The Ontario government is likely to address a tax integration anomaly created by its decision not to match the federal government’s changes to the passive investment income rules affecting small business taxation, tax experts say.
The current mismatch in the federal-provincial tax treatment of private corporations in Ontario means that a small business with more than $150,000 of passive investment income, and full access to the Ontario small business deduction (SBD) rate only, is subject to a total combined personal/corporate tax rate of 51.33% when dividends are paid out. Meanwhile, a small business with less than $50,000 of passive investment income, and full access to both the federal and Ontario SBD rate, is subject to a higher combined tax rate of 53.97%.
“I suspect it will be corrected, [but] it’s not an easy fix,” said Jamie Golombek, managing director of tax and estate planning with CIBC Financial Planning and Advice. Golombek spoke at the Canadian Tax Foundation’s Ontario Tax Conference in Toronto in last week.
Said Kevyn Nightingale, a partner and business advisor with MNP LLP in Toronto, at the tax conference: “Ontario is going to fix integration because integration makes sense.” Failure to address the issue over the long term might tempt people to “play games” with the tax system, Nightingale suggested.
The federal government introduced new rules, effective this year, to limit the tax deferral opportunity associated with earning passive investment income in a private corporation. Small businesses earning more than $50,000 in passive income in a year lose access to the SBD at a rate of $5 for every $1 over the threshold. At $150,000 and above, access to the SBD is lost entirely.
In late 2018, Ontario announced that it would not match the feds’ new rules governing passive investment income, meaning small businesses in the province are subject to the new federal rules, but not on the provincial level. New Brunswick is the only other province that has decided not to match the federal rules.
Ontario’s decision created a break in tax integration, Golombek said, a result that was likely unintended. Under the concept of integration, the total tax rate on income earned corporately should be roughly equal to the tax rate on income earned on an individual basis. Integration of tax rates is achieved by grossing up dividends paid out of a corporation and then applying a dividend tax credit.
In Ontario, as the federal SBD is clawed back when passive investment income is above the $50,000 threshold, dividends paid out a private corporation are taxed as eligible dividends, meaning they are eligible for a higher dividend tax credit, as opposed to the lower-value dividend tax credit associated with non-eligible dividends. However, this doesn’t account for the fact that the Ontario portion of tax is being paid at a lower SBD rate.
Small businesses in the province with $150,000 or more of passive investment income lose out on a part of the tax deferral opportunity associated with the federal SBD but would gain from the 2.64% tax rate differential on the distribution of dividends as compared to a small business with less than $50,000 in passive investment income.
“For an individual [small business owner] who spends all of his or her money in the current year, you actually have a tax-savings opportunity here by having more than $150,000 of passive income,” Golombek said in an interview.
The province, or even the federal government, could use legislation to “fix” the issue, but that would only increase the complexity of already complex tax rules, Golombek said.
Small business owners in the province should consult with their tax and financial advisors to consider their remuneration, investment and tax-planning strategies in relation to their private corporation in light of the opportunity created by the provincial-federal mismatch in tax treatment of passive investment income, Golombek said.
Nightingale said that achieving integration is tricky, particularly when governments across Canada work at cross-purposes: “We don’t have one government that is going to design a perfect integrated tax system. We have 14 [federal, provincial and territorial] governments that are competing with each other to do all sorts of different things and have different interests at heart.”