This is a question that professional advisors are faced with on a regular basis. The current paper version of the Income Tax Act stretches to almost 2,000 pages! How did we get to this?
The answer partly lies in one of the most fundamental principles of the Canadian taxation system – integration.
The general premise of integration is that income should suffer the same total amount of tax irrespective of the entity that is used to earn the income.
For example, an individual who does business as a sole proprietor, and receives business income directly, should pay the same total tax as a person who does business using a corporation (where both corporate income tax and personal income tax is paid).
This sounds straightforward enough in theory. However, in practice, this is difficult to achieve given the various types of income receivable (business income, salary income, dividend income, etc.).
True integration (the simple concept above) is not possible due to these differences. Some business structures and provinces will be slightly more advantageous or disadvantageous from a tax perspective. However, integration works pretty well in minimizing these differences.
Dividend income example
To demonstrate how this principle can make things complicated in practice. Take the example of income earned in a corporation versus income earned individually
When income is earned by an individual, the tax implications are fairly simple – business profits are taxed at the personal tax rates for ‘other income’ and investment income is largely subject to personal dividend tax rates.
Integration provides that the same income earned through a corporation should have the same tax outcome. However, corporate income tax rates are lower than personal rates because it is understood that there will be a further layer of taxation when corporate funds are distributed to shareholders.
In addition, for business income, shareholders are likely to pay tax on this second layer at dividend tax rates, which are different from the ‘other income’ rates.
To add to this complexity, certain businesses are entitled to a reduced rate of income tax on their first $500k of business income (the small business rate), which further skews the total tax payable, and risks ‘breaking’ integration.
To counter this, a complex system of dividend credits and corporate refundable tax was required. This necessitated the introduction of a whole new type of corporate tax (known as Part IV tax), which introduced a refundable tax on corporations, refunded when dividends are ultimately paid to shareholders.
Tax planning
Many tax plans which exist, are also the result of integration. Because integration results in little or no tax benefits which are entity-dependent, tax planners try to work within the rules of the Income Tax Act to achieve an outcome which is not consistent with the principle of integration, therefore providing their clients with a tax benefit greater than normal.
The growing complexity of the Act means that, more and more, there are some sections which do not properly integrate (no pun intended) with others, providing for the existence of “loopholes” where they can be found.
This necessitates the introduction of anti-avoidance provisions as and when such plans come to light, further adding to the length of the Act and its complexity.
So, what makes tax so complicated? Integration is, in part, the surprisingly simple answer!