Integration and the Taxation of Passive Income: An Economic Perspective Speaker name: Kevin Milligan Affiliation: Vancouver School of Economics University of British Columbia kevin.milligan@ubc.ca

Integration and Passive Income: An Economic Perspective Carter Commission V.4, p. 84 “The system would neither encourage nor discourage the retention of earnings by corporations.”

Integration and Passive Income: An Economic Perspective Roadmap Why integration? Do proposals improve integration? How much will the changes affect businesses? Caveats on Implementation.

Integration and Passive Income: An Economic Perspective What is Integration? Tax at individual level should reflect tax paid at corporate level. Or, all paths for a $ from “profit to pocket” should bear same tax. Also, no financial gain from readjusting location of savings. “The system would neither encourage nor discourage the retention of earnings by corporations.”

Integration and Passive Income: An Economic Perspective Why Integration? Neutrality: Target is for people to make same decisions under taxation as they would without taxation. This is a free-market goal: business decisions based on the business merits. This is the literal definition of economic efficiency for taxation.

Integration and Passive Income: An Economic Perspective Why Integration? Neutrality: Target is for people to make same decisions under taxation as they would without taxation. This is a free-market goal: business decisions based on the business merits. Retirement savings? Maternity leaves? ‘Buffer’ savings? Saving for investment? These are all fine, but inside/outside firm should be a business decision.

Integration and Passive Income: An Economic Perspective Why Integration? Neutrality: Target is for people to make same decisions under taxation as they would without taxation. This is a free-market goal: business decisions based on the business merits. Retirement savings? Maternity leaves? ‘Buffer’ savings? Saving for investment? These are all fine, but inside/outside firm should be a business decision. Reminder: the reason we have SBD is to facilitate investment. Not as a place to tax-advantage savings for those with large portfolios.

Ways Current Integration Falls Short Integration and Passive Income: An Economic Perspective Ways Current Integration Falls Short It’s notional: still get DTC when firm pays no tax. Can do direct passthrough of tax bills, e.g. Taiwan; ‘franking’ in Australia Fed-Prov: one national gross-up rate for whole country. Tax-exempts like pension funds / RRSPs can’t claim DTC. Capital gains rate is currently too low compared to dividends/wages. Firms claiming SBD have ‘head-start’ deferral advantage for saving.

Does Proposal Improve Integration? Integration and Passive Income: An Economic Perspective Does Proposal Improve Integration? Focus on high bracket: why? Flat rate on passive income calibrated for high-bracket investors. High-bracket investors more likely to have substantial passive portfolios. Low-mid bracket investors Currently disadvantaged for passive saving in CCPC. This shortcoming not addressed. More likely to have open RRSP/TFSA room for long-term savings.

Does Proposal Improve Integration? Integration and Passive Income: An Economic Perspective Does Proposal Improve Integration? Current system is over-integrated: favours retained earnings inside firm. Current tax of passive income inside/outside firm is comparable…but… But savings inside the firm get a ‘head start’ from light taxation of SBD. Proposed correction: remove RDTOH. Increases tax on passive income to compensate for ‘head start’. For a high-bracket Ontario investor, effective rate on passive income is 73%. Excessive? Need higher rate to balance big ‘head start’ to achieve integration.

Does Proposal Improve Integration? Integration and Passive Income: An Economic Perspective Does Proposal Improve Integration? Evidence #1: Try to replicate Finance Table 7

Does Proposal Improve Integration? Integration and Passive Income: An Economic Perspective Does Proposal Improve Integration? Evidence #2: Observation If system is currently properly integrated, there should be no advantage to retaining earnings. We observe financial planners advising clients to save in CCPC for tax savings. http://lmgtfy.com/?q=doctors+canada+incorporation+deferral+advantage If system were today properly integrated, all that advice would be wrong…

How much will proposals matter? Integration and Passive Income: An Economic Perspective How much will proposals matter? We need to keep the scale of the change in mind. Imagine $100,000 in passive portfolio; 5% interest. RDTOH is 30.67%, or $1,534. But this is taxed as non-eligible dividend at 45.30% (Ont, high bracket) So, RDTOH is worth $838 if paid immediately. This is <1% of principal, but knocks down rate of return. After 10 years, could affect terminal value of portfolio by 8-15%.

How much will proposals matter? Integration and Passive Income: An Economic Perspective How much will proposals matter? Target savings: $33,333/yr of retained earnings over 3 years @ 5% interest. Maternity leave? Savings for new equipment? No change to cash flow. $3,118 in RDTOH notional account

How much will proposals matter? Integration and Passive Income: An Economic Perspective How much will proposals matter? Terminal value of these savings once personal tax is paid. Status quo: CCPC beats personal by $819. Proposal: Personal beats CCPC by $887.

Integration and Passive Income: An Economic Perspective Carter Commission V.4, p. 84 “The system would neither encourage nor discourage the retention of earnings by corporations.”

Caveats on Implementation Integration and Passive Income: An Economic Perspective Caveats on Implementation Lots of important challenges await… Transition: how the grandfathering will work. Intercompany shareholdings; investments. We will hear more today! This is serious: Need to weigh the costs and benefits of proposals. Finance’s response: are there non-messy fixes?

Integration and Passive Income: An Economic Perspective Final thought This package is clearly a ‘patch’ on a messy system. Should we wait for Carter 2.0 before acting? If we can’t have it all, should we do anything? I argue: no We can all play “fantasy tax reform”…. We must also ask: does this improve on status quo?