Published: April 11, 2020
Last Updated: April 11, 2020
2018 Federal Budget – Passive Income in Private Corporations – A Toronto Tax Lawyer Analysis
In July of 2017, the Canadian government released draft legislation as well as a consultation paper regarding proposed changes aimed at limiting income sprinkling, restricting certain capital gain provisions and introducing a new tax on passive income earned in Canadian Controlled Private Corporations (CCPCs). However, after significant criticism and backlash with regard to these proposals, the Canadian government decided to adopt less drastic changes.
Deferral Advantage for Passive Investments in CCPCs
The justification for changing how passive income is taxed in private corporations is because of a deferral advantage that business owners have when earning active business income and investing their profits through their corporations rather than personally. Part of this advantage was already eliminated through an additional refundable tax on aggregate investment income earned by CCPCs, raising the tax rate on that type of income to approximately the top personal tax rate. However, a deferral advantage remains in that a CCPC entitled to the small business deduction that earns active business income pays a lower rate of tax, approximately 15%, on its profits, which it can then invest. That means that the starting investment capital of the CCPC would be higher than a comparable individual. To illustrate this, consider an individual who has a marginal tax rate of 50% earns $100,000 and has $50,000 left to invest after paying taxes while a CCPC which earns $100,000 would have only paid $15,000 in taxes and would have $85,000 to invest. Though both may end up paying a similar tax rate on the income generated by their investments, the CCPC would be earning more income due to its higher starting capital.
Note that to take into account the fact that investment income earned in a CCPC will eventually be paid out to its shareholders, a portion of the tax paid by the corporation is a refundable tax and is tracked in what is called the refundable dividend tax on hand (RDTOH) account. In effect it is a prepayment of the tax that the individual shareholder will eventually pay. Once an eligible or non-eligible dividend is paid by the corporation, it can then claim a refund for a portion of the tax it paid to the extent that the corporation has enough of a balance in its RDTOH account. The RDTOH account is made up of Part IV tax, which is incurred when a corporation receives a taxable dividend, and the refundable tax paid by CCPCs on aggregate investment income. Call our top Toronto tax law firm and learn more about dividend tax refunds in a CCPC.
Department of Finance Proposals for Passive Investments in CCPCs
In order to address the deferral advantage of investing in a CCPC rather than personally, the Department of Finance contemplated several potential approaches. Many of these methods were extremely complex and required businesses to track the source of funds being invested. Furthermore, several tax changes were suggested such as implementing an additional refundable tax on funds being passively invested or alternatively changing the additional tax on passive investments from a refundable tax to a non-refundable tax.
However, due to the significant criticism and backlash, including from our Canadian tax lawyers, the Department of Finance has taken a less burdensome approach and has settled on two proposed changes. The first change is to reduce the availability of the small business deduction for CCPCs based on the amount of adjusted aggregate investment income that it earns. Currently, the first $500,000 of active business income that a CCPC earns is subject to a lower tax rate due to the small business deduction. However, this change will reduce that $500,000 limit by $5 for every $1 of investment income that the CCPC earns in excess of a $50,000 threshold. What that means is that a CCPC earning $50,000 or less of investment income per year will still be entitled to the full small business deduction. But, if the CCPC earns $100,000 in passive investment income, its small business deduction limit will be reduced to $250,000 ($500,000 – ($100,000 – $50,000) x 5) and if the CCPC earns $150,000 in passive investment income, its small business deduction limit will be reduced to zero ($500,000 – ($150,000 – $50,000) x 5). Furthermore, certain types of passive income are excluded from the definition of adjusted aggregate investment income. Specifically, capital gains from the sale of active business assets, sale of shares of connected small business corporations, and investment income that was earned incidental to the business (such as interest earned on short term deposits or investments held for funding operations) are not counted towards this calculation.
The second change involves limiting the use of RDTOH to non-eligible dividends for CCPCs with certain exceptions. Previously, there was only one RDTOH account which tracked all of the refundable amounts of tax that a corporation has paid that can be used with any kind of dividend the corporation pays. Currently, this allows for a certain degree of optimization for a CCPC that earns both aggregate investment income and active business income over $500,000. Essentially, aggregate investment income is typically paid out as a non-eligible dividend which provides only an ordinary dividend tax credit as opposed to the enhanced dividend tax credit for eligible dividends. The dividend tax credit is basically a flat reduction in tax for the individual who receives a dividend in order to take into account the corporate tax that the corporation already paid on that dividend when it was earned. The enhanced dividend tax credit for eligible dividends is higher than the ordinary dividend tax credit in order to account for the higher corporate tax paid in earning that money. As such, for every dollar of active business income a CCPC earns over $500,000, the CCPC would have paid the general corporate tax rate on that income and thus have a balance in its general rate income pool (GRIP). A CCPC’s GRIP is an account which tracks the amount of income it earned that was subject to the higher general income tax rate as opposed to the income it earned subject to the small business deduction and a CCPC can issue eligible dividends only up to the amount of GRIP it has and for every eligible dividend a CCPC issues, its GRIP is reduced accordingly. The CCPC would then be able to pay out eligible dividends and claim the RDTOH on that dividend, gaining an extra tax advantage. Conceptually, the enhanced dividend tax credit exists to offset the higher corporate tax paid and the RDTOH from tax on aggregate investment income exists to offset the extra tax which was levied on that type of income to reduce the previously discussed deferral advantage; but, GRIP and RDTOH from aggregate investment income are generated from different income streams and any particular income stream cannot generate both. Currently, CCPCs can “double dip” and get both the corporate RDTOH refund as well as let the owner receive the enhanced dividend tax credit simultaneously. As a result of the change, corporation will now need to have two RDTOH accounts, an eligible RDTOH account and a non-eligible RDTOH account. Refundable tax paid on aggregate investment income will be tracked in the non-eligible RDTOH account and can only be used when non-eligible dividends are issued. On the other hand, Part IV tax that is paid when a CCPC receives taxable dividends from eligible dividends is tracked in the eligible RDTOH account and can be used when paying out either eligible or non-eligible dividends.
The new rules will come into effect for CCPCs for taxation years beginning after 2018. What that means is that the current rules are still in effect, and depending on the date of the corporation’s fiscal year end, the current rules will apply on January 1, 2019 at earliest and on December 31 2019 at latest. For example, for a corporation with a fiscal year end of March 1, 2018 would be under the new rules until March 1, 2019, after which the new rules would apply. Additionally, the new rules are paired with a new anti-avoidance rule to prevent the deferral of the application of the rule through methods like triggering a short taxation year (ie. a corporation with a year end of January 1, 2018 would normally have the new rules come into effect on January 1, 2019, but may be able to trigger a short year end later in the calendar year in order to delay the coming into effect of the new rules).
Federal Budget Changes Tax Tip – Pay Eligible Dividends and use RDTOH Balance Before the 2019 Taxation Year
The changes to passive income and RDTOH come into effect after the 2018 taxation year which means that CCPCs that currently have both GRIP and RDTOH can still issue eligible dividends and use their RDTOH balance under the current rules but have to act fast before the new rules come into effect. Once the new rules come into effect, a corporation’s current RDTOH balance will be reallocated such that the lesser of the CCPC’s existing RDTOH balance and 38.67% of its GRIP balance will be allocated to its eligible RDTOH account and the remainder will be allocated to its non-eligible RDTOH account. Talk to one of our experienced Toronto tax lawyers about how we can help you take advantage of the current rules before they change.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."