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UBC Theses and Dissertations

Income taxation of the small business sector in Canada Nilson, Don Bruce 1985

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INCOME TAXATION OF THE SMALL BUSINESS  SECTOR I N CANADA by DON BRUCE NILSON B. Comm., R . I . A . , A THESIS SUBMITTED I N P A R T I A L FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE (BUSINESS ADMINISTRATION) i n THE FACULTY OF GRADUATE STUDIES an d THE FACULTY OF COMMERCE AND BUSINESS ADMINISTRATION We a c c e p t t h i s t h e s i s a s c o n f o r m i n g t o t h e r e q u i r e d s t a n d a r d THE UNIVERSITY OF B R I T I S H COLUMBIA S e p t e m b e r 19 85 © Don B r u c e N i l s o n , 1985 In presenting t h i s thesis i n p a r t i a l f u l f i l m e n t of the requirements for an advanced degree at the University of B r i t i s h Columbia, I agree that the Library s h a l l make i t f r e e l y available for reference and study. I further agree that permission for extensive copying of t h i s thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. I t i s understood that copying or publication of t h i s thesis for f i n a n c i a l gain s h a l l not be allowed without my written permission. Department of The University of B r i t i s h Columbia 1956 Main Mall Vancouver, Canada V6T 1Y3 Date INCOME TAXATION OF THE SMALL BUSINESS  SECTOR I N CANADA ABSTRACT T h i s t h e s i s examines t h e impact o f t a x a t i o n on s m a l l b u s i n e s s e s i n Canada. I t r e v i e w s the r e l e v a n t economic and t a x a t i o n l i t e r a t u r e from a h i s t o r i c a l p e r s p e c t i v e t o p r o v i d e a p p r o p r i a t e background f o r p o l i c y a n a l y s i s . Other n a t i o n s ' t a x systems a r e a l s o c o n s i d e r e d . The key elements o f t h e e x i s t i n g system a r e examined i n o r d e r t o d e f i n e t h e p r e s e n t s t a t u s and t o i d e n t i f y t h e s t r e n g t h s and weaknesses. The l e a r n e d p r o p o s a l s o f v a r i o u s academics, p r o f e s s i o n a l s and o t h e r p a r t i e s a re r e v i e w e d i n o r d e r t o seek new i d e a s , comments and c r i t i c i s m on t h e system. The f i n a l c h a p t e r d e f i n e s t h e a u t h o r ' s p e r c e i v e d o b j e c t i v e s f o r s m a l l b u s i n e s s t a x p o l i c y and i d e n t i f i e s some impediments t o t a x r e f o r m . F i n a l l y , g e n e r a l and s p e c i f i c recommendations are d e t a i l e d . The a u t h o r proposes t h a t t h e t a x d e f i n i t i o n o f " s m a l l " be narrowed and t h a t "medium-sized" b u s i n e s s e s be g i v e n r e c o g n i t i o n i n t a x p o l i c y . S m a l l b u s i n e s s t a x p o l i c y s h o u l d r e c o g n i z e as i t s prime purpose the p r o v i d i n g o f f i n a n c i a l a s s i s t a n c e t o c o u n t e r a c t the n a t u r a l p r e j u d i c e s t h a t s m a l l b u s i n e s s e s e n c o u n t e r i n t h e c a p i t a l m a r k e t s . To a c h i e v e t h i s , t h e s m a l l b u s i n e s s t a x r a t e s h o u l d be low e r e d and l o s s p r o v i s i o n s s h o u l d remain l i b e r a l . The co n c e p t o f i n t e g r a t i o n w i t h the p e r s o n a l t a x system s h o u l d a t t a i n ABSTRACT g r e a t e r i n t e g r i t y by c h a n g i n g t h e c a l c u l a t i o n o f P a r t Two Tax on d i s t r i b u t i o n s . V a r i o u s s m a l l b u s i n e s s t a x measures e x t a n t s h o u l d be s c r a p p e d because t h e y a r e i n e f f e c t i v e . Temporary o r s p e c i f i c t a x i n c e n t i v e s s h o u l d be used s p a r i n g l y . INCOME TAXATION OF THE SMALL BUSINESS  SECTOR IN CANADA Table o f Contents Page A b s t r a c t i i Acknowledgement v i i Chapter One - I n t r o d u c t i o n 1 A D e f i n i t i o n o f Small 4 Tax a t i o n , Small Business and F i s c a l Levers 13 Summary 24 Footnotes 26 Chapter Two - Theory of T a x a t i o n 27 N e u t r a l i t y 30 E q u i t y 30 E f f i c i e n c y 32 The Tax Base 33 The Tax Rates 35 Incidence of Corporate Income Tax 3 7 I n t e g r a t i o n and the Corporate Income Tax 3 9 S i m p l i f i c a t i o n 43 Summary 45 Footnotes 47 - i v -Page C h a p t e r T h r e e - H i s t o r i c a l B a c k g r o u n d 49 E a r l y H i s t o r y 49 The C a r t e r C o m m i s s i o n 50 A f t e r t h e C a r t e r C o m m i s s i o n 57 A f t e r t h e W h i t e P a p e r 59 The B u d g e t o f J u n e 1971 67 P o s t 1971 70 Summary 74 F o o t n o t e s 75 C h a p t e r F o u r - I n t e r n a t i o n a l C o m p a r i s o n s 76 F r a n c e 77 U n i t e d K i n g d o m 77 Germany 81 J a p a n 82 A u s t r a l i a 82 U n i t e d S t a t e s 83 S p e c i f i c P r o v i s i o n s 87 Summary 8 9 F o o t n o t e s 91 C h a p t e r F i v e - C u r r e n t P r o v i s i o n s 92 I n t r o d u c t i o n 92 S m a l l B u s i n e s s Tax R a t e s 95 A s s o c i a t i o n 102 I n t e g r a t i o n a n d D i v i d e n d Tax C r e d i t s 103 M a n u f a c t u r i n g a n d P r o c e s s i n g Tax R a t e s 107 C a p i t a l C o s t A l l o w a n c e 108 - v -Page C h a p t e r F i v e - C u r r e n t P r o v i s i o n s Investment Tax C r e d i t s 111 Three P e r c e n t I n v e n t o r y A l l o w a n c e 113 Employment Tax C r e d i t 114 B u s i n e s s L o s s e s 114 B u s i n e s s i n v e s t m e n t l o s s e s 117 Summary 118 F o o t n o t e s 119 Chap t e r S i x - Some P r o p o s a l s f o r Reform 120 Brown P r o p o s a l 121 Doane P r o p o s a l 123 James P r o p o s a l 125 Edwards P r o p o s a l 127 Goodwin P r o p o s a l 128 S m a l l B u s i n e s s A d m i n i s t r a t i o n P r o p o s a l 128 Evans P r o p o s a l 131 M i s c e l l a n e o u s P r o p o s a l s 133 Summary 133 F o o t n o t e s 135 Chap t e r Seven - C o n c l u s i o n s 137 Some P e r s p e c t i v e s on Reform 137 O b j e c t i v e s 140 G e n e r a l D i r e c t i o n 145 S p e c i f i c Recommendations 149 P o s t s c r i p t 161 F o o t n o t e s 163 Appe n d i c e s 165 B i b l i o g r a p h y 167 - v i -ACKNOWLEDGEMENT The author would l i k e to extend r e c o g n i t i o n to some people who have made i n s t r u m e n t a l c o n t r i b u t i o n s i n v a r i o u s forms to the completion of t h i s t h e s i s . In order of appearance, they were; my p a r e n t s , who supported my r e t u r n to graduate s c h o o l as a s a b b a t i c a l from my p r o f e s s i o n a l c a r e e r ; my w i f e , A l i s o n , who p r o v i d e d c o n s t r u c t i v e c r i t i c i s m and s a c r i f i c e d our time together so t h a t I c o u l d escape i n i s o l a t i o n t o w r i t e the bulk of t h i s paper; Dora D a r l i n g , who spent a l o t o f time t r a v e l l i n g , thus p r o v i d i n g me with a w r i t e r ' s p i e d de t e r r e ; and Ken and Joan McCance and Lynda and Tony D a r l i n g who a l s o p r o v i d e d c o n s t r u c t i v e laymen's c r i t i c i s m s . L a s t l y , I am indebted to P r o f e s s o r B i l l Tomlinson, my s u p e r v i s o r , and P r o f e s s o r s A l Dexter and J o o s t Blom who k i n d l y served as my committee. - v i i -Chapter One INTRODUCTION "Canada's c o r p o r a t e tax laws should be s i m p l i f i e d because some companies are paying more f o r the p r e p a r a t i o n of tax r e t u r n s than they are i n t a x a t i o n . " Dennis C u l v e r P r e s i d e n t , CICA "One hundred pe r c e n t of a l l new jobs c r e a t e d between 1975 and 1982 ( i n Canada) came from f i r m s w i t h fewer than f i f t y employees." John B u l l o c h P r e s i d e n t , CFIB T h i s study o v e r l a p s two areas of g r e a t i n t e r e s t i n Canada today - - s m a l l business and t a x a t i o n . The l a t t e r s u b j e c t has been, and probably always w i l l be, high p r o f i l e . The former has r e a l l y only come i n t o i t s own i n the p a s t decade, d u r i n g which time governments, the media and academia have " d i s c o v e r e d " s m a l l b u s i n e s s . Small b u s i n e s s n a t u r a l l y has i t s r o o t s f a r deeper i n h i s t o r y than b i g b u s i n e s s . However, r e c e n t h i s t o r y , p a r t i c u l a r l y the p a s t h a l f - c e n t u r y , has seen s p e c t a c u l a r growth i n l a r g e c o r p o r a t i o n s , i n c l u d i n g the m u l t i n a t i o n a l s and conglomerates. The o r g a n i z i n g of people i n l a r g e r groups i n the work environment has f o s t e r e d a p l e t h o r a of r e s e a r c h on c o n t r o l systems, labour r e l a t i o n s , o r g a n i z a t i o n a l behaviour, time and motion s t u d i e s , e t c . These have a l l taken f r o n t stage i n the t w e n t i e t h century b u s i n e s s world and have overshadowed the problems o f the s m a l l b u s i n e s s . Why the renewed i n t e r e s t ? In no s m a l l way, c r e d i t must go to the CANADIAN FEDERATION OF INDEPENDENT BUSINESS ("CFIB", ne "The C o u n c i l f o r F a i r T a x a t i o n " ) , c r e a t e d i n the e a r l y S e v e n t i e s . I r o n i c a l l y , t h i s o r g a n i z a t i o n owes i t s conception t o the major -1-I n t r o d u c t i o n Chapter One tax reform process o f the S i x t i e s . C r e d i t i s a l s o due to c e r t a i n i n d i v i d u a l s i n academia who have championed t h i s s e c t o r , i n p a r t i c u l a r Kao and Peterson.''" These advocates have r e p e a t e d l y attempted t o prove t o the policy-makers t h a t s m a l l b u s i n e s s i s the prime engine of growth i n the economy, and as such deserves 2 s p e c i a l a t t e n t i o n . CFIB s t u d i e s , such as the one quoted above by John B u l l o c h , have been r e s p o n s i b l e f o r q u a n t i t a t i v e r e s e a r c h on the c o n t r i b u t i o n o f s m a l l business t o the economy. Canada has been a b i t slow i n f o c u s i n g a t t e n t i o n on s m a l l b u s i n e s s . I n t e r e s t i n s m a l l b u s i n e s s i n the Un i t e d S t a t e s pre-dated t h a t i n Canada. P r i o r t o the e a r l y 1950's th e r e was l i t t l e U.S. tax l e g i s l a t i o n t o b e n e f i t s m a l l b u s i n e s s . In 1952, an i n v e s t i g a t i o n of s m a l l business tax p r o v i s i o n s was i n i t i a t e d . L a t e r , i n 1957, the U.S. Senate commenced a major nation-wide review o f smal l business tax problems. New tax r e l i e f r e s u l t e d and was enacted i n 1958. I n t e r e s t waned f o r a decade u n t i l 1967 when f u r t h e r i n v e s t i g a t i o n r e s u l t e d i n r e v i s e d l e g i s l a t i o n i n 1973. Of l a r g e r s i g n i f i c a n c e t o s m a l l business i n the U n i t e d S t a t e s was the c r e a t i o n o f the SMALL BUSINESS ADMINISTRATION i n 1958. T h i s government agency was e x p r e s s l y charged w i t h being the advocate of smal l b u s i n e s s i n areas o f : - p r o v i d i n g management and t e c h n i c a l a s s i s t a n c e ; - p r o v i d i n g f i n a n c i a l a s s i s t a n c e ; - l o b b y i n g the government f o r r e d u c t i o n o f the paperwork burden; and - l o b b y i n g the government f o r a l l o c a t i o n o f government expenditures and c o n t r a c t s . -2-I n t r o d u c t i o n Chapter One C h r o n o l o g i c a l l y , Canada has p a r a l l e l e d the U n i t e d S t a t e s e f f o r t s i n tax reform f o r s m a l l b u s i n e s s . Tax breaks were l e g i s l a t e d i n 1949 and g i v e n a major overhaul i n 1971. The "Small Business Loans Act" was c r e a t e d i n 1960. However, i t s i n t e n t was f a r l e s s grand, and support i n other f a c e t s has not compared. The phenomenal economic success of Japan has been i n t e n s e l y s t u d i e d i n the past decade, i n c l u d i n g the r o l e o f s m a l l b u s i n e s s . P a r t of the success i s a t t r i b u t e d t o the unique p o s i t i o n of small b u s i n e s s i n t h a t economy. There, s m a l l business works together with the conglomerate to achieve n a t i o n a l goals i n what has been termed a " s u b c o n t r a c t i n g " r e l a t i o n s h i p . An o r g a n i z a t i o n e n t i t l e d the "Small and Medium E n t e r p r i s e Agency" was formed t h e r e i n 1948. "The 'Subcontracting Small and Medium E n t e r p r i s e Promotion Law' attempts to both p r o t e c t and promote the use o f s m a l l s u b c o n t r a c t o r s . The law e s t a b l i s h e s standards of business behaviour to be f o l l o w e d by s u b c o n t r a c t and parent e n t e r p r i s e s , and p r o v i d e s f o r sources o f guidance to ensure o b s e r v a t i o n o f these standards." B i g business has been the focus of p o l i c y f o r many years i n B r i t a i n . The B o l t o n Enquiry on Small Firms (1971) marked the swing of the pendulum. The study noted t h a t small b u s i n e s s had been i n long-term d e c l i n e f o r over f o r t y y e ars. The c o n t r i b u t i o n of s m a l l business t o output and employment was a s m a l l e r p r o p o r t i o n than i n any o t h e r i n d u s t r i a l i z e d n a t i o n . A turn-around has been s t a r t e d i n the past four y e a r s . The government has a t h r e e - p a r t program to s t i m u l a t e the s m a l l business s e c t o r : 1. A i d i n the quest f o r c a p i t a l ; 2. Advantageous tax l e g i s l a t i o n ; and - 3 -I n t r o d u c t i o n Chapter One 3 . Reduced a d m i n i s t r a t i v e burden. 4 A D e f i n i t i o n of Small Many d i s s e r t a t i o n s on s m a l l b u s i n e s s t o p i c s address the i s s u e o f d e f i n i n g " s m a l l " . The author t h i n k s t h i s i s a p p r o p r i a t e here, as w e l l , because smallness has a very p e r s o n a l c o n n o t a t i o n . What i s p e r c e i v e d as s m a l l to one may not seem so to another. The f i r s t o b s e r v a t i o n t o make i s t h a t t h e r e probably i s no s i n g l e answer. Smallness i_s i n the eye of the beholder and, more a c c u r a t e l y , i s i n h i s purpose. D i f f e r e n t people seek d i f f e r e n t c r i t e r i a t o s u i t t h e i r needs. Perhaps t h i s i s j u s t . The author b e l i e v e s t h a t a u n i v e r s a l d e f i n i t i o n i s not p r a c t i c a l . A d e f i n i t i o n f o r tax purposes i s important because a l o t o f b e n e f i t s may be bestowed upon those who q u a l i f y . We should be sure t h a t s m a l l b u s i n e s s p r e f e r e n c e i s a c c u r a t e l y t a r g e t e d . I f i t i s not, p u b l i c contempt f o r abuses may undermine the whole concept. However, i n h i s book, "Small Business: B u i l d i n g a Balanced Economy", Peter s o n s t a t e s : "... the problem of agreeing upon a d e f i n i t i o n i s ... i n many ways ... the most important i s s u e i n v o l v i n g s m a l l business p o l i c y i n Canada today." Consensus on the d i f f e r e n t i a t i o n between s m a l l and b i g can be reached most e a s i l y w i t h q u a l i t a t i v e terms, f o r i n s t a n c e : "... independently owned and operatedgand which i s not dominant i n i t s f i e l d o f o p e r a t i o n s " U n i t e d S t a t e s Small Business Act - 4 -I n t r o d u c t i o n Chapter One "... r e l a t i v e l y s m a l l share o f i t s market . . . managed by i t s owners ... not connected t o a _ l a r g e r e n t e r p r i s e ... owners f r e e from o u t s i d e c o n t r o l " U n i t e d Kingdom B o l t o n Report g "... l e g a l l y and f i n a n c i a l l y independent" European Economic Community "... r e t a i n s the r i g h t to make a p r o f i t or l o s s commensurate wi t h ownership" Petersen A l l o f these i d e n t i f y the same s p i r i t o f independence. However apt t h i s d e s c r i p t i o n may be, a l l d e f i n i t i o n s seek a common denominator with q u a n t i t a t i v e terms. Here, consensus i s l e s s common, f o r i n s t a n c e : "... l e s s than two hundred employees f o r m a n u f a c t u r i n g " 1 ^ United Kingdom Bo l t o n Report "... l e s s than one^bxmdred employees AND l e s s than $20 m i l l i o n i n s a l e s " CCH Canadian Small Business Guide 12 "... l e s s than f i v e hundred employees" European Economic Community 13 "... l e s s than f i v e hundred employees" Petersen "... l e s s than $1.5 m i l l i o n i n s a l e s " Department of Finance - Canada 14 "... l e s s than s e v e n t y - f i v e employees" F e d e r a l Business Development Bank (for C.A.S.E. c o u n s e l l i n g ) 15 "... l e s s than $1 m i l l i o n i n s a l e s " Small Business Loans Act - Canada "... l e s s than one hundred employees" M i n i s t r y o f Small Business The Small Business A d m i n i s t r a t i o n ("SBA") i n the Un i t e d States has a branch whose purpose i s t o r e f i n e and i n t e r p r e t the d e f i n i t i o n of smal l f o r the a d m i n i s t r a t i o n o f the Small Business -5-I n t r o d u c t i o n Chapter One Ac t . I t s e t s upper l i m i t s on s a l e s and number of employees f o r d i f f e r e n t i n d u s t r i e s . Any business can apply t o t h i s branch f o r " c e r t i f i c a t i o n " as a "sma l l b u s i n e s s " , thus q u a l i f y i n g i t f o r a p a r t i c u l a r government program. The Georgia I n s t i t u t e o f Technology surveyed s e v e n t y - f i v e d i f f e r e n t n a t i o n a l d e f i n i t i o n s o f s m a l l b u s i n e s s . A s t r o n g consensus was not observed. The most common c r i t e r i a were the number of employees, t o t a l a s s e t s and owners' c o n t r i b u t e d c a p i t a l . S a l e s was not a common c r i t e r i o n . I t i s d i f f i c u l t t o be comfortable with any of these as a determinant o f s i z e . While the number of employees seems a p p r o p r i a t e , how does one count an employee? Do p a r t - t i m e r s count? C e r t a i n i n d u s t r i e s are more i n c l i n e d t o labour i n t e n s i t y than o t h e r s . T e c h n o l o g i c a l advances, l i k e the computer, are a f f e c t i n g employment everywhere. The problem wi t h u s i n g s a l e s as a determinant i s t h a t a middle-man o p e r a t i o n t h a t takes t i t l e t o goods may have l a r g e s a l e s but, i n f a c t , s m a l l value-added. Using t o t a l a s s e t s as a determinant a l s o causes i n e q u i t i e s between labour and c a p i t a l i n t e n s i v e i n d u s t r i e s . Using c o n t r i b u t e d c a p i t a l as a determinant d i s c r i m i n a t e s between d i f f e r e n t d e b t / e q u i t y s i t u a t i o n s . L a s t l y , p r o f i t a b i l i t y i s u n s a t i s f a c t o r y as a determinant because the s i z e of p r o f i t i s not n e c e s s a r i l y r e l a t e d t o the s i z e o f the o p e r a t i o n . Based on h i s d e f i n i t i o n , Peterson concluded t h a t there were one m i l l i o n s m a l l businesses i n Canada i n 1976. U t i l i z i n g 1978 f i g u r e s and a d i f f e r e n t d e f i n i t i o n , the CCH Canadian Small Business Guide c a l c u l a t e d 721,420 s m a l l businesses i n Canada -6-I n t r o d u c t i o n C h a p t e r One ( e x c l u d i n g f a r m e r s a n d f i s h e r m e n ) . F o r t y - s e v e n p e r c e n t o f t h e s e w e r e u n i n c o r p o r a t e d , a n d c o l l e c t i v e l y a c c o u n t e d f o r o n l y f i v e p e r c e n t o f t o t a l s a l e s . I n f a c t , 99.9 p e r c e n t o f t h e u n i n c o r p o r a t e d b u s i n e s s e s h a d s a l e s o f l e s s t h a n $ 2 5 0 , 0 0 0 . N i n e t y - s e v e n p e r c e n t o f a l l b u s i n e s s e n t i t i e s h a d s a l e s o f l e s s t h a n $2 m i l l i o n . T h i s g r o u p a c c o u n t e d f o r t w e n t y - t w o p e r c e n t o f t o t a l s a l e s a n d f o r t y - t w o p e r c e n t o f t o t a l e m p l o y m e n t . PERCENTAGE OF SALES AND EMPLOYMENT, BY SALES CLASS SALES % OF % OF % OF ( -000s) BUSINESSES TOTAL SALES EMPLOYEES l e s s t h a n $50 47 . 6 % 1.5% 6.1% $50 - $250 33 .3 5.5 12.9 $250 - $2 M 15.9 15.0 23.2 $2 M - $20 M 2.9 22.5 22.1 more t h a n $20 M 0.3 55.5 35.7 SOURCE: " S m a l l B u s i n e s s i n Canada - A S t a t i s t i c a l P r o f i l e ( 1 9 7 8 ) " M i n i s t r y o f S t a t e f o r S m a l l B u s i n e s s and T o u r i s m A new b u s i n e s s m a n u s u a l l y makes a c o n s c i o u s d e c i s i o n w h e t h e r t o i n c o r p o r a t e . S o m etimes t h e b u s i n e s s m a n s e e k s p r o f e s s i o n a l a d v i c e on t h i s s u b j e c t a n d o t h e r t i m e s he makes t h e d e c i s i o n h i m s e l f . T h e r e a r e , o f c o u r s e , a number o f n o n - t a x i s s u e s t o c o n s i d e r , f o r i n s t a n c e : - e a s e o f commencement; - c o s t o f i n c o r p o r a t i o n a n d m a i n t a i n i n g a l i m i t e d company; - v a l u e o f l i m i t e d l i a b i l i t y ; a n d - c o n t i n u i t y o f o p e r a t i o n . A c o r p o r a t i o n m u s t be r e g i s t e r e d p r o v i n c i a l l y o r f e d e r a l l y . L e g a l f e e s a r e i n c u r r e d t o i n i t i a l l y i n c o r p o r a t e a n d t o m a i n t a i n - 7 -I n t r o d u c t i o n Chapter One stan d i n g with the r e g i s t r y . Unincorporated ventures are not r e q u i r e d t o r e g i s t e r , though they may wish t o , i n order to e s t a b l i s h r i g h t s t o a p a r t i c u l a r name. In any event, the fees are c o n s i d e r a b l y l e s s . The i s s u e of l i m i t e d l i a b i l i t y i s o f t e n misconstrued. I t s main t h r u s t i s t o l i m i t owners' l i a b i l i t y to the amount of t h e i r i n v e s t e d c a p i t a l : thus p r e s e r v i n g p e r s o n a l a s s e t s from attachment i n a l e g a l a c t i o n . Often, p u b l i c l i a b i l i t y i n s u rance reasonably covers r i s k i n t h i s a r ea. I t i s almost i n e v i t a b l e t h a t t h i r d p a r t y l e n d e r s t o an i n c o r p o r a t e d s m a l l business w i l l circumvent the l i m i t e d l i a b i l i t y b e n e f i t by a l s o r e q u i r i n g p e r s o n a l guarantees. L a s t l y , the i n c o r p o r a t e d e n t i t y enjoys a p e r p e t u i t y of l i f e t h a t i s not assumed i n an un i n c o r p o r a t e d venture. Unless otherwise p r o v i d e d i n a p a r t n e r s h i p agreement, the p a r t n e r s h i p ' s business ceases t o e x i s t upon the death, withdrawal, i n s o l v e n c y or lunacy o f a p a r t n e r . Every new business needs to assess the v a l i d i t y of each of these concerns i n making the i n c o r p o r a t i o n d e c i s i o n . The u s u a l c o n c l u s i o n i s t h a t l a r g e businesses are seldom u n i n c o r p o r a t e d . For s m a l l b u s i n e s s e s , the d e c i s i o n may t u r n on tax advantages or on p e r s o n a l p r e f e r e n c e . No a p r i o r i c o n c l u s i o n can be made. In f a c t the s t a t i s t i c s bear out these o b s e r v a t i o n s i n Canada: - 8 -I n t r o d u c t i o n C h a p t e r One NUMBER OF BUSINESSES INCORPORATED AND UNINCORPORATED, BY SALES CLASS SALES INCORPORATED % UNINCORPORATED % TOTAL ('000) o f c l a s s o f c l a s s $0-$50 137,150 40 207,571 60 344,721 $50-$250 122,790 50 117,812 50 240,602 $250-$2M 97,652 85 17,306 15 114,958 $2M-$20M 20,696 99 276 1 20,972 more t h a n $20M 2,338 100 n i l n i l 2,338 T o t a l 380,626 52 342,965 48 723,591 AVERAGE SALES WITHIN CLASS, INCORPORATED AND UNINCORPORATED, BY SALES CLASS SALES INCORPORATED UNINCORPORATED COMBINED ( '000) l e s s t h a n $50 $ 15,300 $ 24,500 $ 21,000 $50-$250 128,000 104,000 116,000 $250-$2M 677,000 427,000 640,000 $2M-$20M 5. 2M 4.9M 5.2M more t h a n $20M 116.0M n/a 116.0M AVERAGE SALES I N THE CLASS, c e r t a i n s e c t o r s S a l e s M a n u f a c t u r i n g T r a d e S e r v i c e C o n s t r u c t i o n ( '000) l e s s t h a n $50 $ 21,000 $ 23,000 $ 22,000 $ 23,000 $50 - $250 123,000 125,000 111,000 112,000 $250 -$ 2M 769,000 637,000 580,000 628,000 $2M - $20M 5. 8M 5. 0M 4. 6M 4. 6M more t h a n $2 0M 124.0M 9 4. 0M 71.0M 4 6. 0M AVERAGE NUMBER OF EMPLOYEES IN THE CLASS, c e r t a i n s e c t o r s S a l e s ('000) l e s s t h a n $50 $50 - $250 $250 - $2M $2M - $20M more t h a n $2M M a n u f a c t u r i n g T r a d e S e r v i c e C o n s t r u c t i o n 2 6 23 123 1511 2 4 9 45 973 2 6 35 175 1605 2 4 11 54 473 SOURCE : " S m a l l B u s i n e s s i n Canada - A S t a t i s t i c a l P r o f i l e ( 1 9 7 8 ) " M i n i s t r y o f S t a t e f o r S m a l l B u s i n e s s and T o u r i s m - 9 -I n t r o d u c t i o n Chapter One In t o t a l , the s t a t i s t i c s show approximately a f i f t y / f i f t y d i s t r i b u t i o n between i n c o r p o r a t e d and u n i n c o r p o r a t e d e n t i t i e s . For s a l e s below $ 2 5 0 , 0 0 0 , the d i s t r i b u t i o n i s s t i l l f a i r l y e q ual, being f i f t y - f i v e p e rcent u n i n c o r p o r a t e d . Beyond s a l e s of $ 2 5 0 , 0 0 0 t h e r e i s a dramatic swing to i n c o r p o r a t i o n . (Note t h a t these p u b l i s h e d s t a t i s t i c s exclude self-employed farmers, fishermen and p r o f e s s i o n a l s . ) W i t h i n the two lowest s a l e s c l a s s e s , the average volume of s a l e s i s not s i g n i f i c a n t l y d i f f e r e n t between the two forms of o r g a n i z a t i o n . Only beyond $ 2 5 0 , 0 0 0 of s a l e s i s there a s i g n i f i c a n t d i f f e r e n c e i n average s a l e s volume. The average s a l e s w i t h i n a s a l e s c l a s s always tends to be i n the lower h a l f o f the range. In the two lowest c l a s s e s , average s a l e s i n the c l a s s does not vary s i g n i f i c a n t l y amongst i n d u s t r i e s . Combining the lowest two s a l e s c l a s s e s , e i g h t y percent of the businesses have average s a l e s of $ 6 0 , 0 0 0 . T h i s same group, f o r s e l e c t e d i n d u s t r i e s , employs no more than s i x people on average. Is t h e r e any d i f f e r e n c e i n the p r o f i t a b i l i t y o f the two forms o f o r g a n i z a t i o n ? The p r e - t a x p r o f i t s t a t i s t i c s o f both f o r 1978 show some i n t e r e s t i n g i n f o r m a t i o n : AVERAGE PRE-TAX PROFIT, INCORPORATED AND UNINCORPORATED, BY SALES CLASS SALES ( '000) INCORPORATED UNINCORPORATED $ 0 - $ 5 0 $50-$250 $250-$2M $ n i l 9,000 32,600 $ 6 , 3 0 0 1 4 , 2 0 0 2 7 , 5 0 0 SOURCE : "Small Business i n Canada - A S t a t i s t i c a l P r o f i l e (1978) " M i n i s t r y of State f o r Small Business and Tourism -10-I n t r o d u c t i o n Chapter One The n i l p r o f i t s t a t i s t i c f o r the s m a l l e s t c o r p o r a t i o n s r e q u i r e s i n t e r p r e t a t i o n . F i r s t , the comparative f i g u r e i n 1976 was a modest p r o f i t of $800, versus $5,700 f o r u n i n c o r p o r a t e d ventures. Second, i f a business was i n c u r r i n g l o s s e s , prudent tax a d v i c e suggests t h a t the e n t i t y should operate i n the u n i n c o r p o r a t e d mode because these l o s s e s then can be u t i l i z e d to o f f s e t other p e r s o n a l income. T h e r e f o r e , one might b e t t e r expect to see l o s s e s i n t h i s s e c t o r . What i s probably a l s o happening here i s the r e s u l t of the separate l e g a l and t a x a b l e e n t i t y c r e a t e d by i n c o r p o r a t i o n . The e x i s t e n c e of two t a x a b l e e n t i t i e s - c o r p o r a t e and shareholder - permits the tax p l a n n i n g c a l c u l a t i o n s t o a l l o c a t e t a x a b l e income i n the most prudent f a s h i o n . TAmongst other c o n s i d e r a t i o n s , i n 1978 i n d i v i d u a l s c o u l d have b a s i c p e r s o n a l exemptions and t a x - f r e e income o f $4,150. T h e r e f o r e , i t i s e n t i r e l y p o s s i b l e t h a t the c o r p o r a t e e n t i t i e s e xperienced s i m i l a r p r o f i t a b i l i t y , but d i s t r i b u t e d the p r o f i t , p r e - t a x , to the s h a r e h o l d e r s as wages. The d i f f e r e n c e i n pre-tax p r o f i t i n the $50,000 - $250,000 c l a s s may a l s o r e f l e c t an a l l o c a t i o n of wages i n order to u t i l i z e p e r s o n a l exemptions. In the next s a l e s c l a s s , c o r p o r a t e e n t i t i e s s t r o n g l y show b i g g e r o p e r a t i o n s , w i t h gross s a l e s f i f t y percent l a r g e r than u n i n c o r p o r a t e d ventures i n the same c l a s s . The p r e - t a x p r o f i t , as a percentage of gross s a l e s , i s a c t u a l l y lower than f o r the u n i n c o r p o r a t e d e n t i t i e s . Imputing a s i m i l a r p r o f i t percentage to i t s h i g h e r s a l e s and then a l l o w i n g f o r t a x - f r e e p e r s o n a l remuneration, the two s e t s of f i g u r e s are comparable. The Canadian Small Business Guide argues t h a t the d e l i n e a t i o n -11-I n t r o d u c t i o n C h a p t e r One b e t w e e n b i g and s m a l l s h o u l d be w h e r e management s t y l e s a n d t e c h n i q u e s c h a n g e . A g a i n , t h e r e i s l i t t l e r e a s o n t o d i s a g r e e w i t h t h i s q u a l i t a t i v e i n t e r p r e t a t i o n . S u r e l y t h e r e i s a s i g n i f i c a n t d i f f e r e n c e b e t w e e n m a n a g i n g s i x a n d two h u n d r e d e m p l o y e e s ! Once t h e numbers become t h i s l a r g e , t h e n management s t y l e a n d c o n t r o l s y s t e m s h a v e a l r e a d y h a d t o a d a p t . The s h i f t b e y o n d t o one t h o u s a n d e m p l o y e e s , f o r i n s t a n c e , i s r e a l l y o n l y an e x t r a v o l u m e l o a d on t h e s e e x i s t i n g s y s t e m s . I n t h e C a n a d i a n s e t t i n g , " s m a l l " i s v e r y s m a l l . T h i s s h o u l d be e m p h a s i z e d i n a l l f a c e t s o f s m a l l b u s i n e s s p o l i c y f o r m u l a t i o n a n d p r o b l e m i d e n t i f i c a t i o n . C a n a d a n e e d s t o f o l l o w t h e e x a m p l e o f , f o r i n s t a n c e , J a p a n i n r e c o g n i z i n g g r a d a t i o n s o f s i z e . R a t h e r t h a n d e f i n i n g " s m a l l " b u s i n e s s , we s h o u l d be d e f i n i n g " s m a l l " a n d "medium". P r i m a f a c i e , t h i s may a p p e a r t o be c o m p o u n d i n g t h e f u t i l i t y b y r e q u i r i n g more q u a n t i t a t i v e d e f i n i t i o n s . D i s t i n g u i s h i n g h a v e s f r o m h a v e - n o t s i s a l w a y s a d i f f i c u l t u n d e r t a k i n g . T h i s d o e s n o t n e g a t e t h e v a l i d i t y o f t h e e x e r c i s e . The a u t h o r b e l i e v e s t h a t a l l b u s i n e s s e s - b i g , medium o r s m a l l -s h a r e c e r t a i n c h a r a c t e r i s t i c s . H o w e v e r , e a c h h a s i t s own u n i q u e o n e s a s w e l l . Tax p o l i c y t h a t i s a i m e d a t p a r t i c u l a r r e c i p i e n t s i s o f t e n c o m p l i c a t e d b y e x c l u s i o n o r a n t i - a v o i d a n c e c l a u s e s i n o r d e r t o p r e v e n t u n w o r t h y r e c i p i e n t s f r o m b e n e f i t i n g a s w e l l . The r e s u l t a n t l e g i s l a t i o n i s o f t e n o f u s e t o no o n e . The a u t h o r b e l i e v e s t h a t s e p a r a t i n g s m a l l b u s i n e s s f r o m medium b u s i n e s s w i l l a l l o w s i m p l e r a n d more a c c u r a t e t a r g e t i n g o f s m a l l b u s i n e s s l e g i s l a t i o n . The o u t c a s t medium b u s i n e s s e s w o u l d -12-I n t r o d u c t i o n C h a p t e r One h o p e f u l l y b e n e f i t i n t h e l o n g r u n f r o m t h e i r n e w - f o u n d d i s t i n c t n e s s , a s f u t u r e p o l i c y w o u l d be a i m e d a t t h e i r s p e c i f i c n e e d s . I n summary, t h e s e t a b l e s h i g h l i g h t w h a t i s , i n t h e a u t h o r ' s v i e w , a m i s - d e f i n i t i o n o f " s m a l l " . I f e i g h t y p e r c e n t o f t h e b u s i n e s s e s i n C a n a d a : - h a v e a v e r a g e s a l e s o f $60,000 ( a n d n o t more t h a n ( $ 2 5 0 , 0 0 0 ) ; a n d - e m p l o y l e s s t h a n s i x p e o p l e ; t h e n d e f i n i t i o n s t h a t c o n s i d e r two h u n d r e d o r f i v e h u n d r e d e m p l o y e e s , o r $20 m i l l i o n o r $1.5 m i l l i o n i n s a l e s a r e f a r o f f t h e t a r g e t . E v e n i f t h e m i d d l e s a l e s c l a s s ($250,000 - $2 m i l l i o n ) w e r e i n c l u d e d , t h i s l a r g e r g r o u p , e n c o m p a s s i n g n i n e t y - s e v e n p e r c e n t o f a l l b u s i n e s s e s , w o u l d h a v e a v e r a g e s a l e s o f $155,000 a n d e m p l o y l e s s t h a n t h i r t y - f i v e p e o p l e . T h i s e x t r a c l a s s i t s e l f o n l y h a s a v e r a g e s a l e s o f $ 6 4 0 , 0 0 0 . The a u t h o r ' s d e f i n i t i o n o f s m a l l f o r t a x p u r p o s e s w i l l be d e v e l o p e d i n C h a p t e r S e v e n . T a x a t i o n , S m a l l B u s i n e s s a n d F i s c a l L e v e r s The a u t h o r b e l i e v e s t h a t t h e n e e d s o f s m a l l b u s i n e s s s h o u l d f i r s t be s p e c i f i e d i n d e p e n d e n t l y o f t a x l e g i s l a t i o n . The t a x s y s t e m t h e n c a n be c o n s i d e r e d a s a v e h i c l e t o a d d r e s s c e r t a i n p r o b l e m s . The s p i r i t o f t h e C a r t e r C o m m i s s i o n ' s d e l i b e r a t i o n s a b o u t s m a l l b u s i n e s s p o l i c y was f r a m e d by t h e : "... u n d e r l y i n g p r o b l e m w h i c h i s t h e i n a d e q u a c y o f f u n d s f o r e x p a n s i o n b e c a u s e o f t h e i m p e r f e c t i o n s i n t h e c a p i t a l m a r k e t . " - 1 3 -I n t r o d u c t i o n Chapter One E m p i r i c a l l y , i t would seem t h a t the problems c o u l d be q u i c k l y i d e n t i f i e d by l o o k i n g a t s m a l l b u s i n e s s e s t h a t have f a i l e d and a n a l y z i n g the causes of f a i l u r e . The s o l u t i o n would be to a l l e v i a t e these causes. Dun and B r a d s t r e e t a n n u a l l y prepares a review o f bus i n e s s f a i l u r e s i n Canada. In 1979, f o r i n s t a n c e , 97.6 pe r c e n t of the sampled f a i l u r e s were a t t r i b u t e d t o ineptness of the owner/manager, l e a d i n g t o hi g h c o s t s or low s a l e s . Fundamental u n d e r - c a p i t a l i z a t i o n or other l i q u i d i t y problems are never mentioned. I f t h i s problem i d e n t i f i c a t i o n i s c o r r e c t , the author would support the C a r t e r Commission's d i s i n c l i n a t i o n to p r e f e r e n t i a l tax r a t e s , and recommend t h a t the e x t r a tax revenue be a l l o c a t e d t o e d u c a t i o n a l s e r v i c e s f o r en t r e p r e n e u r s ! While the author b e l i e v e s t h a t the Dun and B r a d s t r e e t study i n a d e q u a t e l y c o n s i d e r s the problem, i t i s easy to understand i t s d e r i v a t i o n . One of the problems of s m a l l businessmen i s the complex s e t of management and other s k i l l s r e q u i r e d t o run a b u s i n e s s . In the l a r g e c o r p o r a t i o n , the c o n t r o l l e r , f o r i n s t a n c e , i s a s p e c i a l i s t . He masters the f i n a n c i a l c o n t r o l s and t r e a s u r y of the bus i n e s s ; however, he would be hopeless s u p e r v i s i n g the shop f l o o r . The sma l l businessman i s f r e q u e n t l y c o n t r o l l e r , t r e a s u r e r , book-keeper, salesman, p e r s o n n e l o f f i c e r , shop foreman, worker, PR d i r e c t o r and CEO, a l l r o l l e d i n t o one. I t i s no s u r p r i s e t h a t he would be l e s s competent i n one or more of these r o l e s . Those concerned with the s m a l l business s e c t o r i n Canada have t h e i r own ideas of where smal l b u s i n e s s needs a h e l p i n g hand. -14-I n t r o d u c t i o n C h a p t e r One O t h e r p r o b l e m s i n c l u d e : 1. I n a d e q u a t e o r i n a p p r o p r i a t e f i n a n c i n g T h i s seems t o be t h e one h i g h l i g h t e d by t a x p o l i c y f o r m u l a t o r s . S m a l l b u s i n e s s e s a r e , o f c o u r s e , u s u a l l y d e n i e d a c c e s s t o p u b l i c c a p i t a l m a r k e t s . T h i s l e a v e s i n s t i t u t i o n a l a n d p r i v a t e f i n a n c i n g . The f o r m e r u s u a l l y demands a s i g n i f i c a n t i n v e s t m e n t by t h e o w ner/manager t o m a t c h t h e i n s t i t u t i o n ' s c o m m i t m e n t . I n a d d i t i o n , c o l l a t e r a l demands c a n be e x c e s s i v e . "The C . F . I . B . s a y s t h e a v e r a g e amount o f c o l l a t e r a l p l e d g e d on b u s i n e s s l o a n s i s 2 7 9 % o f t h e amount b o r r o w e d , o f w h i c h two t h i r d s 17 i s p e r s o n a l s e c u r i t y . " 2. I n c o n s i s t e n t b a n k c o o p e r a t i o n Bank p o l i c y f o r s m a l l b u s i n e s s c u s t o m e r s seems t o be i n c o n s i s t e n t o v e r t i m e . The r e c e n t e c o n o m i c d o w n t u r n c a u s e d t h e b a n k s t o c a l l many demand l o a n s and n o t r e n e w o t h e r t e r m a g r e e m e n t s a s t h e y m a t u r e d . B a n k s a l s o h a v e a h a b i t o f t r a n s f e r r i n g p e r s o n n e l q u i c k l y . The r e p l a c e m e n t c r e d i t m anager t y p i c a l l y seems t o come down h a r d i n i t i a l l y ; s u b s e q u e n t l y he may l o o s e n u p . The a u t h o r h a s s e e n one s m a l l b u s i n e s s f a c e t h r e e new m a n a g e r s i n l e s s t h a n a y e a r . I n t h e N e t h e r l a n d s , t h e l a r g e s t s m a l l b u s i n e s s b a n k k e e p s c r e d i t o f f i c e r s i n t h e same b r a n c h f o r a t l e a s t f o u r y e a r s . 3. U n s t a b l e i n c o m e t a x l a w B u s i n e s s m e n c l a i m t h e y n e e d some s t a b i l i t y i n a d y n a m i c e n v i r o n m e n t . The Income Tax A c t s h o u l d p r o v i d e s u c h s t a b i l i t y . T w e n t y y e a r s ago t h e C a r t e r C o m m i s s i o n was - 1 5 -I n t r o d u c t i o n C h a p t e r One f o r m u l a t i n g a s e t o f p o l i c y o p t i o n s i n t h e name o f m a j o r r e f o r m . The m a j o r amendments o f 1971 p l u s f o u r t e e n more y e a r s o f m i n o r amendments h a v e n o t b r o u g h t u s c l o s e r t o t h e C o m m i s s i o n ' s o b j e c t i v e . 4. H i g h c o s t o f c o m p l i a n c e P r o f e s s i o n a l s e r v i c e s a r e e x p e n s i v e . Bank r e q u e s t s f o r i n v e n t o r y o r f i n a n c i a l s t a t e m e n t a u d i t s c a n c u t d e e p l y i n t o c o r p o r a t e p r o f i t s . I n a l a r g e p u b l i c c o r p o r a t i o n t h e a u d i t a l s o s e r v e s o t h e r p u r p o s e s a n d i s more e a s i l y j u s t i f i e d . The a u t h o r h a s s e e n p r o f e s s i o n a l f e e s o f $1,500 t o a u d i t an i n v e n t o r y o f $300,000. I f t h i s was r e q u e s t e d m o n t h l y o r q u a r t e r l y , t h e f e e s w o u l d be en o r m o u s . Some a d v a n t a g e o u s p r o v i s i o n s o f t h e Income Tax A c t a r e a v a i l a b l e t o c o r p o r a t i o n s , l a r g e o r s m a l l . I n a s m a l l b u s i n e s s a m a l g a m a t i o n f o r t h e p u r p o s e o f t r a n s f e r r i n g n o n - c a p i t a l l o s s e s , t h e a u t h o r h a s s e e n p r o f e s s i o n a l f e e s w h i c h e x c e e d e d t h e amount o f t a x e s r e c o v e r a b l e . The r e l e v a n t p r o f e s s i o n a l s a r e n o t t h e o n e s a t f a u l t . To a l a r g e e x t e n t , t h e i r t i m e i s t h e same r e g a r d l e s s o f how many z e r o s a r e b e h i n d t h e n u m b e r s . The b r o a d e r t o p i c o f o v e r a l l p o l i c y - m a k i n g f o r s m a l l b u s i n e s s i s b e y o n d t h e s c o p e o f t h i s s t u d y . H owever, t h e C F I B h a s p o s i t e d a t e n - p o i n t p l a n f o c u s i n g o n g o v e r n m e n t ' s a b i l i t y t o a c t 18 a s a c a t a l y s t f o r s m a l l b u s i n e s s a d v o c a c y . N e e d l e s s t o s a y , a l e s s i n t e r v e n t i o n i s t p o s i t i o n i s h e r a l d e d . - 1 6 -I n t r o d u c t i o n Chapter One "Governments should s i m p l i f y tax systems, p r o v i d e f o r new forms of co m p e t i t i o n among f i n a n c i a l i n s t i t u t i o n s , encourage e d u c a t i o n a l i n s t i t u t i o n s t o develop b e t t e r management c o u n s e l l i n g s e r v i c e s , and use p u b l i c - and p r i v a t e - sector s u b - c o n t r a c t i n g t o encourage technology t r a n s f e r . " T a x a t i o n i s a broad t o p i c i t s e l f . I t i n c l u d e s many forms o f r e v e n u e - r a i s i n g by a l l l e v e l s o f government, eg p r o p e r t y , s a l e s , e x c i s e e t c . T h i s study w i l l c o n s i d e r a c t i v e business income t a x a t i o n o n l y . The Income Tax Act i s a p e r v a s i v e and many-faceted t o o l . I t can be used t o address many of the problems c i t e d e a r l i e r . 20 Wheatcroft p r o v i d e d a summary i n 1969 o f the r o l e o f tax p o l i c y . Many of h i s statements s t i l l have v a l i d i t y today i n the Canadian s e t t i n g : 1. Economic growth i s i n h i b i t e d by high t a x a t i o n , e s p e c i a l l y when taxes outrun t a x a b l e c a p a c i t y . 2. The c o s t of compliance i s hig h and should be reduced whenever p o s s i b l e . More a t t e n t i o n should be p a i d t o s i m p l i f i c a t i o n and c l a r i t y o f tax laws and procedures. 3. Sudden major changes are p a r t i c u l a r l y harmful and c o s t l y t o the economy. Taxpayers have t o spend much time and money i n understanding and adapting t h e i r a c t i v i t i e s a c c o r d i n g l y . Major changes should be p r o p e r l y prepared i n advance, a f t e r f u l l c o n s u l t a t i o n w i t h persons o u t s i d e government. 4. High marginal tax r a t e s and many complicated p r o v i s i o n s i n e v i t a b l y l e a d t o tax avoidance and ev a s i o n , as w e l l as to d i s i n c e n t i v e t o work and i n v e s t . -17-I n t r o d u c t i o n Chapter One 5. The use o f changes i n the g e n e r a l r a t e s o f t a x a t i o n as an economic r e g u l a t o r i s d e s i r a b l e . 6. Human nature must be used t o achieve growth. 