Canada’s Underground Economy

Statistics Canada quietly dropped its annual update of the underground economy in Canada today. I say quietly because even hours after it was released on its Daily, news of it has yet to hit the media in any way. This is a topic that is near and dear to my heart as I cut my teeth as an academic on this topic. My MA thesis was on the Canadian Underground Economy and I co-authored THE book, with the esteemed @DEAGiles, on it as well: Taxes and the Canadian Underground Economy.

The Statistics Canada report estimates the upper bound for the underground economy in 2011 to be $40.9 billion which is equivalent to 2.3% of GDP. According to Statistics Canada, the underground economy in Canada is the smallest in the world and has not changed at all since 2001. Both of these claims are, in a word, laughable.

My own work, which updated the model in my book linked to above, pegged the underground economy to be 15.3% of GDP in 2001. In that year, Statistics Canada estimated the underground economy to be 2.6%. This is quite a gap. I am not the only one estimating the size of the underground economy in this range. Friedrich Schnider, probably the worlds most prolific author of the underground economy, estimates the underground economy in Canada to have been 15.3% in 2003, similar to my own estimate. He further suggests that the underground economy in Canada has shrunk, not staying the same as claimed by Statistics Canada, since then to 11.9% of GDP in 2011. The World Bank estimates that Canada’s underground economy was 15.9% of GDP in 2001, very similar to my own estimate, shrinking to 15.3% by 2007.

We can also compare Statistics Canada’s estimate to those that exist for the comparable countries. Edgar Feige, one of the grandfather’s of academic study of the underground economy, recently pegged the underground economy in the US to be $2 trillion which is equivalent to 15% of GDP. Research for Australia suggests that the underground economy could be as much as 30% of GDP.

Statistics Canada provides no discussion on why their estimate is so much lower than those produced by a multitude of independent academics the world over and they never have and that its estimates of the change of the underground economy does not reflect those produced by others. Given all the policy changes in Canada along with increased enforcement by CRA, Statistics Canada is suggesting that the Canadian Underground Economy does not respond to any of the normal policy changes suggested by academic research.

Let’s consider just one input factor into Statistics Canada’s estimate: undeclared tips. Statistic Canada estimates undeclared tips to amount to as much as $1.7 billion yet CRA estimates peg undeclared tips to be as much as $6 billion. I trust CRAs evidence far more than Statistics Canada on this front.

It is time for Statistics Canada to respond to criticisms of its estimate of the Canadian underground economy. It needs to address why its estimates do not accord with existing evidence, including evidence from CRA as well as from academics around the world. They also need to address their claim that the underground economy in Canada is static to policy changes that have been introduced by our government specifically to curtail the underground economy. Academic evidence shows we have had success in shrinking our underground economy and this disconnect in Statistics Canada’s work is shocking.

Believe it or not: Tax Edition

Back in the 80s there was this show on TV called Ripley’s Believe it or Not that dealt “in bizarre events and items so strange and unusual that readers might question the claims.” This blog post is in the spirit of that show.

Anyone who works in the field of tax policy or expenditures must have a good understanding of constitutional authorities. This is because the powers to tax and spend are outlined in the constitution. While most people think they understand this division of powers, they actually don’t. In this blog post I am going to fundamentally shake your understanding of the Constitution Act. I am going to tell you that, despite the message from Constitutional scholars, provinces do in fact have the power of indirect taxation. Yup, I said it. Provinces can charge indirect taxes. Don’t believe me? Then read this post.

The Constitution Act, 1867 sets out the division of powers between the federal and provincial governments in sections 91 and 92, respectfully. The federal and provincial governments are only able to pass laws on the matters for which they are given authority. If a law is outside of the jurisdiction of a government, that is, the government is not given constitutional authorization to govern in that area, it is ultra vires; if it is within the jurisdiction of a government it is intra vires.

