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2018 Federal Budget proposals target private corporations earning investment income

investment incomeIn July of 2017, the Canadian Department of Finance issued proposals to significantly increase the taxation of investment income earned by Canadian private corporations which would have made their use much less attractive.

As a consequence of the public’s concern with the overall thrust of the government’s tax law amendments, the 2018 Budget issued on February 27, 2018 has largely eliminated the implementation of the July 2017 proposals. Instead the 2018 Budget contains two specific measures to address the government’s concern with the tax deferral related to investment income in a private corporation. The first measure limits access to the $500,000 small business deduction. The second measure limits the refundability of taxes paid by Canadian private corporations on investment income.

Limiting access to the small business deduction

Small business deduction

The government has supported the financial health of Canadian-controlled private corporations (“CCPCs”) for many years by instituting a lower level of corporate tax on the first $500,000 of active business income from a business principally carried on in Canada. Eligibility for the deduction resulting in lower corporate tax rates (commonly known as the “small business deduction”) is based on access to a $500,000 “business limit”.

Lower tax rates for active business income

The small business deduction arises federally and also in all provinces and territories but at varying rates. For example, a full small business deduction represents a tax reduction of $43,500 in Quebec, $65,000 in Ontario, and $75,000 in Alberta and British Columbia. The small business deduction results in a lower tax rate which then allows CCPCs to retain more funds to invest in their business. The government recognizes that these “small business” corporations are to a large extent the motors that generate employment for Canadians.

Reducing the business limit and access to the small business deduction

The first measure limits access to the small business deduction where a CCPC or its corporate group is earning significant investment income.

CCPCs and all other corporations which are associated for tax purposes must share one $500,000 business limit. For the purposes of this article, let us define CCPCs which are “associated” with each other for tax purposes as an “associated group”.

Under the Budget proposal, the $500,000 business limit for an associated group will be reduced on a straight line basis where the associated group has between $50,000 and $150,000 in total investment income for the fiscal periods ending in the previous calendar year. If the investment income of the associated group is less than $50,000 for the year, there will be no reduction of the business limit. Investment income of $150,000 or over will completely eliminate the business limit and access to the small business deduction.

Suppose for example an associated group has $100,000 of investment income for the year. The business limit for the associated group would be reduced from $500,000 to $250,000. If the active business income for the associated group is less than $250,000 there would be no actual reduction in the available small business deduction. However, to the extent that the associated group has combined active business income in excess of $250,000, there would be a reduction in the available small business deduction.

On the assumption that a corporation can earn a 5% return on passive investments, the business limit would effectively be reduced for CCPCs having between $1-3 million dollars of investment assets. Of course, investment returns (which include the taxable portion of capital gains) could be higher or lower than 5% in any given year.

Large corporations

There is an existing rule which reduces the $500,000 business limit to zero on a straight line basis for an associated group where the associated group has between $10-15 million of taxable capital employed in its businesses.

The reduction in a corporation’s business limit will be the greater of the reduction under the proposed passive investment rule and the existing reduction based on total taxable capital of an associated group.

Calculation of investment income

For the purposes of determining the reduction (if any) of a CCPC’s business limit, its investment income will be calculated using the formula currently used to calculate investment income for refundable tax purposes, subject to the following modifications:

  • taxable capital gains and allowable capital losses will be excluded to the extent that they arise from the sale of (i) a property used principally in an active business carried on primarily in Canada by the CCPC or a related CCPC, or (ii) a share of another CCPC that is “connected” with the vendor CCPC where 90% or more of the assets of the CCPC being sold are active business assets related to a business carried on primarily in Canada (provided certain other conditions are met as well);
  • net capital losses carried over from other years will be excluded;
  • dividends from non-“connected” corporations will be included; and
  • income from the investment portion of a non-exempt life insurance policy will be included.

Anti-avoidance rule

An anti-avoidance rule will apply to deem two corporations to be “associated” for the purpose of calculating investment income where one corporation lends or transfers property to another corporation with which it is related but not associated, and it is reasonable to consider that one of the reasons for the loan or transfer was to avoid the application of the new rules.

Date of application

The proposed rules will apply to taxation years that begin after 2018, subject to an anti-avoidance rule which will apply to prevent the deferral of these rules through the creation of a short taxation year.

Limiting refundability of taxes on investment income

The second measure limits the refundability of taxes paid by private corporations on investment income.

Refundable taxes on investment income under existing rules

Active business income earned by Canadian private corporations is taxed at a general corporate rate that is much lower than the top personal rate (and, as discussed above, active business income that qualifies for the small business deduction is taxed at an even lower rate).

