Four months after this year’s federal budget, we cannot be certain.
Budget 2017 indicated that the Government of Canada is continuing to consider implementing measures that will limit the extent to which the use of private corporations and tax planning strategies can be used to unfairly benefit wealthy Canadians.
Budget 2017 stated:
The review of federal tax expenditures highlighted a number of issues regarding tax planning strategies using private corporations, which can result in high-income individuals gaining unfair tax advantages. A variety of tax reduction strategies are available to these individuals that are not available to other Canadians.
The challenge with this approach is that tax planning strategies using private corporations can include strategies used by thousands of small businesses, family-owned businesses, and owner-managed businesses across Canada, many of which are not the property of high-income Canadians.
These strategies are used by convenience store owners, solo consultant businesses and Saturday market vendors just as much (if not more) than they are by trust fund endowed, jet setters.
Eliminating the ability to use tax planning strategies for private corporations can potentially have significant, negative tax consequences for those businesses.
Depending on the actions that the federal government decides to take, changes could substantially add to the tax burden of these small businesses, family-owned businesses, and owner-managed businesses.
What’s more, few people are talking about it.
THREE ISSUES UNDER REVIEW
Specifically, Budget 2017 identified the following three tax reduction strategies that will now be subject to closer review by the Government of Canada:
1. Sprinkling income using private corporations, which can reduce income taxes by causing income that would otherwise be realized by an individual facing a high personal income tax rate to instead be realized (e.g., via dividends or capital gains) by family members who are subject to lower personal tax rates (or who may not be taxable at all).
2. Holding a passive investment portfolio inside a private corporation, which may be financially advantageous for owners of private corporations compared to otherwise similar investors. This is mainly due to the fact that corporate income tax rates, which are generally much lower than personal rates, facilitate accumulation of earnings that can be invested in a passive portfolio.
3. Converting a private corporation’s regular income into capital gains, which can reduce income taxes by taking advantage of the lower tax rates on capital gains. Income is normally paid out of a private corporation in the form of salary or dividends to the principals, who are taxed at the recipient’s personal income tax rate (subject to a tax credit for dividends reflecting the corporate tax presumed to have been paid). In contrast, only one-half of capital gains are included in income, resulting in a significantly lower tax rate on income that is converted from dividends to capital gains.
Of these three tax reduction strategies, income sprinkling is the one that will affect the largest number of small businesses, family-owned businesses, and owner-managed businesses in Canada.
Whether you call it income sprinkling, income splitting, dividend sprinkling, or making it rain, the issue centres on using multiple classes of shares to pay dividends to different classes of shareholders to the exclusion of others.
It is very common for Canadians to have multiple classes of shares in private corporations mainly for the reason of being able to declare a dividend to one class of shares (and therefore pay one shareholder) to the exclusion of the others. This is the starting point of most private corporations from the moment they are incorporated.
This means that a principal business owner can issue separate classes of shares to her or his family members, and then declare dividends to her or his exclusion. The intent is to minimize the amount of taxes paid by a small business and to distribute money earned by the corporation as efficiently as possible for tax purposes
How does this work? Assume my family business operates out of a corporation and my wife has 100 Class A shares and I have 100 Class B shares. Then assume my income is $50,000 in salary for 2017, and hers is $200,000 for 2017. Our corporation will pay me a dividend and she will not get a dividend, so that the amount being paid from the corporation to our family is taxed at the lower tax bracket.
Is this fair? Yes.
A DEFENCE OF DIFFERENT | PREFERENTIAL TAX TREATMENT
The tax system is designed to treat employers differently from employees, and to treat certain types of income (such as dividends and capital gains) differently than income earned as a salary.
There are a number of reasons for this different treatment, but the one I think is most valid is that business owners, employers, or entrepreneurs are the ones taking the risk to start and grow a business.
There are very good policy reasons to provide a tax incentive (or preferential tax treatment) for people to start and operate their own business.
Simply put, with risk comes (the chance of) reward.
If governments want to create jobs they need to keep incentives for people or businesses to start, grow, create opportunities, wealth and jobs. The tax treatment of businesses and income can play a critical role in incentivizing the creation of businesses, opportunities and wealth.
Flip it around the other way – if there is not the reward, many people may choose to stay at home or stay in their cubicle, they may decide it is safer to hang on to their life savings, and as a result they may not launch the next great idea.
If we as a society want entrepreneurship we have to reward entrepreneurship.
At a time when start-ups and innovation is all the rage, it would be a mistake for governments of all levels to take an adversarial position to the people and the businesses that are creating opportunities and wealth in this country.
Moreover, if we want new businesses to start, grow and succeed (especially in the areas of technology) maintaining tax incentives for business owners is critical.
Otherwise our best and brightest entrepreneurs will either head to Silicon Valley, Los Angeles or Boston. Or for those who start a business in Canada, they will have a built-in Canadian tax incentive to sell their ideas to large businesses at the first opportunity rather than attempt to further their ideas or grow their business here in Canada.
If we want innovation we have to foster innovation, and the tax treatment of the commercialization of innovation is key.
KEEP CALM AND WAIT FOR THE WHITE PAPER
If the federal government removes or minimizes the extent to which Canadians can declare dividends to different classes of shares, it could substantially increase the tax bills paid by small businesses.
At this point, it is still too early to know roughly what measures are being considered by the federal government when it comes to income sprinkling.
Details of what may or may not be permitted in the future still remains to be decided by the federal government. Budget 2017 merely highlighted that government’s intent to take action to remove or reduce these tax reduction strategies.
Regarding the federal government’s future plans, Budget 2017 stated:
The Government is therefore further reviewing the use of tax planning strategies involving private corporations that inappropriately reduce personal taxes of high-income earners. In doing so, the Government will also consider whether there are features of the current income tax system that have an inappropriate, adverse impact on genuine business transactions involving family members. The Government intends to release a paper in the coming months setting out the nature of these issues in more detail as well as proposed policy responses. In addressing these issues, the Government will ensure that corporations that contribute to job creation and economic growth by actively investing in their business continue to benefit from a highly competitive tax regime.
Four months after Budget 2017, we are still waiting for the federal government to release a paper setting out the issues under consideration and the government’s potential responses.
This white paper will offer business owners a good glimpse into what measures the federal government is considering. Until then we have little choice but to sit back and wait.
Ultimately, the policy responses proposed by the federal government may or may not end up being a big deal for small businesses, owner-managed businesses and family businesses.
The problem is that it may be.
We cannot say for certain what restrictions the government has in mind – but the government’s paper will be a very important document that should be carefully reviewed by professionals and business-owners to assess its impacts.
For now, not many people are talking about this.
But small businesses, family-owned businesses and owner-managed businesses should keep this issue in mind and be alert to developments in the months ahead.
Depending on the content of the federal government’s white paper and how quickly the government implements its policy responses many businesses may need to quickly reassess their financial and business plans. Others may need to reorganize their business structures and succession plans entirely.
One way or another, more taxes may still be coming. Stay tuned.