The broadest revenue raising powers are provided to the federal government. The relevant provision in the Constitution Act that explains the federal government’s revenue generation authority is s 91(3), which reads,

 s 91. […] it is hereby declared that (notwithstanding anything in this Act) the exclusive Legislative Authority of the Parliament of Canada extends to all Matters coming within the Classes of Subjects next                hereinafter enumerated; that is to say,

(3) The raising of Money by any Mode or System of Taxation.

Section 91(3) has been interpreted to mean that the federal government can pass both direct and indirect taxes.

The revenue raising powers of provinces are more limited than those of the federal government. Section 92(2) governs the raising of revenue in a province. This section reads,

(2) Direct Taxation within the Province in order to the raising of a Revenue for Provincial Purposes.

Section 92(2) has been interpreted to include the legislative power to impose a “fee or charge”, meaning that s 92(2) provides the provincial authority for the charging of both direct taxes and user fees.

And that is where most people stop and conclude that the provinces can only charge direct taxes. This conclusion though ignores section 92(9) which authorizes licences and has been found to also provide for the levying of fees in relation to those licences. This begs the question that if license fees are direct taxes, why would they need to be listed separately from section 92(2)?

This point is taken up in Lawson. The court in Lawson held that the jurisdiction of the provincial government, which is limited in the Constitution Act, s. 92(2) to impose direct taxes, does not carry over to s. 92(9) with respect to licence fees. That is, while many think that according to the Constitution Act, s. 91(3), only the federal government can charge indirect taxes, the Court in Lawson implied that licence fees may be charged as indirect taxes. Specifically, the Court said

“The question has never yet been decided whether or not the revenue contemplated by this head can in any circumstances be raised by a fee which operates in such a manner as to take it out of the scope of ‘direct  taxation’ Prima facie, it would appear, from inspection of the language of the two several heads, that the taxes contemplated by no. 9 are not confined to taxes of the same character as those authorized by no. 2, and that accordingly imposts which would properly be classed under the general description ‘indirect taxation’ are not for that reason alone excluded from those which may be exacted under head 9. On the other hand, the last mentioned head authorizes licences for the purpose of raising a revenue, and does not, I think, contemplate licences which, in their primary function, are instrumentalities for the control of trade—even local or provincial trade. Here, such is the primary purpose of the legislation. The imposition of these levies is merely ancillary, having for its object the creation of a fund to defray the expenses of working the machinery of the substantive scheme for the regulation.

This point is expounded on in the subsequent decision in Allard Contractors Ltd v. Coquitlam (District) [Allard Contractors]. The SCC  succinctly stated in Allard Contractors that there are limitations on the amount that may be recovered by licence fees, “[w]hile Lawson […] gave a reading to s. 92(9) which opened up the possibility for indirect taxation within that section, it did so in the context of language suggesting that the possibility would be limited to the recoupment of regulatory expenses.” In essence, Lawson has been interpreted to mean that licence fees may be charged for both direct and indirect taxes, but the amount of the fee is limited to the costs of regulation. However, because provinces have authority to charge any form of direct tax, the licence fee exemption is only relevant where a levy has been found to be an indirect tax and must be saved. The levy can be found valid if it is a licence fee.

In summary, the federal government has unrestricted powers to charge any form of levy it chooses, including direct and indirect taxes as well as user fees. Provincial governments are limited to direct taxes and licence fees, as provided for in the Constitution Act. License fees can be either direct and indirect taxes. Hence, provinces can charge indirect taxes if they are found to be licence fees. Believe it or not!

Implementation Issues with a Guaranteed Annual Income

On Wed, January 15th there was a Twitter discussion about the idea of a basic income supplement with economists Stephen Gordon (Laval), Kevin Milligan (UBC), Mike Moffatt (Ivey) and myself facilitated by the twitter account, @bis_pilot. To kick off that discussion, I had a blog post that provided some background on the concept. The main items of the twitter discussion itself are featured in this storify and the full discussion can be read by searching #bispilot on Twitter. I would like to follow up on this discussion with some more fulsome thoughts on some key issues.

