DAVID WILKENFELD, CPA, CA, canadian tax CONSULTANT

Posts Tagged ‘Morneau’

Response to Tax Proposals – Part 2

In Canadian Income Tax on September 14, 2017 at 9:00 am

Yesterday, I published Part 1 of my letter to Bill Morneau, addressing the general tone of the presentation of the federal government’s July 18 proposals to reform the taxation of private corporations. In today’s Tax Issue, Part 2 of my submission, dealing with the specific proposals themselves, and offering some suggestions for improvement, and in some cases, abandonment.

Part 2 – The Proposals – Suggestions for Improvement

Having aired my general concerns with the sweeping nature and tone of the Proposals, my experience as a tax professional leads me to acknowledge that there are, within the Proposals, certain areas that should, in all fairness be addressed. In this section I will review the four areas covered by the Proposals and offer my suggestions for improvement where warranted.

Income Sprinkling

The sprinkling of dividends among family members and other shareholders is a legal right sanctioned by the Supreme Court of Canada in the decision of McLurg v. Canada. Since that time, incorporated business owners have often structured their affairs to multiply low marginal income tax rates by issuing shares to family members, often minor children, even new born babies. The ability to use minor children in this manner was eliminated in 2000 with the introduction of the tax on split income (“TOSI”).

The Proposals now seek to extend these TOSI rules even further, to spouses and adult children. They have introduced legislation that will create an inordinate amount of complexity and uncertainty into the system.

First of all, the sprinkling of income with a spouse should not be disallowed. Often, a business is a family endeavour and a spouse offers support in many ways. Further, there are many instances, such as pension income splitting, where the distribution of family income among spouses is specifically allowed. I would recommend that the proposals with regard to spouses be abandoned.

Secondly, the sprinkling of dividend income to adult children is beneficial generally only to the extent that the child is not otherwise employed. In other words, the real benefit accrues during the time the child is still in school and not earning a salary. If it offensive to sprinkle income with adult children, then I would suggest that the TOSI simply be extended to an age where the most benefit is being attained, i.e., to age 25. After that, the benefits are virtually non-existent, unless the child is, in fact, involved in the business full time.

On the other hand, if the government is intent on introducing another reasonableness test with respect to dividend income paid to children, then they should amend the TOSI rules for minor children as well, since even a 15-year-old child, for example, can work in the business in the summertime and after school.

The proposals with regard to Capital Contributions should be abandoned. The fact is anyone who starts a small business through incorporation will normally capitalize the company with a nominal amount of share capital. No dividend paid on a common share of a small business corporation would meet the proposed reasonableness test in this regard, and it simply introduces more complexity into the law.

Lifetime Capital Gains Exemption

I have been involved in the structuring of many corporations where minor children are issued shares for the purposes of multiplying the capital gains exemption. My feeling is that the parent is using for his or her own purpose, without consent, a benefit that belongs to the child that he or she may wish to access in the future. I therefore agree that the participation of minor children in the ownership of a small business corporation for the purpose of multiplying the capital gains exemption should be curtailed.

With respect to family members over the age of 18, my feeling is that if they are legally allowed to contract, they should be allowed to own shares of a corporation, and as such, make their own decisions as to whether or not to claim the capital gains exemption on the sale of their shares. For spouses and children over the age of 18, therefore, I disagree with any restrictions on the use of the capital gains exemption on qualifying shares. These proposals should be abandoned.

Holding Passive Investments

The deferral of income within the corporate structure has been a staple of small business since the 1930’s. It is correctly considered to be the “nest egg” that a business owner can rely upon for retirement. If we add up the pros and cons of small business owners vs. Rich CEO’s as I did earlier, this item is perhaps the biggest reward that a small business owner can look forward to at the end of his or her career. While the Rich CEO can enjoy a large severance package and a generous pension upon retirement, the small business owner can rely on the accumulated investments in a holding company. The income from these investments is taxed at the highest marginal rate, so there is currently no income tax advantage to earning investment income through a holding company.

The idea that the government would attack accumulated wealth within a small business corporation and undermine a lifetime of labour by its owner seems excessive and cruel.

In my view, these proposals should be abandoned.

