The third federal budget tabled by Bill Morneau and I was wondering what type of parachute, or safeguards, he might build into the document to protect himself and the Liberals from more of the same chastising they received last fall in the wake of tax proposals that, quite frankly, made little sense.
In a nutshell, the Liberals have avoided another mutiny by announcing no new tax measures to speak of – except the one we were expecting around passive income earned inside private corporations. If you're a small-business owner, the budget makes two changes that could affect you: (1) reduced access to the small-business tax rate, and (2) limited access to refundable taxes. Here's the lowdown.
Small-business rate
Small businesses are allowed a favourable tax rate (an average of 13.1 per cent across the country) on the first $500,000 of active business income. Under the proposed changes, access to this low tax rate on active business income will be gradually eliminated as the amount of passive income in a corporation increases.
How? The $500,000 small-business limit will be reduced by $5 for every $1 of passive income over $50,000. This would effectively eliminate the availability of the small-business tax rate completely once passive income reaches $150,000 in a year. This isn't ideal. Nevertheless, the proposed approach is better than last summer's proposals because, under the current proposal, you could have up to approximately $3-million of investments (at a 5-per-cent rate of return) in your private company before you lose the small-business tax rate.
This new approach effectively protects the tax treatment of all past savings and investments in private corporations because the proposals don't change the tax rates on passive income. Instead, they reduce the amount of active business income that can enjoy the small-business tax rate in the future. This is a much simpler approach than what the government announced last year.
These proposals should cause you to contemplate how to reduce the amount of passive income earned in your corporation each year. The rules will exclude interest on short-term deposits needed for business operations, and gains on certain venture capital or angel investments where proceeds are reinvested in certain startups.
As for other passive income, consider your asset allocation – and location. The more capital gains you earn, the lower your taxable passive income will be (since capital gains are taxed at half the rates of interest income). Further, taking a buy-and-hold approach where you don't trigger capital gains often will work to your advantage. You might also use corporate dollars to invest inside an insurance policy, which will reduce the amount of passive income in your corporation, and setting up a registered pension plan sponsored by your corporation could also make sense in some cases.
Refundable taxes
Our tax system is intended to work so that you should be indifferent as to whether you are earning income inside a corporation and paying the after-tax income to yourself as a dividend out of the corporation, or simply earning that income personally. This is called the theory of "integration."
How does this work for investment income? Our system taxes investment income earned by private corporations at a high rate (about equal to the highest marginal tax rate personally). Later, when your company pays dividends to you, it will receive a refund of some of those taxes, and you'll face tax personally on the dividend. In the end, the total tax paid by you and the company combined is supposed to be about the same as if you had simply earned that investment income personally from the start.
In cases where a private corporation earns active business income, it will face lower rates of tax on that income than on its investment income. Yet, that lower-taxed active income has been used in the past to pay dividends to the owner, resulting in a refund of taxes and a lower overall rate of tax than was intended.
The budget has proposed to change this to ensure that only higher-taxed investment income earned by the corporation can be paid out as dividends to obtain a refund of taxes. This is going to require tracking cumulative investment income separately from active business income taxed at the general corporate rate starting in 2019, which should not pose much of a burden.
Both measures will apply after 2018, so there's a little time to figure out how you're affected, and what steps you might take to prepare for the changes.
See the Financial Post Article below for additonal commentary
There's still an appalling problem with the Liberals' tax changes for small businesses
The income the ‘passive-income’ proposal would hit may be far from passive and the rate on taxable capital gains will often exceed 100 per cent
Finance Minister Bill Morneau. The finance ministry has abandoned some of its original plans while substantially revising one proposal (namely, new rules for income splitting). But there is one proposal still unresolved: the taxation of so-called “passive income” earned by Canadian-controlled private corporations (CCPCs).Andrew Vaughan/The Canadian Press files
Allan Lanthier
January 16, 2018
12:44 PM EST
In the months of controversy that followed after the federal government issued a number of proposed tax changes for private corporations last July, the finance ministry abandoned some of its original plans entirely while substantially revising one proposal (namely, new rules for income splitting). But there is one proposal still unresolved: the taxation of so-called “passive income” earned by Canadian-controlled private corporations (CCPCs). And it’s still a serious problem: The income that the proposal would hit may be far from passive and, as for fairness, the rate on taxable capital gains will often exceed 100 per cent.
