The Standing Senate Committee on
National Finance
Issue No. 40 - Evidence - October 3, 2017
OTTAWA, Tuesday, October 3, 2017
The Standing Senate Committee on National Finance met this day at 9:31 a.m. to continue its study on the Minister of Finance’s proposed changes to the Income Tax Act respecting the taxation of private corporations and the tax planning strategies involved.
Senator Percy Mockler (Chair) in the chair.
[Translation]
The Chair: Senators, welcome to this meeting of the Standing Senate Committee on National Finance.
[English]
I am Senator Percy Mockler from New Brunswick, chair of the committee.
I wish to welcome all of those who are with us in the room and viewers across the country who may be watching on television or online. As a reminder to those watching, the committee hearings are open to the public and available online on the Senate website at sencanada.ca.
All committee-related business is also found online, including the committee’s special studies, past reports, bills studied and lists of witnesses.
Now I would like honourable senators to introduce themselves, starting on my left.
Senator Jaffer: Mobina Jaffer, British Columbia.
[Translation]
Senator Forest: Éric Forest from the Gulf region of Quebec.
Senator Pratte: André Pratte from Quebec.
[English]
Senator Black: Doug Black, Alberta.
Senator Tannas: Scott Tannas, Alberta.
Senator Neufeld: Richard Neufeld, British Columbia.
Senator Marshall: Elizabeth Marshall, Newfoundland and Labrador.
Senator McIntyre: Paul McIntyre, New Brunswick.
Senator Ataullahjan: Salma Ataullahjan, Ontario.
The Chair: I would like to recognize the clerk of the committee, Ms. Gaëtane Lemay, and our two analysts, Alex Smith and Sylvain Fleury, who team up to support the work of this committee.
Honourable senators and viewers, today our committee is starting a special study on the changes to the Income Tax Act respecting the taxation of private corporations and the tax planning strategies involved, changes that the Minister of Finance proposed during the summer.
I would like to read in full the text of the Senate’s Order of Reference of last week, which was moved by the Honourable Senator Cools and seconded by the Honourable Senator Forest:
That the Standing Senate Committee on National Finance be authorized to examine and report on the Minister of Finance’s proposed changes to the Income Tax Act respecting the taxation of private corporations and the tax planning strategies involved, in particular:
•income sprinkling,
•holding passive investments inside a private corporation, and
•converting income into capital gains;
That the committee take particular note of the impact of the Government’s proposed changes on:
•incorporated small businesses and professionals,
•economic growth and government finances,
•the fairness of the taxation of different types of income, and
•other related matters; and
That the committee submit its final report to the Senate no later than November 30, 2017, and retain all powers necessary to publicize its findings for 180 days after presenting the final report.
To answer our questions, honourable senators, and to explain and discuss the proposed changes and their impacts, we have invited officials from the Department of Finance. Please permit me to welcome and to thank those officials: Andrew Marsland, Senior Assistant Deputy Minister, Tax Policy Branch; Miodrag Jovanovic, General Director, Analysis, Tax Policy Branch; Brian Ernewein, General Director, Legislation, Tax Policy Branch; and Ted Cook, Director, Tax Legislation Division.
I am informed by the clerk that Mr. Marsland will make the opening statement and that his colleagues are also here to answer questions by senators afterMr. Marsland has finished his presentation.
[Translation]
On that note, Mr. Marsland, you have the floor. Thank you for agreeing to appear before the committee this morning.
[English]
Andrew Marsland, Senior Assistant Deputy Minister, Tax Policy Branch, Department of Finance Canada: Thank you for the invitation to be here today. I would like to begin by providing context for the government’s proposals regarding tax planning using private corporations.
One thing to keep in mind is that due to the actions over the past couple of decades by federal and provincial governments, Canada has one of the most competitive tax systems in the G7.
In 2017, Canada’s combined general corporate income tax rate is 26.7 per cent on a weighted federal-provincial average. This is the second lowest among G7 countries and close to the average general corporate income tax rate in the OECD.
Canada’s general corporate income tax rate is currently 12.2 percentage points lower than that of its largest trading partner, the United States.
Canada’s combined small business corporate income tax rate is 14.4 per cent. Again, that’s weighted average on a federal-provincial-territorial basis. This is the lowest in the G7 and the fourth lowest among OECD countries.
[Translation]
Canada’s low tax rates on corporate income — including the preferential rate for small businesses — confer a strong competitive advantage to help businesses grow, create jobs, and innovate. In addition to generous tax support, small- and medium-sized enterprises benefit from direct program support for scaling up, including assistance to access financing and foreign markets, support for innovation, and services to build entrepreneurial and management capacity.
[English]
The second thing to keep in mind is that the basic structure of the existing tax system has been in place for a long time. In particular, the rules with respect to the taxation of passive investment have been in place since 1972.
Since that time the economy has undergone important transformations and, in recent years, there has been a significant increase in the use of private corporations. Specifically, the number of Canadian-controlled private corporations has increased from 1.2 million in 2001 to 1.8 million in 2014.
Growth has been particularly strong in some sectors. For instance, the numbers of corporations in professional services has tripled over the last 15 years.
An increasing proportion of self-employed individuals are choosing to go incorporate.
Private corporations now account for more than twice the share of taxable active business income relative to GDP than they did in the early 2000s.
There are important non-tax reasons that may influence a business’ decision to incorporate. However, the tax advantages accorded by tax planning in relation to private corporations have encouraged many individuals to incorporate their businesses.
[Translation]
Increased rewards from incorporation are at least partly due to the growing gap between personal and corporate tax rates. Specifically, as illustrated graphically in the government’s consultation paper, there is now a 37 percentage point difference between the top personal rate and the small business rate. There is also evidence suggesting that a significant share of taxable income has been shifted from the personal to the corporate tax rate.
[English]
The increased use of private corporations where it is for tax planning reasons raises concerns about the fairness of the tax system. It is in this context that the government has identified the following three areas for action: sprinkling income using private corporations, holding a passive investment portfolio inside a private corporation, and converting a private corporation’s regular income into capital gains.
Perhaps I could briefly explain each of these. Income sprinkling is where the income of a higher income individual is taxed as income of a lower income individual, often a family member. This reduces the progressivity of the tax system by allowing individuals in the highest tax brackets to be taxed at a lower rate of tax.
Some current income tax rules curtail income sprinkling. For example, when a business pays expenses such as salary, the expenses are required to be reasonable in order to be deductible. The tax rules also have a special tax on split income that addresses income sprinkling with minors by imposing flat top-rate taxation on sprinkled income, including dividends from private corporations and certain income derived through trust or partnerships from a family business.
However, the current rules do not fully respond to income sprinkling via dividends involving adult family members. In addition, current rules do not address similar tax planning using distributions from partnerships and trusts to adult family members.
In addressing this strategy, the approach the government is proposing is that, for tax purposes, dividends paid to a family member should be reasonable. In other words, the dividends paid to a family member should reasonably reflect contributions made by that family member to the business, whether they be in the form of capital invested or work performed for the corporation.
In keeping with this principle, the government proposes to extend the existing tax on split income for minors to apply to adults in certain circumstances. Dividends and other amounts received may be subject to a reasonableness test. To the extent that the amount is not reasonable, the top-rate tax will apply.
There are also proposals to address other income sprinkling issues, including the multiplication of claims to the lifetime capital gains exemption.
I would like now to turn to the second tax planning strategy being used by private corporations, that is the holding of passive investments portfolios inside a corporation. For context, I should mention that corporations can generally have either active or passive income. Active business income is earned from conducting a business such as the sale of goods or fees for services. Passive income is income derived from property investments such as interest income, dividends and capital gains.
The proposed measures will affect passive income only, not active business income. Returns on passive investment will differ substantially depending on whether the investment is made in a corporation or not. The key to the different outcome is that corporate income is generally taxed at lower rates than individual income.
The government’s consultation paper illustrates this example by using an individual versus a corporate owner, each of whom make a one-time investment of $100,000 pre-tax income. The corporate owner pays corporate income tax at 15 per cent and invests the balance, or $85,000. The individual pays personal income tax and is left with only $46,450. It is the difference in the amount to invest in passive investments that gives rise to the advantage.
The benefits of holding passive investments in a private corporation increase with the investment horizon and can become quite significant over time.
The objective of the government’s approach in this area is to eliminate the tax deferral advantage on passive income earned by private corporations and to preserve the intent of lower corporate taxes, which is to support growth and jobs. The objective is to make the system more neutral on a go-forward basis.
