If you listened closely on budget day, you could hear a sigh of relief across Canada after the federal government announced new rules on passive investment income. Largely considered a fair improvement from previous iterations of the rules, many tax practitioners welcomed the changes. However, not all were pleased. And some were far from relieved.
When the government initially tabled its proposal on passive investment income in July of 2017, there was an outcry from corporate Canada, citing excessive complexity. The government responded with new rules, outlined in Budget 2018.
What are the new rules?
Put simply, the new rules state as soon as investment income from an associated group hits $50,000, your small business deduction (SBD) will start to grind down by $5 for every $1 of investment income above $50,000. The SBD will continue to decrease until the investment income threshold of $150,000 is met. At this point, the SBD will be entirely depleted, and your corporate tax rate on active business income will increase by an average of 16.25 per cent (see below for a breakdown by province). For calculating the investment income threshold, the new proposed rules specifically define investment income as "adjusted aggregate investment income." This definition does exclude taxable capital gains or losses from active assets.
What are the implications?
From a tax policy point of view, the SBD was designed to facilitate the growth and expansion of small business corporations through the use of a lower corporate tax rate. The SBD was formally introduced as part of the 1971 tax reform legislation, which contained complex legislation to minimize unwarranted access. Private companies utilized the SBD for its intended purpose, but over time began to also use the SBD to accumulate investment assets. Because the Department of Finance never intervened throughout the past four decades, private company owners became accustomed to utilizing the SBD for accumulating both business and investment assets. This tax practice – although unofficial, yet widely accepted – resulted in private company owners altering their investment strategies to utilize private companies to hold investment assets.
One problem with the new rules is the potentially far-reaching jurisdiction. In a public announcement on Oct. 18, 2017, the Department of Finance reported that "all past investments and the income earned from those investments will be protected." This statement was consistent with the message in the original proposal introduced on July 18, 2017, which stated the new rules were intended to apply on a go-forward basis. These statements implied current investment assets and its income would be grandfathered, reassuring private company owners who followed the rules for the past 46 years they would be protected from any rule changes. However, the government abandoned its original proposal in the budget, along with the promised grandfathering. This effectively opened many private companies, which continue to actively contribute to the economy, to retroactive taxation resulting from their supposed grandfathered investments.
Under the proposed new rules in the 2018 budget, current and future investments will be factored into the "income threshold" used to determine the reduction of the SBD limit. Therefore, if a company has current investment assets generating investment income in excess of $150,000, and assuming the company was using the full $500,000 small business limit, then the company's corporate taxes would increase between $70,000 and $95,000 depending on the province.
Who's affected?
Since the grandfathering-in stipulation has been abandoned, private company owners who've built a corporate investment portfolio over the years – and are still actively involved in a business – are now subject to the new rules and will likely pay more tax. Interestingly, private company owners not actively involved in a business with a corporate investment portfolio won't be affected at all. The rules disproportionately affect those actively involved in a business contributing to the economy and attempting to build wealth, while those who've already accumulated wealth and no longer actively involved in a business are unaffected.
This lack of grandfathering is further exasperated when we consider accrued unrealized gains in corporate investment portfolios. These accrued gains will be factored into the investment income threshold if realized in taxation years beginning after Dec. 31, 2018.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
