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A new study, called Private Companies, Professionals and Income Splitting, says a mid-range estimate on the the loss to government coffers is about $500-million based on 2011 tax dataMackon/Getty Images

Some of Canada's highest-earning professionals have been reaping large tax gains for decades by splitting income with their spouses using private corporations, but the practice has fallen into a "dark corner" of tax rules and has received little government scrutiny, according to a new academic study.

A paper co-authored by University of Ottawa Professor Michael Wolfson, one of Canada's top researchers on income and equality issues, said there was much debate of Ottawa's new program this year allowing some income splitting for couples with children, but most people don't realize income splitting has long existed for thousands of professionals such as doctors and lawyers who have been able to funnel their incomes through private companies they create to hold their income.

"Over in this dark corner of the tax system that most people don't know exists and most people don't understand how it works, income splitting has been going on for decades," Prof. Wolfson said in an interview. "But nobody shines a light on it, nobody asks what's going on here."

Income splitting allows people to transfer income to lower-paid spouses to reduce income tax payments.

The new report examines tax filer data and estimates governments are losing hundreds of millions of dollars a year in revenue from strategies used by owners of private companies to shift income to their lower-earning spouses and adult children who live at the same address. Prof. Wolfson says a mid-range estimate of the cost is about $500-million based on 2011 tax data.

"Here we have quite a substantial reduction – for round figures, I'd say in the half billion dollar range – and a bunch of money going out that Parliament never looks at it, and it never gets evaluated," he said.

A majority of private companies – known as Canadian-controlled private corporations (CCPCs) – are created by people in top income brackets to hold a private business. CCPCs can be created by owners of stores, restaurants, farms or other typical small businesses, but they can also be used by doctors, lawyers and some other professionals as a way to incorporate their business activities.

To split income from CCPCs, money is paid out by the company either as salaries or dividends to family members who are in a lower tax bracket. Prof. Wolfson said salaries may be legitimate for family members who work in a business, but they are sometimes over-inflated as an income splitting strategy.

Even when salaries and dividend payments are legitimate, Prof. Wolfson said his research suggests the costs to the tax system have never been calculated and the impact should be understood and analyzed.

He said both the Conservatives and NDP are proposing to lower the tax for small-business owners in the future, but said they should understand that this would benefit many well-paid professionals who use small private companies to incorporate their operations, which may not be the intent of their tax proposals.

The new research paper follows on a report last year co-authored by Prof. Wolfson and two other researchers, who concluded many of Canada's wealthiest people are funnelling a large portion of their income through CCPCs that are not reflected in standard measures of individual earnings.

Prof. Wolfson and co-author Scott Legree of the University of Waterloo have now completed a new report, called Private Companies, Professionals and Income Splitting, to consider how much income is flowing from CCPCs to spouses or adult children who are living at the same address as the company owner, which could indicate a tax-reduction strategy by splitting income with lower-earning family members.

The researchers calculated a range of tax revenue losses depending on different scenarios, including assumptions that different proportions of the wages paid to family members were possibly overstated and were not earned. They also considered the revenue losses under a range of scenarios depending on how much lower the tax rate is for spouses or children who receive income and dividends compared to the company owner.

At the low end, the loss to government coffers is estimated at $72-million in 2011, which assumes most of the salaries paid to family members were legitimately earned, and the family members' tax rates were almost the same as the company owner. At the high end, the tax loss is estimated at $1.7-billion, which assumes 50 per cent of the salary income was not earned for real work performed, and the family member had a 15-per-cent-lower marginal tax rate than the company owner.

Prof. Wolfson said there are a range of public-policy options to address the possibility that the CCPC structure is being used to reduce income tax bills for professionals.

One option, he said, is that governments could limit which sorts of professionals should be allowed to use CCPCs, saying it raises questions of fairness when most high-earning Canadians have to pay income tax rates of 45 to 50 per cent of income, while a small number are allowed to create CCPCs and pay far lower tax rates if the income qualifies for the small-business tax deduction, which is applied at a 15-per-cent tax rate.

The Ontario government changed tax rules in 2005 to allow physicians to issue non-voting shares to family members of physician professional corporations, which means doctors were allowed to begin paying dividends to spouses from their CCPC income, essentially splitting the income between both taxpayers.

The report shows the number of physician-owned CCPCs in Ontario climbed steeply from about 2,000 in 2005 to more than 16,000 by 2011, while there was no similar growth in any other provinces. The report said the data suggests the Ontario rule change spurred the growth because doctors saw a tax advantage to paying dividends to family members.