The third tax planning strategy is the conversion of regular income from salaries or dividends into capital gains. Only one-half of capital gains are included in income. For higher income individuals, dividends are taxed at a higher rate than capital gains. As a result, there is an incentive for higher income individuals to convert dividends and salary that would otherwise be received from their private corporations into capital gains.
There is an existing anti-avoidance rule, but there are indications that this rule is being circumvented. The government’s proposals aim to address this tax planning strategy.
My colleagues and I would be happy now to take any questions from honourable senators.
The Chair: Thank you, Mr. Marsland.
We will go to questions.
Senator Marshall: I have questions on all three areas. I will start with the first one, and hopefully when I finish somebody else can pick up.
For income sprinkling, explain to us how the rules will be tightened up. There are some rules in place now with regard to income sprinkling, so what specifically are the changes?
Based on the notes we were given, it seems to focus on the issue of reasonableness. Can you explain that? Who is to determine the reasonableness?
I’m just trying to get a handle on it. Why do the existing rules have to be tightened since there are rules in place? Just explain that to us in detail.
Brian Ernewein, General Director, Legislation, Tax Policy Branch, Department of Finance Canada: I’ll try to be concise in my explanation, so I will round some corners but hopefully give you the right sense of it.
There was a case about 15 or 18 years ago called Newman in which the Supreme Court found there wasn’t a test in terms of the propriety or appropriateness of the amount of dividends that could be paid on a share. That lack of constraint indicated that you could issue shares to your family members and pay dividends on them without any constraint or examination of the contribution made by that person to justify, if you will, the amount of dividends.
At the time the government of the day responded to that by introducing the so-called tax on split income, or what is sometimes known as the “kiddie tax” because it applies only to minor children to tax dividends at the top tax rate to try to prevent that sort of income splitting. At the time the government didn’t seek to contend with adults because it wasn’t appropriate to say that other family members had to be taxed at the top rate. Adults, it’s fair to say, would be more reasonably expected to have made a contribution that could justify the dividend, so denying that possibility wasn’t appropriate.
The proposals in this package seek to return to that issue and essentially ask if the absence of any constraint on the amount of dividends that one can pay to family members from a company is appropriate, and try to introduce a factual examination of the amount of dividends paid. It parallels rules that already exist in the system for the payment of salaries, that is, that you can’t pay any amount of salaries to your family members. It has to be reasonable. In broad strokes, that’s the test being proposed for dividends as well.
Senator Marshall: I understand the rule for under 18 years of age, but when you issue dividends to somebody over 18, isn’t there a reasonability test already, or is it just open season?
Mr. Ernewein: Effectively it is open season, that is to say, there isn’t a constraint. This court case seems to have found there was not a constraint. That, as I say, was the reason for introducing the rules in respect of minor children.
There is a constraint that requires salaries and wages to be reasonable. That is not the case for dividends, so it may well be the case that the adult family member, spouse or adult child, is making a contribution or they may not be. What this seeks to do is introduce a factual inquiry.
Senator Marshall: They still get the dividends and the dividend tax credit.
Mr. Ernewein: There is nothing turning off the receipt of the income. It is a question of what tax rate you pay on the income.
If it’s judged to be reasonable by reference to the contribution the adult has made, either in the capital they’ve contributed or the sweat equity, the labour they’ve provided to the corporation, then the dividend is taxed as normal within that individual’s marginal tax rate.
Senator Marshall: But it has to pass the reasonability test in order to dip into the current benefits of having received the dividend.
Mr. Ernewein: That’s correct. If it didn’t pass the reasonableness test, then the proposals would say that it’s taxable at top rates to try to prevent the potential income splitting or income sprinkling that would otherwise arise.
Senator Marshall: Just talk about the passive investment income. In reading the briefing notes, the income in a corporation is split up, is it? Does the government know how much is active income and how much is passive income? The government is aware of all the different categories, is it?
They give one example. They show the employee and then they show somebody who has a company. Then they show the $85,000 and as a result, if you leave it in for 10 years, you will end up with more income; but the government gets its share anyway. When the $85,000 comes out, is that taxed at the regular rate?
Miodrag Jovanovic, General Director, Analysis, Tax Policy Branch, Department of Finance Canada: The issue is that the investment income, per se, is taxed at the corporate level, at 50 per cent, of which 30 per cent is refundable when the corporation issues dividends.
Senator Marshall: Yes, I got that.
Mr. Jovanovic: The net effect of that is by and large the investment income is taxed at 50 per cent. The issue, however, is that the individual through a corporation can actually have significantly higher initial capital to invest. For instance, what we’re saying is that on the $100,000 saved in a corporation, there is $85,000 kept that can earn investment income in the corporation.
The individual who would have earned the $100,000 directly would have to pay at least, at the margin, between 50 and 53 per cent tax, and would have potentially been left with less than $50,000 to invest.
While both individuals could be taxed at 50 per cent on their investment income, the fact is that you’re generating investment income on potentially $35,000 more of initial capital than if you had earned it directly, and that is the issue the proposals achieve to address.
Senator Marshall: Just looking at the investment income, I don’t understand why that’s an issue because somebody is making some money off the $85,000 and the other person is making some investment income off the $50,000. The government is to get its 50 per cent of the $85,000 the person got. It’s to the government’s benefit, isn’t it?
I’m not talking about the capital part. I’m just talking about the investment income. The government is to get 50 per cent, so isn’t it better for the government to get 50 per cent of the $85,000 than 50 per cent of the $50,000?
Mr. Jovanovic: What the government is trying to achieve here is to improve the neutrality and the fairness in the system. Taken from the angle of the individuals in these different situations, the one earning the income directly versus the one using the corporation, the fact is that there’s potentially a significant difference in the potential to accumulate savings or a return on investment.
If you just take, for instance, individuals saving in interest bearing assets a return of 3 per cent for five years and having directly earned the income, they would potentially realize a return on the 3 per cent net after tax of 1.4 per cent.
Senator Marshall: I saw that, but it’s also possible that the person who is left with the 50 per cent might end up earning a bigger return than the person with the 85 per cent, depending on where they invest their money.
I don’t see the logic in that part of the argument. I can see where you’re looking at the principal portion and saying, “On the principal portion somebody is taxed at a different rate.” I can see that comparison. It’s just that I didn’t see the reasonableness of the $85,000 versus the $50,000.
I have a few more questions, and I know my time will run out. In the opening remarks where the comment is that we’re the second lowest among the G7 and “close to the average general corporate income tax rate,” what is the overall objective? Is it to move us closer to the average? Is there an overall objective?
We’re just looking at a very small part of the Income Tax Act, so what is the overall objective? There has to be a bigger plan, right? This is a little plan. What is the big plan?
Mr. Marsland: I think successive governments since 2000 have reduced the corporate income tax rates applicable both to general rates and small business. The objective there is to foster an environment that drives investment and attracts capital. With those rates we’ve focused on a number of metrics, not just the statutory rate but also the marginal effective tax rate on new investment.
Both federal and provincial governments have acted to bring those rates down very significantly, with a view that it is very important to drive growth in the economy.
Senator Marshall: It would seem to me that an overall objective is to try. You say there is a growing gap between personal and corporate tax rates. Why not try to close the rates, right? Personal tax rates for higher income went up to 33 per cent last year, but the government didn’t realize the taxes that they thought they were to realize on that.
It seems like some of the movement that has been done in the past has been counterproductive. It would seem to me, if they were looking at the growing gap between personal and corporate tax rates, the overall objective should be to move them closer instead of just getting in there and floating around with a certain aspect of income taxes.
Then you say there’s also evidence suggesting that a significant share of taxable income has been shifted from the personal to the corporate tax base. What would evidence that?
Mr. Marsland: We have a chart in the consultation paper. I don’t know if you have the consultation paper with you, but it shows the trends over time in terms of the different tax rates. I think it’s chart 4.
Senator Marshall: The driving force behind it, though, is the difference in the tax rates, isn’t it? There’s such a big difference between personal and corporate.
Mr. Marsland: There are probably a number of issues that drive that. A large part of that growth has been, as I mentioned, the increasing trend toward the incorporation of professionals as a result of changes in provincial laws that control that. We’ve seen a shift there. That effectively represents a shift of income that was previously taxed on the personal income tax base into the corporate tax base.
We see that as a trend reflecting a number of factors, I guess meaning that more income is taxed through private corporations, exacerbating the problems identified in the paper.
Senator Marshall: I notice a difference between when the new 33 per cent tax rate was put in and now. Do you chart that? What happened with the 33 per cent, when the personal tax rate went up? I’m trying to get a handle on the relationship between personal income taxes and the creation of these corporations.
