Below is commentary from MRSB Tax Partner, Terry Soloman on some initial thoughts on the federal government's most recent tax consultation announcement.
On Monday, October 16, 2017, the federal government provided some initial feedback on the actions they are considering resulting from the consultation period of the July 18, 2017 tax proposals. I have had numerous clients and others from my local business community ask me for my opinion on what today’s announcements mean for them. There is not enough information to make a definitive statement yet but here is a summary of what we know (or do not know):
1) A reinstatement of a previously announced plan to reduce the corporate tax rate on active business income, to be phased in by a one half of one percent decrease in 2018 followed by a further one percent decrease in 2019. This will reduce corporate tax rates on active income eligible for the small business deduction on PEI to 14.5% in 2018 and down to 13.5% in 2019.
While I will never complain about tax decreases on business income, wasn’t the difference between corporate rates and personal rates on business profits one of the reasons provided by government as to why the proposals issued this summer were required? All this change does is make the spread greater. However, any reduction to the corporate rate is a deferral of tax only due to Canada’s fully integrated tax system.
The reduction in the corporate tax rate on business profit does not deal with the much larger issue of applying TOSI rules to the distribution of this profit from the corporation as a dividend to family members, especially spouses, who contribute indirectly to the business success. This tax rate reduction (deferral) is minor and is really a distraction from the real issues at hand.
2) It appears, based on today’s update, that a reasonableness test is still part of the proposals but maybe the test will be less rigorous than initially suggested. I had hoped to see spouses excluded from TOSI rules and maybe limit the TOSI to adults up to age 24. This bright line test would have eliminated the need for the ridiculous amount of red tape and uncertainly a reasonableness test will create.
3) There were some comments that the proposals to limit the availability of the capital gains exemption have been abandoned. Does this mean TOSI will not apply to arms length capital gains? Will minors and non active adults be subject to a reasonableness test and still be restricted from claiming capital gains exemption on share sales? Will family trusts allocating capital gains still be targeted? Again, no details provided.
4) There was complete silence with respect to any update on the taxation of passive income, which in my view is the largest issue of all, effecting both business decisions of the private sector in the short and medium term as well as creating uncertainty over retirement strategies of Canada’s business sector. The business sector deserves better and need certainty in the rules they operate under. Unfortunately there was no update on this issue or on timelines for more clarity on any matters.
Frankly, with the consultation period having been closed only 14 days ago, and in excess of 21,000 submissions provided by Canadians to the Department of Finance, it is surprising that Finance officials would even have had the time to read and properly consider the volume and quality of submissions in such a short time frame, considering some submissions exceeded 150 pages of arguments. As always, the “devil is in the details” and we have not been provided with the details. It was interesting today that Prime Minister Trudeau was intent on answering all questions from the media and for the most part was not allowing the media to directly question Minister Morneau.
The government has committed to further updates and clarifications in the coming days, which many in the tax and business community will be closely watching with interest very closely.
MRSB Tax Partner Terry Soloman, CPA, CA, TEP appeared before the House of Commons Standing Committee on Finance on Tuesday, September 26, 2017 in Ottawa to address the federal government’s proposed tax changes. Terry was the sole tax expert to appear at this meeting from Atlantic Canada.
In his address to the committee, Terry outlined several key areas of concern.
These proposals are very damaging to the small businesses clients of MRSB as well as small businesses across Canada. These changes are the most significant tax changes since the Royal Commission in the 1970s and changes of these magnitude need to be done with proper stakeholder engagement. The proposals were also included with rhetoric such as “closing loopholes” and “using corporate structures in order to avoid their share”. The business community finds this type of language offensive and are being made to feel they are some sort of tax cheat even though they are complying with the laws in Canada. The business sector needs to be encouraged because when they have success it creates jobs in our communities.
These proposals actually miss their stated target of the wealthier section of society. People and businesses will be leaving Canada and it will impact recruitment and retention of skilled labourers such as physicians and others.
The proposals in relation to income splitting will actually disproportionately impact the middle class more so than the upper class. These proposals devalue the recontribution a spouse makes to a family business: whether that contribution is direct or indirect; whether they are actually going to the business every day or whether they are supporting their other spouse in order that the business maximize its profit and the amount of tax it will generate for government. For example, even a family with a $70,000 income could be faced with a 30-40% tax increase if these proposals go through. These are not upper class people, these are our neighbors and small business owners in Canada.
The discussion papers released by the government compares a business person with that of an employee and how much income tax they would pay. It is an overly simplistic analysis and there are many other factors to consider other than the pure up front tax calculation.
