After months of speculation regarding the taxation of passive investment income earned by private corporations, the Minister of Finance tabled Budget 2018 on February 27, 2018. The budget includes a measure to further limit the small business deduction as a result of a perceived tax deferral advantage when passive investment income is earned inside private corporations.

The small business deduction

Ontario corporations are subject to a general corporate income tax rate of 26.5% (15% federal plus 11.5% provincial). The small business deduction results in an Ontario Canadian-controlled private corporation (CCPC) with qualifying active business income (ABI) currently being subject to a combined corporate income tax rate of 13.5% (10% federal plus 3.5% provincial) on the first $500,000 of ABI each year.

In comparison, corporations in Alberta are subject to a general corporate income tax rate of 27% (15% federal plus 12% provincial). CCPCs in Alberta with qualifying ABI are subject to a combined corporate income tax rate of 12% (10% federal plus 2% provincial) on the first $500,000 of ABI each year.

The small business deduction is phased out on a straight-line basis for CCPCs (and their associated corporations) having between $10 million and $15 million of taxable capital employed in Canada.

Aggregate investment income

Defined in subsection 129(4) of the Income Tax Act, Aggregate investment income (AII) is basically a corporation's income from property (capital gains in excess of capital losses, interest, rents, royalties, etc.). AII is not eligible for the small business deduction and is subject to a federal refundable tax of 30.67%. Ontario CCPCs with AII are subject to a combined corporate income tax rate of 50.17% (38.67% federal plus 11.5% provincial).

In comparison, Alberta CCPCs with AII are subject to a combined corporate income tax rate of 50.67% (38.67% federal plus 12% provincial).

Currently, a CCPC earning ABI and paying Ontario corporate income taxes will pay 13.5% in income taxes on the first $500,000 of ABI each year, regardless of the amount of AII it earns, along with its associated corporations, each year.

Current treatment

For example, assume Opco has taxable income of $500,000 from the provision of services/sale of goods after Ms. X's annual remuneration. Each year, any after-tax income not required to be reinvested in Opco has been paid to Holdco by way of an intercorporate dividend to achieve Ms. X's objectives of protecting Opco from creditors and funding her retirement. Over several years, a total of $1,500,000 has been paid in dividends from Opco to Holdco, and Holdco has invested this $1,500,000 in an investment portfolio that generates, on average, an annual return of approximately 8% (or $120,000).

Opco is taxable on its $500,000 ABI from the provision of services/sale of goods and pays Ontario corporate income taxes of $67,500 ($500,000 at 13.5%). Holdco is taxable on its $120,000 of AII and pays Ontario corporate income taxes of $60,204 ($120,000 at 50.17%). In total, the companies pay $127,704 in corporate income taxes.

Proposed treatment

Budget 2018 proposes to reduce the small business deduction limit for CCPCs (and their associated corporations) that have significant income from passive investments. Specifically, the small business deduction limit will be reduced on a straight-line basis for CCPCs having between $50,000 and $150,000 in investment income. In other words, for every $1 of investment income in excess of $50,000, the small business deduction will be reduced by $5.

Considering the Holdco/Opco example again, the Budget 2018 proposals will have the following impact:

  • Opco and Holdco are associated corporations. Holdco earns investment income of $120,000. The small business deduction limit will thus be reduced to $150,000.1
  • Opco is taxable on its $500,000 of ABI from the provision of services/sale of goods and pays Ontario corporate income taxes of $113,000 ($150,000 at 13.5% plus $350,000 at 26.5%).
  • Holdco is taxable on its $120,000 of AII and pays Ontario corporate income taxes of $60,204 ($120,000 at 50.17%).
  • In total, Holdco and Opco pay corporate income taxes of $173,204, an increase of $45,500.

Whether the investment income is earned in Holdco or in Opco does not affect the results of this proposal. The investment income of all associated corporations must be considered in determining the small business deduction limit. Furthermore, the Minister of Finance indicated that anti-avoidance rules will apply to prevent transactions designed to avoid this 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.

Summary

Where applicable, this proposal will further eliminate the small business tax deferral. The impact will vary depending on a corporation's provincial or territorial residency. The proposal will apply to taxation years that begin after 2018.

Footnote

1. $500,000 – $500,000* (($120,000-$50,000)/($150,000-$50,000))

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