Overview
Readers may recall that, last July, the federal government proposed significant changes to the taxation of passive investment income earned by a Canadian-controlled private corporation (“CCPC”). Changes were subsequently introduced in the February 2018 Federal Budget (as noted in last month’s Tax Letter), but the changes were more modest than the original proposals.
Under current law, a CCPC is subject to an annual tax rate on its investment income of around 50% or slightly more, depending on the province. However, when it pays out dividends to its shareholder(s), the corporation gets a refund out of its “refundable dividend tax on hand” (“RDTOH”), an account which tracks its investment income. After the refund, and taking into account the tax paid by a high income shareholder on the dividends, the overall tax rate on investment income is also about 50%. This means that there is “integration” between the corporate and personal income tax systems, such that income earned personally or through a corporation is ultimately subject to about the same total tax.
However, the government believes there is a problem with the current system. The problem stems from the fact that the first $500,000 of active business income of a CCPC is subject to a low rate of tax, typically around 13%, again depending on the province. This low rate results from the small business deduction (“SBD”) that applies to the first $500,000 of such business income, thus lowering the tax rate from the general corporate tax rate of 27-30% to around 13%. If the CCPC then uses the after-tax business income to earn passive investment income, it obtains a deferral advantage not available to other taxpayers. That is, even though the investment income is subject to annual refundable tax as noted above, the CCPC has much more to invest initially because of the low 13% tax rate on business income, compared to business income earned by non-incorporated individuals which may be subject to a tax rate of 50% or more. Put another way, the CCPC has a significant “head start” in terms of how much it can invest relative to a high-income individual. Therefore, the CCPC ultimately comes out ahead relative to an individual who carries on a business personally and invests his or her after-tax high-rate business income.
Under last year’s proposal, the RDTOH would have been scrapped, meaning that there would have been no refund for the CCPC when it paid out dividends from its investment income. This proposal would have significantly increased effective tax rates on the investment income when it was paid out as dividends, relative to the current rules. However, the proposal was never implemented, and as noted, was replaced by a more modest Budget proposal.
Main Budget Proposal
In the February 2018 Budget, the government decided against repealing the RDTOH. As a result, the RDTOH will be retained and the refund of corporate tax will still apply when the CCPC pays out dividends.
The government introduced an alternative proposal. Under this proposal, the business income of the CCPC that qualifies for the SBD in a taxation year will be reduced, on a 5:1 basis, when its passive investment income (and that of its “associated” CCPCs) for the preceding taxation year exceeds $50,000.
For example, if the CCPC’s passive investment income in a taxation year is $70,000, its maximum business income eligible for the SBD for the next taxation year will be reduced to $400,000 (that is, the maximum $500,000 small business income limit minus 5 x ($70,000 minus $50,000)).
In short, the business income of the CCPC that qualifies for the SBD will be reduced in a 5:1 ratio. The business income that does not qualify will then be subject to the higher general corporate tax rate, which, as noted, is about 27-30% depending on the province.
Further Budget Proposal
On a related note, the government introduced a measure that addresses the apparent “mismatch” that applies in certain cases where a CCPC pays dividends. Generally speaking, where a CCPC pays dividends out of income that was subject to the SBD or investment income that is eligible for the refundable tax out of its RDTOH, the dividends are considered “non-eligible” dividends. In the hands of the shareholder, these dividends receive a lower dividend tax credit than that which applies for “eligible dividends”. The latter dividends earn a higher dividend tax credit for the shareholder, because they are normally paid out of business income that was not eligible for the SBD and was therefore taxed more heavily in the CCPC.
However, in certain cases, the current rules allow a corporation to pay eligible dividends even if they are paid out of income that was subject to the SBD or investment income that is eligible for the refundable tax out of its RDTOH. The government fixed this “mismatch”. The Budget introduced a new rule that splits the RDTOH account into two accounts – one that tracks income that can qualify for eligible or non-eligible dividend tax treatment, and another that tracks income that qualifies only for the non-eligible tax treatment.
The above proposals apply to corporate taxation years that begin after 2018. They are included in Bill C-74, the 2018 Budget first bill, which is currently wending its way through Parliament and will almost certainly be enacted this June.