7. S e l e c t i v e taxes designed to d i s c o u r a g e , or encourage, the a c t i v i t i e s o f p a r t i c u l a r s e c t i o n s of the community have a number of disadvantages, and t h i s type of tax i s not the golden key t o growth. I t has harmful short-term e f f e c t s and can o n l y have l i m i t e d uses f o r long term purposes. The l a s t statement proves to be a c o n t r o v e r s i a l one i n the Canadian s e t t i n g . The broad goals of the Canadian income tax system may be 21 summarized as f o l l o w s : 1. To r a i s e a s i g n i f i c a n t p o r t i o n of the t o t a l revenues r e q u i r e d by the f e d e r a l and p r o v i n c i a l governments; 2. To a l l o c a t e the burdens of income t a x a t i o n among taxpayers i n an e q u i t a b l e and n e u t r a l manner, having regard t o the e f f e c t s of o t h e r kinds of taxes t h a t are a l s o i n f o r c e ; 3. To encourage c e r t a i n kinds of economic a c t i v i t y or investment and, perhaps, t o discourage c e r t a i n other k i n d s ; 4. To promote investment i n Canada by Canadians i n p r e f e r e n c e to t h e i r i n v e s t i n g elsewhere, and i n p r e f e r e n c e to investment i n Canada by o t h e r s ; 5. To encourage c e r t a i n kinds of s o c i a l a c t i v i t y ; 6. To reap p o l i t i c a l advantage f o r the government, such as i n g r a n t i n g tax r e d u c t i o n s i n e l e c t i o n y e a r s ; and -18-I n t r o d u c t i o n C h a p t e r One 7. To f a c i l i t a t e t h e a d m i n i s t r a t i o n o f t h e i n c o m e t a x s y s t e m a n d t a x p a y e r c o m p l i a n c e w i t h t h e l a w . T h i s i s a d i v e r s e s e t o f g o a l s . Some o f t h e s e may be i n c o n f l i c t when d e s i g n i n g a p a r t i c u l a r a s p e c t o f t h e A c t . I t i s c l e a r t h a t t h e A c t h a s a l w a y s b e e n u s e d a s a f i s c a l l e v e r . The A c t c o n t a i n s , a t a n y t i m e , a p o t p o u r r i o f p r o v i s i o n s w h i c h a r e i n t e n d e d t o s t i m u l a t e o r s t u n t b u s i n e s s g r o w t h . A number o f t h e s e p r o v i s i o n s a r e a v a i l a b l e t o a l l b u s i n e s s e s , r e g a r d l e s s o f s i z e , f o r e x a m p l e : i n v e s t m e n t t a x c r e d i t s , g e n e r o u s c a p i t a l c o s t a l l o w a n c e r a t e s , e m p l o y m e n t t a x c r e d i t s , m a n u f a c t u r i n g a n d p r o c e s s i n g t a x r a t e s , i n v e n t o r y a l l o w a n c e , l o s s c a r r y i n g p r o v i s i o n s and r o l l o v e r p r o v i s i o n s . H i s t o r i c a l l y , g o v e r n m e n t s h a v e a l s o c h o s e n t o g i v e p a r t i c u l a r i n c e n t i v e s t o s m a l l b u s i n e s s , f o r e x a m p l e : s m a l l b u s i n e s s r a t e s , s m a l l m a n u f a c t u r e r e x e m p t i o n f o r m a n u f a c t u r i n g and p r o c e s s i n g t a x r a t e s , o v e r i n t e g r a t i o n , f a m i l y r o l l o v e r p r o v i s i o n s , e x e m p t i o n f r o m c a p i t a l t a x e s , s m a l l b u s i n e s s d e v e l o p m e n t b o n d s a n d p o t e n t i a l l y p e r m a n e n t m a i n t e n a n c e o f s m a l l b u s i n e s s t a x s t a t u s . B e l i e f i n t h e v a l i d i t y o f e n c o u r a g i n g b u s i n e s s as t h e e n g i n e o f g r o w t h r e a l l y d e p e n d s u p o n o n e ' s p o l i t i c a l s t r i p e . W h i l e t h e p a r t i c i p a t i o n o f g o v e r n m e n t s i n a l l W e s t e r n d e m o c r a c i e s h a s i n c r e a s e d s u b s t a n t i a l l y , i t i s a t e n e t o f c a p i t a l i s t e c o n o m i e s t o l o o k t o t h e p r i v a t e s e c t o r . E c o n o m e t r i c m o d e l s h a v e n o t a l w a y s b e e n a b l e t o v e r i f y s u c c e s s f u l l y t h e b e n e f i t s t o t h e economy o f p a r t i c u l a r s t i m u l a n t s t o b u s i n e s s . I n some c a s e s , t h e v a l i d i t y o f a p r o v i s i o n r e s t s w i t h i t s f o r m , n o t i t s s u b s t a n c e . I n s i m p l e r t e r m s , t h e s u c c e s s o f some p r o v i s i o n s i s d e t e r m i n e d p o l i t i c a l l y -19-I n t r o d u c t i o n C h a p t e r One r a t h e r than e c o n o m i c a l l y . F o r i n s t a n c e , - a package o f s m a l l b u s i n e s s p r o v i s i o n s can s c o r e p o l i t i c a l p o i n t s w i t h t h i s s e c t o r o f t h e e l e c t o r a t e . Governments must view t h e s m a l l b u s i n e s s s e c t o r as a l a r g e c o n s t i t u e n c y when d e v e l o p i n g p o l i c y . T h i s has been r e c o g n i z e d s i n c e t h e budget o f 1949 and c o n t i n u e s t o t h e p r e s e n t t i m e : A p r i l 1983 BUDGET " I have been p a r t i c u l a r l y c o n c e r n e d i n p r e p a r i n g t h i s budget w i t h t h e f i n a n c i a l d i f f i c u l t i e s t h a t Canada's s m a l l b u s i n e s s e s must overcome t o c o n t r i b u t e t o n a t i o n a l economic r e c o v e r y . S m a l l f i r m s a r e one o f t h e most dynamic and i n n o v a t i v e elements o f t h e p r i v a t e s e c t o r . " December 1979 BUDGET "The s m a l l b u s i n e s s s e c t o r i s one o f t h e g r e a t s t r e n g t h s o f t h i s c o u n t r y . " November 19 78 BUDGET "As a r e s u l t o f t a x b e n e f i t s i n t r o d u c e d by t h i s government over the p a s t f o u r y e a r s , s m a l l b u s i n e s s e s i n Canada e n j o y v e r y f a v o u r a b l e t a x t r e a t m e n t . S m a l l C a n a d i a n - c o n t r o l l e d p r i v a t e c o r p o r a t i o n s pay f e d e r a l income t a x a t l e s s t h a n h a l f t h e normal c o r p o r a t i o n r a t e . . . t h e v e r y g e n e r o s i t y o f t h e measures makes i t e s s e n t i a l t o ensure t h a t t h e y a r e e f f e c t i v e l y t a r g e t e d . " March 197 7 BUDGET "The government a t t a c h e s g r e a t importance t o t h e c o n t r i b u t i o n s m a l l b u s i n e s s makes t o t h e Canadian economy. T h i s a n a l y s i s (of v e n t u r e c a p i t a l ) r e v e a l e d t h a t no s i n g l e t a x measure c o u l d r e s o l v e them (the f i n a n c i n g problems o f s m a l l b u s i n e s s ) . A p a r t i c u l a r problem f o r s m a l l b u s i n e s s i s t h e d i f f i c u l t y o f m a t c h i n g h i g h e r s a l a r i e s o f f e r e d by l a r g e r e n t e r p r i s e s . " " E q u i t y " i n a t a x system i s an economic term t h a t w i l l be d i s c u s s e d i n more d e t a i l l a t e r . I t i s wo r t h m e n t i o n i n g a t t h i s j u n c t u r e t h a t " e q u i t y " has a d d i t i o n a l s p e c i f i c i m p l i c a t i o n s f o r b u s i n e s s . F i r s t , e q u i t y must be c o n s i d e r e d between b i g b u s i n e s s and s m a l l . Government p o l i c y makers have c o n s i s t e n t l y b e l i e v e d - 2 0 -I n t r o d u c t i o n Chapter One t h a t s m a l l b u s i n e s s should be taxed p r e f e r e n t i a l l y . The White Paper on Tax Reform d i d not agree. Second, e q u i t y must be c o n s i d e r e d between i n c o r p o r a t e d and u n i n c o r p o r a t e d b u s i n e s s e s . Here e q u i t y p a r a l l e l s n e u t r a l i t y and r e q u i r e s t h a t the Act does not d i s c r i m i n a t e i n the d e c i s i o n to i n c o r p o r a t e a b u s i n e s s . Canadian tax p o l i c y has not been committed to e q u i t y i n t h i s a r e a. A number of p r o v i s i o n s have b i a s e d the c h o i c e towards i n c o r p o r a t i n g , f o r i n s t a n c e : o v e r - i n t e g r a t i o n of c o r p o r a t e tax r a t e s , h i g h e r investment tax c r e d i t s f o r s c i e n t i f i c r e s e a r c h and p r e f e r e n t i a l tax r a t e s f o r manufacturing and p r o c e s s i n g a c t i v i t i e s . U n t i l the Budget of December 1979, u n i n c o r p o r a t e d firms were denied the d e d u c t i b i l i t y of s a l a r i e s p a i d to spouses, even though the payments were f o r s e r v i c e s l e g i t i m a t e l y rendered to the b u s i n e s s . I t was shocking to see such a p r o v i s i o n s u r v i v e f o r over s i x t y y e a r s . The b i a s towards i n c o r p o r a t i n g a l s o c o n t r i b u t e d to the e v o l u t i o n of the term "income s p l i t t i n g " as becoming almost a household word. Here, t a x a b l e income c o u l d be " s p l i t " even without a c o n t r i b u t i o n of e f f o r t , by rewarding nominal ownership through d i v i d e n d s . T h i s i n e q u i t y s t i l l remains and would be c o r r e c t a b l e by amending the p e r s o n a l tax p r o v i s i o n s t o a l l o w t a x a t i o n of the f a m i l y u n i t . Broad s t a t i s t i c a l tax i n f o r m a t i o n i s not simple to a n a l y z e . F i r s t , the i n f o r m a t i o n on i n c o r p o r a t e d f i r m s i s found i n the p u b l i c a t i o n " C o r p o r a t i o n T a x a t i o n S t a t i s t i c s " and on u n i n c o r p o r a t e d f i r m s i s found i n the p u b l i c a t i o n "Taxation S t a t i s t i c s " . The l a t t e r does not p r o v i d e d e t a i l e d i n f o r m a t i o n by s i z e c l a s s e s . The c o r p o r a t e s t a t i s t i c s do provide some -21-I n t r o d u c t i o n C h a p t e r One i n t e r e s t i n g i n f o r m a t i o n (See A p p e n d i c e s ) , f r o m w h i c h t h e f o l l o w i n g d e s e r v e s h i g h l i g h t i n g : 1. A c c o u n t i n g d e p r e c i a t i o n e x c e e d e d c a p i t a l c o s t f o r s m a l l b u s i n e s s e s . The r e v e r s e was t r u e f o r medium a n d l a r g e b u s i n e s s e s . The r e a s o n p e r h a p s was due t o l o s s e s e x p e r i e n c e d b y s m a l l b u s i n e s s e s , w h i c h r e q u i r e d l e s s t a x d e p r e c i a t i o n t o r e d u c e t a x a b l e i n c o m e t o n i l . ( l i n e 17 v s l i n e 2 0 ) . The m e d i u m - s i z e d e n t e r p r i s e s may be i n n e e d o f some d i r e c t e d a s s i s t a n c e , t o o . They a r e t o o l a r g e t o e n j o y t h e s m a l l b u s i n e s s r a t e y e t p e r h a p s t o o s m a l l t o e n j o y c e r t a i n t a x a d v a n t a g e s o f t h e b i g c o r p o r a t i o n s . F o r i n s t a n c e , t h e a v e r a g e e x c e s s o f t a x d e p r e c i a t i o n o v e r a c c o u n t i n g d e p r e c i a t i o n was s i g n i f i c a n t l y d i f f e r e n t b e t w e e n medium a n d b i g b u s i n e s s ( l i n e 21 / l i n e 1 ) : 1981 1980 Medium $ 8,100 $12,000 B i g $2.47 M $2.64 M 2. The n e t a d j u s t m e n t s f r o m b o o k p r o f i t t o t a x a b l e i n c o m e w e r e n e g a t i v e i n a l l c a s e s . H o w e v e r , t h e r e l a t i v e i m p a c t a s a p e r c e n t a g e o f b o ok p r o f i t v a r i e d i m m e n s e l y , a s f o l l o w s ( l i n e 39 / l i n e 9) : 1981 1980 S m a l l 27% 2 5 % Medium 43% 4 0% B i g 6 3 % 5 3 % R e m o v i n g t h e a d j u s t m e n t s p e r t a i n i n g t o c a p i t a l g a i n s and - 2 2 -I n t r o d u c t i o n C h a p t e r One i n t e r - c o r p o r a t e d i v i d e n d s ( l i n e s 10, 1 1 , 12 a n d 13) t h e i m p a c t o f t h e r e m a i n i n g n e t a d j u s t m e n t s c h a n g e s : 1981 1982 S m a l l 1% 1% Medium 16% 16% B i g 3 1 % 28% 3. The l o s s c a r r y b a c k p r o v i s i o n s ( b a c k one y e a r o n l y ) w e re o f s m a l l b e n e f i t t o a n y o n e ; h o w e v e r , t h e b i g g e r c o r p o r a t i o n s made r e l a t i v e l y h i g h e r u s e o f t h e c u r r e n t l o s s e s ( l i n e 56/ l i n e 4 1 ) : 1981 1980 S m a l l 2.3% 15.6% Medium 5.7% 10.9% B i g 1 2 . 0 % 2 5 . 2 % The h i g h e r f i g u r e f o r s m a l l b u s i n e s s i n 1980 p e r h a p s r e f l e c t s h e a v y l o s s e s s u s t a i n e d t h r o u g h o u t b o t h y e a r s . The 1980 l o s s e s w e r e c a r r i e d b a c k t o 1979 b u t t h e 1981 l o s s e s w e r e n o t a b l e t o be u s e d a g a i n s t 1980. 4. Tax c r e d i t s a r e more h e a v i l y e n j o y e d b y b i g b u s i n e s s . The a v e r a g e i n v e s t m e n t t a x c r e d i t u t i l i z e d t o r e d u c e t a x e s o w i n g was ( l i n e 50 / l i n e 1 ) : 1981 1980 S m a l l $ 123 $ 110 Medium 2,687 2,790 B i g 194,000 225,600 - 2 3 -I n t r o d u c t i o n C h a p t e r One R e l a t i v e t o t a x a b l e income, t h e i n v e s t m e n t t a x c r e d i t s a l s o had a b i g g e r impact on b i g f i r m s ( l i n e 50 / l i n e 44) : 1981 1980 S m a l l .8% .7% Medium 1.7% 1.6% B i g 3.6% 3.5% 5. The e f f e c t i v e c o r p o r a t e t a x r a t e s t a t i s t i c s f o r p r o f i t a b l e f i r m s show ( l i n e 54/ l i n e 4 4 ) : 1981 1980 S m a l l 28.3% 27.5% Medium 42.8% 41.9% B i g 41.2% 41.7% Summary The o b j e c t i v e o f t h i s s t u d y i s t o i d e n t i f y a l t e r n a t i v e s f o r r e f o r m o f the Canadian t a x a t i o n o f s m a l l b u s i n e s s . Some groundwork needs t o be c o v e r e d b e f o r e t a c k l i n g t h e problem: 1. Chapter Two i d e n t i f i e s t h e t h e o r e t i c a l b a s i s o f a good t a x system. Any proposed r e f o r m w i l l need t o c o n s i d e r t h e s e c r i t e r i a . 2. C h a p t e r Three c o v e r s an h i s t o r i c a l o v e r v i e w o f c o r p o r a t e t a x a t i o n i n Canada. Any proposed r e f o r m w i l l need t o t a k e l e s s o n s from t h e p a s t . 3. C h a p t e r Four draws from t h e e x p e r i e n c e s o f o t h e r governments. 4. C h a p t e r F i v e d e t a i l s t h e key p r o v i s i o n s o f t h e system e x t a n t . Any proposed r e f o r m w i l l need t o know where we a r e b e f o r e i t s u g g e s t s where we s h o u l d go. We w i l l a l s o -24-I n t r o d u c t i o n Chapter One need to know what the c u r r e n t s t r e n g t h s and weaknesses ar e . 5. Chapter S i x draws from the l e a r n e d p r o p o s a l s o f economists, tax p r a c t i t i o n e r s , government policy-makers and other i n t e r e s t e d p a r t i e s . 6. Chapter Seven a r r i v e s a t a s e t o f recommendations f o r f u t u r e reform. -25-I n t r o d u c t i o n C h a p t e r One FOOTNOTES 1. Raymond Kao o f R y e r s o n P o l y t e c h n i c a l I n s t i t u t e a n d R e i n P e t e r s o n , f o r m e r l y o f t h e same i n s t i t u t i o n . 2. "A S t u d y o f J o b C r e a t i o n i n C a n a d a , 1 9 7 5 - 1 9 8 2 " R.A. W i e t f e l d t . J o u r n a l o f S m a l l B u s i n e s s , S p r i n g 1984,pg 8 3. " S m a l l B u s i n e s s : B u i l d i n g a B a l a n c e d Economy", P e t e r s e n p g 143 4. T h i s s t u d y o f s m a l l b u s i n e s s t a x a t i o n e x c l u d e s p r o f e s s i o n a l s , f i s h e r m e n a n d f a r m e r s 5. I b i d p g 58 6. I b i d p g 58 7. I b i d p g 59 8. I b i d p g 60 9. I b i d p g 62 10. I b i d p g 59 11. C a n a d i a n S m a l l B u s i n e s s G u i d e . CCH C a n a d i a n L t d , p a r a 1005. 12. P e t e r s e n , p g 60 13. I b i d p g 62 14. I b i d p g 69 15. I b i d p g 69 16. The C a r t e r R e p o r t V o l 4 p g 2 70 17. F i n a n c i a l P o s t December 2 5 , 1982 p g 15 18. A t t h e 1 1 t h I n t e r n a t i o n a l S m a l l B u s i n e s s C o n g r e s s , November 1984 19. F i n a n c i a l P o s t November 3, 1984 p g 16 20. " T a x a t i o n E c o n o m i c s " , I l e r s i c , M y d d e l t o n , D a v i e s , M a n s e r and W h e a t c r o f t , M c M i l l a n & Co , E d i n b u r g h 1969 p g s 95-98 21 . C a n a d i a n Income T a x a t i o n , H a r r i s , p g 81 -26 -I n t r o d u c t i o n C h a p t e r Two THEORY OF TAXATION "The a r t o f t a x a t i o n c o n s i s t s i n so p l u c k i n g t h e goose as t o p r o c u r e t h e h i g h e s t q u a n t i t y o f f e a t h e r s w i t h t h e l e a s t p o s s i b l e amount o f h i s s i n g . " An o l d F r e n c h maxim sometimes a t t r i b u t e d t o C o l b e r t T h i s c h a p t e r a d d r e s s e s the t h e o r e t i c a l a s p e c t s o f a system o f t a x a t i o n . W h i l e t h i s paper f o c u s e s on t a x a t i o n o f income i n t h e s m a l l b u s i n e s s s e c t o r , i t w i l l be n e c e s s a r y h e r e t o i n c l u d e t h e t a x a t i o n o f i n d i v i d u a l s f o r t h r e e r e a s o n s : f i r s t , a t a x a t i o n system must encompass a l l t a x p a y i n g e n t i t i e s ; second, c o r p o r a t i o n s and t h e i r i n d i v i d u a l s h a r e h o l d e r s a r e i n e x t r i c a b l y l i n k e d ; and l a s t l y , f o r i l l u s t r a t i v e p u r p o s e s , some o f t h e c o n c e p t s a r e b e s t e x p l a i n e d i n t h e i n d i v i d u a l c o n t e x t . There a r e two p r i m a r y o b j e c t i v e s t o income t a x a t i o n ; revenue and non-revenue. A l l forms o f government t a x a t i o n combined 1 2 c o n t r i b u t e s e v e n t y - f i v e p e r c e n t o f t o t a l government re v e n u e s . C o r p o r a t e and p e r s o n a l t a x e s have c o n s i s t e n t l y produced a p p r o x i m a t e l y f o r t y p e r c e n t o f a c t u a l revenues and s i x t y p e r c e n t 3 o f t h e b u d g e t a r y r e v e n u e s . The f e d e r a l b u d g e t a r y revenues n e a r l y d o u b l e d from 1978 t o 1983 (1978 - $36.1 b i l l i o n ; 1983 - $68.2 4 b i l l i o n ) . The d e f i c i t a g a i n s t t h e s e r e v e n u e s , a n n u a l l y h e l d a t a p p r o x i m a t e l y $10 b i l l i o n s i n c e 1978, more th a n d o u b l e d i n 1983. As t h e most s i g n i f i c a n t s o u r c e f o r t h e f e d e r a l f i s c , income t a x revenues r e c e n t l y have had t o i n c r e a s e s u b s t a n t i a l l y t o keep up w i t h t h e r a p i d l y g r o w i n g f e d e r a l e x p e n d i t u r e s . Indeed, t o t a l d i r e c t t a x e s have i n c r e a s e d s t e a d i l y from $23.2 b i l l i o n i n 1978 t o $42.9 b i l l i o n i n 1983. 5 -27-Theory o f T a x a t i o n Chapter Two The non-revenue o b j e c t i v e o f income t a x a t i o n i s probably e q u a l l y important, though not as q u a n t i t a t i v e l y c h a r a c t e r i z e d . The government u t i l i z e s i t s l e g i s l a t i v e powers t o a f f e c t d e s i r e d r e s u l t s i n employment, growth, i n f l a t i o n , r e g i o n a l and i n d u s t r i a l expansion, income r e d i s t r i b u t i o n , s t a b i l i t y , e t c . The cause and e f f e c t r e l a t i o n s h i p of tax changes on these o b j e c t i v e s i s , u n f o r t u n a t e l y , seldom c l e a r . The i n a b i l i t y t o t a r g e t a c c u r a t e l y s p e c i f i c p r o v i s i o n s and the problem of time l a g s are two arguments a g a i n s t u s i n g tax p o l i c y f o r non-revenue o b j e c t i v e s . C e r t a i n q u a l i t i e s o f a good tax system are bes t a t t a i n e d i n a s t a t i c environment. For i n s t a n c e , " c e r t a i n t y " , " s i m p l i c i t y " and " p r e d i c t a b i l i t y " are g e n e r a l l y regarded as d e s i r a b l e c h a r a c t e r i s t i c s . C e r t a i n t y and p r e d i c t a b i l i t y a l l o w taxpayers a safe environment i n which t o pl a n and f o r e c a s t , knowing f u l l w e l l what the tax consequences of t h e i r a c t i o n s w i l l be. "The Canadian government's White Paper on Tax Reform s t a t e d t h a t , 'the system must be simple enough f o r the taxpayer t o understand'. U n f o r t u n a t e l y , our a c t u a l income tax laws are n e i t h e r simple nor r e a d i l y understandable. In 1975 a former chairman o f the Tax Appeal Board was quoted as saying t h a t , i n h i s o p i n i o n , the Canadian Income Tax Act was the most com p l i c a t e d s t a t u t e ever d e v i s e d by man". As a p r a c t i s i n g tax accountant, i t i s the author's o b s e r v a t i o n t h a t even the most c l e v e r l a y - p e o p l e w i t h the s i m p l e s t tax s i t u a t i o n s f r e q u e n t l y make e r r o r s i n completing t h e i r p e r s o n a l tax r e t u r n s . Indeed, i t i s almost sheer f o l l y f o r a sm a l l businessman t o attempt t o complete h i s own co r p o r a t e tax r e t u r n . Simple, everyday t r a n s a c t i o n s , l i k e buying a f a m i l y home, can c a r r y tax p e n a l t i e s f o r the unwary taxpayer. C e r t a i n t y and - 2 8 -Theory o f Taxa t i o n Chapter Two p r e d i c t a b i l i t y are overlooked i n Canadian tax p o l i c y . A s i t u a t i o n e x i s t e d r e c e n t l y where taxpayers had to p l a n i n an environment o f three s e t s o f l a w — t h e e x i s t i n g law, an unpassed budget and proposed amendments to t h a t unpassed budget. In a s i m i l a r v e i n , amendments to the Canada/United S t a t e s Tax T r e a t y were r e c e n t l y under n e g o t i a t i o n f o r four y e a r s . The tax system i s a s e l f - a s s e s s i n g one. I n c r e a s i n g complexity w i l l c r e a t e a number of consequences: 1. I n c o r r e c t f i l i n g by taxpayers; 2. C o s t l y p r o f e s s i o n a l a s s i s t a n c e w i t h f i l i n g ; and 3. Increased non-compliance. E r r o r s i n the t a x p a y e r s ' favour are captured by the systems o f review and a u d i t . E r r o r s i n the government's favour f r e q u e n t l y w i l l remain u n d i s c o v e r e d . The system should be simple enough t h a t the " r i g h t amount" of tax i s p a i d , p a r t i c u l a r l y where the r i g h t amount i s not a q u e s t i o n of i n t e r p r e t a t i o n concerning a p a r t i c u l a r t r a n s a c t i o n . The q u a l i t i e s of c e r t a i n t y , s i m p l i c i t y and p r e d i c t a b i l i t y are d i f f i c u l t t o a t t a i n , g i v e n the revenue and non-revenue o b j e c t i v e s . I f more tax revenues are needed to balance the f e d e r a l budget, then tax changes are necessary to wring out the e x t r a funds. S i m i l a r l y , i f unemployment i s h i g h , tax changes may be t e m p o r a r i l y enacted to address t h a t problem. T a x a t i o n theory has e v o l v e d a s e t o f c h a r a c t e r i s t i c s t h a t d e s c r i b e a tax system. Some of these concepts are n o t i o n a l o n l y . In some i n s t a n c e s , i t i s not p o s s i b l e t o judge whether a tax -29-Theory of T a x a t i o n Chapter Two system has a p a r t i c u l a r c h a r a c t e r i s t i c . N e u t r a l i t y N e u t r a l i t y i s c l o s e l y l i n k e d t o the b a s i c economic concept o f a l l o c a t i v e e f f i c i e n c y . I t seeks t o remove the tax aspects from b u s i n e s s d e c i s i o n s . T h i s might i n c l u d e , f o r i n s t a n c e , the d e c i s i o n s t o i n c o r p o r a t e or t o make c a p i t a l purchases. A commitment t o p e r f e c t n e u t r a l i t y i s onerous i n tax l e g i s l a t i o n , and a l s o c o n t r a d i c t o r y t o the p u r s u i t o f non-revenue o b j e c t i v e s . E q u i t y E q u i t y has two c o m p o n e n t s — h o r i z o n t a l and v e r t i c a l . H o r i z o n t a l e q u i t y d e s c r i b e s the n o t i o n t h a t equals should be taxed e q u a l l y . V e r t i c a l e q u i t y d e s c r i b e s the n o t i o n t h a t where two i n d i v i d u a l s have unequal incomes, the high e r earner should pay more t a x . H o r i z o n t a l e q u i t y i s simple t o accept and r e l a t i v e l y easy t o implement. A d i f f i c u l t y does a r i s e i n measuring equa l s . Some base of w e l l - b e i n g needs t o be determined. Income i s the most common base. However, t h i s too has f a u l t s . The n o t i o n o f income t h a t i s found i n the A c t has p e c u l i a r i t i e s : f o r i n s t a n c e , the t a x a t i o n of c a p i t a l g a i n s . Adoption o f the White Paper's concept o f comprehensive income may have improved the base. An income base ig n o r e s other i s s u e s , as w e l l . Forms o f imputed income l i k e l e i s u r e time and non-market a c t i v i t i e s are not c o n s i d e r e d . V e r t i c a l e q u i t y i s a l s o simple t o accept, but not easy t o implement. I t i s a s u b j e c t i v e assessment as to how une q u a l l y unequals should be taxed. In essence, t h i s concept addresses the - 3 0 -Theory o f Taxa t i o n C h a p t e r Two p r o g r e s s i v i t y o f t h e s y s t e m . H e r e e c o n o m i c t h e o r y a d v a n c e s t h r e e m e a s u r e s o f u n e q u a l t r e a t m e n t : " a b i l i t y t o p a y " , " b e n e f i t " a n d " u t i l i t y " . / A b i l i t y To P a y T h i s a p p r o a c h s t a t e s t h a t t h e t a x b u r d e n s h o u l d be d i s t r i b u t e d a c c o r d i n g t o some m e a s u r e o f a b i l i t y t o p a y . T h i s m e a s u r e may be i n c o m e , c o n s u m p t i o n o r w e a l t h . A l l t h r e e o f t h e s e h a v e l i m i t a t i o n s . F o r i n s t a n c e , none c o n s i d e r s l e i s u r e n o r t r e a t s t a x p a y e r s w i t h d i f f e r e n t p r e f e r e n c e s , u n e q u a l a b i l i t i e s o r u n e q u a l e f f o r t o n t h e same b a s i s . One s t r o n g c a s e f o r t h e a b i l i t y t o p a y a p p r o a c h r e l a t e s t o t h e i m p o r t a n t r o l e o f f o r e i g n i n v e s t m e n t i n C a n a d a . I f Canada d i s c o n t i n u e d t h e c o r p o r a t e t a x , a l l f o r m s o f r e t u r n t o f o r e i g n o w n e r s h i p ( i n t e r e s t , d i v i d e n d s , r o y a l t i e s , management f e e s , e t c . ) l i k e l y w o u l d be t a x e d i n t h e f o r e i g n d o m i c i l e anyway. S i n c e i n t e r n a t i o n a l t a x r a t e s t e n d t o t h e same r a n g e , t h e c o r p o r a t e t a x b u r d e n w o u l d n o t c h a n g e ; r a t h e r , t h e r e w o u l d be a t r a n s f e r f r o m t h e C a n a d i a n f i s c . B e n e f i t T h i s a p p r o a c h r e q u i r e s t h a t u s e r s p a y f o r t h e g o o d s and s e r v i c e s t h e y consume. T h i s i s c i t e d a s t h e g e n e r a l r u l e i n t h e p r i v a t e s e c t o r — p e o p l e p a y f o r w h a t t h e y r e c e i v e a n d t h e y a r e n o t s u b s i d i z e d b y a n o t h e r p a r t y . I t i s a r g u e d t h a t t h i s a p p r o a c h a i d s i n d e t e r m i n i n g o p t i m u m o u t p u t l e v e l s o f g o v e r n m e n t s e r v i c e s . T h e r e a r e t h r e e v e r s i o n s o f t h e b e n e f i t a p p r o a c h ; " g e n e r a l " , " s p e c i a l " a n d " s o c i a l c o s t " . The " g e n e r a l " b e n e f i t v e r s i o n v i e w s t h e g o v e r n m e n t a s a s i l e n t n o n - v o t i n g p a r t n e r o f b u s i n e s s , who s h a r e s i n t h e p r o f i t s a n d l o s s e s . I n r e t u r n , t h e g o v e r n m e n t -31-T h e o r y o f T a x a t i o n Chapter Two educates the labour f o r c e and ad m i n i s t e r s the economy. The " s p e c i a l " b e n e f i t v e r s i o n says t h a t government p r o v i d e s b e n e f i t s s p e c i f i c t o the c o r p o r a t e s e c t o r - - a l e g a l system of l i m i t e d l i a b i l i t y and an i n s t i t u t i o n a l s e t t i n g o f primary and secondary c a p i t a l markets. The " s o c i a l c o s t " v e r s i o n says t h a t c o r p o r a t i o n s must bear some r e s p o n s i b i l i t y f o r the neg a t i v e e x t e r n a l i t i e s they c r e a t e , l i k e p o l l u t i o n . The o b j e c t i o n t o t h i s approach c e n t e r s on the argument t h a t government s e r v i c e s are not l i k e p r i v a t e s e c t o r ones. F i r s t , some s e r v i c e s are not a l l o c a b l e t o i n d i v i d u a l r e c i p i e n t s ; t h e r e f o r e , b e n e f i t cannot be e a s i l y t r a c k e d . Second, government accepts a r o l e as r e - d i s t r i b u t o r i n the economy. While the b e n e f i t approach i s c l e a r l y a p p r o p r i a t e f o r some forms o f t a x a t i o n , i t i s not so f o r income t a x a t i o n . U t i l i t y T h i s approach i s an a l t e r n a t i v e way of l o o k i n g a t a b i l i t y t o pay; i t i d e n t i f i e s and measures equal l e v e l s o f u t i l i t y . As such, i t can be used b e f o r e the f a c t (ex a n t e ) , r a t h e r than a f t e r the f a c t ( e x p o s t ) . The u t i l i t y approach encompasses consumption of goods and s e r v i c e s as w e l l as l e i s u r e and job s a t i s f a c t i o n . The o b j e c t i v e i s t o pr e s e r v e the u t i l i t y o r d e r i n g o f i n d i v i d u a l s under t a x a t i o n . T h i s approach i s not v a l i d i n the c o r p o r a t e case because c o r p o r a t i o n s do not have h o l i d a y s o r job s a t i s f a c t i o n , i . e . no u t i l i t y f u n c t i o n s . E f f i c i e n c y In the absence of d i s t o r t i o n s , the market f o r c e s o f supply and - 3 2 -Theory of Ta x a t i o n C h a p t e r Two demand a l l o c a t e r e s o u r c e s t o t h e i r b e s t u s e . The i m p o s i t i o n o f a t a x h a s a n i m p a c t on t h e e q u i l i b r i u m p r o c e s s , w i t h t h e r e s u l t t h a t l e s s o u t p u t t e n d s t o be p r o d u c e d a n d s o l d . The more e l a s t i c t h e demand a n d s u p p l y a r e , t h e g r e a t e r w i l l be t h e d r o p i n t h e e q u i l i b r i u m o u t p u t . The g r e a t e r t h e d r o p , t h e more i n e f f i c i e n t t h e t a x . Any t a x w i l l , t h e r e f o r e , be i n e f f i c i e n t . G i v e n t h a t t a x e s a r e a f a c t o f l i f e ; i d e a l l y , t h e y s h o u l d be l e v i e d w h ere t h e y w i l l h a v e t h e l e a s t d i s t o r t i o n a r y e f f e c t , i . e . on i n e l a s t i c m a r k e t s . The T ax B a s e As i n d i c a t e d i n t h e a b i l i t y t o p a y d i s c u s s i o n , t h e b a s e s a v a i l a b l e i n c l u d e c o n s u m p t i o n , w e a l t h a n d i n c o m e . A l l t h r e e a t t e m p t t o a c t a s a s u r r o g a t e f o r e c o n o m i c power. C o n s u m p t i o n C o n s u m p t i o n h a s c e r t a i n a d v a n t a g e s o v e r i n c o m e a s a b a s e . F i r s t , i t i s more e q u i t a b l e b e c a u s e c o n s u m p t i o n i s more c l o s e l y l i n k e d t o u t i l i t y t h a n i s i n c o m e . S e c o n d , c o n s u m p t i o n d o e s n o t t a x s a v i n g s . T h i r d , i t d o e s n o t r e q u i r e a d j u s t m e n t s i n t h e t a x s y s t e m f o r i n f l a t i o n . I t s u f f e r s , h o w e v e r , f r o m t h e same w e a k n e s s e s a s t h e i n c o m e b a s e d o e s b e c a u s e l e i s u r e a n d n o n - m a r k e t a c t i v i t y a r e n o t i n c l u d e d . The c o n s u m p t i o n b a s e i s e n j o y i n g some c u r r e n t p o p u l a r i t y a s a v i a b l e a l t e r n a t i v e . A c o n s u m p t i o n - b a s e d t a x w o u l d i n c r e a s e t h e b u r d e n o n t h e y o u n g a n d t h e o l d , who t y p i c a l l y s p e n d more t h a n t h e y e a r n . W i t h t h e a s s u m p t i o n t h a t l i f e - t i m e e a r n i n g s e q u a l l i f e - t i m e c o n s u m p t i o n , no n e t c h a n g e i n t a x b a s e i s a c h i e v e d — - 3 3 -T h e o r y o f T a x a t i o n C h a p t e r Two o n l y t h e t i m i n g o f t a x a b i l i t y i s c h a n g e d . W e a l t h L i t t l e t h o u g h t i s g i v e n t o p r a c t i c a l l y i n t r o d u c i n g a w e a l t h t a x . The d i f f i c u l t y o f v a l u i n g a s s e t s o n an a c c r u a l b a s i s p r e c l u d e s t h i s a s a w o r k a b l e b a s e . Income The i n c o m e b a s e , t h o u g h c h o s e n b y m o s t e c o n o m i e s , s u f f e r s f r o m d e f i n i t i o n a l d i f f i c u l t i e s . I n t h e o r e t i c a l t e r m s , i n c o m e h a s b e e n d e f i n e d a s : "The v a l u e _ o f t h e n e t a c c r e t i o n o f e c o n o m i c power o v e r t i m e " ; o r "The v a l u e o f c o n s u m p t i o n p l u s t h e c h a n g e i n t h e v a l u e o f p r o p e r t y b e t w e e n t h e b e g i n n i n g a n d t h e e n d o f a g i v e n p e r i o d o f t i m e " . S i m p l y r e - s t a t e d , i n c o m e i s c o n s u m p t i o n p l u s c h a n g e s i n n e t w e a l t h , m e a s u r e d i n d o l l a r t e r m s . P r a c t i c a l l y , i t i s d i f f i c u l t t o m e a s u r e a n n u a l c o n s u m p t i o n a n d t o v a l u e a s s e t s on an a c c r u a l b a s i s . I n p r a c t i c a l t e r m s , t h e ACT h a s n o t a t t e m p t e d t o c l e a r l y d e f i n e " i n c o m e " ; r a t h e r , i t i s d e f i n e d b y a l o n g l i s t o f i n c l u s i o n s a n d e x c l u s i o n s . The o n l y a p p a r e n t g e n e r a l i z a t i o n s t h a t c a n be made a r e : 1. T a x a t i o n i s b a s e d on r e a l i z a t i o n r a t h e r t h a n a c c r u a l . 2. M a r k e t t r a n s a c t i o n s a r e r e q u i r e d t o t r i g g e r r e a l i z a t i o n . 3. N o n - r e c u r r i n g o r i r r e g u l a r s o u r c e s a r e e x c l u d e d . B a s e d on t h e s e g u i d e l i n e s , t a x a t i o n i s a v o i d e d on l o t t e r y - 3 4-T h e o r y o f T a x a t i o n C h a p t e r Two w i n n i n g s , g i f t s a n d b e q u e s t s , i m p u t e d v a l u e o f h o m e - p r o d u c e d g o o d s a n d s e r v i c e s , g o v e r n m e n t a s s i s t a n c e p a y m e n t s a n d c a p i t a l g a i n s ( u n t i l 1972 when g a i n s became p a r t i a l l y t a x a b l e ) . The C a r t e r R e p o r t o p t e d f o r a " c o m p r e h e n s i v e i n c o m e " t a x b a s e , o v e r t h e c o n s u m p t i o n o r w e a l t h b a s e s . "We a r e c o m p l e t e l y p e r s u a d e d t h a t t a x e s s h o u l d be a l l o c a t e d a c c o r d i n g t o t h e c h a n g e s i n e c o n o m i c power o f i n d i v i d u a l s a n d f a m i l i e s . I f a man o b t a i n s i n c r e a s e d command o v e r g o o d s a n d s e r v i c e s f o r h i s p e r s o n a l s a t i s f a c t i o n we do n o t b e l i e v e i t m a t t e r s , f r o m t h e p o i n t o f v i e w o f t a x a t i o n , w h e t h e r he e a r n e d i t t h r o u g h w o r k i n g , g a i n e d i t t h r o u g h o p e r a t i n g a b u s i n e s s , r e c e i v e d i t b e c a u s e he h e l d p r o p e r t y , made i t b y s e l l i n g p r o p e r t y o r was g i v e n i t b y a r e l a t i v e . N o r do we b e l i e v e i t m a t t e r s w h e t h e r t h e i n c r e a s e d command o v e r g o o d s and s e r v i c e s was i n c a s h o r i n k i n d . N o r do we b e l i e v e i t m a t t e r s w h e t h e r t h e i n c r e a s e i n e c o n o m i c power was e x p e c t e d o r u n e x p e c t e d , w h e t h e r i t was a u n i q u e o r r e c u r r e n t e v e n t , w h e t h e r t h e man s u f f e r e d t o g e t t h e i n c r e a s e g i n e c o n o m i c power o r i t f e l l i n h i s l a p w i t h o u t e f f o r t . " N e e d l e s s t o s a y , t h e c o m p r e h e n s i v e a p p r o a c h a d v o c a t e d b y t h e C a r t e r C o m m i s s i o n d i d n o t f u l l y f i n d i t s way i n t o t h e l a w . H o w e v e r , a m o d i f i e d d e s c r i p t i o n o f i n c o m e r e m a i n s t h e t a x b a s e i n C a n a d a a n d m o s t o t h e r c o u n t r i e s t o d a y . The Tax R a t e s "Tax r a t e s t a k e i n t o a c c o u n t t h e r e l a t i o n s h i p b e t w e e n c h a n g e s i n i n c o m e a n d c h a n g e s i n e c o n o m i c power no-| n a l r e a d y a c c o u n t e d f o r b y a d j u s t m e n t s t o t h e b a s e . " Tax r a t e s t r u c t u r e s a r e s e t t o be e i t h e r p r o g r e s s i v e , p r o p o r t i o n a l o r r e g r e s s i v e . PROGRESSIVE - The r a t i o o f t o t a l t a x e s t o t a x a b l e i n c o m e ( i . e . t h e a v e r a g e t a x r a t e ) i n c r e a s e s a s t a x a b l e i n c o m e r i s e s - 3 5 -T h e o r y o f T a x a t i o n Chapter Two PROPORTIONAL - The above r a t i o i s constant f o r a l l l e v e l s of t a x a b l e income REGRESSIVE - The above r a t i o decreases as t a x a b l e income r i s e s The p r o g r e s s i v e and r e g r e s s i v e s t r u c t u r e s may both have i n c r e a s i n g or d e c r e a s i n g marginal r a t e s ; however, w i t h the former, the marginal r a t e i s always g r e a t e r than the c o r r e s p o n d i n g average r a t e , and v i c e v e r s a f o r the l a t t e r . Average and marginal tax r a t e s are equal and constant i n a p r o p o r t i o n a l r a t e s t r u c t u r e . The s e l e c t i o n of a tax s t r u c t u r e does not determine " p r o g r e s s i v i t y " as i t i s commonly r e f e r r e d t o . There i s a d i f f e r e n c e between p r o g r e s s i v e tax r a t e s and a 11 p r o g r e s s i v e tax. The s e l e c t i o n of a r a t e s t r u c t u r e begs the q u e s t i o n s o f v e r t i c a l e q u i t y , e f f i c i e n c y , r e d i s t r i b u t i o n and revenue needs. The i s s u e of i n c r e a s i n g or d e c r e a s i n g marginal r a t e s w i t h i n a g i v e n r a t e s t r u c t u r e i s a l s o important. The optimum r a t e s t r u c t u r e depends on the number of t a x p a y i n g u n i t s w i t h i n each r a t e b r a c k e t . "As a g e n e r a l r u l e , the g r e a t e r the number of persons i n any given b r a c k e t , the lower should be the m a r g i n a l tax r a t e ( f o r e f f i c i e n c y reasons) and the g r e a t e r the number of persons i n h i g h e r b r a c k e t s , the h i g h e r should b e ^ h e marginal tax r a t e ( f o r r e d i s t r i b u t i o n r e a s o n s ) " . A l s o , f o r e f f i c i e n c y reasons, h i g h e r income b r a c k e t s should have lower marginal r a t e s , t o s t i m u l a t e income-earning a c t i v i t i e s , and thus, generate tax revenue. However, p o l i t i c a l l y , t h i s i s not a t t r a c t i v e , even i f the e x t r a revenue i s r e d i s t r i b u t e d i n some othe r f a s h i o n . -36-Theory of T a x a t i o n Chapter Two For a combination of reasons, p r o g r e s s i v e r a t e s t r u c t u r e s are most common. What tends t o vary from country t o country i s the l e v e l o f the top marg i n a l r a t e . P r o g r e s s i v e s t r u c t u r e s w i t h high m a r g i n a l r a t e s tend to discourage r i s k y investment and inc r e m e n t a l e f f o r t . A l s o , more e f f o r t i s c h a n n e l l e d i n t o tax m i n i m i z a t i o n schemes, l i k e income s p l i t t i n g , s h e l l c o r p o r a t i o n s and tax expe n d i t u r e s . I t i s s a i d t h a t a p r o g r e s s i v e income tax i s needed t o o f f s e t the i n h e r e n t r e g r e s s i v i t y i n other forms o f t a x a t i o n . P o l i t i c a l l y , a p r o g r e s s i v e system i s more t e n a b l e , based on the d i s t r i b u t i o n o f e l e c t o r s ' votes i n the v a r i o u s income c l a s s e s . "The most common j u s t i f i c a t i o n f o r p r o g r e s s i v e t a x a t i o n i s based on the p r i n c i p l e o f a b i l i t y to pay. S o c i e t y simply assumes t h a t economic power i n c r e a s e s more r a p i d l y than income; t h e r e f o r e taxes l e v i e d i n p r o p o r t i o n t o a b i l i t y t o tD^y w i l l y i e l d p r o g r e s s i v e r a t e s i n r e l a t i o n t o income." Incidence o f Corporate Income Tax The study o f tax i n c i d e n c e attempts t o a s c e r t a i n who u l t i m a t e l y bears the burden of any tax. The payer o f the tax i s not n e c e s s a r i l y the one who s a c r i f i c e s , because the tax may be s u c c e s s f u l l y s h i f t e d elsewhere. Corporate taxes have been popular s u b j e c t s f o r r e s e a r c h on i n c i d e n c e because o f the b e l i e f t h a t c o r p o r a t i o n s are not b a s i c u n i t s i n the economic s t r u c t u r e . They are separate t a x a b l e u n i t s , granted, but behind them stand t h e i r s h a r e h o l d e r s . One c o n c l u s i o n i s c e r t a i n r e g a r d i n g the i n c i d e n c e o f c o r p o r a t e t a x e s — i t f a l l s somewhere e l s e . The l o g i c a l c h o i c e s a r e : - 3 7 -Theory o f Taxa t i o n Chapter Two 1. S h i f t e d forward t o output p r i c e s and, t h e r e f o r e , consumers; 2. S h i f t e d backward t o i n p u t f a c t o r s , l i k e labour; and 3. S h i f t e d side-ways t o c a p i t a l and, t h e r e f o r e , s h a r e h o l d e r s . In a l l cases, the b e a r e r of the tax u l t i m a t e l y i s an i n d i v i d u a l , but the p a r t i c u l a r i n d i v i d u a l i s u n l i k e l y to be the same i n a l l t h r e e cases. "One s i g n i f i c a n t aspect of the c o r p o r a t i o n income tax i s i t s p o s s i b l e r e s t r i c t i v e i n f l u e n c e on the volume o f c a p i t a l employed, thereby a f f e c t i n g economic e f f i c i e n c y " . The i m p o s i t i o n o f c o r p o r a t e taxes w i l l d i v e r t c a p i t a l from the c o r p o r a t e s e c t o r to the non-corporate s e c t o r , w i t h a r e s u l t i n g dead l o s s of p r o d u c t i v i t y . The i n c i d e n c e o f c o r p o r a t e t a x a t i o n a l s o a f f e c t s e q u i t y i f one s u b s c r i b e s t o the concept of the c o r p o r a t i o n as a " c o n d u i t " . The double t a x a t i o n of c o r p o r a t e - s o u r c e income i n a l l c o u n t r i e s i s a v i o l a t i o n o f both h o r i z o n t a l and v e r t i c a l e q u i t y . In a m o n o p o l i s t i c s e t t i n g with a c o r p o r a t e tax on pure p r o f i t s , the tax i s e s s e n t i a l l y another f i x e d c o s t . I t w i l l n e i t h e r change output p r i c e nor a f f e c t labour i n p u t s . In a s e t t i n g o f p e r f e c t c o m p e t i t i o n , c o r p o r a t e taxes are seen to r a i s e the average c o s t curve, r e s u l t i n g u l t i m a t e l y i n lower output and h i g h e r p r i c e s . N e i t h e r a p r i o r i r e a s o n i n g nor e m p i r i c a l r e s e a r c h has p r o v i d e d c o n c l u s i v e evidence on the s u b j e c t of c o r p o r a t e tax i n c i d e n c e . M 15 Krzyzaniak and R Musgrave concluded t h a t the U.S. c o r p o r a t e tax -38-Theory o f T a x a t i o n Chapter Two was s h i f t e d by more than one hundred p e r c e n t i n the form of h i g h e r b e f o r e - t a x p r o f i t s . I t was not determined whether the s h i f t i n g was forward, backward, or a combination o f both. B 16 Spencer used a s i m i l a r methodology i n the Canadian s e t t i n g and a s c e r t a i n e d a f u l l one hundred p e r c e n t s h i f t . R Dusansky and J 17 Tanner concluded t h a t the c o r p o r a t e tax was s h i f t e d s e v e n t y - f i v e percent i n the Canadian manufacturing i n d u s t r y . R 18 Levesque produced a study f o r the C a r t e r Commission which suggested one hundred percent s h i f t i n g . D e t a i l e d review of these and other s t u d i e s i s beyond the scope and purpose of t h i s t h e s i s . The u n l i k e l i h o o d of f i n d i n g a d e f i n i t i v e r e s u l t has discouraged major r e s e a r c h i n the l a s t decade. I t i s t h i s u n c e r t a i n t y t h a t causes many people to d i s l i k e the c o r p o r a t e tax. However, i t has been a f a c i l e and good revenue producer f o r governments and, p o l i t i c a l l y , c o r p o r a t i o n s do not v o t e ! I n t e g r a t i o n and the Corporate Income Tax Corporate income t a x a t i o n i s u n i v e r s a l i n developed economies. There i s not, however, a u n i v e r s a l approach as to how the c o r p o r a t e tax f i t s i n t o the o v e r a l l tax regime. The a l t e r n a t i v e approaches are: 1. A s i n g l e l e v e l of tax: a) On the c o r p o r a t i o n o n l y - Dividends are f r e e o f p e r s o n a l t a x a t i o n . T h i s was the system a t i n c e p t i o n i n 1917. I t s e r i o u s l y c o n f l i c t s w i t h the e q u i t y c r i t e r i o n and i s t h e r e f o r e not very p o p u l a r ; -39-Theory o f T a x a t i o n C h a p t e r Two b) On t h e i n d i v i d u a l o n l y - No c o r p o r a t e t a x w o u l d e x i s t . H e r e , o n l y d i s t r i b u t i o n s w o u l d be t a x e d . The s i g n i f i c a n t t a x d e f e r r a l o n r e t a i n e d e a r n i n g s makes t h i s a p p r o a c h u n p o p u l a r ; o r c) On e a c h - The c o r p o r a t i o n i s a l l o w e d a t a x d e d u c t i o n , a s f o r i n t e r e s t , when d i v i d e n d s a r e p a i d . T h u s , t h e s h a r e h o l d e r s p a y t a x o n d i s t r i b u t e d i n c o m e a n d t h e c o r p o r a t i o n p a y s t a x o n r e t a i n e d e a r n i n g s . An i s s u e a r i s e s when r e t a i n e d e a r n i n g s a r e s u b s e q u e n t l y d i s t r i b u t e d . T h i s i s t h e s o - c a l l e d " d i v i d e n d - p a i d d e d u c t i o n " s y s t e m . 