Morneau and Trudeau
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Finance Minister Bill Morneau (left) and Prime Minister Justin Trudeau

As they battle a growing backlash, the feds may be missing an opportunity to make tax reforms that encourage entrepreneurship

The federal government’s July announcement that it was proposing changes to the way private corporations are taxed unleashed an uproar that's sure to continue for some time. On October 16, soon after closing the 75-day public consultation period, Prime Minister Justin Trudeau and Finance Minister Bill Morneau said they would reveal adjustments to their tax proposals over the coming week. The also pledged to cut the federal small business tax rate to 9 per cent from 10.5 per cent by 2019.

While many groups are upset about the planned changes, most Canadians may find the whole thing puzzling. Here’s a look at why the government is tinkering with the tax code—and why there’s a backlash.

Back in the day

The current outcry may feel like déjà vu to anyone who has followed the ebb and flow of Canadian tax policy. In 1969, the federal government floated major changes to the tax system, including raising low corporate rates and taxing capital gains. These proposals were watered-down versions of the 1966 Carter Commission report, which famously introduced the phrase “a buck is a buck is a buck” to the Canadian political lexicon and insisted that the tax system should be based on fairness.

So how did Canadians respond to the proposals? It’s safe to say they went crazy. The Canadian Tax Journal notes that “few other government documents in Canadian history have evoked such emotional reactions.”

After huddling for a few years, the Liberals of the day passed a series of milder moves in 1971 that featured many more exemptions and included the introduction of the small business tax deduction for the Canadian-controlled personal corporation (CCPC).

CCPCs are now considered a great vehicle for encouraging the growth of small business. They are eligible for the small business tax deduction, dividends from a CCPC qualify for a small business tax credit, and the owner can avoid capital gains taxes when selling their business, to a lifetime maximum of more than $800,000.

Taxes? You want to talk taxes?

Fast-forward a few decades, and the use of CCPCs has exploded.

A groundbreaking study published in 2016 by a group of economists found a $48-billion increase in retained earnings held inside the roughly two million CCPCs in 2010 alone. Perhaps more troubling for the government: 50 per cent of those in the richest 1 per cent of tax filers and as many as 80 per cent of tax filers in the top 0.01 per cent of income distribution were CCPC owners, while less than 5 per cent of tax filers in the bottom half owned a CCPC.

In its rationale for the proposed tax changes, the government notes that the income flowing through these corporations has doubled from 3 per cent of gross domestic product to 7 per cent in just 12 years. If unchecked, this growth could pose a threat to future government revenue.

The 2016 study suggested that the widening gap between personal and small business rates had led wealthy Canadians to funnel their incomes through corporations to avoid taxes. Essentially, the tax system appears to be increasingly unfair.

The Liberals made tax reform part of their platform in the 2015 election campaign. They wanted to slash the small business tax rate but also ensure that higher-income Canadians didn’t have access to the new standard. The goal: raise taxes on wealthy Canadians and slash taxes for the middle class.

With that promise in mind, in July the Finance Department announced a plan to take aim at three practices used by wealthy CCPC owners to avoid taxes. The target group included owners “sprinkling” their income through family members at a lower tax rate, those who hold passive investments in the corporation rather than reinvesting in the business and those who convert corporate income into capital gains rather than salary.

“These tax advantages are in place to help these businesses reinvest and grow, find new customers, buy new equipment and hire more people,” Finance Minister Morneau said when announcing the proposals. “We want to make sure those rules are used to do just that, and not to give unfair tax advantages to certain—often high-income—individuals.”

The resistance

As the reality of what the Liberals were proposing sank in, one of the first—and loudest—groups to protest was doctors. Since 1990, physicians have been using CCPCs to structure their medical practices to take advantage of limited liability protections and tax breaks. In 2015, the Canadian Medical Association estimated that about 60 per cent of physicians were incorporated. Many operate as small businesses with employees, rent and equipment costs.

For doctors who had been taking advantage of these legal tax measures for decades to build their businesses, pay off student debt and save for retirement, the targeting these “loopholes” felt like a betrayal.

