CHAPTER ONE SOLUTIONS

Solution to Assignment Problem One - 1

The principal other sources of information can be described as follows:

1. Draft Legislation This legislation often provides the only information available with respect to
announced budget changes that require application in the current taxation year. Explanatory notes are
included with released draft legislation but are always set out separately.

2. Income Tax Application Rules, 1971 (ITARs) These are a set of transitional rules that were
introduced when the Income Tax Act was heavily revised at the end of 1971. The rules were largely
designed to ensure that the provisions of the new Act were not applied retroactively.

3. Income Tax Regulations These Regulations provide detailed guidance with respect to the
implementation and administrative enforcement of the provisions of the Income Tax Act.

4. International Tax Treaties These are a group of bilateral tax agreements between Canada and other
countries. They are designed to avoid double taxation of taxpayers who pay taxes in more than one
jurisdiction and to prevent international tax evasion.

5. Interpretation Bulletins These Bulletins give the CRA’s interpretations of particular sections of the
law which it administers and provide a vehicle for announcing significant changes in departmental
interpretation.

6. Information Circulars These Circulars provide information with respect to procedural matters related
to both the Income Tax Act and the Canada Pension Plan.

7. Income Tax Technical News These newsletters are an occasional publication of the CRA which, like
the technical interpretations, provide detailed guidance on various current issues. These newsletters
are equivalent in value to Interpretation bulletins.

8. CRA News Releases, Tax Tips and Fact Sheets The CRA publishes News Releases on a variety of
subjects. They are usually issued in advance of the relevant legislation or coverage in an Interpretation
Bulletin or Information Circular.

9. Pamphlets And Guides These non-technical publications provide guidance for the public on a variety
of income tax issues (e.g., treatment of rental income).

10. Advance Income Tax Rulings For a fee, the CRA will provide an Advance Income Tax Ruling on
how it will tax a proposed transaction, subject to certain limitations and qualifications. These are
rulings that are provided in response to requests from taxpayers.

11. Technical Interpretations The CRA provides both written and telephone Technical Interpretations to
the public free of charge. These Interpretations provide technical information on various current
issues.

12. Court Decisions Decisions by the Tax Court of Canada, the Federal Court and the Supreme Court that
serve to establish precedents for dealing with particular tax issues.
Solution to Assignment Problem One - 2

If tax simplification were the only objective, Mr. Right’s proposal would be appropriate. However, such a
system would be in conflict with other possible objectives of tax policy. For example, it would almost
certainly be in conflict with the objective of fairness in that it would not provide for treating different types
of income (capital gains vs. employment income) or people (the poor vs. the rich) in a suitable manner.
His system would also conflict with other objectives such as a desire to develop particular regions of the
country, the goal of vertical equity, and the need for redistribution of resources. In other words, in meeting
the objective of simplicity, Mr. Right’s system would ignore other possible objectives of a taxation system.
Solution to Assignment Problem One - 3
Note To Instructor If you are assigning this problem, note that only the first answer can be found
in Chapter 1 of the text.

The circumstances under which a general provision of the Income Tax Act can be overridden are as follows:

1. In those situations where there is a conflict between the provisions of an international tax treaty and the
Income Tax Act, the terms of the international tax treaty will prevail.

2. In some cases, a more specific provision of the Act will contain an exception to a general rule. For
example, while ITA 18(1)(b) does not allow the deduction of capital expenditures in computing
business income, ITA 37 contains a provision that allows the deduction of certain capital expenditures
when they relate to scientific research.

3. While court decisions cannot be used to change the actual tax law, court decisions may call into
question the reasonableness of interpretations of the ITA made by either the CRA or tax practitioners.
Solution to Assignment Problem One - 4

Sales taxes, including the GST, are based on certain specified expenditures, not on the income level of the
individual making the expenditure. In most cases, the proportion of an individual’s income that is spent
declines as the individual’s level of income increases. This means that when a flat rate of tax is applied to a
decreasing portion of the individual’s income, the rate of taxation as a percentage of that income will
decline.
For example, a 10 percent sales tax applied to the $150,000 in expenditures made by a person with
$250,000 in income would amount to only 6 percent of that person’s income ($15,000/$250,000). In
contrast, that same 10 percent tax applied to $25,000 in expenditures made by a person with $20,000 in
income would reflect a tax rate of 12.5 percent ($2,500/$20,000) of that person’s income.
Solution to Assignment Problem One - 5

Some of the possible examples of conflicts between objectives would be as follows:

1. Revenue Generation And International Competitiveness The need to lower rates of taxation in
order to be competitive on an international basis is in conflict with the need to generate revenues.

2. Fairness And Simplicity In order to make a tax system simple, a single or small number of tax rates
must be applied to a well established concept of income with only a limited number of deductions or
exceptions available. This is in conflict with the goal of tailoring the system to be fair to specific types
of individuals, such as the disabled.

3. Revenue Generation And Social Goals The desire to provide funds to certain types of individuals
(Old Age Security) or to provide certain types of services (health care) may be in conflict with the need
to generate tax revenues.

