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The Liberals came up with a solution. Now they are desperate to find a problem for it:

The latest chapter in the ongoing battle against Ottawa’s proposed changes to private company taxation unfolded this week. At the request of the Department of Finance, the Canadian Tax Foundation brought together practitioners and academics to provide input into the proposed changes which were described in our July 18, 2017 blogs. The presenters included a virtual “who’s who” of Canadian tax, and ranged from far left leaning academics (and just how left you will see below), to impassioned practitioners fighting to preserve a workable tax system for Canadian entrepreneurs and family businesses.

Roughly 20 officials from Finance attended the meetings, and many were quick to distance themselves from the inflammatory rhetoric of the July 18th release which seemingly accused private company shareholders of being tax cheats. One Finance staffer suggested that we “look at the signature” on the letter – of course Minister Morneau. Interestingly, he has done nothing publicly to apologize or take back any of the disgusting rhetoric that has caused most of the business and advisory community to take issue.

At the end of the day (after Department of Finance representatives declared that they would make no pronouncements!) a number of important messages were delivered. Perhaps most importantly was the message that despite the heavy-handed rhetoric of the Trudeau cabinet, Finance is paying attention to the feedback provided, and while they are bound by the policy direction of the Trudeau government, they are prepared to address at least some of the implementation issues identified by our firm and others.

Highlights of the meeting included:

  1. Finance indicated they do not have a policy of subjecting taxpayers to double taxation. To that end, there was acknowledgement some updates were needed with respect to the proposed changes to section 84.1, which currently would prevent the use of “pipeline planning” to prevent double taxation on the death of private company shareholders. The “fix” for this was unclear, but could include relaxing the one year limitation with respect to the use of the subsection 164(6) loss carryback rules. Also mentioned as a possibility was potential grandfathering provisions to allow the use of the existing version of section 84.1 by estates which pre-date the July 18, 2017 effective date.

    This is welcome news, particularly for taxpayers in cases where a family member’s death occurred more than one year ago, and so is outside the allowable period for the application of subsection 164(6), and where a pipeline was planned, but not yet completed.

  2. Assurances were given by Finance that there will be provisions to grandfather existing passive investments held in existing private corporations, rather than subjecting them to the proposed changes. This could potentially occur by allowing taxpayers to segregate assets into separate corporations or pools which will only be subject to the current taxation regime. While this is somewhat positive, it effectively creates two classes of investors, subject to two different tax regimes, depending on when the corporate surplus was earned, thus creating a lower effective rate of return on passive investments for younger business owners who are haven’t already built up significant retained earnings.

  3. Finance was questioned about the “cost vs. benefit” equation for these proposals and the increased administrative and compliance burdens that will be created for private businesses, in exchange for relatively small increases in overall tax revenues. Finance acknowledged the complexity that the proposals create in many cases, but indicated that their mandate from the Trudeau government was to proceed with implementation.

  4. Finance indicates that they are committed to rules that tax the sale of a private company to non-arm’s length parties significantly more harshly than a sale to arm’s length parties. Existing rules, for example in section 69, were cited as a current example where rules in the Act treat non-arm’s length transactions differently. Let that sink in for a minute (more discussion below).

  5. Finance indicates that their goal for the passive income proposals remains to make the net after tax rate of return for an incorporated individual equal to that of an unincorporated individual (i.e. an employee). Our firm strongly feels that there is a need to ensure entrepreneurs can, for example, create a contingency reserve, a surplus from which to fund business expansion, or a surplus from which to fund maternity/paternity leave, which doesn’t appear to be contemplated in the proposed rules. If, however, it is inevitable that the proposal will be implemented more or less in its current form, then we submit that there is a need to consider all of the taxes that a business will pay, including the hefty payroll taxes that an employer will pay on behalf of their employees. Conversely, the full value of the benefits realized by an employee should be included in the equation as part of the employee’s total income, including employer sponsored pensions, paid vacation days, health benefits, potential access to unemployment benefits and severance packages, potential access to subsidized professional development or education, parking, etc.

  6. Finance did not share the concerns expressed by many of the speakers about the application of “reasonableness” tests to the income splitting measures. Most practitioners strongly believe that the proposed reasonableness tests are unworkable in practice and will result in many disputes. Finance instead indicated that they would release technical notes that provide guidance with respect to the application of these rules which seems to us to be a complete lack of understanding of how the real world exists. Interestingly, the example given suggested that where a parent financed the risky startup business of their child, this would be sufficient to entitle them to an “extraordinary return” on their investment given the risk associated with this investment, even if the parent did not have an active role in the business. As the proposals are written now, we do not see how such a conclusion can be formed.

