Small business, big trouble
Ottawa's call for changes to the way private companies are taxed has sparked widespread outrage and raised questions about the perceived value of entrepreneurs to the Canadian economy. How we got here and where we are headed
The tax-avoidance quagmire that federal Finance Minister Bill Morneau wants to clean up via proposed small-business tax changes is one Ottawa helped create – more than four decades ago, when another Trudeau was prime minister.
Prime Minister Justin Trudeau was only a few days old when a broad package of tax reforms enacted by the government of his father, Pierre Trudeau, took effect on Jan. 1, 1972. While small businesses had received tax breaks before, the 1972 tax reforms instituted the small-business deduction, which made the effective tax rate for small businesses substantially lower than that of larger companies. This is the basis of the tax structure under which small businesses still operate today.
The intent was simply to let small businesses hold onto more of their profits so they could finance their growth. But the changes put in place the foundation for what has become a complex jumble of tax breaks and incentives for small business, creating fertile ground for tax experts to exploit – sometimes in ways that do not promote the small-business growth and job creation that governments had in mind. Toss in the string of federal and provincial corporate tax cuts over the years, which have opened a wide chasm between small-business and personal tax rates, and incorporation has become an increasingly attractive option – particularly for high earners seeking to shelter income from the tax man.
"The rhetoric around 'loopholes' and the rich taking advantage – this stuff has been there for a long time, and governments have contributed," said tax-policy expert Jack Mintz, the president's fellow of the School of Public Policy at the University of Calgary.
Now, Ottawa is trying to put this tax-sheltering genie back in the bottle with its controversial proposals, which rest on three planks. The first would limit a business owner's ability to "sprinkle income" among family members who do not work for the company. The second affects a business owner's ability to convert income to capital gains, which are taxed at a lower rate. And the third would restrict the corporation's ability to take cash out of the business to make so-called passive investments in outside assets, such as equities.
The government has faced an outpouring of heated criticism about the proposals. Doctors, restaurant owners, manufacturers farmers and countless other groups have gathered to discuss them, complain to their MPs and voice their views on social media.
The proposals are complex and will affect companies differently, but they could have serious implications for how businesses operate and for the carefully constructed financial plans of small business owners and their families. While the changes will have a greater impact on wealthy business owners, they also limit the options of the not-so-wealthy. For many, the federal tax changes are yet another burden for businesses facing rising costs and new provincial government policies such as a higher minimum wage.
And the debate surrounding the tax changes is about more than just money. At its core it's about the place of entrepreneurs in our society. Does their role in creating economic activity and jobs justify giving them preferential tax breaks, or are business owners no more deserving than any other taxpayer?
Business owners take issue with the suggestion that the current rules are unfair and feel the government has cast them as uncaring elites who are happy to dodge taxes and beggar other Canadians.
Ken Seto, the CEO of Toronto-based game studio Massive Damage Inc., says entrepreneurs take risks that regular salaried workers do not – and that it's important to encourage them to keep doing so.
"I feel like it's kind of a slap in the face to keep legislating things so that we're put on an even slate with people who are employed full-time," said Mr. Seto, adding that over the past decade he has had to steer his company away from the brink of collapse more than once.
"If the company had actually imploded and went out of business, there's no safety net for me," he said. "I'd have to go out there and try to find a job. There's no cushy EI – there's none of that stuff."
About a decade ago, Mr. Seto sold his Mini Cooper for $16,000 to help fund his mobile app company, Endloop. He says entrepreneurs work long hours and risk everything, including their homes, to get their businesses off the ground. "Shouldn't that be rewarded? Shouldn't that be something that you want people to strive for?"
Joe Camillo, who owns Niko Apparel Systems in Hamilton and co-owns rowing company RegattaSport, echoes the sentiment.
"I don't have a pension plan," Mr. Camillo said. "The future for me versus a salaried employee with a benefits package is very different. So why shouldn't I have some of those advantages, like not being that taxed on my passive investments or not having to worry about passing on an exorbitant tax burden to my kids if they want to carry on the business?"
In fact, that move to restrict passive investments is a concern for many business owners. Under the proposed rules, companies that make investments inside the company will face a higher tax rate than if the business owners made those investments in their personal accounts.
Gavin Semple, owner of Brandt Group of Companies, a Regina-based maker of farm and mine machinery, says the move will limit companies' ability to amass capital for expansion. Mr. Semple says he has used the technique to save money for inevitable economic downturns and, recently, to help fund the purchase of a plant in Saskatoon.
