On February 27, 2018 the federal government presented Canada’s 2018 federal budget. Particular tax changes of note were in respect of passive investment income and confirmation of the income splitting measures as noted in the draft legislation introduced in 2017.
Prior to the introduction of the new taxation measures, the three main tax benefits of incorporation were:
1. The ability to income split with family members
2. Deferral of income taxes
3. Access to the Capital Gain Exemption (CGE)
While the deferral of income tax and access to the CGE remain largely unaffected by the 2018 federal budget, the new income sprinkling rules limit a corporation’s ability to split income with family members, by subjecting the recipients of the income to the top marginal tax rate. As anticipated, the federal budget proposed no significant changes to the draft legislation released in December 2017. Please see our blog post here: http://www.rhncpa.com/splitting-income-small-businesses-family-members/ P
REFUNDABLE DIVIDEND TAX ON HAND
The budget proposes to introduce changes to how corporations are taxed on their investment income. In the past, taxable eligible dividends could be paid to get back refundable taxes paid on investment income. The 2018 federal budget proposes to limit the ability to recover refundable taxes paid when paying out dividends that would be subject to a lower rate of personal tax. These dividends represent income that has been taxed in the company at regular rates (no small business deduction). These rules do not apply, however, when the refundable tax is the result of portfolio dividends received by the company.
CHANGES TO TAXATION OF PASSIVE INCOME
The budget proposes to reduce the small business deduction available to a Canadian Controlled Private Corporations (CCPC) and its associated companies that earn in excess of $50,000 of passive income within the group. Under the current system, the small business deduction (SBD) allows qualifying active business income from an associated group of companies up to $500,000 to be taxed at a preferential low rate of tax (12%). The budget proposes to restrict the CCPCs access to the SBD by reducing the limit by $5 for every $1 of investment income exceeding the threshold. Passive income includes income earned from stocks, bonds, other securities, rental properties, interest income, and capital gains. As a result of a reduced small business limit, active business income in excess of the limit will be taxed at the general federal rate of 27%.
For corporations that are part of an associated group, the mechanism proposed to reduce the SBD is similar to how corporations allocate the business limit for the purposes of the SBD. If the passive income earned by all the corporations in the associated group exceeds $150,000, all corporations in the group will not receive any SBD.
Mr. X owns shares of OpCO and HoldCO and the two companies are associated for purposes of sharing the SBD. OpCO generates taxable active business income of $500,000 and HoldCO earns $75,000 of passive investment income. Under the current tax system, OpCOs taxable income would be fully taxed at the lower rate of 12% through the use of the small business deduction. OpCo would pay tax of $60,000.
Under the proposed rules, the $500,000 small business limit would be reduced by $125,000 ($5 x $25,000 excess). As a result, OpCo’s income would be taxed at two different rates: $375,000 would be taxed at 12%, the remaining $125,000 would be taxed at the general corporate rate of 27%, even though OpCo itself did not earn any passive income. The total tax bill for OpCo under the passive income proposals is $78,750, for a difference of $18,750.
This commentary is intentionally general and is designed to bring to light the basics of these new rules. The detailed changes are extensive and will apply differently in each situation.
Please give us a call if you have any questions that relate to your specific circumstances.