On July 18, 2017, the Department of Finance released legislative proposals and a consultation paper to deal with tax planning strategies that they viewed as creating unfair tax advantages for high income individuals. Click here for a summary.
The Department of Finance requested feedback to the proposed changes, and below is Avail CPA's response.
Click here for a printable version of this letter.
October 2, 2017
Department of Finance Canada
90 Elgin Street
Ottawa, ON K1A 0G5
RE: Tax Planning Using Private Corporations
We are writing in response to the Department of Finance release on July 18, 2017 of various documents for consultation on the proposals to changes in the taxation of private corporations. We are an independent firm of Chartered Professional Accountants located in Southern Alberta. Our clients consist of family owned small businesses with many in the agricultural setting. Our conclusion is that many of our clients will be affected by these proposed changes.
We feel, along with many of our clients, that these proposals are overly complex, have many deficiencies in the draft legislation and will have numerous unintended consequences from whom the government intends to target. In addition, small business owners feel that the government is vilifying them as tax cheats and engaging in loopholes when in actuality they were simply following the rules in the Income Tax Act.
Practically, we believe the Income Tax Act is not about “fairness” but policy decisions of the Government. There are incentives and disincentives in the Act to encourage certain behavior for individuals and corporations alike. The existing rules give some benefits to small business corporations to help them in the economy and to compensate them for the risks they take. We believe these proposed policy decisions will have a negative impact on the behaviors of small business owners.
The purpose of our submission is to outline various concerns that our Firm and our clients have with regard to the proposals released by the Department of Finance on July 18, 2017. Our primary concerns are as follows:
- The proposed measures will impact a majority of small business owners and not just the 1% targeted by these proposals.
- The proposed measures will increase the compliance burden for most small business owners as they try to administer these complex and uncertain provisions.
- The proposed measures appear to have retroactive implications to small business owners hurting these small business owners for following the rules.
- The proposed measures can have a double or triple effect on taxes for business owners and makes administering their affairs after death more difficult.
- The proposed measures make the Income Tax Act more unfriendly to transition a small business corporation to a child.
Tax on Split Income Measures
The proposed measures are intended to prevent splitting income to spouses, children and other non-arm’s length persons. We believe the proposals have some fundamental flaws that would need to be addressed:
- The uncertain nature of “reasonable under the circumstances”- Our understanding is that this will not be defined in the Income Tax Act. We feel this creates uncertainty for small businesses and how they can pay their family in their business. ”Reasonable under the circumstances” is very subjective and will be costly to administer and costly for our clients to challenge the opinion of CRA.
- The term “regular, continuous and substantial basis” is subjective and needs to be defined under the Act. This will add another layer of uncertainty for small businesses.
- There is already a provision in the Income Tax Act (74.4) that deals with spousal attribution through a corporation. If the proposed measures come into force, will 74.4 be abolished or will it continue to apply and provide another layer of tax and complexity.
We feel that if you wish to achieve fairness in the Act regarding the ability to split income, then you should administer taxes on the family unit rather than our current system. Filing as a family would simplify the Income Tax Act as many of the income splitting options would be redundant and provide the same tax planning opportunities to all tax payers.
Conversion of Income into Capital Gains
The proposed measures to tighten up the rules in 84.1 and to bring into force 246.1 appear to remove the ability for income to be converted to capital gains. In our opinion, there are a number of concerns we have with these rule changes:
- The proposed changes do not allow for any grandfathering of existing historical cost base that exists in corporations. As an example, a taxpayer dies and realizes a capital gain on their small business shares in 2013. The existing rules allowed for the estate to sell these shares to a non-arm’s length corporation to turn the high adjusted cost base into a tax paid shareholder loan. Due to a dispute in the estate that is resolved in December of 2017, the taxpayer can no longer utilize this planning. When the family takes the money out of the company in the future, there will be double tax that occurs. We believe existing cost base in shares should be grandfathered such that 84.1 and 246.1 will not apply.
