Tax filing – Doug Carroll

Basic Personal Amount – Will BPA changes truly provide tax relief

The federal government recently put a key piece of their tax platform in place: an increase in the basic personal amount (BPA). This is expected to lower taxes for close to 20 million of us, and eliminate any federal tax liability for almost 1.1 million Canadians.

To deliver on this promise, the government will increase the BPA to $15,000 by 2023. On the face of it, that’s a nice, round, substantial figure, and no doubt many of us will experience tax savings. Still, to give it some proportionality and context, let’s take a closer look to understand how, when, to whom, and to what extent this will provide tax relief.

DEDUCTIONS AND CREDITS

Most non-tax professionals likely don’t pay too much attention to the difference between a tax deduction and a tax credit. Both can reduce a person’s tax bill, but in a very real sense they are applied at opposite ends of the income spectrum.

A deduction reduces the amount on which tax is calculated. Because we have a progressive personal tax system (i.e., higher rates applying to income at higher brackets), a deduction reduces tax exposure at a person’s uppermost or marginal rate.

In terms of tax credits, a non-refundable credit reduces your initially calculated tax due, whereas a refundable credit is more like a subsidy in that it is paid even if you don’t owe tax. In either case, a maximum amount is legislated for a given purpose, against which the appropriate credit rate is applied. With a few exceptions (mainly charitable and political donations), the credit rate most often is at the lowest bracket rate. For federal tax calculations the lowest rate is 15%, but a person’s own income dictates the marginal rate, which may be as much as 33%.

Connecting those dots, a deduction is generally more valuable than a credit.

The most common non-refundable credit is the basic personal amount, sometimes called the basic personal credit.

Either way, it’s referring to the same thing — effectively negating tax on income from zero up to the set level. For instance, when you file your upcoming return for the 2019 taxation year, you’ll claim this credit on your first $12,069 income. At the 15% rate, the value of the credit is $1,810.

While it may seem an obvious point, note that the amount is larger than the credit value, since it is multiplied by the credit rate. Keep this in mind as we turn our attention to the change in the amount, and contemplate the value of that change.

ENHANCED BPA

Over the course of the next four years, the BPA will be bumped beyond its usual inflation indexing until it reaches $15,000 in 2023. The rollout schedule is shown in the first three columns of the table here, reproduced from the Department of Finance backgrounder. The two right-hand columns are my own calculations for the sake of some analysis to follow.

The additional BPA will initially yield $140 in annual tax savings, rising to about $300 in 2023, as featured in official communications. In that last year, the $15,000 amount will equate to a full value for the BPA of $2,250, a 13% improvement over what current indexing would have given.

However, it will be almost four years until early 2024 tax filing when that extra $300 may be claimed. Using the approximate 2% indexing employed by the Department of Finance, that discounts back to about $277 in current dollar value.

To be clear, I’m critiquing, not criticizing; my aim is to couch expectations of the practical implications for individual and household budgets. That last point is especially important, as there are parallel changes to the spousal and eligible dependant amounts, the effect of which will be to double the impact to as much as $600 for families claiming either of those credits.

INCOME CEILING AND TIME HORIZON

Not everyone will enjoy this enhanced BPA. Extra components will be added to the BPA definition to reduce the enhancement as income enters the 29% fourth bracket, until it is eliminated for someone whose income exceeds the 33% top/fifth bracket. For 2020, those thresholds are $150,473 and $214,368. For your curiosity, a $300 loss across this range is a clawback contribution to a marginal effective tax rate of just under 0.5%.

The BPA and brackets will continue to increase each year according to the existing indexation formula, but the BPA enhancement will remain at $15,000 after 2023. This means that the value of the enhancement will continually erode each year thereafter. Using that 2% index factor as a proxy, the BPA would overtake the enhancement by about 2030. Whether this will still be a feature of our tax system a decade from now is anyone’s guess.

Solicitor-client privilege prevails over CRA information gathering powers

At issue

The earliest incarnation of solicitor-client privilege was as a rule of evidence. It served as a shield against confidential professional communications between a lawyer and client being tendered as evidence in a court proceeding.

Over time, privilege has progressed beyond being mere procedure. Indeed, it is now considered to be a substantive legal right (whether in or out of court), and indeed a principle of fundamental justice. But there have always been and continue to be limits. For example, the client must be seeking legal advice and must intend the communications to be kept in confidence. Furthermore, communications in furtherance of a criminal purpose are not protected at all.

Earlier this year, the Supreme Court of Canada (SCC) released rulings in two cases involving privilege claims invoked to resist disclosure demands from the Canada Revenue Agency (CRA).

Solosky v. The Queen, [1980] 1 SCR 821

This judgment marked an explicit acknowledgement from the SCC that case law had progressed such that privilege could be claimed outside court evidence matters, bringing it to a “new plane”. Solosky was an inmate in a federal penitentiary whose correspondence – including that with his lawyer – was being opened by corrections officers. While accepting the evolution of privilege, the Court expressed that limits remain, denying the instant claim in the face of overriding security concerns of the institution.

Section ss. 231.2(1), 231.7 and 232(1) of the Income Tax Act (ITA)

ITA s.232(1) defines solicitor-client privilege as “the right … to refuse to disclose an oral or documentary communication on the ground that the communication is one passing between the person and the person’s lawyer in professional confidence, except that for the purposes of this section an accounting record of a lawyer … shall be deemed not to be such a communication.” [Emphasis added]

This is known as the ‘accounting records exception’, and is brought within CRA’s power to require documentary disclosure under ITA s. 231.2(1). And if there is a refusal to produce the document/communication, the CRA may seek court assistance pursuant to ITA s.231.7.

