On July 18, 2017, the federal Department of Finance issued a highly anticipated consultation paper, which addressed some of the tax strategies that incorporated business owners and professionals use in their tax planning. The view of the government is that private corporations provide high income individuals with an unfair tax advantage that is not generally available to other Canadians.
Needless to say, small business owners are very concerned about these proposals and the effect that they will have on them. And, to be sure, they will certainly have an effect. The question that everyone is pondering is just what the economic cost will be. It is virtually certain, though, that it will be significant.
On August 17, 2017, Brenda Bouw published a piece in The Globe and Mail, entitled “How much will Morneau’s proposed tax changes cost small business? We do the math.”
I thought readers would find it useful to have an overview of what Ms. Bouw had to say on this issue.
The approach that The Globe and Mail took was to ask a number of experts to provide before and after scenarios with respect to three of Ottawa’s proposed changes, including using corporations for so-called “income sprinkling,” among family members; reducing the life-time capital gains allowance for a family; and so-called “passive” investment income, where a business owner invests money that they don’t need right away in their corporation, at a lower tax rate, instead of taking it out as personal income, at a higher tax rate, and investing it.
Before taking a closer look at the scenarios just mentioned, readers should be cautioned that they should consult their own tax professionals before taking any action. Everyone’s situation is different, and the issues are complex.
So, let’s look first at income spitting. One of the most common strategies in this regard is for the small business owner to pay a dividend to a child (or children) who have significant expenses related to their education. Assuming the student has little or no income, the business owner can pay a dividend of $40,000 to the child, with that payment being virtually tax-free. On the other hand, the same dividend paid to the business owner directly would attract tax at 35%. As a result, the net available to the family to finance tuition and other education costs falls from $40,000 per year to $26,000. Needless to say, business owners who have multiple children pursuing a higher education would be hit much harder.
The second scenario involves the lifetime capital gains exemption (LCGE). Many business owners with families have taken advantage of this when they sell their business. The amount that can be sheltered rises with inflation and is currently $835,716. The way this works is that family members become shareholders in the business, even if they have not directly contributed to it. Thus each shareholder can benefit from the LCGE. The government is proposing to limit this exemption to just one family member. It does not take great math skill to understand the tax implications if this proposal becomes law.
Ms. Bouw’s article looks at the effect of this proposed change on a family of four, each with equal shares in the company, where a business is sold with a total capital gain of $4 million. The example also assumes the top marginal tax rate in Ontario. The way things work now, each of the four shareholders would be eligible for the LCGE of $835,716, which results in a total of about $3.3 million not being taxed. The gain is $657,000 and the total tax paid would be $176,000. As mentioned, under the proposed new system, only one family member would receive the LCGE. The gain would be $3.2 million, and the tax paid on that would be $847,000. This equates to the government receiving an additional $671,000 in taxes on the sale of the company.
In looking at passive income, the following example was used: an incorporated business in Ontario that generates $220,000 per year. The business owner takes an annual salary of $144,227 and sets aside $100,000 for personal living expenses for themselves and their family.
After 30 years, with a 7% rate of return, and assuming the business earns the same, takes the same salary and pays the same CPP, the owner will have a little more than $2.2 million in investment income once they take the money out of the corporation. Under the proposed new system, which adds another level of tax on the investment income earned in the corporation (or an extra 30.7%), the business owner would have$1.7 million in investment income once they take the money out of the corporation.
Clearly, the economic cost of these changes, if enacted, will be massive and will affect every small business owner.
President, HG Partners Limited
Director, Private Client Group &
Senior Financial Advisor,
HollisWealth® a trade name of Investia Financial Services Inc.
This article was prepared solely by Howard Goodman who is a registered representative of HollisWealth® a trade name of Investia Financial Services Inc. (a member of the Mutual Fund Dealers Association of Canada and the MFDA Investor Protection Corporation). The views and opinions, including any recommendations, expressed in this article are those of Howard Goodman alone and they are not those of HollisWealth®
HG Partners Limited is an independent company. iA Financial Group and Industrial Alliance companies have no liability for activities outside of HollisWealth®