4. Flexibility And Certainty To make a tax system flexible in changing economic, political, and social
circumstances, there must be some uncertainty.
Solution to Assignment Problem One - 6

A. Diamonds, South Africa In a monopoly, the tax will probably be entirely shifted to employees and/or
consumers. The incidence shift will depend on competition in world markets and employment levels.
If the international diamond market is price sensitive and there is high unemployment in South Africa,
then the tax will be shifted almost entirely to employees.
The shifting assumptions affect evaluation of the tax using the characteristics of a “good” tax system.
A tax that is entirely shifted to employees is similar to one on wages and is non-neutral, as it affects
the decisions of employees to continue working. Some employees will work less and thus increase the
excess burden resulting from imposition of the tax.

B. Diamonds, Sierra Leone The taxing authorities will find it difficult to enforce the tax, due to their
inability to track diamond movements. Records maintained by the mine will likely be inaccessible,
and those presented will be incomplete. The tax will not be effective and the tax revenue will be
uncertain and inadequate.

C. Principal Residences, Canada This exemption is non-neutral because investment decisions are
affected by the tax preference. Given the choice of investing in real estate to hold for resale or a
principal residence, both of which are likely to appreciate, a taxpayer will invest in a principal
residence so that the gain on disposition is tax exempt.
It is also vertically inequitable because it benefits high-income families who can invest in more
expensive residences which have the potential of earning greater returns.
This tax expenditure is spread among all taxpayers, and general tax revenue must be larger to
compensate for the revenue foregone.

D. Business Meals, Canada This deduction is a nuisance to administer, as all business meals have to be
accounted for and accumulated separately from other promotion expenses. The tax could be shifted to
consumers, employees and/or shareholders. If it is shifted to consumers, it would be better to raise
personal taxes so that incidence is more certain. If it is shifted to shareholders or employees, then it
would be non-neutral as it could affect investment decision making and willingness to work.

E. Head Tax A head tax is neutral as it does not affect economic choices. However, it is vertically
inequitable, based on the ability to pay concept of equity, as all taxpayers, regardless of their income
levels are taxed the same. The head tax is very inelastic. This tax serves the objective of certainty and
could promote stability in the economy. Taxpayers would be more conscious of personal tax costs if
the head tax was implemented, and thus would not be as outspoken when budgetary restraint programs
are announced.
Solution to Assignment Problem One - 7

There are a large number of possible responses to a question such as this. Some possibilities would include
the following:

• Simplicity And Ease Of Compliance A very good feature of this tax is that it is very simple and
presents the taxpayer with no compliance problems. Anyone with a head is taxed and no provisions
have been made for any modifications in applicability or amounts to be paid.

• Fairness And Equity In one sense this is a fair tax in that it applies to every Canadian resident and the
amount to be collected from each individual is the same. This could be described as horizontal equity.
However, the tax could also be considered unfair in that it gives no consideration to the individual’s
ability to pay the tax, either in terms of accumulated wealth or income.

• Regressiveness Related to fairness is the fact that the tax is regressive. That is, the tax will take a
higher percentage of income from low income individuals than it will from high income individuals.

• Flexibility And Elasticity Being a very simple tax, it will be very easy to change the rate at which it is
assessed. However, as it is a flat tax based simply on the existence of the individual, it will not respond
to changing economic conditions.

• Enforcement And Dependability Of Revenues Given the presence of a physically visible audit trail
(the HAT), there should be no enforcement problems. Further, demographic statistics are reasonably
predictable, making it relatively easy for the government to anticipate the expected levels of revenue.

• Neutrality Other than decisions related to whether to remain a Canadian resident, the tax appears to be
neutral with respect to economic conditions.

• International Competitiveness It seems unlikely that a $200 tax would be sufficient to influence a
decision to either leave Canada or move to Canada. Therefore, the tax could be thought of as being
internationally competitive.

• Balance Between Sectors The tax might be criticized as an additional burden on Canadian individuals
as opposed to Canadian businesses.

There are, of course, other factors that could be considered.

Solution to Assignment Problem One - 8

Given the subject matter of this question, there are many answers that would satisfy the requirements of the
problem. Those listed below should only be considered as examples of possible solutions.

A. A big advantage here would be the likelihood that Canadian tax revenues would increase. In terms of
qualitative characteristics, two possibilities would be:
• More neutrality, as businesses would no longer make location decisions based on the tax status
of the shipping point.
• Complexity would be added in terms of finding a mechanism to enforce collections.

B. A possible advantage would be economic development in that the deductibility of interest could
encourage real estate purchases. In terms of qualitative characteristics, two possibilities would be:
• Vertical equity in the sense that high income taxpayers benefit most from the non-taxation of
capital gains on the disposition of a principal residence.
• Balance between sectors would be improved as the tax relief on interest payments would reduce
taxes on individuals.

C. A major advantage would likely be increased revenues as the ability to use multiple corporate
structures for tax planning purposes would be reduced. In terms of qualitative characteristics, two
possibilities would be:
• More neutrality, as it would remove the incentive to make investment decisions on the basis of
multiple corporate structures.
• There would be greater ease of compliance as only one tax return would be required.

D. The major advantage here would likely be greater ease of compliance for business. In terms of
qualitative characteristics, two possibilities would be:
• Simplicity and ease of compliance would be improved.
• Certainty would be improved, in that taxpayers would be more aware of the amounts to be paid,
without having to do the additional calculations required for input tax credits.

E. The most obvious advantage of the elimination of the gross up and credit system for dividends would
be less complexity in our tax system. In terms of qualitative characteristics, two possibilities would be:
• Greater simplicity.
• More neutrality, as corporate decision making is not affected by the type of payments to owner-
managers (whether salary or dividends).