Proceedings of the Standing Senate Committee on
National Finance
Issue No. 20 - Evidence - December 2, 2016
OTTAWA, Friday, December 2, 2016
The Standing Senate Committee on National Finance met this day at 9:33 a.m. to give consideration to the subject matter of all of Bill C-29, A second Act to implement certain provisions of the budget tabled in Parliament on March 22, 2016 and other measures, Parts 1, 2 and 3.
Senator Larry W. Smith (Chair) in the chair.
[English]
The Chair: Welcome to the Standing Senate Committee on National Finance. Colleagues and members of the viewing public, the mandate of this committee is to examine matters relating to federal estimates generally as well as government finance.
My name is Larry Smith, a senator from Quebec, and I chair the committee. Let me introduce briefly the other members of the committee.
To my left, standing very strong, from Montreal, Quebec, is Senator André Pratte. To my right, from Toronto, is Senator Salma Ataullahjan. To her right is our deputy chair, Senator Anne Cools. To her right is the former Auditor General and truly great senator, from the province of Newfoundland, Senator Beth Marshall; and more than a capable replacement and a very strong member of the Senate, Senator Judith —
Senator Seidman: Judith Seidman.
The Chair: Seidman. I was looking at this box of Kleenex. Sorry, Judith. Thank you very much.
What happened was I had a "44 counter trap.'' I got the ball and thought I saw a big hole, and all of a sudden I woke up on the ground trying to figure out what hit me. That was one of those moments, so I apologize for that.
We have with us one of the greatest skiers in the history of sport, Senator Nancy Greene Raine. Of course, from New Brunswick, is the ever-charming and great senator, Percy Mockler.
Today we begin our consideration of the subject matter of Bill C-29, A second Act to implement certain provisions of the budget tabled in Parliament on March 22, 2016 and other measures. This bill is also referred to as the Budget Implementation Act, 2016, No. 2. You will recall that we examined the Budget Implementation Act, No. 1, in the spring.
[Translation]
This morning, to start our study of the subject matter of Bill C-29, we're pleased to have with us, from the Department of Finance, Gervais Coulombe, Acting Chief, Sales Tax Division, Tax Policy Branch.
[English]
James Greene, Director, Business Income Tax Division, Tax Policy Branch. James, we spoke earlier.
Pierre Leblanc, Director, Personal Income Tax Division, Tax Policy Branch.
[Translation]
Pierre, please know that I'd like to have a title as impressive as yours at least once in my life.
[English]
Trevor McGowan, Acting Chief, Tax Legislation Division, Tax Policy Branch; and Pierre Mercille, Senior Legislative Chief, Sales Tax Division, Tax Policy Branch.
Welcome, gentlemen.
We have received the department briefing binder on the bill and we thank you for this information. It has been circulated to members of the committee.
We had a discussion coming in with the members of the Department of Finance. We try to make sure that we try to present in the most beneficial way for our senators so every one of us can understand. This is a very intricate and complex group of amendments, changes, et cetera, so I'm excited to hear the presentations that we will receive.
What we are expecting from you now is to go over the measures and to explain each clause and how it supports the measure. If it is all right with you, we would like the opportunity to ask questions as they pertain to each clause to make sure we have the full understanding before we move on to the next.
Mr. McGowan, would you like to give opening comments in terms of how you would like to proceed?
Trevor McGowan, Acting Chief, Tax Legislation Division, Tax Policy Branch, Department of Finance Canada: Of course. I'll provide a brief summary of what is in the bill and then we can go through measure by measure. I understand that our summary table of measures has been circulated, and this shows which clauses in the bill apply to which measure. I trust that will be helpful to members of the committee because some measures have more than one clause that are relevant to them, so we'll deal with it measure by measure.
This, as was noted, is the second Budget Implementation Act of 2016. It contains amendments, either referenced or announced as part of Budget 2016, including a simplification measure to replace the eligibility capital property rules in the Income Tax Act with a new class of depreciable property; rules to prevent the avoidance of certain provisions in the act through the use of what are known as back-to-back arrangements; rules that would exclude derivatives held as inventory from the market-to-market property rules; rules ensuring that the tax treatment on the sale of linked notes is consistent with the tax treatment of the note on maturity; rules clarifying the tax treatment of emissions allowances; rules that apply on when a foreign exchange gain on a debt becomes a parked obligation; rules addressing certain loopholes in the life insurance policy rules; a measure dealing with cross-border surplus stripping to ensure that it applies as originally intended.
There is indexation of the Canada Child Benefit starting in the 2020-21 benefit year, so in July 2020; rules preventing the multiplication of access to the small business deduction; rules dealing with so-called switch funds, preventing a deferral on switches from one fund to another within a corporate class; rules implementing country-by-country reporting standards from the OECD; rules clarifying the application of the back-to-back rules in multiple intermediary situations; rules providing additional flexibility for charitable donations made by a taxpayer's estate; rules clarifying the loss-restriction event rules, in particular as they apply to investment funds; rules providing more flexibility for certain trusts, like special trusts, on the death of the primary beneficiary; rules that were announced as part of Budget 2015 but confirmed as part of Budget 2016, clarifying that alternative arguments can be put forward in support of an assessment after the expiry of the normal limitation period, provided the total amount on assessment doesn't increase. Lastly, for Part 1, there is a measure implementing the common reporting standard recommended by the Organisation for Economic Co-operation and Development.
That's a brief overview of the measures in the bill. If it's okay, we can go through each of the measures in a more detail.
The Chair: Please go ahead, Mr. McGowan.
Mr. McGowan: I will proceed, because we are discussing the contents of a bill, with the measures in the order in which they first appear in the bill. There is some ordering to it, but it is entirely by where they appear in the bill.
The first is the eligible capital property measure. It replaces the current eligible capital property regime, a very complex regime in the Income Tax Act dealing with the tax treatment and, essentially, depreciation of certain tangible interests. Goodwill is the classic example. Those rules are highly complex and have their own regime.
These would be a simplification measure, moving that separate set of eligible capital property rules into a new class of depreciable capital property so that going forward it would be subject to the same existing rules as other classes of depreciable property.
It also includes measures to allow taxpayers more simplification measures to quickly write off small balances of eligible capital property either by taking an accelerated $500 deduction for up to the first 10 years to eliminate small balances of eligible capital property or to exclude the first $3,000 in corporation expenses, which for a lot of small businesses represents the entirety of their eligible capital property balances. So up to $3,000 in corporation expenses would now be currently deductible instead of put into this somewhat more complex depreciation regime.
Senator Marshall: Mr. Chair, are we going to save our questions to the end? How are questions going to be asked?
The Chair: As we go through, once Mr. McGowan has finished a particular clause, then you are free to ask questions, if that's okay.
Senator Marshall: I have a question when he finishes on this clause.
Mr. McGowan: I'm finished. Thank you.
Senator Marshall: Is there an estimate of the cost to the treasury of these changes? Will the changes in that clause raise additional funds for the government, or is there going to be a loss of revenue? Or does it just affect the timing and the money will be collected by the treasury more quickly? What's the impact on taxpayers? I'm just deeply suspicious.
Mr. McGowan: The impact that was announced as part of Budget 2016, this is the annual total revenue increase to the government: $30 million for 2016-17, $190 million for 2017-18, and $255 for 2018-19.
Senator Marshall: That's extra revenue for the treasury?
Mr. McGowan: That's correct. This was announced as part of the supplementary information in Budget 2016. It's the tax treatment of certain intangibles held by a corporation when they're sold. They were previously taxed as active business income, even though it's the sale of properties more capital in nature.
Right after the sale, if the proceeds are paid under the corporation, it's essentially a wash and there is no revenue impact. To the extent the amount is left in the corporation, there is a deferral benefit. These numbers reflect that.
Quotas are the classic example. In the farming context, revisions were made to the rules to ensure that sales of farming quotas qualify for the lifetime capital gains exemption, which for farming property is up to $1 million of tax free capital gains, now that this is capital property. For affected taxpayers, that was intended to address that.
Senator Marshall: As you go through each clause, perhaps you could include in your comments the cost or the benefit to the treasury of each of the clauses.
Mr. McGowan: I will.
Senator Andreychuk: You're saying that it's going to make it less complex and less complicated, but the income tax rules are often complicated to allow for exemptions and undue hardship on people.
You hit the one I was going to talk about, the one I know most about, which is farming. You're saying there is going to be revenue for the government, but how do we know what the impact is going to be on others? You're saying it's simplified. When you simplify, you take away some of the discretions that have been helpful to the farmers, et cetera.
I'm also a little skeptical about making everything simple, because it becomes more complex when you make it simple. You haven't factored in all the variations. It would seem to me that we've added things to take into account special issues.
Farming and capital gains is more than just properties in a city being transferred. It's a way of life. It's a capability of continuing on farms.
Perhaps I don't understand it. I never did understand income tax when I was practising. It's always subject to section so-and-so, which is subject to section so-and-so.
It sounds good to simplify it, but we seem to be simplifying it for the benefit of the government. I really want to be sure it's simplifying it for the taxpayers.
Mr. McGowan: If I may, I could provide some elaboration on what we mean by "simplification'' in this context. There have been, since the introduction of the eligible capital property rules, two parallel sets of rules — eligible capital property and the depreciable property rules — that provide deductions in annual amortizations for the cost of these affected properties.
The eligible capital property rules were introduced separately as a different class of property because they're not truly depreciable in the same sense as an automobile or something like that.
