Passive Investment Income and the Small Business Deduction
Canadian-controlled private corporations (CCPCs) are generally entitled to a preferential rate of tax on the first $500,000 of active business income (the “business limit”). The federal rate on such income is 10.5 per cent in 2018 and will be reduced to 9 per cent in 2019 (compared to the federal general rate of 15 per cent). This is commonly known as the small business deduction (SBD). The provinces similarly provide a reduced corporate tax rate on active business income earned by CCPCs up to a specified limit.
The main purpose of providing this rate reduction is to allow more income to be retained in the corporation to fund future business growth. However, this tax benefit is ultimately recaptured when dividends are paid to individual shareholders, as dividends paid from income that qualifies from the SBD (referred to as ineligible dividends) are taxed at a higher rate than dividends arising from income taxed at the general corporate tax rate (eligible dividends). The goal of the tax system is to ensure that the total amount of tax paid on business income earned by a corporation and distributed as dividends to individual shareholders will generally be equivalent to the amount of tax that would have been paid had the business income been earned directly by the shareholder.
Recently the federal government became concerned that shareholders of CCPCs were obtaining a tax advantage where income qualifying for the SBD was invested in “passive investments” (i.e. shares in public companies, mutual funds and real estate not used in the business) rather than used for business purposes. After much discussion and debate, new legislation (which becomes effective in 2019) will reduce a CCPC’s “business limit” (the amount of active business income eligible for the SBD in any given year) where its passive income in the immediately preceding taxation year exceeds $50,000. Under the formula, a CCPC will have their business limit reduced by $5 for every $1 of investment income in excess of $50,000. The business limit will become nil (i.e. no access to the SBD) where investment income exceeds $150,000.
Due to these changes, it will now be very important for owners of CCPCs to monitor their investment income to reduce or avoid a reduction in the SBD. For example, owners may want to shift to passive investments that primarily produce capital gains, since only 50% of the gain is included in investment income. As well, income earned within an exempt corporate-owned life insurance policy (which is not subject to annual taxation) will not be considered investment income for the purposes of these rules, unless the policy is disposed of prior to death and there is a policy gain. Thus, business owners can purchaselife insurance policies without impacting access to the SBC. Business owners should seek out the advice of tax professionals to determine the best approach for dealing with these new rules.