Finance says Canadians who hold passive investments in private corporations get an unfair tax advantage. That view is problematic.
For this second issue highlighted in its July 18 tax proposal, Finance didn’t provide draft tax legislation or set an implementation date. Instead, Finance outlined concerns with the current passive income tax measures, proposed alternate methods to address its concerns, and requested key stakeholders and taxpayers to comment on the proposed methods by October 2.
Let’s take a deeper look.
Integration is a fundamental principle of Canadian income taxation. In brief, the cumulative total of taxes paid on a dollar of income earned first by a corporation and then paid to an individual as a dividend should equal the tax paid by an individual who earned the same income directly.
Currently, several tax provisions or accounts help achieve integration, such as the Refundable Dividend Tax on Hand account (RDTOH) for private corporations and the dividend gross-up and tax credit for individuals. These prevent double taxation, whereby the same income is taxed twice, which is different than being subject to two intergrated tax layers. See Table 1.
Table 1: Two integrated tax layers
Another example is the Capital Dividend Account (CDA). To preserve tax-preferred treatment on certain types of receipts, such as the 50% non-taxable portion of capital gains or the tax-free portion of a life insurance payout by a private corporation to shareholders, the corporation uses the CDA and pays out tax-free capital dividends.
Without the CDA, a corporation would have to pay a regular dividend to its shareholders to distribute the 50% non-taxable portion of capital gains or tax-free life insurance, which would be taxable in the shareholders’ hands. That wouldn’t be fair: the shareholders would pay more tax on these receipts than individuals who had received these receipts directly.
Finance says current tax measures and the principle of integration on income are insufficient, as they don’t account for the source of passive investments generating such income. Note the distinction here between investments and income. Finance wants to take a step back and apply integration to the original source generating the passive investments. Specifically, Finance wants to focus on whether passive investments are sourced from cheaper after-tax corporate dollars or more expensive after-tax personal or corporate dollars.
For example, Finance says private corporations, particularly those with more favourably taxed active business income, benefit from a significant tax deferral advantage when after-tax dollars are invested in passive investments at the corporate level. Finance is concerned that this deferral provides an incentive for private corporations to become personal savings vehicles — and that’s not fair, it says.
The average combined tax rate (as of June 30, 2017) for a corporation earning $100,000 of active business income is 13.7%, whereas the average combined tax rate for an individual earning regular income is 26.7%. The corporation would have an additional $13,000 ($100,000 × (26.7% − 13.7%)) to invest annually on an after-tax basis. However, when passive corporate investments are liquidated, and, on an after-tax basis, paid out by the corporation, a second layer of income tax — personal — is incurred by the business owner. Hence, tax is deferred, not saved, on corporate passive investments.
For subsequent passive income earned on such investments, an individual investor will be subject to only one layer of tax — personal — as opposed to a corporate investor, who is subject to two layers — corporate and personal, as shown in Table 1. Given the existing punitive tax treatment of passive interest income left in a corporation of 51.7% (average combined tax rate), most tax advisors immediately declare and pay dividends to move such income into the hands of shareholders. Thus, there’s generally minimal or no deferral or tax savings generated on corporate passive income.