There are two parallel systems, one dealing with eligible capital property and one dealing with normal depreciable property. Eligible capital property was put into a separate class, a separate system, apart from normal depreciable capital property, but the rules were intended to essentially parallel each other, and as one was changed usually the other was changed. But you had two parallel systems, two parallel sets of rules that were intended to do largely the same thing, which was to provide an annual deduction for certain costs associated with a business.
Of course, as tax rules tend to do, they increased in complexity over the years. Now you have two highly complex systems dealing with largely the same types of issues. So when I say "simplification,'' I mean that the eligible capital property rules are now going to be repealed, and what was eligible capital property will now be treated the same way as depreciable capital property.
It's not introducing a newer, simpler set of rules for this type of eligible capital property. It's taking two sets of rules that essentially were intended to do the same thing but had developed separately and injected a great deal of complexity into the system and combining them into one set of rules, so that while the depreciable capital property rules are themselves complex, you at least don't have two parallel and largely similar sets of rules operating side by side.
Senator Andreychuk: I think you just contradicted yourself. You said there were two sets of rules essentially starting out with presumably the same basis and rules, but they increasingly became more complex and different. At least I heard that.
Now you're going to put them together, so what are the gains and losses in putting them together? Either they were essentially the same and just for efficiency, administration and understanding you're putting them together, or there were differences. If so, how have you melded the differences?
Mr. McGowan: I intended to say that in terms of policy, they're essentially the same, although eligible capital property deals with things like goodwill. If you buy an automobile, you can say that it's worth so much less every year. If you buy the goodwill of a business, it's an intangible. It's difficult to put that on the same kind of amortization schedule, but still the tax act provides deductions for it. That's, I think, part of the reasoning as to why it was initially put into a separate class because in terms of conceptual purity, it doesn't align perfectly with normal classes of depreciable property.
That said, essentially the same treatment was intended to apply although there are differences in the implementation of the rules. One example is that the new class of depreciable property would be deductible at the rate of 5 per cent. You have the cost of a property and you can deduct 5 per cent of the pool annually, whereas for eligible capital property, 75 per cent or three quarters of the cost gets added to your eligible capital property pool and you deduct that at 7 per cent.
You can see that the two mathematically are very similar, but they just take slightly different approaches and they come with their own differing sets of complexity. In some cases, subtle differences can appear, but the policy is the same or essentially the same. It remains unchanged and is now integrated into the new class of depreciable property.
The Chair: Are we okay, senator?
Senator Andreychuk: I'm not getting the answer.
Senator Raine: I'm not clear. Is there still going to be goodwill as part of the capital property of a small business? Will it be treated differently in the future than it has been in the past?
Mr. McGowan: There will still be goodwill. It will be treated as part of this new class of depreciable property rather than as eligible capital property. So it will be in this new Class 14.1.
Senator Raine: I understand it's in the new class. Will it affect my business where my name is part of the goodwill of my business? How will that affect me?
Mr. McGowan: Well, it's a complex set of rules. I'd say in general terms, under the eligible capital property rules, you would add three quarters of the cost of goodwill to your cumulative eligible capital balance and then deduct that at a rate of 7 per cent annually. Under the new rules, you would add the full amount of the cost of goodwill to your Class 14.1 balance and depreciate that or deduct that at a rate of 7 per cent.
Senator Raine: So are you saying I will have to get the goodwill that I have in my company evaluated and set a value on it? As of what date and who does that?
Mr. McGowan: These deal with goodwill that is purchased, that has a cost. When you buy a business, you pay certain amounts for different assets if you're buying the assets of a business. To simplify somewhat, what's left over that doesn't get a specific value attributed to it is generally classified as goodwill, and that will give you your initial goodwill number.
Businesses that start and are not acquired don't have this. That's the same whether it's under the eligible capital property rules or this new set of rules. The cost is something that you've purchased.
Senator Raine: Thank you.
Senator Marshall: Will the proposed changes to the goodwill raise revenue for the federal government? What's the impact on the treasury for that one?
Mr. McGowan: We did not separate the costing of each component of the measure. My understanding is that the revenue increase to the fisc is largely attributable to the difference I mentioned earlier about the sale —
Senator Marshall: To the entire package?
Mr. McGowan: — of eligibility capital property in a generally small business corporation subject to a lower rate.
Senator Marshall: I'll reword it, then. In the first fiscal year that this takes effect, would you expect businesses to pay more in income tax or less?
Mr. McGowan: Well, the costing we have here, the first year would be as of January 2017, and we have an estimated increase in tax revenues of $30 million. That's more attributable on the sale of property.
Senator Marshall: That answers my question. Thank you.
The Chair: Let's move on. We need to accelerate a bit in terms of making sure we get through this. Good questions.
Mr. McGowan, keep going.
Mr. McGowan: The next measure extends the existing back-to-back rules in the Income Tax Act. Certain tax consequences apply to transactions between taxpayers that are in a certain relationship. The classic example is if you pay interest to a non-resident corporation in a country with which Canada does not have a tax treaty, that could be subject to a withholding tax rate of 25 per cent. The back-to-back rules are intended to apply to situations where an intermediary is inserted into a transaction in order to avoid the tax consequences that would normally arise if the transaction was undertaken directly.
The classic example, as I said, would be a payment of interest from Canada to a non-treaty country, say the Cayman Islands, where a treaty resident intermediary was inserted between the ultimate lender and the borrower in order to achieve a lower rate of withholding tax. So these rules would generally look to the ultimate recipient and apply the tax consequences that would ordinarily arise to prevent the mere insertion of an intermediary corporation between two entities in order to avoid certain tax consequences.
There are three main components of this. One is extending the existing back-to-back rules that apply to interest that are currently in the act to payments of rent royalties for similar payments.
Another is for these rules to apply to what are called multiple intermediary structures. The one I described, the simple example, was inserting one intermediary. But if that was the only rule, then you could just insert two intermediaries or three or four, and you would have a back-to-back-to-back structure instead of a back-to-back structure. This prevents the avoidance of the rules through the use of multiple intermediaries or substituting character payments.
Lastly, they extend the rules to apply in shareholder loan situations where, if a company makes a loan to certain of its shareholders, that's generally under the tax rules in the act. They can be treated as income to the shareholder, and these amendments apply so that those rules cannot be avoided by interposing an intermediary corporation to defeat them.
Senator Marshall: Are you saying that right now these transactions occur and the taxpayer doesn't pay any taxes? Our briefing notes say they don't pay withholding tax; they don't pay any taxes on those transactions.
Mr. McGowan: In some cases, it depends on the rules. For example, in a withholding tax situation, withholding tax on royalties is 25 per cent under the general rules in the act. That could be reduced to 10 or 15 per cent.
Senator Marshall: But our briefing notes say that the total amount of the loan is going to be included in the taxable income; is that correct?
Mr. McGowan: That's for the shareholder loan set of rules. In some cases, like the withholding tax one, you can get a reduction of tax; and in other cases you would have a complete avoidance of tax, so it would not be taxed. If such a loan was made directly from a corporation to an individual under the existing rules in the Income Tax Act, that would be included in the taxpayer's income as a benefit, as an appropriation.
Senator Marshall: But when they repay the loan, do they get any kind of deduction? It just seems like you get a loan, you plug it in and it becomes taxable income. You pay taxes on it, and then next year you repay it. Do you get any reduction in your taxes for repaying it, or are you just being zinged when you get the loan?
Mr. McGowan: I had said that if these shareholder benefit rules apply, then you would have an inclusion in your income. But for these rules to apply, it's not every loan received by a shareholder. A short-term loan would not apply and you wouldn't have the income inclusion.
These rules are intended to apply only in situations where a direct loan would have resulted in an income inclusion under the existing rules. So repaid loans within a particular period are not currently caught within the rules and would not be caught under the extension.
Senator Marshall: It just seems that the total amount of the loan being included in taxable income is a bit unfair.
What's the benefit to the treasury of that? Is there an estimate on that?
Mr. McGowan: No. As part of the budget, we didn't put out a revenue number because it was —
Senator Marshall: But it's definitely more revenue?
Mr. McGowan: It would be. It's preventing —
Senator Marshall: You just don't have a dollar amount. Okay, thank you.
Senator Andreychuk: Going back to your first comment, when you have the intermediaries, is it public policy to try to stop that because we want to be in line with other countries that are moving in the same direction or that have already moved in this direction, or are we really looking for what I would call questionable money? We're very much involved in tracing money these days, where assets move from nefarious regimes, et cetera. There are the numbered companies and this would be all one factor in moving that money somewhere else inappropriately. Or is it that these were legitimate deductions, but now others are closing this capability and we should be in line with them?
Mr. McGowan: There are two points that I'd like to address separately.
One, we're talking about legitimate deductions or legitimate payments versus not. I don't want to suggest that these are illegitimate in the sense that it's dealing with tax evasion. It is international tax planning, where those multinationals affected are not engaging in tax evasion; it's a tax planning and tax minimization strategy. I want to be clear that we're not talking about tax evasion here; it's just tax planning.
In terms of what other countries are doing, recently the OECD and others participated in what's known as the base erosion and profit shifting exercise. It lasted over a span of at least a couple of years and produced a number of working papers and outputs, and combatting what was considered to be inappropriate — or at least not inappropriate to do it, because if it's there, people will do it — but the international tax systems don't work appropriately if they allow for certain types of tax planning.
