On July 18, 2017, the Dept. of Finance released a Consultation Paper on their interpretation of certain unfair tax advantages private corporations and their shareholders benefit from in terms of income splitting, passive investments, multiple capital gains exemptions (CGEs) and the conversion of income into capital gains (not widely used).
This two-part blog provides some of the insights that we at CVTrustCo are hearing as we speak to our professional networks. First part – the rant. Second part – the benefits that survive.
So, where to now?
- What is the chance of this stuff becoming law;
- Do you unwind structures that are in place;
- How am I going to keep track of these new measurements; and
- Where did Finance get it wrong.
These are all great questions that you should discuss with your tax advisor.
What is the chance of this stuff becoming law?
A couple of insights:
- It’s a 60 plus page Consultation Paper. Given the feedback Finance is receiving, the end product will hopefully be dramatically different;
- If not passed, a successor government could send it to the shredder; and
- It could sit out there for years. Ask any old tax hack how many proposals have never hit the Income Tax Act.
Do I unwind structures that are in place?
We haven’t spoken to anyone that recommends unwinding current structures. The best advice is to leave things as is until the final proposals are known. As we will mention in our second post, there are still benefits to structures such as trusts.
How am I going to keep track?
The proposals contain several reasonableness tests – both for dividends and capital gains. As an example, before you pay a dividend to a family member, you must determine the reasonableness of the dividend based on the family member’s labour and capital contributed to the company. If not reasonable, the highest rate of personal tax will apply to the dividend. If a child working in the business is paid a market salary and owns shares that they paid a nominal amount for – say as part of an earlier estate freeze – they likely will always fail a reasonableness test. Similar reasonableness tests need to be met for benefit from the CGE on private company shares.
To lighten the load, there are also provisions to crystallize capital gains during 2018 and tax the gain taxed under the old rules. This will require valuing the company, calculating and possibly paying minimum tax, preparation of corporate reorganization legal documents, discussions with bankers, etc.
Also, minors will not be eligible for the CGE on all gains until they reach 18. This will now require a company valuation when each shareholder turns 18.
These calculations must be prepared (most of them annually), bench marked to arm’s length comps. and preserved for future scrutiny by the CRA.
Where did Finance get it wrong?
If you peruse the Consultation Paper Power Point deck, Finance provides an example of Ontario neighbours making $220k each per year. One a business owner (Jonah) and the other an employee (Susan). The employee pays $35k more in tax per year. The following table will highlight some of the differences between a business owner and an employee making $220k per year.
|Profile||Jonah – Business Owner||Susan – Employee|
|Risk||Full financial risk for business outcome including personal guarantees on bank debt. Possible second mortgage on home.||Nothing of a financial nature. Do a good job and you should have a job. Company goes broke – find a new one.|
|Stress||Never ends. Worry about staff, clients, paying the rent, getting sued, succession, etc. Paid when cash is available.||There is work related stress, but to a much lesser degree without any financial risk. Salary paid bi-weekly.|
|Retirement||Try running the business and saving for retirement when all cash is needed in the business.||How about a defined benefit pension plan?|
|Vacation and benefits||If you’re in the service business, a vacation costs you money, and forget about the health plan.||3 to 4 weeks paid vacation, sick days, full dental and medical with a health club option, maternity leave, paternal leave. The list goes on.|
|Bonus||If the company makes money, you may get a bonus, unless you need to re-invest the funds in the business.||Usually defined up front. Meet metrics and receive the bonus. Bonus not enough? Argue the metrics.|
|Reward criteria||Yes, you can sell the business in the future if you do everything right.||Again, a lifetime defined benefit pension plan.|
|Reward quantum||Most small businesses sell for 3 to 5 times adjusted earnings. At $220k per year – $650k to $1m.||A $80k per year lifetime pension is worth more than $1m.|
There may be sarcasm in the table, but the comparison between Jonah and Susan is real. Jonah is running a business with all the risks and potential benefits, and Susan is an employee with minimal risk and pre-defined benefits. Much, much different and not comparable. Ask Jonah if he would swap places with Susan for $35k per year.
Frankly, these consultative proposals undermine the value of a family business. In terms of reasonableness, how do you calculate the value of having your father miss your ball games because he had to work late, your mother that did the company books after dinner or you having to mow the lawn as there was no parent having the time. These are things that cannot be quantified for the purposes of a tax rule – they are the cost of building a family business.
Finance has lots of options. They could eliminate the small business deduction for professional corporations or simply restrict it to companies with a minimum number of full time employees, say 5. On multiplying the CGE – in 25 plus years, I have seen very few examples where this was a benefit. Many companies sold assets as opposed to shares, or the company has stayed within the family.
The rant is now complete. Benefits that survived will be the subject of our next post – stay tuned!