Simplification of the Tax System

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3 Simplification of the Tax System ISBN Legal deposit Bibliothèque nationale du Québec, 2004 Publication date: July 2004 Gouvernement du Québec, 2004

4 SUMMARY This paper presents the views of the ministère des Finances on the complexity of the income tax system. Briefly, it provides answers to the following questions: Why is income tax so complex? Why simplify it? How can it be simplified? A number of factors can be invoked to explain why income tax has become increasingly complex, such as the difficulty inherent in defining the tax base and a desire to satisfy the principles of horizontal and vertical equity. Furthermore, Québec has complicated the rules by making abundant use of the tax system to carry out developmental measures in the economy. Lastly, the duplication of taxation powers in Canada forces taxpayers to file two tax returns. Despite the benefits that flow from a number of these features, it may nevertheless be desirable to simplify the income tax system, chiefly because of the high cost of compliance with fiscal obligations for the public administration and for taxpayers. The question then is: How can Québec s tax system be simplified? Because of fiscal federalism, a better understanding of the tax system of the other provinces may provide possibilities for simplification. Currently, the other provinces leave it to the federal government, through tax collection agreements, to administer their personal income tax and, accordingly, they agree to bind their tax system to the federal tax system, essentially by using the federal definition of taxable income. Accordingly, one possibility for simplifying Québec s income tax system could be to determine the taxable income of a Québec taxpayer simply by using the taxable income calculated for federal income tax purposes. However, such a major simplification of the tax system would necessitate a consideration of the problems associated with transition rules. This transition could raise substantial difficulties with respect to the introduction of fair, efficient and neutral transition rules. In this context, the desired simplification effect and the resulting costs for taxpayers and the government would depend on the choices made. I

5 Furthermore, while the simplification options that could be identified would present advantages in terms of greater simplicity, they would be achieved at the cost of a significant loss of fiscal autonomy. Québec has used its fiscal autonomy to wield the tax system as an instrument of social and economic policy and the fiscal policy choices made to date reflect the many benefits that stem from such autonomy. However, the complexity of Québec s tax system must remain a concern for those who are responsible for fiscal policy. In this regard, concrete steps to simplify the tax system were taken in the June 12, 2003 Budget Speech and the March 30, 2004 Budget Speech, out of a real concern to make the personal and corporate tax systems more efficient and simpler to apply. The ministère des Finances also examined the recommendations of the Joint Task Force on Tax Administration and the Advisory Panel on Regulatory Relief in this spirit. II

6 TABLE OF CONTENTS SUMMARY...I INTRODUCTION THOUGHTS ON THE NOTION OF COMPLEXITY Why income tax is complex Difficulties associated with the definition of the tax base Tax fairness Integrity rules Developmental measures for the economy Fiscal federalism Conclusion Why simplify Many types of costs Improved transparency How to simplify Less complexity: the example of the other provinces More complexity: Québec s tax system Middle solutions Common consequences of each simplification option Problems associated with transition rules Fiscal autonomy considerations III

7 2. SIMPLIFICATION STEPS TAKEN June 12, 2003 Budget Speech March 30, 2004 Budget Speech Recommendations of the Groupe de travail conjoint sur l administration de la fiscalité Recommendations of the Advisory Panel on Regulatory Reform CONCLUSION...39 IV

8 INTRODUCTION In recent months, the Québec government has initiated research and analysis into various solutions to achieve its objective of modernizing government. The exercise has been divided into six major areas, leading to the creation of an equal number of committees, including one on reducing the tax burden and simplifying the personal and corporate tax system, which is under the responsibility of the Minister of Finance. In addition to the work of this committee, the ministère des Finances has looked into the complexity of the income tax system and examined options for simplifying it. This is not the first time that government has considered the question of the complexity of Québec s tax system. Two task forces with essentially the same simplification objective, in addition to that of regulatory relief, were formed in The Advisory Panel on Regulatory Reform (Advisory Panel), formed in April 2002, 1 was charged with following up on the recommendations made in the June 2000 and May 2001 reports of an initial advisory group 2 and with examining, in that context, the administrative simplification measures proposed by the government, without calling into question the basis of existing regulations. The Advisory Panel tabled its final report on August 5, In addition, the Groupe de travail conjoint sur l administration de la fiscalité (Groupe de travail) was formed in June 2002 to follow up on one of the recommendations of the May 2001 report of the first advisory group. Its mandate consisted in proposing practical measures to simplify the application of Québec s corporate tax system, giving priority to the recommendations formulated in the advisory group s 2000 and 2001 reports as a starting point. 3 The Groupe de travail tabled its final report, written by the ministère du Revenu, on October 3, Order in council , April 24, An initial advisory panel, formed in 1997 and whose mandate was renewed on April 28, 1999 for an additional two years, had already submitted three reports, i.e. in June 1998, June 2000 and May Conseil des ministres decision of March 20,