2. Two l e v e l s o f t a x : a) W i t h o u t r e l i e f - T h i s i s t h e s o - c a l l e d " c l a s s i c a l " s y s t e m . I t r e p u d i a t e s t h e c o n d u i t c o n c e p t o f t h e c o r p o r a t i o n a n d t a x e s c o r p o r a t e i n c o m e a t s o u r c e a n d d i s t r i b u t e d i n c o m e a g a i n s t t h e s h a r e h o l d e r . T h u s , r e t a i n e d e a r n i n g s d e f e r t h e s e c o n d l e v e l o f t a x a t i o n . b) W i t h r e l i e f - R e l i e f may come i n two f o r m s : i ) I m p u t a t i o n s y s t e m - A l l o r p a r t o f t h e c o r p o r a t e t a x i s t r e a t e d a s a w i t h - h o l d i n g t a x a g a i n s t t a x a t i o n o f d i s t r i b u t i o n s t o t h e s h a r e h o l d e r s . i i ) S p l i t - r a t e s y s t e m - D i f f e r e n t r a t e s o f c o r p o r a t e t a x a r e a p p l i e d a g a i n s t d i s t r i b u t e d a n d r e t a i n e d p r o f i t s . The s h a r e h o l d e r p a y s p e r s o n a l t a x o n t h e l o w e r - t a x e d d i s t r i b u t e d i n c o m e . - 4 0 -T h e o r y o f T a x a t i o n Chapter Two With both the s p l i t - r a t e and imputation systems, r e l i e f from double t a x a t i o n o n l y a p p l i e s to d i s t r i b u t e d income. Retained income bears a h i g h e r t a x . "More f a r - r e a c h i n g than the schemes f o r d i v i d e n d r e l i e f ... i s t r u e i n t e g r a t i o n . Under i n t e g r a t i o n the income earned a t the c o r p o r a t e l e v e l , whether d i s t r i b u t e d or not, would be a t t r i b u t e d t o s h a r e h o l d e r s , as i n a p a r t n e r s h i p , and taxed only a t the r a t e s a p p l i c a b l e to the incomes of the v a r i o u s s h a r e h o l d e r s . Advocates of t h i s approach p o i n t out t h a t d i v i d e n d r e l i e f i s d e f e c t i v e because i t p r o v i d e s i n t e g r a t i o n f o r o n l y t h a t p o r t i o n of c o r p o r a t e income t h a t i s d i s t r i b u t e d , whereas a major source of i n e q u i t y and d i s t o r t i o n i n the ... tax system i s the i n t e r p l a y of the c o r p o r a t e income tax and the p r o v i s i o n s of the p e r s o n a l income tax law ... once ... the c o r p o r a t e tax i s p a i d , h i g h income taxpayers can l e t earnings accumulate a^d produce p r e f e r e n t i a l l y taxed long term c a p i t a l g a i n s . " Thus, the d i f f e r e n c e between " d i v i d e n d r e l i e f " and "true i n t e g r a t i o n " must be noted. The former a p p l i e s o n l y to the d i s t r i b u t e d p o r t i o n of c o r p o r a t e e a r n i n g s . The i n t e n t of i n t e g r a t i o n , then, i s t h a t c o r p o r a t e - s o u r c e income should bear tax as earned i n the c o r p o r a t i o n (and r e g a r d l e s s of a c t u a l d i s t r i b u t i o n ) a t c o r p o r a t e r a t e s e q u i v a l e n t to p e r s o n a l m a r g i n a l r a t e s . T h i s approach would remove any n o n - n e u t r a l i t y c r e a t e d by the c o r p o r a t e g u i s e . The p r a c t i c a l d i f f i c u l t i e s o f t h i s system are enormous—income would have to be a l l o c a t e d as earned. With ownership changing hands d a i l y f o r p u b l i c c o r p o r a t i o n s , t h i s a l l o c a t i o n i s e s s e n t i a l l y i m p o s s i b l e . " I n t e g r a t i o n " i n popular a p p l i c a t i o n does not r e f e r t o t h i s " t r u e " i n t e g r a t i o n , but r a t h e r t o i n t e g r a t i o n of d i s t r i b u t e d income. While t h i s i s p r o p e r l y termed " p a r t i a l " i n t e g r a t i o n , the l i t e r a t u r e u s u a l l y r e f e r s to i t as " i n t e g r a t i o n " . -41-Theory of Taxation Chapter Two A system o f gross-up and c r e d i t i s used t o achieve i n t e g r a t i o n . Assuming a f i f t y p e r c e n t c o r p o r a t e tax r a t e , a gross-up and c r e d i t o f one hundred pe r c e n t o f the cash d i v i d e n d r e c e i v e d would succeed i n a c h i e v i n g i n t e g r a t i o n . Two e x t r a p r o v i s i o n s are needed to secure the l o g i c o f i n t e g r a t i o n : 1. Where the p e r s o n a l tax l i a b i l i t y i s l e s s than the c r e d i t , a r e fund should accrue t o the i n d i v i d u a l ; and 2. The c r e d i t f o r co r p o r a t e tax should r e f l e c t a c t u a l c o r p o r a t e tax p a i d ( " c r e d i t a b l e c o r p o r a t e t a x " ) . The l o g i c would break down i f an i n d i v i d u a l w i t h a lower p e r s o n a l tax r a t e c o u l d not r e c e i v e a refund, as determined by the d i f f e r e n c e between h i s tax r a t e and the c o r p o r a t i o n ' s f i f t y p e r c e n t r a t e . The l o g i c a l s o breaks down when there are d i f f e r e n c e s between acc o u n t i n g income and t a x a b l e income. Dividends are p a i d from a f t e r - t a x e a r n i n g s , based on acc o u n t i n g income. However, the tax payable i s c a l c u l a t e d from t a x a b l e income. Th e r e f o r e , i n d i v i d u a l s c o u l d c l a i m c o r p o r a t e tax c r e d i t s where no c o r p o r a t e tax was p a i d . The i n t e g r a t i o n system needs a method of t r a c k i n g the a c t u a l c o r p o r a t e tax p a i d and re d u c i n g the p e r s o n a l tax c r e d i t when necessary. A l s o , the a c t u a l c o r p o r a t e r a t e may d i f f e r due to other p r o v i s i o n s i n the Act, l i k e manufacturing and p r o c e s s i n g r a t e s and s m a l l business r a t e s . The l a t t e r can be allowed f o r by changing the amount of the gross-up and c r e d i t . L a s t l y , the f a c t t h a t the Act p r o v i d e s revenue f o r both p r o v i n c i a l and f e d e r a l f i s c s causes problems. The f e d e r a l f i s c g r a n t s a t e n pe r c e n t abatement on b e h a l f o f the p r o v i n c e s . Each p r o v i n c e l e v i e s i t s own r a t e . When the p r o v i n c i a l r a t e i s -42-Theory of Taxa t i o n Chapter Two d i f f e r e n t from the abated r a t e , the i n t e g r a t i o n scheme i s again thwarted. S i m p l i f i c a t i o n The need f o r s i m p l i f i c a t i o n of the A c t , p a r t i c u l a r l y p e r t a i n i n g to the s m a l l b u s i n e s s p r o v i s i o n s , has r e c e i v e d much a t t e n t i o n of 20 l a t e i n Canada. Couzin recommends t h a t s i m p l i f i c a t i o n be t r e a t e d l i k e other competing i n t e r e s t s i n d e v e l o p i n g tax p o l i c y , e.g. e q u i t y and e f f i c i e n c y . I t should be c o n s i d e r e d whenever new l e g i s l a t i o n i s d r a f t e d , and not j u s t p e r i o d i c a l l y when the weight o f the Act becomes a concern. "The commonly c i t e d 'causes o f complexity' are r e a l l y competing o b j e c t i v e s of the tax2^ystem r a t h e r than d i r e c t impediments t o s i m p l i f i c a t i o n " . "I suggest t h a t there i s no a p r i o r i c o n f l i c t between, f o r example, e q u i t y and s i m p l i f i c a t i o n ... To the extent t h a t these f o r c e s may p r e s s i n opposing d i r e c t i o n s , one i n h i b i t s the o t h e r . But the system i s the r e s u l t of ^ e i r t e n s i o n . No one g o a l completely excludes any o t h e r " . "Tax s i m p l i f i c a t i o n should form p a r t of the tax p o l i c y o b j e c t i v e s t h a t are the b a s i s jjcjr the f o r m u l a t i o n and reform o f the Income Tax A c t " . In s h o r t , s i m p l i f i c a t i o n i s not a simple o b j e c t i v e . I t means d i f f e r e n t t h i n g s t o d i f f e r e n t people, e.g. taxpayers, the Courts of Law, policy-makers, tax p r a c t i t i o n e r s and tax a d m i n i s t r a t o r s . The system t h a t e v o l v e d i n 1971 was not simple from the o u t s e t . Subsequent t i n k e r i n g has made i t worse i n s t e a d o f b e t t e r . Part o f the f a u l t l i e s with the policy-makers' d r i v e t o make the Act a i r t i g h t . T h i s i s not an a t t a i n a b l e g o a l . The p l u g g i n g o f minor l o o p - h o l e s only s p r i n g s l e a k s elsewhere. I t i s s i m p l i f i c a t i o n t h a t i s s a c r i f i c e d by i t e r a t i v e h o l e - p l u g g i n g . Instead, - 4 3 -Theory o f T a x a t i o n C h a p t e r Two p o l i c y - m a k e r s s h o u l d a s s e s s t h e c o s t o f c o m p l e x i t y f o r a l l t a x p a y e r s a g a i n s t t h e b e n e f i t o f c l o s i n g down a few. U n l e s s t h e r e v e n u e l o s s i s s i g n i f i c a n t o r e q u i t y i s b a d l y e r o d e d , h o l e - p l u g g i n g s h o u l d be r e s i s t e d . I t s t r u e a i m i s u s u a l l y p o l i t i c a l . The p e n d u l u m h a p p i l y swung t h e o t h e r d i r e c t i o n , i n t w o s e n s e s , i n t h e B u d g e t o f F e b r u a r y 1984. The n e e d t o m e a s u r e t h e " c u m u l a t i v e d e d u c t i o n a c c o u n t " , f o r p u r p o s e s o f e n j o y i n g t h e s m a l l b u s i n e s s r a t e , was r e m o v e d . T h i s m a r k e d a r e t u r n t o t h e s y s t e m a s i t was b e f o r e 1972, w h i c h means t h a t a l l b u s i n e s s e s c a n e n j o y t h e l o w r a t e a n n u a l l y up t o $200,000 o f t a x a b l e i n c o m e . T h e r e r e s u l t s a s a c r i f i c e o f v e r t i c a l e q u i t y i n t h e name o f s i m p l i c i t y . I t i s q u e s t i o n a b l e j u s t how much t h i s one p r o v i s i o n w i l l s i m p l i f y a s m a l l b u s i n e s s ' s t a x c a l c u l a t i o n s ; h o w e v e r , i t i s a s t e p i n t h e r i g h t d i r e c t i o n . The r e v e n u e l o s t t o b i g b u s i n e s s c o u l d a p p r o a c h 24 $468 m i l l i o n . I f t h i s r e v e n u e m u s t be r e g a i n e d t h r o u g h h i g h e r r a t e s , t h e s a v i n g s i n s m a l l b u s i n e s s p r o f e s s i o n a l f e e s may be q u i c k l y l o s t . I n c o n c l u s i o n , s i m p l i f i c a t i o n m u s t be a d d r e s s e d i n a n y o v e r h a u l o f t h e s m a l l b u s i n e s s t a x s y s t e m . I t s h o u l d r e c e i v e o n l y i t s f a i r w e i g h t , h o w e v e r , a n d n o t become t h e g u i d i n g l i g h t f o r t h e n e x t few y e a r s o f l e g i s l a t i o n . - 4 4 -T h e o r y o f T a x a t i o n C h a p t e r Two Summary I n summary, t h e t h e o r e t i c a l a s p e c t s o f t a x a t i o n p r o v i d e some g u i d e l i n e s f o r r e f o r m : 1. S h o r t o f a r e v e r s a l o f d i r e c t i o n , t h e g o v e r n m e n t f i s c w i l l c o n t i n u e t o n e e d l a r g e r e v e n u e s t o s u p p o r t i t s e x p e n d i t u r e s i d e . T h i s means t h a t t h e r e v e n u e s w i l l h a v e t o be e x t r a c t e d i n some f a s h i o n f r o m someone. The c o r p o r a t e t a x w i l l l i k e l y r e m a i n a f a v o u r i t e . 2. The e q u i t y a n d t a x b a s e i s s u e s a r e c o n f u s e d due t o t h e i n t e r m e d i a r y r o l e o f c o r p o r a t i o n s . One m u s t f i r s t e s t a b l i s h t h e a p p r o a c h t o c o r p o r a t e i n t e g r a t i o n . 3. Tax r a t e s a r e l i k e l y t o be p r o g r e s s i v e , w h a t e v e r b a s e i s c h o s e n . As m e n t i o n e d e a r l i e r , t h i s i s p o l i t i c a l l y a t t r a c t i v e a n d may i n d e e d c o u n t e r - a c t t h e r e g r e s s i v i t y o f o t h e r t a x e s . 4. T h e r e i s a g r o w i n g r e a l i z a t i o n b y g o v e r n m e n t s t h a t t h e t o p m a r g i n a l r a t e s s h o u l d n o t e x c e e d f i f t y t o s i x t y p e r c e n t . The d i s i n c e n t i v e t o e f f o r t becomes t o o g r e a t b e y o n d t h i s . 5. W h i l e t h e i n c i d e n c e i s s u e i s i m p o r t a n t , i t i s u n l i k e l y t o be s o l v e d . T h i s u n c e r t a i n t y c r e a t e s a t e n u o u s b a s i s f o r c o r p o r a t e t a x a t i o n , b u t t h e s i l e n t v i c t i m d o e s n o t h a v e t h e e l e c t o r a l f r a n c h i s e t o p r o t e s t . 6 . A l l a p p r o a c h e s t o c o r p o r a t e i n t e g r a t i o n h a v e b e e n t r i e d somewhere, w i t h t h e e x c e p t i o n o f t r u e i n t e g r a t i o n . A p u r e a n d p e r f e c t s y s t e m i s p r o b a b l y n o t a t t a i n a b l e . I n s t e a d , a n o r d e r i n g o f t r a d e - o f f s m u s t be made. - 4 5 -T h e o r y o f T a x a t i o n C h a p t e r Two 7. The n o n - r e v e n u e o b j e c t i v e s o f g o v e r n m e n t p e r m a n e n t l y p r e c l u d e t h e A c t f r o m h a v i n g c e r t a i n d e s i r a b l e c h a r a c t e r i s t i c s , l i k e p r e d i c t a b i l i t y . 8. S i m p l i f i c a t i o n i s r e a l l y t h e p r o c e s s o f r e s t o r i n g s i m p l i c i t y — a c h a r a c t e r i s t i c d e s c r i b e d a t t h e b e g i n n i n g o f t h i s c h a p t e r . S i m p l i f i c a t i o n i s n e e d e d t o d a y b e c a u s e s i m p l i c i t y was i g n o r e d f o r y e a r s . - 4 6 -T h e o r y o f T a x a t i o n C h a p t e r Two FOOTNOTES 1. I n c l u d e s p e r s o n a l a n d c o r p o r a t e t a x ; p r o p e r t y , s a l e s , s o c i a l i n s u r a n c e , f u e l , a l c o h o l a n d t o b a c c o a n d c u s t o m s t a x e s . 2. " C a n a d i a n Income Tax P o l i c y " , p g 4 3. " N a t i o n a l F i n a n c e s " , p g 43 4. I b i d , p g 45 5. I b i d , p g 45 6. " C a n a d i a n Income Tax f o r B u s i n e s s m e n and A c c o u n t a n t s " , L e o n a r d p g 15 7. " C a n a d i a n Income Tax P o l i c y " , p g 3 6 8. I b i d , p g 36 9. C a r t e r R e p o r t V o l I p g 9 10. " C a n a d i a n Income Tax P o l i c y " , 129 11. W i t h t h e l a t t e r , t h e r e l e v a n t s t a t i s t i c s a r e s t i l l a v e r a g e a n d m a r g i n a l t a x r a t e s ; h o w e v e r , t h e n u m e r a t o r i s n o t c a l c u l a t e d u s i n g t h e d e n o m i n a t o r a s a b a s e , e . g . p r o p e r t y t a x e s o r r e t a i l s a l e s t a x e s . 12. " C a n a d i a n Income Tax P o l i c y " , p g 13 2 13. I b i d , p g 137 14. "The S h i f t i n g o f t h e C o r p o r a t i o n Income T a x " , pg 4 15. "The S t u d y o f t h e C o r p o r a t i o n Income T a x : An E m p i r i c a l S t u d y o f i t s S h o r t - r u n E f f e c t u p o n t h e R a t e o f R e t u r n " , J o h n H o p k i n s P r e s s , B a l t i m o r e 1963 16. "The S h i f t i n g o f t h e C o r p o r a t i o n Income Tax i n C a n a d a " , C a n a d i a n J o u r n a l o f E c o n o m i c s , F e b r u a r y 1969 17. "The S h i f t i n g o f t h e P r o f i t s Tax i n C a n a d i a n M a n u f a c t u r i n g , 1 9 3 5 - 6 5 " , C a n a d i a n J o u r n a l o f E c o n o m i c s F e b r u a r y 1974 - 4 7 -T h e o r y o f T a x a t i o n C h a p t e r Two 18. "The S h i f t i n g o f t h e C o r p o r a t e Income Tax i n t h e S h o r t Run", S t u d i e s o f t h e R o y a l C o m m i s s i o n on T a x a t i o n , No. 18, O t t a w a Queen's P r i n t e r 1967 19. "Must C o r p o r a t e Income Be T a x e d T w i c e ? " , pg 3 20. "The P r o c e s s o f S i m p l i f i c a t i o n " , C a n a d i a n Tax J o u r n a l , M a y / J u n e 1984 p g 487 2 1 . I b i d , p g 494 22. I b i d , p g 495 23. I b i d , p g 500 24. B a s e d o n 1981 C o r p o r a t i o n S t a t i s t i c s : T a b l e I V -4 8 -T h e o r y o f T a x a t i o n C h a p t e r T h r e e HISTORICAL BACKGROUND " T a x a t i o n a n d r e p r e s e n t a t i o n a r e i n s e p a r a b l y u n i t e d . God h a t h j o i n e d them; no B r i t i s h p a r l i a m e n t c a n p u t them a s u n d e r . " E a r l Camden (1768) E a r l y H i s t o r y An i n c o m e t a x was e n a c t e d i n t h e U n i t e d K i n g d o m i n 1799 t o f i n a n c e w ar e f f o r t . Income t a x a t i o n h a s e x i s t e d c o n t i n u o u s l y i n t h e U n i t e d K i n g d o m s i n c e 1842. I n t h e U n i t e d S t a t e s , a s i m i l a r t a x was i m p o s e d a n d w i t h d r a w n i n t h e 1 8 6 0 ' s . I t was a p p a r e n t l y r u l e d u n c o n s t i t u t i o n a l u n t i l a c o n s t i t u t i o n a l amendment i n 1913. The "Income War Tax A c t " was i n t r o d u c e d i n C a n a d a i n 1917 a s a t e m p o r a r y m e a s u r e t o f i n a n c e t h e war e f f o r t . I t was m o d e l l e d a f t e r t h e U n i t e d S t a t e s , a s was t a x a t i o n o f f u e l , r e t a i l s a l e s a n d p r o p e r t y h o l d i n g s . C o n c e i v e d i n a h u r r y , t h e i n c o m e t a x s y s t e m s t u m b l e d t h r o u g h t h e d e c a d e o f t h e G r e a t D e p r e s s i o n a n d i n t o a n o t h e r w ar i n t h e 19 4 0 ' s . The p r o b l e m s o f t h e d a y s o u n d v e r y f a m i l i a r e v e n now: 1. The i s s u e o f g a i n v e r s u s i n c o m e , p a r t i c u l a r l y s i n c e g a i n was n o t t a x a b l e a t a l l t h e n ; 2. S u r p l u s s t r i p p i n g t o c o n v e r t t a x a b l e d i v i d e n d s i n t o u n t a x a b l e g a i n s ; 3. The a d m i n i s t r a t i o n o f " a s s o c i a t i o n " t e s t s t o p r e v e n t m u l t i p l e u s e o f p r e f e r e n t i a l t r e a t m e n t o f s m a l l b u s i n e s s ; a n d 4. D o u b l e t a x a t i o n o f c o r p o r a t e - s o u r c e i n c o m e . S u c c e s s i v e r o y a l c o m m i s s i o n s (The R o w e l l - S i r o i s C o m m i s s i o n i n 1940 a n d t h e I v e s C o m m i s s i o n i n 1945) i d e n t i f i e d t h e a m b i g u i t i e s - 4 9 -H i s t o r i c a l B a c k g r o u n d C h a p t e r T h r e e f r o m t h r e e d e c a d e s o f p a t c h - w o r k l e g i s l a t i o n . P r e s s u r e f o r r e f o r m was a n s w e r e d w i t h a c o m p l e t e l y r e v i s e d A c t i n 1949, t h e n more f a m i l i a r l y c a l l e d t h e "Income Tax A c t " . P r i n c i p a l c h a n g e s i n c l u d e d : 1. E s t a b l i s h m e n t o f t h e Tax A p p e a l B o a r d ; 2. More c l a r i f i c a t i o n o f p o l i c y a n d l e s s r e l i a n c e o n m i n i s t e r i a l d i s c r e t i o n , w h i c h h a d b e e n n e e d e d t o d e a l w i t h t h e " a s s o c i a t i o n " t e s t s ; 3. I n t r o d u c t i o n o f t h e c a p i t a l c o s t s y s t e m ; a n d 4. I n t r o d u c t i o n o f a t e n p e r c e n t d i v i d e n d t a x c r e d i t t o a l l e v i a t e d o u b l e t a x a t i o n . B a r e l y a d e c a d e p a s s e d b e f o r e t h e i n a d e q u a c i e s o f t h e s y s t e m b r o u g h t new c r i e s f o r r e f o r m . The p e r i o d f r o m S e p t e m b e r 1962 t o December 1971 saw a n o t h e r r o y a l c o m m i s s i o n e n q u i r y , a g o v e r n m e n t W h i t e P a p e r a n d , f i n a l l y , l e g i s l a t i o n i n t e n d e d t o t i e up a l l t h e l o o s e e n d s o n c e a g a i n . The C a r t e r C o m m i s s i o n T h i s r e v i e w t o o k f o u r y e a r s a n d was s u b m i t t e d t o t h e g o v e r n m e n t i n December 1966. The C o m m i s s i o n b e l i e v e d t h a t t h e s y s t e m e x t a n t h a d m a r k e d d e f i c i e n c i e s . The g o a l s o f e q u i t y , c e r t a i n t y , c l a r i t y a n d e f f i c i e n c y w e r e n o t b e i n g met. The r e a l i s s u e was f e l t t o be t h e u l t i m a t e w e i g h t o f t a x a t i o n on t h e i n d i v i d u a l t a x p a y e r . P r o g r e s s i v i t y was n o t b e i n g a t t a i n e d . To c o r r e c t t h i s , t h e C o m m i s s i o n f a v o u r e d t h e p e r s o n a l i n c o m e t a x f o r e q u i t a b l e t r e a t m e n t . T h e r e w o u l d be l e s s e m p h a s i s on t h e c o r p o r a t e t a x , w h i c h was v i e w e d a s o n l y a c o l l e c t i o n p o i n t f o r i n d i v i d u a l t a x e s . T h i s a p p r o a c h r e q u i r e d f u n d a m e n t a l r e a l i g n m e n t o f t h e s y s t e m : - 5 0 -H i s t o r i c a l B a c k g r o u n d C h a p t e r Three 1. The f a m i l y , n o t t h e i n d i v i d u a l , would be t h e t a x u n i t . 2. The t o p m a r g i n a l r a t e f o r i n d i v i d u a l s would be a p p r o x i m a t e l y f i f t y p e r c e n t . 3. The income base would be broadened t o encompass o t h e r s o u r c e s o f i n f l o w s , such as c a p i t a l g a i n s . 4. F u l l i n t e g r a t i o n w i t h c o r p o r a t e t a x e s would be a t t a i n e d w i t h a f i f t y p e r c e n t t o p m a r g i n a l r a t e and d i v i d e n d t a x c r e d i t s . The Commission f a v o u r e d a b o l i t i o n o f t h e p r e f e r e n t i a l t a x t r e a t m e n t f o r s m a l l b u s i n e s s . T h i s had been i n t r o d u c e d i n t h e r e f o r m budget o f 19 49, and l e v i e d a reduced r a t e o f t e n p e r c e n t on t h e f i r s t $10,000 o f t a x a b l e income and t h i r t y - t h r e e p e r c e n t beyond. Between 1949 and 1961 t h e r e were t h r e e a d j u s t m e n t s t o t h e r a t e s and t h r e s h o l d amount. I n 1961, t h e reduced r a t e was twenty-one p e r c e n t on t h e f i r s t $35,000 and f i f t y p e r c e n t beyond. The d i v i d e n d t a x c r e d i t i n 1949 was t e n p e r c e n t . To m a i n t a i n a l l e v i a t i o n from do u b l e t a x a t i o n , t h i s was bumped t o twenty p e r c e n t . The Commission f e l t t h a t t h e r e were a number o f problems w i t h t h i s system. F i r s t , i t d i d n o t c o n f e r any b e n e f i t s t o u n i n c o r p o r a t e d s m a l l b u s i n e s s e s who, presumably, f a c e d t h e same problems as t h e i r i n c o r p o r a t e d c o u s i n s . Second, t h e p r e f e r e n c e was n o t s p e c i f i c a l l y t a r g e t e d t o s m a l l b u s i n e s s . The reduced r a t e on i n i t i a l e a r n i n g s a p p l i e d t o a l l i n c o r p o r a t e d b u s i n e s s e s . F u r t h e r m o r e , t h e f a c t t h a t a company had a n n u a l income l e s s t h a n $35,000 d i d n o t i m p l y i n any way t h a t i t was owned by low income -51-H i s t o r i c a l Background Chapter Three s h a r e h o l d e r s , had few a s s e t s or low gross s a l e s , or was a new c o r p o r a t i o n . I f the argument f o r p r e f e r e n t i a l treatment of s m a l l b u s i n e s s was t o p r o v i d e a f i l l i p t o growth and success, t h i s was not the means. By a l l o w i n g the low r a t e i n p e r p e t u i t y , i t tended to c u s h i o n the i n e f f i c i e n t and d e c l i n i n g f i r m s from market p r e s s u r e s . I t a l s o p r o v i d e d no time l i m i t to induce expansion. The Commission noted t h a t the low r a t e was a v a i l a b l e i r r e s p e c t i v e of the u t i l i z a t i o n of the l e s s - t a x e d r e t a i n e d e a r n i n g s . The government's assumption had been t h a t these funds would be u t i l i z e d t o f i n a n c e b u s i n e s s expansion, not investment i n f i n a n c i a l instruments. Based on some s t a t i s t i c s t h a t the Commission gathered, i t concluded t h a t s m a l l b u s i n e s s e s were not u t i l i z i n g the p r e f e r e n t i a l r a t e . I t estimated t h e r e t o be 440,000 s m a l l b u s i n e s s e s i n Canada i n 1959 w i t h a s s e t s l e s s than $1,000,000. Most o f these were u n i n c o r p o r a t e d ventures w i t h a s s e t s l e s s than $100,000. In 1961, t h e r e were 97,355 c o r p o r a t i o n s w i t h a s s e t s l e s s than $1,000,000 and 52,136 c o r p o r a t i o n s w i t h a s s e t s l e s s than $100,000. Only a p o r t i o n o f these a c t u a l l y f i l e d r e t u r n s w i t h t a x a b l e income. The c o n c l u s i o n was t h a t the p r e f e r e n c e was not r e a c h i n g i t s t a r g e t e d group. From the beginning, a p r e f e r e n t i a l r a t e on i n i t i a l income encouraged businesses t o c r e a t e m u l t i p l e c o r p o r a t i o n s i n order to c r e a t e m u l t i p l e i n i t i a l incomes. From 19 49, the government c r e a t e d " a s s o c i a t i o n " t e s t s t o combat t h i s abuse. These were d i f f i c u l t t o a d m i n i s t e r , as the taxpayers' c r e a t i v i t y i n d e s i g n i n g c o r p o r a t e s t r u c t u r e s always seemed to be one step ahead -52-H i s t o r i c a l Background C h a p t e r Three o f a n t i - a v o i d a n c e l e g i s l a t i o n . The t e s t o f a s s o c i a t i o n between c o r p o r a t i o n s was i n i t i a l l y c o n c e i v e d t o be common de j u r e c o n t r o l . T h i s d i d n o t work from t h e s t a r t and was r e p l a c e d i n 1950 by a t e s t based on ownership o f a t l e a s t s e v e n t y p e r c e n t o f th e common s h a r e s o f t h e r e l e v a n t c o r p o r a t i o n s a t any ti m e i n t h e y e a r . T h i s was n o t e f f e c t i v e e i t h e r and t h e r e were numerous a t t e m p t s a t r e f i n e m e n t t h r o u g h t h e 1950's. I n 1960, de j u r e c o n t r o l was r e - e s t a b l i s h e d as t h e t e s t . I n 1963, t h e government found i t n e c e s s a r y t o p r o v i d e a " m i n i s t e r i a l d i s c r e t i o n " c l a u s e w h i c h a l l o w e d t h e M i n i s t e r o f N a t i o n a l Revenue t o deem a s s o c i a t i o n where t h e c o r p o r a t e s t r u c t u r e escaped t h e o t h e r t e s t s and where t h e s t r u c t u r e was d e s i g n e d s o l e l y t o b e a t t h e t e s t s , r a t h e r t h a n f o r good b u s i n e s s r e a s o n s . N a t u r a l l y , t h i s was not p o p u l a r l e g i s l a t i o n amongst t a x p a y e r s because i t p r o v i d e d an i n v i s i b l e l a s t l i n e o f defence a g a i n s t t a x p l a n n i n g . The Commission b e l i e v e d t h a t t h e i n g e n u i t y o f t h e t a x p a y e r would always confound any a s s o c i a t i o n t e s t s . The c o r p o r a t e t a x f a i l e d t o mesh w i t h t h e r e s t o f t h e A c t f o r a number o f r e a s o n s . The a f o r e - m e n t i o n e d problems w i t h t h e p r e f e r e n t i a l t a x r a t e were one r e a s o n . S e c o n d l y , d o u b l e t a x a t i o n o f c o r p o r a t e - s o u r c e income was a c o n c e r n . T h i s a r e a has been an i s s u e i n a l l modern economies. P r e v i o u s l e g i s l a t i o n had att e m p t e d t o i n t e g r a t e e a r n i n g s o f t h e i n d i v i d u a l w i t h t h e c o r p o r a t e c o n d u i t . The C a r t e r Commission wanted t h e i n t e g r a t i o n t o be complete and t h e r e f o r e a d v o c a t e d a d i v i d e n d t a x c r e d i t o f f i f t y p e r c e n t and a g r o s s - u p o f one hundred p e r c e n t . I t was i m p l i c i t i n a c h i e v i n g f u l l i n t e g r a t i o n t h a t t h e c o r p o r a t e t a x r a t e -53-H i s t o r i c a l Background C h a p t e r T h r e e a p p r o x i m a t e d t h e t o p m a r g i n a l r a t e f o r i n d i v i d u a l s . The C o m m i s s i o n w e n t s o f a r a s t o recommend a r e f u n d o f t a x e s t o l o w i n c o m e s h a r e h o l d e r s whose p e r s o n a l r a t e was l e s s t h a n t h e c o r p o r a t e r a t e . L a s t l y , t h e e x e m p t i o n o f c a p i t a l g a i n s f r o m t a x a t i o n g a v e way t o " s u r p l u s s t r i p p i n g " schemes. The o b j e c t i v e h e r e was f o r t h e i n d i v i d u a l t o e x c h a n g e t a x a b l e d i v i d e n d s f o r u n t a x a b l e c a p i t a l g a i n s . I n w h a t became a p o p u l a r s l o g a n , "A b u c k i s a b u c k " , t h e C o m m i s s i o n recommended a c o m p r e h e n s i v e d e f i n i t i o n o f i n c o m e , w h i c h i n c l u d e d f u l l t a x a t i o n o f c a p i t a l g a i n s . I n t o t a l , t h e C a r t e r C o m m i s s i o n p r o p o s a l s t h e o r e t i c a l l y w o u l d h a v e e l i m i n a t e d m o s t o f t h e p r o b l e m s e x t a n t i n t h e s y s t e m , i n c l u d i n g d o u b l e t a x a t i o n , s u r p l u s s t r i p p i n g a nd a s s o c i a t i o n t e s t s . I n t h e C o m m i t t e e ' s own w o r d s : " I t m e e t s more c l o s e l y t h a n a n y o t h e r a l t e r n a t i v e t h e o b j e c t i v e o f a c o m p r e h e n s i v e b a s e t a x e d a t g r a d u a t e d r a t e s , a n d p r o v i d e s a means o f c u r i n g t h e m o s t t r o u b l e s o m e o f t h e p r o b l e m s t h a t h a v e p l a g u e d t h e t a x a t i o n o f c o r p o r a t i o n s f o r h a l f a c e n t u r y . We b e l i e v e .. t h a t i t i s t h e b e s t s o l u t i o n t h a t c o u l d be p u t f o r w a r d . " The C o m m i s s i o n knew t h a t a t h e o r e t i c a l l y s o u n d t a x s y s t e m was n o t n e c e s s a r i l y a n a c c e p t a b l e t a x s y s t e m . S p e c i f i c a l l y , i t may n o t be p o l i t i c a l l y a c c e p t a b l e . F o r t h a t m a t t e r , d e s p i t e t h e h a r s h b l o w d i r e c t e d a t s m a l l b u s i n e s s b y t h e C o m m i s s i o n ' s k e y r e c o m m e n d a t i o n s , t h e r e was empathy f o r t h i s c o m m u n i t y , a s e v i d e n c e d b y t h i s comment: " T h i s d o e s n o t mean t h a t we b e l i e v e t h e Income Tax A c t s h o u l d c o n t a i n no s p e c i a l p r o v i s i o n f o r new b u s i n e s s e s . On t h e c o n t r a r y , we b e l i e v e t h a t t h e e a s y e n t r y o f new b u s i n e s s e s c a n p l a y a n i m p o r t a n t r o l e i n t h e C a n a d i a n economy, a n d t h a t p r e f e r e n t i a l t a x t r e a t m e n t i s one o f t h e ways i n w h i c h t h e y c a n be e n c o u r a g e d . " - 5 4 -H i s t o r i c a l B a c k g r o u n d Chapter Three Two major s u b s t i t u t i o n s were proposed, as w e l l as some minor ones. The f i r s t p r o p o s a l was to tax the shareholders of a c o r p o r a t i o n l i k e a p a r t n e r s h i p . T h i s had been o r i g i n a l l y c o n s i d e r e d f o r a l l c o r p o r a t i o n s , but was r u l e d out due to the p r a c t i c a l problem of a l l o c a t i n g income when shareholders were r e g u l a r l y changing hands on the p u b l i c stock exchanges. At the time, c o r p o r a t i o n s were c l a s s i f i e d as e i t h e r c l o s e l y or widely h e l d . The C a r t e r Commission b e l i e v e d t h a t the p a r t n e r s h i p approach would work f o r c l o s e l y h e l d companies. T h i s method would achieve the s t a t e d o b j e c t i v e of p l a c i n g u l t i m a t e weight o f t a x a t i o n on the i n d i v i d u a l i n a very d i r e c t manner, r a t h e r than i n d i r e c t l y through the p r o v i s i o n s p r e v i o u s l y c i t e d . C e r t a i n r e s t r i c t i o n s were contemplated: 1. N i n e t y p e r c e n t a p p r o v a l would be r e q u i r e d from the s h a r e h o l d e r s . 2. I f passed, the e l e c t i o n would apply to a l l s h a r e h o l d e r s . 3. The e l e c t i o n would not be a v a i l a b l e i f t h e r e were more than f i f t e e n s h a r e h o l d e r s , or any n o n - r e s i d e n t s h a r e h o l d e r s . 4. The e l e c t i o n c o u l d be a r b i t r a r i l y l i m i t e d t o b u s i n e s s e s w i t h annual income l e s s than $ 2 0 0 , 0 0 0 . 5. The e l e c t i o n would be r e q u i r e d w i t h i n n i n e t y days o f the year-end. V a r i o u s e x t r a - o r d i n a r y s i t u a t i o n s and t h e i r r e s o l u t i o n s were d i s c u s s e d by the Commission. The second p r o p o s a l was t o o f f e r a c c e l e r a t e d c a p i t a l c o s t allowance to s m a l l b u s i n e s s , e i t h e r i n c o r p o r a t e d or - 5 5 -H i s t o r i c a l Background Chapter Three u n i n c o r p o r a t e d , w i t h : 1. A s s e t s o f l e s s than $1,000,000 and gross revenue o f l e s s than $10,000,000; and 2. At l e a s t seventy percent Canadian ownership. The b u s i n e s s would be r e q u i r e d t o apply f o r c e r t i f i c a t i o n . The i n c e n t i v e was f r o n t end loaded and a t t r a c t i v e . A l l c a p i t a l a s s e t s c o u l d be f u l l y d e p r e c i a t e d i n the year o f a c q u i s i t i o n . The l i f e - t i m e b e n e f i t o f a c c e l e r a t i o n was r e s t r i c t e d t o $250,000 and, i n any event, c o u l d not exceed a ten year p e r i o d . Other p r o v i s i o n s of the c a p i t a l c o s t system extant would apply, such as r e c a p t u r e . No r e t r o a c t i v i t y was allowed. U n f o r t u n a t e l y , a s s o c i a t i o n t e s t s would be necessary t o prevent abuse. The Commission r e c o g n i z e d t h a t there would be a d m i n i s t r a t i v e d i f f i c u l t i e s w i t h t h i s p r o p o s a l . Other minor p r o p o s a l s were p o s i t e d : 1. The in c r e m e n t a l c o r p o r a t e tax between the o l d p r e f e r e n t i a l r a t e and the new a l l - i n c l u s i v e f i f t y p e rcent r a t e c o u l d be w i t h h e l d by the s m a l l c o r p o r a t i o n . There would be an accumulated c e i l i n g o f $5 0,00 0 and a low nominal i n t e r e s t r a t e charged. In e f f e c t , t h i s would be a government loa n (perhaps a p r e c u r s o r o f the well-known d e f e r r e d income t a x ) . The l o a n would have no due date, s u b j e c t t o winding down or c e s s a t i o n o f r e s i d e n c y . 2. A non-taxable r e s e r v e c o u l d be accumulated i n sh a r e h o l d e r s ' e q u i t y , s u b j e c t t o a desig n a t e d maximum. T h i s sum would not be taxed w h i l e i t was r e t a i n e d or i f -56-H i s t o r i c a l Background C h a p t e r Three i t was used f o r d e s i g n a t e d e x p a n s i o n . Tax would a c c r u e i f the funds were used f o r u n d e s i g n a t e d p u r p o s e s . 3. Super d i v i d e n d t a x c r e d i t s c o u l d be p r o v i d e d f o r d i s t r i b u t i o n s o u t o f s m a l l b u s i n e s s c o r p o r a t i o n s . The e x c e s s c r e d i t would p r o v i d e l a r g e r t a x r e f u n d s t o t h e i n d i v i d u a l , who c o u l d r e - i n v e s t i n t h e c o r p o r a t i o n . A f t e r t h e C a r t e r Commission The C a r t e r R e p o r t was s i x volumes i n l e n g t h . V a r i o u s academics, p r o f e s s i o n a l s and government p e o p l e were commissioned t o w r i t e s u b s i d i a r y r e p o r t s on v a r i o u s t o p i c s . There were t h i r t y such r e p o r t s . A l l t o l d , by t h e w i n t e r o f 1966-67, t h e r e were s e v e r a l thousand pages o f a n a l y s i s , commentary and p r o p o s a l s f o r t h e government and p e o p l e o f Canada t o c o n t e m p l a t e . As one a u t h o r mused, i t i s u n l i k e l y t h a t any C a n a d i a n , l i v i n g o r dead t o d a y , r e a d t h e whole c o l l e c t i o n . The chairman o f the Commission, Kenneth C a r t e r , d i e d s h o r t l y a f t e r r e l e a s e o f t h e main r e p o r t . P r e d i c t a b l y , v i g o r o u s p u b l i c debate ensued. A t f i r s t , t h e government i t s e l f d i d n o t p a r t a k e o f t h e d i s c u s s i o n s . A l m o s t t h r e e y e a r s l a t e r , t h e o f f i c i a l r e s p o n s e came i n t h e form o f a White Paper e n t i t l e d , "PROPOSALS FOR TAX REFORM", s u b m i t t e d by the n F i n a n c e M i n i s t e r Edgar Benson. H i s opening s t a t e m e n t s r e c o g n i z e d t h e need f o r r e f o r m and made a promise t h a t h i s s u c c e s s o r s c o u l d n o t keep: "The need f o r g e n e r a l ^ r e f o r m i s c l e a r , and i n some i n s t a n c e s s t r i k i n g " . "The p r e s e n t r e f o r m o f t h e income t a x s h o u l d produce a r e a s o n a b l y s t a b l e system w h i c h can d e v e l o p , b u t which need not.be f u n d a m e n t a l l y r e v i s e d f o r a c o n s i d e r a b l e p e r i o d " . -57-H i s t o r i c a l Background Chapter Three O v e r a l l , the White Paper c o n s i d e r a b l y d i l u t e d the C a r t e r Report recommendations. As regards the c o r p o r a t e p r o v i s i o n s , the White Paper supported: 1. A comprehensive income base; 2. One c o r p o r a t e tax r a t e a t f i f t y p ercent; and 3. The v o l u n t a r y p a r t n e r s h i p e l e c t i o n f o r c l o s e l y h e l d companies. There were t e c h n i c a l d i f f e r e n c e s . For i n s t a n c e , the requirements f o r the p a r t n e r s h i p e l e c t i o n i n c l u d e d : 1. Shareholder unanimity; 2. Canadian r e s i d e n c y f o r a l l s h a r e h o l d e r s ; and 3. Only one c l a s s of shares i n the company. Where the shareholders d i d not e l e c t the p a r t n e r s h i p treatment, the c o r p o r a t i o n would be taxed a t the s i n g l e r a t e of f i f t y p e r c e n t . However, c r e d i t f o r the f u l l amount o f taxes p a i d would be g i v e n t o s h a r e h o l d e r s upon d i s t r i b u t i o n . I t was proposed t h a t the tax c r e d i t would o n l y apply i f the d i s t r i b u t i o n was made w i t h i n two and a h a l f years of the f i s c a l year-end. Furthermore, c a p i t a l g ains and l o s s e s would r e c e i v e f u l l tax treatment upon d i s p o s i t i o n of shares i n a c l o s e l y h e l d c o r p o r a t i o n . R e c o g n i z i n g the immediate h a r d s h i p t h a t s m a l l b u s i n e s s would face i n l o s i n g the low r a t e , the White Paper proposed a f i v e year phase-out p e r i o d . T h i s p e r i o d was p r e c i p i t a t e d f o r more p r o f i t a b l e companies, a c c o r d i n g t o a formula. Widely h e l d c o r p o r a t i o n s , meanwhile, were to r e c e i v e s l i g h t l y d i f f e r e n t treatment. Tax c r e d i t s on d i s t r i b u t i o n would be - 5 8 -H i s t o r i c a l Background C h a p t e r Three r e s t r i c t e d t o one h a l f o f t h e t a x e s p a i d . On t h e o t h e r hand, c a p i t a l g a i n s and l o s s e s would o n l y b e a r t a x i m p l i c a t i o n s on h a l f o f t h e i r amounts. The w i d e l y h e l d c o r p o r a t i o n s f a c e d t h e same ti m e l i m i t on d i s t r i b u t i o n s and c o n t i n u e d t o e n j o y t h e low r a t e a l o n g w i t h c l o s e l y h e l d c o r p o r a t i o n s , s u b j e c t t o t h e phase-out f o r m u l a . The M i n i s t e r b e l i e v e d t h a t t h e s e new p r o v i s i o n s would ensure t h a t " . . . t h e b e n e f i t would go t o s h a r e h o l d e r s w i t h s m a l l incomes r a t h e r t h a n t o c o r p o r a t i o n s w i t h s m a l l incomes".^ O t h e r w i s e , t h e White Paper d i d n o t propose any p r e f e r e n c e s f o r s m a l l b u s i n e s s . I n p a r t i c u l a r , t h e C a r t e r R e p o r t ' s recommendation f o r p r e f e r e n c e v i a t h e c a p i t a l c o s t system was i g n o r e d . The M i n i s t e r b e l i e v e d t h a t a f t e r twenty y e a r s t h i s system was due f o r r e v i e w , but he p l a c e d t h e i s s u e on t h e b a c k - b u r n e r f o r t h e time b e i n g . The o n l y s i g n i f i c a n t change, a f f e c t i n g a l l b u s i n e s s e s , was t h a t t h e c l a s s o f e x p e n d i t u r e s known as " n o t h i n g s " , such as g o o d w i l l , would q u a l i f y f o r a new c l a s s and be d e d u c t i b l e a t t e n p e r c e n t . P r e v i o u s l y , no w r i t e - o f f had been p e r m i t t e d . A f t e r t h e White Paper The C a r t e r R e p o r t had a l r e a d y g i v e n b i r t h t o much p u b l i c debate o v e r th e Canadian system o f t a x a t i o n . However, t h i s was o n l y t h e b e g i n n i n g . The Senate d i r e c t e d i t s STANDING COMMITTEE ON BANKING, TRADE AND COMMERCE i n November 19 69 t o examine and r e p o r t on the White Paper. The House o f Commons d i r e c t e d i t s STANDING COMMITTEE ON FINANCE, TRADE AND ECONOMICS AFFAIRS i n December 19 6 9 t o r e v i e w t h e White Paper. These two committees s u b m i t t e d t h e i r -59-H i s t o r i c a l Background C h a p t e r Three r e p o r t s i n September and October 1970 r e s p e c t i v e l y . The Senate Committee heard o r r e c e i v e d b r i e f s from 343 s o u r c e s . The Commons Committee r e c e i v e d 524 b r i e f s as w e l l as 1,093 l e t t e r s and o t h e r s u b m i s s i o n s . Newspaper and magazine e d i t o r s and book p u b l i s h e r s were a l s o i n t e r m e d i a r i e s f o r t h e p l e t h o r a o f p u b l i c forum t h a t ensued. T h i s debate a l s o p r o v i d e d t h e g e r m i n a t i o n o f the Canadian F e d e r a t i o n o f Independent B u s i n e s s , f i r s t known as t h e Canadian C o u n c i l f o r F a i r T a x a t i o n . W r i t i n g on t h e White Paper, t a x l a w y e r I . H. A s p e r p r o v i d e d e x c e l l e n t p e r s p e c t i v e t o t h e g o i n g s - o n : "To be s u r e , t h e t a x system i s under r e v i e w , but t h e i s s u e i s n o t t a x a t i o n . What i s i n v o l v e d i n t h e c u r r e n t debate i s s o c i a l and economic r e o r g a n i z a t i o n . The t a x system proposed by Mr Benson, o r by Mr C a r t e r b e f o r e him, o r by o t h e r r e f o r m e r s o f t h e t a x s t r u c t u r e i n bygone d a y s , i s m e r e l y t h e v e h i c l e . I t i s a means, n o t t h e end. The end i s t h e r e s h a p i n g o f s o c i e t y . T h e r e f o r e , what ought t o be d i s c u s s e d i s n o t the t a x changes, per s e , b u t t h e q u e s t i o n o f what k i n d o f s o c i e t y and what k i n d o f r o l e f o r government we r e a l l y want. The t a x r e f o r m s b e g i n on t h e assumption t h a t Canadians want i n c r e a s e d government s e r v i c e s , f u r t h e r a c t i v i t y by government i n t h e i r economic l i f e and s o c i a l r e l a t i o n s h i p s . The White Paper ... i s c r u c i a l l y i m p o r t a n t t o a l l o f us because t h e changes i t recommends i n our f i s c a l , economic, s o c i a l , b u s i n e s s and f a m i l y c o n c e p t s and r e l a t i o n s h i p s a r e most p r o f o u n d . " I t i s t h e a u t h o r ' s o b s e r v a t i o n t h a t t h e p u b l i c debate f o c u s s e d more on t h e d e t a i l s o f t h e "means" t h a n on t h e g e n e r a l i t i e s o f the "ends". A s p e r * s c a l l f o r a h i g h e r l e v e l o f c r i t i c a l a ssessment was n o t e x p l i c i t l y answered. Perhaps t h o s e d e c i s i o n s on t h e r o l e o f government and the k i n d o f s o c i e t y had been made e a r l i e r , and were now t a k e n as g i v e n . -60-H i s t o r i c a l Background C h a p t e r Three "The r e a s o n s f o r t h i s p r e s s u r e ( f o r reform) a r e by no means c l e a r . A s h a r p and o p p r e s s i v e r i s e i n t h e g e n e r a l t a x burden would have e x p l a i n e d i t , b ut i n f a c t t h e t r e n d had been o n l y m i l d l y upward d u r i n g t h e F i f t i e s . What i s much more r e v e a l i n g i s t h e r i s i n g t r e n d o f f e d e r a l e x p e n d i t u r e s d u r i n g t h i s p e r i o d , c o n c e r n o v e r w h i c h may have been masked as i n t e r e s t i n t h e t a x system. The " w e l f a r e s t a t e " had begun t o make i t s appearance. F a m i l y a l l o w a n c e s , u n i v e r s a l o l d age p e n s i o n s , and h o s p i t a l i n s u r a n c e were t h e f i r s t i n s t a l m e n t , and more was on t h e way. The r e s u l t had been an i n c r e a s e i n t h e r a t i o o f f e d e r a l e x p e n d i t u r e s t o GNP from 12.8% i n 1950 t o 18.1% i n 1961, a r i s e o f 40%. F u r t h e r i n s t a l m e n t s would r a i s e t h e r a t i o even h i g h e r , and p r o v i n c i a l and l o c a l e x p e n d i t u r e s were a d v a n c i n g a t a s i m i l a r r a t e . Government deb t was a l s o r i s i n g r a p i d l y , a l t h o u g h n o t a t a r a t e t h a t posed a s e r i o u s f i n a n c i n g problem. I t would appear i n r e t r o s p e c t t h a t , d e s p i t e t h e modesty o f t h e r i s e i n t a x burden, t h e growth o f government e x p e n d i t u r e s and t h e i n c r e a s e i n debt were a cause o f c o n c e r n . " The Senate Committee gave "... a p p r o v a l o f c e r t a i n a s p e c t s o f t h e White Paper b u t s u b s t a n t i a l m o d i f i c a t i o n o r r e j e c t i o n o f many o recommendations c o n t a i n e d t h e r e i n " . The Committee agreed w i t h h a v i n g a t o p t a x r a t e o f f i f t y p e r c e n t . I t a l s o a c c e p t e d t h e t a x a t i o n o f c a p i t a l g a i n s , b u t wanted d i f f e r e n t t r e a t m e n t o f what i t c a l l e d s h o r t term and l o n g term g a i n s . S h o r t term g a i n s were d e f i n e d as b e i n g r e a l i z e d w i t h i n one y e a r . They were t o be f u l l y t a x e d , l i k e o r d i n a r y income. Long t e r m g a i n s were t o be t a x e d a t the l e s s e r o f t w e n t y - f i v e p e r c e n t o r h a l f t h e i n d i v i d u a l ' s m a r g i n a l t a x r a t e . The Committee a l s o a c c e p t e d t h e p a r t n e r s h i p e l e c t i o n , w i t h minor changes. The r u l e s s h o u l d have accommodated: 1. A c o r p o r a t i o n w i t h more t h a n one c l a s s o f s h a r e ; and 2. A c o r p o r a t i o n w i t h a f o r e i g n o w n e r ship element. L a s t l y , t h e Committee agreed w i t h t h e d e d u c t i b i l i t y o f " n o t h i n g s " , b u t w i s h e d t o e x c l u d e g o o d w i l l from t h i s c a t e g o r y . -61-H i s t o r i c a l Background C h a p t e r T h r e e The k e y r e m a i n i n g p r o v i s i o n s c o n c e r n i n g c l o s e l y h e l d c o r p o r a t i o n s a n d i n t e g r a t i o n w e re r e j e c t e d . The S e n a t e C o m m i t t e e c o n c l u d e d t h a t t h e r e a s o n s c i t e d b y t h e W h i t e P a p e r f o r p r o p o s i n g t o a b o l i s h t h e d u a l r a t e s y s t e m w ere d e f i c i e n t . The r e a s o n s t h a t h a d b e e n c i t e d w e r e : 1. C l o s e l y h e l d c o r p o r a t i o n s s h o u l d be i n t h e same t a x p o s i t i o n a s t h e i r c o m p e t i t o r s , n o t a b l y u n i n c o r p o r a t e d b u s i n e s s e s . 