Relief from Complexity: A much-needed overhaul in the taxation of small businesses

The Liberal platform in the 2025 election pledged to “[c]onduct an expert review of the corporate tax system based on the principles of fairness, transparency, simplicity, sustainability, and competitiveness.” This is a welcome and necessary initiative.

The promised review is currently the subject of much discussion. For my part, I would strongly suggest that it be undertaken through various lenses, depending on the taxpayers being considered. In this article, I consider the tax system from the perspective of small businesses and highlight the negative impacts that complex tax legislation has on them.

In my view, the expert review should include a comprehensive examination of the tax provisions that most affect small businesses, with a view to simplifying the legislation wherever possible. The substantive tax rules and tax compliance faced by these enterprises have grown disproportionately complex, particularly given the limited capacity of a small business to spend significant amounts on specialized tax advisers.

Defining Small Businesses

For the purposes of this article, I consider a small incorporated business to be a “small business corporation,” as defined in the ITA—essentially, a Canadian-controlled private corporation whose assets are used principally in carrying on an active business in Canada. Given that businesses with more than $50 million in taxable capital employed in Canada are denied access to the small business deduction, we can further limit the definition, applying it to businesses below that $50 million threshold.

Undue Complexity

McGowan and Gwyer noted, in the December 2024 issue of Perspectives, that simplicity in a tax system “is properly assessed by the complexity experienced by taxpayers and their advisers in applying the tax rules to their particular set of facts. While seemingly obvious, a focus on the user experience can uncover what design choices would have the most meaningful simplification effect.” This quotation addresses simplicity in the tax system, but it also helps define what constitutes the inverse of simplicity (that is, complexity) in a taxing statute.

Tax changes in recent years have had a significant impact on small businesses, dramatically increasing the complexity they face in complying with legislation. In my view, this complexity tends to result in either accidental non-compliance or the excessive allocation of resources (both time and money) to ensure compliance. In this regard, when it comes to small businesses, I agree with the words of Robert Couzin, who wrote, in a 1984 article in the Canadian Tax Journal (32:3), that “a tax measure may generally be said to enhance tax simplification if it facilitates compliance.”

Small businesses are the backbone of Canada’s economy, employing a significant fraction of the workforce. Startups, which typically begin as small businesses, are the companies that most effectively drive innovation, an essential ingredient in a dynamic economy. Unfortunately, the excessive tax complexity faced by small businesses and their owners—while perhaps intended to promote fairness—has, in fact, impaired these firms’ capacity to succeed. Mounting compliance obligations divert management’s attention from the growth and long-term success of the business. This pattern, if left unchecked, will impede growth and expansion and ultimately diminish the tax base—an outcome clearly at odds with the objectives of Canada’s tax legislation. It is time for a critical review of the tax rules that affect small businesses, with a view to simplifying compliance wherever possible.

Tax on Split Income

In the small business context, one striking example of undue complexity is the tax on split income (TOSI) regime in the ITA. These rules came into effect in a substantially revised form in 2018. Introduced as an anti-avoidance measure, TOSI illustrates how a policy designed to curb perceived abuses can, in practice, impose heavy compliance burdens on precisely the taxpayers least equipped to bear them. The intent behind such rules (to ensure fairness and prevent income sprinkling) is understandable. As drafted, however, the legislation—rather than targeting clearly abusive arrangements—casts an overly broad net that captures many ordinary family-run businesses. This dynamic demonstrates the need for proportionality and clarity in tax design, principles that should guide any future review of the small business tax regime.

The policy goal of the TOSI rules is to address the following issue (identified by Finance in its 2017 consultation paper, which was a followup to the 2017 federal budget):

Sprinkling income using private corporations, which can reduce income taxes by causing income that would otherwise be realized by a high-income individual facing a higher personal income tax rate to instead be realized (e.g., via dividends or capital gains) by family members who are subject to lower personal tax rates or who may not be taxable at all.

While higher taxation on entrepreneurs is often controversial and, arguably, does more harm than good, the underlying policy objective is understandable.

One can assume that the TOSI rules achieve their intended policy aim—in theory, at least, though perhaps not always in practice because of inadvertent non-compliance. They do so, however, in an extraordinarily complex fashion. The rules, at their core, aim to eliminate income splitting with related adults unless these individuals are actively engaged in the business or the proprietor has reached the retirement age of 65. There are a host of exceptions and complexities to be worked through to determine whether the rules apply. Virtually every dividend paid by a small business to shareholders that are family members must be carefully and painstakingly analyzed to assess the potential application of the TOSI rules. If TOSI applies, the affected income is taxed at the highest marginal rate.