The base erosion and profit shifting project was undertaken by a number of countries. One of the elements in that was so-called treaty shopping, which is very similar in spirit. There's a question of overlap with these rules, where you interpose a more favourable corporation or entity between two other entities in order to obtain a better tax result under a treaty.
The base erosion and profit shifting project was an output of the OECD, and it is something that the international community is very much looking at.
Senator Raine: What types of businesses are used as intermediaries? For example, do intermediaries include financial institutions and holding companies?
Mr. McGowan: There are different classes, and it depends on the set of rules to be avoided or circumvented. An intermediary could be — I don't want to use jargon — like a cash box or a holding company that is established in a low-tax jurisdiction without much in the way of commercial operations.
It could also be an arm's-length financial institution that agrees to make a loan. Following my earlier example, you would have a Cayman company arm's-length a financial institution to a Canadian company, where the terms of the loan between the financial institution and the Canadian company are linked to the funding coming in from the Cayman company. For example, if there's non-repayment of the loan from the Canadian company, it can essentially be put over or they can have recourse against the Cayman company to ensure that the loan is paid. The financial intermediary, when it is arm's length, would have processes put in place so that they don't have the full economic exposure to the loan, so they really are acting as an intermediary.
Senator Raine: Thank you.
Mr. McGowan: The next measure deals with the valuation for derivatives. These would exclude derivatives that are held as inventory by a business other than a bank. Banks have different sets of rules. So you have inventory derivative financial instruments held as inventory, and it ensures that those derivatives are not subject to the "lower of'' cost and market rules in the act. Those rules allow inventory to be valued at the lower of its fair market value and its cost.
Those rules make a lot of sense if, for example, you have a car dealership where the cars in your inventory decline in value every year, so you want to be able to write them down.
Derivatives, as financial products, are a different sort of property. They don't necessarily depreciate in value the same way that a tangible or physical property would. They also give rise to opportunities for more tax planning and tax avoidance, so it was considered to be inappropriate that they use the market-to-market rules and this would ensure that they don't have access to that. The more general set of rules in dealing with inventory would apply.
We did not have a specific cost in the budget for this one as well.
Senator Marshall: You don't have it costed out. It is a benefit to the treasury, isn't it, because it's going to be based on the amount realized upon their sale and not on the accrued gain or loss?
Mr. McGowan: Well, it would prevent the use of the lower of cost or market method, which would provide accrual deductions, so you get deductions as losses accrue, but any gains would only be taxable in realization, so there could be a tax benefit. In this case, the measure responded to a court case. Our understanding was that this type of planning was not widespread and so it wasn't an exit.
Senator Marshall: Why would the changes not be fully costed out? We're just finishing up Bill C-2 on the income tax rates. The government has costing for certain parts of the changes in the tax rate but not the overall package, and this is similar. Why would changes not be fully costed out?
Mr. McGowan: In this case, the change prevents erosion to the tax base. You have the baseline revenues right now, and it prevents people from adopting this type of tax planning to avoid taxes. It's not necessarily like changing a rate or something like that, which you can cost out more easily because you know what income people are earning or not. It's more preventing people from obtaining or utilizing particular routes.
Senator Marshall: It seems that the government is into these results-based objectives, so one would think that if they're making changes to the Income Tax Act that they would be costing it out in advance so that two or three years down the road they could go back and see if what they thought was going to occur actually occurred.
We had representatives from Finance in here before who said it would take not just one year but a couple of years, which I was kind of surprised about.
Mr. McGowan: That's right. My economist colleagues can speak more in-depth about the costing methodologies, but in situations where you have a court decision that gives rise to the potential for a certain type of tax planning, any costing would necessarily be based on guesses of what taxpayers might come up with to avoid the rules, and then it's not as concrete.
Senator Marshall: It would seem to me that you would need those numbers in order to project your deficit or surplus. We had a similar problem with Bill C-2, and now it seems there's an issue with this one.
Pierre Leblanc, Director, Personal Income Tax Division, Tax Policy Branch, Department of Finance Canada: First, I would say the costing for Bill C-2 was fully comprehensive, so there was nothing missing from that.
Second, I would say that in some measures like this you have a current level of government revenue and you can increase or decrease that. Here, I think it's just a matter of maintaining the tax base and preventing erosion of it. If anything, in the absence of these measures, in all likelihood what we would see is a reduction, in this case, of corporate tax because firms would exploit tax planning opportunities to reduce their tax payable in Canada.
If anything, if you talk about projecting revenues to defer fiscal balance, it's just sort of keeping level.
Senator Raine: Will these measures affect Canadian businesses that use currency hedging to mitigate fluctuations in the Canadian currency relative to the country of its export markets?
Mr. McGowan: No, this measure shouldn't. It deals with derivatives held as inventory, so on trading account for profit. In currency hedging transactions, typically the tax character of a derivative held as a hedge against, in your example, foreign currency would have its character match the character of whatever it is that it's hedging. So if you're hedging a capital asset, it would be capital in nature.
These would apply only to derivatives held as inventory.
Senator Raine: If you're buying a forward contract for a certain amount of time, is there a time limit? If you go over that time, is it considered capital?
Mr. McGowan: No, we don't have a bright-line test in the act as to what is capital or inventory. The U.S. has a similar set of rules for shares, I believe, but we don't have a bright-line saying if you hold it for more than a year, it's inventory, but it's capital if you hold it for less than a year. It's more treated as inventory if the buying and selling of the property is part of a business, venture or concern in the nature of trade.
The next measure deals with the sale of so-called linked notes. These are debt instruments often issued by financial institutions where, under these notes, the return on the instrument, instead of providing a return like 2 per cent per year if you buy a GIC, is determined by reference to an index or another reference portfolio or property. The amount you receive on maturity of the debt obligation is determined by reference to, say, the TSX, the return on the NASDAQ or the return on some bond portfolio, or something like that.
In that case, the positive return that you would receive on maturity would be fully taxable as ordinary income. You would buy one of these five-year bonds for a thousand dollars and then after five years, on maturity, it's worth $1,600 and you'd have $600 of income. This ensures that if you sell the note prior to maturity — say you sell it a week before maturity — the positive return of $600 in this case would have the same character as if you held it to maturity, which is to say fully taxable, ordinary income. It ensures consistency on the economic results.
For the initial years, the costing for that varied for timing reasons, but starting in 2019-20 it stabilizes at around $45 million a year.
Senator Mitchell: Is there a limit to that period of time before it matures after which it becomes income? People trade bonds and make capital gains on them. Is that not going to be the case now?
Mr. McGowan: No, there's no timing limit. If you're buying and selling bonds and claiming your capital gains, these are presumably normal bonds with coupons or predictable yields.
There are existing rules in the Income Tax Act that deal with that and with the accrued interest on a sale and the capital gain treatment. Those remain unaffected.
These are only for so-called linked notes where the return would ordinarily accrue because of the rules in the tax act. But, because the return on maturity is indeterminate — you don't know what you're going to get — you can't have an accrual that comes into your income annually. So these are an example where the current rules don't necessarily work perfectly.
Senator Mitchell: But you can still trade bonds and get capital gains?
Mr. McGowan: Yes.
The Chair: Keep on going, Mr. McGowan.
Mr. McGowan: The next provides rules dealing with emissions trading. This involves the tax treatment where a taxpayer has an emissions allowance that can be delivered to satisfy an emissions obligation of it by a government.
Two problems had been raised by stakeholders with the current state of the tax rules that apply to emissions trading. The first is that there were no specific rules in the Income Tax Act dealing with the purchase and sale of these emissions allowances. One had to turn instead to just the general tax principles, and so taxpayers were left without certainty of how they would be taxed when they buy and sell these emissions obligations. There were various theories of how they ought to work under the current system, whether they're eligible capital property or inventory. These rules would apply to clarify that they are taxed as inventory and provide certainty to taxpayers.
Also, there was the potential for double taxation that could arise in a situation where a taxpayer receives a free emissions allowance from the government and then gets taxed on it as government assistance and then is taxed again when it is used to satisfy an emissions obligation. So these rules would prevent that potential for double taxation.
The Chair: Could you give us a simple example of an emission allowance?
Mr. McGowan: Carbon allowances, I think, are the classic example.
The Chair: So it's carbon.
Senator Pratte: These measures will be enforced once this becomes law, but cap and trade systems have been in force in some provinces for a couple of years. How have companies that have participated in those systems been taxed on emissions allowances up until now?
Mr. McGowan: Thank you; that's a great question. It gets to the next point I wanted to discuss.
The rules would apply as of 2017, but they allow for a retroactive application of the rules back to 2012, because we heard that many taxpayers would find them beneficial and want them to go back a number of years. So there's the potential that they could elect to retroactively have them apply back to 2012.
Prior to that, as I said, the general rules in the Income Tax Act would apply. So whatever the rules were in the 1980s or 1990s for those types of transactions would have applied, but, as I said, many taxpayers found that problematic in that it lacked certainty. So these are intended to provide certainty to investors and to rectify that issue.
Senator Pratte: Were these allowances mostly considered as inventory following the old rules? Is that how they were considered?
Mr. McGowan: My understanding is many taxpayers took that position, but it was not so clear that it was accepted and universal. There was that uncertainty.
Senator Andreychuk: Under the existing system, it went into general rules, so they weren't sure.
