Budget 2015 proposes a number of changes to the taxation of businesses under the Income Tax Act (Canada) (the "Tax Act"). The most significant changes include (i) a 2% reduction in the tax rate applicable to qualifying active business income of certain small businesses, to be phased in over four years, (ii) a corresponding reduction in the effective dividend tax credit in respect of the receipt of non-eligible dividends, and (iii) the introduction of an accelerated capital cost allowance rate in respect of certain manufacturing and processing machinery and equipment acquired primarily for use in Canada.
Budget 2015 also announced several public consultations on tax matters relevant to businesses. In particular, the Government has (i) announced a review of the situations in which income earned from a business, the principal purpose of which is to earn income from property, should qualify as active business income eligible for a lower rate of tax, and (ii) provided an update on its consultation in respect of its proposal, first announced in Budget 2014, to replace the eligible capital property regime with a new capital cost allowance class.
Changes to the Taxation of Small Businesses
Reduction in the Small Business Tax Rate
Under the Tax Act, corporations that are "Canadian-controlled private corporations" ("CCPCs") are subject to certain tax rules that differ from those applicable to other corporations.
One advantage afforded to a corporation that qualifies as a CCPC throughout a taxation year is its eligibility to claim a deduction (the "small business deduction") resulting in a reduced federal corporate tax rate (the "small business tax rate") in respect of up to $500,000 of income from an active business carried on in Canada in that year. A CCPC that is "associated" with other CCPCs for the purposes of the Tax Act must share the $500,000 annual limit. Where a CCPC and any associated corporations collectively employ taxable capital of $15 million or more in Canada, they do not qualify for the small business deduction; where such corporations collectively employ taxable capital of greater than $10 million and less than $15 million in Canada, they are eligible for a reduced small business deduction.
Currently, the small business tax rate is 11%. Budget 2015 proposes to reduce the 11% small business tax rate by increments of 0.5% per year beginning in 2016, ultimately reaching 9% in 2019. Where a CCPC does not have a calendar taxation year, it will be subject to reduced rates on a pro-rated basis.
Reduction in the Dividend Tax Credit Rate on Non-Eligible Dividends
Concurrently, Budget 2015 proposes to reduce the effective dividend tax credit ("DTC") rate in respect of "non-eligible dividends". Non-eligible dividends are, generally, dividends paid out of income eligible for the small business tax rate.
Under current rules, for the purpose of determining the amount of tax to be paid by an individual taxpayer on the receipt of a non-eligible dividend, the amount of the dividend is first "grossed-up" by 18%. A DTC of 13/18 of the gross-up may be claimed by the taxpayer. As a result, a taxpayer is effectively eligible to claim a DTC in the amount of 11% of the grossed-up dividend. This gross-up/DTC mechanism exists to ensure that, when a corporation earns income and distributes it as dividends, such income will bear approximately the same total amount of tax as if the income been earned by the individual directly.
Because Budget 2015 lowers the small business tax rate applicable to qualifying active business income of a CCPC, it also proposes to reduce the effective DTC from 11% to 9% in increments of 0.5% per year, beginning in 2016.
As a result of these proposals, while CCPCs will pay a lower small business tax rate in respect of qualifying income, their shareholders will be required to pay more tax on dividends paid out of such income. This will likely encourage many CCPCs to defer the payment of non-eligible dividends to a later date and, instead, retain active business income within the corporation. The Government expects that these measures will, on a net basis, reduce tax revenues by $2.7 billion over the next five years.
Accelerated CCA Rate for Manufacturing and Processing Machinery and Equipment
Under current rules, capital cost allowances ("CCA") in respect of machinery or equipment acquired after March 18, 2007 and before 2016 to be used in Canada primarily in the manufacturing or processing of goods for sale or lease (or in certain other contexts) may be claimed at a rate of 50% (calculated on a straight-line basis) under CCA Class 29. Had the Government not taken action, the CCA that could be claimed in respect of any such machinery or equipment acquired after 2015 would be limited to a rate of 30% (calculated on a declining-balance basis) under CCA Class 43.
Budget 2015 proposes to create a new CCA Class 53, which would generally provide an accelerated CCA rate of 50% (calculated on a declining-balance basis) for assets acquired after 2015 and before 2026 that currently would be included in CCA Class 29. These assets will be subject to the so-called "half-year rule", which restricts by one-half the amount of CCA that may be claimed in the taxation year in which an asset is first available for use by a taxpayer.
Subject to possible future amendments, Class 53 assets acquired after 2025 will once again be included in Class 43.
Consultation on Active Business Income and Specified Investment Businesses
As indicated above, the first $500,000 of qualifying active business income of a CCPC may be taxed at the lower small business tax rate. However, the Tax Act currently provides that income from a "specified investment business" is not included in active business income.
Subject to certain exceptions, a specified investment business is a business the principal purpose of which is to derive income from property (e.g., rent, interest, or dividends). If the business employs more than five full-time employees throughout the year, it is not considered a specified investment business.
The Government has heard concerns about cases "such as self-storage facilities and campgrounds" falling within the definition of specified investment business. Therefore, Budget 2015 announces a review of "the circumstances in which income from a business, the principal purpose of which is to earn income from property, should qualify as active business income."
It may not be a coincidence that this announcement comes shortly after the Tax Court of Canada released its decision in 0742443 B.C. Ltd. v The Queen.1 In that case, the Court found that a corporate taxpayer in the business of providing storage space and ancillary services was not entitled to the small business deduction because it was carrying on a specified investment business. At the same time, the Court also seemed to express a degree of acceptance for a Canada Revenue Agency administrative position that hotel accommodation does not constitute a specified investment business. This consultation presents a welcome opportunity to clarify the law.
Interested parties are asked to submit their views to email@example.com by August 31, 2015.
Update on Consultation on the Eligible Capital Property Regime
In Budget 2014, the Government announced a public consultation on a proposal to (i) repeal the eligible capital property ("ECP") regime, (ii) replace it with a new CCA class available to businesses, and (iii) transfer taxpayers' existing cumulative eligible capital pools to the new CCA class. The stated purpose of this proposal was to simplify the tax system in light of the increasing complexity of the ECP regime.2
At the time, the Government stated that it would release detailed draft legislative proposals for comment and stated that the timing of implementation of the proposals would be determined following completion of the consultation process. However, no draft legislation has been released to date.
In Budget 2015, the Government has indicated that it has heard from a number of relevant parties on its proposal and continues to receive submissions. It confirmed that it will consider all submissions in drafting new rules (including applicable transitional rules) and that it intends to release detailed draft legislative proposals for comment prior to including them in a legislative Bill.
Given the complexities that inevitably will be involved in transitioning between regimes, it is encouraging that the Government has committed to releasing draft legislation for stakeholder input before implementing any changes. Affected taxpayers and their advisors should strongly consider weighing in on the new draft rules when the Government makes them available.
1 2014 TCC 301. This decision is currently under appeal
to the Federal Court of Appeal.
2 For additional details about this proposal, please see McMillan LLP Bulletin "Budget 2014: Consultation on Eligible Capital Property".
The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.
© McMillan LLP 2015