Tax fairness for the middle class. This has been one of the pillars of the current federal government. Finance Minister Bill Morneau has been quoted as saying “When people pay their taxes, they want to know that their neighbour pays roughly the same taxes. Right now there are some loopholes in our system that means that that is not necessarily always the case.”
When Morneau talks about loopholes in this context, he is speaking about using private corporations. As he has said “You don't want people to be shielding money inside the private corporation at the private corporation tax rate with no long-term intent of actually making investments into the business; it's just a way of shielding their gains from tax.”
What does this mean for business owners?
What these quotes do not mention is differing levels of risk, explains Rachel Gervais, Partner and GTA Tax service line leader. “When comparing a business owner to his neighbour who is an employee, you cannot forget that the business owner creates wealth and drives growth for the Canadian economy but does not have the security that many employees have, nor do they have a pension plan or other retirement benefits. The business owner is taking risks that an employee is not. The primary driver for a business owner to use a corporation is often personal liability protection, not to save taxes.”
That is not to say that there are not tax savings in using corporations, but that simply comparing tax rates between individuals may not be an entirely fair comparison.
In the 2017 federal budget, the government announced that they have been studying the way private corporations are used to save taxes. In the 2017 budget papers, the government identified three main strategies that are currently being used by owners of private corporations to take advantage of preferential tax rates:
A corporation with multiple shareholders and different classes of shares can pay dividends of varying amounts to shareholders, depending on which class they hold. If some of the shares are held by individuals who are not high-income individuals, such as the taxpayer's spouse or adult children, then some income of the company can be paid by way of dividend to the lower-income shareholders. By doing this, some business profits will be taxed at a lower overall tax rate than if all of the income was earned directly by the taxpayer. This is an example of a tax-saving strategy known as “income or dividend sprinkling.”
Canada has a tax system for Canadian private corporations and their shareholders that is built on the concept of “integration.” That is, an owner-manager carrying on a business in a corporation should pay the same amount of tax on that business income as they would pay if such income was earned directly by them in an unincorporated business. When income is earned in a corporation and then paid to an owner-manager as a dividend, there are two levels of tax to consider. There is the initial corporate tax, and a second level of tax that occurs when the dividend is paid to the owner-manager. The initial corporate tax is lower than the tax that would be paid by the owner-manager if the business profits had been paid out in the year to the owner-manager in the form of salary. If the funds are not needed by the owner-manager, then paying just the initial corporate layer of tax and retaining the funds in the corporation can allow for a tax deferral. This strategy defers the payment of the second level of tax, which occurs when dividends are paid from the corporation and are taxed in the hands of the individual shareholder. Where the income earned in the company is in excess of the shareholders' needs and is not re-invested in a business, this indefinite deferral of tax can be a form of real tax savings.
Extracting Funds Tax Effectively
There is currently a tax rate difference between income paid from a private corporation in the form of a dividend and the tax rate that would be paid if the corporation was sold and the individual shareholder paid tax on the resulting capital gain. This rate differential creates an incentive to extract funds from a corporation by creating a capital gain instead of paying a dividend to the shareholder, which is a form of tax savings.
As announced by Minister Morneau at a recent Board of Trade speech in Toronto, we expect the government to release a consultation paper in the coming days or weeks proposing changes to the way private corporations are taxed as a way of dealing with these three tax savings strategies. Following the release of this paper, we will be hosting a webinar with Dave Walsh, Tax Service Line Leader for Canada along with a number of our Partners in order to review and discuss the impact on private corporation owners. Our BDO Canada Tax advisors will remain dedicated to providing you with updates and information as it is released.
Update - July 18, 2017
Finance Minister Bill Morneau released the much anticipated consultation paper on July 18 proposing changes to how private corporations are used to gain tax advantages. The Canadian Department of Finance promised a consultation paper, however, Canadian taxpayers received proposals with effective dates and draft legislation on income splitting and conversion of capital gains. The federal government is asking for further consultation around holding passive investments inside a private corporation.