In July 2017 the Department of Finance released proposals related to income sprinkling (a.k.a. tax on split income or “TOSI”), passive investment income and other tax measures which would significantly modify the taxation of private corporations. After a consultation period Finance did not proceed with certain proposals, however the new TOSI and passive investment income rules in Bill C-74 received Royal Assent on June 21, 2018.
If your corporation earns passive investment income, you may be impacted by these new rules.
What is “Passive Investment Income”
Certain types of income considered “passive” are subject to different corporate tax rules and rates. Common forms of passive income include interest, rental income, royalties, dividends from portfolio investments and taxable capital gains.
What is the “Small Business Deduction”
Canadian-controlled private corporations (CCPCs) have access to the Small Business Deduction (SBD) which effectively taxes the first $500,000 of active income at the small business tax rate of 12.5% (for 2019 and future years, previously 13.5% in 2018). An associated corporate group shares the $500,000 SBD limit and any active income earned over the $500,000 SBD limit is taxed at the general rate of 26.5%.
Some CCPCs with high taxable capital already have a reduced SBD limit.
New Passive Investment Income Rules
The new passive investment income rules apply to CCPCs which alone, or as an associated corporate group, earn passive income in excess of $50,000 per year commencing after 2018. Every $1 of passive income earned over $50,000 will grind the SBD by $5, such that the entire SBD limit will be eliminated for CCPCs and associated corporate groups having $150,000 or more passive income.
Passive income for these purposes will now be called “Adjusted Aggregate Investment income” (AAII). Where the prior year’s AAII will determine the current year’s grind to the SBD. The definition of AAII does exclude capital gains from certain assets if they are used in active business in Canada.
CCPCs impacted by these rules will have an upfront increased corporate tax cost at the time their corporate tax returns are filed, where currently in all provinces and territories except Ontario, the immediate tax cost exceeds 100% of passive income earned. The increased corporate tax does result in a higher General Rate Income Pool (GRIP) giving rise to future payment of eligible dividends to shareholders, which will reduce the personal tax cost. However, the combined corporate and personal tax cost will exceed the taxes which would have been payable if the individual shareholders had earned the investment income directly.
Ontario announced on November 15, 2018 that it will not follow these recent changes, therefore only the Federal portion of the SBD for Ontario CCPCs will be subject to the potential grind. The immediate tax cost for Ontario CCPCs impacted is slightly higher than 80% but the combined corporate and personal tax cost will be approximately 44.5% which is lower than the personal highest tax bracket in Ontario of 53.53%. This is assuming Ontario will make no further tax changes.
To Withdraw or Not to Withdraw
With these changes, many business owners are asking whether the corporately held investments should be withdrawn and held personally. For many owner-managers, a withdrawal requires payment of taxable dividends, generating personal tax and effectively eliminates the deferral of tax by retaining income in the corporation taxed at the lower small business rates.
Does it make sense to withdraw funds from your corporation now? To sacrifice the accumulated historical tax deferral accumulated in retained earnings in order to benefit from future deferrals at the SBD rate?
For example, assume ABC Co. has accumulated $3,000,000 of passive investments on which it earns $150,000 of passive income annually. If no action is taken in fiscal year end 2019, ABC Co.’s SBD limit will be reduced to $nil for their 2020 fiscal year end.
To avoid the grind, assume the $3,000,000 investments are withdrawn and paid out to the shareholders as a taxable dividend, which generates personal tax at approximately 40%. This effective rate is slightly lower than the highest personal tax rate in all jurisdictions, being $1,200,000 of tax leaving the net cash to be invested personally is now only $1,800,000.
Going forward, ABC Co.’s corporate taxes will be reduced by as much as 18% (depending on the province) on its active business income eligible for the SBD. Assuming ABC Co. can use the full $500,000 SBD limit each year, it will have an annual deferral of up to $90,000. It will take over 13 years for ABC Co. to accumulate an additional $1,200,000 of deferrals to offset the personal taxes paid by its shareholders.
However, if ABC Co. is earning $500,000 active income annually and paying tax at the small business rate it will earn after-tax cash of over $400,000 annually, approximately $437,500 in Ontario. Assuming this excess cash is not needed for business expansion or personal spending, these new funds will likely be used to acquire passive investments in the company. In 3 years, over a third of the original passive investments will have been replaced, generating at least $50,000 passive income, and the SBD grind will start again. In less than 8 years, ABC Co. will accumulate $3,000,000 of passive investments, generating $150,000 passive income which originally caused the full SBD grind.
Access to the SBD will not continue for long enough to replace the personal tax cost of withdrawing the capital. The equity accumulated will replace the passive investments, again losing SBD access, before the future deferral fully offsets the up-front personal tax cost.
It is clear, with these new tax rules, the government is trying to force CCPCs to withdraw their excess cash not used in business. If your CCPC or associated corporate group has accumulated investment capital, the increased tax costs of these new rules are obviously high. However, paying dividends now to avoid losing the SBD in the future is even greater cost in most instances. Even with assumptions favouring withdrawal of investments specifically to Ontario CCPCs, the results of the withdrawal could be negative, and Ontario could make tax changes at any time that ultimately removes the tax advantage of the SBD grind.
Other factors should be considered in the decision to withdraw or not. For example, can the funds be withdrawn tax-free by repaying shareholder loans or taking capital dividends? Do the investments have inherent tax costs, such as unrealized capital gains or recapture, which will create more taxes on transfer? Are there other reasons to keep holding the investments corporately, for estate or succession planning, or liability risks inherent in the investments? When will the funds be required for personal spending, requiring dividends in the future?
If capital can be withdrawn at no tax cost, a withdrawal is advantageous in all provinces. This was already the case in all provides, even before the SBD grind, since investment income earned in a corporation is generally taxed at a higher rate than if earned personally. Losing access to the SBD provides a further incentive to extract investment capital, at least where this can be done at no tax cost.
Published on January 31, 2019