Small Business Tax Changes Mean More Tax, Not Less
Several of the federal Liberal government’s tax policy changes, first rolled out in the summer of 2017, then amended shortly thereafter after a 75-day listening tour, have recently come into effect in January 2019. The question on everyone’s mind is, are small businesses paying less tax or more since the Liberal government’s tax changes on small businesses?
This article will attempt to answer that question.
Not surprisingly, the Liberal government has claimed that small businesses and private corporations will now save $7,500 per year in taxes starting in January 2019, as a result of the reduction of the small business tax deduction from 10.5 percent to 9 percent, as of January 2019. It is true that a business will save $7,500, when you compare the difference in taxes on $500,000 from 10.5 percent to 9 percent (10.5% – 9% x $500,000 =$7,500).
However, that is not the full story. Let’s look at the Liberal government’s timeline of promises and amendments to get to the truth.
April 2015: Harper’s Conservatives announces a small business rate reduction from 10.5 percent in 2015 to 9 percent in 2019. The drop, first announced during the lead-up to the 2015 election campaign, would first lower the tax rate to 10 percent on January 1, 2018.
October 2015: The Liberals win the election and cancel the rate reductions to the small business tax rate.
February of 2016: Bill Morneau, federal Finance Minister, announces enhanced measures to the CPP, which would see small business owners paying additional CPP premiums starting in 2019 and increasing steadily until July 2025.
July 18, 2017: Bill Morneau and the Department of Finance release the biggest tax reform that the country has ever seen in 40 years, directly targeting private companies. Prime Minister Justin Trudeau and Morneau argue that the reforms are designed to ensure they target only wealthy individuals who have used the corporation to gain what the government maintained was an unfair tax advantage.
The government propose new draft legislation that would impact the following four tax provisions:
- Income sprinkling
- Passive income
- Capital gains tax exemption
- Conversion of income into capital gains (surplus stripping)
September–October 2017: The business community revolts against the government’s proposals, which many deem as aggressive and offensive. The new proposals belie the government’s presumption that private company leaders and entrepreneurs are perceived as “cheats,” who have unfairly profited for over 40 years from a rigged system, when, in fact, they were following well-established rules that were in place for decades.
Morneau’s embarks on a 75-day “listening” tour to get feedback on his proposals.
October 16, 2017: After the 75-day listening tour concludes, the Liberals announce that it will reinstate Stephen Harper’s tax cuts, bringing down the federal corporate tax rate from 10.5 percent to 9 percent in January 2019.
The measure was taken as a means to calm the uproar made by business owners and professionals, including doctors, lawyers, accountants, shop owners, farmers, premiers and even some Liberal backbenchers. They denounced the proposals, contending they would hurt the very middle class the Trudeau government claimed to be trying to help and that the tax proposal hurt all private companies of all sizes, not just the wealthy.
Along with the reduction of the corporate tax rate, the Liberal government tweak the rules related to income sprinkling and passive income, while scrapping the proposals related to the conversion of income into capital gains and the lifetime capital gains tax exemption.
Changes to Income Sprinkling Rules:
While the government moved ahead with its proposal to limit the ability of owners of private corporations to sprinkle their earnings to family members who do not contribute to their companies, they instituted new reasonableness rules to simplify the process. These came into effect in January of 2018.
Effectively, no reasonableness test would be needed to income sprinkle to a family member in the following circumstances:
- When a family member is a spouse over the age of 65
- When a family member is over 18 who has made a “substantial labour contribution” of at least 20 hours per week.
- When a family member is over 25 and owns at least 10 percent of the votes and value of the shares of a corporation that earns less than 90 percent of its income from the “provision of services.” In simple language – owns at least 10 per cent of a business that sells goods, not services.
Changes to Passive Income Rules:
The government amended the threshold of passive income to $50,000, which would allow for $500,000 in business income to be taxed at the lower small business tax rate of 12.5 percent, untouched by the new penalty. However passive income earned within a corporation in excess of the $50,000 threshold would be subject to punitive provisions that reduce the corporation’s Small Business Deduction (SBD) on a straight-line basis.
Since corporations are taxed at a lower rate than individuals, more after-tax dollars are available for investment if earned through and retained in a corporation. The government expressed concern that surplus funds were being used for passive investment rather than investment in a business. As a result, the government limited the amount of passive income a corporation could earn before triggering the higher corporate tax rate of 26.5%. The objective of the new rules was to incentivize owners to dividend out their earnings to its shareholders, thereby triggering massive personal tax on the shareholder level. If the corporation chose to maintain its retained earnings within the corporation and invest earnings on passive income, it would ultimately face a penalty.
Converting Income into Capital Gains
Along with the tweaks in provisions related to income sprinkling and passive income thresholds, the government scrapped those provisions related to converting income into capital gains and the Lifetime Capital Gains Exemption (LCGE).