As an economist working in a School of Public Administration I have now been well schooled by my public admin colleagues about the importance of implementation. Before moving to the School, I was your typical economist who did not consider such issues. But now implementation is so important to me that it has spurred a whole research agenda. Implementation is the reason why good policy ideas fail (e.g. HST, congestion charges, tax reform). Implementation has been dubbed the ‘missing link’ of policy analysis yet this is what transforms a policy idea into successful delivery. Implementation is not just what happens after an idea or policy design, implementation overshadows policy from an embryonic idea all the way through to evaluation.

With my implementation hat on, what are some key things that really need to be outlined as part of this BIS proposal?

1. Objectives: What objective(s) or goal(s) is/are to be achieved by the policy? What exact problem is the policy attempting to resolve? Objectives outline the desired result to be achieved and give a sense of direction by providing guidelines for activities. Proponents need to be clear about why they are advocating a BIS and to reflect this in clear and transparent objectives.  The primary objective(s) need to be paramount during design and implementation and communicated to the public to make sure they fully understand what is being proposed. There are two caveats to this. First, too many objectives and the policy becomes confused. Second, lots of people agree with an idea because they insert their own objectives into it. Their objectives, however, may not be yours. A lot of mistrust and confusion can arise when objectives are not stated in advance of implementation.

How much a BIS might cost is very dependent on setting out these objectives. Typically, the objectives of a BIS is to help lift at risk groups out of poverty. This requires us to agree on a definition of poverty, who are poor, and to what level to lift them. Do you target only the working poor or all poor? What about those on reserves? What about kids? What about the homeless? What about regional differences? How fair is it to provide $18k to everyone when the costs to live vary by regions and family conditions? Lots of questions need to be answered in order to be able to operationalize this objective.

2. Jurisdiction: Once it has been determined that BIS is the preferred policy instrument for the identified policy problem, the next step is to consider jurisdictional authorities. A BIS either needs to work  in conjunction with or replace our existing social assistance and tax benefit programs. Such programs are delivered by NGOs, municipalities, provinces, and the federal government. Any structure would need to have unprecedented cooperation between all these players. While many people point to the fed-prov agreements for delivering child income support, I would like to point out that these agreements have not done much to reduce child poverty in Canada. In addition, if the notion of  a BIS is delivered as a Negative Income Tax (NIT) by a province rather than Ottawa, than all due respect must be paid to the tax collection agreements.

The key considerations of cost and size of benefit is dependent on knowing how the BIS would work with our existing programs and tax system. It is also key to understanding where the funding for a BIS might come from.

3. Tax considerations: The BIS being advocated is that which takes the form of a Negative Income Tax (NIT). The advantage of delivery the program through the tax system is that it avoids the social stigma that many of our social programs have. In addition, it would force people to file a tax return in order to benefit. But in that lies the rub. For many, particularly the poor, having the knowledge and the trust to fill out a tax return is no small hurdle to over come. It makes me wonder what companion policies need to go hand in hand with the BIS? An expansion of the CVITP? Perhaps even pre-populated tax forms?

We also need to think about what incentive the BIS would have on our old nemesis, tax evasion. The BIS creates very real incentives for those with the ability to under-report their income to maximize their BIS payment. Consider even just those with tip income or those with self-employment income. Tax evasion in the presence of a BIS creates real distortions and challenges with achieving the stated objectives yet overcoming tax evasion is not easy.

The last tax item I will consider for this blog post is those who earn income from non traditional sources like personal corporations and windfalls. WRT to personal corporations these individuals can choose how much they pay themselves and how to pay themselves. How would dividends and other payments factor into the calculation of the BIS? Further, many of these individuals can choose to leave their money in the corporation, extracting it only from the share sale of the business which, low and behold, is tax free assuming a CCPC structure. These individuals can benefit both from the BIS and from the income earned from the corporation. How do you deal with these very real realities of our existing tax system?

