As a successful business owner, you know just how difficult it can be to turn on the lights in the morning and carry on your business with consistent success. Each day, you are faced with important decisions which can impact the success or failure of your business. Here are some practical tips for how you can combat the new passive investment income rules passed by the Federal government in 2018.
As a wealth advisor helping individuals and businesses build and protect their wealth, I’m more than a little bit familiar with the challenges that the Federal government’s new passive investment income rules have caused businesses in Canada. Given my professional background, the information contained herein will focus more on the “solutions” to the problem now faced by many businesses. For specific feedback on the new passive income rules, speak to your accounting professional.
Federal Budget 2018 introduced new rules for how corporate passive investment income is taxed, ultimately reducing the amount of the small business deduction available on active income earned within a corporation. These new rules will affect taxation years beginning after 2018 and could lead to corporations paying more corporate tax.
THE LINK BETWEEN CORPORATE PASSIVE INCOME & CORPORATE TAX
Active business income is normally the main source of income that a corporation earns from a business carried on in Canada. Think of it as the ongoing income generated from actively running your business – just as it sounds. However, passive investment income is the by-product of corporate earnings not directly tied to “active business income” and normally takes the form of things like royalties, rent, dividends received and capital gains. Corporations with significant retained earnings invested in a portfolio of stocks, GICs or cash equivalents, mutual funds or other fixed income investments are perfect examples of “passive investments”.
Currently, many Canadian-controlled private corporations (also known as CCPCs) use what’s known as the Small Business Deduction (SBD) to reduce their overall corporate tax rate on their active business income. By doing so, the corporation is entitled to the small business tax rate which is lower than the general corporate tax rate on business income.
HOW THIS IMPACTS BUSINESS OWNERS
Since 2009, a CCPC using the SBD could claim the small business tax rate on the first $500,000 of its active business income carried on in Canada, representing a fairly substantial reduction in tax. The new rule changes mean that a CCPC’s passive investment income now exposes a business owner to more tax on active business income.
For some business owners, these new rules can have significant consequences. Consider the following example:
A Canadian controlled private corporation in Ontario earns $500,000 of active business income per year. As indicated above, the amount of passive investment income earned by this corporation now effects how much of the $500,000 qualifies for the Small Business Deduction (SBD). As long as passive investment income is below $50,000, the full $500,000 qualifies for the SBD. However, the SBD is reduced by $5 for every $1 of passive income a corporation earns over $50,000 and is completely eliminated once the corporation exceeds $150,000 in passive investment income. The end result is a large increase in tax.
In this case, the corporation has $3,000,000 of passive investments with a 5% rate of return equalling $150,000 of passive investment income. Using a passive investment income calculator, you’ll see that the end result is a $30,000 increase in corporate tax between the old rules and the new rules.
WHAT CAN BUSINESS OWNERS DO
The good news is with any changes in rules, business owners have a number of paths they can take in restructuring their corporations to be as tax-efficient as possible. The key lies in the proactive approach you should take to try and ensure optimal tax efficiency.
Here are just a few ideas that CCPC’s can implement:
- Purchasing a corporately owned, exempt, permanent life insurance policy
- Funding a registered savings vehicle such as an Individual Pension Plan (IPP)
- Purchasing investments with the objective of deferring as much capital gains as needed or possible.
Let’s now expand on each one below:
Corporately owned, exempt, permanent life insurance can be a great way to build tax-deferred wealth within your Canadian business corporation. Aside from tax-planning, there are a number of reasons why business owners would consider life insurance within their corporation as a tool within their overall financial plan. These could include the funding of a buy-sell agreement, helping meet certain estate planning objectives and there are also life insurance policies with retirement planning properties as well. Depending on the solution, these strategies can sometimes offer additional flexibilities that a business owner may need or want as life and business circumstances change and evolve – as they often do.
An Individual Pension Plan or IPP for short, is a defined benefit pension plan established by a company for an individual (sometimes two if the individuals are family members) and is designed to offer the maximum benefits allowable by the CRA. If you own a Canadian Controlled private corporation, are at least 45 years of age and generate T4 income of more than $100,000 per year, you may be a good candidate for an IPP. Key benefits of an IPP are as follows:
- An IPP typically allows for higher contributions than an RRSP giving an individual the possibility to save more for retirement. Like an RRSP, an IPP plan is also registered. This means that all contributions grow on a tax-deferred basis.
- An IPP is funded entirely by the employer as opposed to an individual. All contributions and plan costs are tax-deductible to the corporation.
Lastly, there is a specific type of investment designed to defer as much taxation as possible on a regular basis. Corporate class mutual funds are specifically structured to reduce interest income and foreign dividends, the most highly taxed forms of income. They are also designed to defer as much capital gains as possible. Although these forms of investments cannot eliminate tax altogether, they are designed as a solution for individuals or businesses who have specific and ongoing tax issues.
If you haven’t done an in-depth review of your corporate structure, now is the time to ensure that you sit down with your accounting professional and ensure you are taking all the necessary steps to take an ax to the tax.