Trudeau’s tax reforms: Here’s how the loopholes work
Correction: The original version of this story referred incorrectly to the tax applicable to passive income held inside a corporation. That reference has been removed.
You may have heard that the Liberal government is considering some changes to how small businesses and other corporations are taxed. The proposed reforms impact only a minority of taxpayers, but the blowback from those affected has been so fierce that most Canadians have probably caught wind of it by now.
On the one hand, the Ministry of Finance and some of Canada’s most prominent economists are portraying this as a move that will increase fairness in the country’s tax code, preventing high-earners from using sophisticated accounting techniques to dramatically slash their tax bill.
On the other hand, the Canadian Medical Association (CMA) predicts the changes will “destabilize health care delivery.” The Canadian Federation of Independent Business (CFIB) says they will hurt many small business owners with middling incomes and discourage Canadians from starting new companies or growing existing ones.
In other words, the stakes are potentially high for every Canadian, not just entrepreneurs and incorporated professionals like doctors, lawyers and accountants. So who’s right?
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What proponents of the reforms are saying
The government says the reforms are one step toward increasing tax fairness and reducing income inequality. Several economists contacted by Global News say that’s what the changes would indeed do, provided the reforms are well designed.
The specific issue is how private corporations do their taxes.
What’s a private corporation?
Many small businesses and self-employed professionals in Canada operate as private corporations. Incorporating is about reducing legal and financial liability in case things go wrong. But unlike public corporations, these companies do not sell shares and securities to the public.
What’s the problem?
Corporations are also subject to tax rules that are different from those that apply to personal income.
Small businesses pay an average combined federal and provincial tax of around 15 per cent on their profits. In other words, if you make $100,000 in profits, you’ll pay $15,000 in corporate taxes. But if you wanted to pay yourself the remaining $85,000 as a salary, the current rules make sure that your total tax burden is equivalent to that faced by anyone else who earned that amount during the year.
That said, small businesses and private corporations also enjoy some tax perks.
Those perks are intended to help you grow your business, not boost your take-home pay or personal savings.
However, according to the Ministry of Finance, many people have found ways to do just that. There has also been boom in the number of private corporations in Canada in recent years. Their ranks have ballooned from 1.2 million in 2001 to 1.8 million in 2014. The increase has been particularly steep among self-employed professionals, with the number of those types of corporations tripling over 15 years.
The government is zeroing in on three tax loopholes that it says are allowing Canadians to use corporations to shrink their tax bill.
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Loophole No. 1: Income sprinkling
This is the practice of spreading – or, rather, sprinkling — income accrued through a corporation among family members.
Of course, there’s nothing wrong with paying relatives who work for the company.
Right now, though, the law allows incorporated business owners to split their income with their spouse and any kids between the ages of 18 and 24 even if they had nothing to do with the company. And that’s not cool, according to the Finance Ministry.
This tax scheme is particularly advantageous if your partner and offspring have little or no income, which places them in a low tax bracket.
Here’s a concrete example of how the math works based on an analysis provided by Lindsay Tedds, an economics professor at the University of Victoria whose research focuses on tax policy.
Imagine two Ontario families, the Smiths and the Joneses. In both households, there are two parents and two adult children under the age of 25. Mr. Smith is self-employed but not incorporated. Ms. Jones runs a small company set up as a corporation. In both families, the other spouse and the two kids are not involved in the business.
Mr. Smith and Ms. Jones bring home the same income: $200,000 a year after expenses. But only Ms. Jones can use income sprinkling.
Mr. Smith has to pay federal and provincial tax on his $200,000 earnings, which tallies just over $69,000. Once you account for CPP contributions, his family’s after-tax income is just over $125,600.
Ms. Jones must pay a $30,000 (15 per cent) small business corporate tax on her $200,000 profits. She then has the option of dividing the remaining $170,000 four ways, with each family member getting $42,500. She also pays out that money not as salaries but as dividends, which are eligible for a tax credit.
Each family member ends up paying personal tax of just under $1,500. Multiply that by four, add the small business tax and you still get a total tax bill of only $36,000, an average tax rate of just 18 per cent.
The Joneses take home $164,000, or roughly $38,400 more.
The Smiths can’t keep up.
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Loophole No. 2: Passive income
This is the practice of keeping surplus profits in the corporation and investing them in things like mutual funds and real estate rather than, say, machinery and equipment for the business itself. As long as the extra cash stays inside the company, it enjoys the low corporate tax rate, which means there’s a larger principal to be invested.
Having a pile of money that’s not directly tied up in the company can come in handy. It can serve as an emergency fund if things go south or to finance future expansions.
But the government contends many Canadians are using passive income and its low corporate tax rate to grow their personal savings.
Indeed, for high-income earners, saving through a corporation can be more advantageous than doing so through RRSP and TFSA accounts.
