On July 18, 2017, the Canadian government released a consultation paper and draft legislation that proposed significant changes to small business tax rules. Following a public consultation period that ended on October 2, 2017, the government revised its thinking and in some cases withdrew the proposals. What is left are planned reductions in the small business tax rate, but significant limitations on the generation of what’s known as passive income. These restrictions are of particular concern to small business corporation owners who are also key First National commercial borrowers. To help our clients understand the implications, we sought the perspectives of Jonathan Newton, CPA, CA, a Tax Partner at KPMG LLP. Jonathan has almost two decades of experience as an advisor to companies throughout the real estate sector, including REITs, public corporations, real estate private equity funds and private entrepreneurial real estate enterprises. What follows is an edited transcript of our interview with Mr. Newton.
Jonathan, can you set the stage for what the government is proposing?
The Department of Finance originally made four proposals. Two of the four were subsequently withdrawn in the middle of October and these included curbing the conversion of tax-free gains currently available on qualified property, and curbing the conversion of income into capital gains. One proposal to restrict tax planning as it relates to income splitting, which has been colloquially referred to as income sprinkling, remains. And the final, which is a limitation on the generation of passive income earned inside a private corporation, has been modified.
These were originally far-reaching proposals.
In their original form, they were the most far-reaching in my 18-year career. Some commentators described them as the most significant upheaval of the Tax Act since the late 1960s. And as far as implications, there were scenarios whereby a 90% tax rate could apply. Truth be told, I’ve never seen as much concern expressed by my clients. People were really taken aback and wondering how they could survive such significant tax hikes and what the rule changes might do to the broader economy and to the entrepreneurial class of taxpayers, including the next generation of entrepreneurs who might not have these tax planning strategies in place for support. It is not surprising that the government reworked the proposals.
So we are left with two proposals. Can you describe the implications of income-splitting prohibitions?
Income splitting allows business owners to share their income with lower or non-earning family members by paying them dividends, even if they don’t work for the company, as means of lowering the family’s overall tax burden. The government proposal suggests it will apply a reasonableness test to determine if an owner’s spouse or children actually contribute to the business and whether the level of compensation is justified. These proposals also expand the application of what’s known as the Tax on Split Income or TOSI to include income from certain debt obligations, capital gains from the sale of shares in which the income is subject to the TOSI and compound income on property that is the proceeds from income previously subject to the TOSI rules or the income attribution rules.
And what about the passive income proposal?
Based on the conversations that I’m having, this is the most worrisome to owners of private corporations that operate businesses. Passive investment refers to income derived within a corporation from a portfolio of investments, as opposed to active income earned from operating the business itself. The Department of Finance says that some individuals unfairly benefit from retaining passive investments in their corporations because those investments are funded by income that was taxed at the much-lower corporate rate rather than at the much higher personal rate.
Can you explain how passive investments are currently treated for tax purposes?
Sure and I’ll use an Ontario taxpayer as an example. In this province, the highest marginal tax rate for individuals is 53.53%, while the corporate tax rate is either 15% on business income up to $500,000, if the small business deduction applies, or 26.5% above that amount. As a result, if a business owner keeps surplus earnings inside their corporations for investment, more after-tax dollars are available for investment than if the funds were first paid out to an individual, fully taxed and then invested. The government doesn’t think it’s fair for a business owner to be able to start with a bigger initial investment portfolio than someone who earns employment income, even though there will be a reconciliation at the end when the investment is withdrawn and taxes are paid by the recipient at their personal marginal rate. So under the government’s revised proposal introduced in mid-October, they are planning to increase tax on private corporation’s passive income earned in excess of $50,000 per year from investments that were funded by income taxed only at the lower corporate rate.
It’s an arbitrary amount allowed by the government to permit business owners to accumulate investments in their corporation. Finance notes that $50,000 is how much income would be generated by a $1 million portfolio earning 5% per annum, so this gives you a sense of what amount of investments they consider to be reasonable for private corporations to accumulate from their business earnings.
