In the July 18, 2017 income tax proposals dealing with small business tax issues (see above), one of the main proposed changes relates to the taxation of passive investment income earned by a Canadian-controlled private corporation (“CCPC”) by using its after-tax business income. Under current rules, there is a tax deferral advantage because the active business tax rate for a CCPC (between 11% and 15% depending on the province) is significantly lower than the top marginal tax rate that could apply to the individual shareholder (50% or higher). Even though the integration system of taxing dividends imposes tax on the individual receiving dividends so that the total tax rate is the same, the initial lower corporate tax rate leaves a CCPC with much more income that can be invested until it is eventually paid out.
The Department of Finance announced that it would eliminate that tax advantage, although the change would not be effective until a later date when specifics were provided (those specifics are expected to come in the 2018 Federal Budget). In general, the new system would impose a new tax on investment income of a CCPC so that the top rate of combined corporate and personal tax on such income would be much higher than the current rate – typically somewhere around 73%.
However, in October 2017 the Department back-tracked somewhat in response to a political uproar, and said that the first $50,000 of CCPC passive investment income per year (representing a 5% return on up to $1 million of investments) would not be subject to the new proposals.
So it will still be advantageous – to a certain point – to earn passive income inside of your CCPC. This is an advantage that you would not have if you carried on your business personally or through a partnership rather than through the CCPC. The following example illustrates the tax savings that can still result.
- 50% personal tax rate;
- 13% tax rate on CCPC active business income;
- 50% “refundable tax” on CCPC passive investment income;
- Perfect “integration” between the personal tax and corporate tax, meaning that the total corporate and personal tax on CCPC income that is subsequently paid out as a dividend to a shareholder is equal to the CCPC shareholder’s marginal rate of tax;
- $500,000 of business income; and
- Rate of return on passive investments of 10%.
Taxpayer 1 carries on a business personally and earns $500,000 in year 1, leaving him with $250,000 after the 50% ($250,000) tax. He invests the after-tax amount at the beginning of year 2, earning another $25,000 by the end of year 2. The $25,000 is subject to 50% tax, leaving $12,500. Taxpayer 1 is left with a total of $262,500 ($250,000 plus $12,500).
Taxpayer 2 carries on a business through a CCPC, which earns $500,000 of active business income in year 1, leaving it with $435,000 after the 13% ($65,000) tax. That amount is invested at the beginning of year 2, earning another $43,500 by the end of year 2, when the maximum amount is paid out as a dividend to the shareholder Taxpayer 2. Assuming perfect “integration” between the personal and corporate tax, the $43,500 of investment income will be subject to total tax of 50% (CCPC refundable tax net of refund, plus personal tax on dividends), leaving $21,750. The $435,000 part of the dividend will be subject to a further tax of $185,000 tax in the hands of Taxpayer 2 (i.e. the $185,000 tax plus the initial CCPC tax of $65,000 equals 50% of the $500,000 business income), leaving $250,000. In total, Taxpayer 2 is left with $271,750 ($250,000 plus $21,750).
In the example, Taxpayer 2 has a significant advantage over Taxpayer 1, owing to the effective tax deferral of a large portion of the $500,000 of business income. That is, since the CCPC was subject to initial tax of only 13% compared to Taxpayer 1 who was subject to initial tax of 50%, the CCPC had a “head start” in terms of how much it could invest. (As noted, the example assumes perfect integration between the personal and corporate tax. In most provinces the integration for CCPC investment income is currently less than perfect. So Taxpayer 2 might be left with less than $271,750, but will definitely be left with more than the $262,500 amount for Taxpayer 1.)
In short, business owners who carry on their businesses through a CCPC have significant tax advantages over those who carry on businesses personally. In addition to the small business tax rate for CCPCs, there is also the lifetime capital gains exemption for gains on shares of qualified small business corporations, and, as illustrated above, an advantage for earning passive investment income.