You're also saying that there's some incentive in the new system. Is that what I'm hearing you say, that they came and said that that was unfair, or did they say it was unclear? By now creating the provisions that you've put in here, is it a tax advantage? In other words, is it an incentive to do the trading, or is it simply an accounting difficulty that they have?
Mr. McGowan: It is intended to rectify the lack of specific rules. There aren't specific rules in the tax act, and my understanding is that there aren't specific accounting rules either. They're intended to be neutral and to provide a fair and reasonable tax treatment for emissions allowances.
That said, I don't know that it would be an advantage. But, as I mentioned earlier, there was the potential for double taxation in the case of free emissions allowances, and this would alleviate that problem so that you're appropriately taxed once in those cases.
I don't want to leave that out, but it does solve a real problem of double taxation. So if you consider that a benefit, there is a benefit.
The Chair: Moving on, Mr. McGowan.
Mr. McGowan: The next set of rules deals with the use of so-called debt parking techniques to avoid foreign exchange gains. If you have a debt denominated in a foreign currency, on repayment of that debt you can have a foreign exchange gain or loss when you have to use the foreign currency to repay it. That can lead to a taxable gain in certain circumstances. A tax planning technique had previously been used to avoid tax consequences that could apply on the forgiveness of a loan, the so-called debt forgiveness rules. The same kinds of techniques were devolved to involve those rules, and there are rules in the act to prevent you from doing that. They had been used to avoid foreign exchange gains on the settlement of a debt denominated in a foreign currency.
That involves what's called parking the debt. Instead of repaying the debt, which could lead to a gain, a corporation or a group of companies could have some other company in the group acquire the debt so that it doesn't get repaid. It doesn't trigger the foreign exchange gain. Then that debt, because now it's owed between two members in the same group, would become what's called a parked obligation. The consequences of the foreign exchange gain or loss could be indefinitely deferred or avoided because it's just a debt owing between two affiliates and can be left open almost indefinitely.
Similar to the debt forgiveness rules that kick in with parked obligations, these rules apply where a debt becomes a parked obligation, triggering an accrued foreign exchange gain.
Senator Marshall: How do you define a parked obligation? What criteria have to be met, and who makes the ultimate decision that it's a parked obligation? You are trying to separate the parked obligations from bona fide ones, right?
Mr. McGowan: That's right. The amendments in the bill contain a set of reasonably objective criteria for determining when a debt becomes a parked obligation. As I said, in general terms, that's when a non-arm's length member of your corporate group acquires the debt. It could also apply on change of status of the debtor so that instead of having an affiliate buy the lender, you buy the lender.
But there is a very important commercial exception so that it doesn't apply in bona fide commercial transactions. If there's a real business purpose to it, then it would not apply. That might happen, for example, in mergers and acquisitions planning where you, for business reasons, buy one of your customers or buy a debtor.
So there is a commercial purpose exception to these rules that is intended to ensure that they only apply where it is a debt-parking transaction designed to avoid the realization of a foreign exchange gain.
Senator Marshall: Who decides whether it's a parked obligation? Is it the Department of Finance or the Canada Revenue Agency?
Mr. McGowan: The Canada Revenue Agency is responsible for the application of the rules.
The test to see whether it becomes a parked obligation is somewhat objective, and then the business purpose test has more of a subjective element to it. It's the CRA.
Senator Marshall: What if there is a foreign exchange loss the first year rather than a foreign exchange gain? The gain is taxable, but if it's a loss, is that tax deductible?
Mr. McGowan: If there is an accrued loss that can be realized and deducted for tax purposes, one wouldn't look to enter into these parking transactions. You would just realize the loss and take the deduction.
Senator Marshall: The full gain is taxable the first year, right? It's not amortized. It's right away. So if there is a loss that first year, is the full amount of the loss tax deductible the first year?
Mr. McGowan: Under these rules the gain is taxable when the debt obligation becomes a parked obligation. Whether it's in the first year or in the tenth year, these rules would only apply when it becomes a parked obligation, so when it gets acquired, for example, by a member of your group.
Senator Marshall: What if it's a loss the first year? Maybe there isn't a gain. Maybe it's a full loss. Another possibility is there might be a gain the first year, which is taxable, but the year after that there could be losses. Are they tax deductible? Are the gains being taxed but the losses aren't deductible?
Mr. McGowan: No. Under the realization principle, the gain or loss could be realized when the debt is repaid.
Senator Marshall: When the debt is repaid, not right away like you would with a gain?
Mr. McGowan: If I have a foreign exchange debt that has a five-year term and it's just normal capital property — that is, it's not inventory or market-to-market property or anything like that — then that gain would be realized at maturity after five years, not in the first year. It would typically be realized on repayment of the debt or under these rules if that debt becomes a parked obligation.
Senator Marshall: What's the benefit to the treasury on this one?
Mr. McGowan: We do not have a specific estimate on this one either.
Senator Marshall: What's the total estimate of the benefit to the treasury of the entire bill?
Mr. McGowan: I don't think we have that.
Mr. Leblanc: Estimates are provided for all budget measures. As Trevor has explained, there are certain ones for which we have a specific estimate. What did we call the annex this year? It used to be at the end of the budget and was called the supplementary information. There is a separate booklet, "Tax Measures: Supplementary Information,'' and the first table in this is our revenue estimates for every measure.
Senator Marshall: If I look at the annex attached to the budget document "Growing the Middle Class,'' I'll see it there, will I?
Mr. Leblanc: Yes. You'll see it there.
Senator Raine: I just want to be clear. This is really only dealing with foreign exchange debts and not Canadian currency?
Mr. McGowan: Yes, it's foreign exchange debt.
Senator Raine: It's not parked in Canadian dollars in some other system with obligations. We're dealing really with foreign exchange debt incurred in a foreign currency?
Mr. McGowan: Under the general rules in the tax act you compute your taxes in Canadian dollars.
Senator Raine: Yes, I recognize that.
Mr. McGowan: My only hesitation is that some taxpayers can make what's called a functional currency election, so they can compute their tax results in another currency. The general rule is you compute your tax results in Canadian dollars. This would only apply to those folks where you have a foreign denominated debt.
Senator Raine: Thank you. That's what I thought.
The Chair: Moving ahead, Mr. McGowan.
Mr. McGowan: The next measure stops two inappropriate tax results dealing with life insurance policies. These arise in two situations and prevent the extraction of retained earnings from a corporation free of tax through the use of certain life insurance planning.
The first involves the transfer of a life insurance property to a related company; that is, not a sale to an arm's-length person, which has its own set of rules and the proceeds are realized as income. This is a transfer of life insurance to a related company.
In those circumstances the rules didn't work perfectly, so you could take back more consideration than was recognized under the rules. In essence, you could remove that excess from a corporation on a tax-free basis.
The second set of rules deal, again, with the extraction of earnings from a corporation on a tax-free basis. When the life insurance pays out and is realized, the excess of the proceeds of the life insurance policy over what's called the adjusted cost basis is added, when it's held by a corporation, to its capital dividend account, and then the amount of your capital dividend account can be paid tax-free to shareholders. It effectively comes out tax-free, but the calculation for what you add to your capital dividend account is based on your proceeds, less your adjusted cost basis. That works just fine where the policyholder gets the proceeds, because the policyholder has an adjusted cost basis. Planning is involved in splitting up the policyholder from the corporation that receives the proceeds so that the corporation that receives the proceeds would not have a cost basis. Instead of $100 in proceeds less a $20 cost, it gets an $80 capital dividend account addition which is paid out tax-free. Apparently the position was taken that the company receiving the proceeds got $100. It didn't have a cost basis because the policyholder was somewhere else, so they added the full $100 which could be paid out tax-free. This ensures that the appropriate calculation is taken and the adjusted cost basis of a policyholder is taken into account when looking at that capital dividend division.
Sorry if that veered towards the technical, but these are technical changes designed to address deficiencies in the existing act as they apply to life insurance.
Senator Andreychuk: Is this an overwhelming problem? In other words, how many corporations did it involve before it came to the attention of the CRA?
Does this cover foundations also? I'm just not sure of the definition.
Mr. McGowan: The tax consequences were estimated at around $35 million a year as part of the budget.
When you say "foundations,'' do you mean charitable foundations?
Senator Andreychuk: Yes, trusts; foundations that have been set up by companies to do some of their goodwill work. Does it cover those, or is that under the definition of "foundations and charities''?
Mr. McGowan: No, it wouldn't apply to trusts. The rules only apply to corporations and partnerships.
Senator Andreychuk: Thank you.
The Chair: Moving ahead.
Mr. McGowan: The next is another technical measure dealing with cross-border surplus stripping. The "cross- border'' part of that title refers to the international element, so you have an amount being paid from Canada to a non- resident.
"Surplus stripping'' refers to the extraction of retained earnings from a corporation, free of tax. Typically, retained earnings would be paid out as a dividend to the extent they can't be paid out as a return of capital. Typically in these situations retained earnings would be paid out as dividends that would be subject to withholding tax at a rate of 25 per cent, reduced under our tax treaties generally to 5 per cent or 15 per cent.
There is a set of tax rules currently in the act designed to prevent companies from paying amounts to their foreign parents on a tax-free basis when they would otherwise presumably be paid as a taxable dividend. Those are the anti- surplus stripping rules. They in effect prevent the change of a dividend to what would be a tax-free gain being paid to a parent.
