Passive Income: Historical and Legislative Context …. 25...Passive Income: Historical and Legislative Context and Comments 2 2017 Taxation of Private Corporation Policy Conference

Disclaimer:

This material is for educational purposes only and is not intended to be

advice on any particular matter. No one should act on the basis of any

matter contained in these materials without considering appropriate

professional advice. The presenters expressly disclaim all liability in respect

of anything done or omitted to be done wholly or partly in reliance upon the

contents of these materials.

Tax Planning Using Private Corporations -

July 18, 2017:

Analysis and Discussion with FinanceOttawa, ON

Speaker name: David G. Duff Affiliation: Allard School of Law, University of British Columbia

Passive Income: Historical and Legislative Context and Comments

2 2017 Taxation of Private Corporation Policy Conference

Background to Proposals

● long-term reductions in corporate rates (general and small business) and

recent increases in personal rates – incentive to earn and retain income in a

corporation (both for business and non-business purposes)

● lower tax on capital gains than dividends with LCGE and 50% inclusion rate

– incentive for surplus stripping

● individual unit and progressive rates – incentive for income-splitting and

multiplication of LCGE, facilitated by SCC decision in Neuman (1998),

limited scope of TOSI in section 120.4, and provincial regulatory changes



Is there a problem?

● 50% growth in CCPCs from 2001 to 2014

● substantial increase in ABI of CCPCs as a share of GDP and decrease in

self-employment income as a share of GDP

● revenue losses, efficiency/neutrality concerns, and implications for tax

fairness (horizontal and vertical equity)

● are all these tax benefits necessary to encourage small businesses?



Possible Structural Reforms

● reduce personal rates, increase corporate rates, adopt a single corporate rate,

and/or adopt a dual rate income tax with higher and progressive rates on labour

income and a lower flat rate on capital income

● repeal LCGE and increase capital gains inclusion rate to restore symmetry between

effective tax rate on capital gains and dividends

● flatten rates and/or adopt a spousal or familial unit either generally or for specific

tax benefits like the LCGE



Alternatives to Structural Reforms

● rules denying low corporate rates (and LCGE) to specific categories of taxpayers,

to income other than active business income (passive income), and/or to income

used to acquire assets not used in an active business (passive investments)

● anti-avoidance rules to prevent surplus stripping

● attribution and other rules (like the TOSI) to regulate income-splitting and

multiplication of LCGE



Rules Excluding Specific Kinds of Taxpayers

● personal services businesses (incorporated employees) excluded from SBD after

November 12, 1981

● > 5 FTE exception (arm’s length until 1984)

● additional 5% federal tax applicable after 2015 (so 33%)

● non-qualifying businesses (professional practices of accountants, dentists, lawyers,

doctors, veterinarians, chiropractors and certain services businesses) excluded

from SBD from 1979 to 1984

● Quebec approach limits SBD to primary and manufacturing businesses or

businesses with a minimum number of employees (at least 5,500 hours)



Higher Rates on Passive Income

● portfolio dividends received by private or subject corporations – refundable Part IV

tax (similar to effective tax rate on non-eligible dividends)

● investment income of a CCPC – not eligible for SBD, additional tax under section

123.3, partly refunded (but not fully integrated)

● includes income from property, income from a specified investment business [> 5 FTE

exception], and net taxable capital gains

● excludes income from property incident or pertaining to an active business or used or

held principally for the purpose of gaining or producing income from an active business

● cases generally recognize reasonable reserves for business purposes but not passive

investments for later investment in active business



Higher Rates on Income Used to Acquire Passive Investments

● refundable tax on ineligible investments – enacted in 1972 and retroactively

repealed in 1973

not “actively” considered by the Government “at the present time” due to liquidity

issues

● alternative approach: deferred taxation with no dividend refund for tax on

investment income, and tax on dividends (including dividends from the non-

taxable portion of capital gains) based on the source of the capital used to

acquire passive investments (apportionment or elective methods)

consultation on “any aspect” of possible rule to tax corporate passive income



Comments on Passive Income Proposals (1)

● deferral advantage from passive investment of retained corporate income is a

legitimate concern, particularly for high-income earners who have already maxed

out on tax-favoured savings vehicles

● deferred taxation is conceptually ingenious but not intuitively obvious and extremely

complex (particularly for CCPCs)

● refundable tax on ineligible investments is more easily understood, much less

complex, and more clearly consistent with the core purpose of the SBD to help

CCPCs grow through internal finance



Comments on Passive Income Proposals (2)

● tax on ineligible investments puts pressure on distinction between passive

investments for business purposes and passive investments for personal

wealth accumulation

passive investment to finance later expansion?

passive investment to finance parental leave?

passive investment with mixed purposes (retirement and business

emergencies)?

● consider combining a tax on ineligible investments with safe harbours or a

threshold, which might also help address liquidity issues


Disclaimer:




professional advice. The presenters expressly disclaim all liability in

respect of anything done or omitted to be done wholly or partly in

reliance upon the contents of these materials.


