Tax Planning and SR&ED

I’m often amazed that some Canadian technology companies spend a fortune on complex tax planning structures and ignore rudimentary compliance functions to support SR&ED tax incentives.

While SR&ED is becoming more difficult and less predictable, it is still the best deal around for companies investing in new and improved technologies. The benefits of claiming SR&ED successfully will generally dwarf most other tax planning strategies for early stage technology companies in Canada – particularly those with 100 or fewer employees.

In the example above, a small tech company with a 20 person development team – has $750 K in eligible costs. If planned and documented properly, the company should be entitled to a $467 K tax refund.

If they aren’t careful in managing their expenditure limit, the refund could be reduced to $ Nil – and they would restricted to claiming SR&ED against taxes otherwise payable. (cost $146 K to $467 K)

In the 3rd scenario, when the company doesn’t adequately document SR&ED activities, it loses all entitlement to SR&ED tax incentives. (cost $467 K)

HOW TO DOCUMENT SR&ED ACTIVITIES

Most companies with a 20-person development team has some form of documentation. For a software company that might mean project management software, source code repositories and/or timesheet systems.

What they don’t have is documentation of technological uncertainties faced – and how they attempted to address these. The fact is that businesses engage in R&D to build and improve products or services. They aren’t really interested in overcoming technological uncertainties – except as a by-product of their product development work.

It makes much more sense to use existing – proven – technology to build new products. Extending and/or enhancing the underlying technology is risky business. That is precisely why the SR&ED program was introduced. It was designed to help share the technological risk with innovative companies.

In order to qualify for SR&ED tax incentives, companies must be able to identify which technological uncertainties they faced – and how they attempted to overcome them. However in our experience companies do a lousy job of documenting the technological uncertainties (“TUs”) they faced. Instead they focus on functions and features that they successfully developed.

That is the biggest single problem that the CRA finds with SR&ED claims. A decade or 2 ago the CRA would do their best to infer the technological uncertainties from the product improvements described in the SR&ED claim. These days however, CRA’s technology advisers not only expect TUs to be specifically identified, they expect documentation to describe how and when a specific uncertainty was identified and how eligible costs claimed relate to the attempt to resolve the uncertainty.

This is problematic for businesses that wouldn’t otherwise consider an “activity-based costing system”:

Introducing activity-based costing is not a simple task—it is by no means as easy as ABC. For a start, all business activities must be broken down into their discrete components. As part of its ABC programme, for example, ABB, a Swiss-Swedish power company, divided its purchasing activity into things like negotiating with suppliers, updating the database, issuing purchase orders and handling com-plaints.

Large firms should try a pilot scheme before implementing the system throughout their organisation. The information essential for ABC may not be readily available and may have to be calculated specially for the purpose. This involves making many new measurements. Larger companies often hire consultants who are specialists in the area to help them get a system up and running.

The easy approach is to use ABC software in conjunction with a company’s existing accounting system. The traditional system continues to be used as before, with the ABC structure an extra to be called upon when specific cost information is required to help make a particular decision. The development of business accounting software programs has made the introduction of activity-based costing more feasible.

The Economist – June 29th, 2009

Obviously the latter approach is the only viable option for small technology companies.

We have designed a custom form that can be modified for our clients, to log TUs encountered by senior technical staff during the course of product development activities. In the video that follows I describe the form can be designed and modified using Smartsheet™.

Once built the form can easily be incorporated into a simple ABC system, layered on top of a traditional accounting system, and used for tracking SR&ED expenditures.

 

CRA’s Voluntary Disclosure Program Needs an Overhaul

Our tax system is referred to as a “self-assessment” system, meaning that it relies upon taxpayers to self-assess their taxes.

This approach is far more efficient from an administrative perspective than the alternative, and results in a much lower administrative cost per dollar of tax collected. However when some taxpayers inevitably find that they have not complied in the past, the cost of penalties and interest on unreported (or under-reported) income can become a huge barrier to becoming compliant.

In order to encourage taxpayers to come forward and correct historical tax filings, the Canada Revenue Agency (“CRA”) created the Voluntary Disclosures Program (“VDP”). Taxpayers who come forward of their own volition (i.e. on their own – before their taxes are audited by CRA), are theoretically forgiven penalties on under-reported income by virtue of the VDP.

The problem is that the program is administered in such a way that VDP officials work tirelessly to find ways to characterize the disclosures themselves as insufficient – thereby denying the protection of the VDP program.

After one too many experiences with the officious behavior of VDP employees, I took it upon my self to write our MP, and enclosed a copy of the letter from the official.

