In response to the Federal Government’s proposals on taxation of private corporations, Sullivan & Co. has made a submission to the Department of Finance and written to the Member of Parliament.
September 29, 2017
Kim Rudd, M.P.
12 Elgin Street East, Unit 4
Cobourg, ON K9A 0C5
Dear Ms. Rudd:
RE: Tax Planning Using Private Corporations
I am writing to you as my Member of Parliament, in response to the July 18, 2017 Department of Finance Canada (the ‘Department’) proposals by the Honourable Minister of Finance, William F. Morneau (Tax Planning Using Private Corporations, Department of Finance Canada (‘proposals’)).
I have lived in Newcastle since 1990, with my wife, and together we operate an accounting firm located in Bowmanville, established in 1997. Including ourselves, we employ six people, and are responsible for providing professional services to hundreds of individuals, businesses and not-for-profit entities. When we started in 1997 we had one client.
Previously, in 1986 my wife and I started a franchise business in the hospitality industry. I was 22 at the time, and this was a new start-up. With some luck and a lot of hard work, we made a success of the business, which was sold in 1990, that allowed us the opportunity to return to school. We both graduated from the University of Toronto in 1993. My major was in economics.
My firm’s clientele consists of mostly owner-managed businesses, an area in which I have considerable expertise, and am passionate about. As a business owner, and a professional advisor to owner-managers, I understand what it takes to successfully operate a business, and how owners think. (For simplicity, I will refer to private enterprise owner-managers as ‘owners’).
Clients’ Response to Proposals:
I have spoken to many client’s regarding the Department’s July 18, 2017 announcement, which can be summarized as follows:
• With few exceptions, clients are emphatically opposed to the proposals. Many are angry, in a way that I have not previously seen. They see the proposals as out of touch, not well thought out, and disconnected with the reality of operating a business. They see the process as rushed. They see them as unfair, given the degree of proposed changes.
• They see the proposals as ‘an attack’ on business, on capitalism, and success.
• With few exceptions, if (the proposals are) enacted, owners will make changes to how they do business, in some cases, dramatically.
In my opinion, the proposals represent the most significant changes to taxation of private businesses since at least 1972.
The Minister’s letter stated that, “In addition to efforts to combat international tax evasion and avoidance, our Government is looking closer to home, and is taking steps to address tax planning strategies and close loopholes that are only available to some—often the very wealthy or the highest income earners—at the expense of others.” (Pg. 3)
To include reference to tax evasion as part of the proposals is disingenuous and misplaced. Perhaps the Department can identify how complying with existing and previously enacted Income Tax Act (‘ITA’) is similar to tax evasion. Furthermore, owners do not operate their businesses ‘at the expense of others’, no action was taken on their part to misappropriate from ‘others’.
The proposals are based on the principal of fairness. In the proposals (document, ‘Tax Planning Using Private Corporations), the word fair (or unfair, fairness) is used 37 times, but no attempt is made at defining what ‘fair’ means, and by whose standard, except on Page 3, “We don’t think that’s fair.”. Who is ‘we’? And how is ‘fair’ defined?
Is it fair that,
• Owners have to use their savings, home equity, RRSPs, TFSAs to raise cash to start an enterprise? Risk loss of all these? Provide personal guarantees against all assets to obtain financing?
• Owners frequently miss seeing their children grow up due to the long hours required?
• Owners take on the incredible stress of running a business, which necessitates not only having expertise in their particular industry, but also in human resources and labour legislation (including union management), financial management, information technology, etc., etc.?
• Owners have to manage competitive threats, economic cycles, foreign currency, interest rates, bank and creditor demands, industry obsolescence, theft and misappropriation, etc.?
• Owners have to understand and manage regulatory risk, including standards for labour (ESA, WSIB,CRA, etc.), environmental, privacy, accessibility, taxation, etc.?
• Owners ‘eat, breathe and sleep’ their business, so that it never shuts off, just to be successful?
• Owners do not have pension plans, with no guarantees regarding future income or retirement?
The proposals refer to fairness of taxation as similarity in tax rates between corporate owners and employees, that a corporate owner should not have a tax advantage over an employee. However, I would suggest that an owner and an employee are not the same, since employees do not take on the risks and extent of responsibilities required from an owner. Consider the factors listed above, perhaps some of these may apply to managerial employees, but not all of them, and certainly not the risk. Given the risk and responsibility of the owner, what then is considered ‘fair’ in exchange?
The proposals require application of a reasonableness test in order to determine how payments of dividends are taxed. Specifically, TOSI (tax on split income) would apply where payments are made to adult specified individuals (refer to the proposals for definitions) that are unreasonable, based on either labour or capital contributions. Payments would be unreasonable based on what an arm’s-length party would have agreed to pay.
