On February 27th, the Finance Minister, Bill Morneau, delivered his third budget. The budget expects a deficit of $19.4 billion for fiscal 2017-2018, and forecasts deficits of $18.1 billion for 2018-2019 and $17.5 billion for fiscal 2019-2020. There are still no indications by the Finance Minister of when the annual budget is to be balanced.
Business Income Tax Measures
Passive Investment Income
Last year, the government released a consultation paper that would have profoundly affected private corporations. The measures included dividend sprinkling, the taxation of investment income inside a corporation, and the conversion of retained earnings to capital gains within a corporate organization.
Mr. Morneau has confirmed the government’s intention to control dividend sprinkling and has completely backed off any rules (at least for now) pertaining to the conversion of retained earnings to capital gains. There was a hint, late in the fall that investment income earned by a private corporation of less than $50,000 would not attract any punitive taxation. It was originally proposed that this kind of income would attract a tax of the order of 73 percent. The actual budget papers below indicate the method of dealing with this perceived inequity, will be by way of limiting a corporation’s access to the small business rate where its investment income is greater than $50,000. These new rules come into effect after 2018.
Active business income earned by private corporations is taxed at corporate income tax rates that are generally lower than personal income tax rates, giving these corporations more money to invest in order to grow their businesses. In addition, a small Canadian-controlled private corporation (CCPC) can benefit from a corporate income tax rate on qualifying active business income that is lower than the general corporate income tax rate.
The intention of the lower small business tax rate is to leave small CCPCs, which may have difficulty accessing capital, with more retained earnings to reinvest in their active businesses.
Business income retained in a corporation, however, can also be used to finance passive investments. The current tax regime relating to passive investment income earned by private corporations has been in place since 1972. In contrast to active business income (which includes investment income that is incidental to an active business), additional taxes apply to passive investment income in the year in which it is earned. These additional taxes are intended to ensure that taxes payable by private corporations on investment income approximate top federal-provincial-territorial personal income tax rates. A portion of the tax on investment income is refundable to a corporation upon the payment of taxable dividends, and the income is then subject to progressive personal income tax rates in the hands of its individual shareholders.
Where funds invested passively within a private corporation have been financed with retained earnings that have been taxed at preferential corporate income tax rates, owners of the corporation can benefit from a tax deferral advantage relative to a situation where the corporation distributes the retained earnings and the owners invest personally in passive investments. This issue was the subject of public consultations that were launched in July 2017.
Budget 2018 proposes two measures, applicable to taxation years that begin after 2018, to limit tax deferral advantages on passive investment income earned inside private corporations. These measures take into account the feedback received from stakeholders in response to the July 2017 consultation.
The Government has proposed to reduce the tax rate for qualifying active business income of small CCPCs from 10.5 per cent to 10 per cent for 2018 and to 9 per cent as of 2019. This lower rate – relative to the 15-per-cent general corporate rate – is intended to increase the after-tax income available for reinvestment in the active business, in recognition that small businesses tend to have more difficulty accessing capital. This rate reduction is provided through the small business deduction.
This preferential tax rate applies on up to $500,000 of qualifying active business income of a CCPC (the “business limit”). There is a requirement to allocate the business limit among associated corporations. The business limit is reduced on a straight-line basis for a CCPC and its associated corporations having between $10 million and $15 million of total taxable capital employed in Canada.
When retained earnings taxed at the small business rate are used to invest passively, rather than in the active business, significant tax deferral advantages can be realized relative to an individual investor.
Budget 2018 proposes to reduce the business limit for CCPCs (and their associated corporations) that have significant income from passive investments.
Business Limit – Reduction
Under this measure, the business limit will be reduced on a straight-line basis for CCPCs having between $50,000 and $150,000 in investment income.
The measure will affect CCPCs only to the extent that their business income exceeds the reduced business limit. For example, a CCPC with $100,000 of investment income would have its business limit reduced to $250,000. As long as the reduced business limit remains above the active business income of the CCPC, all of that income would continue to be taxed at the small business tax rate. A CCPC with $75,000 of business income would have to earn more than $135,000 in passive income before its business limit is reduced below its business income. This feature of the proposed rules recognizes that CCPCs with lower amounts of business income generate less retained earnings that can later be used for reinvestment in the business, and may have more difficulty accessing capital. CCPCs with business income above the reduced business limit will be taxed on income above the business limit at the general corporate tax rate.
