In honour of the Dog Days of summer, I am going to do a couple lazy, hazy, crazy mini-rants on some topics that managed to get under my skin this week. One is energy related, the other is uniquely Canadian so no offense taken if my American readers take a pass on it, but it’s a big deal to us Canadian business owners.

 

Dog # 1

 

A recent news article said that Petronas  (of crushed BC LNG dreams fame) was considering investing in a pipeline in Western Canada to help to monetize its tremendous gas asset in the Montney and that it was also contemplating a 10% stake in the LNG Canada project sponsored by Royal Dutch Shell in Kitimat, BC.

 

Are you kidding me?

 

For those of you who have recently been on vacation, it was only a matter of weeks ago that Petronas pulled the proverbial pin on what was to be the largest private sector project in BC history, the Pacific Northwest LNG project. As you may recall, in my review of that, I suggested that Petronas would need to find an outlet for its gas, which at the time I thought would lead to an investment in an American project they could ship gas to. I did not, however, consider the possibility that they would throw their lot in with another Canadian LNG proponent, no matter how likely or unlikely their project would be to get an FID. I suppose of course if they know something about the project we don’t (entirely possible) and that the pipeline they were thinking of supporting was TransCanada’s Coastal Gas Link, then maybe we are on to something. But seriously folks, does anyone actually believe that?

 

The highest and best use of the Montney gas resource owned by Petronas was to ship it to itself via its own project that it planned, had control of and was approved by the Federal Government. The next highest and best use is to ship the gas to the US and hope it ends up on a cold filtered boat for Asia. Anything else makes no sense.

 

And a pipeline? Vraiment? Do these people not read newspapers? The odds of a new pipeline to the US from the Montney being planned, sanctioned, approved and built before I retire are pretty darned slim. Just stop. You ditched our market, you’ve left yourself with trillions of cubic feet of stranded gas and now you’re wondering what to do? Do us all a favour, drill it, produce it and sell it to the US via whatever existing network there is and pay your royalties. Don’t engage us in any more false hope. Fool me once and all that.

 

Dog #2

 

This one would be the Canadian gripe, and it has to do with proposed changes to how small and mid-market private businesses are taxed in Canada. Full disclosure, we will be directly affected by these changes and we are hopping mad. Any commentary herein is completely and absolutely self-serving and I don’t expect any sympathy at all from salaried people who are being bent over by Canada’s egregious personal tax rates (highest in the G7! We’re number 1!).

 

But the comments need to be made as the changes being proposed are pretty significant both in terms of dollars and the critical policy message they are telegraphing.

 

Background

 

Earlier this summer on July 18, Finance Minister Bill Morneau released a set of proposed changes to the tax act to address three specific so called “loopholes” used by the “elite 1%” to “not pay their fair share” and thus not contribute to “strengthening the middle class”. In a nutshell they want to close the tax gap between owners of small and mid-sized businesses and those of personal tax paying salaried Canadians by creating a mini class war as cover for raising taxes on no less than 1.8 million Canadian corporations.

 

Ask me how I really feel…

 

The problem they are trying to address is the use of corporations by small business owners to, among other things, pay less current tax and save “excess profits” on a tax-deferred basis for retirement. They are accomplishing this through changing the rules on income sprinkling (the spreading of income to non-active family members of the business owner to reduce the overall tax bill) and the deferral advantages of keeping excess profits in a corporation. The ultimate goal is of course “fairness” in the tax system and the goal of having Joe the risk-taking business owner pay the same tax rate as any comparably salaried Canadian.

 

I won’t get into the arcane details because I ain’t no tax guy, but I will do my best to summarize the implications using the example Joe the business owner to show how it works in Canada and how the proposed changes will alter the landscape.

 

So, Joe decides to go into business for himself and on the advice of his accountant, he incorporates and owns the business 50/50 with his spouse. Joe makes money every year, maybe a little more than the household needs so he pays out what is needed, typically as a dividend and leaves the rest in the business, where it probably gets invested somewhere, like a dividend paying Canadian stock.

 

In Canada, as long as Joe’s profit is less than $500,000, he gets the advantage of Canada’s preferential small business tax rate. Joe’s a welding company in Alberta so call it 12%. So if he makes $400k and wants about $170k to live on, he’ll pay $48k in tax inside the business and collectively about $30k on the dividends he’ll pay to the shareholders, the balance of $152k stays in the business and can be invested on a tax deferred basis until he pulls it out as a dividend or salary sometime in the future or, you know, reinvests it in his business by doing something subversive like hiring an employee or buying equipment.