• The proposals do not recognize how family members are valued and remunerated within active family businesses, including adult children (aged 18-24). The Canada Revenue Agency (‘CRA’) already recognizes this, as such family members are not normally considered insurable for EI (employment insurance) purposes. This is because the nature of their work is not similar typical employees; they go far beyond regular expectations in terms of working hours, roles, conditions, etc. The economic value of such contributions are difficult to measure, and much of the time there is no objective way of measuring (including determining what an arm’s-length party would have paid).
• A reasonableness test is very subjective, and determining such an amount will lead to continual challenge by CRA, and risk to the owners (in determining what is reasonable), resulting in spending significant public resources (CRA administration, the tax courts), as well as professional fee costs.
• Payments to adult specified children age 18-24 would effectively be blocked in many cases, since the individual would have to be “actively engaged on a regular, continuous and substantial basis in the activities of the business.” This is not fair. For example, if such an individual was attending a post secondary institution, payments would be prohibited (i.e. under the labour contribution test; the capital contribution test restricts payments to the prescribed rate times the value of the assets contributed will almost always be impossible to meet since adults age 18-24 would not yet have accumulated significant assets).
• The proposals do not recognize the nature of a family (incorporated) business: (1) Where the labour contributions by given family members may have occurred in past years, however dividends continue to be paid in lieu of past service. For example, a parent and child may be both shareholders of a family business, and the parent and child each have separate classes of shares that have nominal values, however the parent is retired but continues to receive dividends in recognition of the parent’s past contributions. Based on the proposals, this payment would not be considered reasonable. (2) Where a husband and wife are equal shareholders, having the same class of shares which have nominal values, however one of the parents remains home for years when their children are young and therefore the “labour contribution” is reduced. Both parents receive (significant) equal dividends. Based on the proposals, the payments to the parent who stays home would not be considered reasonable. This is not fair.
• Finally, dividends are in the first place a return on capital, and the contribution of labour is irrelevant to determining payments.
Double Taxation on Death of an Owner
The proposals eliminate the current post-mortem tax planning that alleviates double taxation on death. On the death of an owner, there is a deemed disposition reported on the owner’s final personal tax return at fair value. Prior to the proposals, it was common to restructure the estate using what is known as the ‘pipeline’ method. This method will no longer be available under the proposals. Consequently, double taxation is likely as a result of winding up the owner’s corporation (in practice, it is generally difficult to sell the shares of private enterprises, especially if they are small to medium in size for example). This is not fair.
Further, there is an unfair advantage to individuals who own public company shares, for which there is a ready market to dispose.
Elimination of the Lifetime Capital Gains Exemption (‘LCGE’)
The proposals eliminate the LCGE on shares held by a family trust. Typically trusts will own the shares of active businesses, and the family members are beneficiaries of the trust. The intention of the proposals is to eliminate the ‘multiplication’ of the LCGE.
1. Family trusts have been in use for a considerable time, and the primary reason for using a trust rather than direct ownership is typically for risk management (i.e. asset protection). By eliminating the LCGE, owners are put in a position of assuming higher risk. Given all the existing risks that is commensurate with being an owner, this additional risk is unfair to the owners of private enterprises.
2. It appears that the Department’s concern regarding the multiplication of the LCGE relates to individual beneficiaries not active in the business. However, by excluding all beneficiaries, this is unfair to the owners who would have otherwise have been able to utilize the LCGE had the shares been owned directly (i.e. none of the owners would be eligible for the LCGE). This is not fair.
The proposals intention is to eliminate the deferral of corporate income tax on income “beyond what is needed to re-invest and grow the business.” Examples are provided for acceptable “investments”, such as adding employees and purchasing new equipment.
1. Under the proposals, if a private corporation invests in assets that generate passive investment income (i.e. generally interest, rents, dividends, and capital gains), a tax rate of approximately 50% will be paid on this income (regardless of whether the apportionment or elective method is used). When the net income is subsequently paid to shareholders (through dividends), additional taxes will be payable, resulting in an effective tax rate of in excess of 70%. This would include rental properties, stock and portfolio investments. Currently, the non-taxable portion of a capital gain is paid into a Capital Dividend Account (‘CDA’); this would be eliminated. Currently, refundable taxes are paid on public company (and non-connected) dividends; this would be eliminated. Currently, refundable taxes are paid on investment income, and refunded when paid to shareholders; this too would be eliminated. With a tax rate of over 70%, owners will not save within their corporations, and will be effectively forced to pay out the funds that would have been invested. This will result in owner’s marginal tax rates much of the time at approximately 50% (i.e. the owner would rather pay 50% now versus 70% on future withdrawal). This is unfair.