Finance’s proposed alternatives
Despite these existing disincentives for corporate passive income, Finance is proposing to move integration up one level — where the passive assets are generated. To do so, Finance proposes that Canadian-controlled private corporations elect to use one of the following methods for taxing their passive income:
|Method||Effect on corporation||Effect on shareholder||Considerations|
|Deferred taxation on general active business income||Tax passive investment income at top combined marginal personal tax rate, with removal of RDTOH||Non-eligible dividends are the only type of dividend||Non-eligible dividends are the only type of dividend|
|Deferred taxation by apportionment method on passive income||Apportion passive income by tracking three pools of capital: income subject to active/small business tax rate, income subject to general tax rate and amounts contributed by shareholder on an after-tax personal rate. Corporate tax rate would determine nature of shareholder dividend||There could be eligible, non-eligible or tax-free dividends||There could be eligible, non-eligible, or tax-free dividends|
|Deferred taxation by elective method||Default||Tax passive investment income at top combined marginal personal tax rate, with removal of RDTOH||Non-eligible dividends are the only type of dividend||Non-eligible dividends are the only type of dividend|
|Elective||Subject passive income to additional refundable taxes. Further, the non-refundable tax rate would equal the top combined marginal personal tax rate. No income would be eligible for active/small business rate||Eligible dividends are the only type of dividend||Eligible dividends are the only type of dividend|
|Holdco election||Considers all income passive income, subject to top combined marginal personal tax rate using refundable tax system, like current RDTOH regime||Eligible dividends are the only type of dividend||An additional refundable tax would bridge the gap between corporate tax rate and top combined marginal personal tax rate|
You’ve probably heard of the potential 70%+ tax rate reported on passive income using these proposed methods. That can indeed happen.
In brief, this tax rate occurs when $10 of interest is subject to 50% corporate tax (equal to the average top combined marginal personal rate) and the remaining after-tax $5 is paid out to the shareholder in the form of a non-eligible dividend where it is taxed at 20% on average. The 20% tax rate can vary dramatically depending on the individual’s province and respective marginal tax rate. Simply put, integration doesn’t occur under the proposals, as no adjustment is made to corporate tax paid on the interest and when paid out as a dividend to the individual shareholder. See the above chart, specifically “Deferred taxation on general active business income” and “Default,” under the Elective method.
Finance intends that any tax measures subsequently introduced will apply to passive investments on a go-forward basis, and it asked stakeholders and taxpayers to submit recommendations during the consultation period on how to grandfather or preserve the tax treatment of existing passive investments.
Carson Consultants Corporation (CCC)
Consider this example of how passive income is treated now versus under the proposals:
Aja Carson, a 53-year-old divorcee with no dependants, incorporated her oil and gas resource engineering consulting practice, CCC, more than 15 years ago. When additional assistance is needed to meet clients’ demands, CCC uses outside contractors.
Over the years, CCC has set aside, withdrawn and replenished funds for anticipated capital needs or to help carry expenses when receivables aren’t paid on a timely basis or during an economic downturn, as recently experienced. CCC currently has $1.2 million invested in a diversified conservative portfolio to meet these needs.
What Aja Carson and CCC should know
Though Finance hasn’t yet provided proposed tax legislation or an implementation date for such, the following points should be highlighted and discussed now with Aja Carson and clients like her.
Complexity leads to costs — The proposed methods are complex and few business owners have time or expertise to assess their passive investments and provide the relevant income information to be compliant. This burden will fall to their tax advisors, thus increasing the associated costs of compliance (preparing corporate tax returns). How will Finance explain such cost increases to business owners?
Genuine corporate savings incur a cost — Finance hasn’t distinguished between the various uses for accumulating passive investments in the corporation. Such uses include future growth; capital assets, such as equipment, buildings or farmland; an operations cushion in an economic downturn; or business owner retirement. Growth and expansion aren’t linear, and unplanned events can become opportunities if a business owner has passive investments on hand. With little savings, what are the chances a business manufacturer can approach a bank or credit union to extend a mortgage to acquire a warehouse? Saving corporately, for whatever reason, will be a lot more expensive tax-wise.
Dividends affect retirement savings — Where business owners pay themselves dividends, they don’t generate RRSP contribution room, as dividends aren’t considered earned income for RRSP purposes. The proposed methods severely compromise business owners needing flexibility in saving for both corporate growth and retirement. Sure, they can always pay themselves a salary; however, there are numerous other considerations when contemplating salary versus dividends.
