Canada’s approach to tax rates: a comparison to U.S.
In this presidential campaign, we have heard the phrases “the 47 percent” and “effective tax rate of 14 percent.” The former is the percentage of U.S. individuals who reportedly do not pay any federal individual income tax, and the latter is the effective rate of tax that Republican presidential candidate Mitt Romney reportedly pays in federal income taxes.
These numbers have been used and twisted in many ways by both the media and candidates. The reality of the situation is that the U.S. tax system is continually updated, amended and revised. As a result, it is never exactly the same from one year to the next. This leads to confusion among taxpayers and difficulties in advisers and the government in understanding and interpreting the rules.
The fiscal cliff is looming and the sunset in certain Bush-era tax cuts will cause a dramatic rise in some tax rates. There is concern the country may drive over the edge of the cliff. If nothing is done to change tax rates, the top individual federal tax rates for ordinary income in 2013 will be 43.4 percent (with the Medicare investment tax added into the total). A compromise may be crafted in the coming months, just as in 2010.
A reminder: The president signed on to the 15 percent rate for capital gains and dividends and the extension of the other Bush-era tax cuts, and now that very tax rate has become a campaign issue. The campaign discussion may actually lead to a larger effort of a general tax reform.
The last major overhaul of Internal Revenue Code (including tax rates and deductions) was in 1986. The top individual tax rate was dropped from 50 percent to 28 percent and the top corporate rate from 46 to 34 percent. Capital gains rates were subject to tax at the same rate of tax as ordinary income.
In 1986, when these changes were enacted, U.S. tax rates were lower than almost all of our major trading partners. How times have changed. Today, the U.S. has some of the highest corporate tax rates of any major economy. Tax policy is a combination of social policy, economic policy and revenue generation. Many countries have adopted competitive tax rates in their tax codes to encourage companies to conduct business in their specific jurisdictions.
With the tax discussions in the presidential debates and on the campaign trail, I have reflected on what other countries are doing. I do a good share of cross-border tax work with businesses going into Canada from the U.S. and from Canada coming into the U.S. I am a member of the U.S.-Canada tax desk for my firm. I am by no means an expert in Canadian taxation, though I do have some working knowledge of many aspects of its tax system. I thought it might prove worthwhile to look at Canada’s tax rates and whether the U.S. is significantly different with respect to its approach to corporate and individual tax rates.
Canadian corporate income tax rates, once in excess of U.S. corporate income tax rates, are now significantly lower than U.S. rates. The U.S. federal corporate tax rate is 35 percent, and state tax rates can easily add 5 or more points to that rate, with the resulting combined effective tax rate approaching or exceeding 40 percent. In Canada, the federal corporate income tax rate is 15 percent, with provincial taxes adding another 10 or 11 points for a 25 or 26 percent tax rate.
Some of the recent tax debate has been over the rate of tax on dividend and capital gains income. The issue is whether the 15 percent rate allows higher-income taxpayers to not pay their fair share of tax.
Canada has a preferential tax rate for capital gains earned by individuals and corporations. The effective tax rate on such income is half the tax on income and is obtained by excluding 50 percent of the gain from taxation. For corporations, this results in an effective tax rate on gains of about 13 percent, and for individuals the top capital gains rate is 23 percent. In addition, individuals are allowed an exclusion of $750,000 for gains on sales of Canadian private small business company shares. For husband and a wife, this results in a total of $1,500,000 of excluded gains on private company shares sales and a 23 percent rate on all other capital gains. The current 15 percent rate is certainly lower than the Canadian rate, though the lifetime exemption may provide a greater benefit to those Canadians operating a small business in Canada.
Canada, like many other countries (including Australia or the U.K.), subjects dividend income to a lower tax or allows a portion of the corporate taxes as a credit against the individual’s income taxes. The reduced rate of tax only applies to certain dividends from Canadian-based companies. This differs from the U.S. rules that allow for the 15 percent tax rate on dividends from U.S. publicly traded foreign shares and foreign company shares located in countries where the U.S. has a tax treaty. Thus, the tax benefit in Canada is not extended to foreign shares.
The Canadian system essentially reduces the individual tax rate on dividends by granting a tax credit for a portion of the Canadian corporate tax paid by the Canadian dividend-paying corporation. Since a dividend is a return of after-tax corporate income, the Canadian system grosses up the dividend for the amount of corporate tax paid, and a significant portion of that additional divided amount for taxes is allowed as a tax credit against the Canadian income tax on the grossed up dividend. The resulting effective tax rate on eligible dividend income is reduced by nearly one-third. For those in Canada at the top marginal tax rate of 46 percent, the dividend tax rate is approximately 29 percent.
It should be noted that Canada also has its version of a value-added tax or VAT in the PST, HST, GST and QST levies (all depending on which province one resides in). The imposition of this tax may allow for some lower rates against certain types of income as noted earlier. The U.S. has state sales taxes, but, to date, there is no U.S. federal sales tax or value-added tax.
My final observation is the final tax — the death tax. Canada does not have a specific death or estate tax. It does, however, have a tax on the disposition of assets that subjects any assets of a decedent to the capital gains tax rate on any unrealized gains at death. The rate of tax is significantly lower than the top U.S. estate tax rate. However, the current (2012) U.S. lifetime estate exemption may equal the playing field at its current $5M amount, although the sunset of this exemption after 2012 and its reset to $1M if no extension is enacted may give the Canadian system an edge.
Setting the precise rate of tax on different types of income may be more of an art than science. This can be influenced by many factors. It is clear, by looking at our neighbors, that others have taken similar approaches in taxing capital gains and dividends at preferential tax rates.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed above are those of the author and are not necessarily those of BDO. The comments are general in nature and not to be considered specific tax or accounting advice.