Changes to the small business tax rate have entrepreneurs on guard

Possible changes to the way the federal government taxes small businesses has many entrepreneurs watching developments warily

Tax Week

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Prime Minister Justin Trudeau’s mandate letter to the new Minister of Small Business and Tourism last November contained a somewhat puzzling directive. The ministry was to ensure that the tax code is used to “support small businesses, rather than used to reduce personal income tax obligations for high-income earners.”

It’s a sanitized version of a statement Trudeau made during last year’s election campaign, when he charged that “a large percentage of small businesses are actually just ways for wealthier Canadians to save on their taxes.” With Finance Minister Bill Morneau set to deliver the budget on March 22, small business owners are still in the dark about what exactly the government has in store for them. Experts point to two options it might take—neither of which small business owners are going to like.

The uncertainty around the government’s plans is creating some uneasiness for SMBs. “In every meeting we’ve had, we’ve been asking, ‘What is the policy issue you’re trying to solve?’” says Corinne Pohlmann, senior vice-president of national affairs at the Canadian Federation of Independent Business (CFIB). “There is some confusion around what the government actually means by making that kind of statement.”

What is clear is that the Liberals will follow through on reducing the small business tax rate from 11% to 9% by 2019. Businesses that meet the standards of a Canadian-Controlled Private Corporation (CCPC) pay the lower small business rate on the first $500,000 of active business income, and the general corporate tax rate beyond that. The CCPC structure is also favoured by professionals in medicine, law, accounting and other fields. Profits paid out from the corporation to shareholders as dividends are taxed at a significantly lower rate than personal income and income can be split with family members to further offset taxes.

Michael Wolfson, a professor at the University of Ottawa, has estimated that based on 2011 data, the government loses as much as $500 million in tax revenue because of high-net-worth individuals who use CCPCs to income-split. That’s why tightening income-splitting provisions could be one approach the Liberals take in the budget. For example, corporate dividends payable to minor children are already taxed at the highest marginal rate—essentially removing the incentive to split income. A variation could be applied to dividends paid to spouses and adult children as well. This approach wouldn’t necessarily be straightforward, notes Alaina Spec, a lawyer with Low Murchison Radnoff in Ottawa. The spouses of professionals and SMB owners often work part-time for these businesses, for example, which might entitle them to favourable tax treatment. “It’s not as clear cut as with a minor child, who is not able to contribute in any way to the business,” she says.

Further tweaks could include changes to the country’s associated corporation rules, says Allan Lanthier, a tax consultant and former chair of the Canadian Tax Foundation. Through deft tax planning, it’s possible for a small business owner to form related corporations and essentially circumvent the $500,000 cap on active business income, Lantier says—a tactic known as doubling up. “Associated corporation rules could be tightened to provide fewer tax planning opportunities to double up,” he recommends.

But such changes amount to tinkering around the edges, as far as Lanthier is concerned. A more significant move would be to restrict access to the small business tax deduction based on the number of employees a corporation has. This is exactly what the government of Quebec did in its budget last year. Starting in 2017, only firms with more than three employees will be entitled to the province’s small business tax deduction. (Manufacturers are exempted). Part of the justification is that restricting access serves as a “growth premium.” In other words, it encourages the smallest companies to expand and hire employees—thus making a bigger contribution to the economy—in order to take advantage of the tax break.

That argument doesn’t hold water with the CFIB. “The smallest companies are the ones that have the least amount of extra income to grow,” Pohlman says. “If we’re going to start them at a higher tax rate, that’s sending a signal that we’re not really as supportive of those smaller companies to grow.” CFIB president Dan Kelly wrote in an editorial last year that if the federal government attempts to reduce access, the organization will “take action.” Professional associations are concerned for their members, too. The Canadian Medical Association, argued in its pre-budget submission that the government should maintain access to the small business deduction for physicians, since they enter the workforce later in life and often with significant debt, and unlike small businesses are unable to pass on higher costs to clients.

Lanthier questions the value of maintaining the small business deduction as is, however. “The point of the deduction is to allow businesses more after-tax funds to reinvest and grow employment. But if you don’t have at least four full-time employees, then you’re not much of an employer to start with,” he says. The government’s plan to reduce the small business tax rate to 9% means Ottawa is foregoing $5 billion in annual tax revenue, according to Lanthier, and that other taxpayers will have to bear those costs. He’s argued the small business deduction should be abolished entirely, since there is little evidence showing it “contributes to economic growth or job creation in any significant way.”

Indeed, there is a robust debate about merits of the policy. Tax expert Jack Mintz has argued the deduction discourages growth by offering small businesses an incentive to stay small in order to pay lower taxes. (During last year’s election campaign, Mintz recommended cutting the deduction in half). The CD Howe Institute has argued the deduction carries a cost to the economy by shifting investment from large companies to small ones, which are less productive. The CFIB, for its part, maintains the deduction is justified since small businesses endure comparatively higher tax compliance costs, and can’t engage in the same kind of complicated tax efficient strategies afforded to larger corporations.

Small business owners can breathe a sigh of relief knowing that this larger debate about the merits of small business tax policy is on hold for now. But they might not want to relax too much until budget day.