Tax fairness requires tackling tax avoidance in small businesses
I find taxation a fascinating topic. Given that you’re actually reading my ramblings on this topic you do too. Either that or you’re just being kind in spending your time reading about a topic that’s consumed the last several months of my political readings. Generally, people don’t like paying taxes because it’s feels like you’re losing your money to the government. This has been the conservative talking point from years and it’s very persuasive, particularly when the public perception of government is of a wasteful bureaucratic behemoth. However, people really like the services that governments provide, especially when they are provided with no upfront cost; health care, education, roads, police and fire departments, military, national parks, etc. Taxes are needed to pay for all these services so why is paying taxes considered such a burden? It should be a celebration, a great patriotic act where you give some of your own money to help build and run the country that we are all supposed to celebrate. I have issues with nationalism and patriotism but that’s not relevant for this discussion.
The actual area of taxation that I wanted to write about relates to the Liberal government’s proposal to change the taxation rules as they apply to small businesses. The finance minister’s reason for proposing amendments lies in the growing number of wealthy Canadians who, by incorporating, have access to “tax planning” avenues that reduce the amount in tax they have to pay. Nobody debates that these avenues exist, the blowback has been from small business owners (including doctors, dentists, farmers, lawyers, architects, etc.) whose defense is one of the following:
- the backbone of the economy, and taxing them risks economic growth
- if their tax bill increases they will stop working, work less, or leave the country, which as a medical professional will hurt patients
- that they worked really hard and deserve this reward
- they took risks in starting their own business and their reward should include these tax reduction strategies, removing these incentives will discourage others from starting businesses
- Small business owners aren’t automatically given health coverage, sick days, vacation, maternity leave, or EI so the least we can do is give them these tax breaks
My issue with these arguments don’t have an ideology behind them. The small business owners using these arguments against the proposed changes typically oppose when these benefits are given to others. Small business owners who like their tax breaks argue that Bombardier shouldn’t get any tax support. Before I get to my critiques of these positions, take note that the vast majority of complainants are professionals whose income is in the top 1% in Canada, meaning above 150K. If all these rich people are so upset about the proposed changes maybe we might be moving towards a more progressive tax system. The top 0.1% are still somewhat elusive but that we have to start somewhere. Anyway, there are three areas targeted by the proposed changes: income sprinkling, converting income to capital gains, and passive investment income.
Income sprinkling is the process by which a small business owner who earns more money than his or her family members can spread (or sprinkle) this income to family members, thereby paying less tax. Without having a business, individuals are not allowed to transfer their income to a partner, child, or relative, that would be income splitting, which is against the rules. Income sprinkling is particularly advantageous for couples where one person earns significantly more than their family members so that instead of income being taxed at the highest marginal rate get taxed at a lower rate. The government is proposing that income paid out to family members will have to pass a reasonable test, demonstrating that the pay is in line with work done for the business. This will be tough to implement but just because something is hard does not mean it shouldn’t be tried. The only time a business would have to demonstrate this reasonable compensation for family members would be during an audit so it’s hardly arduous. This is a sensible change to the law allowing discretion on the part of the CRA while still allowing family members to work in the family business.
The proposals to prevent businesses converting salary income to capital gains is the least controversial change. Income earned through capital gains is taxed at 50% of regular income. Someone owning multiple businesses can convert income into capital gains but selling shares from one company to another company that they own and thereby take advantage of the tax discount given to capital gains. Apparently all that is required for this change is a small tweak to a section of that tax code that was supposed to prevent this activity but has turned out to be ineffective.
The government’s proposals to prevent individuals from using their small business accounts, and the associated tax advantages, for personal gain have caused the biggest uproar. For unincorporated people, the way one saves for retirement is by contributing income into either an RRSP or TFSA, or a pension if you’re lucky enough to have one from an employer. You do not pay any income tax on money that you contribute to your RRSP account, on withdrawal you pay tax on it as if it were income. TFSA contributions come from your post-tax money pot but any growth in that account is tax-free. You have to be either a very aggressive saver or earning a lot of money to max out the contribution limit to both of these savings vehicles. Incorporated individuals have another option, instead of paying themselves the salary that they would like to earn and use the RRSP and TFSA options, they can leave that money in the business allowing it to grow through passive investments. Because the small business tax rate is so much lower than personal income tax rates you can end up with a much larger principal to invest and therefore boost your returns. The proposals are aimed at disincentivizing this savings option.
The complication here is that people are using their business account for personal reasons, but we don’t really want to prevent businesses from savings money because for stability and growth it’s important to have some saving options to store or grow capital. These savings are needed to cover economic downturns, purchase new equipment, hire new employees, expand the office, etc. Note how these are all business costs. The 1971 budget dropped the tax rate of small businesses to encourage business creation. The corporate tax rate in 1971 was 50%, the government introduced a rate of 25% for small businesses. Think about that for a second, the corporate tax rate was 50%, it’s currently 15%, the combined federal and provincial tax rate for income over 400,000 was 80%. I wonder if all those people who look back fondly on those golden years remember how progressive tax rates used to be. Thanks to globalization and a concerted effort from business and the wealthy to stigmatize taxation, the small business tax rate is now 10.5% and both the NDP and Liberals proposed dropping it to 9%.
Some clever accountants and tax strategists saw the 35% difference between the small business tax rate and the top marginal income rate and realized that there are savings to be had. Rather than pay themselves the salary they want to have, you pay yourself a smaller salary keeping whatever money you would have put towards personals savings in the business account (avoiding paying the 40+% marginal tax rate on that money) and invest from the business account to save for retirement. Larger principal results in larger growth, basically you have 40% more money to earn returns from, and over the course of 25 or more years the difference is staggering. Comparing two people earning 500K a year, one with a corporation and one without, the incorporated individual can effectively earn 50K a year more just through having a business account.
You will see some people, doctors mainly, claiming that governments encouraged them to use small business tax planning strategies as a way to increase their income. For doctors this is true because it allowed the doctors to earn more without the provincial government having to pay them more. But these options are available to everyone, so the easiest fix is to remove the passive investment option and pay doctors more to match what they lost from these changes. We can do that considering that we pay them anyway. It’s clear from the 1971 budget document that small business accounts were not to be used for personal savings.
“If a corporation employs the tax savings that result from the low rate for non-business purposes, such as Portfolio investments, a special refundable tax will be imposed to recover the low-rate benefit. “
Bill Morneau has suggested adding a refundable 30% tax on passive investments that are not used for business purposes thereby not affecting a business’s actual savings but individuals using their business account for personal savings. I wanted to tackle the arguments that people put forward against the reforms but this is already long enough, I’ll (try to) refute those in my next post. The spirit behind the proposed changes is promising and the proposals themselves are decent, bringing us closer to tax neutrality, where financial decisions by an individual or business should be made based on their economic merit and not because of any tax advantage.