The federal government is moving ahead to limit the tax advantages of holding passive investments within private corporations, but is taking a much simpler and far more limited approach than it had originally proposed back in July 2017.
In the Feb. 27 budget, Finance Minister Bill Morneau confirmed that the government has scrapped its earlier proposal to directly increase the taxes payable on passive investment income earned within a private corporation. Passive investments are assets held by the corporation, such as stocks, bonds and investment funds, that generate non-business income.
Instead, the government will limit the ability of businesses with significant passive investments to benefit from the preferential small-business rate. This rate varies by province but is generally around 15%. Currently, up to $500,000 of active business income is subject to the lower small-business tax rate. By comparison, the general tax rate for businesses is about 25%, or 10 percentage points higher.
What's new in the 2018 budget is an additional restriction on eligibility for the small-business deduction, based on the corporation's passive investment income. The budget proposed that if a corporation (including associated corporations) earns more than $50,000 of passive investment income a year, the amount of income eligible for the small-business tax rate would be reduced in that year.
The small-business deduction limit will be reduced by $5 for every $1 of investment income above the $50,000 threshold. (This is equivalent to $1 million in passive investments with a 5% return.) Applying this formula, if a small business has annual passive investment income of $150,000 or more, it would become ineligible for the small-business tax rate.
The budget estimates that the tax changes affecting passive investments will affect about 50,000 Canadian-controlled private corporations, or fewer than 3% of the total. Further, more than 90% of the tax revenues would be generated from corporations whose owners' household income is in the top 1% of taxpayers.
Part of the increased tax revenues would come from new provisions restricting the ability of larger private corporations to obtain refunds of taxes paid on investment income while distributing dividends from income taxed at the general corporate rate.
Tax expert John Wonfor, a spokesperson for the Chartered Professional Accountants of Canada, said the budget provisions concerning passive income are a substantial improvement over the complex and punitive proposals released by Morneau last July. "This is a much simpler way of dealing with the problem," said Wonfor, who heads the national tax office of BDO Canada in Toronto. Under the earlier proposals, passive corporate income would have been taxed at a higher rate than had it been earned by an individual taxpayer.
The tax rates applicable to investment income of private businesses remain unchanged. " No existing savings will face any additional tax upon withdrawal, thereby maintaining the government’s commitment to protect the tax treatment of all past savings and investments," according to a budget document tabled in the Commons.
Since corporations are taxed at lower rates than higher-income individuals, business owners can increase their after-tax returns by holding investments in their private corporation rather than in their personal accounts. The budget seeks to eliminate this benefit for the wealthiest business owners, while retaining it for business people and incorporated professionals with more modest incomes.
Using a simple illustration, Wonfor explained how the tax advantage works. For every $100 of business income earned that a business owner in the 50% tax bracket decided to invest personally, only $50 would be available to invest after tax. But it the owner decided to invest within a small-business corporation, only 15% would be taxed, leaving $85 available to invest.
Over time, assuming a reasonable investment return, the benefit of starting off with a higher amount to invest would be compounded. The government argued that tax changes were needed to ensure that owners of private corporations use lower corporate tax rates to support their businesses, not for significant personal tax advantages beyond the $50,000 passive-income limit.
