On July 18, 2017, a blockbuster package of proposed tax law changes (the “proposals”) aimed at private corporations and their shareholders, was released by the Department of Finance. The proposed changes target common tax management practices available to private business owners, such as income splitting amongst family members, investing in passive assets with corporate funds, and repatriation of corporate earnings as capital gains rather than dividends.
In many ways, the broad-sweeping proposals and the accompanying “consultation document”, heavily laced with offensive rhetoric, reads like a class warfare manifesto against private businesses. Many in the business and professional community have started rallying against such damaging rhetoric and the countless unintended consequences arising from the proposals (including effective tax rates of 73% on certain passive income, and 93% on the death of certain non-active shareholders of private corporations). We heartily agree with such criticisms. These proposals, if implemented, will – without a doubt – have a negative effect on Canada’s economy.
Notwithstanding, the purpose of this article is to explore the other side of the argument of one of the proposals: Income splitting. What is income splitting? An example is the paying of dividends to family shareholders (active or non-active), which often results in a reduced overall family tax burden as compared to the situation where dividends were simply paid to the active shareholder. Is income splitting really that offensive and unfair as suggested by our government?
A typical private business is often started and capitalized with family assets. In many cases, the operations of the business are run by family members. Often, but not always, one of the spouses / common-law partners stays home to raise the children while the other focuses on the operations of the business. In many cases, both spouses / common-law partners (and sometimes the children either directly or indirectly) are shareholders of the business. Such an arrangement allows the eventual rewards of the business – often after many years of struggle to make the business successful against the odds – to be split amongst the family. Any dividends or capital gains realized are taxed according to each family member’s individual tax brackets (with the exception of minors who are generally always taxed at the top marginal tax rate under the current “kiddie tax” regime).
Part of the proposals will extend the “kiddie tax” regime to adults. Starting in 2018, not only will minors be taxed at top marginal tax rates, but any dividend or capital gain realized by family members – including spouses and common-law partners – over a “reasonable” amount will also be taxed at the top marginal tax rate (with additional requirements applying to those between 18 and 24 years old). Repealing the common practice of income-splitting with a spouse / common-law partner (or another family member who does not directly contribute to the business) has intuitive appeal at first glance: Why should someone get something unless they’ve worked for it? However, is a reasonableness test appropriate in a spouse or common-law partner scenario when the province’s various matrimonial property regimes grant property rights to such persons, regardless of who contributes to the business? Is basing taxation on an individual-by-individual basis, rather than on a family unit basis, the right or fair approach? Do the proposals contradict our current government’s emphasis on gender equality when many entrepreneurial families have a stay-at-home parent?
It turns out that our forefathers already thought about many of these questions over 50 years ago. In 1966, the Royal Commission on Taxation, chaired by Kenneth Carter, carried out a comprehensive review to recommend reforms to the Canadian tax system. Part of that review was to determine the proper taxing unit in Canada. The Commission noted the substantial contribution each family member usually makes to the family’s finances, and strongly recommended the family unit be the appropriate taxing unit: “We believe firmly that the family is today, as it has been for many centuries, the basic economic unit in society.” While many things have changed over the last 50 years, we submit that this assertion remains just as true today, particularly with respect to families that run businesses. A spouse / common-law partner who stays home to raise children and manage the household is as much a key ingredient to the family’s success as the other spouse’s day-to-day hustle for the business. When you combine that with the fact that non-active spouses / common-law partners have property rights with respect to family assets that have been used – directly or indirectly – to grow the business, is it really offensive from a tax policy perspective for the non-active spouse / common-law partner or other family member to receive dividends, or realize capital gains despite not having expended the same level of direct effort in the business as other family members?
Today, the Carter Commission Report largely forms the foundation of the modern Canadian tax regime. However, the government went against the Commission’s recommendation with respect to adopting the family as the taxing unit, and decided on the individual as the proper taxing unit. This is why today we file tax returns as individuals, whereas in the U.S. there is a form of the family as the taxing unit (for example, couples can file joint tax returns if desired). As expected, over the years, taxpayers have found many ways to split income despite the taxing unit being the individual, and the Canadian government has occasionally responded by compounding the complexity of the Income Tax Act to prevent it. These preventive measures have included the so-called “attribution rules,” introduced in 1985, which, if applicable, attribute certain income back to the transferor if property is transferred between spouses / common-law partners or minors with certain exceptions, the “kiddie tax” regime, introduced in 2000, and other rules beyond the scope of this article. There are also existing rules that prevent the deduction of unreasonable salaries or other amounts when computing business income.
By extending the “kiddie tax” rules to adults, the government will completely deny a family’s ability to income split amongst adults who are not active in the business, thereby ignoring the reality that the family is the basic economic unit of society, that non-active spouses / common-law partners contribute significantly to the success of the family business, and the fact that those spouses / common-law partners have property rights with respect to such family business assets. We routinely deal with many successful entrepreneurs and almost all of them credit their success to their family, irrespective of whether they are active in the business or not. Such entrepreneurs also acknowledge that every member of their family bears some degree of risk associated with their business. In their eyes, their own success is indistinguishable from their family’s success.
What does this proposed change mean to the bottom-line of the owners of a family business? Let’s assume a business has $300,000 of after-tax corporate profits, and is owned by two spouses. The private corporation pays $150,000 of dividends to each spouse. Under existing rules, assuming they are residents of Ontario, the family’s personal tax burden is approximately $68,000. Under the proposals, if the two spouses contribute equally to the business, then their tax burden remains the same as under the existing rules. However, if one of the spouses is a stay-at-home parent and not active in the business, the total tax burden increases to approximately $90,000. Beyond the increased tax burden, for stay-at-home parents, gender inequality will likely also be an unfortunate consequence of the proposals. Is all of this fair? Not in our view.
The proposals will specifically disallow the splitting of dividends or capital gains from private corporations, but in contrast, our government has allowed the splitting of pension income between spouses / common-law partners since 2007. This results in a glaring taxation distinction between pension income and business income. Is this fair? Not in our view.
The resulting tax rules that the government is proposing to prevent income splitting are some of the most complicated tax rules we have ever seen. The average small business owner – who usually does not have the resources to have an internal tax department to interpret and navigate complex tax rules – will be burdened with extreme complexity. Is this fair? Not in our view.
We believe that what is old is new again. Just as it was in 1966, and for many centuries, the economic unit today is still the family unit. Rather than playing an endless cat and mouse game with taxpayers on income splitting (which results in very complex legislation that will likely not be workable in practice) – all in the name of “fairness” – we believe the Government should revisit the Carter Commission’s recommendation of basing taxation on the family unit. This, in our view, would be a worthwhile tax reform initiative for Canada. And it would be fair.