Passive Income: Historical and Legislative Context and Comments

Transcription

1 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Passive Income: Historical and Legislative Context and Comments 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. Speaker name: David G. Duff Affiliation: Allard School of Law, University of British Columbia

2 Passive Income: Historical and Legislative Context and Comments 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 Taxation of Private Corporation Policy Conference

3 Passive Income: Historical and Legislative Context and Comments 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? Taxation of Private Corporation Policy Conference

4 Possible Structural Reforms Passive Income: Historical and Legislative Context and Comments 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 Taxation of Private Corporation Policy Conference

5 Passive Income: Historical and Legislative Context and Comments 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 Taxation of Private Corporation Policy Conference

6 Passive Income: Historical and Legislative Context and Comments 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) Taxation of Private Corporation Policy Conference

7 Passive Income: Historical and Legislative Context and Comments 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 Taxation of Private Corporation Policy Conference

8 Passive Income: Historical and Legislative Context and Comments 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 nontaxable 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 Taxation of Private Corporation Policy Conference

9 Passive Income: Historical and Legislative Context and Comments 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 Taxation of Private Corporation Policy Conference

10 Passive Income: Historical and Legislative Context and Comments 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 Taxation of Private Corporation Policy Conference

11 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Integration and the Taxation of Passive Income: 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. Speaker name: Kevin Milligan Affiliation: Vancouver School of Economics University of British Columbia kevin.milligan@ubc.ca

12 Integration and Passive Income: Carter Commission V.4, p. 84 The system would neither encourage nor discourage the retention of earnings by corporations Taxation of Private Corporation Policy Conference

13 Integration and Passive Income: Roadmap Why integration? Do proposals improve integration? How much will the changes affect businesses? Caveats on Implementation Taxation of Private Corporation Policy Conference

14 What is Integration? Integration and Passive Income: 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 Taxation of Private Corporation Policy Conference

15 Integration and Passive Income: 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 Taxation of Private Corporation Policy Conference

16 Why Integration? Integration and Passive Income: 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. Retirement savings? Maternity leaves? Buffer savings? Saving for investment? These are all fine, but inside/outside firm should be a business decision Taxation of Private Corporation Policy Conference

17 Why Integration? Integration and Passive Income: 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. 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 Taxation of Private Corporation Policy Conference

18 Integration and Passive Income: 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 Taxation of Private Corporation Policy Conference

19 Does Proposal Improve Integration? Focus on high bracket: why? Integration and Passive Income: 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 Taxation of Private Corporation Policy Conference

20 Integration and Passive Income: Does Proposal Improve Integration? 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 Taxation of Private Corporation Policy Conference

21 Integration and Passive Income: Does Proposal Improve Integration? Evidence #1: Try to replicate Finance Table 7 STATUS QUO STATUS QUO PROPOSAL INSIDE INDIVIDUAL INSIDE CCPC CCPC ITEM RATE SAVINGS SAVINGS SAVINGS Start with $100 of pre-corp tax active businss income Federal SBD tax rate 10.50% Ontario SBD tax rate 4.50% Starting Principal Interest at 3% 3.00% Special tax on passive income 50.17% 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 Refund of pre-paid tax RDTOH 8.37 Amount available for distribution as dividend Taxable personal income after grossup 17.00% Federal personal tax 33.00% ONT personal tax 20.53% Dividend tax credit, federal 10.52% Dividend tax credit, ONT 4.30% After-Tax Net Worth after 10 years Taxation of Private Corporation Policy Conference

22 Evidence #2: Observation Integration and Passive Income: Does Proposal Improve Integration? 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. If system were today properly integrated, all that advice would be wrong Taxation of Private Corporation Policy Conference

23 How much will proposals matter? We need to keep the scale of the change in mind. Integration and Passive Income: 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% Taxation of Private Corporation Policy Conference

24 Integration and Passive Income: How much will proposals matter? Target savings: $33,333/yr of retained earnings over 3 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 Taxation of Private Corporation Policy Conference

25 Integration and Passive Income: How much will proposals matter? 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 $ Taxation of Private Corporation Policy Conference

26 Integration and Passive Income: Carter Commission V.4, p. 84 The system would neither encourage nor discourage the retention of earnings by corporations Taxation of Private Corporation Policy Conference

27 Lots of important challenges await Caveats on Implementation Transition: how the grandfathering will work. Intercompany shareholdings; investments. We will hear more today! Integration and Passive Income: This is serious: Need to weigh the costs and benefits of proposals. Finance s response: are there non-messy fixes? Taxation of Private Corporation Policy Conference

28 Final thought This package is clearly a patch on a messy system. Integration and Passive Income: 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? Taxation of Private Corporation Policy Conference

29 Tax Planning Using Private Corporations - July 18, 2017: Analysis and Discussion with Finance Ottawa, ON Tax Planning Using Private Corporations: Passive Income Jack Mintz The School of Pubiic Policy University of Calgary 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.

30 Passive Income Rules 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 18 th proposals) Taxation of Private Corporation Policy Conference

31 Passive Income Rules Benefits of July 18 th 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 About $23 billion of passive income is roughly 16% of active business income (total industry passive income is 10% of operating income) Taxation of Private Corporation Policy Conference

32 Passive Income Rules 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) Taxation of Private Corporation Policy Conference

33 Passive Income Rules 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 Taxation of Private Corporation Policy Conference

34 Marginal Effective Tax Rate Passive Income Rules Canada s Tax on Small Business not Competitive 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% $1M $2M $3M $4M $5M $6M $7M $8M $9M $10M $11M $12M $13M $14M $15M $16M $38M $39M $40M Size of Capital (CAD$ Million) Canada Small Business Entrepreneur USA Entrepreneur (S Corporation) USA Entrepreneur (Small Business) Taxation of Private Corporation Policy Conference

35 Passive Income Rules 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 Taxation of Private Corporation Policy Conference