9 Accordingly, this paper brings together the views of the ministère des Finances on the simplification of Québec s income tax system. More specifically, it suggests answers to the following questions: Why is income tax so complex? Why simplify it? How can it be simplified? The first part provides a brief description of the factors that add complexity to an income tax system, the reasons why simplification is desirable, possible options for simplification as well as some of the pitfalls that may hamper attempts to simplify an income tax system. The second part describes the concrete simplification measures taken to date and their benefits for Québec s taxpayers. 2

10 1. THOUGHTS ON THE NOTION OF COMPLEXITY The primary objective of a tax system is to generate revenue that will allow government to fund public expenditures. The taxes paid by individuals and corporations fund, in particular, the health system, the education system and assistance of last resort. However, taxation is also a policy tool (social, economic, cultural and so on) and an instrument for reducing inequalities by redistributing wealth. In this way, it reflects society s values and socio-economic objectives. In pursuit of these objectives, fiscal policy decisions are taken in light of the three basic principles of any tax system: fairness, neutrality and simplicity. More specifically, under the principle of horizontal equity, taxpayers with the same ability to pay bear a similar tax burden. The principle of vertical equity holds that a taxpayer with greater ability to pay pays more tax. In reality, this principle is reflected essentially in the progressive structure of tax rates by taxable income bracket. 4 The neutrality principle seeks to ensure that taxpayers decisions are based on factors other than tax considerations. A neutral tax system has no influence on the behaviour of economic agents and allows the free market to operate efficiently. Lastly, the principle of tax simplicity is based on the premise that a system that is simple to understand and administer is easier to comply with and less costly in every regard. While the objective of this principle is just as important, its achievement is often hampered in the interests of fairness and neutrality, as well as other considerations that are just as legitimate. Accordingly, a good understanding of the causes of complexity of a tax system based on income is crucial. 4 The Québec sales tax (QST) credit is another example of the application of this principle since its objective is to make the QST less regressive. 3

11 1.1 Why income tax is complex Many factors, which at times are in conflict with each other, can be invoked to explain why tax legislation based on income tax can grow increasingly complex Difficulties associated with the definition of the tax base The complexity of a tax system based on income tax is largely attributable to the inherent difficulty in defining the system s tax base. The tax base is the amount on which tax is payable. In the case of income tax, the base is taxable income or profit. Accordingly, the notion of tax base encompasses not only what is considered income, but also all the deductions and exemptions stipulated in the course of determining such income. When costs are incurred to earn income, they must be taken into account to determine the portion of such income that must actually be taxed. At times, it can be difficult to adequately determine a tax base that allows for the nature of various sources of income, while making the specific and necessary adjustments to take account of the economic realities underlying the production of a given type of income. Moreover, the growing complexity of commercial operations has an effect on tax rules. Globalization and technical advances have radically transformed how business is done. New questions are thus raised and the tax base is inevitably and recurrently adjusted to reflect new commercial realities Tax fairness Two of the basic principles of a tax system, fairness and simplicity, have objectives that are essentially contradictory. The principle of tax fairness is often the primary obstacle to the principle of simplicity. 4

12 Accordingly, many initiatives that make a tax system more complex are in fact simply the result of a desire to make allowance for various economic realities in the distribution of the tax burden. La théorie économique en politique de taxation nous apprend rapidement que le principe d équité fiscale s oppose très souvent à ceux d une simplicité des lois et à leur respect au moindre coût pour les contribuables. 5 Fairness regarding personal income tax One of the main sources of complexity of a personal income tax system is the variety of items to consider in establishing ability to pay tax, in particular with regard to the characteristics of a taxpayer, his family situation or financial situation. For example, a single person with a smaller income than a head of family whose spouse has no income could nonetheless pay tax similar to the latter because existing rules take into account the fact that the head of family bears a greater financial burden to meet the essential needs of his family (housing, food, clothing). In general, fair treatment regarding personal income tax is achieved through tax credits and tax deductions that help evaluate a taxpayer s true ability to pay. Such is the case in Québec in particular for the basic personal tax credit and the amounts granted for dependent children who are students and for a person living alone. Such is also the case for deductions for contributions to a registered retirement savings plan (RRSP) or a registered pension plan (RPP), which allow taxpayers to defer, until their retirement, payment of tax payable on these amounts. Fairness regarding corporate income tax Turning to corporate income tax, adjustments are allowed to subtract the costs assumed to earn income so that only the economic gain, i.e. the profit, is subject to tax. In addition, the system takes account of operating losses sustained in prior or subsequent years in order to better match income and losses within a business cycle. Furthermore, integration rules are specifically designed to avoid double taxation of the same income. One example is the exemption of dividends received from another corporation. 5 R. Lachance, Fiscalité des entreprises à l aube de l an 2000 : Entre le rêve et la réalité, in Congrès 1996, APFF, Montréal, October 1996, p