Converting Income into Capital Gains

Currently, the rules in section 84.1 address the issue of surplus stripping. Furthermore, the avoidance transaction that the Proposals are trying to address in this area has essentially been settled in cases such as Macdonald v. Canada. The CRA has successfully applied the General Anti-Avoidance Rule to curtail abusive transactions in this regard. Due to the CRA’s success in the courts in attacking these transactions, I would not recommend them to any of my clients. I therefore see no need to introduce legislation that would not only target abusive transactions, but would also deny capital gains treatment in cases where bona fide share sales were made. The Proposals make no allowances for the possible transfer of a business from a parent to a child or a sale between siblings. In fact, the Quebec government has recently gone in the reverse direction, introducing legislation that facilitates business transfers to the next generation.

Furthermore, these proposals will subject estates to double and in some cases triple taxation. Upon the death of an individual, there is a deemed disposition of shares at fair market value. The estate pays capital gains tax. When the company then liquidates its assets for distribution, there is a second tax that must be paid on the accrued increase in the value of investments within the company. Finally, upon distribution of the corporate assets to the heirs, a third dividend tax is levied. This is clearly unfair.

There is only one mechanism currently in place within the law that directly relieves this burden. Subsection 164(6) allows for an election to be made to offset the capital gains tax on death, but only where the company is dissolved within one year from the date of death. The administration of an estate can run much longer than one year. The government has acknowledged this with its newest laws regarding Graduated Rate Estates (“GRE”), which have a life of 36 months.

The Proposals will eliminate the ability of estates to implement what is commonly referred to as the “Pipeline” plan, which involves capitalising the cost base of shares that were taxed on death. In my opinion, the Pipeline is not an unfair advantage. The capital gain triggered on the death of an individual is clearly not a voluntary tax outcome. It is an automatic tax triggered by virtue of the law. The government seems not to be satisfied with this tax, and by denying the ability to plan to limit their taxes to this involuntary event, wishes to force a second and more onerous tax on the estate. Again this seems cruel and unfair.

My recommendation is that the anti-avoidance provision contained in the Proposals be abandoned and that the “Pipeline” transaction be expressly sanctioned by the CRA.

Failing this, at the very least, the election under subsection 164(6) should be made available to an estate for as long as it remains a GRE. Further, the designation currently allowed in certain circumstances under paragraph 88(1)(d) should be extended to corporations that have been liquidated in favour of a GRE. This would limit the tax burden on an estate to one incidence of tax, albeit the result of a forced transaction yielding a higher tax burden.

Response to Tax Proposals – Part 1

In Budgets, Canadian Income Tax on September 13, 2017 at 9:00 am

As predicted, the Minister of Finance, Bill Morneau started a firestorm in July with his proposals to reform the small business corporations tax system. I have added my voice to the concerns of my colleagues and clients in a letter to the minister. Due its length, I will reproduce it here in two parts. Part 1, deals with the general tone and sweeping nature of the proposals. In Part 2, to be published tomorrow, I address the specific proposals themselves, offering suggestions for improvement.

Part 1 – Overall Tone and Targeting of Incorporated Small Businesses

I am troubled, as are many of my clients and colleagues, by the language used in the Minister’s letter introducing the proposals. He states that the government is taking steps to “close loopholes that are only available to some – often the very wealthy or the highest income earners – at the expense of others.” He goes on to state that “There is evidence that some may be using corporate structures to avoid paying their fair share, rather than to invest in their business and maintain their competitive advantage.”

This language is disturbing. The Income Tax Act sitting on my desk at this moment weighs in at 2484 pages of charging provisions, income inclusions, allowable deductions, tax rates, formulas, incentives, penalties and anti-avoidance rules. The rules used by everyday small business owners in carrying on their day-to-day businesses, which you have characterized as “loopholes” have been entrenched in the law since its inception. They were addressed in the Carter Commission report in 1966. They have been sanctioned and approved in numerous decisions of the Supreme Court of Canada. For you to suggest that incorporated small business owners are using “loopholes” to “avoid paying their fair share” “at the expense of others” seems unfair. With respect, it appears that you are using this kind of inflammatory language to bolster your popularity among what you perceive as your political base of support, at the expense of hard working and honest tax-paying Canadian small business owners.

Furthermore, for you to suggest that small business owners should be using their accumulated earnings to “invest in their business and maintain their competitive advantage” is presumptive and unwarranted. The business decisions made by owners of small enterprises are not the concern of the government. While the tax system currently does provide incentives for certain types of investment behaviour, the suggestion that a business owner who chooses to invest his hard-earned money for his retirement rather than risk it in further business investment is going beyond your purview. Indeed, even the Supreme Court of Canada, in the Case of Stewart v. Canada refused to allow the government to interfere with a taxpayer’s business decisions, regardless of whether they generated profits or losses.

