Big Change Proposed for Tax on Passive Investment Income in a Corporation

The Finance Department is proposing alternatives to the taxation of passive income earned in a private corporation. This will dramatically alter after-tax income results, essentially taxing the income earned by corporate investing at the top marginal rates and then taxing distributions once more at personal tax rates. 

The government is targeting the earnings on passive investments that are held as retained earnings for future investment. Citing that there is an unintended advantage in this structure, allowing savings within those corporations to go beyond the sheltering afforded through RRSPs and TFSAs, the proposals quite possibly miss an important reality: at a time when interest rates have just risen on lines of credit and operating lines, the passive earnings in a corporation offset the costs of borrowing to sustain business operations.

The proposals make the point that many smaller or less profitable private corporations would not be able to make the same investments after paying out salary and or dividends to shareholders. This seems to have the effect of taking every business down to the lowest common denominator, so astutely pointed out by the commentary provided by Moodys Gartner in their tax blog, which goes on to say, “these proposals are making changes to rules that are commonly used to prevent double and triple taxation of the same income.” 

In essence, these proposals change the long-standing rules on the taxation of passive income in a corporation, introduced in 1972. Much of the reason for the change stems from the government’s observation that our new economy is shifting away from the production of goods, prevalent in the 1972 tax reforms, to the production of services. The background documents note that the amount of taxable passive investment income earned by private corporations has increased from $8.6 billion in 2002 to $26.8 billion in 2015.  

But in addition, the proposals compare the retirement results of a private corporation owner with her employee: “An individual earning salary income would have no alternative but to invest in a personal account... a business owner can realize a personal portfolio advantage that is the consequence of low corporate tax rates, which are intended to support the growth of active businesses – not to confer a personal savings advantage.” 

This only makes sense if one looks at one side of the net worth statement. But, in the absence of understanding what personal guarantees a business owner has to provide – against personal homes and other assets – the tax fairness of this situation cannot be properly judged. 

In making these changes, the government argues that they want to see business owners use lower corporate tax rates for new capital investment — in better machinery and more efficient technology — that makes workers more productive. This is interesting, considering we live in a growing digital world where machinery is increasingly being run without humans.  There is also reference to the reduction of non-tax costs of incorporation, without reference to increasing costs of wages and benefits payable to employees. 

The government is considering two approaches to changing the taxation of passive investments in a private corporation: the apportionment method and the elective method. We’ll embellish on these in future issues of Knowledge Bureau Report and at Knowledge Bureau’s Educational Workshops, the new CE Summits, being held across Canada later this fall.  

Briefly, these alternative tax calculations challenge the 1972 tax system which was comprised of two elements: first, the RDTOH (Refundable Dividend Tax on Hand), which denied the lower small business tax rate when income is earned in the corporation and then second, the refund of the high rate tax when income was distributed to shareholders, where it was taxed personally. 

The government is now not actively considering the reintroduction of a refundable tax in respect of ineligible investments. A new approach would also change how passive income is “categorized” and then taxed personally when distributed as a dividend. Essentially the proposals would tax passive investment income in an incorporated business at the top personal income tax rate a salaried employee would pay before investing in a personal savings account. 

The problem is that that salaried individual would benefit from graduated tax rates; the passive investments in the corporation — also an individual entity for tax purposes — do not. In summary, it appears that the new proposals seek to:

• Eliminate the RDTOH and tax income from passive investments immediately with a non-refundable tax equivalent to the highest MTR for individuals.
• Dividends from publicly traded shares, if received in a CCCP, will be treated as non-eligible dividends
• The non-taxable half of capital gains earned from portfolio investments in a CCCP will not be added to the capital dividend account and therefore will no longer be eligible for a tax-free flow-through to the shareholders.

The important thing to remember here is that the new rules will be on a go-forward basis. The government attempts further reassurances in its proposal documents: “Once a new approach is determined for the tax treatment of passive investment income, the Government will consider how to ensure that the new rules have limited impacts on existing passive investments.” 

While that is so, it appears that the government is intent on forging complexity onto the private business owner and penalizing those who finance their own operations in their small business enterprises through investment earnings on their corporate investments.  

On the good news side for tax accountants, and lawyers at any rate, is the flurry of work that will evolve in the 2018 tax planning year.   

In the meantime, we at Knowledge Bureau will continue to pour over the documents for you and provide interpretations and examples as we write, speak and educate on the subject throughout the rest of the year. Happy summer, everyone...a storm of complexity is coming your way!

Evelyn Jacks is President of Knowledge Bureau, a national educational institute focused on providing excellence in continuing professional development for tax and financial advisors. She is also the author of 52 books on tax and wealth planning.

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