Accountants across the country have been scratching their heads over Ottawa's proposed tax changes and how they will work in practice. Prime Minister Justin Trudeau says the proposed reforms are meant to make the wealthy pay their fair share and are aimed at people making more than $150,000, and Finance Minister Bill Morneau wrote in The Globe and Mail that most middle-class Canadians and small businesses will be unaffected. But critics, including the Canadian Federation of Independent Business (CFIB) and the Conservative Party, argue the proposals will in fact hurt middle-class business owners and their families, the lifeblood of the Canadian economy.
Who's right? The Globe and Mail did a detailed analysis of four fictitious families at different income levels. While in reality there is an infinite number of family and business situations, we selected common scenarios to get a sense of the impact of these proposals on middle class and wealthy business owners. Each family has a business set up as a private corporation, as the proposed reforms only affect businesses structured as Canadian Controlled Private Corporations, not sole proprietorships or partnerships.
Meet our four families
Family 1 is an entrepreneur with a business income after expenses of $35,000 and a spouse who makes $20,000 in outside employment income. While these numbers may seem low to you – particularly if you are a professional living in a big city – remember that the median income of an individual in the last census was $34,204. While there are various ways to define who is middle class, this would be one of them. This family's combined income is less than the household average of $70,336, so if this family doesn't meet your personal definition of middle class, use Family 2 as a reference.
Family 2 is an entrepreneur making $75,000 in business income a year after expenses, with a spouse making $40,000 in outside income.
Family 3 is an entrepreneur making $150,000 in business income after expenses with a spouse making $50,000 in outside income, so this is the type of family Mr. Trudeau says may be affected impacted by the proposals.
Family 4 is an entrepreneur making $300,000 in business income after expenses with a spouse making $50,000 elsewhere. In Canada, earning $225,409 or more means you are in the top 1 per cent of income earners, so this entrepreneur would definitely make the cut.
Specific scenarios like these don't show all the potential effects, which change dramatically due to factors such as family composition and business practices. But even so, they give a general sense of who will face higher tax bills under the federal government's proposals.
We're focusing on four areas where private corporations could be affected by new rules: income splitting, converting income into capital gains, selling the business, and holding passive investments.
New limits on income-splitting rules
Income splitting – or income "sprinkling," as the government calls it in these proposals – is a technique that involves shifting income from an individual in a higher tax bracket to a family member in a lower bracket in order to reduce the overall tax payable. Unlike the general public, entrepreneurs can do this by making their spouse or adult children shareholders and paying them dividends, even if they don't invest or do any work for the company. The family members pay tax on the dividends, but at a lower rate than the business owner would have paid. The government's proposal could shut down this option, potentially raising the tax bill for families using it, although families members who actively contribute or who have invested in the business will still be able to use this technique.
Ross McShane, vice-president of financial planning at Doherty & Associates in Ottawa, did the calculations for this scenario. All figures in this story are calculated with Ontario rates, but the patterns are applicable across the country.
Family 1, with the entrepreneur making $35,000 (net business income before paying the 15-per-cent corporate tax at the small-business rate) and the spouse making $20,000 from his or her own employment, would see no impact under the proposed changes. That's because both individuals are in the lowest tax bracket already, so they won't benefit from shifting income to a spouse at a lower marginal tax rate. Furthermore, the cost of setting up and maintaining a corporation for a company at this income level is unlikely to be worth it.
Family 2, with a net corporate income before taxes of $75,000 and a spouse with $40,000 of outside income, wouldn't see much difference either. They would pay slightly more in taxes – $603, according to Mr. McShane's calculations – but it's hardly a life-changing sum. However, it's important to note that if Family 2's spouse had no income from other sources, the family's combined tax bill would face a notable jump under the new rules, paying an additional $2,369 in tax, as it would no longer benefit from income splitting.
Family 3, with an entrepreneur earning net corporate income before taxes of $150,000 and a spouse with a salary of $50,000 from outside the company, sees a bigger impact under the new income splitting rules. Their combined tax bill climbs by $5,224, assuming the entrepreneur reports 100 per cent of the dividend.
Meanwhile Family 4, with net corporate income before taxes of $300,000 and a spouse with $50,000 in salary from outside the company, sees the biggest tax jump, paying an additional $14,546 under the proposed rules, provided the entrepreneur reports 100 per cent of the dividend income. The tax bill could jump even more if the entrepreneur had a spouse with no additional income, or adult children shareholders.
