The new CRA passive income changes took effect at the beginning of 2019, upsetting corporate passive investment income and exposing businesses to more corporate tax.
Passive Investment Income in Your Private Corporation
For many small business owners their private company is a key component in saving for their family and their future retirement. Below we review the impact of recent CRA passive income changes to the taxation of passive investment income in private corporations and some possible planning that may be considered.
Passive Income Changes Limit the Small Business Deduction
The majority of Canadian small businesses are carried on through Canadian controlled private corporations (“CCPCs”). Subject to a restriction for large corporations1, CCPCs and associated groups of CCPCs have, until recently, been allowed to claim the small business deduction to pay tax on up to $500,000 of active business income at the small business tax rate.
For 2019, the small business deduction can reduce the tax rate on the first $500,000 of active business income for a corporation resident in BC from 27% to 11% - a corporate tax saving of 16% worth a maximum of $80,000.
The 2018 federal budget saw the introduction of a set of new passive income rules in Canada to restrict the small business deduction for CCPCs that alone (or as part of an associated group) earn more than $50,000 of passive investment income.
These new CRA passive income changes will first apply to fiscal years that start in 2019 and will reduce the maximum small business deduction available to a CCPC (or associated group of CCPCs) by $5 for every $1 of passive investment income earned in the previous fiscal year in excess of $50,000.
As a result, the maximum small business deduction for a CCPC or associated group will be reduced to $nil if the passive investment income for the preceding year was $150,000 or more.
Passive investment income includes:
- Rent (excluding rent from associated corporations carrying on active business)
- Dividends from portfolio investments and non-connected corporations
- Taxable capital gains
Passive investment income does not include:
- Income that is incidental to an active business
- Taxable capital gains from the sale of assets used in an active business
- Taxable capital gains from the sale of shares of a connected CCPC where all or substantially all the company’s assets are used principally in an active business carried on primarily in Canada
To illustrate the impact of these CRA passive income changes, let’s assume we have a CCPC with a December 31 fiscal year-end. In 2018 the company earned $100,000 of passive investment income. In 2019 the company will earn $500,000 of active business income. As illustrated in the table below, the passive income rule change will result in the company paying $40,000 more tax than it would have before the CRA passive income tax changes.
How to Mitigate These Passive Income Changes
To mitigate the impact of these new CRA passive income changes, business owners may want to consider the following:
- Ensure that all expenses related to earning passive investment income are accounted for to minimize the total amount of investment income that is reported. This includes an appropriate allocation of expenses to both active and passive income sources.
- If the investment assets are primarily marketable securities, consider adjusting the investment mix to a portfolio that is focused on capital growth rather than interest and dividends.
- Reinvest surplus back into the business by paying down debt or purchasing new equipment instead of acquiring investment assets that generate passive investment income.
- Disassociate the company with the investment activity from the company with the active business operations. There are a number of anti-avoidance rules that need to be considered and this type of planning should not be undertaken without appropriate tax advice.
- Structure future investment activities in another company that is not associated with the company with the active business operations.
- Distribute surplus to shareholders. This may have corporate and personal tax consequences to be considered.
Restricting the Ability to Recover Refundable Taxes
The 2018 federal budget also brought in rules to restrict the ability to recover refundable tax paid on passive investment income. For fiscal years beginning in 2019, CCPCs will, in many cases, only be able to recover refundable tax paid on investment income through the payment of non-eligible dividends.
The Canadian government was concerned that business owners could structure their affairs to recover refundable tax paid by CCPCs on passive investment income through the payment of eligible dividends, which are taxed in the hands of the individual shareholders at a lower rate than non-eligible dividends. For an individual resident in BC, the top marginal tax rates on dividends received in 2019 are:
Prior to introducing rules to restrict the recovery of refundable tax on investment income, a CCPC could recover its refundable dividend tax on hand (“RDTOH”) at the rate of $38.33 for every $100 of taxable dividends paid by the company. If the company recovered its RDTOH through the payment of eligible dividends, the company could recover tax at a rate that was greater than the rate of tax being paid by the individual shareholder.
The table below illustrates the advantage of recovering RDTOH with eligible dividends compared to non-eligible dividends.
Assuming a CCPC has RDTOH of $10,000. To recover this refundable tax, it would need to pay a dividend to its shareholders of $26,100. If this was paid as an eligible dividend, the individual shareholders would pay $3,445 less tax on the dividend compared to a non-eligible dividend.
To fix this perceived imbalance, for fiscal years starting in 2019, the RDTOH of a CCPC will be split into two pools:
- The eligible refundable dividend tax on hand (“ERDTOH”) pool
- And the non-eligible refundable dividend tax on hand (“NERDTOH”) pool
Going forward the company will be able to recover the ERDTOH pool with eligible and non-eligible dividends. The company will only be able to recover the NERDTOH pool with non-eligible dividends.
On transition, the CCPC’s RDTOH pool, at the start of its fiscal year beginning in 2019, will be apportioned first to the ERDTOH pool to the extent of the company’s ability to recover the RDTOH with eligible dividends. Generally, this allocation will be calculated at 38.33% of the company’s general rate income pool (“GRIP”) at the start of the fiscal year. Any remaining balance in the company’s RDTOH pool will be allocated to the NERDTOH pool.
Going forward, only the refundable tax paid on dividends received from portfolio investments, non-connected corporations and the dividend refunds obtained by connected corporations from their ERDTOH pools will be added to the company’s ERDTOH pool. The refundable tax paid on all other forms of investment income will be added to the company’s NERDTOH pool.
To take advantage of the planning opportunity to recover RDTOH with eligible dividends, business owners will want to ensure that GRIP and RDTOH are consolidated in the same company before the start of their fiscal year that begins in 2019. In some cases, this may be as simple as paying dividends from a subsidiary to a parent company. In other cases, more complex restructuring may be required.
Corporate groups with substantial GRIP balances but no RDTOH may consider planning to trigger capital gains to generate refundable tax before the start of their fiscal year that begins in 2019. This type of planning is complex, will result in an up-front payment of tax, and should not be undertaken without appropriate tax advice.
The recent CRA passive income changes to the taxation of investment income earned by private corporations have created challenges for small business owners, but planning is available to mitigate some of the issues or take advantage of opportunities. For more information, please contact Manning Elliott tax advisor, Bryan Hubbell, CPA, CGA with any questions or submit a contact form inquiry.
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1A large corporation is a corporation that alone or as part of an associated group has taxable capital of $10 million or more. For large corporations, the allowable small business deduction is reduced on a straight-line basis for taxable capital between $10 million and $15 million. Once a corporate group has taxable capital of $15 million or more there is no small business deduction available.
This content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent change. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.