The updated Federal budget was presented on Tuesday of this past week. There are a few changes from the originally proposed outline are are important to keep in mind.
The July 2017 proposals took a somewhat draconian approach to the receipt of passive income inside small corporations (interest, rental income, and dividends received).
Any passive income generated inside of a corporation over the $50,000 level would have faced an increase in tax rates from roughly 26% to 60-75% depending on circumstances. The significant proposed increase in tax burden caused considerable backlash in the small business and professional communities.
Numerous federal cabinet ministers have inferred modifications were coming in order to make changes more palatable. The Feb 27th budget update is a final proposal that, if passed, will become law.
The July 2017 proposals were going to be an administrative nightmare for both accountants and the CRA to implement and enforce.
The Feb 27th budget simplifies the process by implementing a phase-in before implementing the higher tax rates. Instead, the federal finance department is going to reduce the small business deduction by $5 for every $1 over the $50,000 threshold. So a small company with $100,000 of passive investment income would have a small business deduction reduced to $250,000 before the higher tax rates apply.
The old saying is: “follow the money”. The PBO (Parlimentary Budget Officer) has apparently reported that the projected tax take on these changes has been reduced from roughly $6 Billion to $3.5 Billion over the next ten years which assumes that nobody will change their investment income tax reporting habits.
We included a snippet of commentary provided on the most recent budget:
The Federal Budget proposes two measures for passive investments held in a corporation, effective for taxation years beginning after 2018.
Business Limit Reduction
The 2018 Federal budget proposals for passive investments will not change how investment income is taxed, or eliminate the RDTOH (refundable dividend tax on hand) as previously announced. Instead, it proposes to reduce the small business limit for CCPCs (and their associated corporations) on a straight-line basis when investment income ranges between $50,000 and $150,000. The small business deduction will be eliminated for use on active income when passive investment income reaches $150,000 (reduced by $5 for every $1 of investment income above the $50,000 threshold). Earning a rate of return of 5%, passive investments of $1,000,000 can be held without a reduction in the small business limit (could vary based on your rate of return). For example, a CCPC with $100,000 of investment income would have a business limit reduction to $250,000. Active income up to $250,000 will still benefit from the use of the small business limit and active income in excess of the reduced business limit will be taxed at the general corporate tax rate.
Adjusted Aggregate Investment Income – The budget proposes to introduce a new concept of “adjusted aggregate investment income” for determining the business limit reduction. The current concept of aggregate investment income includes interest, royalties, foreign dividends and rent as well as the taxable portion of capital gains. The new concept will have some specific exclusions.
Refundability of Taxes on Investment Income
Currently, investment income is taxed at the corporate passive investment rate similar to the top personal income tax rate. Some of this tax paid is refundable at a rate of $38.33 for every $100 of taxable dividends paid to shareholders. Dividends may be eligible or non-eligible.
- Non-eligible dividends (taxed at higher personal tax rates) are usually paid from income subject to the small business tax rate (including non-eligible dividends received by the corporation) or from passive investment income (except non-taxable portion of capital gains and eligible portfolio dividends).
- Eligible dividends (taxed at lower personal tax rate) generally result when active income is taxed at the general rate as well as portfolio dividends from publicly traded Canadian corporations.
The current system allowed a corporation to receive an RDTOH refund when an eligible dividend was paid. This could provide a tax deferral advantage on passive investment income by allowing private corporations paying eligible dividends sourced from active business income taxed at the general corporate income tax rate to generate a refund of taxes paid on passive income.
New RDTOH accounts
- To better align the refund of taxes paid on investment income, the Federal budget proposes that a refund of RDTOH will be available only when a private corporation pays non-eligible dividends or when RDTOH arises from eligible portfolio dividends received.
- The former RDTOH account will now be referred to as the non-eligible RDTOH account and will track refundable corporate taxes paid on investment income as well as under non-eligible portfolio dividends. In addition, different treatment proposed regarding the refund of taxes imposed on eligible portfolio dividend income will necessitate the addition of a new RDTOH account. This new account (eligible RDTOH) will track refundable taxes paid on eligible portfolio dividends. Taxable dividends paid (i.e., eligible or non-eligible) will entitle the corporation to a refund from its eligible RDTOH account but will be restricted by the new ordering rule described below.
RDTOH Refunds – Ordering Rule
- The budget implements a new ordering rule for RDTOH refunds. Generally a non-eligible RDTOH refund must be refunded before a refund from the eligible RDTOH account.
- When a dividend is received by a connected corporation, the recipient corporation will include Part IV tax to their RDTOH account. The RDTOH account of the recipient corporation must match the RDTOH account from which the payer corporation obtained its refund.
Treatment of existing RDTOH Balance
- The transition of the existing RDTOH account will be allocated as follows. The lesser of;
- the existing RDTOH balance, and
- 38⅓ per cent of the balance of its general rate income pool will be allocated to its eligible RDTOH account.
- Any remaining balance will be allocated to its non-eligible RDTOH account. For any other corporation, all of the corporation’s existing RDTOH balance will be allocated to its eligible RDTOH account.
In summary, the budget proposals continue to reinforce the importance of tax efficient investing for passive investments in a corporation. Corporate class mutual funds remain an integral component of corporate investment portfolios.
This summary is very technical in nature, so if you have any questions or would like us to assess how these changes will impact your particular situation, please contact us!
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