Michael Dolson is a tax lawyer at Felesky Flynn LLP in Edmonton.
On Wednesday, federal Finance Minister Bill Morneau proposed changes that would, among other things, curtail income-splitting and introduce a new regime for the taxation of passive investment. Not surprisingly, pushback to the potential changes was immediate.
In The Globe and Mail, KPMG, the Canadian Chamber of Commerce and the Canadian Federation of Independent Businesses warned of the potential unanticipated or undesirable impact of the changes. While I generally accept Mr. Morneau's stated policy rationale for some of the proposed amendments, the concerns surrounding income-splitting and the taxation of passive investment are justified.
While the Department of Finance has stated that the proposed income-splitting rules are intended to apply to wealthy, high-income earners, they also have the potential to affect every incorporated family business where more than one family member is engaged in the business. It is astounding that Finance's proposed rules are approximately 20 pages long and require many new or amended defined terms – replete with circular references – together with four pages of modifications to those defined terms. The rules bristle with traps for the unwary and the drafting style is hostile to the reader. Businesses that cannot afford top-tier tax advisers will have a very difficult time complying.
There is nothing wrong with complex tax rules when the complexity is proportionate to the objective to be achieved and the sophistication of the affected taxpayers: It is acceptable for legislation that could collect billions of dollars of tax from public companies to be more complex than legislation implementing a small tax credit for senior citizens. The Department of Finance estimates the total revenue loss from income-splitting is only in the range of $250-million – an inconsequential portion of government revenue. Imposing significant compliance burdens on all businesses is not the optimal way to collect this amount from Canada's wealthiest taxpayers.
Furthermore, it is questionable whether this $250-million revenue gain will ever be realized. Issuing shares of a corporation and paying dividends to family members became popular over the past 25 years as a substitute for the payment of wages to family members, the deductibility of which by the corporation was subject to a reasonability test. I expect many small-business owners will simply revert to paying salaries rather than retaining tax lawyers to determine how the proposed rules will apply to dividends, forcing the CRA to devote valuable audit resources to assessing the reasonability of salaries in an attempt to realize this revenue.
Similar concerns exist with respect to Finance's contemplated rules for the taxation of passive income. The policy concerns relating to the taxation of passive investments are premised on the belief that an employee earning $100,000 and a business owner earning $100,000 through a corporation should necessarily be in the same tax position when they invest their after-tax earnings. This is questionable given the different risks and rewards associated with entrepreneurship and employment, so these taxpayers may not be as comparable as would appear at first instance.
Despite Finance's professed desire for simplicity, the rules as proposed will impose very significant compliance burdens and create the prospect of severe unintended tax consequences for some businesses. These compliance burdens and unanticipated consequences will be the product of proposed legislation that will apply to all private corporations, and is based in part on a questionable premise, and is intended to address a perceived revenue loss that Finance cannot estimate.
Again, there is considerable reason to doubt whether the proposed rules for the taxation of passive income will actually raise revenue or level the playing field. The proposed rules do not create an immediate additional tax hit for private corporations or their shareholders when they invest after-tax business income in passive assets; their ultimate effect is to increase the tax payable by the shareholders when they receive dividends funded by investment income. Private corporations, therefore, have an incentive to retain after-tax profits and invest in passive assets that will appreciate in value without generating income (such as Amazon.com shares), in the hope that a future government will alter the rules in their shareholders' favour. If no such alterations come to pass, the shareholders can instead engage in creative tax planning to lower or avoid the tax hit on withdrawal.
It is not surprising that the Department of Finance is attempting to raise additional revenue given the government's current deficit position, but the manner in which they have chosen to do so is alarming. The current approach needs a rethink.