A Sigh of Relief Regarding Passive Investment Income: But No Grandfathering

Two new measures were introduced in the February 27, 2018 budget that curtail the advantages of investing inside a private corporation, starting in 2019. All was met with a collective sigh of relief, considering the flawed fall proposals. However, there is still a twist - no grandfathering provisions for private corporations under two new proposals:

Reduction of the Small Business Deduction.  The Small Business Deduction, which is also known as the “business limit” is currently reduced on a straight-line basis when there is between $10 million and $15 million of taxable capital employed in Canada.  Taxable capital is calculated on Schedule 33 of the T2 corporate tax return and includes retained earnings, share capital, certain forms of debt and advances and declared but unpaid dividends.  The Small Business Deduction is not allowed when taxable capital exceeds $15 Million.

Now, in addition to the provisions above, and starting in tax years after 2018, private corporations that earn more than $150,000 in passive investment income that is not incidental to an active business, will be taxed at the general tax rate, currently 15%.  If both restrictions apply to the corporation, the greater of the two will apply.

More specifically, the business limit of $500,000 will be reduced, also on a straight-line basis, when Canadian Controlled Small Business Corporations (CCPCs) have passive investment income between $50,000 and $150,000.  The reduction in the business limit is calculated as $5 for every $1 of “adjusted aggregate investment income” above $50,000 and will be calculated annually based on the prior year’s passive investment income.

The calculations focus in on three things: The adjusted aggregate investment income, the small business deduction available and the amount of active business income earned. The active business income of the CCPC must remain below the reduced business limit, for all the income to continue to be taxed at the small business tax rate, which is currently 10% and will drop to 9% in 2019.

This is a game changer in that small business corporations will experience a 6% tax hike on active business income starting in 2019, should passive investment earnings exceed $150,000.  But is it a huge deal?  We asked Larry Frostiak, FCPA, FCA, CFP, TEP, Managing Partner, Frostiak & Leslie Chartered Professional Accountants Inc. who will be teaching new strategies resulting from the budget at the Knowledge Bureau fall CE Summits.

“What Finance accomplished with the Budget, he said, “is that they are removing the tax deferral that was enjoyed by reinvesting low rate active business income, but we are now getting full integration on passive income, at the expense of low rate taxation of active income.  But, it’s just a pre-payment of tax… not more tax.”

And that leads us to changes proposed to the RDTOH account:

Changes to RDTOH account.  Effective after 2018, the RDTOH account will feature two categories that limit the recovery of RDTOH for non-eligible portfolio dividends included in active business earnings, normally paid out as a non-eligible dividend:

• The “eligible RDTOH” account will track Part IV taxes paid on eligible portfolio dividends (38.33%).  A refund from the eligible RDTOH will be possible on distribution of any taxable dividend – eligible or non-eligible.
• The “non-eligible RDTOH” account will track refundable taxes paid under Part 1 (15%) on investment income plus Part IV taxes (38.33%) on non-eligible portfolio dividends from a non-connected corporation.  Refunds are possible only on payment of non-eligible dividends. These refunds must be obtained before those from the eligible RDTOH account.

Knowledge Bureau will be discussing these changes in detail in the May CE Summit events, coming to Winnipeg, Calgary, Vancouver and Toronto starting May 29 to June 6 and their implications not just in Canada but in relation to the U.S. Tax reforms recently announced.  Join me and U.S. tax expert Dean Smith as we explore personal/corporate tax strategies resulting from these changes.  Register for early bird rates by May 15.

Evelyn Jacks is President of Knowledge Bureau, which brings continuing financial education in the multiple areas of specialization to advisors and their clients. She is the author of 52 books on tax and wealth planning.

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