So what can we take away from all this? It's fair to say most of the impact of this change to income-splitting rules falls on high-income earners. Under the current rules, this strategy already isn't beneficial for entrepreneurs in the lowest tax bracket, single people (except for those with adult kids in low brackets) or couples where both spouses have similar incomes. Also, if a spouse is actively contributing to the business, he or she will still be allowed to collect income from the corporation without paying increased taxes.
A recent study from the Canadian Centre for Policy Alternatives said that only one in eight small business owners would be hit by the proposed changes to income splitting. However if you are a middle-class business owner in a certain situation – say you're one of the 18 per cent of Canadian couple families with children that has a stay-at-home spouse – it is possible you could be affected by this measure.
Converting income into capital gains
This proposal is meant to crack down on people using sophisticated tax-planning techniques to convert income from private corporations into capital gains to get a lower tax rate. One way to do this is by selling shares in a business that have appreciated to a related company and then declaring the income made on the sale as a capital gain. This results in a lower tax bill than if the income had been paid out as a dividend.
Which of our four families would be interested in using these techniques? "The fact is none of these would," says Derek Wagar, a tax specialist at Fuller Landau LLP. This strategy is very rare, he says, and would only be of interest if you were pulling significant amounts of money – hundreds of thousands of dollars – out of a company at once. The manoeuvre would cost thousands in professional fees.
Even Family 4, with a business owner making $300,000 and a spouse making $50,000, would not be a likely candidate for this strategy, Mr. Wagar says. If that family was stashing away $100,000 a year in the passive portfolio inside their corporation, that money would likely be their retirement fund, and it wouldn't make sense to pull it all out at once. This move would usually be used by a high-net-worth person with hundreds of thousands of dollars inside a company who wanted to pull it all out at once, for example, to purchase an expensive new asset, Mr. Wagar says.
Selling the business
There has been a great amount of angst in rural communities as word has spread that intergenerational transfers could be affected by the tax proposals, making it more difficult to keep farms within the family. But there's been a lot of confusion around what the effects will be for business owners' succession plans. That's because there are various overlapping aspects of the proposals that could affect succession planning, as well as possible unintended consequences from other parts of the proposals.
Currently, active business owners can use the Lifetime Capital Gains Exemption (LCGE) to shelter $835,716 of income (indexed to inflation) from tax on the sale of a business (or $1-million for a qualified farm or fishing property), and this will remain the case under the new rules. However, one part of the proposals moves to restrict the "multiplication" of the LCGE by family members who are not active in the business. For example, under current rules a spouse who didn't invest and doesn't work in the business could be set up as a co-owner and shelter an additional $835,716 of income from a sale.
Could new restrictions on the multiplication of the LCGE impact Family 1? It really depends on the value of their business. However, the reality is that many businesses with this low level of profit (Family 1's business earned $35,000 after expenses) aren't saleable at all. "Joe Blow's business may have assets and goodwill, but the goodwill is Joe Blow and without him the business really isn't worth much," says Mr. McShane.
Assuming the businesses of our four families are saleable, let's do a back-of-the-envelope estimate of what each one might be worth. Using a rough rule of thumb – a valuation of six times profit – Family 1's business would be worth $210,000; Family 2's business $450,000; Family 3's business $900,000 and Family 4's business $1.8-million.
Family 1's and 2's business sales would still be easily covered under one owner's LCGE of $835,716, meaning they would face no increased tax with a sale if the active owner was set up as the sole owner. Family 3's business could see a small impact due to the loss of the multiplication of the capital gains exemption, but the real pain would be felt by Family 4.
It's a separate part of the proposal – the rules intended to prevent people from converting income into capital gains by flowing money through related-party transactions – that create the potential complications for intergenerational transfers. "If these rules get enacted, if you're running a family business and you're going to transfer it at fair market value, it will cost more to sell it to the family members than it will to sell it to a third party," says Dave Walsh, partner at tax advisory firm BDO Canada LLP.
There are already some rules in place which can make it more expensive to sell a business to a related party, but the proposed rules could increase the tax bill further. This is because a sale to a related party by a non-active shareholder who is related to the active shareholder could be taxed as a dividend at the highest possible tax rate, rather than a capital gain. These changes could potentially affect anyone in this situation regardless of their income bracket, and the LCGE can't be used to shield the tax.