The taxes from the 33 per cent didn’t materialize for the government, so what happened? Why didn’t it? Do you know that?
Mr. Marsland: I’m not sure we have the data on that. It’s a fairly recent change, but the trend goes over a period of years. I think we identify in the paper from 2002 to 2015.
The Chair: Thank you, senator. Could you provide the clerk with additional information on that, Mr. Marsland?
Mr. Marsland: Yes, certainly.
The Chair: Thank you.
Senator Black: Gentlemen, thank you for being here. I note that you must have checked your flak jackets at the door. We are appreciative of the work that you have done.
I have a number of questions arising from the research I have done independently and, of course, the overwhelming number of Canadians and business associations that have reached out to me and to my colleagues. While my questions may appear to have an edge, I am reflecting the points of view that have been communicated to me.
May I ask initially whether anyone at this table, or anyone in the senior ranks of the tax division, has any business experience outside of the government tax world? Do we have any representatives of small business, people who have been in a small business and have confronted the issues that would be confronted by a small businessman?
No, I presume is the answer.
Mr. Ernewein: I can offer that I come from a family of small businesses. My father ran one and my uncles as well. I was involved with that all the time.
Senator Black: I am interested in the folks that are taking these policy decisions. It is good to hear about your family, but this is what I am interested in.
I am trying to understand the sensitivity. I assume, so that I can move on, that the answer is no, correct?
Mr. Marsland: I can’t say for all of the officials in the department, but, personally, no.
Senator Black: Thank you very much, sir.
I am advised that these proposals, which we assume would have been generated with the best of intentions, of course, have created a number of unintended consequences. Have you informed yourself, either independently or by reading the media or presentations that are overwhelming the country now, as to what these unintended consequences are? If so, are you able to comment on them?
Mr. Marsland: We have certainly paid a great deal of attention to the submissions that have been received and the commentary made on the proposals.
Senator Black: Specifically, I am concerned about the adverse effects on small business. You would have read the presentations that have been tendered in that regard. I am concerned about the adverse effects on young entrepreneurs, which I understand is a targeted group within the targeted groups, that will drive young entrepreneurs, I am told, out of Canada to create their innovative strategies. I am concerned about the broadening competitiveness gap with the U.S. Then, of course, there is the adverse impact on professionals and skilled entrepreneurs that you referred to, the increasing trend for professionals to incorporate.
Can you comment specifically on any of those adverse effects and whether or not you are prepared to change these proposals to reflect the damage being done?
Mr. Marsland: Perhaps I could comment on the three areas of proposals.
The first one relates to, as I mentioned, income sprinkling. It is really a question about the personal tax liabilities of the business owners, the appropriateness or not of the application of the payment of those dividends, and their impacts on the progressive nature of the tax system.
Senator Black: You would have seen the overwhelming reaction of the farming and fishing communities in the country to the suggestions and rhetoric around income sprinkling. Has that in any way affected your point of view?
Mr. Marsland: As I mentioned, we are paying very close attention to the submissions received.
On the income sprinkling, I would like perhaps to reinforce the point we made: The proposals are not intended to affect or certainly don’t apply to the payments of salaries to family members. As we discussed earlier, they are intended to not apply where the dividend payment reflects a contribution by way of capital or by way of labour to the corporation.
Senator Black: On innovation, you would have seen that the CEO of Hootsuite, one of Canada’s most successful innovation stories, has simply said that if he were doing it again under these rules, he would build his business in the U.S.
You would have seen the petition started last Thursday among innovators and entrepreneurs in Canada, which now has over 100,000 signatories of people who have started and built businesses, and they are worried about their ability to continue in Canada. What is your reaction to that?
Mr. Marsland: In crafting the proposals, the intention was not to reduce the impact of the competitive tax rates we have in Canada. They are focused on passive investments, on income sprinkling and on approaches to convert dividends to capital gains.
Senator Black: I know what your intention was, but I am suggesting there are unintended consequences to your intention. That is what I want to hear about.
When I tell you that the business in Alberta of angel investors who fund start-up businesses has stopped because of your proposals, what do you say to that?
Mr. Marsland: I’m not aware that it stopped.
Senator Black: I am telling you it stopped. That is the kind of thing that these proposals are doing in Canada. I want to know, as a final question on this round, when will you come forward with changes to these proposals?
Mr. Marsland: The government, of course, will consider carefully all of the input received in the consultation period and no doubt make decisions.
Senator Tannas: I want to ask a few questions around passive income, recognizing that small business people, by definition, are risk takers. They may make investments that are not specific to their business but actually invest in other small businesses and small business people, such as start-ups and so on. This is something, certainly from my perspective and my experience as a small business person, I have participated in and been active in.
Let us say I am a dairy farmer and I am going to invest and buy 5 per cent of a creamery that needs capital for new equipment. Is that a passive investment under these rules?
Mr. Jovanovic: Passive investment would typically include interest, rental income, portfolio dividend income, as well as capital gains. If there is an investment made in equity in another corporation, typically they’re dividends or capital gains if these shares are disposed of.
I would like to get back to the proposal and intent of the different approaches that are proposed in the paper with respect to passive investment income.
Senator Tannas: Sorry, could you just answer the question? There is a creamery down the road and I am a dairy farmer. He is going around because he needs some new equipment. He would like to get guys who understand the milk business to invest, so I buy 5 per cent of the creamery.
Will that be taxed if there are dividends or if I sell that? If I keep it in my farm corporation, will I get the 50 per cent tax rate on any dividend or any capital gain that happens in that scenario?
Or, if you do not like that example: If I am a welder and there is a business starting up that will help me in my welding business. I am going to buy 5 per cent of that or loan the guy some money through a note. Will that all get taxed at that kind of rate?
Mr. Jovanovic: Let me explain how the measure would or could potentially work. We don’t have a specific final proposal in the paper, but we have approaches.
One of the approaches would be to say the root of the problem is when you invest money that is originally financed with low-tax business income. The first step of that approach would be to determine: Is this investment income coming from low-tax business income or from shareholders’ contributions that will be fully taxed? If it is coming from shareholders’ contributions, it would continue to benefit from the current refundable tax regime. That is the first step. Maybe these shares were financed directly by the shareholders’ contributions. Then they would not be subject to new rules.
The second step would be to determine the nature. We raise that question in the consultation paper. We say with respect to capital gains, in particular, is there reason to believe that some of these assets are actually active in nature, more than just passive? We should look into that. That could be the second level of exclusion, if you will. Once this is determined, they would also be eligible for the current regime.
The example we put in the paper is seen as the starting point for the discussion in the context of this consultation, in a way, and what we are going to be looking at. The example that we put is the typical case where the corporation is holding shares of another corporation that it controls and then disposes of these shares. Should it be excluded? Should it continue to receive the current treatment?
This is an important question we looked at as part of the consultation and we continue to look at.
Senator Tannas: Further to Senator Black’s comments about small business experience, I want to give you a little taste of that.
As I said, these are the risk takers. These are the people who, by their nature, are taking risks. If they are forced to strip money out and pay their 50 per cent tax, they will buy Royal Bank shares, just like you do when you get your 50 per cent tax rate. They won’t be interested in investing as part of their business mind. Once it leaves the company, it’s their money. They have to plan for their future, fund their RRSPs and are far less interested or apt to provide investments in businesses that they know.
With their 50 per cent that needs to go fund their retirement, they will not take a flyer on the creamery guy. In all of those activities, I urge you to look very closely at how you can protect local knowledge, local understanding, and business expertise that strictly may be corporation to corporation, small business to small business. If you guys screw that up along with everything else, we will be in deep trouble.
Mr. Ernewein: May I make a comment on that? I want to make sure it is understood what the passive income proposal or approach, as my colleague has put it because there isn’t a specific proposal in the paper, would do. It doesn’t change the tax rate or the taxes applying to investment income earned by private corporations.
Take the creamy as an example. Today, if you own less than 10 per cent of another company and receive dividends from it, it is subject to a tax as matters stand. It is also subject to capital gains tax as matters stand.
The proposal is seeking to make modifications to the refundability of some of those taxes to account for the fact that when you have earned small business income you are only paying a 15 per cent tax rate, generally, and have 85 per cent left to invest.
The second point I wanted to make is that the concern the paper reflects is that when people have 85 per cent in their private corporation left, it’s intended to be there to reinvest in the active business to do the things you suggest should be done; but today you are entitled to have that 85 per cent and say that you don’t want to put money in the small business, that you want to buy Royal Bank shares instead and have 85 cents on the dollar to do that.