While it may be true that there are certain ways in which taxpayers who conduct their businesses through corporations have the potential to enjoy certain advantages from a tax point of view, there are many factors and moving parts in making the decision to incorporate. Furthermore, there are many extraneous factors that affect incorporated businesses which should be taken into account when comparing the tax status of an incorporated business with that of an employed individual. It appears that these factors have been totally ignored by your government, which is why the only conclusion that many taxpayers, myself included can reach, is that that these proposals are a clear attack on a specific segment of the taxpaying public, designed to increase the government’s political capital with so-called “average Canadians”.

Here are some of the factors that I refer to:

A taxpayer who makes the decision to go into business takes risks with their lives that cannot be measured in dollars and cents. They often leave the security of a job for an uncertain future. If the rewards of success are diminished, as they surely would be under the Proposals, the incentive to leave a job and risk starting a business endeavour is reduced.

The Proposals are a clear attack on small business owners. While it is true that the tax benefits of incorporation don’t really kick in unless the business earns, as a general rule of thumb, more than $150,000 of profit, the Proposals are singling out business owners as being so-called “wealthy Canadians”. Firstly, the use of the buzzword “wealthy” was clearly intentional and has its obvious negative connotations in a political context. Secondly, small business owners are not the only taxpayers who earn higher than average incomes. The government does not address the advantages enjoyed by salaried individuals. And let’s not compare small business owners earning over $150,000 with the average salaried employee who makes $50,000. Let’s compare them with employed individuals who make over $150,000 per year. Let’s call them “Rich CEO’s”, for lack of a less inflammatory term. Rich CEO’s, in general are able to enjoy the following benefits:

  1. No risk to personal capital
  2. Stock option benefits
  3. Company-funded private registered pension plan
  4. Paid vacation time
  5. Paid maternity/paternity leave
  6. Employment insurance
  7. Severance package upon termination
  8. Low-interest housing loans
  9. Health insurance benefits
  10. Life insurance benefits
  11. Automobile benefits
  12. Entertainment expense accounts
  13. Reimbursements for travel expenses
  14. Reimbursement of relocation expenses
  15. Golf club membership
  16. Prizes and corporate scholarships
  17. Christmas bonuses
  18. Performance bonuses

None of the above seems to have been affected by the Proposals.

On the other hand, a small business owner enjoys none of the above Rich CEO perks. On the contrary, he or she makes the following sacrifices when becoming involved in a business endeavour:

  1. Risk of capital – often life’s savings
  2. Risk of start-up losses
  3. Risk of business failure
  4. Risk of personal bankruptcy
  5. Risk of legal attack from clients and suppliers
  6. Risk of audit by CRA and/or Revenu Quebec
  7. Incurring personal debt, often mortgaging their homes
  8. Entering into lease obligations
  9. Requirement to keep bookkeeping records and file corporate returns
  10. Payroll obligations
  11. GST/HST/QST obligations
  12. Employer portion of CPP/EI/Health care
  13. Personal liability for deductions at source
  14. Personal liability for GST/HST/QST payments
  15. Unstructured and unlimited working hours
  16. Need for family involvement

None of the above risks are taken by Rich CEO’s and again, none of these factors is mentioned in the Poposals.

I personally offer my services to both incorporated business owners and Rich CEO’s. I would like to offer an example of a comparison of the annual accounting and legal fees involved in incorporating and maintaining a small business with those incurred by a Rich CEO.

Incorporated Business                                                          Rich CEO

 

Initial Incorporation fees                         $     2,500
Annual bookkeeping fees                               10,000
Annual legal fees                                                2,000
Annual external accounting fees                   15,000
Annual registration fees                                        107
Annual personal tax preparation                     1,500                         1,500

Total fees                                                      $    31,100                        $1,500

As you can see, the increased costs faced by a business owner simply to comply with existing tax laws and legal obligations makes the Proposals that much more difficult to digest.

In conclusion, the Proposals seem to me to be a clear attack on a large sector of the population that the average middle class Canadian – your constituency, would not have a problem hurting, especially given that you have characterized them as wealthy Canadians taking advantage of tax loopholes. This is clearly not the case, and the Proposals in general are prejudicial and unfair.

