Will a minority government revisit small business taxation?

Private corporation taxation: “surplus stripping”

Some tax experts expect the Liberals to address certain tax-planning opportunities involving private corporations that they were unable to tackle two years ago.

“I think you’ll see a second wave of attack on small businesses,” says Peter Weissman, a partner at Cadesky Tax in Toronto.

The Liberals did not mention small business taxation in their election campaign platform; however, the issue was a major part of their agenda during the past four years.

In July 2017, the Liberals proposed significant changes to the taxation of small businesses, focusing on income splitting, passive investment income, and the conversion of retained earnings held in a private corporation from dividends to capital gains — a strategy sometimes referred to as “surplus stripping.” These tax-planning opportunities provided small business owners with unfair tax advantages, the government argued.

Facing significant pushback from business owners and entrepreneurs, the Liberals backtracked on several proposals over the following months, but ultimately introduced limits to income splitting using private corporations. They also restricted access to the small business tax rate when annual passive investment income exceeded $50,000. However, the Liberals completely abandoned their attempt to address the conversion of dividends to capital gains.

Several tax experts say the Liberals may try to shut down surplus stripping again, this time in a targeted way so as not to affect legitimate business transfers from one generation to another, which had been an issue with the initial proposals.

“I suspect with a new mandate, and particularly if the Liberals end up working with the New Democratic Party or the Greens, who would be in favour of something like this, that strategy would likely be shut down,” says Jason Nicola, a financial advisor with Nicola Wealth in Vancouver, who adds that it’s possible that the government could address surplus stripping within the next six months.

Says Michelle Connolly, director of tax and estate planning at Sun Life Financial in Toronto: “I think in terms of the intent of such [surplus-stripping] planning, the Liberals would get buy in from the NDP, who would agree with them on that.”

Business owners may want to discuss the strategy with their advisors while they still can.

“There are professionals and business owners who may want to look at some of these strategies with their advisors to see if it’s right for them,” says Prashant Patel, vice president, high net-worth planning at RBC Wealth Management, who says there’s been more activity in taking advantage of these strategies since the government introduced their proposals two years ago. “Typically, if there’s a change in the legislation, it’s effective that date and going forward, as opposed to retroactive.”

One tax expert, however, suggests the Liberals will shy away from addressing small business taxation once again, having faced significant opposition the first time.

“[It was] a pretty long process,” says Curtis Davis, senior consultant, tax, retirement and estate planning services, retail markets at Manulife Investment Management in Toronto. “There was a lot of pushback from the business and tax community, so I think the Liberals will probably focus elsewhere.”

Capital gains inclusion rate

The Liberals did not address the capital gains rate in their election platform, but this is another area tax experts will be watching closely, particularly with a minority government in power.

“We kind of hold our breath every federal budget in terms of the capital gains inclusion rate,” Patel says. “It has been talked about quite a bit in the [tax] community the past number of years.”

Currently, only 50% of eligible capital gains is subject to tax. During the campaign, the NDP indicated it would raise the capital gains inclusion rate to 75% if were to form government. The Green Party wanted to raise the inclusion rate to 100%.

“A Liberal-NDP coalition would certainly do nothing to stop the speculation on raising the capital gains inclusion rate, because the NDP have specifically said they would [raise it],” Davis says.

Nicola says that depending on who the Liberals partner with, raising the inclusion rate “could very much be on the table for the upcoming budget.”

Doug Carroll, practice lead for tax, estate and financial planning at Meridian Credit Union in Toronto, says he doubts the Liberals would touch the capital gains rate because they would risk “becoming an opposition party the next time around if they did that without having [a capital gains inclusion rate increase] as part of their platform coming in.”

Connolly says raising the capital gains inclusion rate would be a blow to Canadians trying to save for retirement, particularly in an age when fewer people have access to workplace pensions. “There would be a revolt,” she says.

However, it is conceivable that a Liberal minority government, in coalition with an opposition party, could propose limiting access to the current preferential capital gains inclusion rate to those earning below a certain threshold of income, she says.

“If they do go after the capital gains rate, I don’t think it’ll be straight across the board,” Connolly says. “I think they’re going to distinguish by marginal tax brackets.”

However, if the Liberals do go ahead with a variety of promised spending programs, they may be looking for new sources of tax revenue.

“The revenue that would be realized from shutting down surplus stripping would be peanuts compared to if [the Liberals] were to change the capital gains inclusion rate that was applied to everybody,” Nicola says.

Personal exemption credit increase and income splitting

The Liberals’ election platform promised to increase the federal personal tax credit by about $2,000 to $15,000 over the next four years, a move applauded by tax experts.

“It’s a good thing, generally, in terms of tax policy, to have a large basic credit available across the whole population, so people do have that ability to get themselves going,” Carroll says.

However, the increased portion of the personal tax exemption would be clawed back starting at about $147,000 and gone entirely at more than about $210,000 of income.

The increasing of the personal exemption credit raises the opportunity for high-earning individuals to benefit even more from income-splitting opportunities, such as using a prescribed rate loan strategy with low-income family members, Nicola says — particularly “when we’re paying such high tax rates in corporations and personally.”

The Liberals’ promised change to the personal exemption amount would only apply to the federal personal tax credit, not on personal amounts at the provincial level, Patel notes.