Unless you’ve been living under a rock this summer, you’re no doubt aware by now of the federal government’s plans to change the way businesses and incorporated professionals are taxed. The tax strategies being challenged can be categorized into three main areas: income sprinkling; earning passive investment income in a corporation; and converting a corporation’s ordinary income into tax-preferred capital gains.

Although the income sprinkling rules would effectively eliminate opportunities for business owner clients to sprinkle dividends and capital gains among adult relatives (unless they contribute “reasonable” labour or capital to the business), it’s the change being proposed to the taxation of passive investment income inside a corporation that should have us most concerned.

What seems to be of particular concern to the government — and what it calls “an unfair benefit” — is the potential for a tax-deferral advantage inherent in our corporate tax system. To understand what the government is targeting, we need to revisit the theory of integration. This tax principle, in a nutshell, asserts that an individual earning income personally (as opposed to inside a corporation) should be left with the same after-tax cash at the end of the day as the shareholder who earns income through a Canadian corporation (which has paid corporate taxes) and receives the after-tax amount personally as a dividend.

Read: Industry groups come out strongly against Ottawa’s proposed tax changes

Owner-managers who run their businesses through corporations can choose to receive compensation as either a salary (including a bonus) or dividends. If salary compensation is chosen, the corporation claims a deduction against its income for the amount of salary or bonus paid, and the owner manager pays personal taxes on the salary or bonus income received.

Alternatively, if dividend compensation is chosen, the company pays corporate taxes on the income earned and the owner-manager pays personal taxes when after-tax income is distributed as a dividend. In tax parlance, “perfect integration” is said to exist when the amount of after-tax cash in the owner-manager’s hands is the same regardless of whether the corporate earnings are paid out as a salary or taxed first in the corporation and then paid out as a dividend and taxed in the owner’s hands at dividend tax rates.

Absent perfect integration, a tax savings exists when there’s a tax rate advantage from paying dividends, whereby the total corporate and personal taxes paid on dividend compensation is less than the personal taxes paid on salary compensation. Currently, we have almost perfect integration on small-business income across most provinces such that there’s no tax rate advantage from incorporation for businesses earning less than $500,000 of active business income annually and actually a tax rate disadvantage of having active business income taxed inside the corporation for income above this threshold. There’s a similar tax rate disadvantage associated with earning investment income, including capital gains, in a corporation as opposed to earning that same investment income personally.

That being said, if the business owner doesn’t need all of her cash in the current year, she could consider leaving excess funds in the company and defer taking dividends until a future year. This is the “tax-deferral advantage” that the government is targeting. This deferral exists since corporate taxes on business income are payable in the current year but personal taxes on the dividend can be deferred until the money is ultimately taken out in a future year. The difference between the corporate taxes and the personal taxes that would be paid on business income (the deferred amount) can be reinvested within the corporation to earn additional income until the dividend is ultimately paid, possibly many years later. The current deferral advantage on small business income ranges from 35% to 40%, depending on the province.

To fix this problem, Ottawa is proposing to increase the tax rate on corporately held passive investment income in which the capital invested arose from active business earnings. This would result in a combined corporate/personal tax burden for an Ontario business owner, for example, of 73% on corporately earned investment income and 59% on corporately realized capital gains, where the source of such capital arose from active business income.

Rather than issue draft legislation immediately to effect this change, however, the government has released a discussion paper on how the new rules may work. If you and/or your clients are affected by these proposed new rules, be sure to have your say through the consultation process that continues through Oct. 2.

Written comments should be sent to fin.consultation.fin@canada.ca and you may also consider e-mailing your local MP.