The Morneau Massacre of 2017

In Canadian Income Tax on August 8, 2017 at 9:00 am

loopholes

If you’ve just returned from vacation and wondering what’s new in the tax world, you’d better sit down and take a pill. On July 18, finance minister Bill Morneau rolled out the federal government’s proposals designed to “close loopholes and deal with tax planning strategies that involve the use of private corporations”. In short, Finance is proposing to tax an axe to many of the tax strategies that have been available to small business owners and professionals up until now.

The proposals are complex, comprehensive and wide-ranging, covering the following main areas of tax planning:

  • Income sprinkling
  • Multiplication of the capital gains exemption
  • Converting a private corporation’s regular income into capital gains
  • Holding investments inside a private corporation

Income Sprinkling

This strategy involves the splitting of income to take advantage of lower marginal tax rates available to family members. Many rules have been put in place over the years to curtail this practice. Most notably, the tax on split income (TOSI), or “kiddie tax” applies the highest marginal tax rates to certain dividends paid to minor children.

With the new proposals, the TOSI will no longer be limited to minor children. Complex new rules will apply the TOSI to dividends paid to adult individuals unless such dividends are reasonable in light of that individual’s labour contributions and/or capital contributions to the corporation.

The TOSI will also be expanded to apply to capital gains on property, the income from which was subject to the TOSI. Further, it will also apply (for individuals under age 25) to “compound income” that was previously subject to attribution rules or the TOSI.

These proposals are scheduled to apply to for the 2018 and later years.

Multiplication of the capital gains exemption

A capital gains exemption (CGE) of up to $800,000 (indexed) is currently available to any individual on the sale of qualifying shares of a private company. Issuing shares to family members, either directly or through a trust, is a common way to multiply this tax benefit.

The finance minister has proposed a three-pronged approach that will eliminate the multiplication of the CGE:

Age limit: The CGE will no longer be available to individuals where the gain occurs in any year before the individual reaches the age of 18 years.

Reasonableness test: In essence, this rule will deny the CGE on any gain on the sale of shares if the gain from those shares is subject to the TOSI measures described above.

Trusts: With exceptions for spouse or alter ego trusts the GCE will no longer be available on any gain on a share that is held by a family trust.

These proposals will apply to dispositions after 2017. However, there will be transitional rules that will allow an elected deemed disposition at any time in 2018. The fair market value of the shares would have to be determined, and the qualification criteria for the CGE will be treated as being satisfied if they are met at any time in the preceding 12 months.

Converting a private corporation’s regular income into capital gains

Normally, a distribution of a corporation’s retained earnings is considered a dividend and taxed as such. The top rate on dividends is approximately 44%. Strategies have been used with varying degrees of success to arrange for dividends to be transmogrified into capital gains, which are taxed at 25%. This involves the utilization of the high cost base on shares that have been acquired through a non-arm’s length transaction that had previously triggered a capital gain. Current rules are in place to curtail such “surplus stripping” in limited circumstances. Section 84.1 effectively forces a return to dividend treatment where the capital gains exemption was claimed on the previous capital gain.

The government proposes to extend these rules to any situation where a non-arm’s length transaction involved even a fully taxable capital gain. This proposal is meant to address what has become known as the “pipeline” transaction.

The pipeline has been used extensively in recent years as a post-mortem planning tool to avoid double-taxation where the capital is deemed to occur on the death of a corporate shareholder. Unless the current proposals are altered, the pipeline strategy will no longer be available to an estate.

These proposals will take effect for all dispositions that occur after July 18, 2017. There will be no room for transitional planning.

Holding investments inside a private corporation

One of the long-standing advantages of incorporation is the tax deferral that comes with lower rates on business income. Once the retained income has accumulated over time, the company will have a larger amount available for investment. This has been a great contributor to the retirement of many small business owners. However, it is an advantage that salaried persons or those who don’t incorporate cannot access. Accordingly, the government proposes to eliminate it.

Of all the proposals announced, this is the only one that is not fully developed with draft legislation. The Minister has included some suggested strategies to deal with the issue, each one complex in its own right, and generally altering the system of integration currently in place by eliminating the effect of the corporate tax deferral for future passive investment.

The Minister acknowledges that there currently exists a significant amount of capital invested within private corporations, and it is not his intent to affect these holdings. Any new rules will have effect on a going-forward basis.

These proposals are subject to a consultation period which will end on October 2, 2017. Interested parties should write to the Minister of Finance with any concerns before that date. I suspect that it will be an interesting and eventful autumn for the tax community.