Under existing rules, a CCPC pays immediate tax of about 50 per cent on its investment income, including on one-half of capital gains. Under “tax integration,” a large portion of this tax is refunded when the CCPC pays taxable dividends to its owners. In addition, the CCPC can pay the one-half, non-taxable portion of capital gains to its owners as tax-free dividends. All of this would change under the new proposal tabled last summer.
The government is concerned that a small number of CCPCs are using low-taxed business or professional income to finance the purchase of investments such as stocks, bonds and mutual funds. In response, the government proposes that a CCPC would still pay 50 per cent on its investment income; however, none of this tax would be refundable. In addition, dividends paid out of the non-taxable half of capital gains would now be taxable to the shareholder. The impact on many small-business owners who are approaching retirement could be devastating.
The combined tax cost would be an effective rate of 114% on passive income
Take the hypothetical example of Zoey. In the early 1970s, Zoey decided to follow her dream and purchase a motel. She formed a company (Zco). Zco borrowed $200,000 from a bank, and used the proceeds to purchase a small motel: $160,000 for the building and $40,000 for the land. During the 1970s and early 1980s, Zco earned enough after-tax income to repay the bank debt.
After managing the motel operations for 45 years, Zoey is ready to retire. The motel has fallen into disrepair, and will be shuttered and closed at the end of this year. However, the land has increased substantially in value, and can be sold for $1 million above its original cost, hopefully enough to fund Zoey’s retirement. Zoey’s accountant has advised her to wind-up the company in early 2019, and have Zco transfer the land to her as part of the winding-up: Zoey would then sell the land. So what is the tax cost?
Zco has a capital gain of $1 million on the land, one-half of which is taxable. Under existing rules, the combined tax to Zoey and Zco will be about $285,000 if Zoey is in the top rate bracket in Ontario — an effective rate of 57 per cent on the $500,000 taxable portion of the gain. While this tax is substantial, the potential result under the July proposal can only be described as disastrous.
Zco used after-tax earnings to repay its bank loan many years ago. Also, the taxable half of any capital gain is taxed as passive income to a CCPC. As a result, the government’s proposal will apply to the capital gain on the land. Even after a proposed exemption for $50,000 of annual passive income, the combined tax cost to Zoey and Zco would be $569,000: That’s an effective rate of 114 per cent on the taxable capital gain of $500,000. After selling the land and using much of the proceeds to settle her tax liabilities, Zoey will be left with an after-tax amount of only $431,000. Assuming a return of five per cent, Zoey would receive $22,000 annually to sustain her in her golden years.
This clearly fails the fairness test. Draft legislation on the new tax rules is to be released as part of the government’s 2018 budget. What can be done? There are a number of possibilities.
First, the government might conclude — as many in the tax community already have — that the immediate corporate tax of 50 per cent that applies on investment income under existing rules is more than sufficient, and that the proposal should be abandoned. Don’t hold your breath for that.
Second, the July 2017 framework might be retained, but with a number of additional rules and exceptions. For example, existing law could be grandfathered to all assets — not only passive investments — held at this time. This would let Zoey off the hook, but not future small-business owners. In addition, special rules might apply going forward for capital gains on assets used in an active business. However, the proposed framework is already bewilderingly complex, and these types of changes would only make a legislative nightmare even worse.
Third, instead of a new regime for investment income, the government could introduce a refundable tax on post-2017, low-taxed corporate earnings used to acquire non-business assets. The tax would be refunded when the CCPC disposes of the assets, either as a taxable dividend to its shareholders or by investing the proceeds in its business. The tax would be simple and targeted, would avoid the confiscatory rates that apply under the proposed regime, and would eliminate the government’s tax-deferral concern. This is how the government should proceed.
Allan Lanthier is a former chair of the Canadian Tax Foundation and a retired partner of Ernst & Young.