13 Accordingly, like the personal income tax system, the corporate income tax system estimates corporation s true ability to pay so that they are made to bear a tax that is fair. Consequently, if income tax is complex, it is partly because it tries to achieve fairness for all taxpayers. Through the application of its specific rules, it attempts to adequately measure taxable income by taking a taxpayer s real situation into account, thus effectively affording fair treatment. From many points of view, substantial simplification of the tax rules would be at the cost of a loss of tax fairness or justice Integrity rules Over the years, many measures have been implemented to protect the tax base. To eliminate loopholes that would allow tax avoidance, the government made the applicable rules more complex so that each taxpayer assumes his fair share of the overall tax burden. Indeed, it can be said that the more hermetic and fair a tax system, the more complex it is. Furthermore, while it is acknowledged that a taxpayer can organize his affairs to pay only his fair share of tax in a given jurisdiction, it follows that in the absence of any integrity rules, it would be possible for a taxpayer to avoid income tax through tax planning that is completely legal. Although legitimate because of their objective, provisions protecting the integrity of the tax base make the tax system more complex. In Québec, rules relating to affiliated foreign corporations, non-resident trusts and transfer pricing, as well as the general anti-avoidance rule, are all examples of complex measures designed to protect the integrity of Québec s tax system. Furthermore, since tax evasion is a problem that is constantly changing, the proliferation of integrity rules helps limit the negative effects of the underground economy but, once again, at the expense of the simplicity of the tax system Developmental measures for the economy As part of its role of supporting economic policy, the tax system enables government to carry out developmental measures for the economy to foster beneficial economic activities or behaviour, for instance by encouraging a type of initiative. Such incentive measures are important for the development of certain economic sectors. 6

14 In Québec, the most striking example in this regard is clearly the government s support for scientific research and experimental development (R&D) activities. The government supports research and innovation carried out on its territory because it considers that the direct and indirect spin-offs of R&D activities are beneficial for persons, businesses and every sector of the economy. Apart from the actual conduct of research, its results are enjoyed by all of Québec society: creation of high-quality jobs, growth of the knowledge-based economy, attraction of foreign capital, improvements in business productivity through the integration of innovations, etc. Support for R&D is necessary because of the higher risks assumed by companies that invest in such activities compared to companies that instead invest in commercialization activities. Without incentives, companies would necessarily do less R&D, and Québec s economic performance would suffer accordingly. Hence, R&D activities are essential to technological progress, one of the key factors of productivity growth. Many studies have confirmed this and shown that innovation has significant effects on productivity. 6 A tax system can play a key role in the growth of an economy and job creation. By means of developmental measures, it can encourage saving, stimulate investment, attract foreign capital and sustain both the creation of new businesses and the expansion of existing ones. Consequently, while the many refundable tax credits for businesses make the corporate tax system more complex, their economic objective often justifies the fiscal policy choices made Fiscal federalism The duplication of taxation powers in Canada has a direct influence on the complexity of Québec s tax legislation. To the degree that Québec fully assumes its fiscal autonomy, the direct result of Québec s initiatives is to add considerably to the complexity of the rules applicable to taxpayers, because they are subject to two different tax systems. 6 See in particular, D. Guellec and B. Van Pottelsberghe de la Potterie, Recherche-développement et croissance de la productivité : analyse des données d un panel de 16 pays de l OCDE, OECD Economic Review, n 33, 2001/2; Also, OECD (2000), Enquête sur l innovation; les leçons de l expérience des pays de l OCDE, STI Review, N 27, Volume , p. 85 to

