By John Fisher

Special to the Financial Independence Hub

As many of you are aware, the Canadian government announced new rules in February concerning the taxation of passive income in Canadian controlled private corporations (CCPCs).

The Liberals’ original draft legislation proposed to target tax strategies that have been used by small businesses and professionals since the early 1970s, so naturally the initial announcement in July 2017 drew widespread condemnation.

The government’s concern with the accumulation of passive income-generating investments in private companies stems from the fact that CCPCs pay a blended federal and provincial small business tax rate of 13.5% (in Ontario) on active business income up to the small business deduction (SBD) limit of $500,000 in 2018. This compares favorably to the tax rates on income earned by individuals. On a combined federal and provincial basis, the differential between the highest marginal tax rate on personal income and the small business tax rate ranges between about 36% and 41%, depending on the province in which a CCPC resides.

As a result of this tax rate differential, owners of a CCPC are almost always better off retaining corporate earnings and investing within their corporation. While a similar amount of combined corporate and personal tax is ultimately paid by business owners when monies are withdrawn through dividends, taxes can be deferred until such time as the money is required personally. This effectively allows business owners to temporarily obtain the benefit of investing a larger amount of money than would otherwise be available if they earned the money personally or immediately withdrew profits from their corporation.

One side note worth highlighting here: it is a common misconception that passive investment income earned within a corporation can be taxed at the lower small business tax rate. This is incorrect, as passive income is generally taxed at about the same rate (over 50%), whether earned inside or outside a corporation; so there is no real benefit, per se, from earning investment income in a corporation. Rather, the advantage is that the corporate entrepreneur is able to temporarily invest the amount of taxes deferred by delaying the withdrawal of funds from his/her company.

So what are the new rules governing passive income?

The government has announced its intention to introduce legislation that will reduce the SBD limit by $5 for every $1 of investment income above a $50,000 threshold, beginning in 2019. Once passive investment income exceeds $150,000, the SBD limit will be reduced to zero and the CCPC will pay tax at the general corporate tax rate of 26.5% as opposed to the 13.5% SBD Rate (for Ontario CCPCs).

The $50,000 threshold applies to passive income earned on both legacy and new investments which is important to note given the government’s original promise to “grandfather” any passive income earned from investments previously accumulated

How will the rules affect you as an owner of a CCPC?

Many entrepreneurs are asking if the new rules will result in them paying additional taxes if their corporations generate passive income in excess of $50,000. In most circumstances, the answer is that they will pay more corporate taxes, thereby reducing the size of their tax deferral advantage (from 40% down to 27% on their 2019 corporate income earned in Ontario).

The loss of the entire SBD limit would cost an Ontario CCPC about $65,000 in additional annual corporate taxes ($500,000 x 13% increase in the corporate tax rate). However, once income is paid out by way of dividends from the CCPC, the analysis we have reviewed suggests that the combined personal and corporate tax burden will increase by only about 1% as compared to the current tax regime.

What can you do in light of the proposed changes? Continue Reading…