Morneau vs. business: How Ottawa created its tax  Problems

The tax-avoidance quagmire that federal Finance Minister Bill Morneau would like to clean up via suggested small-business tax changes is one Ottawa helped create — over four years ago, when another Trudeau was primenbsp;minister.

Prime Minister Justin Trudeau was just a couple of days old when a broad package of tax reforms enacted by the authorities of his father, Pierre Trudeau, took effect on Jan. 1, 1972. While small companies had received tax breaks before, the 1972 tax reforms instituted the small-business deduction, which made the effective tax rate for small companies substantially lower than that of larger businesses. This is the cornerstone of the tax structure under which small companies still operatenbsp;now.

The intent was to allow little companies hold onto more of the profits so that they could fund their growth. However, the changes put in place the basis for what is now a complicated mess of tax breaks and incentives for small business, creating fertile ground for taxation specialists to exploit — sometimes in ways that don’t encourage the small-business growth and job creation that authorities had in mind. Toss in the series of national and provincial corporate tax cuts through time, which have opened a broad chasm between small-business and personal tax rates, and incorporation has become an increasingly attractive alternative — especially for high earners trying to shield income from the taxnbsp;guy.

“The rhetoric about ‘loopholes’ and the wealthy taking advantage — this stuff has been around for quite a long time, and authorities have led,” said tax-policy specialist Jack Mintz, the president’s fellow of the School of Public Policy at the University ofnbsp;Calgary.

Now, Ottawa is trying to place this tax-sheltering genie back in the bottle with its controversial proposals, which rest on three boards. The first would limit a company owner’s ability to “scatter income” among family members who don’t work for the corporation. The second affects a business owner’s ability to convert earnings into capital gains, which are taxed at a lower rate. And the third would limit the corporation’s ability to take cash from the business to produce so-called passive investments in external assets, for example asnbsp;stocks.

The government has faced an outpouring of heated criticism about the suggestions. Physicians, restaurant owners, producers farmers and countless other groups have gathered to talk about them, complain to their MPs and voice their perspectives on socialnbsp;networking.

The proposals are complex and will affect companies differently, but they might have serious consequences for how companies operate and for the carefully assembled financial plans of small business owners and their families. While the changes will have a greater effect on wealthy business owners, they also limit the choices of the not-so-wealthy. For many, the federal tax changes are yet another burden for companies facing increasing costs and new provincial government policies such as a greater minimumnbsp;wage.

Along with the debate surrounding the tax changes is about more than just cash. In its core it is about the area of entrepreneurs in our society. Does their role in generating economic activity and jobs warrant giving them preferential tax breaks, or are business owners no longer deserving than any othernbsp;citizen?

Business owners take issue with the proposal that the present rules are unfair and believe that the government has cast them as uncaring elites that are delighted to dodge taxes and beggar othernbsp;Canadians.

Ken Seto, the CEO of Toronto-based game studio Massive Damage Inc., says entrepreneurs take risks that regular salaried employees don’t — and that it is important to encourage them to maintain doingnbsp;so.

“I feel like it’s kind of a slap in the face to keep legislating things we are put in an even slate with individuals that are employed full-time,” stated Mr. Seto, adding that over the last decade he’s had to steer his company from the edge of collapse more thannbsp;after.

“If the company had actually imploded and went out of business, there is no safety net for me,” he said. “I would have to go out there and try to discover a job. There is no cushy EI — there is none of thatnbsp;stuff.”

About a decade ago, Mr. Seto sold his Mini Cooper for $16,000 to help fund his mobile program company, Endloop. He states entrepreneurs work long hours and risk everything, including their homes, to get their companies off the ground. “Shouldn’t that be rewarded? Should not that be something that you would like people to strivenbsp;for?”

Joe Camillo, who possesses Niko Apparel Systems in Hamilton and co-owns rowing business RegattaSport, echoes thenbsp;opinion.

“I do not have a retirement plan,” Mr. Camillo said. “The future for me versus a salaried employee with a benefits package is extremely different. So why shouldn’t I have any of those benefits, such as not being that taxed in my passive investments or not needing to worry about passing an exorbitant tax burden to my children if they would like to continue thenbsp;company?”

In actuality, that move to limit passive investments is a concern for many small business owners. Under the proposed rules, companies which make investments inside the organization will face a higher tax rate than if the company owners made those investments in their personalnbsp;balances.

Gavin Semple, owner of Brandt Group of Companies, a Regina-based manufacturer of mine and farm machines, says that the move will restrict employers’ ability to collect capital for expansion. Mr. Semple says he’s used the method to save money for inevitable economic downturns and, lately, to help finance the purchase of a plant innbsp;Saskatoon.

