Closing the Income Sprinkling Loophole: Fair and Likely Efficient

By Frédéric Tremblay, Queen’s University

The Canadian government has recently announced that it intends to address what it considers to be three loopholes that allow tax planning using private corporations: income sprinkling, passive investments made by private corporations, and the conversion of a private corporations’ income into capital gains. This post will focus on the first form of tax planning, income sprinkling.

Income sprinkling refers to the use of the flexible structure of a Canadian-controlled private corporation (CCPC) to do income splitting with family members in lower tax brackets. This allows some Canadian small business owners to reduce their income tax burden in a way that is unavailable to other Canadians. Finance Canada estimates that closing the income sprinkling loophole would generate $250 million yearly in additional tax revenue[1]. Since the impact on federal finances is likely to be negligible, I focus my analysis on the issues of fairness and efficiency.


Fairness is an important consideration when it comes to policy design as it makes the policy socially acceptable even when it is economically suboptimal. It is, however, a very contentious issue, as fairness can be defined in many different ways. For example, there is disagreement as to whether it is fair for a family in which one adult earns $45,000 while the other earns $125,000 to pay over $4,000 more in income tax than a family in which both adults earn $85,000 even though the family income in both cases is $170,000 (approximation based on Ontario’s tax brackets). Without reviving the debate about the merits and drawbacks of income splitting, the same logic can be used to motivate the fairness of income sprinkling; small business owners are trying to pay the same amount of income tax as other households whose income happens to be separated more evenly amongst family members.

Ultimately, whether we believe that fairness requires income to be taxed at the individual or the family level, we should agree that closing this loophole is the right thing to do in order to preserve the integrity of our tax system, as the unit of taxation in Canada is the individual (as per the definition of the benchmark tax system). If we then decide as a society that it is unfair to charge more or less income tax to families earning the same family income, we can address those concerns through the creation of a tax expenditure, or by changing the unit of taxation to families such as in the United States.


Efficiency is another important consideration when evaluating the proposed measure aimed at closing the income sprinkling loophole. However, not everyone in society is identical so the effects on efficiency will be considered in the context of the affected small business owners. These small business owners can be broadly divided into three groups:

  • incorporated professionals (doctors, dentists, lawyers, etc.)
  • start-ups (or, more generally, small businesses that are intended to grow)
  • small businesses that are not intended to grow

Each of those groups is affected differently by the following distortions caused by both the loophole as well as the proposed measure:

  • the proposed measure creates a disincentive to work by raising the effective marginal tax rate on small business owners
  • the loophole creates a disincentive to invest and grow in cases where changing the business’ corporate structure to add a business partner or an outside investor may prevent future income sprinkling
  • the loophole creates a disincentive to work for spouses and adult children who partake in income sprinkling and face a higher marginal tax rate as a result

The disincentive to work that may arise as a result of the proposed measure is likely to be limited to start-ups and small businesses that are not intended to grow, as incorporated professionals provide labour in a way that is generally indivisible like employees (they cannot easily choose the number of hours that they work as in Hansen (1985)[2]. The disincentive to invest and grow caused by the loophole is limited to start-ups, and while this may seem like a small fraction of the targeted small business owners, it goes directly against the job creation arguments used to justify a lower corporate income tax rate for small businesses. Finally, the disincentive to work that the loophole creates by raising the marginal income tax rate of family members affects all three groups and is likely the most significant of all in terms of overall magnitude.

Ultimately, with such a wide range of small businesses affected, whether closing the loophole is efficient or not relative to other revenue raising taxes is unclear. Research has however shown that incorporated professionals are the most likely to benefit from the loophole while “traditional small businesses, such as family-run farms or restaurants, are 2.5 times less likely than professionals to benefit from income sprinkling”[3]. The proposed measure could, therefore, be expected to be at least as efficient as other taxes. Regardless of where the measure falls on efficiency, however, it is imperative from a fairness point of view to close the loophole such that the policies are consistent with Canada’s benchmark tax system and politically chosen tax expenditures.


[1] “Report on Federal Tax Expenditures 2017, Part 1 – Tax Expenditures and the Benchmark Tax System: Concepts and Estimation Methodologies”, Department of Finance Canada, 2017. URL:

[2] Hansen, G.D., “Indivisible labor and the business cycle”, Journal of Monetary Economics, 16(3), November 1985.

[3]  Macdonald, D., “Splitting the Difference – Who really benefits from small business income splitting?”, Canadian Centre for Policy Alternatives, September 2017. URL: