If your business-owner clients will be affected by the new passive investment rules, ensure they have effective planning in place.
Those rules, introduced in the 2018 federal budget for the 2019 tax year, include the “potential looming loss” of the small business deduction (SBD) for corporations with more than $50,000 of passive investment income in 2018, says Jamie Golombek in a report co-authored with Debbie Pearl-Weinberg. Golombek is managing director and Pearl-Weinberg is executive director of tax and estate planning at CIBC Financial Planning and Advice.
The SBD is available to Canadian-controlled private corporations (CCPCs), including incorporated professionals that earn active business income up to $500,000 (in most provinces). Under the new rules, the SBD will be reduced by $5 for every $1 of investment income above $50,000, and reduced to zero at $150,000 of investment income.
“The government was concerned that business owners were accumulating additional investment income in their corporation[s] as a result of the low small business tax rate,” said Golombek in a mid-October interview. For example, in Ontario that rate is 13.5% (federal and provincial combined), while the top personal marginal rate is 53.5%. Thus, income eligible for the SBD that was left inside a corporation benefited from a tax deferral of 40%.
The new rules limit or eliminate that deferral, depending on a corporation’s passive investment income in the previous year, based on adjusted aggregate investment income (AAII).
Possible tax strategies
For clients who could lose access to the SBD, one option to reduce AAII is to withdraw money from the corporation to make RRSP and TFSA contributions. This is something business owners should already do regardless of the new rules, Golombek said.
“Business owners should be maximizing RRSPs and TFSAs first before leaving excess funds in the corporation,” said Golombek, who has contributed to reports showing that, given sufficient time, RRSP and TFSA investing outperforms corporate investing when earnings come from interest, eligible dividends, annual capital gains or a balanced portfolio.
For purposes of AAII, “when you take the money out of the corporation to make an RRSP or a TFSA contribution, that money is no longer accumulating inside the corporation and therefore does not give rise to excess passive investment income,” said Golombek.
Another option is tax-free withdrawals from the corporation. “For example, if there’s a shareholder loan, maybe that could be paid back from the company tax-free to the shareholder as a way of taking excess funds out of the company that aren’t needed for operations,” he said.
Another way to reduce capital that’s earning passive income inside the corporation is through paying capital dividends. “If there are capital dividends to be paid that resulted on the non-taxable portion of a capital gain or death benefit associated with life insurance, pay out a capital dividend tax-free to the shareholder,” said Golombek.
Investment strategies also come into play. For example, with capital gains investing, “only 50% of the income is included in the passive test,” said Golombek, referring to the capital gains tax rate.
He also suggested a buy-and-hold strategy to defer capital gains in a year or to stagger them in different years.
Another possibility is using investments that pay a mixture of income and return of capital, such as T-Class units of mutual funds and REITs. “Return of capital is not included in income in the year received,” say Golombek and Pearl-Weinberg in the report. “Rather, it reduces the adjusted cost base of the investment and increases the capital gain (or decreases the capital loss) on the future disposition of the investment.”
The report adds that any investment strategy should account for the overall investment plan, as well as AAII expectations for future years.
Other strategies include using an individual pension plan (IPP) or life insurance. “Since the corporation contributes to the IPP and the income earned in the IPP does not belong to the corporation, that income is not AAII,” says the report.
A corporately owned life insurance policy can be considered where a client has a life insurance need in addition to a desire to limit AAII.
“By funding corporate insurance with cheap corporate dollars inside the corporation [that are taxed at a lower rate relative to income earned personally], you’re effectively removing the funds from the corporation and therefore the income on those funds isn’t generating passive investment income,” said Golombek.
Further, as long as income from investments underlying the policy isn’t included in the corporation’s income on an annual basis, it shouldn’t be included in AAII, says the report. That’s the case for permanent life insurance policies qualifying as exempt policies.
Before discussing strategies with clients, however, consider that not all business owners will be affected by the new rules, said Golombek. For example, a holdco or investment company that earns only passive income wouldn’t be subject to the small business rate.
“Similarly, if you’ve got an incorporated professional that operates as a partner with one of the major accounting or law firms, they probably don’t already access the small business rate, and therefore they really have nothing to lose,” he added.
For more details, read the CIBC report.
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