What Governments can Learn from Startups

What Governments Can Learn from Startups

Every few years the electorate votes the ruling party out of office — often in favour of a new, reinvigorated opposition party. Effectively we vote in a ‘startup government’ led by a few individuals with political experience, marketing savvy and the support of political opportunists with deep pockets, or at least committed ‘followers’ who ‘like’ a particular party.

The parallels with startup culture are clear except for one thing:

Canadian governments control organizations that employ about 18% of all working Canadians. The percentage of public sector employees seems consistent across the country — at least in BC and Ontario.

All of which means that every few years we can expect to be governed by a team of relatively inexperienced cabinet ministers. It is almost frightening to consider that these individuals will take charge of a set of different organizations that collectively represent a huge percent of the workforce — as large and as diverse as only the largest multinational corporations.

Can these (hopefully) well-intentioned individuals effectively adapt and take control of such a large and complex set of organizations?

It is almost inevitable that new governments rely extensively on senior management in the public sector to draft public policy.

While this may be understandable, it also represents a significant challenge to any new government.

The Art of the Pivot

When we replace governments we don’t replace the civil service. While many of the functions of the civil service are critical, they are incredibly resistant to change. We should look to startup culture to help re-invent the business of government.

Of course there is deep expertise within each organizational component of Government. But, simply because the bureaucracy — and public sector unions — have managed to put a stranglehold on virtually every public sector organization, that does not mean that we must allow them to dictate the way in which government services are delivered.

New governments need to identify groups of creative people with a fundamental understanding of the various business units — both within the regulators and the regulated — and task them with disrupting the status quo by building prototypes of new business models. In other words we need to consider the ‘Minimum Viable Process’ for achieving our organizational goals.

We don’t need to look very far for processes in Canada that need to be disrupted. Consider:

  1. The Phoenix Payroll System
  2. Support for Disabled Veterans
  3. The CRA’s Voluntary Disclosure Program
  4. Shared Services Canada
  5. Sexual assault in the military and the RCMP
  6. The Missing and Murdered Inquiry — and Indian and Northern Affairs Canada generally
  7. Bankruptcy Laws (think of Sears Canada)
  8. Tackling climate change

However the government’s resources are limited and they need to prioritize. Unfortunately there isn’t all that much bench strength or creativity among our members of parliament. Our partisan approach to politics and our ‘first past the post’ electoral system isn’t very fertile ground for creativity. Instead it is all about conformity to ‘family values’ , improving the lot of ‘working people’ (aka ‘making the rich pay’) or helping ‘the middle class and those who want to join it’ (aka ‘ trying to appeal to everybody’).

All of the power appears to be centred in the PMO (Prime Minister’s Office). This was true under Stephen Harper — and is just as true under Justin Trudeau with his ‘sunny ways’. Individual members are expected to toe the party line. Our political system actively works to stifle creativity.

The horrible truth is that our governments don’t have the right DNA to act as disruptors. What’s more — we do need predictability in Government — so while disruption must occur, it must be controlled.

HOW TO PIVOT THE CRA

Like a great many Canadians I have opinions about how we could do things better. But realistically my expertise lies within our tax system. I am one of the 40.25% of professional accountants that works in “professional, scientific and technical services” (most of whom practice as public accountants).

The CRA is administering the most complex set of legislation in the country. It relies on individuals and corporations assessing themselves. This is generally referred to as a ‘self-assessment system’.

The majority of complex returns are prepared by professional accountants. For their part the CRA hires and/or trains accountants to administer the Income Tax Act (and the Excise Tax Act).

According to Industry Canada 11.01% of accountants work in public administration and 40.25% work in “professional, scientific and technical services”. (Of course not all of these work in CRA or in public practice — however the CRA is the largest federal employer of accountants.) My point is that if we can encourage better compliance the administrative costs — paid for by the government — goes down.

The question is:

How do we take what is supposed to be a ‘self-assessment’ system and improve both compliance and efficiency? 

POSSIBLE INITIATIVES

  1. Encourage public accountants to provide ‘better’ tax filings in exchange for reduced audit levels on a firm-by-firm basis (contingent on the quality of filings). Try to reduce the number and extent of audits by improving the quality of original filings.
  2. Increased penalties for egregious behaviour on the part of public accountants (consider the recent offshore fiasco in which practitioners weren’t sanctioned)
  3. Use professional discipline of the CPAs for inadequate work (as part of the toolbox for sanctioning practitioners)
  4. Charge a fee for Professional Development courses as a part of their mandatory annual professional development of CPA members (why not monetize training instead of just paying for it)
  5. Rather than attacking benefits enjoyed by businesses — make similar benefits available (eg. income splitting) to ordinary employees.
  6. Rather than attacking benefits enjoyed by civil servants — allow other taxpayers to simply deduct medical expenses (at least up to a certain level of income).
  7. Reduce the number of public sector employees administering the Income Tax Act by beginning a pilot program allowing public practice firms to review income tax returns for a fee — much like lawyers provide legal aid (CPA firms are already capable of auditing large international firms — why not tax returns)

While I am sure that some public sector employees possess the necessary creativity for this kind of re-positioning work, they necessarily have different perspectives than private sector workers.

