Small Businesses Insulted by Minister Morneau

July 18, 2017 will live on in infamy as the Federal Government of Canada officially declared war on small businesses. Small businesses form the backbone of the Canadian economy, but Minister Morneau believes they are the scoundrels who “avoid paying their fair share” of tax. I’m I being overly or deliberately inflammatory? Maybe, but I feel this is the only way any of us will be hear by the tone deaf department of Finance.

Let’s start with a short explanation of the proposed changes. The Consultation Document: Tax Planning Using Private Corporations is the Department of Finance Canada’s attempt at explaining their view of the tax landscape in Canada today. It’s written in reasonably plain English, but if this is too much detail you might want to look at the Department of Finance’s summarized PowerPoint presentation. In essence there are three parts to Finance’s attack on small businesses:
  1. Income Sprinkling
  2. Passive Investment Income
  3. Converting Income into Capital Gains
I realize that most people reading this are not tax specialists, so let’s tackle each of these in very simple terms.
  1. Income Sprinkling

As a small business owner, you issue shares in the corporation to adult family members (e.g. spouse, children, parents). The most common example is of a husband/wife who’s running a small business and issues shares in the company to their spouse. The business owner now has the ability to allocate a portion of the income earned in the corporation to a spouse in a lower income bracket. Many of my clients use this strategy, as the spouse takes care of the house and children so that the business operator can generate sufficient income for the family. The effect is that the family tax burden is lower than if all the income was taxed in the hands of the business operator. This strategy helps compensate the family for the following hidden costs:
  • The business owner does not have an “employer paid” health plan
  • The business owner does not receive paid vacation
  • The business owner has to pay the employee portion of CPP contributions on their income and the employer portion of CPP, resulting in a doubling of the cost
  • The business owner does not qualify for EI and therefore can’t take paid maternity of parental leave, and can’t receive any EI income if the business fail
Under the new proposal, their will now be a “reasonableness test” for the dividends paid to this arrangement. So, unless you can justify that your spouse provided services to the company or had committed significant capital to the company, then the dividend will be taxed at the maximum personal tax rate. The Department of Finance is killing one of your options to compensate you for the risk and hidden cost of running your own business.

Part B to the Department of Finance’s attack on income sprinkling is focused on the lifetime capital gains exemption for the disposal of qualified small business corporation shares. Under the current system, there are structures available that will allow a family to “multiply” the LCGE by making multiple family members party to the ownership and eventual disposition of the company. The effect is that each family member qualifies for the LCGE, greatly increasing the tax benefit released from the disposal of the company. The Department of Finance has proposed changes to the legislation that will kill the structure.

Takeaway: Speak to your tax advisor to find out what you can do to minimize the impact? E.g. Can you document the value your spouse provides to the company? For part B, you should speak to your tax advisor to find out what impact the proposed changes will have on your multi-generational business and family trust.
  1. Passive Investment Income

Many employees in Canada receive either a defined benefit pension, defined contribution pension or matching RRSP contributions from their employer. If you’re lucky enough to work for the Government of Canada (or Provincial Governments) you receive an amazing defined benefit pension plan, which no private business can ever compete with. As a small business owner you have none of these. So, what can you do to compensate for this lost benefit after you take the risk of starting a business? You have two options: (1) take your own money and invest it into a self-funded RRSP, (2) leave the excess cash inside your company and have it taxed at a lower rate. This tax saving compensates for the fact that you don’t have an contributions from an employer for your pension or RRSP. You then invest this money inside the corporation and earn income on the money. The passive income is taxed at one of the highest rates possible in Canada when you earn it, so you don’t get any benefit on the investment income. When you retire, you then start pulling the money out of your company and get taxed personally. This deferral strategy therefore helped you fund your retirement.

Under the new proposal, you will be penalized for leaving the money inside your corporation to invest in assets that earn passive income. You will be penalized with a higher tax rate on the income you left in the company and then invested in assets that earn passive income, so that you end up with the same amount of cash as you would if you pulled the money out of the company. The Department of Finance is therefore proposing to kill your retirement plan without any intention to give you one of those cushy tax payer funded defined benefit pension plans.

Takeaway: You may now have to start stripping the money out of the company in maxing out your RRSP and TFSA. Speak to your tax advisor to explore strategies to optimize investment in your spouses RRSP and TFSA as well. Remember that all income earned inside a RRSP is taxed in full when you start pulling it out, even capital gains. So, you may want to invest in income generating assets in your RRSP and TFSA, with assets generating capital appreciation done outside these as you only pay tax on 50% of the gain realized.
  1. Converting Income into Capital Gains

This is a more specialized area of tax planning, which most people won’t fully understand. So, I’m not going to discuss it here in detail. I’ll just say, that there are some specialized transactions that can help individuals “convert” some income that previously would have been taxed a normal tax rates into capital gains that is taxed at essentially half the normal rate. While legal, this is one area I’ll give the Department of Finance some leeway. I do believe this is a loophole that should be closed as this doesn’t compensate small business owners for the risk and hidden cost of running a small business, or the ability to save for their retirement.

Takeway: This only applies to some small business, but if it does then you need to speak with your tax advisor to understand the impact . You may also need to speak with your lawyer and possibly your insurance provider, as many Unanimous Shareholder Agreements contemplate these kinds of transactions combing the use of insurance policies.

“When you have an economy that works for the middle class, you have a country that works for everyone. That’s the spirit in which we are asking Canadians for input into how to close loopholes and address tax planning strategies that give unfair tax advantages. Many of the richest Canadians are unfairly exploiting the tax rules designed to help businesses thrive. We know that businesses, including small businesses, help grow the Canadian economy. These tax advantages are in place to help these businesses reinvest and grow, find new customers, buy new equipment and hire more people. We want to make sure those rules are used to do just that, and not to give unfair tax advantages to certain – often high-income – individuals.”
Bill Morneau, Minister of Finance

The vast majority of my clients is part of the “middle class” Minister Morneau purports to work for, but with these proposed changes I strongly disagree with him. The proposed changes will hurt the middle class small business owner much more than the Department of Finance’s disingenuous calculations suggests. The significant increases in the CPP contribution rates over the next decade, the elimination of the multiplication of the small business deduction rate, the minimum wage increases proposed or implemented in many provinces and now these three major proposed changes, it is clear that the Government of Canada has decided to declare war on small business. As Jack Mintz argues in his Financial Post article,

These 'tax changes won't just hurt the 'rich', they will hurt growth'Click To Tweet

Short of a tax payer revolt, I don’t know what can be done to stop the Department of Finance to implement to proposed changes. I urge all small business owners to speak up and reach out to every advocacy group you can think of to put pressure on the tone deaf Department of Finance to start working with the small business, the backbone of the Canadian economy, to spur growth rather than increasing the tax burden already experienced by all Canadians. Maybe they can start by changing the cushy government pension we all have to fund rather than asking us to pay more than our “fair share”.

Resources if you want to study these topics further:

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