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Changes to proposed tax rules 'less damaging' for small businesses

Although elements of the previously proposed changes to the small business tax in Canada have survived and will create compliance burdens for taxpayers, a vigorous response from the public and professional advisers has led to changes that are less damaging than the original release, Canadian tax lawyer David J. Rotfleisch writes in The Lawyer’s Daily.

“After burning as much political capital as possible and still facing a voter base in revolt, Finance Minister Bill Morneau announced multiple revisions to the federal government’s previously proposed changes to the small business tax in Canada. They also offered a large carrot,” Rotfleisch, founding tax lawyer at Rotfleisch & Samulovitch Professional Corporation, explains in the article.

Likely the “least sensible” new tax change announced on July 18, 2017, writes Rotfleisch, was the proposal that would see retained income in a Canadian controlled private corporation subject to an additional level of tax.

“The proposals that probably garnered the most opprobrium were to income sprinkling as well as the curtailment of the lifetime capital gains exemption. The final straw was rules to prevent the conversion of income into capital gains,” he adds.

The public consultation period ended on Oct. 2, and included much “outrage and pushback.”

In the days that followed, he says, the prime minister announced that the anti-income sprinkling proposals would not affect the lifetime capital gains exemption and promised to lower the small business tax rate to nine per cent, from 10.5 per cent.

“Then on Oct. 18, in the first of a series of orchestrated announcements, Finance Minister Morneau announced a ‘tweak’ to the proposed passive income tax rules. The new rules would allow a reinvestment of income earned from an active business without an increase to corporate tax up to a limit of $50,000 per year. Purportedly, this would allow those self-employed and small business owners to shelter a limited amount of their income in order to save for retirement, economic downturn, or other unexpected problems,” writes Rotfleisch.

As Rotfleisch says in the article, in 1971, after the Royal Commission on Taxation under Kenneth Carter had reported to Parliament with a plan for a radical transformation of Canada’s tax system, a tax on corporate retained earnings was enacted that was similar to what the Liberals have been proposing through the summer.

“Those changes served only accountants who, though they began losing their hair, nevertheless became richer due to the significant complexity involved and the additional fees they could collect as a result. Taxpayers were left with crushing professional fees and the Canada Revenue Agency [CRA] found that administration of such a tax impossible to track,” he writes.

Those changes, he adds, were repealed only one year after they were implemented.

“What’s old is new again: our government seems intent on revisiting the gambit in the interests of what it calls ‘tax fairness,’ says Rotfleisch.

Canada’s Income Tax Act is based on the concept of “integration,” says Rotfleisch, which means there are rules in place that serve to ensure every dollar of income is taxed in the same way, regardless of where it is earned.

One example, says Rotfleisch, is the small business owner.

“Let’s say that a small incorporated business earns $100 in income in a year. It pays the small business tax rate of 15 per cent (combined federal and Ontario in this example). It then has three choices: reinvest the funds in growing the business; invest the funds in a passive investment; or flow out the income to the shareholder.

"When the income is paid out to the shareholder by way of dividend, the taxpayer recognizes the $100 into their income, but to ensure fairness, the $15 previously paid by the corporation is given as a credit to the individual. This means that, in effect, the owner pays only the difference between the 15 per cent and their marginal tax rate. In this case, integration ensures that the overall tax is the same as if the shareholder had earned the income directly rather than through a corporation, or had withdrawn it as salary from the corporation,” he writes.

If the owner chooses to reinvest this income in a passive investment, there is a tax deferral advantage, says Rotfleisch.

“What the minister glosses over is this: a deferral advantage is not as big as it seems,” he adds.

The “tax abuse” that is the subject of these new rules concerns the $15 tax on active income in the example above, writes Rotfleisch.

“If the funds had been taken out by the shareholder, about another $35 of tax would have been paid by the shareholder. So, this $35 of deferred tax is left in the corporation to earn passive income (that is taxed at top rates).”

Rotfleisch notes Canada already imposes a tax on passive income in a corporation called Part IV tax, which brings the tax on passive income up to just above the highest marginal personal rate and encourages owners to dividend out the income to themselves in exchange for a refund of the Part IV tax to the corporation.

“Take money out, pay tax at top tax rates. Leave money in the corporation, pay tax at the same top rate. Sound complicated? It is,” he says.

The new proposals, he says, add another level of complexity, where business owners will be required to track dollar amounts reinvested in their corporations and allocate them to passive as opposed to active, but only once they pass the $50,000 threshold.

“This will have the effect of driving up professional fees for accounting services and increasing compliance costs for the CRA itself when it comes time to audit taxpayers,” says Rotfleisch.

On Oct. 19, says Rotfleisch, the minister also announced that the Department of Finance will not pursue its proposed measures targeting transactions which are intended to convert income into capital gains.

“So, what does this leave? Some form of offensive against income splitting or sprinkling that will be introduced in the future, probably in the next budget,” he writes.

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