Double standards — Many business owners save for retirement in their corporations because of the aforementioned flexibility concerns. Yet passive income earned in an RRSP is subject to tax only upon redemption, whereas passive income earned in a corporation is never sheltered from tax. In addition, when anyone is paid a salary and makes RRSP contributions, and subsequently converts the RRSP to an RRIF or other similar retirement income stream, the eligible pension income can be split with their spouse. Yet, Finance with their proposed tax measures wants to eliminate spousal income splitting for private corporations.
Choosing a method today — Finance’s proposed methods require that a corporation elect a method to track its passive assets, and/or income from such, to determine the tax treatment of passive income on a go-forward basis. How many business owners have the knowledge or expertise to make such a decision, and can forecast which method will be in their best interests in five, 10 or 20 years? Times and circumstances change, not to mention tax legislation.
Capital gains are penalized — Finance will no longer add the 50% non-taxable portion of a capital gain to a private corporation’s CDA. In brief, integration of capital gains will be severely compromised, and capital gains will be taxed at a much higher combined tax rate than if they had been reported personally.
Specific points for Aja to address with a tax advisor
Corporate reorganization may be needed — Should a corporate reorganization be considered, as CCC has $1.2 million in passive investments? Would the creation of a holding company, or perhaps a butterfly transaction, be prudent to separate CCC’s existing passive assets from its active, ongoing operations? Such steps would make it easier to preserve the grandfathering of existing passive investments, allow for a separate election to be made by the new holding company, and ease future tax compliance associated with the passive investments. On the downside, if the passive assets are needed by CCC to fund capital expansion or maintain operations in an economic downturn, a corporate loan between the two corporations will be required, which introduces its own associated issues.
Plan for future passive investments — Once Finance has drafted and implemented its new tax measures for passive investments, what should CCC’s tax advisors consider when accumulating new passive investments in CCC? Undoubtedly, the new tax measures will impact the quantum and nature of Carson’s compensation, as well as how CCC accommodates future growth or cash flow needs.
Advisors must act
Canadian small businesses that don’t fund future growth with after-tax earnings each year will be penalized with higher corporate income tax rates on passive income. They’ll also likely incur additional compliance costs due to the complexity of reporting passive investments and income in future.
Finance has expressed the following objectives for its tax regime on passive investments held in corporations:
- Preserve the intent of the lower tax rates on active business income earned by corporations, which encourages growth and job creation.
- Eliminate the tax-assisted financial advantages of investing passively through a private corporation.
- Limit, to the extent possible, the complexity of any new tax rules.
Finance’s proposed methods address only the second objective, achieving it at the cost of the other two. In an effort to capture those taxpayers Finance says are unjustly advantaged, Finance penalizes those who genuinely drive Canada’s economy. Many Canadians are employed by Canadian private corporations, purchase goods and services from them, and provide goods and services to them. That means all Canadians will be impacted by these proposed tax measures.
Admittedly, there are private corporations and respective shareholders that benefit unjustly from current tax measures. Tax reform is needed. However, what I have outlined in this and previous articles is that, in their current form, the proposed measures and methods are too broad, impacting all private corporations. They don’t exclusively capture high-income-earning Canadians.
Finance has also failed to provide adequate consultation and sufficient time for corporations to consider restructuring. Finance recognized the increase in private corporations more than 10 years ago. Over that time, they drafted and considered various tax measures for private corporations. The current government had at least 21 months to consider Finance’s proposed measures before announcing them. Yet, Finance allowed stakeholders and taxpayers only 75 days to research, consider and comment on the proposed measures and methods outlined in its July 18 tax proposal.
Private corporations that incorporated years ago, with appropriate authorized share classes and shares that were issued onside with historical corporate and tax legislation, may now be offside and require major restructuring, which in turn requires the time and attention of sophisticated corporate legal and tax advisors, which will be costly.
Advisors should reach out to private corporation clients and provide them with information on their passive investments. Clients should also be prompted to reach out to their tax advisors to consider Finance’s proposed methods and determine what alternatives they might have. Your value proposition lies in being proactive, and delivering timely information, as clients might have only a short time to react before the tax measures become law.