Federal Finance Minister Bill Morneau tabled the Liberal’s third budget on February 27, 2018. The release of the budget was significant in that we would finally get to see how the government would approach the taxation of investment (passive) income earned by private corporations.
To refresh your memory, on July 18, 2017 the government released a consultation paper (and draft legislation) to:
- Extend the existing kiddie tax rules to prevent “income sprinkling” amongst adult family members and to curtail access to the capital gains exemption,
- Shut down planning that allowed money in a corporation to be paid to a shareholder that attracted a capital gain tax rate, instead of a dividend tax rate (i.e.: a lower tax rate), and
- Introduce measures that would deter the earning of investment income in private corporations by subjecting such income to punitive tax rates (references were made by tax advisors to tax rates exceeding 70%).
The income sprinkling rules have been introduced, effective January 1, 2018. The government did not move forward with measures to deal with the extraction of funds from corporations or with measures limiting access to the capital gains exemption.
Passive Investment Income Earned by Private Corporations
As it turns out, much of the fuss made by the government in its July 18, 2017 consultation paper has not made its way into the 2018 Federal Budget, and hence, will not become part of the income tax landscape. The government should be commended for listening to the feedback provided since July of last year as the proposals if implemented would have been catastrophic.
The measures announced in the 2018 Federal Budget will impact Canadian-controlled private corporations (CCPCs) that earn business income in Canada, access the small business tax rate on that income, and also at the same time earn investment income in the company or another associated company. Specifically, the CCPC’s access to the small business tax rate will be reduced to the extent the CCPC and any associated corporations earn investment income exceeding $50,000. Access to the small business rate of tax will be completely eliminated where the investment income of the CCPC and any associated corporations exceeds $150,000. The existing taxable capital measures that also limit access to the small business tax rate remain in place. Therefore, it will be necessary to manage taxable capital and investment income in ensuring access to the small business tax rate.
The measures announced are effective with taxation years commencing after 2018.
The small business tax rate is accessed on the first $500,000 of active business income earned in Canada – this is the “small business deduction”. The investment income range of $50,000 to $150,000 means that for every $1,000 of investment income exceeding $50,000, the small business deduction will be reduced by $5,000. In Alberta, and in 2019, this means the $5,000 will be subject to corporate tax at 27% instead of 11%.
For purposes of determining access to the small business tax rate only, investment income of a CCPC and any associated corporations will not include taxable capital gains from the disposition of “active assets”. Active assets of a corporation include:
- property used principally in an active business carried on primarily in Canada by the CCPC or a related CCPC,
- A share of a connected corporation carrying on an active business primarily in Canada (ie: similar to the requirements that would need to be met in order for an individual to sell the shares and claim the capital gains exemption), and
- An interest in a partnership, where various requirements are met.
In addition, net capital losses carried-forward and utilized in the taxation year to offset taxable capital gains, will be ignored. The premise for this is not yet apparent to us.
The concern with the July 18, 2017 proposals as it relates to investment income earned by private corporations, was that taxpayers were using their companies as savings vehicles or “private pension plans”, and that the proposals would significantly penalize those taxpayers that had saved in their companies – the penalty of course being the potential 70% tax rate.
The measures introduced in the 2018 Federal Budget eliminate this fear. Stand-alone investment holding companies are not impacted by these measures. The budget, as referenced above, will impact those CCPCs and any associated corporations that carry on an active business and at the same time earn investment income. If the magnitude of the investment income is less than $50,000, then the measures have no effect.
It should be noted that the investment income of the CCPC and any associated corporations in a taxation year will impact the ability of the CCPC to access the small business rate of tax in the following taxation year. However, if a CCPC experiences a situation where it cannot either partially or fully access the small business tax rate, because of, for example, a large unforeseen capital gain in the previous taxation year, the CCPC and its shareholder will not be subject to punitive tax rates on the business income or the investment income due to the integrative nature of the tax system. More corporate tax will be paid on the business income, but less personal tax when a dividend is eventually received by the shareholder.
Finally, the government in October 2017 announced that any measures introduced in reference to the taxation of investment income of CCPCs, would grandfather existing investment holdings. While the taxation of investment income itself has not been altered per se, returns generated on existing investment holdings may reduce access to the small business tax rate in the future. In other-words, there is no grandfathering.
Another 2018 Federal Budget Measure – Refundable Taxes
When a CCPC pays tax on investment income, part of the tax is refundable to the corporation. The refund is obtained by the corporation when it pays a dividend to an individual shareholder. The refund mechanism is meant to place an initial tax burden on the company so that it does not have an investment advantage compared to an individual, and the refund mechanism is in place to ensure that tax integration is achieved.
The budget is proposing measures that are going to make this refund mechanism more complicated. The existing refund mechanism of a corporation, referred to as “refundable dividend tax on hand” or RDTOH, is being modified to track eligible and non-eligible dividends.
New accounts referred to as “eligible RDTOH” and “non-eligible RDTOH” are being introduced. In short, effective with taxation years commencing after 2018, eligible dividends paid by a CCPC will only result in a dividend refund to the extent there is an existing “eligible RDTOH” balance. An eligible dividend will not result in the refund of “non-eligible” RDTOH. On the other hand, a non-eligible dividend payment will result in the refund of “non-eligible RDTOH” first, and then to the extent there is an “eligible RDTOH” balance. This may become more of an exercise for the accountants, but nonetheless, the government expects this measure to raise additional tax revenue.
There are also transition rules to apply where a CCPC (and other private corporations) enter into the 2019 taxation year with an existing RDTOH balance.
In summary, managing dividends and the RDTOH account is going to become a bit more complicated, but at least the principle of tax integration between individuals and private companies will be maintained.
If you have any questions, contact:
Carl Scholz, CPA, CA, TEP
Partner – Tax Advisory
Jeff Fortin, CPA, CA, CPA (Illinois, USA)
Partner – Tax Advisory
 Generally, eligible dividends are paid by Canadian public companies and CCPCs where the corporate income did not benefit from the small business tax rate. An eligible dividend retains its status as it is paid between CCPCs. A non-eligible dividend is paid by a CCPC where the corporate income benefited from the small business tax rate. An eligible dividend is taxed more favourably when received by an individual because a higher corporate tax rate has been paid.