The Department of Finance Canada is considering major changes to how corporations are taxed. The proposed changes could have a significant impact on many Canadian businesses: potentially raising taxes, increasing the administrative burden on SMEs and heightening the impact on family-run businesses. In 2015 small businesses employed more than 70 per cent of Canadians who work in the private sector. They also account for 27 per cent of total research and development expenditures by spending $13 billion between 2011 and 2013.

On July 18, Finance Canada launched a consultation on how “tax-planning strategies involving corporations are being used to gain unfair tax advantages.” The document contains proposed policies to close these “loopholes.” There are four key changes that will affect business:

1. Sprinkling income using private corporations: The government wants to tighten rules to prevent a business owner from transferring income to family members (via salaries or dividends) who are subject to lower personal tax rates. Specifically, the new rules will now also include children between the age of 18-24-year-old to more stringent reasonability test to ensure their year round contributions to the family businesses (the rules previously only applied to children under the age of 18). The proposals stand to create additional bureaucracy and litigation for businesses in the process of being forced to prove “reasonableness”.It is also unclear whether there will be an exemption for children who heavily contribute during certain portions of the year; e.g: A child attending post secondary education for eight months while working at their family owned farm in the summer and/or others contributing services remotely (bookkeeping, marketing, and communications).As an illustrative example via the Globe and Mail:“An Ontario doctor who draws a salary from her corporation of $55,300 (allowing her to maximize CPP contributions) and a dividend of $50,000, for a total income of $105,300. The tax paid here is $22,055.Assuming she pays a $40,000 dividend to her 20-year-old son, who is attending university, the dividend is essentially tax-free. If the doctor can’t sprinkle that income to her son and has to report the $40,000 dividend as her income, the tax on it is about $14,000 (or 35 per cent). As a result, the family nets $26,000, instead of $40,000 available for education costs.”
2. Long Term Capital Gains Exemption: When an individual sells a small business, the first $835,716 of capital gain is exempt from taxes, these exemptions can be claimed by all shareholders within the family unit. The government wants to prevent tax planning structures that enable multiple family members to use their exemptions and limit it solely to members directly providing investment risk and proven labour contributions. The proposals are also looking to not allow any LCGE on shares that were sold that were held by a family trust.Example: “A family of four – each with equal shares in the company – is looking to sell a business with a total capital gain of $4-million. The example assumes the top marginal tax rate in Ontario. In the current system, each shareholder could be eligible for the LCGE of $835,716, which is a total of about $3.3-million that isn’t taxed. The gain is $657,000 and the total tax paid would be $176,000, or at a capital gain rate of 26.8 per cent. Under the proposed new system, only one shareholder in the family would receive the LCGE. The gain would be $3.2-million and the tax paid on that would be about $847,000. That means the government would receive an extra $671,000 in taxes on the sale of the company.
3. Reducing the tax deferral advantage on portfolio investment inside a corporation: Currently, an owner can accumulate excess income and passive investments (real estate, stocks) inside a corporation and pay the lower corporate income tax rates versus the marginal income tax paid by an employee of a corporation. In Ontario, an incorporated business currently pays a tax rate of 15 per cent on the first $500,000 of income each year, and 26.5 per cent for anything beyond that.The owner can currently defer personal income or dividend taxes on these after (corporate) tax investments until the money is taken out of the business. Many businesses utilize this exemption to generate additional capital, expansion, emergency and retirement funds.

   The government is considering alternatives that would reduce this tax advantage.
   Example: An incorporated business in Ontario that generates $220,000 a year. The business owner takes an annual salary of $144,277 and sets aside $100,000 for personal living expenses for themselves and their family. After 30 years, with a 7-per-cent 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 per cent), the business owner would only have $1.7-million in investment income once they take the money out of the corporation (a net loss of $500,000).