Brandt Group is not a small business – it is Saskatchewan's largest privately held company, employing 1,800 people in Canada and the United States. But Mr. Semple says the proposed tax changes – he is unhappy with them all – will be felt at businesses large and small.
"This is an attack on private businesses across the country. It doesn't matter whether you're a dry cleaning outfit with four employees or you're a company like Brandt with 1,800 employees," he said. "The cumulative effect is brutal. What it does to our decision-making is we start to question our direction and our strategy. Do we want to invest here?"
For some business owners, such as farmer Megz Reynolds, the issues literally strike close to home.
A 640-acre section of farmland just outside of Kyle, Sask., has been in her husband's family for over a century. But under the government's proposed tax changes, Ms. Reynolds is afraid she and her husband may not be able to afford to buy it from her in-laws when they retire.
"If we were to buy that land from my father-in-law, we would actually be taxed at a much higher bracket than if he was to sell it to a complete stranger," she said – effectively because, under the new rules, it would be taxed as a dividend rather than a capital gain.
Peter Weissman, a partner with the accounting firm Cadesky Tax in Toronto, says the tax rate if the business is transferred to one's kids would be about 45 per cent, versus just 25 per cent if were sold to an outsider.
Losing the family land would be a big hit to the couple's crop farming business, Ms. Reynolds said. The section of land in question, which the couple currently rents, constitutes just under half their farmable land. But there are emotional implications in addition to financial ones, she says, noting that every generation of farmers in her husband's family has lived on that land.
"It's a legacy thing," she explained. "Our girls are fifth-generation farmers. That land could potentially be in the family for another hundred years. It would be extremely emotional to lose land that's been in the family for 107 years.
"The Trudeau government's response is that we don't need to worry unless it's over a million dollars," Ms. Reynolds said. "But the reality is that a million dollars really doesn't get you much in the way of farmland any more."
Obviously, the government's efforts to sell the proposals to Canadians has not gone well and has spurred at least two Liberal MPs to denounce the process. Mr. Trudeau has signalled he is willing to listen to criticism and make changes to some of the proposals, but he is not backing down from his position that the rich need to pay their fair share.
"A lot of those wealthy folks are really fighting to keep those benefits that they have – and they're making a lot of noise," he said in a CBC interview aired on Sept. 12. "We just want to make sure that people using private corporations don't have benefits that aren't available to average Canadians, and that's where we're making a little tweak."
Lars Osberg, an economics professor at Dalhousie University in Halifax whose specialties include income and wealth distribution, says Mr. Trudeau's political foes and the business community are issuing "crazy exaggerations" in order to "muddy up" the government. Dr. Osberg says the changes would help bring equity to a tax system that favours the well-off.
"I think there's been an enormous amount of fear and misinformation pumped into the debates," he said. "You've got very small fractions of the population who are going to be affected, but you've got a whole lot who are now worried."
In fact, misinformation – or a lack of information – is at the heart of the debate. Despite Ottawa's zeal to close loopholes in the small-business tax system that can be exploited to reduce personal tax bills, no one really knows how big this problem is. There is no detailed research revealing how many people are incorporating as small businesses primarily as a tax-avoidance strategy.
University of Ottawa researcher Michael Wolfson has been doing his best to shine a light on what he calls the "dark corner" of Canada's income tax system. In 2015 and 2016, he co-authored two influential reports on the topic of small-business incorporation and its use by high-income Canadians. (Indeed, it was Mr. Wolfson's work that inspired the government to look into tightening the rules surrounding small-business tax breaks.)
His research came to a couple of key conclusions. First, incorporation is heavily skewed toward the country's highest earners. And second, one of the most lucrative tax advantages of earning income in a corporate structure is income splitting, the ability to spread income among family members – typically through corporate dividend payments – to substantially reduce the family's overall personal income tax bill. In fact, he calculated that income splitting within the corporate small-business structure is costing the federal government about $500-million a year in lost revenue – an estimate he characterized as "conservative."
"Substantial tax benefits are likely flowing to a select group of mostly higher-income families, where the objectives of supporting worthy objectives such as entrepreneurship and job creation are unlikely to be realized," he concluded.
