Income averaging is an old idea that deserves another shot

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There are a lot of good things about getting older. One of them in my work life is that I recall the “good old days” with respect to certain taxation matters.

Yes, indeed, there are many good things in taxation policy that have been eliminated over the years, but as time has passed, one wonders if consideration should be given to thinking about the lessons learned and whether such lessons mean giving those policies another shot.

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One of those lessons is in averaging income. With the progressive taxation system that Canada has, you pay more personal income tax as your income increases. That is generally fair.

But what happens if you have a once-in-a-lifetime monetization event such as being fired from your job and you receive a significant severance amount? Or you receive some sort of significant damages from a lawsuit and such amounts are taxable (some forms of damages are not taxable and I’m not talking about those forms). Or you withdrew, for a variety of financial reasons, a significant amount of money from your various registered pension funds? Or you receive a dream offer for the sale of your business?

All the above are examples of when you might pay significant income taxes for a short period of time, in many cases, in the one and only year, and then your income will regress in the following years to more modest and normal levels. Is it fair that those types of spikes in income will result in significant taxation? Some economists call this extra spike in tax the “fluctuation penalty.”

Canada’s first and only Royal Commission on Taxation from 1962 to 1966 (which studied the income tax system and published a report and its recommendations) spent significant time on this issue. It recommended forms of income averaging be available to enable taxpayers to spread out their income over a period of time in order to normalize the tax liability and bring a measure of fairness into such situations. In other words, to reduce the fluctuation penalty.

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A couple of forms of income averaging provisions were brought in when Canada introduced major tax reform on Jan. 1, 1972. However, they didn’t last very long and were eventually fully repealed by 1997.

In addition, “retiring allowances” paid to a person upon retirement from an employment position were able to be contributed to your registered retirement savings plan (pursuant to a formula tied to years of service) in addition to normal RRSP contribution limits. This was also a form of income averaging since it enabled extra deductions to the extent that such amounts were timely contributed to your RRSP. Those rules were also fully repealed for any years of service after 1995.

After all the repeals of income averaging, the government introduced a new provision (for tax geeks, it’s section 120.31 of the Income Tax Act) that was and remains a very ineffective attempt (because of its poor design) to provide retroactive averaging of certain kinds of lump-sum income payments. Its use has been almost non-existent since 1995 and should be repealed.

Proponents of the repeal of income averaging argued that the tax-rate brackets were greatly simplified over the years so there was no need to average or normalize income to take advantage of the lower brackets. In addition, they argued that income-averaging provisions failed to meet their objectives and were complex to administer.

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In my view, and those of many other tax practitioners and economists, it’s time to re-think those criticisms in order to restore fairness and equity.

Let’s illustrate with a simple example. Let’s say Ms. Apple, a resident of Ontario, has worked as an employee for OrangeCo for about 25 years. She makes a modest income and her marginal personal tax rate is 20 per cent. Ms. Apple and OrangeCo have agreed to part ways and the company has offered her $500,000 as a lump-sum payment in settlement of all her employment rights.

Ms. Apple has agreed to accept such an offer, and it will be taxable to her in the year it is received and will significantly push up her marginal tax rate. Let’s assume her new marginal rate is now 40 per cent (these percentages are only for illustrative purposes). She already has another job offer, but, unfortunately, it is for a lower annual income. If her marginal rate is now 40 per cent, approximately $200,000 of her settlement will be exhausted for tax, leaving only $300,000 to help her with her retirement needs. This is a significant fluctuation penalty, especially since she now has a lower-paying job.

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In this case, it won’t take much income to push her marginal rate up. However, can such an increase be a little more reasonable so as to leave more money in her hands to assist her with retirement needs? Yes, and that is the purpose of income averaging.

It’s time to pull out the old lessons learned from income averaging provisions and make them new again. It’s only equitable and fair.

Kim Moody, FCPA, FCA, TEP, is the founder of Moodys Tax/Moodys Private Client, a former chair of the Canadian Tax Foundation, former chair of the Society of Estate Practitioners (Canada) and has held many other leadership positions in the Canadian tax community. He can be reached at kgcm@kimgcmoody.com and his LinkedIn profile is www.linkedin.com/in/kimmoody.

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