Passive income changes could net feds $6 billion, PBO says

Parliament's spending watchdog says Liberal changes to passive investment rules for small businesses could rake in up to $6 billion annually in new tax revenues after a decade.

Report says 2.5% of Canadian-controlled private corporations would be affected

The Senate Committee on National Finance hears from Finance Minister Bill Morneau during a meeting on Parliament Hill in Ottawa on November 1, 2017. (Sean Kilpatrick/Canadian Press)

The federal government could eventually rake in up to $6 billion annually in new revenue as a result of a proposed change in the tax rules for incorporated small businesses, Parliament's budget watchdog estimated Thursday.

A parliamentary budget office report concluded changes to passive investment rules would add up to $1 billion to federal coffers in the first couple of years, rising to as much as $4 billion in 10 years and as much as $6 billion in 20 years.

Those estimates were disputed by Finance Minister Bill Morneau's office.

"We've been clear, this is not and has never been a revenue-generating exercise," the minister's spokeswoman, Chloe Luciani-Girouard, said in an email.

"It is about ensuring that wealthy individuals do not have an incentive to incorporate just so they can get a better tax rate than the middle class."

Only once final details of the proposed changes are unveiled in the 2018 budget will it be possible to accurately predict the impact on the federal treasury, Luciani-Girouard said. Nevertheless, she added that the government believes the measures will "likely generate significantly less revenue than what the PBO has estimated."

The PBO report comes amid continuing opposition to the proposed changes in tax rules for incorporated businesses — even after Finance Minister Bill Morneau last month scaled back the plan in a bid to quell an outcry by doctors, lawyers, accountants, shop owners, farmers, premiers and even some Liberal backbenchers who contended the changes would hurt the very middle class the Trudeau government claimed to be trying to help.

But the PBO's report backs up Morneau's contention that the plan would impact only a tiny percentage of wealthy businesses — at least when it comes to the passive investment proposal.

"In terms of distribution, the impact of these changes is likely to be highly concentrated on a relatively small share of CCPCs, which hold the vast majority of passive investment assets," the report says.

The tax rule changes are aimed at ending the ability of wealthy individuals to use incorporation to gain what the government maintains is an unfair tax advantage. The most contentious proposal would limit the ability of a corporation to make so-called passive investments in things unrelated to the business, like real estate.

In response to criticism, Morneau revised the proposal last month, adding a proviso that the change would apply only to passive investments exceeding an annual income threshold of $50,000 — a change the government maintains will ensure the measure applies only to three per cent of the wealthiest private corporations.

Passive income shells

Nevertheless, a coalition of some 80 business groups is continuing to pressure Morneau to drop the proposed restriction on passive investments altogether. In a letter to the minister earlier this week, the Coalition for Small Business Tax Fairness says the $50,000 threshold is too low and would prevent small businesses from making investments that will help them grow.

However, the PBO report backs up the government that only a very small number of businesses, some 47,000, would be impacted by the change.

In 2014, it says just 2.5 per cent of Canadian controlled, private corporations (CCPCs) earned 88 per cent of all taxable passive income.

Moreover, the report says 60 per cent of all passive income is earned by CCPCs with "no active business income, suggesting they were set up solely for the purpose of generating passive income."

Revenue uncertain

Morneau is also proposing to limit the ability of incorporated business owners to sprinkle their income to other family members, creating a "reasonableness test" to determine whether a spouse or children actually do any work for the business.

In response to the backlash against his initial reform proposals, Morneau dropped a plan to limit the ability to convert income to capital gains, which are taxed at a lower rate.

He also threw in a sweetener, resurrecting a Liberal promise to cut the small business tax rate to nine per cent by 2019 from the current 10.5 per cent.

The PBO report warns that its estimates of the revenue the government stands to gain from the passive investment measure alone don't account for any steps small business owners may take to avoid paying more taxes, which could decrease revenue estimates by as much as 15 per cent.

It also can't be certain about its estimates without more details from the federal government.

The government has estimated that it would gain about $250 million a year in additional tax revenue from the proposal to limit income sprinkling. It has not provided an estimate of revenue from the passive investment measure.