purpose of investing.

There's actually a whole segment of mutual funds designed as tax advantaged funds for CCPCs which reduce investment income (distributions) and convert those to capital gains and return of capital which are deferred until they are actually withdrawn from the corporation. These are wrapper-type products known as corporate class or C-class funds.

This effectively means a corporation can have an investment account which acts like a "Super-RRSP". The corporation pays less than 15% tax on profits and invests more than $85 per $100 in pre-tax profits in passive investments. Those investments can grow for an indefinite time period without triggering any tax situations (realized capital gains or dividends) along the way. Then the investments can be sold (triggering a taxable event at low tax rates) and paid out to the individual at up to half the tax paid on a RRSP withdrawal.

By using a CCPC, an individual can achieve substantial tax benefits when passively investing compared to a regular individual investing in an RRSP, TFSA, or a regular investment account with salary dollars. This means incorporated individuals can accumulate much more wealth just because of tax advantages even though this investment has nothing to do with the business operation.

The proposed legislation changes the rules by substantially increasing taxes and preventing tax deferral on investments held in corporations which are not later used for business purposes (equipment, employee salaries, expansion facilities, etc.). The taxes will be so high that it will not make any sense for business owners to use their corporations for investing in non-business related instruments. This means business owners will likely re-invest profits in business operations, or take money out of the corporation as salary and dividends and invest in personal accounts like the rest of us.

Opinion: This policy change makes absolute sense to anyone with any common sense. Private corporation owners should not be able to create "Super-RRSPs" which are not available to the minions. We've got TFSAs, RRSPs, and nice tax advantages on most investment income as it is. Corporations should be using their profits to grow their corporations, not to set up fat investment accounts with even bigger tax advantages. The arguments of the CFIB and doctors to retain this benefit are hogwash. If you are maxing you and your spouse's TFSAs, RRSPs, and still have so much money left over that you will be paying "too much" tax on your regular investment account I have great news for you: you are rich! Stop whining.

3. Reduce Conversion of Income into Capital Gains

In current legislation, a corporation can do a somewhat complex conversion of business income from one corporation into another related corporation and their shareholders through share transactions and have this income treated as a capital gain. As we know from regular investing, only half the capital gain is included for tax purposes. This also applies to capital gains within corporations, so capital gains are effectively taxed at 6-7%.

When the second corporation owner sells this gain for their personal income, it gets taxed as a capital gain and just half of the gain is included as regular income. This means the business owner ends up paying less than half the tax on this type of transaction compared to regular employment income.

It's important to recognize that legislation has previously attempted to prevent this type of income switch from happening, but clever accountants and tax lawyers figured out a way to circumvent the current rules and do it anyway through a complex set up of corporations and manipulating the adjusted cost base of an operating corporation's shares. (Many wealthy business owners have seperate corporations which conduct business activity called OpCos and holding corporations for further liability and tax advantages called HoldCos).

In the proposed legislation, the adjusted cost base of a private corporation's shares can not be increased through transactions which have not taken place between parties not at arm's length (generally relatives).

Opinion: Again I believe this is a good policy change that primarily targets owners of larger corporations which have substantially increased in value over the years and have the ability to hire expensive accountants and corporate lawyers to set up and execute the transactions properly. Small business owners already benefit from capital gains exemptions up to $1,000,000. The value of this exemption can run in the hundreds of thousands of dollars and is a substantial tax benefit for owners of successful small businesses. These exemptions are ample reward for the risk and effort of running a successful small business, so creative tax plans to further increase these benefits go against fairness principles. Individuals investing in public company shares don't get a capital gains exemption at all, we just get a preferred tax rate on capital gains for risking our capital.

Summary

These tax changes are a good step in the right direction addressing some of the more complex strategies used by wealthy Canadians to reduce their tax bills to dollar levels paid by people who earn far, far less.

Don't get me wrong here, I am a firm believer in entrepreneurship, business growth, and reasonable taxation. Hell, I'm risking about $600,000 in capital right now in various businesses. But that doesn't mean these strategies which provide huge, and unfair benefits, to a small portion of the population should be defended.

It especially means the CFIB and related associations should stop with the manipulation of public opinion by spreading lies about the real effects of the proposed changes. These changes will have little to no impact on the average farmer and "middle class" small business owner who is actively trying to grow their business, take risks, and employ people including their family members; it might even save them a few bucks in tax accounting and corporate lawyer bills.

I have said over and over that we should encourage smart taxation but focus our criticism on government spending. Government spending should be as efficient and sustainable as possible in the context of a large organization and there is no doubt we can make substantial improvements from where we are today. But that's an entirely different argument that shouldn't be a factor in this small business tax issue.

Governments spending is funded in two ways – taxes or debt. Funding spending with debt is stupid and unsustainable. So that leaves taxes. If we accept the role of government and government services, we must also accept taxes. The only people who can disagree with this are the true, hard-core anarchists who don't accept government or their services (a justice system, health services, old age security, income redistribution, protection services, etc.). There are not too many real anarchists.

If we accept taxes, lets at least make sure our tax system is efficient and fair for all. This means taxes should be simple to understand, the system should be easy to execute and enforce, and people who earn more should pay more to a reasonable level.

We already have very low tax rates on small business income compared to most other developed countries. Business owners also get taxed at low rates on dividends, can distribute income to their spouses to lower their overall tax bills, and can claim a lot of expenses resulting in a lower requirement for personal income. This will not change.

Those with capital to invest (at the personal level, of course) will still be rewarded with tax advantaged vehicles like RRSPs and TFSAs, plus they can pay low tax rates on dividend and capital gains income from passive investments. This will not change.

My only criticism of these changes is that it makes our tax codes even longer and somewhat more complex. Our government should be moving the other direction, revamping and streamlining our tax codes, making it easier to start a business, and reducing the costs of running a business to promote reinvestment in the business. Let's be honest, lawyers and accountants are very much like many government employees – they provide little economic benefit and cost more than they should.