When Bill Morneau rose to deliver his first budget speech as Finance Minister in Justin Trudeau’s new federal government, entrepreneurs and the owners of Canada’s small- and medium-sized businesses held their breath.
Concerns over the small business tax deduction, stock options for startup employees and capital gains exemptions made this a crucial policy document for SMBs. Here’s what the 2016 federal budget will do and change, and what that means for you and your business.
1. Small business tax rate frozen
Companies that meet the criteria for a Canadian-Controlled Private Corporation (CPCC) pay a reduced effective rate on their first $500,000 of active business income. In last year’s budget, the then-Conservative government proposed to drop that rate in increments from 11% at the time to 9% by 2019.
As of January 1, 2016, the small business rate was 10.5%, and the 2016 budget “proposes that further reductions in the small business income tax rate be deferred.” In effect, that means the rate will stay where it is today until the government decides otherwise.
“Small businesses are going to pay more tax as a result of the budget than they would have pre-budget,” says Ryan Ball, a tax partner in the mid-market practice at Ernst & Young LLP. The 1.5 percentage point difference between the frozen and previous target rate amounts to a “$7,500 cost per year [starting in 2019] ¦ assuming that the company earned the full $500,000,” he notes.
The Canadian Federation of Independent Businesses (CFIB) called the decision a broken promise, and predicted it would cost small firms more than a collective $900 million per year as of 2019.
SMBs may find the thinnest of silver linings in what the government didn’t do on small business tax policy. Before the budget, some experts were calling for eligibility to be restricted to companies with a minimum number of employees, as Quebec has done, or for the deduction to be eliminated altogether. Fortunately, those policy suggestions appear to have been ignored—for now.
And Canadian businesses still have a tax edge over their neighbours to the south, notes Ball. “This still leaves us very competitive with our counterparts in the U.S., as far as private businesses [are concerned],” he says. “Even without the small business deduction, our rates for comparable income are still significantly lower in Canada.”
2. A let off on capital gains
In weeks prior to Morneau’s speech, experts speculated that the government might significantly increase the capital gains exemption rate. It didn’t come to pass, to the relief of businesses of all sizes.
“If you look at a business that sells its building and has a capital gain, it pays tax on only half of that,” explains Ball. “There was a rumour that could be increased, and I heard numbers up to 75%. But any increase would have been a direct increase in tax.” That won’t be happening.
3. Sidecars could be run off the road
Some businesses structured as partnerships use what’s called a “sidecar”structure to take advantage of the small business tax deduction.
“If you operate say a machine shop ¦ as a corporation, it gets one small business deduction,” explains Ball. “[If that] machine shop operated in a partnership, the two corporate partners by rule would also share the small business deduction.” To get around that obstacle, a partner could pay a fee from the partnership-owned business to a private corporation, which would then utilize the deduction in its own right.
“The changes to the rules are designed to curtail that kind of planning,” says Ball, though he notes that the details of the new system have not been revealed.
4. Stock option benefits stay the same
A Liberal campaign proposal to reduce tax benefits for employees who exercise stock options met with opposition from Canada’s burgeoning tech sector, where it’s a crucial way to attract skilled talent. Tobias LÃ¼tke, the otherwise spotlight-shunning co-founder and CEO of Shopify led the charge.
Current rules allow individuals to deduct about half their net gains from the exercise and sale of options. The mooted changes would have capped the deduction at the first $100,000 of options.
The tech sector’s feedback seemed to work—the government chose not to go forward with the changes, and Morneau told reporters in the budget lockup that it has no plans to do so in the future. “From a small business perspective, certainly in the high-tech industries, [that] is good news,” says Rolph. “It’s a normal part of how they would compensate their people.”
5. CPP expansion is still on the agenda
Enhancing the Canada Pension Plan (CPP) has been a key tenet of the Liberal both federally and in Ontario, and the budget doesn’t change that. Though it contained no new news, the document did note that the government will soon “launch consultations to give Canadians an opportunity to share their views on enhancing [CPP].”
Rolph says CPP enhancement would be a “much more efficient and prudent way” to improve retirement benefits than efforts like the Kathleen Wynne government’s province-specific Ontario Pension Plan (OPP). “[That] is going to mean, if they do enhance it, higher employer contributions on CPP,” he notes.
Watch for more developments on CPP in the coming months.
6. Changes to eligible capital property
Currently, if you sell non-tangible assets—goodwill, trademarks, patents and so on—and you have no cost on them, only half the amount they sell for is taxable, in the form of business income, explains Ball. “For example, under current rules you could sell $1 million of goodwill, and have $500,000 of income, and because it’s business income, that amount could be eligible for the small business rate,” he explains.
The budget proposes to repeal this regime, and replace it with a capital cost allowance system. It would also allow up to $3,000 in incorporation costs to be deducted as a current expense.
But Ball says the new system would classify the gain in our example sale of goodwill as a capital gain, making it investment income instead of business income. “That’s significant because investment income is taxed such that there’s no deferral to leaving that money in your corporation,” he explains. With business income, you pay the deduction-influenced rate now, and the rest when you take the money out of the company as a dividend. With investment-type income, you’re charged the full rate up front—as much as 50%, depending on the province—and regain some of that when you take out a dividend. “So it’s taken away the advantage of a deferral.”
7. Life insurance loophole closed
Melissa Shin at Advisor explains:
“A loophole in the tax code allowed business owners to transfer their life insurance policies to their corporations in return for tax-free proceeds of the policy’s fair market value (FMV), usually in the form of a note. Then, when the business owner died, the corporation would receive the proceeds of the death benefit—again, essentially tax-free. Private corporations can add the value of the benefit, less the adjusted cost base, to their capital dividend accounts, and then pay out capital dividends, which aren’t taxable in the hands of shareholders. There are equivalent rules for partnerships.”
That loophole is set to be closed.
8. PSE you can use
The budget promised a “bold new plan” for innovation, to be developed through this year and next. In the meantime, the government is putting $2 billion into a Post-Secondary Institutions Strategic Investment Fund, over three years beginning in 20162017. In concert with provincial governments, the fund will contribute up to half the costs of infrastructure projects at universities and colleges.
Among the eligible projects the budget lists are on-campus incubators and accelerators, which “could be expanded to increase and improve support for entrepreneurs and startups.” Also beneficial to businesses would be training facilities for trades.
9. A missed opportunity on IP
While the government seems to want to retool universities for research, it missed a different innovation-boosting opportunity according to Rolph: patent boxes.
“Patent boxes are tax incentives that provide preferable tax rates to income earned by a business that generates profit from R&D they’ve commercialized or from patents that they own,” he explains.
The U.K. has used patent boxes with some success, and Rolph says similar incentives would have helped small tech companies in particular.
MORE PERSPECTIVES ON THE 2016 FEDERAL BUDGET:
- Personal Finance: 25 Ways the Liberal Budget Affects You »
- Families: 6 Big Changes in the Federal Budget Parents Should Know About »
- Students: 5 Highlights for the 20162017 Tax Year »
- Investors: An Advisor’s Letter to a Client on the 2016 Budget »
Which of these changes or decisions will most impact your business? What are you happy or angry about? Share your reactions to the 2016 federal budget by commenting below.