July 18, 2017:


Speaker name: Kevin Milligan Affiliation: Vancouver School of EconomicsUniversity of British Columbia

[email protected]

Integration and the Taxation of Passive Income: An Economic Perspective


Carter Commission V.4, p. 84

“The system would neither encourage nor

discourage the retention of earnings by

corporations.”

Integration and Passive Income: An Economic Perspective


Roadmap

• Why integration?

• Do proposals improve integration?

• How much will the changes affect businesses?

• Caveats on Implementation.



What is Integration?

● Tax at individual level should reflect tax paid at corporate level.

● Or, all paths for a $ from “profit to pocket” should bear same tax.

● Also, no financial gain from readjusting location of savings.

“The system would neither encourage nor discourage the retention of earnings

by corporations.”



Why Integration?

● Neutrality: Target is for people to make same decisions under taxation as

they would without taxation.

This is a free-market goal: business decisions based on the business merits.

This is the literal definition of economic efficiency for taxation.



Why Integration?




● Retirement savings? Maternity leaves? ‘Buffer’ savings? Saving for

investment?

These are all fine, but inside/outside firm should be a business decision.



Why Integration?




● Retirement savings? Maternity leaves? ‘Buffer’ savings? Saving for

investment?

These are all fine, but inside/outside firm should be a business decision.

● Reminder: the reason we have SBD is to facilitate investment.

Not as a place to tax-advantage savings for those with large portfolios.



Ways Current Integration Falls Short

● It’s notional: still get DTC when firm pays no tax.

Can do direct passthrough of tax bills, e.g. Taiwan; ‘franking’ in Australia

● Fed-Prov: one national gross-up rate for whole country.

● Tax-exempts like pension funds / RRSPs can’t claim DTC.

● Capital gains rate is currently too low compared to dividends/wages.

● Firms claiming SBD have ‘head-start’ deferral advantage for saving.



Does Proposal Improve Integration?

● Focus on high bracket: why?

Flat rate on passive income calibrated for high-bracket investors.

High-bracket investors more likely to have substantial passive portfolios.

● Low-mid bracket investors

Currently disadvantaged for passive saving in CCPC. This shortcoming not

addressed.

More likely to have open RRSP/TFSA room for long-term savings.




● Current system is over-integrated: favours retained earnings inside firm.

Current tax of passive income inside/outside firm is comparable…but…

But savings inside the firm get a ‘head start’ from light taxation of SBD.

● Proposed correction: remove RDTOH.

Increases tax on passive income to compensate for ‘head start’.

For a high-bracket Ontario investor, effective rate on passive income is 73%.

Excessive? Need higher rate to balance big ‘head start’ to achieve integration.




Evidence #1: Try to replicate Finance Table 7


STATUS QUO

STATUS

QUO PROPOSAL

INDIVIDUAL INSIDE CCPC

INSIDE

CCPC

ITEM RATE SAVINGS SAVINGS SAVINGS

Start with $100 of pre-corp tax active businss income 100.00 100.00 100.00

Federal SBD tax rate 10.50% 10.50 10.50 10.50

Ontario SBD tax rate 4.50% 4.50 4.50 4.50

Starting Principal 46.50 85.00 85.00

Interest at 3% 3.00% 27.29 27.29

Special tax on passive income 50.17% 13.69 13.69

RDTOH account 30.67% 8.37

Federal personal tax 33.00%

ONT personal Tax 20.53% 7.00

Portfolio value at end of 10 years 53.41 98.60 98.60

Refund of pre-paid tax RDTOH 8.37

Amount available for distribution as dividend 106.97 98.60

Taxable personal income after grossup 17.00% 125.15 115.36

Federal personal tax 33.00% 41.30 38.07

ONT personal tax 20.53% 25.69 23.68

Dividend tax credit, federal 10.52% 13.17 12.14

Dividend tax credit, ONT 4.30% 5.38 4.96

After-Tax Net Worth after 10 years 53.41 58.52 53.94



Evidence #2: Observation

● If system is currently properly integrated, there should be no advantage to

retaining earnings.

● We observe financial planners advising clients to save in CCPC for tax

savings.

http://lmgtfy.com/?q=doctors+canada+incorporation+deferral+advantage

● If system were today properly integrated, all that advice would be wrong…


http://lmgtfy.com/?q=doctors+canada+incorporation+deferral+advantage


How much will proposals matter?

● We need to keep the scale of the change in mind.

● Imagine $100,000 in passive portfolio; 5% interest.

RDTOH is 30.67%, or $1,534.

But this is taxed as non-eligible dividend at 45.30% (Ont, high bracket)

So, RDTOH is worth $838 if paid immediately.

This is <1% of principal, but knocks down rate of return.

After 10 years, could affect terminal value of portfolio by 8-15%.




● Target savings: $33,333/yr of retained earnings over 3 years @ 5% interest.

Maternity leave? Savings for new equipment?