15 Differences from the federal tax system have historically been created by the introduction of numerous features specific to Québec that have made it possible to intervene in various sectors to achieve specific objectives. Furthermore, despite its significant degree of harmonization with the basic federal tax system, Québec s tax system has differences, especially regarding the wording of legislative texts, interpretations and forms. In reality, the differences between Québec s tax system and the federal tax system are attributable chiefly to the following four sources: fiscal policy: disparities arising from a government decision on objectives; legislation: disparities arising from the wording of legislative texts. This source divides itself into two sub-groups: 8 structural disparities, 7 resulting from the existence of a civil law system in Québec and a common law system elsewhere in Canada; disparities in wording, resulting from the writing style adopted by the writers, or from linguistic demands; 7 With respect to structural legislative disparities, it should be mentioned that tax law is consequential law in the sense that it is not a source of law between persons but applies after the fact, whose legal consequences are established, in Québec, by the civil law. Until the end of the 1970s, the Income Tax Act was written in English in a common law context, with the French version being but a translation of the English text. As a result, some provisions of the law were poorly adapted to Québec s civil law context and differences were unavoidable. Beginning in 1978, federal methods of drafting legislation were changed so that the French version of the new provisions of the Income Tax Act were no longer a simple translation of the English version, but were a French adaptation of the concepts developed for a common law legal system. While this was an improvement for the purposes of adapting the Income Tax Act to the Québec context, some disparities between the Income Tax Act and the Taxation Act remained unavoidable because each statute sought to govern the tax consequences arising from two different legal systems. Lastly, in 1995, the federal government adopted a method of drafting legislation based on the principle of bijuralism, i.e. a method of drafting legislation in which the texts can apply indiscriminately to a common law context or a civil law context. As a result, the provisions of the Income Tax Act drafted using this method are theoretically applicable to the Québec civil law context with no special adaptation. This drafting method may not settle all the structural legislative differences between the two laws but can certainly help eliminate most of them.

16 interpretation: disparities resulting from differing opinions of the ministère du Revenu or the Québec courts as to the appreciation of facts regarding a specific situation, or diverging views of the tax authorities concerning the scope of a given measure; forms: disparities attributable in part to the above sources (fiscal policy, legislation, interpretation) and in part to the style of the designers for whom harmonization with federal forms is not always the primary concern. Accordingly, although the conceptual bases of Québec s income tax system are similar for the most part to the federal tax system, its legal and administrative requirements make it different from the federal system. In other words, the specific features of Québec s tax system and the disparities resulting from legislative and administrative differences increase its complexity, in spite of a long-standing policy of conceptual harmonization with the federal tax system. Consequently, at the practical level, such conceptual harmonization is not always reflected in greater simplicity in the administration and management of Québec s tax system. However, simple fiscal duplication, i.e. a Québec taxpayer s obligation to file two tax returns each year, one for each order of government, is not necessarily a source of complexity in itself though some taxpayers may perceive it that way if the details of Québec s tax system are not different from the federal tax system, both in conceptual and legislative terms Conclusion The list of factors contributing to the complexity of the tax system described above is not exhaustive. The rules applicable in an inter-provincial and international taxation context, frequent amendments made to the legislation, transition measures and the time between the announcement of a new tax measure and the availability of the relevant legislation and forms are all examples of other factors that generate complexity. In short, like any tax system based on income, Québec s tax system is a demonstration of the ongoing opposition of a number of principles. Achieving a significant reduction in the complexity of Québec s tax system raises major problems of consistency, fairness, integrity and efficiency of Québec s fiscal policy. 9

17 Moreover, there is nothing exceptional about the complexity of Québec s tax system compared with other member jurisdictions of the Organization for Economic Cooperation and Development (OECD), especially the United States. 8 In addition, the other two provinces that formulate and administer their own corporate income tax, namely Alberta and Ontario, have a tax system that is more complex that that of the provinces that rely exclusively on tax collection agreements. Consequently, the degree of complexity of Québec s tax system is relative, although the presence of many factors adding complexity must be acknowledged. 1.2 Why simplify In many ways, some of the complexity factors noted above produce benefits and many reasons can be invoked to justify the level of complexity of a tax system. However, the government must also be concerned with reducing the compliance burden on taxpayers and so it is useful to see why a simpler system is desirable Many types of costs Essentially, the need for simplification arises from the high cost of compliance with tax obligations, both for taxpayers and the public administration. The cost of complying with tax obligations, in particular because of the large number of forms to complete to satisfy the requirements of the tax laws, has a negative impact on the efficiency of a tax system. For taxpayers, this cost is calculated in the time and labour needed to comply with the various tax obligations, particularly regarding the filing of tax returns and prescribed forms. For many taxpayers, this cost is increased by the expenses associated with the services of tax advisers to understand how the legislation applies to their specific situation, to ensure that they comply with the various tax rules, while assuming no more than their fair share of the tax burden. 8 OECD (2001), Increasing Efficiency and Reducing Complexity in the Tax System in the United States, OECD Economics Department Working Papers, N 313. See also Bronchi B. and R. Herd (2001), Improving to U.S. Tax System, OECD Observer, Paris. 10

