Canada: Private Companies And Passive Investments

Last Updated: August 8 2017
Article by Scott McLeod, Cathie Brayley, Richard T. Weiland and Areet Kaila

This is the fourth in a series of posts arising out of the Liberal Government's paper "Tax Planning Using Private Corporations."

In previous posts we presented an overview of the proposals outlined in the Liberal Government's paper, "Tax Planning Using Private Corporations" released July 17, 2017 (the "Paper") involving income splitting and access to the capital gains exemption. In this post, we outline proposed new changes to the taxation of passive income earned by private corporations. For this purpose, passive investments are those that give rise to interest, dividends, rental income or capital gains.

Under current tax rules, active business income is taxed at lower rates when earned by a corporation as compared to an individual, thereby allowing funds to be reinvested to grow the business. According to the Paper, the Government views it as unfair that business owners can retain passive investments in a corporation and use it as a personal savings vehicle. The Paper states its objective is to ensure that a dollar of passive investment income earned by a corporation bears a tax burden that is roughly equivalent to that of a dollar of passive investment income earned directly by an individual.

While the Government acknowledges that the corporate tax rate coupled with the personal taxes payable when distributions are made to the business owner are roughly equivalent to the tax applicable to individuals earning income directly, it sees three issues. First, the lower tax rate on corporate income allows more after-tax income to be invested by the corporation than would be the case if the after-tax income was invested by a salaried employee. Second, because personal taxes are payable only when there is a distribution by the corporation to the business owner, there can be a significant tax deferral if distributions are delayed. Third, dividends or capital gains earned in an RRSP are subject to tax as regular income when they are withdrawn where passive income earned in a corporation is taxed at preferential rates. In summary, the Government believes that passive investments through private corporations have resulted in wealth accumulation which was never intended. In their view it is unfair for successful business owners to have an advantage that is not available to salaried employees.

The Paper outlines two proposals to correct the perceived problem:

  1. Under the "Apportionment Method," a corporation would be required to track whether its available funds had already been taxed at the general corporate rate, the preferential small business rate, or contributed by shareholders from income that has already been subject to personal tax. Income earned on passive investments would be subject to up to three different tax treatments, depending on the proportion of funds attributed to each of the three sources.
  2. Under the "Elective Method," by default, all passive income earned in a private corporation would be subject to non-refundable taxes equivalent to the top personal income tax bracket. Alternatively, a corporation may elect a tax treatment whereby it would pay additional taxes on passive income, but dividends paid out would be eligible for a dividend tax credit. By making this election, the company would no longer be eligible for the small business rate on any income earned.The Government is seeking input on a variety of matters including the approach to dealing with passive income, which method is preferred, non-tax factors that should be considered, the treatment of capital gains, transitional issues, and gender and other equity factors that should be considered.

The Government acknowledges that either method will add layers of complexity to the tax system. Unlike the proposals dealing with income splitting and the capital gains exemption, the proposals are set out in broad terms and there is no draft legislation. When enacted, it is proposed that the new rules will apply on a go-forward basis thereby necessitating transitional rules.

The next posting will deal with the draft legislation effective July 17th which prevents the conversion of income into capital gains.

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.

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