Executive Summaries Mar 20, 2018
2018 Federal Budget – Analysis of Passive Investment Income's Mesures
The proposed amendments to the Income Tax Act essentially concern the measures relating to passive investment income of corporations. These new modifications will have an impact on the small business deduction and will tighten the requirements for reimbursable dividend tax on hand.
On February 27, 2018, Canada’s Finance Minister Bill Morneau tabled his latest budget in the House of Commons (the “Budget”). The Budget proposes a number of measures affecting the taxation of personal income and business income, including the details on the much awaited measures relating to passive investment income of corporations. The present text summarizes and focuses on the measures on passive investment income proposed in the Budget (the “Proposed Measures”).
Following the uncertainty created by the Finance Minister’s announcements of July and October 2017 on the potential amendment to the taxation of passive investment income for corporations, the Proposed Measures are received with some relief.
The Proposed Measures are far less complicated than initially announced and have a more limited impact. Here is a brief summary and analysis of such Proposed Measures.
PROPOSED MEASURES ON PASSIVE INVESTMENT INCOME
The Proposed Measures provide legislative amendments to the Income Tax Act with respect to the following two (2) tax concepts:
- Small business deduction; and,
- Refundable dividend tax on hand (“RDTOH”).
The Proposed Measures will apply for taxation years of corporations starting after December 31, 2018.
1. SMALL BUSINESS DEDUCTION
The Proposed Measures with respect to the small business deduction provide a gradual reduction of the small business deduction limit of $500,000 (the “Business Limit”) for Canadian controlled private corporations that generate, together with their associated corporations, aggregate investment income between $50,000 and $150,000 per year. The reduction is effectively decreasing the annual Business Limit by $5 for each $1 of annual aggregate investment income earned in excess of $50,000. Pursuant to the Proposed Measures, when the annual aggregate investment income of an active corporation and its associated corporations is $150,000 or higher, the active corporation will not have access to the small business deduction for that year.
Adjusted Aggregate Investment Income
For the purpose of the calculation of this reduced Business Limit, the Proposed Measures provide the following adjustments to the aggregate investment income:
- Exclusion of capital gains (losses) from the disposition of active assets (assets used principally in an active business carried on in Canada, shares of a connected corporation which would qualify for the capital gains exemption if they were held by an individual and interests in a partnership qualifying under the same conditions as the shares of a corporation);
- Exclusion of capital losses carried-back from previous years;
- Addition of dividends from non-connected corporations; and
- Addition of income from savings in a not exempt life insurance policy, to the extent it is not otherwise included in aggregate investment income.
IMPACT OF THIS PROPOSED MEASURE
Essentially, this Proposed Measure results in an increase of up to 9.6% of the taxes payable by a corporation on the portion of its active business income which would have normally qualified for the small business deduction if it, together with its associated corporations, earn investment income in excess of $50,000 for a year. The following table demonstrates examples of the impact of this Proposed Measure, for a corporation which earns $500,000 in active business income.
Under the current legislation, a private corporation pays taxes at a rate of 50.37% (50.27% in 2019) on its aggregate investment income. Furthermore, a Canadian controlled private corporation pays taxes at a rate of 38.33% (“Part IV tax”) on dividends received from a corporation other than a connected corporation, or from a connected corporation when the payment of such dividends caused a refund of RDTOH to the connected corporation . The RDTOH includes 30.67% of the aggregate investment income earned and 100% of the Part IV tax paid. The RDTOH account balance is refundable to the corporation at a rate of $38.33 for every $100 of taxable dividends paid by the corporation. ** Principle**
The Proposed Measures propose to amend the definition of RDTOH and to replace the current RDTOH account with two (2) separate accounts: Eligible RDTOH and Non-Eligible RDTOH.
- The Eligible RDTOH will be composed of the Part IV tax payable on (i) eligible dividends received from corporations other than connected corporations, and (ii) dividends received from connected corporations which caused a refund of such corporations’ Eligible RDTOH. This account will mainly consist of Part IV tax paid on dividends received on shares of public companies.
- The Non-Eligible RDTOH will be composed of (i) 30.67% of the investment income, as under the current legislation, and (ii) the Part IV tax paid on non-eligible dividends received from corporations other than connected corporations.
The Non-Eligible RDTOH will be refunded only on the payment of non-eligible dividends and the Eligible RDTOH will be refunded on the payment of eligible and non-eligible dividends. The payment of a non-eligible dividend will first result in the refund of the Non-Eligible RDTOH before it results in the refund of the Eligible RDTOH.
Since the investment income of a corporation will generally generate Non-Eligible RDTOH, this Proposed Measure will essentially result in an increase of up to 4.69% in personal taxes payable on dividends paid by a corporation to an individual to recuperate RDTOH, where the corporation earns both active business income not benefitting from the small business deduction, and investment income:
A corporation’s RDTOH account at the end of its taxation year immediately before the application of the Proposed Measures will be converted as follows:
- The lesser of (i) the corporation’s RDTOH at the end of the year and (ii) 38.33% of the corporation’s General Rate Income Pool (“GRIP”) account at the end of the year will be added to the Eligible RDTOH; and
- The balance of the corporation’s RDTOH, if any, will be added to the Non-Eligible RDTOH.
Therefore, contrary to the Finance Minister’s repeated promises, the Proposed Measures do not include transitional measures that would exclude prior passive investments and the revenues generated by them from the application of the Proposed Measures. The only protection a corporation will have from the application of the Proposed Measures to passive investments held prior to the Proposed Measures coming into force will be the ability to obtain the reimbursement of its RDTOH balance at the end of its last taxation year beginning before 2019 through the declaration of an eligible dividend for up to its GRIP account at the end of such last taxation year beginning before 2019.
WHAT TO DO?
Each corporation’s situation should be assessed and analyzed on a case-by-case basis before the Proposed Measures come into force. Depending on such assessment, certain steps may be taken to minimize the impact of the Proposed Measures and to maximize the use of the GRIP account to recuperate RDTOH resulting from investment income, which may include :
- The opportunity to trigger the capital gain on certain investment assets, for example if such assets were to be disposed of in the short term, to increase the corporation’s transitional Eligible RDTOH up to 38.33% of the corporation’s GRIP account;
- Extract dividends out of an active corporation’s GRIP account in favour of its corporate shareholders earning investment income and having a RDTOH balance higher than 38.33% of their GRIP account.
Do not hesitate to contact your BCF tax specialist for further information. We can help assess and analyze the application of the Proposed Measures to your specific structure and elaborate investment and tax strategies to minimize the potential impact of the Proposed Measures.