Three targets, two principles, and one underlying cause

Marvin JS Ferrer

The federal government is proposing changes to rules around corporation taxes, which would affect Canadians who control corporations.  Instead of being paid directly (for example, with a salary), Canadians can form a corporation, or “incorporate,” and direct income into the corporation, then receive a salary or dividends from that corporation.  The federal government is proposing changes to rules about how (generally wealthy) Canadians can form private corporations to shelter some forms of income from taxation.

How are corporations being used to avoid tax?  Why are some Canadians outraged?  And what is the rationale behind the changes in the first place?  Corporation and investment tax policy is a complex policy area; here are some of the basics you need to know.

WHAT IS THE FEDERAL GOVERNMENT ADDRESSING?

While some Canadians use fraudulent means to evade taxes by moving income offshore, the federal government’s proposed reforms will end practices that are currently legal.  Nevertheless, Canadians who use corporations feel they are being painted as “cheaters” by proponents of the change.

The federal government is targeting three tax reduction strategies related to incorporation.

1. Income Sprinkling

Generally, Canadian income tax is calculated without regard for income of anyone else in the household.  Individual Canadians also pay a higher income tax rate as their income increases.

For example, in Ontario, the combined federal and provincial marginal tax rate for someone with $40,000 of income is 20.05% (if they make an extra dollar, you pay an extra $0.2005).  However, the marginal tax rate for someone earning $250,000 is 53.53% (if they make an extra dollar, they pay an extra $0.5353).

However, a person earning the same amount, but with a corporation, can choose to “pay” family members or others instead of themselves.  That family then collectively pays less tax because they are all taxed as individuals with less income, instead of one individual with a high income, as shown in Figure 1 for a hypothetical person in Ontario making $500,000 annually.

If the pay is through dividends instead of a salary, the tax savings might be even greater.  Tax savings would also be greater as the amount of sprinkled income and number of recipients increases.

2. Saving Money in a Corporation

When self-employed people make employment income, they pay tax on that income, and then may choose to save or spend the rest.  However, corporation income is taxed lower than individual income to encourage corporations to invest and grow.  This means instead of paying themselves income and then saving it, someone with a corporation can leave the income within the corporation, pay the lower corporate income tax rate, then save the rest within the corporation.  An example of how this strategy can be used to reduce tax liability is shown in Figure 2.

Savings accrue returns (income) over time.  Since the corporation tax is so much lower than the marginal tax rate for the very wealthy, keeping savings within the corporation becomes more lucrative over a prolonged period of time as shown in Figure 3.

3. Converting Corporate Earnings into Capital Gains

When a wealthy shareholder of a corporation finally receives income from the corporation, they could save even more tax money by receiving the income as capital gains, which is taxed at a much lower rate than dividends or salary.

Capital gains, which are income from investments, are taxed at a lower rate to encourage more investment.  The tax rate on salaries is generally double the tax rate on capital gains.  For dividends, the tax rate ranges from 5% lower than the capital gains tax rate in the Yukon Territory, to 47% higher than capital gains in Ontario, to 63% higher in Newfoundland.

WHAT ARE SOME PRINCIPLES BEHIND THE TAX CHANGES?

People in equal situations should be equally well off

A principle called “horizontal equity” demands that people in identical situations (who make the same income, with the same assets) should be treated equally.  This implies that someone making $200,000 per year from a salary should pay the same taxes as someone making $200,000 that controls a corporation.

Federal proposals aim to remove tax reduction strategies available to people who control a corporation that are not available to people who earn salaries.

People with a greater ability to pay tax should pay more tax

Another principle called “vertical equity” demands that people with higher incomes should pay more taxes.  This is reflected in the structure of the income tax system; as noted earlier, marginal tax rates rise as people earn more income.

Federal proposals aim to remove tax reduction strategies using corporations that allows those with higher incomes to avoid tax obligations required by an income tax system that is designed with vertical equity in mind.

THE ROOT OF THE PROBLEM

Wealthy Canadians have been incorporating at a higher rate; the proportion of GDP formed by the taxable income of Canadian controlled private corporations doubled from 2002 to 2014.  The number of private corporations grew from 1.2 million to 1.8 million from 2002 to 2014.

There are several advantages to incorporation, but a common thread throughout the three tax strategies being addressed by the federal government is the much lower capital gains and corporation tax rate compared to the marginal personal income tax rate paid by the wealthiest Canadians.  There is a 37.2 percentage point gap between the top marginal personal income tax rate and the small business tax rate.

Presumably, reducing the gap by lowering the top marginal personal income tax rate or increasing the small business tax rate would reduce tax incentives to incorporation.

Considering the aforementioned corporation-related tax reduction strategies are legal, Canadians who use them are upset that they face what is essentially a tax hike.

Other Canadians without access to these tax reduction strategies may view the removal of these strategies as a matter of fairness, related to either horizontal or vertical equity.  They may claim that the changes are only fair because the tax reduction strategies should not have been available in the first place.

One thing is clear: competing definitions of fairness in the tax system are contributing to the intensity of this debate.

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Marvin JS Ferrer previously completed his master’s and doctoral degree in the cell biology of reproduction and fertility at Queen’s University, where he helped many Canadians start new families. His policy interests include science and research policy, industry-government relations, and health policy.  As a politically-minded scientist, he would like to advance the use of the scientific method to improve evidence-based decision making.