The July 18th Tax Proposlas - Simplified
Originally Published on LinkedIN - https://www.linkedin.com/pulse/july-18-tax-proposals-simplified-michael-sadovnick-cpa-ca-fea/
You have probably read quite a bit on these proposals, but they are likely mainly rants or articles that are too complex to share with those not as familiar with tax. You may have also seen the rhetoric from the Finance Minister (per the above photo) I was requested to write a document that explains the tax proposals... simply. These are complex and broad proposals but I have put together the below simplified explanation to help those trying to understand the changes.
Tax on Split (Sprinkled) Income
This will tax dividends paid to related family members (ie. everyone with a name other than cousin) from private corporations that are not currently being tax at the top rate of 40%, even if they have no other income. There are exceptions for reasonable dividends but these exceptions are more fit for a theoretical world.
Why does government want this? The proposal assumes that every business with family members as shareholders must be doing this for only tax driven motivations, especially if the person investing is 24 or younger. While there is recognition by the proposals that reasonable rates of return may be allowed, their definition of reasonableness is based on the world of mature public businesses.
Why is this bad? It disincentives people from investing in or staying invested in businesses that are set up by family members. Unfortunately, most startups start with money from family members.
Capital Gains on Selling Investments in Private Family Businesses
The sale of your shares of a business run by a related family member will result in the gain being taxed as a dividend at the top tax rate (40%) opposed to a capital gain (24% or nothing if eligible for the Lifetime Capital Gains Exemption). This will also apply on sales to family members.
Why does government want this? There are two things being attacked here: First is trying to prevent family members investing in family businesses being able to benefit from the lifetime capital gains exemption if they are not active in the business. The second is that in order to get around the tax on split income (see above) companies may allow investments to build up in the company and then sell it to a third party who will then trigger capital gains in the hands of the family shareholders so they want family shareholders to be in the same situation if they sell the business or if they take out dividends under the tax on split income regime.
Why is this bad? Would you sell your $4-million dollar business to a child and pay tax of $1,600,000 compared to selling to a third party and pay tax of $760,800? Can you say business consolidation? (See STEP recently released examples).
Corporate Owned Passive Investments
You have money sitting in your corporation and you want to invest it. Sounds like a good idea as you don’t want to distribute the funds as they may be needed in future. The tax rate on this income generated from these investments may be in the 70% range once taken in to personal hands. If the funds are not distributed there is still going to be a 50% (non refundable) tax on the investment income. (Note that these rules DO NOT apply to public companies and foreign competitors).
Why does government want this? The government is being creative in trying to figure out how to have someone who builds up a significant investment portfolio in their business by benefiting from the low small business tax rate to at the end of the day have the same amount of money as an employee who invests with after tax dollars. (Note: see various articles on why the comparison of an entrepreneur and an employee is an apples to oranges comparison)
Why is this bad? For many businesses it does not always make sense to reinvest in the business at this moment, sometimes businesses just need to save up their money for downturns and if they leave the funds sitting in cash they will lose value due to inflation. Also, idea that tax policy is telling you how to manage the excess cash in your business is dangerous, just look at how governments manage their own cash. (There is also a very complex system being proposed to track where each dollar comes from).
Converting income in to Capital Gains
When someone dies they are considered to have sold everything they own, including their private corporation. This person pays on death capital gain tax of around 24%. However, when they access the cash sitting in the company they will also have to pay up to 40% tax on the funds. This results in double taxation. As a result, for those who have private corporations where it makes sense to redeem the shares of the person who died within 12 months of their death, the tax rate can be reduced to around 40% (this is due to a special election). Under current rules, a special procedure called the ‘pipeline’ allows them to pay as low as 24% tax. However, under the tax proposals the only option for those who have the shares for more than 12 months after death will be the a 24% tax on death and a 40% tax on withdrawal of funds. The resulting tax cost to access a company with $200,000 in cash by the beneficiaries may be $128,000 ($48,000 + $80,000) a tax rate of 64% in this situation compared to $48,000 in the first scenario and $80,000 in the second scenario. (NOTE: An emigrant of Canada falls under similar rules as they are also deemed to sell everything they own when they leave the country).
Why does government want this? The government has been unhappy for years about people converting 40% dividend tax rate to a 24% capital gain tax rate. However for some reason they have not extended the 12 month period, and in fact indicate that if a pipeline is to be done it needs to be done after a year.
Why is this bad? This is known as double taxation, paying two taxes on the same money. This is bad policy and simply unfair. (There is also the possibility that the deemed disposition of the shares could qualify for the tax on split income treatment which would effectively result in dividend rate tax of 40% being applied twice opposed to just the 24% and 40% each once.)
( Note: BC rates are being used)
Michael Sadovnick CPA, CA, FEA is an accountant focused on taxation, family enterprises, professionals and high-net worth clients. He services both Edmonton and Vancouver. Michael also enjoys writing articles for LinkedIn discussing the new tax proposals, although he really should be trying to find more clients to help. If you want to reach him you can email [email protected].