The 2018 federal budget signifies another chapter in the Department of Finance's saga to overhaul the taxation of private corporations and their shareholders. The department's initial July 18 2017 consultation paper was met with significant criticism throughout the summer and autumn (for further details please see "Department of Finance proposes substantial changes to private corporation taxation"). In October 2017 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 2017 the Department of Finance released substantially redrafted income-splitting rules to be effective January 1 2018.
In the July paper, the Department of Finance floated ideas to reduce the advantages of investing passively through a private corporation. Each outlined approach amounted to a fundamental shift in the way that 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 2017.
Budget 2018 sets out two changes to the taxation of private corporations:
- a reduction of the small business deduction based on the amount of passive investment income earned at a corporate level; and
- a restriction on obtaining refunds of corporate tax on dividends paid from income taxed at the reduced small business rate.
A Canadian-controlled private corporation (CCPC) is eligible for a reduced tax rate on its first C$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 C$500,000 limit is shared among associated corporations and is reduced where the associated corporate group has more than C$10 million of taxable capital employed in Canada.
Budget 2018 proposes to restrict the small business deduction for CCPCs that earn, together with any associated corporations, more than C$50,000 of certain types of passive income in a year. The restriction operates on a straight-line basis for passive income between C$50,000 and C$150,000. Therefore, if a CCPC earns C$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 (so-called 'adjusted aggregate investment income') generally includes:
- taxable capital gains;
- rental income; and
- portfolio dividends.
However, adjusted aggregate investment income will exclude certain taxable capital gains realised from the sale of active business assets and shares of certain connected CCPCs, as well as investment income that is incidental to the business. Further, the adjusted aggregate investment income of not only other CCPCs, but also any associated corporation, will reduce the small business deduction of the CCPC. The Department of Finance has included anti-avoidance rules to address the transfer or lending of property to unassociated but related corporations.
Taken together, this measure affects only CCPCs that earn active business income and seek to claim the small business deduction.
If enacted, the changes will apply to tax years beginning after 2018.
At present, 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 C$38.33 for every C$100 of taxable dividends declared. This refund mechanism applies regardless of whether the corporation designates the taxable dividends to be eligible.
Eligible dividends are taxed at a lower rate in an individual shareholder's hands on the assumption that the corporation paid the full general corporate tax rate on the originating income. Non-eligible dividends are taxed at a higher 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.
Budget 2018 notes that the current system enables private corporations that declare 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 receive a dividend refund of the RDTOH only on declaring non-eligible dividends or where the RDTOH is sourced from eligible portfolio dividends.
To track these amounts, the RDTOH account will be split into an eligible 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 on 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 on 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 payer corporation. This tax will be added to the RDTOH account from which the payer corporation received the refund.
An ordering rule requires that a corporation paying a non-eligible dividend must deplete its non-eligible RDTOH account before receiving a refund from its eligible RDTOH account.
The new rules are intended to apply to tax 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. The Department of Finance has included an anti-avoidance rule designed to prevent the deferral of this application through the triggering of a short tax year.
For further information please contact Leonard Gilbert, Nicholas McIsaac or Kyle Lamothe at Thorsteinssons LLP by telephone (+1 416 864 0829) or email (firstname.lastname@example.org, email@example.com or firstname.lastname@example.org). The Thorsteinssons LLP website can be accessed at www.thor.ca.
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