In the 2018 Federal Budget, the Department of Finance released another chapter in its saga to overhaul how private corporations and their shareholders are taxed. Finance’s initial consultation paper of July 18, 2017 (see our summary here) was met with significant criticism throughout the summer and fall. In October, the Minister of Finance announced that the final measures would be reined in and that small businesses would receive a tax cut. On December 13, Finance then released substantially re-drafted income splitting rules, proposed to be effective January 1, 2018.
In the July paper, Finance floated ideas to reduce the advantages of investing passively through a private corporation. Each approach outlined amounted to a fundamental shift of how private corporations and their shareholders are taxed, and would have been worryingly complex to implement and maintain. Thankfully for Canadian taxpayers, the measures proposed in Budget 2018 bear little resemblance to those discussed in July.
Budget 2018 sets out two changes to the taxation of private corporations: (i) a reduction of the small business deduction based on the amount of passive investment income earned at a corporate level; and (ii) a restriction on obtaining refunds of corporate tax on dividends paid from income taxed at the reduced small business rate.
Restricting the Small Business Limit
A Canadian-controlled private corporation (“CCPC”) is eligible for a reduced tax rate on its first $500,000 of qualifying active business income (a combined provincial-federal rate of 13.5% in Ontario and 12% in British Columbia for 2018). This $500,000 limit is shared amongst associated corporations, and is reduced where the associated corporate group has more than $10 million of taxable capital employed in Canada.
The 2018 Budget proposes to restrict the small business deduction for CCPCs that earn, together with any associated corporations, more than $50,000 of certain types of passive income in a year. The restriction operates on a straight-line basis for passive income between $50,000 to $150,000. Thus, if a CCPC earns $150,000 or more of certain types of passive income together with any associated corporations, the small business deduction will be reduced to nil.
Income that counts towards this total (a new definition “adjusted aggregate investment income”) generally includes taxable capital gains, interest, rental income, and portfolio dividends. However, adjusted aggregate investment income will exclude certain taxable capital gains realized from the sale of active business assets and shares of certain connected CCPCs, as well as investment income that is incidental to the business. Of note, the adjusted aggregate investment income of any associated corporation, not just other CCPCs, will reduce the small business deduction of the CCPC. Finance has included anti-avoidance rules to address the transfer or lending of property to unassociated but related corporations.
Taken together, this measure only affects CCPCs that earn active business income and seek to claim the small business deduction.
If enacted, the changes will apply to taxation years beginning after 2018.
Refundability of Taxes on Investment Income
Under the current rules, the refundable portion of a CCPC’s tax on investment income and a private corporation’s Part IV tax on portfolio dividends is accounted for in the refundable dividend tax on hand (“RDTOH”) account. When a private corporation (including a CCPC) declares taxable dividends, it is entitled to a refund from its RDTOH account of $38.33 for every $100 of taxable dividends declared. This refund mechanism applies regardless of whether the corporation designates the taxable dividends to be “eligible” or not.
Eligible dividends are taxed at a lower rate in an individual shareholder’s hands on the assumption the corporation paid the full general corporate tax rate on the originating income. Non-eligible dividends are taxed at a lower rate on the assumption that the corporation paid a lower corporate tax rate on the originating income. Therefore, a corporation’s income taxed at the lower small business rate and its passive investment income does not entitle it to pay eligible dividends.
Finance notes in Budget 2018 that the current system permits an advantage where a private corporation declares eligible dividends with funds sourced from income subject to the higher general corporate tax rate, to generate a refund of taxes paid on passive investment income. To address this, a private corporation will only receive a dividend refund of RDTOH upon declaring non-eligible dividends, or where RDTOH is sourced from eligible portfolio dividends.
To track these amounts, the RDTOH account will be split into an “eligible RDTOH account” and a “non-eligible RDTOH account”:
- The “non-eligible RDTOH account” tracks the refundable tax paid on investment income and Part IV tax on non-eligible portfolio dividends. A private corporation will receive a refund from its “non-eligible RDTOH account” only upon declaring non-eligible dividends.
- The “eligible RDTOH account” tracks Part IV tax on eligible portfolio dividends. A private corporation will receive a refund from its “eligible RDTOH account” upon declaring either an eligible or a non-eligible taxable dividend.
Where a private corporation receives a taxable dividend from a connected corporation, it is subject to Part IV tax equal to the refund obtained by the payor corporation. This Part IV tax will be added to the same RDTOH account from which the payor corporation received the refund.
An ordering rule requires that a corporation paying a non-eligible dividend must first deplete its “non-eligible RDTOH account” before receiving a refund from its “eligible RDTOH account”.
The new rules are intended to apply to taxation years beginning after 2018. Transitional rules have been proposed for the division of a corporation’s existing RDTOH account into eligible and non-eligible portions. Finance has included an anti-avoidance rule designed to prevent the deferral of this application through the triggering of a short taxation year.