18 In the specific case of businesses, the financial and human resources devoted to tax compliance are a relatively unproductive use of capital and labour, which limits production capacity accordingly. The cost of tax complexity for businesses is reflected in reduced productivity. In this context, simplifying the tax system and reducing the administrative burden on businesses would be a positive factor encouraging better economic performance. For the public administration, the complexity of the tax system generates costs relating to the effort invested in drafting legislation that is constantly evolving, correctly interpreting and applying it, and explaining the rules to taxpayers through a variety of customer services and the production and publication of forms and related explanatory and information documents. The complexity of the tax system also requires that substantial resources be allocated to entering information sent by taxpayers and mandataries, auditing and revising it, when considered necessary, to ensure that the tax legislation is applied fairly and evenly. Simplifying the rules could result in less need for audits and the resulting disputes, which would generate greater security for taxpayers with regard to compliance with their obligations. To sum up, when a tax system is simple and understandable, compliance and administration are easier Improved transparency The need for simplification also arises when the volume of legislation is such that it compromises the transparency of the tax system. Taxpayers need to know and understand the tax legislation if they are to apply it correctly, with legal certainty. However, the vast majority of taxpayers do not always find the tax legislation easy to understand or grasp. Simplifying the tax system to reduce the body of legislation would contribute to transparency and make Québec s tax system more accessible. Furthermore, the lack of transparency has a direct effect on taxpayers confidence in the fairness and efficiency of the tax system. When a tax system is based on self-assessment, it is essential that a taxpayer feel sure that he is bearing no more than his fair share of the overall tax burden. Otherwise, the underground economy grows and taxpayers end up accepting behaviour designed to circumvent their tax obligations as normal. 11

19 A simpler tax system would entail greater transparency, accessibility and confidence in the system s fairness and efficiency. 1.3 How to simplify Simplification of a tax system based on income tax raises various expectations that depend on the various users of the system. For taxpayers, simplifying income tax should result in better understanding of the rules so that it becomes easier to file their tax return. For the ministère du Revenu, simplifying income tax should result in more efficient and less costly administration. For tax advisers, a simpler income tax would mean greater certainty in the application of the tax rules, which would facilitate their advisory role. For the courts, simplifying income tax would promote greater legal security, based on the clarity of the tax legislation. For government, a simpler income tax should, in addition to the effects expected by all users of the system, enable it to achieve its financial and economic objectives without prejudicing the guiding principles of fairness and neutrality. Accordingly, the appropriate simplification approach should be considered in relation to the results sought by each player. It is not easy to simplify income tax in a way that satisfies the multiplicity and variety of expectations. Indeed, just simplifying the tax system without doing away with its basic principles is in itself a complex undertaking. Adding the achievement of tangible and measurable results for each user may require substantial effort. The other provinces currently have a different tax system than Québec s. In this context, in view of the fiscal federalism that is common to all the provinces, an understanding of the main features of the tax system of the other provinces could point to options for simplifying Québec s tax system. 12

20 1.3.1 Less complexity: the example of the other provinces The federal government and the provincial governments collect a personal income tax and a corporate income tax. All the provinces, with the exception of Québec, leave it to the federal government to collect their personal income tax, through tax collection agreements (TCA). All the provinces other than Québec, Ontario and Alberta have also entered into TCAs for corporate income tax. Under the TCAs, the federal government applies various fiscal measures on behalf of the provinces, collects the assessed income tax and remits it to the provinces. More specifically, the provinces can collect personal income tax either on the basis of a tax base represented by taxable income determined for federal income tax purposes, or on the basic federal tax. In so doing, provinces who are party to these TCAs (agreeing provinces) agree to tie their tax system to the federal tax system, by maintaining a high degree of harmonization with it to reduce the complexity and administration costs of this collection mechanism. Essentially, this harmonization of the tax base is reflected in the use of the federal definition of taxable income so that the federal government does not have to administer a separate tax system for each province that has signed a TCA. Thus, agreeing provinces incorporate their own specific fiscal policy components in the calculation of tax payable, through the tax table, tax credits, tax reductions and surtaxes. While using the federal tax base has the advantage of simplifying the administration by federal authorities of provincial tax systems, through the fact that there is only one calculation of taxable income, the TCAs allow the participating provinces only a relative autonomy regarding their fiscal policy. Furthermore, while these provinces theoretically have the possibility of themselves administering a specific tax measure, this is generally difficult for them because they do not have the administrative structures for income tax. Accordingly, while a TCA offers definite advantages with respect to simplicity and administration costs of a province s tax system, there is also a loss of fiscal policy autonomy. 13