For example, calculations by Jennifer Horner, a senior manager at BDO Canada, show that if Family 1 sold a business to an adult child for $210,000, they could pay $62,551 in tax under the proposed rules, versus $28,216 under the old rules.
There may be further effects for the child down the road if he or she wants to transfer the business to a related corporation, something typically done to finance the purchase so they can access after-tax corporate funds to pay for the shares.
While these changes could potentially be costly and affect low- and middle-earners, the Liberal government is talking about clarifying the rules to prevent effects on intergenerational transfers.
"We're looking closely at what those arguments are," said Mr. Morneau at a meeting with The Globe and Mail's editorial board on Sept. 27. "And we're going to make sure we don't have consequences that aren't intended. Nothing about what we're doing was intended to make it more difficult for people to transfer assets between generations."
The proposals include additional changes to succession rules – for example, preventing minors from using the LCGE for capital gains accrued before they are 18 – and experts are still weighing the potential impacts.
On the whole, it looks like these changes were by and large designed to hit higher earners. However, some middle-class families could face increased taxation, and the government may have to clarify the legislation to avoid impacting them.
The proposed rules could increase the cost of selling a business in specific situations
Proposed changes would disallow a spouse who is not active in a business from claiming the Lifetime Capital Gains Exemption (LCGE) during the sale of a company. This mainly impacts companies worth more than $835,716, as the entrepreneur alone would still be able to shield this amount from tax. However, if a company was set up under the current rules so that the entrepreneur and a spouse who isn't active in the company share ownership, they may face increased taxes under the proposed rules regardless of the value of the sale. This is because appreciation on the spouse's shares would be attributed to them and couldn't be transferred to the active owner without a sale at a fair valuation. These figures, prepared by Ms. Horner of BDO Canada, show the potential impacts.
Experts warn that selling a business to a family member could become more expensive
These figures, prepared by Jennifer Horner of BDO Canada LLP, show the tax impacts of the proposed rules when selling a business to an adult child. This scenario assumes the corporation is owned 50/50 by an entrepreneur and a spouse who isn't active in the business.
In these examples, the sellers don't claim the Lifetime Capital Gains Exemption. This is because under existing rules, a seller who claims the LCGE can trigger higher taxation if the buyer transfers the business into their own corporation, a strategy often used to finance the purchase so the buyer can pay out an income stream to the parents. These figures show the tax increase the proposed rules could cause for the parents; there could be additional tax increases for the child as well.
The Liberals say they want to rework the proposals to avoid impacts on intergenerational transfers, so it's not clear if these proposals will be enacted. In addition, there is not currently full agreement amongst tax professionals about the impacts of the proposals, which could be varied as there are numerous ways to structure intergenerational sales.
Holding passive investments inside a corporation
The government brought in this measure – one of the most contentious parts of the proposals – because it believes corporate owners have an unfair advantage in building personal portfolios inside their companies.
This is because income earned by the corporation is taxed at the low small-business tax rate – 15 per cent in Ontario – giving the owner a sizable head start in building a nest egg when compared with a salaried employee starting with money taxed at their personal rate. The government wants to increase the tax payable on the growth of this money (not the original amount earned by the corporation) to eliminate the advantage of starting with more money. Mr. Morneau has said this change will not affect existing savings or growth from money that is already inside the corporation. He's also said this change is not aimed at money to be used for business purposes, but rather for people amassing money inside their corporation for eventual personal use.
Technically, this change could impact any corporation, regardless of its income. But the reality is, with Family 1's household income of $55,000 and Family 2's at $115,000, they likely won't have the ability to save large amounts of money inside their corporations. "At that level of income, I would suspect that they're going to need to draw out most of the business income to cover the cost of cornflakes," says Mr. McShane.
Also, if you're not in a high tax bracket, the advantage you get by paying the lower small-business tax rate isn't as dramatic. Many financial advisers would tell Family 1 to skip holding personal money inside of a corporation, and advise them instead to take it out and invest any excess inside a TFSA.
Family 2 and 3 might consider holding money inside the corporation, but they could also choose to put excess savings into their RRSPs. "It's not a big deal for Family 3," says Andrew Zakharia, founder of AZ Accounting Firm. "They could still do the RRSP route. Family 4 is the one who is crying."
