October 2, 2017
This submission is made by the CPA firm of MacNeill Edmundson Professional Corporation, which is located in London, Ontario.
Our constituency is small businesses and their owners, and we have practiced in the area for 38 years. You have our permission to disclose any representations contained herein to the public.
Our experience dates back to the Tax Reform of 1972, wherein capital gains formed part of taxable income for all taxpayers, corporate and individual.
At that time, Canadian Controlled Private Corporations (CCPC’s) accessed the lower tax rates through what was called, cumulative deduction account, wherein if a CCPC accumulated $750,000 of retained earnings then the lower corporate tax rate ceased. CCPC’s could “refresh” their Cumulative Deduction Account through the payment of dividends.
Also in the early 1970’s, and as a way of dislodging corporate surplus, there existed an opportunity to pay out tax paid undistributed income (TPUI) to shareholders on a tax-free basis, provided that the CCPC paid a 15 per cent withholding tax on such distributions.
This whole exercise was implemented to put these surpluses to work in the economy.
Finally, the concept of integration, which causes a shareholder to be indifferent to holding assets in a CCPC vis-à-vis personally has been with us since 1972. The primary aspects of this are the dividend gross-up and dividend tax credit from a personal perspective, and the capital dividend account and refundable tax regime from a corporate perspective.
All of the above have been tweaked many times over the years to offset anomalies and changes in tax policies.
But, to be sure, the system has been in place continuously since 1972, and taxpayers and shareholders have made conscious business and financial decisions expecting a result, with certainty.
The thrust of the latest proposed income tax changes are as follows:
1) Sprinkling of income using private corporations;
2) Holding a passive investment portfolio inside a private corporation;
3) Converting a private corporation’s regular income into capital gains.
We will comment on each of these in the above order.
Income splitting in this context is a by-product of estate planning, which is a very normal thing to turn one’s attention to, at some point in one’s life. It is no different than drawing a new will or updating an existing will. Tax considerations are always contemplated, but other factors (i.e., succession, family needs, family breakdowns, and divorces, etc.) are the main reasons for visiting this area.
Once participating shares are held by the trustee of a family trust, the director of a corporation may, in their unfettered right, declare and pay dividends to the shareholders, and there is never a requirement to “determine whether compensation is reasonable, based on the family member’s contribution of value and financial resources to the private corporation.” This is a long-standing legal principle and common law principle.
It is no different and no less fair than a start-up company that grants shares to founders and others for nominal consideration. At a later date, and depending upon the success of the underlying business, the directors could declare and pay dividends to the shareholders of the corporation, regardless of their contributed valued and financial resources.
To attempt to create a “test” insofar as the entitlement of a distribution to a shareholder would create chaos in tax law as it would be very difficult to set the bar on the matter of “contribution” vis-à-vis “entitlement”. The courts would have to rule in favour of the taxpayer every time, as their only point of reference would be corporate law, common law and its consequential interpretation within the confines of the Income Tax Act.
Case law, developed in the areas of “reasonable expectation of profit”, reasonability of salaries and other expenses, would not be relevant as it relates to the construction of income for tax purposes and it does not touch upon the principle of fettering a director’s decision to act upon such issues as the declaration and payment of dividends.
Holding of Passive Assets Inside a Private Corporation
This particular matter seems to be raised from the perspective of fairness, and suggests that a certain class of persons are not paying their share of taxes.
Recently, this has been played out in the press, and it has been very unfortunate that both Mr. Morneau and Mr. Trudeau, have labelled these same people as “tax cheats”.
Our economy is filled with real tax cheats. The underground economy involved in home renovations and the compliance of persons working in restaurant and bar businesses are serious matters that CRA turns a blind eye to. Many billions of dollars of tax revenue are lost to just these two examples.
Based on our experience, these would be very easy to bring into compliance and the fact that this has not happened, indicates, perhaps a policy decision to avoid this confrontation.