The business limit reduction under this measure will operate alongside the business limit reduction that applies in respect of taxable capital in excess of $10 million. The reduction in a corporation’s business limit will be the greater of the reduction under this measure and the existing reduction based on taxable capital.
The reduction of the business limit for any particular corporation under this measure will be based on the investment income of the corporation and, consistent with the reduction in the business limit based on taxable capital, any other associated corporations with which it is required to share the
business limit for a taxation year.
Business Limit – Adjusted Aggregate Investment Income
For the purpose of determining the reduction of the business limit of a CCPC, investment income will be measured by a new concept of “adjusted aggregate investment income” which will be based on “aggregate investment income” (a concept that is currently used in computing the amount of refundable taxes in respect of a CCPC’s investment income) with certain adjustments. The adjustments will include the following:
• taxable capital gains (and losses) will be excluded to the extent they arise from the disposition of:
– a property that is used principally in an active business carried on primarily in Canada by the CCPC or by a related CCPC; or
– a share of another CCPC that is connected with the CCPC, where, in general terms, all or substantially all of the fair market value of the assets of the other CCPC is attributable directly or indirectly to assets that are used principally in an active business carried on primarily in Canada, and certain other conditions are met;
• net capital losses carried over from other taxation years will be excluded;
• dividends from non-connected corporations will be added; and
• income from savings in a life insurance policy that is not an exempt policy will be added, to the extent it is not otherwise included in aggregate investment income.
Consistent with existing rules relating to aggregate investment income, adjusted aggregate investment income will not include income that is incidental to an active business.
This measure will apply to taxation years that begin after 2018.
Rules will apply to prevent transactions designed to avoid the measure, such as the creation of a short taxation year in order to defer its application and the transfer of assets by a corporation to a related corporation that is not associated with it.
Refundability of Taxes on Investment Income
The current tax regime relating to refundable taxes on investment income of private corporations seeks to tax income from passive investments at approximately the top personal income tax rate while that income is retained in the corporation. Some or all of these taxes are added to the corporation’s
refundable dividend tax on hand (RDTOH) account and are refundable at a rate of $38.33 for every $100 of taxable dividends paid to shareholders.
For income tax purposes, dividends paid by corporations are either “eligible” or “non-eligible”:
• Non-eligible dividends are presumed to have been paid from a corporation’s active business income that has been subject to the small business tax rate (including non-eligible dividends received by the corporation) or from passive investment income, but excluding the non-taxable portion of capital gains as well as eligible portfolio dividends (i.e., dividends that are paid by non-connected corporations as eligible dividends). An individual who receives non-eligible dividends is entitled to the ordinary dividend tax credit which, at the federal level, the Government has proposed be 10 per cent in 2018, and 9 per cent after 2018.
• Eligible dividends are presumed to have been paid from a corporation’s active business income that has been subject to the general corporate income tax rate (including eligible dividends received by the corporation). An individual who receives eligible dividends is entitled to the enhanced dividend tax credit which, at the federal level, is 15 per cent.
Generally, investment income earned by private corporations must be paid as non-eligible dividends (exceptions include eligible portfolio dividends, which may be paid as eligible dividends, and the non-taxable portion of capital gains, which may be paid as tax-free capital dividends). A corporation, however, may obtain a refund of taxes paid on investment income, reflected in the corporation’s RDTOH account, regardless of whether the dividends paid are eligible or non-eligible.
As a result, the current system allows a corporation to receive an RDTOH refund upon the payment of an eligible dividend (which entitles an individual receiving the dividend to the enhanced dividend tax credit) in situations where the corporation’s RDTOH was generated from investment income that
would need to be paid as a non-eligible dividend. This can provide a tax deferral advantage on passive investment income by allowing private corporations paying eligible dividends sourced from active business income taxed at the general corporate income tax rate to generate a refund of taxes paid on passive income.
