Are The Proposed Tax Changes Really Fair?

By Theresa Lo, CPA, CGA

September 6, 2017

On July 18, 2017, the Liberal government released a consultation paper “Tax Planning Using Private Corporations”.  In this paper, the government proposes three changes to Canada’s current taxation system: 

1. Eliminating income sprinkling
2. Discouraging holding passive investments inside a private corporation by disallowing the use of Refundable Dividend Tax On Hand (RDTOH) and Capital Dividend Account (CDA)
3. Converting capital gains into taxable dividends using section 84.1 of Income Tax Act

Income Sprinkling

From the example in the consultation paper, Jonah and Jonah’s family purchased Jonah’s corporation shares and then using the shares to pay out bonuses to Jonah and dividends to Jonah’s family to reduce the tax payments for the whole family.  This is what the government called, Income Sprinkling technique.  There’s one thing I’d like to point out.  All these years, people purchase shares and invest into different corporations to earn investment incomes such as dividends and capital gains.  Some people have very good luck and put very little money into buying start up corporations’ shares that, after few years of time, receiving dividends due to the profitability of the start up corporations.  From the government’s example, I don’t see that the government has problems for these investors receiving dividends from these corporations.  Just because, the investors are family members of these corporations, all the investment gains from the corporations become so unreasonable.

Besides, for a business to grow, the business owner needs to spend tremendous of time building the business.  In doing so, his spouse must step in and support the business owner by building and maintaining the family.  How should the spouse be compensated?  Maybe you would say that an employee’s family also has sacrifices because of his job.  But these employees would get compensated with overtime pays.  Would the business owner be compensated with overtime pays?  Honestly, I never heard of it.  In addition, as we all know, there used to be income splitting between family members, but it was eliminated by current government starting 2016 tax year.

Holding passive investments inside a private corporation

On one hand, the government provides small business deduction to small businesses with active business incomes less than $500,000 per year.  On the other hand, the consultation paper wants to discourage the small businesses to save their corporate money for future uses by taking away RDTOH and CDA.  The reason provided in the paper indicates that these small businesses have tax advantages using the small business deduction from its active business income to earn passive income. 

So, per Table 7 and Table 8 of the consultation paper, they show that, due to less corporate tax rate for small businesses, business owners can put more money into investments in corporations and earn more money.  As a result, the government takes away CDA and RDTOH so the business owners would get the same after-tax investment money as the one with individual taxpayers.  However, comparing with individual taxpayers’ tax rates, the business owners have to pay 10% more under Table 7 while with Table 8, the business owners have to pay 4% more taxes.  When the business owners are doing both types of investments, the business owners have to pay 7% more taxes.

Converting Income into Capital Gain

At the beginning of section D of the consultation paper, the government indicates that “Individual shareholders with higher incomes can obtain a significant tax benefit if they successfully convert corporate surplus that should be taxable as dividends, or salary, into lower-taxed capital gains.”  The paper then goes on explaining Section 84.1 of Income Tax Act and the additional measure in changing Section 84.1 so the section would apply to non-arm’s length transactions by converting capital gains transactions into taxable dividends.

Let’s put it this way.  On one hand, an arm’s length person wants to do some investments.  When an arm’s length person buys corporate shares, no matter how big or small, people call it “legitimate investment transactions”.  When this person sells the shares for cash, these shares are categorized as “capital gains” by the government and the person pays lower taxes.  On the other hand, a business owner wants to retire. His adult son wants to invest into his father’s business and continues his father’s legacy.  When an adult son buys his father’s corporation’s shares, no matter how big or small, people call it “tax cheating”.  When the father sells the shares for cash, these shares categorize as “dividends” by the government and the business owners pays higher taxes.  In the end, as Appendix A shows, when the business owner wants to sell his shares to his family member for retirement, he is heavily taxed by the government by paying additional 27% more than individuals who put their money into regular investments.

Conclusion

Is it really fair?  To be fair, all individuals, no matter they are business people, employees or investors, should have the same tax rates.  To be fair, all individuals should share the same risks and benefits.  In other word, when an employee works 12 hours per day, the employee gets to have overtime to compensate his working hours.  Same should be for the business owner as well.  When a business owner works 12 hours per day, the government should pay the business owner overtime to compensate his working hours as well.  In the worker’s paycheque, the worker pays only 1 out of 2.4 for EI and 1 out of 2 for CPP, the rest has to be paid by the corporation owned by business owners.  When the worker losses his job or when the worker is on maternity leave, he gets to have EI.  The same should go to business owner as well.  In the owner’s paycheque from his own corporation, he should pay for EI as well for his future protection.  And the EI and CPP should contains the same portion as employee’s:  1 out of 2.4 for EI and 1 out of 2 for CPP, the rest should be paid by the government since the owner owns the corporation.  When the owner losses his corporation or when the owner is on maternity leave, he should get to receive EI as well.

Are these happening?  No!  So, what is fair?  Look at the tax dollars the government will be collecting from these business owners just by using the government’s numbers.  I can definitely conclude that this so call “fairness of the tax system” is just a disguise the government wants more money and they are targeting the small businesses this time. 

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