Physicians were soon joined by a broad coalition of small businesses. Family businesses were particularly vexed because the loss of income sprinkling would make it more expensive to compensate hard-working relatives and changes to the capital gains exemption could make it harder to transfer the business to a new generation. Farmers feared the threats to the passive investments they stockpiled for a rainy day.

“In 10 years at the Canadian Chamber, I’ve never seen an issue that has generated greater concern among our members,” said Perrin Beatty, president of the Canadian Chamber of Commerce in late August. “To make matters worse, allotting only 75 days for comment in the midst of the summer holidays is not a consultation, it’s a stealth attack on farmers and family businesses.”

Fair game

At the heart of the issue is the issue of tax fairness.

Doctors claim that altering the status quo is unfair because unlike salaried employees, physicians don’t have access to pensions, paid vacation or maternity leave. Sheltering income in a corporation helps them pay for these necessities.

However, a group of unincorporated doctors have answered with an open letter saying it’s unfair for incorporated doctors to get tax breaks unavailable to others with similar incomes simply because they don’t have a personal corporation.

Similarly, business owners charge that the reforms are unfair because their ability to fund retirement savings and cover health costs would be eroded, not to mention their ability to grow their business. But UBC economics professor Kevin Milligan says there’s a misconception that middle-class entrepreneurs will be swept up in the government’s tax net.

“There’s this sense out there that it’s going to be very broad,” Milligan explains. “I don’t think it’s going to be very broad. A lot of regular business owners pay themselves dividends, pay themselves salary....Those people are not going to be affected by this.”

Fairness can be a slippery slope. The current system is unfair for the many Canadians who aren’t wealthy enough to benefit from getting a break on taxes through a CCPC, Milligan adds. “When they hear that there’s these opportunities out there for higher-income folks to set up corporations to flow their incomes through, this makes them really upset because they think, ‘How come he can do that and I can’t?’”

Looking at the big picture, the present system is fair, according to one tax law expert. “I wouldn’t say it’s unfair,” says Joyce Lee, a Vancouver-based tax partner with Deloitte Tax Law LLP. “Different taxpayers have different profiles. In the government consultation paper, the words ‘fair,’ ‘fairness,’ and ‘loophole’ come up many times. I certainly do not think it’s a loophole. These are solid, well-accepted tax planning practices.”

A better way?

Although many groups are keen on the status quo, the backlash suggests the Canadian tax system, which has had the same basic structure since 1972, needs broader reform. That’s not on the table. UBC's Milligan describes the proposals as just a patch, but better than nothing.

Still, government must be careful to avoid unintended consequences. Milligan sees potential for small businesses to be overburdened in complying with the new law. There are also questions about whether the government’s measures will succeed in doing what they intend: to raise taxes on the wealthy and trim the middle-class tax burden.

As an example, Milligan points to imprecision in the proposed changes to the capital gains exemption that could mean it’s more expensive to sell your business to a family member than to an outsider. “This is pretty complex stuff, and you want to make sure the tax law is as clear as possible,” he says.

Milligan believes many of the issues will be worked out following the consultation period. But in his view, the larger question of whether there's a more efficient way for government to stimulate business growth will go unaddressed.

“My point of view as an economist is that it might be a better way to go to make sure those tax dollars that we’re using now in the current system could be refocused to where the economic margin is best, which is entrepreneurs, startups and growing companies,” Milligan says. “But that’s hard to do because people seem really attached to the status quo of the tax system, which makes it really hard to change those things.”

What's next?

If the tax reforms do go through as drafted, some are warning of shuttered small businesses and doctors being forced to reduce their hours. There’s even the threat of physicians fleeing the country. We’ll have to wait and see.

In the meantime, tax experts are telling business owners to plan ahead. Talking with your tax adviser to the first step. Deloitte’s Lee says there are some things owners could do in advance, depending on the structure of their business:

  • Those contemplating a sale of their qualified small business corporation shares should close the transaction before the end of 2017.
  • Ahead of new income-sprinkling rules that kick in next year, a business owner could declare a bigger dividend in 2017 to different family members to establish a higher amount of remuneration.
  • If a business owner has a family trust in place, and the reasons for the existence of that trust no longer apply, they could consider collapsing it and distributing the dividends to family members.