Many tax professionals resort to detailed flowcharts to help navigate the rules at a general level. (Many such charts are available online; I am partial to Moody’s.) From there, in my experience, advisers turn to the underlying legislation itself to ensure compliance at a granular level. The scenarios in which TOSI may apply are unique and complex, requiring further detailed research to determine the proper application of the rules. Only after this analysis can a reporting position be recommended to a client. In practice, it is virtually impossible for small business owners to comply with the TOSI rules on their own initiative (that is, without professional advice), unless they abstain entirely from paying dividends to related parties (which may, in fact, have been the policy goal).

What has always bothered me, however, is that these rules are aimed squarely at small businesses. They apply to family-owned enterprises—the corner store, the autobody shop, the barber shop, and the like. It is only these sorts of businesses—not the BCEs or Scotiabanks of the world, nor their shareholders—that could possibly fall within the scope of Finance’s income-splitting concerns.

When taxing legislation is meant to apply to small businesses, it should, in my view, tend toward transparency and simplicity, and away from complexity. Granted, the average business owner may always need professional advice when it comes to tax legislation. But the authorities ought to make the law as approachable, transparent, and intuitive as possible for small business owners, who have a right to understand the tax laws applicable to them without incurring high professional fees that are disproportionate to the amount of tax at issue. This is not currently the case.

How Did We Get Here?

The government’s position is that taxes on small businesses have been reduced over the years (although I question whether this is the case) and that this favourable treatment has given rise to “unfair tax planning strategies.” In the Backgrounder to the TOSI rules, Finance stated the following in this regard: “As the Government of Canada reduces taxes on small businesses, it is ensuring that the benefits of these lower tax rates are shared fairly, and support owners who invest in their business, create jobs, strengthen the middle class and grow the economy.” This rationale has brought us to the current, excessively complex tax situation for small businesses.

In seeking to address the risk of abuse, the government appears to be attempting to capture in tax legislation every possible eventuality—every plan a tax practitioner may devise, every shortcut a taxpayer might take, every exploitable advantage. The result is legislation that tax practitioners need to make great efforts to apply to particular facts and to communicate to their clients—all at great expense to taxpayers.

The design of the tax system should take into account the types of taxpayers likely to be affected by particular legislative measures. Small businesses seeking to comply with the ITA should not have to incur professional fees that are vastly disproportionate to the companies’ income. Taxing provisions that affect these businesses should be as simple as reasonably possible, allowing owners to focus on running their businesses. A better balance should be struck between capturing every conceivable instance of tax planning and minimizing unnecessary complexity.

TOSI, to be sure, is just one example of the many rules introduced in recent years that have added significant complexity to the tax obligations of small businesses. (For further reading on this subject, see Adam Friedlan’s article, “Tax Simplification for the Owner-Manager,” in the December 2024 issue of Perspectives.)

Where Do We Go?

Tax legislation should be evaluated in relation to the taxpayer groups for whom it is designed. A tax system that is understandable to those it governs is inherently fairer and more transparent than a less comprehensible system. If compliance with tax legislation requires professional intervention disproportionate to the quantum of tax at issue, the design has failed. When it comes to small businesses in particular, legislative drafters should place simplicity at the forefront. Only then can we achieve a tax system that is fair and transparent to our small business tax base.

Take the so-called kiddie tax, the predecessor to TOSI, which effectively prevented income splitting with minors. The kiddie tax was drafted much more simply and comprehensibly than TOSI. It was an example of relatively straightforward legislation that achieved the government’s aim. Despite the simplicity of its drafting (by the standards of tax legislation), the kiddie tax was not readily open to abuse and could be easily explained to a small business client. This is the goal: to remove any unnecessary complexity from tax legislation that affects small businesses and their owners.

Conclusion

A comprehensive examination and reworking of the ITA is long overdue. All statutory provisions affecting small businesses and their owners, particularly those introduced in the last decade or so, should be reviewed. Provisions that are disproportionately complex should be overhauled to enhance their simplicity and transparency. Only then will the tax system be fair and transparent to small businesses, which represent a vital segment of the tax base. This will certainly pose a great challenge, but I am confident that it can be achieved without compromising the integrity of the tax system.

First published by the Canadian Tax Foundation in (2025) 6:4 Perspectives on Tax Law & Policy.