On Wednesday March 22, Finance Minister Bill Morneau will deliver his second federal budget and that has some small business owners scrambling to complete tax-motivated transactions prior to budget day.
Others have been postponing any substantial tax planning until they learn whether the budget will alter the favourable taxation of small business corporations, including professional corporations, entities the Liberals have promised to ensure are not being used solely to reduce personal income taxes for high-income earners. Here’s a look at the two main small business tax measures that are the subject of concern, the small business deduction and the lifetime capital gains exemption.
Small business deduction
Business owners, including incorporated professionals, who operate their businesses through a Canadian-controlled private corporation (CCPC) are able to claim the small business deduction (SBD) on the first $500,000 of active business income, thereby paying an extremely low rate of tax when the income is initially earned. This results in a significant tax deferral advantage by leaving the after-tax corporate income inside the corporation as opposed to paying it out immediately.
The SBD costs the federal government $4 billion annually in reduced corporate income tax and costs provincial governments even more.
In his report “Tax Exemptions for Investment Income: Boon or Bane?” Peter Spiro of the Mowat Centre at the School of Public Policy & Governance at the University of Toronto calls the SBD “a tax preference that has broad ramifications … and affects the relative competitiveness of different types of businesses.”
Spiro suggests that the SBD fails on two fronts: it supports the proliferation of economically inefficient businesses and worsens inequality in the distribution of income, through income splitting techniques.
In his report, Spiro examines the effect the SBD has on economic efficiency, citing a major review of the corporate tax system undertaken for the Minister of Finance in 1997 which noted the risk that this tax rate differential “encourages the growth of small corporations at the expense of large businesses for reasons other than the economic advantages that small enterprises may bring to the economy.”
Analysts at the OECD observed that Canada has one of the most generous tax regimes for small business in the developed world. As a result, the share of the economy occupied by small businesses is greater in Canada than in the U.S. which, according to another report cited by Spiro, can explain about two-thirds of the productivity gap between Canada and the U.S. In 2015, the United Kingdom eliminated its small business tax preference.
Spiro recommends gradually increasing the small business rate to match or at least come closer to the general corporate tax rate while at the same time recognizing that “new, dynamic small firms that may lead to innovation are worthy of some special incentives.” This could be accomplished by providing time-limited tax reductions for the first few years of a corporation’s life, rather than an indiscriminate permanent tax reduction for all small businesses.
This latter recommendation was echoed in C.D. Howe’s recent “Shadow Budget” wherein it recommended that the SBD be only available to “young, growth-oriented firms rather than simply all businesses that are small. Targeting such young firms would help mitigate the growth-disincentive tax effect…The tax benefit would be highest for young businesses with little in taxable capital assets.”
The other concern with the use of CCPCs is the availability of income splitting, either among different members of the owner’s family to reduce the total amount of tax paid or between the corporation and the owner as an individual, who may enjoy a significant tax deferral advantage by leaving retained earnings in the corporation to postpone paying personal income tax until the time of withdrawal.
These earnings might ultimately be transformed into partially taxable capital gains if the earnings are retained and reinvested inside the corporation until the business is sold. In some cases, the gain could escape tax altogether through the use of the lifetime capital gains exemption (LCGE), which may also be on the government’s radar.
Lifetime capital gains exemption
The LCGE exempts the first $835,716 of lifetime capital gains on the sale of qualifying small business corporation shares from tax. For qualified farm or fishing property, the exemption is $1 million.
The LCGE represents a tax expenditure of nearly half a billion dollars per year. Spiro argues that one of the issues with the LCGE is that the requirements to qualify are “not very stringent.” In order to claim the LCGE, the company is required to have been involved in active business activity (e.g. not primarily earning passive investment income) for at least two years prior to the sale.
He cites the example of an individual who may have accumulated retained earnings in a corporation that came from activities that would not otherwise qualify for the LCGE, such as by earning investment income, who can then use their capital to purchase a “safe operating business, such as a franchised coffee shop, and then re-sell it two years later, effectively converting their previous earnings into a tax-free capital gain.”
By doing some effective tax planning in advance through splitting the business ownership among members of a family, a couple with two kids may be able to realize more than $3 million tax-free, through the claiming of four LCGEs.
Consistent with his views on the reforms of the SBD, Spiro would redesign the LCGE so that it encourages more dynamic growth by small businesses.
In the meantime, small business owners who are worried that the government may somehow change or eliminate the LCGE in next week’s budget, are hurriedly exploring “crystallization” transactions that may allow them to access the exemption prior to the budget date. It would also have the potential benefit of taking advantage of the 50 per cent current capital gains inclusion rate to shelter any gains beyond the LCGE limit should the government decide to increase the inclusion rate in the budget.