The federal government is on the hunt for new tax revenue from Canada’s small businesses, mainly because of an erosion of the personal tax base and a significant shift of taxable income to the corporate tax base instead. Specifically, the amount of taxable passive investment income earned by private corporations has increased from $8.6 Billion in 2002 to $26.8 Billion in 2015. And the government wants a bigger piece of that pie.
The view is that because small business tax rates are low, any returns made on passive investments from that capital provide an unfair advantage to the small business investor. “Preferred tax rates for corporations were never intended to facilitate passive wealth accumulations, such as through passive investments,” the Department of Finance says in recent proposals to make sweeping changes to tax planning within private corporations.
In fact, the private corporation does now pay additional taxes on passive investment income at a rate that equates to the top tax bracket paid by individuals. These pre-paid taxes are then refundable when dividends are paid out to the individual shareholder, who again pays taxes on those dividends on the personal tax return. The integration of the two tax systems is almost perfect when a dividend gross-up and dividend tax credit are combined to reconcile the amounts on the personal return to avoid double taxation. How perfect that integration is depends on where you live in Canada.
Passive investments held by small business owners within the corporation as part of their retained earnings are often parked there in readiness for new opportunities or as a hedge against other risks. Pre-funding operating lines, and guaranteeing them personally, are often a pre-requisite for borrowing, which must be secured by other assets. Investment income earned also offsets the costs of expensive financing and interest. Yet, the government compares an investor who is an employee – who bears none of those risks – with a successful entrepreneur in making a new case for new taxation.
The assumption is that the business owner would prefer to retain business income, for passive investment purposes, within the corporation, to reap tax benefits. However, since the 33% top marginal tax rate was introduced in 2016, the advantages of earning dividends within a small business corporation have already been curtailed, when combined personal/corporate tax rates are considered.
In its proposals, the government presents the case that capital taxed at low corporate rates within small business corporations and then invested there, will compound and grow faster, when compared to the investments made by an individual employee, where tax is lopped off the top, leaving fewer after-tax dollars for investment purposes. Now proposed is that the “source” of the earnings used to fund passive investments will be tracked in the future. Top marginal tax rates will be applied to earnings if the investment was made with low-taxed corporate dollars.
The proposals are mostly silent on the fact that the individual taxpayer benefits from the progressive personal tax system – a basic personal amount and a variety of tax brackets. However, deep in the fine print there is an acknowledgment that the corporate investor who pays personal tax at a rate below the top marginal rate, would in the future be incentivized to draw money out of the business to invest in a personal savings account of some kind.
For owners of Canadian Controlled Private Corporations (CCPCs) who want to invest retained earnings to prepare for the next business opportunity, the news is not good under these proposals, especially if the investment of choice is publicly-traded securities.
The current system of taxation on portfolio dividends – prepayment of tax at top tax rates with a refundable tax when passive income is distributed to shareholders – would be replaced. Instead, all income generated would be taxed inside the corporation at an amount equivalent to the top personal tax rates; then once again as “non-eligible dividends” once the money flows through to the individual. This would apply to both capital gains (the non-taxable portion of the capital gain would no longer be eligible for tax-free distribution to shareholders) and dividend income from publicly-traded securities.
Corporations that only earn income taxed at the general rate could elect to pay additional non-refundable taxes in return for “eligible” dividend tax treatment, for which investors receive a higher dividend tax credit personally.
For corporations focused on passive investments – that is, not set up to earn active income – not much would change under the proposals, as the earnings are already taxed at the highest rates inside the corporation.
All of the proposals under discussion would necessitate complex and expensive annual recordkeeping and reporting, as business owners sort the capital available for investment purposes into categories of income taxed at low and high rates before making an investment. Sorting is required again before distribution to the individual taxpayer, this time through the pools of eligible dividends, non-eligible dividends and tax-free dividends.
If the changes do take effect as described, they will significantly raise taxes on new passive income investing activities within the corporation, making that option prohibitively expensive.
Here’s an example of how $1,000 passive income earned in a CCCP would be taxed when flowed through to the shareholders (assuming they pay at the highest rate in Manitoba – 45% on non-eligible dividends):
New tax (50.4% in Manitoba) ($504)
Dividend to shareholder $496
Personal tax @45% on dividend ($223)
After-tax income to shareholder $273
Total taxes ($504 + $223) $727
Effective rate of tax $727/$1000 = 72.7%
With the current tax system, the tax rate would be 50.4% (assuming perfect integration). This is obviously a huge tax increase.
Alternatively, the personal tax system offers progressive tax rates, 50% capital gains treatment, and the opportunity to have dividends from publicly-traded securities taxed as “eligible” rather than “ineligible.” Small business owners will no longer be incentivized to park retained earnings within the corporation if their income falls below top personal tax brackets in the future. In that case, distributing corporate earnings as salary or dividends in order to make passive investments personally will make more sense. In the process, complex and expensive tax preparation costs within the corporation will also be avoided.
What will happen to the large existing pools of passive investments within private corporations if the changes as proposed should come to pass? Business owners with retained earnings subject to low corporate rates may wish to make passive investments inside the corporation now to avoid the punitive new rules after the proposals take effect. After public consultations end on October 2, 2017, there is a promise in the proposals that “time will be provided before any such proposal becomes effective.” However, there is no guarantee on the effective date of change.
Whether this leaves the business itself at a disadvantage remains to be seen. Planning is required to determine “what if” scenarios now. In addition, tax and financial advisors will want to work together with business owners to understand the effect of the proposed changes on family compensation planning, business succession planning and debt and cash flow management.