Finance Minister Bill Morneau delivered on a promise from Budget 2017 by releasing a consultation paper on the taxation of small business corporations. By shifting income through a corporation, individuals can lower their tax bill compared to someone else who just earns regular wage income. The new package of tax measures is aimed at shutting down these tax advantages some high earners have exploited until now. Below I explain the origin and aims of these new tax measures and assess how likely they are to succeed.
First, a disclosure. In 2016 I provided advice to the Department of Finance as part of the Review of Federal Tax Expenditures. The contents of the new tax package are fully the result of decisions made by the Department of Finance, while the opinions expressed here are completely my own. A full disclosure statement is here.
To begin, let’s walk through how small business corporations are taxed right now. Companies are taxed federally at a special preferred rate of 10.5 per cent on their first $500,000 of corporate income through the existing small business deduction. Some of these companies are the kind of “mom-and-pop” operations that might come to mind when you think of a small business. However, the same small business deduction can also be used as a tax saving vehicle through which high-earning Canadians can flow income that otherwise would be taxed at regular rates.
During the 2015 election, Prime Minister Justin Trudeau attracted some heat for pointing out the problems with the existing small business tax regime. I dug into this debate for Maclean’s at that time, arguing that the case for refocusing the small business tax regime was strong. According to tax expert Jack Mintz, 60 percent of the tax benefit is realized by those with incomes over $150,000. Economist Michael Wolfson showed that those in the top 0.01 per cent of income earners are more than 10 times as likely to hold shares in a small business corporation compared to median-earning Canadians.
The new Department of Finance consultation paper adds new evidence, pointing out that the share of income passed through these small business corporation has more than doubled since 2002, for an increase of more than three full points of GDP. At the same time, the rate of self-employment has barely budged so it seems clear that much of this big shift has been tax-motivated rather than reflecting changes in actual economic activity.
Addressing the tax treatment of income passed by high earners through small business corporations should be central to an agenda of tax fairness. But, it also matters for economic efficiency. A key principle of good tax design is neutrality—the tax system should not favour one form of organizing economic activity over another. If the tax system is pushing people to incorporate when they otherwise wouldn’t that is inefficient.
Setting aside the issue of high earners for a moment, there is an economic case to be made for special treatment for active small businesses in order to encourage them to invest and grow. Not all economists find that case persuasive—for example the U.K. followed the advice of its independent tax review to equalize the tax rates for small and large businesses and remove the small business tax advantage. Morneau doesn’t engage this big-picture economic debate on small business taxation with his new tax package, however. Instead, he is attempting to leave untouched the tax advantage for regular mom-and-pop small businesses while chopping back on the tax planning opportunities for high earners. This requires a deft and delicate touch.
There are three main measures in Morneau’s package.
The first measure aims to combat so-called “income sprinkling.” If someone earns consulting income through a corporation, the income can be passed on to children and other family members through dividends or other lightly-taxed payments. This income being “sprinkled” across the family can confer a substantial tax advantage to the incorporated consultant compared to a family with a regular wage earner who would have to pay full tax on any money given to other family members. Since 1999, section 120.4 of the Income Tax Act has already cut back on income sprinkling through the so-called “kiddie tax” rules, which makes it difficult to sprinkle income to children under age 18. The new measures try to extend the “kiddie tax” idea to children and other family members older than age 18 who have not been actively involved in the business.
The second measure relates to passive income earned through a small-business corporation. Right now, if you retain profits from a small business inside the company there are special higher taxes imposed if the profits are invested passively—in bonds or stocks or real estate—rather than active investment in new machinery or equipment for employees. The idea here is to make sure that people face the same tax on passive investments whether inside or outside a corporation. Otherwise, people will just set up a small business corporation to avoid taxes on saving—and that’s not the point of giving advantaged tax rates to small businesses. There was $27 billion of passive income earned through small business corporations in 2015, so this is not a trivial issue.
The Department of Finance consultation paper argues that the current regime of extra taxes on passive investment is not sufficient to counteract the existing tax advantage for saving inside a corporation. The light taxation of small business profits gives the business owner a head start on saving, which confers an advantage not realized by those saving outside a firm. The new proposed measures aim to restore full neutrality and balance between the taxation of savings inside and outside a corporation. This is the right economic principle to pursue—the tax system shouldn’t bias the decision where to put your savings.
The third part of the tax package is more narrow in scope. It aims to clamp down on the use of passing income through multiple corporations to transform regular income into lightly-taxed capital gains.
If these proposed tax measures are successful, small businesses will retain their advantages for active business investment by active mom-and-pop operations, but no longer deliver special advantages to others using the small business tax regime as a tax planning loophole. Are these new tax measures likely to achieve these goals?
The success depends on how deftly the legislation for these new tax measures is crafted. There are highly-technical legal questions that need to be answered, such as who is an active participant in earning small business income, and what is passive business income? Not being a lawyer or accountant, I must leave the technical assessment to those with the training to do so—and I expect Canada’s tax community will provide a robust response to these proposals.
But I can find a reason to be optimistic: both the income sprinkling and passive income measures are constructed as extensions to existing tax measures that have been tested in courts and in practice for years. Whether these extensions were well-crafted remains to be seen, but Morneau’s approach is clearly less risky than inventing new tax definitions never before seen in practice or in law.
A last question: does this package for recalibrating small business taxes go far enough? Some analysts advocate a full-scale revocation of small business tax advantages like in the U.K., while others think the existing broadly-based small business preferential rate should be replaced with measures more targeted to start-ups and growing firms. This is a broader debate we still need to have. Moreover, some of the tax advantages of small-business corporations remain untouched by this package. For example, when small business shares are sold, the first $835,714 is exempt from capital gains taxation. A more ambitious package might have scaled back this big capital gains tax advantage.
The proposed consultation period for the small business tax proposals ends on October 2. Presumably, any action to implement these new measures would happen later in the Fall of 2017 or in the Spring 2018 budget. Canadians who care about tax fairness and improving our small business tax regime should let the Department of Finance know their thoughts.
Kevin Milligan teaches at UBC’s Vancouver School of Economics. His research looks at Canada’s tax and transfer system and how it affects work, saving, inequality, children and the elderly.