Tax Expenditures and Evaluations 2008 : 1
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Preface

Since 2000, the tax expenditure report has been separated into two documents. This document, Tax Expenditures and Evaluations, is published on an annual basis. It provides estimates and projections for broadly defined tax expenditures as well as evaluations and descriptive papers addressing specific tax measures. This year's edition includes an analytical paper entitled "Considerations in Setting Canada's Corporate Income Tax Rate."

The companion document, Tax Expenditures: Notes to the Estimates/Projections, was published in 2004. It is a reference document for readers who wish to know more about how the estimates and projections are calculated and who want descriptions of, or information on the objectives of, particular tax expenditures. New tax expenditures are described in the relevant section of this document.

Part 1
Tax Expenditures:
Estimates and Projections

Introduction

The principal function of the tax system is to raise the revenues necessary to fund government expenditures that reflect society's priorities. The tax system can also be used directly to achieve public policy objectives through the application of special tax rates, exemptions, deductions, rebates, deferrals and credits that affect the level and distribution of tax. These measures are often described as "tax expenditures" because they achieve policy objectives at the cost of lower tax revenue.

To identify and estimate tax expenditures, it is necessary to establish a "benchmark" tax structure that applies the relevant tax rates to a broadly defined tax base—e.g. personal income, business income or consumption. Tax expenditures are then defined as deviations from this benchmark. Reasonable differences of opinion exist about what should be considered a normal part of the tax system and hence about what should be considered a tax expenditure. For example, a deduction for expenses incurred in earning income is generally considered part of the benchmark and thus not as a tax expenditure. But in some cases the deduction may confer some personal benefit, making its classification ambiguous.

This report takes a broad approach and includes estimates and projections of the revenue loss associated with all but the most fundamental structural elements of the tax system, such as the progressive personal income tax rate structure. This includes not only measures that may reasonably be regarded as tax expenditures but also other measures that may be considered part of the benchmark tax system. The latter are listed separately under "memorandum items." For instance, the dividend tax credit is listed under this heading because its purpose is to reduce or eliminate the double taxation of income earned by corporations and distributed to individuals through dividends. Also included under this heading are measures for which there may be some debate over whether they should be considered tax expenditures, or where data limitations do not permit a separation of the tax expenditure and benchmark components of the measure. This approach provides information on a full range of measures.

Caveats

Care must be taken in interpreting the estimates and projections of tax expenditures in the tables for the following reasons.

• The estimates and projections are intended to indicate the potential revenue gain that would be realized by removing individual tax measures. They are developed assuming that the underlying tax base would not be affected by removal of the measure. However, this is an assumption that is unlikely to be true in practice as the behaviour of beneficiaries of tax expenditures, overall economic activity and other government policies could change along with the specific tax provision.
• The cost of each tax measure is determined separately, assuming that all other tax provisions remain unchanged. Many of the tax expenditures do, however, interact with each other such that the impact of several tax provisions at once cannot generally be calculated by adding up the estimates and projections for each provision.
• The federal and provincial income tax systems interact with each other to varying degrees. As a result, changes to tax expenditures in the federal system may have consequences for provincial tax revenues. In this publication, however, any such provincial effects are not taken into account—that is, the tax expenditure estimates and projections address strictly the federal tax system and federal tax revenue.
• The tax expenditure estimates and projections presented in this document are developed using the latest available taxation data. Revisions to the underlying data as well as improvements to the methodology can result in substantial changes to the value of a given tax expenditure in successive publications. In addition, estimates and projections for some tax measures, such as the half inclusion rate on capital gains, are particularly sensitive to economic parameters and hence may also differ significantly from one publication to the next.

What's New in the 2008 Report

New tax measures were introduced and others modified in Budget 2008 and in the 2008 Economic and Fiscal Statement. The major changes introduced are described below^[1], along with some improvements in the estimation methodology for several ongoing measures.

Personal Income Tax

Eliminating Capital Gains Tax on Donations of Certain Exchangeable Securities

Budget 2008 announced the extension of the existing capital gains tax exemption for donations of publicly traded securities. Effective February 26, 2008, capital gains realized on the exchange of certain unlisted securities for publicly traded securities that are donated within 30 days of the exchange are eligible for the exemption.

Registered Education Savings Plans (RESPs)

Budget 2008 announced changes that make RESPs more responsive to the changing needs of families and students by:

• raising the maximum time limit that an RESP may remain open by 10 years;
• raising the maximum time during which contributions can be made by 10 years; and
• providing a six-month grace period for students applying to receive Educational Assistance Payments from RESPs.

The changes to RESP time limits apply to the 2008 and subsequent taxation years. The grace period applies to RESP beneficiaries who cease to be enrolled in a qualifying program after 2007.

