Passive Income Proposals for Private Corporations
Budget 2018 contains two new measures to deter the accumulation of passive assets within private corporations. These changes are a welcome departure from the Federal Government’s July 18, 2017 announcement on the treatment of passive income, which many commentators criticized for resulting in total taxes of over 70% in some situations, and for creating unintended consequences which were inconsistent with good tax policy.
The measures included in Budget 2018 are aimed at (1) discouraging small businesses from earning relatively large amounts of passive income by restricting access to the small business deduction, and (2) eliminating tax deferral advantages by restricting the refund of tax on investment income upon payment of eligible dividends.
Both measures are effective for taxation years beginning in 2019.
Restriction on the Small Business Deduction
The Government proposes to reduce the availability of the small business deduction (SBD) which allows a Canadian controlled private corporation (CCPC) to pay tax at a lower rate on its first $500,000 of active income. The $500,000 threshold will be reduced by $5 for every $1 of passive income earned in excess of $50,000. This is in addition to the current phase-out of the SBD for corporations having more than $10 million of taxable capital, and amendments in 2016 which introduced new heights of complexity in the SBD rules. Despite chipping away at the SBD in recent years, the Federal Government continues to espouse the SBD as serving a useful purpose for small businesses which might have difficulty accessing capital.
The “aggregate investment income” as defined in s. 129(4) of the Income Tax Act (Canada), is currently used to compute a CCPC’s refundable taxes on investment income. CCPCs (together with their associated corporations) will now have to also calculate “adjusted aggregate investment income” by excluding the following:
- income which is incidental to an active business;
- gains and losses from property used principally in an active business carried on primarily in Canada by the CCPC or a related CCPC;
- shares of a connected CCPC, whose assets are all or substantially all used in an active business carried on primarily in Canada; and
- net capital losses carried over from other years;
and by adding:
- dividends from non-connected corporations; and
- income from savings in non-exempt life insurance policies, to the extent not already included.
With the federal small business tax rate down to 10% for 2018, and set to decline to 9% for 2019, the loss of the SBD will come at a significant cost – from 13% to 16% depending on the province. Business owners should review their current and expected investment income to ensure they will not be caught by these new restrictions and should pay particular attention to inherent gains in the value of passive assets which will cause a spike in “adjusted aggregate investment income” in the year of disposition. Business owners should also consider repositioning investments to items which will not affect the SBD limit, such as exempt life insurance policies, and declaring dividends by December 31, 2018, to avoid a loss of SBD in future years. However, caution must be exercised when moving passive investments out of a CCPC, or taking steps to disassociate CCPCs. Budget 2018 states that anti-avoidance measures will be included to prevent taxpayers from circumventing the new rules.
The $50,000 passive income threshold does allow small businesses to accumulate some savings. Businesses which earn less than $500,000 of active business income can earn even more passive income without a loss of SBD. However, businesses which earn over $150,000 of passive income will lose access to the SBD entirely. Moreover, the proposed changes to the refundable tax regime, discussed below, may discourage business owners from earning any passive income at all within a corporate entity.
Refundable Tax on Investment Income
Much has been said about the perceived unfairness of allowing business owners to defer a portion of taxes by using private corporations as a savings vehicle.
The current system discourages the accumulation of investment income in corporations by levying a refundable tax which approximates the top personal tax rate on investment income, while that income is retained in a corporation. This tax is tracked in the corporation’s refundable dividend tax on hand (RDTOH) account, and refunded when the corporation pays taxable dividends.
Dividends are taxed as either “eligible” or “non-eligible,” depending on the rate of tax paid by the dividend payor on its underlying corporate income. Dividends paid out of corporate earnings which were taxed at the SBD rate, are taxed at a higher rate in the shareholder’s hands, and vice versa. Investment income (other than eligible portfolio dividends and the non-taxable portion of capital gains) is paid to shareholders as non-eligible dividends. However, a corporation which pays eligible dividends obtains a refund of RDTOH. This creates the opportunity for tax deferral on passive income, where a corporation also has active business income taxed at the general tax rate.
