- Charles Rotenberg
Submissions to Department of Finance
TO ALL MEMBERS OF THE HOUSE OF COMMONS AND THE SENATE:
Ladies and Gentlemen,
As the “consultation” period set by Mr. Morneau expires on Monday, October 2nd, I am taking a further opportunity to write to you all, and to the Department of Finance consultation office, to discuss these proposals. I will apologize in advance for the length of this letter.
The proposals are, with respect, badly conceived and poorly drafted. In addition to significant increases in taxes, for all small businesses, not just for those earning in excess of $150,000, they will add untold complexity to an already overly-complex tax system. They will lead to years of costly tax litigation which could tie up the appeals process for, without exaggeration, ten years.
Many submissions have been made to date, and many more will be made to the Senate National Finance Committee. Some focus on the errors in the fundamental assumptions underlying the proposals, and some focus on the numerous inaccuracies contained in the figures put forward by the Minister of Finance.
I do not propose to discuss either of those matters. I will leave that to colleagues who are much more capable than I.
I would like to concentrate on only certain issues:
The negative perception generated by these proposals
The lack of a true consultation and the implementation of the proposed changes
The ownership of shares in family trusts,
The election to trigger The Lifetime Capital Gains Exemption (LCGE), including the Farm Capital Gains Exemption, and
The “conversion of ordinary income into capital gains
I would also like to speak to the ability of our system to administer the new rules and what these rules will mean for taxpayer, the Canada Revenue Agency, and the Courts.
A main tenet of the proposals is the belief that small businesses are using, or abusing, the current rules and splitting, or sprinkling, income among family members. This position also speaks to the ability of family members to share in the capital gains exemption upon the sale of the business or farm.
Assuming that I accept that this is a problem, and, again, there have been, and will be, many submissions that speak to this, the manner in which the rule changes are drafted and will be implemented pose significant unintended problems.
Mr. Morneau has consistently referred to many provisions that are being utilized by taxpayers are “unintended” and has labelled them as “loopholes”. The term “loophole” has extremely negative implications and suggests some manner of wrongdoing. A loophole is actually a provision that yields an unintended tax consequence. The fact that many of the provisions he wishes to change have been in place since Prime Minister Trudeau (Sr.) implemented tax reform in 1972, suggests that these provisions are not unintended. Many of these provisions have operated for more than 40 years, exactly as designed.
When the Ontario Liberal Minister of Finance, in his 2005 Budget Speech specifically stated,
Recent negotiations with the Ontario Medical Association have resulted in the government’s commitment to extend the share structure of physician professional corporations to include non-voting shares for family members. The government is also proposing to implement this change for dentists who operate their practices through a professional corporation.
The primary reason to include family members as shareholders, is the payment of dividends. In view of the above statement, it is disingenuous for another, albeit Federal, Liberal Finance Minister to suggest that this yields an unintended result.
Small business people are feeling, rightly or wrongly, like they are being labelled as tax cheats, and they are truly resentful of the Prime Minister and Finance Minister labeling them as such.
We all know that perception is often more important that reality, so a simple denial that this is the intent is completely ineffectual.
These are the most significant tax changes in 45 years. When Prime Minister Pierre Trudeau implemented tax reform, the Carter Commission, an independent Royal Commission, had spent 6 or more years analyzing the tax system and preparing its report. It then took 2 additional years to implement the changes.
The Government of Prime Minister Justin Trudeau has set aside 75 days for “consultation” much of it being during a period when Parliament wasn’t sitting.
Messrs. Trudeau and Morneau continually say that they are not changing their position – that hardly sounds like consultation.
Tax changes such as these have never been undertaken without true consultation with the public and the tax community. If they are so sure about their position, they should not be afraid of a true period of consultation. You have all seen the overwhelming opposition coming from the tax community. This opposition comes from a true understanding of the tax system and the realization that the proposals are inequitable, badly drafted and unworkable.
There is no doubt that we are probably due for major tax reform, but it cannot be done piecemeal. We need an independent Advisory Group, if not a full blown Royal Commission, to review the entire tax system and to bring about true tax reform.
The one thing that all, except Messrs. Trudeau and Morneau, apparently agree on, is that there should not be such a rush to implement these changes. Let’s take the time to do it right.
Along with the consultation period, there is a significant problem with the implementation date. Certain changes are stated to take effect as of July 18th, 2017. These will actually have potential retroactive effect in respect of transactions that have already been completed.