2. The d u a l r a t e s y s t e m c a u s e d t h e p r o b l e m w i t h a s s o c i a t i o n t e s t s . 3. The d u a l r a t e s y s t e m c r e a t e d a p a r t i a l t a x d e f e r r a l i n t h e c o r p o r a t i o n o n t h e f i r s t $ 3 5 , 0 0 0 . I t s h o u l d be n o t e d t h a t t h i s l i s t d o e s n o t i n c l u d e a l l o f t h e r e a s o n s c i t e d b y t h e C a r t e r R e p o r t . W h i l e t h e W h i t e P a p e r p r o b a b l y a c c e p t e d t h e same r e a s o n s i n f a c t , i n p r i n t t h e r e was an a p p a r e n t d i f f e r e n c e . The S e n a t e C o m m i t t e e jumped o n t h e h i a t u s . F o r i n s t a n c e , t h o u g h p r a i s i n g t h e d u a l r a t e s t r u c t u r e , t h e C o m m i t t e e saw two f a u l t s : 1. The l o w r a t e s h o u l d n o t be a v a i l a b l e t o b i g b u s i n e s s a s w e l l . 2. The l o w r a t e s h o u l d n o t a p p l y t o i n v e s t m e n t i n c o m e . T h e s e w e r e b o t h c i t e d i n t h e C a r t e r R e p o r t . The C o m m i t t e e a l s o d i s m i s s e d t h e c o n c e r n w i t h a s s o c i a t i o n t e s t s , s a y i n g t h a t t h e m i n i s t e r i a l d i s c r e t i o n c l a u s e was s a t i s f a c t o r y . I n t h e a u t h o r ' s v i e w , t h i s i s a q u e s t i o n o f o p i n i o n r a t h e r t h a n f a c t . The a r g u m e n t a g a i n s t m i n i s t e r i a l d i s c r e t i o n i s t h e u n c e r t a i n t y i t i m p l a n t s . I t i s a q u e s t i o n o f p e r s o n a l p r e f e r e n c e w h e t h e r - 6 2 -H i s t o r i c a l B a c k g r o u n d Chapter Three u n c e r t a i n t y makes a f a i r p i l l a r i n tax l aw. One o f the most c o n t r o v e r s i a l , and i n t e r e s t i n g , a t t a c k s on the White Paper c e n t e r e d on the comment t h a t c l o s e l y h e l d c o r p o r a t i o n s s h o u l d be i n the same t ax p o s i t i o n as t h e i r u n i n c o r p o r a t e d c o m p e t i t o r s . The White Paper s t a t e d c l e a r l y t h a t " these c o r p o r a t i o n s u s u a l l y compete i n markets w i t h 9 u n i n c o r p o r a t e d b u s i n e s s e s s u b j e c t o n l y t o p e r s o n a l income t a x " . T h i s s tatement indeed deserves a t t a c k . The Senate Committee c o r r e c t l y r e c o g n i z e d t h a t the c l o s e l y h e l d c o r p o r a t i o n s a l s o compete w i t h l a r g e , p u b l i c companies . However, the Committee went on t o say : " F o r the most p a r t , the u n i n c o r p o r a t e d t axpayer i s r e p r e s e n t e d by s a l a r i e d employees , t axpayer s i n the p r o f e s s i o n s , and those t axpayer s whose b u s i n e s s i s o f such na ture t h a t t h e r e i s no p a r t i c u l a r b e n e f i t t o them by i n c o r p o r a t i n g a company. THE UNINCORPORATED BUSINESS WILL USUALLY FALL INTO THE NON-GROWTH CATEGORY. IN NO SENSE OF THE WORD DOES THE SMALL AGGRESSIVE BUSINESS CORPORATION COMPETE WITH THE SALARIED EMPLOYEE, THE PROFESSIONAL, OR THE NON-GROWTH KIND OF BUSINESS." (my emphasis) The C a r t e r Commission had a s c e r t a i n e d t h a t s e v e n t y - e i g h t p e r c e n t o f the b u s i n e s s e s w i t h a s s e t s l e s s t h a n $1,000,000 i n 1959 were u n i n c o r p o r a t e d . A p p a r e n t l y the s m a l l b u s i n e s s s e c t o r was dominated by t h i s form o f l e g a l s t r u c t u r e . The Senate Commit tee ' s comments do not appear t o be v a l i d . The Committee r e j e c t e d the i n t e g r a t i o n p r o p o s a l s f o r c l o s e l y and w i d e l y h e l d c o r p o r a t i o n s . I n s t e a d , i t f avoured r e t e n t i o n o f the e x i s t i n g d i v i d e n d tax c r e d i t sys tem, e m b e l l i s h i n g the c r e d i t f o r the f i r s t $500 o f d i v i d e n d s and r e d u c i n g i t f o r d i v i d e n d s i n -63-H i s t o r i c a l Background C h a p t e r T h r e e e x c e s s o f $5,000. I t a l s o r e j e c t e d t h e s t a l e - d a t i n g p r o v i s i o n s , s t a t i n g t h a t t h i s w o u l d e x e r t undue p r e s s u r e f o r d i s t r i b u t i o n . The C o m m i t t e e t o o k t h e o p p o r t u n i t y t o comment on some a l t e r n a t i v e p r o p o s a l s t o t h e d u a l r a t e s y s t e m . I n f a c t , t h e s e w e r e a d v a n c e d b y t h e C a r t e r C o m m i s s i o n , n o t t h e W h i t e P a p e r . I n s h o r t , none o f t h e a l t e r n a t i v e s was v i e w e d a s s a t i s f a c t o r y . I n summary, t h e S e n a t e C o m m i t t e e recommended r e t e n t i o n o f t h e d u a l r a t e s y s t e m a n d some new p r o v i s i o n s t o r e s t r i c t t h e l o w r a t e t o c o m p a n i e s w i t h a n n u a l i n c o m e b e l o w $100,000. The Commons C o m m i t t e e was l e s s c r i t i c a l o f t h e W h i t e P a p e r t h a n i t s S e n a t e c o u n t e r p a r t . I t s u p p o r t e d t h e p a r t n e r s h i p e l e c t i o n . The m i n i s t e r i a l d i s c r e t i o n p o w e r s f o r a s s o c i a t i o n t e s t s w e r e n o t "... a g o o d way o f i m p o s i n g taxation"."'"''' The d u a l r a t e s y s t e m s h o u l d n o t s u p p o r t t h o s e who do n o t n e e d h e l p , s u c h a s b i g b u s i n e s s . S t a l e - d a t i n g i m p o s e d u n n e c e s s a r y a c t i o n b y c o r p o r a t i o n s . Any s y s t e m o f t a x d e f e r r a l t h r o u g h r e t a i n e d e a r n i n g s was f a u l t y i f t h e f u n d s w e r e n o t u s e d f o r b u s i n e s s e x p a n s i o n . The Commons C o m m i t t e e recommended t h e f o l l o w i n g : 1. B o t h c l o s e l y a n d w i d e l y h e l d c o r p o r a t i o n s s h o u l d r e c e i v e h a l f , r a t h e r t h a n f u l l , i n t e g r a t i o n , e x c e p t t h a t t h e f o r m e r w o u l d e n j o y f u l l i n t e g r a t i o n o n t h e f i r s t $50,000 o f t a x a b l e i n c o m e . 2. The l o w r a t e w o u l d a p p l y t o c o r p o r a t i o n s w i t h t a x a b l e i n c o m e up t o $35,000; b e y o n d t h i s , t h e r e l i e f w o u l d be p h a s e d i n u n d e r a n o t c h p r o v i s i o n , up t o t a x a b l e i n c o m e -6 4 -H i s t o r i c a l B a c k g r o u n d C h a p t e r Three o f $105,000. 3. The low r a t e would n o t a p p l y t o w i d e l y h e l d c o r p o r a t i o n s and t h e i r s u b s i d i a r i e s and t o f o r e i g n c o n t r o l l e d c o r p o r a t i o n s . The r e p o r t s o f b o t h o f t h e s e committees were i n f l u e n c e d by, but not n e c e s s a r i l y m o d e l l e d a f t e r , t h e m u l t i t u d e o f p u b l i c s u b m i s s i o n s . One hundred and f i f t y o f t h e s e were summarized i n the "White Paper on Tax Reform: Summary o f P u b l i c H e a r i n g s 1970". T h i s p u b l i c a t i o n p r o v i d e s much i n s i g h t i n t o t h e a t t i t u d e s o f t h e man i n t h e s t r e e t . The l e a s t a c c e p t a b l e o f t h e s m a l l b u s i n e s s p r o v i s i o n s was t h e a b o l i t i o n o f d u a l r a t e s . I t was unanimously agreed by a l l t h a t s m a l l b u s i n e s s s h o u l d have some form o f p r e f e r e n c e t o c o u n t e r p r e j u d i c e i n t h e c a p i t a l m a r k e t s . I n a l l b u t two c a s e s , the d u a l r a t e system was f a v o u r e d as t h e b e s t v e h i c l e . The two s u p p o r t e r s o f a s i n g l e r a t e system ( The Canadian Labour Congress and G u l f O i l Canada L i m i t e d ) b o t h wanted t o see some o t h e r form o f p r e f e r e n c e . I n g e n e r a l , t h e r e was ac c e p t a n c e t h a t t h e low r a t e s h o u l d n o t a p p l y t o l a r g e c o r p o r a t i o n s . V a r i o u s c r i t e r i a were p u t f o r t h t o s e p a r a t e t h e "haves" from t h e "have-nots". A t a x a b l e income c e i l i n g o f $100,000 was t h e most common c r i t e r i a . Gross revenue, t o t a l a s s e t s o r a l i f e - t i m e maximum were a l s o p roposed. I n t h e absence o f t h e low r a t e p r e f e r e n c e , generous c a p i t a l c o s t a l l o w a n c e o r d e f e r r e d t a x e s were t h e most common a l t e r n a t i v e s . However, a number o f s u b m i s s i o n s p o i n t e d o u t t h a t t h e former was o n l y a minor b e n e f i t f o r s m a l l b u s i n e s s e s w i t h low c a p i t a l i n v e s t m e n t . L a s t l y , t h e r e was one i n t e r e s t i n g o b s e r v a t i o n from The I n s t i t u t e -65-H i s t o r i c a l Background Chapter Three of Canadian A d v e r t i s i n g : "There i s l i t t l e evidence t o suggest t h a t taxpayers, and i n some cases l e g i s l a t o r s , f u l l y understand the p r o p o s a l to e l i m i n a t e the reduced r a t e o f tax on c o r p o r a t e income under $3 5,00 0. The lower r a t e i s t o be r e p l a c e d , not by the h i g h e r c o r p o r a t e r a t e o f approximately f i f t y p ercent, but r a t h e r by the h i g h e s t m a r g i n a l ^ t a x r a t e s o f the sha r e h o l d e r s o f the c o r p o r a t i o n . " T h i s o b s e r v a t i o n i s v a l i d w i t h i n t e g r a t i o n , except where the i n d i v i d u a l marginal r a t e i s l e s s than the c o r p o r a t e r a t e . The C a r t e r Commission had recommended an a c t u a l tax re f u n d i n t h i s s i t u a t i o n , but the White Paper i g n o r e d t h i s . The o b s e r v a t i o n i s a l s o v a l i d f o r the p a r t n e r s h i p e l e c t i o n . As f o r oth e r p r o p o s a l s , the p a r t n e r s h i p e l e c t i o n was g e n e r a l l y accepted. R e s t r i c t i o n s concerning m i n o r i t y or n o n - r e s i d e n t shareholdings were i d e n t i f i e d f o r improvement. The p r e j u d i c e d treatment o f c a p i t a l g ains f o r c l o s e l y h e l d c o r p o r a t i o n s was unanimously d e p l o r e d . In review, the White Paper c o n t a i n e d some t h e o r e t i c a l e r r o r s and some p o l i t i c a l e r r o r s . I t i s hard t o imagine t h a t the M i n i s t e r a c t u a l l y b e l i e v e d t h a t the busi n e s s world worked so n e a t l y and t i d i l y -- b i g busi n e s s competed a g a i n s t b i g business and s m a l l b u s i n e s s competed a g a i n s t s m a l l b u s i n e s s . The s t a l e - d a t i n g p r o v i s i o n would f o r c e q u i c k d i s t r i b u t i o n or impose a heavy burden on r e t e n t i o n . I t was an o v e r - k i l l . The no n - r e s i d e n t r e s t r i c t i o n on p a r t n e r s h i p e l e c t i o n c o u l d cause undue h a r d s h i p i n c e r t a i n c ircumstances. The c a p i t a l g a i n p r o p o s a l r e c e i v e d l e s s a t t e n t i o n than the dua l r a t e system, probably because i t was a l e s s immediate hardship; however, i t would l i k e l y cause b i g g e r - 6 6 -H i s t o r i c a l Background C h a p t e r T h r e e p r o b l e m s i n t h e l o n g r u n f o r e s t a t e a n d s u c c e s s i o n p l a n n i n g . S t a t e d s i m p l y , t h e b i g g e s t e r r o r was a p o l i t i c a l one — one t h a t t h e C a r t e r R e p o r t r e c o g n i z e d b u t t h e W h i t e P a p e r c h o s e t o i g n o r e . N o t h i n g was g i v e n t o s m a l l b u s i n e s s t o c o m p e n s a t e f o r i t s l o s s e s . Had t h i s n o t b e e n t h e c a s e , t h e c r i t i c s w o u l d h a v e d w e l l e d l e s s o n t h e c u r i o u s comment a b o u t who c o m p e t e s w i t h whom. I t w o u l d n o t h a v e b e e n n e c e s s a r y f o r a l m o s t e v e r y o n e t o q u o t e f r o m F i n a n c e M i n i s t e r A b b o t t ' s B u d g e t s p e e c h o f 1949 c o n c e r n i n g t h e g o v e r n m e n t ' s f o r m e r l y f a v o u r a b l e a t t i t u d e t o w a r d s s m a l l b u s i n e s s . A g a i n , I . H. A s p e r p r o v i d e d a c c u r a t e i n s i g h t : " Taken i n d i v i d u a l l y , i t i s p r o b a b l e t h a t no s i n g l e W h i t e P a p e r p r o p o s a l w i l l be s u f f i c i e n t t o wound t h e s m a l l b u s i n e s s m o r t a l l y , b u t t a k e n c u m u l a t i v e l y , when t h e f u l l i m p a c t o f t h e e n t i r e r e s t r u c t u r i n g o f t h e t a x s y s t e m i s f e l t , i t i s q u i t e l e g i t i m a t e l y f e a r e d t h a t t h e r e s u l t c a n n o t be b e n e f i c i a l . A l t h o u g h t h e r e i s much t o be s a i d f o r t h e l o g i c o f t h e W h i t e P a p e r p r o p o s a l s a n d t h e a c a d e m i c p u r i t y o f m a k i n g no d i s t i n c t i o n b e t w e e n l a r g e a n d s m a l l b u s i n e s s e s f o r t a x p u r p o s e s , e v e n t h e m o s t d e t a c h e d o b s e r v e r i s l e f t w i t h t h e f e e l i n g t h a t s o m e t h i n g i s w r o n g " . The B u d g e t o f J u n e 1971 The two p a r l i a m e n t a r y c o m m i t t e e s h a d r e p o r t e d b y l a t e 19 70. The l a s t w o r d on t a x r e f o r m f o r t h e t i m e b e i n g was i s s u e d i n J u n e 1971 when t h e r e s u l t s o f n i n e y e a r s o f d e b a t e c u l m i n a t e d i n a b u d g e t . The B u d g e t was p a s s e d i n December 1971 i n t i m e t o be e f f e c t i v e f o r 1972. S u c c e s s was s w e e t f o r t h o s e who o p p o s e d a n d a c t i v e l y c a m p a i g n e d a g a i n s t t h e p r o p o s e d r e f o r m s . The r e s u l t i n g l e g i s l a t i o n was r a d i c a l l y d i f f e r e n t t h a n t h e W h i t e P a p e r . The p a r t n e r s h i p - 6 7 -H i s t o r i c a l B a c k g r o u n d C h a p t e r T h r e e e l e c t i o n was s c r a p p e d i n i t s e n t i r e t y . A d u a l r a t e s y s t e m was r e t a i n e d . The s t a l e - d a t i n g p r o v i s i o n t o p r e c i p i t a t e c o r p o r a t e d i s t r i b u t i o n s was w i t h d r a w n . W i d e l y a n d c l o s e l y h e l d c o r p o r a t i o n s w e r e n o t g i v e n d i f f e r e n t t r e a t m e n t f o r d i v i d e n d c r e d i t s o r c a p i t a l g a i n t a x a t i o n . The o l d d i c h o t o m y o f " w i d e l y " a n d " c l o s e l y " h e l d was c h a n g e d . I n s t e a d t h e r e w e r e now p r i v a t e c o r p o r a t i o n s , p u b l i c c o r p o r a t i o n s a n d C a n a d i a n - c o n t r o l l e d p r i v a t e c o r p o r a t i o n s . The l e g i s l a t o r s p a i d h e e d t o two c a v e a t s f r o m t h e S e n a t e C o m m i t t e e : f i r s t , t h a t b i g b u s i n e s s s h o u l d n o t e n j o y t h e l o w r a t e ; a n d s e c o n d , t h a t t h e l o w r a t e s h o u l d n o t a p p l y t o i n v e s t m e n t i n c o m e . A l o w r a t e was made a v a i l a b l e t o C a n a d i a n - c o n t r o l l e d p r i v a t e c o r p o r a t i o n s o n l y , t h u s a n s w e r i n g t h e S e n a t e C o m m i t t e e ' s f i r s t c o n c e r n . F o r e i g n - o w n e d s m a l l c o m p a n i e s w e r e c l a s s i f i e d a s " p r i v a t e " a n d , t h u s , a l s o b a r r e d f r o m t h e l o w r a t e . The t e c h n i c a l d e f i n i t i o n s w e r e : P u b l i c - R e s i d e n t i n C a n a d a a n d l i s t e d on a p r e s c r i b e d C a n a d i a n s t o c k e x c h a n g e P r i v a t e - R e s i d e n t i n C a n a d a , n o t p u b l i c o r c o n t r o l l e d b y a p u b l i c c o r p o r a t i o n C a n a d i a n P r i v a t e , b u t n o t c o n t r o l l e d b y n o n -c o n t r o l l e d p r i v a t e - r e s i d e n t s o r p u b l i c c o r p o r a t i o n s The l e g i s l a t o r s a d d r e s s e d t h e s e c o n d c a v e a t by a l l o w i n g t h e l o w r a t e t o a p p l y t o " a c t i v e " i n c o m e o n l y . T h i s was a new t e r m , one d e s t i n e d t o c a u s e much l i t i g a t i o n . The o b j e c t i o n t o e t e r n a l p r e f e r e n c e t o s m a l l b u s i n e s s was a n s w e r e d i n one p r o v i s i o n a n d , c u r i o u s l y , undone i n a n o t h e r . The c o n c e p t was i n t r o d u c e d o f a " c u m u l a t i v e d e d u c t i o n a c c o u n t " t o m e t e r an i n d i v i d u a l f i r m ' s - 6 8 -H i s t o r i c a l B a c k g r o u n d C h a p t e r T h r e e e n j o y m e n t o f t h e l o w r a t e . The f i r s t $400,000 o f t a x a b l e p r o f i t s w e r e t o be t a x e d a t t w e n t y - f i v e p e r c e n t . A f t e r t h i s , a s m a l l b u s i n e s s was assumed t o h a v e r e a c h e d m a t u r i t y and w o u l d b e a r f u l l t a x a t i o n a t f i f t y p e r c e n t . A l s o , a n a n n u a l c e i l i n g was p l a c e d a t $ 5 0 , 0 0 0 . A n n u a l p r o f i t i n e x c e s s o f t h i s amount was a l s o t a x e d a t t h e f u l l r a t e . The c u r i o u s c o u n t e r - p r o v i s i o n a l l o w e d a s m a l l b u s i n e s s a c c e s s t o a " f o u n t a i n o f y o u t h " . The p r o v i s i o n was commonly r e f e r r e d t o a s " f r e s h e n i n g t h e C D . A . " and i t a l l o w e d t h e l i f e - t i m e p r o f i t a c c u m u l a t i o n n e v e r t o r e a c h $ 4 0 0 , 0 0 0 , by p a y i n g d i v i d e n d s w h i c h w o u l d r e d u c e t h e a c c o u n t . The s m a l l b u s i n e s s c o u l d r e m a i n s m a l l i n t h e v i e w o f t h e A c t f o r e v e r . The B u d g e t o p t e d f o r a d i v i d e n d g r o s s - u p a n d c r e d i t m e c h a n i s m w h i c h p r o v i d e d f o r t h e t w e n t y - f i v e p e r c e n t t a x p a i d by t h e c o r p o r a t i o n . The B u d g e t a l l o w e d t h e c r e d i t t o a t t a c h t o a n y d i v i d e n d f r o m a t a x a b l e C a n a d i a n c o r p o r a t i o n , n o t j u s t f r o m one t h a t h a d a c t u a l l y p a i d t a x e s . I m p l i c i t i n t h e B u d g e t ' s r e n e w e d commitment t o a p r e f e r e n t i a l r a t e s y s t e m was a n e n d o r s e m e n t o f t h e c o n t r o v e r s i a l a s s o c i a t i o n p r o v i s i o n s . C o m p l e x l e g i s l a t i o n was r e q u i r e d t o f o r c e a s s o c i a t e d c o m p a n i e s t o s h a r e t h e a n n u a l and c u m u l a t i v e l i m i t s . L a s t l y , two new c o r p o r a t e t a x e s w e r e p r o p o s e d t o s e a l two l e a k a g e s t h a t t h e B u d g e t saw a s r e p r e h e n s i b l e . " P a r t F o u r Ta x " was i m p l e m e n t e d t o t a x i n c o m e n o t c o n s i d e r e d t o be " a c t i v e " , s u c h a s i n v e s t m e n t i n c o m e p a s s e d b e t w e e n c o r p o r a t i o n s . " P a r t F i v e T a x " was i m p l e m e n t e d t o c o u n t e r n o n - b u s i n e s s u s e o f r e t a i n e d e a r n i n g s . T h i s c o n c e r n h a d b e e n v o i c e d b y t h e C a r t e r C o m m i s s i o n . - 6 9 -H i s t o r i c a l B a c k g r o u n d Chapter Three In review, the Budget seemed t o have drawn l i t t l e b i t s from many sources and not very much from any one source. The l e g i s l a t i o n turned one hundred and e i g h t y degrees from the White Paper. While the l a t t e r was c l i n i c a l l y ambivalent t o s m a l l b u s i n e s s , the former p r o v i d e d a complete metamorphosis. The p r e f e r e n c e s t o sma l l b u s i n e s s exceeded those i n the o l d system. In any event, the f o u n d a t i o n f o r a new tax system was f i n a l l y l a i d . Post 1971 I t d i d not take long f o r the new system t o crumble under s t r e s s . The P a r t F i v e Tax was r e t r o a c t i v e l y scrapped i n February, 1973. P r e d i c t a b l y , the a s s o c i a t i o n r u l e s needed constant refinement t o plug h o l e s . The i n t e g r a t i o n formulas were p e r i o d i c a l l y m o d i f i e d , t e m p o r a r i l y r e s u l t i n g i n " o v e r - i n t e g r a t i o n " , or excess c r e d i t , t o more than a l l e v i a t e double t a x a t i o n . The a c t i v e income concept kept the Courts b u s i e r than ever, c u l m i n a t i n g i n the d e v a s t a t i n g d e c i s i o n i n The Queen vs Cadboro Bay Holdings L t d . i n which the F e d e r a l Court h e l d t h a t : "Any quantum of b u s i n e s s a c t i v i t y t h a t g i v e s r i s e t o income i n a t a x a t i o n year f o r a p r i v a t e c o r p o r a t i o n i n Canada i s s u f f i c i e n t t o make mandatory the c h a r a c t e r i z a t i o n o f sucb^income from an ' a c t i v e b u s i n e s s c a r r i e d on i n Canada'". T h i s f r e e run on a c t i v e income, p l u s the l e g i s l a t e d o v e r - i n t e g r a t i o n i n t r o d u c e d i n the Budget of March 1977, p l u s broader exemption from P a r t Four Tax caused a stampede o f i n c o r p o r a t i o n s . The o v e r - i n t e g r a t i o n meant t h a t the d i v i d e n d tax c r e d i t and gross-up was i n c r e a s e d from 33 1/3 perc e n t t o f i f t y p e r c e n t s t a r t i n g i n 1978. The main reason f o r t h i s was to -70-H i s t o r i c a l Background C h a p t e r T h r e e i m p r o v e t h e r e t u r n o n C a n a d i a n e q u i t i e s a n d t h u s b o o s t t h e e q u i t y m a r k e t , w h i c h h a d b e e n s a g g i n g . The i n c r e a s e b r o u g h t p u b l i c c o r p o r a t i o n s c l o s e r t o t r u e i n t e g r a t i o n and n a r r o w e d t h e gap b e t w e e n t h e t a x a t i o n o f d i v i d e n d s a n d c a p i t a l g a i n s . H o w e v e r , t h i s o v e r - i n t e g r a t i o n c r e a t e d a b o o n f o r b u s i n e s s e s e n j o y i n g t h e s m a l l b u s i n e s s r a t e . The t a x c r e d i t c l a i m e d by i n d i v i d u a l s o n d i v i d e n d s e x c e e d e d t h e t a x p a i d b y t h e c o r p o r a t i o n o n t h a t i n c o m e . A t h l e t e s , p e r f o r m e r s a n d e m p l o y e e s w e r e i n c o r p o r a t i n g t o e n j o y t h e b e n e f i t s o f i n c o m e s p l i t t i n g a n d d e f e r r a l . P r o f e s s i o n a l s , l e g a l l y d e n i e d t h e c o r p o r a t e f o r m i n m o s t p r o v i n c i a l l e g i s l a t i o n , w e r e i n c o r p o r a t i n g t h e n o n - p r o f e s s i o n a l a s p e c t s o f t h e i r p r a c t i c e s t o e n j o y t h e same b e n e f i t s . Many k i n d s o f i n v e s t m e n t i n c o m e q u a l i f i e d a s a c t i v e . The p e r i o d 1977-79 saw a m a r k e d i n c r e a s e i n b o t h t h e number o f f i r m s d e c l a r i n g d i v i d e n d s a n d t h e s i z e o f t h e a v e r a g e d i s t r i b u t i o n . 1979 1977 Number o f CCPCs p a y i n g d i v i d e n d s 79,966 29,868 A v e r a g e d i v i d e n d p e r CCPC $30,943 $21,295 I n t o t a l , d i v i d e n d d i s t r i b u t i o n s f r o m CCPCs i n c r e a s e d f r o m $636 m i l l i o n t o $2.5 b i l l i o n b e t w e e n 1977 a n d 1979. The g o v e r n m e n t was q u i c k l y aware o f i t s f o l l i e s . The B u d g e t i n November 1978 i n t e n d e d t o c l o s e some o f t h e s e l o o p - h o l e s by s p e c i f i c a l l y t a r g e t i n g t h e s m a l l b u s i n e s s r a t e t o p a r t i c u l a r b u s i n e s s a c t i v i t i e s . I n c l u s i o n by d e f i n i t i o n , r a t h e r t h a n e x c l u s i o n , was n o t p o p u l a r . The r e s u l t was t h e e s t a b l i s h m e n t o f a - 7 1 -H i s t o r i c a l B a c k g r o u n d C h a p t e r T h r e e m i d - r a t e f o r " n o n - q u a l i f y i n g b u s i n e s s e s " . W h i l e t h i s B u d g e t was n e v e r p a s s e d b y t h e d e f e a t e d g o v e r n m e n t , c e r t a i n m e a s u r e s were a d o p t e d b y i t s s u c c e s s o r s i n O c t o b e r 1979. The December 1979 B u d g e t a d d r e s s e d two a r e a s o f a p p a r e n t i n e q u i t y . The f i r s t , a n d m o s t w e l c o m e , was t o a l l o w t h e d e d u c t i b i l i t y o f wages p a i d t o a s p o u s e b y an u n i n c o r p o r a t e d b u s i n e s s . The s e c o n d was more s p e c i f i c a n d more c o m p l e x . B u s i n e s s v e n t u r e s h a d b e e n a b l e t o m u l t i p l y t h e b e n e f i t s o f t h e s m a l l b u s i n e s s r a t e b y f o r m i n g a c o r p o r a t e p a r t n e r s h i p o f u n a s s o c i a t e d e n t i t i e s . A t t h e c o s t o f more c o m p l e x i t y , t h i s B u d g e t managed t o s h u t o f f a n o t h e r l e a k i n t h e a s s o c i a t i o n r u l e s . W h i l e t h i s B u d g e t a l s o d i e d w i t h a n o t h e r d e f e a t e d g o v e r n m e n t , t h e s e p r o v i s i o n s w e r e a d o p t e d b y t h e p r e v i o u s i n c u m b e n t s i n 1980. The m o s t b o l d a n d e x t e n s i v e m o d i f i c a t i o n s s i n c e 1971 o c c u r e d i n t h e B u d g e t o f November 1 9 8 1 . "Whether t h e 1981 B u d g e t p r o p o s a l s s h o u l d be r e g a r d e d a s a n i n s t a l m e n t o f t a x r e f o r m i s a m a t t e r o f 15 j u d g m e n t " . Some o f t h e p r o p o s a l s w e r e i n t h e s p i r i t o f r e f o r m o f t h e S i x t i e s w h i l e o t h e r s w e r e h a r s h a n d u n e x p e c t e d . W h i l e t h e r e f o r m s w e r e a l m o s t o n t h e s c a l e o f t h o s e i n t h e S i x t i e s , none o f t h e p u b l i c a n d g o v e r n m e n t d i s c u s s i o n was i n v i t e d . The o v e r - i n t e g r a t i o n f o r s m a l l b u s i n e s s , c r e a t e d i n 1977, was now s e e n a s a t r a v e s t y . A P a r t Two d i s t r i b u t i o n t a x was c r e a t e d t o undo t h e o v e r - i n t e g r a t i o n . A new t a x o f 12 1/2 p e r c e n t was now e x i g i b l e u p o n d i s t r i b u t i o n o u t o f a CCPC. The c u r i o u s i t y f r o m 1971 c a l l e d " f r e s h e n i n g " was r e m o v e d . On t h e p l u s s i d e , t h e s m a l l b u s i n e s s l i m i t s , w h i c h h a d b e e n i n d e x e d u p w a r d o v e r t h e l a s t d e c a d e , w e r e bumped a g a i n - t h i s t i m e t o $200,000 a n n u a l l y a nd - 7 2 -H i s t o r i c a l B a c k g r o u n d C h a p t e r T h r e e $1,000,000 c u m u l a t i v e l y . The s m a l l m a n u f a c t u r e r s e x e m p t i o n f o r m a n u f a c t u r i n g a n d p r o c e s s i n g c r e d i t s was i n c r e a s e d f r o m $50,000 t o $ 2 0 0 , 0 0 0 . The November 1981 B u d g e t may r e s t a s t h e b i g g e s t b l u n d e r i n t h e h i s t o r y o f C a n a d i a n t a x l e g i s l a t i o n . I t t o o k t h r e e amended b u d g e t s t o a r r i v e a t a p a c k a g e t h a t f i n a l l y became l a w i n M a r c h 1983 . M o s t a n a l y s t s s u g g e s t t h a t t h e g o v e r n m e n t c o m p l e t e l y m i s - r e a d t h e p o l i t i c a l a n d e c o n o m i c c l i m a t e . H o w e v e r , G i l l e s p i e 1 b e l i e v e d t h a t t h e i l l - p r e p a r e d , e x t e n s i v e r e f o r m s w e r e m e r e l y a " s m o k e - s c r e e n " f o r one k e y c h a n g e t h a t t h e g o v e r n m e n t s o u g h t -d e - i n d e x a t i o n o f t h e p e r s o n a l t a x s y s t e m . By c a p i t u l a t i n g t o t h e wave o f p u b l i c p r o t e s t o n a s c o r e o f o t h e r p r o p o s a l s , t h e f i s c a l l y - e x p e n s i v e i n d e x a t i o n r u l e s c o u l d f a l l t h r o u g h i n t o t h e g o v e r n m e n t ' s n e t . I n t h e name o f s i m p l i f i c a t i o n , t h e B u d g e t o f F e b r u a r y 19 84 came f u l l c i r c l e i n a c e r t a i n a s p e c t o f s m a l l b u s i n e s s t a x a t i o n . The 1971 r e f o r m s o u g h t a means t o t a r g e t t h e s m a l l b u s i n e s s r a t e . Th " c u m u l a t i v e d e d u c t i o n a c c o u n t " was c r e a t e d t o c a p t h e p e r i o d o f e a r n i n g s w h i c h c o u l d e n j o y t h e l o w r a t e . W h i l e s o u n d i n t h e o r y , i t was c o m p l e x t o a d m i n i s t e r . The B u d g e t d i d away w i t h t h i s c o n c e p t , a l l o w i n g a n a n n u a l w i n d f a l l t a x r e d u c t i o n t o b i g b u s i n e s s . - 7 3 -H i s t o r i c a l B a c k g r o u n d C h a p t e r T h r e e Summary I n summary, a n h i s t o r i c a l r e v i e w o f s m a l l b u s i n e s s t a x a t i o n p r o v i d e s some o b s e r v a t i o n s f o r r e f o r m : 1. E v e r y o n e h a s a n o p i n i o n o n w h a t i s " f a i r " i n t a x p o l i c y . 2. The p u b l i c b e l i e v e s t h a t s m a l l b u s i n e s s s h o u l d be t r e a t e d p r e f e r e n t i a l l y . 3. The p a r t n e r s h i p e l e c t i o n , w h i c h was o p p o s e d i n p r i n c i p l e b y no o n e , seemed t o h a v e q u i e t l y f a l l e n o f f t h e t a b l e i n t h e b u d g e t o f 1 9 7 1 . 4. I t i s n o t c l e a r how e q u i t y s h o u l d be a p p l i e d i n t a x i n g i n c o r p o r a t e d s m a l l b u s i n e s s . Some b e l i e v e t h a t s m a l l b u s i n e s s e s c o m p e t e o n l y w i t h t h e m s e l v e s a n d u n i n c o r p o r a t e d b u s i n e s s e s . O t h e r s b e l i e v e t h a t t h e y c o mpete w i t h b i g b u s i n e s s a s w e l l . 5. P o l i t i c a l i s s u e s a r e s i g n i f i c a n t i n d e v e l o p i n g s m a l l b u s i n e s s t a x p o l i c y . - 7 4 -H i s t o r i c a l B a c k g r o u n d Chapter Three FOOTNOTES 1. The C a r t e r Report Volume 4 pg 7 0 2. I b i d Volume 4 pg 2 71 3. "Proposals f o r Tax Reform" pg 5 4. I b i d pg 7 5. I b i d pg 50 6. "The Benson Iceberg: A c r i t i c a l a n a l y s i s o f the White Paper on Tax Reform i n Canada" pg i i 7. "Background of C u r r e n t F i s c a l Problems" pg 75 8. "Report on the White Paper Pr o p o s a l s f o r Tax Reform Presented t o the Senate of Canada", pg v i i 9. I b i d pg 11 10. I b i d pg 81 11. "18th Report o f the Standing Committee on Finance, Trade, and Economic A f f a i r s Respecting the White Paper on Tax Reform", pg 51 12. "White Paper on Tax Reform: Summary of P u b l i c Hearings 1970", pg 33 6 13. "The Benson Iceberg: A c r i t i c a l a n a l y s i s of the White Paper on Tax Reform i n Canada", pg 22 9 14. The Queen vs Cadboro Bay Holdings L t d 77DTC5155(FCTD) 15. "Taxation i n Canada", pg 117 16. Canadian Tax J o u r n a l November/December 1983, pg 975 -75-H i s t o r i c a l Background Chapter Four INTERNATIONAL COMPARISONS "In t h i s world nothing i s c e r t a i n but death and t a x e s . " Benjamin F r a n k l i n In open economies, governments can seldom make d e c i s i o n s without c a s t i n g an eye o u t s i d e t h e i r borders. T h i s i s t r u e f o r t a x a t i o n p o l i c y . I n t e r n a t i o n a l c a p i t a l flows, m u l t i n a t i o n a l c o r p o r a t i o n s and mobile labour f o r c e s r e q u i r e each country's i n t e r n a t i o n a l t a x a t i o n p o l i c y t o be as t i g h t as i t ' s domestic one. Where the domestic tax p o l i c i e s of two c o u n t r i e s d i f f e r , t h e i r i n t e r n a t i o n a l agreement must work to mesh the two systems. In f a c t , the Western c a p i t a l i s t economies have developed t h e i r tax systems i n tandem. V i r t u a l l y a l l had some form of income t a x a t i o n i n p l a c e w i t h i n the decade ending w i t h World War One. " I t i s p o s s i b l e t h a t one c o u l d show income t a x a t i o n was not a simple p o l i c y c h o i c e by the government o f the day, but r a t h e r an i n e v i t a b l e s e l e c t i o n determined by the s o c i a l and economic needs o f a d e v e l o p i n g , modern t e c h n o l o g i c a l s o c i e t y " . When Canada f e l t the g r e a t urge f o r reform i n the S i x t i e s , so too d i d other c o u n t r i e s ; France - 1965; United Kingdom - 1965 and 1973; Spain - 1964; Germany - 1977 (reform commenced i n 1971). Again s i m i l a r t o Canada, i t appears t h a t the e f f i c a c y o f the r e c e n t round of reform was s h o r t - l i v e d . In 1975, the Commission of the European Communities submitted a p r o p o s a l to harmonize the c o r p o r a t e t a x a t i o n and w i t h h o l d i n g tax on d i v i d e n d s f o r a l l member c o u n t r i e s . I t was not approved. The United S t a t e s i s s u e d a reform document i n 1977 e n t i t l e d , " B l u e p r i n t s f o r B a s i c Tax Reform". -76-I n t e r n a t i o n a l Comparisons Chapter Four The f o l l o w i n g reviews the tax systems of some developed c o u n t r i e s i n order to compare t o the Canadian system and perhaps uncover some new i d e a s . France In 1965 France i n s t i t u t e d a system of p a r t i a l r e l i e f from double t a x a t i o n . With the c o r p o r a t e r a t e of f i f t y p ercent, the s h a r e h o l d e r adds f i f t y p e rcent of the d i v i d e n d r e c e i v e d to the amount of d i v i d e n d s to be i n c l u d e d i n t a x a b l e income. A tax c r e d i t ("avoir f i s c a l " ) i s claimed f o r h a l f the c o r p o r a t e tax a t t r i b u t a b l e t o the d i v i d e n d s . C r e d i t i s o n l y allowed f o r taxes a c t u a l l y p a i d . An i n d i v i d u a l may r e c e i v e a refund i f the c r e d i t exceeds the p e r s o n a l tax payable; a c o r p o r a t i o n r e c e i v i n g d i v i d e n d income may not. The French system does not tax world-wide income sources. T h e r e f o r e , a supplementary tax ("precompte") i s l e v i e d on p r o f i t d i s t r i b u t i o n s out o f untaxed c o r p o r a t e income. The tax i s equal t o one h a l f of the cash d i v i d e n d (or one t h i r d of the d i v i d e n d grossed up f o r the shareholder c r e d i t ) . The i n d i v i d u a l t r e a t s the d i v i d e n d i n the same manner as above. Long term c a p i t a l gains and e a r n i n g s r e t a i n e d beyond f i v e y e a r s , without d i s t r i b u t i o n , are a l s o s u b j e c t t o the precompte. T h i s l a s t c a t c h n e c e s s i t a t e s an o r d e r i n g of d i s t r i b u t i o n s from c u r r e n t l y taxed sources, p r e v i o u s l y taxed sources and, l a s t l y , precompte sources. U n i t e d Kingdom The separate t a x a t i o n of companies commenced i n the U n i t e d Kingdom i n 1947. Major overhauls were e f f e c t e d i n 1958, 1965 and 1973. U n t i l 1965, a system of gross-up and c r e d i t was used. The -77-I n t e r n a t i o n a l Comparisons Chapter Four c r e d i t was granted a t a standard r a t e , whether c o r p o r a t e tax had been p a i d or not. The c l a s s i c a l system was adopted i n 1965. I t embodied the p r i n c i p l e t h a t the tax l i a b i l i t y o f a c o r p o r a t i o n should be completely independent of i n d i v i d u a l l i a b i l i t y . The o b j e c t i v e of the "separate e n t i t y " approach was to make c o r p o r a t i o n s more re s p o n s i v e to f i s c a l p o l i c y and independent o f i n d i v i d u a l s . A f l a t c o r p o r a t e r a t e was assessed. T h i s d i s c r i m i n a t e d between r e t a i n e d and d i s t r i b u t e d e a r n i n g s , the l a t t e r being taxed a second time i n the i n d i v i d u a l ' s hands. The c o r p o r a t e r a t e was changed f i v e times i n seven y e a r s , always f a l l i n g between f o r t y and f o r t y - f i v e p e r c e n t . To t a c k l e the problem of t a x - d e f e r r e d r e t a i n e d e a r n i n g s , a surtax was l e v i e d on c l o s e l y h e l d c o r p o r a t i o n s who f a i l e d t o d i s t r i b u t e a reasonable p r o p o r t i o n of p r o f i t s , b e a r i n g i n mind c a p i t a l needs f o r expansion. T h i s round of reform a l t e r e d the circumstances and l e v e l of p r o f i t a t which there were advantages to i n c o r p o r a t i n g . The p e r i o d 1965-69 saw a s i g n i f i c a n t drop i n net c o r p o r a t e r e g i s t r a t i o n s . In f a c t , there were net d e c l i n e s i n 1968 and 1969. F u r t h e r reform study i n 1971 contemplated a r e t u r n t o the o l d imputation system or a s p l i t - r a t e system. The former was s e l e c t e d i n 1973 w i t h one c h a n g e — o n l y " c r e d i t a b l e " tax, t h a t i s d i s t r i b u t i o n s on which c o r p o r a t e tax had been p a i d , q u a l i f i e d f o r the p e r s o n a l c r e d i t . The imputation system i n v o l v e d : 1. A s i n g l e c o r p o r a t e r a t e on a l l income, d i s t r i b u t e d or r e t a i n e d ; 2. No source w i t h - h o l d i n g s on d i v i d e n d s ; 3. An advance payment by the c o r p o r a t i o n upon d i s t r i b u t i o n ; -78-I n t e r n a t i o n a l Comparisons Chapter Four 4. A c r e d i t t o the i n d i v i d u a l equal to the advance ta x . The tax i s added to the d i v i d e n d f o r i n c l u s i o n i n income. The payment of d i v i d e n d s c r e a t e d a l i a b i l i t y o f the c o r p o r a t i o n c a l l e d "advance c o r p o r a t i o n tax" ("A.C.T."), and was equal to one h a l f of the cash d i s t r i b u t i o n . T h i s tax c o u l d be o f f s e t a g a i n s t the r e g u l a r c o r p o r a t e t a x . The c o r p o r a t e r a t e was s e t a t f i f t y - t w o percent, or f o r t y percent where p r o f i t s o f a s s o c i a t e d c o r p o r a t i o n s were l e s s than £70,000. Recently, the r a t e was dropped to t h i r t y - e i g h t percent and the c e i l i n g was i n c r e a s e d to 1100,000. The imputation system i s geared t o a n o t i o n a l tax r a t e of 33 1/3 p e r c e n t . The purpose of the A.C.T. i s to ensure t h a t the i n d i v i d u a l only r e c e i v e s tax c r e d i t f o r c r e d i t a b l e e a r n i n g s . In t h i s r e g a r d , i t i s a k i n to the French "precompte". The l i m i t a t i o n on the o f f s e t of A.C.T. a g a i n s t r e g u l a r c o r p o r a t e tax to one t h i r d of t a x a b l e income ensures t h a t the c o r p o r a t i o n w i t h income t h a t has not been taxed a t the f u l l r a t e w i l l have p a i d , a t minimum, a tax of 33 1/3 p e r c e n t . T h i s equates to the e f f e c t i v e r a t e of tax c r e d i t t h a t flows t o the i n d i v i d u a l . I f A.C.T. exceeds r e g u l a r c o r p o r a t e tax i n a year, there are carryback and c a r r y f o r w a r d p r o v i s i o n s . P r o v i s i o n s were r e t a i n e d t o f o r c e d i s t r i b u t i o n i n c l o s e l y h e l d c o r p o r a t i o n s c o n t r o l l e d by l e s s than s i x i n d i v i d u a l s . I f t r a d i n g p r o f i t s exceeded 11,001, f i f t y p e rcent had to be d i s t r i b u t e d and i f investment income exceeded E101, one hundred percent had to be d i s t r i b u t e d . F a i l u r e t o do t h i s may i n c u r a deemed d i s t r i b u t i o n . -79-I n t e r n a t i o n a l Comparisons Chapter Four Proof of c a p i t a l needs f o r expansion c o u l d a l l e v i a t e these p r o v i s i o n s . R e s t r i c t i o n s were a l s o p l a c e d on e x c e s s i v e remuneration or i n t e r e s t payments. The r e l i e v i n g p r o v i s i o n of A.C.T. payments i s of course no use to c o r p o r a t e cash flow f o r companies w i t h no other c o r p o r a t e tax l i a b i l i t y . An imputation system r e s t s u n e a s i l y w i t h a c o r p o r a t e tax base under which many companies have no l i a b i l i t y . I t was c r i t i c a l i n the 1970's i n the U n i t e d Kingdom to p r o v i d e some form of tax r e l i e f from i n f l a t i o n . Companies were e a r n i n g paper p r o f i t s but had no cash. In 1973, companies c o u l d deduct f o r tax purposes the excess of the change i n the book v a l u e o f i n v e n t o r y over ten percent of gross t r a d i n g p r o f i t s . In 1976, t h i s was changed t o f i f t e e n p e r c e n t of t r a d i n g p r o f i t s a f t e r d e p r e c i a t i o n . Other r e c e n t changes i n the U n i t e d Kingdom w i l l a f f e c t s m a l l b u s i n e s s : 1. The p e r s o n a l m a r g i n a l r a t e s have been s i g n i f i c a n t l y reduced. 2. New u n i n c o r p o r a t e d b u s i n e s s e s may c a r r y l o s s e s back up to three y e a r s . 3. Self-employed pension l i m i t s have been i n c r e a s e d . 