For example a public sector worker is almost guaranteed a job for life. This differs markedly from unionized workers in the private sector, where collective bargaining often revolves around ‘job security’. In fact unionization rates have fallen precipitously since at least 1981. According to Statistics Canada about 42% of workers were unionized in 1981. By 2012 that number had declined to 29.9%.

Too often public sector unions stifle any kind of initiative that may reduce jobs or job security. Unfortunately it may be difficult to involve them in streamlining business processes, if that view dominates their perspective.

According to Statistics Canada’s Labour Force Survey: 1999, 2007 and 2012, the percentage of public sector workers that were unionized was 71.4% in 2012 (up 0.6% from 1999). By contrast the percentage of private sector workers that was unionized was 16.4% (down 2% from 1999).

Public sector workers almost invariably have defined benefit pension plans. At retirement these plans — which are untaxed during their working years — typically have a present value of between $500,000 and $1.5 million. Except for the legendary ‘one percent’ virtually no other group of workers has anything like the ‘cradle-to-grave’ security of our public sector workers.

Another key difference between public sector workers is that they generally work for regulatory bodies. Those of us in the private sector tend to be regulated as opposed to regulating others. Clearly this causes a difference in the perspective between the regulators and the regulated. In particular I think of the Finance Department and the Canada Revenue Agency and the difference between their perspective and that of accounting professionals in the private sector.

Much has been said about the recent furore around proposals to address issues around “tax fairness” and the use of private corporations to confer an unfair advantage on that same legendary ‘one percent’. In my view this resulted in a rookie mistake by an otherwise competent Finance Minister. In short he relied on the regulators that worked for him.

Predictably the regulator attempted to defeat their rivals in the regulated sector. What’s more they discounted both the costs of compliance (which they routinely do, since they don’t bear these costs), and the value of their own job security and ‘gold-plated’ benefits, which they would rather keep quiet about.

A better approach would have been to create a dialogue between the regulator and the regulated. We need to improve regulations in a much more collaborative way. Neither perspective should be expected to produce a workable system without significant input from the other.

Some years ago, while still in the private sector, our current Finance Minister is purported to have said the following at a private sector conference on pensions:

”Who believes that the average Canadian, without a defined benefit plan, and without the demonstrated capacity to save enough to support their retirement, will, over the long term agree to fund public sector pensions at a level that they can only dream about attaining themselves?”

– Bill Morneau — 2013 (according to an article in the National Post)

Given the current government’s success with so-called ‘progressives’ in the last election, it can be easily understood why this issue wasn’t addressed in their recent foray into ‘tax fairness’. It comes down to math:

In the last 2 elections the winning party earned strong majorities with 39.5% and 39.6% respectively of the votes. If workers in public sector unions account for between 18% and 19% of the working population, it wouldn’t be wise to target their incredibly rich pension plans in any discussion of tax fairness. This is particularly true for a party that is courting progressive voters.

To be clear, I too consider myself a ‘progressive’ voter. However I believe in basing policy on evidence, whether scientific or statistical. When it comes to fairness I am most concerned with the over 60% of working Canadians that don’t have the kind of job security, or defined benefit pension plans enjoyed by most public sector employees.

A Brief History of Bookkeeping

In 1494 an Italian mathematician by the name of Luca Pacioli published “Summa de arithmetica, geometria, proportioni et proportionalità” (Venice 1494), a textbook for use in the schools of Northern Italy. It was a synthesis of the mathematical knowledge of his time and contained the first printed work on algebra written in the vernacular (i.e. the spoken language of the day). It is also notable for including the first published description of the method of bookkeeping that Venetian merchants used during the Italian Renaissance, known as the double-entry accounting system. The system he published included most of the accounting cycle as we know it today. He described the use of journals and ledgers, and warned that a person should not go to sleep at night until the debits equaled the credits. His ledger had accounts for assets (including receivables and inventories), liabilities, capital, income, and expenses — the account categories that are reported on an organization’s balance sheet and income statement, respectively. He demonstrated year-end closing entries and proposed that a trial balance be used to prove a balanced ledger. He is widely considered the “Father of Accounting”. Also, his treatise touches on a wide range of related topics from accounting ethics to cost accounting.”