An important exception to those rules is intended to apply where a Canadian company purchases a foreign company with a Canadian subsidiary and simply wants to unwind that structure — so that the Canadian subsidiary is now under the Canadian company. They want to unwind what's called a sandwich structure because you have a non- resident between two Canadians. That exception is intended to apply only in the situation I described, where you have a Canadian multinational with foreign subs.
Tax planning has arisen where foreign multinationals with Canadian subsidiaries were reorganizing so as to take advantage of this exception from the cross-border surplus stripping rules, and these amendments would help ensure that the existing exception applies as intended; that is to say, where there is a Canadian parent company.
This is another one where we did not provide a specific cost estimate, but it is designed to prevent erosion of the tax base.
The Chair: Moving ahead.
Mr. McGowan: The next is an important change; thankfully a break from the technical tax changes.
The Canada Child Benefit would be indexed to inflation starting in the 2020-21 benefit year, and that's in July of 2020. When it was initially announced and implemented as part of Bill C-15, there were no indexation provisions. This would add indexing to inflation so that the benefit of the Canada Child Benefit is maintained once the indexation rules apply.
Senator Marshall: Why is the government waiting so long?
Mr. Leblanc: The Canada Child Benefit represents a very significant increase in child benefits provided to Canadian families. The government decided to fully implement its change despite current economic uncertainty; despite the current fiscal pressures. Balancing that with cost considerations, Trevor just explained that the 2020-21 benefit year is the chosen time to introduce indexation.
Senator Marshall: Do you go back to this past July or is it just the annual at that point in time? Do you know what I mean?
Mr. Leblanc: It will be the annual at that point in time. It will be the same factor that applies to the 2020 tax system, so basic credit amounts and thresholds that will be indexed.
Senator Marshall: Would you have an estimate of that?
Mr. Leblanc: We do. Earlier, senator, I told you that this is actually the one that's not in there because a decision hadn't been made, but it was published in the fall economic statement. In the 2020-21 fiscal year it will be $505 million, and in the 2021-22 fiscal year it will be $1.2 billion.
Senator Pratte: That's based on the CPI, is it?
Mr. Leblanc: It is indexation for the tax system, so as I mentioned, bracket thresholds, credit amounts, and also for income tested benefits delivered through the tax system, it's based on CPI.
Senator Pratte: What's the estimate of CPI for 2021?
Mr. Leblanc: It's 2 per cent.
The Chair: Mr. Leblanc, as a point of information, the new child benefit program cost versus the former government's, what's the difference in the cost?
Mr. Leblanc: If you're just taking child benefits, if you're looking at the difference, so replacing the Canada Child Tax Benefit, the National Child Benefit supplement and the Universal Child Care Benefit with the Canada Child Benefit, in the 2016-17 benefit year it would be about $3.5 billion.
The Chair: More than the past year?
Mr. Leblanc: More than this system. Then in 2017-18, basically since it started in July, that's three quarters of the 2016-17 fiscal year. In the 2017-18 fiscal year it would be slightly more than $4 billion.
The Chair: If I understand correctly, was the former program was $20 billion or $18 billion?
Mr. Leblanc: I'll express this in terms of a full benefit year because that will give a more accurate picture of the situation. Once you took account of federal personal income tax paid on the Universal Child Care Benefits, it would be a bit more than $17 billion.
The Chair: Okay. So we're saying 17 versus 21? Is that fairly accurate?
Mr. Leblanc: Yes.
Senator Raine: When you're looking at the past cost, does that include the child sport credit and the arts?
Mr. Leblanc: No. The differences I just mentioned don't reflect the elimination of income splitting for families with children, nor does it represent the phase-out of the children's fitness tax credit and the children's art tax credit.
Senator Raine: Do you have those numbers?
Mr. Leblanc: The elimination of income splitting for families with children is in the ballpark of $2 billion a year. We're phasing out the children's arts and fitness tax credits, so on a mature basis it would be about $250 million a year.
Senator Raine: Each?
Mr. Leblanc: No, together.
Senator Mitchell: My question is a follow-up to that. That means that while the difference in your previous iteration of answer was $4 billion, that $4 billion difference will be reduced by $2.25 billion?
Mr. Leblanc: That's right, if you were to include those measures as well.
Senator Mitchell: So it's actually an increase of $1.75 billion only? Thanks.
The Chair: Comparing apples to apples versus apples to oranges, it's 17 versus 21.
Senator Mitchell: I would argue that's not the case. I would argue the latter is comparing apples to apples, so I would take it in the reverse.
Mr. Leblanc: I apologize for this. My quick subtraction didn't work out that well. In the 2017-18 benefit year it will be closer to $5 billion. Our estimate of the cost of the Canada Child Benefit is $22,875,000,000. We estimate we would save, in the 2017-18 fiscal year, $10.7 billion from eliminating those two supplements. The after-tax savings from eliminating the Universal Child Care Benefit would be about $6.8 billion.
I apologize for that mistake. I wanted to correct that.
The Chair: If you compare the net-net old versus new, so we all understand the difference, what would that be?
Mr. Leblanc: It's would be about $5.2 billion or $5.3 billion.
The Chair: The difference?
Mr. Leblanc: Yes, just taking those programs.
Senator Raine: You have to take them all.
Mr. Leblanc: I'm just explaining what the differences mean.
The Chair: But is there a $5 billion difference between the old program and the new program?
Mr. Leblanc: If you just took child benefits it would be $5 billion, but if you also took income splitting for families with children, that would reduce it to closer to $3 billion, and the two children's art and fitness tax credits.
The Chair: The net-net difference is plus $3 billion?
Mr. Leblanc: In the 2017-18 fiscal year, yes.
The Chair: With so many programs, we want to try to understand where it all flushes out.
Mr. Leblanc: They're all very good questions.
Mr. McGowan: The next measure relates to the multiplication of the small business deduction and the avoidance of the taxable capital limit in respect of the small business deduction. There is currently a small business deduction provided of up to $500,000. Small business is measured in terms of taxable capital. A corporation's taxable capital starts to be phased out when it exceeds $10 million and is completely phased out when it exceeds $15 million. That small business limit of $500,000 applies where you have a business carried on through a corporation. One $500,000 limit applies where a partnership carries on the business. That limit is shared amongst its corporate partners. And there is a $500,000 limit that must be shared amongst associated corporations. This addresses tax planning that arose and would effectively multiply access to the small business deduction.
I mentioned partnerships. There is a $500,000 small business limit or specified partnership limit or businesses carried on by a partnership which gets shared amongst its partners. The tax planning being addressed by these amendments involved partners of the partnership setting up separate corporations that were not themselves partners but that provided services. Typically the service of the partner to the partnership, and each of those corporations would claim its own $500,000 limit.
So where you had a partnership with 10 equal corporate partners, each of those would have up to a $50,000 small business deduction. One $500,000 in the partnership is split between 10 corporate partners. Each of those corporate partners would have a $50,000 limit.
What this plan attempted to achieve is that for each of the partners that set up one of these service corporations, each of those service provider corporations would have its own $500,000 limit. In respect of the partnership's business, it would go from, in my example, a $500,000 limit to 10 partners each having their own $500,000 limit, so $5 million or maybe $5.5 million. This prevents the multiplication of assets to the small business limit, bringing the rules back in line with the existing policy so that each of the partners shares in the single small business limit.
The second component relates to the avoidance of the taxable capital limit. The benefits of the small business deduction begins to be ground down where taxable capital exceeds $10 million, completely eliminated after $15 million. Some tax planning arose that took advantage of an election that in certain circumstances would allow for the purpose of determining the limit. Corporations not considered associated could each, through the use of this election, have their own taxable capital limit. Ordinarily they would have to share it, which could multiply that so that much larger corporations could have full access. Again, that was considered to be an inappropriate use of that highly technical election.
The costing for these measures was $60 million a year for the multiplication measure and $10 million a year for the avoidance of the taxable capital limit.
The Chair: Of course, it's probably for the media to understand exactly from your perspective how this new change to small businesses impacts medical practitioners, which has been highlighted as an example.
Senator Andreychuk: A lot of professional groups have used this mechanism. We're not talking about huge corporations. We're talking about the clustering of lawyers or whatever. This measure was there.
If the measure is put in as you say, they will pass the taxes on somewhere or other. They are going to have to because it's going to reduce their profits. Particularly with medical, a lot of these structures weren't "tax advantaging.'' They have a purpose for having done those structures for efficiency. This has grown up. I always had a system where I went to a doctor and the doctor was there, and then there were groups of doctors that might have shared space, but it has become much more sophisticated, and it looks like you're trapping them there.
The bottom line from all the emails I'm getting is it's going to drive doctors out of Canada because they can't pass on their tax. They're trapped with what they can charge patients because of the way our medical system is set up. It's going to be a disincentive for some of the highly productive doctors in these associations. I'm not sure whether they can overcome it, but we're setting up another impediment in our medical system.
Mr. McGowan: Thank you for your comments. As you correctly point out, this is a measure of general application. Obviously we've heard from doctors. It applies to lawyers, accountants, anyone who could make use of this type of tax planning.
Again, thanks for clarifying. It's not targeted at doctors. It doesn't just apply to doctors. It is lining the rules in the tax act with the existing policy of having one limit per business.
In terms of some of the submissions we've received, one of the comments was passing on costs to consumers, whether it's a consumer of legal services or so on. I don't know that if a lot of lawyers could bill more they would, so there is that negotiation.
Senator Andreychuk: Be careful. You're talking to a lawyer.
