Tax changes on the horizon
Published by CME Manitoba on September 13, 2017
In its 2017 budget, the federal government announced that it would be making changes to the tax treatment of Canadian-Controlled Private Corporations (CCPCs). These changes were motivated by the government’s desire to treat like income earners alike: There are a number of strategies available to incorporated individuals that reduce the amount of taxes they pay compared to someone earning the same income as a salaried individual.
The Budget highlighted three specific issues:
• Income sprinkling: Individuals who own a CCPC are able to distribute their income among family members through a variety of means, allowing more of that money to be taxed at lower brackets and therefore reducing the overall tax paid.
• Treatment of passive investments inside a corporation: Because of preferential small-business tax rates, individuals making passive investments (in stocks, bonds or other assets not directly related to the business itself) inside a CCPC pay less in tax compared to someone investing the same amount out of their normal wages.
• Conversion of income into capital gains: Because half of capital gains are tax-exempt, if an individual uses a CCPC to convert its regular income into a capital gain, they pay a lower tax rate on that income.
On July 18 2017, the federal Department of Finance issued a paper, Tax Planning Using Private Corporations that spelled out the specific issues and proposed solutions in considerable detail. The release of that paper also triggered the beginning of a 75-day consultation process on the proposed changes, some of which could be in place as early as January 1, 2018.
CME’s Guiding Principles on Taxation
CME believes that an internationally-competitive tax system is critical to attract new manufacturing investment to Canada and to foster entrepreneurship and growth. Small businesses are the engine of the Canadian economy. In the manufacturing sector alone, there are 81,400 self-employed individuals. The tax system needs to encourage these small businesses to innovate and grow by investing in their own future: in new facilities, technologies, machinery and equipment; and to reward entrepreneurial activity and risk-taking.
In short, we have drafted three specific guiding principles that we believe must govern any and all changes to the tax system for manufacturers in Canada. The tax system should:
- Incentivize investment and growth
- Reward and support risk-taking, innovation and entrepreneurship.
- Be simple, clear and fair
We believe that, by focusing on a narrow view of tax fairness, the federal government’s proposed changes by and large fail to meet these criteria. In an effort to clamp down on some cases of legitimately unfair tax avoidance, the changes to the tax treatment of CCPCs are too broad and create a number of unintended consequences:
- They penalize entrepreneurship, risk-taking and job creation;
- They fail to account for key differences between small-business income and employee salaries;
- They raise business costs and add to the complexity and administrative cost of tax compliance;
- They inconsistently apply the “tax fairness” principle and create new instances of unfairness;
- They distort incentives to invest in the business; and
- They penalize individuals who use passive investment income to smooth out income flows or to save for retirement.
CME believes that the proposed changes are short-sighted and could have significant negative consequences for many manufacturing businesses. In our view, the Government of Canada should not rush to implement piecemeal efforts to amend the tax code. Instead, the government should work towards longer-term and more comprehensive reforms to create a tax system that is simple and equitable, and that encourages investment and rewards success.
Specific concerns with the proposed CCPC tax changes
Failure to account for key differences between business income and wage income
The stated policy goal of these tax changes is, essentially, to treat like income earners alike. According to the Canadian government, a dollar in income earned through a CCPC should be taxed at the same marginal rate as the same dollar earned through wages and salaries. While they appear to achieve that narrow goal, the proposed changes fail to account for many key differences between the type types of income.
a. Personal risk
The first of these differences is in personal risk. There is a tremendous difference in the risks borne by CCPC owners compared to an employee earning a salary or wage. For one, income for many small manufacturing businesses can vary considerably from one year to the next while income for salaried workers is far more secure. Moreover, manufacturing income is far more variable than income from the intended target of these reforms – wealthy individuals operating CCPCs in services-sector industries.
Second, most CCPC owners in manufacturing have a significant personal stake in the success of their business. Many have invested their own personal wealth or taken on debt to finance their enterprise. They have drawn down their personal assets. They have taken out a second mortgage on their home. They have opened a personal line of credit or secured personal loans. Each of these incurs direct costs (in the form of interest payments) that do not apply to salaried workers. On top of that, business owners are personally backstopping their enterprise. If they fail, their home may be on the line. And that is to say nothing about the long hours, stress and family tension that often result.
As one CME member noted, the only risk that salaried employees face is in their morning commute. Their income stream typically does not fluctuate from one year to the next; they incur no personal financial risk in earning their salaries; and in the event they lose their job, most have access to severance pay and Employment Insurance benefits.
b. Non-salary compensation
The second issue is that the proposed tax changes are only concerned with direct income – is $100,000 earned through a CCPC being taxed at the same rate as $100,000 earned as a salaried employee?
