There has been a lot of shouting back and forth about the federal government’s proposed tax changes. Both supporters and opponents have loosely thrown around the word “fair” as a way of justifying their position. But, how will these changes actually effect the structure of Canadian tax system?
One of the fundamental pillars of federal taxation is integration. Through various tax policies, integration is a principle that works to ensure income is taxed at the same rate regardless of whether it is earned by an individual directly or through a corporation.
Tax experts may disagree on the merits of the new changes but they can agree that a more integrated tax system is best.
“Whether this is moving towards or against integration is the key debate I think” said Kevin Milligan professor of economics at the University of British Columbia.
The benefit of integration is that taxes don’t bias anyone’s financial decision. If a professional pays the same amount of taxes regardless of whether they’re incorporated or not, then they can make the decision that’s best for them and their business without the influence of taxes according to Milligan.
Although there is widespread agreement on the value of having an integrated tax system, where income is taxed the same regardless of business structure, there is less agreement on what the ultimate effect the proposed federal tax changes will have on integration.
Milligan says that while our current taxation system strives to be integrated it falls short.
“The proof of that is simply that financial advisers are telling doctors, dentists and everyone else to set up their pensions through their corporation,” said Milligan. “If we were properly integrated there would be no [tax] advantage to doing that.”
While Milligan considers the current corporate tax rate to be a discounted rate for corporations, opponents of the changes consider deferred tax as necessary to stimulate investment. According to William Kai, tax partner at HGK LLP, corporations need to have a lower tax rate in order to allow greater investment in the business. Instead of paying a high tax rate on income earned by a business, it is taxed at a lower rate in order to leave the business with more capital to invest. Once the money is taken out of the corporation the tax deferral is paid.
Another fundamental pillar of the Canadian Tax system is that as long as the earning remain in the corporation they cannot be used to finance personal lifestyle without tax ramifications. Cash needed to fund personal lifestyle can only be withdrawn as a wage, salary, bonus or dividend, at which point they are taxed and any deferral is eliminated.
Milligan highlights the fact that professionals like lawyers and doctors are advised to incorporate so that income earned through vehicles like pensions can be taxed at the business rate as opposed to the individual rate.
Passive income like interest and rents earned by a corporation is currently taxed at approximately 50%, however, with the proposed changes it will be taxed at roughly 75% depending on the province it operates in. Kai points to this increase as an example of how the proposed changes are moving us away from an integrated system. Milligan says he’s heard this view from many senior accountants. While Milligan agrees with the tax impact of the proposed changed as calculated by opponents, he believes it is incomplete.
People claiming that the new changes will hurt integration are starting their accounting at the wrong point, according to Milligan. While rent and interest income earned within a corporation is taxed at a higher rate, some are not considering the fact that the money used to generate the capital that creates passive income was taxed at a dramatically lower rate. Milligan says that the higher rate within the corporation on passive income compensates for the lower rate charged upfront on the principle investment used to earn passive income. Without this higher tax rate on passive income, money earned through a corporation would be taxed less than if it had been earned by an individual.
While Kai agrees with the logic, similar to Milligan’s criticism, Kai says that tax change proponents aren’t considering that money inside the company could be used for investments outside of those that generate passive income such as buildings and capital equipment.
There are also concerns that the proposed changes will make it more onerous to earn investment income through a corporation. This could encourage people to take money out of their business in salary or dividends and invest a significantly lesser amount individually rather than deciding whether to invest inside or outside the corporation based on business merits.
One of the proposed changes involves eliminating the Dividend Refund, a tool that allows corporations to recoup some of the corporate taxes paid when it pays out dividends to the shareholders.
Milligan believes that by eliminating the Dividend Refund, the government is taking away one of the ways in which corporations can pay less tax than if the income was earned individually. Kai fundamentally disagrees, saying that the Dividend Refund is a way the tax system ensures integration, offsetting the higher rates of tax on passive income earned in a company. Kai says that the removal the Dividend Refund would be primarily responsible for the tax increase to 75% (from 50%) on passive income.
“For many, many years, that’s what we depended on,” said Kai. “When income was taxed in the company and ultimately paid out of the company to its shareholders, the overall tax would be similar to he money being earned directly by an individual. Small businesses are allowed to pay taxes at a lower rate, allowing small businesses to invest in themselves.”
Milligan says that removing the Dividend Refund means that investment income earned by businesses is no longer taxed at a lower rate than income earned individually.
Iain Black, President and CEO of the Greater Vancouver Board of Trade made the point that tax fairness is subjective on BIV’s radio show. The subjectivity of fairness becomes increasingly evident with both sides proclaiming their desire to make the tax code more fair.
Milligan argues that the current system is “unfair” in that income earned by a professional with an incorporated business is taxed at a lower rate than an employee who is taxed as an individual. Kai argues on similar grounds, saying that it is “unfair” that employees who receive a pension are taxed less than small business owners who often don’t have a private pension plan and rely on their business or sale of it for their retirement.
There will likely never be total agreement on what tax system is fair for everyone, but the effects of integration within the tax system are integral to the concept of fairness and any changes will have a lasting effect on the Canadian tax system.
