By Geoffrey S. Turner
The gap between top personal income tax rates and small-business income tax rates has widened over the past 20 years, making it more attractive for professionals to incorporate and earn income through their Canadian-controlled private corporations (CCPCs). With top marginal tax rates now exceeding the psychological barrier of 50 per cent, the incentive to incorporate can be powerful. At the same time, Canada’s general corporate tax rate for non-CCPCs (including public corporations) is now higher than recently reduced rates in other key countries. The coming federal election is an opportunity to debate improvements to Canada’s tax system that would help close these twin tax gaps.
In 2016 Ottawa lowered the personal income tax rate for individuals in the middle bracket but increased it by a full four percentage points for people making more than $210,000 (after indexing). Adding in provincial taxes, the top marginal rate for individuals now stands at 53.5 per cent in Ontario and at comparably high levels in other provinces. Statistics Canada reports that in 2017 about 1.3 per cent of individual filers — 364,140 people — paid tax at this highest rate and in so doing collectively contributed 25.5 per cent of Ottawa’s revenue from the personal income tax.
The laudable focus of tax relief on the “middle class” (whatever that means) overlooked the profound disincentives faced by ambitious people whose incomes approach or exceed the relatively low threshold for the top marginal tax rate. When more than half of each extra earned dollar goes to taxes, there is much less incentive to work harder, longer and more productively. Our high personal tax rates, particularly compared to the United States, have motivated some of our “best and brightest” to leave Canada for countries with less confiscatory taxation. Progressivity and redistribution are widely accepted features of our personal tax system but there is ample room to reduce the top marginal tax rate below 50 per cent and raise the income threshold at which it applies.
Canada’s general corporate tax rate (combined federal and provincial) is now 26.5 per cent in Ontario, with comparable rates in other provinces. However, a much lower rate — 12.5 per cent in Ontario — applies under the “small business deduction” (SBD) to the first $500,000 per year of Canadian-source active business income earned by CCPCs.
The original rationale for the SBD was to promote the growth of employment in small Canadian businesses and to improve their access to capital at a time when many were having difficulty obtaining cost-effective financing. But Canadian capital markets have matured markedly and domestic and foreign venture capital sources are now relatively abundant. Nor is it clear that small private businesses are so much better at generating good jobs and positive externalities than public corporations or other non-CCPC entities. Yet the SBD persists, and was even recently enhanced, despite the absence of a compelling tax policy justification. Its 2019 tax expenditure cost is an estimated $5.6 billion.
In light of other longstanding tax preferences for CCPC owners, including the lifetime capital gains exemption for share sales and favourable deductibility of business investment losses, we should phase out the small business deduction and reduce the general corporate tax rate. Eliminating the SBD would establish fiscal neutrality for businesses regardless of their size or form of ownership and allow repeal of complex rules policing the SBD’s boundaries, thus simplifying the Income Tax Act. At the same time, lowering the general rate would help restore the global competitiveness of Canada’s corporate tax system.
Reducing the top personal tax rate to under 50 per cent for residents of all provinces and harmonizing our small business and general corporate tax rates into a single rate closer to the U.S.’s 21 per cent would narrow the personal/corporate tax differential and thus blunt incentives to use professional corporations and other CCPCs for tax deferral. The large and recently widened gap between the small-business rate of 12.5 per cent and the top personal rate of 50-plus per cent encourages thousands of doctors, lawyers, dentists, accountants, veterinarians, architects and other professionals to incorporate. Instead of earning their business income directly and paying a top rate over 50 per cent they earn it inside their CCPC and pay at the much lower corporate tax rate. This defers full taxation of that income until it is paid out to the owner as a dividend.
But dividends can be deferred, usually to retirement, so that the owner may only ever pay “middle class” tax rates, never the top rate. This widespread deferral strategy effectively shifts the tax burden from high-income professionals who can incorporate to high-salaried employees who can’t.
In 2017, the Department of Finance tried to make it more difficult for professionals to shelter income through professional corporations but a brushfire of political opposition forced it to back down. It might have better luck making professional corporations less attractive by reducing the currently wide gap between very high personal and very low small-business tax rates. Doing so would make our tax system both fairer and more competitive, a rare policy double.
Geoffrey S. Turner is a tax lawyer in Toronto and adjunct professor at Osgoode Hall Law School, where he teaches business taxation.
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