2. Many businesses need to hold significant amount of cash for long periods of time, due to long term plans (e.g. family farm that desires to acquire another farm property), to cyclical nature of the industry (e.g. downturn in the construction cycle), bad debt write offs, etc. To prudently manage capital, good managers will hold long term investments in planning for those future events. Taxation of this income at the rates outlined above is not fair.
3. Owners economic purpose in going into business is not to employ people or purchase equipment, but rather to earn a profit. Employees and equipment are costs, and good financial management seeks to minimize costs in order to maximize profits. Owners do not prepare year end financial statements for the purpose of measuring the number of employees added during the year, or the equipment purchased. An income statement reports net income, and the owner is interested in return on capital invested. The point here is not to be facetious, but rather to point out the obvious, that is business enterprises are measured by profit. Capitalism seeks to maximize returns on capital. While it may be desirable to reinvest in a business, through acquisition, organic expansion, etc., for many private enterprises there is a limit to growth, whether by personal choice of the owner, their capability and expertise, etc. The proposals intent of preventing non-active investment is punitive to success.
4. A basic economic principal is that ‘savings equals investment’. The proposals will succeed in reducing investment (at the most basic level, since fewer dollars will be retained in a corporation for investment, even if similar investments are made personally using personal after-tax income, the amount of dollars available for investment will be less). This will negatively impact the economy.
5. The proposals state that, “the tax advantage conferred on private corporations—the lower rate of tax—was never intended to be used to realize higher personal savings.” (Pg 32).
• That is incorrect. As noted in the proposals, the relevant tax law has been effective since 1972. That is 45 years ago. When did the Department during that time, ever, propose that this stated ‘tax advantage’ was “never intended”? Specifically, if this has been a problem within the last 45 years, why has there been silence?
• It is unreasonable to state that income retained in a private corporation is “personal savings.” Retained earnings are not available for personal use, whether for savings or consumption, until they are paid to the shareholders, at which time additional tax is payable.
• The current tax system already adequately addresses corporate and personal income through integration.
6. The proposals create an unfair advantage for large (public) corporations over private corporations.
• Public corporations tax rate is 26.5%, which is 23.5% lower than the effective proposed rate to owners. Conversely, public corporations will have after tax proceeds of 73.5% for investment purposes, compared to owners after tax proceeds of approximately 50% (as outlined above). The proposals intend to eliminate the acquisition of passive investments by private corporations, but no similar restriction will apply to public corporations. Public corporations can and do acquire passive investments as well, and under the proposals will continue to do so. That is not fair.
• Public corporations already have many benefits versus private corporations, (and especially within the small to medium sized enterprises), such as market dominance, cost of capital, sources of capital, in house expertise, advantage of scale, etc. It is already an uneven playing field for private corporations.
7. The proposals equate employee income tax rates with corporate owner’s (at the corporate and personal level) tax rates. This is unreasonable and unfair. As outlined herein, there is no comparison between employment and business ownership.
8. The proposals suggest that owner’s methods of savings be similar to employees, specifically identifying RRSPs and TFSAs as suitable for both. In my experience, this is flawed, as it does not correspond with the reality of how owners actually save. They do not generally use either RRSP’s or TFSAs, because they prefer to retain earnings in their businesses. It is misplaced to simply suggest that owners should ‘maximize’ their RRSPs, since it presupposes that the Department knows better how to best allocate capital than the owner. This is not fair.
9. The proposals are very complicated, which will result in lack of understanding by owners (and therefore lack of transparency), high costs of compliance, and high risk of non-compliance. This is not fair.
The proposals list expected impacts, which are very brief, and in my opinion, completely miss what the actual impacts and outcomes will be:
1. There will be ‘chill’ within the private enterprise sector. Confidence in a stable and reliable tax system will have been lost. What plans can be made if a government can introduce new tax proposals on short notice, without first seeking input from stakeholders, that upend long standing tax planning and expectations. How will an owner implement a corporate reorganization in the future when a new government can arbitrarily determine what it believes to be ‘fair’.
2. Successful owners that have the means will consider emigrating from Canada. This is especially applicable to the very successful owners, those that are being targeted as the ‘1%’. However, those are often the best and the brightest, the innovators. Consider all the owners who are service based, information technology, internet based, who can operate from anywhere. Owners, and capital, will leave Canada.
3. The perception of tax unfairness and excessive taxation will encourage the underground economy.
4. Owners will curtail activity. When the amount of tax being paid exceeds the amount of net income being retained, many owners will quit.
5. Tax revenues will not increase, but decrease. The Laffer Curve will apply.
I am not sure that any of what I have outlined herein will make any difference. However, I do think that the proposals, if implemented as outlined, will be very consequential.
Sullivan & Co. (Professional Corporation)
Michael Sullivan, CPA, CA, LPA, CFP
C.c.: Department of Finance Canada
All M.P.’s in Canada