It has often struck me that a system described so eloquently more than 500 years ago, could somehow be reproduced in software and used by publishers to create an annuity. However that is precisely what software publishers like Intuit Inc. and The Sage Group, plc have done with their popular accounting software.

The fundamentals of accounting theory are basically unchanged since Pacioli’s day. In spite of this, by simply updating tax tables and changing the format of data files, the publishers force small companies – and their accountants – to upgrade their accounting software every year.

As a public accountant this is particularly irksome since most of us use audit software – called Caseware™ – and only purchase low-end desktop accounting software to accommodate our clients. What’s more, the bookkeeping done by our smaller clients is most often done very poorly. In fact it is often so badly done that I am frequently better off to export the bank account from within the accounting software to a spreadsheet, and use that as the framework for a more accurate set of books.

Thankfully the current crop of online accounting software allows companies to “invite” their accountant to collaborate and access their accounting data online – without purchasing a license.

It is a tribute to his genius that the bookkeeping algorithm described by Pacioli is as simple as it is. There are really only 2 very simple equations that form a part of the algorithm:

2 Underlying Equations:

  1. For each transaction the sum of debit parts is equal to the sum of credit parts
  2. The sum of assets is equal to the sum of liabilities plus the sum of equities (aka “the balance sheet equation”)

Professional Advice Isn’t Scalable

Terms like “Pivot”, “Lean Startup”, “Minimum Viable Product”, “Product / Market Fit”, “Gazelles“, “Unicorns” and “Scale Up” are ubiquitous.

However that doesn’t mean that these concepts are key to each and every small business. In fact all of the writers, investors and academics that use these terms, seem intent on building a new, uniform kind of startup culture.

If every business was the same, they wouldn’t need professional advice, we’d just need to send everyone to one of a handful of startup boot camps.

As professionals, most CPAs know that each business is unique and that advice must be tailored to meet a client’s individual needs.

So What Is A Startup?

From the perspective of a company like Google or from a venture capitalist’s point of view, a startup is a company that was formed within the last 4 or 5 years and has grown to 20 – and sometimes as many as 50 employees.

I guess that is understandable, since what most practitioners think of as a startup wouldn’t register on the radar of most venture capitalists.

In British Columbia where I practice, every year BC Stats publishes a study called ‘Small Business Profile‘. Every year the studies show that only around 5% of companies have more than 20 employees. In fact companies with 50 or more employees are considered large companies (in BC at least) – which might seem to turn conventional wisdom on it’s head. In that respect BC differs from Canada, which has the cut-off for medium-sized businesses at 100 employees.

 

Note that “non-employer” businesses include 2.7 million self-employed Canadians – so that this table contains less that one third of all businesses in Canada in 2014.

So while a VC may think of a 6 year old company with 25 employees as a startup, the rest of us know better. A startup is really a company at the seed stage with a couple of founders and 4 or 5 employees at most. The difference between a seed stage company and one that is ready for a Series B round of financing, is as striking as the difference between a high school student and an infant.

Professionals need to nurture companies at a seed stage and avoid over-feeding (i.e. providing too many services).

For professionals, servicing startups is kind of like taking care of goldfish – feed them too much and you’ll kill them.

Startups need the right services at the right time – and their needs change very quickly.

Taxation of Employee Stock Options

When a company issues stock options to employees, there may be taxable benefits either when the stock option is exercised (in the case of a public company share), or when the resulting share is sold (in the case of a Canadian-Controlled Private Corporation “CCPC”).

If the exercise price of the option – at the time of issue – is equal to the fair market value of the share, there other potential benefits to the employee.

Public Company (and other non-CCPC) Shares

If the value increases, typically the employee would consider exercising the option if there is a ready market for the shares. The difference between the current fair market value and the exercise price is considered an employee benefit.

Since the option price equaled the fair market value at the time of issue, the employee is entitled to a deduction of 1/2 of the benefit.

CCPC Shares

For employees with options to acquire shares of a CCPC, the benefit is only taxable when the acquired shares are sold.

Similarly the employee would be entitled to a deduction of 1/2 of the benefit (if the exercise price of the option – at the time of issue – is equal to the fair market value of the share)

There are other considerations. For example the employee must be dealing at arm’s length with the corporation. Since these provisions are complex, make sure that you get advice specific to your situation before putting in place a stock option plan.

Is the CRA Out of Control?

