The Stikeman Elliott Federal Budget Commentary 2018

PRIVATE CORPORATIONS WIN 2 - 1 IN QUADRUPLE OVERTIME

Highlights

Business Tax Measures

Substantial pullback on passive income proposals Additional rules to prevent the realization of "artificial" losses by financial institutions Green v. R. (FCA) overturned - limited partnership losses trapped in tiered partnerships International Tax Measures

Extension of cross-border surplus stripping rule to partnerships and trusts Foreign affiliate amendments to shutdown "tracking arrangements" Sales and Excise Tax Measures

Minor modifications to previous proposals in respect of GST/HST on management services provided to "investment limited partnerships" New federal excise duty for cannabis On July 18, 2017, the government indicated that there were three aspects of the taxation of private corporations that, while legal, were unfair to the undefined "middle class". First, private corporations were able to split or sprinkle income among family members so as to unfairly reduce the aggregate level of family tax. Second, because corporate tax rates are lower than personal rates, income retained within a private corporation benefited from a substantial deferral that enabled its shareholders to indirectly enjoy more passive investment income than would otherwise be the case. Third, numerous structures were available that enabled the owners of private corporations to reduce or eliminate tax on a disposition of their shares.

The first of these issues is dealt with by the Tax On Split Income rules that were released as draft legislation on December 13, 2017. The government decided to abandon the third issue because, although "unfair", it could not be addressed without affecting inter-generational transfers of businesses, including farms, in a way that was acceptable to the government.

The second issue was left to be dealt with in Budget 2018. In a display of common (and perhaps political) sense, the government effectively abandoned the passive income rules in this budget. It is a shame that the Department of Finance officials, with many other things to do, spent countless hours drafting legislation that has now been rightfully abandoned.

No matter how well-intentioned or "fair" the previously proposed passive income rules may have been, they were simply too complex. Complexity is a serious issue that deserves more than lip-service. Complexity breeds unfairness for many reasons. First, fairness is largely a matter of perspective and cannot be measured or experienced by anyone who doesn't understand the rules. As a result, it undermines a self-assessing system. Second, complexity fosters unintentional and intentional non-compliance that the Canada Revenue Agency (the "CRA") does not have the capacity to uncover. Third, it favours those with the means to obtain expensive advice. Fourth, it results in further overburdening an already underfunded and over-worked judicial system.

In a perfect world, it would be great to eliminate all "unfairness" in life. In the very small world of tax, "fairness" would involve taxing on the basis of ability to pay based on a "fair" mixture of commodity tax, wealth tax and income tax, and an accurate measurement of everyone's consumption, earnings and wealth. Most economists would agree that we don't have the right mix.

Starting with an imperfect mix of taxes and an impossible to perfectly measure calculation of anyone's annual earnings, the objective of any income tax measure should never be more than "good enough". It is not that anyone prefers rules that are less than perfect, but rather a realization that starting with a less than perfect basis for taxation and knowing that no one can draft rules that will cover every conceivable fact pattern, or establish a clear legislative scheme, means that "good enough" rules are the best that anyone can do. In fact, good enough rules are "fairer" than rules that are designed to achieve perfection through complex drafting. This is because added complexity can create more unfairness than the extra fairness that can theoretically result from attempting the impossible task of drafting perfect rules.

One of the inherent imperfections in our system is that we tax on an annual basis with no averaging over years. Just ask a doctor who spends 14 years accumulating substantial student debt during university and residency before she starts making any reasonable amount of money and then retires 30 years later without a pension, what she thinks about the heavily subsidized pensions received by members of Parliament. How is it "unfair" that the doctor cannot use the current rules to save for retirement? Isn't it "fair" that she be allowed to bump up her savings to partially "compensate" her for the lean years?

In abandoning the passive income rules that were meant to make the system "fairer", the government has left the system far fairer than it would have been had they proceeded with the previous proposals. The surviving amendments dealing with passive income in private corporations are discussed below.

Balancing the Budget or Not

Warning: the next two sentences are scary. Since being elected, this government has increased program spending by an incredible 20.1%, from $253.9 billion in 2014-2015 to a projected $304.6 billion in 2017-2018. This 6.3% annualized growth rate is about double the rate of growth in each of revenue, inflation plus population growth and growth in nominal GDP.1

Budget 2018 shows program spending increasing by 23% over the next five years to reach $350.1 billion in 2022-2023. The drop to less than 5% per annum is like training your dog to only bite the mail carrier every third day, instead of every second day. Budget 2018 projects a $19.9 billion deficit this year, declining to $12.3 billion by 2022-2023.

In the last budget the government decided that it was politically best to stop emphasizing deficits and surpluses and, instead, judge fiscal results by reference to the federal debt-to-GDP ratio. Budget 2018 projects a current debt-to-GDP ratio of 30.4%, reducing to 28.4% in 2022-2023. One issue with the debt-to-GDP ratio is that it appears to legitimize increasing government debt when GDP is rising, which seems to us to be contrary to sound fiscal management.

Ratios and deficit numbers aside, adding $51 billion to program spending over three years seems to us to be excessive. As Winston Churchill famously said, "For a nation to try to tax itself into prosperity is like a [person] standing in a bucket and trying to lift [themselves] up by the handle." Perhaps the government should try a bit harder to reduce income tax rates and more than make up the difference by cutting back on the program spending. The Chretien - Martin team reduced program spending by 9.7% from 1994-1995 to 1996-1997 by finding savings through a comprehensive review of programs.2

For the first time in many years, U.S. corporate tax rates are roughly equal to or lower than Canadian rates. There is buzz now that the U.S. is the place to do business, which could have significant repercussions for the Canadian economy. The government appears to be taking a "wait and see" attitude but we trust they will be monitoring the situation carefully and be ready to move quickly, if necessary. Corporate income has a tendency to flow towards the lowest taxing spot and we question Budget 2018's projected growth of corporate revenues from $42.2 billion in 2016-2017 to $52.2 billion in 2022-2023. Personal rate differences will continue to create a challenge for retaining people in...