This argument fails to account for a wide range of non-salary benefits that provide financial gain to employees but are largely unavailable to CCPC owners. Employees get paid vacations. Most have a pension plan (Government workers have defined-benefit plans). And the vast majority enjoys health/dental/life insurance plans for which they only pay a fraction of the cost.
By contrast, CCPC owners have none of these benefits unless they pay for them themselves. The proposed tax changes are aimed at treating each dollar in income equally, regardless of how it was earned. But that principle of equality and fairness needs to reflect the full range of financial benefits, not just the surface-level compensation.
Deterring job creation and entrepreneurship
a. Job creation
CCPC owners in the manufacturing sector are not just self-employed individuals, they are job-creators. The clear intended target of the proposed CCPC changes is wealthy individuals who have no intention of creating work for other Canadians, but instead are exploiting the tax advantages of incorporation to minimize their overall tax burden. However, the proposed changes cast too wide a net. Caught in that net are legitimate small business owners that are trying to succeed, expand their operations and create jobs for other Canadians. The current CCPC tax arrangement recognizes that key difference and provides a modest incentive for business owners to take risks to help build a healthy, vibrant economy. The proposed changes remove those incentives.
Small businesses are the engine of the Canadian economy. In the manufacturing sector alone, there are nearly 68,000 establishments with fewer than ten employees. While not all these businesses may be CCPCs, they do employ nearly 274,000 Canadians. Those business owners should be rewarded for their efforts and encouraged to do more to create jobs in Canada.
In CME’s consultations on this issue, one member company pointed out that his business employs 50 people directly or through domestic outsourcing to other small companies. He compared that to a federal government bureaucrat who earned a higher salary, worked fewer hours, was entitled to a defined-benefit pension and enjoyed many other benefits not available to the business owner. The public employee did not create a single additional job through his or her work and represented a net draw on government revenues rather than a generator of those revenues. Taxing the two as if they were alike sends the wrong message about economic growth and self-sufficiency.
b. Entrepreneurship and Innovation
A related issue is that the changes to the tax treatment of CCPCs effectively discourage entrepreneurship and innovation in a time when the federal government has made an Innovation Agenda one of its hallmark policy priorities.
The current tax advantages that are available to small business owners exist in recognition of the risk inherent in entrepreneurship and because of the job-creating potential that starting a business represents. The proposed changes aim to treat a business owner just like an employee earning the same wage. But as already discussed above, the two are not the same.
In its pursuit of tax fairness, the Department of Finance argues that the decision to incorporate should be based on the potential economic returns of starting a business and not on the personal tax benefits that result. However, because the tax changes consider only a partial view of financial reward and ignore risk altogether, they in fact do the opposite: they discourage entrepreneurship and distort economic decision-making.
In effect, the proposed changes remove any incentive for an individual to start a business; they could earn the same salary by taking a job with someone else. They would pay the same taxes, while also enjoying more extensive company-paid benefits and enduring far less personal risk in the process. This is surely not the intent of the proposed changes.
Adding complexity and raising the cost of doing business in Canada
a. Cost of doing business
One of the most important issues raised by manufacturers is that the proposed tax changes add to the relentless increase they have seen in the cost of doing business in Canada. Governments often point to Canada’s relatively low headline corporate tax rates as a signal of our global tax competitiveness. But this paints an incomplete picture; a whole range of tax and regulatory changes, and other government policies are adding to business costs and eroding our competitiveness. Some of these include:
- Rapidly-increasing electricity costs in Ontario, Manitoba and elsewhere
- The move to a $15 minimum wage in Ontario, Alberta and BC
- Higher Canada Pension Plan premiums
- Plans to implement a nation-wide price on carbon
- Rising property tax rates in some jurisdictions
These examples are on top of recent and planned increases to corporate tax rates in some provinces, as well as the federal government’s cancelled plan to reduce its small business tax rate from 10.5 per cent to 9 per cent. While most of these changes fall outside the purview of the federal government, this is a distinction that seldom matters to small businesses: They see their costs rising; they see government as responsible.
It is also true that no single one of the items listed above is alone enough to fundamentally alter Canada’s competitive landscape. Together, however, they represent death by a thousand cuts. The proposed changes to the CCPC taxation rules only add to that burden.
Moreover, the trend of rising business costs in Canada stands in sharp contrast to the stated intention of the US government to dramatically lower its business tax burden. Canada could soon find itself with a significant business cost disadvantage, leading to the migration of investment and jobs south of the border.
b. Tax complexity and the compliance burden
There is also the issue of administrative and compliance costs. Evident to anyone who reads the Department of Finance’s discussion paper on the subject, the proposed tax changes are complex and highly nuanced. While closing certain tax “loopholes” will simplify some elements of tax compliance, the new restrictions on income sprinkling will impose significant short-term costs as businesses try to adjust to the new rules.
