The Liberal Party of Canada’s election platform in 2015 led with the theme of “growth for the middle class.” The goal was that everyone from the unionized worker putting in a meaningful amount of overtime to the successful small business owner could see himself or herself as part of this group or as close as an aspiration away from joining it.

Delving into the specifics of the program, voters who sought to learn how this appealingly broad policy approach would actually assist their pocketbooks found that they had strayed into a semantic debate (or, for the mathematically minded, a statistical one). For example, the platform promised to create a new maximum tax bracket (33 percent, up from 29 percent) for those earning more than $200,000, on the pretext that such an income puts the taxpayer in the prestigious category of Canada’s top 1 percent of earners. Does someone who makes $200,000 actually think of themselves as rich? It may well be that a very small proportion of Canadians achieve such a level of income, but that might only prove, as former finance minister Michael Wilson once said, that “Canada has an acute shortage of rich people.”

It is likely that the policy brain trust behind this measure sold it to the party leadership on the grounds that even if it infuriated the individuals whose ox was being gored, they were, after all, only a tiny minority of the voting public. However, once the new bracket was put in place, the “tax the rich” mentality turned out not to produce anything like the revenue gleefully anticipated by its proponents.

An ex post facto analysis of the flaws in this initiative probably revealed that its failure to raise big bucks was due to excessive tax planning, involving the use of private corporations. This conclusion inspired the tax-policy gurus to recycle a prescription they had tried on previous finance ministers without success. It is a tactic that, in quite another context, I had been taught to anticipate and resist.

A few days after I was named deputy finance minister in September 1985, one of my most illustrious predecessors, Simon Reisman, took me out to lunch and gave me some strong advice. “Watch out for the tax guys,” he said. “They’ll come to see you and present some loophole in existing law and/or enforcement policy that people are exploiting, and try to convince you that this or that loophole needs to be shut down. Once you agree that the practice in question seems to require some legislative correction and authorize them to spend time and resources on it, they will come back to you with a massive overkill in their solution, sideswiping hundreds or even thousands of parties who were never taking advantage of the system.”

Armed with this advice, I made it my business to read the Ways and Means Motions that were the product of these efforts to stop overly aggressive tax planners, with the goal of paring back the excesses in legislative drafting. It was with this experience in mind that I approached my reading of the discussion paper published in July by the Department of Finance Canada: Tax Planning Using Private Corporations. The paper raises three areas of concern: income “sprinkling,” holding passive investments inside a private corporation and converting income into capital gains.

The “sprinkling” the policy-makers object to is the practice of employing immediate family members (spouses and children) and/or making them shareholders, eligible to receive dividends or capital gains from a private family corporation. This enables the head of the household to spread the tax burden among several taxpayers, all of whom benefit from the progressive rate structure of our system, thus reducing the family’s overall tax burden. The premise of the paper is that tax sprinkling violates the principle of horizontal equity: it is unfair that the family that has a business can arrange to pay less tax on a given dollar amount of aggregate income from the business than an employee who earns the same dollar amount in salary would owe. The subsidiary premise is that the income paid to a family member “may exceed what would have been expected, having regard to the family member’s labour and capital contributions” had the arrangements been made with persons dealing at arm’s length with the corporation.

The small business deduction in our corporate tax system was not invented by tax planners. It was meant to encourage the establishment of new enterprises and assist in their survival during their early-stage growth periods. It was never intended that the use of the corporate form of business organization would provide a tax dodge. The dividend tax credit — which integrates the tax imposed on the corporation with the tax collected a second time when profits are distributed by way of dividends — is not a loophole. The business owner was never intended to pay the same amount of tax as his neighbour who was an employee.

And if the business owner introduces his wife to the operations of the business, so that she can succeed him if he predeceases her, or if he trains his children in the intricacies of the family’s commercial venture to give them a taste of what would be involved if they decide to carry on the family business instead of going on to other careers, who can say whether the appropriate wage or “skin in the game” in the form of share ownership is comparable to an investment of money or effort by a stranger? Can an income tax auditor truly determine the fair market value of the labour or investment contributed in this context?

The paper attempts to invoke the existing rules on attribution of investment income received by a minor child and the “reasonableness” tests already found in the Income Tax Act to lead the reader to believe that the proposed measures represent a mere extension of existing principles. In fact, the rules to address the perceived ills raised in the paper would involve the extension of the existing “tax on split income” provisions to a huge number of adult taxpayers. The proposed measures would also extend the current reasonableness test to a universe of taxpayers that would make Big Brother blush: in effect, any adult connected to an individual having a certain measure of influence over the corporation. The Canada Revenue Agency will never have enough personnel, market data or insight into the purpose and value of every corporation’s circumstances to adequately and fairly enforce such a subjective standard of compliance.