I received a link to the following article from LEDGERS.COM. Their experience pretty much mirrors our own:

As Canadians, we have an inherent obligation to pay taxes; we also have rights under “The Taxpayer Bill of Rights” CRA however, does not seem to believe in a lot of these rights lately.

We have seen directly and heard from other Accounting Firms, how unbelievably aggressive the CRA has become lately, and how they have thrown the rules out the window.

Here are a couple of examples:
Client A had no payroll to report in 2016 so there were no T4’s issued. (they had payroll in 2015); The CRA arbitrarily assessed them for the missing taxes, plus interest and penalties amounting to a total of more than $30,000!

Since the client refused to pay, the CRA seized the client’s bank account! When the client called CRA to explain, they would not listen. The CRA’s position was “pay the amount owing, then we  will discuss it”.

If you owe money to the CRA, and try to negotiate a repayment
schedule, you will always get the same response: “You have only 6 months to pay the outstanding balance”.

NOWHERE in the Income Tax Act does this appear! What the Act says is: “payment arrangements are to be made based upon the taxpayers ability to pay”

CRA’s Commitment to Small Business says ”The Canada Revenue Agency is committed to administering the tax system in a way that minimizes the costs of compliance for small businesses”

Again, this is hard to believe;

Client B had a GST Review. The CRA did not like the way the books (computer program) listed the GST charged and the ITC’s.

They forced the client to redo the books to show the information in a format that was acceptable to the auditor. THIS is not required under the Excise Tax Act! The Act states that the taxpayer must be able to provide RECEIPTS and other supporting documentation to justify the amount of the ITC being claimed; this has also been upheld numerous times by the Tax Court of Canada.

So why does the CRA feel they can force taxpayers to incur tremendous costs in reprocessing information? Simple – they are trying to cut costs (for themselves)! They rarely have field audits anymore;

it is up to the taxpayer (or their accountant) to prepare the information (in a format acceptable to the CRA, not what legislation requires), then to send it to CRA either via fax (ancient technology) or by file upload through the CRA website (cumbersome at best).

They are transferring the costs of the reviews to the taxpayer!

Have you tried to call the CRA lately?

The General Business Inquiry number is busy more often than not. If you do get through, plan on waiting for someone to answer.

Requests for changes? Good luck. We have seen items that are supposed to take 14 days take several months and longer.

The CRA is so focused on collecting tax dollars, that they have completed neglected their other obligations.

Rule # 6 – “You have the right to complete, accurate, clear, and timely information”.

Where did timely go?

Of course, if they want information from you, you better get it to them immediately or else.

Perhaps it is time for our politicians to stop trying to find ways to further tax and burden small business and to work together with small business to streamline the CRA policies and procedures.

See the Taxpayer Bill of Rights HERE

Thanks to Ledgers.Com for this post

 

Changing Tax Environment for Canadian Small Business

The Canada Revenue Agency (“CRA”) is becoming increasingly process-driven. While the Income Tax Act is by far the most complex piece of legislation in the country, the people administering it are not up to the job.

The reason is simple. Skilled tax practitioners are highly-trained and expensive.  The CRA is trying to reduce their costs by centralizing their services and substituting skilled staff with processes and checklists.

THINK MCTax

Contacting CRA by phone is getting. more and more difficult. Often CRA staff don’t answer phone messages.

You can’t even email auditors anymore since they no longer have email addresses.

In one file where an auditor did not respond to my telephone queries or acknowledge receipt of uploaded documents, I was forced to write to his supervisor, documenting all of the instances where he did not respond to my phone messages and mistakenly told me he had not received documents that were submitted earlier.

The general enquiries line is usually busy and often inaccessible. That means many attempts simply to get on hold. What’s more, they don’t offer an option to leave a message and receive a call back.

If you are foolish enough to try and call within about 30 minutes of closing, you are often disconnected abruptly at closing time (after 30 minutes on hold).

Field audits are mostly a thing of the past. That means that documents must often either be digitized and uploaded on their website – which is awkward to use and very time-consuming (if you even have a document scanner) – or packaged up and mailed. Of course CRA does not keep copies of documents received – they return them to you.

That means if an incompetent auditor – whom you will never meet in person –  improperly assesses your return, he or she simply returns your documents to you. If you wish to appeal – and once again you will never meet your appeals officer – you will have to gather up your documents and mail or upload the same documents to the appeals officer.

When I worked as a field auditor in the 1980s, the Appeals Section was highly skilled and independent from audit. These days appeals auditors are equally as unskilled as the auditors. Their role has apparently been re-defined as a  simple re-audit of the taxpayer’s file.

Having two incompetent people audit your file is not much of an improvement over having one incompetent person audit it. However it does introduce huge delays.