By adjusting the refundability and trying to improve the integration so it is more neutral for those passive investments, it can be fairly argued that it concentrates the incentive on small business.
Senator Tannas: I want to be clear here. What you are saying if I have extra income in my small business and I invest it in another small business? Even though I will not be running it, I see an opportunity because of my unique circumstances. I am not buying Royal Bank shares. I am going to buy that small business, but within my corporation. Am I okay?
Mr. Ernewein: I am responding to your example. A 5 per cent investment is treated and has been treated for decades as a portfolio investment, just as a bright line test; but investing more than 10 per cent is not subject to tax on the dividends today.
Senator Tannas: And it would be in the future?
Mr. Ernewein: Again, it is not in the proposal.
Senator Tannas: If I bought 10 or 11 per cent of the creamery, under this rule that is what you are trying to catch.
Mr. Ernewein: According to current rules there wouldn’t be a tax on the dividends. There would be a tax on the capital gains generated from those shares with the rules today, and part of the discussion in the proposals is whether the half that is not taxable should continue to be able to be paid up on a tax-free basis.
The proposal is not to change the taxation of this investment income when it is found to be investment income in the corporation itself. It is a question of what happens on payout.
Senator Pratte: To follow up briefly on passive income, in the brief submitted by Chartered Professional Accountants and the Canadian Bar Association by their joint committee, they mentioned that they wish the current definitions used by the CRA on passive investment and active investment income are not used because they say those definitions are used for other purposes.
Are you saying in fact that on the passive investment proposal what you are looking at is possibly using other definitions, rather than the ones presently used in the act?
Mr. Ernewein: What I was meaning to say was simply to respond to the example of a less than 10 per cent interest and the 5 per cent stake in a creamery. I was making the point that under today’s rules there is a taxation on dividends received by a private corporation on a stake of less than 10 per cent.
The joint committee and others have made the same comment, essentially making a point, which I think is a fair one, that we have in the system today distinctions between passive and active business income. It is fair to say that those distinctions are relevant and matter today, but as a result of the possible proposals or approach described in the paper they would matter more.
What I take the joint committee to be saying, and I confess to not having gone through all of their submission that came to us yesterday, is that we should think harder about whether or not those definitions are solid enough or require more definition to make the delineation clear.
Senator Pratte: I want to talk about the reasonableness test as far as income sprinkling is concerned. There is a lot of concern about using such a test, even though it is used now for salary purposes. The fact that it would be used now for adults and for dividends and so on, would introduce a lot of uncertainty and a lot of subjectivity for tax planning purposes. I am sure you have heard those comments. What do you have to say about that?
Mr. Ernewein: The paper itself recognizes this challenge. Yes, it really does bring to the fore or make relevant a factual inquiry as to the contribution that a person has made to the corporation in order to support the amount of dividends they received. I am looking at the paper. It says:
. . . the reasonableness test depends on the facts of each case, and questions concerning the measurement of contributed value, or the evidence required to support such contributions, will not always be straightforward.
I think we can be accused of understatement there. There are some challenges in its application.
Having said that, I will say that it is the test that we have, as I have said already, for salaries and wages paid to family members. There is more involved with a dividend test because it is not just looking at current periods but also past periods; but the base test is the same as we have already.
Senator Pratte: I will just throw things at you that I have heard. For instance, as far as a small business entrepreneur is concerned, there is a high risk involved. If a spouse stays at home to take care of the children, there is a share of the risk involved that this person, the at-home spouse, shares. He or she shares the risk of the business even though she or he may not work or even invest capital in the business. That may not be true of a doctor, but it is certainly true of an entrepreneur.
How will you measure this? It wouldn’t be fair if you did not take that into account.
Mr. Ernewein: I don’t mean to sound hardhearted, but I do challenge the premise of the question that a couple, where one decides to stay at home to look after the family, is entitled to a share. I don’t think that is true. I don’t think it is true if I decide I will stay at home so my spouse can put in 80 hours pursuing her employment that she is entitled to share with me. Nor would it be true in the particular facts you bring forward. It really is a personal decision of that couple in those circumstances.
Senator Pratte: I am sure a lot of people would disagree with that. That is a very different situation. The situation in a family that decides to start a business is very different from that of a doctor or a university professor because a very high risk is involved that you don’t have when one member of the couple has a job with a salary and maybe a pension, benefits and so on. It’s a different situation because there is a risk factor involved.
There is a challenge that you recognize with the reasonableness test. What I have heard is that the CRA already has difficulty managing the current situation, so that it will increase the difficulty for everyone as far as tax planning is concerned and for the CRA. Can that be managed?
Mr. Ernewein: It is essential that it be managed for the proposal to work satisfactorily. In our discussions with CRA we believe we can arrive at that. It does stem from or run off the same test we have today.
I don’t think CRA is out auditing every taxpayer on salaries and wages to determine their right to the nickel. It is the case that it is a limit. You don’t have to identify that it is the actual only right amount but, rather, that it is within reason. We think that the same outcome can be achieved in relation to dividends as salaries.
Senator McIntyre: My question is a follow up to questions that have been asked by other senators regarding income sprinkling.
As I understand, your department estimates that its proposals to eliminate income sprinkling would result in approximately $250 million in additional revenue for the government. Obviously, your department used assumptions in its calculations of additional revenue for addressing income sprinkling.
Has your department had its calculations validated by an external reviewer such as the Parliamentary Budget Officer?
Mr. Marsland: I believe that the Parliamentary Budget Officer is examining the issue. I don’t believe that review is complete.
Senator McIntyre: As a follow up to the question I have just asked, has your department undertaken studies to assess the impact of its proposed changes on the economy? Is your department planning a larger, more comprehensive review of the Canadian tax system?
Mr. Marsland: As to whether or not we have done studies of the impact of this, in looking at any measure we look at the impacts. We have models based on the tax data available. In the particular case of income sprinkling, we could determine how many families would potentially be affected by this measure by virtue of looking at the underlying data.
What we can’t determine, of course, is in how many cases that is reasonable because it is a question of fact in every case.
As to whether the department will do a broader review, I think that is a decision for the government.
[Translation]
Senator Forest: Thank you very much for being here. I am not a tax specialist, but I do have some life experience. To my mind, a tax system must be fair and competitive. Those are certainly your objectives also. We were talking earlier about broader objectives. Have you assessed the impact of the costs of the reform on the revenue it can generate and the way it can enhance the fairness of the tax system for Canada?
Mr. Jovanovic: As to the impact on revenue, we assessed the effect of the measure designed to limit income splitting. That is estimated at $250 million per year. There is still no estimate for the taxation of passive income, simply because that measure is not in place. We have suggested approaches, but no specific measures. There is no estimate for the third measure involving the conversion of income into capital gains. We have no information on which to base an estimate.
Senator Forest: Your approach in the three proposed measures involves fairness. I am thinking among other things about the fairness of e-commerce, the Amazons of the world, and what they can contribute to the economy, while small Canadian merchants make a significant tax contribution. We know an agreement has been reached with Netflix. A major reform of the tax system is being considered in the interest of fairness. Have you considered reaping some revenue from e-commerce, which is increasingly widespread in the 21st century?
Mr. Jovanovic: I must point out that these measures do not have a direct impact on corporate tax. The government is seeking to restore balance in the system, but the tools being used do not directly impact corporate tax. The general tax rate for small businesses will remain close to 27 per cent, which is very low and competitive in relation to other countries. There is no direct effect in this regard.
Senator Forest: There will not be any direct effect for big companies such as the Amazons of the world either.
I am concerned about something in the third component regarding capital gains. I think our system is already quite unfair as regards the sale of companies to foreign buyers. Canadian businesses have a serious problem with succession planning. For example, if I sell my agricultural enterprise to a family member, this reform would result in greater unfairness, as I understand it. As an agricultural entrepreneur, it would be more profitable to sell my farm off in parts, my quota and my machinery, than passing the farm on to someone in my family. I am concerned about preserving agricultural production and economic activity in this sector. When I look at the proposal, it seems to me that it will exacerbate the unfairness when businesses are sold to foreign buyers as opposed to family members.
Mr. Jovanovic: First, the proposed measure pertains to the conversion of business income, that is, business surplus into capital gains, and seeks to strengthen the anti-avoidance rule already in section 84. This rule is designed to prevent business owners from pulling money out of a company through a series of transactions in order pay the lower rate on capital gains. In reality, this amount should be taxed as a dividend. There is a significant difference between the two rates, as you know. The proposed measure is simply intended to address a weakness in these rules. The government clearly indicated that it is seeking input on changing the rules to create a better framework for intergenerational transfer of ownership, to the extent that we can define what a real intergenerational transfer is. That is actually the key: how should we define these transactions in order to preserve the integrity of the system on the one hand, while also allowing for the intergenerational transfer of companies on the other.