In Canada, windfall gains (also prescribed prizes which will be a topic of a future blog post) are not considered income. A windfall gain is a type of payment that is unexpected or unplanned and usually does not recur, such as a lottery. So someone could win a lottery or take home the pot from gambling and still get the BIS unless we explicitly change our treatment of this gain such that it is reported, and perhaps even taxed. But again, this requires tax reform for which there seems to be little political appetite.

These are just some of my concerns, not with the idea of a BIS, but with the implementation of a BIS. You cannot implement a BIS without breaking some eggs and changing a lot of other policies. Other concerns were raised during our discussion like cost, benefit levels, affordability, labour market attachment, and revenue sources. Settling these and other issues matter a great deal for my acceptance of any particular proposed program.  I worry that the good folk pushing the Basic Income System (BIS) do not fully understand that by leaving “such details to the experts” the idea is likely to once again not get off the ground. After all, the devil is indeed in the details.

Guaranteed Annual Income

On Wed, January 15th at 8pm EST there will be a Twitter discussion about the idea of a basic income supplement with economists Stephen Gordon (Laval), Kevin Milligan (UBC), Mike Moffatt (Ivey) and myself facilitated by the twitter account, @bis_pilot. To kick off that discussion, this blog post will provide some background information on this policy idea.

A basic income supplement, better known as a Guaranteed Annual Income (GAI), provides a floor level of income, usually set to a level to alleviate poverty. There are two forms of a GAI: Negative Income Tax (NIT) and Universal Demogrant (UD). The NIT involves the payment of money to those earning below a specified level, no taxes paid by those above that but below another threshold, and finally those earning above the second threshold pay tax on that income above the threshold. The UD is instead a non-taxable transfer to all citizens. The NIT is the more popular version of the GAI, especially among economists, probably because it is more targeted to the poor and far less costly than a UD.

A GAI is not a new idea by an means. As far as I can tell, it dates back to 18th century England and the Speenhamland system, which was intended to mitigate rural poverty, and later became the Elizabethan Poor Law. This law set a basic income floor that was scaled to the price of bread needed to sustain a given family size

In modern times, Milton Friedman brought the notion of a GAI back to the policy agenda with his argument for a negative income tax (NIT). His work spurned a series of NIT experiments in the US between 1968 and 1979. The first was the New Jersey Income Maintenance Experiment that included just under 1400 families. This was followed by the Rural Income Maintenance Experiments in Iowa and North Carolina. Two others took place in Gary, Indiana as well as Seattle and Denver. This last one was in operation until 1982. The main findings of the experiments was that there did exist a work disincentive.

The idea of a GAI is not at all new in Canada either. In 1974, we ran the Mincome pilot in Manitoba. This was a collaboration between the federal government and the province on a pilot program to assess the affect of a GAI on work incentives. It was a 3-year pilot that included 1300 families and had 3 different GAI levels. The key finding was that work disincentives were modest, especially compared with the data from the US: there was some reduction in work hours, but predominantly among female breadwinners with young children. This demonstrates the need to not rely on American evidence of policy matter and collect our own evidence regarding policy implications (similar to that regarding minimum wage).

Not only did Canada run that avant garde experiment but it comes as a surprise to many Canadians that we actually have many GAI like program. Many of our current programs are a form of GAI, including the OAS, GIS, CPP, CCTB, EI, and social assistance.

The GAI has been advocated by many in recent years, including Senator Hugh Segal. Many argue it is a preferred policy to minimum wage or in-kind transfers as it gives money to those most in need and does not rely on private businesses to deliver on social policy. Canada has had great success with using GAI policies to dramatically reduce senior poverty. Such policies could be used to do that same for child poverty, which has not seen any decline over the same period.

