On July 18, the Liberal Government proposed small business tax reform. The draft legislation proposed by Finance Minister Bill Morneau has been a much-debated topic over the past few months. This blog post will:
- Provide an overview of three of the proposed tax changes;
- Outline monetary examples of how the new legislation could affect small business owners; and,
- Suggest how you can make your voice heard should you want to provide feedback on the proposed changes.
What are the Proposed Changes?
On July 18, 2017, Finance Minister Bill Morneau introduced draft legislation proposing to overhaul the system of taxation for private companies, their shareholders, and family members of the company’s owners. These proposals are broad-based and primarily target Canadian-controlled private corporations (CCPC) regardless of sector, industry, or economic grouping.
While some academics and politicians suggest that the proposed changes will equalize the income tax treatment between independent businesses and employees, tax advisors report a very different story. Estimates are that businesses could pay up to 73 percent in taxes on earnings, far higher than even the highest rates charged to employees. Additionally, as a result of some transitional issues, earnings could be taxed at 93 percent under the proposals.
The Globe and Mail asked financial experts to provide before-and-after scenarios of three of Ottawa’s proposed changes including:
- Amending the ability to use corporations for so-called “income sprinkling” among family members;
- Reducing the lifetime capital-gains allowance for a family; and,
- Increasing the tax rate on earnings from corporate after-tax income that is reinvested in passive investments.
The government is looking to restrict the ability of business owners to reduce their taxes by sprinkling income among adult children in lower tax brackets through salary or wages, or through dividends, which are taxed at a lower rate tax plan
The following example was used to look at the impact of a business owner not being able to pay a dividend to a child for their education and, instead, having to take the draw as their income (in a higher tax bracket):
- An Ontario doctor draws a salary from her corporation of $55,300 and a dividend of $50,000 for total income of $105,300. Tax paid is $22,055.
- Assuming she pays a $40,000 dividend to her 20-year old son, who is attending university, the dividend is essentially tax-free.
- If the doctor can’t sprinkle that income to her son, and must report the $40,000 dividend as her income, the tax on it will be about $14,000 (or 35%). As a result, the family nets $26,000 instead of the full $40,000.
Lifetime Capital Gains
Many business owners with families have taken advantage of their lifetime capital gains exemption (LCGE) when they sell their business. The amount that can be sheltered rises with inflation and is $835,716 in 2017. Tax planners have set up structures where family members become shareholders in the company, and the government is proposing to crack down on this by allowing just one family member to receive the credit.
The following example was used whereby a family of four – each member having equal shares in the company – sells a business with a total capital gain of $4 million.
- In the current system, each shareholder could be eligible for the LCGE of $835,716, which is a total of about $3.3 million that is not subject to tax. The gain in this scenario is about $657,000 and the total tax paid would be approximately $176,000 (assuming top marginal tax rate), or a capital gain rate of 26.8%.
- Under the proposed new system, only one shareholder in the family would receive the LCGE. The gain would be about $3.2 million and the tax paid on that would be about $847,000. That means the government would receive an extra $671,000 in taxes on the sale of the company.
Lower capital gains exemptions mean that eligible business owners will ultimately take home less income. This decreases the financial incentive to start a business and will likely lead to more people seeking employment rather than taking the risk of venturing out to create new businesses.
Currently, corporate business income is taxed at a lower rate than personal income, which leaves corporations with more money to invest in their business. If a private corporation does not need to reinvest all its earnings to expand the business, or is not ready to reinvest (perhaps waiting for new machinery to become available or waiting for a new opportunity to buy a building), they may invest those earnings into passive investments. Different options for passive investments have historically included savings accounts, GICs or stock portfolios.
Under the proposed passive income tax system, which adds another level of tax on the investment income earned in the corporation, business owners would have to pay significantly more tax when they remove money earned from their investments out of the corporation.
How You Can Make Your Voice Heard
The Department of Finance is accepting feedback on the proposed tax changes up until October 2, 2017, and there are many resources and groups you can utilize to make your voice heard before the deadline:
- Contact the Canadian Federation of Independent Business (CFIB). Dan Kelly, President and CEO of the CFIB, said his organization has been working around the clock to mobilize business owners to pressure their local MPs. If you would like to find out who your local MP is, please click here.
- Research industry-specific organizations and associations that are likely collecting feedback from small business owners in their respective spaces. For example, the Grain Growers of Canada is putting together an internal working group to create a formal response to the tax proposals and is reaching out to other business stakeholders.
- Join the Coalition for Small Business Tax Fairness, a new alliance of business groups made up of doctors, farmers, retailers, lawyers, home builders, and other businesspeople. The coalition recently released a public letter to Finance Minister Bill Morneau expressing their disappointment in the proposals and asking him to abandon the wide-ranging reforms.
- Sign online petitions against the proposed changes:
- Sign one of the petitions started by employee groups in favour of the tax changes, such as this one started by lawyers pushing back against the Canadian Bar Association’s opposition to the changes.
“No matter which side of the fence you stand on, it is essential that any changes which affect more than 1.1 million small business owners and their families in Canada are carefully considered and examined before being implemented. This is not a question of tax fairness or equality but rather ensuring we have a well measured and carefully thought out plan for any changes that could cause a fundamental change to the small business landscape in the country and thereby our economy as a whole.”
-Cato Pastoll, Co-founder and CEO, Lending Loop