Will Bill Morneau's crackdown on tax avoidance work? - Macleans.ca
 

Will Bill Morneau’s crackdown on tax avoidance work?

The measures will likely make it harder for high-earning Canadians to avoid the taxman, but the government could have gone further


 

Finance Minister Bill Morneau delivered on a promise from Budget 2017 by releasing a consultation paper on the taxation of small business corporations. By shifting income through a corporation, individuals can lower their tax bill compared to someone else who just earns regular wage income. The new package of tax measures is aimed at shutting down these tax advantages some high earners have exploited until now. Below I explain the origin and aims of these new tax measures and assess how likely they are to succeed.

First, a disclosure. In 2016 I provided advice to the Department of Finance as part of the Review of Federal Tax Expenditures.  The contents of the new tax package are fully the result of decisions made by the Department of Finance, while the opinions expressed here are completely my own. A full disclosure statement is here.

To begin, let’s walk through how small business corporations are taxed right now. Companies are taxed federally at a special preferred rate of 10.5 per cent on their first $500,000 of corporate income through the existing small business deduction. Some of these companies are the kind of “mom-and-pop” operations that might come to mind when you think of a small business. However, the same small business deduction can also be used as a tax saving vehicle through which high-earning Canadians can flow income that otherwise would be taxed at regular rates.

During the 2015 election, Prime Minister Justin Trudeau attracted some heat for pointing out the problems with the existing small business tax regime.  I dug into this debate for Maclean’s at that time, arguing that the case for refocusing the small business tax regime was strong. According to tax expert Jack Mintz, 60 percent of the tax benefit is realized by those with incomes over $150,000. Economist Michael Wolfson showed that those in the top 0.01 per cent of income earners are more than 10 times as likely to hold shares in a small business corporation compared to median-earning Canadians.

READ MORE: Why small business taxation needs fixing

The new Department of Finance consultation paper adds new evidence, pointing out that the share of income passed through these small business corporation has more than doubled since 2002, for an increase of more than three full points of GDP. At the same time, the rate of self-employment has barely budged so it seems clear that much of this big shift has been tax-motivated rather than reflecting changes in actual economic activity.

Addressing the tax treatment of income passed by high earners through small business corporations should be central to an agenda of tax fairness. But, it also matters for economic efficiency. A key principle of good tax design is neutrality—the tax system should not favour one form of organizing economic activity over another. If the tax system is pushing people to incorporate when they otherwise wouldn’t that is inefficient.

Setting aside the issue of high earners for a moment, there is an economic case to be made for special treatment for active small businesses in order to encourage them to invest and grow. Not all economists find that case persuasive—for example the U.K. followed the advice of its independent tax review to equalize the tax rates for small and large businesses and remove the small business tax advantage. Morneau doesn’t engage this big-picture economic debate on small business taxation with his new tax package, however. Instead, he is attempting to leave untouched the tax advantage for regular mom-and-pop small businesses while chopping back on the tax planning opportunities for high earners. This requires a deft and delicate touch.

READ MORE: The unmasking of Bill Morneau, caped budget crusader

There are three main measures in Morneau’s package.

The first measure aims to combat so-called “income sprinkling.” If someone earns consulting income through a corporation, the income can be passed on to children and other family members through dividends or other lightly-taxed payments. This income being “sprinkled” across the family can confer a substantial tax advantage to the incorporated consultant compared to a family with a regular wage earner who would have to pay full tax on any money given to other family members. Since 1999, section 120.4 of the Income Tax Act has already cut back on income sprinkling through the so-called “kiddie tax” rules, which makes it difficult to sprinkle income to children under age 18. The new measures try to extend the “kiddie tax” idea to children and other family members older than age 18 who have not been actively involved in the business.

The second measure relates to passive income earned through a small-business corporation. Right now, if you retain profits from a small business inside the company there are special higher taxes imposed if the profits are invested passively—in bonds or stocks or real estate—rather than active investment in new machinery or equipment for employees. The idea here is to make sure that people face the same tax on passive investments whether inside or outside a corporation. Otherwise, people will just set up a small business corporation to avoid taxes on saving—and that’s not the point of giving advantaged tax rates to small businesses. There was $27 billion of passive income earned through small business corporations in 2015, so this is not a trivial issue.