Mr. McGowan: As am I. I practised for a number of years. If they could have billed me a little more, they would have.
It is a provision of general application, and it applies of ensuring that the existing policy of having one small business limit of $500,000 applies where it's carried on through a partnership. It ensures that that policy is respected where you have either a corporation as a central business or a partnership.
Senator Andreychuk: I know that there were some consultations, but it seems to me the consultations were pushbacks but were not listened to. You still went ahead saying "of general application.'' It seems to me this warrants another look.
Mr. McGowan: There have of course been consultations. If you look at the version of the legislation released as part of the budget, there were amendments made, in particular to more appropriately deal with situations where payments were made within a group.
I mentioned earlier that within an associated group you share a single small business limit, so refinements were made to the rules to accommodate those situations where the tax planning or the tax erosion concern was not as prevalent. So it has changed as a result of the consultations. We have of course been discussing with a number of stakeholders, including the Canadian Medical Association and others.
You mentioned the different estimates of the costing of the measure, and I would be happy to quickly go through them in more detail if that would be preferred.
Perhaps I'll use the example presented by the Canadian Medical Association because they did say it was a factual, real-life scenario, even if the math is a bit more difficult than a more abstract version. In their example, they have a side corporation that provides services to a partnership earning $500,000. Through a combination of salaries and dividends, $286,000 is paid out of the corporation, leaving $214,000 in the corporation. It's worth pointing out, as I said, that it maintains the current policy. If there's one partnership, you still get one small business deduction, and so if there were 10 partners — this one has 150 members, so they're probably just assuming that is the way. If there were 10 equal partners, then each would still get their $50,000 limit, Setting that aside, but remembering that it's important, they still get it, but it's less important as you have more partners.
They have $214,000 that they can leave in the corporation to be taxed. That tax, if it is fully sheltered by the small business deduction federally, would be at a rate of 10.5 per cent. If the small business deduction is not available, or to the extent that it's not available, it's taxed at 15 per cent, which federally is a 4.5 per cent change. Of course there are provincial taxes on top that increase the cost beyond that. I don't want to ignore the provincial ramifications, but federally we're talking about a change from 10.5 per cent to 15 per cent.
The Chair: Can we move on? We do have three other people on I believe the same issue.
Senator Marshall: I'd really like to speak to this one. We've been receiving a lot of emails on this one, and there have also been a lot of articles in the media. There was one this morning from David Dodge. He is a former Deputy Minister of Finance and former Governor of the Bank of Canada, so when he takes issue with a tax change, I think a lot of people sit up and take notice.
It will affect not only medical doctors. It will affect lawyers, architects. The government is embarking on this innovation strategy and trying to attract smart people to the country and keep smart people in the country, but the impact this will have on professionals will be significant because the 33 per cent tax rate has gone into effect and now you're making this change.
A lot of our medical doctors were trained in other countries, so they've already moved to another country. They've moved to Canada. I think a lot of them will find the transition to another country not that difficult.
When we look at what's happening down in the States with the new government and what they're saying about what they're going to do, reducing their tax rates, when we think about doing these changes, do we look at things besides the revenue generation? What impact will this have? What impact will this have on our health care system?
We have a health care system now that we're not exactly proud of when you see the reports that have come out recently. We're no longer going to be competitive, and I really think that we're going down the wrong road. I must say that I fear about the impact of not just this change but the 33 per cent tax rate. All these changes that are being made are sending a message to a certain group of people. I think that at some point in time people are going to say, "Canada is not the place for me.''
I don't know if you can answer that question. Do you look at the overall impact this will have?
Mr. McGowan: If it's okay before moving on to that, I should finish explaining how the tax benefits work and from that we can have a clearer discussion on the impacts.
As I was saying, to the extent you don't have access to a small business deduction as taxed federally at a rate of 15 per cent in a corporation, that rate is lower than the 33 per cent rate, obviously, but it's what we would call a deferral benefit. In this case it was $214,000. When it's paid out of the corporation as a dividend or a salary, then it is taxed in the hands of the recipient at the normal marginal rates.
To take the first example in the CMA submission, where a doctor sets up one of these corporations and it earns $500,000 of revenue, if that is paid all out to the doctor, then due to the corporate integration rules in the tax act, they would be taxed at roughly the same rate as if they earned the money directly. Whenever the money is paid out of the corporation to an individual, it is taxed as income to that individual. So the real benefit of having these small business deductions is it provides a deferral. That $214,000 is taxed at a federal rate of 15 per cent — and I think Ontario would be 27 per cent or so — and that leaves a larger pool of money to be invested. However, when the money is paid out, the tax benefit goes away, so it is a deferral of taxation.
I know in the CMA's submission they talked about a $32,000 savings reinvested annually. It's worth keeping in mind that the benefit is really a deferral once you take into consideration the corporate and shareholder level taxation. So this is money for the deferral benefit to be achieved that is left in the corporation.
In terms of what we look at, as you know, we cost out the measure to determine how much of a revenue impact it will have, and beyond that we look at competitiveness factors.
We also look at, of course, the appropriate tax policy. As I said, currently the appropriate tax policy is that where you have one business through one partnership, you have a single small business deduction limit.
You had mentioned providing additional support to a particular industry. I would say from a tax policy perspective that the relevant question is whether that support is best delivered through the preservation of a loophole in the tax system or whether it could be delivered in a more direct manner.
Not all doctors or lawyers or professionals use this type of structure, and so in a sense, having these loopholes available benefits those in those circumstances to the detriment of some others.
Of course an employee in a law firm wouldn't be able to do this because if they set up beside a corporation that provided services to the law firm it would be treated as a personal services business, like a senior associate making $250,000 or so. They wouldn't be able to do that because they'd be fully taxed on it at the normal marginal rates.
So respecting the tax policy, depending on perspective, can also preserve fairness, ensuring that the same rules apply to everyone.
Senator Pratte: I have two related points. When you adopted this kind of policy, you said there were consultations. I'd like to know more about the process you go through when you do these kinds of changes, what kind of consultations you go through.
The case of medical doctors seems to be quite specific for at least two reasons. The partnerships put forward specific reasons. Oftentimes the provincial governments incited them to form those partnerships for public health reasons.
The other thing is the lawyers or other professionals can't pass on the costs to their clients or patients. Obviously they can't pass on the costs. The costs are paid by the government. They will find themselves in a different situation from other professionals. Have you taken that into account?
Mr. McGowan: In the consultation process, measures are developed in advance of, in this case, tabling of the federal budget. In those cases, there are government secrecy concerns with identifying proposed changes ahead of their public announcement. But at the same time, to the extent possible, all due diligence and background analysis is undertaken in providing the best advice possible to the minister.
After the tabling of the budget, there is a consultation. We received a number of comments on both the draft legislation and the policy. Some of that was reflected in changes that would have been seen in the summer release of the revised draft amendments dealing with this measure in July. After that there was an additional consultation period on the draft legislation where we received more comments on the rules.
There have been ongoing public consultations certainly since the announcement of the measure. Prior to that there was the background research. We're always, to one extent or another, engaged in consultations with affected stakeholders about how we can improve the tax system.
You'll see later on in the bill three changes dealing with loss restriction events, spousal trusts and charitable donations that all arose as a result of our continuing consultations with stakeholders in respect to changes announced in Budget 2013. So this is an ongoing process that never stops, hearing comments from affected stakeholders in trying to improve the tax system.
One other comment I hope I made clear in this context, it was mentioned that the partnerships set up by doctors are not tax motivated. We never suggest they are; just the same as tax law firms who operate through a partnership are not doing that for tax reasons. Many of our older and prestigious law firms that predate the income tax that came in in 1917; so, of course, they weren't set up to avoid it.
A partnership is not necessarily set up to avoid the Income Tax Act or the tax consequences of these rules. The rules ensure that the appropriate consequences take place, given that there is a partnership.
Senator Pratte: Would you please remind the committee of the revenue consequences of this change?
Mr. McGowan: The multiplication of the small business deduction was estimated at $60 million, and that's for the 2017-18 year. The avoidance of the business limit was estimated at $10 million.
Senator Raine: I, too, am very concerned about the impact on the medical clusters, because this has been a trend encouraged by provincial health organizations for more efficient use of our scarce medical professionals. Any professional that we lose is a big loss. In consideration that a partnership in the medical profession is not operating on an open-market situation, could that be differentiated from other partnerships with regard to this legislation?
They can't increase the fees to cover the costs. Any extra costs of this taxation will definitely come from the income of the doctors, and that could have a serious impact on our supply of doctors.
Mr. McGowan: We had a number of comments along those lines throughout our consultation. For instance, in our discussions with the representatives of the CMA and others, we talked about these specific structures and why they were put in place. We were told that some operate through partnerships and some operate through cost-sharing arrangements, to which these rules would not apply. We asked and followed up about the potential for restructuring and heard that some view that that would not be viable.
Because the rules in the Income Tax Act are based at least on identifying what is a partnership or not, upon the relevant provincial law, that partnership is a relationship between people carrying on business in common with a view to a profit. To the extent that is the case and you really do have that partnership relationship in place, and we have our rules in the act that apply — to reiterate, regardless of what industry you're in — when you have a partnership, which is by definition people carrying on business with a view to a profit.
Senator Raine: Did you consult with the provincial government authorities?
Mr. McGowan: We have heard from provinces.
Senator Raine: In the consultation, did you consult with them before you made this change?