STATUS QUO STATUS QUO PROPOSAL

PERSONAL INSIDE CCPC INSIDE CCPC

ITEM TAXABLE

Balance in RDTOH notional account at

end of Year 3 $3,118 $0

Balance in CCPC retained earnings at end

of Year 3 $0 $105,067 $105,067

No change to cash flow.

$3,118 in RDTOH notional account



● Terminal value of these savings once personal tax is paid.


PERSONAL INSIDE CCPC INSIDE CCPC

ITEM TAXABLE

Balance in RDTOH notional account at

end of Year 3 $3,118 $0

Balance in CCPC retained earnings at end

of Year 3 $0 $105,067 $105,067

Balance on personal account at end of

Year 3 $58,370 $59,189 $57,483

Status quo: CCPC beats personal by $819.

Proposal: Personal beats CCPC by $887.


Carter Commission V.4, p. 84

“The system would neither encourage nor

discourage the retention of earnings by

corporations.”



Caveats on Implementation

● Lots of important challenges await…

Transition: how the grandfathering will work.

Intercompany shareholdings; investments.

We will hear more today!

● This is serious: Need to weigh the costs and benefits of proposals.

Finance’s response: are there non-messy fixes?



Final thought

● This package is clearly a ‘patch’ on a messy system.

● Should we wait for Carter 2.0 before acting?

If we can’t have it all, should we do anything?

● I argue: no

We can all play “fantasy tax reform”….

We must also ask: does this improve on status quo?


Disclaimer:




professional advice. The presenters expressly disclaim all liability in respect

of anything done or omitted to be done wholly or partly in reliance upon the

contents of these materials.


July 18, 2017:


Jack MintzThe School of Pubiic PolicyUniversity of Calgary

Tax Planning Using Private Corporations: Passive Income


● Economic role of passive assets:

Retained earnings held in passive assets provides liquidity.

Provides equity finance for investment – investment has been shown to be

higher if firms have cash flow.

Internal resources enable better firms to separate themselves from poor quality

firms to raise equity and debt finance.

Passive assets improve credit risk.

Passive asset provides savings within the corporation for investors when

withdrawn (this is the focus of the July 18th proposals).

Passive Income Rules


Benefits of July 18th Passive Income Rules

● Intent is to improve integration of corporate and personal taxes by clawing

back deferral if active business income is invested in passive assets.

● Reduces (but does not achieve fully) neutrality between savings held inside

and outside the CCPCs by investors.

● Reduces the incentive to create CCPCs rather than sole proprietorships or

partnerships (no particular evidence provided on the size of the distortion –

U.S. studies (e.g. Austin Goolsbie suggest not large).

● Raises more revenue for government to lock-in high personal income tax

rates levied in 2015. About $23 billion of passive income is roughly 16% of

active business income (total industry passive income is 10% of operating

income).



Distortions/Complexity created by Passive Income Rules

1. Given limitations on full refundability of losses – self-employed losses can

be generally used against other personal income while losses trapped in a

company – rules lead to higher taxes on corporate risky investment.

2. Limits deferral with passive assets – creates a bias towards deferral

achieved through real assets, which could lead to sub-marginal

investments.

3. Indifference works for investors at the top rate – tax neutrality does not

approximate for CCPC owners with marginal tax rates below the top rate.

4. Passive assets for business purposes, as opposed to savings, would need

some sort of brightline test but difficult to properly do (eg. private equity

investments by venture capitalists).



Distortions/Complexity created by Passive Income Rules

5. Tax on passive income already results in a significant loss in real principal

with non-tax sheltered assets. (Bond paying 3 percent with 2 percent

inflation and 50% tax rate as real return of -0.5%).

6. Private companies becoming public or non-CCPC could avoid passive

income rules – leads to a new distortion with respect to ownership.

7. Rules are exceedingly complex especially with allocation method.

8. Few countries follow Canadian rules – potential loss in tax competitiveness

especially relative to the United States.



Canada’s Tax on Small Business not Competitive


0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

$1M $2M $3M $4M $5M $6M $7M $8M $9M $10M $11M $12M $13M $14M $15M $16M $38M $39M $40M

Marg

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ffecti

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ax R

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Size of Capital (CAD$ Million)

Canada Small Business Entrepreneur USA Entrepreneur (S Corporation) USA Entrepreneur (Small Business)


A Better Approach

● To reduce distortions and complexity as well as encourage growth:

Consider an election to pass income of corporation to owner (egU.S. sub-chapter S

corporations)

Removes the distinction between passive and active business income.

Reduces distinction between self-employed income and private corporate income.

Treats losses similarly to self-employed income and therefore risk.

Would eliminate benefit (if any left) of small business deduction. IIntroduce

investment and employment tax credits instead to encourage investment.

Given small business deduction is of little value with integration, move to single

corporate income tax rate and dividend tax credit. Equalize capital gains and dividend

tax rates.


Documents

Passive Income: Historical and Legislative Context …. 25...Passive Income: Historical and Legislative Context and Comments 2 2017 Taxation of Private Corporation Policy Conference