On June 20, 2012, Ontario’s legislature passed a bill that introduces a 2% tax increase on the taxable income of individuals in excess of $500,000. The 2% increase will be implemented gradually, with the first percentage point hike coming into effect on July 1, 2012, and the second percentage point increase coming into effect in 2013. The “wealth tax” is expected to affect one quarter of the top 1% of earners in Ontario and the government projects that it will generate approximately $470 million in revenue each year. The government intends to use all revenues generated by the tax increase to reduce the province’s $15.2 billion deficit and has committed to eliminating the tax increase when Ontario’s budget is balanced, which is projected to occur in 2017-2018. Whether or not the “wealth tax” will be phased out by this proposed date remains to be seen.
The “wealth tax” will increase the highest marginal tax rate in Ontario to 12.16% for 2012 and to 13.16% for 2013 (the top federal marginal rate for 2012 is 29% and it is expected to remain at this rate for 2013). The wealth tax will also have an effect on Ontario’s two-tiered surtaxes, which are calculated as a percentage of the amount of provincial tax payable by an individual in a taxation year, in excess of specified amounts. When the Ontario surtaxes are factored into the 2% wealth tax rate increase, individuals who earn income in excess of $500,000 will face an overall increase in the amount of provincial tax payable equal to 3.12%. Accordingly, an Ontario resident with taxable employment income of $1,000,000 in 2013, will pay approximately $15,600 more in provincial income taxes than they would have otherwise had to pay under the current tax rate. The combined top federal and Ontario tax rates, taking into account the Ontario surtaxes, will be 47.97% in 2012 and 49.53% in 2013.
In light of this new development, individuals should consider strategies to reduce the impact of the “wealth tax” on their income.
Strategies may include the use of professional corporations to carry on an individual’s professional practice. The tax deferral advantage can be achieved to the extent that income is retained in the corporation and the professional does not need to draw all income out of the professional corporation for personal needs.
The tax deferral advantage is primarily attributable to the “small business deduction”, which enables Canadian-controlled private corporations (“CCPCs”), as defined in the Income Tax Act (Canada) (the “Tax Act”) to pay tax at a lower rate on “active business income” earned in Canada. For example, for the 2012 taxation year, the small business deduction would reduce a professional corporation’s combined federal and Ontario rate of tax to approximately 15.5% on the first $500,000 of active business income, as compared to the personal combined federal and Ontario marginal tax rate of 46.41% (before implementation of the “wealth tax”) that would otherwise apply.
High earning individuals may consider investing surplus income within a holding corporation or a professional corporation. Currently, this is not an attractive option due to the existence of the refundable tax system in the Tax Act, which eliminates the opportunity for tax deferral by imposing a tax on passive investment income that is equivalent to the highest personal marginal tax rate. However, the implementation of the “wealth tax” will create new tax deferral opportunities for those who earn investment income through a corporation, because the combined top federal and Ontario personal tax rate will exceed the corporate tax rate on investment income. For example, the combined federal and Ontario tax rate on passive income earned through a CCPC is currently at 46.17%, whereas the combined federal and Ontario personal tax rate after full implementation of the “wealth tax” will be 49.53%. In addition, after full implementation of the “wealth tax”, the effective integrated tax rate on grossed-up eligible and ineligible dividends will be 46.75% and 48.86% respectively, as compared to the 49.53% personal tax rate.
Accordingly, the new Ontario “wealth tax” will provide tax deferral opportunities for individuals who earn passive investment income through a corporation. It is important to note, however, that there is some cost and complexity in operating and unwinding investment holding corporations, and individuals should seek legal advice to determine the most optimal strategy for their particular circumstances.
Other opportunities to shift investment income are available by way of income splitting with a low-income spouse or low-income children or grandchildren. One of the ways to effect income-splitting is to make a prescribed rate loan (currently at a historical low of 1%) to a family trust or to a spouse in order to shift investment income to the borrower.