4. C a p i t a l g a i n r e l i e f has been p r o v i d e d f o r the r e t i r i n g self-employed and f o r i n t e r - g e n e r a t i o n a l b u s i n e s s t r a n s f e r s . A "Business Expansion Scheme" was i n t r o d u c e d i n 1981 to encourage venture c a p i t a l t o i n v e s t i n new b u s i n e s s . The i n d i v i d u a l may - 8 0 -I n t e r n a t i o n a l Comparisons Chapter Four deduct the investment (not to exceed a c e i l i n g , c u r r e n t l y £40,00 0) a g a i n s t income, p r o v i d e d h i s ownership does not exceed t h i r t y p e r c e n t . A separate scheme allows c a p i t a l l o s s e s from smal l businesses to be t r e a t e d as income, not c a p i t a l , l o s s . There i s f u r t h e r d i s c u s s i o n c u r r e n t l y t o i n s t i t u t e graduated r a t e s w i t h i n the s m a l l business range of 3E100,000. T h i s would generate more i n t e r n a l funds, which the government sees as d e s i r a b l e . Germany Germany operated a s p l i t - r a t e system from 1953 t o 1976. C o r p o r a t i o n s were taxed a t f i f t y - o n e percent on u n d i s t r i b u t e d p r o f i t and a t f i f t e e n p e r c e n t on d i s t r i b u t e d p r o f i t . The reform process commenced i n 1971 and r e s u l t e d i n the adoption of a h y b r i d of imputation and s p l i t - r a t e systems. The b a s i c c o r p o r a t e r a t e i s f i f t y - s i x p e r c e n t but twenty percent i s refunded upon d i s t r i b u t i o n , b r i n g i n g the e f f e c t i v e c o r p o r a t e r a t e on d i s t r i b u t i o n s t o t h i r t y - s i x p e r c e n t . The i n d i v i d u a l grosses up h i s cash d i v i d e n d by 9/16ths f o r i n c l u s i o n i n h i s p e r s o n a l tax r e t u r n and claims a tax c r e d i t f o r t h a t 9/16ths. In a d d i t i o n , a t w e n t y - f i v e percent w i t h - h o l d i n g tax i s l e v i e d , which i s a l s o claimed on the p e r s o n a l tax r e t u r n . To d e a l w i t h the i s s u e of c r e d i t a b l e tax, the German system r e q u i r e s the t r a c k i n g o f three e a r n i n g s p o t s : one t h a t has borne the f u l l f i f t y - s i x p ercent; one t h a t has borne the t h i r t y - s i x percent; and one t h a t has borne no t a x . Dividends are presumed to be drawn from these t h r e e pots on a "H.I.F.O." ( h i g h e s t - i n , f i r s t - o u t ) b a s i s . I f the f i r s t two pots are d r a i n e d , the c o r p o r a t i o n must pay a tax on d i s t r i b u t i o n s from -81-I n t e r n a t i o n a l Comparisons Chapter Four the tax-unpaid pot i n the amount of the i n d i v i d u a l ' s c r e d i t , i . e . 9/16ths. This i s ak i n t o the French precompte and the B r i t i s h A.C.T. Japan The Japanese system i s a m o d i f i e d imputation system. The co r p o r a t e r a t e i s a composite o f thr e e j u r i s d i c t i o n a l t a x e s . The r a t e s i n each l e v e l are a f u n c t i o n o f paid-up c a p i t a l and annual t a x a b l e income. D i f f e r e n t r a t e s apply a t two of the l e v e l s f o r d i s t r i b u t e d and u n d i s t r i b u t e d p r o f i t s . The tax a l s o v a r i e s by g e o g r a p h i c a l j u r i s d i c t i o n . In t o t a l , the tax r a t e s range as f o l l o w s : ON DISTRIBUTED INCOME 43.0% to 44.3% ON UNDISTRIBUTED INCOME 54.7% to 56.4% There i s a f i f t e e n p e r c e n t w i t h - h o l d i n g tax on d i v i d e n d s . Ungrossed d i v i d e n d s are i n c l u d e d i n p e r s o n a l income and r e c e i v e a tax c r e d i t of ten pe r c e n t . A p e n a l t y surtax may be l e v i e d on f a m i l y c o r p o r a t i o n s with c o n t r o l owned d i r e c t l y or i n d i r e c t l y by l e s s than four i n d i v i d u a l s ( a b l o o d - r e l a t e d f a m i l y counts as one). The le v y occurs f o r d e f e r r i n g tax on r e t a i n e d e a r n i n g s . The formula i s complicated and won't be d i s c u s s e d f u r t h e r . A u s t r a l i a Companies i n A u s t r a l i a pay a f o r t y - s i x percent tax r a t e , r e g a r d l e s s of s i z e or d i s t r i b u t i o n . Shareholders are taxed on d i v i d e n d d i s t r i b u t i o n s without c r e d i t . P r i v a t e companies are r e q u i r e d to make s u f f i c i e n t r e g u l a r d i s t r i b u t i o n s or e l s e face a tax. The r e q u i r e d d i s t r i b u t i o n must be made w i t h i n t e n months o f -82-I n t e r n a t i o n a l Comparisons Chapter Four the r e l e v a n t year-end. The requirement i s to pay d i v i d e n d s a t l e a s t equal t o d i s t r i b u t a b l e income l e s s a r e t e n t i o n allowance. D i s t r i b u t a b l e income i s e s s e n t i a l l y a f t e r - t a x income. The r e t e n t i o n allowance i s a percentage amount which can be r e t a i n e d without p o t e n t i a l p e n a l t y . I t i s the sum o f : - s i x t y percent of d i s t r i b u t a b l e income l e s s p r o p e r t y income - ten per c e n t o f p r o p e r t y income. A tax of f i f t y p e rcent i s l e v i e d on t h i s s h o r t f a l l . U n i t e d S t a t e s The U n i t e d S t a t e s u t i l i z e s a c l a s s i c a l system. The c o r p o r a t e r a t e s are p r o g r e s s i v e , peaking a t f o r t y - s i x percent, as f o l l o w s : Taxable income Tax r a t e $ 0 - 25,000 17% 25,000 - 50,000 20 50,000 - 75,000 30 75,000 -100,000 40 beyond 100,000 46 There i s no w i t h h o l d i n g tax on d i v i d e n d d i s t r i b u t i o n s . The i n d i v i d u a l adds the cash d i v i d e n d t o h i s p e r s o n a l tax r e t u r n and cla i m s no c r e d i t . C o r p o r a t i o n s are prevented from accumulating excess u n d i s t r i b u t e d p r o f i t s by the i m p o s i t i o n o f a p e n a l t y t a x . Tax i s imposed a t 27 1/2 percent on the f i r s t $100,000 o f such excess and a t 38 1/2 percent on any remainder. The pot i s allowed to accumulate, without p e n a l t y , $250,000 o f p r i o r and c u r r e n t earnings as w e l l as a l l long term c a p i t a l g a i n s . A f t e r - t a x income beyond t h i s i n c u r s the tax. The prime o b j e c t i v e here i s not r e v e n u e - r e l a t e d , per se, but an inducement t o t r i g g e r the second l e v e l o f tax on c o r p o r a t e income. -83-I n t e r n a t i o n a l Comparisons Chapter Four The U n i t e d S t a t e s Treasury i s c u r r e n t l y pondering some 2 s i g n i f i c a n t s h i f t s i n c o r p o r a t e t a x a t i o n p o l i c y . The p r o g r e s s i v e r a t e s t r u c t u r e above may be r e p l a c e d by a s i n g l e r a t e o f t h i r t y - t h r e e p e r c e n t . I t i s a l s o proposed t o e l i m i n a t e or reduce investment tax c r e d i t s and pro v i d e some form of r e l i e f when d i v i d e n d s are p a i d . L a s t , and almost c o m i c a l , the "Dom Perignon" s e t i s i n danger I The Treasury proposes t o c u t down on the d e d u c t i b i l i t y o f "promotion". B u s i n e s s - r e l a t e d meal expense would be r e s t r i c t e d t o ten d o l l a r s per person f o r b r e a k f a s t , f i f t e e n d o l l a r s f o r lunch and t w e n t y - f i v e d o l l a r s f o r d i n n e r . Complimentary t i c k e t s t o s p o r t i n g events and the l i k e would become non - d e d u c t i b l e . The ambitious g o a l o f t r u e i n t e g r a t i o n i s t o s e t a s i d e the cor p o r a t e conduit i n the t a x a t i o n o f co r p o r a t e - s o u r c e income. There are p r a c t i c a l d i f f i c u l t i e s i n a d m i n i s t e r i n g t h i s method f o r p u b l i c c o r p o r a t i o n s . However, prima f a c i e , the a d m i n i s t r a t i v e o b j e c t i o n does not seem so g r e a t f o r p r i v a t e c o r p o r a t i o n s . The United S t a t e s attempted t h i s i n 1958 wit h i t s "Subchapter S" l e g i s l a t i o n . The i n t e n t was to minimize the e f f e c t o f income taxes as a f a c t o r i n the i n c o r p o r a t i o n d e c i s i o n . The c o r p o r a t i o n ' s income would be a l l o c a t e d t o shareholders and taxed a t p e r s o n a l r a t e s o n l y , l i k e p a r t n e r s h i p income. T h i s i s p a r t i c u l a r l y a t t r a c t i v e i n the Un i t e d S t a t e s where t h e r e i s no r e l i e f from double t a x a t i o n o f d i v i d e n d s . "For the c l o s e c o r p o r a t i o n , the response t o t h i s double t a x a t i o n i s g e n e r a l l y to 3 a v o i d payment of d i v i d e n d s i n s o f a r as f e a s i b l e . " -84-I n t e r n a t i o n a l Comparisons Chapter Four Complete s p e c i f i c a t i o n of t h i s concept i n tax law made the l e g i s l a t i o n complex and f u l l of t e c h n i c a l t r a p s f o r the unwary. " I t has been e v i d e n t f o r the l a s t twenty-four years however, t h a t the complex formulas to i n t e g r a t e the v a r i o u s segments of the new system and the many safeguards i n c o r p o r a t e d to prevent abuse have caused Subchapter S t o be one of the foremost t r a p s i n the Code." The l e g i s l a t i o n developed a complex maze o f p r o v i s i o n s to determine whether to t r e a t d i s t r i b u t i o n s as t a x a b l e d i v i d e n d s from p r o f i t s or as untaxable d i v i d e n d s from p r e v i o u s l y taxed income or as a r e t u r n of c a p i t a l . The o p t i o n s of e l e c t i n g i n and out a t w i l l a l s o r e q u i r e d much l e g i s l a t i o n . The r e s u l t was t h a t most s m a l l businesses i g n o r e d the p r o v i s i o n s . T h i s concept r e c e i v e d a major overhaul and s i m p l i f i c a t i o n , e f f e c t i v e f o r 1982 and subsequent tax y e a r s . Now, the c r i t e r i a i n order t o q u a l i f y f o r the Subchapter S e l e c t i o n are: 1. No more than t h i r t y - f i v e s h a r e h o l d e r s . Over the years t h i s number has i n c r e a s e d from ten to f i f t e e n t o t w e n t y - f i v e . M a r r i e d couples count as one; 2. Shareholders must be c i t i z e n s , r e s i d e n t s , e s t a t e s or  c e r t a i n t r u s t s . C o r p o r a t i o n s , p a r t n e r s h i p s and most t r u s t s are i n e l i g i b l e ; 3. Only one c l a s s of stock. D i f f e r e n t c l a s s e s may e x i s t i f the s o l e d i f f e r e n c e i s v o t i n g r i g h t s . A shareholder debt instrument i s not t r e a t e d as a c l a s s of s t o c k , provided c e r t a i n c o n d i t i o n s are met; and 4. Must be a domestic c o r p o r a t i o n . Members o f an a f f i l i a t e d group are i n e l i g i b l e . -85-I n t e r n a t i o n a l Comparisons Chapter Four A unanimous e l e c t i o n must be f i l e d no l a t e r than the s e v e n t y - f i f t h day of the f i s c a l year i n q u e s t i o n . A c o r p o r a t i o n must meet the q u a l i f y i n g t e s t s throughout the p e r i o d i n q u e s t i o n . The e l e c t i o n c o n t i n u e s u n l e s s d i s q u a l i f i e d or revoked. D i s q u a l i f i c a t i o n e s s e n t i a l l y occurs i f a c o r p o r a t i o n ceases to meet the c r i t e r i a . The change i n s t a t u s becomes e f f e c t i v e on the date t h a t circumstances change. D i s q u a l i f i c a t i o n may a l s o occur i f more than t w e n t y - f i v e percent of gross r e c e i p t s i n t h r e e s u c c e s s i v e years a r i s e s from p a s s i v e sources and the company had accumulated earnings and p r o f i t s from p e r i o d s p r i o r to b eing an S c o r p o r a t i o n . Here the d i s q u a l i f i c a t i o n i s e f f e c t i v e a t the b e g i n n i n g of the f o u r t h year. V o l u n t a r y r e v o c a t i o n may be f i l e d by a m a j o r i t y of the ownership, e f f e c t i v e on a s e l e c t e d date. The o l d l e g i s l a t i o n p e r m i t t e d a new shareholder to s i n g l e - h a n d e d l y t r i g g e r a r e v o c a t i o n . Now, new s h a r e h o l d e r s are bound by the e l e c t i o n u n l e s s they a c q u i r e c o n t r o l . An S c o r p o r a t i o n t h a t d i s c o n t i n u e s i t s s t a t u s may e l e c t back a f t e r f i v e y e a r s . "Under the new law, i n s t e a d of merely a l l o c a t i n g b o ttom-line income or l o s s ... as was the custom under p r i o r law, an S C o r p o r a t i o n w i l l now pass through each item of income, ded u c t i o n , l o s s or c r e d i t which c o u l d a f f e c t the tax l i a b i l i t y o f any shareholder based on the p r o - r a t e d number o f days d u r i n g the r e l e v a n t S year t h a t each h e l d stock i n the c o r p o r a t i o n . " In o t h e r words, each shareholder w i l l determine each item's tax treatment based on p e r s o n a l circumstances. Income i s i n c l u d e d i n the i n d i v i d u a l ' s c a l e n d a r tax year f o r the c o r p o r a t i o n ' s f i s c a l p e r i o d ending i n t h a t year. While l o s s e s a l s o pass through d i r e c t l y t o the p e r s o n a l r e t u r n s , t h e r e are - 8 6 -I n t e r n a t i o n a l Comparisons Chapter Four r e s t r i c t i o n s . The l o s s i s l i m i t e d t o the sum of the a d j u s t e d b a s i s of stock a t the beginning o f the year p l u s the a d j u s t e d b a s i s o f shareholder advances. Thus, l o s s e s i n excess o f these two bases do not pass f r e e l y t o the i n d i v i d u a l but must be c a r r i e d forward t o a subsequent tax year when there i s adequate b a s i s . As w i t h p a r t n e r s h i p s , d i s t r i b u t i o n s g e n e r a l l y are non-taxable t r a n s a c t i o n s as long as the share h o l d e r s have b a s i s . I f d i s t r i b u t i o n s exceed b a s i s , the excess i s t a x a b l e as a c a p i t a l g a i n . However, the l e g i s l a t i o n becomes complicated here. C o r p o r a t i o n s may have accumulated ea r n i n g s and p r o f i t s from p e r i o d s p r i o r t o , or between, S e l e c t i o n s . These have not been s u b j e c t t o p e r s o n a l t a x a t i o n . T h e r e f o r e , d i s t r i b u t i o n s from t h i s pot are t a x a b l e d i v i d e n d s . D i s t r i b u t i o n s are ordered so as t o apply f i r s t l y t o the t a x - p a i d pot. S p e c i f i c P r o v i s i o n s The p r e c e d i n g has o u t l i n e d the b a s i c c o r p o r a t e tax systems o f s e l e c t e d c o u n t r i e s . The f o l l o w i n g w i l l h i g h l i g h t other tax p r o v i s i o n s of i n t e r e s t i n v a r i o u s c o u n t r i e s . Tax D e p r e c i a t i o n Most developed c o u n t r i e s have pursued s i m i l a r systems o f tax d e p r e c i a t i o n , or " c a p i t a l c o s t allowance". Almost a l l p r o v i d e r a t e s and methods t h a t are generous v i s - S - v i s a c c o u n t i n g d e p r e c i a t i o n , which encompasses a n o t i o n a l estimate o f the l i f e and salvage value of an a s s e t . S t r a i g h t l i n e and d e c l i n i n g balance methods are e q u a l l y common. Some c o u n t r i e s , l i k e Japan, - 8 7 -I n t e r n a t i o n a l Comparisons Chapter Four France and B r i t a i n , p r o v i d e a c c e l e r a t e d d e p r e c i a t i o n f o r s p e c i f i c purposes ( f o r i n s t a n c e , i n c e n t i v e s t o depressed g e o g r a p h i c a l a r e a s ) . Since 1982, the U n i t e d S t a t e s has allowed a c c e l e r a t e d d e p r e c i a t i o n a t one hundred percent on $5,000 of annual c a p i t a l a d d i t i o n s . The t r a d e - o f f i s t h a t no investment tax c r e d i t s may be claimed on t h i s amount. Therefore, the tax saving from a c c e l e r a t e d d e p r e c i a t i o n i s o f f s e t by the foregone tax c r e d i t . Investment Tax C r e d i t s Some c o u n t r i e s , l i k e Germany, have no such p r o v i s i o n s . Japan o f f e r s 5 1/4 percent t o seven percent f o r energy-saving e x p e n d i t u r e s , as w e l l as c r e d i t s f o r r e s e a r c h and development r e l a t e d a c t i v i t i e s . The United S t a t e s o f f e r s a ten pe r c e n t c r e d i t f o r c e r t a i n e x penditures. Corporate Losses I n t e r - p e r i o d l o s s u t i l i z a t i o n i s very common, though the s p e c i f i c p r o v i s i o n s vary. France, A u s t r i a and Denmark, f o r i n s t a n c e , a l l o w f i v e year c a r r y f o r w a r d s o n l y . Germany does l i k e - w i s e , but a l s o allows a one year c a r r y b a c k . I n f l a t i o n Adjustment Japan p r o v i d e s an " i n v e n t o r y allowance", s i m i l a r t o Canada, o f 3.8 percent of c l o s i n g i n v e n t o r y . B r i t a i n p r o v i d e s a l e s s c l e a r - c u t allowance o f the i n c r e a s e i n i n v e n t o r y over the year minus f i f t e e n percent of t a x a b l e income. The United S t a t e s allows L.I.F.O. i n v e n t o r y a c c o u n t i n g f o r tax purposes; however, the r e q u i r e d methodology i s so complex t h a t most smal l b u s i n e s s e s would not bother. -88-I n t e r n a t i o n a l Comparisons Chapter Four Investment Allowances and Reserves In t h e i r purpose, investment allowances are r e a l l y a surrogate f o r investment tax c r e d i t s . They s t i m u l a t e investment i n c a p i t a l a s s e t s by way of tax i n c e n t i v e . A u s t r i a , Holland and A u s t r a l i a a l l o w a twenty pe r c e n t deduction from t a x a b l e income on the c o s t of c a p i t a l a d d i t i o n s . T h i s allowance u s u a l l y does not lower the c o s t amount f o r d e p r e c i a t i o n purposes. Investment r e s e r v e s are r e l a t e d , but d i f f e r e n t . The concept a l l o w s funds t o be a p p r o p r i a t e d i n e q u i t y , with tax p r e f e r e n c e , f o r c a p i t a l expansion at a l a t e r d a t e . I t i s hoped t h a t t h i s scheme would s t i m u l a t e investment i n a r e c e s s i o n . In Sweden, f o r i n s t a n c e , a maximum of f i f t y p e r c e n t of annual t a x a b l e income may be s e t a s i d e , tax f r e e . H a l f of t h i s fund must be secured by bank d e p o s i t investments. Approval i s needed to a p p r o p r i a t e funds to v a r i o u s s p e c i f i c purposes. Denmark and A u s t r i a both a l l o w up to t w e n t y - f i v e percent of annual t a x a b l e income to be s e t a s i d e tax f r e e f o r s i m i l a r purposes. The A u s t r i a n system s e t s a time l i m i t of four y e a r s . Summary In summary, i n t e r n a t i o n a l comparisons o f s m a l l b u s i n e s s t a x a t i o n p r o v i d e some o b s e r v a t i o n s f o r reform: 1. Our s m a l l b u s i n e s s tax r a t e s appear t o be lower than most. 2. Our system i s l a x , i n t h a t the flow-through of c o r p o r a t e tax c r e d i t s i s not dependent on c r e d i t a b l e tax being p a i d . 3. Even c o u n t r i e s t h a t p r o v i d e d i v i d e n d r e l i e f may l e v y an - 8 9 -I n t e r n a t i o n a l Comparisons Chapter Four a d d i t i o n a l w i t h h o l d i n g tax on d i v i d e n d d i s t r i b u t i o n s . 4. Co u n t r i e s which monitor c r e d i t a b l e tax al l o w p e r s o n a l refunds when d i v i d e n d tax c r e d i t s exceed p e r s o n a l taxes. 5. Many c o u n t r i e s impose a tax to f o r c e d i s t r i b u t i o n s and disco u r a g e long term r e t a i n e d e a r n i n g s . 6. Other c o u n t r i e s s u f f e r from the complexity o f s m a l l business r u l e s as w e l l . 7. Our c a p i t a l c o s t allowance and investment tax c r e d i t systems are a t l e a s t as generous as other c o u n t r i e s . 8. The l o s s c a r r y o v e r p r o v i s i o n s i n the A p r i l 1983 Budget are more generous than i n most other c o u n t r i e s . 9. I f one accepts the "conduit" concept, then some form of d i v i d e n d r e l i e f i s b e t t e r than none. -90-I n t e r n a t i o n a l Comparisons C h a p t e r F o u r FOOTNOTES 1. " C a n a d i a n T a x a t i o n " W i n t e r 1981 " H i s t o r y o f t h e Income Tax" pg 170 2. G l o b e & M a i l , November 28, 1984 3. S o b e l o f f W e i d e n b r u c h p g 12 4. "An a n a l y s i s o f t h e S u b c h a p t e r S R e v i s i o n A c t : e l i g i b i l i t y , e l e c t i o n , t e r m i n a t i o n " R Shaw and J A u g u s t , The J o u r n a l o f T a x a t i o n , J a n u a r y 19 83, pg 2 5. " S u b c h a p t e r S R e v i s i o n A c t Makes S i g n i f i c a n t C h a n g e s i n T a x i n g S C o r p o r a t i o n O p e r a t i o n s " R Shaw a n d J A u g u s t , The J o u r n a l o f T a x a t i o n , F e b r u a r y 1 9 8 3 , pg 84 - 9 1 -I n t e r n a t i o n a l C o m p a r i s o n s Chapter F i v e CURRENT PROVISIONS "A r a d i c a l f u g i t i v e tax p r o t e s t e r from North Dakota k i l l e d a l o c a l s h e r i f f , then d i e d F r i d a y n i g h t i n an i n f e r n o o f exploding ammunition and dynamite i n a concret e b u n k e r - l i k e house. The s i x t y - t h r e e year o l d member o f Posse Comitatus, an u l t r a - c o n s e r v a t i v e s u r v i v a l i s t group t h a t r e f u s e s t o recog n i z e the government's r i g h t t o l e v y income tax, was c o n v i c t e d o f f a i l i n g t o f i l e a tax r e t u r n i n 1977." New York Times S e r v i c e I n t r o d u c t i o n Chapter Three p r o v i d e d h i s t o r i c a l background on the i s s u e s and e v o l u t i o n of the Canadian c o r p o r a t e tax system. T h i s chapter w i l l look a t s p e c i f i c tax p r o v i s i o n s which are intended t o e l i c i t c e r t a i n behaviour from the co r p o r a t e s e c t o r . Some p r o v i s i o n s are d i r e c t e d a t busi n e s s i n g e n e r a l , o t h e r s g i v e p r e f e r e n c e t o the co r p o r a t e form o n l y , and s t i l l o t h e r s aim s p e c i f i c a l l y a t i n c o r p o r a t e d s m a l l b u s i n e s s . Governments use tax l e g i s l a t i o n as a f i s c a l l e v e r , as w e l l as a t o o l t o achieve other s o c i a l and p o l i t i c a l o b j e c t i v e s . Small bu s i n e s s l e g i s l a t i o n i s one such example. F i s c a l measures are t y p i c a l l y s h o r t term i n d u r a t i o n and, t h e r e f o r e , u n s t a b l e . One must c o n s i d e r the q u e s t i o n s : Can bus i n e s s r e a c t q u i c k l y enough t o s h o r t term measures to h e l p achieve the intended g o a l s ? and: Is the Income Tax A c t an a p p r o p r i a t e v e h i c l e f o r s h o r t term r e s u l t s ? S i x t y years o f l e g i s l a t i o n has not been ab l e t o r e s o l v e c o n c l u s i v e l y a number of i s s u e s t h a t were problems from the s t a r t . The major commitment t o reform i n the S i x t i e s d i d not s e t t l e those i s s u e s . I t d i d r e s u l t i n the most comprehensive changes to-date. However, s i n c e 1971, the numerous budgets have, l i k e the l i t t l e Dutch Boy, attempted to plu g a myriad o f l e a k s . -92-Current P r o v i s i o n s Chapter F i v e T h i s r e p a i r work has not been p a r t i c u l a r l y s u c c e s s f u l e i t h e r . Perhaps the b i g g e s t problem - i n s t a b i l i t y - stems from t h i s ongoing c o n s t r u c t i o n . The oth e r problems i n c l u d e ; i n t e g r a t i o n o f the co r p o r a t e tax system, the a s s o c i a t i o n t e s t s , t a x i n g i n f l a t i o n a r y p r o f i t s , the d e f i n i t i o n o f a c t i v e b u s i n e s s income, income s p l i t t i n g techniques, shareholder loans and b e n e f i t s and tax d e f e r r a l i n e q u i t i e s . The Income Tax Act f r e q u e n t l y uses the term "person" to d e f i n e a ta x a b l e e n t i t y and t h i s i n c l u d e s both c o r p o r a t i o n s and i n d i v i d u a l s . T h i s broad d e f i n i t i o n o f "person" allows much o f the Act t o address a l l e n t i t i e s s i m u l t a n e o u s l y . Thus, from the tax aspect, i n many i s s u e s t h e r e would be no d i f f e r e n c e between i n c o r p o r a t i n g and not i n c o r p o r a t i n g . However, there remain areas o f d i f f e r e n t treatment when a c o r p o r a t i o n i s i n v o l v e d . Some o f the d i f f e r e n c e s are permanent and some are t i m i n g d i f f e r e n c e s . I t i s these d i f f e r e n c e s t h a t have spawned volumes of e d i t o r i a l s , books and s t u d i e s . The l a r g e s t c o n t r o v e r s y c e n t e r s on i n t e g r a t i o n and double t a x a t i o n . I t i s a matter o f o p i n i o n as t o whether there i s a s a t i s f a c t o r y r e s o l u t i o n t o t h i s problem. However, other d i f f e r e n c e s e x i s t as w e l l , and these are not to be condoned i f one accepts the premise t h a t the d e c i s i o n t o i n c o r p o r a t e should not be i n f l u e n c e d by tax i s s u e s . For i n s t a n c e , i t i s amazing t h a t , u n t i l the i l l - f a t e d C o n s e r v a t i v e Budget of 19 79, and d e s p i t e the l a r g e number of un i n c o r p o r a t e d e n t i t i e s i n the country, s a l a r i e s p a i d t o the spouse o f an u n i n c o r p o r a t e d b u s i n e s s person were not d e d u c t i b l e . E q u a l l y amazing s t i l l today, the a c t i v i t y of manufacturing and p r o c e s s i n g r e c e i v e s a tax -93-Current P r o v i s i o n s Chapter F i v e p r e f e r e n c e i n the c o r p o r a t e s e c t o r but not i n the un i n c o r p o r a t e d s e c t o r . A l s o , s c i e n t i f i c r e s e a r c h by i n c o r p o r a t e d s m a l l b u s i n e s s e s r e c e i v e s an investment tax c r e d i t f i f t e e n p e r c e n t h i g h e r than t h a t r e c e i v e d by u n i n c o r p o r a t e d e n t i t i e s . The sm a l l b u s i n e s s development bond ("SBDB") concept t h a t was i n t r o d u c e d i n 1979, i n i t i a l l y t o f a c i l i t a t e s m a l l b u s i n e s s f i n a n c i n g o f s c i e n t i f i c r e s e a r c h and c a p i t a l expansion, was r e s t r i c t e d t o co r p o r a t e e n t i t i e s . 1 I t i s a common b e l i e f t h a t s m a l l b u s i n e s s tax p r e f e r e n c e i s intended t o m i t i g a t e i n a c c e s s a b i l i t y t o p u b l i c c a p i t a l markets. T h i s was the b e l i e f t h a t l e d t o the c u r r e n t s m a l l b u s i n e s s system c r e a t e d i n 1971. The same b e l i e f e x i s t e d almost a decade l a t e r , as evidenced by the o r i g i n a l SBDB l e g i s l a t i o n . The e x i s t i n g Canadian answer to double t a x a t i o n , "gross-up and c r e d i t " o f d i v i d e n d s , p r o v i d e s f o r ( p o t e n t i a l l y long term) d e f e r r a l o f the second l e v e l of t a x a t i o n on the i n d i v i d u a l . T h i s t a x - d e f e r r e d pot of r e t a i n e d earnings i s supposed t o p r o v i d e i n t e r n a l f i n a n c i n g . I t i s c o n t r a d i c t o r y p o l i c y t h a t the un i n c o r p o r a t e d b u s i n e s s s u f f e r s from the same f i n a n c i n g d i f f i c u l t i e s ; y e t , i t s income i s taxed c u r r e n t l y year a f t e r year. The i n c o r p o r a t i o n d e c i s i o n i s a l s o a f f e c t e d by tax p r o v i s i o n s concerning the short-term a n t i c i p a t e d p r o f i t a b i l i t y o f a new vent u r e . Unincorporated l o s s e s can o f f s e t , without l i m i t , other income sources of an i n d i v i d u a l taxpayer. Corporate l o s s e s , however, must remain w i t h i n the c o r p o r a t i o n without immediate tax advantage. For t h i s reason, wise c o u n s e l suggests t h a t , where l o s s e s occur i n the i n i t i a l y e a r s , i n c o r p o r a t i o n may be -94-Current P r o v i s i o n s Chapter F i v e i n a p p r o p r i a t e . " R o l l o v e r " p r o v i s i o n s i n the Act a l l o w a going-concern p a r t n e r s h i p or p r o p r i e t o r s h i p to t r a n s f e r i t s busi n e s s a s s e t s and a c t i v i t y i n t o a c o r p o r a t i o n l a t e r when p r o f i t s commence. These t w i s t s o f the Act r e s u l t i n convoluted tax p l a n n i n g and high p r o f e s s i o n a l f e e s . As i n d i c a t e d a t the o u t s e t , t h i s study i s not intended t o p r o v i d e a comprehensive t e c h n i c a l r e f e r e n c e on s m a l l b u s i n e s s t a x a t i o n . T h i s s e c t i o n i s intended as a survey o f the s e t o f small b u s i n e s s f i s c a l l e v e r s c u r r e n t l y i n p l a c e . Small Business Tax Rates Small b u s i n e s s c o r p o r a t i o n s have r e c e i v e d p r e f e r e n t i a l tax r a t e s s i n c e the reform of 1949. U n t i l t h a t time, double t a x a t i o n o c c u r r e d without r e l i e f , and the lower r a t e was supposed t o compensate f o r t h i s i n e q u i t y v i s - a - v i s the u n i n c o r p o r a t e d s e c t o r . 2 A d u a l - r a t e c o r p o r a t e tax s t r u c t u r e was e s t a b l i s h e d i n 1949 a t : 10 percent on the f i r s t $10,000 of t a x a b l e income; and 33 per c e n t on the excess. By the time of reform i n 1972 the r a t e s t r u c t u r e was: 21 per c e n t on the f i r s t $35,000 o f t a x a b l e income; and 50 percent on the excess. T h i s low r a t e a p p l i e d t o s m a l l and l a r g e businesses a l i k e . When the smoke c l e a r e d over the reform process o f the S i x t i e s , s m a l l b u s i n e s s p r e f e r e n c e remained but the s h a r i n g o f the low r a t e w i t h b i g bus i n e s s was gone. The "haves" were separated from the "have-nots" by two new c o n c e p t s — a n n u a l and cumulative l i m i t s . To q u a l i f y f o r the low r a t e (now t w e n t y - f i v e percent) a -95-Current P r o v i s i o n s Chapter F i v e c o r p o r a t i o n had t o be C a n a d i a n - c o n t r o l l e d , p r i v a t e and have annual and cumulative l i m i t s l e s s than $ 5 0 , 0 0 0 and $ 4 0 0 , 0 0 0 , r e s p e c t i v e l y . V a r i o u s adjustments have been made to the l i m i t s : Annual l i m i t Cumulative l i m i t 1 9 7 2 $ 5 0 , 0 0 0 $ 4 0 0 , 0 0 0 1 9 7 4 1 0 0 , 0 0 0 5 0 0 , 0 0 0 1 9 7 6 1 5 0 , 0 0 0 7 5 0 , 0 0 0 1 9 8 2 2 0 0 , 0 0 0 1 , 0 0 0 , 0 0 0 The p r i n c i p l e behind the cumulative l i m i t i s t h a t a s m a l l b u s i n e s s should be allowed a g e s t a t i o n p e r i o d to grow i n t o a p r o f i t a b l e e n t i t y . The government c o n t r i b u t e s t o t h i s n u r t u r i n g by r e d u c i n g the tax burden f o r a minimum of f i v e years and p o t e n t i a l l y much longe r . Of course, t h i s r a t e advantage i s not a v a i l a b l e to u n i n c o r p o r a t e d e n t i t i e s . A l s o , the base o f the accumulation i s t a x a b l e income. V a r i o u s deductions are allowed i n a r r i v i n g at t h a t f i g u r e , i n p a r t i c u l a r s a l a r i e s , wages and bonuses to owner/managers. T h i s allows the remuneration tax p l a n n i n g e x e r c i s e to s h u f f l e p r e - t a x income between the c o r p o r a t i o n and the i n d i v i d u a l s h a r e h o l d e r s . I t was envisaged t h a t the accumulation would be monitored i n a simple "cumulative d e d u c t i o n account" ("CDA"). However, the CDA d i d not remain simple f o r very long a f t e r i t s c r e a t i o n . The ever-tenuous a s s o c i a t i o n t e s t s r e q u i r e d the CDA to be shared amongst a s s o c i a t e d companies. E l a b o r a t e c o r p o r a t e t r e e s p e r m i t t e d one company t o o b t a i n a r e d u c t i o n i n i t s CDA by d i s t r i b u t i n g d i v i d e n d s to an a s s o c i a t e , which might not have t o i n c r e a s e i t s CDA p r o p o r t i o n a t e l y . D i s t r i b u t i o n o f d i v i d e n d s c o u l d r e v e r s e the p r o g r e s s i o n to the cumulative l i m i t (termed, " f r e s h e n i n g " ) . In - 9 6 -Current P r o v i s i o n s Chapter F i v e 1980, c r e a t i o n of another c l a s s of t a x a b l e e n t i t y , the " n o n - q u a l i f y i n g b u s i n e s s " , i n t r o d u c e d a new requirement f o r v a r i o u s bumps and g r i n d s t o the CDA. Tax p l a n n i n g might d i r e c t a company t o b r i n g i t s t a x a b l e income below the annual l i m i t , i n order t o f u l l y q u a l i f y f o r the low r a t e . I f the CDA added annual p r o f i t s above the annual l i m i t , the excess amount was deadweight i n the a c c o u n t — i t c o u l d never be removed by paying d i v i d e n d s . I f the CDA was over, or approaching, i t s l i m i t , then d i v i d e n d s c o u l d be p a i d t o preserve the low r a t e f o r the next year and, p o t e n t i a l l y i n a s i m i l a r f a s h i o n , f o r e v e r . The November 1981 Budget changed p o l i c y and i m p l i e d t h a t i t was a t r a v e s t y t o grant " e t e r n a l l i f e " t o s m a l l business tax p r e f e r e n c e . "Freshening" was abandoned and everyone's CDA would e v e n t u a l l y approach the cumulative l i m i t . Of course, the s m a l l e r a b u s i n e s s was, the longer i t would take. Then the February 19 84 Budget determined t h a t the CDA concept was not necessary a t a l l . The s m a l l b u s i n e s s r a t e should be a v a i l a b l e e t e r n a l l y , s u b j e c t t o the annual l i m i t . Without the CDA, however, the measure o f " s m a l l " was eroded. Now the c r i t e r i a t o q u a l i f y f o r the s m a l l b u s i n e s s r a t e were: C a n a d i a n - c o n t r o l l e d ; and p r i v a t e . A number of l a r g e c o r p o r a t i o n s met these t e s t s and they enjoyed an o v e r n i g h t enrichment of approximately $50,000 per year i n lower t a x e s . T h i s r e p r e s e n t e d a h a l f - s t e p backward to the pre-reform days. The d e c i s i o n i n the May 1977 Budget t o enhance the d i v i d e n d tax c r e d i t l e d t o the " o v e r - i n t e g r a t i o n " and r a s h o f i n c o r p o r a t i o n s d i s c u s s e d p r e v i o u s l y . Many taxpayers were r e - a r r a n g i n g t h e i r a f f a i r s t o s t r u c t u r e a l i m i t e d company. T h i s i n c l u d e d -97-Current P r o v i s i o n s Chapter F i v e p r o f e s s i o n a l s , a t h l e t e s and e n t e r t a i n e r s . The government responded with a d d i t i o n a l l e g i s l a t i o n i n the November 1978 Budget which s p e c i f i c a l l y excluded c e r t a i n a c t i v i t i e s from the s m a l l b u s i n e s s r a t e . Instead, a new c l a s s i f i c a t i o n was c r e a t e d , " n o n - q u a l i f y i n g b u s i n e s s " ("NQB"), and g i v e n a mid-rate o f 33 1/3 p e r c e n t . T h i s was not always the exact r a t e , however, due t o the f e d e r a l / p r o v i n c i a l s h a r i n g of the income tax revenues. In B r i t i s h Columbia, f o r i n s t a n c e , the p r o v i n c i a l r a t e assessed on NQBs e q u a l l e d the b i g b u s i n e s s r a t e r a t h e r than the s m a l l b u s i n e s s r a t e . The p r o v i n c i a l r a t e thus exceeded the f e d e r a l abatement to the p r o v i n c e , r e s u l t i n g i n a f o r t y p e r c e n t r a t e f o r NQBs. Those caught i n the NQB net complained b i t t e r l y . The author b e l i e v e s t h a t , b e f o r e the enhancement to the d i v i d e n d tax c r e d i t and the ensuing stampede to i n c o r p o r a t e , t h i s d i v e r s e group of taxpayers f e l l r i g h t where the Act wanted t h e m — t a x e d on a c u r r e n t b a s i s a t t h e i r m a r g i n a l r a t e s . In order to achieve e q u i t y , t h i s i s where the Act would l i k e a l l taxpayers. T h i s i s a l s o where the e x i s t e n c e of c o r p o r a t i o n s causes a problem and where the concept of i n t e g r a t i o n i s important. The d e s i g n a t e d p r o f e s s i o n a l s were n e a t l y caught i n the d e s i r a b l e net because, p r o f e s s i o n a l l y , they were not allowed t o i n c o r p o r a t e . The enhancement of s m a l l b u s i n e s s t a x a t i o n p o p u l a r i z e d the concept o f s p l i t t i n g the p r o f e s s i o n a l s ' s e r v i c e s i n t o component p a r t s — p r o f e s s i o n a l and "support". The l a t t e r a c t i v i t y was operated i n the c o r p o r a t e e n t i t y . Beyond the d i v i d e n d tax c r e d i t enhancement, the tax pot was sweetened by two o t h e r o p p o r t u n i t i e s : f i r s t , the d e f e r r a l of the second l e v e l of t a x a t i o n on r e t a i n e d earnings; -98-Current P r o v i s i o n s Chapter F i v e and second, the use of income s p l i t t i n g w i t h a low-income or no-income spouse. I t was p o s s i b l e t h a t the NQB net a l s o trapped some innocent taxpayers as w e l l . I t was c o n c e i v a b l e t h a t one c o r p o r a t i o n c o u l d be p u r s u i n g both " a c t i v e " and " n o n - q u a l i f y i n g " a c t i v i t i e s . The policy-makers c o r r e c t l y a s c e r t a i n e d t h a t i t would be an a d m i n i s t r a t i v e and book-keeping nightmare t o segregate the revenues and expenses of these two a c t i v i t i e s i n order t o tax each net p r o f i t a t the a p p r o p r i a t e r a t e . While i t was understood to be u n f a i r , the " t a i n t i n g " concept s a i d t h a t any modicum o f " n o n - q u a l i f y i n g " a c t i v i t y would t a i n t the a c t i v e b u s i n e s s income and s u b j e c t the whole business t o the hi g h e r r a t e . As a r e s u l t , i n these s i t u a t i o n s i n t e l l i g e n t tax p l a n n i n g r e q u i r e d s e p a r a t i n g the two a c t i v i t i e s i n t o d i s t i n c t e n t i t i e s . More p r o f e s s i o n a l fees were i n c u r r e d ! Only a few years l a t e r , the February 1984 Budget dropped the NQB concept, and a l l o f the e a r l i e r r e o r g a n i z a t i o n s became unnecessary. S i m p l i s t i c a l l y , i t c o u l d be s a i d t h a t Canada has a d u a l - r a t e s t r u c t u r e of co r p o r a t e t a x a t i o n : one f o r b i g business and one f o r s m a l l . However, the i n t r a c a c i e s o f the system prove otherwise: 1. Agreements between the f e d e r a l and p r o v i n c i a l governments g e n e r a l l y a l l o w one tax r e t u r n t o be f i l e d f o r both f i s c s . The f e d e r a l government g i v e s a ten percent abatement i n r e c o g n i t i o n o f the p r o v i n c e s ' r i g h t t o tax c o r p o r a t i o n s . T h e r e f o r e , i f each p r o v i n c e a p p l i e s d i f f e r e n t r a t e s , t h e r e can be t e n , not two, r a t e s . A l s o , some p r o v i n c e s charge d i f f e r e n t r a t e s to b i g and small -99-Current P r o v i s i o n s C h a p t e r F i v e b u s i n e s s e s . T h e r e f o r e , t h e r e can be twenty, n o t t e n , r a t e s . 2. The m a n u f a c t u r i n g and p r o c e s s i n g t a x c r e d i t s g i v e d i f f e r e n t r a t e r e d u c t i o n s t o q u a l i f y i n g s m a l l and b i g b u s i n e s s . T h e r e f o r e , t h e r e can be f o r t y , n o t twe n t y , r a t e s . 3. S u r t a x e s have a p p l i e d r e c e n t l y t o s m a l l o r b i g b u s i n e s s . T h e r e f o r e , t h e r e can be e i g h t y , n o t f o r t y , r a t e s . 4. U n t i l t he F e b r u a r y 1984 Budget, t h e r e was a l s o t h e n o n - q u a l i f y i n g b u s i n e s s r a t e . The p r o v i n c e s t a x e d t h i s a l s o w i t h v a r i o u s r a t e s . T h i s added a n o t h e r twenty r a t e s . 5. I f a s m a l l b u s i n e s s exceeded e i t h e r i t s a n n u a l o r c u m u l a t i v e l i m i t i n t h e y e a r , p a r t o f i t s income was t a x e d a t a h i g h r a t e and p a r t a t a low r a t e . 6. I f a s m a l l b u s i n e s s had n o n - a c t i v e income, t h e n t h i s would be t a x e d a t h i g h r a t e s . 7. The " s p l i t - r a t e " system employed i n some c o u n t r i e s encourages d i s t r i b u t i o n by t a x i n g r e t a i n e d e a r n i n g s a t a h i g h e r r a t e . The P a r t Two Tax, which was needed t o r e s t o r e i n t e g r a t i o n , t a x e s d i s t r i b u t e d e a r n i n g s a t a h i g h r a t e . T h i s p o t e n t i a l l y adds a n o t h e r f o r t y r a t e s . 