Firm but fair

The Globe and Mail (Alberta Edition) - - FRONT PAGE - IAN McGUGAN im­cgu­gan@globe­and­mail.com

It’s time to con­sider more com­plete re­form

The Lib­eral plan to tweak the sys­tem, while well-in­tended, will just make an al­ready com­plex sys­tem even more com­plex

The near hys­ter­i­cal de­bate over the small-business tax­a­tion demon­strates a sim­ple truth: Canada’s tax sys­tem has be­come mind-numb­ingly com­pli­cated. Maybe, just maybe, it’s time to con­sider more-com­plete re­form.

The cur­rent sys­tem is plagued by huge dif­fer­ences in how dif­fer­ent types of in­come are taxed. It’s rid­dled with com­plex­i­ties and in­equities. Taken to­gether, those prob­lems are driv­ing the cur­rent rush among Canada’s big earn­ers to in­cor­po­rate them­selves.

Ottawa is ab­so­lutely right to take is­sue with this trend. Among other ab­sur­di­ties, the cur­rent rules al­low the owner of an in­cor­po­rated small business to pay sub­stan­tially less tax than the owner of an iden­ti­cal small business that isn’t in­cor­po­rated, even though both earn the same amount of money.

This is not the way tax­a­tion is sup­posed to work in Canada. You shouldn’t get a big re­ward from the tax­man sim­ply for do­ing the same thing but in­side a dif­fer­ent eco­nomic wrap­per.

But the govern­ment’s at­tempts to crack down are ham-handed. And that re­flects how dif­fi­cult it is to tin­ker with a sys­tem that has grown into a labyrinth de­signed to dis­cour­age any­one ex­cept the bravest tax ac­coun­tant.

Con­sider, for in­stance, in­come sprin­kling – the en­tirely le­gal prac­tice in which the owner of a Cana­dian-con­trolled pri­vate cor­po­ra­tion passes on in­come to other adult fam­ily mem­bers by pay­ing them div­i­dends. If those other fam­ily mem­bers don’t have much in the way of earn­ings – if they’re univer­sity stu­dents or a stay-at-home spouse, for ex­am­ple – they pay very lit­tle tax on the money they re­ceive.

Ottawa wants to rein in the prac­tice, most no­tably by look­ing at whether the amount re­ceived is rea­son­able com­pen­sa­tion for what the fam­ily mem­ber has con­trib­uted to the business. But de­ter­min­ing what con­sti­tutes rea­son­able com­pen­sa­tion would pose end­less prob­lems, ob­serves Kevyn Nightin­gale, a part­ner at the ac­count­ing firm MNP LLP.

What would hap­pen, for in­stance, if a woman comes up with a bril­liant idea for a business, her sis­ter ex­e­cutes it, while a brother fig­ures out how to make the prod­uct sub­stan­tially more ef­fi­cient? Or if par­ents lend their tech-ge­nius kid a vi­tal few thou­sand dol­lars that en­ables him to start a com­pany that un­ex­pect­edly turns into a huge suc­cess?

Mak­ing the problem even worse is that the whole point of in­come sprin­kling is to spread out earn­ings to low-in­come, lightly taxed fam­ily mem­bers. This means the amounts in­volved typ­i­cally aren’t huge. “How does one rea­son­ably de­ter­mine that a per­son’s con­tri­bu­tions are worth $30,000, $40,000 or $50,000?” Mr. Nightin­gale asks.

The ques­tions be­come even more com­plex in the case of Ottawa’s two other pro­posed re­forms. Govern­ment wants to re­duce the in­cen­tive to use pri­vate cor­po­ra­tions as tax-shel­tered piggy banks for large amounts of pas­sive in­vest­ments that aren’t di­rectly tied up in run­ning a business. In ad­di­tion, it aims to make it tougher for the owner of a pri­vate cor­po­ra­tion to en­joy a lower tax rate sim­ply by con­vert­ing reg­u­lar in­come into cap­i­tal gains.

Both pro­pos­als are em­i­nently rea­son­able in con­cept, but they come with enough am­bi­gu­i­ties to fuel years of de­bate and lit­i­ga­tion. “This is adding a huge amount of com­plex­ity onto a sys­tem that is al­ready com­plex,” Jack Mintz of the Univer­sity of Cal­gary told a con­fer­ence this week.

What’s the pay­off for all that angst? The govern­ment says it does not know the ex­act fig­ure. But the im­pact on fed­eral rev­enue is likely to be small; the in­come-sprin­kling mea­sure, for ex­am­ple, is ex­pected to yield only $250-mil­lion. Stacked up against Ottawa’s $315-bil­lion an­nual bud­get, the po­ten­tial re­wards seem in­con­se­quen­tial to many an­a­lysts. “These pro­pos­als in­volve a great deal of added com­plex­ity and un­cer­tainty for a small gain in eq­uity and rev­enue,” Mr. Nightin­gale says.

Oth­ers dis­agree. Kevin Mil­li­gan of the Univer­sity of Bri­tish Columbia ar­gues that it’s im­por­tant for the tax sys­tem to main­tain neu­tral­ity – in other words, for govern­ment not to push peo­ple to pack­age their eco­nomic ac­tiv­i­ties into dif­fer­ent shapes sim­ply as a way of avoid­ing tax.

