Special Feature

Special Report on Taxes 2017

In this special feature: evolving changes for private corporations; large TFSAs under review; yearend tax tips; receipt management software and much more from the Mid-October 2017 issue of Investment Executive.

The Liberals' recent proposed tax changes for private corporations are part of a larger effort by the feds to eliminate opportunities for wealthier Canadians to split income and reduce taxes. The question is, does that make for good tax policy?

By Rudy Mezzetta | Mid-October 2017

The federal government's endgame on tax policy remains a murky guessing game. But at least one strategy for collecting more from affluent taxpayers is emerging: the rules for private corporations that professionals and owners of small to mid-sized businesses use routinely to direct income to family members and other non-arms' length individuals are likely to be revised.

These proposals may be just the most recent in a series; the Liberals appear to have embarked on an agenda to reduce income-splitting opportunities available in Canada's tax regime, overall. Whether getting rid of income splitting for couples with children, or reducing the TFSA contribution limit, the Liberals are signalling a return to the principle of taxation based on individual income, not the family unit.

"None of this should come as a surprise to anyone who read the Liberal [election] platform," says David Macdonald, senior economist with the Canadian Centre for Policy Alternatives (CCPA) in Ottawa. The Liberals stated in their 2015 campaign document that, if elected, they would ensure private corporations weren't used to "reduce income tax obligations for high-income earners" and that the party was generally against "income splitting and other tax breaks for the wealthy."

In contrast, the previous Conservative government did much to shift the Canadian tax system toward one based on the collective income of family members. Most notably, it introduced the Family Tax Cut, which allowed a high-earning parent to split up to $50,000 with a low- or no-income spouse for a maximum benefit of $2,000, and pension income splitting, which allowed some retired couples to lower their overall tax bill by transferring pension income from one spouse to the other. The Conservatives also launched, and then expanded, the TFSA program. An individual can gift money to a spouse or adult child to be used to fund a TFSA without triggering the rules that would normally attribute income and gains to the individual giving the money.

"The Tories weren't willing to go the full route of [introducing] a joint return for spouses, but they were getting at it indirectly," says Rick Robertson, associate professor with the Richard Ivey School of Business at the University of Western Ontario in London, Ont.

Canada taxes its residents on the basis of the individual, as do most countries in the OECD, in part on the grounds that joint taxation reduces the incentive for lower-income spouses - women still remain the more likely spouse to earn a lower income - to participate in the labour market.

"Income splitting always helps couples most when one individual isn't working, because then [the couple] get the lowest possible tax rate by shifting some of the income of the higher earner into the lower earner's account," says Elisabeth Gugl, associate professor in economics at the University of Victoria. Indeed, there are several provisions in the Income Tax Act to prevent individuals from lowering total tax by splitting income with a spouse or a family member.

Even so, the Income Tax Act does allow for a limited number of income-splitting opportunities, such as the use of spousal RRSPs, or pension income splitting. The latter is a Conservative-era program the Liberals have kept.

The current mishmash of rules that sometimes allow or sometimes prevent income splitting creates complexity, inconsistency and inequity in the tax system overall, argues Jamie Golombek, managing director of tax and estate planning with Canadian Imperial Bank of Commerce's wealth strategies group in Toronto.

"Canada should come down with an equal policy of who's allowed to income split, and when and why," he says. "If not, we should look at something like joint returns." The U.S. tax system allows for the joint filing of tax returns by couples, including opportunities for income splitting.

Given both Canada's relatively high tax rates and the low thresholds for reaching those rates, it's no surprise that high income Canadians would be increasingly interested in opportunities to split income, including via the private corporation structure, Robertson says: "We have these massive differences in our tax rates [between income thresholds], and you get to a top tax rate really, really quickly in this country."

The Liberals' consultation paper regarding taxes argues that the use of the private corporation structure to achieve income splitting between family members provides an unfair advantage to a small number of wealthy, incorporated business owners looking to avoid their "fair share" of taxes.

A CCPA paper regarding the proposed changes, published in September, seems to bolster the government's argument. That paper states that the benefits of income splitting via private corporations is "heavily skewed" toward the wealthiest and cites statistics that suggest that Canada's richest 10% of families received two-thirds of the total tax benefit, in terms of lost government revenue, from the "loophole."

Indeed, critics of income splitting, as a general concept, argue that it usually favours only a few. For example, a couple in which both spouses earn similar incomes wouldn't receive any advantage from income splitting, nor would a single-parent family. Only couples with a high-income earner and a low- or no-income earner would see a significant benefit.

Proponents of income splitting argue that splitting income meets the principle of "horizontal neutrality" - that families earning the same total income should pay the same amount of taxes. Right now, at similar income levels, one-earner families typically pay more taxes than dual-earner families with the same total income.

However, critics of income splitting argue that this view doesn't take into account the value of work done by the spouse who manages the home and often provides child care, tasks that dual-earner couples usually have to pay for. Single-earner and dual-earner couples, even at the same income level, are not equal "because the dual-earner couple has to spend more money on transportation and other work-related costs [associated with the second spouse participating in the labour force], as well as on child care, when the [single-earner] couple doesn't," says Alexandre Laurin, the director of research at the Toronto-based C.D. Howe Institute. In this view, the single-earner family with two adults has an advantage: greater ability to pay taxes in relation to a dual-income family at the same income level.

Gugl suggests that, by giving one spouse an incentive to remain home and provide child care, income splitting also may lead to negative consequences for that spouse. For example, he or she may see his or her earning power reduced over time because he or she remains out of the labour force and, if the relationship breaks down, that spouse then may find seeking work more difficult because of lack of skills and experience.

To be sure, none of the major political parties in Canada is advocating that Canada introduce joint taxation, but Robertson suggests that we are likely to see the pendulum continue to swing back and forth in support of more or less income splitting.

"Maybe, as a country, we should be deciding what to do [about income splitting]," Robertson says. "There's no doubt, if the Tories got back in, we would see more income splitting."

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