Morneau’s Tax Proposals causing Harm
The July tax proposals that target small businesses have been the topic of much discussion in the media. These proposed rules are supposedly intended to close so-called “loopholes” used by wealthy individuals. However, if these rules are enacted in the form proposed, the collateral damage will extend to vulnerable members of our society, being the elderly and disabled – in particular, those who are beneficiaries of discretionary family trusts. Many immigrants who own small businesses will also be affected. Despite Minister Morneau’s recent assertion that the proposals will not affect “small” businesses, the fact is we have several clients with business income in the $100,000 to $200,000 per year range that will absolutely be affected if these proposed rules are passed into law.
Trusts can be used for income splitting (or “income sprinkling”) among lower-income family members and maximizing capital gains exemptions on the sale of a business. For example, dividends paid to a family trust can be allocated to family members who are beneficiaries of the trust, taking advantage of their lower marginal tax rates or capital gains deductions. These strategies have traditionally been well-accepted forms of tax planning, and are precisely the things that the Department of Finance is targeting with the proposed tax rules. It is certainly true that these tax strategies are often used to benefit the wealthy. But in our experience, they also benefit middle-class small business owners, family members who have special needs, and aging parents. Our firm has implemented trusts for owners of small businesses to benefit these types of individuals specifically.
The general idea behind income splitting through a trust is straightforward, it is to shift income, often in the form of dividends paid by private companies, to lower-income family members. In the case of a first-generation business owner, there is often an opportunity to provide for aging parents who were perhaps less successful than the younger entrepreneur, by having the trust allocate income to them. Similarly, income can be allocated to special needs children or other family members. Finance Minister Morneau seems to be offended by income sprinkling in general, and the proposed tax rules would generally tax this type of “split income” at the highest marginal tax rate. The exception to this punitively high tax rate would be where the person who receives the income has made a reasonable contribution to the business (which is itself a legal test that is fraught with uncertainty and difficult to apply).
Are elderly parents and disabled or special needs children expected to work in the business in order to avoid being subject to the punitive top tax rate? Under the current draft of the proposed rules, the blunt answer to that question is “yes”. In fact, if the special needs child happens to be between the ages of 18 to 24, an even stricter test must be met. The special needs child would need be engaged on a “regular, continuous, and substantial basis” in the business activities.
In the writer’s experience, it is not unusual for new immigrants to Canada to own small businesses such as restaurants, drycleaners, convenience stores, or services businesses. This is often because English is their second language, and as such, it is more difficult for them to find jobs as employees than to be self-employed. These types of immigrants are tremendously valuable to the Canadian economy. They are often great savers, and use their savings to finance their children’s education, who go on to become successful professionals or business owners themselves. By denying the tax planning that was traditionally available in the form of income splitting and potentially accumulating savings in a holding company, Minister Morneau’s tax proposals take money out of the pockets of these hard-working immigrants by denying the tax savings that has historically been available to them. The risk-taking, job creation, and business activities of these entrepreneurial immigrants should be encouraged and rewarded instead of punished.
The tax proposals concerning small businesses have been presented under the guise of tax “fairness”. Obviously, fairness is a subjective term. While the proposals may reach their intended target of the top “one per centers”, they will also needlessly harm the elderly, disabled, and productive immigrants who are business owners – at least if the proposals are enacted in the form presently drafted. That being the case, the tax proposals are, at best, not very well thought through. At worst, they are unfair, blunt instruments.
The examples discussed in this article are just a few of the harmful consequences of the proposed changes to the Income Tax Act. Without a doubt, there will be further collateral damage resulting from these amendments. It is hoped that the Canadian Government will reconsider both the underlying principles and the specific details of these tax proposals.
Invitation for Discussion:
If you would like to discuss this article in greater detail, or any other tax or business law matter, please do not hesitate to contact Robert Worthington or one of the lawyers in the Tax Law group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.