The Department of Finance consultation paper argues that the current regime of extra taxes on passive investment is not sufficient to counteract the existing tax advantage for saving inside a corporation. The light taxation of small business profits gives the business owner a head start on saving, which confers an advantage not realized by those saving outside a firm. The new proposed measures aim to restore full neutrality and balance between the taxation of savings inside and outside a corporation. This is the right economic principle to pursue—the tax system shouldn’t bias the decision where to put your savings.

READ MORE: Seven business tax changes in federal budget 2017

The third part of the tax package is more narrow in scope. It aims to clamp down on the use of passing income through multiple corporations to transform regular income into lightly-taxed capital gains.

If these proposed tax measures are successful, small businesses will retain their advantages for active business investment by active mom-and-pop operations, but no longer deliver special advantages to others using the small business tax regime as a tax planning loophole. Are these new tax measures likely to achieve these goals?

The success depends on how deftly the legislation for these new tax measures is crafted. There are highly-technical legal questions that need to be answered, such as who is an active participant in earning small business income, and what is passive business income? Not being a lawyer or accountant, I must leave the technical assessment to those with the training to do so—and I expect Canada’s tax community will provide a robust response to these proposals.

But I can find a reason to be optimistic: both the income sprinkling and passive income measures are constructed as extensions to existing tax measures that have been tested in courts and in practice for years. Whether these extensions were well-crafted remains to be seen, but Morneau’s approach is clearly less risky than inventing new tax definitions never before seen in practice or in law.

A last question: does this package for recalibrating small business taxes go far enough? Some analysts advocate a full-scale revocation of small business tax advantages like in the U.K., while others think the existing broadly-based small business preferential rate should be replaced with measures more targeted to start-ups and growing firms. This is a broader debate we still need to have. Moreover, some of the tax advantages of small-business corporations remain untouched by this package. For example, when small business shares are sold, the first $835,714 is exempt from capital gains taxation. A more ambitious package might have scaled back this big capital gains tax advantage.

The proposed consultation period for the small business tax proposals ends on October 2. Presumably, any action to implement these new measures would happen later in the Fall of 2017 or in the Spring 2018 budget. Canadians who care about tax fairness and improving our small business tax regime should let the Department of Finance know their thoughts.

 

Kevin Milligan teaches at UBC’s Vancouver School of Economics. His research looks at Canada’s tax and transfer system and how it affects work, saving, inequality, children and the elderly. 


 

Will Bill Morneau’s crackdown on tax avoidance work?

  1. Don’t you just love these Ivory Tower leftists and their theories?!
    Hurray for more taxation! Hurray for class warfare! Booo to reigning in crazy government spending, deficits and debt. Oh ya, who wants that?
    Yes, I can very easily see the bias here (professor who advised Trudeau on how to get more tax revenue).
    I also noticed right away that there is absolutely (conveniently) no mention of how the PEOPLE who own/run these businesses are the biggest JOB CREATORS in the nation. But let’s call them “rich” and “1%’ers” and really go after them, the b@st@rds!
    Enjoy your taxation Kevin and Justin. I’m sure the 1 or 2 full time (with benefits) workers I will be FORCED TO LAY OFF b/c of all of these extra taxes will be fine with it, because hey, it’s worth it to get those damn dirty rich people.
    BTW, do you people think employers like me are going to take it on the chin and not pass on the pain?
    Kevin…?

    • “reining in”

  2. In his media brief the finance minister talked about changing tax rules for business professionals who have their business income paid to a small business. He stated that these are “rich” people that are getting unfair tax breaks. This is hogwash! I have been in financial services for 35 years and the rich have low incomes. The rich are the billionaires and multi-millionaires! Wealth is determined by assets not income. If the federal government goes ahead with this change it will hurt the middle class and not the rich at all. The rich are able to avoid having high incomes because their house and assets are all paid off so they don’t have to draw much of an income.

    It is time the federal government started putting fairness into its taxation policy and collected more taxes from the many elite Canadian billionaires who use all our public services for free without paying their fair share of taxes.

    More importantly, maybe the finance minister should spend more time at the PMO working at controlling their out of control spending and they would not be so much in debt that they need to steal from the middle class once more!

    • As always, this will hurt those trying to get rich a lot more than those who already are. And doctors will now demand higher fees from Provincial governments since they were clearly the target of this measure.

  3. Tax crackdown on the little guy. Meanwhile Morneau’s privatization bank is poised to aid the global 0.1’ers asset strip Canada, and extract rentier streams and users fees, all of this leveraged with loans guaranteed by the Canadian taxpayer, and where all the risk is assumed by the Canadian taxpayer.