We also know that since the turn of the century, the use of small-business incorporation has soared. Department of Finance figures show that the number of Canadian-controlled private corporations, or CCPCs, (which qualify for the small-business tax rate on their first $500,000 of annual income) increased by 50 per cent from 2001 to 2014, to about 1.8 million. (The number of self-employed Canadians, including those whose businesses have employees, rose just 20 per cent over the same period.)
This growth has come during an era of generally declining small-business tax rates in Canada, both at the federal and provincial levels.
"By far the most important [factor] is that the incentive has gotten bigger as the small-business tax rate has declined over the past 10 or 20 years," Mr. Wolfson said in an interview this week.
The federal tax rate on small-business income has fallen from 13.12 per cent a decade ago to 10.5 per cent today. When combined with differing provincial rates, the Finance Department calculates that the average combined federal-provincial tax rate for small business has fallen from about 20 per cent in 2000 to just 14.4 per cent today.
At the same time, the combined federal-provincial top marginal personal income tax rate has risen, from about 41 per cent to 51.2 per cent. That widening gap between the tax hit on personal income and small-business income has made incorporating a compelling tax strategy, especially for high-income Canadians.
"We kept lowering the small-business tax rate on active business income, because it was very popular with small businesses, and kept opening up the differential between the corporate rate and the personal rates as a result," Mr. Mintz said. "That helps push more people to incorporate."
Among professionals such as doctors and lawyers, the number of incorporations has tripled since the turn of the 21st century, as regulatory changes first made it an available option for them.
Mr. Wolfson points to a change in Ontario's regulations for doctors in 2005 as a case in point. As part of the province's fee negotiations with the Ontario Medical Association, the government agreed to allow family members to own shares in physicians' corporations. It was, in effect, a way for the government to deliver more income to doctors without raising their fees, by enabling income splitting. The result: CCPCs among Ontario physicians soared tenfold from 2005 to 2011. (At the same time, Mr. Wolfson found, CCPCs among restaurant owners were essentially flat.)
Taken together, the evidence points to an increased use of small-business incorporation as a tax shelter. But there is a concern that the government has not only overreached with its proposals but has jumped the gun – penning policy before it has invested in this additional level of research. This is, after all, a government that came into office pledging evidence-based policy-making.
"I think it's really a shame that they don't seem to have the numbers readily at hand," Mr. Wolfson said. "If public policy is to be done on an evidence-based manner, then a substantial investment needs to be made … on making sure you have the information in order to understand and monitor what's going on with these programs."
Dr. Osberg of Dalhousie says the increased use of tax shelters by professionals isn't an economic trend but rather a relabelling of income for tax purposes. "Once a trend like that gets going, you're sucking an awful lot of tax revenue out of the system. … Once you start, it just keeps on going. Everybody says: Well, if he gets it, why don't I? The rest of us, who are actually paid on salary, we end up paying for it because the tax revenue has to be made up somewhere."
But when Mr. Trudeau says the proposals will close loopholes enjoyed by the "wealthy," many business owners take it personally. They see themselves as the very middle class the government is always talking about helping. They work hard, employ others, pay taxes.
"The message has been very insulting to us. That's why we're so mad. It really is upsetting," said Chris Struthers, owner of Struthers Technical Solutions Ltd., an electrical engineering company in Penticton, B.C., that works in Canada and around the world.
"I think business owners in general, we're happy to pay taxes. We're happy to pay our share under the existing rules," Mr. Struthers said. "I do a lot of work in countries where people don't pay taxes … and they're not good places to work. So we recognize that taxes need to be paid and we contribute a lot. So to be labelled as guys ripping off the rest of the taxpayers with these loopholes … it's upsetting."
Mr. Struthers started his electrical engineering company almost seven years ago. He says that if he could do it all over again, he likely wouldn't – not if the proposed tax changes were in place.
"I sat on the fence for a very long time," he said. "I had a draft business plan that I sat on for about a year, and finally my wife prodded me to go meet with an accountant to have the business plan reviewed. He said: You've got some great ideas and here's some tax incentives you might be able to utilize to reduce your risk. And those made a huge difference in taking the leap. … The biggest one was the income splitting."
Being able to share income with his wife allowed him to reduce the tax bill and spend the money on equipment and new employees.
"We took minimal income in those years so we could invest in the business and grow. In those years, my wife and I were the lowest-paid people in the business for the first three years," he said. "It was not until the fourth year that I started pulling ahead and enjoying some of the fruits of our labours. Retroactively speaking, if those rules were in place then, I'm sure they would have stunted our growth."