Increasing the Northern Residents Deduction

Budget 2008 announced increases to the maximum daily residence deduction from $15 to $16.50. This increase will bring the maximum annual amount of the residency deduction to $6,022.50 from $5,475 for residents of the Northern Zone and to $3,011.25 from $2,737.50 for residents of the Intermediate Zone.

This measure is effective as of January 1, 2008.

Medical Expense Tax Credit (METC)

Budget 2008 announced additions to the list of eligible expenses under the METC to include the cost to purchase, operate and maintain the following devices prescribed by a medical practitioner:

• altered auditory feedback devices for the treatment of a speech disorder;
• electrotherapy devices for the treatment of a medical condition or a severe mobility impairment;
• standing devices for standing therapy in the treatment of a severe mobility impairment; and
• pressure pulse therapy devices for the treatment of a balance disorder.

In addition, Budget 2008 extended eligibility under the METC to recognize eligible expenses for service animals specially trained to assist an individual who is severely affected by autism or epilepsy to cope with the individual's impairment.

These measures are effective for the 2008 and subsequent taxation years.

Tax-Free Savings Account

Objective: To improve incentives for Canadians to save by reducing taxes on savings.

Budget 2008 introduced a new Tax-Free Savings Account (TFSA). The TFSA is a registered, general-purpose savings account that allows individuals to earn tax-free investment income.

Starting in 2009, Canadian residents 18 years and older will automatically acquire $5,000 of TFSA contribution room each year, with unused room being carried forward. The $5,000 limit will be indexed to inflation in $500 increments. TFSA contributions will not be deductible, but investment income, including capital gains, earned in the account and amounts withdrawn will not be included in income for tax purposes or taken into account in determining eligibility for federal income-tested benefits and credits. Withdrawals will also create contribution room for future savings.

Mineral Exploration Tax Credit for Flow-Through Share Investors

The mineral exploration tax credit is a reduction in tax, available to individuals who invest in flow-through shares, equal to 15 per cent of specified mineral exploration expenses incurred in Canada and transferred to flow-through share investors. The credit was introduced on a temporary basis in 2000 and has been extended since then. Budget 2008 extended eligibility for the credit for an additional year, to flow-through share agreements entered into on or before March 31, 2009. Under the one-year "look-back" rule, funds raised with the benefit of the credit in 2009, for example, can be spent on eligible exploration up to the end of 2010.

One-Time Reduction in Required Minimum Withdrawals From Registered Retirement Income Funds (RRIFs)

The November 2008 Economic and Fiscal Statement announced a reduction of 25 per cent in the required minimum withdrawal amount for RRIFs for 2008. The measure is expected to reduce federal revenues by $200 million for the 2008 taxation year. This tax expenditure is not presented as a separate item in this document but is part of the Registered Retirement Savings Plan (RRSP) tax expenditure. It is reflected in lower tax revenues collected on withdrawals for 2008 and hence a higher RRSP tax expenditure.

Flow-Through Share Deductions

Flow-through shares are a financing mechanism that assists oil and gas, mining and renewable energy corporations to raise capital for exploration, development and project start-up expenses—specifically Canadian Exploration Expenses (CEE), Canadian Development Expenses (CDE), and Canadian Renewable and Conservation Expenses (CRCE). In addition to receiving an equity interest in the issuing corporation, an investor buying a flow-through share is also entitled to claim deductions on account of CEE, CDE and CRCE transferred to him/her by the corporation. Investors are willing to pay more for such shares than for regular equity because of the flow-through tax deductions. Flow-through shares are typically issued by corporations that are not able to immediately use deductions themselves, e.g. because they are not taxable.

In previous years, in the absence of sufficiently detailed data, flow-through share deductions were covered as part of a broader memorandum item titled "deduction of resource-related expenditures." This item reflected the fiscal cost of deductions for both exploration and development expenses incurred indirectly by individuals through investment in flow-through shares, as well as those expenses incurred directly by individuals (e.g. as prospectors). This year, new segregated data has facilitated isolation of the expenses transferred under flow-through shares.

The tax expenditure associated with flow-through shares is equal to the difference between the fiscal cost of the flow-through deductions claimed by the investor and the deductions forgone by the issuing corporation. A tax expenditure arises to the extent that: (i) the deduction is taken by the investor earlier than it would have been taken by the corporation (indeed, in many cases, the corporation may never have been able to use the deduction), or (ii) where the investor is an individual, his or her tax rate is higher than the corporate tax rate.

The estimates indicate the fiscal cost of the deduction by individuals of expenses transferred to them under flow-through shares. The estimates represent an upper bound on the value of the tax expenditure associated with flow-through shares, since it is effectively assumed that the issuing corporations would never have been able to deduct the transferred expenses. To the extent that they could, the tax expenditure would be smaller than the estimates in this document. There is no data, however, to allow determination of when, if ever, the expenses would otherwise have been deducted by the issuing corporations. The data does indicate that in 2006, for example, 98 per cent of expenses transferred under flow-through shares were from corporations that were not taxable, and thus not in a position to immediately deduct the expenses themselves.