Mr. McGowan: You mean before the tabling —
Senator Raine: The policy was written.
Mr. McGowan: Before the tabling of the budget?
Senator Raine: You were indicating that there was ongoing consultation even after the budget was tabled. The policy is now coming to us in this proposed law, and I'm just thinking there's an unintended consequence that we have to look after.
Mr. McGowan: It's difficult to describe precisely the contents of what happened before the tabling, when it became public. I don't want to break any cabinet confidence rules by setting out what was in our advice to the minister or anything like that. One of the reasons I've been focusing on the public consultations is that that's public, and I wouldn't be breaching any confidentiality rules.
In terms of the bill before us, it has been the subject of consultation — we've heard from affected stakeholders — and we continue to be of the view that the rules in the bill are appropriate and the policy is as well. That is with the benefit of consultations.
Senator Raine: The medical profession in Canada is a different beast than the private sector because we have publicly funded medicine and health services. Does it not make sense to recognize that somehow in our tax legislation? Maybe you don't call it a partnership. Maybe you call it a medical cluster, or there's something that can be designed that will work to ensure that we do not lose these scarce resources that, in a way, are public resources. I believe you need to work with the new health accord that's coming up.
I think that somehow our medical professionals need assurance that this is a recognized issue and that it will be dealt with in a fair and just way, so that they are not being squeezed between payments that come from the taxpayer through government for their services and being forced to operate like a private business, when they really aren't a private business because their services aren't freely sold on the private markets.
James Greene, Director, Business Income Tax Division, Tax Policy Branch, Department of Finance Canada: I appreciate the concerns that are being raised here. I would just make the comment that the general purpose of the income tax system is to measure the income of businesses and individuals on a common basis, based on common principles, and that's what we mean by a fair tax system.
Businesses vary in the degree to which they can pass on costs. There are many businesses that operate in competitive markets where they're not in a position to pass on costs through increased prices, but the tax system, as a general rule, doesn't aim to subsidize or supplement the earnings of a particular professional group. Generally we don't look to the tax system for that purpose. There's a process by which compensation for medical professions is set, and that's obviously an important and delicate process, but generally the Income Tax Act is a distinct process from that.
Senator Raine: Do we not provide income tax incentives for other areas that the government sees as in the best interests of Canadian taxpayers? Yet somehow we're saying in this case we're not going to do that. We don't see a reason to have a tax incentive to keep medical professionals — scarce professionals serving the public — in our country?
We're going to force the provincial governments to raise their payment schedules substantially to avoid losing our doctors. It's all coming from the same taxpayer. Why wouldn't we do it through the taxation system?
Mr. Leblanc: To build on Jim's point, some senators mentioned the introduction of the 33 per cent rate and what might happen in the States; we'll see. Those are issues we certainly think about in all the policies we consider.
People can have debates on the 33 per cent rate. The government made its decision in terms of how it wanted to manage the trade-off between what it viewed as fairness versus incentive. That's very much open to debate. I think there's quite a bit of merit in looking at that across the board and considering what Canada's personal income tax rates should be — applying generally versus for specific groups.
The Chair: In Quebec we're at 53.7 per cent with the new tax at $200,000 and over, which puts Canada in the top seven G7 or G8 countries in the world in taxes.
What it probably leads to is the question: Is the intent of the government to try to influence — is it fair taxation or is it trying to earn revenue through taxation to fund itself? Or is it really telling Canadians, "We really don't want you to earn a lot of money''?
David Dodge said this morning that it's an enormous problem when you get effective tax rates that are widely out of line. This is the former head of the Bank of Canada. So there's a concern.
It's easy to say no one thought Trump would get in, so that's obviously one of the factors that may influence further policy. But I guess as a policy statement, the balancing you were talking about before seems to be something that's going to be topical right now for discussion.
Let's move forward to Senator Mitchell.
What I'd like to do, gentlemen, is we will have this go on until about 10 to 12:00, because senators have schedules that they have to follow. Then we'll ask our other two witnesses to maybe come back on Tuesday afternoon. I apologize for the delay, but we've had some very good conversation and questioning. We still have quite a bit to do in section 1, so we may be able to get through that. We appreciate your interaction with us, because we don't get a chance to talk to you all that often.
Senator Mitchell: By way of a very quick comment, of course doctors generally earn a lot more in the U.S. than in Canada. Unless we're at some critical threshold where a marginal increase in tax is going to throw off that balance completely, we would have expected most of our doctors to have already left, because they can make a lot more money in the United States, quite apart from any tax differential, absolutely. There was a period of time when doctors did leave, but it seems that they're not as much.
Anyway, let me ask the first question. It looks like $70 million of extra tax, 60 and 10. How many professionals; how many lawyers, doctors, architects and accountants are in these? Is it 10,000? I'm trying to say, how much is this seventy million bucks per professional?
Mr. McGowan: The numbers we have published aren't broken down by profession.
Mr. Greene: I don't have a breakdown of those figures.
Senator Mitchell: Do you have a rough idea of how many professionals this would affect? I'm not saying how many doctors versus lawyers, but just how many.
Mr. Greene: I don't know. I don't have that information.
Senator Mitchell: Could you get us that?
Mr. Greene: We can try to. I would say that the estimate is based on trying to use the available data to estimate the number of structures in place that would be impacted. But they're not directly identifiable from the tax data. You have to piece things together and make assumptions and so on.
Senator Mitchell: Maybe I missed this, because it is complicated. What I'm trying to get at is how much this is actually going to cost a given doctor. I know it depends on how many people are in a partnership.
To use Mr. McGowan's example, let's take a partnership of 10 people — 10 doctors, 10 lawyers. Let's say they're earning an average of $250,000 a year. What's the net differential to each of them, the net increase in their tax because of this change?
Mr. McGowan: I can walk through that and just tweak the example slightly, earning $300,000, just because those are the numbers I have handy.
So you have a doctor — or professional; we shouldn't reflexively say "doctor,'' but a professional earning $300,000. As I said, the planning really provides a deferral benefit to the extent that money can be left in the corporation. If it's all earned by the corporation and paid out in the same year, there's no real benefit. You'd be paying tax at up to the marginal rate of 53.53 per cent in Ontario, on the income you earn directly.
For the sake of the example, let's say that they pay out $200,000 to themselves as salary and leave $100,000 in the corporation. In that case, that $100,000 would be taxed federally at a rate of 10.5 per cent. If it was paid out of salary, it would be taxed at 53 per cent.
Senator Mitchell: So they would pay $10,500 on the $100,000 this year?
Mr. McGowan: That's right, federally. Again, there are provincial taxes, but to illustrate the point, maybe we can just talk about federal because there are different rates.
If they paid it out of salary, they would be taxed at 33 per cent and have the 67 per cent left over. Taxed at the small business rate, that's $10,500. With this change, to the extent that they don't qualify for the small business deduction, they would be taxed at 15 per cent.
In the example mentioned, there are 10 partners. We'll assume that each of them gets their equal share of the $500,000 small business deduction, so in that case, the partner, half of the income, so $50,000.
Senator Mitchell: It would be 50 and 50, which is $7,500.
Mr. McGowan: That's right, so $50,000 at 10.5 per cent and $50,000 at 15 per cent. To look at the benefit, pre- Budget 2016, they'd have $15,000; afterwards, they would have about $20,000. In this example I have here, they have extra $5,000 to invest. Again, if all the money was paid out they'd lose the deferral benefits, so they'd have extra money on hand to invest. Assume that has a rate of say 5 per cent, so you have an extra $5,000 in cash because of the tax savings. Say that yields a 5 per cent return. That would be the pre-tax savings, because whatever income you earn on that would be taxed, so that gets you to the tax savings for an affected professional earning $300,000, leaving $100,000 in the corporation.
Senator Mitchell: That's what they're saving right now, that they'll lose $250?
Mr. McGowan: That's right, in that example.
Senator Mitchell: They would lose $250 by this? That's the difference? I don't know; would you move to the States for that?
Mr. McGowan: As you correctly point out, in making that decision, there are a number of complex factors, which is part of why it's so difficult to anticipate. There are not just the tax rate changes. There are also income earnings.
I remember years ago, as a lawyer, there was a big concern about tax rates and young lawyers leaving Canada. I remember starting out. I'd have gotten literally three times as much going to Clifford Chance in New York than I could have here, so even if my tax rate was nil, it was a wash. That's from my experience, but all of these factors weigh in and are important.
You will see the CMA submission. Their numbers were a little different but not in substance. Their example is $500,000 of income, leaving $200,000 in, and then as I said in our example, there is $5,000 extra left that could be invested. Their number was $32,000. Again, that's available to be invested. You have to look at the return you get on those extra funds after tax, and it gets smarter. I think their number is 4.8 per cent of 32, which gets you closer to $1,000.
The Chair: Mr. Leblanc, did you want to add something?
Mr. Leblanc: I would just add that in making Canada-U.S. comparisons, as Trevor rightly put it, there are so many complex factors involved about how doctors would be taxed in the U.S. To the best of our understanding, it's essentially what's called flow-through treatment, so you pay full income tax at the rates that apply in the year you earn the income. So the possibility of deferral by incorporating, which Trevor described very well, does not apply in the U.S.
Senator Mitchell: So that's an advantage of being a partner in Canada.
Mr. McGowan: Right. Our corporate tax rates are highly competitive as well.
Senator Mitchell: That's interesting. Why now? This has been going on for a long time. Why the changes now?