What are the implications of this proposal?
They are negative. Suppose for example that a business generates $2 million of income. After paying 26.5% corporate tax on that income, the owner would be left with $1,470,000 for a passive investment portfolio. Let’s say that money is invested in a bond that pays a 5% annual interest rate, which generates $73,500 of interest income per year. The first $50,000 of income earned is taxed at the existing rates on passive income. Every dollar above that amount would be taxed at an effective rate of 73%. This proposed rule, in effect, puts a relatively modest cap on how much a business can hold in passive investments. The concern for many small business owners is that they need to save and invest much more than a few million dollars for purposes such as funding retirement or as a rainy-day fund in case of business stress, or as a nest egg to pay for a future business asset or expansion. While the government has said it would be willing to make exceptions to this amount under certain circumstances, it is not clear how it will decide when a business can exceed this amount of passively earned income.
What would happen to a business owner earning more than $50,000 annually from their passive investments?
Depending on the type of investment income, that excess income would be taxed at punitive rates of 60% to 73%, compared to approximately 50% under the current rules. This reflects the government’s view that business owners should be motivated to fully distribute most of their earnings to shareholders, and that those shareholders should pay an additional level of tax as individuals on the receipt of the income, with no deferral such that the after-tax amount they have to invest would be comparable to what they would’ve had, had they earned that money as an employee. This is a fundamental change to our tax system and, in talking to my clients, it’s viewed as demotivating. Remember that many business owners use passive investing to make up for not having access to a company-sponsored pension plan or unemployment insurance. A pension paying $50,000 per year isn’t that much relative to the pension payments received by some Canadians with defined benefit pension plans.
Why is tackling passive income the most worrisome for First National’s commercial clients?
Let me put it in this context. Many of my clients are small real estate companies that earn income from speculative real estate ventures such as developing single family homes, condos or apartments. The active income they earn from those ventures is taxed in Ontario at 26.5%. As a result of their success, these clients find themselves with surplus income. For risk management reasons or to create a more stable flow of income for their families or for retirement, they don’t want to constantly reinvest all those funds in their active business which is speculative real estate. They want to diversify. As a result, they purchase passive real estate investments like rental properties or stock and bond portfolios inside their companies. The concern is that under proposed changes, the income from those investments will be subject to this punitive rate of 60% to 73% on every dollar of passively earned income above $50,000 in a given year.
How would a real estate company that makes an investment in an income-producing property possibly get caught up by this change to passive income taxation?
Rental income would seemingly be subject to the higher rate unless it is considered active income. It comes down to what’s known as the 6-person test. When a real estate company earns rental income, by default the tax rules define that as passive income. However, there is an exception. If the company earning that rental income employed, during the year, more than five full-time employees whose work pertained to the generation of the rental income, then the rents received are deemed to be active income. The problem is that a small business owner would have to accumulate a pretty large real estate portfolio to justify having more than five full-time employees engaged in generating rental income. So you can see that many owners would be easily caught up in this passive income scenario.
Hasn’t this 6-person test always been in place?
It’s been in place for some time but consider what happens currently versus what’s being proposed. If passive rental income is earned inside a corporation, it is currently taxed at 50%. However, that 50% consists of a 20% and a 30% component. 20% is a permanent tax that the company pays and never gets back. 30% is a refundable tax that means when profits are distributed up to the shareholder in the form of a taxable dividend, the shareholder pays tax on the dividend but at the same time, the company gets a refund on some of the tax it pays which is intended to generally offset the tax paid by the shareholder. Accordingly, you can basically move money up from the company to the shareholder without a significant additional layer of tax. In the proposed new regime, the concern is that investment income over $50,000 will be taxed at rates of 60% - 73% with no refundable component.
When will these changes be implemented?
The government has indicated that they will include enabling legislation in their 2018 fiscal budget. Typically those budgets are introduced in Parliament in February or March. So while it is anyone’s guess as to when the changes will come into effect, some commentators think they will be effective on the date of the budget, some believe they will be deferred until January 1, 2019 and another school of thought is that they will be retroactive to January 1, 2018. Regardless it looks like they are coming.
