John Nicola is chairman and CEO of Nicola Wealth Management and Elliott Levine is president of Levine Financial Group.
On September 5, the Globe and Mail published an op-ed by Finance Minister Bill Morneau titled “Tax changes are about leveling the playing field.” He wrote that he wants to make the middle class equal to business owners from a taxation point of view. As his government has repeatedly stated, it is concerned about “the ability of high-net-worth individuals to use private corporations to inappropriately reduce or defer tax.”
Why is his analysis incomplete?
- Logically speaking, the majority of owners of the 1.1 million small businesses in Canada must be in the middle class, since there are 17 million tax filers in Canada (only 170,000 can be in the 1%).
- Business owners take significant risks with respect to starting their enterprises. They’re also responsible for contributing 100% of funds toward their retirement and benefits.
- Conversely, civil servants face no such risk. Fairly compensated civil servants receive benefits and pensions that are far greater than can be accumulated by the majority of incorporated business owners and professionals, as we’ll see.
Any reasonable analysis of Minister Morneau’s conception of equality must include a comparison between an incorporated professional and a career civil servant. We have done such a comparison below, contrasting Bob, a dedicated civil servant, to Cheryl, an equally committed doctor. The results are both surprising and telling.
The playing field
First, let’s provide some context. According to Statistics Canada, as of December 2015, there are 1.17 million employer businesses in Canada, of which 1.14 million (97.9%) are considered small businesses (defined as having 100 employees or fewer). These small businesses collectively employ 8.2 million Canadians, or 70.5% of the private workforce.
Minister Morneau states in his op-ed that “over the past 15 years […] the number of private corporations has increased by 50%.” He attributes this increase to a greater number of small business owners, entrepreneurs (plumbers, farmers, electricians, etc.) and professionals (accountants, doctors, dentists, lawyers, etc.) incorporating, and implies that this is unsustainable and unfair.
Yet the federal government’s own “Benefits of federal incorporation” website states: “Business corporations are taxed separately from their shareholders. The corporate tax rate is generally lower than the individual tax rate. In some cases, incorporation offers some fiscal benefits.” Minister Morneau, how can you imply that incorporated Canadians are tax cheats, when the government encourages them to do so?
Morneau’s proposals also take aim at passive investments, even though the Income Tax Act already taxes passive investment income equally to regular income when withdrawn from a company; this is called tax integration.
The Department of Finance’s July 18 proposals compared “ordinary” Canadians to those who have incorporated. We propose a fairer comparison: ordinary Canadians to civil servants.
According to Statistics Canada, there are 3.6 million public sector employees in Canada. The ones who work full time generally enjoy guaranteed salaries, group benefits, paid sick leave and paid vacations. Such civil servants also receive generous defined benefit pension plans at retirement.
Consider a comparison of these further areas:
|Incorporated individuals||Employees||Civil servants|
|Work week||Not fixed; coud be up to 60 to 70 hours per week||40 hours per week, on average||40 hours per week|
|Group benefits||Potentially; if so, paid for through own corporation||Potentially; if so, paid for by employee and employer||Yes; paid by government|
|Paid parental leave||None (unless paid into through EI)||Up to one year||Up to one year|
|Paid sick days||None||Yes||Yes|
|Retirement pension||Potentially; if so, paid for through own contributions (e.g., IPP)||Potentially; if so, paid for by employee and employer||Defined benefit plan, paid for by taxpayers|
Civil servant pensions provide guaranteed, indexed income based on the average of their highest-paid five consecutive working years. Unlike with an RRSP, TFSA or corporate investment portfolio, those with indexed defined benefit plans don’t have to concern themselves with market volatility, portfolio risk, asset allocation or management fees.
Civil servant versus incorporated doctor
Let’s now compare the retirement incomes of Bob, a career civil servant with Cheryl, an incorporated physician.
Bob graduates from university at age 25 and begins working in the civil service with a starting salary of $40,000 plus benefits. During his career, he enjoys a guaranteed salary, 40-hour work week, group benefits, paid sick leave, paid parental leave, paid vacation days and an indexed DB pension plan. Bob is both dedicated and ambitious and decides to get his MBA. His employer (in Bob’s case, the federal government) supports this decision and pays for more than half the tuition. With his newfound credentials, his salary will increase at a faster rate (as it should), leading to a significantly higher long-term pension benefit.