Senator Forest: I conclude that the system must be fair while also creating an environment that is conducive to economic activity. We must prevent the selling off of company assets, which would lead to the end of economic activity in the system.
[English]
Senator Neufeld: Thank you, gentlemen, for being here. I notice on the first page that you say, “Canada has one of the most competitive tax systems in the G7.” I guess that would mean our whole tax system: personal, corporate and small business.
I don’t disagree with what you’re saying about corporate income tax. Often the comparison is made between Canada and the U.S. in corporate income tax but, for some reason, you don’t make the case about personal income tax. As I understand it, some of the states have no personal income tax and some of them have a personal income tax rate of maybe 10 per cent.
To say that we have the most competitive tax system in the G7, you’re only taking part of the box of apples and talking about it. You’re not talking about the whole tax system. I doubt you’ve ever thought about this but, instead of saying those people who pay 50 per cent tax are paying too much, maybe we should lower the personal income tax rate so that we can be more competitive on a tax system across the whole system.
That certainly isn’t what governments are looking for. They’re looking for more money. They’re looking for ways to tax more. I just make that as a point.
Can I ask who developed the proposals? Did this come from you folks? Did it come from a minister? Did it come from somewhere else? Who generated the idea that we should go out and revamp these three things?
I’ve been a minister before, so I understand how some of this stuff works. I don’t know about you directly, but did someone like you say to the minister, “Here is where we can get more money?” Is that what happened, or was it a political decision that we can change some of these things?
Mr. Marsland: I think you’ll understand that I can’t really comment on discussions between the department and the minister but, of course, we support the minister with advice. I think you know how the system works, as a former minister.
Senator Neufeld: I understand how that works, fully, and I get your answer. I’ll read between the lines that this didn’t come from the bureaucracy, per se; it came the political way. Would you say yes or no?
Mr. Marsland: I would not respond to the question, with respect.
Senator Neufeld: Okay.
Mr. Marsland: I guess I would suggest that you should not read between the lines, with respect.
Senator Neufeld: Thank you.
There have been lots of questions asked around my next question, which is about this reasonable test in income sprinkling. As I understand it, and in fact it was said earlier, I think by Senator Pratte, the department expects to gain $250 million in changing the way income sprinkling happens.
How do you do that? Do you have some ideas about what a reasonableness test that you’re just not saying now? I think that’s the question a lot of people have. On a farm, for instance, does the wife or husband, whoever is working out in the field, or maybe not working steadily in the field but has to come out and do a lot of work like maybe drive a tractor for three or four days, have to account for that in a book? Do they have to say, “This is what I’ve done for a whole year,” so that when CRA comes to investigate they feel comfortable there has been a reasonable test?
To come up with the $250 million as an estimate, you must have had some ideas of what a reasonableness test would be. I can’t imagine you did that in a vacuum. You would have had to have said, “This is a reasonable test compared to what it is today.” Do you have some reasonableness test that you used to develop the $250 million figure?
Mr. Jovanovic: There are obviously a number of assumptions you have to make to get to a number like that. We have been working with information from the tax returns of individuals and corporations. We’ve been trying to link the two to understand family structure and corporate structure and whether a dividend has been paid from a high earner to a spouse who happened to be in a very low tax bracket, which suggests there could be something at play, just by nature of the importance of the tax arbitrage.
There are obviously some judgments that have to be put in when you do these estimations. You are working with not necessarily knowledge of the best quality because you’re not necessarily able to perfectly recreate all these structures.
You have to take all that into consideration, and the $250 million reflect the best use of the knowledge we have to come to that. It is obviously an estimate.
Senator Neufeld: Would you provide us with your assumptions?
Mr. Jovanovic: As Andrew said earlier, we are working with the PBO and sharing all of that with the PBO. That’s something we obviously can share as well with the committee, I guess.
Senator Neufeld: Do I get the answer that you are telling me you will share all the assumptions you have made about what is a reasonableness test with the committee, and will you do that before we go out on the road?
Mr. Jovanovic: Yes, that seems reasonable.
Senator Neufeld: I think we’re planning on going out on the road in a couple of weeks. We’re usually used to some of this stuff not getting to us too quickly, so I appreciate your word that you will provide to us all those assumptions on how you came to the $250 million. Perhaps you could provide it to the clerk so that we all get it.
The Chair: Mr. Marsland, do you agree that this will be forthcoming?
Mr. Marsland: Yes, we will certainly provide a description of the methodological approach we took to coming up with the estimate.
Senator Neufeld: I have one final, quick question. Although I grew up on a farm, I left it a long time ago, so I’m not familiar with it. However, I understand that young people who want to farm can’t afford to go out and start farming. This is something that is usually passed through generations and processes that Senator Forest talked about.
Is there anyone in the Department of Finance who’s looking at maybe providing some of the information and the background on how to develop this, someone who has ever been a farmer, understands how you transfer this between generations and how to keep the family farm going?
The family farm, as I understand it from when I grew up to what it is today, is not there anymore. They are multinationals. If that’s where the governments want to force farming to, I am really upset at that because I think we need to keep the family farm going and to keep the family farm going, it has to be transferred intergenerationally. Tractors are a million dollars nowadays. Combines are the same price. You just don’t go to the Royal Bank and say, “I need all this money and I want to go farming.” It doesn’t happen. It takes some hard work for a lot of years to get your farm running.
In terms of any change in how that is done, I want the Department of Finance to be darned careful about what you do that could totally destroy what we have left of the family farm. If there’s no one in the department that has ever grown up on a family farm or had any intergenerational transfers, I’d be a little disappointed, unless you’re out there talking to people about it. I would be surprised if you are; maybe you are. Perhaps you can give me a bit of an answer to that, please.
Mr. Ernewein: Sure, if I may. It’s something we are very sensitive to. You’ve really explained a lot of the background to this and the motivation in trying to ensure that there is a possibility for transferring farms between generations. The budget and the consultation paper both discuss this point. There is a real challenge. Without going on too great a length, we have a system today whereby the top tax rate applying to dividends is in the 40 to 45 per cent range and the tax rate applying to capital gains is about 25 per cent.
The reality is that it sets the stage for possible what’s called surplus stripping, that is, trying to avoid taking money out of the company by way of dividends and instead trying to do a sale to yourself, to another corporation that you own, to try to generate a capital gain and characterize it as that to pay only 25 per cent.
There was an event marking the hundredth anniversary of the Income Tax Act a week or two ago. At that event it was mentioned that surplus stripping rules were part of the original Income War Tax Act, so it has been around forever. We have rules that have been around for a very long time trying to put constraints on the ability to sell to yourself, essentially, in order to get dividend rates down to capital gains rates. The consultation paper includes a proposal to try to tighten that in one respect because there was a gap identified in a different court case a couple of years ago.
That has kind of prompted a new discussion of sort of an old rule, that is to say: Is it appropriate to impose this dividend taxation when you sell to yourself or, more precisely, when you sell to your children through a corporation, that is, they have a corporation that’s buying yours?
I will try to be as quick as I can, but I want to emphasize that the same rules apply on the sale by a parent of their farm corporation or their small business corporation to the child directly. Capital gains rules can apply there and the lifetime capital gains exemption can apply there because the child as an individual is essentially stepping into the shoes of the parent. There is no greater ability to surplus strip, as I call it, than in those circumstances.
When you transfer the shares of the corporation to a corporation owned by the child it sets up the possibility, in the absence of having special rules of generating a capital gain, of still being able to pull the money out of the corporation to send back to mom or dad to pay for the company and to pay 25 per cent rather than 45 per cent. These so-called anti-surplus-stripping rules are intended to limit that kind of situation.
The challenge is that can also interfere with the transfer of something like a family farm, where the child wants to use a corporation because they want to refinance within the company to help pay the purchase price, among other things. Both the budget and the consultation paper have sought views on what possible exceptions could be made for what we kind of vaguely call legitimate intergenerational transfers.
We put forward one idea that sort of follows the U.S. model that says if a parent really gets out of it altogether, stands back, then capital gains treatment can apply. From the people we’ve talked to, farm groups and others, it’s almost universally decried. The view seems to be that isn’t the natural way things happen. In a family transfer you transfer some interest. The parent stays very much involved as mentor, as ongoing investor, and sort of withdraws over time. That doesn’t seem satisfactory in terms of kind of a commercial reality test.
