Bill Morneau faces a backlash about tax breaks, not hurt feelings

The unrelenting uproar over the federal government’s proposed small-business tax reforms has gotten so complicated that it might be helpful to try setting aside some of the less worrisome parts before diving into what matters.

Maybe hurt feelings, for instance, don’t need to be a prime concern. I’m referring to the idea that sensitive small-business owners are wounded, just terribly insulted, by loose Liberal talk about closing some tax loopholes. The entrepreneurs I know would take greater offence if anyone dared hint that they had failed to clue in on any and all legal ways of minimizing their tax bills.

This clash isn’t over affronted dignity; it’s about bottom lines. Yet I detect a spreading tendency to conclude that the outcry from professionals, entrepreneurs and farmers has been sustained so long now, at such a sorely aggrieved pitch, that this in itself proves Finance Minister Bill Morneau has blown it.

READ: Inside Ottawa’s crackdown on small business tax loopholes

But is it possible to imagine any reform meant to end a tax advantage that wouldn’t incite impressive howls of protest? The decibel level of the objections is no guide to the policy’s fairness or unfairness. For that, you’d need to figure out what Morneau is up to, not just observe how he’s being drowned out in question period and town hall meetings.

By now his three aims have been widely reported on. He wants to stop small businesses owners from splitting income with family members who neither invested in the company nor work in it. He wants to make it harder for firms to turn what’s really income into lower-taxed capital gains. And he wants to boost the tax on income small firms earn from investing “passively,” in stuff like stocks and bonds.

None of these pops out as a transparent injustice. On so-called “income sprinkling,” it’s hard to justify letting, say, a doctor split income with a spouse or kid who doesn’t have much to do with the practice, just so a chunk of income can be taxed in a lower bracket. Any genuine debate on this point isn’t over principle, but enforcement, like setting out what’s a reasonable split when family members really do contribute.

The debate around income being converted to capital gains is densely technical. But the hottest element here is the way farmers, passing their spreads on to children, often do what’s called “surplus stripping.” At the point when ownership is transferred, the retiring farmer pockets income from the farm as a capital gain. Morneau admits that no longer allowing this would make intergenerational transfers of farms less attractive, and he’s promised to adjust the policy accordingly.

That leaves passive income, arguably the most fiercely opposed of Morneau’s three measures, and the one on which his policy proposal is least fully developed. Pierre Poilievre, the tenacious Conservative finance critic, has made a splash by saying the Liberals want to tax this narrow slice of small-business income at up to—gulp—73 per cent.

READ: Bill Morneau shows a flash of temper in the small-business tax battle

Which does sound excessive, and the government hasn’t disputed Poilievre’s arithmetic. Instead, Morneau accuses his nemesis of “trying to move people’s attention away from the issue at hand” by concocting a big but misleading number. That’s not quite the same, however, as explaining what the 73 per cent figure is all about. And it needs explaining.

I went looking for a patient guide, and was advised to call Prof. David Duff, of the University of British Columbia’s Peter A. Allard School of Law, who is the primary author of the 2015 page-turner The Taxation of Business Organizations in Canada. What, haven’t read it? Me neither. But students of tax law do. Duff agreed to walk me through what Morneau and Poilievre are fighting about.

Here’s what I took away. A Canadian Controlled Private Corporation (CCPC)—it might be a doctor’s practice, or a farm, or a restaurant—pays about 15 per cent tax on profits from its main business line. But when that CCPC reinvests any surplus in, say, mutual funds or bonds, the passive income from those investments is taxed at a rate of about 50 per cent.

Often a CCPC owner is relying on those passive investments as retirement savings, much the way a Canadian earning a salary might use a Registered Retirement Savings Plan. Like withdrawals from an RRSP, dividends paid to the CCPC’s owners, typically after they’ve retired, are taxed as personal income.

Here, though, it gets a little tricky. Roughly 30 per cent of that tax the CCPC paid up front on passive income is refunded when the dividends are distributed. That brings the effective tax rate on the income down to about 20 per cent. And, finally, the individual shareholder pays his or her marginal tax rate on the dividend income.

This sort of multi-stage calculation is why accountants do well off small-business clients. But the policy issue boils down to this: CCPC owners can defer paying taxes on far more income, passively invested by their small businesses, than the upper limit of about $26,000 a year in RRSP contributions allowed for salary-earning taxpayers.

So, if a CCPC is making enough income to begin with—for example, the hundreds of thousands raked in by specialist doctors—its owner can defer paying tax on far more savings than could be sheltered in an RRSP, and also enjoy more flexibility on how to invest that money and when to withdraw it.

And that is the small-business tax edge Morneau wants to erase. His department has floated a couple of possible fixes. An up-front tax on CCPC income that’s not reinvested in active business operations is one option, although it hasn’t attracted much attention. The more widely debated alternative is eliminating that 30 per cent refund, now paid when those CCPC dividends are distributed.

Morneau stresses that income from a CCPC’s active business would still be subject only to the roughly 15-per-cent small-business rate. The change would be eliminating the dividend refund that comes later, which could bump the effective tax rate on passive income, in cases of high income earners, to the 70-per-cent-plus level Poilievre talks about. It sounds awfully steep, but that’s the point—to discourage a small minority of well-to-do CCPC owners from deferring a whole lot of tax that way.

Duff said upping the tax hit when dividends are distributed strikes him as “difficult to explain and unduly complex for most small businesses.” Still, he agrees with Morneau’s underlying objective. “I share the government’s concern about the deferral advantage,” Duff said. “But I think that the up-front tax approach is easier to understand and simpler to administer.”

There’s another dimension to this argument. Poilievre says that under Morneau’s proposal, public corporations, the sort traded on stock markets, would end up paying less tax than private corporations on passive income. Duff doesn’t see that as a valid comparison. “The additional tax on passive income of a CCPC reflects the fact that these corporations, unlike public corporations, can be readily used as vehicles for personal savings,” he said.

Nobody is so authoritative that they automatically deserve the final word in this argument. Still, several leading tax experts I’ve interviewed—including Duff—don’t see Morneau’s project as deeply misguided. Their complaints are narrower. A top tax lawyer with a big firm said Morneau’s consultation period was too short and his proposals too precise to invite a free-flowing discussion about other approaches.

A professor of tax law who likes Morneau’s thrust overall said the government must still clarify its reasonableness test for when “income sprinkling” would be allowed. Another said the government needs to devise a more flexible way for a CCPC owner to set aside money that might be used for either long-term personal savings or reinvested in the business.

These are sensible criticisms, but fall far short of explaining all the commotion. If it’s a matter of getting the details right, you’d expect a dull debate among well-paid specialists, not the deluge of denunciations raining down on Morneau. The real reason that’s happening seems to have less to do with the policy he’s put on the table than the money that was already there.