In addition, the new rules will also increase government scrutiny of family-member employment, income and investment for CCPC owners. Without clear rules on auditing, record-keeping requirements and other administrative procedures, small family-run businesses could find themselves unintentionally offside the tax code and inadvertently face stiff financial penalties.
Inconsistent application of the “tax fairness” principle
Changes to the taxation of private corporations are motivated by the government’s desire to achieve tax fairness; a marginal dollar of income should be taxed consistently regardless of how it is earned. Many of the points above demonstrate why comparisons between salaried income and business income is inappropriate, failing to reflect key differences in risk, as well as considering only a narrow and incomplete view of income.
However, there is another problem: the governing principle of tax fairness is being arbitrarily and inconsistently applied across the tax code. Consider the following examples:
- Treatment of savings and investment income. The Government of Canada offers a dividend tax credit on income earned from investing in a Canadian public corporation. By contrast, interest income earned from bonds or other similar instruments is taxed at the full marginal rate. Like income is not being treated alike. Moreover, one reason why such a tax policy would be permitted is to reflect the fact that equity investments are potentially riskier and provide a benefit to the Canadian economy. If these considerations apply in this case, they should also apply when comparing CCPC income with employees’ wages and salaries.
- Income splitting. Federal government tax policy considers income splitting to be unfair on the basis that, for tax purposes, individuals should be treated alike regardless of their personal circumstances. However, in clear violation of this principle, the income splitting option remains available for pension income – even in cases where seniors are considerably wealthier than working-age Canadians. Consistent application of the tax fairness principle requires eliminating income splitting for pensioners.
- Lifetime capital gains exemptions on the sale of a home. Capital gains on the sale of a principle residence are generally exempt from taxation. In other words, a certain type of capital gain is being treated differently from other types. On top of that, this exemption also provides an explicit benefit to wealthier homeowners and to those living in large urban centres.
- Treatment of self-employed individuals. Self-employed (but unincorporated) individuals that incur losses in a given tax year are able to deduct those losses from future earnings. For CCPCs, however, they bear the full risk of any losses (without tax compensation), but pay full taxes in profitable years. In effect, CCPC risk is being penalized by the tax code.
Creation of new instances of unfair taxation
In its effort to eliminate a certain type of perceived tax inequity, the proposed changes in fact create a number of new instances of tax unfairness that were surely unintended. According to Jack Mintz, these include:
- Discrimination against family succession. Under the proposed changes, a CCPC owner would be taxed more heavily if he or she sold their business within the family compared to if it was sold to unrelated domestic or foreign investors.
- Unfair treatment of corporations. In an effort to tax individuals alike, the proposed changes mean that public corporations and non-Canadian private corporations would be treated more favourably by the tax code compared to CCPCs.
- Punitive marginal taxation. Under the new changes, passive income within a corporation could be taxed at an effective rate of over 70 per cent. This is extremely punitive and is inconsistent with effective taxation of other income sources.
Distorting incentives to invest in business growth
Minister Morneau was clear in stating that the proposed tax changes are not intended to affect business’ ability to grow, create jobs and support their communities. On the surface, this principle is upheld by the proposed changes. The Tax Planning Using Private Corporations consultation paper emphasizes that, so long as income remains within the corporation, it can still take advantage of the small-business tax rate and its effective tax burden will be unaffected.
However, we have three concerns. The first is that the proposed changes do nothing to encourage investment beyond penalizing individuals for remove money from the corporation and paying it out as income or dividends. The second is that when companies do invest in new facilities or machinery that expand operations and profits, those profits would be more heavily taxed when they are distributed to business owners. In other words, the investment risks are unchanged, but the potential rewards are diminished.
Finally, as several experts have noted, the proposed changes result in a punitive tax rate on investment. CCPC owners may choose to invest passively in their company in good years and withdraw money in bad years to smooth out volatility in their annual income. Alternatively, they may choose to invest passively in the company as a retirement fund since they do not have access to pensions as do most paid employees earning the same income. Under the proposed reforms, an individual taxed at the highest marginal bracket would face a combined corporate-personal tax rate on their investment income of about 73 per cent. This rate is unnecessarily high.
CME will continue to advocate on behalf of members, while providing the resources and tools you need to stay informed. While the above article is not our formal submission, it provides an in-depth explanation of members concerns and CME's draft policy position. For more information on proposed tax policy changes and CME’s advocacy efforts on your behalf, contact Ron.Koslowsky@cme-mec.ca or Mike.Holden@cme-mec.ca
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