If Family 4 had $150,000 to save inside their corporation every year for 10 years, with a 4-per-cent rate of return, it would end up with a portfolio of more than $1.4-million after corporate taxes are paid, according to Mr. Zakharia's calculations. To spend it, they'd need to take it out of the corporation and pay tax at the personal level. If the business owner pulled this money out over 10 years during retirement with no additional income, the business owner would have $897,216 to spend after taxes were paid at the personal level (more if he or she split income with a spouse).
The government hasn't determined exactly how it would apply the increased taxes for passive income. But if the end result means Family 4 ended up in the same situation as a family that saved the same amount in a taxable account outside a corporation, they would be left with $772,438 after all taxes were paid.
In general, it's fair to say the proposed changes to passive income will be mostly felt at the higher income levels. But even so, there are a lot of questions about how this change would be implemented, and it's possible that in practice, the new rules could limit flexibility for both low- and high-income businesses.
For example, business owners can currently tap money intended for personal use inside their company for business purposes if there's an unanticipated need for cash. Also, business owners are wondering how it would work if they were saving for a long-term project – for example, the down payment on a building. Corporations that use passive income to invest in other companies could be affected, and another fear is that the complexity of the new regulations would add to the administrative burden of running a company.
Proposed changes to passive income rules are meant to discourage people from amassing investments for personal use
These figures, provided by Mr. Zakharia of AZ Accounting, show the size of a portfolio that an entrepreneur can build inside their corporation under current rules compared with a portfolio created in a taxable account outside a corporation.
Portfolio size if the business owner saves $5,000 a year for ten years inside the corporation: $47,449
Value of this portfolio after taxes if money is withdrawn over ten years during retirement: $47,449
Size of portfolio of an individual who saved the same amount in a taxable account outside of a corporation after all taxes are paid: $49,920
Portfolio size if the business owner saves $15,000 a year for ten years inside the corporation: $142,347
Value of this portfolio after taxes if money is withdrawn over ten years during retirement: $133,621
Size of portfolio of an individual who saved the same amount in a taxable account outside of a corporation after all taxes are paid: $116,897
Portfolio size if the business owner saves $30,000 a year for ten years inside the corporation: $284,695
Value of this portfolio after taxes if money is withdrawn over ten years during retirement: $267,243
Size of portfolio of an individual who saved the same amount in a taxable account outside of a corporation after all taxes are paid: $175,120
Portfolio size if the business owner saves $150,000 a year for ten years inside the corporation: $1,423,474
Value of this portfolio after taxes if money is withdrawn over ten years during retirement: $897,216
Size of portfolio of individual who saved the same amount in a taxable account as outside a corporation after all taxes are paid: $772,438
Notes: Money saved inside corporation is net business income before any taxes are paid (including corporate tax). The investments earn a 4 per cent rate of return over the ten year accumulation period. Retirement scenario assumes the business owner has no additional income besides the corporate portfolio withdrawals. All income is taken out in dividends by the business owner – splitting income with a spouse would result in additional tax savings. These figures do not consider the impact of the time value of money.
Adding it all up
So if the proposals are enacted, does it mean great suffering for the "average Joe" business owner – for example, the mechanic cited by Conservative Leader Andrew Scheer cited in Question Period?
In most cases, no. By looking closely at the impacts at different income levels, it's clear these proposals were designed to hit high-net-worth individuals, not mom-and-pop shops. The reforms are impactful, but their narrow scope means the spectre of ills attributed by some opponents – business closures, mass layoffs and recession – seem exaggerated.
For high-income business owners, the combined weight of the reforms won't put them in the poorhouse or result in the failure of their businesses, but they could result in a need to rejig retirement plans and make some tradeoffs. These people often havecarefully crafted plans around the existing rules, so they say the proposals feel like a slap in the face.
At the same time, it’s clear there will be some effects for business owners making less than $150,000. The measures will give them less investment flexibility and could complicate their tax filings. Most middle-class business owners won’t see their taxes soar, but a small number of families in specific situations could see increases. The succession issues are potentially problematic to a wider group of businesses. The fact that cases like these exist gives critics ample fodder to continue to paint the entire project as an attack against middle-class business owners.