The job of the PBO is to support parliament by providing analysis of
macro-economic and fiscal policy so that the quality of debate in
Parliament can be enhanced, and greater transparency and accountability can
be promoted with regard to Canada’s budget process. It’s a good thing,
especially with these provisions, which the government sprang on business
owners in the middle of Canada’s 150th birthday summer and with only a
75-day consultation window.
The federal government believes private corporations reap unfair tax
advantages in investing capital that is already taxed at low rates,
compared with the opportunities afforded to certain employees whose
after-tax dollars are smaller before they invest.
In response, it proposes to tax the passive investment income earned by
small businesses at rates of over 70% (when corporate and personal rates
are combined), and after a cap of $50,000 is applied. (As a concession to a
significant outcry this fall, the government would allow $50,000 to be
earned at current tax rates – a total of just over 50% depending on where
you live – which is certainly high enough, some would say.)
This new investment income cap represents a 5% return on $1 million of
capital; not a huge sum when you consider that any income earned from rent
is included in the definition of passive income. But perhaps even more
important, “second generation” earnings – or the reinvestment of the income
sheltered by the cap – would be subject to the new high tax rates. This
assumption by the PBO seems to be contrary to the Minister’s statements in
October, which left the impression that all income on existing savings in a
private corporation would be grandfathered.
The PBO analysis is worth the read, as it provides more depth on how the
government is thinking about implementing changes in tax treatment of
private corporations. It also lends some much-needed transparency to the
government’s proposals, which were introduced without draft legislation or
impact studies. Notably, three changes are considered:
1. No More RDTOH (Refundable Dividend Tax on Hand):
This refers to the proposal that refundable taxes on property income,
portfolio dividends, and capital gains would no longer be refundable where
the source of funds for these investments benefited from low corporate tax
2. No capital gains for private corporations:
Mr. Morneau’s promises after the March 2017 budget that the income inclusion rate for capital
gains would not be changed, this does not appear to be the case for capital
gains earned by private corporations that are subject to low corporate tax
Specifically, capital gains dividends, which represent the 50% tax-exempt
portion of capital, would have to be extracted from the corporation as
non-eligible dividends under the proposals, instead of being distributed
tax-free. The Minister also gave no reassurances on the exemption for
tax-free proceeds of life insurance policies within the capital dividend
account, so this is a concern as well.
3. Retained earnings as basis of “value”:
Existing passive investment portfolios, as defined by their “nominal dollar
value” per firm, would not be affected by the changes. Rather, the policy
changes would apply only to passive investment income on new investments
exceeding the income threshold of $50,000.
Consider the footnote in the PBO analysis that describes the nominal dollar
value per firm as the firm’s retained earnings. This would be used
as a “proxy,” or value, for the passive investment asset portfolio. As the
new policy is phased in, the PBO report says, the ratio of old vs. new
retained earnings would determine the amount of investment income subject
to the new rules.
But there is another concern here. Retained earnings of a passive
corporation do not account for gains accrued to the date of implementation
of these new rules, says Larry Frostiak, FCPA, FCA, CFP, TEP, Managing
Partner, Frostiak & Leslie Chartered Professional Accountants Inc. in
Winnipeg, who has been on tour with Knowledge Bureau lecturing on these
changes at the November CE Summits. As a result, there is uncertainty
whether the “grandfathered assets” will be valued at “cost” or at “FMV,”
and how they will be tracked on a go-forward basis.
Add to this that “second generation” earnings from this grandfathered
capital would be taxed at the new high tax rates if reinvested. This
together with other proposed changes – the new Tax on Split Income rules,
for example – would force costly and time-consuming complexity on the
Clearly, under the new rules, there would be an incentive to pay out salary
and dividends into personal hands. Shareholders of these small business
corporations otherwise give up progressive tax rates on their dividends and
face the prospect of keeping less than 30% of their passive investments –
before inflation – once dividends on retained earnings are distributed into
However, these actions would also strip the company of its ability to shore
up savings to meet cash flow crunches, or to retain equity to enable
borrowing from financial institutions for future growth plans or to allow
shareholders to save adequately for their retirement as business revenues
ebb and flow.
There is no apparent acknowledgement that retained earnings fluctuate with
major unforeseen obstacles like economic, legislative, and currency
changes, to name only a few. For example, the analysis does not take into
account the behavioral impact of looming minimum wage and CPP hikes, or the
negative outcomes of other factors beyond the control of business owners,
such as the fate of trade agreements.
I have outlined below four potential outcomes of these proposed tax
reforms, now even more glaring after the PBO analysis.
1. Thwarted economic growth and brain drain
We are still led to believe that only a few CCPCs (Canadian Controlled
Private Corporations) will be affected by these changes: 47,000 of the
largest CCCPs, or 2.5% of all private corporations. Yet there is legitimate
concern that the changes will be much more broad based.
But, if the assumptions are accurate and apply only to the minority at the
top, does the government believe these businesses are going to stay in
Canada to grow? Canada would have to provide a compelling reciprocal path
in exchange for a return of only 30 cents on each passive investment
dollar, after tax.
2. A blow to risk management
With capital gains on financial and real estate assets (traditionally
representing after-tax earnings on active business activities) proposed to
be recharacterized as non-eligible dividends, taxpayers must consider
whether they are being adequately compensated for the risk taken in their
passive investments. Should tax-exempt life insurance policy benefits lose
their exempt status, the tax shock on the death of owner-managers may
affect the stability of these private corporations, and that risk cannot be
mitigated if the shareholder is no longer insurable.
3. Significantly reduced retirement savings
The PBO analysis states that 60% of all passive income is earned by CCPCs
with no active business income, suggesting they were set up solely for the
purpose of generating passive income. This would be absolutely true in the
context of an aging demographic. Owner-managers who sell their enterprises
in order to retire would now have to draw non-eligible dividends from these
now passive corporations. There is no income splitting on these dividends,
as an employee would be eligible for a defined benefit plan. With the
enormous tax erosion on reinvested earnings, these retired business owners
face an incredibly unfair result for a lifetime of hard work and
4. 90% of revenue gains go to the federal government
While the PBO has estimated that provincial revenues would also increase as
a result of these policy changes, the majority of the tax gains will be the
federal government’s. Provincial government responses to their own
debt-management woes are yet to be understood by private business owners,
as another variable to the fate of their after-tax dollars.
The government’s ultimate goal is to force owners of private corporations
to distribute corporate income (taxed at low corporate rates) into personal
hands immediately, rather than keep that money invested inside their
corporations. The tax take is estimated by the PBO to be $1 billion in the
first one to two years after implementation, $3 to $4 billion over the
medium term up to 10 years after implementation, and up to $6 billion over
the longer term after that.
The PBO also notes that estimated revenues could be reduced by 10% to 15%
due to the potential of “behavioural responses” by the targeted taxpayers,
compounding over time as each year less income is invested inside CCPCs.
However, it’s quite possible the cost will be much, much higher, as
professionals and business owners look to other jurisdictions to shore up
their futures. That would indeed be Canada’s great loss.
originally appeared in the
Knowledge Bureau Report, © 2017 The Knowledge Bureau, Inc. Reprinted with permission. All
rights reserved. Follow Evelyn Jacks on Twitter
@EvelynJacks. Visit her blog at www.evelynjacks.com.
Evelyn Jacks’ latest book,
Family Tax Essentials, is now available.
Notes and Disclaimer
©2017 by Fund Library. All rights reserved.
The foregoing is for general information purposes only and is the opinion
of the writer. No guarantee of investment performance is made or implied.
It is not intended to provide specific personalized advice including,
without limitation, investment, financial, legal, accounting or tax advice.