8. I n t e g r a t i o n t h e o r y i s based on a f l o w - t h r o u g h o f t a x c r e d i t s w i t h an assumed f e d e r a l / p r o v i n c i a l s h a r i n g . A t p r e s e n t , t h i s assumes t h a t t h e p r o v i n c e s l e v y p e r s o n a l t a x a t f i f t y p e r c e n t o f t h e f e d e r a l t a x . As p r o v i n c i a l p e r s o n a l r a t e s a l s o v a r y c o n s i d e r a b l y , t h i s assumption b r e a k s down a c r o s s t h e c o u n t r y . -100-C u r r e n t P r o v i s i o n s C h a p t e r F i v e Beyond a l l t h i s , one must remember t h a t our t a x system a l l e g e d l y v i ews the c o r p o r a t i o n as a c o n d u i t — u l t i m a t e l y t h e " f a i r " amount o f t a x i s l e v i e d a g a i n s t t h e i n d i v i d u a l s h a r e h o l d e r . T a b l e IV o f " C o r p o r a t i o n T a x a t i o n S t a t i s t i c s " (see Appendix) p r o v i d e d the i n f o r m a t i o n t h a t 209,897 f i r m s d e c l a r e d p o s i t i v e t a x a b l e income i n 1981 t o t a l l i n g $28,831 m i l l i o n . The remainder o f 277,784 f i r m s d e c l a r e d l o s s e s t o t a l l i n g $9,793 m i l l i o n . Of t h e p r o f i t a b l e f i r m s , 20 2,516 were CCPCs showing t o t a l t a x a b l e income o f $11,636 m i l l i o n . W i t h i n t h i s group, n i n e t y - f o u r p e r c e n t had t a x a b l e income below $150,000, the a n n u a l c u t - o f f i n t h a t y e a r f o r t h e s m a l l b u s i n e s s r a t e . The average t a x a b l e income i n t h i s group was $34,000. In f a c t , t w o - t h i r d s o f t h i s group had t a x a b l e income below $35,000. The average t a x r e d u c t i o n from t h e s m a l l b u s i n e s s r a t e f o r a l l s m a l l f i r m s was $2,400 (1980 - $2,400). The average t a x r e d u c t i o n f o r t a x a b l e f i r m s l i k e l y t o be e l i g i b l e f o r t h e r e d u c t i o n was $5,500. U s i n g a n o t h e r e s t i m a t e by a p p l y i n g t h e twenty-one p e r c e n t r e d u c t i o n a g a i n s t t h e average t a x a b l e income o f $34,000 y i e l d s an average t a x r e d u c t i o n o f $7,000. T h i s l a t t e r f i g u r e i s c o n s i s t e n t 3 w i t h e s t i m a t e s by S h m d e r who c a l c u l a t e d average r e d u c t i o n s o f $5,640, $6,270 and $6,830 f o r t h e y e a r s 1977 t o 1979 r e s p e c t i v e l y . The t a x r e d u c t i o n exceeded $1 b i l l i o n b o t h i n 1980 and 1981 and r e p r e s e n t e d a r e d u c t i o n o f t h i r t y - s i x p e r c e n t o f t h e t a x l i a b i l i t y t h a t would o t h e r w i s e have been owed. I t was e n j o y e d s i g n i f i c a n t l y by a l l i n d u s t r i a l s e c t o r s . -101-C u r r e n t P r o v i s i o n s C h a p t e r F i v e A s s o c i a t i o n As l o n g as t h e r e i s some form o f p r e f e r e n t i a l t a x system aimed a t s m a l l b u s i n e s s , t h e r e w i l l always be abuse by d i v i s i o n . I f t h e system p r o v i d e s a low r a t e on t h e f i r s t $10,000 (as i t d i d i n 1949) and a b u s i n e s s e a r n s $20,000, a t a x s a v i n g o f $2,300 w i l l r e s u l t from d i v i d i n g t h e b u s i n e s s i n two. I t was n e c e s s a r y i n 1949 t o c r e a t e t h e a s s o c i a t i o n t e s t s t o deny t h i s m u l t i p l i c a t i o n o f p r e f e r e n t i a l t a x t r e a t m e n t amongst r e l a t e d e n t i t i e s . S a t i s f a c t o r y , c l e a r - c u t l e g i s l a t i o n has n o t y e t been d r a f t e d t o a d d r e s s t h i s problem. The i n g e n u i t y o f t h e t a x p a y e r and h i s p r o f e s s i o n a l c o u n s e l always seems t o be one s t e p ahead o f t h e l e g i s l a t i o n . The government f i n a l l y i n v o k e d " m i n i s t e r i a l d i s c r e t i o n " i n 1963 t o o v e r - r i d e t h e t a x p a y e r s ' i n g e n u i t y . One o f t h e r u s e s t h a t worked f o r a w h i l e i n v o l v e d o p e r a t i n g as a c o r p o r a t e p a r t n e r s h i p . Two o r more c o r p o r a t i o n s , w i t h t h e r i g h t share o w n e r s h i p , c o u l d form a p a r t n e r s h i p t o own a b u s i n e s s . Each would be a l l o c a t e d a p o r t i o n o f t h e p r o f i t s , i n t h e u s u a l p a r t n e r s h i p manner, and each c o u l d r u n i t s own meter o f a n n u a l and c u m u l a t i v e d e d u c t i o n l i m i t s . The December 1979 Budget c l o s e d t h i s o f f by r e q u i r i n g t h e s e l i m i t s t o be a l l o c a t e d amongst c o r p o r a t e p a r t n e r s . A g a i n , p r o f e s s i o n a l f e e s f o r r e o r g a n i z a t i o n were wasted. The a s s o c i a t i o n t e s t s t h e m s e l v e s a r e so c o m p l i c a t e d i n t h e A c t t h a t even th e t r a i n e d p r o f e s s i o n a l needs t o a d dress an a s s o c i a t i o n q u e s t i o n w i t h a c l e a r mind. The t e s t s p r o ve unfathomable f o r t h e l a y - p e r s o n . -102-C u r r e n t P r o v i s i o n s C h a p t e r F i v e By d o i n g away w i t h p r e f e r e n t i a l s m a l l b u s i n e s s t a x r a t e s , t h e C a r t e r Report would have e l i m i n a t e d t h e need f o r the a s s o c i a t i o n l e g i s l a t i o n . I n t e g r a t i o n and D i v i d e n d Tax C r e d i t s T a x a t i o n o f c o r p o r a t e - s o u r c e income has always caused a quandary. A t i n c e p t i o n i n 1917, d i v i d e n d s f l o w e d t o i n d i v i d u a l s f r e e o f any p e r s o n a l t a x . Then, i n 1926, a c l a s s i c a l approach was a d o p t e d — d i v i d e n d s were f u l l y t a x e d on i n d i v i d u a l s , w i t h no r e l i e f . W i t h t h e i n c r e a s e i n c o r p o r a t e t a x r a t e s i n 1949, p a r t i a l r e l i e f was p r o v i d e d by a t e n p e r c e n t d i v i d e n d t a x c r e d i t . T h i s was i n c r e a s e d , a l o n g w i t h t h e c o r p o r a t e r a t e s , t o twenty p e r c e n t i n 1953. Note t h a t t h e g r o s s - u p system was not i n e f f e c t . I n t e g r a t i o n was, o f c o u r s e , a t t h e c r u x o f t h e problem i n c o r p o r a t e r e f o r m d u r i n g t h e S i x t i e s . The i s s u e o f d o u b l e t a x a t i o n was b e i n g s t u d i e d i n many Western economies. The C a r t e r Report recommended f u l l i n t e g r a t i o n f o r s m a l l b u s i n e s s , a l o n g w i t h a s i n g l e f i f t y p e r c e n t c o r p o r a t e and t o p m a r g i n a l r a t e . The s p i r i t o f t h e C a r t e r R e p o r t , adopted by t h e White Paper, was t h a t c o r p o r a t e t a x s h o u l d be t r e a t e d as a prepayment o f p e r s o n a l t a x e s , t h u s s t i m y i n g t h e t a x d e f e r r a l u s u a l l y a v a i l a b l e t h r o u g h u n d i s t r i b u t e d p r o f i t s . The p r o p o s a l was t o g r o s s up by one hundred p e r c e n t any d i v i d e n d s r e c e i v e d and a l l o w a c r e d i t f o r p e r s o n a l t a x e s a t f i f t y p e r c e n t o f t h e grossed-up amount ( e f f e c t i v e l y a t the c o r p o r a t e r a t e ) . However, t h e White Paper proposed t h a t , f o r w i d e l y h e l d companies, t h e g r o s s - u p be f i f t y p e r c e n t , w i t h a c r e d i t o f 33 1/3 p e r c e n t o f t h e grossed-up amount. -103-C u r r e n t P r o v i s i o n s Chapter F i v e The 1971 Budget r e j e c t e d the s i n g l e r a t e system and, n a t u r a l l y , the i n t e g r a t i o n p l a n had t o f a l l as w e l l . One system was c r e a t e d f o r a l l c o r p o r a t i o n s . Dividends were t o be grossed up by one t h i r d and c a r r y a tax c r e d i t of twenty percent o f the grossed-up amount. The gross-up was a l s o taxed. The concept o f " c r e d i t a b l e e a r n i n g s " was absent. In other words, the tax c r e d i t s would flow through r e g a r d l e s s of the a c t u a l c o r p o r a t e tax p a i d . I t c o u l d not be s a i d t h a t the system a t t a i n e d i n t e g r a t i o n . The c r e d i t t h a t flowed through was o n l y a p o r t i o n of the c o r p o r a t e tax presumably p a i d . The i n t e g r a t i o n f e l l s h o r t , p a r t i c u l a r l y f o r l a r g e c o r p o r a t i o n s . No doubt i n response to the s h o r t - f a l l , the system was e m b e l l i s h e d i n 1977 to make e q u i t y investment more a t t r a c t i v e . The t a x a b l e gross-up i n c r e a s e d from one t h i r d t o one h a l f . The tax c r e d i t i n c r e a s e d t o 33 1/3 percent o f the grossed-up amount, up from twenty p e r c e n t . The M i n i s t e r r e c o g n i z e d a t the time t h a t t h i s would pr o v i d e s u b s t a n t i a l b e n e f i t f o r s m a l l b u s i n e s s — b u t he probably had no i d e a what would ensue. I t commenced the f l o o d of i n c o r p o r a t i o n s . The p e r s o n a l tax c r e d i t f a r exceeded what c o u l d p o s s i b l y be p a i d i n c o r p o r a t e tax by the s m a l l b u s i n e s s . T h i s was termed " o v e r - i n t e g r a t i o n " . I t c r e a t e d an e x c i t i n g time f o r tax p l a n n e r s who c o u l d c o n s t r u c t s a l a r y / d i v i d e n d remuneration combinations with a wide v a r i a n c e i n t o t a l tax b i l l s . An optimum mix c o u l d be s e l e c t e d , s u b j e c t to o t h e r tax and non-tax c o n s t r a i n t s . Rather than modify the i n t e g r a t i o n system, which would have an impact on l a r g e c o r p o r a t i o n s as w e l l , the next budgets attempted -104-Current P r o v i s i o n s Chapter F i v e t o c o r n e r the new "abusers". The n o n - q u a l i f y i n g income concept was i n t r o d u c e d t o tax c e r t a i n e n t i t i e s at a mid r a t e . The November 19 81 Budget i n s t i t u t e d a new P a r t Two Tax on d i v i d e n d d i s t r i b u t i o n s out of s m a l l business c o r p o r a t i o n s . T h i s was the measure t h a t c o u l d be s p e c i f i c a l l y p o i n t e d a t s m a l l b u s i n e s s t o c o u n t e r - a c t the o v e r - i n t e g r a t i o n . The f o l l o w i n g t a b l e shows the impact o f i n t e g r a t i o n on s m a l l b u s i n e s s e s a f t e r v a r i o u s budget amendments. T h i s t a b l e was prepared u s i n g a n o t i o n a l c o r p o r a t e r a t e o f t w e n t y - f i v e p e r c e n t . Taking i n t o account the m u l t i p l e s e l e c t i o n o f r a t e s t h a t may be a p p l i c a b l e i n a p a r t i c u l a r case, i t i s u n l i k e l y t h a t t w e n t y - f i v e percent i s the a c t u a l r a t e f o r many s m a l l b u s i n e s s e s . The "1977 Budget" column shows t h a t the i n d i v i d u a l c o u l d r e c e i v e more c r e d i t than was a c t u a l l y p a i d by the c o r p o r a t i o n . The grossed-up amount became g r e a t e r than the c o r p o r a t i o n ' s o r i g i n a l income. However, the shareholder was s t i l l ahead as long as the p e r s o n a l marginal r a t e was l e s s than one hundred p e r c e n t . The "1981 Budget" column shows how the P a r t Two Tax b r i n g s the co r p o r a t e tax p a i d up t o the amount of the c r e d i t c l a i m e d by the i n d i v i d u a l . As p o i n t e d out, d e v i a t i o n s from the assumptions confound the t e c h n i c a l f i t of i n t e g r a t i o n . For i n s t a n c e , a smal l b u s i n e s s i n B.C. wit h "M & P" q u a l i f i c a t i o n i s taxed at eighteen p e r c e n t . Even with the P a r t Two Tax, an i n d i v i d u a l i n the f o r t y p ercent p e r s o n a l b r a c k e t can reduce the o v e r a l l tax by s i x percentage p o i n t s . -105-Current P r o v i s i o n s C h a p t e r F i v e INTEGRATION OF PERSONAL AND CORPORATE TAX FOR SMALL BUSINESS W h i t e 1971 1977 1981 P a p e r B u d g e t B u d g e t B u d g e t C o r p o r a t e p r e -t a x p r o f i t $100 $100 $100 $100 C o r p o r a t e t a x 50 25 25 25 P a r t Two Tax — — — 8.3 A f t e r - t a x p r o f i t a n d d i v i d e n d 50 75 75 66.7 G r o s s - u p 50 25 37.5 33.3 T a x a b l e d i v i d e n d 100 100 112.5 100 Tax c r e d i t 50 20 37.5 33.3 Tax c r e d i t a s a p e r c e n t a g e o f : G r o s s e d - u p amount 5 0 % 20% 33 1/3% 33 1/3% C a s h d i v i d e n d 1 0 0 % 26 2/3% 50% 5 0 % C o r p o r a t e t a x 100% 80% 150% 1 0 0 % - 1 0 6 -C u r r e n t P r o v i s i o n s Chapter F i v e Manufacturing and P r o c e s s i n g Tax Rates In 1973, a r a t e r e d u c t i o n of f i v e and nine percent was i n t r o d u c e d f o r s m a l l and b i g c o r p o r a t i o n s , r e s p e c t i v e l y , which engaged i n manufacturing and p r o c e s s i n g a c t i v i t i e s . Unincorporated b u s i n e s s e s were not i n c l u d e d . The term i s d e f i n e d by e x c e p t i o n and everyday meaning. In t h i s l i g h t , "manufacturing" normally i n v o l v e s c r e a t i o n of something, or shaping or forming an o b j e c t out of something. " P r o c e s s i n g " r e f e r s to a technique o f p r e p a r a t i o n , h a n d l i n g or other a c t i v i t y designed to e f f e c t a p h y s i c a l or chemical change. S p e c i f i c a l l y excepted are farming, f i s h i n g , l o g g i n g , e x p l o r a t i o n , c e r t a i n types of c o n s t r u c t i o n and r e p a i r and s e r v i c e a c t i v i t i e s . Where a company's a c t i v i t i e s p a r t i a l l y q u a l i f y , a complicated s e t of c a l c u l a t i o n s i s r e q u i r e d to segregate the p o r t i o n o f a c t i v i t i e s which do q u a l i f y . O r i g i n a l l y , s m a l l c o r p o r a t i o n s were exempt from t h i s c o m p l icated e x e r c i s e i f t h e i r t a x a b l e incomes d i d not exceed $50,000 and they were p r i m a r i l y engaged i n the q u a l i f y i n g a c t i v i t i e s . The Budget o f November 1981 bumped the exemption l e v e l t o $200,000. With a f i v e p o i n t tax r e d u c t i o n , "M&P" c l a s s i f i c a t i o n i s very v a l u a b l e . A company may d i s c o v e r t h a t some sm a l l re-arrangement o f i t s r o l e i n the p r o d u c t i v e process may make i t e l i g i b l e f o r the r e d u c t i o n . As an e x t r a sweetener, a b u s i n e s s engaged i n "M&P" can w r i t e o f f r e l a t e d equipment at an a c c e l e r a t e d r a t e . V a r i o u s s t u d i e s have attempted t o q u a n t i f y the impact of the tax p r e f e r e n c e to manufacturers and p r o c e s s o r s . One e a r l y government 4 study i n 1975 concluded t h a t there was a s i g n i f i c a n t i n c r e a s e i n -107-Current P r o v i s i o n s C h a p t e r F i v e c a p i t a l i n v e s t m e n t due t o t h e p r o v i s i o n s . S u b s e q u e n t p r i v a t e 5 s t u d i e s a l l d e t e r m i n e d t h a t t h e e a r l i e r c o n c l u s i o n was s t r o n g l y o v e r - s t a t e d . M o s t c o n c l u d e d t h a t , a f t e r c o n s i d e r i n g t h e f o r e g o n e t a x r e v e n u e s f r o m a c c e l e r a t e d d e p r e c i a t i o n and l o w e r c o r p o r a t e r a t e s , t h e t a x c o s t o f e a c h d o l l a r o f i n d u c e d i n v e s t m e n t e x c e e d e d a d o l l a r . The "M&P" r e d u c t i o n p r o v i d e d $42.1 m i l l i o n o f t a x r e l i e f f o r f i r m s w i t h a s s e t s u n d e r $1 m i l l i o n i n 1981 ( 1980 - $42.1 m i l l i o n ) . T h i s a v e r a g e s $96 f o r a l l f i r m s i n t h i s c a t e g o r y ( 1 9 8 0 - $100) and a v e r a g e s a p p r o x i m a t e l y $215 f o r a l l t a x a b l e f i r m s i n t h i s c a t e g o r y . H a l f o f t h e c r e d i t s c l a i m e d w e r e f o r t h e m a n u f a c t u r i n g s e c t o r , w h i c h o n l y a c c o u n t e d f o r s e v e n p e r c e n t o f t h e s m a l l f i r m s . I n summary, t h e "M&P" r e d u c t i o n h a s n o t p r o v e n t o be a l a r g e b e n e f i t t o s m a l l b u s i n e s s . C a p i t a l C o s t A l l o w a n c e The c a p i t a l c o s t a l l o w a n c e s y s t e m h a s b e e n a f a v o u r i t e l e v e r o f g o v e r n m e n t s i n C a n a d a f o r y e a r s . The p r o v i s i o n s h a v e b e e n c h a n g e d r e g u l a r l y t o e n c o u r a g e o r d i s c o u r a g e c a p i t a l a d d i t i o n s . The p r o v i s i o n s a r e , i n t h e o r y , e q u a l l y a v a i l a b l e t o b i g a n d s m a l l , i n c o r p o r a t e d a n d u n i n c o r p o r a t e d . G o v e r n m e n t s b e l i e v e t h a t f a s t r e s u l t s c a n be o b t a i n e d f r o m m a n i p u l a t i n g t h e CCA s y s t e m . B u s i n e s s may n o t v i e w CCA c h a n g e s a s t h e r a i s o n d ' e t r e f o r e x p a n s i o n o r c o n t r a c t i o n , b u t r a t h e r a s a s w e e t e n e r t o e x i s t i n g c o m m i t m e n t s . I n o t h e r w o r d s , t h e CCA s y s t e m may n o t i n i t i a t e a c t i v i t y . I t i s commonly h e l d t h a t t h e b i g g e s t p r o b l e m f o r s m a l l b u s i n e s s i s f i n a n c i n g . A c c e l e r a t e d CCA i s - 1 0 8 -C u r r e n t P r o v i s i o n s C h a p t e r F i v e s u p p o s e d t o p r o v i d e c a s h f l o w b y way o f d e f e r r e d t a x e s . I n r e a l i t y , t h e r e a r e t h r e e p r o b l e m s w i t h t h i s scheme. F i r s t , CCA i s o n l y u s e f u l t o o f f s e t t a x a b l e i n c o m e . New s m a l l b u s i n e s s e s may n o t g e n e r a t e t a x a b l e p r o f i t s i n t h e e a r l y y e a r s ; t h u s CCA i s o f no b e n e f i t . A l s o , g o v e r n m e n t s t y p i c a l l y b e e f up CCA p r o v i s i o n s i n an e c o n o m i c d o w n t u r n . I n t h i s e n v i r o n m e n t , e x i s t i n g s m a l l b u s i n e s s e s may n o t h a v e t a x a b l e p r o f i t s e i t h e r . S e c o n d , some b u s i n e s s e s a r e n o t c a p i t a l i n t e n s i v e . T h i s i s o f t e n n o t a f u n c t i o n o f b e i n g s m a l l , b u t a f u n c t i o n o f t h e a c t i v i t y , f o r i n s t a n c e e n g i n e e r i n g c o n s u l t i n g . T h e s e f i r m s s t i l l h a v e c a s h p r o b l e m s , b u t t h e y n e e d t o f i n a n c e r e c e i v a b l e s a n d w o r k - i n - p r o g r e s s , n o t f i x e d a s s e t s . R e t a i l i n g o f t e n r e q u i r e s s m a l l f i x e d a s s e t f i n a n c i n g , b u t i s h e a v y on i n v e n t o r y b u r d e n . Many s m a l l b u s i n e s s e s a r e l o c a t e d i n t h e s e r v i c e s e c t o r . T h e r e i s a l s o a g e n e r a l n o t i o n t h a t s m a l l b u s i n e s s i s , b y d e f i n i t i o n , l e s s c a p i t a l i n t e n s i v e t h a n b i g b u s i n e s s . A c c e l e r a t e d CCA i s l i k e a W a i l i n g S i r e n t o s m a l l b u s i n e s s , e n t i c i n g i t away f r o m i t s i n a t e c o m p e t i t i v e a d v a n t a g e . T h i r d , a c c e l e r a t e d CCA i s a t a x d e f e r r a l o n l y . The same amount o f t a x d e d u c t i o n e x i s t s i n a b s o l u t e d o l l a r s , w h a t e v e r t h e r a t e o f w r i t e o f f . L e s s t a x i n t h e e a r l y y e a r s means more t a x l a t e r , u n l e s s f u r t h e r e x p a n s i o n o c c u r s . The p i l i n g on o f s u c c e s s i v e l a y e r s o f t a x d e f e r r a l r e c e i v e d n a t i o n a l a t t e n t i o n when D a v i d L e w i s , t h e n l e a d e r o f t h e N.D.P. P a r t y , r e f e r r e d t o t h i s phenomenon i n c a l l i n g c o m p a n i e s " c o r p o r a t e w e l f a r e bums". V a r i o u s t a x p r o v i s i o n s , i n c l u d i n g CCA, w e r e r e s p o n s i b l e f o r m a s s i v e a c c u m u l a t i o n s o f d e f e r r e d t a x e s o n c o r p o r a t e b a l a n c e s h e e t s . -109-C u r r e n t P r o v i s i o n s C h a p t e r F i v e C a p i t a l e x p a n s i o n i s n o t a n e n d i n i t s e l f , b u t a means. The e n d r e s u l t i s i n c r e a s e d e m p l o y m e n t , r e d u c e d i n f l a t i o n , e c o n o m i c g r o w t h , e t c . T h e r e i s an assumed c a u s a t i o n w h i c h e c o n o m e t r i c m o d e l s h a v e n o t b e e n a b l e t o p r o v e o r d i s p r o v e . A b r i e f h i s t o r y o f CCA a d j u s t m e n t s shows t h e p o p u l a r i t y o f t h i s l e v e r : YEAR PROVISION 1949 A c c e l e r a t e d CCA r a t e s f i r s t i n t r o d u c e d 1951 D e f e r r e d CCA d e n i e d a n y c l a i m i n t h e y e a r f o r new e q u i p m e n t 1961 A c c e l e r a t e d CCA i n t h e f i r s t y e a r f o r m a n u f a c t u r i n g a n d and p r o c e s s i n g e q u i p m e n t i n c e r t a i n g e o g r a p h i c 1963 r e g i o n s 1966 D e f e r r e d CCA t o h a l f t h e r e g u l a r p r o v i s i o n f o r new a n d e q u i p m e n t 1969 1970 S u p e r CCA f o r m a n u f a c t u r i n g a n d p r o c e s s i n g e q u i p m e n t 1981 H a l f y e a r r u l e i n t h e y e a r o f p u r c h a s e As d i s c u s s e d i n C h a p t e r One, t h e t i m i n g d i f f e r e n c e b e t w e e n a c c o u n t i n g and t a x d e p r e c i a t i o n was n o t i n s m a l l b u s i n e s s ' f a v o u r i n 1980 o r 1 9 8 1 . The d i f f e r e n c e was i n f a c t n e g l i g i b l e . W h i l e CCA r a t e s a r e s u p p o s e d t o be g e n e r o u s and p r o v i d e t a x d e f e r r a l , s m a l l b u s i n e s s h a s n o t b e e n a b l e t o t a k e a d v a n t a g e o f t h i s . O n l y t h e m a n u f a c t u r i n g s e c t o r managed t o c l a i m h i g h e r CCA. The a v e r a g e c l a i m was a p p r o x i m a t e l y $7,000 i n b o t h y e a r s . T h i s r e s u l t c o u l d be l i n k e d t o s m a l l b u s i n e s s ' u n p r o f i t a b i l i t y . S i n c e CCA i s e l e c t i v e , i t may be n e c e s s a r y t o c l a i m o n l y e nough t o b r i n g t a x a b l e i n c o m e t o n i l . A c c o r d i n g t o g e n e r a l l y a c c e p t e d a c c o u n t i n g p r i n c i p l e s , a c c o u n t i n g - 1 1 0 -C u r r e n t P r o v i s i o n s Chapter F i v e d e p r e c i a t i o n i s not e l e c t i v e , but must be claimed r e g a r d l e s s o f p r o f i t a b i l i t y . T h e r e f o r e , one has a rough i d e a of the r e l a t i v e s i z e o f d e p r e c i a t i o n i n s m a l l b u s i n e s s . Even i f f u l l CCA c l a i m s were used, and assuming the CCA system is_ generous, the impact of tax d e p r e c i a t i o n on c r e a t i n g tax d e f e r r e d f i n a n c i n g i n the s m a l l f i r m i s probably i n s i g n i f i c a n t . Investment Tax C r e d i t s Since i t s i n c e p t i o n i n 1975, t h i s v e h i c l e has been p r o v i d e d to s t i m u l a t e c a p i t a l investment i n c e r t a i n s e c t o r s and g e o g r a p h i c a l areas. In p a r t i c u l a r , r e s e a r c h and development has been ear-marked c u r r e n t l y f o r s t i m u l a t i o n , as have d e s i g n a t e d "depressed" r e g i o n s . Firms are granted a tax c r e d i t based on a percentage of t h e i r investment i n q u a l i f i e d e x p e n d i t u r e s . The c r e d i t i s u n i v e r s a l l y a v a i l a b l e t o a l l b u s i n e s s e s , i n c o r p o r a t e d and u n i n c o r p o r a t e d , b i g and s m a l l . However, the s c i e n t i f i c r e s e a r c h aspect o f f e r s p r e f e r e n t i a l c r e d i t s t o i n c o r p o r a t e d e n t i t i e s . The c r e d i t a l s o c a r r i e s a c a t c h - - t h e c a p i t a l c o s t of the a s s e t s purchased must be reduced, f o r d e p r e c i a t i o n purposes, by the amount of the c r e d i t . Investment tax c r e d i t s have not been p a r t i c u l a r l y w e l l s u i t e d to s m a l l b u s i n e s s e s . T h e i r problems, l o g i c a l l y , p a r a l l e l those c i t e d f o r CCA p r o v i s i o n s . F i r s t , the c r e d i t i s an i n c e n t i v e to mechanization and, to some extent, a commitment to l a r g e r s c a l e . I t i s an accepted b e l i e f t h a t s m a l l b u s i n e s s e s have an advantage over t h e i r l a r g e r competitors due to the f l e x i b i l i t y o f a s m a l l e r o p e r a t i o n . In a downturn, i t i s e a s i e r to l a y o f f workers than to l a y o f f equipment. Investment tax c r e d i t s encourage a s h i f t i n - I l l -C u r r e n t P r o v i s i o n s Chapter F i v e the l a b o u r - t o - c a p i t a l balance. Second, the tax c r e d i t s are l e s s u s e f u l t o businesses which are not c a p i t a l - i n t e n s i v e . In a d d i t i o n , much of the smal l business s e c t o r i s concerned w i t h the r e t a i l and s e r v i c e s e c t o r s , not the manufacturing or re s o u r c e s e c t o r s . Thus, t o many of them, investment tax c r e d i t s are not even a v a i l a b l e . T h i r d , the tax c r e d i t s are onl y u s e f u l t o apply a g a i n s t taxes otherwise owing. Thus, they t y p i c a l l y p r o v i d e no r e l i e f or cash flow i n the e a r l y or u n p r o f i t a b l e y ears o f a b u s i n e s s . T h e i r e x i s t e n c e adds another c o m p l i c a t i n g f a c t o r i n determining an op t i m a l owner remuneration package. Amendments i n the A p r i l 1983 Budget a l l o w p a r t i a l cash r e a l i z a t i o n s i n the absence o f tax otherwise owing. The unused c r e d i t s are a l s o e l i g i b l e t o be c a r r i e d backward and forward. The p o l i c y i n t e n t behind investment tax c r e d i t s i s not t o spur investment, per se, but to i n c r e a s e employment i n those s e c t o r s t h a t manufacture equipment e l i g i b l e f o r the c r e d i t . There has been no d i r e c t evidence o f the e f f e c t o f investment tax c r e d i t s i n Canada. While s e v e r a l e m p i r i c a l s t u d i e s have been conducted i n the U n i t e d S t a t e s , t h e r e has been no c o n c l u s i v e r e s u l t . Rather than an i n c r e a s e i n net investment, t h e r e may be a s h i f t from n o n - q u a l i f y i n g a s s e t s t o q u a l i f y i n g a s s e t s . As i n d i c a t e d i n Chapter One, investment tax c r e d i t s have a r e l a t i v e l y minor impact on s m a l l f i r m s . The average c r e d i t amongst a l l s m a l l firms was $123 i n 1981 (1980 - $110). Given -112-C u r r e n t P r o v i s i o n s Chapter F i v e t h a t o n l y t a x a b l e f i r m s would be c l a i m i n g these c r e d i t s , the average c r e d i t amongst t h i s group was approximately $275. The a g r i c u l t u r a l and manufacturing s e c t o r s claimed s i x t y - t w o percent of these t o t a l c r e d i t s f o r s m a l l f i r m s i n 1981 (1980 -f i f t y - e i g h t p e r c e n t ) . These comprise ten percent of the s m a l l f i r m s . The author concludes t h a t t h i s p r o v i s i o n does not have a s i g n i f i c a n t impact on s m a l l b u s i n e s s . I f t a x a b i l i t y was a f a c t o r i n c l a i m i n g t h i s r e d u c t i o n , there may be some i n c r e a s e w i t h the new p r o v i s i o n s i n t h i s a r e a . However, i t appears t h a t , f o r the reasons c i t e d , investment tax c r e d i t s w i l l never be a s i g n i f i c a n t p r o v i s i o n f o r s m a l l b u s i n e s s . Three Percent Inventory Allowance G e n e r a l l y accepted a c c o u n t i n g p r i n c i p l e s permit the s e l e c t i o n from a range of methods of measuring i n v e n t o r y movement. In c e r t a i n circumstances, t h i s c h o i c e can have a s i g n i f i c a n t impact on p r o f i t s . In p e r i o d s of high i n f l a t i o n , the "L.I.F.O." method matches c u r r e n t c o s t s a g a i n s t c u r r e n t revenues. The Act does not permit the use of the "L.I.F.O." method. As a r e s u l t , taxes may be l e v i e d on i n f l a t i o n a r y p r o f i t s . The Act allows a deduction from such bu s i n e s s p r o f i t s of three percent o f the opening i n v e n t o r y v a l u e . T h i s i s a v a i l a b l e to a l l forms o f b u s i n e s s . The p r o v i s i o n i s an a r b i t r a r y s o l u t i o n t o a problem t h a t v a r i e s i n s e v e r i t y with the g e n e r a l i n f l a t i o n c o n d i t i o n s . T h i s allowance i s d i s c r e t i o n a r y ; however, i t i s l o s t a n n u a l l y i f not c l a i m e d . A l s o , the allowance i s not a v a i l a b l e i n the f i r s t -113-Current P r o v i s i o n s C h a p t e r F i v e f i s c a l y e a r o f o p e r a t i o n s . O n e w o u l d c o n c l u d e t h a t a l l f i r m s w h i c h c a r r y i n v e n t o r y w o u l d t a k e t h i s d e d u c t i o n . The a v e r a g e a l l o w a n c e f o r s m a l l f i r m s i n 1981 was $658 (1980 - $ 6 4 1 ) . The a c t u a l t a x b e n e f i t i s d e t e r m i n a b l e by a p p l y i n g t h e r e l e v a n t c o r p o r a t e t a x r a t e t o t h i s d e d u c t i o n . F o r t a x a b l e f i r m s , t h i s m i g h t a p p r o x i m a t e $150. F o r n o n - t a x a b l e f i r m s , t h e t a x b e n e f i t may o n l y b e r e a l i z e d t h r o u g h t h e n o n - c a p i t a l l o s s c a r r y o v e r p r o v i s i o n s ; t h e r e f o r e , t h e p r e s e n t v a l u e may be r e d u c e d . N i n e t y - t w o p e r c e n t o f t h e a l l o w a n c e c l a i m e d was i n t h e m a n u f a c t u r i n g , w h o l e s a l e a n d r e t a i l s e c t o r s . T h e s e c o m p r i s e one t h i r d o f t h e s m a l l f i r m s . E m p l o y m e n t Tax C r e d i t E m p l o y e r s r e c e i v e a t a x c r e d i t , o r wage s u b s i d y , o f up t o two d o l l a r s p e r h o u r f o r h i r i n g p e o p l e u n d e r c e r t a i n c o n d i t i o n s . The s u b s i d y i s i t s e l f t a x e d , s o t h a t t h e b e n e f i t i s s o m e t h i n g l e s s t h a n t h e a c t u a l c r e d i t . The c r e d i t s a r e o f no i m m e d i a t e b e n e f i t when t h e r e i s n i l t a x a b l e i n c o m e ; h o w e v e r , t h e c r e d i t s may be c a r r i e d f o r w a r d f o r f i v e y e a r s . The h i r i n g m u s t be d one t h r o u g h a g o v e r n m e n t manpower a g e n c y a n d m u s t r e p r e s e n t i n c r e m e n t a l e m p l o y m e n t . S e p a r a t e s t a t i s t i c s a r e n o t a v a i l a b l e a s t h i s c r e d i t i s l u m p e d w i t h o t h e r s l i k e t h e f o r e i g n , l o g g i n g a n d p o l i t i c a l c o n t r i b u t i o n t a x c r e d i t s . H o w e v e r , t h e t o t a l t a x c r e d i t s c l a i m e d f o r a l l o f t h e s e i n 1981 was $8 m i l l i o n (1980 - $20 m i l l i o n ) . B u s i n e s s L o s s e s B u s i n e s s l o s s e s ( p r o p e r l y t e r m e d " n o n - c a p i t a l l o s s e s " ) g e n e r a l l y - 1 1 4 -C u r r e n t P r o v i s i o n s C h a p t e r F i v e r e f l e c t p o o r o p e r a t i n g r e s u l t s . F r om t h i s , one may d e d u c e o t h e r u n h e a l t h y c o n d i t i o n s , l i k e p o o r l i q u i d i t y . T h e r e f o r e , t h e v a l u e o f b u s i n e s s l o s s p r o v i s i o n s i n a t a x s y s t e m l i e s i n t h e a b i l i t y t o g e n e r a t e c a s h f l o w , v i a t a x r e f u n d s . I n one s e n s e , t h i s i s e q u i v a l e n t t o t h e " i n c o m e a v e r a g i n g " c o n c e p t i n p e r s o n a l t a x a t i o n , w h i c h h a s f o s t e r e d p r o v i s i o n s l i k e f o r w a r d a v e r a g i n g , g e n e r a l a v e r a g i n g and I A A C s . L o g i c a l l y , t h e p r e s e n t v a l u e o f l o s s p r o v i s i o n s i s s i g n i f i c a n t l y g r e a t e r when t h e l o s s e s c a n be c a r r i e d b a c k . A s s u m i n g t a x was p a i d i n p r i o r y e a r s , t h i s means i m m e d i a t e r e f u n d s . R e f u n d s u n d e r c a r r y f o r w a r d p r o v i s i o n s a r e a t l e a s t one y e a r away. A l s o , t h e g r e a t e r t h e number o f y e a r s , i n t o t a l , t h a t l o s s e s may be a p p l i e d , t h e h i g h e r t h e l i k e l i h o o d o f e n j o y i n g r e f u n d s . H i s t o r i c a l l y , C a n a d a h a s p r o v i d e d a one y e a r c a r r y b a c k a n d f i v e y e a r c a r r y f o r w a r d . A s t u d y by B a r l e v a n d L e v y c o n f i r m e d t h e a p r i o r i h y p o t h e s i s t h a t l o s s c a r r y b a c k p r o v i s i o n s s i g n i f i c a n t l y e n h a n c e t h e p r o b a b i l i t y o f r e a l i z i n g a r e f u n d . The e x p e c t e d p r e s e n t v a l u e o f t a x s a v i n g s was i n c r e a s i n g l y h i g h e r f o r l o n g e r c a r r y b a c k p r o v i s i o n s . The s t u d y d i d n o t f i n d a s i g n i f i c a n t i m p r o v e m e n t when t h e c a r r y f o r w a r d p e r i o d a l o n e was e x t e n d e d . The B u d g e t o f A p r i l 1983 d i d e x t e n d t h e p r o v i s i o n s g e n e r o u s l y t o t h r e e y e a r s b a c k and s e v e n y e a r s f o r w a r d f o r s m a l l b u s i n e s s . U n d e r t h e p r e v i o u s l e g i s l a t i o n , t h e r e was a c h r o n o l o g y o f d e d u c t i b i l i t y : f i r s t , t h e c u r r e n t y e a r ; s e c o n d , t h e one y e a r c a r r y b a c k ; and t h i r d , t h e f i v e y e a r c a r r y f o r w a r d ( a l s o i n c h r o n o l o g i c a l o r d e r ) . S i n c e t h e A p r i l 1983 B u d g e t , t h e t a x p a y e r - 1 1 5 -C u r r e n t P r o v i s i o n s C h a p t e r F i v e h a s b e e n g i v e n d i s c r e t i o n r e g a r d i n g when t o a p p l y a l o s s a f t e r t h e c u r r e n t y e a r . As a c o n s e q u e n c e , a t a x p a y e r n e e d n o t d e d u c t any o r a l l o f an a v a i l a b l e l o s s i n a p a r t i c u l a r t a x a t i o n y e a r , s u b j e c t t o c e r t a i n f i l i n g d e a d l i n e s f o r c a r r y b a c k a p p l i c a t i o n . L a s t l y , t h e A p r i l 1983 B u d g e t p r o v i d e d one more c h a n g e , o f s i g n i f i c a n c e t o i n d i v i d u a l s . P r e v i o u s l y , t h e amount o f b u s i n e s s l o s s c l a i m e d i n a y e a r was r e q u i r e d t o r e d u c e i n c o m e t o n i l b e f o r e p e r s o n a l d e d u c t i o n s . T h i s i s no l o n g e r r e q u i r e d a n d t h o s e d e d u c t i o n s a r e no l o n g e r f o r e g o n e . S m a l l f i r m s w i t h a s s e t s l e s s t h a n $1 m i l l i o n d e c l a r e d l o s s e s o f $2,479 m i l l i o n i n 1981 (1980 - $2,090 m i l l i o n ) . T h i s i s an e s t i m a t e d $10,000 p e r f i r m i n 1 9 8 1 . Of t h i s t o t a l i n 1 9 8 1 , $58 m i l l i o n was c a r r i e d b a c k t o 1980. A l s o , $597 m i l l i o n o f p r i o r l o s s e s w e r e c l a i m e d t o o f f s e t i n c o m e f r o m 1 9 8 1 . W h i l e t h e l o s s p r o v i s i o n s f o r p r o p r i e t o r s and c o r p o r a t i o n s a r e t h e same, p e r s e , t h e l e g a l f o r m w i l l i n f a c t make a d i f f e r e n c e : CASE A - assume a b u s i n e s s l o s s o f $14,000 - t h e i n d i v i d u a l h a s no o t h e r i n c o m e a n d o n l y t h e b a s i c e x e m p t i o n - i g n o r e c a r r y b a c k o p p o r t u n i t i e s H e r e , u n d e r b o t h o l d and new l e g i s l a t i o n , t h e p r o p r i e t o r w o u l d l o s e h i s b a s i c e x e m p t i o n f o r t h e y e a r a n d c a r r y t h e $14,000 l o s s f o r w a r d . The same i n d i v i d u a l , u n d e r c o r p o r a t e g u i s e , w o u l d p r u d e n t l y t a k e a s a l a r y f r o m t h e company t o u t i l i z e h i s p e r s o n a l e x e m p t i o n and i n c r e a s e t h e l o s s c a r r y f o r w a r d . - 1 1 6 -C u r r e n t P r o v i s i o n s Chapter F i v e CASE B - assume the f a c t s as i n CASE A, except t h a t the i n d i v i d u a l has $10,0 00 of other income. Here, again, under the o l d law the p r o p r i e t o r would l o s e h i s p e r s o n a l exemption f o r the year. He would enjoy i t under the new l e g i s l a t i o n , thus i n c r e a s i n g h i s c a r r y f o r w a r d amount. The shareholder i s not i n as good a p o s i t i o n . Remuneration plans can t r a n s f e r income, but not expenses or l o s s e s , from the c o r p o r a t i o n to the sh a r e h o l d e r . T h i s i n d i v i d u a l w i l l bear some c u r r e n t p e r s o n a l taxes and leave a l l o f the l o s s b e n e f i t t o the f u t u r e . A c o n c l u s i o n as to the n e u t r a l i t y o f l o s s p r o v i s i o n s on the i n c o r p o r a t i o n d e c i s i o n i s n o n - t r i v i a l . Each s e t o f circumstances may render a d i f f e r e n t r e s u l t . More v a l i d than the t i m i n g o f the l o s s c l a i m s i s the tax va l u e o f those c l a i m s . T h i s r e s u l t w i l l vary due to the p r o g r e s s i v e and p r o p o r t i o n a l r a t e s t r u c t u r e s o f p e r s o n a l and c o r p o r a t e t a x a t i o n . Business Investment Losses T h i s i s a c a p i t a l l o s s r e a l i z e d on the d i s p o s i t i o n i n an arm's l e n g t h t r a n s a c t i o n o f a share or debt w i t h a CCPC. One h a l f o f the l o s s i s an " a l l o w a b l e " business investment l o s s which may be deducted from income without l i m i t . Any u n u t i l i z e d p o r t i o n may be c a r r i e d over as a n o n - c a p i t a l l o s s . -117-Current P r o v i s i o n s C h a p t e r F i v e Summary In summary, a r e v i e w o f t h e p r e s e n t s t a t e o f s m a l l b u s i n e s s t a x a t i o n p r o v i d e s some o b s e r v a t i o n s f o r r e f o r m : 1. P o l i c y towards s m a l l b u s i n e s s t a x r a t e s has appeared t o be i n c o n s i s t e n t o ver t h e l a s t e i g h t y e a r s . 2. The c o m p l e x i t y o f t h e t a x system makes i t c o m p l e t e l y i n a c c u r a t e t o s t a t e t h a t Canada has a t w o - r a t e system. I t i s i n f a c t a m u l t i p l e - r a t e system. 3. I t appears t h a t a s s o c i a t i o n r u l e s a r e i n e v i t a b l e . 4. Over h a l f o f t h e CCPCs had n i l t a x a b l e income i n 1981 and d i d not u t i l i z e t h e s m a l l b u s i n e s s d e d u c t i o n . 5. The t a x c o n c e s s i o n t o s m a l l b u s i n e s s does c o s t t h e government s i g n i f i c a n t f o regone revenue. 6. I n t e g r a t i o n has been e s s e n t i a l l y r e s t o r e d w i t h t h e P a r t Two Tax. 7. Other t a x c o n c e s s i o n s , l i k e M&P r a t e s , generous CCA p r o v i s i o n s , i n v e s t m e n t t a x c r e d i t s , and employment t a x c r e d i t s a r e o f n e g l i g i b l e v a l u e t o s m a l l b u s i n e s s . 8. Loss c a r r y o v e r r u l e s a r e o f s i g n i f i c a n t advantage when the p e r i o d and d i r e c t i o n o f c a r r y o v e r i s extended. -118-C u r r e n t P r o v i s i o n s C h a p t e r F i v e FOOTNOTES 1. T h i s p r o v i s i o n was s o o n c h a n g e d t o e x c l u d e t h e a b o v e p u r p o s e s a n d , i n s t e a d , o n l y t o p r o v i d e l i f e j a c k e t r e l i e f f r o m i n s o l v e n c y . 2. T h i s s h o u l d n o t be c o n f u s e d w i t h t h e d u a l - r a t e s t r u c t u r e r e l e v a n t t o d o u b l e t a x a t i o n r e l i e f o n d i s t r i b u t e d a n d u n d i s t r i b u t e d e a r n i n g s 3. "The T a x a t i o n o f S m a l l B u s i n e s s : An H i s t o r i c a l a n d T e c h n i c a l O v e r v i e w " , C a n a d i a n Tax F o u n d a t i o n Symposium o n S i m p l i f i c a t i o n p g 10 4. Tax M e a s u r e s R e v i e w C o m m i t t e e 5. M c F e t r i d g e & May - " The E f f e c t s o f C.C.A. on C a p i t a l A c c u m u l a t i o n i n t h e C a n a d i a n M a n u f a c t u r i n g S e c t o r " ; May - " I n v e s t m e n t I n c e n t i v e s a n d I n d u s t r i a l S t r a t e g y " ; Harman & J o h n s o n - "An E x a m i n a t i o n o f G o v e r n m e n t Tax I n c e n t i v e s f o r B u s i n e s s I n v e s t m e n t i n C a n a d a " ; a n d J o h n s o n & S c a r t h - "Tax E x p e n d i t u r e s f o r B u s i n e s s I n v e s t m e n t : T h e i r E f f e c t i v e n e s s a n d t h e i r B e n e f i c i a r i e s " 6. " L o s s C a r r y b a c k a n d t h e C a r r y o v e r P r o v i s i o n : E f f e c t i v e n e s s a n d E c o n o m i c I m p l i c a t i o n s " B B a r l e v a n d H L e v y , N a t i o n a l Tax J o u r n a l , J u n e 1 9 7 5 , p g 182 -1 1 9 -C u r r e n t P r o v i s i o n s Chapter S i x SOME PROPOSALS FOR REFORM "The term 'tax reform', u n f o r t u n a t e l y , can mean many thi n g s t o many people. Yet, such i m p r e c i s i o n i s not s u r p r i s i n g s i n c e taxes by nature r e l a t e to the d i s t r i b u t i o n f u n c t i o n of economics which r ^ s t s upon i n d i v i d u a l and s o c i e t a l value judgments." T h i s chapter w i l l review some r e c e n t p r o p o s a l s f o r reform. The backgrounds of the authors are v a r i e d . The ambits o f the p r o p o s a l s vary from sweeping and d e t a i l e d new ideas t o minor amendments to the o l d ways to r e - b i r t h o f o l d a l t e r n a t i v e s . As i t was not p o s s i b l e to l a b e l each p r o p o s a l w i t h a s u c c i n c t t i t l e d e s c r i b i n g i t s c e n t r a l t h r u s t , the author has simply named them a f t e r t h e i r authors. The J o i n t Committee on Taxa t i o n of the Canadian Bar A s s o c i a t i o n and the Canadian I n s t i t u t e o f Chartered Accountants p r e s e n t an annual r e p o r t t o the government, e n t i t l e d "Recommendations on the Income Tax A c t " . The comments focus on the anomalies i n the f i n e d e t a i l of the A c t . The 1983 r e p o r t had the f o l l o w i n g t o say about the s t a t e of small b u s i n e s s r u l e s : " I t i s the view of our committee, based on comments r e c e i v e d from many p r a c t i t i o n e r s , t h a t the system with r e s p e c t t o t a x a t i o n of p r i v a t e c o r p o r a t i o n s , p a r t i c u l a r l y as i t r e l a t e s t o the small business deduction, i s bre a k i n g down. The r u l e s have become so complex, t h a t they are d i f f i c u l t f o r most tax s p e c i a l i s t s to cope with and completely beyond the grasp o f those p r a c t i t i o n e r s who do not devote f u l l - t i m e to tax p r a c t i c e . The c o s t of o b t a i n i n g proper p l a n n i n g advice, p a r t i c u l a r l y w i t h r e s p e c t t o r e - o r g a n i z a t i o n s and a c q u i s i t i o n s i s extremely c o s t l y . C l i e n t s f i n d the system d i f f i c u l t to understand. Anomalies abound. As a r e s u l t , the c o n f i d e n c e of the p r o f e s s i o n a l and busi n e s s communities i n the system has been s e r i o u s l y eroded. We urge the government t o proceed as soon as p o s s i b l e with i t s review of these r u l e s f o l l o w i n g the n a t i o n a l symposium h e l d by the Canadian Tax Foundation i n e a r l y J u l y 1983". -120-Some Proposals f o r Reform Chapter Six I t should be p o i n t e d out t h a t the Budget of February 1984 enacted two common recommendations i n the name o f s i m p l i f i c a t i o n . Thus, these recommendations w i l l now appear redundant i n the ensuing p r o p o s a l s . The changes were: 1. To scrap the CD.A. concept; and 2. To scrap the N.Q.B. concept, which had become l e s s necessary with the i n t r o d u c t i o n of the P a r t Two Tax and, i n some p r o v i n c e s , a c t u a l l y was unduly harsh. 3 Brown Pr o p o s a l Brown r e - i n t r o d u c e d the p a r t n e r s h i p e l e c t i o n . T h i s was p r o f f e r e d by the C a r t e r Commission and the White Paper. I t has staggered through l e g i s l a t i v e e x i s t e n c e i n the U n i t e d S t a t e s f o r a number of y e a r s . Recent r e v i s i o n s " r e s u l t e d i n v a r i o u s s e c t i o n s of (the) I n t e r n a l Revenue Code t h a t were approximately t r i p l e the l e n g t h 4 of the o r i g i n a l s e c t i o n s . " By way of b r i e f review, the e s s e n t i a l tax i m p l i c a t i o n s are t h a t : 1. Income, l o s s and c r e d i t s would flow through the c o r p o r a t i o n t o the i n d i v i d u a l shareholders 2. The a l l o c a t i o n would be based on r e l a t i v e s h a r eholdings 3. Dividend d i s t r i b u t i o n s would flow through t a x - f r e e . The q u a l i f y i n g r u l e s vary from p r o p o s a l to p r o p o s a l . Brown's suggestions are: 1. Unanimous e l e c t i o n r e q u i r e d 2. A l l shareholders must be r e s i d e n t i n d i v i d u a l s 3. There should be some maximum number of s h a r e h o l d e r s , say one hundred -121-Some Proposals f o r Reform Chapter S i x 4. The r u l e s would only apply t o companies wi t h simple c a p i t a l s t r u c t u r e s . Brown's s t a t e d advantages of the system would be: 1. Achieves true i n t e g r a t i o n 2. Allows l o s s e s t o co u l d c a r r y immediate tax advantages to sha r e h o l d e r s ' p e r s o n a l tax r e t u r n s 3. Allows c u r r e n t l y u n i n c o r p o r a t e d e n t i t i e s t o enjoy l i m i t e d l i a b i l i t y i f they r e - o r g a n i z e 4. E l i m i n a t e s complicated s e c t i o n s extant p e r t a i n i n g t o the small business deduction, the cumulative d e d u c t i o n account, P a r t Two Tax and P a r t Six Tax The author sees the f o l l o w i n g disadvantages: 1. The flow-through o f l o s s e s only p r o v i d e s c u r r e n t tax breaks f o r those with other c u r r e n t income. T y p i c a l l y , s m a l l b u s i n e s s people i n v e s t a l l o f t h e i r time and most of t h e i r f i n a n c i a l r e s o u r c e s ; t h e r e f o r e , i t i s u n l i k e l y t h a t they have much other income. 2. The system o n l y p r o v i d e s tax advantages i n the above case. I f the f i r m i s p r o f i t a b l e , t h i s system i s not d e s i r a b l e because no tax d e f e r r a l can e x i s t . 3. The twin p r o v i s i o n s o f unanimity and having up t o one hundred s h a r e h o l d e r s are, p r a c t i c a b l y , mutually e x c l u s i v e . Given the v a r i a t i o n i n p e r s o n a l tax r e s u l t s , i t i s u n l i k e l y t h a t such a l a r g e group of shareholders c o u l d a l l b e n e f i t , and t h e r e f o r e favour the e l e c t i o n . 4. The a l l o c a t i o n would be based on i n v e s t e d c a p i t a l . As the s o l e a l l o c a t i o n , t h i s would be i n a p p r o p r i a t e i n many -122-Some Proposals f o r Reform Chapter S i x s i t u a t i o n s , eg s i l e n t versus working p a r t n e r s . T h i s would probably s t i l l r e q u i r e some s a l a r y remuneration to reward e f f o r t . T h e r e f o r e , remuneration p l a n n i n g c a l c u l a t i o n s would s t i l l e x i s t i n a m o d i f i e d f a s h i o n . 5 . I f the p r o p o s a l i s e l e c t i v e , and not compulsary, then a l l of the e x i s t i n g s m a l l business p r o p o s a l s must remain. 6. I f the e x i s t i n g r u l e s remain, then i t cannot be s a i d t h a t the o v e r a l l system i s any more n e u t r a l than b e f o r e . 7. The e x i s t e n c e o f p e r s o n a l tax l i a b i l i t y without cash d i v i d e n d s to pay the tax l i a b i l i t y may cause h a r d s h i p f o r some sh a r e h o l d e r s . 8. T r a n s i t i o n a l r u l e s t o opt i n t o the e l e c t i o n would cause complexity. I f the United S t a t e s system i s f o l l o w e d , a l l o w i n g o p t i n g i n and out r e g u l a r l y over time, the system would become even more complex. 