Mr. McGowan: A number of factors go into that. A decision was taken by the government; I can't say why. There are always a number of factors, including the availability of resources, our understanding of the tax planning going on and triaging what can be reasonably done in any one year.
Senator Mitchell: If I leave that $100,000 in and I pay $10,500 and some on something, when I take it out I'm still going to pay my marginal tax rate; right? So I have to leave it in for quite a while to make that difference up.
Mr. Leblanc: I think what's important here, too, is just like we have two corporate tax rates, we also have two effective personal income tax rates on dividends. Where income was taxed at a higher rate at the corporate level, it's taxed at a lower rate at the personal level.
Mr. McGowan: The next measure relates to the taxation of switch fund shares. These are shares of a mutual fund corporation where each class of shares represents a different investment fund. Generally speaking, you can invest in investments in a number of ways. One way is through shares in a mutual fund corporation. Another way would be through units of a mutual fund trust or held directly. If you move from mutual fund to another and it's held in trust form, that's taxable transaction. If you sell shares or bonds held directly, that's taxable.
But shares of a mutual fund corporation that were set up as a switch fund, where you switch from one to another, that was treated as a tax-deferred event, and this resulted in inequality between different forms of investment vehicles. This measure would eliminate the tax deferral on a switch from one fund to another within a mutual fund corporation. The elimination of that deferral was estimated at around $75 million $75 million for 2017-18 and then 145 starting in 2018-19.
The Chair: Any questions?
Mr. McGowan: One thing I forgot to mention: This would not apply to any investments held in a tax-deferred plan, like an RSP or TFSA. It's only for taxable investors that it would have an impact.
The next would be implementing the country-by-country reporting standards recognized by the Organisation for Economic Co-operation and Development. These relate to transfer pricing risk assessment tools for the Canada Revenue Agency. They were developed in conjunction with a number of other countries. This is information that would be exchanged relating to, on a very high level, the global operations of a multinational, giving an indication of certain important factors, revenues and employees and so on, spread out amongst jurisdictions.
A Canadian multinational with income above a specified threshold — 750 million euros was the agreed-upon threshold — would be reported to the CRA and shared with our partners after Canada is satisfied that there are appropriate safeguards for privacy in place. Likewise, if there is a multinational headquartered in another country, Great Britain, for example, it could be shared with the Canadian tax authorities to provide this information.
The Chair: Moving on.
Mr. McGowan: Next is a measure dealing with estate donations. This was one I had mentioned earlier. Donations in a taxpayer's estate that arise on the death of an individual can be applied in the year the donation is made.
A graduated rate of estate is a special type of estate that arises on the death of an individual and there is an entitlement to use the personal income tax brackets instead of being subjected to flat, top rate taxation. They exist for 36 months, or three years, after the death of an individual. For donations made by these graduated rate estates, they can be set off against income in the year the donation is made, any previous year of the graduated rate estate or the last two years to be applied against the income of the deceased individual.
These amendments would extend that period for carry-back donations from 36 months to 60 to provide more flexibility for donations. Made in the fourth year, even after they lost the graduated rate estate status, it could still be applied more flexibly against the last two years' income of the deceased individual.
This is a refinement of rules that were introduced and announced a few budgets ago.
Senator Andreychuk: Is this extension a result of some presentations in your round tables? Is it intended to accelerate and increase more interest in giving, or is it really a tax measure response?
Mr. McGowan: The amendment came out of our continuing consultations with stakeholders, who informed us that the 36-month window that was currently available for estate donations wasn't sufficient, so they weren't able to make the donations they wanted to make within that window. If another two years was provided, that would provide sufficient flexibility. It was in response to our ongoing consultations with stakeholders.
Senator Andreychuk: Do you believe that this will encourage giving, in other words, or is it just going to make it easier for those who are already engaged?
I'm constantly looking at how we can increase the basket in Canada compared to other countries where giving is an issue. We're ahead of some countries and not others. Is this a measure that could lead to more giving?
Mr. McGowan: It's certainly intended to facilitate giving. I don't know that we have any data saying we're expecting it to increase by 2 per cent or anything like that.
If you have an estate, many of them take some time to wind up. For example, if you have an estate where there is a direction that after paying out this, this and this, the remainder of the estate goes to charity, there is pressure, if these rules are to be relied upon, to meet the deadline of 36 months. These measures would facilitate that kind of giving and make it work more smoothly.
Senator Andreychuk: I'm thinking that often, as you said, it may be for other purposes, the estate, and then the residual is given to a charity. I know that that kind of planning is being done. This should give them more time to accomplish that and have some comfort that their first choices will be met, but it will not preclude or exclude the benefits to a charitable donation.
Mr. McGowan: Yes, exactly.
Senator Andreychuk: Thank you.
The Chair: Gentlemen, we still have to deal with spousal and similar trusts, alternative arguments in support of assessments, and OECD common reporting standards. Can we get that done in the next 10 minutes so that we can break?
Mr. McGowan: I will do my best.
The Chair: You're doing a heck of a job
Mr. McGowan: The next amendment deals with loss restriction events and trusts. Certain tax attributes can be restricted in how they're used when, for example, control of a corporation is taken over or a similar change of ownership occurs in the trust context.
Rules were announced a number of years ago to deal with trust loss restriction events. That's where losses are restricted when a trust's ownership is changed.
Again, as a result of ongoing consultations, we heard from the investment fund industry that in certain circumstances the existing rules didn't work appropriately. For example, there was a rule requiring them to constantly tell if they're onside as an investment fund. Investment funds are excluded from these rules. In addition, on redemption of funds, they might be offside when it's appropriate.
These rules ensure that the loss restriction event rules apply more appropriately to investment funds. This is as a result of our ongoing consultation with them.
If I can move on to spousal or similar trusts, this is another measure that came from consultations with stakeholders. These are spousal trusts, and rules apply on the death of the primary beneficiary. The old rules were that the trust had a tax liability for accrued gains that were realized on the death of the primary beneficiary. Amendments were announced a few years ago that would shift that to the estate of the beneficiary. We heard from stakeholders that that would create difficulties in certain circumstances.
This would put the liability back to the trust but with an election to move it to the estate of the beneficiary. So this provides appropriate tax consequences for taxpayers affected by these rules, and they were developed in the context of our ongoing consultations to provide more favourable treatment.
Senator Andreychuk: Just a clarification on spousal similar trusts, non-resident/resident, is there any implication there?
Mr. McGowan: There are situations in which residency is relevant in the context of these trusts, but these rules deal with the liability for tax as between the trust and the beneficiary. I don't believe that residency is relevant in that context, although I don't want to suggest that it's not relevant in the broader scheme of the spousal trust rules.
Senator Andreychuk: You're saying this shouldn't?
Mr. McGowan: No. This is intended to help ensure that the tax liability arises in the hands of who can pay it. If that's the trust because they have the property, then that's appropriate. If, instead, the trust can't pay and it's better that the individual estate does, then that's now provided for.
Senator Andreychuk: I'm concerned about offshore again, that there be equality in the spousal arrangements, that there is no benefit of having claimed residency elsewhere.
Mr. McGowan: No. There was, I believe, a Supreme Court case dealing with spousal trusts — I think it was Antel — where a similar type of that planning had occurred. That's in a different context than these amendments.
Senator Andreychuk: So this should not affect any of that.
Mr. McGowan: No.
The Chair: Thank you.
Next?
Mr. McGowan: Next is alternative arguments in support of assessments. This measure confirms that the Canada Revenue Agency can put forward alternative arguments in support of their assessments after the expiry of the normal reassessment period, provided that the total amount assessed doesn't increase.
This is in response to a somewhat recent court decision and puts the rules back to where the government understood them to be before the announcement of the rules.
The amendment was initially announced as part of Budget 2015. It was confirmed as part of Budget 2016. The draft legislation was released this summer for public consultation as well, and that's why it's in Bill C-29, as opposed to Bill C-15 where a number of the other Budget 2015 measures were.
Senator Andreychuk: They will not increase or change the assessment, but they'll be able to if there is new evidence or they reflect on a different position, as long as it's within the ambit or framework of the original assessment. Is that what you're saying?
Mr. McGowan: That's right. The total amount assessed cannot increase. So they can't say, you said you owed us $50,000, and now we're going to put it up to 70. We had said that that's a capital gain, but then you argued successfully that it's ordinary income or taxed on some other basis. They can change their argument so that the $50,000 is taxed but it can't go above that.
The Chair: We're down to the wire, Mr. McGowan, Mr. Leblanc and Mr. Greene; you fellows have been great.
Mr. McGowan: Lastly is the implementation of the OECD common reporting standard. That is a tool developed for the prevention of tax evasion and the sharing of information relating to non-residents with accounts in a jurisdiction. That has been developed along with the OECD, but also I believe that over 100 countries have signed on, so it's an international project.
From a Canadian perspective, it involved the sharing of information on non-residents with accounts in Canada. Likewise, our international counterparts would share with the Canada Revenue Agency information on Canadians with accounts in those jurisdictions.
The Chair: Are there any questions for Mr. McGowan?
Gentlemen, on behalf of the committee I would like to thank you for a very engaging discussion on a variety of points today.
I take it that we finished Part 1, Mr. McGowan. We'll have your confrères in on Tuesday afternoon to walk through Part 2 and Part 3 with us, and the minister with us at one o'clock.
Thank you.
(The committee adjourned.)