Among the proposals made in July of 2017 was draft legislation to further extend the reach of the anti-avoidance provision, which results when a company attempts to trigger a capital gains deduction by making a sale to a “non-arm’s length corporation.” The government sought to institute new rules, whereby the profits made by the sale are treated as a dividend rather than a capital gain, resulting in higher taxes having to be paid.
The government scrapped this legislation having recognized that the proposed changes would cause genuine hardship to families, including:
- The potential for double tax upon the death of a shareholder; and
- The potential double tax upon the transfer of a family business from one generation to the next.
Lifetime Capital Gains Exemption (LCGE)
Finally, proposed changes to the LCGE was also scrapped. The proposed change sought to deny multiple family members from making use of their capital gains exemption on the sale of a family-owned business.
November 2017: A coalition of industry associations respond that Morneau’s adjustments are not enough. A letter sent to Morneau’s office from the Coalition for Small Business Tax Fairness, representing 80 associations, read: “While we thank you for making progress … we remain very concerned by the remaining proposals that appear to be moving ahead.”
December 2017: A few days before Christmas, the final version of TOSI (tax on split income) and private company savings tax are released, which would see the end of income sprinkling among family members within private corporations in most instances. See conditions above where income sprinkling can still be enacted.
The Standing Senate Committee on National Finance also publishes a report entitled, “Fair, Simple and Competitive Taxation: The Way Forward for Canada.”
This report includes a brief history of taxation, the proposed changes to the taxation regime made by the Liberal government, and a host of recommendations.
The report concludes with the following:
“The moral authority of constitutional governments rests upon the consent of the governed. The people place a trust in their government, through their representatives, to govern wisely and justly behalf. Governments must never break that trust by undertaking actions that are excessive, unreasonable or unjustified. Taxation is one of the most sacred elements of that trust, because it involves using private monies for public purposes. The tax system must be seen to be fair and equitable, and contribute to economic competitiveness. The use of public money must be appropriate, responsible and economical. This explains why reforming the tax system is delicate task for governments. If not undertaken with due care and consideration of the possible ramifications, tax reform risks rupturing the trust with citizens and disturbing their sense of fairness. Our cross-country hearings made it clear that the Government of Canada risks breaking the trust with Canada’s business owners, farmers, and physicians over its proposed changes to the taxation of private corporations. Once trust is lost, it is hard to regain. The government should take greater care in its approach to tax reform, in order to maintain, if not restore, trust in our tax system.”
January 2018: In spite of the objections regarding the Liberals’ tax changes expressed by the business community and other stakeholders, the 2018 Federal Budget passed all these measures into law. The SBD is brought down to 10 percent.
January 1, 2019: The SBD is brought down to 9 percent, reinstating the Conservative platform of 2015 with respect to this tax, along with congratulatory announcements that small businesses are now saving up to $7,500 a year in taxes.
With all the above in mind, let us address our original question posed at the outset: Are small businesses paying less or more tax in 2019 than before?
If we consider the larger economic context, we see a picture emerging that supports the view that small businesses are paying a great deal more in tax than ever before.
Along with the SBD reduction, 2019 has also ushered in the carbon tax, which will increase almost all goods and services that a small business relies on, including food, heating, gas, inventory, etc.
The enhanced CPP has also kicked in, increasing the tax from 4.95 percent to 5.1 percent. This means that owners of private companies will be paying an extra $85 per employee/per year in CPP premiums. This is slated to continue on an upward swing up until 2025, at which time it is expected that business owners will be paying an extra $645 per employee per year in CPP premiums.
Finally, with the government’s dis-incentivizing passive income growth within corporations, there is the consequent pressure to withdraw retained earnings in fully distributed dividends. These dividends are taxed at a higher rate (combining personal and corporate tax rates), than corporate tax rates alone.
Effectively, this not only wipes out the benefits of the SBD, but businesses will now pay more taxes in fully distributed corporate earnings than before.
In addition, with the new passive income limitations, more corporate active income will be subject to the higher corporate tax rate of 26.5 percent than before the provision (while less income will be subject to the lower SBD rate of 12.5 percent).
The bottom line?
Small business owners will be paying more in taxes overall in 2019 than they did in 2018, not less.
What a shame that small business, the lifeblood of our economy, is being drained from all sides through a tax regime that inhibits business growth, reduces business wealth, and makes it less likely for businesses to reinvest, hire new employees, and increase the tax base overall. Since these changes, we have seen businesses leave Canada and move to the U.S., which has a tax regime far more friendly and conducive to the growth of small business, including mom-and-pop shops and family-owned businesses.
Let’s not forget the Liberal governments changes were made under the following banner we’ve all heard one too many times in question period – “The Liberal Government is working for the middle class and all those working hard to join it.”
The proof in the pudding indicates otherwise.
-Shira Kalfa, BA, JD, Partner and Founder
© Kalfa Law 2019