9. T r a n s i t i o n a l r u l e s c o u l d not be m i t i g a t e d by r e q u i r i n g t h i s e l e c t i o n and r e p e a l i n g the small business r u l e s extant because r u l e s would s t i l l be needed f o r firms who evolve i n and out through growth or changed circumstances. T h i s p r o p o s a l has t h e o r e t i c a l p u r i t y . As a p r e f e r e n c e f o r small b u s i n e s s , though, the author b e l i e v e s t h a t i t has good and bad p o i n t s ; furthermore, we should r e l y on the experience i n the U.S. with "Subchapter S" and not c o n s i d e r t h i s t o be a panacea. Doane P r o p o s a l ^ Doane s u b s c r i b e s to the C a r t e r and McFetridge b e l i e f i n p r o v i d i n g a s s i s t a n c e t o new bu s i n e s s e s . He proposed a v a r i a t i o n -123-Some Proposals f o r Reform Chapter S i x on the system extant, as f o l l o w s : 1. Scrap the P a r t Two Tax and i n c r e a s e the smal l business r a t e t o 33 1/3 percent (which i s where i t ends up a f t e r the P a r t Two Tax). 2. Allow a d e f e r r e d tax l i a b i l i t y t o accumulate i n t e r e s t - f r e e f o r f i v e y e a r s . D e f e r r a l i s t o be l i m i t e d to income of $200,000 a n n u a l l y . 3. Draw down the d e f e r r a l over ten years i n t e r e s t - f r e e . 4. Dividend d i s t r i b u t i o n s would t r i g g e r immediate draw-downs. 5. Apply only t o companies w i t h l e s s than ten sha r e h o l d e r s . Doane 1s s t a t e d advantage of the system would be to scrap the e x i s t i n g r u l e s p e r t a i n i n g t o P a r t Two Tax, the cumulative deduction account, the s m a l l business deduction and the manufacturing and p r o c e s s i n g r a t e . H i s p r o p o s a l would indeed p r o v i d e c a p i t a l a s s i s t a n c e to smal l b u s i n e s s . In extreme cases, the author b e l i e v e s t h a t the present v a l u e o f the d e f e r r a l would be enormous. The p r o p o s a l i s p r e j u d i c i a l i n t h a t o n l y p r o f i t s earned i n the f i r s t f i v e years would be e l i g i b l e . T h i s would p r e f e r e n t i a l l y reward the f a s t - s t a r t e r s . A l s o , i t p r o v i d e s no c u r r e n t r e l i e f f o r the s l o w - s t a r t e r s who i n c u r i n i t i a l l o s s e s . The system rewards r e t e n t i o n . The a s s o c i a t i o n r u l e s would remain important. The revenue aspect would be of concern t o government. The long-term d e f e r r a l c o u l d r e s u l t i n s i g n i f i c a n t bad debts from i n s o l v e n t f i r ms who have expended the cash r e t a i n e d from unpaid t a x e s . -124-Some Proposals f o r Reform Chapter S i x In c o n c l u s i o n the author b e l i e v e s t h a t t h i s p r o p o s a l swings the pendulum h e a v i l y i n favour of c e r t a i n s m a l l b u s i n e s s e s . P o l i t i c a l l y , the p r o p o s a l would be u n p a l a t a b l e . James P r o p o s a l ^ James proposes an i n n o v a t i v e change w i t h i n the e x i s t i n g system. His d e t a i l e d schema i n c l u d e s : 1. Redefine a "modified s m a l l b u s i n e s s c o r p o r a t i o n " 2. Increase the annual l i m i t t o $250,000, which i n c l u d e s remuneration t o owner/managers 3. A l l funds d i s t r i b u t e d to owner/managers are p e r s o n a l income 4. I f such d i s t r i b u t i o n s are l e s s than the l e a s t o f : - t a x a b l e c o r p o r a t e income - a c t i v e business income - $250,000 the excess would be s u b j e c t t o a t w e n t y - f i v e percent refundable tax 5. T h i s excess, net of the r e f u n d a b l e tax, i s added to a "modified s m a l l business c o r p o r a t i o n d i v i d e n d account" 6. I f d i s t r i b u t i o n s exceed the l e a s t o f the above t h r e e , t h a t excess draws down the "modified small b u s i n e s s c o r p o r a t i o n d i v i d e n d account" 7. The draw-down t r i g g e r s a refund of the t w e n t y - f i v e percent r e f u n d a b l e tax 8. Dividends p a i d t o non-employee owners a l s o draw down t h i s d i v i d e n d account, but without g e n e r a t i n g a refund 9. These payments would, however, generate a gross-up and -125-Some Proposals f o r Reform Chapter S i x d i v i d e n d tax c r e d i t o f one t h i r d 10. The cumulative deduction account concept i s r e t a i n e d , but only t o capture annual income g r e a t e r than $250,000 11. Annual income g r e a t e r than $250,000 i s taxed a t the n o n - q u a l i f y i n g business r a t e 12. I f owner/manager draws exceed $250,000, the excess i s taxed p e r s o n a l l y , not c o r p o r a t e l y 13. Once the cumulative deduction account exceeds $1 m i l l i o n , the "modified s m a l l b u s i n e s s c o r p o r a t i o n " s t a t u s i s surrendered, a t which time the r e g u l a r r a t e s apply 14. The owner/manager may not, by d e f i n i t i o n , draw d i v i d e n d s from the "modified small b u s i n e s s c o r p o r a t i o n d i v i d e n d account" 15. Dividends from the cumulative deduction account generate gross-up and d i v i d e n d tax c r e d i t o f one h a l f 16. Owner/managers may draw d i v i d e n d s , without p r e j u d i c e , from t h i s account 17. The a s s o c i a t i o n r u l e s are s t i l l needed f o r c o r p o r a t e groups or c o r p o r a t e p a r t n e r s h i p s . James sees the f o l l o w i n g b e n e f i t s from t h i s proposed system: 1. Remuneration mix c a l c u l a t i o n s become unnecessary 2. Shareholder loan d e b i t s cease t o be a problem 3. I t p r o v i d e s a system of f u l l i n t e g r a t i o n t o $250,000 4. The reasonableness of s a l a r i e s and bonuses ceases t o be a problem 5. S p l i t t i n g , w i t h or without an a c t i v e l y p a r t i c i p a t i n g spouse, becomes l e s s of a problem -126-Some Proposals f o r Reform Chapter S i x 6. I t allows some tax d e f e r r a l , a f t e r the t w e n t y - f i v e percent r e f u n d a b l e tax, on r e t a i n e d e a r n i n g s . The author agrees with James' l i s t o f p e r c e i v e d advantages. However, some c r i t i c a l comments are i n o r d e r : 1. The t r a c k i n g of v a r i o u s p o t s , cash withdrawals, tax w i t h - h o l d i n g s , e t c may become complicated 2. The c o r p o r a t e tax f i l i n g w i l l become more complicated 3. I t w i l l be important to d e s i g n a t e owners as "employees" or "non-employees". T h i s d e f i n i t i o n would have t o be q u a n t i f i e d . A l s o , an owners' employment s t a t u s may change over time 4. Implementation of the system may prove d i f f i c u l t . Do a l l q u a l i f y i n g c o r p o r a t i o n s s t a r t w i t h t h e i r pots a t zero? 7 Edwards Prop o s a l The q u i d d i t y of Edwards p r o p o s a l i s s i m i l a r t o Mr Doane's — r a i s e the small business r a t e to 33 1/3 percent and e l i m i n a t e the P a r t Two Tax and the cumulative deduction account. As a q u i d pro quo, the investment and employment tax c r e d i t s c o u l d be i n c r e a s e d f o r s m a l l b u s i n e s s . A l s o , t h i s r a t e would apply ad i n f i n i t u m . The annual l i m i t would be r e t a i n e d . As the February 1984 Budget granted e t e r n i t y f o r a low r a t e anyway, t h i s p r o p o s a l now does not seem to be very a t t r a c t i v e . Small business would be s a c r i f i c i n g 8 1/3 percentage p o i n t s of d e f e r r e d tax f o r , e s s e n t i a l l y , n o t h i n g . The p r o p o s a l to i n c r e a s e the investment and employment tax c r e d i t s i s a poor replacement. P r e v i o u s a n a l y s i s showed t h a t n e i t h e r of these p r o v i s i o n s are o f -127-Some Proposals f o r Reform Chapter S i x s i g n i f i c a n t b e n e f i t to the small b u s i n e s s s e c t o r . I n c r e a s i n g the r a t e s would not make them b e t t e r . g Goodwin P r o p o s a l Goodwin proposes a system d i s c u s s e d i n Chapter Two, whereby d i v i d e n d s become tax d e d u c t i b l e , l i k e i n t e r e s t payments. The c o r p o r a t e tax i s , thus, a tax on u n d i s t r i b u t e d p r o f i t s . I f d i v i d e n d d e d u c t i b i l i t y was accompanied by the a b o l i t i o n of d i v i d e n d tax c r e d i t s and f u l l t a x a t i o n of c a p i t a l g a i n s , a l l types of c o r p o r a t e - s o u r c e income would be put on the same b a s i s at the i n d i v i d u a l l e v e l . However, d i v i d e n d d e d u c t i b i l i t y would have two problems: 1. I t would not tax r e t a i n e d c o r p o r a t e earnings e q u a l l y to other forms of investment income un l e s s a l l income was d i s t r i b u t e d 2. I t would have an impact on payout r a t i o s and e x e r t pressure to d i s t r i b u t e . The l a t t e r problem may not be s e r i o u s f o r small b u s i n e s s e s , whose owners can simply r e - i n v e s t the d i v i d e n d s as shareholder l o a n s . The c o r p o r a t e r a t e , presumably, would be i n c r e a s e d ; otherwise, r e t e n t i o n would be d e s i r a b l e . The annual p l a n n i n g d e c i s i o n would s t i l l r e q u i r e a comparison of p e r s o n a l versus c o r p o r a t e tax l i a b i l i t y . Loss r e l i e f i s not addressed i n t h i s system. 9 Small Business A d m i n i s t r a t i o n P r o p o s a l The Small Business A d m i n i s t r a t i o n has proposed to d e f i n e more narrowly a small b u s i n e s s . The SBA s t a t e s t h a t "A new tax d e f i n i t i o n must p r o v i d e a framework f o r the problems and -128-Some Proposals f o r Reform Chapter S i x c h a r a c t e r i s t i c s of two d i s t i n c t types o f s m a l l b u s i n e s s ; the sma l l business e n t e r p r i s e and the medium business e n t e r p r i s e . " " ' ^ To e s t a b l i s h the dichotomy, the p r o p o s a l f i r s t d e f i n e s the c h a r a c t e r i s t i c s of a s m a l l business e n t e r p r i s e ("SBE"): - No more than ten e q u i t y owners ( f i f t e e n i n cases where e x t r a owners a c q u i r e d t h e i r i n t e r e s t s by i n h e r i t a n c e , or where the SBE has been i n e x i s t e n c e f o r f i v e y e a r s ) . - No e q u i t y owners other than i n d i v i d u a l s , e s t a t e s o f deceased e q u i t y owners, c e r t a i n t r u s t s and Small Business Investment Companies. - No e q u i t y owners who are n o n - r e s i d e n t a l i e n s . - No e q u i t y owners who c o n t r o l more than one SBE (using c o n s t r u c t i v e ownership r u l e s ) . - Only one c l a s s of e q u i t y ownership. - E q u i t y not i n excess of $500,000 as averaged over a f i v e year p e r i o d . - Annual gross p r o f i t not i n excess of $1 m i l l i o n as averaged over a f i v e year p e r i o d . - No investments i n other b u s i n e s s e n t e r p r i s e s . - No f o r e i g n income. - No income from n a t u r a l r e source or timber o p e r a t i o n s . - No tax exempt income other than proceeds of insurance on the l i f e o f a deceased e q u i t y owner r e c e i v e d by reason of death. - I f i t i s o r g a n i z e d as a c o r p o r a t i o n , i t has never been taxed as one. The r u l e s would apply r e g a r d l e s s of the l e g a l form o f -129-Some Proposals f o r Reform Chapter Six o r g a n i z a t i o n . The SBE would be taxed l i k e an u n i n c o r p o r a t e d b u s i n e s s but would have c e r t a i n tax c h a r a c t e r i s t i c s o f a c o r p o r a t i o n . The e s s e n t i a l tax treatment would be as f o l l o w s : - Income would be taxed p r o - r a t a t o e q u i t y owners as i t i s earned, r e g a r d l e s s o f whether or not i t i s a c t u a l l y d i s t r i b u t e d t o them. - Losses would be d e d u c t i b l e p r o - r a t a by e q u i t y owners a g a i n s t t h e i r income from other sources t o the extent o f t h e i r investment i n the SBE. I f l o s s e s exceed the investment, they would be c a r r i e d forward and be u t i l i z e d when the e q u i t y owner generated f u r t h e r investment. - Income or l o s s would be c a l c u l a t e d at the SBE l e v e l , g e n e r a l l y under r u l e s now a p p l i c a b l e t o c o r p o r a t i o n s . - Some s p e c i a l items, such as the investment tax c r e d i t , would be a l l o c a t e d p r o - r a t a t o e q u i t y owners and u t i l i z e d by them on t h e i r i n d i v i d u a l tax r e t u r n s . - D i s t r i b u t i o n s of money or p r o p e r t y t o e q u i t y owners would be t r e a t e d i n a manner s i m i l a r t o the present treatment of such d i s t r i b u t i o n s by p a r t n e r s h i p s t o p a r t n e r s . "The Medium Business E n t e r p r i s e ("MBE") should be d e f i n e d i n the tax law as any taxpayer other than a Small Business E n t e r p r i s e which q u a l i f i e s as a smal l business f o r loans by the Small Business A d m i n i s t r a t i o n or one which q u a l i f i e s as a s m a l l b u s i n e s s f o r ^ a s s i s t a n c e by Small Business Investment Companies". MBEs are co n s i d e r e d t o be l a r g e r , w i t h more s o p h i s t i c a t e d managerial and f i n a n c i a l e x p e r t i s e than SBEs. The MBE would be taxed a c c o r d i n g t o i t s l e g a l form, under the e x i s t i n g laws. The purpose of t h i s dichotomy i s t o i s o l a t e the group t h a t need -130-Some Proposals f o r Reform Chapter S i x s i m p l i c i t y i n t h e i r tax a f f a i r s . The MBEs are c o n s i d e r e d v a l i d l y t o be between smal l and b i g because they s t i l l need a s s i s t a n c e i n ways other than tax s i m p l i f i c a t i o n , e.g. i n f i n a n c i n g . T h e i r i d e n t i f i c a t i o n would a l l o w l e g i s l a t i o n t o be t a r g e t e d a c c o r d i n g l y . The SBA regards the Subchapter S l e g i s l a t i o n to have been w e l l intended but u n s u c c e s s f u l . "The c u r r e n t e l e c t i o n under Subchapter S would continue f o r new MBEs orga n i z e d as c o r p o r a t i o n s and MBEs c u r r e n t l y e l e c t i n g under i t s p r o v i s i o n s . Once a Subchapter S e l e c t i o n were t o be terminated, however, r e - e l e c t i o n would be p r o h i b i t e d except by s p e c i a l p e r m i s s i o n by the I n t e r n a l Revenue S e r v i c e t o a v o i d undue ha r d s h i p . F u r t h e r , a c o r p o r a t e MBE which has at any time i n i t s e x i s t e n c e , been taxed as a r e g u l a r c o r p o r a t i o n would be p r o h i b i t e d from e l e c t i n g under Subchapter S. This l i m i t a t i o n o f Subchapter S s t a t u s t o new c o r p o r a t i o n s would e l i m i n a t e many of the t e c h n i c a l c o m p l e x i t i e s now necessary because the p r o v i s i o n s of the Subchapter now accommodate c o r p o r a t i o n s t e m p o r a r i l y e l e c t i n g . I t i s a n t i c i p a t e d t h a t the c r e a t i o n o f the SBE combined with the l i m i t a t i o n on Subchapter S e l e c t i o n s w i l l e v e n t u a l l y enable Subchapter S t o be re p e a l e d because of non-use. T h i s would, indeed, be a major v i c t o r y i n the b a t t l e f o r small b u s i n e s s tax s i m p l i f i c a t i o n . " Evans P r o p o s a l Evans contends t h a t "... our c u r r e n t system o f t a x a t i o n remains a 14 major impediment to growth and p r o s p e r i t y . " The b a s i c i n c e n t i v e s to e n t r e p r e n e u r i a l i s m and r i s k - t a k i n g need t o be r e s t o r e d t o promote growth and employment. He b e l i e v e s t h a t the margi n a l tax r a t e s are too h i g h . T h i s has caused growth i n the underground economy and the use of tax s h e l t e r s (or "tax e x p e n d i t u r e s " ) . The saga of MURBs, f e a t u r e f i l m s and s c i e n t i f i c r e s e a r c h tax c r e d i t s a l l b e l i e an investment c l i m a t e where the tax break i s foremost and the a s s e t i t s e l f i s secondary. Evans views these developments as the taxpayers' attempt to reduce what i s p e r c e i v e d as e x c e s s i v e t a x a t i o n . -131-Some Proposals f o r Reform Chapter S i x Evans proposes a p r o g r e s s i v e m a r g i n a l r a t e s t r u c t u r e up t o $12,000. Beyond t h i s l e v e l , a l l income i s taxed a t a f l a t top marginal r a t e of t h i r t y percent ( f e d e r a l and p r o v i n c i a l combined). He b e l i e v e s t h a t the key t o the s i m p l i f i c a t i o n of the complex co r p o r a t e tax system i s t o tax firms and t h e i r s h a r e h o l d e r s a t the same r a t e . "The crux of the problem, as I see i t , r e s i d e s i n the f a c t t h a t the tax s t r u c t u r e s f a c i n g persons and c o r p o r a t i o n s are d i f f e r e n t . T h i s i s f u r t h e r complicated by the d i s t i n c t i o n which i s made between smal l and l a r g e f i r m s . I n s o f a r as two cor p o r a t e tax r a t e s e x i s t , both of which d i f f e r from the r a t e s imposed under the pe r s o n a l tax system, there i s a need f o r a separate tax on d i v i d e n d d i s t r i b u t i o n s . T h i s i n t u r n c r e a t e s the requirement f o r a d i v i d e n d tax c r e d i t i n an attempt, mostly u n s u c c e s s f u l l y , t o account f o r cor p o r a t e tax p a i d so as to a v o i d double t a x a t i o n . Moreover, the low sm a l l business tax r a t e , i n c o n j u n c t i o n w i t h these other f e a t u r e s , makes it ^ D . e c e s s a r y to tax the c a p i t a l gains a r i s i n g from share ownership". "The e x i s t e n c e o f d i f f e r e n t r a t e s t r u c t u r e s , t h e r e f o r e , has been the p r i n c i p a l f a c t o r contributing^ ^ to the growing complexity and i n e f f i c i e n c y of the tax system". Under Evans' system " I t would then make no d i f f e r e n c e whether the tax was p a i d by the c o r p o r a t i o n o r the i n d i v i d u a l owner, although f o r p r a c t i c a l reasons ... I propose t h a t the tax be p a i d a t the cor p o r a t e l e v e l w i t h subsequent d i s t r i b u t i o n s t o shareholders made on a t a x - f r e e b a s i s . " ^ ^ Evans a l s o recommends a s h i f t from the income tax base t o the expenditure base. "The movement to an expenditure tax base, while not e s s e n t i a l f o r the v a l i d i t y of the other p a r t s o f my p r o p o s a l , would a c t to f u r t h e r enhance the i n c e n t i v e s to sav i n g and 18 investment i n the economy". He r i g h t l y p o i n t s out t h a t the p e r s o n a l tax system i s p a r t i a l l y -132-Some Proposals f o r Reform Chapter S i x on an expenditure base a l r e a d y , e.g. the d e d u c t i b i l i t y o f c a p i t a l c o n t r i b u t i o n s ("savings") to RRSPs. An expenditure base, simply, removes the cap on such deductions. The s p i r i t o f an expenditure base, on the co r p o r a t e s i d e , would e s s e n t i a l l y e r a d i c a t e the c a p i t a l c o s t allowance system and al l o w c a p i t a l o u t l a y s t o be expensed. M i s c e l l a n e o u s P r o p o s a l s M i s c e l l a n e o u s p r o p o s a l s have been p o s i t e d i n l e s s d e t a i l . The C.F.I.B. r e c e n t l y proposed the f o l l o w i n g package t o a s s i s t small b u s i n e s s : 1. Expand the l o s s c a r r y o v e r p r o v i s i o n s . 2. Increase the r e s e a r c h and development tax c r e d i t s . 3. Enact a p a r t n e r s h i p e l e c t i o n t o flow through tax l o s s e s . 4. Allow RRSP funds t o be a source o f venture c a p i t a l . 19 Kao proposed a f u l l d eduction from income, with l i m i t s , f o r t h i r d p a r t y e q u i t y c a p i t a l i n a s m a l l b u s i n e s s . He a l s o proposed a tax deduction t o busi n e s s based on a n o t i o n a l r a t e o f r e t u r n on i n v e s t e d c a p i t a l . The deduction would reduce c o r p o r a t e tax, but not be ta x a b l e as income t o the s h a r e h o l d e r s . The amount would be c r e d i t e d t o a c a p i t a l s u r p l u s account, which would be a p p r o p r i a t e d t o prevent d i s t r i b u t i o n . A c e i l i n g o f $500,000 would be a v a i l a b l e . Summary In r e v i e w i n g the p r o p o s a l s , c e r t a i n elements appear w i t h c o n s i s t e n c y : 1. S i m p l i f i c a t i o n was sought, t o v a r y i n g degrees. -133-Some Proposals f o r Reform Chapter S i x 2. A s s o c i a t i o n t e s t s were g e n e r a l l y necessary. 3. The commitment to some form o f i n t e g r a t i o n was d e s i r a b l e . 4. Some form of t a x - a s s i s t e d f i n a n c i n g was d e s i r a b l e . 5. The focus was o f t e n on new b u s i n e s s . -134-Some Proposals f o r Reform Chapter S i x FOOTNOTES 1. B. Herber, "Personal Income Tax Reform and the I n t e r a c t i o n Between Budgetary Goals: A U.K. and U.S. Comparison", i n "Reforms of Tax Systems", pg 55. 2. Recommendations on the Income Tax A c t 1983 by the J o i n t Committee on Taxation of the Canadian Bar A s s o c i a t i o n and the Canadian I n s t i t u t e of Chartered Accountants, pg VI -16. 3. R. Brown, F.C.A., Pa r t n e r - P r i c e Waterhouse, " P a r t n e r s h i p E l e c t i o n : S i m p l i f i c a t i o n or Greater Complexity". 4. G. Padwe, "Taxation and the Small B u s i n e s s — t h e U.S. Approach", pg 1. 5. L. Doane, F.C.A., Chairman - Doane Raymond, " I n t e g r a t i o n and D e f e r r a l of Domestic Corporate T a x a t i o n " . 6. L. James, C A . , P a r t n e r - Peat Marwick M i t c h e l l , "Compensating the Owner/Manager of an Incorporated Small B u s i n e s s " . 7. S. Edwards, Q.C., P a r t n e r - F r a s e r & Beatty, "A Suggestion f o r S i m p l i f i c a t i o n o f the P r o v i s i o n s R e l a t i n g to the Small Business Deduction and Refundable Tax". 8. R. Goodwin, LLB., P a r t n e r - F i l l m o r e & R i l e y , "The D i v i d e n d s - P a i d deduction, an A l t e r n a t i v e t o the Current Income Tax Treatment of Small B u s i n e s s " . 9. Small Business A d m i n i s t r a t i o n , "The Impact o f T a x a t i o n on Small B u s i n e s s " . 10. I b i d , pg 32. 11. I b i d , pg 35. -135-Some Proposals f o r Reform Chapter S i x 12. I b i d , pg 35. 13. J . Evans, Ph.D., Former Member o f Parliament, "The Case f o r Tax Change - A P r o p o s a l " . 14. I b i d , pg 1. 15. I b i d , pg 5. 16. I b i d , pg 5. 17. I b i d , pg 5. 18. I b i d , pg 6. 19. R. Kao, "Small Business F i n a n c i n g , Risk C a p i t a l , and Tax Measures", J o u r n a l of Small Business, S p r i n g 1984 pg 2 6 -136-Some Proposals f o r Reform Chapter Seven CONCLUSIONS "Great designs are r a r e i n p o l i t i c s " A French H i s t o r i a n In t h i s f i n a l chapter, the author w i l l i d e n t i f y h i s o b j e c t i v e s f o r s m a l l business tax p o l i c y and make some comments on the task of reform. The author's recommendations are not a s i n g l e , c ohesive replacement f o r the presen t system. They are a c o l l e c t i o n of i d e a s : some are i n t e r - r e l a t e d , some are independent, some are mutually e x c l u s i v e , some are broad and some are narrow. The recommendations are i n two p a r t s ; the f i r s t s ets out g e n e r a l d i r e c t i o n f o r p o l i c y ; and the second p r o v i d e s s p e c i f i c recommendations. Some P e r s p e c t i v e s on Reform "Income tax reform normally seeks t o broaden the tax base i n order to achieve g r e a t e r d i s t r i b u t i o n a l e q u i t y , a l l o c a t i o n a l n e u t r a l i t y and a d m i n i s t r a t i v e s i m p l i f i c a t i o n ... (These) goals have not always been c o n s i d e r e d e q u a l l y important. Instead, there has been a dominant concern with d e s i g n i n g and implementing a comprehensive income tax s t r u c t u r e t h a t w i l l a t t a i n g r e a t e r e q u i t y i n the d i s t r i b u t i o n of tax burden. E q u i t y , i n t u r n , has u s u a l l y been d e f i n e d i n r e f e r e n c e t o the a b i l i t y t o pay benchmark." " I t i s suggested t h a t tax reform i s i n e x t r i c a b l y i n v o l v e d with d i s t r i b u t i o n a l c o n s i d e r a t i o n s , even when the l a t t e r do not outwardly appear t o be the primary reason f o r a s p e c i a l tax p r o v i s i o n being adopted." B i r d advanced t h r e e pragmatic arguments f o r the s t a t u s quo of cor p o r a t e t a x a t i o n ; f i r s t , i t i s a l r e a d y here; second, i t i s p o l i t i c a l l y a c c e p t a b l e ; and t h i r d , none o f the a t t r a c t i v e a l t e r n a t i v e s seem f e a s i b l e and none of the f e a s i b l e a l t e r n a t i v e s seem a t t r a c t i v e . He emphasized t h a t there i s a s i g n i f i c a n t d i f f e r e n c e between d e s i g n i n g a tax system f o r a new economy and -137-Con c l u s i o n s Chapter Seven d e s i g n i n g changes t o an e x i s t i n g one. The i d e a l system i n a new economy would probably c o n t a i n no c o r p o r a t e tax. He views the c o s t s o f t r a n s i t i o n from the s t a t u s quo to be h i g h , and probably g r e a t e r than the b e n e f i t s of any new system. The e x i s t i n g c o r p o r a t e tax i s deeply entrenched i n the Canadian tax system, both f o r i n d i v i d u a l and business d e c i s i o n s . In B i r d ' s words, "Old taxes need not be good taxes but there must be good reasons f o r changing them s i n c e any change i s i t s e l f costly."'''''' B i r d a l s o b e l i e v e s t h a t , "The removal o f some of the major d i s t o r t i o n s caused by i n f l a t i o n should probably r e c e i v e the h i g h e s t p r i o r i t y 12 i n c o r p o r a t e tax reform." L a s t l y , Canada's system must continue to mesh with the r e s t of the world. "Indeed, i n the end, the importance o f f o r e i g n ownership i s probably the major reason why Canada's corpor a t e tax s t r u c t u r e i s not l i k e l y t o be a l t e r e d 13 s u b s t a n t i a l l y i n the near f u t u r e . " Given t h a t the U n i t e d S t a t e s i s Canada's b i g g e s t f o r e i g n i n v e s t o r , Canada should r e t a i n a co r p o r a t e tax t h a t approximately a l i g n s w i t h the U.S. D r a f t i n g , a d m i n i s t e r i n g and complying w i t h the Act consumes an enormous amount of energy. The A c t may indeed c o l l a p s e i n due course under i t s own weight. Despite the apparent c r i t i c a l moment, the process of reform seems almost f u t i l e a t the s t a r t . The u l t i m a t e authors are p o l i t i c i a n s . T h e r e f o r e , income tax p o l i c y must s t r a d d l e the c o n s t r a i n t s o f economics and p o l i t i c s . T h i s i s sometimes achieved and other times the p o l i c y f a l l s i n t o an abyss, s e r v i n g n e i t h e r . The C a r t e r Commission Report i n the S i x t i e s put f o r t h a d e t a i l e d schema. The White Paper spurned some of the p r o v i s i o n s . The f i n a l l e g i s l a t i o n was as much the product -138-Con c l u s i o n s Chapter Seven of a year of i n t e n s e l o b b y i n g as i t was o f a decade o f s k i l l e d r e s e a r c h . T h e r e i n l i e s the sense of f u t i l i t y with renewed reform. A second o b s e r v a t i o n i s t h a t t a x a t i o n i s only a means to some p o l i c y o b j e c t i v e and not an end i n i t s e l f . U n f o r t u n a t e l y , the patchwork design of the system o c c a s i o n a l l y obscures the o r i g i n a l p o l i c y i n t e n t . The C a r t e r Commission wanted "more boldness and 14 s t e a d f a s t n e s s i n p u r s u i n g s t a b i l i z a t i o n g o a l s " . I t d i d not favour o v e r - r e l i a n c e on annual tax changes to i n f l u e n c e the economy. These took too long to b r i n g i n t o a c t i o n and were delayed i n t h e i r e f f e c t . Often, they were not l e f t long enough to achieve the d e s i r e d r e s u l t . In approaching reform, one must f i r s t ask, "Is the s t a t u s quo a l i t t l e b i t wrong, or a l o t ? " I f i t i s o n l y a l i t t l e wrong , then minor amendments w i l l s u f f i c e . I f i t i s a l o t wrong, then a second q u e s t i o n must be asked, "Are we prepared to change i t a l o t , or only a l i t t l e ? " S h a l l the h u b r i s o f the Act prevent major change? As B i r d p o i n t e d out, sometimes i t i s not the change i t s e l f , but the t r a n s i t i o n , t h a t i s d i s t a s t e f u l . The sheer momentum of the s t a t u s quo and the complexity of the necessary t r a n s i t i o n a l r u l e s can quash many a good reform p r o p o s a l . I t i s the author's p o s i t i o n t h a t i t would be f u t i l e t o sequester o n e s e l f away long enough t o design the p e r f e c t system. Such does not e x i s t . " P e r f e c t i o n " i s not d e f i n e d here by one person's c r i t i c a l judgment—not even t h a t o f an e x p e r t . As was seen i n the S i x t i e s , p o l i t i c a l c o n s i d e r a t i o n s d i c t a t e t h a t p e r f e c t i o n r e s u l t s from the n e g o t i a t e d t e n s i o n of the democratic system. -139-Co n c l u s i o n s Chapter Seven O b j e c t i v e s A key i s s u e must be r e s o l v e d before s m a l l business t a x a t i o n p o l i c y can be addressed: Who i s the t a r g e t ? The h i s t o r y of Canadian sma l l business tax p o l i c y i s f r a u g h t with c o n t r a d i c t i o n s on t a r g e t i n g p r e f e r e n c e to small b u s i n e s s , both i n u n d e r l y i n g i n t e n t and i n a c t u a l l e g i s l a t i o n . The C a r t e r Commission's b i a s was not towards s m a l l b u s i n e s s , per se, but towards new b u s i n e s s . Growth and success were the g o a l s to be s t i m u l a t e d . The tax system should not s h i e l d d e c l i n i n g f i r m s . The Commission's p r o p o s a l s r e f l e c t e d t h i s p h i l o s o p h y : 1. The p a r t n e r s h i p o p t i o n would s u b j e c t small b u s i n e s s to p e r s o n a l m a r g i n a l r a t e s . These would be low f o r l e s s p r o f i t a b l e f i r ms and high f o r the s u c c e s s f u l ones. 2. Otherwise, the f u l l c o r p o r a t e r a t e would apply. 3. The a l t e r n a t i v e schemes a l l p r o v i d e d f r o n t - e n d loaded b e n e f i t s t h a t would e x p i r e over time. 2 T h i s same philosophy re-appears twenty years l a t e r . McFetridge concluded t h a t the s m a l l business community i s h e a v i l y c o n c e n t r a t e d i n non-export, non-growth, non-innovative i n d u s t r i e s . A l s o , s e v e n t y - f i v e percent o f s m a l l b u s i n e s s e s are not i n the s t a r t - u p phase. While he conceded t h a t t h e i r a c t i v i t i e s are not unimportant, i t i s hard t o j u s t i f y the s i g n i f i c a n t tax advantages which a t t r a c t resources to t h i s s e c t o r . He s a i d t h a t tax breaks w i l l not change the nature or s c a l e of t h e i r o p e r a t i o n s i n a s i g n i f i c a n t way. He p r e f e r r e d t h a t s m a l l business tax p o l i c y be d i r e c t e d towards the new and those " l i k e l y t o c o n t r i b u t e t o the achievement of n a t i o n a l economic -140-C o n c l u s i o n s Chapter Seven 3 development g o a l s " . Given t h a t employment may be a n a t i o n a l economic g o a l and t h a t s m a l l b u s i n e s s may have an impact on t h i s g o a l , McFetridge suggested t h a t i t would be b e t t e r t o o f f e r employment tax c r e d i t s or wage s u b s i d i e s . In response, the author suggests t h a t export o r i e n t a t i o n i s not an easy g o a l f o r s m a l l b u s i n e s s . The r i s k exposure and management knowledge r e q u i r e d i n c r e a s e s u b s t a n t i a l l y when f o r e i g n markets 4 5 are contemplated. P e t e r s e n would d i s a g r e e w i t h McFetridge's d i s m i s s a l of small business as an engine of i n n o v a t i o n . As f o r growth p o t e n t i a l , the U n i t e d Kingdom experience i n t h i s century underscores the need to c u l t i v a t e the s m a l l business s e c t o r . McFetridge i s c o r r e c t on one p o i n t . There are d o u b t l e s s a l a r g e number of small b u s i n e s s e s t h a t are simply a means of employment f o r the owner/manager. However, t h e i r p u r s u i t of self-employment removes l a r g e numbers from the unemployment r o l l s . There are a l s o those who argue t h a t , i n f a c t , s m a l l business i s the prime source of job c r e a t i o n . ^ I t i s apparent to the author t h a t the dynamism of democracy d i d not s u b s c r i b e to the C a r t e r Commission's p o s i t i o n i n the S i x t i e s and would l e s s agree w i t h McFetridge today. The o p i n i o n s expressed i n the p u b l i s h e d p u b l i c h e a r i n g s r e s o u n d i n g l y endorsed p r e f e r e n c e f o r s m a l l , not j u s t new, b u s i n e s s . The t h r u s t of f e d e r a l budgets concurs with t h i s . So, who do we i n c l u d e i n " s m a l l " business? Does i t i n c l u d e both i n c o r p o r a t e d and u n i n c o r p o r a t e d e n t i t i e s ? -141-Co n c l u s i o n s Chapter Seven N e u t r a l i t y r e q u i r e s t h a t t a x a t i o n should not e f f e c t business d e c i s i o n s . Some c o u n t r i e s , l i k e Germany, b e l i e v e n e u t r a l i t y i s important; o t h e r s , l i k e France, t h i n k i t i s not. While the C a r t e r Report favoured n e u t r a l i t y , the r e s u l t a n t reform i n 1972 d i d not pay much a t t e n t i o n t o i t . The form of business o r g a n i z a t i o n i s one b u s i n e s s d e c i s i o n f o r which tax p o l i c y i s s c h i z o i d . E q u i t y r e q u i r e s t h a t equals be taxed e q u a l l y . N e u t r a l i t y r e q u i r e s t h a t the form of o r g a n i z a t i o n should not be e f f e c t e d by t a x a t i o n . F i r s t , we observe t h a t u n t i l 1979 a p r o p r i e t o r c o u l d not l e g i t i m a t e l y deduct wages p a i d t o a spouse. T h i s was l e g i t i m a t e i n the cor p o r a t e g u i s e . Second, th e r e i s gre a t debate over the d e f e r r a l of some tax on r e t a i n e d income i n a c o r p o r a t i o n . The Act denies t h i s i n some s i t u a t i o n s (Part Four Tax) and condones i t i n oth e r s (Part Two Tax). Unincorporated businesses enjoy no such d e f e r r a l — t h e p r o f i t s are taxed c u r r e n t l y and p e r s o n a l l y , whether d i s t r i b u t e d or r e t a i n e d . I f tax p o l i c y deems i t wise to fi n a n c e s m a l l business through d e f e r r e d tax on r e t a i n e d e a r n i n g s , then the system i s i n e q u i t a b l e and no n - n e u t r a l between i n c o r p o r a t e d and u n i n c o r p o r a t e d e n t i t i e s . A f t e r reviewing the s m a l l business tax pr e f e r e n c e s l i s t e d i n Chapter One, the author concludes t h a t , i n f a c t , u n i n c o r p o r a t e d  e n t i t i e s r e a l l y are not i n c l u d e d i n a tax p o l i c y d e f i n i t i o n o f  small b u s i n e s s . They are denied the sm a l l business c o r p o r a t e r a t e s along with the p o t e n t i a l f o r d e f e r r a l . They are excluded from p r e f e r e n t i a l M&P r a t e s and SBDBs and they r e c e i v e lower investment tax c r e d i t s i n c e r t a i n s i t u a t i o n s . The tax d e f i n i t i o n o f smal l has evolved t o become the "annual -142-Co n c l u s i o n s Chapter Seven busi n e s s l i m i t " of $ 2 0 0 , 0 0 0 , a f t e r owner remuneration. Combined with owners' s a l a r i e s and bonuses, the pre-remuneration p r o f i t c o u l d a c t u a l l y be q u i t e h i g h , w h i l e s t i l l e n j o y i n g the small b u s i n e s s r a t e on $ 2 0 0 , 0 0 0 . With average s a l e s of $ 6 4 0 , 0 0 0 i n the s a l e s c l a s s of $ 2 5 0 , 0 0 0 t o $2 m i l l i o n , i t i s u n l i k e l y t h a t these s m a l l businesses would have net p r o f i t to ownership o f , say, $ 3 0 0 , 0 0 0 . T h e r e f o r e , the $ 2 0 0 , 0 0 0 l i m i t must be b e n e f i t t i n g the l a r g e r businesses i n t h i s c l a s s and beyond. The author's p r e f e r r e d tax d e f i n i t i o n of s m a l l appears l a t e r i n the chapter. The author's s a l i e n t o b s e r v a t i o n s f o r d e v e l o p i n g s m a l l business tax p o l i c y i n c l u d e the f o l l o w i n g : 1. Major overhaul i s not a v i a b l e s o l u t i o n . 2 . The i s s u e of c a p i t a l shortage i s foremost. I t does not seem f e a s i b l e f o r most s m a l l businesses to tap the p u b l i c c a p i t a l markets. There are undoubtedly economies o f s i z e f o r l e n d i n g i n s t i t u t i o n s t h a t work a g a i n s t small b u s i n e s s . Even venture c a p i t a l i s t s are concerned about the d i s p r o p o r t i o n a t e a d m i n i s t r a t i v e time i n v o l v e d i n l e n d i n g money to s m a l l b u s i n e s s . 3 . Government must p l a y a r o l e i n s o l v i n g the c a p i t a l shortage problem. T h i s has been achieved t o some extent through the FBDB. T h i s approach i s c o s t l y t o a d m i n i s t e r and s e l e c t i v e i n a p p l y i n g a s s i s t a n c e . Grants are s i m i l a r l y c o s t l y t o a d m i n i s t e r and s e l e c t i v e . 4 . Broad tax p o l i c y l e v e r s are a more e f f i c i e n t means o f government involvement. - 1 4 3 -C o n c l u s i o n s Chapter Seven 5. Tax p o l i c y should p r i m a r i l y d i r e c t support a t i n t e r n a l f i n a n c i n g of s m a l l b u s i n e s s . To a s s i s t s e l f - f i n a n c i n g , tax d e f e r r a l on r e t a i n e d income should be p r o v i d e d and not viewed as an e v i l t h i n g . In a l o s s s i t u a t i o n , t h i s means l i b e r a l i z i n g l o s s a p p l i c a t i o n r u l e s . I f there i s some abuse, we should e i t h e r accept t h i s as a c o s t o f s i m p l i c i t y or we should attempt to f i n e - t u n e the t a r g e t i n g . 6 . Tax p o l i c y should p r o v i d e permanent support f o r s m a l l b u s i n e s s . A d d i t i o n a l p r o v i s i o n s should be t e m p o r a r i l y a v a i l a b l e f o r new b u s i n e s s . Tax l e g i s l a t i o n has been s c h i z o p h r e n i c i n p r o v i d i n g f i n a n c i n g a s s i s t a n c e . The C a r t e r Report wished to a i d success, not prop up f a i l u r e . However, the Small Business Development Bond, which has been l a r g e l y emasculated from i t s o r i g i n a l i n t e n t , i s designed to help f a i l i n g b u s i n e s s e s . 