Ottawa’s tax reforms: Still unfair
In the months of controversy that followed after the federal government issued a number of proposed tax changes for private corporations last July, the finance ministry has now abandoned some of its original plans entirely while substantially revising one proposal (namely, new rules for income splitting). But there is one proposal still unresolved: the taxation of so- called “passive income” earned by Canadian-controlled private corporations ( CCPCs). And it’s still a serious problem: The income that the proposal would hit may be far from passive and, as for fairness, the rate on taxable capital gains will often exceed 100 per cent.
Under existing rules, a CCPC pays immediate tax of about 50 per cent on its investment income, including on one- half of capital gains. Under “tax integration,” a large portion of this tax is refunded when the CCPC pays taxable dividends to its owners. In addition, the CCPC can pay the one- half, non-taxable portion of capital gains to its owners as tax-free dividends. All of this would change under the new proposal tabled last summer.
The government is concerned that a small number of CCPCs are using low-taxed business or professional income to finance the purchase of investments such as stocks, bonds and mutual funds. In response, the government proposes that a CCPC would still pay 50 per cent on its investment income; however, none of this tax would be refundable. In addition, dividends paid out of the nontaxable half of capital gains would now be taxable to the shareholder. The impact on many small-business owners who are approaching retirement could be devastating.
Take the hypothetical example of Zoey. In the early 1970s, Zoey decided to foll ow her dream and purchase a motel. She formed a company ( Zco). Zco borrowed $ 200,000 f rom a bank, and used the proceeds to purchase a small motel: $160,000 for the building and $40,000 for the land. During the 1970s and early 1980s, Zco earned enough after-tax income to repay the bank debt.
After managing the motel operations for 45 years, Zoey is ready to retire. The motel has fallen into disrepair, and will be shuttered and closed at the end of this year. However, the land has increased substantially in value, and can be sold for $ 1 million above its original cost, hopefully enough to fund Zoey’s retirement. Zoey’s accountant has advised her to windup the company in early 2019, and have Zco transfer the land to her as part of the winding-up: Zoey would then sell the land. So what is the tax cost?
Zco has a capital gain of $1 million on the land, one-half of which is taxable. Under ex- isting rules, the combined tax to Zoey and Zco will be about $285,000 if Zoey is in the top rate bracket in Ontario — an effective rate of 57 per cent on the $500,000 taxable portion of the gain. While this tax is substantial, the potential result under the July proposal can only be described as disastrous.
Zco used after- tax earnings to repay its bank loan many years ago. Also, the taxable half of any capital gain is taxed as passive income to a CCPC. As a result, the government’s proposal will apply to the capital gain on the land. Even after a proposed exemption for $50,000 of annual passive income, the combined tax cost to Zoey and Zco would be $569,000: That’s an effective rate of 114 per cent on the taxable capital gain of $ 500,000. After selling the land and using much of the proceeds to settle her tax liabilities, Zoey will be left with an after-tax amount of only $ 431,000. Assuming a return of five per cent, Zoey would receive $22,000 annually to sustain her in her golden years.
This clearly fails the fairness test. Draft legislation on the new tax rules is to be released as part the government’s 2018 budget. What can be done? There are a number of possibilities.
First, the government might conclude — as many in the tax community already have — that the immediate corporate tax of 50 per cent that applies on investment income under existing rules is more than sufficient, and that the proposal should be abandoned. Don’t hold your breath for that.
Second, t he July 2017 f ramework might be retained, but with a number of additional rules and exceptions. For example, existing law could be grandfathered to all assets — not only passive i nvestments — held at this time. This would let Zoey off the hook, but not future small- business owners. In addition, special rules might apply going forward for capital gains on assets used in an active business. However, the proposed framework is already bewilderingly complex, and these types of changes would only make a legislative nightmare even worse.
Third, instead of a new regime for investment income, the government could introduce a refundable tax on post-2017, low- taxed corporate earnings used to acquire non-business assets. The tax would be refunded when the CCPC disposes of the assets, either as a taxable dividend to its shareholders or by investing the proceeds in its business. The tax would be simple and targeted, would avoid the confiscatory rates that apply under the proposed regime, and would eliminate the government’s tax- deferral concern. This is how the government should proceed.
THE COMBINED TAX COST WOULD BE AN EFFECTIVE RATE OF 114% ON ‘PASSIVE’ INCOME.