Are You Prepared for the New Passive Income Tax Rules for Private Corporations?
As many of you are aware, the Canadian government announced new rules in February concerning the taxation of passive income in Canadian controlled private corporations (CCPCs).
The Liberals’ original draft legislation proposed to target tax strategies that have been used by small businesses and professionals since the early 1970s so naturally the initial announcement in July 2017 drew widespread condemnation.
The government’s concern with the accumulation of passive income-generating investments in private companies stems from the fact that CCPCs pay a blended federal and provincial small business tax rate of 13.5% (in Ontario) on active business income up to the small business deduction (SBD) limit of $500,000 in 2018. This compares favorably to the tax rates on income earned by individuals. On a combined federal and provincial basis, the differential between the highest marginal tax rate on personal income and the small business tax rate ranges between about 36% and 41%, depending on the province in which a CCPC resides.
As a result of this tax rate differential, the owner of a CCPC is almost always better off retaining corporate earnings and investing within their corporation. While a similar amount of combined corporate and personal tax is ultimately paid by business owners when monies are withdrawn through dividends, taxes can be deferred until such time as the money is required personally. This effectively allows business owners to temporarily obtain the benefit of investing a larger amount of money than would otherwise be available if they earned the money personally or immediately withdrew profits from their corporation.
One side note worth highlighting here – it is a common misconception that passive investment income earned within a corporation can be taxed at the lower small business tax rate. This is incorrect as passive income is generally taxed at about the same rate (over 50%), whether earned inside or outside a corporation, so there is no real benefit, per se, from earning investment income in a corporation. Rather, the advantage is that the corporate entrepreneur is able to temporarily invest the amount of taxes deferred by delaying the withdrawal of funds from his/her company.
So what are the new rules governing passive income?
The government has announced its intention to introduce legislation that will reduce the SBD limit by $5 for every $1 of investment income above a $50,000 threshold, beginning in 2019. Once passive investment income exceeds $150,000, the SBD limit will be reduced to zero and the CCPC will pay tax at the general corporate tax rate of 26.5% as opposed to the 13.5% SBD Rate (for Ontario CCPCs).
The $50,000 threshold applies to passive income earned on both legacy and new investments which is important to note given the government’s original promise to “grandfather” any passive income earned from investments previously accumulated
How will the rules affect you as an owner of a CCPC?
Many entrepreneurs are asking if the new rules will result in them paying additional taxes if their corporations generate passive income in excess of $50,000. In most circumstances, the answer is that they will pay more corporate taxes, thereby reducing the size of their tax deferral advantage (from 40% down to 27% on their 2019 corporate income earned in Ontario).
The loss of the entire SBD limit would cost an Ontario CCPC about $65,000 in additional annual corporate taxes ($500,000 x 13% increase in the corporate tax rate). However, once income is paid out by way of dividends from the CCPC, the analysis we have reviewed suggests that the combined personal and corporate tax burden will increase by only about 1% as compared to the current tax regime.
What can you do in light of the proposed changes?
Given the pending changes, we think there are a few key things that CCPC investors should keep in mind:
- The new rules may not impact you much unless you have a sizeable passive investment portfolio in your corporation. Keep in mind that a $1 million corporate investment portfolio which generates a 7% rate of return will generate $70,000 of return, but not all of that return may be taxable as a portion could be attributable to unrealized appreciation from stocks, for example.
- If you do have a large corporate portfolio, it may make more sense to hold equities versus fixed income as realized gains and losses from stocks are taxed at 50% as opposed to interest income from investments like bonds and GICs which are fully taxable.
- Following the same logic, it is highly preferable for corporations to invest in low turnover investment portfolios that minimize realized taxable capital gains and generate a larger portion of returns from unrealized appreciation.
- According to Derek Wagar, a Tax Partner at Fuller Landau LLP in Toronto, if an investor is considering selling certain investments at a profit in the near future, it may make sense to trigger those gains gradually over several years (to the extent possible) as the new passive income rules come into effect in 2019 (based on 2018 passive income). Spreading out gains across tax years may allow your CCPC to preserve more of its SBD limit in future years.
- Similarly, if an investor knows they are likely going to need to withdraw funds from their corporation for personal use over the next few years, they should consider paying dividends in 2018 if it will allow for the preservation of more of the SBD limit in 2019 and beyond.
- Consider establishing an Individual Pension Plan (IPP). Although IPPs have been available for a long time, they have become more attractive as a result of the new passive income rules for CCPCs as they can facilitate the transfer of passive income from your company into a separate vehicle not subject to the passive income rules.
- It may be worth revisiting with your accountant whether it makes sense to withdraw funds from your CCPC to make RRSP and/or TFSA contributions.
- Consider having your CCPC invest in permanent insurance where investment savings can accumulate on a tax-free basis.
- Finally, it is important for the CCPC owners to keep the new passive income rules in perspective and not “let the tail wag the dog”, meaning if it makes sense to do something business or investment-wise then you should generally do it and not let short term tax considerations lead to bad decision making.
Please feel free to give us a call if you would like more information about the passive income rules and how you may wish to structure your corporate investments in the future.