On February 27, 2018 (Budget Day) the Honourable Bill Morneau, Minister of Finance (the Minister), tabled the federal government's third budget (Budget 2018). Based on recent developments nationally—and the Liberal government's previously announced policies—it should come as little surprise that the expansion of government programs, promotion of gender equality, legalization of marijuana, and other sociopolitical issues take center stage in Budget 2018.
On the fiscal front, Budget 2018 introduces some important, albeit incremental, tax changes for businesses and individuals. In general, these new measures target the politically-charged issue of perceived tax advantages that a small percentage of wealthy individuals enjoy over the rest of the population, which the Minister previously raised in 2017. As the Minister stated in his speech to the House of Commons, "We can't have an economy that works for everyone, if everyone doesn't pay their fair share." Also included are measures aimed at closing so-called loopholes and increasing the administrative efficacy of the Canada Revenue Agency (CRA).
This briefing addresses some of the salient tax aspects of Budget 2018, with a focus on those measures that are most anticipated to affect business in Canada.
Domestic Tax Measures
Reduction in Tax Rate for Small Businesses
Budget 2018 confirms the October 2017 announcement that the corporate tax rate for qualifying active business income of Canadian-controlled private corporations (CCPCs) will be decreasing from 10.5 per cent to 10 per cent in 2018—and eventually to 9 per cent in 2019. For CCPCs with taxable capital employed in Canada of less than $10 million, this lower rate continues to apply to their first $500,000 of qualifying active business income (the Business Limit) and provides significant relief from the general corporate tax rate of 15% federally.
Earning Investment Income in a Corporation
In July 2017, the Minister announced complicated proposals to tax investment income earned in a corporation, asserting that some Canadians were able to achieve unfair advantages over regular, working Canadians.
Strong criticism sent the Minister back to the drawing board, and Budget 2018 largely retreats from those proposals. Budget 2018 now intends to limit the tax advantages of private corporations earning investment income with two simpler measures: one that reduces the Business Limit for a CCPC's active business income, and another that limits the refund of tax on investment income to instances where that income is actually paid out as dividends.
Proposal #1 Reducing the Business Limit for CCPCs with Investment Income
The first proposal targets private corporations' eligibility for the $500,000 Business Limit. For every $1 of investment income a CCPC earns in excess of $50,000, its Business Limit will decrease by $5. This means that a corporation earning up to $50,000 of passive income in a taxation year remains unaffected, while a corporation that earns $150,000 of investment income in a taxation year would no longer enjoy the lower small business tax rate on any of its active business income.
For the purpose of this new rule, investment income will generally include its income from property and capital gains. Capital losses will only reduce the amount of investment income in current years, and cannot be carried over from other taxation years. However, capital gains on the sale of "active assets"—i.e., property used in carrying on an active business primarily in Canada1, will not be included in the computation. Importantly, there is also an exception for investment income that is incidental to an active business, such as interest earned on short-term deposits held for operational purposes.
This measure will come into effect for taxation years beginning after 2018.
Proposal #2 Limiting the Refundability of Tax on Investment Income to Non- Eligible Dividends
Under the existing rules, private corporations are generally required to pay a higher rate of tax on their investment income (approximately equivalent to the highest marginal rate for individuals). Companies are incentivized to pay out this investment income to shareholders, by the "refundable dividend tax on hand" (RDTOH) mechanism. This provides a refund of the additional tax when the income is paid as a dividend to shareholders. The RDTOH tax refund is not currently tied to whether dividends are "eligible" or "non-eligible".2
Under the current rules, a corporation that earns both active business income and investment income may be able to pay an eligible dividend3 using funds sourced from investment income. In these circumstances, the shareholder would be entitled to the enhanced tax credit from the eligible dividend (and thus a lower amount of tax paid on the dividend), and the company would receive an RDTOH refund. Effectively, a corporation could defer tax on its investment income by receiving the RDTOH refund while only paying out an eligible dividend from its active business income.
Budget 2018 shuts down the tax advantage that can be achieved with this type of planning. The new proposals will ensure that investment income is paid as a non-eligible dividend through the use of two, separate RDTOH accounts. 4 This measure will come into effect for taxation years beginning after 2018, and transitional rules will provide for allocation of a CCPC's existing RDTOH account balance between the two new RDTOH accounts.
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Footnotes
1 This can also include shares of a corporation or a partnership interest, under certain conditions.
2 The distinction is generally that eligible dividends are paid from amounts that have been taxed at the higher, general corporate rate.
3 If it has paid the general corporate rate of tax on its active business income.
4 An exception is investment income in the form of what Budget 2018 calls "eligible portfolio dividends"—i.e., eligible dividends from corporations not connected to the CCPC, or dividends (eligible or non-eligible) from connected corporations that received a refund upon paying such dividends—which a CCPC may itself pay as eligible dividends.
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.