 

Pretty straightforward right?

 

Not so fast.

 

What the government is saying is two things: first that the splitting of income between spouses shouldn’t be allowed unless both parties are active in the business (good luck testing that) and that leaving the cash you don’t need in the business on a tax deferred basis is also bad. Basically, you need to strip all the profits out of the business as salary or dividends, planning be damned. Why? Because some guy being paid an equivalent salary at, say, a bank, or the civil service would be taxed at a much higher rate.

 

Putting aside for a moment the fact that the “employee” has benefits and other soft components to their compensation that the self-insured business owner doesn’t have such as pension entitlements, typically a high end health and disability plan, paternity/maternity leave, paid vacation, sick days, EI back stop, employer paid CPP contributions (and entitlement), job security (and in the case of the civil service – collective bargaining and tenure), severance entitlements on employment termination and no near-constant fear of business failure, let’s take a look at how these situations compare.

 

Although truth be told, it is hard to compare, because it’s really apples and cows. However, compare we must!

 

Taken to the extreme, if Joe had to pull all of his $400k profit out as income, this would raise the tax bill on our hypothetical company/shareholder to $159,000 rather than $78,000. Ouch! Of course a smart business person would figure out how to split the salaries to the two shareholders, so to get to the same after tax number ($170 in our example) they would take $115,000 each out of the company, leaving a $70,000 profit which would have $8,400 in tax and $62,600 in deferral. The difference in all this is a current tax bill of $68,400 vs what would have been $78,000 in the other example.

 

Interestingly, this shows that with a little jiggery pokery that Joe can actually end up better off – umm what? This tells me that the real target of the changes is the deferral of tax on excess profits which is where it actually starts to get really punitive under the new proposed changes. This is the amount that the government wants to get its hands on as the number can, in theory, get quite high. Because we all know that companies always make money, the amount goes up, up and up.

 

But stop complaining say supporters of the changes, because you are going to get a sweetheart deal on capital gains exemptions when you eventually sell your business because in Canada, owners of a qualifying small business receive the first $850,000 (estimated) of capital gains tax free!

 

But… there’s always a but and that but is a big but…

 

You only get that exemption if a) your business is actually saleable and b) at least 90% of the assets of the business have been actively used in the business for the 24 months prior to a transaction. So the government already has a lever in place to discourage the retention of passive investments in a small business. And anyone who has a sole proprietorship or is a physician or similar personal service business will NEVER see the benefit of the lifetime capital gains exemption, because those businesses aren’t saleable – so it’s a red herring. Instead, they are going to play tax catch up when they start taking their life savings out of their corporations and pay their fair share at the end of the day. Wow. Go figure.

 

It’s dumb and it’s complex but those are the rules which have been there for decades. And these rules were put in place to encourage entrepreneurs. The government is calling something a problem that isn’t actually a problem.

 

Are there abuses? Absolutely. A significant number of the personal service corporations that exist are on the “hmm” side of the rules, but if (as it is alleged) it’s the federal government that created the specific conditions that have led to this abuse (such as Ontario telling physicians they can’t have a raise and that they should use this structure to increase their take-home pay), then it is up to government to use a scalpel to fix the issue, not to swing the policy sledgehammer to blow up 50 years of tax planning and structuring for thousands upon thousands of tax payers..

 

Let’s be crystal clear and acknowledge that this incentive to incorporate exists because personal tax rates in Canada are extremely high and increasing. If you don’t want a physician incorporating and looking for whatever tax advantages exist in that structure, then maybe don’t make the top marginal tax rate more than 50% and, I don’t know, maybe pay them more.

 

What’s equally egregious is that they plopped this on an unsuspecting public in the middle of summer and gave only a 75 day period for comment – this on a subject that went through two years of consultation the last time it was adjusted – all the while unleashing the usual class war dog whistle rhetoric and sending minions scurrying about talking about fairness and protecting the middle class and sticking it to those elite rich bastards when any analysis of the proposed rules show that the biggest impact will be on small business owners and not the 1% – people like Bill Morneau and Justin Trudeau who have enough money squirreled away in incorporated investment holding companies that they conveniently escape the effects of these changes.