Another concern is the significant uncertainty around the reasonability tests. These tests will give Canada Revenue Agency (CRA) the power to unilaterally determine the value of certain adult’s contribution to a business. This test will be very subjective. This is a significant burden to small businesses who are not going to have tracked the information that would be needed to defend themselves and is likely to be subject to much litigation and disagreement. As an example, does a wage that’s paid for a service in PEI differ than a wage that’s paid in Ontario? How will CRA administer this reasonability test in reality?
The most egregious proposal is in relation to passive income. Passive corporate income is already taxed between 50-55%, depending on the Canadian province. In fact, it is taxed at a higher rate than most personal rates. There is a tax deferral on the initial capital that the passive income may have generated if that capital may have some from the small business reduction. But this is not a loophole – that was something government intended to give small business access to capital for either future expansion or for working capital during slower periods. These proposals will eliminate the long standing concept of tax integration at least on the payment of some dividends. The effect of this from a PEI corporation is the passive tax rate could reach 74.55% and would have a similar result in other provinces. This is clearly unacceptable and hopeful the government would not have intended this tax result.
Holding companies are also used as a vehicle to accumulate funds for retirement in lieu of an RRSP. Funds accumulated are similar in some ways to an employee who has a registered pension; however, an employee and employer contributions to a pension and the income realized bear no tax whatsoever until withdrawn, which could be many decades later. Whereas a business owner who uses a holding company for an investment has already paid a tax of between 15-30% on the initial capital and an annual tax of 50% on the earnings that are realized. For all these reasons, we suggest the proposals for passive investment be abandoned entirely.
Non-arm’s length sale of shares
Another concern is in regards to some of the proposed changes in section 84.1 of the Income Tax Act. While we do believe that some changes here are required to address certain planning that was happening, the proposals, as currently worded, lead to double and even triple taxation and will negatively impact estates and common post-mortem techniques, some of which were already in progress at the time of the announcement. Government has recognized that this section does impede succession planning for family business and we encourage them as part of this consultation process to deal with that and not just in discussion paper.
These proposals do have retroactive application. Business owners and tax payers are entitled to structure business affairs with certainty with many structures having the blessing of the CRA and the courts. It is not fundamentally fair to change the system as they are currently doing.
The proposals, as currently outlined, are deeply flawed and should be set aside. We believe that the best approach going forward is a review of the current tax system, and specifically, the establishment of a Royal Commission on tax reform, which would be given a mandate, among other things, to review the many other suggestions that have been made by various expert commentators as part of this process and with an adequate time frame for proper debate and consideration.
The committee meeting is a part of public record and is available for viewing here.
In its 2015 Economic Action Plan budget, the federal government stated, “The Lifetime Capital Gains Exemption for farm or fishing property provides an incentive to invest in the development of productive farm and fishing businesses and helps farm and fishing business owners to accumulate capital for retirement.”
Fast forward to 2017 when times have changed. In its 2017 document Tax Planning Using Corporations, the federal government is proposing to tax part of this incentive back from the family farm, the backbone of our rural communities.
A segment of the document states, “specifically, individuals would no longer qualify for the capital gains exemption in respect of capital gains that are realized or that accrue before the taxation year in which the individual attains the age of 18.” Furthermore, the document states, “the second measure would introduce a reasonableness test for determining whether the lifetime capital gains exemption applies in respect of a capital gain” and “the third measure would no longer permit individuals to claim the lifetime capital gains exemption in respect of capital gains that accrue during a period in which a trust holds the property.”
The following examples illustrate how each of these proposed changes would affect the family owners of shares of a family farm corporation or interest in a family farm partnership:
- A farmer and spouse co-own a farm through a farm partnership or corporation. On disposition of their shares or partnership interest the spouse may lose all or part of their capital gains exemption if they do not meet a reasonableness test. Whether the reasonableness test is met or not will be determined by the Canada Revenue Agency (CRA). This test is based on the amount that would have been paid to an unrelated individual considering their labour contribution, past earnings, asset contributions and business risk. To add insult to injury, any portion of the taxable gain that is not considered reasonable will be taxed at the highest PEI rate of 51.37%. It is a well-known fact that the farm spouse contributes in many ways to the family farm operation and their involvement is critical to its success. However, this contribution may not meet the reasonableness test as it cannot always be assigned a dollar value and most farms would not be tracking this information.
- Another common structure is where a family trust owns the shares of the family farm corporation. Even where the farmer is the main beneficiary of the trust, on the disposition of the shares by the family trust, capital gains exemption would no longer be allowed.
We would encourage all farmers to contact their local MP. These MPs have to stand up for the farm community who are being unfairly targeted by these proposals.