So, for example, a mother may reorganize the capital of her company so that she becomes a holder of non-participating preferred shares with a redemption value of 100 percent of the undisputed current worth of the business. She conveys to her two children, one a minor and the other age 18, for a nominal sum, the common shares representing all of the future growth in the enterprise, as a means of encouraging them to take over the business and keep it in the family when she retires. Morneau’s proposed new rules could completely nullify this perfectly well-intentioned plan, since no one would ever make such an arrangement with a stranger.

The second section of the discussion paper takes aim at the practice of retaining passive investments within a private corporation. The complaint of the paper’s authors seems to be that, if profit from a small business is invested in passive (meaning, in this context, unrelated) entities or instruments, it can produce greater after-tax returns than if the money were invested by a taxpayer who is a salaried employee, because it can grow within the corporate entity and benefit from the lower tax rate on small business income . Again, the insistence on the appearance of horizontal equity is misplaced. If the small business owner is, say, a franchisee who is growing his capital as part of a plan to acquire a second, third or fourth franchise outlet, what possible benefit to the Canadian treasury would outweigh the cost of having him abandon or slow down his growth plan? The proposed reforms would force him to distribute the income by way of salary or dividend and then invest his capital personally instead of within his corporation (or would tax him as if he had done so). He would end up paying more tax but delaying or giving up his intended job-creating investment. The paper proposes a number of ways to achieve its goals, all of which are punitive and rest on the premise that an unfair advantage is gained by allowing private corporations to continue to earn passive investment income at small business rates of taxation.

The third section addresses a practice known as surplus stripping, whereby the disposition of a corporation’s shares in exchange for shares in a non-arm’s-length corporation can be used to “step up” (that is, increase the fair market value of) the cost base of the sold shares. The result is that on a further sale, even to a non-arm’s-length entity for cash, the surplus that would otherwise have to be paid out as taxable salary or dividends can be converted to a capital gain. An anti-avoidance measure already exists in the Act to address surplus stripping; the Canada Revenue Agency has found it to be less than totally effective and now hopes to extend and reinforce it, even in the face of objections to the existing rule from shareholders of family businesses, who see this provision as an impediment to intergenerational transfers of their companies. In response to these objections, the paper suggests an approach that would require that the vendor (in family businesses, the parent) not have any financial interest or participate in the management and operations of the business.

In the real world, businesses are not transferred to children in one fell swoop. There is a transitional period of passing the torch and handing down the accumulated knowledge and wisdom, which would not fit into the tidy categories of the proposed “solution.” The assumption that family relationships are all directed toward shortchanging the tax collector is what is wrong with this entire paper.

The measures proposed in the paper are being vigorously opposed by many groups: doctors and lawyers who use professional corporations not only to limit personal liability but also as part of the current, legitimate tax regime under which they set up their practices; small business owners everywhere; associations representing investors in innovative, breakthrough technologies; and others. Some of the arguments are less than convincing, such as the assertion that members of the medical profession were induced to accept, from the provinces, lower fees than they wanted, in exchange for being given the right to incorporate. That view is being widely dismissed because it presumes that federal tax policy should be used to make up for provincial lack of funds. The successful opposition will emerge only when it becomes clear that, in essence, the finance minister has declared war on the middle class.

The May 1985 budget delivered by Michael Wilson contained a provision related to the federal government’s attempt to end the country’s “inflation is inevitable” mentality. In order to ensure that every citizen had a stake in maintaining price stability, it was proposed that Old Age Security cheques continue to be adjusted for inflation only after the first 3 percent increase in the price level, which would be absorbed by pensioners. A 63-year-old Ottawa resident named Solange Denis confronted Prime Minister Brian Mulroney as he emerged from his car on Parliament Hill one morning and shouted, “Touche pas à nos pensions, ou c’est Goodbye, Charlie Brown.” The measure was dropped soon after. What this discussion paper needs is a Solange Denis moment, when some affected citizen, in a poignant, personal way, captures what is wrong with statistical assumptions about where the middle class begins and ends. Such assumptions, based on theories about taxing every dollar the same way, undermine thoughtful tax policy.

Photo: Minister of Finance Bill Morneau stands during question period in the house of commons on Parliament Hill in Ottawa on Thursday, Sept. 21, 2017. THE CANADIAN PRESS/Sean Kilpatrick.

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Stanley Hartt
Stanley Hartt is a strategic counsellor at Norton Rose Fulbright. He has decades of leadership experience in business, law and public policy, which include serving as deputy minister in the Department of Finance from 1985 to 1988 and chief of staff for Brian Mulroney from 1989 to 1990.

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