 

Let’s bring it back home to the energy sector, which is the most entrepreneurial sector in the country and is comprised, by and large, of 100’s of mid to large size public and private companies and literally tens of thousands of companies just like Joe the welder – all of whom employ tens of thousands of Canadians, pay their corporate taxes (full pin in great years, small business rate in others) and are going to get swept up in these ill-thought out changes.

 

It’s hurtful, it’s a shame and it demonstrates a complete absence of knowledge about what drives the Canadian economy.

 

Is there a solution to this? Probably. And I can’t believe I am actually going to say this. The solution is to ditch these dumb proposals, lower personal taxes and gradually raise and eventually get rid of the small business tax rate (sorry everyone) and leave the deferral nonsense alone.

 

This will eventually shut the door on those who abuse the system by removing the incentives, but leave sufficient incentive in place for small businesses that have the ability to effectively tax plan by using a mix of salary, dividend and corporate tax. But remember, there are attribution rules – the GOVERNMENT WILL ALWAYS GET ITS MONEY.

 

Unless you are super rich or Bombardier or a politician or Mike Duffy. Then they give you money. Which of course is a discussion point for another day.

 

These changes? They need to be locked up in a kennel.

 

Woof.

 

Prices as at August 25, 2017 (August 18, 2017)

• The price of oil fell during the week despite solid US inventory draws but rallied on Friday with the appearance of Hurricane Harvey in the Gulf Coast
  • Storage posted a large decrease
  • Production was up
  • The rig count in the US appears to have plateaued
• Natural gas fell during the week as we sit in summer doldrums. Injections continue to feel small this year, especially with the incremental rig count.
• WTI Crude: $47.80 ($48.63)
• Nymex Gas: $2.899 ($2.900)
• US/Canadian Dollar: $0.8016 ($ 0.7954)

Highlights

• As at August  18, 2017, US crude oil supplies were at 463.2 million barrels, a decrease of 3.3 million barrels from the previous week and 29.8 million barrels below last year.
  • The number of days oil supply in storage was 26.5 behind last year’s 31.3.
  • Production was up for the week by 26,000 barrels a day at 9.528 million barrels per day. Production last year at the same time was 8.548 million barrels per day. The change in production this week came from equal increases in Alaska deliveries and Lower 48 production.
  • Imports rose from 8.126 million barrels a day to 8.790 compared to 8.642 million barrels per day last year.
  • Refinery inputs were down slightly during the week but still strong at 17.461 million barrels a day
• As at August 18, 2017, US natural gas in storage was 3.125 billion cubic feet (Bcf), which is 1% above the 5-year average and about 7% less than last year’s level, following an implied net injection of 43 Bcf during the report week.
  • Overall U.S. natural gas consumption was up by 4% during the week – led by increases in power and industrial demand
  • Production for the week was flat and imports from Canada were up 7% compared to the week before. Exports to Mexico were up 2%.
  • LNG exports totalled 11.0 Bcf.
• As of August 21 the Canadian rig count was 205 (32% utilization), 134 Alberta (31%), 29 BC (41%), 36 Saskatchewan (31%), 6 Manitoba (40%)). Utilization for the same period last year was just above 15%.
• US Onshore Oil rig count at August 18 was at 759, down 4 from the week prior.
  • Peak rig count was October 10, 2014 at 1,609
• Natural gas rigs drilling in the United States was down 2 at 180.
  • Peak rig count before the downturn was November 11, 2014 at 356 (note the actual peak gas rig count was 1,606 on August 29, 2008)
• Offshore rig count was up 1 at 17
  • Offshore rig count at January 1, 2015 was 55

• US split of Oil vs Gas rigs is 80%/20%, in Canada the split is 56%/44%

Drillbits

• Wildfires continue to rage in British Columbia. Please consider a Red Cross donation if you can. It’s simple, easy and it helps
• All eyes are on the Gulf Coast and the storm, now a hurricane, named Harvey. This slow moving storm is the first major storm to hit the Gulf Coast in almost a decade. It is uncertain at this point how production will be impacted, but with refineries squarely in the path of the storm, it is a given that the industry will be impacted.
• Trump Watch: There was a speech on Tuesday that was very odd. No one got fired – so that’s a good week!.