The unintended consequences of Canada’s tax system
The year was 2015, and income splitting had barged into a federal election that was putting the future of Stephen Harper’s ruling Conservatives at risk. The previous year, the federal government had proposed an income-splitting benefit for families with children—a move consistent with Harper’s affection for demographically laser-focused tax breaks. But during the campaign the following year, Justin Trudeau, then the leader of the third party in the House of Commons, added some populist seasoning to the politics of income splitting, alleging that such measures, when used in the context of corporate taxes, were merely a way for affluent business people to duck their taxes.
“We have to know that a large percentage of small businesses are actually just ways for wealthier Canadians to save on their taxes,” he said in an interview with the CBC. “[W]e want to reward the people who are actually creating jobs and contributing in concrete ways.”
Trudeau’s Liberals won that contest, and in their first budget tabled the following year, the new government introduced the “specified corporate income” rule—a move designed to prevent private companies from shifting income to unassociated companies as a means of reducing the overall corporate tax rate by gaining access to multiple small business deductions. This was accomplished by excluding income from the small business deduction of that corporation when it was received from a private company where the corporation or one of its shareholders (including non-arm’s-length persons) held a direct or indirect interest in that private company.
Yet this new anti-avoidance policy came with potential unintended consequences: it also placed a hefty burden on companies that didn’t engage in aggressive tax planning, to better understand and document these non-arm’s-length relationships.
“These rules basically required businesses to know everything about their clients,” says CPA Joe Devaney, director of education at Video Tax News in Edmonton. “It required corporations to know exactly who has an interest in each of their corporate customers—not just knowing who their shareholders are, but, potentially, who their lenders are and beyond.” He points out another wrinkle, saying that “the rule doesn’t require customers to disclose that information to vendors, it just requires vendors to know the information, which is a problem.”
Intended as an incentive, the federal transit tax credit didn’t lead to increased transit usage (Getty)
It can be difficult for small companies that have intricate relationships to comply with the rule, he says, which leaves these small businesses and their accountants in a tricky spot: business owners would have to spend heavily in order to follow the letter of the law, but even then, they still may not be able to comply.
Tax systems inevitably grow more complicated over time, and this evolution isn’t unique to Canada. But in recent years, Canada’s tax system has become increasingly convoluted and difficult to comprehend, even for experienced tax professionals. That trend began to accelerate during the Harper years, with the profusion of bespoke tax credits, like the children’s fitness tax credit, and has significantly accelerated under the Trudeau government. Tax experts point, by way of the latest example, to the advent this year of a whole new reporting regimen governing bare trusts.
While tax experts say the government’s policy objectives may be well-intentioned, the actual provisions appear to be hastily drafted, without adequate public and expert consultation, with little acknowledgement of the reporting burden on tax filers, and with a surprising lack of input from CRA, which is tasked with administering all the new rules that come out of the Department of Finance and the legislative process.
The CRA, on many occasions, has been left trying to guide taxpayers and their advisors on proposed tax provisions that have not been enacted. As well, newly minted regulations don’t always integrate well with older ones, but the government hasn’t sorted out the contradictions, leaving it up to tax advisors to figure out a way through the maze. “There are a lot more requirements to report than we had a number of years ago,” says Heather Evans, CTF’s executive director, adding that efforts by policymakers to halt avoidance may have precisely the opposite effect because “complexity makes compliance difficult.”
Others see an erosion of some core principles in the way the tax system is organized. “Not only do they want you to self-assess,” says Al Walker, vice-president of tax and internal audit at J.D. Irving in New Brunswick, “they want you to point out any areas where you might have some risk that you might not be right in the way you’ve calculated. It’s not just that you have to satisfy yourself that you’ve calculated correctly, but you have to point out the areas where you might have a little bit of weakness, or where someone else might think the answer should be different.”
John Oakey, CPA Canada’s vice-president of taxation, adds that the reporting burden has had a noticeable effect on both CRA and the profession itself. “All the firms say, ‘We don’t have enough tax people to do the work we need to do,’” he observes, adding that some practices are becoming more selective in who they take on as tax clients.
While many tax practitioners agree that the rules have become complicated, there’s less consensus on how to reverse this dynamic. Some, like Kim Moody, founder of Moodys Private Client, wants to see a wholesale review, modelled on the royal commission on taxation that began in the early 1960s and eventually influenced the 1972 Income Tax Act. He also argues that Canada should become markedly less dependent on income tax to raise revenues, and turn instead to higher consumption or value-added taxes, which are more transparent and easier to administer.
But quite apart from the debate over pulling the Band-Aid off quickly or slowly, the most pressing problem is the need for some sort of acknowledgement by policymakers that the current approach has backfired. “The system is almost at a breaking point,” says Moody. Adds Evans: “You need a government that wants to take this on.”
The process by which the federal government changes the Income Tax Act is one characterized by opacity, and the complicated dance between the government of the day and the Department of Finance officials tasked with translating political intention into legal language. Many changes to the act originate on the political side of that relationship. Measures such as the transit tax credit, the various other Harper-era tax benefits, or the more recent Underused Housing Tax emerge from the political process.
