The federal government has made changes to its rules around passive income in private corporations, gradually reducing access to the small business tax rate for those with significant passive investment income.
The plan put forward in Tuesday’s federal budget takes a different approach to the one the government proposed last summer that received considerable blowback from business owners.
The budget introduces a new eligibility mechanism for the small business deduction based on a Canadian controlled private corporation’s (CCPC) passive investment income: if a corporation earns more than $50,000 of passive investment income in a year, the amount of income eligible for the small business tax rate is reduced and more of its active income is taxed at the general corporate rate.
The $50,000 threshold, originally announced in changes the government made to its proposals while under pressure from business groups in October, is equivalent to $1 million in passive investment assets at a 5% return.
The small business deduction limit will be reduced by $5 for every $1 of investment income above the $50,000 threshold. The limit would be reduced to zero at $150,000 of investment income ($3 million in passive assets at a 5% return), the budget says.
The new rules target the small business tax rate to ensure small businesses “reinvest in their active business, not accumulate a large amount of passive savings,” the document says. They will come into effect after the 2018 tax year.
“The new approach will be much simpler to comply with, will not require the tracking of new and legacy pools of passive investments, and will target only private corporations with more than $50,000 in passive investment income per year or approximately $1 million in passive investment assets (assuming an average 5% return),” the budget adds.
The current small business deduction limit allows for up to $500,000 of active business income to be subject to the lower small business tax rate.
The budget provides some long-awaited clarity for business owners, says Doug Carroll, head of tax, estate and financial planning at Meridian Credit Union. The new rules are much “simpler” and “cleaner” than what was originally proposed, he says.
“It’s not affecting passive income taxation directly in the corporation. Instead it’s pointing over towards the small business rate,” he says.
“The thresholds that you break through, where you are going to lose your availability for the small business rate, are clear. There’s a formula there.”
Bruce Ball, vice-president of taxation at CPA Canada, says the new rules are better targeted at what Finance was trying to achieve.
“The main issue seemed to be people earning small business income and reinvesting it in passive investments,” he says. “They tried to deal with it by over-taxing the investment income. This proposal actually goes more to the heart of the issue: it determines whether they should be eligible for the small business deduction in the first place. We think that’s a better approach.”
The rules will apply to “any other associated corporations with which it is required to share the business limit for a taxation year,” the accompanying Tax Measures document says.
Refunds through distribution of dividends
The budget also changes how CCPCs can access refunds through dividends.
Currently, private corporations’ investment income is taxed at a higher rate, a portion of which is refunded when investment income is paid out to shareholders in dividends. In practice, though, taxable dividends can allow for a refund of taxes on investment income, whether that dividend comes from investment income or active business income (which is taxed at a lower rate), the document says.
This allows CCPCs to pay out lower-taxed dividends from their active income and claim a refund on taxes paid on their investment income, which the budget calls “a significant tax advantage.”
The budget will prevent CCPCs from being able “to obtain refunds of taxes paid on investment income while distributing dividends from income taxed at the general corporate rate,” the budget says.
A refund of the refundable dividend tax on hand (RDTOH) will only be available “in cases where a private corporation pays non-eligible dividends,” the accompanying Tax Measures document says.
“There was always a quirk in the tax system that you could earn business income, and pay a lower-rate dividend and trigger a dividend refund at the same time,” Ball says. “What they’ve done is they’ve tried to get you to trace the sources of the refundable tax to match it up with the appropriate dividend that’s paid out.”
No further changes to income splitting
The passive income changes will only apply to less than 3% of CCPCs, or roughly 50,000 corporations, the budget says, and more than 90% of the revenues from the two measures would come from business owners whose household income is in the top 1%.
Together with the income sprinkling rules released in December, the government expects the measures to raise $233 million in 2018-19 and $925 million by 2022-23.
The changes come after months of challenges to the Liberal government’s original proposals from business groups and even from the Senate finance committee. In a December report, the committee said the passive investment proposal “is based on a one-size-fits-all approach, which would constrain the growth of small businesses and the regular operations of medium and large businesses.”
The Liberals responded to pushback in the fall by cancelling elements of the original plan related to the lifetime capital gains exemption and promising to reduce the small business tax rate from 10.5% to 9% over two years.
The government also clarified its original proposals on incoming sprinkling, which were not changed in the budget. Unlike the passive income rules, which come into effect for 2019, the income sprinkling rules came into effect on Jan. 1. That implementation date was not pushed back, as some business groups were requesting.
In brief, a tax on split income now applies to dividends paid to family members, except when they are:
- the business owner’s spouse, provided the owner meaningfully contributed to the business and is aged 65 or older;
- aged 18 and older and make “regular, continuous and substantial” labour contributions to the business during the last five years; or
- aged 25 and older and own at least 10% of a corporation that earns less than 90% of its income from services, and isn’t a professional corporation.