21 1.3.2 More complexity: Québec s tax system At the other end of the spectrum, the Québec government fully exercises its power to design and administer all the taxes it wants, within the Canadian constitutional framework. In exercising this power, the Québec government has historically made fiscal policy choices. One by one, rules have thus been added to the initial tax system to form the current body of rules. Accordingly, Québec now has an original, innovative and autonomous tax system that incorporates social and economic concerns that are specific to Québec society. While drawing to a large degree from the federal tax system, Québec s tax system is notably different. For example, regarding the personal income tax, taxpayers have had the choice, since 1998, between the general tax system and a simplified income tax system. By choosing the simplified tax system, taxpayers elected a flat amount in place of many tax credits and deductions offered in the general system. Taxpayers who made extensive use of the tax benefits offered in the general system used the general tax system. Agreement on the simplicity offered by this choice was not unanimous and the simplified tax system was eliminated in the March 30, 2004 Budget Speech. 9 While the simplified system reduced complexity relating to filing the tax return for those who used it, 10 it made Québec s tax system more complex overall. Accordingly, the existence of two tax systems caused the volume of legislation to increase, led to a degree of anxiety regarding optimization of the choices available, and an increase in the number of forms adapted to each specific situation Middle solutions Between these two examples of tax system design, development and administration, a range of middle systems could be developed with a specific concern to simplify Québec s tax system. It is worth examining a number of these Budget, Additional Information on the Budgetary Measures, section 1, subsection This simplification consisted in replacing many tax credits and deductions by the flat amount, and filing a single tax return form for the two spouses who so wished. 14

22 Using federal taxable income The first simplification option could be to determine a taxpayer s taxable income simply by using the taxable income calculated for federal income tax purposes. For the purposes of tax credits and transfers determined or reduced depending on net income, the net income used would also be the one calculated for federal income tax purposes. Advantages of this option Essentially, the simplification gains resulting from using taxable income calculated for federal income tax purposes would consist of a substantial reduction in the: number of forms; volume of legislation; number of interpretation bulletins; audit activities of the ministère du Revenu; activities relating to the entry of tax information by the ministère du Revenu; ongoing training requirements of ministère du Revenu staff. More specifically, a count was undertaken of the current provisions of the Taxation Act and the Taxation Regulations concerned with the calculation of income, calculation of taxable income, profit-sharing plans and other special arrangements relating to income, as well as the related administrative documents. This exercise provided an estimate of the number of provisions that could be repealed and the number of documents that could be withdrawn under this option, as indicated in the following table. Act Regulations Interpretation bulletins Forms, statements, guides Number

23 Moreover, since the Canada Revenue Agency would then be the sole authority for determining the reference taxable income for Québec income tax purposes, the ministère du Revenu would only have authority over features specific to Québec. However, the ministère du Revenu would continue to administer Québec s tax system, though the extent of the activities needed to efficiently carry out this mandate would be considerably reduced. Lastly, any objections by taxpayers concerning Québec tax would only concern features specific to Québec, which would reduce the number of disputes considerably. In this context, simplifying income tax by making use of taxable income determined for federal income tax purposes could be an attractive option. Disadvantages of this option The disadvantages of simplifying the tax system by making use of taxable income calculated for federal income tax purpose would be significant. First, at the technical level, to avoid penalizing or conferring an advantage on certain taxpayers, implementation of this option would require a transition system, 11 or perhaps even an Application legislation, as was the case with the 1972 tax reform. Briefly, a transition system would be necessary to take account of disparities created over the years because of differences in the Québec and federal tax systems, between the Québec and federal tax values of many items: historical accounts (depreciation, losses, etc.), costs and capital costs of certain assets, for instance. The rules that would have to be introduced to ensure a fair transition between the two tax systems would substantially reduce, for many years, the simplification effect that is the objective of this option. And if a simple transition were implemented, it could have a major, though one-time, financial impact. Moreover, some may see an automatic reference to federal legislation as a surrender by the Québec government of its fiscal autonomy For an analysis of considerations relating to transition rules, see the sub-section of this paper that deals with this subject. 12 For an analysis of the considerations concerning fiscal autonomy, see the sub-section of this paper dealing specifically with this subject. 16

24 Use of federal net income In the same vein, another simplification option could be to determine a taxpayer s net income for Québec income tax purposes by simply using net income calculated for federal income tax purposes. Advantages of this option The advantages of this option would be much the same as for the use of federal taxable income as far as the reduction in the number of legislative and regulatory provisions, interpretation bulletins, forms, statements and guides is concerned. Disadvantages of this option The main disadvantage of this option would be the difficulty in determining the balance of certain cumulative accounts affecting a taxpayer s taxable income, in particular the amount of his losses to be carried over. Since the amount of losses to be carried over is established from amounts (income and deductions) otherwise considered in the calculation of net income, using federal net income would limit the access and competence of the ministère du Revenu regarding tax information required in the course of determining a taxpayer s losses. Moreover, in view of the measures specific to Québec s tax system and discretionary deductions, 13 the balance of Québec losses to be carried over could be different from federal losses, which would eliminate the possibility of using the federal amount established in this regard without stipulating a transition system to eliminate disparities created over the years. 14 In addition, since using federal net income would maintain the requirement of a separate calculation for determining taxable income subject to Québec income tax, the simplification gains resulting from this option would be less than those resulting from using taxable income determined for federal income tax purposes. 13 Such discretionary deductions include deductions for depreciation, for an amount relating to eligible capital property, for doubtful debts, etc. 14 See note