For most governments with policy objectives to advance, it can be easier to raise revenues by changing the tax system than passing spending bills. Some, like the Canada Child Benefit, are broadly acknowledged to be effective policy tools, but others produce modest results. The transit tax credit is a case in point: while transit pass users claimed the credit, the incentive itself produced little in the way of the behavioural change sought—increased transit usage. The credit was eventually repealed, but such revisions are infrequent. “Once [a benefit] is in the act, it rarely comes out,” says Hugh Neilson, director of taxation services at KRP LLP.
Yet the problem of accruing complexity isn’t just caused by poorly conceived political action. Too often, the Department of Finance is left with too little time to properly consult with tax experts and ordinary Canadians.
A third factor, notes Oakey, has to do with Ottawa’s desire to plug loopholes in the Income Tax Act specifically to protect the national tax base from leaks, especially in highly competitive global environments where Canada’s trading partners and rivals are trying to attract investment using various means, including tax incentives.
Another driver of complexity has to do with the accumulation of internal contradictions in the tax code, as well as seemingly redundant duplication—two different forms that both require filers to report foreign income, albeit in slightly different ways. Many tax professionals say that recent guidance published by the Department of Finance and CRA increasingly poses difficult choices for filers and advisors, with the difficulty driven by ambiguities within the tax law. “Increasingly, the Income Tax Act has a drafting system that is very complex,” says Evans. “It’s a bit of a morass. What is the government trying to say here?”
In some cases, of course, recent changes are driven by factors other than bureaucratic or political sloppiness. The global push in the past decade or so to find ways to stop money laundering, terrorist financing and the leakage of capital to opaque offshore tax havens has forced policymakers to require tax filers to increase their reporting. “Everyone agrees on the importance of stopping this from happening,” says Walker. “But how does the Department of Finance and CRA approach that? They don’t understand the tools they need to stop those things, so they make complex rules for everyone.”
The UHT is a perfect case in point. In Vancouver and Toronto, rampant real estate speculation and suspicions about money laundering in the housing market inspired municipal and provincial governments to impose restrictions on investment. Those moves, in turn, came with demands that governments also create tax penalties for offshore investors who leave homes vacant. When the federal government moved to follow suit with its own tax, the legislation inadvertently overreached.
As it turned out, a broad range of ownership vehicles were covered by the reporting obligations even though their beneficial owners were Canadians. “Many Canadians are required to file these forms even though the UHT targets foreigners,” says Neilson, adding that the federal government ignored warnings from the Senate that it had been given too little time to review changes. “Nobody realized how big this would be.” (In the Liberals’ 2023 fall economic statement, the government promised to relieve Canadian filers of the unintended reporting obligations created by the original version of the UHT regulations.)
The unintended consequence of onerous reporting obligations is that the cost and complexity of adhering to the rules may create even more incentive for filers to adopt aggressive avoidance practices or seek out low-cost tax advice as a means of hedging their accounting expenses. As Moody says, there’s “very aggressive tax avoidance, bordering on tax evasion, and complicated punitive rules are also a factor.”
Tax experts differ sharply on how to remedy an admittedly gnarly dilemma, the solutions to which will almost inevitably create their own ripple effects in public finances and politics. Moody, for his part, favours a tabula rasa approach, modelled on the process that led to the last major reforms of the Income Tax Act in 1972. He also supports a broad shift toward consumption taxes and away from income tax, which was only introduced in the First World War as a temporary means of raising revenues to fund the war effort. But, Moody concedes, such a drastic shift seems unlikely. “I don’t see that happening in my lifetime.”
Evans strongly urges policymakers to exercise restraint when considering new credits or other reporting obligations. She also says Ottawa could begin to demystify the system by slowing down the legislative process, seeking out more external advice and ensuring that the administration of the tax laws evolves in lockstep with policy changes. “There could be a more collaborative approach to drive change,” she says, citing a U.K. initiative to simplify its tax code.
Asked what metric the government might track to see if it has made progress in such efforts, Evans says CRA could track how many individuals succeeded in filing their taxes without mistakes or significant amendments. A more indirect method involves measuring the uptake in entitlements provided through tax law. One way of interpreting a low take-up on a new kind of benefit is that the government has failed to properly educate Canadians on both the benefits and the means of taking advantage of it.
From his vantage point at Video Tax News, Devaney agrees that the Department of Finance needs to slow down its legislative cycle. He argues that this would give the department’s officials more time to work closely with the CRA and other stakeholders to gain a clearer understanding of whether a new rule can actually be administered in ways that don’t lead to huge collection costs or sharp increases in the fees incurred by taxpayers and businesses simply trying to file correctly.
“The biggest problem for CPAs and Canadians in general is that the people who want to do it right often can’t because to comply with everything as it is written would cost more than any taxpayer could afford,” Devaney observes, saying that the most striking symptom of what he calls the complexity spiral is the proliferation of egregious reporting mistakes. “We know there’s something wrong, but we just can’t put our finger on what it is.”
For CPA Canada’s Oakey, when it comes to tax, any legislation must be accompanied by robust consultation with experts and, especially, the CRA. “CPA Canada continues to advocate for a comprehensive tax review, led by an independent panel,” he says. “In the interim, we recommend that the government adhere to a principled approach to tax policy and administration that is driven by purpose and vision, as opposed to politics and expediency. Simplicity, fairness, efficiency and competitiveness are among the most basic principles of a good tax system.”
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Photo caption: In recent years, Canada’s tax system has become increasingly convoluted and difficult to comprehend (Freepik)