A tax rate of 93%? The tax on private companies could allow

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Small business owners across the country are still reeling from last month’s announcement by Finance Minister Bill Morneau targeting private corporations and fundamentally changing the way incorporated businesses and professionals are imposed. The challenged tax strategies can be classified into three main categories: income sprinkling, passive investment income in a corporation, and the conversion of a corporation’s ordinary income into tax-efficient capital gains.

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In a previous column, I discussed proposed income splitting rules that would effectively eliminate opportunities for business owners to split dividends and capital gains among adult relatives, unless they contribute labor. or “reasonable” capital to the business.

But this change, combined with the other two changes, could lead to a tax rate as high as 93%, as tax lawyer Michael Goldberg of Minden Gross LLP in Toronto pointed out in a report sent to clients this week. As Mr. Goldberg writes, “The mere proposal of these changes has already upended the Canadian tax system for private business owners and, unfortunately, the government and the Department of Finance do not seem to appreciate and perhaps do not understand the extent of the damage the (plan) will cause to Canadian business owners, the employees of their businesses and the economy as a whole.

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In addition to income sprinkling, what seems to be of particular concern to the government and what it calls “unfair advantage” is the possibility of a tax deferral advantage inherent in our corporate tax system . To understand what the government is aiming for, we need to review the theory of integration. This tax principle, in a nutshell, states that a person who earns income personally (as opposed to inside a corporation) should end up with the same amount after tax at the end of the day as the shareholder who earns income through a Canadian corporation (which paid corporation tax) and personally receives the after-tax amount as a dividend.

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Owner-managers who manage their business through corporations can choose to receive compensation in the form of salary (including a bonus) or dividends. If salary compensation is elected, the company claims a deduction from its income for the amount of salary or bonus paid and the owner-operator pays personal tax on the salary or bonus received.

Alternatively, if dividend remuneration is chosen, the company pays corporation tax on the income earned and the owner-manager pays personal tax when after-tax income is distributed as a dividend. In tax parlance, “perfect integration” is said to exist when the after-tax amount of money in the owner-manager’s hands is the same whether the company’s profits are paid out as a salary or taxed as a tax. first in the corporation, then paid as a dividend and taxed in the hands of the owner at dividend tax rates.

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In the absence of perfect integration, a tax saving exists when there is a tax advantage linked to the payment of dividends, the total of the corporate and personal tax paid on the remuneration of the dividends being less than the personal income tax paid on wages. Currently in almost all provinces for 2017 we have almost perfect small business income integration so there is no tax rate advantage of incorporation for businesses earning less than $500,000 of active business income per year and makes it a tax rate disadvantage of having active business income taxed inside the corporation for income above this threshold. There is a similar tax disadvantage associated with earning investment income, including capital gains, in a corporation as opposed to earning that same investment income personally.

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That being said, if the business owner does not need all of her money in the current year, she might consider leaving excess funds in the business and deferring the payment of dividends to a future year. . This is the “tax deferral advantage” that the government is aiming for. This deferral exists since corporate tax on business income is payable in the current year, but personal tax on the dividend can be deferred until the money is finally withdrawn in a future year. . The difference between corporate tax and personal tax that would be paid on the business income (the deferred amount) can be reinvested in the company to earn additional income until the dividend is finally paid , perhaps several years later. The current small business income deferral benefit ranges from 35% to 40%, depending on the province.

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To address this problem, the government is proposing to increase the tax rate on passive investment income held by a corporation when the invested capital is derived from active business income. According to calculations by report co-authors Mac Killoran of Fruitman Kates LLP and Jay Goodis of Tax Templates Inc., this would result in a combined corporate and personal tax burden for an Ontario business owner of 73% on income. investment and 59% on capital gains realized by the company.

Rather than immediately publishing a bill to implement this change, however, the government has released a discussion paper on how the new rules might work. With over 20 pages of analysis, nine charts, tables, and graphs, and a three-page appendix that includes algebraic formulas not seen since high school math (i.e. [A x (1 – t^CIT ) x (1 + r(1 – 0.5t^PIT)) + RDTOH] x (1 – G(t^PIT -t^ICT)) + CDA), the proposed system is not for the faint-hearted. And while the government may believe the new methodology is theoretically sound, it may be virtually unworkable for small businesses with limited accounting and professional compliance resources.

Indeed, Mr Goldberg believes the rules “are so complex and the potential harm is so great” that, rather than trying to fix them through the consultation process (which continues until October 2), it calls on the government to abandon the proposals in their entirety and “relaunch the process of finding an effective way to achieve its legitimate policy objectives”.

Jamie.Golombek@cibc.com

Jamie Golombek, CPA, CA, CFP, CLU, TEP is Managing Director, Tax and Estate Planning at CIBC Wealth Strategies Group in Toronto.