25 Using basic federal tax To achieve even greater simplification, it could be decided to make use of basic federal tax. That would mean that Québec s tax would be determined as a percentage of the basic federal tax (tax-on-tax system). While the Québec government would continue to collect its taxes, the federal government would be the sole competent authority for determining sources of income subject to tax, allowable deductions and exemptions, marginal tax rates and income brackets used to calculate tax. Once basic federal tax is calculated, the Québec government would apply a tax rate to this amount to determine Québec tax payable. It is worth mentioning in this regard that until 2000, the personal income tax system of the other provinces was exclusively a tax-on-tax system. Advantages of this option The main advantage of this option is its extreme simplicity. Taxpayers would have just one additional calculation to carry out to determine their provincial tax payable. Of course, the other advantages would be largely the same as those provided by using federal tax payable regarding, among others, the reduction in the number of legislative provisions, interpretation bulletins and forms. Disadvantages of this option The major and unavoidable irritant of such a system would be that any tax cut by the federal government would directly reduce Québec s tax base and, consequently, its revenue. Since Québec s tax base would consist of the basic federal tax, any change made by the federal government that reduces basic federal tax would also reduce Québec s tax base. Essentially, this system would make the Québec government s revenue from income tax dependent on that of the federal government. In addition, adopting such a tax-on-tax system would automatically tie Québec s fiscal policy to that of the federal government, in particular regarding non-refundable tax credits, the tax thresholds, the number of tax brackets and the rates applicable to them. In other words, the Québec government would give up the power to control the progressivity of its tax system. 18

26 Lastly, simplifying Québec s tax system by introducing a tax-on-tax system would mean the Québec government would almost completely surrender its fiscal autonomy. 15 However, it is precisely to end such dependence and provide the provinces participating in TCAs with more autonomy that the governments of those provinces and the federal government agreed to replace provincial tax-on-tax systems with the current system under which tax is calculated on taxable income. While the other provinces still have the option to choose a tax-on-tax system under the current TCAs, they all now use a system of tax calculated on taxable income. In this context, the experience of the other provinces indicates the limits of such a tax system. Mirror legislation Another simplification option would be to first eliminate all the features specific to Québec currently stipulated in the calculation of net income and taxable income for Québec income tax purposes, and then adopt Québec legislation that mirrors federal legislation regarding the determination of taxable income. This simplification option could lead to an overhaul of the Taxation Act. Such an operation ultimately would allow Québec to join, at the conceptual level, the other provinces, without referring, in its own legislation, to taxable income calculated for federal income tax purposes. In concrete terms, federal and Québec legislation would be identical and Québec taxpayers would have to carry out just one calculation to determine their taxable income for Québec and federal income tax purposes. Advantages of this option This simplification option would make it possible to deal directly with the complexity factor arising from fiscal federalism by eliminating almost all the existing disparities in this regard. Taxpayers would then have a better understanding of Québec s tax system since, for Canadian income tax purposes, there would be only one taxable income. 15 See note

27 Disadvantages of this option The greatest disadvantage of this option is the amount of time that would be needed to implement it. Such a legislative overhaul would be long and would require a great deal of effort since, in the case of the Taxation Act, it would imply rewriting over pages of legislation. This option would also require reassessing the relevance of many aspects of Québec s fiscal policy, evaluating the scope of all the required changes and coordinating the action of all the stakeholders concerned. While passing mirror legislation would eliminate all the fiscal policy disparities and most legislative disparities, the simple coexistence of two pieces of legislation, however similar they may be, would always carry a risk of distortion because of the different interpretations that the ministère du Revenu or the Québec courts may have. In this context, the success of this option would depend on implementing an administrative policy under which, barring notice to the contrary, the ministère du Revenu would recognize interpretations of federal legislation regarding concordant Québec legislation, 16 and on carrying out a wide-ranging operation to harmonize Québec forms with federal forms with the ultimate objective of allowing these forms to be interchangeable Common consequences of each simplification option In all the options examined, there would be a risk of loss regarding tax statistics. The Québec public administration would no longer collect a good deal of tax information. In the course of formulating Québec fiscal policy, the availability of tax data enables the government to make informed decisions and to confirm the relevance or appropriateness of a given initiative. 16 This administrative policy would enable the ministère du Revenu to adopt federal interpretation bulletins, avoid duplication of work and concentrate its interpretation efforts on features specific to Québec that would remain in the calculation of tax payable. 17 Such harmonization would optimize the practical advantages, such as the elimination of certain Québec forms that would be replaced with recognition of certain federal forms. 20

