Your doctor, lawyer and accountant clients may face some unwelcome changes when Budget 2016 drops. And you could feel the pain, too.
The tax community is abuzz with rumours that Prime Minister Justin Trudeau could change Small Business Deduction (SBD) eligibility in a way that would significantly lower how much these clients have to invest every year.
The SBD gives corporations a low tax rate on the first $500,000 of income. In Ontario for 2016, that rate is 15%.
“This is very attractive for doctors and dentists who make a significant amount of money, to the extent they leave profits in their corporations,” says James Kraft, vice-president and head of Business Advisory & Succession at BMO Wealth Management in Toronto. “If they had taken that same profit out and ran it through a personal tax cycle, they would have 47% [left] after 53% tax.”
Kraft notes many of these professionals keep as much as they can within the corporation and do their stock and bond investing there. “The investment earnings will be taxed at a higher rate, but they’re saving 85 cents on the dollar.” That gives them “a much larger pool [to invest].”
Many believe Trudeau may end this practice by mimicking a new approach taken in Quebec. Kraft explains that qualifying for the lower tax rates in la belle province now requires clients to meet one of two criteria:
- they have more than three full-time employees throughout the year; or
- their business is in the primary sector or manufacturing sector. (Primary sector activities involve extraction of raw materials from nature and include “agriculture, forestry, [the] fishing and hunting sector and the mining, quarrying, and oil and gas extraction sector.”)
So, if your client is a farmer with one employee, he gets the lower rate. If she’s a lawyer with four employees, she also gets it. But if he’s a doctor with one employee, no dice.
Kraft notes some estimates suggest the federal government stands to gain $500 million in tax revenue if it adopts the Quebec model nationwide.
The original intent of the SBD, says Kraft, was “to allow businesspeople to pay less tax and reinvest in their businesses.” The goal was to help energize small business, which accounts for an important part of our economy. But some professionals are currently using the deduction in a way that amounts to an investment portfolio subsidy. “When you don’t have many employees and you accumulate vast sums of money, […] should that be government sponsored?”
Also on the corporate front, Kraft wonders if the Liberals will nix or stall the Conservatives’ phased corporate tax rate cuts (from 11% to 9% by 2019).
“It’s easier to deny something that’s going to come in the future than to change something [that’s already in place].”
The tax community is also watching for a possible rule change that would prevent clients from using their Canadian Controlled Private Corporations (CCPCs) as income-splitting tools.
The concern revolves around shareholders who are not active in the company, says Lynne Zulian, partner, Tax Services at Grant Thornton LLP in Barrie, Ont. “If you pay [an inflated] salary to somebody, that’s subject to scrutiny; CRA can come back and say that’s an unreasonable salary. But if somebody’s a shareholder, there isn’t the same reasonability test.”
For example, say your client incorporated his or her business on day one and the spouse got the same number of shares. “But perhaps [the spouse] doesn’t work outside the home. Dividends out of the company can be paid to anybody who’s a shareholder. So rather than the first spouse, who’s active in the business, taking high-rate dividends to keep the family going, they can split it between the two spouses and everybody gets marginal tax rates.”
Zulian says it’s possible the government “may restrict who can be shareholders.”
Active or passive income?
Tax practitioners are hoping Budget 2016 brings some much-needed clarity to the rules surrounding income generated from property, such as rental units, storage units and camp grounds.
With few exceptions, this income is considered passive. It doesn’t, therefore, qualify for the favourable tax rate active business income gets. However, if your client has an income-generating property business that has more than five full-time employees throughout the year, he or she will qualify for the active income tax rate.
Sounds like a simple rule, though in practice it’s been anything but. If Americans can debate “what the meaning of the word ‘is’ is,” then we can go to court over what the word “more” means. Does “more than five full-time” mean “at least six full-time,” or does it mean “more employees than five full-timers”?
The courts have had their hands full.
“My favourite court case,” says Kraft, “was where the guy had five full-time and one part-time. The judge said you’ve got five [full-time] plus something, so that’s more than five. So the taxpayer won that one.”
Zulian notes “the federal court in one case said [the test] means at least six full-time employees; but the Act doesn’t say that. That’s why some cases have been won were they’ve had five full-time and then a couple of part-time.”
Adds Kraft: “All the fights are over grammar.”
Property income businesses that don’t meet the employee test are currently classified as Specified Investment Businesses. The current federal tax rate is 38.67%. “When you look at the combined Ontario rate you would add another 11.5% to that,” explains Zulian. “When you leave the money in the corporation you’re only going to get 50 cents on the dollar. Once [the CCPC] pays it out to the individual shareholder [it’ll] get some of that back because the shareholder is going to pay personal tax.”
She expects the government to clarify the rules. “I can’t see them going the other way on investment businesses,” meaning she doesn’t anticipate Finance will make it easier for Specified Investment Businesses to qualify for the lower tax rates associated with active business income.