The are two main criticisms of the GAI. The first involves the work disincentives, but the evidence is mixed on this feature and depends on the implementation of the GAI. The second is the cost. GAI can be costly, especially if the UD form of GAI is chosen. If instead, existing programs are consolidated and it is implemented as a form of NIT, then the cost is much lower. The cost could also come from eliminating many of our boutique tax credits that disproportionally benefit the rich, as I have written about before.

If this is a topic that is of interest to you, join our discussion on Wednesday and see what it is all about.

Stupid tax policy, mining edition

Section 66(1) of the Income Tax Act allows principal business corporations (certain corporations in the mining, oil and gas, and renewable energy and energy conservation sectors) to fully deduct exploration and pre-development expenses incurred in Canada from its income in the year the expenses were incurred.

Many corporations with exploration and development expenses, however, are in a non-taxable position in a given tax year and are unable to deduct these expenses.  Whilst unused exploration and pre-development expenses can be carried forward indefinitely, qualifying corporations can also choose to transfer these deductions to flow-through-share (FTS) investors.

FTSs are attractive to corporations that have difficulty raising capital to finance exploration and pre-development activities, notably junior resource corporations, which have little prospect of generating revenue in the foreseeable future, and which will go out of businesses and not be able to use the deductions without FTS investments. They are also attractive to investors as they are permitted to fully deduct the cost of their FTSs from their income: the deduction is worth more to an individual than to a corporation since personal income tax rates are notably higher than corporate tax rates.

While FTSs are not a recent addition to the Canadian tax regime, the super flow-through-share (SFTS) is. In the 2000 Economic Statement and Budget Update (Finance Canada 2000), the Government of Canada announced the non-refundable Investment Tax Credit for Exploration (ITCE).  It was intended to be temporary (expiring at the end of 2003) 15% investment tax credit for investors in flow-through shares of mineral exploration companies. The impetus for the SFTS was the low price of metals that occurred throughout the 1990s and which caused a significant contraction in mineral exploration. While metal prices rebounded to historical highs by the mid 2000s, the tax credit was renewed for additional one year periods.  It was re-instated in 2006 as the Mineral Exploration Tax Credit (METC) which was set to expire March 31, 2009 but subsequent budgets have extended the credit for one year periods and is currently set to expire March 31, 2014. Many provinces also have comparable programs.

It is useful to provide an example of how FTSs in general and the tax credit specifically benefit the investor.  Mary is an investor located in BC who earns $150,000 a year and is taxed at the highest rate both federally (29%) and the second highest provincially (14.7%).

She decides to invest $10,000 in a mining exploration company though the purchase of FTS. In the tax year in which she makes the purchase, she is able to deduct the $10,000 from her income.  Had she not made the purchase, she would have paid $2,900 in federal taxes and $1,470 in provincial taxes on the $10,000.  As a result of the deduction, Mary saved $4,370 in income taxes making the cost of the investment to Mary only $5,630.

Since Mary invested in a mining exploration company, she is also eligible for provincial and federal tax credits.  The value of the BC tax credit is 20% or $2,000.  The federal METC is 15% but is calculated on the value of the investment minus any provincial tax credit.  In Mary’s case it is calculated on $8,000 for a federal tax credit worth $1,200. Because the tax credits are in effect a grant, the value of the federal and provincial tax credit is subject to income tax, resulting in Mary incurring a tax liability of $1,390. In total, Mary garners a tax benefit of $6,180. Of the $10,000 initial investment, Mary shoulders $3,820 (38.2%) of the cost while taxpayers bear $6,180 (61.8%) of the cost of the investment.

In order for Mary to break even (ignoring inflation and other time costs of money), she only needs to sell the $10,000 investment for $4,888.03 (the adjusted cost basis of the shares is zero). If she sells for this amount, she will only pay $1,068.03 in capital gains taxes, leaving Mary with the initial after-tax cost of the investment ($3,820). In this scenario, the taxpayer is left with a $5,111.97 deficit. Because Mary sold at a value less than her original investment, this implies that the company’s stock price decreased and it can be assumed that they did not find any mineral deposits of value implying no additional corporate taxes to make up the difference.

