Deboning the Backbone of the Canadian Economy

Commentary, Lee Harding, Taxation

With its proverbial filleting knife in hand, last July, the federal government announced changes to income splitting, passive investment, and capital gains that had farmers, small business owners, doctors, and lawyers howling. The good news is that some of the proposed changes won’t happen. But, the bad news is that some of them will—and fast.

“Most witnesses told our committee that the proposed changes should be withdrawn in their entirety,” the Standing Senate Committee on National Finance reports. “We are inclined to agree. We are not convinced that the government has made a good case for its proposals.”

The federal government’s proposals are inspired by some academic papers, and on the Prime Ministers  belief that self-employed people are avoiding taxes by using provisions for business. A set of proposals were introduced with only 75 days  for feedback. The senate committee listened from September until the report’s release in December. Tax reform, it said, should begin with consultation to really listen to Canadians, then identify the problems and present solutions.

The senate report states proposed changes should not apply until 2019, at the very least. Incredibly, the Finance Minister  announced, “everything’s a go” for January 1, 2018 because taxes won’t be paid until 2019. “They’ll have 12 months to figure that out,” he said. “We think this is entirely appropriate and consistent with past practice.”

That naïve conclusion had already been disproven in September when a tax expert and former finance minister said wealthy Canadians had already moved their money out of the country. A spokesperson  from the Canadian Federation of Independent Business (CFIB) added, “There’s all sorts of business immigration programs that are out there encouraging entrepreneurs to pick up and leave.” Whether the business community waited or not, the picture of what will soon be implemented is now more clear.

Let’s begin with income sprinkling. Some family-owned businesses use dividends to sprinkle income to all adult members of the family, preventing high taxes on personal income for the top earners. Canada Revenue Agency will now place a ‘reasonableness test’, requiring recipients to prove their contribution to the business through labour or property, or by assuming risks.

Public backlash led exemptions for spouses over 65, those 18 and over who work 20 hours or more per week, or those over 25 who own ten per cent or more of the company. Even so, the senate report predicts, “The difficulty of understanding and complying with the rules will lead to uncertainty, foster tax appeals and litigation.”

Additionally, the government wants to target passive investment income, a move that the Parliamentary Budget Officer expects will get the government an extra billion dollars annually in the short term, and as much as $6 billion annually, 20 years from now. It has always been an advantage for a company to invest the money it retained because the only tax paid on the base amount was the small business tax, not the personal income tax. Proposals from last July suggest removing the refundability of passive investment taxes, which means a whopping marginal tax rate of 73 percent on passive income.

Following public outcry, the government is allowing the first $50,000 a year of this passive investment income to remain as it was, which leaves 97.5 percent of Canadian businesses untouched by the new rules. The threshold is too low for the CFIB, which says a $250,000 threshold would be less threatening to business growth.

The government also abandoned the concept to keep family members from splitting the lifetime capital gains exemption (LCGE). Now, those couples intending to sell their business to retire can breathe a little easier. However, it is still more expensive and complicated to sell a business to an owner’s children at 45 percent than to a third party at 26 percent.

These small adjustments leave most of the bad ideas intact. No one doubts that Canada needs tax reform. However, there is filleting and then there is butchering, people should be aware of the difference.