Other changes are designed to take effect effective January 1st, 2018. Unfortunately, there is a complete dearth of detail in the draft legislation as to how these rules will be brought into effect only on a “going forward” basis.
Taxpayers have arranged their affairs based upon a series of rules that have been consistently applied for many years. Expecting them to reorganize their affairs in time for a January 1st, 2018 implementation date is extremely unfair and unrealistic. One practitioner with whom I correspond has estimated that a proper reorganization could easily cost a taxpayer $10,000 - $15,000 in professional fees. This is not an exaggerated estimate.
It is, however, unrealistic to expect taxpayers to be able to effect the necessary changes by the end of the year. Recognize that most small businesses cannot afford to pay for the cost of such a reorganization until the provisions have been passed into law. If a reorganization is undertaken and the rules are then changed before passage, the reorganization would not only be an expensive exercise, but potentially a damaging one.
To understand the problem, it is necessary to understand Trust Taxation 101. As the rules currently operate, when a trust earns income either the trust pays the tax or the trust allocates the income to one or more beneficiaries who then include it in their income and pay tax at their tax rates. Because a trust pays tax at the top personal tax rates, this allocation to beneficiaries is the norm.
A number of years ago the trust rules were changed. Now, only certain types of income retain their tax characteristics when flowed through the trust. Accordingly, a dividend received by a trust is still treated as a dividend when allocated to a beneficiary. Similarly, a capital gain retains it characteristics.
If a capital gain is realized by a family trust in respect of Small Business Corporation Shares or farm properties, and the gain then allocated to beneficiaries, each beneficiary declares the capital gain, and he or she may or may not qualify for the LCGE. A capital gain may qualify for one beneficiary but not for another, for a number of different reasons, which are beyond the scope of this letter.
If the object is to disallow the LCGE to “non-active” shareholders, the current rules do that effectively. If a taxpayer does not qualify for the LCGE, either under the existing rules, or because they are considered to be “non-active”, then they would pay the normal tax in respect of the capital gain and not get the benefit of the LCGE. The rules are already structured this way – if it ain’t broke, don’t fix it.
To disallow the LCGE for any period of ownership by a trust assumes that a trust is, somehow, a “tax dodge”. This is completely inaccurate and yields poor results in many circumstances.
Assume a father who owns a business wants his daughter to take over the business. She is currently operating and managing the business. Unfortunately, for many years his daughter struggled with the disease of addiction. I can say definitely that there isn’t one member of the House or Senate who doesn’t know a family dealing with this problem.
For the security of the daughter and the family business, it makes perfect sense for the shares to be held in a trust until the daughter has enjoyed a long period of recovery. Relapse is always a problem.
The proposed rules penalize this family because the ownership of the shares by the trust will not qualify for the LCGE. For what reason? Is it preferable to transfer the shares to a child who may be at risk just to ensure the availability of the LCGE?
Shares are held in trusts to protect them from creditors, to protect them in the event of marriage breakdown and for any number of business succession purposes that, frankly, are not tax driven.
The existing rules do not need to be changed; businesses do not have to spend tens of thousands of dollars to reorganize their holdings, often at the risk of the business itself, to gain the some hidden tax objective. And frankly, I am not clear on what the objective might be.
Election to trigger the LCGE and the Farm Capital Gains Exemption (FCGE)
Mr. Morneau has proposed that, in 2018, family members who might be caught in the new rules that would disallow their ability to claim the LCGE or the FCGE will be entitled to make a one time election to trigger capital gains and claim their current available exempt gain.
This sounds like a reasonable offer, but it is one that will not be able to be accepted by the vast majority of taxpayers.
Let’s assume a small business family or farm family with only one member “qualifying” to claim the LCGE or FCGE under the new rules. The other family members have the right to make the election in 2018.
BUT, we have an Alternative Minimum Tax (AMT) that provides a separate tax calculation, adding back certain types of preferential income. If the AMT is higher than the ordinary tax, the AMT is paid. Over the next 7 years, the AMT amount can be recovered as an offset against regular tax.
Let’s assume that there is a family member making a salary of $50,000 per year who, in 2018, elects to trigger either the LCGE, in respect of small business shares (currently $835,716) or the FCGE ($1,000,000). Although the gain is, arguably, exempt, the AMT will be payable. In Ontario, the AMT for the LCGE would be approximately $46,000 and for the FCGE the AMT would be approximately $57,000. The AMT would be payable by the seemingly exempt taxpayer when filing his or 2018 tax return.