Brandt Group isn’t a small business — it’s Saskatchewan’s largest privately held firm, employing 1,800 people in Canada and the USA. However, Mr. Semple says the proposed tax changes — he’s miserable with them all — will be felt at companies large andnbsp;little.

“This is an assault on private companies throughout the country. It doesn’t matter whether you are a dry cleaning outfit with four employees or you are a company like Brandt with 1,800 workers,” he said. “The cumulative effect is barbarous. What it does to our decision is we begin to question our leadership and our strategy. Do we wish to investnbsp;here?”

For many business owners, such as farmer Megz Reynolds, the problems literally hit close tonbsp;home.

A 640-acre part of farmland just outside of Kyle, Sask., has been in her husband’s family for over a century. But under the government’s proposed tax changes, Ms. Reynolds is fearful she and her husband might not be able to afford to purchase it out of her in-laws when theynbsp;retire.

“If we were to purchase that property from my father-in-law, we would really be taxed at a higher bracket than if he was to sell it to a complete stranger,” she explained — efficiently because, under the new rules, it would be taxed as a dividend instead of a capitalnbsp;profit.

Peter Weissman, a partner with the accounting firm Cadesky Tax in Toronto, says that the tax rate if the company is transferred to one’s children would be about 45 percent, versus just 25 percent if were marketed into annbsp;outsider.

Losing the family land could be a significant hit to the couple’s crop farming company, Ms. Reynolds said. The section of land in question, which the couple now rents, constitutes just under half of their farmable land. However, there are emotional implications along with financial ones, ” she says, noting that each and every generation of farmers in her husband’s family has lived on thatnbsp;territory.

“It is a legacy thing,” she clarified. “Our women are fifth-generation farmers. That property could potentially be in the family for another hundred years. It would be extremely emotional to shed land that has been in the family for 107nbsp;years.

“The Trudeau government’s answer is that we do not need to worry unless it is more than a thousand dollars,” Ms. Reynolds said. “But the truth is that a million dollars does not get you much in the means of farmland anynbsp;more.”

Evidently, the government’s attempts to market the proposals to Canadians hasn’t gone well and has spurred at least two Liberal MPs to denounce the procedure. Mr. Trudeau has signalled he’s prepared to listen to criticism and make changes to some of the suggestions, but he isn’t backing down from his position that the rich need to pay their fairnbsp;discuss.

“A lot of these wealthy folks are actually fighting to maintain those benefits that they have — and they are making a great deal of sound,” he said in a CBC interview aired on Sept. 12. “We only want to be certain that individuals using private corporations do not have benefits that are not available to average Canadians, and that is where we are making a littlenbsp;tweak{}”

Lars Osberg, an economics professor at Dalhousie University in Halifax whose specialties include income and wealth distribution, says Mr. Trudeau’s political foes and the business community are devoting “mad exaggerations” in order to “muddy up” the authorities. Dr. Osberg says the changes would help bring equity into a tax system that favours thenbsp;wealthy.

“I think there has been an enormous amount of fear and misinformation pumped in the debates,” he said. “You have got very little fractions of the population that are likely to be affected, but you have got a whole lot that are nownbsp;stressed.”

In actuality, misinformation — or too little information — is in the core of the debate. Despite Ottawa’s zeal to close loopholes in the small-business taxation system which may be tapped to reduce personal tax statements, nobody really knows how big the problem is. There’s absolutely no thorough research revealing how many individuals are integrating as small companies primarily as a tax-avoidancenbsp;plan.

University of Ottawa researcher Michael Wolfson was doing his best to shine a light on what he calls the “dark corner” of Canada’s income tax system. In 2015 and 2016, he co-authored two influential reports on the subject of small-business incorporation and its use by high-income Canadians. (Really, it was Mr. Wolfson’s work that motivated the government to check into tightening the rules surrounding small-business taxnbsp;fractures.)

His study came to a few important conclusions. First, incorporation is heavily skewed toward the nation’s highest earners. And second, among the most lucrative tax benefits of earning income in a corporate structure is income splitting, the ability to spread income among family members — typically through corporate dividend payments — to substantially decrease the family’s overall personal income tax invoice. In actuality, he calculated that income splitting inside the corporate small-business arrangement is costing the federal government about $500-million annually in lost revenue — a quote he characterized asnbsp;”conservative{}”

“Substantial tax advantages are probably flowing into a select group of largely higher-income households, where the goals of supporting worthy goals like entrepreneurship and job creation will probably not be accomplished,” henbsp;reasoned.

We also know that since the turn of the century, using small-business incorporation has jumped. Department of Finance figures demonstrate that the amount of Canadian-controlled private corporations, or CCPCs, (which qualify for the small-business tax rate in their first $500,000 of annual earnings) increased by 50 percent from 2001 to 2014, to about 1.8 million. (The range of self-employed Canadians, including those whose companies have employees, climbed just 20 percent over the same period.)

