By Ted Mallett
Published in the Globe and Mail on August 30, 2017
As with anything to do with tax, no matter how beneficently new proposals are described, the devil is in the details. Such is the case with the federal government's plans to address the use of some common tax-management tools for private corporations.
The proposals certainly fit with an active government interest to be seen as bringing fairness and neutrality to the tax system. One can't really oppose fairness in principle, but because the world is multidimensional, a tax change that improves fairness in one dimension can worsen it in another.
The stated targets – and ones that remain perennially so in the eyes of most governments in this country – are high-income individuals who use tax-planning techniques to limit their tax exposure. Despite claims of surgical precision, ordinary businesses and modestly compensated owners are going to wake up to a few missing organs.
There are three main avenues of attack in the federal proposals: 1) Limit the spreading of income and capital gains (and in some cases the capital-gains exemption) among family members associated with a corporation; 2) prevent a corporation from investing in passive assets using corporate after-tax earnings; and 3) ensure that capital-gain tax treatment cannot be used in taking out corporate earnings in lieu of taxable dividends.
Although each of these three approaches take aim at high-income individuals, each will end up seriously hampering the activities of ordinary business owners of modest means.
The new rules on income splitting would significantly complicate tax compliance for family enterprises – yet have relatively little impact on revenue for the federal government. Even if owners convert to paying salaries instead of dividends to family workers, they would still be subject to yet-to-be-defined "reasonableness" rules from the CRA. With the wide variation of business types across the country and the differing levels of contributions made by family members – both tangible and intangible – tracking and record-keeping will have to be heroic.
In an example of induced unfairness, a business-owning couple expecting to retire by splitting a modest $80,000 a year each from the proceeds of their business could see one of them hit with a tax bill at the highest marginal personal tax rate on their $40,000 share. By comparison, another couple with similarly sized employee pension earnings are allowed to share the earnings in a way that minimizes taxes.
The draft rules on the treatment of passive income are also highly problematic for small businesses – and not just the well-to-do. Because these firms do not have access to public equity markets or bank credit to any large degree, the only real source of financing for growth-based investment comes from after-tax profits. This is usually a multiyear process, so money has to be placed in passive investments, such as interest earning accounts, stock market, rental properties, etc. The trouble is the government now wants to treat that passively earned income as if it is going to be immediately distributed out to the owner(s) – and, potentially push up the total tax rate on those earnings to more than 70 per cent.
This measure would significantly curtail money available for internal business reinvestment. When a business puts money aside for savings, it is unknown what that pool will eventually be used for. Unused surpluses may end up as retirement funds, but those amounts are rarely large. More likely, amounts set aside for capital equipment or retirement may have to be used instead as emergency cash lifelines in hard times. For the tax system to presuppose the money is for immediate distribution to high-income owners, it ignores the realities and uncertainties of doing business.
Finally, with the looming changes to capital-gains treatment, arm's-length or non-arm's-length succession planning would become precipitously more difficult. Though aimed at distributions to minors, through trusts, or via split income, the rules would likely ensnare business value appreciations from the past. For some, it could be a form of retroactive taxation. For others, double taxation of estates would become a problem.
This creates especially adverse situations for family businesses, raising massively perverse dollar incentives to sell a business at arm's length rather than passing it on to the next generation.
The basic principles of the present-day small-business tax treatment have been the result of decades of experience, balancing and compromise. The aim has been to recognize the uncertainty and variability of small-business earnings and the considerable financial risk ordinary people take when starting, operating or expanding their businesses. These latest tax measures, with radical new approaches not just proposed but set in motion, were released in mid-summer and with barely 75 days for the public to react. More time is needed – both to understand the government's objectives and to work through the potential effects of any needed changes.
Expediency should not come at the cost of complexity, inequity, double taxation and retroactivity.
This story was originally published in the Globe and Mail.