We’re still struggling to find another approach to this. When we’ve been talking to farm groups and others, we’ve really been trying to emphasize the point that we’re looking for comments on this. I can’t say, at least, that I’ve looked at all of the submissions because most of them just landed with us in the last couple of days with the consultation period closing yesterday. We’re hopeful there’s something in there that will give us inspiration.
Senator Jaffer: I want to continue with what Senator Neufeld was saying, and then I have my own question. You were talking about the farmer selling or staying involved. If the farmer dies, what are the rules?
Mr. Ernewein: I’m sorry. Is this a circumstance where the farmer dies owning a farm corporation or would you like to consider both cases?
Senator Jaffer: Both cases.
Mr. Ernewein: If the farmer dies owning land, buildings and livestock, the general rule is that there is a deemed disposition on death at fair market value generating a capital gain or sometimes ordinary income. The person taking over that property, the estate could be a child or perhaps an arm’s length buyer. Let’s just talk about the estate or the child receiving it by way of will. They would acquire that property at fair market value.
Alternatively, there is also a rollover available for farm property that could apply. If the will provides for this, it’s possible that it just goes at original tax costs and no tax paid at that time. There might be situations where they would like to use the lifetime capital gains exemption, so there will be some different questions at play.
When a farm corporation is what is used to hold the farming assets and the parent dies owning the shares of that farm corporation, I believe a rollover is available when there is a deemed disposition of those shares for a capital gain. In the circumstance where the rollover does not apply, then the child would acquire those shares at fair market value and could carry on the business, run the corporation and farm for quite a long time.
It’s also possible they may wish to wind up the company or to undo or dissolve the corporation because there aren’t children or the children aren’t interested in farming. In those circumstances there are rules exist that can allow you to do that windup. You end up taking a dividend out of the company and you end up cancelling the capital gains. Effectively, there is a net dividend tax paid on the windup.
Senator Jaffer: How would the rules change if the child keeps the farm? Would there be more tax to pay under the new rules?
Mr. Ernewein: It gets even more complicated if the child keeps the farm. I’ll just talk about the farm corporation now.
As I’ve already said, it’s possible that they inherit the shares of the farm corporation and that’s all there is to it in terms of tax consequence for the immediate future. They continue to farm, earn money, take money out of the company, and 30 years down the road when they should die or decide to retire and sell it, they’ll have further capital gain if there has been further appreciation, or they may have dividend treatment if they wind up the company at that time.
I’m sorry. I’m just not sure whether I should get into this, but it is possible that if they acquire the shares they would like to do some sort of reorganization themselves immediately after having acquired it. That can give rise to dividend treatment if they pull money out of the corporation on acquisition. There are various ways of trying to ameliorate that effect.
Senator Jaffer: You have set out the situation of the corporate owner and the employee. Going with some of the things Senator Black was saying, I believe you have in one consultation sort of brought Canadians together but also divided Canadians. I truly believe you all have done a great disservice to us in the way you’ve divided us on tax situations.
This is what I mean. You’ve set the example that the corporate owner pays corporate income tax at 15 per cent and invests the balance. The employee pays personal tax and is left. One invests and one is left with $46,000. I believe you have been comparing oranges and apples. These are two different ways of working. Now you’ve put a nurse against a doctor. You have sort of divided us.
What does a business person do? I grew up with business people. My grandfather always said you spend now or you invest for another day. You grow your business. You take risks. You go without. It’s a different kind of upbringing, a different way of doing things than if you work.
I work here in the Senate. I get my salary and I can do anything with it, and you tax it. It’s a very different kind of thing that I am doing than a person in business is doing. By trying to compare both the employee and the business person in the same way, you’re taking away what they do. They do two different things.
At the end of it, as an employee, I will have a pension. The business person does not have a pension. You don’t mention all that. You just talk about your example, and you divide us. They’re not the same, and I am really confused as to why you think they are the same.
Mr. Marsland: The objective here, firstly, is to preserve the significant advantages of lower corporate tax rates where the money earned is invested back in the business. As my colleague explained earlier, the issue is where the money is not invested directly in the business, where it is invested passively.
Again, this is a situation where you’re looking at the personal circumstances of the corporate owner and the circumstances of an individual. We aim, and the system was constructed in this way, to achieve neutrality between those two results.
The proposal in the paper is intended not to change the cash situation in the corporation where the money is invested. The same tax rates apply. The issue is when the money is withdrawn from the corporation after having been invested passively. The intent there is to achieve a neutral outcome between those two circumstances, again with respect to passive investments, not with respect to investments in the active business.
Senator Jaffer: One of the questions I have been asked many times by British Columbians where I come from is about passive. They say you don’t get what passive is. For example, an owner may not use the money in the business for a number of years, for whatever reason, but later they will and you will tax it.
I heard what you said. I got all that. There is passive money or dead money. People think of passive money as using it later. It’s not in the business. The people I speak to are of the opinion that you’re not taking that into account.
Mr. Jovanovic: I will highlight the fact that the proposed approaches in the paper are such that we taking into account the fact that when a corporation or a corporate individual gets, let’s say $100,000 of income and is then left with $85,000 after tax, a decision could be made as to whether to reinvest in the business or invest passively, but only for a few years, for instance, to build capital to reinvest in machinery or in the business.
The approach we’ve tried to take here is to make sure the adjustments that are proposed happen only when the money goes out of the corporation. Actually, if they continue to invest in the corporation the effect is immaterial. They will keep the $85,000 on the $100,000. They will still be able to invest passively. They will continue to pay 50 per cent on that passive investment income, as currently. Then, when they decide to put it back into the business five or six years down the road, they are not materially affected by these approaches. That is critical in the approach.
We feel it’s important to maintain the ability of corporations to do that and to reinvest.
[Translation]
Senator Moncion: I have a number of comments, as well as a few questions for you.
There is propaganda in the newspapers and in public forums these days pertaining to the new rules you are studying now. I think many people do not fully understand the tax rules you are studying now. That is my personal view, but I think the majority of what is said is not entirely consistent with your information and analysis.
My understanding is that you are still in a consultation period. You are studying the practice known as surplus stripping and the practice of income splitting, and the third component, involving passive investments. In any case, the government’s objective is to prevent companies and SMEs from avoiding taxes, because they have found ways of avoiding taxes that are due.
Do you know how many businesses will be affected by the new measures you are proposing?
Mr. Jovanovic: We estimate that about 50,000 family businesses could be affected by the income splitting proposal. We do not have an estimate for the third proposal involving the conversion of income into capital gains. There is not enough information available.
As to investment income, we do not have a final proposal, so it is hard to give an accurate figure. From the latest figures from 2015, however, we see that just over 300,000 companies report investment income year after year. About 40,000 companies report exclusively investment income. Those companies would likely not be compromised by the rules to the extent that those investments are not funded from business income taxed at a low rate, since there is no business income from those companies. It is strictly passive income.
That leaves about 280,000 companies with passive income. A good many of those companies have revenues of less than $150,000 or $200,000. In those cases, as regards passive income, the business owner, as a rule, should earn roughly the same amount if they are using a savings plan rather than saving through the company. We can therefore assume that these companies would not be greatly affected by these rules.
That leaves about 130,000 or 140,000 companies, but once again the final figure will depend on the final design of the measure. So that is an approximation.
Senator Moncion: You are in a consultation period and I know that, based on the feedback you have received thus far, changes can be expected. I imagine the consultation is designed to gather more information from the market to see if you have missed anything in your work. Is that correct?
Mr. Jovanovic: That is definitely the purpose of the consultation, which ended yesterday, on October 2. We received more than 20,000 submissions. We have a lot of work to do, but we intend to take into account the various comments received.
Senator Moncion: When do you expect to present your results, so that we can make an analysis based on the 20,000 submissions received, and then make the possible or potential changes that you would like to make?
M. Jovanovic: It will be up to the government to decide on the timing. Our job will be to review the various submissions and provide our advice to the minister.
Senator Moncion: The consultation period is relatively short, since the changes are to come into effect in 2018, would you not say?
Mr. Jovanovic: Let me clarify something. The coming into force date is for just two of the three proposed measures. There is no date yet for passive income, since there is no proposal as of yet.
Senator Moncion: Very well. My last question is a follow-up to Senator Pratte’s question about families with one spouse who stays at home to look after the children. In contrast perhaps to the observation made on which you based your analysis, the choices made by those families are the same as those made by families in which one person earns an income and their spouse chooses to stay home and look after the children. These families do not have any more income or tax breaks than others.