Canada (Attorney General) v. Chambre des notaires du Québec, 2016 SCC 20

Over recent years, many Quebec notaries in the course of law practice had been served with a “requirement to provide documents or information” relating to one or more of their respective clients who were the subject of tax audits. The Chambre des notaires du Québec was unable to negotiate a compromise with CRA, so it launched a court action which eventually made its way to the SCC.

The top court noted that information in accounting records could be subject to solicitor-client privilege, with the client name alone sufficing in some situations. Accepting that the requirement scheme is a legitimate tax collection tool for CRA generally, the intrusion on privilege nonetheless went too far. The SCC ruled the ITA sections were unconstitutional with respect to accounting records of lawyers and notaries (as had the lower courts), as an unreasonable search and seizure of information under s.8 of the Charter.

Canada (National Revenue) v. Thompson, 2016 SCC 21

Both Chambre and this case dealt with the accounting records exception, and the two judgments were released on the same day. But whereas in the former it was the clients whom CRA pursued, in this case Mr. Thompson himself was the subject of an income tax audit, the CRA having served him a requirement to produce the accounts receivable of his law practice in addition to personal finance documents.

Though constitutionality was not argued here, the finding followed from the Chambre ruling, ironically allowing Mr. Thompson to prevail due to his clients’ rights, not his own. This was emphasized by the Court in noting that privilege is that of the client, not the lawyer, and could only be waived by the client. It went on to remark that if Parliament decided to rectify the disclosure scheme, it would have to build in a process for clients to participate and protect their rights in a situation such as Thompson.

Practice points

Solicitor-client privilege is the right of a client in the course of obtaining confidential professional legal advice, and for clarity it is not a right of the lawyer consulted.
Pursuant to Chambre, it is unconstitutional for CRA to require production of accounting records from lawyers and notaries, as that would presumptively compromise clients’ privilege rights. As regards the accounting records of other professionals, the relevant ITA sections remain in effect.
Parliament may act to amend the ITA to enable access to accounting records of lawyers and notaries, but will have to do so in a manner that continues to protect solicitor-client privilege.

New 33% tax bracket effect on passive income in private corporations

No doubt there was disappointment in the business quarter when the 2016 Federal Budget held the small business corporate tax rate at 10.5%. It was scheduled to decline by half points to reach 9% in 2019. Taking an optimistic view, this may only be a reflective pause, given that the Liberal government had earlier stated its intention to reduce the rate to that level. We shall see.

The news is even less rosy for those same business owners when considering the implications of the new 33% top bracket tax rate that was ushered in with the “middle class tax cut.” Not only will this new rate apply to personal income over $200,000, it also affects passive income inside their corporations. And the impact could be most costly to the smallest of those small business owners if they fail to adjust how they manage their corporate investments.

Corporate-personal tax integration

The proper functioning of our tax system is based in part on the integration of personal and corporate taxes. Absent such a coordinated approach, the use of a private corporation – especially a Canadian-controlled private corporation (CCPC) that uses the small business tax rate – could lead to unintended tax benefits or unfair tax costs.

Integration is carried out using a number of mechanisms at the corporate level and on passing income from corporation to individual as shareholder. Business owners would have some familiarity with integration when they think of the following two-stage process of how their dividends are taxed:

The grossed-up dividend is the amount used to calculate the shareholder’s initial tax due as if he or she had earned the income out of which the corporation paid the dividend
This initial amount is reduced by the dividend tax credit (representing the tax revenue the Canada Revenue Agency (CRA) already collected from the corporation) to arrive at the shareholder’s net tax bill

Tax system’s response to passive corporate income

While the gross-up/tax-credit process applies on a dividend distribution from corporation to individual, there remains the matter of how to deal with undistributed income.

When that income is reinvested to generate more business income, there is no problem from a tax policy perspective. Indeed, one of the main purposes of the small business rate (which is actually in the form of a deduction from the general corporate rate) is to enable greater reinvestment and business growth than would otherwise be the case if a higher tax rate applied, whether the business was run as a sole proprietorship or through a corporation.

But where excess corporate cash is not going back into operations and instead placed into portfolio investments, a problem arises. As only the corporate portion of the ultimate tax bill has yet been paid, more cash is being passively invested than would be possible in the shareholder’s hands. As the small business rate is intended as a business booster and not a portfolio bonus, the tax system’s answer is to impose a tax cost that emulates the corporation as a top-bracket personal taxpayer. In a sense, it is the reverse of the gross-up on dividends, but in a much more complex way.

Integration mechanisms, 2016 and beyond

Not only is a CCPC not entitled to use the small business deduction on its investment income, but it also faces an additional tax on that income, specifically the Part I refundable tax. This is tracked in the corporation’s tax records as refundable dividend tax on hand (RDTOH), a portion of which is refunded from the CRA to the corporation when taxable dividends are paid to shareholders. However, Canada-sourced dividends are subject to a different rate as Part IV tax, all of which is refundable. On the other hand, foreign dividends are given a reduced RDTOH credit.

Suffice it to say, there are a lot of moving parts, the full details of which are beyond the scope of this brief article. As to the changes, the increase in the top personal tax rate from 29% to 33% necessitates adjustments to these integration mechanisms, the clearest illustration being the four-percentage-point increase in the Part I refundable tax. The rest of the changes are produced here for reference, without getting into the underlying calculations.

Taken together, the changes make it a bit more punitive to earn investment income in a CCPC beginning in 2016. A shareholder whose personal income tax bracket is below $200,000 should take particular note, and perhaps consider adjusting how and when income is taken out of a corporation. And for all affected corporations, a closer look at the tax efficiency of investment choices in corporate accounts may be in order, to explore if and how exposure to RDTOH may be mitigated.

TABLE: Corporate-personal integration mechanisms