It’s what small business owners have been waiting for ever since the federal government released its July proposals: clarity on how passive income will be treated.
While tax experts say the new rules are clearer and simpler, there are disadvantages.
The Canadian Federation of Independent Business points out in a release that some businesses will lose access to the small business tax rate for past investments. That’s because the $50,000 to $150,000 threshold encompasses all passive income, regardless of whether the asset was acquired before or after Budget Day.
The government’s changed tack was largely unexpected, says Matthew MacAdam, partner and leader for tax services in Nova Scotia at Grant Thornton.
“I don’t think the business world was necessarily [ready for this]—all indications were that it was going to go a different route,” he says.
He says he feels for clients who transferred passive assets into their corporations ahead of the budget, “thinking they were doing themselves a favour,” only to realize today that their passive income will cause the corporation to lose some of its small business deduction starting in 2019.
Aaron Schechter, tax partner at Crowe Soberman LLP in Toronto, says that private corporations with large accrued gains will bear the brunt of the new rules. “If they liquidate those investments in a particular year, they can find themselves without access to the low corporate tax rate for the year in question.”
Since the new rules take effect in the 2019 tax year, Schechter says it may be possible to act now.
“If the corporation plans to liquidate [their passive] investments in the next year or two, and they’re also earning business income, then it may make sense to take the hit this year,” he says. “But if they have long-term holdings, it probably pays just to hold on to those investments and liquidate them slowly so there’s no grind down of the small business deduction limit.” He adds that a future government may reduce the corporate tax rate or change the rules again, reducing the tax hit of realizing gains in the distant future.
Besides, Schechter says, the majority of people who hold passive investments in their corporations do so for long-term purposes, not short-term.
Choosing passive investments
MacAdam says the $50,000 passive income threshold only encompasses taxable income, so “if you shifted your investment strategy to [earn] less interest and more capital gains, then your threshold may go a little bit further.” He adds that clients could consider tax-efficient investments such as those that generate return of capital (e.g., systematic withdrawal plans), non-dividend-earning stocks and ETFs that don’t make annual distributions. (PWL Capital advisor Justin Bender provides more strategies in an article written before Budget 2018’s release.)
“You can say these rules, to some degree, also impact the investment choices that some Canadians are making,” says MacAdam. He emphasizes, however, that the tax tail shouldn’t wag the investment (or business) dog.
“In some cases, the proper business decision is to have that war chest of passive investments to be able to fund a downturn or make the next acquisition or grow the business,” he says. “It’s those businesses you feel concern for, because you don’t want see situations where businesses are forced to make decisions solely on tax motivations.”
Active investments exempted
In positive news, the new measures will not encompass capital gains from the sale of active investments.
Schechter defines “active investments” as assets “used in your active business,” and provides
“If you have a piece of real estate, like a building used in your operations, and you decide to sell it, ordinarily, the capital gain on that asset would have been considered to be passive income. They’re going to exclude that from the passive income [pool] so it won’t count toward the grind down of the small business deduction limit.”
Another example: if you sell shares of a subsidiary, “that also will not grind down your small business deduction limit.”
Schechter says there’s no brightline test to differentiate active and passive assets. “I don’t know if the government needs to address what is going to be considered to be an active asset unless they start seeing abuses, […] and I can’t think of a way a company would be able to circumvent these rules.”
He also points out that the rules prevent one person from setting up two different corporations, one to hold active assets and the other to hold passive investments “and be able to circumvent the rules.”
Rental income: passive or active?
CRA said in 2016 that “the specified investment business rules make it clear that if a corporation’s only business is […] to earn income from renting out real property, it is not eligible for the small business deduction.”
Matthew MacAdam of Grant Thornton points out that if a professional owns a property and rents out extra space to an unrelated party (e.g., a doctor renting office space to an accountant), that income is considered passive.