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The rich are set to go to war over Trudeau’s tax changes

Trudeau is trying to close tax loopholes, but an angry coalition of doctors and farmers are vowing to fight tooth-and-nail against them.

by Justin Ling and Vanmala Subramaniam
Sep 12 2017, 3:05pm

Canada has the lowest small-business tax rates in the G7, without much competition.

You wouldn’t know it, from the fire and fury that has been aimed at Prime Minister Justin Trudeau and his Finance Minister Bill Morneau.

Their government has opened a consultation period on closing loopholes in the tax system that allow high earners to pass their income through a corporation, lowering their tax bill in the process by “sprinkling” their income to their adult children, putting the lower-tax cash in investment funds, or claiming that the income is a ‘capital gain.’

The Canadian Medical Association has threatened that doctors across Canada could stop practising. The Canadian Federation of Independent Businesses has promised the changes will “harm every Canadian small business.” Conservative Party leader Andrew Scheer calls it a “tax grab,” that will hit farmers hard. At a townhall in Kelowna, angry high-earners heckled the prime minister as he tried to explain the changes.

The government, and a phalanx of economists, have contended that the changes are merely about “tax fairness” and that the changes only target specific practises from the top 10 percent of earners in the country.

This fight may not have spilled over to the general public, few of whom have any clue what it means to incorporate yourself nor what these tax changes mean, but it’s nevertheless an important fight.

These tax loopholes could be pillaging tens of millions from the federal coffers, and further extending income inequality in the country.

We took a look at the numbers.

What’s a corporation for?

It’s first of all essential to note that the bulk of these proposed tax changes target small businesses and incorporated individuals.

A small business in Canada pays, on average, just 14.4 percent tax rate on the money it earns, not including other benefits and breaks. That low rate is aimed at encouraging businesses to reinvest in more equipment, staff, or operations.

Finance Canada reports that there were 1.8 million Canadian-controlled private corporations in the country in 2014, a 50 percent increase over 2001. For professional services corporations (doctors, lawyers, accountants, etc) the number has tripled over the same period.

One tax journal reports that these private corporations are incredibly rare for anyone making less than $100,000. For those who earn upwards of $200,000 a year, however, it’s more common — one analysis suggests that a majority of those in the top tax bracket have a stake in some kind of private corporation.

“Not everybody who has [one] are rich, but a large number of people who are rich have one,” says Stephen Gordon, an economics professor at Laval University in Quebec City. “It’s only worth it if you have lots of money to put away.”

Incorporating is a completely valid practise. Most importantly, it helps shield self-employed professionals from financial and legal liability if things go bad. So while many professionals incorporate, doing so isn’t in-and-of-itself a way to skirt taxes.

It’s true that corporations pay just around 15 percent, while high-earners — like doctors, lawyers, accountants — face a top combined marginal tax rate of above 50 percent. But even if you incorporate, you’ll need to draw the income from your corporation to pay yourself. That means, at some point, you’ll be paying your own personal tax rate.

Let’s say a lawyer, operating Lawsuits Inc, earned $500,000 in revenue in a given year. While the revenue might face just a 15 percent tax at the corporate level, the lawyer will still need to pay their personal income tax rate on that total if they try to withdraw it from the corporation.

Luckily for the lawyer, Canada has “tax integration,” which means they’ll pay no more in total taxes than they would have paid if they had directly earned the amount — meaning they won’t pay the corporate rate on top of their personal rate.

So, on paper, there’s no direct financial benefit to incorporation, but there are plenty of other reasons. There are also a host of financial breaks for self-employed professionals who don’t incorporate.

But many have looked at incorporating as a way to reduce their tax burden. And they’ve come up with some clever ways to do it.

The sprinkling loophole

One of the existing tax provisions that the Liberal government is intent on changing is something called “income sprinkling”.

It’s a process whereby you can spread your income to your family members, ideally those who have little-to-no income (like your university-age children) and enjoy lower tax rates.

Let’s say a dentist incorporates himself into The Teeth Company and, in a year, takes in $250,000, before tax. If the dentist were to deposit that amount directly to their account, they’d reach the highest tax bracket in Ontario, and would be left with an after-tax income of about $152,000, for an average tax rate of about 38 percent.

If you were to take advantage of a popular tax loophole, however, you could choose to split your income your partner and kids under the age of 24. To do so, however, you could make them a shareholder in your company and pay them dividends — as though they were a shareholder.

If the dentist were to pay each of their children $60,000 in dividends, it would put them in just the fifth tax bracket, with an average tax rate of 19 percent. The dentist, then, could report the remaining $130,000 for themself, facing an average rate of 29 percent.

The three family members would take home over $188,000, after taxes. That saves the dentist $35,000 in taxes.

That’s all well and good if your kids actually work for the business. There’s currently rules around that, and the government isn’t going to tinker with those. What many top-earning self-employed professionals and small businesses have been doing, however, is “sprinkling” income to their family despite the fact that no family member actually contributes to the business.

The Liberals want to restrict the ability of incorporated individuals and small businesses to pay dividends to their adult children between the age of 18 and 24, through the introduction of a “reasonableness test”. Business owners or incorporated individuals are now going to have prove that their kids actually contribute to the business, and are not pawns a scheme to pay less taxes.

This is one proposal the government has good data on.