This expansion has come through an era of generally declining small-business tax rates in Canada, both in the national and provincialnbsp;amounts.

“By far the most important [factor] is that the incentive has gotten larger as the small-business tax rate has declined over the past 10 or 20 years,” Mr. Wolfson said in an interview thisnbsp;week.

The federal tax rate on small-business income has dropped from 13.12 percent a decade ago to 10.5 percent today. When coupled with differing provincial prices, the Finance Department calculates that the average joint federal-provincial tax rate for small business has dropped from about 20 percent in 2000 to only 14.4 per centnbsp;now.

At exactly the exact same time, the joint federal-provincial top marginal personal income tax rate has risen, from about 41 percent to 51.2 percent. That widening gap between the tax hit on private income and small-business income has made integrating a compelling tax plan, particularly for high-incomenbsp;Canadians.

“We kept lowering the small-business tax rate on active business income, since it was quite popular with small businesses, and kept opening up the differential between the corporate rate and the private rates consequently,” Mr. Mintz said. “That helps push more people tonbsp;incorporate.”

Among professionals such as physicians and lawyers, the amount of incorporations has tripled since the turn of the 21st century, as regulatory changes first made it an available alternative fornbsp;them.

Mr. Wolfson points to a change in Ontario’s regulations for physicians in 2005 as a case in point. As part of the state’s fee negotiations with the Ontario Medical Association, the authorities agreed to allow relatives to own stocks in doctors’ corporations. It had been, in effect, a means for the government to deliver more income to physicians without increasing their fees, by allowing income splitting. The result: CCPCs among Ontario doctors jumped tenfold from 2005 to 2011. (At the same time, Mr. Wolfson discovered, CCPCs among restaurant owners were basically flat.)

Taken together, the evidence points to an increased use of small-business incorporation as a tax shield. But there’s a concern that the government hasn’t only overreached with its suggestions but has jumped the gun — penning policy before it’s invested in this extra degree of research. That is, after all, a government that came into office pledging evidence-basednbsp;policy-making.

“I think it’s really a shame that they don’t appear to have the numbers easily at hand,” Mr. Wolfson said. “If public policy is to be performed on an evidence-based fashion, then a significant investment has to be made … on ensuring you have the information so as to comprehend and monitor what’s happening with thesenbsp;apps.”

Dr. Osberg of Dalhousie claims the increased use of tax shelters by professionals is not an economic trend but instead a relabelling of income for taxation purposes. “After a trend like that gets moving, you are sucking an awful lot of tax revenue from the system. … Once you start, it just keeps on going. Everybody says: Well, if he gets it, why not I? The rest of us, who are actually paid on wages, we end up paying for it since the tax revenue must be made upnbsp;someplace.”

However, when Mr. Trudeau says the proposals will close loopholes enjoyed by the “wealthy,” many business owners take it personally. They see themselves as the exact middle course the government is talking about helping. They work hard, employ others, paynbsp;taxation.

“The message has been quite insulting to us. That is why we’re so angry. It is really upsetting,” said Chris Struthers, owner of Struthers Technical Solutions Ltd., an electrical engineering business in Penticton, B.C., that works in Canada and about thenbsp;planet.

“I believe business owners generally, we’re delighted to pay taxes. We’re delighted to pay our share under the present rules,” Mr. Struthers said. “I do a whole lot of work in countries where people do not pay taxes … and they are bad places to work. So we realize that taxes will need to be compensated and we contribute a lot. So to be tagged as men ripping off the remaining citizens with these loopholes … it’snbsp;upsetting.”

Mr. Struthers began his electrical engineering company nearly seven decades back. He states that if he could do it all over again, he probably would not — not if the proposed tax changes were innbsp;set.

“I sat on the fence for a lengthy time,” he said. “I had a draft business plan which I sat on for about a year, and my wife prodded me to go meet with an accountant to have the business plan examined. He said: You have got some terrific ideas and here is some tax incentives you may have the ability to use to reduce your risk. And those made a massive difference in taking the jump. … The largest one was that the incomenbsp;dividing.”

Having the ability to share income with his wife allowed him to decrease the tax bill and spend the money on gear and newnbsp;workers.

“We took minimum income in these years so we can invest in the company and grow. In those years, my wife and I were the lowest-paid folks in the company for the first three decades,” he said. “It wasn’t till the fourth year that I started pulling ahead and appreciating a few of the fruits of our labours. Retroactively speaking, if these principles were in place then, I am sure they would have stunted our growth{}”

Courtesy: The Globe And Mail

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