Budget 2018 proposes to prevent private corporations from obtaining a refund of taxes on investment income upon payment of eligible dividends. The only exception will be for eligible portfolio dividends, which will be tracked through a new RDTOH account, to allow them to flow out to shareholders and generate a refund of RDTOH. Accordingly, upon payment of a non-eligible dividend, private corporations will be required to obtain a refund of “non-eligible RDTOH” before obtaining a refund of “eligible RDTOH.”
At current rates, there is a net tax cost to earning investment income through a corporation. The removal of any remaining tax deferral advantage should encourage shareholders of private corporations to hold passive investments personally rather than inside a corporate entity. Businesses that need to save for future growth, business cycle fluctuations, or other business purposes, will be forced to prepay the full corporate and personal tax on those savings. This runs counter to the stated policy behind the SBD, which is to allow small businesses greater access to capital.
Business owners should explore a rigorous and ongoing “purification” strategy which moves earnings out of the corporate entity, by way of an optimal salary/dividend mix. Capital that is still needed for the business could be loaned back by way of secured shareholder loans.
In each case the analysis should examine the reasonableness of salaries and dividends, particularly in light of proposals to expand the tax on split income, also known as TOSI, which were released on December 13, 2017 and confirmed in Budget 2018, as well as the availability of the SBD, the current and future capital needs of the business, creditor-proofing strategies, and a host of other considerations.
Increased Reporting Requirements for Trusts
Under the heading of “Cracking Down on Tax Evasion and Combatting Tax Avoidance,” Budget 2018 proposes a series of increased filing and reporting requirements applicable to most trusts, including both Canadian-resident trusts and non-resident trusts. Although there are carve-outs for certain kinds of trusts, typical family trusts, spousal trusts and testamentary trusts will be subject to the new requirements.
These measures are being proposed to give tax authorities sufficient information to determine taxpayers’ tax liabilities and to effectively counter aggressive tax avoidance, tax evasion, money laundering and other criminal activities. No statistics were cited in support of these alleged activities and, in fact, existing trust reporting requirements would appear to be sufficiently robust to determine the tax liabilities of compliant taxpayers. The fact that these requirements cast a wide net covering most trusts suggests that the government’s targets reach well beyond alleged criminal activity.
Trusts resident in Canada, and deemed-resident trusts that are currently required to file, will now be required to file a T3 trust return for every year regardless of whether the trust has tax payable or distributes a portion of its income. The information required to be reported will also be expanded. Trusts that are required to file will now be required to report the names and details of the settlor of the trust, the trustees, beneficiaries and any person who has the ability to exert control over trustee decisions, such as a trust “protector.” It is proposed that returns will now include a “beneficial ownership schedule.”
The new requirements raise a number of possible compliance issues. First, the expanded reporting requirements may have the effect of creating a “chill” on persons who might be asked to act as a settlor, or a protector, for trusts, thereby creating additional burdens on the formation and settlement of trusts. Second trusts are already required to report information regarding trustees, and are required to file with CRA a copy of the trust instrument. It may be difficult, if not impossible, to not only identify but also provide meaningful reporting information on the “beneficiaries” of a trust. In cases where trusts, including testamentary trusts, may benefit a class of contingent or unascertained beneficiaries (including, for example, unborn persons or corporations not yet formed), these requirements will pose real risks of non-compliance on trustees. And third, in the case of discretionary trusts, trustees will not be in a position to report the “ownership” of any particular beneficiary unless a benefit is appointed to that person.
In support of the new requirements, Budget 2018 proposes to introduce new penalties for failure to file, ranging from a minimum of $100 to a maximum of $2,500, with additional penalties equal to 5% of the fair market value of the property held by the trust.
The new reporting requirements and penalties are proposed to apply to returns required to be filed for 2021 and subsequent taxation years.
Undoubtedly, these new requirements will create additional burdens upon, and increased risks to, settlors, trustees and beneficiaries of affected trusts.