  4. This is maddening. Do small businesses income sprinkle? Yes 100%. Using the Toronto Star example a person making $220,000 (few that income sprinkle make this amount but yes some do and some make more) has an advantage of $35,000 = 15.9%. This needs to be put into perspective. The average federal government worker makes (including benefits (pensions etc)) 33% more than the equivalent private sector worker. So the net is even with income sprinkling the average person still has half the advantage of a federal worker. (BTW also less than provincial and municipal).

    If we project out a number of years the only wealthy person will be a retired government worker; this is pathetic

  5. We really need to crack down on the Liberal government or we are all going to be broke. Its sad that what the US government wants to change in the NFTA agreement is going to help save Canadians money while the Canadian government is just trying to figure out how to take even more money from us.

  6. Once again we have a typical Librano plan that punishes the middle class under the guise of “taxing the rich” by “making them pay their fair share”. It ignores the fact that 10% of the people pay 75% or more of all taxes. Often, the practices described in the crackdown are the pay-off of years of sacrifice and risk. Having never operated businesses, most of the Libranos fail to grasp that the practices they are trying to eliminate also entail certain risks.
    For example, putting your kids on the payroll doesn’t actually avoid taxes. It’s the legit way of distributing cash to family members. If they’re receiving a salary, they’re paying tax and CPP, etc. If it’s being paid as a dividend, then the recipient has to to be a shareholder. This entails taking on certain risks, like it or not. This can make the individual responsible for debts incurred by the corporation, should profits become scarce, even if no dividends have been paid in quite some time. This may make other things such as getting a loan or a mortgage difficult. Student loans are out of the question.
    This effort is also being done in the vacuous atmosphere where the myth of government infallibility is taken as gospel truth. It makes no sense to attempt to punish taxpayers for using legitimate avenues of tax avoidance, which will undoubtedly create thousands of victims of unintended consequences, and produce far, far less revenue than planned for and subsequently pre-spent, we we let billions of hard-earned tax dollars go out the door in the form of sloth, waste, fraud, and outright corruption. Canadians are right to make efforts to hide income from the ravenous maw of the tax man. It’s the moral and ethical thing to do, when the government makes little or no efforts to economize, and instead merely chooses to increase what its level of confiscation by demonizing those who are already paying more than their fair share.
    As another poster has noted, government employees are already a sheltered class. We are on a trajectory to where the only wealthy people will be those who toiled in government, and those who inherited wealth derived from public service. The rest of us will have been taxed into oblivion by governments that lack the intellectual heft to grasp that there can be no public sector without a very healthy private sector to fund it.

  7. The government gave Canadian physicians the ability to incorporate because US physicians get pensions and retirement plans, while Canadian physicians don’t because they are contractors. Since the government didn’t want to have to negotiate pensions for Canadian physicians they chose to do it this way.
    Currently Canadian physicians aren’t avoiding taxes, as is the common myth, they are deferring them. They pay a corporate tax rate of 15% on earnings but can only use that for investments. They cannot go buy a car or house or vacation, etc., with that money. They invest that and when they retire they take it out and pay personal income taxes on it — ergo it gets taxed twice, but maybe at a lower personal rate since they aren’t living high on the hog when they are retired.
    What the government plans to do is make it so that when Canadian physicians retire they pay the highest marginal tax rate on what they make off the investments and then take out (after it is already taxed at 50%).
    So basically all doctors who are planning to retire in the next few years are screwed as their retirement plans are punished. As well doctors get taxed several times and at a higher rate.
    I’m sure we’ll hear the old refrain, I don’t feel sorry for those rich doctors they make enough. That’s fine. But if you give someone something as part of their salary and then you take it away, you need to provide some sort of justification or they will be angry. Ontario physicians already have taken a near 15% cut in salary from the Province, due to the economic mess that Ontario is in.
    Many of the young graduates Ontario has now are leaving for other provinces. And others are looking at relocating to the US.

  8. Socialist charity worker calls for confiscation of private property. Hopefully this quisling will be sent to camp trump along with the dauphin.

  9. When you have profligate governments, taxing the rich just doesn’t cut it. Eventually they have to come for your money. So don’t cheer so much when a government says that are going to go after those who are richer than you are. You’ll get yours.