A parallel item for flow-through share expenses transferred to corporate investors appears in the section below on corporate income tax.

Reclassification of Expenses Under Flow-Through Shares

This ongoing provision allows a corporation to reclassify as Canadian Exploration Expenses (CEE—100 per cent deductible in the year incurred) the first $1 million of eligible oil and gas Canadian Development Expenses (CDE—30 per cent deductible per year) renounced to shareholders under a flow-through share agreement. The reclassified amounts are referred to as "deemed CEE."

In previous years, this measure was covered by a memorandum item that reflected the fiscal cost of the deemed CEE claimed in a year for both individuals and corporations. This year, new data has facilitated isolation of the reclassified expenses transferred under flow-through shares to individuals and corporations. This new data allows the actual tax expenditure to be estimated by comparing the tax value of the deemed CEE claimed by individuals to a benchmark where the underlying CDE is flowed out as CDE rather than being reclassified as CEE. It is assumed that the issuing corporations would have been able to fully flow out the expenses as CDE, even though CDE is generally less attractive to investors than CEE. To the extent that they could not, the tax expenditure would be higher than this estimate.

Like any measure that accelerates the timing of deductions and defers taxes payable, this measure results in a positive tax expenditure in the initial year(s) of any particular investment, and a negative tax expenditure in the later years. A parallel item for reclassification of expenses transferred to corporate investors in flow-through shares appears in the section below on corporate income tax.

Corporate Income Tax

Scientific Research and Experimental Development (SR&ED) Tax Incentive Program

Budget 2008 announced measures to enhance the availability and accessibility of the financial support for research and development by small and medium-sized businesses. The expenditure limit for the 35 per cent SR&ED investment tax credit was raised from $2 million to $3 million and the upper limit for the taxable capital phase-out range was increased from $15 million to $50 million. The upper limit of the taxable income phase-out range was also increased, from $600,000 to $700,000.

In addition, Budget 2008 announced that SR&ED investment tax credits would be available for some salary or wage expenses incurred for SR&ED carried on outside Canada, up to a limit of 10 per cent of the total salary and wages directly attributable to SR&ED carried on in Canada by the taxpayer during the year.

These changes are applicable for taxation years ending on or after February 26, 2008, with applicable limits pro-rated based on the number of days in that taxation year that are after February 25, 2008.

Flow-Through Share Deductions

This is a new item reflecting the fiscal cost of the deduction of expenses transferred to corporate investors in flow-through shares, which is explained above in the parallel item in the personal income tax section. Estimates are made using the same assumptions as for the personal income tax case. They represent an upper bound on the value of the tax expenditure associated with flow-through shares held by corporate investors.

Reclassification of Expenses Under Flow-Through Shares

A new tax expenditure estimate is included this year relating to the measure that allows a corporation to reclassify as Canadian Exploration Expenses (100 per cent deductible in the year incurred) the first $1 million of eligible oil and gas Canadian Development Expenses (30 per cent deductible per year) renounced to corporate shareholders under a flow-through share agreement. The tax expenditure estimate is discussed above in the parallel item in the personal income tax section.

The Tax Expenditures

Tables 1 to 3 provide tax expenditure values for personal income tax, corporate income tax and the goods and services tax (GST) for the years 2003 to 2010. The estimates for the years 2003 to 2006 are based on tax data supplied by the Canada Revenue Agency, or are calculated from data supplied by Statistics Canada and other government departments and agencies, with a few exceptions. In these cases, and for all projections, the values shown are determined from the historical relationship between a tax expenditure and relevant economic variables. The economic variables used to develop the projections are generally based on the average of private sector forecasts presented in the November 2008 Economic and Fiscal Statement. See Chapter 1 of Tax Expenditures: Notes to the Estimates/Projections^[2] for additional details on the methodology.

The tax expenditures are grouped according to functional categories. This grouping is provided solely for presentational purposes and is not intended to reflect underlying policy considerations.

All estimates and projections are reported in millions of dollars. The letter "S" ("small") indicates that the absolute value of the tax expenditure is less than $2.5 million, "n.a." signifies that data is not available to support a meaningful estimate/projection, and a dash means that the tax expenditure is not in effect. The inclusion in the report of items for which estimates and projections are not available is warranted given that the report is designed to provide information on measures included in the tax system even if it is not always possible to provide their revenue impacts. Work is continuing to obtain quantitative estimates and projections where possible.

 

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¹ A number of measures introduced in Budget 2008 to improve the application of the goods and services tax/harmonized sales tax to a range of health care services, prescription drugs and medical devices as well as a number of clarifying measures are not described in this document. [Return]

² Available on the Department of Finance website at www.fin.gc.ca. [Return]

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