Uncertainty, lack of consultation surround proposed tax changes

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Published on Friday, September 22, 2017

By Kate Jackman-Atkinson
The Neepawa Banner 

Proposed changes to Canada’s income tax act have created uncertainty and anger among Canadian professionals, small business owners and farmers. In announcing the proposed changes to the taxation of private corporations on July 18, federal Finance minister Bill Morneau said that the changes are aimed at creating tax fairness and closing loopholes used by high income Canadians to reduce their tax bills. Many have countered that the proposed changes are too far reaching and will have a financial impact on a range of small business owners.

Small businesses create jobs and drive the Canadian economy. Because of this, they have been given a low tax rate that promotes reinvestment in the business. Currently, private corporations with an annual net income below $450,000 pay a 10.5 per cent tax rate. While the corporation itself may pay a low tax rate, when the owner draws money from the company in the form of a salary or dividend, that money is taxed at the personal rate.

Since the early 2000s, the number of Canadian controlled private corporations has increased by 50 per cent and three times more professionals have incorporated over that time period. Morneau and Prime Minister Justin Trudeau have said that the changes are aimed at high net worth Canadians who are operating as private corporations for the tax advantage and will even the playing field between the middle class and the wealthiest. “Many of the richest Canadians are unfairly exploiting the tax rules designed to help businesses thrive. We know that businesses, including small businesses, help grow the Canadian economy. These tax advantages are in place to help these businesses reinvest and grow, find new customers, buy new equipment and hire more people. We want to make sure those rules are used to do just that, and not to give unfair tax advantages to certain – often high-income – individuals,” said  Morneau in a statement. But many, including Ian Thomson, owner of Kinley Thomson Chartered Accountants, doubt how effectively the changes will target the highest earning taxpayers.

The proposed changes won’t impact the small business tax rate, but will apply to three types of transactions which the government says are being employed by wealthy Canadians to unfairly reduce their tax bills. Tax professionals have concerns about the unintended consequences of the proposed changes, which have been met with strong and vocal opposition from small business owners, incorporated professionals and incorporated farm owners who are concerned about the financial impact. Thomson said he’s been fielding many calls from clients concerned about what the changes could mean for them.

Eliminating the

corporate advantage

The first practice targeted is what’s known as income sprinkling. This involves diverting income from a high-income individual to family members who have a lower personal tax rate. The proposed changes would impact family members who have no role in the business and would raise the amount of taxes they pay.

Matt Bolley, a partner with MNP’s specialty tax group, based out of Brandon, said that income sprinkling, which on the surface seems straight forward, has the potential to create problems in a number of areas, including succession planning. For example, explained Bolley, a business owner could build a business from nothing to a $1 million valuation and want to pass it on to their adult child.  At the time of the transfer, they would create shares with a fixed value of $1 million to be paid out over time, for the founder, and another class of shares for the child.  However, the founder would now be receiving income from the business, while not actively involved in its operations, and be in a situation to fall under the income sprinkling regulations.

The second practice relates to passive investments held by corporations. Investing through a corporation doesn’t reduce the amount of tax paid on the proceeds of the investment, but merely defers it until the investment is taken out of the corporation.

However, because the initial investment is made with net income that was taxed at a corporate rate instead of a higher personal tax rate, it’s is larger.  The government wants to eliminate the additional value created by this larger initial investment and the proposed changes would increase the tax rate to eliminate the added value. In some cases, these investments could end up being subject to a 72 per cent tax.

There are many reasons why small business owners might wish to keep passive investments in their corporation. One of which is to generate income that can be used for retirement, since small business owners don’t have access to corporate retirement plans.  The other is that the money is more easily available to reinvest in the business or cover shortfalls, which isn’t the case if the money is paid out to the business owner and then invested in an RRSP or TFSA.