Hasn’t the government also indicated that the proposed changes to passive income generation will not affect current passive investment portfolios?
That’s correct. Monies passively invested now will be grandfathered and therefore not subject to this $50,000 annual income generation cap.
Does that provide a window of opportunity should a First National client wish to increase the size of their passive investment portfolio now?
Absolutely. Knowing that there has been an assurance that taxes on existing passive investments won’t be changed, it may provide an opportunity for business owners to increase the size of their basket of passive investments prior to passage of the enabling legislation. One idea may be to liberate cash right away that can be used to make additional investments. There are probably various ways people can do that, but one thing I have discussed with members of First National’s commercial team is that real estate owners could refinance existing passive real estate holdings. This scenario is appealing in situations where the existing property or properties have increased in value, providing the means to take some equity off the table that can be used to purchase additional investments. The tax rules are also generally favourable for using debt to finance investments because interest on the loan is tax deductible where the borrowed funds are used for an income-earning purpose.
Are you advising real estate clients to do that?
It’s important to acknowledge the fact that this is a proposed change only. We aren’t dealing with an actual rule. So while it looks highly likely that the change is coming, we can’t give any degree of comfort that a refinancing strategy like this is appropriate. On the other hand, we do have very black-and-white statements from the Finance Minister saying he won’t increase tax on existing passive investments and that the rules (which don’t yet exist) would apply on go-forward basis. And there has been no suggestion that they might apply a higher tax rate to debt-financed investments. Bottom line, it’s a strategy worth considering.
If a First National borrower is interested in a refinancing strategy, what would you suggest?
There are a number of things that need to be considered including things that don’t have tax implications. First, taking debt to make investments introduces risk, so that needs to be assessed. Second, refinancing takes time as it involves seeking arrangements with your lender who will need to do appropriate due diligence to approve a new loan. So I would suggest that if this is something that a First National client wants to pursue, they start looking into it immediately to leave time to work with their accountants, lenders and investment advisors to assess the pros and cons. And the pros and cons will depend on a number of factors such as the age of the taxpayer, rate of interest on a refinanced loan, and the opportunity for investment income to be earned. There’s a lot to be thought about and analyzed but in general, it’s an interesting scenario given possible tax implications.
So even though it’s not clear whether this new tax will be enacted, it’s not advisable to wait to find out?
Let me answer this way. It will take time to figure out how to put yourself in the best possible position. If you wait until final legislation is passed, and that legislation is effective on the date of the budget in early March 2018, it will be too late. In my view, it’s important to determine the right course of action now so that if you choose to do a refinancing, you have time to work with your lender to achieve a refinancing approval. Really what’s most important to this passive income strategy is the date at which the rules take effect. Whether it’s in three months or 12 months, it’s time to get started on advance planning.
Are you also consulting with clients about what to do after these proposals come into place?
Yes, given my profession I’m having a lot of conversations with various people, including of course clients, about the changes. People are contemplating everything from moving out of Canada, which has significant tax implications, looking for investments that generate active income or exploring unwinding their corporations. The modifications the government has made by removing two of the original proposals and slightly softening the passive income rule may have ameliorated some of the concerns that spawned these more drastic ideas, but there is definitely planning that must be done now to avoid triggering punitive tax rates for those with passive investment portfolios.
My personal opinion when all four proposals came out was that they were too far reaching, and could be detrimental to the Canadian economy. But the modifications made since have reduced some of the sting for my clients, including the planned reduction to the small business tax rate on income below $500,000. Nevertheless, the proposed changes that are left are serious in nature and it is advisable to plan and to consider your options.
Jonathan Newton can be reached at firstname.lastname@example.org. To discuss refinancing options, contact your First National representative or for the full text of the Department of Canada’s proposals, visit https://www.fin.gc.ca/activty/consult/tppc-pfsp-eng.pdf.