7. Tax p o l i c y should s e c o n d a r i l y d i r e c t support a t t h i r d - p a r t y  f i n a n c i n g . Two c r i t i c a l moments need to be c o n s i d e r e d -- the i n i t i a l time o f investment and the subsequent time of r e s u l t s . The e x i s t i n g Act p r o v i d e s no i n c e n t i v e s a t the i n i t i a l time to encourage 7 investment. Kao favoured an approach l i k e the B r i t i s h "Business Expansion Scheme" which g i v e s p e r s o n a l tax deductions f o r investments i n small f i r m s by o u t s i d e p a r t i e s . The r e l e v a n t p r o v i s i o n s extant i n the Act p e r t a i n to the r e s u l t s of the investment. I f a new business i s s u c c e s s f u l , the c a p i t a l gains exemption may p r o v i d e i n c e n t i v e t o i n v e s t i n s m a l l b u s i n e s s . I f i t f a i l s , the business investment l o s s p r o v i s i o n s -144-C o n c l u s i o n s Chapter Seven o f f e r some tax r e l i e f . The CFIB and Kao both have proposed r e l a x i n g the e l i g i b i l i t y o f RRSP funds to be channeled i n t o s m a l l b u s i n e s s . The Budget of May 1985 moved i n t h i s d i r e c t i o n , but only to a l i m i t e d e x t e n t . Pension Funds w i l l be p r o v i d e d w i t h i n c e n t i v e s to l e n d to small b u s i n e s s . S e l f - d i r e c t e d RRSP funds may be i n v e s t e d i n s m a l l b u s i n e s s a t arm's l e n g t h . T h i s l a s t p r o v i s o takes much of the punch out of the l e g i s l a t i o n . As a r e s u l t , s m a l l b u s i n e s s e s must s t i l l seek o u t s i d e p a r t y c a p i t a l . The tax a t t r i b u t e s of RRSPs are a d i s i n c e n t i v e t o i n v e s t w i t h these funds versus f r e e s a v i n g s . The c a p i t a l gains exemption would not apply to gains i n an RRSP and the l o s s r e l i e f s i m i l a r l y would not be a v a i l a b l e . Armed with these o b s e r v a t i o n s and value judgments, the f o l l o w i n g recommendations are proposed. General D i r e c t i o n Change the t a r g e t i n g of s m a l l b u s i n e s s tax p r e f e r e n c e F i r s t , l e t i t become p u b l i c f a c t t h a t s m a l l business tax p r e f e r e n c e a p p l i e s t o i n c o r p o r a t e d e n t i t i e s o n l y . Leave the u n i n c o r p o r a t e d s e c t o r to a t t r a c t the "non-growth, non - i n n o v a t i v e " firms r e f e r r e d t o by McFetridge. Armed w i t h t h i s knowledge, sma l l b u s i n e s s owners can d e c i d e which group they choose to f a l l i n t o . By p u b l i c l y pronouncing t h i s p o l i c y , the Act need not be complicated i n the name of n e u t r a l i t y and e q u i t y between the i n c o r p o r a t e d and u n i n c o r p o r a t e d s e c t o r s . Second, narrow the tax d e f i n i t i o n o f i n c o r p o r a t e d s m a l l b u s i n e s s e s . The c u r r e n t d e f i n i t i o n i s based on an annual p r o f i t -145-C o n c l u s i o n s Chapter Seven a f t e r owner remuneration of $200,000. T h i s captures too broad a spectrum of business endeavours. Encourage e n t r e p r e n e u r s h i p T h i s sounds t r i v i a l , but the author b e l i e v e s i t i s not. There must e x i s t an o v e r a l l b e l i e f i n b u s i n e s s and, s p e c i f i c a l l y , e n t r e p r e n e u r s h i p . I t i s always c o n t r o v e r s i a l i n Canada t o p o i n t to the U.S. f o r role-models; however, the author b e l i e v e s t h a t t h e i r s p i r i t o f e n t r e p r e n e u r s h i p i s indeed g r e a t e r . For the tax system, t h i s means t h a t i n c e n t i v e s should be a v a i l a b l e and promoted. Pursue s t a b i l i t y i n tax p o l i c y The p l e t h o r a of changes i n the l a s t f i f t e e n years has been an undue burden on taxpayers and p r o f e s s i o n a l s . I t i s r e c o g n i z e d t h a t the government needs some f a s t l e v e r s . S o r t these out from l e v e r s t h a t are long term and use each a c c o r d i n g l y . Accept t a x - a s s i s t e d f i n a n c i n g f o r s m a l l business The tax d e f e r r a l break on r e t a i n e d income should be applauded, not d e p l o r e d . While some abuses may occur, on the whole i t i s b e n e f i c i a l . In t h i s r e g a r d , l o s s c a r r y o v e r p r o v i s i o n s should remain l i b e r a l . They are, i n e f f e c t , income averaging f o r b u s i n e s s . Where the c o r p o r a t e carryback p r o v i s i o n s cannot p r o v i d e r e l i e f , the system should pass the l o s s e s t o i n d i v i d u a l s i f they can c r e a t e a tax break. Create more a p p r o p r i a t e s m a l l b u s i n e s s tax p r e f e r e n c e s When tax breaks are a p p r o p r i a t e , p r o v i d e ones t h a t s m a l l b u s i n e s s i n g e n e r a l can use. Most i n d u s t r i e s i n the s m a l l -146-C o n c l u s i o n s Chapter Seven busi n e s s s e c t o r are labo u r , not c a p i t a l , i n t e n s i v e . P r o v i d e i n c e n t i v e s a c c o r d i n g l y . Reduce the government * s r o l e i n the economy A s i g n i f i c a n t problem r e l a t e s t o the revenue o b j e c t i v e o f t a x a t i o n . I t i s the author's o p i n i o n t h a t the o v e r a l l l e v e l s o f t a x a t i o n are too h i g h . They are high because of the l a r g e revenue needs. The revenue needs r e s u l t from the l a r g e expenditures o f government. Despite the high l e v e l s o f t a x a t i o n , huge d e f i c i t s have p i l e d up i n the l a s t f i v e y e a r s . S u c c e s s i v e governments have s h i e d away from t h i s problem, d e s p i t e p r o t e s t a t i o n s from the busin e s s s e c t o r . The author r e f l e c t s on Asper's o b s e r v a t i o n s i n Chapter Three t h a t the r e a l i s s u e i s not the l e v e l o f t a x a t i o n but the r o l e of government i n our s o c i e t y . The lobby f o r smal l business tax p r e f e r e n c e may r e a l l y be a lobby f o r lower taxes, i n d i s g u i s e . Somehow, c o n c l u s i o n s on t h i s r o l e have c r e p t i n without much p u b l i c p r o f i l e . On the other hand, e x a c t i n g the revenues t o meet the expenditures r e c e i v e s much p u b l i c p r o f i l e . In Chapter One, Wheatcroft observed t h a t economic growth i s i n h i b i t e d by high t a x a t i o n . A l s o , he observed t h a t human nature must be used to achieve growth and t h a t h i g h marginal r a t e s encourage avoidance and evasi o n . The author would p r e f e r t o see o v e r a l l l e v e l s of revenue and expenditure reduced. The economy should be re t u r n e d t o the p r i v a t e s e c t o r . U n f o r t u n a t e l y , s p e c i f i c p r o p o s a l s i n t h i s r e g ard are o u t s i d e the ambit of t h i s study. Avoid "quick f i x e s " and s e l e c t i v e tax changes Su c c e s s i v e governments have used the income tax to achieve "quick -147-C o n c l u s i o n s Chapter Seven f i x e s " i n the economy. Most o f t e n t h i s i s done by s p e c i f i c t a r g e t i n g . One can r e f l e c t on the l i s t o f schemes over the r e c e n t years — MURBs, f i l m s , o i l and gas s h e l t e r s and, most r e c e n t l y , the d i s a s t r o u s SRTCs. Again, the author agrees w i t h Wheatcroft's o b s e r v a t i o n s . Sudden, major changes should not be i n t r o d u c e d to achieve q u i c k r e s u l t s . F i r s t , i t i s not reasonable to expect f a s t r e - o r i e n t a t i o n o f taxpayers' a c t i v i t i e s . Second, there i s l i t t l e econometric proof t h a t many of the changes can q u i c k l y achieve the d e s i r e d r e s u l t . A l s o , s e l e c t i v e changes to encourage or discourage a c t i v i t i e s i n c e r t a i n s e c t o r s are u s u a l l y harmful i n the s h o r t run and o f dubious value i n the long run. Instead, changes i n the g e n e r a l r a t e s of t a x a t i o n should be used. Do not get c a r r i e d away w i t h s i m p l i f i c a t i o n As d i s c u s s e d i n Chapter Two, s i m p l i f i c a t i o n has r e c e i v e d much a t t e n t i o n of l a t e . Couzin p o i n t e d out t h a t s i m p l i f i c a t i o n i s not so simple. I t i s a l s o r e l a t i v e t o the p a r t i c u l a r audience. O b j e c t i n g to s i m p l i f i c a t i o n would be l i k e o b j e c t i n g to motherhood and apple p i e . However, i t i s the author's perhaps h e r e t i c a l view t h a t s i m p l i f i c a t i o n from a l a y - p e r s o n ' s viewpoint i s completely u n a t t a i n a b l e . The author concurs w i t h Edwards' o b s e r v a t i o n t h a t "... by i t s nature an income tax s t a t u t e cannot be very simple. I t i s somewhat naive t o adopt an o b j e c t i v e of s i m p l i c i t y . In my view, the t a r g e t s i n t h i s area should be u n d e r s t a n d a b i l i t y and 15 m a n a g e a b i l i t y . " S i m p l i f i c a t i o n should be viewed from the vantage p o i n t of those who work w i t h the A c t . T h i s may sound s e l f - s e r v i n g t o c e r t a i n p r o f e s s i o n s . But, s t a t e d simply, the -148-C o n c l u s i o n s Chapter Seven author b e l i e v e s t h a t the modern busi n e s s world i s complicated; i t i s unreasonable to attempt to superimpose a simple tax system on a complicated world. The t h r u s t of f u t u r e s i m p l i f i c a t i o n should be mainly to c o n s i d e r the c o s t s , b e n e f i t s and m a t e r i a l i t y of new tax p r o v i s i o n s . S p e c i f i c Recommendations I t i s proposed t h a t the tax d e f i n i t i o n of s m a l l b u s i n e s s be amended to i n c l u d e i n c o r p o r a t e d b u s i n e s s e s o n l y w i t h : 1) An annual gross s a l e s l i m i t o f $1.5 m i l l i o n ; and 2) An "annual b u s i n e s s l i m i t " o f $100,000. The e l i m i n a t i o n of the cumulative deduction account was s a i d t o remove some compliance burden and p r o v i d e permanent d e f e r r a l advantages to s m a l l b u s i n e s s i n exchange f o r a leakage o f d e f e r r a l t o b i g p r i v a t e b u s i n e s s e s . The a d d i t i o n of a s a l e s t e s t w i l l be c o n s i s t e n t w i t h the a n a l y s i s i n Chapter One w i t h r e s p e c t to i d e n t i f y i n g " s m a l l " and w i l l a l s o r e v e r s e t h i s break t o b i g p r i v a t e b u s i n e s s e s . The annual business l i m i t w i l l s t i l l be c a l c u l a t e d a f t e r owner remuneration. T h e r e f o r e , small b u s i n e s s e s which are very p r o f i t a b l e can s t i l l q u a l i f y , but p r o f i t i n excess o f $100,000 w i l l be taxed e i t h e r p e r s o n a l l y immediately or a t a h i g h e r c o r p o r a t e r a t e . The $100,000 amount a n n u a l l y e l i g i b l e f o r d e f e r r a l should p r o v i d e s u f f i c i e n t b e n e f i t f o r the b u s i n e s s e s who t r u l y q u a l i f y as " s m a l l " . -149-C o n c l u s i o n s Chapter Seven In the a l t e r n a t i v e , i t i s proposed t h a t the annual b u s i n e s s l i m i t be r e d e f i n e d to i n c l u d e owner remuneration In t h i s case, the l i m i t would be i n c r e a s e d t o , say, $200,000. T h i s i s i n the s p i r i t o f James 1 p r o p o s a l i n Chapter S i x . T h i s approach would p r o v i d e g r e a t e r d e f e r r a l f o r p r o f i t a b l e businesses with c a p i t a l needs whose owners do not p e r s o n a l l y r e q u i r e l a r g e draws. In the a l t e r n a t i v e , i t i s proposed t h a t u n i n c o r p o r a t e d s m a l l b u s i n e s s owners be a b l e to e l e c t t o be taxed p r e f e r e n t i a l l y on income not drawn out I f i t i s unacceptable to t a r g e t s m a l l business tax p r e f e r e n c e to i n c o r p o r a t e d e n t i t i e s o n l y , the Act should be amended to r e p a i r the unequal d e f e r r a l o p p o r t u n i t i e s between the i n c o r p o r a t e d and u n i n c o r p o r a t e d s e c t o r s . Where an u n i n c o r p o r a t e d e n t i t y was p r o f i t a b l e and owner draws d i d not exceed the p r o f i t , the owner should be able to e l e c t t o be taxed a t p e r s o n a l m a r g i n a l r a t e s on draws o n l y . The excess amount would be taxed a t a w i t h - h o l d i n g r a t e s i m i l a r to the c o r p o r a t e s m a l l business r a t e , say t w e n t y - f i v e p e r c e n t . T h i s payment would serve as a p e r s o n a l tax c r e d i t i n a year when draws exceeded p r o f i t . When busi n e s s l o s s e s are i n c u r r e d , draws would f i r s t be taxed p e r s o n a l l y , with the w i t h - h o l d i n g tax c r e d i t . The l o s s c o u l d e i t h e r be taken p e r s o n a l l y or a p p l i e d to the remaining w i t h - h o l d i n g tax balance, c r e a t i n g a r e f u n d i n e i t h e r case. -150-C o n c l u s i o n s C h a p t e r S e v e n I t i s p r o p o s e d t h a t a t a x d e f i n i t i o n be c r e a t e d f o r medium b u s i n e s s e s , d e f i n e d t o i n c l u d e i n c o r p o r a t e d b u s i n e s s e s w i t h : 1) A n n u a l g r o s s s a l e s b e t w e e n $1.5 m i l l i o n a n d $5 m i l l i o n ; o r 2) A n n u a l g r o s s s a l e s l e s s t h a n $1.5 m i l l i o n a n d a n n u a l b u s i n e s s l i m i t g r e a t e r t h a n $ 1 0 0 , 0 0 0 . T h i s w i l l a l l o w m e d i u m - s i z e d b u s i n e s s e s t o be r e c o g n i z e d i n C a n a d a . They w i l l r e c e i v e some p r e f e r e n c e s o v e r b i g b u s i n e s s e s , b u t l e s s t h a n s m a l l b u s i n e s s e s . F o r t h e r e m a i n d e r o f t h i s p a p e r , t h e b u s i n e s s e s t h a t a r e i n c l u d e d i n t h i s t a x d e f i n i t i o n o f s m a l l w i l l be r e f e r r e d t o as " S m a l l B u s i n e s s " . I t i s p r o p o s e d t h a t t h e c o m b i n e d f e d e r a l a n d p r o v i n c i a l S m a l l B u s i n e s s t a x r a t e be d r o p p e d t o 20% on t h e f i r s t $100,000 o f a n n u a l b u s i n e s s l i m i t T h i s w o u l d r e p r e s e n t a 1 3 % f e d e r a l r a t e a n d a n o t i o n a l p r o v i n c i a l r a t e o f 7%. T h i s w o u l d p r o v i d e 13 1/3% o f d e f e r r e d t a x f r o m t h e i n t e g r a t i o n r a t e o f 33 1/3%. The maximum a n n u a l t a x d e f e r r a l c o u l d be $13,333. I t i s p r o p o s e d t h a t t h e c o m b i n e d f e d e r a l a n d p r o v i n c i a l medium b u s i n e s s t a x r a t e be e s t a b l i s h e d a t 33 1/3% T h i s r a t e i s l e s s t h a n t h e f u l l c o r p o r a t e r a t e a n d a l l o w s t h e s e e n t e r p r i s e s t o e n j o y t h e t e c h n i c a l f i t o f i n t e g r a t i o n . C ompared t o some o t h e r c o u n t r i e s , C a nada h a s made a n o b l e a t t e m p t - 1 5 1 -C o n c l u s i o n s Chapter Seven to address the b i g i s s u e of double t a x a t i o n . The gross-up and c r e d i t system extant has, i n the author's view, a number of p o s i t i v e f e a t u r e s . The f i r s t i s simply t h a t attempting t o d e a l with i t i s b e t t e r than not. The Un i t e d S t a t e s , f o r i n s t a n c e , s t i l l uses the c l a s s i c a l system. A u s t r a l i a a l s o g i v e s no c r e d i t . Second, the v a r i o u s budget " f i x e s " t o the c r e d i t mechanism i n the l a s t f o u r t e e n years have f i n a l l y brought the system t o a r e l a t i v e l y s a t i s f a c t o r y r e s u l t . The p r e f e r r e d r a t e o f s m a l l b u s i n e s s tax on r e t a i n e d income i s approximately t w e n t y - f i v e p e r c e n t . T h i s r a t e p r o v i d e s the temporary r e l i e f from tax on income r e t a i n e d i n the c o r p o r a t i o n . A l s o , the new P a r t Two Tax b r i n g s the cor p o r a t e tax p a i d on d i s t r i b u t e d income up t o the r a t e assumed i n the gross-up and c r e d i t system. When r e t a i n e d income bears a lower r a t e o f tax, there may be an i n c l i n a t i o n t o accumulate earnings i n the c o r p o r a t i o n . France l e v i e s a supplementary tax on earnings r e t a i n e d beyond f i v e y e a r s . The United Kingdom has p r o v i s i o n s to f o r c e d i s t r i b u t i o n s i n c l o s e l y h e l d c o r p o r a t i o n s . Proof o f c a p i t a l needs f o r expansion can a l l e v i a t e these p r o v i s i o n s . Japan exacts a p e n a l t y surtax on f a m i l y c o r p o r a t i o n s who do not d i s t r i b u t e e a r n i n g s . A u s t r a l i a f o r c e s annual d i s t r i b u t i o n a t l e a s t equal to a f t e r - t a x income l e s s a " r e t e n t i o n allowance". These v a r i o u s approaches add complexity t o the systems. Canadian tax p o l i c y does r e f l e c t some para n o i a over the d e f e r r a l of tax on u n d i s t r i b u t e d income. However, a n t i - a v o i d a n c e p r o v i s i o n s are not s t r i c t compared t o these other c o u n t r i e s . In r e a l i t y , the t e c h n i c a l p u r i t y o f i n t e g r a t i o n breaks down f o r -152-Conclusions Chapter Seven a number of reasons. The model of i n t e g r a t i o n assumes a s p l i t at both c o r p o r a t e and p e r s o n a l l e v e l s of approximately 2:1 between f e d e r a l and p r o v i n c i a l f i s c s , r e s p e c t i v e l y . The u n d e r l y i n g problem i s t h a t the d i v i d e n d tax c r e d i t s o f t e n exceed the c o r p o r a t e tax t h a t they are assumed to a l l e v i a t e . The causes are many f o l d . F i r s t , the adjustments from accounting p r o f i t t o t a x a b l e income al l o w a shareholder to r e c e i v e d i v i d e n d tax c r e d i t s where no tax was a c t u a l l y p a i d . T h i s happens because d i v i d e n d s are p a i d from accounting p r o f i t s and taxes are p a i d from t a x a b l e income. France, Germany and the United Kingdom a l l have p r o v i s i o n s to stop t h i s . Tax c r e d i t s o n l y flow through where tax was p a i d — " c r e d i t a b l e tax". The system must add complexity by m o n i t o r i n g c r e d i t a b l e and unpaid tax i n v a r i o u s p o t s . Where d i v i d e n d s are p a i d from a pot of untaxed p r o f i t s , an a d d i t i o n a l c o r p o r a t e tax i s l e v i e d and the i n t e g r i t y of i n t e g r a t i o n i s upheld. The e f f e c t of tax adjustments i s s i g n i f i c a n t l y g r e a t e r f o r medium 16 and b i g businesses than s m a l l . The leakage may r e s u l t i n a s i g n i f i c a n t revenue d r a i n f o r the government. I t i s proposed t h a t a system be i n s t i t u t e d f o r medium and b i g b u s i n e s s e s to monitor c r e d i t a b l e tax T h i s would l i k e l y f o l l o w the European example by c r e a t i n g v a r i o u s e a r n i n g s "pots" and e x a c t i n g an a d d i t i o n a l tax when necessary. Second, the v a r y i n g p r o v i n c i a l c o r p o r a t e tax r a t e s mean t h a t i t i s o n l y c o i n c i d e n t a l t h a t the c o r p o r a t e tax r a t e i s 33 1/3%, to -153-C o n c l u s i o n s Chapter Seven match the d i v i d e n d tax c r e d i t . T h i r d , the v a r y i n g p r o v i n c i a l p e r s o n a l tax r a t e s mean t h a t i n f a c t the amount of the d i v i d e n d tax c r e d i t may be more or l e s s than 33 1/3%. There can be no argument wi t h the p r o v i n c e s l e v y i n g t h e i r own chosen l e v e l s of t a x . T h i s i s needed t o counter r e g i o n a l d i s p a r i t i e s across the country. However, the i n t e g r a t i o n system should not be abused as a r e s u l t . I t should be remembered t h a t c o r p o r a t e tax i s e s s e n t i a l l y a w i t h - h o l d i n g tax. The o b j e c t i v e i to p r o v i d e f i n a n c i n g through tax d e f e r r a l on r e t a i n e d income. Once the income i s no longer r e q u i r e d i n the b u s i n e s s , i t i s d i s t r i b u t e d and s u b j e c t e d to the p e r s o n a l marginal r a t e s c a l e . The system should work such t h a t when a t a x a b l e d i s t r i b u t i o n o c c u r s , i t i s guaranteed t h a t 33 1/3% tax has been p a i d . To ensure i n t e g r i t y of the system, two p r o p o s a l s are needed. I t i s proposed t h a t the P a r t Two Tax system be amended to ensure t h a t the t o t a l c o r p o r a t e tax p a i d on t a x a b l e d i s t r i b u t i o n s from Small Business i s 33 1/3% Information accounts would need to be e s t a b l i s h e d to monitor the r e l a t i o n s h i p of t a x a b l e income to tax p a i d . The c u r r e n t 12 1/2% r a t e of P a r t Two Tax would be scrapped. Instead, the r e q u i r e d r a t e on a d i s t r i b u t i o n would be c a l c u l a t e d from these two new 17 accounts. The a p p r o p r i a t e r a t e c o u l d be c a l c u l a t e d on one o f three bases: -154-C o n c l u s i o n s Chapter Seven a) C h r o n o l o g i c a l - assume income d i s t r i b u t i o n s on a FIFO or LIFO b a s i s and charge d i s t r i b u t i o n tax a c c o r d i n g l y . b) Rate - assume income d i s t r i b u t i o n s i n ascending or descending order from the r a t e s o f tax i n i t i a l l y p a i d . c) Average - i f both of the above are too complicated, s e t t l e f o r a weighted average c a l c u l a t i o n . I t i s proposed t h a t the p r o v i n c i a l p o r t i o n o f d i v i d e n d tax c r e d i t s be c a l c u l a t e d i n a d i f f e r e n t f a s h i o n C u r r e n t l y , the p r o v i n c i a l r a t e i s assessed a g a i n s t " b a s i c f e d e r a l tax", which has a l r e a d y allowed f o r the f e d e r a l p o r t i o n o f the d i v i d e n d tax c r e d i t . Instead, the p r o v i n c i a l r a t e should be a p p l i e d a g a i n s t f e d e r a l tax bef o r e the tax c r e d i t d e d u c t i o n . Then, each p r o v i n c e w i l l a l l o w deduction o f i t s share i n the assumed 2:1 p r o p o r t i o n . The tax c r e d i t s w i l l not be more v a l u a b l e i n some pr o v i n c e s than o t h e r s . I t i s proposed t h a t d i v i d e n d tax c r e d i t s be able t o c r e a t e "negative p e r s o n a l t a x" C u r r e n t l y , d i v i d e n d tax c r e d i t s do not work i n the same f a s h i o n as other tax c r e d i t s . They can o n l y b r i n g a tax p o s i t i o n t o n i l and cannot c r e a t e a "negative" tax, or refund. I n t e g r a t i o n i s weakened by t h i s , a t the expense of lower income i n d i v i d u a l s . -155-C o n c l u s i o n s C h a p t e r S e v e n I t i s p r o p o s e d t o p e r m i t t h e p e r s o n a l f l o w - t h r o u g h o f S m a l l B u s i n e s s c o r p o r a t e l o s s e s i n t h e f i r s t f i v e y e a r s o f o p e r a t i o n T h i s c o u l d be a c h i e v e d b y a d j u s t m e n t on t h e f o r m T 2 S ( 1 ) and by p e r m i t t i n g s u c h a d e d u c t i o n on t h e p e r s o n a l t a x r e t u r n s . The c o s t b a s e o f t h e s h a r e s w o u l d be a d j u s t e d a c c o r d i n g l y . A l t e r n a t e l y , t h e a c c o u n t i n g r e c o r d s c o u l d draw down t h e s h a r e h o l d e r s ' a c c o u n t s by t h e amount o f t h e l o s s . The l o s s c a r r y o v e r p r o v i s i o n s c o n t a i n e d i n t h e A p r i l 1983 B u d g e t s h o u l d be r e t a i n e d . The r e s u l t w i l l be t h a t e x i s t i n g S m a l l B u s i n e s s e s t h a t h a v e b e e n s u c c e s s f u l o v e r t i m e w i l l h a v e ample o p p o r t u n i t y t o g e n e r a t e c a s h f r o m t a x r e c o v e r i e s d u r i n g p e r i o d s o f l o s s . U n t e s t e d and u n e s t a b l i s h e d new b u s i n e s s e s w i l l be g i v e n f i v e y e a r s t o become s u c c e s s f u l . I t i s p r o p o s e d t h a t b u s i n e s s i n v e s t m e n t l o s s e s n o t be r e d u c e d by h a l f f o r t h e f i r s t $100,000 i n v e s t e d i n a S m a l l B u s i n e s s The b u s i n e s s i n v e s t m e n t l o s s p r o v i s i o n s w e r e i n t e n d e d a s a s a f e t y n e t i n c e n t i v e t o p r i v a t e l e n d e r s . The m i x o f b u s i n e s s and c a p i t a l a p p r o a c h e s d e t r a c t s f r o m t h e r e l i e f p r o v i d e d . A l s o , t h e a u t h o r h a s s e e n s i t u a t i o n s w h e r e t h e a c t u a l b e n e f i t was s i g n i f i c a n t l y 18 r e d u c e d due t o o t h e r m i t i g a t i n g c i r c u m s t a n c e s . The $100,000 f i g u r e s h o u l d be a r e a s o n a b l e amount f o r S m a l l B u s i n e s s . I t i s p r o p o s e d t h a t , when t e m p o r a r y s t i m u l u s o r a i d i s r e q u i r e d , some c o m b i n a t i o n o f f e d e r a l / p r o v i n c i a l c o r p o r a t e t a x h o l i d a y s be g i v e n t o S m a l l B u s i n e s s -156-C o n c l u s i o n s Chapter Seven An e a r l i e r recommendation proposed no quick f i x e s or s e l e c t i v e tax changes. I t i s u n r e a l i s t i c t o expect governments w i t h f i v e year terms t o operate without f a s t f i s c a l l e v e r s . For i n s t a n c e , i t was obvious t h a t something needed t o be done f o r s m a l l b u s i n e s s through the r e c e n t r e c e s s i o n . The remedy should be a r e d u c t i o n of co r p o r a t e tax r a t e s t h a t apply to a l l Small Business f o r a s p e c i f i c p e r i o d o f time. Some of the p r o v i n c e s have alr e a d y been doing t h i s . T h i s w i l l serve t o p r o v i d e cash savings f o r the d e s i r e d reasons. The e a r l i e r p r o p o s a l t o amend the P a r t Two Tax w i l l ensure t h a t 33 1/3% tax has been p a i d when the cash savings are no longer r e q u i r e d by the c o r p o r a t i o n . I t i s proposed t h a t the manufacturing and p r o c e s s i n g tax pr e f e r e n c e be d i s c o n t i n u e d f o r Small Business The t a r g e t i n g of t h i s p r e f e r e n c e does not produce d e s i r a b l e r e s u l t s to j u s t i f y i t s tax c o s t and complexity. I t s p o i l s the f i t 19 of i n t e g r a t i o n . The e f f o r t r e q u i r e d t o c l a i m t h i s r e d u c t i o n under Schedule B of Form T2S(27) i s s i g n i f i c a n t . Many Small Businesses who c l a i m t h i s r e d u c t i o n are not a f f e c t e d a t the margin and c o u l d continue without t h i s p r e f e r e n c e . I t i s proposed t h a t the presen t investment and employment tax c r e d i t s be scrapped or r e p l a c e d f o r Small Business The s t a t i s t i c a l review i n Chapter One showed t h a t these two schemes have l i m i t e d b e n e f i t f o r Small Business. A r e v i s e d employment tax c r e d i t scheme c o u l d be i n t r o d u c e d as a temporary measure i n bad economic times. The system might f o l l o w the one c u r r e n t l y i n p l a c e i n B r i t i s h Columbia. A tax c r e d i t o f d o l l a r s -157-C o n c l u s i o n s Chapter Seven per employee i s g i v e n . The system would need to a l l o w f o r p a r t - t i m e employees and c o u l d be based on the annual T-4 f i l i n g s . I t i s proposed t h a t the a s s o c i a t i o n r u l e s remain unchanged The a s s o c i a t i o n t e s t s have always been c o n t r o v e r s i a l and awkward. As long as a s m a l l b u s i n e s s p r e f e r e n c e e x i s t s , the t e s t s w i l l be 20 necessary to prevent abuse. The author concurs w i t h Edwards t h a t these t e s t s are r e l a t i v e l y e s t a b l i s h e d i n law and j u r i s p r u d e n c e now. I t i s proposed t h a t the c a p i t a l g ains exemption p r o v i s i o n s i n the May 1985 Budget be amended to i n c l u d e a p p r e c i a t i o n o f g o o d w i l l i n an u n i n c o r p o r a t e d b u s i n e s s T h i s p r o v i s i o n was a r e a l gem f o r some taxpayers. U n f o r t u n a t e l y , the e q u i t y c r i t e r i o n i s s e v e r e l y eroded f o r the u n i n c o r p o r a t e d venture. I f shares i n a s m a l l business are s o l d , then a p p r e c i a t i o n of g o o d w i l l w i l l be i n c o r p o r a t e d i n t o the share p r i c e and s u b j e c t to the c a p i t a l g ains exemption. An u n i n c o r p o r a t e d business does not have shares and t h e r e f o r e must s e l l i t s a s s e t s , i n c l u d i n g g o o d w i l l . Goodwill i s not d e f i n e d to be a c a p i t a l a s s e t (although i t i s t r e a t e d s i m i l a r l y f o r other tax purposes) and t h e r e f o r e cannot q u a l i f y f o r the exemption. I t i s proposed t h a t Small Business owners be able to i n v e s t one h a l f of the c o s t v a l u e of t h e i r RRSPs i n t h e i r own b u s i n e s s e s T h i s p r o p o s a l i s the e x t e n s i o n of the new p r o v i s i o n s i n the May 1985 Budget. At p r e s e n t , these funds cannot be used d i r e c t l y or i n d i r e c t l y . The RRSP c o n t r i b u t i o n i t s e l f has c r e a t e d tax d e f e r r a l -158-C o n c l u s i o n s C h a p t e r S e v e n a t t h e p e r s o n a l l e v e l . T h i s p r o p o s a l i s , i n e f f e c t t h e n , t a x - a s s i s t e d s e l f - f i n a n c i n g . I n t h e a l t e r n a t i v e , i t i s p r o p o s e d t h a t S m a l l B u s i n e s s o w n e r s ' RRSPs be a b l e t o be u s e d a s s e c u r i t y f o r t h i r d p a r t y d e b t o b l i g a t i o n s A t p r e s e n t , l e n d e r s c a n o n l y u s e t h e e n t r e p r e n e u r ' s RRSP f u n d s a s an i n d i c a t o r o f n e t w e a l t h . They a r e n o t a b l e t o a t t a c h t h e RRSP f u n d s s p e c i f i c a l l y . Many S m a l l B u s i n e s s o w n e r s c h a n n e l a s i g n i f i c a n t p o r t i o n o f t h e i r a n n u a l s a v i n g s i n t o RRSPs. As a r e s u l t , t h e i r " f r e e " s a v i n g s a r e l e s s . T h i s p r o p o s a l w o u l d e n h a n c e t h e c r e d i t p r o f i l e o f s m a l l b u s i n e s s o w n e r s . 21 The b u r d e n o f p a y r o l l t a x e s o c c a s i o n a l l y r e c e i v e s p u b l i c i t y . I n 1985, t h e r a t e s o f C a n a d a P e n s i o n P l a n a n d u n e m p l o y m e n t i n s u r a n c e c o n t r i b u t i o n s w e r e 1.8% a n d 2.35% ( 3 . 2 9 % f o r e m p l o y e r s ) r e s p e c t i v e l y . The maximum c o n t r i b u t i o n s w e r e $379.80 a n d $562.12 ($786.96 f o r e m p l o y e r s ) r e s p e c t i v e l y . The p a y r o l l t a x e s a r e , o f c o u r s e , a s s e s s e d a g a i n s t w ages, n o t p r o f i t s . T h i s i s s e e n b y some as a n u n f a i r b u r d e n ; i n p a r t i c u l a r , a b u r d e n t o s m a l l b u s i n e s s i n e x c e s s o f i t s f a i r s h a r e , due t o t h e l a b o u r i n t e n s i t y o f t h i s 22 s e c t o r . B e a c h s t u d i e d t h e r e l a t i o n s h i p b e t w e e n CPP r a t e s a n d e m p l o y m e n t . He c o n c l u d e d t h a t an e m p l o y e r r a t e o f 4.5% ( a s s u m i n g e q u a l s p l i t w i t h e m p l o y e e s ) w o u l d r e s u l t i n t o t a l e m p l o y m e n t l o s s e s o f .43%, o r a b o u t 46,000 j o b s . He f u r t h e r c a l c u l a t e d t h a t an e m p l o y e r r a t e o f 10% w o u l d r e s u l t i n 139,400 l o s t j o b s . P e n s i o n s a r e e s s e n t i a l l y f o r c e d - s a v i n g s p l a n s . E m p l o y e r s t y p i c a l l y c o n t r i b u t e t o p r i v a t e p e n s i o n p l a n s . U.I.C. premiums - 1 5 9 -C o n c l u s i o n s C h a p t e r S e v e n a r e an i n s u r a n c e p l a n . W i t h o t h e r f o r m s o f i n s u r a n c e t h e premiums f r o m p o t e n t i a l b e n e f i c i a r i e s m ust e q u a l o r e x c e e d t h e p a y o u t s t o c o n t r i b u t o r s . I t i s p r o p o s e d t h a t t h e b u r d e n o f U.I.C. premiums be l i g h t e n e d f o r S m a l l B u s i n e s s I n t h e e x t r e m e , t h e a u t h o r m i g h t p r o p o s e t h a t t h e e n t i r e p r e mium be b o r n e by t h e e m p l o y e e . T h i s w o u l d be p o l i t i c a l l y u n a c c e p t a b l e . A l t e r n a t e l y , t h e r e l a t i v e b u r d e n s b e t w e e n e m p l o y e e a n d e m p l o y e r s h o u l d be s h i f t e d t o t h e e m p l o y e e o v e r t i m e . I t i s p r o p o s e d t h a t t h e r e g i s t r a t i o n f e e s f o r a new S m a l l B u s i n e s s be w a i v e d The f e d e r a l o r p r o v i n c i a l f e e s f o r i n c o r p o r a t i n g c a n r a n g e f r o m $600 t o $750. T h i s c o s t c a n be a d e f e r e n t t o i n c o r p o r a t i n g f o r a new b u s i n e s s . I f t h e p o l i c y i s a c c e p t e d t o t a r g e t t a x p r e f e r e n c e s p e c i f i c a l l y t o t h e i n c o r p o r a t e d s e c t o r , t h e n t h e g o v e r n m e n t s h o u l d p r o v i d e e a s y a c c e s s t o t h o s e who c h o o s e t o j o i n t h i s s e c t o r . T h i s p r o p o s a l w o u l d p r o v i d e a s m a l l amount o f s t a r t - u p f i n a n c i a l a s s i s t a n c e a n d , more i m p o r t a n t l y , w o u l d r e f l e c t t h e s u p p o r t o f e n t r e p r e n e u r s h i p . A g o v e r n m e n t s e r v i c e may a l s o b e p r o v i d e d t o s a v e l e g a l f e e s by a s s i s t i n g w i t h t h e c o m p l e t i o n o f an a p p l i c a t i o n f o r i n c o r p o r a t i o n . The s e r v i c e c o u l d be r e s t r i c t e d t o u n c o m p l e x c a p i t a l s t r u c t u r e s and s i t u a t i o n s . I t i s p r o p o s e d t h a t S m a l l B u s i n e s s o w n e r s s h o u l d be p e r m i t t e d t o v o l u n t a r i l y c o n t r i b u t e U.I.C. premiums i n t h e r o u t i n e m a n n e r , b a s e d on e a r n i n g s . - 1 6 0 -C o n c l u s i o n s C h a p t e r S e v e n New e n t r e p r e n e u r s t a k e r i s k s i n commencing a new b u s i n e s s . I n a d d i t i o n t o l o s i n g t h e i r own s a v i n g s , u n s u c c e s s f u l e n t r e p r e n e u r s w i l l f a l l t h r o u g h t h e s o c i a l s e c u r i t y n e t i f t h e b u s i n e s s f a i l s . The a r g u m e n t a d v a n c e d a g a i n s t t h i s p r o p o s a l w o u l d be t h a t s m a l l b u s i n e s s o w n e r s c o n t r o l t h e i r own e m p l o y m e n t . W h i l e t h e U nemployment I n s u r a n c e C o m m i s s i o n w o u l d be f a c e d w i t h some p o l i c i n g d i f f i c u l t i e s i n t h i s s i t u a t i o n , i t l i k e l y w o u l d be no w o r s e t h a n t h e p o l i c i n g p r o b l e m s w i t h t h e famous "U.I.C. s k i t e a m " . Many u n e m p l o y e d p e o p l e a l r e a d y u s e U.I.C. b e n e f i t s t o f i n a n c e t h e s t a r t - u p o f a n e n t r e p r e n e u r i a l v e n t u r e . Why s h o u l d n ' t t h e s y s t e m work i n t h e o p p o s i t e way? I t i s p r o p o s e d t h a t S m a l l B u s i n e s s o w n e r s be a b l e t o c l a i m r e l e v a n t b u s i n e s s c o u r s e t u i t i o n a s a t a x c r e d i t , r a t h e r t h a n a s a t a x d e d u c t i o n S m a l l b u s i n e s s f a i l u r e o f t e n h a s b e e n a t t r i b u t e d t o management i n c o m p e t e n c e . As d i s c u s s e d i n C h a p t e r One, t h e demands on e n t r e p r e n e u r s a r e i n d e e d m u l t i t u d i n o u s . Two c o n s t r a i n t s on management e d u c a t i o n a r e f i n a n c e and t i m e . A t a x c r e d i t w o u l d p r o v i d e i n c e n t i v e t o t h e S m a l l B u s i n e s s p e r s o n t o t a k e t i m e away f r o m t h e j o b and p e r h a p s h i r e e x t r a h e l p d u r i n g t h e a b s e n c e . T h i s p r o p o s a l w o u l d r e f l e c t t h e s u p p o r t o f e n t r e p r e n e u r s h i p , a s w e l l a s e d u c a t e t h e p o p u l a t i o n . An a n n u a l c e i l i n g o f , s a y , $500 c o u l d be i m p o s e d . P o s t s c r i p t As m e n t i o n e d a t t h e b e g i n n i n g o f t h e c h a p t e r , t h e s e s p e c i f i c r e c o m m e n d a t i o n s do n o t c o m p r i s e a s i n g l e s e t o f t a x r e f o r m -161-C o n c l u s i o n s Chapter Seven p r o p o s a l s . A l s o , some of the recommendations are more s i g n i f i c a n t than o t h e r s . Each reader may p r e f e r a d i f f e r e n t "basket" o f i d e a s . In p a r t i c u l a r , the author would l i k e t o see: 1. The tax d e f i n i t i o n of s m a l l be narrowed; 2. The c r e a t i o n of a tax d e f i n i t i o n f o r medium s i z e d b u s i n e s s e s ; 3. A lower r a t e f o r Small Businesses; 4. A system t o monitor " c r e d i t a b l e tax"; 5. The proposed changes t o the P a r t Two Tax; 6. The p e r i o d i c use of t e m p o r a r i l y reduced c o r p o r a t e tax r a t e s ; 7. The a b i l i t y of Small Business owners to use a p o r t i o n o f t h e i r own RRSP funds; and 8. The proposed i n c r e a s e o f tax breaks on a l l o w a b l e business investment l o s s e s . T h i s p a r t i c u l a r package of changes would go a long way towards the s t a t e d g o a l of a s s i s t i n g s m a l l b u s i n e s s w i t h f i n a n c i n g needs. The narrower d e f i n i t i o n of " s m a l l " and the added d e f i n i t i o n o f "medium" w i l l achieve a b e t t e r t a r g e t i n g o f a s s i s t a n c e , commensurate with need. -162-Con c l u s i o n s C h a p t e r S e v e n FOOTNOTES 1. "The M a r c h o f F o l l y " , B a r b a r a Tuckman, p g 23 2. " S m a l l B u s i n e s s , E c o n o m i c D e v e l o p m e n t and Tax P o l i c y " 3. I b i d , p g 2 4. P e r h a p s t h e r e i s room f o r t h e s m a l l b u s i n e s s s e c t o r h e r e , b a s e d on t h e J a p a n e s e s u b - c o n t r a c t i n g s y s t e m . M i g h t t a x i n c e n t i v e s be s t r u c t u r e d t o e n c o u r a g e b i g and s m a l l f i r m s t o c o - o p e r a t e ? The e n v i r o n m e n t a l s e t t i n g i n C a n a d a may p r e c l u d e t h i s , p a r t i c u l a r l y i n a r e a s and i n d u s t r i e s w h e r e u n i o n s a r e d o m i n a n t . 5. " S m a l l B u s i n e s s — B u i l d i n g a B a l a n c e d Economy" 6. "A S t u d y o f J o b C r e a t i o n i n C a n a d a , 1 9 7 5 - 1 9 8 2 " , R. W i e t f e l d t 7. " S m a l l B u s i n e s s F i n a n c i n g , R i s k C a p i t a l , a nd Tax M e a s u r e s " 8. " P e r s o n a l Income Tax R e f o r m and t h e I n t e r a c t i o n B e t w e e n B u d g e t a r y G o a l s : A U.K. a n d U.S. C o m p a r i s o n " , B H e r b e r , pg 55 9. I b i d , p g 56 10. " T a x i n g C o r p o r a t i o n s " , R i c h a r d B i r d 1 1 . I b i d , pg 10 12. I b i d , pg v 13. I b i d , p g v 14. " B a c k g r o u n d on C u r r e n t F i s c a l P r o b l e m s " , pg 17 15. " D r a f t i n g F i s c a l L e g i s l a t i o n " , p g 3 16. See A p p e n d i x 17. The P a r t Two Tax s h o u l d i n t e g r a t e w i t h t h e c o r p o r a t e t a x r a t e , s u c h t h a t t h e f o l l o w i n g e q u a t i o n h o l d s : (1 - c o r p o r a t e t a x r a t e ) = .6666 P a r t Two Tax r a t e - 1 6 3 -C o n c l u s i o n s C h a p t e r S e v e n 18. A l l o f t h e i n v e s t o r ' s d i v i d e n d t a x c r e d i t s a nd p e r s o n a l e x e m p t i o n s w ere l o s t f o r t h e y e a r 19. The p r e f e r e n c e c o u l d be r e t a i n e d i f t h e p r o p o s e d c h a n g e s t o P a r t Two Tax w e r e i m p l e m e n t e d 20. "A S u g g e s t i o n f o r S i m p l i f i c a t i o n o f t h e P r o v i s i o n s R e l a t i n g t o t h e S m a l l B u s i n e s s D e d u c t i o n a n d R e f u n d a b l e T a x " , p g 3 21. "The M a g a z i n e T h a t ' s A l l A b o u t S m a l l B u s i n e s s " , M a r c h 1984, p g 3 6 22. I b i d , p g 40 -164-C o n c l u s i o n s Appendix T A B L E 3. Reconci l iat ion o( Book Profit. Taxable Income and Income Taxes, by Asset Size Group by Industrial Di 1980 and 1981 - C o n c l u d e d N o T o l a l a l l T o l a l l o u t e s h d u s i n e s e s i n d u s l n e s S I C C A E 001 8 9 9 U n d e i $ M o m s d e 0 0 0 0 0 0 1  0 0 0 , 0 0 0 $1 0 0 0 0 0 0 - $ 2 4 , 9 9 9 9 9 9 $ 2 5 , 0 0 0 , 0 0 0 a n d o v e r $ 2 5 , 0 0 0 , 0 0 0 ul p l u s T o l a l 19B0 1981 1 9 8 0 1 9 8 1 1 9 8 0 1981 1980 1 9 0 1 1 Numbe' ol corpoial/ons •122.321 4 3 8 . 728 4 1 . 5 8 2 ' 4 6 , 144 2-172 2.809 •166.378 4 8 7 681 m i l l i o n s ol d o l l a r s - m i l l i o n s d o d o l l a r s 2 B o o k prof i t after t a x e s ' 4 ,672 .9 4 , 6 2 9 . 8 7 . 1 1 3 . 1 6 , 3 0 1 . 4 2 4 , 0 6 2 . 5 2 3 , 3 8 1 . 5 3 5 , 8 4 8 . 6 3 4 , 3 1 2 . 7 3 L e s s b o o k profit of l a * e x e m p t c o i p o r a l i o n s 8 3 2 5 4 321 8 3 4 7 2 2 386 8 3 , 0 1 4 1 2 , 7 1 7 0 3 . 3 8 6 7 4 B o o k prof i t after t a x e s - T a x a b l e c o r p o r a t i o n s ' 4 .664.6 4 ,604 .4 6 ,791 .4 5 , 9 5 4 . 2 2 1 . 6 7 5 . 7 20,367.4 3 3 , 1 3 1 , 6 30,9 2 6.0 P r o v i s i o n s for d i rect t a x e s 5 C u r r e n t i ncome t a x e s 1 6 0 5 7 1 6 9 0 4 3 0 0 5 1 2 9 1 1 0 7 0 2 2 7 6,288 1 1 1,633 5 1 0 . 8 0 9 5 6 D e l e r r e d i n c o m e t a x e s 2 5 - 5 B 4 5 8 7 4 7 0 2 3 , 4 8 6 0 3 3 5 6 2 3 . 9 4 7 2 3 8 2 0 6 7 P r o v i n c i a l m i n i n g a n d l o g g i n g t a x e s 6 5 9 0 4 7 2 7 0 9 1 3 0 6 2 8 0 4 1 35 9 8 P e t r o l e u m a n d 93s r e v e n u e l a x 2 8 33 3 6 9 2 3 9 2 8 4 9 B o o k p r o f i t b e f o r e t a x e s ' 6 , 2 7 3 4 6.292.3 10.264.2 9,373 5 32,455 2 3 1 . 0 3 4 . 5 4 8 , 9 9 2 . 8 4 6 . 7 0 0 . 3 E x e m p t i n c o m e 10 C a n a d i a n d i v i d e n d s 4 7 •) 5 5 4 0 9 1 185 6 1 2 2 3 9 3 3 5 8 9 6 2 9 2 1 - 7 0 1 8 0 - 8 0 5 6 9 ] 1 N n n t a x a b l e l o r e i q n ( l i v u l r u , 1;, 1 J 3 21 5 8 0 3 7 3 2 7 9 5 4 5 9 7 0 0 0 7 6 C a p i t a l i t ems 12 N e l c a p i i a l g a m s l o s s e s - Per c o m p a n y b o o k s 1 3 4 4 4 1,638 9 - 1 7 3 0 0 - 1 . 9 2 2 2 - 3 , 0 3 3 9 - 4 0 4 8 2 - 6.108 3 - 7 6 0 9 3 13 N e l t a x a b l e g a m s a l l o w a b l e l o s s e s l o r tax p u i r x i s o s j o 13 4 5 4 2 0 5 0 0 9 631 9 1 0 2 6 1 1 2 6 5 9 1,896 4 2 4 3 9 71 4 N o n - t a x a b l e p o r t i o n - 9 7 5 0 - 1 0 9 6 , 9 - 1 2 2 9 . 0 - 1.290.4 - 2 0 0 7 , 8 - 2 .782 4 - 4 . 2 1 1 . 8 - 5 . 1 6 9 fa W r i t e - o f f s . 1 5 C a p i i a l c o s t a l l o w a n c e .' !>',' 7 . ' ' ' 6 3 5 •1 2 4 3 5 •1 1,02 6 1 2 , 8 2 2 ? 14 9 1 2 1 19.719 5 2 2 6 0 0 2 16 E x p e n s e i t e m s c a p i l a l t j o d 3 'j 1 5 5 8 9 8 8 2 • 9 9 7 B 1563 8 - 1 , 0 6 0 6 1,653 3 ' 7 T o l a l 2 053 b 3 9 8 7 0 4 3 0 4 4 4 . 6 9 0 0 13.820 0 • 16 4 7 5 9 - 20 7B0 1 - 24.153 7 18 B o o k d e p r e c i a t i o n 2 9 2 3 6 3 3 0 9 6 3 7 8 0 2 4 2 9 5 1 7 5 3 8 4 8 , 8 2 1 3 14.242 2 1 6 . 4 2 6 0 19 C a p i t a l i t e m s e x p e n s e d 2 9 4 21 6 2 1 7 175 9 2 4 0 3 200.3 2 6 2 4 2 0 T o l a l 2 . 9 2 6 5 3 , 3 1 0 0 3.801 7 4.316 B 7 , 7 1 4 3 9 . 0 6 1 6 14,442 5 16.688 4 21 N e l d i f f e r e n c e 270.9 323 0 - 502 .7 - 3 7 4 . 0 - 6 , 1 0 5 . 8 - 7 , 4 1 4 . 2 - 6 , 3 3 7 . 6 - 7 , 4 6 5 . 3 E x p l o r a t i o n a n d d e v e l o p m e n t e x p e n s e s : 22 C a n a d i a n e x p l o r a t i o n e x p e n s e s - 2 5 6 - 6 9 - 1 6 4 7 - 18 6 - 4 , 1 6 4 5 - 3 , 7 6 6 5 - 4.354 8 - 3.892 1 2 3 C a n a d i a n d e v e l o p m e n t e x p e n s e s 3 8 3 3 3 - 8 8 3 8 5 5 • 1 0 7 1 2 - 8 7 2 6 - 1 1 2 1 2 • 961 - l 24 C a n a d i a n o i l a n d g a s p i o p e r l i e s e x p e n s e 1 1 • 15 9 - 10 9 - 1 0 7 2 • 10  7 - 1 2 3 0 - 1911! 25 F o r e i g n e x p l o r a t i o n a n d d e v e l o p m e n t e x p e n s e s 4 4 - 9 3 • 19 0 • 121 2 - 1 4 4 0 - 1 3 0 8 - 1 6 3 -1 26 O l h o / 1 R 7 3 1 1 3 2 2 2 7 449 1 - 2 3 0 1 - 4 6 1 3 27 T o l a l 12 3 1 1 6 • 2 U 5 4 2 4 3 3 9 . 6 U 0 B 5,4 12 9 6 . 9 6 9 U 3 0 6 9 9 2 8 D e p l e t i o n a l lowance - 15 4 14 6 - 34 0 2 2 4 - 1 5 6 0 5 - 1 , 1 6 0 1 - 1 .609 9 - 1.197 1 29 T o t a l c l a i m e d lor lax p u r p o s e s - 3 1 2 6 1 • 319 4 - 2 6 7 9 - 7 2 4 7 2 - 6 5 7 3 0 - 7 .569 7 - 6.867 1 3 0 E x p l o r a t i o n and d e v e l o p m e n t e x p e n s e s a n d d e p l e t i o n 3 8 6 ? 8 9 2 0 5 7 2 4 2 0 3 H 9 0 3 , 3 4 6 5 3 , 3 6 3 2 3 . 6 6 7 .1 c h a r g e d per c o m p a n y b o o k s 31 Net d i f f e r e n c e 35.S 5 2 , 8 - 113.7 - 25 .8 - 4 . 1 2 8 , 3 - 3,226.6 - 4 . 2 0 6 . 5 - 3 . 1 9 9 t O t h e r i tems . 3 2 C h a r i t a b l e d o n a t i o n s a l l o w e d - 13 3 - 20 3 6 3 3 - 8 0 2 - I I 8 9 - 1 2 7 3 - 195 4 3 2 7 i-3 3 P a t r o n a g e d i v i d e n d s p a i d 14 0 10 0 48 1 5 5 1 219 8 - 2 8 5 3 - 2 6 1 9 - 3 5 0 -1 34 i n v e n t o r y a l l o w a n c e - 2 7 0 7 2 B 9 6 • 5 8 8 4 6 1 4 0 - 9 6 4 1 - 1 135 3 - 1.823 2 - 2 0 3 0 ', 35 R e s o u r c e a l l o w a n c e • 2 ? 0 3 2 7 - 145 3 1 3 2 2 - 3 8 0 6 9 3 . 4 4 9 5 - 3 . 9 7 4 3 • 3 0 1 4 -6 P r o v i n c i a l r o y a l t i e s 21 0 18 1 81 5 151 5 4 3 6 4 2 4 5 0 4 8 4 5 6 6 8 4 6 7 4 ., 37 A d d i t i o n a l a l l o w a n c e lor s c i e n t i f i c r e s e a r c h 2 2 - 2 1 - 33 2 51 0 175 1 - 2 4 7 8 - 2 1 0 4 - 3 0 0 3 3 8 Other d e d u c t i o n s a n d a d d i t i o n s (net ) - 1 0 5 4 116 1 - 3 7 5 7 - 3 4 7 1 1 8 9 2 1 1 . 7 7 7 7 1 4 1 1 0 1 . 3 1 4 1 39 T o t a l net d i f f e r e n c e b e t w e e n b o o k prof i t b e f o r e t a x e s a n d - 1.549.1 - 1.719.0 - 4 . 1 2 5 . 0 - 4,050.2 - 1 7 . 2 0 4 . 3 - 19,473.4 - 2 2 . 8 7 8 , 4 - 25 242 t c u r r e n t year net t a x a b l e i n c o m e 4 0 C u r r e n t year ne l t a x a b l e i n c o m e ' 4,724 3 4 , 5 7 3 . 3 6 . 1 3 9 2 5 . 3 2 3 3 15.250 9 11,561 .2 2 6 , 1 1 4 . 4 21.457 I 4 1 C u r r e n t year l o s s e s Id ' l ax pur[M3Sr.-S 2 0 9 0 9 2 4 7 9 0 I . 9 I U 1 2 7 5 2 3 2 0 1 7 1 4 , 5 6 2 1 6.026 7 9 . 7 9 3 • 4 2 C u r r e n t year p o s i t i v e t a x a b l e i n c o m e 6.815.3 7 . 0 S 2 4 8 . 0 5 7 , 9 8 . 0 7 5 . 6 1 7 . 2 6 8 . 0 1 6 , 1 2 3 . 3 3 2 , 1 4 1 . 1 31 ,251 . 4.3 Pr-rv v<'-H l o s s e s 5 7 a 0 3 9 7 6 ' 2 3 3 6 5 2 ! 1 4 14 2 1 1 7 0 0 2 716 5 - 2 4 2 0 . 44 T a x a b l e i n c o m e ( t a x b a s e ) 6 , 2 3 6 . 3 6,454 8 7,334.6 7.422 .9 1 5 , 8 5 3 . 7 1 4 . 9 5 3 . 4 2 9 . 4 2 4 . 6 28,831 4 5 T a x o i h e i w i s e p a y a b l e ? 861 a 2,967 3 3 35 7 2 3.408 8 7 2 B 4 2 6.846 9 13,503 2 13 2 2 3 I 4 6 C o r p o r a t e s u r t a x • >,i 5 44 3 8 5 7 13 8 2 3 9 0 2 4 9 6 3 4 9 2 4 0 7 ' Tax c red i t s . 47 F e d e r a l tax a b a t e m e n t b 1 3 8 6 3 9 6 7 18 5 7 3 3 7 1 54a 2 1 4 5 6 1 2 . 8 7 8 5 2 . 8 2 9 : 4 f l S m a l l b u s i n e s s d e d u c t i o n 1 0 3 6 5 1 0 4 7 6 2 1 6 5 2 2 5 8 9 1 0 1.264 0 1 2 7 4 -4 9 M a n u f a c t u r i n g a n d p r o c e s s i m ; p r o l i l s rji.iJur.hon 4 2 1 4 2 1 135 9 1 34 4 3 3 0 9 2 9 5 7 516 9 4 7 2 . 5 0 I n v e s t m e n t tax c r e d i t 4 6 b 34 0 1 1 6 0 1 2 3 7 557 7 5 4 4 7 7 2 0 3 7 2 2 ' 5 ' O m e r r e d t s 2 0 3 8 0 6 9 1 37 4 3 0 6 5 3 6 3 3 3 9 5 . 9 4 0 8 I n c o m e t a x e s 5 2 F e d e r a l ( P a r t l i 1 1 2 7 0 1 2 2 0 3 2 186 8 2 , 2 6 5 7 4,773 0 4.435 5 8 . 0 8 6 . 8 7 . 9 2 1 • 5.1 P r o v i n c i a l 591 6 6 0 9 5 8 8 9 4 9 1 4 2 1 8 4 5 8 1 728 0 3 . 3 2 6 . 8 3 . 2 5 1 54 Tota l 1.718 6 1.829.8 3,076.1 3 , 1 7 9 . 9 6,618.9 6 , 1 6 3 . 4 11 .413 .6 11.173 5 5 R e s e r v e lor f u t u r e i n c o m e t a x e s 5 2 0 1 6 0 4 4 3 2 6 5 8 3 7 7 6 1 2 0 4 7 0 2 4 . 0 9 9 4 24.202 9 2 8 , 4 7 9 5f> C u r r n r i l y e a r l o s s e s r a m i - d h a r k 3 2 6 -1 511 0 2 0 9 1 1 6 7 ? 5 0 8 0 5 4 6 5 1 044 1 7 6 ! N e l o l l o s s e s SOURCE: Corporation Taxation S t a t i s t i c s (1981), pg 25 -165-Appendix T A B L E IV. Taxable Income, by Type of Corporation, by Taxable Income Size Group, 1981 T A B L E A U IV. Revenu imposable, par genre de societe, par tranche de revenu imposable, 1981 Taxable income size group Tranche de revenu imposable Canadian controlled private Societes privees contr&lees au Canada Olher Aulres Tolal Number 1 Nombre 1 Taxable income Revenu imposable Number' Nombre' Taxable income Revenu imposable Number' Nombre' Taxable income Revenu imposable $•000.000 $'000,000 $ 000,000 » . Under $35,000 - Moms do $35,000 126.360 1,580 1 2.379 27 0 128,739 1.607,1 S 35.000-S 49.999 19,171 795.0 4 28 18,0 19.599 813.1 50.000- 99.999 29.178 2.043.9 650 47.0 29.828 2.090,8 100.000- 149.999 16,411 2.088.7 391 48.4 16.802 2.137,1 150.000- 199.999 5.242 857.6 311 54,0 5.553 911.6 200.000- 499.999 4.040 1,209.5 945 301.5 4.985 1.511,0 500.000- 999.999 1.207 034,4 660 468 8 1.867 1.303.3 1,000.000- 4.999.999 836 1.562 9 1.107 2.532.1 1.943 4.094,9 5.000.000 and over - el plus 71 664.2 510 13.697,9 581 14,362.1 Total 202,516 11.636.3 7,381 17.194.7 209.897 28.831.1 For corporations reporting taxable income of S500 or more. Pour los societes declarant un revenu imposable dc S500 ou plus SOURCE: Corporation Taxation S t a t i s t i c s (1981), pg x -166-BIBLIOGRAPHY P e r r y , J . H a r v e y . P e r r y , J . H a r v e y . BACKGROUND OF CURRENT F I S C A L PROBLEMS. C a n a d i a n Tax P a p e r No. 68. T o r o n t o : C a n a d i a n Tax F o u n d a t i o n , 19 82. 1 - 119. 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