 

Tax Fairness for All Canadians

The Federal Government recently embarked on a review of certain provisions of the Income Tax Act, presumably in an attempt to deliver on a campaign promise to address issues around perceptions of tax fairness during the 2015 election. Unfortunately they failed to deliver on an even more important promise during that same election “to make this election the last election based upon the ‘first past the post’ system”.

This is important because politics is a terribly divisive and partisan pursuit in this (and likely every) country. In the last election the Liberals received 39.5% of the vote. This compares with the 2011 election in which the Conservatives received 39.6% of the vote. In both of the last two elections, 100% of the political power was ‘earned’ by political parties representing less than 40% of the electorate. So the governing party need only convince around 40% of Canadians that their proposals are generally “fair” – which generally means “fair to their supporters”.

The problem with addressing perceptions of ‘tax fairness’ is that the Income Tax Act is incredibly complex and not well understood by many of us – and that includes politicians. The Income Tax Act (“ITA”) is by far, the most complex piece of legislation in Canada. It is generally best understood by professional accountants who are required to study it and often to work with it. As a CPA myself, I have studied and worked with the ITA for more than 30 years, and my practice is centred around tax and tax compliance for small business.

However I don’t mean to imply that I am an expert in working with high net worth Canadians and strategies such as ‘dividend sprinkling’ and the creative use of trusts. My practice is focused on small business – primarily technology companies – and I’m a specialist in the Scientific Research & Experimental Development tax credit program (aka “SHRED”).

The Liberal proposals will negatively affect most of my small business clients. It will inevitably increase complexity and hence compliance costs. This may not be a tax increase – but it will reduce income nonetheless. As a sole practitioner focused on tax, it may actually benefit me personally in some sense. However pointless compliance is not the kind of work I enjoy or take pride in.

For some of my clients however, there will be negative tax consequences not merely from this set of proposals, but also from the 2016 Budget which added excessive complexity to the determination of the Small Business Deduction (“SBD”). In 2016 the Liberals introduced the notion of “specified corporate income” in a misguided attempt to stop the multiplication of the SBD by loosely affiliated corporate ‘groups’.

This was the first of a series of unworkable tax proposals from this Finance Minister and this government. It is understandable that most Canadians don’t understand the issues with the calculation of the small business deduction. As a tax professional myself, I missed the significance of that measure at the time.

From March to June I am working flat out and simply thought that this was a minor technical adjustment. When I finally came up for air, I realized the significance and have signed up for a one-day professional development course on the subject of this, and other recent measures.

A great deal has been written about the Federal Government’s recent tax fairness proposals. Predictably most of it has been either incomplete, biased, self-serving or simply trivial. How could it be anything else?

The vast majority of politicians and political observers have opinions which they are happy to share with other Canadians. But neither they nor their audience generally has the requisite technical background to understand tax issues. I challenge most Canadians to intelligently discuss the meaning of the theory of tax integration or to describe in one or two paragraphs what the capital dividend account is and what it is meant to accomplish.

The term “tax fairness” rests not only upon a detailed understanding of tax theory, it also relies on a reasonable understanding of who working Canadians are, and what their wages, working conditions and benefits are.

The Liberals’ proposals attempted to deal with perceived advantages enjoyed by a small group of “wealthy Canadians who don’t pay their fair share of taxes”. They have ignored the circumstances of a great many other Canadians. I frankly believe that – like most Canadians – they don’t really understand the make up of our economy.

Most of us simply don’t understand the importance of small business. In BC about 22-24% of those who participate in the workforce, work in organizations with 4 or fewer employees. 

LIMITATIONS OF METHODOLOGY

At the outset I should admit that my analysis is necessarily is somewhat ‘idiosyncratic’. I am a self-employed accountant with very little in the way of time or resources to spend on my analysis. I will therefore rely on credible information that is available to me and can help inform the analysis.For example, as a British Columbian CPA in public practice, I am familiar with an annual publication put out by BC STATS called SMALL BUSINESS PROFILES.

In order to understand the statistical make up of working British Columbians, I rely on this publication. I have used the 2016 version of this publication (based upon 2015 statistical data) in my analysis.

Canadian statistics will be different. I understand that BC has a somewhat higher percentage of people engaged in and employed by small business than does Canada as a whole. In spite of that I will use the BC statistics as a proxy for Canadian statistics.

I will also perform rudimentary assessments about the value of non-taxable benefits such as indexed retirement pensions and health benefits earned by public sector employees. I am not privy to statistical data on public sector wages and benefits and so will perform some rudimentary present value analysis on the potential value of such benefits.

