September 26, 2017 12:45 pm
Updated: September 26, 2017 12:50 pm

Morneau’s income sprinkling tax changes would mostly hit professionals, not farms and mom-and-pop shops: report

The tax changes proposed by Finance Minister Bill Morneau to discourage a tax planning strategy called income sprinkling would mostly affect high-income earners, not middle class small businesses according to a new report by a left-leaning think tank.

Ben Nelms/The Canadian Press

Only 13 per cent of small business families in Canada gain from one of the practices that have come under the microscope as part of Finance Minister Bill Morneau’s proposed tax changes, says a new report by the Canadian Centre for Policy Alternatives (CCPA), a left-leaning think tank.

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The practice, known as income splitting or sprinkling, consists of sharing business income among family members — whether or not they’re involved in the company — through dividend payments. From a tax point of view, this is especially advantageous for families where the business owner, who would otherwise place in the highest tax bracket, can distribute income to relatives with little or no income.

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The government contends the practice, which is perfectly legitimate in the current tax code, has become a way for high-income earners to lower their tax burden. Critics of the Liberals’ proposed tax changes say they will hurt small businesses across the country, including those that use dividends to pay family members who do contribute to the company and middle-class entrepreneurs.

The proposed rules on income sprinkling are only one of three sets of tax provisions the proposed reforms would change.

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The CCPA study, which uses Statistics Canada’s tax modelling software, finds that only about 900,000 families in Canada receive small business dividends. Of those, just 13 per cent see a financial benefit of more than $1,000 from splitting income.

(Splitting income doesn’t yield a tax advantage unless the business owner can distribute income to relatives in lower tax brackets.)

That 13 per cent represents the families whose income splitting the government might want to scrutinize under a proposed “reasonableness test” aimed at assessing whether the distribution of dividends among family members reflects compensation for real contributions to the company, the author of the report, economist David Macdonald, told Global News.

An even smaller subset of small business families, five per cent, currently see significant tax savings from income sprinkling and are thus more likely to fail the reasonableness test, which would result in a financial hit under the new tax rules, Macdonald added.

That five per cent represents just 47,000 households, or 0.3 per cent of all Canadian families, noted the report.

“Closing the income-splitting loophole will have almost no impact on small business families, much less Canadian families in general,” Macdonald said in a statement.

WATCH: Morneau explains why closing tax loopholes helps average Canadians

The report also finds that middle-class families receive only three per cent of the benefits of sprinkling small business income, while the wealthiest five per cent, those earning more than $216,000 a year, receives around half of the tax benefit.

The findings are broadly in line with what previous research has shown and economists’ understanding of how the reforms would play out, said Lindsay Tedds, an economist at the University of Victoria and a tax policy expert.

In particular, “traditional small businesses like family farms and mom-and-pop restaurants are 2.5 times less likely to benefit from income sprinkling than high-earning professionals in the health care, legal and accounting, real estate and insurance industries,” according to the CCPA.,

On the other hand, small businesses in the health care sector, including the offices of physicians and dentists, were the most likely to see a tax advantage from splitting small business income, according to the analysis.

The findings appear to support the government’s claim that these tax changes are aimed at a small number of high-income earners. Ottawa has estimated about 50,000 families use income sprinkling as a way to save at tax time.

READ MORE: Do Trudeau’s tax changes really only hit the rich?

Rules would add paperwork, other costs for much larger number of small businesses: tax accountant 

Even if the proposed reforms on income splitting would result in more taxes for only a small percentage of small businesses, critics argue there would be other, broader drawbacks.

Many tax accountants argue that the cost of complying with the new tax provisions on income splitting would affect large number of small enterprises.

READ MORE: Tax changes do not impact family trusts or numbered companies, used by Trudeau, Morneau

“The complexity in the rules that the Department of Finance has actually drafted is enormous,” said John Oakey, tax partner at Collins Barrow Nova Scotia.

“And they drafted the rules in such a way that if you have [a Canadian incorporated small business] and you have family members that can receive a dividend, you’re in the rules.”

This means a much larger share of small businesses than the ones that draw a financial benefit from income splitting would have to make sure that they are complying with the new regulations.

READ MORE: Saskatchewan farmers and small businesses protest proposed tax changes

“There are 10 pages of technical rules to go through to see if you’re OK or not,” said Oakey.

Of course, any kind of tax change would result in some new rules to be learned. On the other hand, experts on both sides of the debate have voiced concern about the potential complexity of the new rules.

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What does the CRA think is reasonable?

Oakey also worries about the reasonableness test. Like many of his colleagues, he has little confidence in what the Canada Revenue Agency (CRA) might consider reasonable.

To be fair, the idea of a reasonableness test is nothing new, as Macdonald noted while speaking with Global News.

Incorporated small business owners already deal with similar scrutiny when they pay out salaries, which must be “reasonable” in order to qualify as tax-deductible expenses.

Giving your wife and adult kids a much fatter paycheque than they would likely receive in a similar company given their skills and responsibilities might get you audited. And if CRA concludes those salary levels are unreasonable, your deduction will be disallowed and you might face penalties.

The new tax rules would extend the concept of a reasonableness test to compensation via business dividends, Macdonald said.

WATCH: Majority of Canadians against support tax reforms to small businesses: Ipsos

Oakey, though, argues that the reasonableness test on salaries is already problematic and that introducing one on dividends would be even trickier to implement.

“If you think that you can take the [thousands of CRA auditors] across the country and teach them what the criteria is for reasonableness and make sure that […] each individual auditor is applying that in a consistent manner – that’s just not fathomable, it’s never going to happen.”

The problem would be magnified if the CRA tried to assess what’s a reasonable dividend payment for a family member who contributed to the business by putting in money rather than work, Oakey believes.

Say, for example, that you start a business with your brother, who puts in $40,000 of his own savings in exchange for a certain percentage of shares in the company. Once the business starts making money, you distribute some of it to your brother via dividends to reward him for his initial investment. If, at a later date, you start running losses, there will likely be no dividends for anyone. And if the company goes belly up, your brother might suffer a net loss, too. How would the CRA determine what’s reasonable for your brother to receive in dividends when there are profits to be shared?

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Are these tax fixes worth the trouble?

There is also the question of whether all these new rules would be worth the potential benefits of the reforms.

While the CCPA report finds that only a small number of high-income families would likely end up paying more taxes as a result of the Liberals’ proposed crackdown on income sprinkling, it also notes the reforms would have only a “modest,” if positive, impact on reducing income inequality.

The study finds that income sprinkling costs $280 million a year in lost revenue to the federal government and $110 million to the provinces.

The Department of Finance has provided a similar estimate of $250 million in annual federal revenue losses. Research shows provinces likely lose another $250 million.

Critics of the reforms say that’s not much compared to how much revenue Ottawa raises in personal taxes every year.

“The budget, with regards to personal taxes is around $15-16 billion, so $250 million is not a large amount of lost revenue,” said Oakey.

Still, others argue that even an extra quarter or half-a-billion dollars per year can make a difference. The money could help boost spending on health care, education and infrastructure Rhys Kesselman, the Canada Research Chair in Public Finance with the School of Public Policy at Simon Fraser University previously told Global News.

“These changes, if they’re done, will help not only federal revenues but provincial revenues too, because they piggyback onto the personal income tax, except in Quebec, and corporate tax as well,” Kesselman said while speaking about the whole suite of proposed tax reforms.

© 2017 Global News, a division of Corus Entertainment Inc.

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