Passive income – Keep it below $50K

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Passive income – Keep it below $50K

In our previous article “Tax Planning challenges for Private Corporations – Items need to consider” we talked about government’s proposal to neutralize the benefits of investing after-tax active earnings in a corporation.  In the February 27, 2018 budget, the federal government announced changes to its rules, gradually reducing access to the small business tax rate for those Canadian-controlled private corporations (CCPCs) with significant passive investment income.

The changes in the taxation of Passive Income

The small business tax rate will be reduced from 10.5% to 10% in 2018, and to 9% in 2019.  This compares favourably with the general corporate tax rate of 15%.

The key conclusion with changes is that the small business deduction (SBD) limit for CCPCs will be gradually reduced for corporations earning between $50,000 and $150,000 of investment income. It is proposed that the small business deduction be reduced by $5 for every $1 of investment income above the $50,000 threshold. Thus, the small business deduction would be reduced to zero once a corporation reaches $150,000 of investment income a year.  In summary, if you earn more than $50,000 of passive income per year, you will gradually shift over to the general tax rate of 15%.

The table below shows the impact of increasing levels of investment income on the small business deduction limit and the corresponding Federal Tax impact only:

For example, suppose that you have $90,000 of investment income.  This would be $40,000 above the threshold of $50,000.  The reduction in the small business deduction limit would be $200,000 (i.e., $40,000 x 5), resulting in a reduced SBD limit of $300,000 (i.e., $500,000 – $200,000).  The increased Federal tax would be $10,000 (i.e., $200,000 x (15% – 10%)).  The actual additional taxes would be higher since we have not included the impact on provincial taxes in the above example.

This new measure will work in addition to the existing taxable capital rule whereby the small business deduction is phased out on a straight-line basis for associated CCPCs if they have between $10 million and $15 million of aggregate taxable capital employed in Canada. The overall effect in a small business deduction limit will be the greater of the reduction under the new and the existing taxable capital rules.

Adjusted aggregate investment income

Under the new rules, investment income will be tweaked with a number of adjustments to come up with a new amount called, “adjusted aggregate investment income”. In other words, the new concept requires you to begin with existing aggregate investment income as defined in subsection 129(4) of the ITA  and adjust for the following:

  • Reduce taxable capital gains (and losses) 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;
  • Reduce taxable capital gains (and losses) to the extent they arise from the disposition of 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;
  • Reduce net capital losses carried over from other taxation years;
  • Add dividends from non-connected corporations;
  • Add income from savings in a life insurance policy that is not an exempt policy, to the extent it is not otherwise included in aggregate investment income; and
  • Reduce capital gains from the sale of active investments or investment income incidental to the business (e.g., interest on short-term deposits held for operational purposes).

New passive income strategy

Since this new measure will apply to taxation years of a taxpayer that begin after 2018, it may be advisable to act now.

  • If you have accrued investment income in your corporation, you may choose to realize the profit in 2018, rather than later to avoid the clawback of the small business deduction. However, if you have long-term investments, it is advisable to liquidate these holdings gradually, to prevent a grinding of the small business deduction limit.
  • Consider transferring investments from the corporation to yourself, so that they are owned personally. Figure out what portion of investments may generate investment income above the $50,000 threshold to determine the amount of investments to transfer to yourself;
  • Consider using tax-efficient investments such as those that generate a return of capital such as systematic withdrawal plans, or investments which do not distribute dividends each year (e.g., non-dividend earning stocks, ETFs that don’t make annual distributions). If you shift your investment strategy to earn more capital gains and less interest income, this will allow the $50,000 threshold to go further. This involves a deferral of the investment income, rather than a solution of the problem.
  • Consider taking more salary, rather than dividends from your corporation. Salary income would increase your RRSP contribution room and allow you to make RRSP contributions.  It is prudent to have more than one retirement savings strategy available, just in case the government changes the rules again.
  • Consider purchasing permanent corporate-owned life insurance, e.g., exempt life insurance policies that earn investment income related to the cash value accumulation inside the policy without producing any annual investment income that would have to be reported. (Nearly all life insurance contracts currently available in Canada are structured to be exempt life insurance policies for tax purposes.)

Author: Timur Lidzhiev

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