The recent federal budget proposed changes (the Proposals) that will restrict access to the small business deduction (SBD) for many corporations. These changes will apply where a corporation earns passive investment income and also earns income from active business that is taxed at the small business rate, or small business income.
The Proposals are the result of an extensive public debate around the taxation of passive investment income in private corporations. In July 2017, the federal government released a consultation paper on the topic. Then, in October, the government responded to public criticism by revising its July approach. The Proposals put forward in the budget continue to address the concerns expressed by the tax and small business community. They are to come into effect for taxation years starting after 2018.
The small business clawback
In 2018, Canadian-controlled private corporations (CCPCs) pay corporate income tax on small business income at 10 percent federally. This rate is to be reduced to 9 percent in 2019. The small business limit (the amount of income annually that is eligible for the small business rate) is $500,000 federally and in most provinces (except for Manitoba where it is $450,000 until 2019 and Saskatchewan where it is $600,000).
Under the Proposals, the small business limit will be reduced by $5 for every $1 of investment income above a $50,000 threshold. Under this formula, the SBD will be eliminated when investment income reaches $150,000 in a given taxation year. The chart below shows the reduction of the small business limit at selected passive income levels.
Reduction of the small business limit at selected passive income levels
|Passive income earned||Reduction of small business limit||Small business limit available|
|$70,000||5 x ($70,000-$50,000) = $100,000||$400,000|
|$90,000||5 x ($90,000-$50,000) = $200,000||$300,000|
|$100,000||5 x ($100,000-$50,000) = $250,000||$250,000|
|$120,000||5 x ($120,000-$50,000) = $350,000||$150,000|
|$150,000||5 x ($150,000-$50,000) = $500,000||$nil|
To quantify this clawback, let's consider a corporation taxable in Alberta, assuming no change in the projected tax rates for 2019, and assuming that Alberta follows the federal changes in the Proposals.
The combined federal and provincial small business tax rate in 2019 will be 11 percent. The combined general corporate income tax rate will be 27 percent (15 percent federal tax plus 12 percent Alberta tax). Therefore, in 2019, the difference in combined tax rates between general rate income and small business income is 16 percent. Where the small business limit of $500,000 is fully clawed back under the Proposals, the increased annual corporate tax cost will be $80,000 for 2019 calendar-year corporations taxable in Alberta (the costs will vary by province).
However, where the profits of the corporation are routinely paid to an individual shareholder who is resident in Canada, this additional cost is really a loss of a deferral of tax. When profits are paid from a corporation to its individual shareholders, the total tax cost should be measured against the net after-tax profits retained by the shareholder after receipt of the dividend. Dividends paid to a Canadian individual shareholder from profits that were taxed at the small business rate (non-eligible dividends) are taxed at a higher tax rate than dividends paid from profits that were taxed at the general business corporate tax rate (eligible dividends). The actual difference in tax will depend on provincial tax rates.
This example can be illustrated with the following chart:
The difference in tax will depend on provincial tax rates
| ||Scenario 1||Scenario 2||Difference|
|Amount of investment income earned in 2018||$50,000||$150,000|| |
|Corporate active business income||$500,000||$500,000|| |
|Amount taxed at small business rate (A)||$500,000||-|| |
|Amount taxed at general corporate rate (B)||-||$500,000|| |
|Corporate tax on small business income||$55,000||-|| |
|Corporate tax on general rate income||-||$135,000|| |
|Total corporate tax (C)||$55,000||$135,000||$80,000|
|Amount paid as eligible dividend (B - C)||-||$365,000|| |
|Amount paid as non-eligible dividend (A - C)||$445,000||-|| |
|Tax on eligible dividend (31.71%)||-||$115,742|| |
|Tax on non-eligible dividend (42.56%)||$189,392||-|| |
|Total personal tax (D)||$189,392||$115,742||$73,650|
|Combined corporate and personal tax (C + D) = E||$244,392||$250,742|| |
|Net proceeds to shareholder (A - E) or (B - E)||$255,608||$249,258||$6,350|
Considering projected 2019 federal and Alberta tax rates, the increased tax cost after the payment of dividends to an individual shareholder would be about $6,350 on $500,000 of corporate business income. This assumes that $500,000 of income is taxed at corporate tax rates and then paid out to the shareholders as a taxable dividend. This uses a projected top marginal tax rate on eligible dividends received by an individual in 2019 of 31.71 percent, and similarly, a top marginal tax rate on non-eligible dividends of 42.56 percent.
The additional $80,000 of tax paid in the corporation in the example above would be mostly offset by a decrease in personal taxes on receipt of an eligible instead of a non-eligible dividend. The difference in tax on receiving an eligible and not a non-eligible dividend is about $73,650. This leaves a net $6,350 tax cost, or just over 1 percent of $500,000 of profit.
The Proposals target the small business limit rather than change the taxation of passive income directly. The consequences to a company claiming the SBD and having more than $50,000 of passive income in the year are limited to a loss of a deferral of tax ($80,000 as shown in the example above) and a relatively small increase in the integration cost of earning active business income in a corporation (approximately 1 percent in the example above).
Investments in corporations that do not have small business income, such as investment holding companies that are not associated with a corporation claiming the SBD, will not be affected by the Proposals.
Note that the Proposals are limited to federal tax. However, we anticipate that the provinces will follow suit and mirror the proposed federal changes to the small business limit.