If the election is for the FCGE, the taxpayer CAN NOT recover the full AMT over the 7 year carry forward.
Where is a small business or family farm expected to come up with the money to pay the AMT for EACH family member?
The AMT will prevent many, of not most, non-active family members from making the election.
There is a better way.
Capital gains first became taxable in Canada as of January 1st, 1972. In respect of property owned at that time, a Valuation Day was set and property was valued. If a property is sold some time after 1972, only the gain that has accrued after Valuation Day is taxable.
There is no reason that a new valuation day could not be established at December 31st, 2017. When the shares or the farm property are subsequently sold, for those “non-qualifying” family members, only the gain accrued up to December 31st, 2017 would qualify for the exemption.
Again, if the purpose of the provision is to ensure that non-active family members should not be entitled to the LCGE or the FCGE going forward, a valuation day approach would satisfy that purpose.
The cynics among us might suggest that the purpose is either a large tax grab in the form of payment of AMT or merely providing the optics of an effective tax election. Unfortunately, the rules as drafted support this latter view.
Conversion of ordinary income into capital gains
On the face of it, if taxpayers are truly converting income into capital gains, which are then taxed at a lower rate, this is not an unreasonable idea.
Unfortunately, the changes to Sections 84.1 go well beyond that.
On death, a taxpayer is treated as selling all of his or her property at fair market value, and tax is payable in respect of any accrued gain.
Currently, a tax structure known as a “pipeline” is often used in this situation. The pipeline structure allows the estate beneficiaries to withdraw the TAX PAID amount without an additional level of tax. Keep in mind that tax has already been paid on the accrued gains.
The changes proposed for Section 84.1 will prevent the estate beneficiaries from withdrawing this tax paid amount and will require them to take this amount as a taxable dividend. THIS IS NOT PREVENTING A SLY TAX MOVE, THIS IS IMPOSING DOUBLE, AND IN SOME CASES, TRIPLE TAXATION.
There are numerous examples, which I would be happy to share, that show that the changes to Section 84.1 can have the effect of raising the total tax, between the deceased and the estate beneficiaries to an unbelievable 93%. Canada abolished its Estate Tax in 1972. The U.S. is proposing to abolish its Estate Tax. Should we be imposing a new estate tax of 93%?
The other impact of Section 84.1 is to make it more expensive, by a large margin, for a taxpayer to sell his or her business to children. If one sells his or her shares, or interest in a family farm, to a third party, the LCGE or FCGE can be claimed. Because of the technical rules in Section 84.1, the LCGE or FCGE cannot be claimed if selling to a child. The cost of giving up the LCGE or FCGE will be in excess of $200,000 for small business shares and in excess of $250,000 for an interest in a family farm.
At a Canadian Tax Foundation symposium this week:
Rachel Gervais, a tax partner with BDO, suggested that the way to avoid the new rules is to not go into business with your children. Is this what our government wants to promote – avoiding going into business with one’s children?
Michael Wolfson, the university economist whose writings are behind many of the proposals said, "Why should there be any tax assistance for inter-generational transfer at all in the first place. If we are really serious about the equality of opportunity we'd say, well, let the kids start off all in the same starting point".
If we accept that proposition, then let’s provide equality of opportunity and not make it prohibitively more expensive to sell to one’s children than to an outside party.
Wolfson has also said that there may be better ways to produce food than through family farms!! Again, is this the message that the government wants to deliver?
Administration of Proposed Rules
Even the best tax system in the world must be capable of being managed. These proposals are completely unworkable.
Rather than overburden you more than necessary, I am linking this letter to my earlier letter to The Honourable Diane Lebouthillier, Minister of National Revenue. That letter sets out the implementation problems of these new rules, based upon my 40 years of tax practice.
At this time, when the U.S. is proposing lower corporate taxes, a much simpler system, the abolition of Alternative Minimum Tax and the abolition of Estate Taxes, if our taxes continue to rise and become more complicated, capital and business investment will begin a stampede to the border.
Having spent a significant portion of every day since July 18th reviewing and commenting on these proposals, I could continue for many more pages, but I won’t.
For those of you who will take the time to read my ramblings, I thank you.
I would be pleased to hear from anyone with questions or concerns about these proposals.
I hope that we will see a true consultation and consideration of our tax system as a whole. Perhaps the hearings by the Senate National Finance Committee will be the beginning of that process.
Yours very truly,
Charles M. Rotenberg