Now let’s explore his pension in more detail.
Bob works his way up to more senior positions and finishes his career as an associate deputy minister at age 60 with a final salary of $200,000. After a 35-year career, Bob’s DB pension will provide him $133,000 per year indexed to inflation. That makes the present value of Bob’s pension $3.3 million.
If Bob had tried to build an RRSP account worth $3.3 million during his 35 years of civil service (assuming he earned a 4% return after inflation and fees), he would have needed to make deposits equivalent to 50% of his salary. That amount is far more than he could deposit under today’s regulations, where the maximum contribution rate for RRSPs is 18% of salary to a limit of $26,010 for 2017.
In 2007, the government announced that pension splitting would be allowed. As a result, when Bob retires he can split his pension with his spouse (or common-law partner). If they have no other income at retirement, they will have a joint tax bill in the range of $26,000 (or 20% of $133,000). This ability to income split (which one could refer to as income sprinkling) is one of the benefits Minister Morneau wishes to now eliminate for incorporated individuals, but not civil servants.
Now let’s compare Bob’s lifetime compensation (working years plus retirement) to that of his friend Cheryl, a physician.
Cheryl graduates at 25 from medical school. After a year of residency, she is able to earn an income as a family physician.
Once she starts her practice, she will work 60 to 70 hours a week and be on call five days a month. Her medical practice will gross $350,000 per year, she will employ two staff who each earn $50,000 ($100,000), rent office space ($25,000), pay expenses ($10,000), provide group benefits ($8,000), and pay malpractice insurance ($5,000). She will take a salary of $144,000 to maximize her RRSP contribution of $26,000 per year. That leaves her with net income in her medical practice of $58,000 before tax, or $49,000 after tax in Ontario. As she plans on having two children, the funds saved in the corporation for the first four years will be used over the next five years as she works part-time to help raise her young family. She returns to full-time work at age 39 and is now able to add her corporate savings to her RRSP funds.
By age 60, Cheryl’s RRSP account will be worth just over $1.5 million, assuming she earns 4% after inflation and fees. Note that there is no guarantee she can consistently generate this kind of return, whereas Bob’s pension returns are fully guaranteed by the government.
The only way for Cheryl to accumulate a pension somewhat close to that of Bob is to save money in a corporate investment account. She cannot save the funds necessary to equal Bob’s pension because she does not make enough money, but she could save $50,000 per year. Her medical corporation will pay a tax rate of 50.17% on this investment income, which is the current tax rate before proposed changes.
If Cheryl earns the same rate of return as in her RRSP, less the tax she pays from age 39 to 60, she will have about $1.4 million in her corporation and $1.5 million in her RRSP. When she withdraws the funds from her corporation during retirement, she will pay a dividend tax. If the new proposals are passed, Cheryl’s tax rate on her passive income earned in her medical corporation will ultimately be 71% (combined corporate and personal tax in Ontario) when she starts to receive them at retirement, compared to Bob’s 20%.
There are a few other factors that must also be considered in this comparison. First, Cheryl funds 100% of her RRSP, disability, critical illness, life insurance and any health benefits she and her family require. Second, Bob has an opportunity for salary increases over his lifetime — at minimum, at the level of inflation, but in his case considerably higher because of his MBA. In contrast, most physicians’ fees decrease in real terms.
Perhaps most important, however, is that this analysis shows that Cheryl’s current savings plan (RRSP and corporate investment plan) will result in a substantially smaller retirement nest egg than Bob. This is in addition to bearing the burden of investment, volatility and business risk.
We have no issue with the total compensation enjoyed by civil servants. Instead, we’re arguing that we should return to the original narrative Minister Morneau used to describe the unfair advantage incorporated professionals and business owners have over other Canadians. The real issue here is that Minister Morneau is only looking at half of the picture; with all due respect, his analysis is incomplete.
We ask that he consider not only the benefits incorporated people accrue during their working years but also how they are able to able to plan for retirement compared to employees and civil servants.
In our opinion, the existing system is not only fair, but plays out far better for the 3.6 million government employees than it does for the 1.1 million small business owners.