Don’t panic – at least not yet. That’s the caution coming from financial advisors following the recent announcement by Finance Minister Bill Morneau to close three specific tax “loopholes” for businesses and professionals that use private corporations.
“I have more than 200 clients potentially affected by this,” said Kurt Rosentreter, a senior financial advisor with Manulife Securities in Toronto. “What I’m telling my clients right now is to wait and see because right now there’s nothing to act on.”
In making the proposals in July, Morneau said the three tax measures are meant to help businesses reinvest, grow and hire more employees. “We want to make sure those rules are used to do just that, and not to give unfair tax advantages to certain – often high-income – individuals,” he said in a statement.
The three main strategies that the Finance department is looking at deal with:
- “income sprinkling” better known as income splitting, which allows a higher-income family member to shift income to a lower-income family member to lower the total amount of tax paid
- the practice of earning passive investment income in a private corporation and paying lower corporate taxes on income earned from those investments for a prolonged time, rather than investing directly in the growth of the company
- those who claim regular business income as lower-taxed capital gains to reduce their marginal tax rate.
Morneau’s comments should come as no surprise to the industry since the Liberals ran their election platform on levelling the tax playing field to make the system fairer for the middle class. Building a strong middle class was also echoed in the government’s March budget, said Aaron Schechter, a tax partner with Crowe Soberman in Toronto.
But Schechter said what Morneau doesn’t realize is that many small businesses with private corporations consider themselves part of that middle class.
“The government is taking an elephant gun to shoot a mouse,” said Schechter. “These proposals are affecting 1.2 million small businesses. They are not impacting – I think – what the government has issues with.”
Chris Ireland, senior vice president of planning services at PPI Advisory, characterized the proposals as complex and “arguably the most significant changes to our tax system in 40 years. Effectively this is tax reform.”
The government announced there would be a 75-day consultation period which officially ends October 2. Until then, advisors say there are only a few things they can do to help their clients.
Rosentreter said advisors should be having a conversation with their clients about what past strategies may theoretically be taken away and whether there is any benefit to changing their portfolios before the proposals get finalized. “To me, that’s the key strategy to look at.”
However, he noted, that a major question that needs to be answered is whether any of the proposals, if enacted, are retroactive or forward looking.
“The temptation about having good conversations with clients is to say: they are about to make the tax consequences worse,” he said. “But at the same time, what if they back off on it [later] and make it retroactive? There is really no reason to take this view until we know what we’re talking about.”
Rosentreter pointed, for example, to the former Conservative government that increased the annual contribution limit for tax-free savings accounts to $10,000 from $5,500 in its 2015 budget. But shortly after the Liberals came into power in October 2015, the government announced that the contribution limit would be rolled back to $5,500 effective Jan. 1, 2016.
And there is no telling whether a potential new government that comes in after the next election will want to roll back some regulations, he said.
“So even if there is an adverse decision here the right answer will probably be: are you going to grit your teeth and suffer through it a couple of years even if it costs you more because you want to see if it lasts? History has shown that it doesn’t always last.”
But Schechter said some clients may want to take action now. For example, a family trust that is a shareholder of an operating company will want to make sure that dividends are paid to the trust in 2017 for children 18 or older or to a spouse because it may be the last time this can happen without adverse tax implications.
Schechter echoed the view of a number of organizations that came together in Toronto recently to discuss the consequences of the proposals in saying that the government hasn’t thought through all the implications of these rules.
Some groups have called for a longer consultation period in hopes of explaining more clearly the reasons why they believe the current rules should stay.
PPI’s Ireland said many business groups want a “true” consultation period, noting the government has already issued some rather detailed draft legislation for income splitting and “surplus stripping.”
“With so much detail in the proposals, one hopes that the goal is for a full consultation with those who are impacted,” added Ireland.
He said true consultation occurred with the life insurance industry in 2012 after the federal government decided to introduce changes to the tax exempt test on some life insurance policies, sharply reducing the maximum cash value accumulations that were allowed to build up tax-free. The rule came into effect Jan. 1, 2017.
Ireland said it took several years to complete the complex consultations and the final version of the legislation for that tax change as each side learned from the other.
He added that some of the language used by the Liberal government on the recent tax proposals has been over the top by calling the tax strategies that had been in place for decades “loopholes.”
“Certainly some of the messages from some of the organizations across the country is [for government] to tone down the rhetoric. Let’s just have a proper consultation and let’s all work together to make the tax system fairer. I don’t think anyone is suggesting that our tax system shouldn’t have some changes and maybe we do need another kind of tax reform that we had 40-plus years ago. Let’s just do it together and do it properly.”
Failing further consultations, Schechter said he has a “gut feeling” that the proposed rules about income splitting and converting income into capital gains might well be enacted before the end of the year.
He said the government has not released draft legislation on the topic of deferring tax or investing through a corporation. “If they take the consultation period seriously I would hope that they digest all the comments that they are going to receive which likely wouldn’t leave them any time to draft legislation and get it enacted for Jan. 1, 2018. My feeling is that those measures might be deferred for another year.”
Without proper consultations, Schechter said he can foresee some unwanted consequences for the economy, particularly in Ontario.
“I think with minimum wage going up in Ontario and the small business tax rate not coming down as was originally proposed, and these new rules coming in, it’s going to make it increasingly more difficult for managers to operate businesses here in Ontario,” he said. “So I would expect to see companies leaving Ontario and businesses not being set up in Ontario over the next few years and I find that disconcerting.”