Bloomberg via Getty Images Bill Morneau, Canada's finance minister, speaks during an event at the Vector Institute at the MaRS Discovery District in Toronto, Ont., on Thursday, March 30, 2017.

Over the last number of months, federal Finance Minister Bill Morneau has repeatedly used the example of two neighbours that are earning the same amount of money (his example is $220,000/year). One is an employee, and the other owns a private corporation. As described in the discussion paper released on July 19, one neighbour (the employee) is paying $35,000 per year more in income tax than their self-employed neighbour. Mr. Morneau claims this is unfair and he proposes to put a stop to what he described as "tax loopholes." When most people hear the government talking about those making $220,000 a year, there usually isn't a whole lot of sympathy because most people can't relate to earning that amount. According to Statistics Canada, in 2015 there were 390,220 Canadians who reported incomes of $200,000+ (which is 1.5 per cent of taxpayers)

Bloomberg via Getty Images Bill Morneau, Canada's finance minister, speaks during an event at the Vector Institute at the MaRS Discovery District in Toronto, Ont. on Thursday, March 30, 2017.

The information Mr. Morneau is presenting to Canadians is both misleading and deceptive. I would go so far as to call it a magic show, but there's nothing entertaining about what's going on. As a matter of fact, it's terrifying. Let's look at a more realistic situation that involves so many more Canadians, not just the top 2.35 per cent. Meet Joe and Darlene. Joe has been retired for the last five years after working for 40 years as a contractor. Joe and Darlene have two grown children and three grandchildren. Darlene says she was fortunate enough to be a stay-at-home mom and never worked in Joe's business. When Joe first started his contracting business, his lawyer suggested he incorporate and so in 1972 Joe incorporated his business. Initially all the extra money Joe earned was invested back into the business. In 1976 Joe's company was as big as he wanted it to be so he decided that he would set up a second company (an investment company) where he could start to accumulate some assets for retirement. In the early '80s there was a huge pullback in the housing industry (because of the high interest rates) and Joe had to spend all the money he had set aside just to keep his small company going.

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Looking back over those 40 years, Joe could recall two other times that he had to spend all the money he saved in his investment company just to keep his company going. He realizes he would be better off financially now if he would have laid off some employees during those bad times but he knows he did the right thing by keeping them employed. He's thankful that he had the extra money in his investment company for emergencies. Now that Joe is retired, he and Darlene live quite comfortably on money they draw from Joe's investment company. Since Joe was advised not to take a salary from his company, neither Joe nor Darlene contributed to the Canada Pension Plan (CPP) or their Registered Retirement Savings Plans (RRSP). Their only outside source of income is Old Age Security (OAS). Darlene's income last year was $6,846.24

Joe's income last year was $72,000 According to Mr. Morneau, Joe and Darlene are using tax loopholes because all of their retirement savings are in Joe's investment company. So here's what Mr. Morneau would like to do. He would like to increase their overall tax rate by over 700 per cent. This is not a misprint. The number is 700 per cent! Let's look at how this would happen: Suppose that instead of Joe holding his investments inside his company, he had a personal non-registered investment account. Now, let's say this account held Royal Bank common shares and that last year the dividend paid on those shares was $1,000. Since Joe's personal income was $72,000, he would personally pay $63.90 in income tax on that $1,000 Royal Bank dividend. Here's what Mr. Morneau thinks is fair: To increase Joe's tax rate on his $1,000 dividend from $63.90 to $490.42. This represents an increase of 767 per cent. We know, however, that Joe's investment account is in his investment company. Assuming it is invested in the exact same RBC common shares, under the current tax system, when Joe takes the $1,000 received from Royal Bank out as a dividend, he'll pay $63.90 in income tax. There is no difference in tax between these dividends, regardless of whether they are earned personally or corporately. This is called tax integration and is the concept on which the Canadian tax system is built. When you own an incorporated business, there are only two ways to get money out of your company. You can pay yourself a salary or you can take dividends (dividends are after-tax corporate distributions). Since Joe is retired, he is not allowed to pay himself a salary, so he must take dividends. Mr. Morneau believes that having money invested inside a company is unfair, and so has proposed the following: When Joe's investment company receives the $1,000 dividend from Royal Bank, it will pay $383.30 in income tax, leaving him with only $616.70 available to take. When he takes the $616.70 out of his investment company, he will then have to pay an additional $107.12 in income tax, which results in a net amount of $509.58.

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