Prof. Mil­li­gan and oth­ers point out that the pri­vate-com­pany struc­ture de­liv­ers the great­est ben­e­fit to high earn­ers. It de­vi­ates from the guid­ing prin­ci­ple that peo­ple who earn the same amount should pay the same amount of tax. Left unchecked, the cur­rent trend to­ward in­cor­po­ra­tion risks cre­at­ing a two-tiered sys­tem – a flex­i­ble, low-tax one for peo­ple who can take ad­van­tage of in­cor­po­ra­tion and a much sterner, higher tax one for those who can’t.

But all of that brings us back to the case for wider re­form.

At the mo­ment, Cana­dian-con­trolled pri­vate cor­po­ra­tions pay a spe­cial, low rate of tax on their first $500,000 in ac­tive business in­come thanks to what is known as the Small Business De­duc­tion. This re­sults in an ef­fec­tive com­bined fed­eral-pro­vin­cial tax rate of 10.5 per cent to 18.5 per cent – which just hap­pens to be the low­est such rate in the Group of 7.

Other business in­come is taxed at a gen­eral rate that is much more oner­ous – 26 per cent to 31 per cent. But even that looks like a mad bar­gain next to per­sonal tax rates. Le­vies on the big­gest earn­ers have surged in re­cent years and top mar­ginal rates now nudge 54 per cent in On­tario and sev­eral other prov­inces.

Given this pyra­mid of pain, there has been a grow­ing and over­whelm­ing mo­ti­va­tion for peo­ple to ar­range their af­fairs so that as much in­come as pos­si­ble is taxed at the small-business rate rather than at the per­sonal rate. This has re­sulted in a boom in in­cor­po­ra­tion – and also in­creas­ing con­cern that the grow­ing swarm of pri­vate cor­po­ra­tions are be­ing used pri­mar­ily as tax shel­ters rather than for their in­tended pur­pose of pro­vid­ing an ef­fec­tive ve­hi­cle for a grow­ing business.

An ideal sys­tem would sim­plify the tax code and re­move the need for elab­o­rate ma­noeu­vres de­signed to shuf­fle dol­lars from one in­come bucket to an­other. Most im­por­tantly, it would pro­vide in­cen­tives for com­pa­nies to grow.

The bold­est idea would be to abol­ish the small-business de­duc­tion. Hav­ing only a sin­gle cor­po­rate tax rate with no pref­er­en­tial rate for smaller en­ter­prises might in­fu­ri­ate Canada’s small­busi­ness lobby, but it would go a long away to sim­pli­fy­ing Canada’s byzan­tine tax struc­ture.

It would also re­move a dis­in­cen­tive to growth. At the mo­ment, com­pa­nies that are nudg­ing up against the $500,000 in­come limit have a strong mo­ti­va­tion to split into smaller units to avoid pay­ing a higher tax rate. This can re­sult in a pro­lif­er­a­tion of small com­pa­nies that are too tiny to ever achieve economies of scale. They’re pri­mar­ily tax shel­ters rather than growth ve­hi­cles.

A move to a sin­gle cor­po­rate tax rate could be sweet­ened by re­duc­ing per­sonal or cor­po­rate tax rates. The small-business de­duc­tion now costs the govern­ment $4.1-bil­lion a year. Elim­i­nat­ing it would give Ottawa room to bring down rates else­where or to in­tro­duce in­cen­tives aimed at small com­pa­nies that are ac­tu­ally ex­pand­ing.

To be sure, mov­ing to a sin­gle tax rate for all cor­po­ra­tions may be a fan­tasy in the cur­rent po­lit­i­cal cli­mate. Dr. Mil­li­gan ar­gues that, for now, pol­icy mak­ers have to fo­cus on mak­ing the cur­rent pro­pos­als work by find­ing ways to re­duce their ad­min­is­tra­tive bur­den.

He sug­gests bal­anc­ing the re­forms with mea­sures that would do more for com­pa­nies that ac­tu­ally want to grow. For in­stance, firms could be al­lowed to im­me­di­ately ex­pense a cer­tain amount of cap­i­tal in­vest­ment an­nu­ally rather than de­fer­ring the de­pre­ci­a­tion de­duc­tions. “This gives an ad­van­tage to smaller firms, and the ad­van­tage is di­rectly tar­geted where we want it: in­cen­tives to grow in­vest­ment,” he said.

For his part, Dr. Mintz be­lieves sev­eral al­ter­na­tive poli­cies would have been prefer­able to Ottawa’s cur­rent pro­pos­als. For in­stance, he would have favoured mov­ing to a sin­gle cor­po­rate tax rate, such as Bri­tain in­tro­duced in 2015. But he ar­gues that even more sweep­ing changes are needed to ad­dress is­sues rang­ing from dou­ble tax­a­tion of sav­ings to how the tax sys­tem han­dles risk. “These re­form pro­pos­als should have been put in the con­text of ma­jor re­form,” he told the Cal­gary con­fer­ence.

Ex­actly. The most pos­i­tive thing to emerge from the cur­rent fire­fight would be a com­mit­ment to a wider re­think­ing of a sys­tem that has grown too messy, too com­plex, for any­one’s com­fort.

CHRIS WATTIE/REUTERS

As part of tax changes spear­headed by Fi­nance Min­is­ter Bill Morneau, Ottawa has set its sights on in­come sprin­kling – the prac­tice in which the owner of a Cana­dian-con­trolled pri­vate cor­po­ra­tion passes on in­come to other adult fam­ily mem­bers by pay­ing them div­i­dends.

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