The point of my analysis will be to highlight the importance of such information to any credible study of tax fairness. It should be pointed out that in spite of the limitations in my methodology, I have attempted understand who ‘working Canadians’ really are.

The Federal Government has not really attempted to address tax fairness for all Canadians. Instead they have targeted tax increases for a single group of Canadians based upon an election promise to 39.5% of the electorate. Presumably they don’t believe the targeted group includes many Liberal voters.

UNDERSTANDING WHO WORKING CANADIANS ARE

According to BC STATS (Small Business Profile 2016), 18% of working British Columbians work in the public sector.

The second chart breaks out small business employment between employees and the self-employed. It is interesting to note that there are virtually the same number of self-employed British Columbians as there are public sector employees.

It is also important to understand there is almost a one-to-one relationship between small business owners and their employees. In other words most small businesses are very small (most involve 3 or fewer individuals).

Collectively however they represent the single largest group of workers (45%) in the BC economy. I suspect that this is true in Canada as a whole. It should be noted that BC Stats considers a large business as one which employs 50 or more people. By contrast I understand that Statistics Canada defines a large business as having 100 or more employees. As discussed in the preceding section the percentage of self-employed workers in BC (18%) is likely somewhat higher than the percentage for Canada as a whole.

According to a study by the Fraser Institute, the percentage of public sector workers is higher in the rest of Canada. If the estimates in the Fraser Institute study are correct, the difference is significant. All of which makes it even more important to consider the value of untaxed public sector benefits in any balanced study of “tax fairness”.

THE VALUE OF BENEFITS
It is almost always true that the self-employed – and those who work for small businesses with fewer than 10 employees (88% of all businesses in BC) – simply don’t have company pensions or health benefits.

Some of us have Private Health Service Plans (“PHSPs”) that allow us to pay an administrator a fee to enable business owners to fully deduct medical expenses from income for a fee (generally about 10% of the medical expenses claimed). In this way we can circumvent the miserly personal tax credits allowed for the ‘uninsured’.

While having fully-funded (and indexed) health benefits is a “nice to have”, the value of untaxed public sector pensions makes for a massive difference between the compensation levels of those working in or for small business and those working in the public sector.

I’m not an actuary and don’t have access to data which is readily available to the Finance Department regarding public sector pensions. Accordingly I simply did a quick present value analysis in order to determine the value of a monthly pension of $3,000, indexed to inflation. As of yesterday’s date I tried to determine the appropriate discount rate using interest rates for a $100,000 GIC over a 5 year (locked-in) term. I then subtracted the annual inflation rate resulting in an annual interest rate of 1.11%

The present value of a combination of monthly pension and health benefits of $3,000 for a period of 30 years equates to a tax-free benefit at retirement of $916,922.

Then I simply used the built-in Present Value function in Microsoft Excel for a monthly annuity of $3,000 over 30 years. Of course the actual amount of the monthly benefit will vary depending on the contract,  income level and length of service. For example a $4,000 monthly benefit would be worth $1.22 million at retirement. The present value of a combination of monthly pension and health benefits of $3,000 for a period of 30 years equates to a tax-free benefit at retirement of $916,922.

Note that even at a relatively modest level of benefits, this result is probably worth a great deal more than the value of the maximum Lifetime Capital Gains Exemption available to owners of qualified small business corporation shares. I would point out that most small businesses fail. Only a very tiny percentage ever actually realize the full $800,000 (2014 and indexed thereafter) capital gain. By contrast every public sector worker who retires receives a pension based upon their time in.

In light of this it is interesting that the Federal Government chose not to address their excessive generosity to their own employees who take few if any risks and instead wag the finger of unfairness at those in the private sector who happen to be very successful. While I don’t quarrel with the principle that the wealthiest Canadians should pay more in tax and that wealthy professionals aren’t really ‘entrepreneurs’ taking significant risks, it is clear to me that the current direction of the Federal Government regarding “tax fairness” isn’t fair and seems designed to appeal to their base.

In their haste to paint the “wealthy other” as a politically acceptable bogeyman (they vote conservative after all) they have injured a great many innocent bystanders who will be saddled with increased compliance costs as well as increased taxes. They have also ignored another group who collectively are far more numerous and important to the economy and expect the rest of us “to fund public sector pensions at a level that we can only dream about attaining ourselves?” (in Bill Morneau’s own words).

At a 2013 pension conference, Morneau described defined benefit plans, which are on the “path to extinction” in the private sector, as a “public sector problem.”

He questioned their sustainability, which he argued came down to two “stark” choices. Government can continue to fund “rigid” defined benefit plans, creating labour strife and discord between the sectors and generations, or bring flexibility and consider target benefit plans where the risks of lower fund returns or unexpected longevity are shared.