Passive investment income earned by private corporations, on the other hand, is subject to a special refundable tax system that is designed to achieve two objectives:

  • prevent a tax deferral advantage to earning investment income through a corporation instead of personally by imposing additional taxes on that income that are designed to bridge the gap between the corporate tax rate and the top personal tax; and
  • achieve tax integration, the principle that an individual should pay the same amount of tax on income regardless of whether that income was earned directly or indirectly through a corporation, by refunding those additional taxes to the corporation when it pays taxable dividends.

Some or all of these refundable 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. These refundable taxes are imposed under Part I (for investment income other than dividends) or Part IV (generally for portfolio dividends) of the Income Tax Act (Canada).

Taxable dividends are classified as either “eligible” or “non-eligible”. Eligible dividends are sourced from active business income taxed at the general corporate rate and entitle the recipient to the enhanced dividend tax credit. Non-eligible dividends are sourced from investment income and active business income taxed at the small business rate and entitle the recipient to the ordinary dividend tax credit.

Investment income is taxed in a corporation at a rate that is close to the top personal rate. That income is paid to shareholders as non-eligible dividends and taxed in their hands at relatively high dividend tax rates. Active business income taxed at the general corporate rate is taxed in the corporation at a rate that is much lower than the top personal rate. That income is paid to shareholders as eligible dividends and taxed in their hands at relatively low dividend tax rates by virtue of the enhanced dividend tax credit.

Under the existing rules, a corporation can obtain a dividend refund whether it pays eligible or non-eligible dividends. The government does not want to provide a tax deferral advantage for active business income taxed at the general corporate rate and then permit a dividend refund when that income is paid to shareholders as eligible dividends and taxed in their hands at relatively low dividend tax rates.

Budget 2018 proposal

Accordingly, in order to address this perceived tax deferral advantage and “better align the refund of taxes paid on passive income with the payment of dividends sourced from passive income”, Budget 2018 proposes to amend the rules so that a corporation will only be able to obtain a dividend refund when it pays non-eligible dividends, subject to an exception for Part IV tax.

Refundable taxes on investment income under proposed rules

The proposed rules provide that a corporation will have two RDTOH accounts:

  • a new account, which will be called the “eligible RDTOH account”, and will generally include Part IV tax paid on portfolio dividends; and
  • the existing RDTOH account, which will be called the “non-eligible RDTOH account”, and will generally include Part I tax paid on investment income.

If the corporation pays an eligible dividend, it will only be able to obtain a refund from its eligible RDTOH account.

If the corporation pays a non-eligible dividend, it will be able to obtain a refund from its non-eligible RDTOH account and, to the extent it has exhausted its non-eligible RDTOH account, its eligible RDTOH account.

RDTOH recapture

Under the existing rules, if a corporation (the “Payer Corporation”) obtains an RDTOH refund when it pays a dividend to a “connected” corporation (the “Recipient Corporation”), the Recipient Corporation must pay Part IV tax equal to the amount of that refund. That Part IV tax is added to the Recipient Corporation’s RDTOH account.

Under the proposed rules, the Recipient Corporation will still pay Part IV tax equal to the amount of the Payer Corporation’s refund. That Part IV tax will be added to the Recipient Corporation’s RDTOH account that matches the Payer Corporation’s RDTOH account from which the refund was obtained. For example, if the Payer Corporation obtains a refund from its non-eligible RDTOH account, the Part IV tax paid by the Recipient Corporation would be added to its non-eligible RDTOH account.

Date of application

The proposed rules will apply to taxation years that begin after 2018, subject to an anti-avoidance rule which will apply to prevent the deferral of these rules through the creation of a short taxation year.

Transitional rule

A corporation’s existing RDTOH account will be grandfathered as follows:

  • for a CCPC, the lesser of its RDTOH balance and 38.33% of its “general rate income pool” (“GRIP”) will be added to its eligible RDTOH account, and any remaining RDTOH balance will be added to its non-eligible RDTOH account; and
  • for any other corporation, all of its RDTOH balance will be added to its eligible RDTOH account.

Because of the grandfathering rule for CCPCs, it will be important for each member of a corporate group to have its RDTOH and GRIP accounts properly aligned.

By: Mark A. Potechin, TEP and Christopher Ross, DLA Piper

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In addition to our regular guest bloggers, Inside Internal Controls blog published by First Reference, provides occasional guest post opportunities from various subject matter experts on the topics of risk management and best practices in finance and accounting, information technology, environmental issues, corporate governance, sales/marketing and operations, not-for-profits and business related issues in Canada. If you are a subject matter expert and would like to become an occasional blogger, please contact Yosie Saint-Cyr at editor@firstreference.com. If you liked this post and would like to subscribe to Inside Internal Controls blog click here.
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