In fact, in order for the taxpayer to break even (assuming no additional corporate taxes), Mary would have to sell the shares for $28,283.75 which represents an unlikely 182% return on her (and the taxpayers) investment. Clearly, the tax regime for FTS is preferential even without the METC and one has to wonder how much additional influence the tax credit has had on investment in mining FTS.

There is evidence to indicate that the investments in mining FTS is predominately done for tax planning reasons as demand for these products increases at the end of the calendar year. They are also actively marketed to investors who are looking for last-minute tax deductions. An unintended cost of the SFTS regime is that it is likely shifting investment dollars away from other, less risky, and unsubsidized investments.

The Prospectors & Developers Association of Canada credits the METC as contributing significantly to mineral exploration activity and new mineral discoveries in Canada. In particular: increasing exploration expenditures from approximately $300 million in the late 1990s to an estimated $3.9 billion in2012, well in excess of the lows seen in the late 1990s. If one examines exploration expenditures along with the Metal Price Index (MPI) one see a high correlation between expenditures and metal prices and it is likely that the true driving force behind the expansion was the increase in metal prices.

In terms of the value of the deposits found, the value has increased, however, most of this increase is due solely to the rise in prices. This indicates that the increase in exploration is not paying off in terms of an increase in the value of located deposits.

There is little evidence that the METC and their related provincial counterparts induces increased exploration activity over that stimulated by commodity prices. On the investor side, the METC subsidizes high risk investments and appears to be predominately used for tax planning purposes by high income taxpayers rather than for calculated investment purposes. On the administration side, the FTS regime is associated with high administrative and compliance costs and most of the benefits accrue to tax lawyers and accountants.

Many low and middle income tax payers are themselves unable to benefit from deductions yet there is no corresponding ability for them to flow through their deductions to other.It is time to end these tax credits that benefit only wealthy investors and restore fairness to our tax system.

My Name is Earl, tax edition

My Name is Earl was a show I liked to watch from time to time. Episode 17 of season 1 was one of my favourites, because Earl Hickey made a transformation that I wish many people would make. The episode is called Didn’t Pay my Taxes.

The episode starts with Earl realizing that he needed to add “cheated the government” to his list. That he needed to pay the government the taxes he owes them. Randy says “What for? Government doesn’t do anything for us….” The episode revolves around Earl’s many attempts to pay his taxes only to be confronted by rules and bureaucratic red tape. In essence, the government did not have a record of him owing taxes so they would not accept his payment.

Earl decides that to pay the money back, he will incur a fine for trespassing that accords with the amount he owes in taxes. That way there is a record of his debt and the government will take his money. As a result of his trespassing, Earl and Randy get stuck in an abandoned water tower. Earl blames the government for him and Randy getting stuck in the tower

“Stupid government. They think I’m bad. They’re the ones who are bad, Randy. The tax woman who wouldn’t take my money. The cop who wouldn’t let me fix the pothole. The guard who threw me in solitary. I never want to pay them back. Screw the government. They never did anything for us”.

But just then a voice shouts into the tower “Hello you guys alright down there?”

It turned out the government had been busy doing something for them but they just did not know it. Willie the mailman brought Joy a letter saying Earl’s car was towed to the impound yard. Then when Joy came to the motel to yell at Earl for not changing his address, Catalina saw that Earl’s car had been impounded. She got worried because she hadn’t seen Earl and Randy for days. So she reported it to a police man. He went and filed a missing persons report then went down the impound yard to investigate. When the police found where Earl’s car had been towed from, they got suspicious and called a city worker to come unlock the gate. And when the city worker saw that Earl’s and Randy’s ropes were tied to the top of the tower they called the fire department for help.

