Liberal plan to close tax loopholes has raised questions: Here's a look at 3 of them

Ever since Finance Minister Bill Morneau announced he was going to close tax loopholes used by private corporations, there has been a growing backlash from small businesses and professionals.

Morneau pitched the change as necessary to ensure the wealthy were not paying less tax than the middle class.

But fast forward a couple of months and the grumbling has become a raging roar.

The Coalition for Small Business Tax Fairness, a group of 35 organizations from across the country, joined forces to present a unified voice against the proposed move.

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The coalition effectively led by the Canadian Chamber of Commerce includes associations representing farmers, builders, retail stores, accountants, lawyers, doctors and others.

Morneau has asked for Canadians to weigh in on his proposed tax changes, with a deadline of Oct. 2. 

In the meantime, those proposed changes have sparked a number of questions.

Will it still be OK to pay family members through a business?

One of the practices the Liberals want to stop is business owners dividing up their income by paying family through a dividend, money that they would otherwise pay themselves at a higher rate of tax.

If a business owner were to pay a spouse or child a straight salary, that salary has to face a reasonableness test to ensure that the pay they receive is earned.

"If a three-year-old child doesn't work in your business you can't really pay them a $10,000 salary, but there is no such provision for a dividend for a three-year-old child, because dividends never had a reasonableness clause," explains David Steinberg, an accountant and partner at Ernst & Young Canada.

Under the new rules, Steinberg says, a dividend paid to a child aged 18 or older, or a spouse, would now face the same reasonableness test that has traditionally been applied to family members receiving a salary. Business owners, however, can still pay a dividend to a child under the age of 18, even children as young as three years old, without that dividend being subject to a reasonableness test, but that dividend would be (and is now) taxed at the highest marginal rate.

Steinberg notes the government is likely targeting self-employed professionals who incorporate and essentially operate a business of one, but reduce their taxes by spreading money around their family.

But by casting the net so wide, Steinberg said, the change will affect small family-run businesses or farms where members of a family do perform legitimate roles, forcing the business to justify their earnings against yet to be defined criteria.

Will small businesses be able to avoid taxes by investing profits?

The short answer is no.

At present a small business that makes a profit will pay corporate tax on that profit. The top combined small business tax rate in Canada is 14.4 per cent.  

If the business owner decides to use that after-tax profit to pay themselves a dividend, taking the money out of the business, the proprietor would have to pay personal income tax at the dividend rate on that money.

The federal-provincial income tax rate on dividends is 45 per cent in Ontario, but as high as 47 per cent in Nova Scotia and as low as 36 per cent in the N.W.T.

By making a passive investment, and keeping that money inside the company, no dividend tax is paid.  

The government says allowing a company to make passive investments was intended to help a firm to build up capital so it could expand and hire new workers, but it has been used as a way to avoid paying tax and enrich business owners.

The document put out by Finance Canada outlining the proposed changes suggests one way to deal with this issue is to eliminate "the tax-assisted financial advantages of investing passively through a private corporation."

Critics of the move say that small businesses need that financial break so they can build up a war chest to make investments down the road, float a company through hard times or supplement their pension, since they likely do not have one.

"My concern over this area is you are hamstringing entrepreneurs, which is a bad idea," said Jason Safar, a partner at PricewaterhouseCoopers. "These folks generate a ton of wealth for our country and create a whole bunch of jobs, and you're trying to monitor, or to determine whether or not they are spending their capital appropriately. That doesn't seem like a good idea to me."

Will it make it harder to pass on the family farm?

No, but it will make it harder to pass on other family businesses.

One of the ways the Liberal government says the tax system is unfair is that it currently allows a business owner, through a complicated set of transactions, to convert money in a company from a dividend to a capital gain, which has a lower rate of tax.

One of the unintended consequences of changing that rule, says Steinberg, is that it would treat leaving a family business to a family member as a dividend, and will thus be taxed at the much higher dividend tax rate.

Right now if a business owner wants to pass on a business to the next generation they can do it a few ways.

An owner can sell or give the business to the next generation. If they sell it then they have to pay capital gains tax. If they give it, their child has to pay capital gains tax. Either way there is a 27 per cent tax bill coming the family's way.

If the business owner instead decides to leave their company to a child in their will, the transaction is treated as though it were a sale. The child will still have to pay capital gains on the increased value of the business they now own. But the proposed rules would change that.

"Now the tax on death is not going to be 27 per cent, it's going to be 40 or 45 per cent," says Steinberg. "There's now a real hindrance to passing the business on to the second generation — you might as well sell it."

The proposed changes do not mention eliminating the qualified farm property transfer. The transfer allows a farmer to pass on a farm to a family member without incurring any tax penalty so long as the new owner does not sell the farm.

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