Despite federal Liberal Finance Minister Bill Morneau’s attempt to soften his plan to tax private Canadian companies, tax lawyers still see major problems with the proposals.
Despite federal Liberal Finance Minister Bill Morneau’s attempt to soften his plan to tax private Canadian companies, tax lawyers still see major problems with the proposals.
Pamela Cross, a tax partner at Borden Ladner Gervais LLP in Toronto, says in the government’s proposals to tackle income sprinkling rules are still “fairly complicated.”
“There will be disputes over whether these rules apply or not,” she says.
Raj Juneja, a tax partner at Davies Ward Phillips & Vineberg LLP in Toronto, adds that while the government softened the income sprinkling blow by providing more exemptions, the legislation is still complex and there are still glitches in it.
“There is no question there is going to be litigation for sure,” he says.
Claire Kennedy, a tax partner at Bennett Jones LLP in Toronto, notes that the federal government has “eased off in some important respects.”
“I think this entire approach is not the best path forward. They have increased pressure that is at the heart of the kind of planning that they deem problematic,” she says, pointing to a further reduction in the small business tax rate to nine per cent by 2019.
The changes come at a time when the top combined marginal rate on income in Ontario is hitting 54 per cent, creating an even greater chasm between the employed and self-employed.
“You are inviting leakage and you are inviting planning,” she says, regarding that type of differential.
If the government’s intention was to address what it perceived to be abusive or excessive tax planning in some aspects of the private corporate space, she says, then it was the wrong approach.
For example, the government could have limited the small business deduction to new businesses and young businesses, but instead it “compounded the problems by doubling down on the small business deduction” for all businesses.
“They really need to do some more root and branch reform and look at some inefficiencies in the system, some of which are generated by the small business deduction,” she says.
Morneau’s tax problems began last July, when he released a reform proposal, which was subject to a 75-day comment period.
It resulted in an immediate backlash by private business owners who felt under attack by the Liberal government.
The plan had three key changes. The first was to tackle income sprinkling among business owners and family by implementing a new “reasonableness test” to examine how involved family members are in the business to justify any dividends they receive. For that, there was draft legislation.
Second, the government proposed putting restrictions on the ability of business owners to hold a passive investment portfolio inside their companies by proposing to tax it at a higher rate, which in Ontario could have reached 73 per cent.
The concern is that highincome individuals are using the lower tax rates in a corporation to garner an unfair advantage over other investors.
Third, the government wanted to prevent private companies from converting income into capital gains, which are taxed more favourably than income.
The response was swift. Business organizations and tax professionals panned the proposals and the government was on its heels.
Not since the proposed implementation of the Goods and Services Tax has there been as much outrage over tax changes.
The government received almost 21,000 responses to its plan and Morneau faced a daily barrage of criticism, which culminated in attacks in Parliament calling out his investment in his family firm.
One of the biggest criticisms of the tax proposals is that they represent major tax reform and not enough time has been spent consulting.
Cross noted that “this is the most significant and fundamental change to our tax system in 40 years.”
During the last round of reform in the 1970s, there were commissions and years of discussion before the changes were implemented.
Instead, the government released a watered-down version of its proposals in December, only a few months after the consultation period closed.
Some think the consultation period was meaningless.
Juneja doubts public servants reviewed all the comments on the proposals, which included a 150-page joint submission by the Joint Committee on Taxation of the Canadian Bar Association and Chartered Professional Accountants of Canada.
“Basically, they wasted everybody’s time,” he says.
Under the revamped plan, the government is moving forward on income sprinkling. The reasonableness test still applies, but it will be subject to a number of safe harbours or bright-line tests under what are known as the “TOSI rules” or “tax on split income.”
For example, there are exemptions for seniors and adults who have made a “substantial” labour contribution to the company during the year or any five previous years.
Cross notes that one of the income-sprinkling problems relates to adult children who are attending university and are paid dividends.
The new proposals set a bright-line test of 20 hours per week of work in the business as the baseline for being exempt from paying higher taxes on the dividends. She notes that if a child is in university full time, it’s “difficult” for them to work 20 hours a week each week.
Notably, though, the changes mean dividends that service firms and professional corporations pay to family members will be subject to a higher tax rate.
The government will also pursue its attempts to rein in passive investment in companies.
However, it dropped, at least for now, the third element, which included limiting family members from accessing the small business capital gains exemption and converting earnings into capital gains.
Lawyers, however, still see problems.
Juneja says the whole reasonableness test for determining if someone contributes to the company distorts basic corporate law.
“What’s reasonable in the context of a shareholder?” he asks. “Why does a shareholder have to be involved in a company to get income on their shares?
“If a third party invested in a company, they don’t have to do anything. I think that’s where it just doesn’t make sense.”
However, it’s the passive income proposals, which have yet to be fully released, that are causing much concern.
Under the plan, companies will be able to shelter $50,000 of passive income before a higher tax will apply on investment income earned, which roughly means about $1 million in savings based on a five-per-cent return.
“You need cash to run your business,” says Juneja, noting that large private businesses with $100 million in revenue will only have a $50,000 exemption.
The problem will come in tracking the passive investment over time, he says. How do you track old investments from cash generated going forward and what happens when that passive investment earns more investment income?
“The legislation is going to be insanely complex,” he predicts.
All of this will come to a head shortly as the government enters its budget period.
Cross adds that while the government backed down on converting income to capital gains, known as surplus stripping, she doesn’t expect the issue has gone away.
“I don’t think they will give up,” she says.
Cross says one simple way to tackle the problem would be to return the capital gains inclusion rate back to 75 per cent from 50 per cent, thereby lowering the differential between the tax paid on dividends versus capital gains.
Whether the government has the appetite to do that remains to be seen.
“I don’t think we have seen the last of surplus stripping,” she says.
Lawyers continue to urge the government to rein in its plan in favour of a more comprehensive tax overhaul.
Kennedy nots that with U.S. tax reform underway it would be “an opportune time to look at corporate taxation in Canada.”
“I still have a glimmer of hope that [the politicians] will wake up and say, ‘This is stupid,’ but they have been pushing so hard, I doubt it,” says Juneja.
