The Tax Changes Proposed for Small Businesses will have Side Effects
Posted August 25, 2017
Doctors, lawyers, and other professionals, together with organizations like the Canadian Federation of Independent Business, are up in arms about the proposed changes to the rules for income tax on small businesses.
The possibility of establishing professional practices as small businesses, owned by family trusts, emerged more than twenty years ago.
Some of the rules have been tightened in recent years but there are still some major advantages:
- They can divert some of their income by paying dividends to their spouses and adult children, where it will be taxed at a much lower rate.
- Their corporate income tax rate is only 13.5% in Nova Scotia. Having paid that, they can keep those earnings in the company, earning investment income for retirement or as a rainy-day fund.
- Through a series of complex transactions, they can have some of their earnings be taxed as tax-privileged capital gains.
These advantages are under attack from the proposed changes. They apply equally to other businesses, but this article will focus primarily on incorporated professionals.
It is usually wrong when one group of workers receives benefits that are unavailable to others. Members of that group nevertheless feel it is a massive injustice when there are threats to take those benefits away.
Think, for example, of the retirement allowances received, in addition to defined benefit pensions, by Nova Scotia public sector workers. Or the coddled position of farmers benefitting from supply management.
Those who have benefitted from the special favours for small businesses likewise feel that they are under assault.
The doctors have been the most vocal of the professions. The examples cited by their advocates may not earn much sympathy from those not making six-digit incomes:
- Canadian Medical Association president Granger Avery insists that it will be “near impossible… to save for retirement.” This is puzzling, since doctors will have the same room for tax-deductible RRSP investments ($26,010) as other Canadians.
- He argues that they will likely be unable “…to finance maternity or parental leave, to work part time while raising a family (or support a spouse doing so) and to repay debt accrued during their studies.”
He is shocked at the disproportionate impact on female physicians. It must be bewildering to him that people making average incomes are able to have families.
- A financial planner cites the example of “an Ontario doctor who draws a salary from her corporation of $55,300 (allowing her to maximize CPP contributions) and a dividend of $50,000, for a total income of $105,300. The tax paid here is $22,055. Assuming she pays a $40,000 dividend to her 20-year-old son, who is attending university, the dividend is essentially tax-free.” No doubt everyone would like to be able to do that.
The problem with these arguments is that none of the situations described are peculiar to physicians. The possibility of income splitting with spouses for all taxpayers was favoured by many of the Harper Conservatives, but was ultimately shelved because the benefits would accrue disproportionately to the wealthy.
Nevertheless, the current proposals bring into focus two other issues.
First are the top tax rates for high income earners. These are above 50% in every province east of Manitoba, with Nova Scotia at the top with 54%.
This just doesn’t work. None of us loves paying taxes, but there is a disproportionate reaction when the government gets more of your next pay than you do.
People respond by using every possible tax management strategy, or by just working less, or by moving to another jurisdiction. As a result the revenue governments get from implementing those levels are always much smaller than projected.
If the federal government goes ahead with its plans for small business taxation it should cooperate with the provinces to get the top marginal tax rates down to a maximum of 50%. In Nova Scotia that could mean each level of government reducing its maximum by 2%.
Secondly, doctors are unlike other professionals. Lawyers and accountants can decide to raise their rates or take on more clients. Physicians have their pay set by the government as single payer. Surgeons can only do as many operations as allowed for in their carefully rationed operating room time.
The proposed changes could exacerbate the difficulties already being experienced in attracting and retaining doctors, particularly family physicians. Nova Scotia is at the low end of compensation for doctors in Canada, never mind comparisons with the United States. A US dollar is today worth $1.25 Canadian.
Two thirds of the extra tax revenue from the proposed changes for small businesses will go to Ottawa, with the rest going to the provinces. But the full cost of increasing pay for doctors will be provincial.
It will nevertheless need to be done, particularly for family physicians. As well, the government should make it easier for doctors to earn additional money doing work outside of the public system—for example, by establishing a medical tourism business on the side.
Nova Scotian doctors, especially family physicians, are not well-paid for the training and skill they provide. Tax privileges that apply to a much broader group have kept this issue from erupting. The proposed changes to those privileges should bring this important issue into focus.
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