Imagine two interior designers in Ontario who make $250,000 in income a year. One is a non-incorporated freelancer, while the other runs her own company, MarbleCountertops Inc. Both use $100,000 a year for living expenses and save the rest of their after-tax money for retirement.
The freelancer pays in personal income tax on all her $250,000. She is left with $67,000, with which she maximizes her RRSP contribution (about $26,000 a year) and fills up her TSFA ($5,500 a year).
The owner of MarbleCountertops pays $37,500 for the small business tax on her $250,000. Subtract from that the $100,000 in living expenses and the low tax rate she pays on her dividend compensation and she is left with a whopping $90,000, which she invests as passive income inside her company.
Having $90,000 a year vs $67,000 a year for retirement makes a big difference. But it makes an even bigger difference to enjoy that advantage over a prolonged period of time.
Let’s say both designers put all of their leftover money toward retirement for the whole 25-year period of their working lives, earning a six per cent return on all of their investments.
When all is said and done, the freelance designer will have a nest egg of $2.8 million.
That’s nothing to sneeze at, but it’s quite a bit smaller than what she would have been able to accumulate through a corporation.
Even though the business owner will pay a hefty tax when she withdraws the money from the company in year 25, she ends up with $3.4 million in retirement savings. That’s 18 per cent more than her non-incorporated colleague.
Loophole No. 3: Capital gains
This is by far the most sophisticated – and some would say shifty – of the three tax schemes. It involves paying very low taxes when taking money out of a corporation.
This time, let’s take a fictional example provided by the Ministry of Finance.
Picture Jean-Paul, who owns a large incorporated business in Manitoba called JPCo. The company makes $650,000 a year and generally pays him $250,000 in salary.
Let’s say this year he wants to take another $300,000 out. There are two straightforward ways of doing so.
One, he pays himself a $550,000 salary and pays Manitoba’s top personal income tax of $151,200.
Two, he pays himself the $300,000 as a dividend, which brings down his personal tax bill to $137,220.
But wait, he can shrink that tax even more. He can move the cash around by transferring shares through a series of connected corporations. Eventually, he can claim that money isn’t business profit anymore but a capital gain, which is subject to much lower tax. The trick personal tax is now only $75,600.
Closing the loopholes
The Liberals want to deter income sprinkling by asking entrepreneurs to prove that family members are truly involved in the business through a “reasonableness test.” The Ministry of Finance said the practice is costing $250 million a year in federal revenue.
On passive income, one possible fix involves taxing business income at a higher rate and then refunding some of that if a business reinvests directly in its operations. Passive investments within corporations generated $27 billion in income in 2015, according to the ministry.
On the capital gains issue, Ottawa wants to make the practice outright illegal.
What critics of the reforms are saying
The proposals have provoked furious reactions from the groups whose pocketbooks would be affected by the reforms.
Some of those objections are easy to rebuff.
For example, one argument the CFIB has used to defend income sprinkling is that family members deserve to be paid even for providing “informal support” to a business.
Doctors are consistently arguing that these tax perks serve to compensate the fact that they don’t enjoy the generous benefits and job security of civil servants. (One might point out that many Canadians with significantly lower incomes also have no benefits, job security or special tax treatment to speak of.)
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Still, many other questions raised by opponents of the current Liberal proposals have no clear answers.
Dan Kelly, president and CEO of the CFIB, worries, among other things, about the amount of paperwork involved in the new reasonableness test meant to deter income sprinkling. And he wonders how the government will be able to tell when passive income is being accumulated for personal instead of corporate purposes.
He also disputes the notion that small business owners shouldn’t be allowed to accumulate personal savings insider their company, arguing, among other things, that they face higher financial risks than regular employees.
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The CMA maintains that the new rules on passive income would make it harder for female doctors to save up for maternity leave. Although doctors, like all other self-employed Canadians, can opt into EI maternity and parental benefits, they also often face the steep overhead costs tied to running a medical office.
Prime Minister Justin Trudeau has said the changes are aimed at those making over $150,000. Several economists Global News spoke to have backed this up, noting that both income sprinkling and passive income yield the greatest benefits for high earners. The capital gains tax trick is so sophisticated that only well-heeled taxpayers tend to use it.
Tax accountants tend to disagree, noting that many small businesses with ordinary incomes use these tax strategies, as well.
In general, there is a widespread feeling that the government moved too quickly on the changes. Consultations on the proposals officially close Oct.2 and both the CFIB and the CMA have told Global News they believe that’s not enough time.
Even academics who are vocally supporting the need to close the loopholes say they have some concerns about how the new rules will turn out.
“The legislation might be ambiguous,” Kevin Milligan, professor of economics at the University of British Columbia, told Global News.
“It’s important that the compliance burden [for small business] be fair.”
It’s hard to argue with the fact that the government has spotted a bunch of tax provisions that aren’t being used the way they were intended.
Whether Ottawa will fix things or make them worse is a matter of – rather heated – debate.
© 2017 Global News, a division of Corus Entertainment Inc.