The business lobby says Liberal reforms are class warfare. Nope.

Nation | by Gregory Beatty

No shots have been fired or tea bales dumped overboard, so it’s not on par with the Boston Tea Party — at least, not yet. But the backlash to federal Liberal tax tweaks has been FIERCE.

The right-wing Canadian Federation of Independent Business, Canadian Taxpayers Federation and various chambers of commerce, along with their political allies —including federal Conservative leader Andrew Scheer and Saskatchewan premier Brad Wall — have declared the proposed reforms to the small business corporate tax regime to be “class warfare”.

Even the usually progressive comedian Rick Mercer weighed in with one of his famous Rick Rants, decrying the tax changes as an attack on farmers and family businesses.

So what’s the fuss about?

Under Canadian law, a small business is defined as a Canadian corporation with fewer than 100 employees and under $500,000 in annual income. Until the late 1990s, provinces didn’t allow regulated professionals such as doctors, lawyers and accountants to incorporate — although they were able to deduct office and staff expenses like regular businesses.

Since that prohibition was lifted, Finance Canada reports, the number of Canadian-controlled private corporations has skyrocketed — jumping by 50 per cent to 1.8 million from 2001 to 2014.

Over the same period, the number of incorporated professionals tripled.

What’s going on?

“One factor [driving that] is governments have slashed corporate tax rates for small business which has made it much more lucrative for people to incorporate and pay the small business rate rather than the personal tax rate,” says Regina Lewvan NDP MP Erin Weir, an economist who supports the Liberal tax proposal.

“Using Saskatchewan as an example, the top personal tax rate is 48 per cent which breaks down as 33 per cent federal and 15 per cent provincial,” he says. “The corporate tax rate for small business is 12.5 per cent — 10.5 per cent federal and two per cent provincial. So by incorporating, a high-income professional can cut their tax rate to one-quarter of what an individual pays.”

To be fair, the tax advantage isn’t as extreme as it sounds. The corporation pays 12.5 per cent, but when the professional takes money out as salary they get dinged at the higher personal rate.

Then again, incorporated professionals have access to other tax tricks.

One such trick that the Liberals are addressing is “income/dividend sprinkling”. That’s where the business owner pays out wages, fees and dividends from the corporation to family members, such as a spouse or child above age 18.

“There’s no doubt that some small businesses are family operations,” says Weir. “If members are participating in the business, then it could be entirely proper to share the proceeds. But if you have a doctor earning a very high income and paying some of it to their spouse simply because they’re in a lower tax bracket, there’s no business justification for that. It’s simply tax avoidance.”

The Liberals propose to apply a “reasonableness” test where the owner would have to show that the family member(s) were legitimately earning the money. The business lobby, unsurprisingly, complains that would increase “red tape” for professionals.

But other taxpayers have to justify their tax breaks. Why shouldn’t small business professionals?

Another area the Liberals are looking at is “passive investing”. That involves money the professional keeps in the corporation, where it’s taxed at a lower rate. They can then invest it in stocks and bonds, and gain an advantage over an unincorporated professional earning the same income.

Imagine two Saskatchewan lawyers earning $500,000. One is incorporated, the other isn’t. In the first instance, if the lawyer paid themself a salary of $300,000, they’d be left with around $175,000 to invest within the corporation. The unincorporated lawyer pays the higher personal rate on all their income, so would only have $130,000 left.

The Liberals want to address that disparity.

They also want to tackle a particularly diabolical tax planning scheme professionals use, where they set up multiple shell companies and then swap shares among them to convert income to capital gains.

“To begin with, capital gains enjoy preferential tax treatment, as only half the gain is included in taxable income,” says Weir. “Then there’s the $750,000 lifetime capital gains exemption that the owner can receive before they have to pay any tax.”

Currently, the Liberals are consulting on the changes, and the business lobby and their allies have been savvy in drumming up opposition, says Weir.

“Politically, they’ve tried to frame this as being about farmers, mom and pop business and tradespeople who might be incorporated as independent contractors. But the concern that motivated these proposals is about very high income professionals who incorporate simply to avoid tax.”

Like other Canadians, professionals can access tax planning tools such as RRSPs and TFSAs. The cost to set up and administer them is minimal, so it’s only those professionals who have extra income available after maxing those tools out who would gain a tax advantage from incorporation.

Bottom line is that the Liberals’ proposed changes will impact very few small businesses. In fact, only around 10 per cent of high income earners will be affected.

So maybe don’t fall for the crocodile tears.

The Income Trust Battle

The brouhaha recalls the income trust battle Finance Minister Jim Flaherty fought in the first Harper Conservative government in 2006 when he acted to close a loophole that mega-billion dollar corporations were exploiting to reduce their tax bills.

The stakes here are smaller, but still significant. According to Finance Canada, the preferential small business tax rate reduces federal corporate tax revenue by $4 billion annually. Provinces lose billions more. There’s also an estimated $250 million hit to personal tax revenue due to income/dividend sprinkling.

“Even after these reforms, Canada will have the lowest small business tax rate in the G7,” says Weir. “The government’s not proposing to take away anyone’s ability to incorporate, or even to remove all the tax advantages of incorporation. The government is really proposing to rein in the most egregious tax planning strategies.”

The proposals will be fine-tuned once the Liberals have completed the consultation process. Will the business lobby and its allies score a “Tea Party” style victory? Or will the principles of tax neutrality and fairness that underscore the Liberal tax measure prevail? Stay tuned. ❧