- The proposed rules do not address the 164(6) loss carry-back rules. Under the existing rules, the estate will receive a dividend and can carry back a loss within the first year to the final estate to wipe out the deemed capital gain on the final return. This planning prevents double taxation on corporately owned assets. We believe that the proposed provisions do not allow sufficient time to administer the estate without incurring double taxation. Our preference would be to not change the provisions or extend the loss carry-back provisions to be at minimum 3 years from date of death. In addition, there should be an ability to ask the Minister to extend this period via election if there are disputes to the estate.
- These proposed rules and existing 84.1 rules make the transition of a business to a family member more complicated and more expensive. We understand that the rules are meant to prevent surplus stripping in families. We would encourage the Minister to provide some exemptions to the 84.1 rules to allow the legitimate transfer of a business to a family member. We do not believe that our tax system should impose a higher tax burden on a family member compared to an arm’s length person on a legitimate sale.
- The proposed rules will require taxpayers to review the history of ownership of companies before a purchase from an arm’s length party to understand if there has been any historical non-arm’s length ownership. This adds additional cost and complexity to share purchases. We feel this rule should be removed and CRA should place greater reliance on GAAR to address areas of perceived abuse.
- We believe section 246.1 of the proposals contains few limits and could be applied retroactively to legal transactions that occurred in the past and could apply to ordinary business transactions such as sale of assets to a third party or family member as part of legitimate succession planning. This provision provides significant uncertainty as to whether capital dividends can be paid out. We feel that this section should be removed or reworded to limit its scope as intended by the Minister.
The proposed options in the white paper are meant to address the inequity between corporately-held investments and personally held investments. The apparent injustice is that corporations are allowed to utilize cash that has been taxed at the small business tax rate and have more cash available to invest compared to the cash available to an individual. We believe these proposed changes will impact small businesses.
- We believe the current system allows businesses to save for retirement, paternity, future business asset purchases, and/or to provide a cash reserve for the business. We also believe that the current rules appropriately provide an incentive to pay out dividends each year to get back the refundable tax. Our experience is that most of our small businesses tend to pay out dividends to the shareholders to get back this refundable tax.
- Under the current system and in most provinces, a small business corporation earning passive investment income in a company will pay more tax than if you held these investments personally. Therefore the current system already penalizes companies from holding investments in their company. To change this system and effectively tax this investment income at rates exceeding 70% seems very punitive and will drive taxpayers to make poor investment decisions or incentivize them to not report this income properly.
- The proposed tax rate for the investment income assumes all taxpayers are in the highest tax brackets. These proposals treat the smallest business owners savings with the same brush as the wealthiest 1%.
- Many clients struggle with understanding the complexity of the current system for passive investments. Introducing passive investment pools will require tracking and analysis will make their compliance more complex. In the white paper, it notes that these amounts should be easily obtainable by the tax payer but the reality is the implementation of such tracking is not as simple as you may think. While some clients have more sophisticating accounting systems some are still using paper ledgers. Those clients that are fantastic at running the operations of their business but may not be as electronically or financially literate would be at a significant disadvantage here. This will increase the costs for all small businesses to monitor and report these pools.
We believe these rules are not practical and increase the costs of complying with the Income Tax Act. If the options discussed are pushed through, we believe a more acceptable approach might be to limit the amount of passive investments in the company to allow for small businesses to save for a rainy day, paternity or retirement.
We believe the Income Tax Act is getting to be too complex. Over the last couple years, changes to the section 55 rules and the small business rules have created more complexity and uncertainty for our clients. These new proposed provisions will add even more complexity, more uncertainty and higher administration costs to all small businesses. We believe the Income Tax system should be as simple as possible and we would rather see a wholesale change to the Income Tax system rather than these complex band-aid solutions. We believe a tax system that rewards behaviors such as creating jobs and investing capital into your business would be more beneficial to Canadians. These could be implemented in a new taxation system.
We would recommend deferring the implementation of these provisions until a full review of the Income Tax system as a whole can be conducted or at minimum a full review of these proposed measures can be studied. The July 18, 2017 implementation of the 84.1 and 246.1 rules seems fairly harsh and should be delayed until further discussion is held.
We would welcome the opportunity to discuss these proposals, our concerns and our suggestions with anybody at the Department of Finance. If you have any questions on this submission, please do not hesitate to contact us.
AVAIL CPA LLP
Click here for a printable version of this letter.