Scenarios outline impacts of tax changes

Tax changes proposed by the federal government will hurt local farmers, business people and doctors, according to a tax lawyer who spoke in Olds.

Calgary tax lawyer Arthur Olson laid out three scenarios during a talk at the Evergreen Centre conference room on Monday, Sept. 18.

According to Finance Minister Bill Morneau, the goal is to close "loopholes" that he says enable wealthy Canadians to pay taxes at lower rates than they otherwise would have.

That includes people who incorporate themselves, then draw income from their businesses or farms by paying lower rates of tax that are allowed under incorporation.

In general, according to critics and accountants, the federal government wants to eliminate or drastically change the following:

Income sprinkling, whereby a business owner pays family members a salary or dividend in order to cut the business's total tax burden.

Passive investment retention, under which a business owner invests income for reasons other than immediate reinvestment into the business. According to those attending the Aug. 23 meeting, that can include taking income from the business as a source of retirement income.

Income conversion to capital gains, which, according to critics, is essentially declaring income in a way that creates a lower tax burden.

One scenario involved "Joe the plumber."

According to that hypothetical scenario, in 1998, Joe incorporated the business as LeadCo Plumbing.

"Joe hired employees, and so never had extra money to save for retirement," Olson said. "Mary, his wife, stayed at home to raise the family so that Joe could build his business.

"Last year, Joe sold his business for $500,000 after tax in an asset sale. The plan was for LeadCo to invest the sale proceeds and dividend $40,000 in cash to Joe and Mary to pay for their retirement."

Olson said under current tax rules, Joe and Mary would pay a combined tax rate of about 20 per cent on investment income generated by the company.

However, he said under the proposed new rules, Leadco would no longer be able to pay dividends to Mary because "the tax rate is prohibitive (74.4 per cent.)"

In addition, Olson said, Joe would pay 53.4 per cent tax on the investment income earned by his company.

"This is 2.6 times the tax they were paying before," he said. "If Joe takes out much more, he could also face a 15 per cent clawback on his OAS (Old Age Security) ñ in other words, an effective tax rate of 68.4 per cent."

Olson also said the proposed tax changes could drive doctors out of small towns.

He cited the hypothetical example of "Sally the doctor."

He said Sally, a family doctor, lives in a small town and runs her practice via a professional corporation.

Olson said Sally plans to take a year off after her child is born but is only entitled to "minimal maternity benefits."

Olson said under existing rules, through her professional corporation, Sally would be able to split dividend income with her spouse in order to reduce her tax bill. She could also save income to cover costs generated during her maternity leave.

But under the new proposed rules, "the money that Sally has earned from her investments inside her professional corporation will now be subject to a combined personal and corporate tax rate of 66 per cent," Olson said.

Also, Sally would no longer be able to cut her tax bill by splitting income with her spouse.

"Sally still has to pay her expenses at the clinic. So now, she is thinking about a shorter maternity leave or maybe leaving small-town practice altogether," Olson said.

The third scenario involved "Farmer John," who Olson said owns a section of land near Olds and, through a family corporation (FarmCo), has several quarters as well as farm equipment, cattle and other related things.

Since 2010, the value of the land has increased significantly.

John's 20-year-old son, Jack, wants to take over the family farm but his daughter, Jill, 19, would rather move to Calgary.

"John wants to see the family farm continue and be run by Jack, but at the same time, he wants to leave something for Jill," Olson said.

Under the current rules, John could sell $50,000 worth of FarmCo shares to his wife, Jane, in exchange for a promissory note. He would then realize a capital gain of $50,000 and pay $8,785 in tax.

He would not use any of his Lifetime Capital Gains Exemption (LCGE) to shelter that capital gain from taxes. As a result, Jane's adjusted cost base of the shares she purchased would be $50,000.

Jane would then sell the shares to Jane Holdco, a corporation she owns, for a $50,000 promissory note.

That way, Jane Holdco could receive $50,000 worth of tax-free dividends from Farmco via the promissory note owed to her. She could then pay that off.

That would save the couple thousands of dollars, according to Olson.

Farmer John would be required to take the amount as dividend and pay 1.5 to two times the tax amount.

Under the current tax rules, Farmer John could cut the tax bill owed by paying his son Jack for his work during harvest.

"Because of his education credits and expenses, Jack pays no tax on the dividends," Olson said. However, under the proposed new tax rules, "since Jack is not employed on a continuous and substantial basis, he now has to pay tax at (a) 48 per cent rate on the dividends from FarmCo."

Under the new tax rules, Jack decides to pass the farm to the next generation.

"If Jill decides to sell the land to Jack, she will only be eligible to claim the capital gains exemption to calculate her exemption based on the day she turned 18," Olson said.

"In other words, not only is most of the gain not sheltered (from tax), Jill gets less of an exemption than her brother Jack, even though they received the land on the same day," Olson said. "This will make it harder for Jack to buy out his sister."

Also in this scenario, John decides to use a family trust in order to shelter gains received by the increase in land value.

However, under the proposed new rules starting on Jan. 1, 2018, family trusts can no longer be used to distribute capital gains to beneficiaries so they utilize their capital gains exemptions, Olson said.

"There is a one-time election available in 2018 to claim the capital gains exemption. However, it can frequently result in triggering alternative minimum tax, and so may be of little use to many family farms," Olson said, adding, "this will make it harder to pass on the farm to the next generation."