Draconian tax reforms can’t be ‘tweaked’
During the 2015 election campaign, the Liberals promised to eliminate the small-business deduction, which would have meant the same, single corporate income tax rate for businesses large and small. It was a good idea. Eliminating special rates for small business, at the federal and provincial level, would reduce distortions between differentsized businesses and make the tax system much simpler (including adopting just one rather than two dividend tax credit regimes), significantly improving the business- tax structure. Of course, small businesses and their lobby groups would have complained. But what the Liberal government is now proposing — with its changes to rules for Canadian-controlled private corporations (CCPCs) — is far more pervasive and, in some cases, draconian.
Finance Minister Bill Morneau’s plan to change the rules around private corporations will only add new types of distortions to the mix, while introducing new forms of unfairness. The Liberals say they’re standing by the plan, but will consider making a few tweaks. If we are to encourage growth with an internationally competitive regime for young entrepreneurs, these proposals require much more than a few tweaks to minimize their harm. It is not surprising that the Liberal government has poked a large hornet’s nest with these proposals. Tax reform is something Canada needs, but this is a piecemeal and, thus, highly flawed ap- proach.
The prime minister says that the rich will be asked to “pay a little more” to help the middle class, which shows that he has a sense of humour. Really, more than 70 per cent of families receiving dividends from small business CCPCs have household income below $ 200,000 (a majority of families have two- earners, so the practice of business owners incomesplitting with a spouse is relatively minor). These are not Canada’s one-per-centers.
A lot of middle- class taxpayers will be hit by the new rules. And it won’t be just doctors, dentists, accountants, lawyers and other professionals. Those groups account for just 12 per cent of federal small- business tax revenues. There will be manufacturers ( 12 per cent of small- business revenue), high-tech innovators (10 per cent) and construction operators ( 12 per cent), among many others.
Morneau’s new tax proposals are supposedly aimed at evening out the difference between corporate and personal taxes paid on income earned by private corporate income with other self- employed income, making the system “neutral.” In some ways they will, but in other ways they’ll actually make things less neutral. Under the new rules, public corporations and non- Canadian private corporations will be more favourably treated and certain other remaining disparities between business types will remain.
Under the existing system, the government gives preference to losses experienced in self- employed i ncome — which can be deducted against other income — compared to corporate losses that are, in most cases, trapped in the company. In this way, the government helps itself to a healthy share of the corporation’s profits, but not its share of losses, penalizing risky investment more heavily for corporations than for the unincorporated. The proposals do little to improve the maltreatment of corporate risk.
The proposals also introduce a new form of distortion. They plan to claw back the difference between corporate tax rates (15 or 17 per cent, depending on size) and personal tax rates (roughly 50 per cent) if corporate profits are invested in passive investments, rather than active business operations. I can think of no country that has introduced this form of distortion. Maybe one reason is because it can plainly lead to owners making marginally profitable investments simply to defer paying tax. It also effectively turns the smallbusiness tax deduction into an investment and employment tax credit.
If one really wanted to achieve neutrality between unincorporated and incorporated businesses, a different approach would be to treat the private corporation as a partnership ( much like “S corporations” in the U. S.). Then, any income would flow out of the company, to the owners. That way, when governments want to provide incentives for business expansion, they can use tax credits for investment and employment tax credits available to all businesses, whether or not they’re incorporated. This would be a far better an approach than the monster of complexity the government is now promising to create.
If you want a sense of how draconian these new proposals get, consider this: Under the new rules, passive income could now be taxed at an almost- confiscatory tax rate of over 70 per cent, as government claws back the benefits of the low corporate income tax rate on business income. The rules also result in heavier taxation on family succession compared to selling the company to unrelated domestic or foreign investors, resulting in a potential 90 per cent “estate tax” on distributions of corporate shares to children.
All of these huge upheavals to our existing smallbusiness t ax system are meant to happen largely in one fell swoop. It is unusual for Canada to attempt such an abrupt move, with so little by way of a gradual, transitional relief plan. Millions of Canadians have been basing their business decision on a system that has been in place for 45 years. Incredibly, their tax plans will apparently enjoy no amount of grandfathering. Given these excessive tax rates and poor transition rules, I already know of one high- income owner of a private corporation now arranging to leave Canada because of this. I’m sure there will be others.