What the federal tax increases mean for your small business

Posted by: Kaitlyn Mason on September 15, 2017

Recently the Government of Canada announced some of the most sweeping changes to business tax laws seen in 50 years – a set of three major tax changes and increases for small business:

  1. Limiting income-splitting.
  2. Higher tax rate on passive investments.
  3. Limiting the conversion of regular income into capital gains.

Your Chamber has been actively fighting for your business: working to extend the consultation around these changes, making sure the government understands the negative impact they will have on many legitimate small businesses, and strongly encouraging them to rethink the taxes altogether. 

As a member of the Chamber, this advocacy work is one of the most important ways that we are delivering value for you, by fighting for you even while you are busy running your business. And we want to engage with you.

Here are three ways to get engaged: 

Background

The government is framing these practices as tax evasions, or “loopholes.” They suggest some - specifically the “very wealthy or the highest income earners” – are using private corporations to avoid “paying their fair share” of taxes, or to gain a tax advantage.  

While the government has suggested that these changes are targeted to close tax loopholes aimed at the wealthy one-percenters, the truth is that the proposals will affect many business owners that are firmly rooted in the middle class.

Data collected from Statistics Canada, and other official government sources, shows that two thirds of small business owners earn less than $73,000 per year and half of those earn less than $33,000. We have heard from tax experts that many higher income individuals do not use these relatively simple tax planning strategies.

Don’t be fooled by the rhetoric, the wealthy will not be the only ones paying for these tax changes. 

Given that these broad-reaching proposals may be the largest tax reform in decades, a 75-day consultation period – released with proposed legislation – in the dead of summer, is far too hasty. We believe that further discussion between government and business is needed to guard against unintended consequences to the Canadian economy. As such, the Calgary Chamber recommends that the federal government extend the consultation period.

The proposed changes

1. Limiting income-splitting

Current rules

High-income earners who pay higher personal income tax rates are able to split income with spouses, adult children, and other adult relatives who pay a lower personal income tax rate. 

Proposed change

The government will broaden the existing income-splitting rules, which generally only apply to certain passive income earned by individuals under the age of 18, to now apply to spouses, adult children, and other adult relatives.  

The Government will impose a “Reasonableness Test” on income of individuals 18 years or older to assess their labour and/or capital contributions by looking at both current and previous returns or remuneration.

To the extent that the income received by a family member is deemed as “unreasonable,” it will be subject to the highest personal marginal tax rate. 

Impact on your business

The change may be felt heavily by family businesses that may not be trying to shift income from high-income earners to those in lower tax brackets, but rather rely on income splitting to garner tax savings for reinvestment.

These proposals will also limit the ability to compensate spouses who share in the business risk and who may incur large opportunity costs in order to support the business.  

The concept of “reasonable” contributions is vague and may increase uncertainty for businesses. Proposed changes may also increase administrative burdens for business owners.

2. Higher tax rate on passive investments

Current rules

Corporate income taxes are generally lower than personal income taxes. As such, individuals have an incentive to earn income in a corporation and retain the after-tax earnings in the corporation to earn passive income. When the income is taken out of the corporation it is then taxed at the corresponding personal income tax rate.

The Canadian income tax system contains many provisions that are designed to ensure that an individual receives the same treatment when earning passive income through a corporation or when earning it directly (this concept is generally referred to as "integration"). 

Proposed change

Finance Canada is looking to deter the financial incentive to invest passively through a private corporation. Under the methods proposed by Finance Canada, there will be no refundable taxes on passive income to corporations, and the effective tax rate on passive income may significantly increase.

Impact on your business

Businesses will face a higher tax burden, reducing funds available from passive investment portfolios maintained within a corporation. Estimates suggest that under the new rules, passive income could now be taxes at a rate of over 70%.

By discouraging passive investments, the proposed changes will have serious implications on retirement planning of small businesses, who rely on these investments for their retirement funds.

These changes will also make it harder for businesses to continue a similar scale of operations during periods of slower economic activity. The complexity of the proposed changes will likely increase tax compliance costs for businesses.

3. Limiting the conversion of regular income into capital gains

Current rules

Income that is normally taxes as dividends could under certain circumstances be converted into capital gains which face a lower tax rate. Furthermore, taxpayers could minimize double taxation that could be realized by a successor who has an interest in a corporation.  

Proposed change

Limit transactions that convert income into capital gains.  

Impact on your business

Proposals may affect business valuations from the past, acting as a form of retroactive taxation. The proposed changes could also make it harder for business owners looking to do intergenerational business transfers.

The proposed rules may result in a potential 90% “estate tax” on the distribution of corporate shares to children.

Next steps

Watch this video from our live Webinar on September 20, 2017 with experts from PwC and EY to learn more about the changes: