Unintended Financial Market Consequences from Liberal’s Tax Proposal

 

Dear Finance Minister Morneau,

The general discussion thus far has been the impact on small businesses and retired professionals with corporate funds. In an effort to change many of my clients’ tax planning on how to deal with these proposed changes I had encountered what I believe to be an unintended consequence that will affect capital markets in Canada.

Is it really 73% taxes on portfolios

First lets discuss the proposed mechanism in how the 73% tax on corporate stock portfolios is supposed to work. Currently the tax rate on passive investments is approximately 48% inside corporations if we include the 38% Part IV refundable tax. This amount is refundable if the shareholders issue a dividend to themselves at a ratio of roughly 3:1 of each earned dollar to eliminate the Part IV refundable tax. Thus taxes earned on the portfolio are taxed at approximately the highest marginal personal rate and it would be better off if the shareholder pushed the income onto their personal side instead of leaving it in the corporation.

Should the proposals come into effect then the 38% Part IV refundable tax won’t be refundable anymore even if the shareholders dividend the income out of the corporation. Thus leading to a situation where there is going to be 48% corporate taxes, plus an approximate 25% personal taxes paid by the shareholder, for a total of 73% taxes combined.  This will differ across provinces and personal income situations but this is how the math roughly works.

My professional work planning for my clients in Calgary and Victoria

I operate two accounting firms serving small to medium businesses and wealthy individuals, one in Calgary and the other in Victoria. I’ve been running different scenarios changing client tax plans at least 4 to 5 times a day for the last 2 months; it’s been busy. It’s fair to say that I have a very good idea of the mechanics and how to tax plan under the new regime should these proposals become law.

My recommendation to my clients has been that we should consider doing a salary to disburse the income generated by the passive portfolio. Thus if we disburse all of the income generated by the company using a company expense then there is no passive income to be taxed at the 48% in the first place and we obtain a tax neutral scenario where the individual will pay at their own personal tax rates on the passive income. All I’m changing then is simply no more dividends and doing a salary instead.

This is not a perfect tax plan which I won’t get into here but at least it will deal with the immediate problem of keeping taxes at each shareholder’s individual tax rate instead of paying 73%.

Possible Side Effect Discovered

Upon running different tax scenarios I found that it turns out all types of passive income work using this simple change in planning. Rental income, interest, foreign dividends, and capital gains all more or less work to some degree. The problem was Canadian dividends, and by that I mean dividends issued from a publicly traded Canadian company, ie. stocks on the TSX. Part IV tax is triggered automatically and cannot be eliminated even if the company is in a loss position.

Then it reminded me of what was the original intent of Part IV tax, dividend gross ups, dividend tax credits, etc. and the entire mechanism that we’ve all grown accustomed to the last several decades. The original intent was in fact to give Canadian investors an incentive to invest in Canadian companies because the dividends paid out of these investments are tax advantaged, and I understood this as something that the government of Canada wanted.

It’s a protectionist measure by the government to give our home grown companies a competitive edge when looking for investment in Canadian markets. Effectively then if these tax proposals are implemented then instead of giving Canadian financial markets a protectionist advantage it has given them a disadvantage because a Corporate investment portfolio would rather invest in US investments if it paid the same returns than its Canadian counterpart due to the fact that a tax neutral scenario cannot be achieved when a Corporation receives Canadian portfolio dividends.

What does this mean?

I think an unintended consequence of deploying these proposed tax changes could inadvertently hurt Canadian stock markets and ultimately Canadian public companies.

Any rational investor holding a Corporate stock portfolio in Canada, would choose to hold US stocks in favour of a Canadian stock even if it paid the same dividend returns. Perhaps then a possible scenario is over a period of time we will see a devaluation of Canadian stocks because people would sell these investments from their portfolio.

With a lack of value being generated overall in the Canadian stock markets then in turn companies that wish to pursue an initial public offering (IPO) would choose to do it in more lucrative markets where they may get more investment capital. Companies are going to relocate their head offices to the US to pursue better valuation on public offering.

This is a huge issue with huge widespread consequences affecting everyone in Canada, not just small businesses anymore. Again I repeat that thus far, I haven’t seen anyone talk about this aspect of it yet. I don’t think this is an intended consequence and I don’t think the government has factored in the possible loss of jobs from corporate relocation, loss of market value for Canadians that want to retire off their RRSP’s, loss of investment capital in Canada, and loss of tax revenue from all of these things combined.

Final Remarks

This cannot possibly be measured effectively with any degree of assurance even if you have thought about these consequences. It could be a small impact or it could be a massive impact, you simply cannot measure what it would do to the stock markets. This is why the system was setup in the first place to consider all of these things like Part IV tax, dividend gross up, dividend credits, and the entire mechanism. They’re all intertwined as a complex system to support Canadian companies large and small, and the overall health of financial markets in Canada and for the average Canadian.

Sincerely Concerned,

 

Wilson Wong, CPA, CA.

 

 

Leave Comment

Your email address will not be published. Required fields are marked *

Click here to Call for a Free Consult