Perhaps I do not understand the distinction made between a family of business owners and one of workers. Are they assessed in the same way?
Mr. Jovanovic: You have to remember that risk-taking is something the government recognizes through the tax system. We are not disputing the fact that business owners take risks that employees do not.
The question is whether income splitting is a better way of recognizing those risks, since it has a highly variable effect depending on the family situation of each business owner.
If your spouse does not work and you have two adult children in university, that automatically gives you a tremendous advantage as compared to a business owner who is single.
So I think we have to determine whether this is appropriate or not. The tax system includes measures that recognize risk and that apply to all corporations, especially those under Canadian control, that is, CCPCs. This includes, for example, the lifetime capital gains exemption, very generous research and development credits, the reduced tax rate for small businesses, which applies to the first $500,000 in earnings. All these measures serve to recognize the risk taken and to support investment in small businesses.
[English]
Senator Wetston: Thank you very much for coming today. I certainly recognize the complexity of the issue and the challenges associated with tax reform. I want to take a slightly different approach, if I might.
This is just a technical question, and perhaps my information is incorrect, but it is my understanding as I look at the three categories that two of the three are in effect now. Is that correct? Did you do so by way of a ways and means motion, or am I incorrect?
Mr. Marsland: The first measure is proposed to be in effect as of January 1, 2018.
Senator Wetston: Is it by way of a ways and means motion? How are you doing it? Are you bringing forward a budget implementation bill? What are you doing? I don’t know what the process is that you’re contemplating, should you proceed.
Mr. Ernewein: The consultation paper released on July 18 included draft legislation for the first and third measures.
The first one on income sprinkling, as my colleague has said, has a proposed effective start date of January 1, 2018.
The third one on surplus stripping is proposed to be effective as of July 18.
There was no ways and means motion tabled. Parliament was not sitting in the middle of the summer, but to move forward the government may well decide to table a motion, yes.
Senator Wetston: That may be the process which you will use to implement this should you proceed. That’s really my question.
Mr. Ernewein: Implementation, of course, requires parliamentary approval, which is more than a ways and means motion.
Senator Wetston: I guess that is my question. Will you potentially move to budget implementation bill? I am just trying to understand the process and the role of the Senate in that process.
Mr. Ernewein: Yes, it will be of necessity a legislation, a bill to implement any measures out of this package to come to Parliament. I think implicit in your question is whether or not it will be this fall. I don’t know the answer to that.
Senator Wetston: As I look at the three categories here, I recognize that tax reform is challenging and invariably quite complex. It has a lot of implications but, at the end of the day, whatever reform you make it is not just about collecting more taxes. I think you would agree with me there. It certainly has to be good public policy.
From what I understand there has been much written on this and you have your consultation paper. I am looking at the three categories, but let’s just say sprinkling because I am looking for the public policy rationale and not at being able to collect more taxes. Sprinkling seems to be driven by the concept of fairness, as I understand what you are saying or what appears to be the suggestion.
I realize that proposal continues to be discussed, but it seems to be based not on fairness but on neutrality. Then if you look at converting the private corporation, the third category, it seems to be based on anti-avoidance. That is my sense of it. You may disagree with that.
If that is the case, obviously you would need in your consideration, and the government would need it too, to balance the various interests at stake on all of those because it has implications for all taxpayers.
My question really is: If that is the rationale, what are the tradeoffs that you have had to consider for all taxpayers in the event that you move toward tax reform taking into account fairness? Frankly, you might agree with me, it is not an absolute term. For some it might be fair; for others it might be unfair. You have to balance those tradeoffs.
The same with neutrality. For some it might be neutral; for others it may not be. You have to balance those factors.
The same with anti-avoidance, although that might be a little clearer because it is a well-known concept in tax law.
Can you help me with how you are viewing this from a public policy point of view? At the end of the day, collect as much tax as you want. It has to be good public policy; I am still searching for that rationale.
Mr. Marsland: Thank you for the question. I think the question sums up, in a sense, the issues at play in any public policy issue.
In terms of tax policy, we further define fairness in terms of vertical equity and horizontal equity. That means essentially both of those concepts of equity are engaged in this discussion, particularly in relation to the sprinkling issue.
In terms of vertical equity, the tax system represents an assessment of the tax burden that should be borne according to the ability of the taxpayer to pay that. That is reflected in the progressive rate structure of the tax.
In that context that there is an issue around vertical equity in the sense that some of these arrangements where there is no contribution to the farm and the dividend is paid, it frustrates the progressive rate structure in terms of allowing someone to essentially opt out of that progressive rate structure by making a payment to a family member and thereby reducing the effective rate of tax on that payment.
In terms of horizontal equity, that issue is engaged as well in terms of taxpayers in similar circumstances should be treated similarly. Obviously there is a debate about how one interprets that, but clearly that issue is engaged here.
Neutrality is where we try to achieve an equivalent outcome where equivalent economic actions are taking place. Clearly that is engaged here in these proposals.
Equally, there is debate that we should try to make the tax system as simple as possible, but obviously there is often a conflict between trying to achieve a neutral or equitable outcome without having rules to effect that.
I hope I have responded to your question, at least in part.
Senator Wetston: I have a brief follow up. I am of the strong opinion that these tax proposals raise as many economic issues as they raise social justice issues.
From what we are hearing and seeing there needs to be balance in the economic tax policy efforts that you are attempting to eventually implement. You have draft legislation, which is a little more than concept, but not quite implementation. I think social justice becomes a very important consideration in how you view the implications of this tax reform.
I express as a concern, and I am trying to understand it more, that you are taking those matters into account. It goes beyond the objectivity associated with neutrality or fairness, which I think we both might agree have tradeoffs in how various groups might be affected by tax reform.
Those are my thoughts there. You might have a view of that or you may not. I understand I might just be getting it off my chest.
Mr. Marsland: With any public policy issue there are tradeoffs. From a tax policy perspective we tend to approach these things with a set of principles, but your comment about the economic effects of any policy is an overriding one.
Senator Cools: Thank you very much, gentlemen, for appearing before us. I do have great admiration and respect for individuals such as yourselves who dedicate your lives to the Public Service of Canada.
I was saying to these two young men who work for us that when the Income Tax Act was created back in 1918, or around there, it was intended to be temporary. Everyone has long forgotten that, but it was intended to be a temporary measure. I guess it is inevitable now that it will keep on going for quite a long time.
Someone here raised the question of ways and means motions, and so on. There are two committees of the whole in the House of Commons whereby they try to maintain their “control” over the public purse. One of them is a committee of supply and the other is a committee of ways and means. In that way one looks after expenditures and one looks after the raising of taxes. It is a very complicated business but very natural in today’s modern parliaments.
I have heard repeatedly that these proposed reforms are the largest ever in the history of taxation. I have read many times and I have heard that many times. I do not know if to believe it, but let us say for the sake of argument that I am taking it as a fact.
I wonder if you could you tell me, then, how such a decision is made in this grand, great adventure of tax reform. Could you tell me a bit about that? CRA is not a department anymore. There was a time when there was a Department of National Revenue, but I think it was about 20 years ago that they created CRA as an agency which, at the time, raised concerns among many of us who would have preferred to see the old structure of the civil service or the public service be maintained.
How does one take a decision in the next little while we will undertake the largest overhaul or reform of the taxing system, and who does it?
Mr. Marsland: Perhaps I take issue with that assertion. While I don’t discount that these are important proposals, I think we have possibly been through two real tax reforms in the country: one following the Carter Royal Commission on Taxation, which reported in 1966 and laid out in the implementing legislation that followed that royal commission the system that is currently in place. In fact, the rules governing passive investment were part of that, but there was a lot more involved than just the taxation of passive investment.
Again, I recall there were some important tax changes brought forward in the late 1980s and early 1990s. How are these decisions made? They are made in the same way as the development of any public policy in our system: ministers are elected, the public service provides advice, and decisions are made.
Senator Cools: I understand perfectly the situation that you refer to, but I also lived through the GST when it came before us. That was a novel tax at the time.
The rest is for another day. Thank you very much.
Senator Tannas: Gentlemen, I would like to take a bit of a different approach here and ask you a question that does not have to do with small business but with large business.
You talked about the average corporate tax in our country being 26.7 per cent. Granted, that is not what small business pays, but that is what you expect that large businesses would pay across the country on average.
I will talk about a favourite bug bear of mine and bring it back to what we are dealing with here. As an example, and they are all the same, in the third quarter the Royal Bank nine-month numbers hit $11.131 billion of net income before tax. Their tax rate was 22.4 per cent. That is 4.3 per cent below what we think is the average that corporations should pay.