4. Converting a private corporation’s regular income into capital gains: Income is normally paid out of a private corporation in the form of salary or dividends that are taxed at the owner’s personal income tax rate. In contrast, when a business is sold, it is taxed as a capital gain, where only one-half of capital gains are included in income, resulting in a significantly lower tax rate on income that is converted from dividends to capital gains. The government wants to tighten the rules to prevent certain tax planning structures, but it is open to more favorable treatment for genuine family business transfers.

The immediate reaction from our members and businesses across Canada was negative. While messaging within the media has been focused primarily on “high-income individuals” and professionals who are currently eligible to utilize these policies, we believe a “one size fits all” approach will be damaging to thousands of small business owners and the millions of people they are responsible for employing.

Some of our concerns we’ve already heard from our membership and other organizations include:

• The foundation of all advanced economies is based around encouraging entrepreneurship and risk taking. Unlike employees who have pension income, insurance plans and other social nets, business owners are allowed to accumulate and invest after-tax retained earnings so they have money to get them through an economic downturn or to make big capital investments.
• Unlike employees, business owners do not receive health insurance, paid vacation and sick days, severance or Employment Insurance and only generate contributions to the Canada Pension Plan and annual RRSP contribution exemptions based on the salaried income they can opt and afford to pay out of their own company. Profits and Dividends are utilized in lieu.
• Income sharing within family members also reflects the direct involvement many of them have. Many small businesses within our membership are hands on family enterprises, with spouses and children putting in well over 40 hours a week and in most cases capitalized with their combined assets There are already rules in place to prevent unreasonable payments to family members who are not earning them. Some also have put forward the argument, if the income is headed to members of a single family unit, why is one member taxed at the highest rate?
• The Canadian Chamber of Commerce is also concerned about the cost benefit impact of a proposal, which in its attempts to pull in $250 million in revenue, will have to tax over $1 billion in salaries, audit and litigate hundreds of thousands of businesses.
• With succession planning for businesses a growing concern in our community, this proposal also negatively distorts the market for private business owners seeking to sell their businesses by restricting and halving capitals gains exemptions upon a sale. Capital Gains Tax already applies upon a sale or gift of a family business to children, however, the proposals would now also treat businesses written into a will as a “sale”, leaving their children with a tax bill of over 40%. 
• The proposed changes, instead of simplifying our tax code also create a new compliance burden for small business owners while reducing incentives for capital investment and expansion. South of the border, the new United States government is currently finalizing sweeping small business tax reforms, an especially enticing prospect for border communities like ours.
• These proposals also add to the cumulative regulatory burden, with the government canceling promised reductions in the small business tax rate in addition to provincial pressures (Bill 148, Carbon pricing, Electricity prices). Many of these regulations were evaluated in isolation by individual government departments, without acknowledgment of the collective day to day impact.

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As an organization, we support reasonable attempts to curtail tax evasion or loopholes. However, these changes are to our surprise applicable to all private corporations, without reasonable justification or mitigation incentives for legitimate small businesses. Early analysis by some accounting firms paints a dire picture, with one report suggesting a tax rate of 93% in certain scenarios! The government should fairly recognize that the tax environment today is a legacy of decades of amendments and concessions, some of them even considered politically motivated. Some experts believe that concerns with income splitting can also be addressed through treating the entire family unit as a singular entity (as originally recommended by the Carter Commission in 1966), however, such ideas, as well as the currently proposed amendments, need extensive consultation and impact analysis.

We are currently working with the Canadian Chamber of Commerce network to develop an engagement strategy with the Government that ensures they understand the significant impact this will have on small businesses. In particular, we are looking for detailed examples and personal stories of how a specific small business will be affected by the changes. We feel concrete examples will be most effective in making our case for easing the changes. We would ask that you send them to the contact information below by September 11th.

Click here to view the full set of consultation documents released by Finance Canada.

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For more information please contact: Huzaifa Saeed | Policy & Research Analyst | Hamilton Chamber of Commerce | t: 905-522-1151 ext: 230 | e: h.saeed@hamiltonchamber.ca

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