Finance Canada estimates 50,000 individuals use their corporations to pay dividends to family members. Ottawa estimates it’s losing out on $250 million a year thanks to that practise.

The passive income loophole

One of the largest changes being proposed by the Liberal government is taking aim at how corporations earn passive income.

As it works now, professionals are leaving cash inside their corporations and treating it like a savings account, making personal investments and enjoying a corporate tax rate on that money instead of a personal one.

Imagine a doctor earns $500,000, paid directly to their private corporation, Medicine Ltd. They can pay themself $300,000 in income, and leave $200,000 in the account. That amount left in the account faces the corporate rate, while the amount withdrawn faces the personal rate.

The big difference here is the tax on that initial capital. Because it is not being withdrawn from the corporation, that $200,000 they set aside to invest faces a 15 percent rate and is shaved down to just $170,000.

A self-employed, non-incorporated doctor, meanwhile, would face the personal rate on the entire $500,000. That means the $200,000 they had planned on investing would face an average tax rate of about 35 percent, whittling down their investment capital to less than $130,000.

After investing the money, corporations and individuals see roughly similar tax rates on their returns (which could be between 50 and 60 percent.) Even so, that difference in initial capital is huge.

Let’s say both doctors found a fund with a high rate of return, at seven percent, and left their initial capital to sit there for a decade. Thanks to the initial tax disparity, the unincorporated doctor would earn roughly $54,000 in income, while Medicine Ltd would earn the other doctor more than $70,000. The only difference is that one is sheltering that fund inside a personal corporation, and the other is not.

To fix that, Ottawa is floating a few possible changes.

One is an automatic 35 percent tax on all corporate investment income (which would, combined with the corporate tax rate, mimic the non-corporate tax rate for the same income.) The money would be refunded if the income were to be reinvested into business operations (which, by the way, is the whole point of the differential tax rate for corporations.)

The other proposal is simply slapping a new tax on investment income for corporations, to eliminate the gains from the lower taxes applied to the capital amount.

There are other solutions floated by the federal government, but they all generally revolve around the idea that corporate investments shouldn’t be used to maximize investment capital for individuals.

Ottawa’s data on this isn’t as good. Finance Canada estimates 300,000 corporations in Canada report investment income, but it’s safe to say that not all of those — perhaps not even most of them — would be affected by any possible changes.

The capital gains loophole

While the other two loopholes that Ottawa is looking to close have been defended by advocates as tax options aimed at helping high-skill self-employed individuals, the third target for Morneau is unquestionably dodgy.

It boils down to a way for those with private corporations to avoid the high tax rate for dividends — the amount paid by a corporation to a shareholder or owner (but not in salary.)

Generally speaking, thanks to Canadian tax law, individuals who pass their income through a private corporation and pay themselves, either through salary or dividends, won’t be taxed twice; they’ll only face their personal income rate, as opposed to personal and corporate taxes.

But some particularly crafty individuals in Canada have been converting their dividends into capital gains — an amount that, at least on paper, is the result of a sale of a capital asset, and which is only half taxable.

So, instead of paying themselves a $300,000 salary, an engineer who owns Bridges Inc could convert that amount into a capital gains. While their salary would face a top tax rate of 53 percent, the capital gains tax (which only applies to half of the total) would be around 26 percent.

The actual conversation is, at its core, magic. It involves swapping shares in two or three different corporations owned by someone in your family. You basically put revenue in on one end, move some shares around, and come out the other end with magic capital gains that face a much lower tax level.

The difference means the engineer would walk away with $222,000 by calling his revenue capital gains, instead of $176,000.

The thing about this scheme is that there’s already rules in the tax code about not turning revenue into capital gains in order to avoid taxation. The courts, however, are not clear on whether this applies to the situation Morneau and Trudeau are targeting — so their plan is to make it crystal clear.

It’s not clear at all how often this practise is used, but given its complexity, it’s probably somewhat rare.

Who’s getting soaked?

First off, it’s worth noting that none of these proposed changes are set in stone. The Trudeau government has signaled strongly that they intend to go forward on closing these loopholes, but they are currently running consultations, set to wrap-up in early October, to gauge reactions on the proposals.

“I don’t think they’re expecting to get much in the way of money, I think it’s about the perception that the tax system is rigged for the rich.”

And the reaction has been fierce.

The reality is, however, the tax loopholes currently being enjoyed by those with private corporations were never intended to be used to dodge personal income. They have, increasingly, become domestic tax shelters by rich professionals to lessen their tax burden.

That sort of aggressive tax planning is a huge driver for income inequality. And it blunts the effectiveness of the Trudeau government’s effort to cut taxes for the middle class while hiking them for the rich.

“If you tax the rich, they can divert income away from the taxable income and park it somewhere else,” says Gordon. He says these changes are aimed at that sheltered wealth at the top.

But he also adds that this isn’t just about stuffing the federal coffers.

“I don’t think they’re expecting to get much in the way of money, I think it’s about the perception that the tax system is rigged for the rich,” he says. “This is demonstrating that we’re concerned about fairness here.”

And on that front, he says that while this sort of tax avoidance might be legal, “it’s certainly not the spirit of the tax code.”

While there are plenty of good arguments to be made that Canada’s top marginal tax rate — a 33 percent rate created by Trudeau in 2015 — is too high, and that tax deductions for professionals and family businesses are too meagre, defending these absurd tax loopholes as a means-to-an-end isn’t the answer, either.

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