You have testified that the U.S. system is much higher. We know that the Royal Bank has substantial operations in the U.S. We also know the Royal Bank doesn’t have much going on outside of Canada and the United States. There is a problem here, and I think we know what the problem is. Some people call it the Caribbean shuffle. We don’t need to go into it.
Let me ask you this question. If you are tasked with the job of finding money for the government and you are going to attack small business in the country in order to try to come up with $250 million, if you could figure out how to get the Royal Bank to the average corporate tax rate after nine months of this year, just from the Royal Bank you would get $445 million.
Why don’t you hunt where the ducks are? Why is it that year after year after year we see this going on and nothing happens, but within the same year that you jack up tax rates on personal income you are all over small business? Why is that?
Mr. Marsland: With respect, I obviously can’t comment on any particular corporation.
Senator Tannas: Would you like to go back and have a look at it to see if you can figure out how you get there?
Mr. Marsland: In my presentation I referred to the weighted average federal-provincial-territorial rate, which is the average when you look at the population waves.
When you look at any particular taxpayer I guess there is the statute rate that applies, but obviously it is not always the case that their tax liability equates to the statute rate. That may be for a range of reasons depending on the source of income, and so on.
The department looks at the tax system as a whole. The government, with the support of the department in budget after budget, brings forward proposals to hopefully improve the effectiveness of the tax system. Those measures can relate to all areas of the tax system.
Senator Black: I am also changing tack a bit and I want your comments on another of what I am advised is an unintended consequence of your proposals.
I am advised because of the provisions on the transfer of assets within families, as Senator Forest referred to, there is a potential series of candidates who will pay between 91 and 93 per cent tax on transfer. I am told that the result of that is that some of Canada’s leading entrepreneurs and creators have already become non-residents of the country. Will you comment, please?
Mr. Ernewein: We have seen at least one law firm’s commentary suggesting that. I would challenge the view that people would put themselves in that position to pay the most tax possible. In broad strokes, the conjecture is that it’s a combination of rules that would deliver this result.
At least I have seen an example in a case involving death whereby the sprinkling rules would apply to shares owned by somebody who had made zero contribution to the company. Therefore, on death, it is possible that a rule treating that as a deemed dividend tax at the top possible rate would apply. As I mentioned earlier that could be 45 per cent, to make the math work in support of that example. Further, after that person’s death, the company is wound up to pull all the value out of the company, triggering yet another actual dividend, and the 45 per cent applies again.
First, whether the dividend tax would apply on the death of that person is a question of fact and wouldn’t necessarily be the case.
Second, there are provisions I referenced briefly earlier that allow you to integrate the two taxes paid on death to end up with a single rate of tax applying.
To be fair, there is a question as to whether or not our proposals make that integration work or whether we need to make further changes to do that; but the intention is not to arrive at that double tax that you describe. It would be to achieve a single rate of tax.
Senator Black: Thank you very match for your frankness on that. It is very important that you go back and check on that, because I can tell you that some of Canada’s wealthiest Canadians have become non-residents of Canada because of their interpretation of your proposal. They’re not thinking about it but have done it. You might check that.
The Chair: Mr. Marsland, will you please follow up on that question?
Mr. Marsland: As my colleague noted, issues and questions have been raised in the consultation, which is why we have consultations. To the extent there is an issue with the proposal, we will look into that, of course.
Senator Marshall: I want to talk about the estimated revenues that the government anticipates it will collect under the three proposals.
I know $250 million is attributed to the income sprinkling, which is not a significant amount, but there is no estimate for the other two proposals. I don’t understand why.
When you look at the budget documents there are estimates for all the changes put forward in the government’s budget. When we were discussing earlier about passive income, you provided information regarding 40,000 companies reporting investment income.
Why isn’t there an estimate of the anticipated revenues that will flow as a result of the other two proposals?
Mr. Marsland: Let me start with the third one, if I may. As we have discussed today, this is in the nature of an integrity measure. There is an existing rule in the Income Tax Act. We are aware that people have planned or managed to circumvent that rule, so the proposal is to effectively bolster that rule.
You will see measures appear in budget after budget when it is often difficult to determine the revenue impact because there is not necessarily a line of sight on the number of transactions that may be structured that way. We cannot always, and it is true in this case, provide a revenue estimate related to that.
Senator Marshall: Are we talking in the millions or the billions? There must be some estimate or some deal for the additional revenues. I can’t see the government putting forward proposals and having no idea whatsoever of how much they will raise in revenues. This is a revenue raising exercise, so there must be some feeling as to what will be collected.
Mr. Marsland: It is very difficult. In a sense we know there is a difference in the effective rate between capital gains and dividends. We know where the incentive is. We know there are certain arrangements that have been developed that escape an element of the rules, but we don’t know the extent of how often that is going on.
We know how much is taxed as dividends and we know how much is taxed as capital gains, so we know the scope.
Senator Marshall: It looks suspicious and leads me to suspect the dollar amount is so high that it will probably scare people. By not providing the estimate, even though estimates are quite often wrong, as we know, people are wary and suspicious because there is no estimate given. That is adding to people’s discomfort with the proposals.
In the long term the $250 million is a lot of the money but compared to the government’s revenues it is not. I would expect that would go to the Consolidated Revenue Fund and be spent. However, the other two proposals, I would think, would generate a lot more revenues.
What is the plan for the additional revenues? Is it to spend or is it to pay down the debt? I guess it wouldn’t pay down the debt. It would be to reduce the deficit. What is the plan for the additional tax revenues? Is it to spend or is it to reduce the deficit?
Mr. Marsland: Perhaps I could come back to your earlier comment on no revenue estimate for the third measure. If one looks at budget after budget after budget there is a series of integrity measures. It is not at all uncommon for us not to put a revenue estimate there. It is to protect the integrity of the base. We don’t know the extent of the problem, so I don’t think it is necessarily appropriate to read something into that. It is just how we often deal with these kinds of what we label integrity measures.
As to what would happen to the revenues, that is a decision for the government as to how those revenues are dealt with.
Senator Marshall: That hasn’t been in the long-term plan of the Department of Finance. That hasn’t been finalized yet.
Mr. Marsland: No. As I said, that is a decision for the government as to how revenues are applied.
[Translation]
Senator Pratte: Mr. Jovanovic, in answering Senator Moncion’s question earlier, you cited some figures as to the number of companies that would be affected by the changes. Could you forward the exact figures to the clerk?
Mr. Jovanovic: Yes, we should be able to do that.
Senator Pratte: When you said that 50,000 businesses would be affected by income splitting, do you also have a breakdown by corporate tax bracket?
Mr. Jovanovic: I will have to check to see exactly what we have.
Senator Pratte: More detailed figures would be helpful for us because the number of businesses and companies affected is a major consideration for us. We want to know whether these measures will affect a lot of people or not very many.
Mr. Jovanovic: You have to understand that these are potential figures. It is difficult to estimate.
Senator Pratte: I fully understand that.
[English]
I will ask my last question. There were a lot of suggestions in the submissions that you received from the people or experts I talked to. The problem seems to be, especially for passive income and for income sprinkling, with corporations for professional services. That’s where the increase in the number of CCPCs has been. In fact there has been a tripling.
Have you looked at ways where you could have distinguished those types of companies offering professional services, doctors and so on, like some have suggested, and maybe aimed those kinds of measures directly at those companies or corporations rather than at the whole small business sector?
Mr. Marsland: Yes, there have been suggestions that could be an approach. My response to that would be: The issues of neutrality and equity that have been raised apply elsewhere as well in terms of other types of business where, for example, some corporation is paying dividends to a family member. The same issue of equity would apply in that case.
Similarly, in terms of passive investment income, the issue would be common to both professional and non-professional corporations.
Senator Pratte: I don’t know if the statistics confirm that there seems to be this idea that the rationale for creating a CCPC in the professional sector would be different. The numbers you show seem to indicate that you would have more cases of corporations created simply for fiscal purposes rather than for business purposes, let’s call it, in the professional sector rather than the entrepreneurial sector.
Mr. Marsland: As I indicated it my opening comments, I think there are a number of important reasons that someone might incorporate, but equally there may be tax advantages to incorporation that drive an individual decision. I’m not sure that it would be appropriate to single out particular occupations for rules of general application.
The Chair: To the officials of the Department of Finance through you, Mr. Marsland, thank you for being here this morning. We appreciate your information.
(The committee adjourned.)