The government has said that the changes will only apply to high income Canadians who have maxed out their RRSP and TFSA contributions, but Bolley said that there are concerns about how wide-reaching this might be in practice. Bolley said that the biggest question is what exactly will be considered a passive investment. While publicly traded stocks and bonds are obvious examples, there are a number of situations which could fall under these new rules. For example, a group of small businesses might decide that their town needs a new hotel and each make a small investment in the new business. None of them would own more than 50 per cent or be involved in the daily operations and could find themselves facing higher taxes on the investment.

The final change relates to converting a corporation’s income into capital gains.  Income, in the form of either salaries or dividends, are taxed at a higher rate and a series of transactions can convert this money into capital gains, which are taxed at a lower rate. Bolley said that the proposed changes are so broad, they can start targeting transactions which have nothing to do with minimizing tax bills, for example, those aimed at succession or estate planning. He noted that even an incorporated farmer selling land to another family member operating an entirely separate farm could be penalized under the proposed changes.

The impacts of the changes could be widely felt, “This will affect a lot of farm clients in particular,” said Thomson.

Climate of uncertainty

What is most concerning to many is the wide-sweeping nature of the changes, combined with the lack of consultation. Tax professionals are calling these the most significant changes since 1972 and they are being implemented with a 75 day consultation period, much of which fell over the summer. The changes that were implemented in 1972 began with consultations in 1966.

Bolley points out that not only is the input of Canadians being limited, so too is the input of tax professionals. He notes that there appears to have been no consultation with either the Chartered Professional Accountants of Canada, the Canadian Bar Association or the joint committee between the two organization dealing specifically with taxation issues. These professionals are now speaking out against the changes, when they could have helped draft legislation to better target the areas of most concern to the government. “The brakes need to be pumped,” said Bolley, noting the need for broader consultations, and adding, “They need to slow down and get it right, as opposed to ramming [the legislation] through.”

“What [the government] is proposing could potentially affect anyone in business…There are lots of clients set up in a structure [that could] now be basically obsolete,” said Thomson, adding that the impact won’t just be felt by current business owners, but could potentially impact succession plans put in place with practices that today are perfectly fine. He added that the uncertainty has many engaged in tax planning frozen, “We still don’t really know what’s going to be in the [legislation].”

Another unknown is just how much money the government plans to raise with the proposed changes.  The government has said that it expects to collect $250 million in additional taxes from the changes to income sprinkling, which are expected to impact 50,000 Canadian families. But for the other two components, neither the government, nor any private sector analysis, has been able to pinpoint the money at stake. The white paper outlining the proposed changes says that private corporations currently hold passive investments which in 2015 generated approximately $27 billion in income. However, they caution that a portion of this income is currently taxed appropriately and would not be affected by the new tax rules. For the third measure, the conversion of income into capital gains, the white paper says that the fiscal impacts of the proposed measure can’t be determined based on currently available information.

Ultimately, one of the major problems with the changes is that they are creating a climate of uncertainty. “The government is making it out to be minor changes but it will change how we approach planning, it’s going to change a lot of things,” said Bolley. He explained that the draft legislation is unclear, opening the door to wide-ranging interpretation by CRA.

While the Finance department establishes the rules, it’s up to CRA to implement them. Bolley said, “[The proposed changes] would give CRA the weapons to go after innocuous [transactions],” including ones motivated by succession or estate planning. Ultimately, accountants are currently in a position of not being able to advise their clients because the proposed rules leave so much room for interpretation. “We have to tell clients, ‘We don’t know,’ That’s a concern to me as an advisor,” said Bolley. If CRA and a taxpayer disagree, it will ultimately be up to the courts, including possibly the Supreme Court of Canada, to decide. “What’s coming down? We’re not sure, but it’s not looking good... We definitely know changes are coming,” said Thomson. He added that a year or so after the changes are implemented, they’ll begin to find out the unintended impact.

Bolley worries that this uncertainty will make people less willing to start businesses. “This will affect a lot more people than the government [is saying], this is not just targeting the super wealthy,” he said.