The Liberal Government will be delivering their first Federal budget on March 22, 2016. Much of the coverage so far has been on the expected amount of the planned deficit and the impact of the fallen price of oil.
There are many rumours about potential changes in the income tax system and rates. The main rumours fall into two categories:
- Potential changes to the capital gains inclusion rate.
- Potential changes to the small business tax rate.
Capital Gains Inclusion Rate
If the capital gains inclusion rate were to increase, then there would be an incentive to realizing capital gains prior to the date of the increase, but not losses. Consideration should be given to whether it would be beneficial to realize accrued gains now to avoid a potential tax increase. Possible assets that might bear unrealized gains to consider would be, portfolios of stocks, bonds, mutual fund assets, real estate such as investment properties, cottages, residences not subject to the principal residence exemption, vacant land, shares of a private corporation not eligible for the capital gains exemption, farm and fishing properties not eligible for the capital gains exemption, goodwill, quotas and many other items.
The current capital gains inclusion rate is 50% of the amount of realized capital gain (or loss). Speculation suggests that the 50% rate could be increased. Prior to 1972 capital gains were not taxable. Since then the capital gains inclusion rate has varied according to the following chart:
| Year | Inclusion Rate |
| Before 1988 | 50% |
| 1988 and 1989 | 66 2/3% |
| 1990 to 1999 | 75% |
| Jan 1 to Feb 27, 2000 | 75% |
| Feb 28 to Oct 16, 2000 | 66 2/3% |
| Oct 17 to Dec 31, 2000 | 50% |
| 2001 to present | 50% |
It should be noted that in all cases the rate in effect at the time of the realization of a gain has been the rate used to calculate the gain and hence the tax, as opposed to a system where gains would be allocated by year to the rates above.
The non-taxable portion of a capital gain earned through a corporate structure is added to the capital dividend account. A capital dividend is an amount that can be paid out by a corporation tax free to the shareholder. The result is that the shareholder is put in the same position as if they had earned the capital gain in their personal hands. An increase in the capital gains inclusion rate, based on historic transitions between rates, would result in a decrease in the amount added to the capital dividend account but not an adjustment to amounts already added to the capital dividend account prior to the change in inclusion rate. There is always the possibility that the government would break from past precedent.
The following table shows a tax difference of $13,383 ($40,148 – $26,765) crystallizing a $100,000 gain now at the 50% inclusion rate vs. triggering a gain at a hypothetical 75% inclusion rate (assuming only personal tax applies at 2016 rates for simplicity):
| Tax result at 50% Inclusion rate | Tax result at 75% Inclusion rate | |
| Amount | $100,000 | $100,000 |
| Taxable amount | 50,000 | 75,000 |
| Income tax at 53.53% | 26,765 | $40,148 |
| Net after tax | $73,235 | $59,852 |
One must also consider the time value of money, so assuming any gain crystallized now would have been deferred into the future at the higher tax rate, the following rates of return are applicable over the following time periods:
| Time | Rate (approximate) |
| 1 year | 50% |
| 5 | 8.45% |
| 10 | 4.14% |
| 15 | 2.74% |
| 20 | 2.05% |
Given the number of previous changes in the inclusion rate over the 44 year history, any analysis of a long term cost/benefit is almost meaningless as any future government could simply lower the inclusion rate again, but could also increase it further.
Small Business Tax Rate
Possible ways to avoid a potential additional tax cost should the Small business deduction become unavailable to your company include operating as a proprietorship or partnership, earning income before a rate change where possible (although in the event of a change it might be that income for the fiscal year would be prorated by the number of days before and after a change), taking advantage of the tax deferral and graduated rates available to an incorporated entity and splitting income with family members at lower tax rates where possible to reduce or eliminate the incremental tax cost.
The current tax rate on the first $500,000 of active business income for a small business is 10.5% for 2016. In combination with the Provincial tax on small business income the overall tax rate on the first $500,000 of active business income is 15% in Ontario for 2016.
Speculation is that access to the Small Business Deduction may be restricted for companies not meeting certain criteria. There are precedents in that the current law does not allow a small business deduction for a specified investment business or a personal service business. There is also a recent change to the qualification criteria for the Small business deduction in Quebec, the main changes being that for tax purposes in Quebec:
- any corporation that employs more than three full-time employees in its business throughout the year or that would usually have used the services of more than three full-time employees had financial, administrative, maintenance, management or other similar services not been provided to the corporation in the year by a corporation associated with it, and
- any corporation in the primary or manufacturing sector,
are eligible for the Quebec small business deduction.
Should the Federal government adopt a similar set of rules, the changes will apply in Ontario as well. Ontario has adopted the Federal tax rules in this regard.
The good news is that unless the government were to stray far from the current tax theory that says no matter how you earn a dollar you should pay roughly the same amount of tax on it, a comparison of the possible loss of the Small Business Deductions can be made by comparing the tax rates for income over $500,000 vs. income eligible for the deduction using 2016 rates:
| Small Business Income up to $500,000 | Active Business Income over $500,000 | |
| General Federal rate after abatement | 28% | 28% |
| Small Business Deduction | (17.5) | 0.0 |
| Rate reduction | 0.0 | (13.0) |
| Net Federal tax rate | 10.5 | 15.0 |
| Ontario | 4.5 | 11.5 |
| Total corporate tax rate | 15.0 | 26.5 |
Example showing incremental tax on $100,000 in Ontario assuming personal income is over $220,000:
| Earned by a Proprietorship | Small Business Income up to $500,000 | Active Business Income over $500,000 | |
| Taxable income | $100,000 | $100,000 | $100,000 |
| Corporate income tax | 0.0 | (15,000) | (26,500) |
| Net | 100,000 | 85,000 | 73,500 |
| Personal tax on dividend (45.30%/39.34%) | 0.0 | (38,505) | (28,915) |
| Personal tax on income (53.53%) | (53,530) | 0.0 | 0.0 |
| Net after tax dollars at top tax rate | 46,470 | 46,495 | 44,585 |
If you would like to discuss the above prior to the release of the 2016 Federal budget please contact your trusted advisor at Graham Scott Enns LLP Chartered Professional Accountants.
