As outlined in the March Tax Alert, the 2018 Budget includes a measure designed to slow the accumulation of passive investments within active corporations. This measure is based on a calculation that considers both the amount and the type of investment income earned in a corporation. Understanding this calculation will guide an investor in developing a tax-efficient investment strategy going forward.
The calculation
Aggregate investment income (AII) is carved out from active business income and is both ineligible for the small business deduction and subject to a higher tax rate than ordinary business income. The definition of AII remains unchanged with the 2018 Budget but has become the starting point for the calculation of adjusted aggregate investment income (adjusted AII). A corporation is entitled to $50,000 of adjusted AII. Thereafter, its small business deduction limit decreases by $5 for every additional $1 of adjusted AII and is completely eliminated at $150,000 of adjusted AII.
The calculations for AII and adjusted AII are:1
| AII | = | net income from property (rent, interest, royalties, etc.) |
| + | taxable capital gains for the year (including gains from the sale of active assets) | |
| + | taxable dividends | |
| + | foreign investment income | |
| - | taxable dividends | |
| - | capital losses for the year | |
| - | capital losses from prior years applied in the year |
| Adjusted AII | = | aggregate investment income |
| + | taxable dividends not received from a connected corporation | |
| + | capital losses from prior years applied in the year | |
| - | capital gains from the sale of active assets |
Key Differences
There are three key differences between AII and adjusted AII:
- Portfolio dividends, although not taxable2 and not
included in AII, are included in adjusted AII.
- Capital losses for the year only reduce adjusted AII
in the year incurred, and only if there are adequate capital gains
in that year against which they may be applied. That is, capital
losses from prior years applied in the current year do not reduce a
corporation's adjusted AII.
- For the purposes of AII, a capital gain is income from property, regardless of the use of the asset that generated it. For adjusted AII however, as the purpose of this new limitation is to penalize corporations with passive investments, a carve-out of capital gains from active assets is permitted. For these purposes, an active asset is one used principally in an active business carried on primarily in Canada or by a related CCPC.
These differences provide a roadmap to managing a corporation's adjusted AII and limiting its small business deduction clawback:
Moving away from interest
and dividends and toward capital gains
Only half of a capital gain is included in adjusted AII, and
managing when a capital gain is triggered will provide a
corporation with some control over its annual clawback.
Monitoring when capital
losses are triggered
Capital losses triggered in a year in which there are no capital
gains to offset are wasted for the purposes of adjusted AII.
Triggering capital losses in years in which large capital gains are
expected will make the most of the losses. Investors should meet
with their advisors before the end of each year to discuss this
timing.
Purchasing appreciable
active assets
Investors might consider (for example) investing in the building in
which they operate. The capital gain from eventual sale will not
affect adjusted AII, and if structured properly, related rent can
be charged and treated as active income.
Tax-deferred
distributions
Some investments can provide tax-deferred distributions. Consider,
for example, a real estate investment trust (REIT). A portion of
each REIT unit's distribution is a return of capital, which
does not affect adjusted AII and is not taxable until the unit is
ultimately disposed of. Limited partnerships and mortgage-backed
securities are some other common types of investments that provide
tax-deferred distributions.
Off-balance-sheet
investing
Investors might consider funding Individual Pension Plans (IPPs).
IPPs allow for higher contributions than traditional RRSPs, and
funding payments, administrative costs and investment costs are
fully deductible to the corporation. However, growth of the plan
assets is tax-deferred and thus does not affect adjusted AII.
Overfunding a life insurance
policy
Life insurance policies provide the tax-deferred accumulation of
investment assets (to certain limits), they do not affect adjusted
AII, and they provide tax-advantaged
distributions.
The spirit of the small business rate available to private corporations is to provide business owners with more after-tax income to grow their businesses. This new measure is intended to curtail the ability to reinvest funds taxed at the small business rate which is consistent with Finance's original intent. Bear in mind, after-tax business income reinvested in passive investments within a corporation – whether taxed at the small business rate of 13.5 per cent or the general rate of 26.5 per cent – still provides an initial deferral benefit that corporations can continue to use. But with some strategic investing, the benefit can be maximized to its fullest extent.
Footnotes
1 The calculations of AII and adjusted AII have been simplified here for illustrative purposes to include only common types of investment income.
2 Subject to 38.33 per cent refundable tax unless the dividend is received from a connected corporation.
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.
