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The federal government's proposed changes to the tax treatment of "passive" investment income in small business were among the most criticized elements of the consultation paper released last July. Wednesday's announcement from Finance Minister Bill Morneau addresses one of their most serious flaws: the threat to the retirement prospects of many small-business owners. The revised proposals strike a better balance between the government's "fairness" objective and the need for business owners to use their corporations to save for both future business and personal purposes.

To recap, the July proposals would have ended the refundability of taxes on passive investment income in Canadian private corporations when the owners took the money in dividends. The result would have been that people investing money not needed for the business inside private corporations would pay about the same tax as if they were individual investors in fully taxable accounts. While the government believes that is fair, a closer look at the facts shows that the vast majority of personal financial assets, including retirement savings, are not held in fully taxable accounts because taxes cascading on the investment income can be really punitive.

A study released by the C.D. Howe Institute criticized these proposals. It pointed out that business owners earning income taxed at the small-business tax rate and saving it in the corporation for future personal consumption get tax treatment pretty much on par with others saving through an RRSP, a pension plan or a TFSA. If there is a fairness issue, it would be that tax rules limit the amount of retirement saving individuals are allowed annually, while small-business owners are not limited in the amount of earnings they may retain in their corporation.

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But the problem of uneven tax treatment of retirement goes well beyond differences between small-business owners and savers in RRSPs. People who have a comprehensive pension plan, for example, can accumulate retirement wealth two or three times the amount a person can accumulate in an RRSP.

Worse, many business owners have planned their retirements on the expectation that the current rules on taxation of passive income would continue.

Because they took out dividends for current compensation, and were planning to take the savings out in dividends after retiring, they did not pay themselves salaries, and therefore did not even accumulate the RRSP room they would need to achieve the more modest retirement wealth an RRSP permits.

Yesterday's announcement addresses these issues. Up to $50,000 annually of passive income on new investments, on top of all existing investments, will not be subjected to the tax treatment of the proposed rules. On a portfolio of retirement-appropriate assets yielding 4 per cent annually, the $50,000 threshold is equivalent to a maximum lifetime accumulation of $1.25-million of new investments, available for either business or personal purposes without penalty. Add this to potential future RRSP contribution room over a lifetime, and the gap in tax-deferred saving opportunities between small-business owners and people in public-sector pension plans gets a lot smaller.

To say that it is smaller does not mean that it disappears. And this change adds further complexity to a package that already had tax experts and small business people alike rolling their eyes. Moreover, in combination with the previous announcement that the federal government will lower the small-business tax rate, these changes will increase the tax incentives to incorporate – completely at odds with the thrust of the July proposals. It will make complex tax planning activities more rewarding, instead of discouraging them. And because it does nothing to address the high combined corporate/personal tax burden on the most successful, medium-sized private corporations earning income beyond the small-business threshold, it raises the incentive for companies to remain small.

Addressing those problems will require cuts to other business and personal tax rates – something the government seems loath to do. Meanwhile, however, Wednesday's tweaks will limit the damage of the new regime for most small-business owners. This new regime now recognizes that small-business owners save for legitimate purposes inside their companies, and avoids worsening the unfairness that federal tax policy creates between different Canadians saving for retirement.

Bill Robson is president and CEO, and Alex Laurin is director of research, of the C.D. Howe Institute.

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