In addition, larger CCPCs are already restricted when trying to access the small business tax rate. The small business limit begins to be phased out for associated CCPCs with greater than $10 million of aggregate taxable capital employed in Canada and is eliminated when aggregate taxable capital reaches $15 million. Therefore, larger CCPCs that do not have access to the small business deduction because of this rule will not be impacted by the Proposals.
Adjusted Aggregate Investment Income
The Proposals will apply to a new definition of investment income: adjusted aggregate investment income (AAII). This definition generally includes the following types of investment income:
- Taxable capital gains in excess of allowable capital losses of the current taxation year from the disposition of passive investments
- Portfolio dividends
- Dividends from foreign corporations that are not foreign affiliates
Also included in the proposed definition of AAII is income from savings in a life insurance policy that is not an exempt policy.
Specifically excluded from AAII will be gains or losses from the disposition of “active assets” such as from the disposition of shares of a company that is carrying on an active business. “Active assets” is a newly defined term in the Proposals. Also, when determining AAII under the Proposals, it will not be possible to reduce capital gains realized from non-active assets in the relevant taxation year with unused net capital losses (realized from the disposition of non-active assets) which are available for carryover from a previous or subsequent taxation year.
Dividends received from connected corporations will be excluded from this new definition, as will income from AgriInvest and also rents or interest received from an associated corporation if such income is re-classified for income tax purposes to be active business income. In addition, where the activity of earning income from property is sufficient, it will be excluded from AAII on the basis that it is income from an active business and not investment income. For example, if more than five full-time employees were engaged in earning rental income, that rental income would be active business income, and it would therefore not be AAII.
Keep in mind that the definition of AAII is only applicable for purposes of this proposed clawback of the small business limit. It does not impact references to investment income for other purposes of the Income Tax Act, such as the definition of aggregate investment income under the refundable tax rules.
It is also important to note that when determining if a clawback of the small business limit will occur under the Proposals, it is the AAII earned in each taxation year that ended in the previous calendar year that impacts the clawback calculation for the relevant taxation year. For example, when dealing with calendar-year corporations, any clawback that will occur for the December 31, 2019 taxation year will be based on the AAII earned in the December 31, 2018 taxation year.
No grandfathering of investment income
In July and October 2017, proposals to tax investment income in private corporations were put forward by the federal government. These proposals were put forward in concept only (and not in draft legislation) and would have taxed passive income at higher rates of tax. In addition, these proposals would have grandfathered income from existing investments from the higher tax. However, unlike those earlier plans, the Proposals do not increase the tax rate on investment income. Therefore, the government has determined there is no need for grandfathering. Also, taxpayers no longer need to separate assets held at the end of 2018 into separate accounts — as was suggested by some planners in response to the July 2017 proposals.
Corporations with less than $500,000 of active business income?
The proposed clawback of the small business limit is based on the amount of investment income, and not on the amount of small business income in the corporation. If a corporation has $150,000 of business income and $75,000 of investment income, the clawback will be 5 x ($75,000-$50,000), or $125,000. This will reduce the small business limit to $375,000. Since the corporation has only $150,000 of small business income, it will be fully eligible for the small business deduction.
The significance of $50,000
This $50,000 threshold was previously announced in October 2017 and is based on the government's estimate that it represents approximately $1,000,000 in invested assets, using an assumed 5 percent rate of return. This threshold is aimed at providing flexibility for small business owners to save for multiple purposes such as sick leave, parental leave, an economic downturn or retirement.
Associated corporations, such as an operating company and its parent company, must share the small business limit. Similarly, under the Proposals, investment income in associated companies must be aggregated to determine if the $50,000 threshold has been surpassed and to determine the amount of the small business limit that will be clawed back. The reduced small business limit is then what must be shared within an associated group of companies.
Ways to minimize the impact of the Proposals
There is some planning that could be carried out that would reduce the impact of the Proposals assuming that they come into effect in 2019. We encourage you to discuss these ideas with your BDO advisor. Effective planning can focus on two main areas:
- Reducing investment income to reduce the Proposals' impact
- Minimizing the impact of the Proposals when it is evident they will apply
Reducing net investment income
AAII includes income net of expenses, for example, interest expense incurred to earn investment income would reduce such income in determining if AAII exceeds the $50,000 threshold. Consider what expenses are already, or could be incurred in the CCPC to reduce AAII. In addition to interest, other examples of such expenses could be investment counsel fees, and a salary paid to the owner-manager, as long as that amount is reasonable.
If you can avoid earning investment income in your corporation, you can avoid the clawback of the small business limit. An exempt life insurance policy or an Individual Pension Plan (IPP) could allow you do to this if passive investments are put into these type of plans – but taxpayers should consider whether these plans make sense otherwise, before doing it just to avoid these rules.
Minimizing the impact
Since the impact of the Proposals is fully in effect with investment income of $150,000, there is no further tax cost to earning more than $150,000 of investment income in a given year. If you have accrued but not realized gains in your corporation, you may choose to realize them in a year where you have exceeded the maximum $150,000 investment income, rather than in a year when the total of other investment income is less than the maximum. This type of strategy will depend on the type of investment income earned on a regular basis, and will work better when investment income varies significantly from year to year rather than being relatively constant.
Conversely, it may be beneficial to realize investment gains in a year of low small business income, as the impact of the loss of the small business limit will not be as great as in years of higher levels of small business income.