Also notable was the blasé dismissal of the impact of the proposals to eliminate income splitting on lower and middle income private company owners by retired bureaucrat Michael (“Let’s Kill the Family Farm”) Wolfson. Wolfson is widely credited with authorship of the paper which during the 2015 election provided the impetus for the Liberal’s rhetoric against private business, and the resulting proposed private company tax reforms. At the conference Wolfson presented strangely disjointed data which provided information for individuals with total T1 income of $25,000 to $100,000, $200,000 to $350,000, and $500,000 plus.[1] His numbers show that while there are approximately 845,000 individuals who are CCPC owners in the low to middle income $25,000 to $100,000 T1 total income group, the number of individuals in the $200,000 to $350,000, and $500,000 plus groups were 57,800 and 21,300 respectively. As one presenter pointed out, Wolfson’s numbers suggest that barring significant changes to the proposed income splitting rules, literally hundreds of thousands of low and middle class families will face additional compliance costs and additional taxes as a result of a blind focus on less than 80,000 “wealthy” business owners. Talk about using a blunt instrument.

Perhaps equally concerning was Wolfson’s assertions that this was new and unique data, and in fact he went so far as to present it as a preliminary estimate enabled by “special tabulations” performed by his colleagues at Statistics Canada. Wolfson asserted that he was the first and only person to have ever looked at the income distribution of private company owners. If this is true, it would seem perhaps the Trudeau government crafted a “solution” in the heat of the election, and now faces the rather daunting task of trying to manufacture a problem to fit their “solution”. Interestingly, Wolfson suggested that a “fix” for these middle-class families caught by the proposed rules was to simply unwind their corporations. Unfortunately, this suggestion doesn’t solve the problem as then the family members’ venture would then constitute a partnership, and the rules as proposed would still apply. Such a suggestion is absurd, non-sensical and displays a complete lack of understanding of the underlying business and commercial reasons why family businesses use private corporations to carry out their business. It seems morally repugnant to us that no governmental department will hire a contractor without that individual being incorporated (to eliminate any risk that they will be treated as an employee), and yet Ottawa wishes to severely penalize them for that incorporation.

Wolfson went on to speak about equality of opportunity, and questioned whether there should be any measures that enable the intergenerational transfer of wealth, suggesting that if we are really serious about equality of opportunity, then we should have no intergenerational transfer of wealth and instead let the kids all start out at the same place as this would make for a more “convivial society”. Coupled with a governmental confiscation of that deceased parent’s wealth of course. You cannot make this stuff up.  This is our firm’s “WTF” moment in this national comedy labelled as tax reform.  The Liberal Party is basing their entire tax reform platform on Wolfson’s study (which by the way is chock full of bias and unrealistic assumptions), whose author has publically stated that he thinks family farms are outdated and inefficient, and NOW proposes imposing a Marxist-style wealth confiscation on the Canadian taxpayer in a manner that would make Stalin proud.   And we are not embellishing that – this is exactly what these proposals entail for the inter-generational transfer of a family business. 

The meeting also allowed tax advisors to compare notes on their concerns with respect to the private company proposals, both at a technical level, and at a macro level. The technical concerns we have previously written about were broadly shared by the attendees. A common macro level theme which emerged was the need for taxpayers to have some reasonable level of certainty with respect to how they will be taxed, and the amount of taxes they will owe. Another prevailing theme was concerns with respect to competitiveness with the tax rates in the United States. Since July 18th our firm has seen a significant number of clients asking for help to emigrate their capital out of Canada. Even before the July 18, 2017 proposals, our firm was seeing an increased number of private individuals leaving Canada and we wrote about that fact here.   

Finance was unable to definitively identify their next steps, beyond reviewing the submissions made during the consultation period. Many of the speakers at the event suggested that the government slow down and take the time needed to get these sweeping changes right, rather than rushing through a 75-day consultation period. Suggestions included striking a royal commission, or similar group that broadly includes stakeholders – including Finance – to study these topics, define the problems, and find solutions that fit the problem, instead of using a sledge hammer to drive a nail. Our firm echoes this call.

Overall, the conference was a valid confirmation that the private corporation tax proposals need a complete rethink.  Any good policy changes that might exist within such proposals – and there are some – have been completely lost in the rhetoric, divisiveness, class warfare language, the appearance of the consultation not being a true consultation, the proposals being vigorously defended by the Department of Finance and the Minister over social media, and the complete lack of appreciation for some of the very valid concerns that have been raised by the business and tax practitioner community. 

Never before (at least in recent memory) has Canada ever seen a revolt by the business and tax community of this magnitude.  Ottawa – and specifically Minister Morneau – should listen to those concerns.  Slow down and do this right. 

[1] Note that we can only assume that the number of individuals in the missing $350,000 to $500,000 range must be very small, or would have been included in the analysis.