Federal budget closes a tax loophole popular with high-net-worth Canadians (updated)

The budget promises to step up compliance of a rule that prevents investment income in a private corporation being taxed at the small business rate


The Liberal budget will close a loophole many high-net-worth Canadians had been using to get a much lower tax rate on investment income.

Canadian controlled private corporations (CCPCs) are often set up by doctors, lawyers and other professionals. Under current rules, business income inside a CCPC is taxed at the lower small business tax rate, but it is supposed to be "active" business income, not investment or "passive" income. The budget promises to step up compliance of this rule.

“Active versus passive [investment] income is an important area to clamp down on,” said Lindsay Tedds, an economics professor at the University of Victoria who studies taxation.

“We should have been doing it a long time ago.”

Tedds said it is unknown how common the practice of shielding investment income inside CCPCs is, but “we know it’s significant enough that it’s a budget item.”

Another CCPC loophole that was not addressed in the budget is the practice of designating spouses as shareholders, which means they are able to receive funds they themselves didn’t generate, said Kevin Milligan, a professor of economics at the University of British Columbia.

“Doctors and dentists will make their spouse a shareholder, you can pay them dividends of $40,000 a year before you pay taxes on it,” he said. “There’s an estimate that it costs the government $500 million a year.”

The budget also promises to get rid of loopholes currently in the system that allow CCPC owners to get the lower small business tax rate on separate $500,000 batches of money (the revenue limit for the small business rate), and another loophole that allows “private corporations to use a life insurance policy to distribute amounts tax-free that would otherwise be taxable.”

Cracking down on taxation compliance goes along with the budget’s emphasis on reducing income inequality. The restructured Child Tax Benefit — which is estimated will lift a third of low-income families with children out of poverty — and higher income tax rate for earners who make over $200,000 are important planks in that strategy, Milligan said.

But as income inequality has risen across developed economies over the past three decades, corporations and wealthy people have also become increasingly adept at shielding income from taxation.

The budget earmarks $444 million over five years for the CRA’s compliance and enforcement efforts.

Tedds said there is more to be done in recovering tax revenues. Increasing third-party reporting — for instance, when a workers’ employer reports how much that worker makes to Canada Revenue Agency — could be extended to areas like tips and rental income.

She noted that there used to be a tax credit for renters, which required the renter to state their address and the name of their landlord, effectively letting CRA cross-check who should be reporting rental income.

“The [Organization for Economic Cooperation and Development] has been saying this for a long time that Canada lags the world in the amount of income subject to third party reporting and withholding,” she said.

The government backed off a previous pledge to tax stock options higher out of fear it would hurt the tech industry. But Milligan said most stock options go to executives at large companies, not employees who take a pay cut to work at a scrappy tech startup.

“I don’t understand why you couldn't separate out the tech industry guys from the big established executive guys,” he said.

Many economists have called for the removal of “boutique” tax credits, often used to target specific consituents, but Tedds said the budget doesn’t do very well on this front. While the Liberals have removed the Children’s Fitness and Art Tax Credits, it introduced another for teachers who buy school supplies.

While the Liberals have promised a parliamentary review of the tax system, Tedds said a complete overhaul done by an independent commission is needed.

“It’s 2016 – we have not overhauled our tax system in 60 years,” she said. “The world is different, our economy is different.”

CORRECTION: This story has been updated to clarify that the issue Lindsay Tedds identifies in terms of active versus passive income is one of compliance — making sure that income identified as active business income in a CCPC, and therefore eligible for the lower small business tax rate, is actually active and not investment income.