Small business owners, along with incorporated doctors, lawyers and other professionals, breathed a collective sigh of relief on Tuesday night as they started to parse through the government’s entirely new approach to dealing with passive investment assets held by Canadian controlled private corporations (CCPCs).
You’ll recall that the small business tax debacle began last summer when the government announced that it was conducting a review of tax planning strategies involving private corporations. The Department of Finance released a paper in July 2017 outlining three areas of concern: income sprinkling using private corporations, converting a private corporation’s regular income into capital gains and passive investments inside private corporations. The government announced in October 2017 that they were not proceeding with the proposals regarding converting regular income to capital gains. The income sprinkling proposals were revised in December 2017 and the detailed rules concerning restricting the earning of passive investment income inside a corporation were to be released as part of the 2018 federal budget.
Last fall, the government stated that investments already made inside of private corporations, including the future income earned from such investments, would be protected. The rules were to apply only on a go-forward basis and the first $50,000 of passive income annually would not be subject to the new rules.
During the period of consultation, the government heard that its proposals, which would have taxed investment income earned in a corporation at punitive total effective tax rates exceeding 70 per cent, could be very complex and the tracking of pre- and post-grandfathered assets would add significant administrative burdens on businesses.
Responding to heavy criticism, the government listened and decided to take an entirely different approach that is far more targeted and much simpler than what was proposed in July 2017.
The government’s concern is that under the current rules, a “tax deferral advantage” exists because the tax rate on active business income earned in a corporation is generally much lower that the top marginal tax rate for individuals earning business income or employment income directly. If this after-tax corporate business income is not needed for a shareholder’s living expenses and is retained in the corporation, there is more after-tax income to be used as capital for investment than there would be if the business income was earned by the individual.
If these corporate funds are invested for a sufficiently long period of time, shareholders may end up with a higher after-tax amount than if income was earned directly by the individual shareholder and invested in the shareholder’s hands, due to the larger amount of starting capital to invest. The purpose of the new passive investment income proposals is to remove some of this tax deferral advantage.
The size of the tax deferral advantage depends on the difference between the applicable corporate tax rate and the shareholder’s personal tax rate.
Federally, the first $500,000 of active business income is taxed at the small business deduction tax rate (SBD rate). This $500,000 is referred to as the “business limit.” The SBD rate is a lower tax rate than the general corporate tax rate on active business income (ABI); thus, the tax deferral advantage is magnified for small business income and the deferral ranges from 35.5 per cent to 41.0 per cent in 2018, depending on the province. For ABI, the tax deferral advantage ranges from 20.4 per cent to 27.0 per cent.
The primary measure that the government introduced in the budget was to restrict access to the SBD rate starting in 2019. The new budget measure proposes to reduce the business limit for CCPCs with over $50,000 of “adjusted aggregate investment income” in a year, and to reduce the business limit to zero, on a straight-line basis, once $150,000 of adjusted aggregate investment income is earned in a year.
Essentially, in certain circumstances, this proposed measure will limit the tax deferral advantage available on “new” (i.e. post 2018) ABI to the difference between the personal tax rate on ordinary income and the tax rate on ABI earned in a corporation that is not eligible for the SBD rate.
Practically, what does mean?
Let’s take Jeff, an incorporated Ontario physician, who earns $500,000 of net income annually in his professional corporation. He has accumulated $2,000,000 of retained earnings which will be used to fund his retirement. Assume he earns a 5 per cent annual rate of return which produces $100,000 of annual investment income. For simplicity’s sake, we’ll also assume that this is ordinary investment income, although in reality it would likely be a mix of dividends and current and deferred capital gains, which would further complicate our math.
The new rule means that, starting in 2019, Jeff’s corporation would only be entitled to the SBD rate on $250,000 of his professional income ($500,000 – ($100,000 – $50,000) X 5).
Does that mean he actually pays more tax? Yes, but only slightly more on a fully integrated basis (i.e. once the funds are distributed corporately as a dividend to Jeff’s hands).
Jay Goodis of Tax Templates Inc. has crunched the numbers and concluded that for an Ontario CCPC with an Ontario-resident shareholder taxed at the highest marginal personal tax rates, the integrated tax cost of being subject to the general ABI rate instead of the SBD rate is only an additional 1.51 per cent.
The main purpose of this new rule is to reduce Jeff’s future corporate tax deferral from 40 per cent down to 27 per cent on the $250,000 of 2019 income no longer subject to the SBD rate.
As Mr. Goodis says, “It’s a huge relief for many that the Federal Government rethought its approach towards passive income. It’s a better tax policy to limit access to the SBD rate to reduce the tax deferral rather than manipulate investment decisions.”