28 Furthermore, since the federal government would be responsible for a significant share of the interpretation and application of existing Québec tax legislation, simplification of Québec income tax would inevitably result, in the medium and long term, in a loss of technical expertise in the Québec public service in the personal income taxation field Problems associated with transition rules Any major simplification of a tax system requires a consideration of the problems associated with unavoidable transition rules 18 to assess their consequences on the simplification objective and the possible costs for taxpayers and the government. For example, moving from the current system to one based on using taxable income determined for federal income tax purposes would cause transition problems chiefly attributable to the existence of disparities between existing federal and Québec s tax values relating to numerous tax concepts. Currently, a taxpayer may hold an asset that is completely depreciated in the federal system but for which he claimed no depreciation deduction under the Québec system. Accordingly, using the amount of the federal depreciation balance regarding such asset for Québec tax purposes would take away the benefit of Québec depreciation with regard to such asset. Concepts likely to show disparities include historical accounts, such as depreciation balances and loss carryovers, allowances and the R&D expense account, or the costs and capital costs of certain assets. To illustrate the source of disparities and their impact in the context of a possible move from the current situation to a system based on using taxable income determined for federal income tax purposes, the example of depreciation balances is given. Depreciation balances The most common disparities between existing Québec s and federal tax values, and generally the most significant, are those that concern depreciation balances. 18 The analysis in this sub-section assumes that a new system is implemented based on using taxable income determined for federal income tax purposes. 21

29 More specifically, the disparity between the amount of the undepreciated portion of capital cost (UPCC) of an asset under the Québec system and the amount of the undepreciated capital cost (UCC) of the same asset under the federal system may stem from specific Québec features pertaining to the inclusion rules for various classes of assets, or from the election a taxpayer may make to claim an amount as a depreciation deduction that is different for each order of government, since depreciation is a discretionary deduction. Moreover, certain tax relief measures in Québec s income tax system may encourage some taxpayers to claim, as a depreciation deduction, amounts that are considerably different for each order of government. For these reasons, the Québec and federal depreciation balances relating to the same asset can be different. The lack of a transition rule to recognize such disparities when a new system is introduced could penalize taxpayers and, in a way, would be equivalent to retroactively changing the conditions under which certain measures stipulated by the existing tax system apply. 19 Transition system options A transition system that makes perfect allowance for disparities between provincial and federal tax values could be complex. Accordingly, the choice of transition rules would directly influence the degree to which the simplification objective is achieved. Simple transition The simplest transition mechanism between the current Québec tax system and a given simplification option would be one under which immediately following the coming into effect of the reform simplifying Québec s tax system, taxpayers disregard the historical Québec data covered by the reform and instead use the figures determined for federal tax purposes. In doing so, existing disparities would simply be cancelled for the purposes of the new Québec tax system, with no compensation for taxpayers or for the Québec government, as the case may be. 19 For example, the provisions relating to the five-year tax holiday for new corporations did not require an eligible corporation to deduct depreciation during the period it benefited from the tax holiday. 22

30 Consequently, some taxpayers, because of their specific situation, would benefit from this kind of transition while in other cases, the government might benefit from the cancellation of the disparities. One-year transition period To keep the transition simple, yet still allow the tax recognition of disparities, a short transition period, extending over a single taxation year, could be considered. During such taxation year, Québec taxpayers would have to recognize the tax consequences arising from the disparities. For instance, a taxpayer with assets whose Québec s undepreciated balance would be less than that established at the federal level would have to pay tax on the difference between the two balances in the transition year. A short transition period could also prove restrictive for some taxpayers, or generate costs for the government, as the case may be. However, the cost would be non-recurring. Transition with retention of disparities A transition mechanism that would retain the disparities created prior to the reform could also be considered. Under this assumption, all the disparities that exist at the end of the last taxation year of a taxpayer, for the purposes of the current tax system, would be defined. Temporary disparities could be grouped within an account and reversed, over a given period, by an addition to or a deduction from federal taxable income. 20 Other types of disparities, such as those attributable to the cost and capital cost of assets of a taxpayer, would be recorded and taken into consideration at the appropriate time, upon disposal for instance. The rules relating to the application of a transition system with retention of disparities could be extremely complex at the technical level. Accordingly, the consequences of such a transition system would considerably reduce, and for many years, the desired simplification. 20 Temporary disparities are those attributable to discretionary deductions. 23