Private company taxes - from complexity to confusion
Private company tax proposals have left business owners and their advisors relieved in some respects and confused in others. The Government spread out announcements throughout the week of October 16th with broadcasts made from various small business locations and on the Department of Finance website. To kick off the week, they also mixed in a proposed reduction to the small business corporate tax rate phasing in from Jan 1, 2018. This was curious, as the reduction will increase the tax rate gap between corporate income and personal income, which is part of the policy concern that precipitated the original July 18 proposals. It is unlikely that the government has had the opportunity to fully review and digest the 21,000+ submissions made in respect of the proposals by taxpayers including submissions from our firm, so the difficult question being asked by business owners is: where are we now and what’s next?
Lifetime capital gains exemptions
The Government has decided not to proceed with the proposals to restrict access to utilization of capital gains exemptions by family members. Stepping back from this proposal was a welcome relief to many business owners, as the proposal represented a significant tax cost to many on business transfers.
Conversion of dividends to capital gains
The Government has decided not to proceed with the proposals that would convert capital gains to taxable dividends in certain instances. The retraction was in response to the various situations highlighted to the Government whereby the proposals resulted in consequences beyond their intent ― specifically punitive and adverse tax consequences on inter-generational transfers of family business vs sales to arm’s length parties such as public companies and additional taxes on death for owners of private company shares. This is welcome news for taxpayers that these measures are also now withdrawn.
The Government did confirm they would be proceeding with the proposals to limit income sprinkling, noting that the complexity associated with administration of these rules will be simplified. It remains to be seen what final form these proposals will take later this fall. These rules would continue to be effective Jan 1, 2018, if enacted.
There are many published positions from a non-tax perspective on why spouses and families share in the risk and reward of any business venture undertaken by a family member, and the quantification of their contribution has to include more than just their direct engagement in the business. Spouses who choose to stay home to raise a family to support the time demands of the business on the owner sacrifice their future earning potential, retirement pensions and benefits to ensure the success of the business and may put their own assets as collateral for business loans. As economic conditions change, families may often be required to put every spare dollar into the business to meet banking requirements or operating expenses including payroll, and they may have to forego RESP or RRSP contributions. The comparison of family members to arm’s length employees when determining reasonability is fraught with challenges, as these two groups are in fundamentally different economic situations with different risk profiles. Certainty and simplicity may become lost in these rules when business owners and their advisors are faced with determining what amounts are considered reasonable when making payments to family members.
Passive income proposals
The Government also confirmed they would be proceeding with the passive income proposals in a modified format such that the non-refundable tax will not apply to the first $50,000 of passive income earned by a private corporation (assuming a 5 per cent rate of return on $1 million) and existing passive investments will be grandfathered. Details on the mechanics of how these rules will operate will be forthcoming with the 2018 budget. The decision to proceed with implementation of the passive income proposals has prompted some discussion around specific situations that are of concern:
- 'Passive income' stems from investments in or loans made to public corporations, private corporations and the government (i.e. government bonds). These investments represent funding of economic activity in both the public and private sectors. The proposals will constrain reinvestment into the economy by reducing available capital to invest.
- By grandfathering current passive investments, how are the new rules going to target the existing investment capital being deployed and second generation income earned thereon? Will these proposals serve as a deterrent to new wealth creation?
- Private business owners frequently leave excess capital in corporations to provide flexibility to save for retirement or readily have funds available for redeployment into their business. Removing the ability to save in this manner without a punitive tax result could change behaviours which drive risk taking and entrepreneurial risk taking activities.
- Earning an annuity of $50,000 (prior to the application of corporate and personal tax) in retirement on corporately invested assets may be arguably inadequate to sustain an individual in retirement that does not have access to an RRSP or pension.
- The $50,000 threshold doesn’t adequately address larger private companies, which need to be able to weather significant downturns and continue to pay employees and operating expenses. How will passive income taxed under the new rules be treated if re-deployed into the business in the event of a downturn? Will non-refundable taxes previously paid on passive income become refundable again? How will this be tracked without imposing considerable additional compliance burdens on taxpayers?
- The rules put larger private companies at a competitive disadvantage against their public company counterparts, which will not be subject to the same rules. Public companies and their shareholders will continue to enjoy a tax rate of between 25 per cent -28 per cent on corporate earnings and preferential dividend rates.
- The proposals introduce significant complexity in compliance. Being able to appropriately track the various pools from year to year and monitoring which passive income is subject to the current rules vs. the new rules will not promote simplification of the tax system.
- There are certain businesses which only earn what is considered passive investment income such as real estate rental, leasing operations and campgrounds. These businesses may be subject to this treatment for a variety of reasons and the additional tax penalty to those owners will be substantial. Will specialized exemptions be available for such businesses and would this create tax unfairness among different types of business operations?
There are elements of the tax legislation which are in need of reform from a policy perspective, and the goal here is certainly a noble pursuit. However such pursuits must be undertaken with care, and it is perhaps advisable from a policy perspective to step back and re-examine where best to deploy time and resources in the pursuit of tax fairness with a comprehensive economic analysis and taxpayer consultations. We encourage government representatives to work towards tax reform that benefits all Canadians and the economy as a whole.