And that’s when Earl realized that maybe the government doesn’t always see people as bad or good. Sometimes it just sees people that need help. And even if you don’t see the government working for you every day, it is  out there working for somebody. And that day that somebody was Earl and Randy.

Earl happily paid the $500 fine for trespassing but then learned it cost the government $4000 to rescue him. He tried to pay them, but the government would not take the money. Earl says “Turns out being saved by the government is free to taxpayers. Taxpayers like me”.

My point here is that tax evasion means you are stealing, you are getting stuff for free. From running water, to roads, even peace, order, and good government. Your tax money goes to things you use, things you might need to use even though you might not think it, and things other people desperately need and from which we all benefit.

Yes, some of our hard earned money is wasted by those in the legislature and parliament. That is not sufficient reason to engage in tax evasion. Tax evasion is illegal and the penalties for doing so are rightfully high and may even include prison time. Consider the case of Ty Warner, who plead guilty to hiding more than $100M in an offshore account. He paid a $53M penalty and at least $16M in back taxes and interest. In addition, he now now faces 57 months in jail, but is begging the judge to not put him behind bars, believing he should be let off easy because he paid back the taxes owed and because he had ‘a rough childhood’. I believe many people currently in prison could argue the same. I have no sympathy for Ty Warner and other evaders and neither should you.

GAAR me maties Part II

GAAR me maties. Prepare to be audited!

Part I of this series on GAAR introduced GAAR as part of an indicator of the complexity of our tax system. As a reminder, GAAR is about perceived misuses or abuse of the tax system. I use the word perceived because it is all about someone using the provisions of the tax law but doing so in what CRA determines is an abusive manner.

GAAR has been one of the key drivers of tax litigation in Canada in recent years. All proposed assessments that invoke GAAR must be reviewed first by the GAAR committee. The GAAR committee is comprised of members of the Income Tax Ruling, Legislative Policy, and Tax Avoidance units at CRA as well as tax lawyers and members of the Tax Policy Division at the Department of Finance. In 2011-2012, 83 new cases were referred to the committee, which concluded that GAAR applied to a whopping 80 (96%) of those cases. Over its lifetime, the Committee has reviewed nearly 1100 cases with a ‘success’ rate (those cases they decided that GAAR did apply) of 76%. The increase in the success rate in recent years could be due to the Committee being more aggressive with GAAR’s application, CRA being better at deciding when GAAR should apply, or tax payers becoming more aggressive with tax avoidance maneuvers. I think it is more likely a combination of all three of these.

According to this report by KPMG, the biggest incidence of GAAR cases involve surplus or dividend stripping. Surplus stripping is a long used method of extracting retained earnings and profits from a corporation other than in the form of dividends. The Canadian Tax Journal has an excellent article on this method for those interested in more information.

This is followed closely by loss creation via a stock dividend. This technique is well discussed in this paper by McCarthy Tetrault. The very short summary of this is that A Co creates B Co. Then A Co transfers assets into B Co in exchange for divided paying shares. B Co then sells those assets and with the proceeds pays a dividend to A Co. A Co then sells B Co to someone else for a capital loss. A Co not only gets the dividend but also a tax loss for having sold something for a loss.

The third most common application of GAAR is the kiddie tax. This was a very popular way to income split in the 1990s but not so much now, since section 120.4 of the ITA was added which closed this ‘loophole’. In this scheme, a business owner issues dividend paying shares to his/her children. Since the children have little or no income and can use their basic personal and dividend tax credits , the dividends are essentially tax free. The dividend stream would then be used to pay for the kids expenses (like private school).

Despite these crackdowns, there is still some skepticism with GAAR. GAAR is great at cracking down on these known loopholes, but what it is not good at is seeing these ‘loopholes’ before they become well known. That is, it takes years for new and novel abusive tax schemes to get on CRAs radar and even more years before moving onto GAARs radar. The more you are operating on the cutting edge of tax avoidance, the more likely you will get away with it.