There has been surprisingly little critical commentary on the 2018 federal Budget legislative proposals regarding the taxation of passive investment income in private corporations. This sorry saga has now come to an end, but with very little progress made in terms of gains in public revenues and the promotion of greater tax fairness.
Many very high income taxpayers, especially self-employed professionals, use Canadian Controlled Private Corporations (CCPCs) to shelter their income from high rates of personal income tax. A key advantage of setting up and earning investment income within a private corporation is that such income is taxed at the special small business rate of 14.4% compared to the top personal income tax rate of 51.6%. (The numbers are the average combined federal and provincial rates in 2017.)
Research by former Assistant Chief Statistician Michael Wolfson and colleagues published in the Canadian Tax Journal in recent years has shown that the use of CCPCs is common among the very affluent, and of significant benefit to them. The share of all Canadian income earned by the top 1% of individuals jumps from 10.0% to 13.3% once this tax sheltering is taken into account, and the share of the top 0.1% jumps from 3.7% to 5.2%.
In the 2015 election, the Liberals promised to review the rules “to ensure that CCPC status is not used to reduce personal income tax obligations for high income earners rather than supporting small business.” (Liberal Platform p.80)
In July, 2017 the Department of Finance released a discussion paper which detailed the large difference between the small business rate and top personal income tax rates which strongly favoured the former. This was deemed to be inappropriate and costly. The paper said that action would be taken on this issue together with other contemplated changes to the taxation of small business such as those covering the “sprinkling” of income to family members not involved in the enterprise.
Following a storm of criticism from small business, the Department belatedly released a consultation paper in October which showed that just 2.9% of CCPCs accounted for 88% of all passive investment income earned within all CCPCs, and that the top 1% of income earners (earning more than about $200,000 per year) accounted for 83% of all passive investment income within Pecos. In total. Some$18.4 Billion of investment incomes is earned within CCPCs.
In October, the Department of Finance and Minister Morneau insisted rather late in the game that their target was not genuine small enterprises but the very small number of CCPCs owned by high income taxpayers sheltering large amounts of passive investment income. They proposed to set a threshold or limit of $50,000 in passive income, equivalent to a 5% annual rate of return on $1 million of financial assets not relating to the core business of the corporation. The implication was that income above the threshold would be taxed at much higher rates under the personal income tax.
The Parliamentary Budget Office (PBO) estimated in November, 2017 that the proposed changes to the passive investment rules would generate between $3 billion and $4 billion in additional annual revenues in the medium-term.
In the event, Budget 2018 proposes to tax business investment in excess of $50,000 at the regular corporate rate (now 15% at the federal level) instead of at the special small business rate which will soon be 9% at the federal level. The increased business tax rate will be phased in from $50,000, with the tax rate advantage being lost completely when passive investment income is more than $150,000.
While the tax advantage of earning passive investment income in CCPCs is reduced, taxation at the regular corporate rate (about 25% combined federal – provincial rate) still represents a significant benefit to the very affluent compared to holding passive investment income within a non sheltered account subject to taxation at the top combined federal – provincial personal income tax rate of more than 50%
The Budget estimates that the new passive investment rules will result in extra revenues of about $700 million when fully phased in ( $705 million in 2022-23.) That seems significant, but it is well below the PBO estimate.
As well, the federal government responded to fierce lobbying pressure by small business in October, 2017 by cutting the special small business tax rate from 10.5% to 9.0% in 2019. The forecast reduction in revenues from that change is $675 million in 2022-23.
Thus the increased revenues from the proposed rules for taxing passive investment income will, in effect, all be used to cut small business taxes, including for the very affluent owners of CCPCs. There will be no net gain in overall tax revenues.
And the very affluent will now enjoy a lower rate of corporate tax on passive investment income of up to $50,000 per year.
The incentive for persons to set up a private corporation to lower their effective tax rate on passive income has actually been increased by the reduction in the small business rate, notwithstanding the initial promise of the government to equalize returns from investing within and outside private corporations.
While this episode illustrates the political heft of the small business lobby, the result could have been different if the federal government had, from the outset, made a stronger fair tax argument rather than leave this to outside experts such as Michael Wolfson and Kevin Milligan of the University of British Columbia who pointed out from the outset that the vast majority of small businesses were not the major beneficiaries of the rules.
Further, as many have noted, this episode also bears out the argument that tax reform is best promoted as a package of measures which achieves fair results overall and increases the revenues we need to pay for better programs and services.
Andrew Jackson is the Senior Policy Advisor at the Broadbent Institute