Morneau’s folly

So you finally agreed to meet the tax accountant that everyone has been talking about. “He reduced my tax bill by thousands of dollars,” your neighbour says. “And it’s all perfectly legal.”

You live in the province of Quebec, and are married with two children, ages 19 and 22, both attending university. You are self- employed and earn $ 150,000 a year. Your husband works for a larger company, and has an annual salary of $50,000. Last year, you and your husband paid combined federal-provincial taxes of about $ 66,400, including Quebec Pension Plan and health-care levies.

You sit down with the tax adviser. “The amount of tax that you’re paying is ridiculous,” he says. Then he shows you … “The Plan.”

First, you set up a private corporation, “Taxco.” From now on, Taxco — not you — will carry on your business. Taxco will have four classes of shares: A,B,C and D. You will get one class A share, and your husband one class B. Each child gets one share as well, one gets a class C and the other gets a class D. Now here’s the trick. The directors can declare dividends on any single class of shares, to the exclusion of the other three classes. In other words, each share is entitled to discretionary dividends in whatever amounts you choose.

In the first year, Taxco earns the $150,000 you used to earn, and, at a federal- Quebec rate of 18.5 per cent, pays tax of $ 27,750, leaving the corporation with an after-tax amount of $ 122,250. Taxco’s directors — you and your husband — decide to pay you a dividend of $ 72,250, and your two children dividends of $ 25,000 each. Your husband receives nothing. Your children pay almost no tax on the dividends. In total, including the corporate tax paid by Taxco, the family pays tax of $ 51,600, a savings of close to $15,000.

Now, Finance Minister Bill Morneau comes along. On July 18, 2017, the federal government issued a consultation paper dealing with the taxation of private corporations, primarily Canadiancontrolled private corporations ( CCPCs). The govern- ment says it has three areas of concern. One of its concerns is “income sprinkling” — the strategy being used by Taxco. The government’s paper would put an end to these types of shenanigans. Sounds reasonable enough, don’t you think?

Well, not according to those impacted by the paper: small- business owners, professionals such as incorporated doctors and dentists, and, of course, the tax advisers who make a living putting these schemes together. In fact, they are outraged. “The most radical change to the taxation of private corporations in 50 years,” they say. “These proposals will have a devastating impact on small business.” They ask why anyone would ever consider starting a small business in Canada after this.

We should all take a deep breath. Some of the government’s proposals actually make sense, and are long overdue. Others go too far and need to be reconsidered. And some are misguided and should be abandoned.

The “income sprinkling” proposals go well beyond the example described above. The proposals include complex rules that would impose a significant compliance burden on taxpayers, and have an adverse impact on many families that own CCPCs with relatively conventional share structures. The proposals should be rethought and significantly narrowed. For example, the new rules might be redrafted to only apply to family members up to age 24. That’s where most of the money is.

A second proposal to change the rules around corporate portfolio investments is a different matter. The government’s concern is that if a CCPC uses after-tax business income to acquire passive investments, such as mutual funds, rather than investing the funds back into the business, it has a deferral advantage that is not available to an individual taxed at higher rates, in particular salaried earners. The CCPC has a greater amount of starting capital to invest in its investment portfolio and, as a result, can amass more, more quickly than a salary-earner over time. Under Morneau’s proposal, the CCPC would still pay 50-per-cent immediate tax on investment income as at present, but the shareholder would face additional tax when the CCPC pays the after-tax investment income as dividends. An individual taxed at the highest personal tax rate would face a combined corporate- personal rate of about 73 per cent on investment income.

This proposal is neither fair nor workable. It’s also unnecessary and would be extraordinarily complex. A CCPC relies on portfolio investments to weather possible business downturns, to save money for future business expansions, and to accumulate retirement funds for its owner. The government should jettison this proposal.

Morneau’s third proposal has to do with surplus stripping. It deals with the conversion of dividend income into lower- taxed capital gains. The proposal is not particularly controversial, although some modifications are required, including to the rules governing the death of a taxpayer.

The government has handled the tax-reform initiative in a ham-handed way. Its proposals overshot their target. It was not seeking genuine consultation, and its classwarfare rhetoric was excessive and offensive to millions of hard- working business owners and professionals. Both civility and sanity must return to Disneyland on the Rideau. Allan Lanthier is former chairman of the Canadian Tax Foundation, and a retired senior partner of Ernst & Young.

THE GOVERNMENT HAS HANDLED THE TAX-REFORM INITIATIVE IN A HAM-HANDED WAY.