At the same conference, he posed a question that has unsettled some union leaders about his appointment in Finance.
“Who believes that the average Canadian, without a defined benefit plan, and with the demonstrated capacity to save enough to support their retirement, will, over the long term agree to fund public sector pensions at a level that they can only dream about attaining themselves?”

SOME SIMPLE PROPOSALS

Recognizing that it is often difficult – perhaps impossible – to take away benefits enjoyed by specific  groups without engaging in class warfare, I would suggest that we avoid talking about “loopholes” and instead offer benefits to other groups as a way of addressing some of the inequities in the tax system.

INCOME SPLITTING

Why not offer income splitting to all Canadians couples, thereby eliminating most of the advantage enjoyed by the self-employed? This is done in many other countries.

MEDICAL EXPENSES

Replace the miserly medical expense tax credit system for all Canadians up to the median income level. This will act to level the playing field a little for the self-employed, employees of small businesses and for people on a fixed income.

A NEW CLASS OF CORPORATION FOR INCORPORATED PROFESSIONALS

Eliminate the small business deduction for the incorporated practices of lawyers, doctors and accountants (and engineers?). Leave in place income splitting with spouses – and increase penalties on excessive wages paid to other family members. Eliminate the ability to sprinkle income using multiple classes of shares for these corporations.

CONSIDER INCREASING CORPORATE TAX RATES FOR LARGE BUSINESSES WHO DON’T PAY ADEQUATE WAGES

Expand the concept of differential rates on active business income where corporations pay all (eg. 50 or more arm’s-length) employees at an average of say 25% (i.e. at a prescribed rate) or more above the median wage of all Canadians.

RESCIND CHANGES INTRODUCED IN THE 2016 BUDGET TO THE CALCULATION OF THE SMALL BUSINESS DEDUCTION

The concept of Specified Corporate Income complicates the determination of the small business deduction and is simply not workable.

To the extent that these measures result in decreases in total revenue consider increasing the top marginal rates of tax for high income taxpayers.

 

Do Government Employees Earn More?

According to a study by the Fraser Institute this year, public sector workers in Ontario enjoy a 13.4% compensation advantage over their private sector counterparts.

“Using data on individual workers from January to December 2015, this report estimates the wage differential between the government and private sectors in Ontario. It also evaluates four available non-wage benefits in an attempt to quantify compensation differences between the two sectors. After controlling for such factors as gender, age, marital status, education, tenure, size of firm, type of job, industry, and occupation, Ontario’s government sector workers (from the federal, provincial, and local governments) were found to enjoy a 13.4 percent wage premium, on average, over their private sector counterparts in 2015. When unionization status is factored into the analysis, the wage premium for the government sector declines to 10.3 percent.

The available data on non-wage benefits suggest that the government sector enjoys an advantage over the private sector. For example, 82.1 percent of government workers in Ontario are covered by a registered pension plan, compared to 25.2 percent of private sector workers. Of those covered by a registered pension plan, 97.0 percent of government workers enjoyed a defined benefit pension compared to just under half (45.1 percent) of private sector workers.

In addition, government workers retire earlier than their private sector counterparts—about 1.4 years on average—and are much less likely to lose their jobs (3.2 percent in the private sector versus 0.5 percent in the public sector). Moreover, full-time workers in the government sector lost more work time in 2015 for personal reasons (10.9 days on average) than their private sector counterparts (6.8 days).”

While I often take studies by the Fraser Institute with a grain of salt – in terms of objectivity they’re on a par with those of the Canadian Centre for Policy Alternatives – in this case they probably have a point.

The thing is that public sector workers have much better benefits than those in the private sector. Specifically their pensions are – in the Finance Minister’s own words “are at a level that they (i.e. most Canadians) can only dream about”.

Of course I don’t believe that public sector workers actually believe that they are better paid than their private sector counterparts. The value of their tax-free, indexed pensions are clearly too high. However a young family with kids can’t live on gilt-edged pensions that they will start to enjoy long after their kids are grown.

‘public sector workers don’t actually believe that they are better paid than their private sector counterparts’

In the mean time they won’t be able to afford housing in Canada’s most expensive housing markets. That puts government departments like the Canada Revenue Agency in a difficult position. How do they provide services in high cost markets like Vancouver and Toronto, if they can’t afford ‘competitive wages’ (not including retirement benefits) in those centres?

The simple answer – don’t bother. Instead they will replace skilled people with processes – and do most of their processing in lower cost communities where wages are lower. This means that small businesses will absorb most of the costs of the resulting inefficiencies.