The Federal Budget, released February 27, 2018, has clarified federal plans to change the tax treatment of private corporations and represents a substantial retreat from proposals announced in July 2017. In July 2017, the government released a consultation paper and draft legislation which proposed to radically change the taxation of private corporations and their shareholders. The proposals were aimed at: (a) income splitting among family members; (b) passive investment income of private corporations; (c) use of the capital gains exemption by family members; and (d) realizing capital gains on private corporation shares instead of receiving dividends. The proposals were not well received in the small business sector.
In October 2017, the government announced that it would not move forward with proposed changes to limit access to the capital gains exemption or changes relating to capital gains. In December 2017, the government released revised draft legislation to simplify proposed income splitting rules.
The budget reveals the government's intended approach to passive investment income earned by private corporations. The government has abandoned its proposal to levy tax on investment income at rates over 70 percent. Instead, the budget proposes two measures. The first will limit access to the preferential small business tax rate. The second will limit a modest tax-deferral advantage that may arise regarding refundable taxes on investment income. Both measures will apply to taxation years beginning after 2018.
Limiting Access to the Small Business Tax Rate
The first measure will reduce or eliminate the small business deduction if a Canadian-controlled private corporation (CCPC) has significant investment income. According to the government, about 3 percent of CCPCs claiming the small business tax rate will be affected by the measure.
A CCPC is generally eligible for the preferential small business tax rate on its first $500,000 of active business income. Under the budget proposal, if a CCPC earns more than $50,000 of passive investment income in a year, the income eligible for the small business tax rate will be reduced by $5 for every $1 of investment income above the $50,000 threshold. Once a CCPC has more than $150,000 of investment income, it will lose the small business tax rate entirely. In contrast to the July 2017 proposals, private corporations only taxable at general corporate rates will not be affected.
A CCPC's investment income for the new measure will exclude capital gains on capital assets used in an active business, and capital gains on shares of connected corporations that meet an active business asset test. Portfolio dividends and income from a life insurance policy might reduce the small business deduction.
Limiting Access to Refundable Taxes
The budget's second measure limits the ability of a CCPC to access refundable taxes when paying eligible dividends.
The Canadian tax system integrates corporate income with dividends paid to shareholders, meaning that income earned by a corporation and distributed to a shareholder is taxed at about the same rate as income earned directly by an individual. The tax system provides nearly full integration for active business income taxed at the general corporate rate and active business income taxed at the small business rate, by permitting active business income taxed at the higher general corporate rate to be distributed as eligible dividends that are taxable to a recipient at a lower rate, and requiring that active business income taxed at the preferential small business rate be distributed as non-eligible dividends, taxable to the recipient at a higher rate.
To eliminate any deferral benefit from earning investment income in a private corporation, the system levies an additional refundable tax on such income. A portion of the corporate tax payable is refundable through the "refundable dividend tax on hand" (RDTOH) account, which provides the corporation with a tax refund when dividends are paid to shareholders. Ordinarily, investment income would be distributed as a non-eligible dividend, taxable to the recipient at a rate higher than an eligible dividend. However, a corporation that earns active business income taxed at the general corporate rate can pay eligible dividends and receive an RDTOH refund. In these circumstances, a modest tax-deferral benefit arises, since the corporation receives an RDTOH refund and the shareholder receiving the eligible dividend is taxed at lower rates.
The second measure targets this deferral advantage by providing that RDTOH generated from investment income can be refunded only if a non-eligible dividend is paid. The purpose of the measure is "to better align the refund of taxes paid on passive income with the payment of dividends sourced from passive income." The budget proposes the creation of an "eligible RDTOH" account, which will include refundable tax paid on eligible dividends received by a corporation, and will be refundable on the payment of an eligible dividend. The current RDTOH account will become a "non-eligible RDTOH" account and will include refundable taxes paid on investment income other than eligible dividends.
Under the proposals, a CCPC can only obtain a refund from its "non-eligible RDTOH" account by paying a non-eligible dividend. In contrast, a CCPC can obtain a refund from its "eligible RDTOH" by paying any taxable dividend (eligible or non-eligible). Any non-eligible dividend, however, must first obtain a refund from "non-eligible RDTOH".
Under transitional rules, a CCPC will have an opening "eligible RDTOH" account equal to the lesser of its existing RDTOH account or 38.33 percent of its "general rate income pool", representing income taxed at the higher general corporate rate. The balance of its existing RDTOH will be included in its "non-eligible RDTOH" account. As a result, CCPCs may generally continue to receive a refund of taxes paid on investment income earned prior to 2019 through distributing eligible dividends. The transitional period before the new regime comes into effect may provide planning opportunities.