There are usually three sides to a situation. The side that is seen as the problem, the side seen as opposing the problem and the side trying to understand both sides and work with what will happen next.
In July 2017, Finance Minister Bill Morneau released a package of tax reforms aimed at “fairness and small businesses”. The proposal was a result of academic studies that denoted small businesses as having an unfair tax advantage over salaried taxpayers. A 75-day consultation period was provided for businesses and legal and accounting professionals to give their input. Up to this point, there have been daily articles, blogs written by the media, lawyers, accountants and small business groups decrying the unfairness of this tax change.
There are three main proposals:
The first is aimed at “income sprinkling”. A small business can pay family members wages or dividends depending on the circumstances through the business. It is a fairly common practice which is probably why the government is taking a closer look. The proposals want to limit the amount paid as reasonable compensation for the amount of work provided and dividends to be based on financial resources actually provided. This will eliminate the shifting of income from the high earners to low income earners (ie spouses and/or student children). The Liberals are most concerned with corporations that have young adult shareholders particularly in the age range 18 to 24 who have not given any initial financial contribution but who now receive substantial dividends causing little to no tax consequences.
While this appears fair to close this loophole, it is unsure of what the government considers reasonable. Many spouses and children do contribute to family businesses in various ways. They are an extension of the main income earner or front person. Who is to determine their worth? When shares are purchased in a small business corporation, typically it is at a nominal value such as $1. Why could a child not purchase a share at that amount? Or should there be a change to the “in trust for rules” for purchasing shares?
The second proposal deals with holding investments within a corporation. The profits that are retained in the business are invested rather than paid out to shareholders. The corporation invests the balance as it will need the funds for seasonal low periods, new equipment, buildings or further expansion. Some small businesses keep these investments for years until the business winds down. The proposals are examining the taxation of the excess profit that fund these investments and the future income it will earn. It is proposed that taxes are to be paid up front before investments are made. Presently, income earned on small business investments are already taxed at a higher rate in a corporation. However, when dividends are issued, part of that higher tax is refunded to bring the effective tax rate back to the small business rate. The shareholder would then personally pay the appropriate tax on the dividend plus other regular income.
For many years, small business corporations have had a preferential tax rate in order to stimulate growth. It was encouraged by prior governments as small businesses were seen to hire more employees and use more local resources. Now the government wants this savings to be taxed at a higher rate making it more tax efficient for shareholders to withdraw the money than to leave it in the company. If this money was withdrawn by the shareholder in the years that wages were withdrawn, it would be taxed at a higher rate immediately. In the present situation, it is possible for shareholders to build up the investments within the corporation until they are retired and their income is lower. Taxes are eventually paid but at a slightly lower rate. Could this proposal also be considered by the government of the day to get more tax money immediately versus waiting for slightly less tax money later?
There is the argument by small businesses that the corporation is used as a pension plan. Income earned would have the preferential tax treatment within the corporation as a non-registered account does (ie capital gains 50%, dividends a tax credit). Money can then be removed from the corporation by alternate methods not available to a salaried taxpayer. For the salaried taxpayer, pension and RRSP income such as capital gains and dividends are taxed as regular income when withdrawn causing them to pay more tax.
Again, we are not sure what the parameters of this tax reform will be and what small businesses who are not the 1% will be caught in this trap. Corporate investments are often used to fund other projects stimulating growth in other sectors. What will happen to these funds if taxation is increased?
The last proposal is to combat the conversion of retained profits into capital gains through the sale of the small business shares to other corporations. This involves complex planning and is not normally used by most small businesses. It also touches on the lifetime capital exemption for small business shares which may be tweaked.
While there seems to be quite the uproar at the moment, it is important to remember these tax proposals are still under discussion. There will be some tax adjustments made affecting small businesses and the manner in which they operate. The government is trying to make taxation fair and equal across the board but again, they seem to be targeting the middle class. It is not easy to start and run a business with government regulations, taxation from many different angles. Small businesses feel that they are being targeted unfairly by the government. These proposals have to be tweaked as Prime Minister Trudeau has said in order to affect only those who take an unfair advantage of the tax system.
The tax proposals may affect some real estate professionals. The government will be looking closely at income splitting in a proprietorship and a corporation. However, if the spouse or child receives reasonable compensation for work provided, there should not be an issue. If a professional incorporated and his family are shareholders, the government should be able to see the flow of money used to purchase the shares.
Those professionals that hold investments within a corporation should wait for the government to make its decision on the tax changes. It will affect income going forward, not past investment funding and income. At the time it becomes law, discussions should be held with their accountants on whether it is cheaper to leave investment money in the corporation or withdraw and invest personally.
Any tax change affects each situation differently. Please see your tax advisor on how it may impact you.