Canadians may not always get the tax math, but they do get tax fairness. That’s why the controversial proposals to dramatically change the taxation of private business in Canada are proving three things: tax literacy is alive and well in Canada, most people understand and value the incredible entrepreneurial spirit that drives the economic engine in this country, and the government thought these tax changes wouldn’t be a big deal. But they are. Here’s why:
We’re not comparing apples to apples
The government set out a theory that households earning similar levels of income should pay the same taxes. All things being equal, that seems fair. Unfortunately, all things are not equal when you compare the income attributes of the employed with the self-employed.
For the owner of a small business to earn a “wage” similar to that of a non-owner employee, there is a prerequisite: he or she must first come up with capital, either borrowed or retained. If they don’t have it, they can’t pay themselves a wage and as a result, they also miss the opportunity to fund their CPP and RRSP contribution room. Non-owner employees don’t have to meet that burden, nor do they need to fund the employer’s share of CPP premiums for themselves or forfeit EI coverage. That makes the cost of earning the non-owner’s wage much lower. That’s a big deal.
Employees don’t have tax audit risk
The take-home pay of a non-owner employee is certain; that is, the government cannot come back years later and question the tax rate applied to it. However, the tax proposals on the table for private business owners introduce tremendous uncertainty, especially if you are a family member who works in the business. The proposed “reasonableness” tests on the labour and financial contributions by adult family members leave too much discretion with the CRA, who will be able to change the tax attributes on these earnings. That brings tremendous tax risk to the value of the after-tax income of a family working in the business, It also removes access to progressivity for those employees. That’s not comparable to the after-tax wage a non-related employee makes, and that’s a big deal.
Employees enjoy progressive tax rates on investment income
The government proposes to charge a flat, top rate, non-refundable tax on passive income earned when a small business corporation invests its retained earnings. It suggests that if business owners want to enjoy progressive tax rates on that investment income, including rental income, they should flow active earnings out of the corporation as a wage and invest their net wages personally.
But that’s a big deal: business owners need to have the discretion to save and invest retained earnings as they see fit, to meet the burdens of responsibility they bear for their employees and new demands to grow their businesses to meet an emerging future. Further, because the government proposes to require the business owner to track the source of the passive investment, under a system of mind-numbing complexity, the costly tax and bookkeeping expertise that will be required, is sure to wipe out any advantage of investing the lower taxed capital. But that’s not the full extent of the bad news.
Employees don’t pay taxes twice on investment income
The government is proposing to significantly distort the integration of the personal and corporate tax systems. Two provisions, a refundable dividend tax and a notional Capital Dividend Account will be eliminated on a go-forward basis in calculating tax on passive investments that result from the investment of low-taxed retained earnings. This will result in exorbitant combined personal/corporate tax rates on dividends and capital gains earned by individual business owners.
Further, proposed new rules on the sale of business assets, will make it more attractive to sell those assets to an unrelated third party rather than to family members. It also appears there will be a triple tax on capital gains when a business owner dies – once on the final individual return, then on the sale of the asset within the company and again on the distribution of dividends.
Employees, on the other hand, can invest their after-tax earnings in a much more attractive tax environment, especially on dividends earned from publicly traded companies. All of this is a very big deal, because the new tax reforms provide a disincentive to invest in a private business.
Capital is mobile
Unfortunately, the people who today have the intellectual and financial capital to invest in and grow the small businesses that provide employment for millions in Canada, also have the ability to move to tax friendly jurisdictions. The reforms before us have the potential to cause a brain drain of our highly educated, most innovative young citizens, and that means Canadians lose access to goods, services, jobs. When that happens the tax burden to fund all that we need, unfortunately, falls to the middle class. That’s a big deal.
Canadians are very tax compliant
Over 90% of Canadians—individuals and corporations—voluntarily comply with their complex tax system. They buy into progressivity—the more you make, the more you should pay—and they willingly file and pay their taxes, largely on time. They also take on the burden of proof for their tax declarations under our self-assessment system. They do so because they understand that in arranging their financial affairs within the framework of the law to pay the least taxes possible, they are exercising their rights as taxpayers to pay the correct amount of tax, but no more.
A law-abiding taxpayer cannot, therefore, be labelled a tax cheat a few years later, when a new government wants to change the law. That’s a big deal, because it makes our tax system uncertain, and Canadians are telling the government today that they aren’t good with that.
Evelyn Jacks is Founder and President of Knowledge Bureau, a national educational institute for the continuing professional development of tax and financial advisors and author of 52 books on the subject of tax preparation, planning and wealth management for Canadian families.
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