The Tax Changes for Small Businesses Won’t Amount To Much

The fussing over Finance Minister Morneau’s personal financial disclosures has distracted attention from the rather more important issue of the changes to proposals for taxing small business.

Morneau followed the rules. But he discovered, as have many before him, that compliance is often not enough. Being a major shareholder in a corporation that stands to benefit from the work that his policy proposals will generate is a bad idea.

That said, Morneau has likely made an economic sacrifice by choosing public service over a career as executive chairman of a major corporation. The editorial hand-wringing about whether Prime Minister Trudeau should make a change was a bit ridiculous. The Liberals do not have a better choice.

The tax proposals floated in July had some technical problems, but the biggest flaw was in the messaging. It suggested the change was to remove provisions which enable many Canadians—especially wealthy ones—to legally but “unfairly” cut down how much tax they pay.

The problem is that the proposals impact lots of Canadians who are not wealthy, and did not have the impression that they were doing anything “unfair.”

Worse, the proposals did not touch many of the methods used by Canadians who are seriously wealthy, such as Messrs. Morneau and Trudeau.

The real unfairness has been between those who earn their income as employees and those who do so as small business owners.

Consider a trio of hypothetical sisters.

Alice is an important researcher for a pharmaceutical company. She makes $200,000 per year (a nice wage but not enough to get her into the 1%), including the cost of her health and dental benefits. There is no pension plan, but she contributes the maximum $26,010 this year to her RRSP.

Bethany is a small business owner—let’s say a pharmacy. She pays herself $144,500 as lead pharmacist and the business makes another $150,000 per year. Her university aged children are given jobs on a timetable that accommodates their studies, and are paid well over the minimum wage.

Bethany’s husband helps with the bookkeeping. He gets paid for that and receives a large share of the profits as a dividend. Bethany contributes $26,010 to her RRSP, and still has a lot left that she retains in the corporation as a further savings for retirement. That provides a tax sheltering benefit very similar to her RRSP.

When Bethany retires there are special provisions that allow her to pass the business on to one or more of her children without triggering the usual taxable capital gain.

Alice finds it surprising and annoying that Bethany makes more income but pays less income tax than she does.

Caroline is a pediatrician making $200,000 per year. She is incorporated as a small business. That required six more years of schooling, and quite a bit larger investment, than Bethany needed to buy her pharmacy from an owner who was retiring.

Caroline makes the same RRSP investment and, like Bethany, sprinkles her income among family members. Her province encouraged her to take this route to make up for years of paltry pay increases. She also pays less tax than Alice.

The changes proposed in July would have reduced each of the three advantages for small businesses: sheltering savings, preferred treatment on disposition, and sprinkling income among family members.

The always effective small business lobby swung into action. The first voices to be deployed were doctors, who felt that the tax advantages were compensation for their low pay. Discreetly in the background were legions of lawyers, accountants, engineers, financial consultants and others who receive the same benefits as doctors without the legitimate grievance about government-controlled pay.

Second up were farmers anxious about being able to pass on their “small” businesses worth millions of dollars to their children without having to pay the usual capital gains tax. Saving the family farm is always popular. Quietly cheering on the farmers were thousands of other owners of pharmacies, plumbing supply businesses, real estate brokerages, bars, Tim Horton’s franchises, and myriad others less likely to generate empathy.

In the face of these pressures, coupled with Morneau’s travails, the government has caved in. It is almost entirely abandoning its proposals to restrict sheltering and giving ground on inter-generational transfers. As a bonus the government will further reduce the small business tax rate to 9%.

Some tax professionals believe that the benefit of paying dividends to family members will still be curtailed. That remains to be seen.

The announcement stated that government will “simplify the proposal to limit the ability of owners of private corporations to lower their personal income taxes by sprinkling their income to family members who do not contribute to the business. The vast majority of private corporations will not be impacted by the proposed income sprinkling measures.”

Caroline has no idea what that means but suspects she is going to be worse off. Bethany can’t believe her good luck. She may end up better off than before the proposals were made. Alice is even more annoyed and is wondering whether she should try to persuade her employer to let her incorporate.

It does not feel like the cause of tax fairness has been advanced.


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