HOW TO CLOSE THE TAX LOOPHOLES
Full disclosure: many years ago I was advised to set up a corporation, and to direct that any freelance earnings be paid to it rather than to me. There was no practical benefit to doing so. It was strictly a tax play: as a corporation, or more particularly as a small business, I would pay a much lower rate of tax on those earnings than I would as a mere person.
I never did realize much in the way of the promised tax savings: as soon as corporate me paid personal me, the difference in tax seemed to disappear. But that is because I was too impatient to get my hands on the money: the real savings accrue from being able to defer tax, by leaving the money in the corporation and investing it.
Others, however, more competent and less greedy than me, seem to have figured it out. The number of private corporations in Canada has soared in recent years, from 1.2 million in 2000 to 1.8 million in 2014. And as the number of corporations, many of them sole proprietorships — doctors, dentists, and the like — has mushroomed, so has the amount of income being sheltered from tax, and the cost to governments: at least $250 million to the feds alone.
Not surprisingly, the federal Finance Minister, Bill Morneau, last month announced plans to crack down on some of the more lucrative aspects of the practice: not only the use of private corporations to shelter investment income, but also “income sprinkling,” in which the corporation pays family members a salary or dividends, resulting in a lower tax burden than if the person who earned the income had also paid all the tax on it — like, say, a person.
Equally predictably, the proposal has provoked an enormous amount of caterwauling from those affected. The rhetoric has at times bordered on the apocalyptic. The federal government is “killing the entrepreneurial spirit,” said one. “A blatant tax grab,” said another. No, it was “tax warfare,” a “massive attack on high earners,” evidence that “class envy, pettymindedness and misinformation are the defaults in Liberal-land.” Doctors seemed particularly peeved, warning darkly of unspecified consequences for “patient care.”
Of course, whenever you hear this kind of braying, it’s usually a sign of an ox being gored: the extra tax of which they complain is tax they are now avoiding — tax that others, earning the same income, do pay. A federal discussion paper cites the example of two families, each with $220,000 in gross income, one of which pays $35,000 less in tax than the other by virtue of “sprinkling.” It’s perfectly legal, of course, but it’s hard to call it fair.
Mind you, the same logic argued for allowing income splitting between spouses, which the Liberals cancelled — two couples earning the same combined household income should pay the same rate of tax, rather than the single-earner couple paying substantially more than its dual-earner neighbours. If it is encouraging that the Liberals have now discovered the concept of horizontal equity, it is dismaying that their critics have forgotten it. Hilariously, many of the more specific critiques of the federal proposals actually make the case for them. A financial columnist complained: “They call into question the purpose, really, of having a corporation.” Another said the changes would “destroy tax planning as we know it.” My favourite was the political pundit who fumed, incredulously, that “Morneau and his bureaucrats seem to want all income taxed at the same level.”
Well, yes — and yes, and yes. The ideal tax policy would indeed tax all income at the same rate, no matter how it was earned or to whom it was paid, such that there would be no reward for “tax planning,” including incorporation. We want people to make financial decisions based on the real economic costs and benefits of each option, not the tax goodies attached.
A particular objection seems to be that income earned by a small business, even one that looks an awful lot like a person, should not be treated the same as salaries and wages, because of the allegedly greater risks the former takes on than a mere employee. Whether that is true or not — there are often risks associated with taking a job just as there are with investing in a business — the larger point is that this is no concern of the tax system. Again: the return on risk is supposed to be the return, not the tax preference. Society does not benefit from paying people to take on risks they would not otherwise assume, whether the payment takes the form of a subsidy or a special tax rate.
If I have an objection to the federal plan, it is not in their assessment of the problem, but their proposed solutions. These amount to attempts to discourage people from doing what the current tax system so plainly encourages them to do. Thus there would be intrusive new tests to see whether family members, specifically adult children, were really performing useful work in return for the money they were paid. Investment income earned inside a corporation would be subject to complex new calculations of tax owing. And so on. Some have even proposed banning people from incorporating altogether.
The alternative approach would focus on reducing the incentive to incorporation, which is to say the current massive disparity between the top rate of personal income tax — now in excess of 50 per cent, federal and provincial combined — and the small business rate, typically less than a third of that. That gap has only widened in recent years, as governments have increased personal taxes and lowered corporate and small business rates.
Bring those rates more in line, and you’ll soon see fewer people turning themselves into corporations. Like me, they will find it not worth the bother. Financial Post
Critics of crackdown on sheltering tricks have forgotten idea of horizontal equity