By and large, the corporations that you speak of that have built up investment portfolios from corporate earnings that are taxed at a variety of rates, have complied with tax laws, and they do not hide in the underground economy nor are deceitful in their tax filings. A corporation that has, say a $1 million investment portfolio, paid corporate tax every inch of the way, and most business owners are fully expecting to use the return from this investment portfolio to supplement their retirement income. Unlike the players in the underground economy and those who are deceitful in their tax filings, this class of taxpayer has completely laid out their finances for CRA to audit, yet they are being painted as “tax cheats”.
If you want to compare two persons making $220,000 per year, why can’t one of them be a member of the underground economy, where they pay no income tax and collect no HST on your behalf.
If this is about money, and of course it is, your case should be made against those people who truly cheat our tax system out of many billions of dollars on an annual basis, rather than the persons that are compliant and transparent.
Corporate rates are subject to a number of factors, that give rise to a corporation’s propensity to accumulate earnings on an after-tax basis. History is one factor, in that tax rates applicable to corporations have been all over the place over the last 45 years. Other factors have contributed to this such as capital gains inclusion rates, and expenditures subject to Scientific research and experimented design, donations, political donations, and employment tax credits (i.e., co-op students and apprentices). Further, the quantum of income earned each year will drive the overall rate of tax, as the first $500,000 within an associated group of companies will attract a rate of 15 per cent, in Ontario, and 26.5 per cent thereafter.
This “dead” money, that is being referred to in the press represents a lifetime to most small businesses.
Firstly, many small businesses require cash resources to offset the possibility of a bad year, loss of a significant customer, or general interventions on such matters as NAFTA, changes in fiscal policy that affects either foreign currency rates or interest rates in general. This is not “dead” money.
Everyone retires eventually, and a business can either be sold or it is wound down and its assets are converted to cash. Surely this surplus cannot be viewed as “dead” money as its original source was quite vibrant. A person should not be forced to liquidate their corporation, solely to pay an additional layer of tax, in order to create the illusion of “fairness”.
Besides, this equity is taxed in any event, through the deemed disposition rules upon death, with a further taxation of the same surplus at dividend rates. In other words, there could be three layers of taxation on this surplus.
On the matter of creating another source of retirement income, business owners have been counting on this surplus within their corporation to enhance their retirement. We have witnessed, within our practice, defined benefit pension plans that provide in excess of $275,000 per year in pension income. Under the current terms of the Registered Retirement Savings Plan (RRSP) regime, a person who is contemplating retirement now, cannot even come close to that level of retirement income. Where is the fairness in this?
Why can’t a small business owner aspire to the same level of retirement income that certain executives of corporations and unions have, not to mention retired bureaucrats and members of the armed forces.
The proposed suspension of the RDTOH rules on passive income traps the small business owner with nowhere to go to enhance their retirement income, and their retirement income planning could have started decades before, with a certain amount of faith in the tax regime.
While the proposals are very complicated, it appears that they are attempting to create a balance between a notional return of an individual with a corporation when there are two different amounts of capital being invested. The attempt to create this balance appears to be made from eliminating the dividend refund, eliminating the inclusion of the non-taxable portion of a capital gains from the capital dividend account and the arbitrary classification of public company dividends as eligible dividends.
Besides creating administrative mayhem, this flies in the face of what the entire concept of integration was all about. To wit, that a person would be indifferent in holding an asset personally versus corporately. The concept of integration has been in place since 1972, and there has always been a difference in corporate tax rates versus personal income tax rates. So, this is not new and should not be such an epiphany. The fact that two different entities may have different capital bases to invest from, has always been treated as irrelevant, so long as the actual return is taxed in the same manner.
It is no different than a person at the lowest tax bracket, being able to save more of their income than a person who is at the highest marginal rate. That has never been held to be unfair.
We would be willing to be questioned further on these matters and we would look forward to participating in any hearings.
Yours very truly,
James B. MacNeill