To better align the refund of taxes paid on passive income with the payment of dividends sourced from passive income, Budget 2018 proposes that a refund of RDTOH be available only in cases where a private corporation pays non-eligible dividends. An exception will be provided in respect of RDTOH
that arises from eligible portfolio dividends received by a corporation, in which case the corporation will still be able to obtain a refund of that RDTOH upon the payment of eligible dividends.
The different treatment proposed regarding the refund of taxes imposed on eligible portfolio dividend income will necessitate the addition of a new RDTOH account.
• This new account (eligible RDTOH) will track refundable taxes paid under Part IV of the Income Tax Act on eligible portfolio dividends. Any taxable dividend (i.e., eligible or non-eligible) will entitle the corporation to a refund from its eligible RDTOH account (subject to the ordering rule described below).
• The current RDTOH account (which will now be referred to as non-eligible RDTOH) will track refundable taxes paid under Part I of the Income Tax Act on investment income as well as under Part IV on non-eligible portfolio dividends (i.e., dividends that are paid by non-connected corporations as non-eligible dividends). Refunds from this account will be obtained only upon the payment of non-eligible dividends.
RDTOH Recapture – Connected Corporations
Currently, if a corporation obtains a refund of RDTOH upon the payment of a dividend to a connected corporation, the recipient corporation pays refundable tax under Part IV of the Income Tax Act equal to the amount of tax refunded to the payor. This amount is then added to the recipient corporation’s RDTOH account. Under this measure, the corporation receiving such a dividend will continue to pay an amount of Part IV tax equal to the refund obtained by the payor corporation. This amount, however, will be added to the RDTOH account of the recipient corporation that matches the RDTOH account from which the payor corporation obtained its refund.
RDTOH Refunds – Ordering Rule
Upon the payment of a non-eligible dividend, a private corporation will be required to obtain a refund from its non-eligible RDTOH account before it obtains a refund from its eligible RDTOH account.
This measure will apply to taxation years that begin after 2018.
An anti-avoidance rule will apply to prevent the deferral of the application of this measure through the creation of a short taxation year.
A corporation’s existing RDTOH balance will be allocated as follows:
• For a CCPC, the lesser of its existing RDTOH balance and an amount equal to 38⅓ percent of the balance of its general rate income pool, if any, will be allocated to its eligible RDTOH account. Any remaining balance will be allocated to its non-eligible RDTOH account.
• For any other corporation, all of the corporation’s existing RDTOH balance will be allocated to its eligible RDTOH account.
Other Income Tax Measures
• The government is turning the Working Income Tax Benefit into a new Canada Workers Benefit. The changes mean that if you are single and earn $15,000 or less in 2019 you may earn an extra $500 per year. In the past, you had to check a box on your return to apply, but this is no longer the case. You will now be automatically enrolled.
• The medical expense tax credit will be expanded to include eligible expenses incurred after 2017, in respect of an animal specifically trained to perform tasks for a patient with a severe mental impairment, to help the patient cope with their impairment (e.g., a psychiatric service dog trained to assist with post-traumatic stress disorder). Expenses will not be eligible if they relate to an animal that provides only comfort or emotional support.
• As of June of 2019, the government will offer five additional weeks of EI Parental Sharing Benefits when both parents commit to sharing parental leave. It’s available to all two-parent families, including adoptive and same-sex couples. If you’re going for the standard parental leave option of 55 percent of EI benefits over 12 months, you’ll have a total of 40 weeks of leave instead of 35 weeks. As well, where families have opted for extended parental leave at 33 percent of earnings for 18 months, the second parent would be able to take up to 8 weeks of additional parental leave.
• A new Apprenticeship Incentive Grant for Women would give women in male-dominated trade fields $3,000 per year of training (or up to $6,000 over two years). Almost all Red Seal trades are eligible.
• As expected, there will be a tax on cannabis as well, which depends on whether the plant product is a seed, flower, trim or seed-bag. In the meantime, cannabis growers and manufacturers will be required to obtain a cannabis license from Canada Revenue Agency and remit the excise duty, where applicable. Details to come when non-medical marijuana will become available for legal retail sale.
• If you have a Health and Welfare Trust, you need to convert it to an Employee Life and Health Trust by the end of 2020.
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